UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
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(Mark One)
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| ☒ | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2019
OR
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| ☐ | 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 000-55424
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PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
(Exact Name of Registrant as Specified in Its Charter)
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| Maryland | | 46-2822978 |
(State or Other Jurisdiction of
Incorporation or Organization) | | (I.R.S. Employer
Identification No.) |
11150 Santa Monica Blvd., Suite 400 Los Angeles, California | | 90025 |
| (Address of Principal Executive Offices) | | (Zip Code) |
(424) 208-8100
(Registrant’s Telephone Number, Including Area Code)
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Securities registered pursuant to Section 12(b) of the Act:
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| Title of each class | Trading Symbol(s) | Name of each exchange on which registered |
| None | N/A | N/A |
Securities registered pursuant to Section 12(g) of the Act:
Class A Common Stock, $0.01 par value per share
Class T Common Stock, $0.01 par value per share
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Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐ No ☒
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒
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 ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
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| Large Accelerated Filer | | ☐ | | Accelerated Filer | | ☐ |
| Non-Accelerated Filer | | ☒ | | Smaller reporting company | | ☒ |
| | | | Emerging growth company | | ☒ |
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
There is no established market for the Registrant’s shares of common stock. On December 17, 2019, the board of directors of the Registrant approved an estimated value per share of the Registrant’s common stock of $10.25 based on the estimated value of the Registrant’s assets less the estimated value of the Registrant’s liabilities divided by the number of shares outstanding, all as of September 30, 2019, with the exception of the following adjustments: (i) consolidated investments in real estate properties were valued as of October 31, 2019; (ii) an adjustment to reduce cash for the amount of capital expenditures incurred in October 2019; (iii) an adjustment for disposition costs and fees incurred in connection with the disposition of 2200 Paseo Verde. For a full description of the methodologies used to value the Registrant’s assets and liabilities in connection with the calculation the estimated value per share as of December 17, 2019, see Part II, Item 5, “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Market Information.” There were approximately 29,829,329 shares of common stock held by non-affiliates as of June 30, 2019, the last business day of the Registrant’s most recently completed second fiscal quarter.
As of March 23, 2020, there were 17,842,301 and 12,222,529 outstanding shares of Class A and Class T common stock of the Registrant, respectively.
TABLE OF CONTENTS
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| ITEM 1A. | | |
| ITEM 1B. | | |
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| ITEM 7A. | | |
| ITEM 8. | | |
| ITEM 9. | | |
| ITEM 9A. | | |
| ITEM 9B. | | |
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| ITEM 10. | | |
| ITEM 11. | | |
| ITEM 12. | | |
| ITEM 13. | | |
| ITEM14. | | |
| PART IV. | | | |
| ITEM 15. | | |
| ITEM 16. | | |
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FORWARD-LOOKING STATEMENTS
Certain statements included in this Annual Report on Form 10-K are forward-looking statements. Those statements include statements regarding the intent, belief or current expectations of Pacific Oak Strategic Opportunity REIT II, Inc. and members of our management team, as well as the assumptions on which such statements are based, and generally are identified by the use of words such as “may,” “will,” “seeks,” “anticipates,” “believes,” “estimates,” “expects,” “plans,” “intends,” “should” or similar expressions. Actual results may differ materially from those contemplated by such forward-looking statements. Further, forward-looking statements speak only as of the date they are made, and we undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time, unless required by law.
The following are some of the risks and uncertainties, although not all of the risks and uncertainties, that could cause our actual results to differ materially from those presented in our forward-looking statements:
•We depend on our advisor to conduct our operations and eventually dispose of our investments.
•Because our new advisor, Pacific Oak Capital Advisors, LLC, was recently formed, it could face challenges with employee hiring and retention, information technology, vendor relationships, and funding; if Pacific Oak Capital Advisors faces challenges in performing its obligations to us, it could negatively impact our ability to achieve our investment objectives.
•All of our executive officers, our affiliated directors and other key real estate and debt finance professionals are also officers, directors, managers, key professionals and/or holders of a direct or indirect controlling interest in our advisor, and other Pacific Oak-affiliated entities. As a result, they face conflicts of interest, including significant conflicts created by our advisor’s compensation arrangements with us and other Pacific Oak-advised programs and investors and conflicts in allocating time among us and these other programs and investors. These conflicts could result in unanticipated actions.
•We face potential business disruptions due to the recent global outbreak of COVID-19 (Coronavirus). The virus has significantly disrupted economic markets and impacted commercial activity worldwide, including the US, and the prolonged economic impact is uncertain. Our tenants and potential tenants of the properties we own could be adversely affected by the disruption to business caused by the virus.
•We raised substantially less than the maximum offering amount in our initial public offering. Therefore, our portfolio of properties may not be as diverse as it otherwise would, which will cause the value of our stockholders’ investment to vary more widely with the performance of specific assets.
•Our advisor and its affiliates receive fees in connection with transactions involving the management of our investments. These fees are based on the cost of the investment, and not based on the quality of the investment or the quality of the services rendered to us. This may influence our advisor to recommend riskier transactions to us and increase our stockholders’ risk of loss.
•Our distribution policy is generally not to use offering proceeds to pay distributions. However, we may pay distributions from any source, including, without limitation, from offering proceeds or borrowings (which may constitute a return of capital). If we pay distributions from sources other than our cash flow from operations, we will have less funds available for investment in properties and other assets and the overall return to our stockholders may be reduced.
•Our policies do not limit us from incurring debt until our total liabilities would exceed 75% of the cost of our tangible assets (before deducting depreciation and other non-cash reserves), and we may exceed this limit with the approval of the conflicts committee of our board of directors. To the extent financing in excess of this limit is available on attractive terms, our conflicts committee may approve debt such that our total liabilities would exceed this limit. High debt levels could limit the amount of cash we have available to distribute and could result in a decline in the value of an investment in us.
•Disruptions in the financial markets and uncertain economic conditions could adversely affect our ability to implement our business strategy and generate returns to stockholders.
•Our opportunistic property-acquisition strategy involves a higher risk of loss than would a strategy of investing in stabilized properties.
•Our estimated net asset value per share does not currently represent our enterprise value and may not accurately reflect the actual prices at which our assets could be liquidated on any given day, the value a third party would pay for all or substantially all of our shares, or the price that our shares would trade at on a national stock exchange.
•Certain of our debt obligations have variable interest rates and related payments that vary with the movement of LIBOR or other indexes. Increases in these indexes could increase the amount of our debt payments and limit our ability to pay distributions to our stockholders.
All forward-looking statements should be read in light of the risks identified in Part I, Item 1A of this Annual Report on Form 10-K.
PART I
ITEM 1. BUSINESS
Overview
Pacific Oak Strategic Opportunity REIT II, Inc. (formerly known as KBS Strategic Opportunity REIT II, Inc) was formed on February 6, 2013 as a Maryland corporation and elected to be taxed as a real estate investment trust (“REIT”) beginning with the taxable year ended December 31, 2014 and it intends to continue to operate in such a manner. As used herein, the terms “we,” “our” and “us” refer to Pacific Oak Strategic Opportunity REIT II, Inc. and as required by context, Pacific Oak Strategic Opportunity Limited Partnership II, a Delaware limited partnership formed on May 21, 2013 (the “Operating Partnership”), and its subsidiaries. KBS Capital Advisors LLC was previously our external advisor and on October 31, 2019 ceased to be our advisor or have any advisory responsibility to us immediately following the filing of our Quarter Report on Form 10-Q for the period ending September 30, 2019. On November 1, 2019, Pacific Oak Capital Advisors, LLC (“Pacific Oak Capital Advisors”) became our advisor. As our advisor, Pacific Oak Capital Advisors manages our day-to-day operations and our portfolio of investments. Pacific Oak Capital Advisors also has the authority to make all of the decisions regarding our investments, subject to the limitations in our charter and the direction and oversight of our board of directors. Pacific Oak Capital Advisors also provides asset-management, marketing, investor-relations and other administrative services on our behalf. We have sought to invest in and manage a diverse portfolio of real estate related loans, opportunistic real estate, real estate-related debt securities and other real estate-related investments. We conduct our business primarily through our Operating Partnership, of which we are the sole general partner.
KBS Capital Advisors entered a sub-advisory agreement with STAM Europe (“STAM”), a real estate operating company based in Paris, France, pursuant to which STAM would provide real estate acquisition and portfolio management services to our advisor in connection with investments in Europe. Effective April 17, 2019, STAM terminated the sub-advisory agreement with KBS Capital Advisors.
On July 3, 2013, we commenced a private placement offering exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”), to offer a maximum of $105,000,000 of shares of common stock for sale to certain accredited investors, of which $5,000,000 of shares were offered pursuant to our dividend reinvestment plan. We ceased offering shares in our private offering on August 11, 2014. KBS Capital Markets Group LLC, an affiliate of KBS Capital Advisors, served as the dealer manager of the offering pursuant to a dealer manager agreement and was responsible for marketing our shares in the offering.
On November 14, 2013, we filed a registration statement on Form S-11 with the Securities and Exchange Commission (the “SEC”) to register for sale to the public a maximum of 180,000,000 shares of common stock, of which 80,000,000 shares were to be offered pursuant to our dividend reinvestment plan. The SEC declared our registration statement effective on August 12, 2014 and we retained KBS Capital Markets Group LLC to serve as the dealer manager of the initial public offering pursuant to a dealer manager agreement. On February 11, 2016, we filed an amended registration statement on Form S-11 with the SEC to offer a second class of common stock designated as Class T shares and to designate our initially offered and outstanding common stock as Class A shares. Pursuant to the amended registration statement, we were offering to sell any combination of Class A and Class T shares in our primary offering and dividend reinvestment plan offering but in no event could we sell more than 180,000,000 of shares of our common stock pursuant to the offering. We commenced offering our Class T shares of our common stock for sale to the public on February 17, 2016. The dealer manager was responsible for marketing our shares in the initial public offering.
We ceased offering shares of common stock in our initial public offering on July 31, 2018 and terminated our initial public offering on September 28, 2018. We continue to offer shares of common stock under our dividend reinvestment plan. In some states, we will need to renew the registration statement annually or file a new registration statement to continue our dividend reinvestment plan offering. We may terminate our dividend reinvestment plan offering at any time.
We have used substantially all of the net proceeds from our offerings to invest in and manage a portfolio of opportunistic real estate, real estate-related loans, real estate equity securities and other real estate-related investments located in the United States and Europe. As of December 31, 2019, we had invested in two hotel properties, three office properties, one apartment building and owned two investments in unconsolidated joint ventures and an investment in real estate equity securities. Additionally, as of December 31, 2019, we had entered into a consolidated joint venture to develop one office/retail property.
We sold 11,977,758 and 11,537,701 shares of Class A and Class T common stock, respectively, for aggregate gross offering proceeds of $228.6 million in our initial public offering. As of December 31, 2019, we had sold 723,641 and 333,841 shares of Class A and Class T common stock, respectively, under our dividend reinvestment plan for aggregate gross offering proceeds of $9.8 million. Also as of December 31, 2019, we had redeemed 718,962 and 107,945 shares of Class A and Class T common stock, respectively, for $7.4 million.
We sold 3,619,851 shares of Class A common stock for gross offering proceeds of $32.2 million in our private offering. Additionally, on each of April 2, 2014 and July 31, 2014, we issued 120,106 shares of Class A common stock to an entity affiliated with two of our officers and affiliated directors for $1.0 million in separate private transactions exempt from the registration requirements of the Securities Act. On July 14, 2017 and February 13, 2018, we issued 214,175 shares and 10,935 shares, respectively, of Class A common stock to a business associate of two of our officers and affiliated directors for $2.0 million and $0.1 million, respectively, in a separate private transaction exempt from the registration requirements of the Securities Act.
On February 19, 2020, we, Pacific Oak Strategic Opportunity REIT, Inc. (“POSOR I”), and Pacific Oak SOR II, LLC, an indirect subsidiary of POSOR I (“Merger Sub”), entered into an Agreement and Plan of Merger (the “Merger Agreement”). Subject to the terms and conditions of the Merger Agreement, we will merge with and into Merger Sub (the “Merger”), with Merger Sub surviving the Merger (the “Surviving Entity”), such that following the Merger, the Surviving Entity will continue as an indirect subsidiary of POSOR I. In accordance with the applicable provisions of the Maryland General Corporation Law, the separate existence of our company shall cease. At the effective time of the Merger and subject to the terms and conditions of the Merger Agreement, each issued and outstanding share of our common stock will be converted into the right to receive 0.9643 shares of POSOR I common stock. The combined company after the Merger will retain the name “Pacific Oak Strategic Opportunity REIT, Inc.” The Merger is intended to qualify as a “reorganization” under, and within the meaning of, Section 368(a) of the Internal Revenue Code of 1986, as amended. See “Proposed Merger” below for more information.
Objectives and Strategies
Our primary investment objectives are:
•to preserve and return our stockholders’ capital contributions;
•to realize growth in the value of our investments; and
•to provide increasing cash distributions to our investors through increased cash flow from operations or targeted asset sales.
We have completed our acquisition stage and we plan to lease-up and stabilize existing assets, as well as explore value-add opportunities for existing assets. We will seek to realize growth in the value of our investments by timing asset sales to maximize their value.
Investment Strategies
We have sought to achieve our objectives by using substantially all of the net proceeds from our offerings and debt financing to invest in and manage a portfolio of opportunistic real estate, real estate-related loans, real estate equity securities and other real estate-related investments located in the United States and Europe. We believe that we are most likely to meet our investment objectives through the careful selection and underwriting of assets. When making an investment, we emphasized the performance and risk characteristics of that investment, how that investment fits with our portfolio-level performance objectives, the other assets in our portfolio and how the returns and risks of that investment compare to the returns and risks of available investment alternatives.
Real Estate Investments
As of December 31, 2019, we owned two hotel properties with an aggregate of 649 rooms, three office properties encompassing in the aggregate 806,115 rentable square feet which were 68% occupied and one apartment property with 292 units which was 93% occupied. Additionally, as of December 31, 2019, we had entered into a consolidated joint venture to develop one office/retail property. For more information about our real estate investments, see Part I, Item 2 of this Annual Report on Form 10-K.
Real Estate-Related Investments
As of December 31, 2019, we owned an investment in real estate equity securities with a total book value of $9.9 million.
Other Investment
As of December 31, 2019, we owned two investments in unconsolidated entities. On June 28, 2016, we originated a participating loan facility to STAM in an amount up to €2.6 million ($2.9 million at closing). We funded approximately €2.1 million ($2.3 million at closing). In addition to the amount funded at closing, we also capitalized an additional $0.2 million of acquisition costs and fees. STAM used the proceeds to fund a general partner interest in a STAM-sponsored institutional real estate fund with an unrelated third party joint venture partner. The real estate fund invested in European real estate which STAM manages on behalf of the joint venture. As part of the terms of this investment with STAM, we receive a portion of the fees STAM receives from the fund. During the year ended December 31, 2019, STAM completed the liquidation of the portfolio and we recognized $2.8 million of equity in income of unconsolidated entity with respect to this investment.
On December 31, 2019, the Company acquired 13 Class A Units for $2.9 million in Pacific Oak Opportunity Zone Fund I, LLC. As of December 31, 2019, Pacific Oak Opportunity Zone Fund I consolidated two joint ventures with real estate under development.
Financing Objectives
We have financed a portion of our investments with debt. We have used debt financing in various forms in an effort to increase the size of our portfolio and potential returns to our stockholders. Access to capital is crucial to our business, since we earn income based on the spread between the yield on our investments and the cost of our borrowings. The following table shows the current and fully extended maturities, including principal amortization payments, of our debt as of December 31, 2019 (in thousands):
| | | | | | | | | | | | | | |
| | Current Maturity | | Extended Maturity |
| 2020 | | $ | 79,931 | | | $ | 21,922 | |
| 2021 | | 76,575 | | | 37,129 | |
| 2022 | | 173,089 | | | 96,165 | |
| 2023 | | — | | | 25,419 | |
| 2024 | | — | | | 148,960 | |
| | | | |
| | $ | 329,595 | | | $ | 329,595 | |
We have focused our investment activities on obtaining a portfolio of opportunistic real estate, real estate-related loans, real estate equity securities and other real estate investments. Careful use of debt has helped us to achieve our diversification goals because we have more funds available for investment. We expect our debt financing to be 60% or less of the cost of our tangible assets (before deducting depreciation and other non-cash reserves). This is our target leverage as established by our board of directors. There is no limitation on the amount we may borrow for any single investment. Our charter limits our total liabilities such that our total liabilities may not exceed 75% of the cost of our tangible assets (before deducting depreciation or other non-cash reserves); however, we may exceed that limit if a majority of the conflicts committee approves each borrowing in excess of our charter limitation and we disclose such borrowing to our common stockholders in our next quarterly report with an explanation from the conflicts committee of the justification for the excess borrowing. As of December 31, 2019, our borrowings and other liabilities were approximately 60% of the cost (before depreciation and other noncash reserves) and book value (before depreciation) of our tangible assets.
We do not intend to exceed the leverage limit in our charter. Careful use of debt will help us to achieve our diversification goals because we will have more funds available for investment. However, high levels of debt could cause us to incur higher interest charges and higher debt service payments, which would decrease the amount of cash available for distribution to our investors, and could also be accompanied by restrictive covenants. High levels of debt could also increase the risk of being unable to refinance when loans become due, or of being unable to refinance on favorable terms, and the risk of loss with respect to assets pledged as collateral for loans.
Except with respect to the borrowing limits contained in our charter, we may reevaluate and change our debt policy in the future without a stockholder vote. Factors that we would consider when reevaluating or changing our debt policy include: economic conditions, the relative cost and availability of debt and equity capital, any investment opportunities, the ability of our investments to generate sufficient cash flow to cover debt service requirements and other similar factors. Further, we may increase or decrease our ratio of debt to book value in connection with any change of our borrowing policies.
Disposition Policies
The period that we will hold our investments will vary depending on the type of asset, interest rates and other factors. Our advisor has developed a well-defined exit strategy for each investment we have made. Pacific Oak Capital Advisors will continually perform a hold-sell analysis on each asset in order to determine the optimal time to hold the asset and generate a strong return for our stockholders. Economic and market conditions may influence us to hold our investments for different periods of time. We may sell an asset before the end of the expected holding period if we believe that market conditions have maximized its value to us or the sale of the asset would otherwise be in the best interests of our stockholders. During the year ended December 31, 2019, we sold one office building and there were no properties classified as held for sale as of December 31, 2019. The disposition strategy is consistent with our objectives of acquiring opportunistic investments, improving the investments and timing asset sales to realize the growth in the value that was created during our hold period.
Proposed Merger
If the Merger were to occur today, the combined company’s portfolio would consist of nine office properties, one office portfolio consisting of four office buildings and 14 acres of undeveloped land, in the aggregate, approximately, 3.8 million rentable square feet and 77.7% leased occupancy (based on data as of March 24, 2020), two hotel properties, two apartment properties, one residential home portfolio consisting of 993 single-family rental homes, three investments in undeveloped land with approximately 1,000 developable acres, an investment in an office/retail property redevelopment, six investments in unconsolidated entities and four investments in real estate equity securities.
The Merger is conditioned upon receipt of the approval of the holders of a majority of our outstanding shares with respect to the Merger. In addition, the Merger Agreement provides certain termination rights for POSOR I and us. In connection with the termination of the Merger Agreement, under certain specified circumstances, we may be required to pay POSOR I a termination fee of $9.3 million.
Under the terms of the Merger Agreement, in exchange for each share of our common stock owned, our stockholders will receive 0.9643 shares of our common stock. Following the closing of the Merger, POSOR I and our stockholders are expected to own approximately 69.4% and 30.6% of the combined company, respectively. We expect the transaction to close in the second half of 2020, subject to certain closing conditions, including the approval of the merger by our stockholders.
Concurrently with the entry into the Merger Agreement, POSOR I and Pacific Oak Capital Advisors (which is also the external advisor to us) entered into the Amended and Restated Advisory Agreement (the “Amended Advisory Agreement”). The Amended Advisory Agreement amended POSOR I’s existing advisory agreement to provide that no acquisition fees will be paid in connection with the Merger and to set the “issue price” ($10.63 per share) of the shares issued in the Merger for purposes of calculating the Pacific Oak Capital Advisors’ incentive fee. The Merger itself will not trigger an incentive fee to Pacific Oak Capital Advisors by POSOR I or us.
Concurrently with the entry into the Merger Agreement, we and Pacific Oak Capital Advisors entered into a termination letter agreement (the “Termination Agreement”), effective as of February 19, 2020. Pursuant to the Termination Agreement, the advisory agreement between us and Pacific Oak Capital Advisors (the “POSOR II Advisory Agreement”) will be terminated at the effective time of the Merger. Also pursuant to the Termination Agreement, Pacific Oak Capital Advisors waived any disposition fee it otherwise would be entitled to receive from us with respect to the Merger. If, however, we are ultimately sold to another bidder, then Pacific Oak Capital Advisors may be entitled to a disposition fee from us in an amount as set forth in the POSOR II Advisory Agreement.
The foregoing descriptions of the Merger Agreement, the Termination Agreement and the Merger are not complete and are subject to and qualified in their entirety by reference to the Merger Agreement and the Termination Agreement, copies of which were filed as exhibits to our Current Report on Form 8-K filed with the SEC on February 20, 2020. There is no guarantee that the Merger will be consummated.
Economic Dependency
We are dependent on our advisor for certain services that are essential to us, including the disposition of investments; management of the daily operations of our investment portfolio; and other general and administrative responsibilities. In the event that our advisor is unable to provide these services, we will be required to obtain such services from other sources.
Competitive Market Factors
We face competition from various entities for prospective tenants and to retain our current tenants, including other REITs, pension funds, insurance companies, investment funds and companies, partnerships and developers. Many of these entities have substantially greater financial resources than we do and may be able to accept more risk than we can prudently manage, including risks with respect to the creditworthiness of a tenant. As a result of their greater resources, those entities may have more flexibility than we do in their ability to offer rental concessions to attract and retain tenants. This could put pressure on our ability to maintain or raise rents and could adversely affect our ability to attract or retain tenants. As a result, our financial condition, results of operations, cash flow, ability to satisfy our debt service obligations and ability to pay distributions to our stockholders may be adversely affected.
Although we believe that we are well-positioned to compete effectively in each facet of our business, there is enormous competition in our market sector and there can be no assurance that we will compete effectively or that we will not encounter increased competition in the future that could limit our ability to conduct our business effectively.
Compliance with Federal, State and Local Environmental Law
Under various federal, state and local environmental laws, ordinances and regulations, a current or previous real property owner or operator may be liable for the cost of removing or remediating hazardous or toxic substances on, under or in such property. These costs could be substantial. Such laws often impose liability whether or not the owner or operator knew of, or was responsible for, the presence of such hazardous or toxic substances. Environmental laws also may impose restrictions on the manner in which property may be used or businesses may be operated, and these restrictions may require substantial expenditures or prevent us from entering into leases with prospective tenants that may be impacted by such laws. Environmental laws provide for sanctions for noncompliance and may be enforced by governmental agencies or, in certain circumstances, by private parties. Certain environmental laws and common law principles could be used to impose liability for the release of and exposure to hazardous substances, including asbestos-containing materials. Third parties may seek recovery from real property owners or operators for personal injury or property damage associated with exposure to released hazardous substances. The cost of defending against claims of liability, of complying with environmental regulatory requirements, of remediating any contaminated property, or of paying personal injury claims could reduce the amounts available for distribution to our stockholders.
All of our real estate properties, other than properties acquired through foreclosure, will be subject to Phase I environmental assessments at the time they are acquired.
Segments
We have invested in opportunistic real estate investments and originated a loan secured by a non-stabilized real estate asset. In general, we intend to hold our investments in opportunistic real estate and other real estate-related assets for capital appreciation. Traditional performance metrics of opportunistic real estate and other real estate-related assets may not be meaningful as these investments are generally non-stabilized and do not provide a consistent stream of interest income or rental revenue. These investments exhibit similar long-term financial performance and have similar economic characteristics. These investments typically involve a higher degree of risk and do not provide a constant stream of ongoing cash flows. As a result, our management views opportunistic real estate and other real estate-related assets as similar investments. Substantially all of our revenue and net income (loss) is from opportunistic real estate and other real estate-related assets, and therefore, we currently aggregate our operating segments into one reportable business segment. In addition, we have invested in a participating loan facility secured by a portfolio of light industrial properties located in Europe. However, based on our investment portfolio and future investment focus, we do not believe that our investment in the European asset is a reportable segment.
Employees
We have no paid employees. The employees of our advisor or its affiliates provide management, acquisition, disposition, advisory and certain administrative services for us.
Principal Executive Office
Our principal executive offices are located at 11150 Santa Monica Blvd., Suite 400, Los Angeles, California 90025. Our telephone number and web address are (424) 208-8100 and http://www.pacificoakcmg.com/offering/reit-ii.
Available Information
Access to copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and other filings with the SEC, including amendments to such filings, may be obtained free of charge from the following website, http://www.pacificoakcmg.com/offering/reit-ii., through a link to the SEC’s website. These filings are available promptly after we file them with, or furnish them to, the SEC.
ITEM 1A. RISK FACTORS
The following are some of the risks and uncertainties that could cause our actual results to differ materially from those presented in our forward-looking statements. The risks and uncertainties described below are not the only ones we face but do represent those risks and uncertainties that we believe are material to us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also harm our business.
Risks Related to an Investment in Us
In January 2020 we exhausted funds available for redemptions under our share redemption program, other than those submitted in connection with a stockholder’s death, “qualifying disability” or “determination of incompetence” for which we had $0.5 million available as of March 1, 2020. Therefore, except in limited circumstances, our stockholders will be unable to sell their shares under our share redemption program.
During any calendar year, we may redeem only the number of shares that we could purchase with the amount of net proceeds from the sale of shares under our distribution reinvestment plan during the prior calendar year provided that $500,000 of this amount is reserved for redemptions made upon a stockholder’s death, “qualifying disability” or “determination of incompetence.” In 2019, our net proceeds from the distribution reinvestment plan were $2.2 million. As of the January 1, 2020 redemption date, we had exhausted the amount available for ordinary redemptions, and as of March 1, 2020, we had $8.2 million outstanding and unfulfilled redemption requests representing 808,172 shares. We have $0.5 million available to fund special redemptions during the remainder of 2020. We can provide no assurances as to whether our board of directors will make additional funds available for our share redemption program.
We raised substantially less than the maximum offering amount in our initial public offering. Therefore, our portfolio of assets may not be as diverse as it otherwise would, which will cause the value of our stockholders’ investment to vary more widely with the performance of specific assets.
Our initial public offering was made on a “best efforts” basis, whereby the broker-dealers who participated in the offering had no firm commitment or obligation to purchase any of the shares. In the public offering, we raised fewer proceeds than our sponsor and dealer manager originally expected. As a result, we raised substantially less than the maximum offering amount in the public offering. Therefore, we made fewer investments than originally intended, resulting in less diversification in terms of the number of investments owned and the geographic regions in which our investments or the collateral securing our investments are located. Adverse developments with respect to a single asset, or a geographic region, will have a greater adverse impact on our operations than they otherwise would.
Our board of directors has begun to explore strategic alternatives for us. If we consummate a merger or pursue another exit strategy in the near term, stockholders may not receive an amount per share equal to our estimated NAV per share.
Our estimated NAV per share of $10.25, as established by our board of directors on December 17, 2019, did not take into account estimated disposition costs and fees for real estate properties, entity liquidation costs, and debt prepayment penalties that could apply upon the prepayment of certain of our debt obligations. These fees may be substantial. Thus, to the extent we consummate a merger or pursue another exit strategy in the near term, stockholders may not recover the estimated NAV per share due to the impact of these fees and costs.
Because no public trading market for our shares currently exists, it will be difficult for our investors to sell their shares and, if they are able to sell their shares, it will likely be at a substantial discount to the offering price.
No public market currently exists for our shares, and at this time we have no plans to list our shares on a national securities exchange. Our charter does not require our directors to provide our stockholders with a liquidity event by a specified date or at all. Until our shares are listed, if ever, our stockholders may not sell their shares unless the buyer meets the applicable suitability and minimum purchase standards. Any sale must comply with applicable state and federal securities laws. In addition, our charter prohibits the ownership of more than 9.8% of our stock by any person, unless exempted by our board of directors, which may inhibit large investors from purchasing our stockholders’ shares. Moreover, our share redemption program includes numerous restrictions that limit our stockholders’ ability to sell a stockholders’ shares to us, and our board of directors may amend, suspend or terminate our share redemption program upon 10 business days’ notice to stockholders. In addition, in January 2020 we exhausted funds available for redemptions under our share redemption program, other than those submitted in connection with a stockholder’s death, “qualifying disability,” or “determination of incompetence.” Therefore, it will be difficult for stockholders to sell their shares promptly or at all. If stockholders are able to sell their shares, they would likely have to sell them at a substantial discount to their public offering price. It is also likely that our shares would not be accepted as the primary collateral for a loan.
Because of the concentration of a significant portion of our assets in California, any adverse economic, real estate or business conditions in this area could affect our operating results and our ability to make distributions to our stockholders.
As of December 31, 2019, our real estate investments in California represented 56.2% of our total assets. As a result, the geographic concentration of our portfolio makes it particularly susceptible to adverse economic developments in the California real estate market. Any adverse economic or real estate developments in this market, such as business layoffs or downsizing, industry slowdowns, relocations of businesses, changing demographics and other factors, or any decrease in demand for office space resulting from the local business climate, could adversely affect our operating results and our ability to make distributions to stockholders.
Disruptions in the financial markets and uncertain economic conditions could adversely affect market rental rates, commercial real estate values and our ability to secure debt financing, service future debt obligations, or pay distributions to our stockholders.
We have relied on debt financing to finance our real estate properties and we may have difficulty refinancing some of our debt obligations prior to or at maturity or we may not be able to refinance these obligations at terms as favorable as the terms of our existing indebtedness and we also may be unable to obtain additional debt financing on attractive terms or at all. If we are not able to refinance our existing indebtedness on attractive terms at the various maturity dates, we may be forced to dispose of some of our assets. Market conditions can change quickly, which could negatively impact the value of our assets.
Disruptions in the financial markets and uncertain economic conditions could adversely affect the values of our investments. Any disruption to the debt and capital markets could result in fewer buyers seeking to acquire commercial properties and possible increases in capitalization rates and lower property values. Furthermore, declining economic conditions could negatively impact commercial real estate fundamentals and result in lower occupancy, lower rental rates and declining values in our real estate portfolio and in the collateral securing our loan investments, which could have the following negative effects on us:
•the values of our investments in commercial properties could decrease below the amounts paid for such investments;
•the value of collateral securing our loan investments could decrease below the outstanding principal amounts of such loans;
•revenues from our properties could decrease due to fewer tenants and/or lower rental rates, making it more difficult for us to pay distributions or meet our debt service obligations on debt financing; and/or
•revenues generated by the properties and other assets securing our loan investments could decrease, making it more difficult for the borrowers to meet their payment obligations to us, which could in turn make it more difficult for us to pay distributions or meet our debt service obligations on debt financing.
All of these factors could reduce our stockholders’ return and decrease the value of an investment in us.
Subsequent to December 31, 2019, there was a global outbreak of a new strain of coronavirus, COVID-19 which has been designated as a pandemic by the World Health Organization, continues to adversely impact global commercial activity and has contributed to significant volatility in financial markets. The global impact of the outbreak has been rapidly evolving, and as cases of the virus have continued to be identified in additional countries, many countries have reacted by instituting quarantines, restrictions on travel, and limiting hours of operations of non-essential offices and retail centers. Such actions are creating disruption in global supply chains, and adversely impacting a number of industries. The outbreak could have a continued adverse impact on economic and market conditions and trigger a period of global economic slowdown. The rapid development and fluidity of this situation precludes any prediction as to the ultimate adverse impact of the novel coronavirus. Nevertheless, the novel coronavirus presents material uncertainty and risk with respect to the Company’s performance and financial results, such as the potential negative impact to occupancy at its properties, financing arrangements, increased costs of operations, decrease in values of its investments, changes in law and/or regulation, and uncertainty regarding government and regulatory policy. The Company is unable to estimate the impact the novel coronavirus will have on its financial results at this time.
Uncertainty and volatility in the credit markets could affect our ability to obtain debt financing on reasonable terms, or at all, which could reduce the number of properties we may be able to acquire and the amount of cash distributions we can make to our stockholders.
The U.S. and global credit markets have in the past experienced severe dislocations and liquidity disruptions, which caused volatility in the credit spreads on prospective debt financings and constrained the availability of debt financing due to the reluctance of lenders to offer financing at high leverage ratios. Similar conditions in the future could adversely impact our ability to access additional debt financing on reasonable terms or at all, which may adversely affect investment returns on future acquisitions or our ability to make acquisitions.
If mortgage debt or unsecured debt is unavailable on reasonable terms as a result of increased interest rates, increased credit spreads, decreased liquidity or other factors, we may not be able to finance the initial purchase of properties. In addition, when we incur mortgage debt or unsecured debt, we run the risk of being unable to refinance such debt upon maturity, or of being unable to refinance on favorable terms.
If interest rates are higher or other financing terms, such as principal amortization, the need for a corporate guaranty, or other terms are not as favorable when we refinance debt or issue new debt, our income could be reduced. To the extent we are unable to refinance debt on reasonable terms, at appropriate times or at all, we may be required to sell properties on terms that are not advantageous to us, or that could result in the foreclosure of such properties. If any of these events occur, our cash flow could be reduced. This, in turn, could reduce cash available for distribution to our stockholders and may hinder our ability to raise more capital by issuing securities or borrowing more money.
Because we depend upon our advisor and its affiliates to conduct our operations, adverse changes in the financial health of our advisor or its affiliates could cause our operations to suffer.
We depend on Pacific Oak Capital Advisors, its affiliates and the key real estate and debt finance professionals at Pacific Oak Capital Advisors to manage our operations and our portfolio of real estate-related loans, opportunistic real estate, real estate equity securities and other real estate-related investments. Our advisor depends upon the fees and other compensation that it receives from us and other Pacific Oak-sponsored public programs in connection with the origination, purchase, management and sale of assets to conduct its operations. Any adverse changes in the financial condition of Pacific Oak Capital Advisors or its affiliates or our relationship with Pacific Oak Capital Advisors or its affiliates could hinder their ability to successfully manage our operations and our portfolio of investments.
We have paid distributions in part from financings and expect that in the future we may not pay distributions solely from our cash flow from operating activities. To the extent that we pay distributions from sources other than our cash flow from operating activities, the overall return to our stockholders may be reduced.
Our organizational documents permit us to pay distributions from any source, including offering proceeds or borrowings (which may constitute a return of capital), and our charter does not limit the amount of funds we may use from any source to pay such distributions. We have paid distributions in part from financings and expect that in the future we may not pay distributions solely from our cash flow from operating activities, in which case distributions may be paid in whole or in part from debt financing. We may also fund such distributions with proceeds from the sale of assets. If we fund distributions from borrowings, our interest expense and other financing costs, as well as the repayment of such borrowings, will reduce our earnings and cash flow from operating activities available for distribution in future periods. If we fund distributions from the sale of assets, this will affect our ability to generate cash flow from operating activities in future periods. To the extent that we pay distributions from sources other than our cash flow from operating activities, the overall return to our stockholders may be reduced. In addition, to the extent distributions exceed cash flow from operating activities, a stockholder’s basis in our stock will be reduced and, to the extent distributions exceed a stockholder’s basis, the stockholder may recognize capital gain. There is no limit on the amount of distributions we may fund from sources other than from cash flow from operating activities.
For the year ended December 31, 2018, we paid aggregate distributions of $4.9 million, including $1.9 million of distributions paid in cash and $3.0 million of distributions reinvested through our dividend reinvestment plan. Our net loss attributable to common stockholders for the year ended December 31, 2018 was $23.5 million and cash flow provided by operations was $4.6 million. We funded our total distributions paid, which includes net cash distributions and dividends reinvested by stockholders, with $3.8 million of cash flow from operating activities and $1.1 million of prior period cash flow from operating activities in excess of distributions paid. For purposes of determining the source of distributions paid, we assume first that we use cash flow from operating activities from the relevant or prior periods to fund distribution payments.
For the year ended December 31, 2019, we paid aggregate distributions of $3.6 million, including $1.4 million of distributions paid in cash and $2.2 million of distributions reinvested through our dividend reinvestment plan. Our net loss attributable to common stockholders for the year ended December 31, 2019 was $7.5 million and cash flow used in operations was $0.1 million. We funded our total distributions paid, which includes net cash distributions and dividends reinvested by stockholders with $5.7 million of prior period cash flow from operating activities in excess of distributions paid. For purposes of determining the source of distributions paid, we assume first that we use cash flow from operating activities from the relevant or prior periods to fund distribution payments.
To the extent that we pay distributions from sources other than our cash flow from operating activities, we will have less funds available for the acquisition of real estate investments, the overall return to our stockholders may be reduced and subsequent investors will experience dilution.
The loss of or the inability to retain or obtain key real estate and debt finance professionals at our advisor could delay or hinder implementation of our investment strategies, which could limit our ability to pay distributions and decrease the value of an investment in us.
Our success depends to a significant degree upon the contributions of Keith D. Hall and Peter McMillan III, each of whom would be difficult to replace. Neither we nor our affiliates have employment agreements with Messrs. Hall or McMillan. Messrs. Hall and McMillan may not remain associated with us, our advisor or its affiliates. If any of these persons were to cease their association with us, our advisor or its affiliates, we may be unable to find suitable replacements and our operating results could suffer as a result. We do not intend to maintain key person life insurance on any person. We believe that our future success depends, in large part, upon our advisor’s and its affiliates’ ability to attract and retain highly skilled managerial, operational and marketing professionals. Competition for such professionals is intense, and our advisor and its affiliates may be unsuccessful in attracting and retaining such skilled individuals. If we lose or are unable to retain or obtain the services of highly skilled professionals our ability to implement our investment strategies could be delayed or hindered, and the value of an investment in us may decline. Furthermore, some or all of these individuals may become employees of another Pacific Oak-sponsored program in an internalization transaction or, if we internalize our advisor, may not become our employees as a result of their relationship with other Pacific Oak-sponsored programs. If these events occur, our operating performance and the return on an investment in us could suffer.
Our rights and the rights of our stockholders to recover claims against our independent directors are limited, which could reduce our stockholders’ and their recovery against our independent directors if they negligently cause us to incur losses.
Maryland law provides that a director has no liability in that capacity if he performs his duties in good faith, in a manner he reasonably believes to be in our best interest and with the care that an ordinarily prudent person in a like position would use under similar circumstances. Our charter provides that no independent director shall be liable to us or our stockholders for monetary damages and that we will generally indemnify them for losses unless they are grossly negligent or engage in willful misconduct. As a result, our stockholders and us may have more limited rights against our independent directors than might otherwise exist under common law, which could reduce our stockholders and our recovery from these persons if they act in a negligent manner. In addition, we may be obligated to fund the defense costs incurred by our independent directors (as well as by our other directors, officers, employees (if we ever have employees) and agents) in some cases, which would decrease the cash otherwise available for distribution.
We have no target investment allocation and we may change our targeted investments without stockholder consent.
Except with respect to unimproved or non-income producing property, we are not limited in the percentage of net proceeds of our initial public offering that we may allocate to a specific real estate asset type. Thus, we may make all of our investments in investments which present an increased risk of loss. In addition, we may change our targeted investments and investment guidelines at any time without the consent of our stockholders, which could result in our making investments that are different from, and possibly riskier than, our targeted investments described our prospectus. A change in our targeted investments or investment guidelines may increase our exposure to interest rate risk, default risk and real estate market fluctuations, all of which could adversely affect the value of our common stock and our ability to pay distributions.
We face risks associated with security breaches through cyber-attacks, cyber intrusions or otherwise, as well as other significant disruptions of our information technology (“IT”) networks and related systems.
We face risks associated with security breaches, whether through cyber-attacks or cyber intrusions over the Internet, malware, computer viruses, attachments to e-mails, persons inside our organization or persons with access to systems inside our organization, and other significant disruptions of our IT networks and related systems. The risk of a security breach or disruption, particularly through cyber-attack or cyber intrusion, including by computer hackers, foreign governments and cyber terrorists, has generally increased as the number, intensity and sophistication of attempted attacks and intrusions from around the world have increased. Our IT networks and related systems are essential to the operation of our business and our ability to perform day-to-day operations. Although we make efforts to maintain the security and integrity of these types of IT networks and related systems, and we have implemented various measures to manage the risk of a security breach or disruption, there can be no assurance that our security efforts and measures will be effective or that attempted security breaches or disruptions would not be successful or damaging. Even the most well-protected information, networks, systems and facilities remain potentially vulnerable because the techniques used in such attempted security breaches evolve and generally are not recognized until launched against a target, and in some cases are designed not be detected and, in fact, may not be detected. Accordingly, we may be unable to anticipate these techniques or to implement adequate security barriers or other preventative measures, and thus it is impossible for us to entirely mitigate this risk.
A security breach or other significant disruption involving our IT networks and related systems could:
•disrupt the proper functioning of our networks and systems and therefore our operations;
•result in misstated financial reports, violations of loan covenants and/or missed reporting deadlines;
•result in our inability to properly monitor our compliance with the rules and regulations regarding our qualification as a REIT;
•result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of, proprietary, confidential, sensitive or otherwise valuable information of ours or others, which others could use to compete against us or which could expose us to damage claims by third-parties for disruptive, destructive or otherwise harmful purposes and outcomes;
•require significant management attention and resources to remedy any damages that result;
•subject us to claims for breach of contract, damages, credits, penalties or termination of leases or other agreements; or
•damage our reputation among our stockholders.
In addition, we rely on the security systems of our third-party managers and franchisors to protect proprietary and customer information from these threats.
Any or all of the foregoing could have a material adverse effect on our results of operations, financial condition and cash flows.
Risks Related to Conflicts of Interest
Pacific Oak Capital Advisors and its affiliates, including all of our executive officers and our affiliated directors and other key real estate and debt finance professionals, face conflicts of interest caused by their compensation arrangements with us and with other Pacific Oak-sponsored programs and Pacific Oak-advised investors, which could result in actions that are not in the long-term best interests of our stockholders.
All of our executive officers and our affiliated directors and other key real estate and debt finance professionals are also officers, directors, managers, key professionals and/or holders of a direct or indirect controlling interest in our advisor, our dealer manager and/or other Pacific Oak-affiliated entities. Pacific Oak Capital Advisors and its affiliates receive substantial fees from us. These fees could influence our advisor’s advice to us as well as the judgment of its affiliates. Among other matters, these compensation arrangements could affect their judgment with respect to:
•the continuation, renewal or enforcement of our agreements with Pacific Oak Capital Advisors and its affiliates, including the advisory agreement and the dealer manager agreement;
•offerings of equity by us, which entitle Pacific Oak Capital Markets Group to dealer-manager fees and will likely entitle Pacific Oak Capital Advisors to increased acquisition and origination fees and asset management fees;
•sales of investments, which entitle Pacific Oak Capital Advisors to disposition fees and possible subordinated incentive fees;
•acquisitions of investments and originations of loans, which entitle Pacific Oak Capital Advisors to acquisition and origination fees based on the cost of the investment and asset management fees and, in the case of acquisitions of investments from other Pacific Oak-sponsored programs, might entitle affiliates of Pacific Oak Capital Advisors to disposition fees and possible subordinated incentive fees in connection with its services for the seller;
•borrowings to acquire investments and to originate loans, which borrowings increase the acquisition and origination fees payable to Pacific Oak Capital Advisors;
•whether and when we seek to list our common stock on a national securities exchange, which listing could entitle Pacific Oak Capital Advisors to a subordinated incentive fee; and
•whether and when we seek to sell the company or its assets, which sale could entitle Pacific Oak Capital Advisors to a disposition fee and/or a subordinated incentive fee.
The fees our advisor receives in connection with transactions involving the acquisition or origination of an asset are based on the cost of the investment, and not based on the quality of the investment or the quality of the services rendered to us. This may influence our advisor to recommend riskier transactions to us and increase our stockholders’ risk of loss.
Further, existing and future Pacific Oak-sponsored programs and Pacific Oak-advised investors and Messrs. Hall and McMillan generally are not and will not be prohibited from engaging, directly or indirectly, in any business or from possessing interests in any other business venture or ventures, including businesses and ventures involved in the acquisition, origination, development, ownership, leasing or sale of real estate-related investments.
Pacific Oak Capital Advisors and the key real estate professionals associated with Pacific Oak Capital Advisors face conflicts of interest relating to the leasing and disposition of properties due to their relationship with other real estate programs and such conflicts may not be resolved in our favor, which could limit our ability to pay distributions to our stockholders and reduce our stockholders’ overall investment return.
We rely on our sponsor, Pacific Oak Holding Group, LLC, and other key real estate professionals at our advisor, including Messrs. Hall and McMillan, to identify suitable investment opportunities for us and to supervise the property management and leasing and eventual disposition of properties. POSOR I is also advised by Pacific Oak Capital Advisors. Keppel Pacific Oak US REIT is externally managed by a joint venture between (i) an entity in which Messrs. Hall and McMillan have an indirect ownership interest and (ii) Keppel Capital Holding Pte. Ltd., which is not affiliated with us, and has also engaged Pacific Oak Capital Advisors to act as its asset manager in the United States. Through Pacific Oak Capital Advisors these programs rely on many of the same real estate and debt finance professionals as will future programs advised by our advisor or professionals associated with our advisor. As such, we and other programs that currently have funds available for investment rely on many of the same real estate and debt finance professionals employed by Pacific Oak Capital Advisors, as will future Pacific Oak-sponsored programs, Pacific Oak-advised investors and other programs sponsored by Messrs. Hall and McMillan. Many investment opportunities that are suitable for us may also be suitable for other programs and investors. When these real estate and debt finance professionals direct an investment opportunity to any program or investor they, in their sole discretion, will offer the opportunity to the program or investor for which the investment opportunity is most suitable based on the investment objectives, portfolio and criteria of each program or investor.
In addition, we and other programs advised by Pacific Oak Capital Advisors and its affiliates or key real estate professionals, rely on our sponsor and other key real estate professionals at our advisor to sell our properties. These programs and Pacific Oak-advised investors may possess properties in similar locations and/or of the same property types as ours and may be attempting to sell these properties at the same time we are attempting to sell some of our properties. If our advisor directs potential purchasers to properties owned by other programs they advise when it could direct such purchasers to our properties, we may be unable to sell some or all of our properties at the time or at the price we otherwise would, which could limit our ability to pay distributions and reduce our stockholders’ overall investment return.
Pacific Oak Capital Advisors will face conflicts of interest relating to joint ventures that we may form with affiliates of Pacific Oak Capital Advisors, which conflicts could result in a disproportionate benefit to the other venture partners at our expense.
If approved by a majority of our independent directors, we may enter into joint venture agreements with other Pacific Oak-sponsored programs or affiliated entities for the acquisition, development or improvement of properties or other investments. Pacific Oak Capital Advisors and its affiliates, the advisors to the other Pacific Oak-sponsored programs and the investment advisers to Pacific Oak-advised investors, have some of the same executive officers, directors and other key real estate and debt finance professionals; and these persons will face conflicts of interest in determining which Pacific Oak program or investor should enter into any particular joint venture agreement. These persons may also face a conflict in structuring the terms of the relationship between our interests and the interests of the Pacific Oak-affiliated co-venturer and in managing the joint venture. Any joint venture agreement or transaction between us and a Pacific Oak-affiliated co-venturer will not have the benefit of arm’s-length negotiation of the type normally conducted between unrelated co-venturers. The Pacific Oak-affiliated co-venturer may have economic or business interests or goals that are or may become inconsistent with our business interests or goals. These co-venturers may thus benefit to our and our investors’ detriment.
Pacific Oak Capital Advisors, the real estate and debt finance professionals assembled by our advisor, their affiliates and our officers face competing demands on their time and this may cause our operations and our stockholders’ investment to suffer.
We rely on Pacific Oak Capital Advisors and the real estate, management, accounting and debt finance professionals our advisor has assembled, including Messrs. Hall, McMillan and Michael A. Bender for the day-to-day operation of our business. Messrs. Hall, McMillan, and Bender are executive officers of POSOR I. As a result of their interests in other Pacific Oak programs, their obligations to other investors and the fact that they engage in and they will continue to engage in other business activities on behalf of themselves and others, Messrs. Hall, McMillan and Bender face conflicts of interest in allocating their time among us, POSOR I, Pacific Oak Capital Advisors and other Pacific Oak-sponsored programs as well as other business activities in which they are involved. In addition, Pacific Oak Capital Advisors and their affiliates share many of the same key real estate and debt finance professionals. During times of intense activity in other programs and ventures, these individuals may devote less time and fewer resources to our business than are necessary or appropriate to manage our business. Furthermore, some or all of these individuals may become employees of another Pacific Oak-sponsored program in an internalization transaction or, if we internalize our advisor, may not become our employees as a result of their relationship with other Pacific Oak-sponsored programs. If these events occur, the returns on our investments, and the value of our stockholders’ investments, may decline.
All of our executive officers and some of our directors and the key real estate and debt finance professionals assembled by our advisor face conflicts of interest related to their positions and/or interests in Pacific Oak Capital Advisors and its affiliates, which could hinder our ability to implement our business strategy and to generate returns to our stockholders.
All of our executive officers, some of our directors and other key real estate and debt finance professionals assembled by our advisor are also executive officers, directors, managers, key professionals and/or holders of a direct or indirect controlling interest in our advisor, and other affiliated Pacific Oak entities. Through Pacific Oak-affiliated entities, some of these persons also serve as the investment advisors to institutional investors in real estate and real estate-related assets and through Pacific Oak Capital Advisors and its affiliates these persons serve as the advisor to POSOR I and other Pacific Oak-sponsored programs. As a result, they owe fiduciary duties to each of these entities, their members and limited partners and these investors, which fiduciary duties may from time to time conflict with the fiduciary duties that they owe to us and our stockholders. Their loyalties to these other entities and investors could result in action or inaction that is detrimental to our business, which could harm the implementation of our business strategy and our investment and leasing opportunities. Further, Messrs. Hall and McMillan and existing and future Pacific Oak-sponsored programs and Pacific Oak-advised investors generally are not and will not be prohibited from engaging, directly or indirectly, in any business or from possessing interests in any other business venture or ventures, including businesses and ventures involved in the acquisition, development, ownership, leasing or sale of real estate investments. If we do not successfully implement our business strategy, we may be unable to generate the cash needed to make distributions to our stockholders and to maintain or increase the value of our assets.
Our board of directors’ loyalties to POSOR I and Keppel Pacific Oak US REIT and possibly to future Pacific Oak-sponsored programs could influence its judgment, resulting in actions that may not be in our stockholders’ best interest or that result in a disproportionate benefit to another Pacific Oak-sponsored program at our expense.
Three of our directors, including one of our independent directors, Mr. Yee, are also directors of POSOR I. In addition, one of our directors, Mr. McMillan, is also a director of Keppel Pacific Oak US REIT. The loyalties of our directors serving on the boards of directors of POSOR I and Keppel Pacific Oak US REIT, or possibly on the boards of directors of future Pacific Oak-sponsored programs, may influence the judgment of our board when considering issues for us that also may affect other Pacific Oak-sponsored programs, such as the following:
•The conflicts committee of our board must evaluate the performance of Pacific Oak Capital Advisors with respect to whether Pacific Oak Capital Advisors is presenting to us our fair share of investment opportunities. If our advisor is not presenting a sufficient number of investment opportunities to us because it is presenting many opportunities to other Pacific Oak-sponsored programs or if our advisor is giving preferential treatment to other Pacific Oak-sponsored programs in this regard, the conflicts committee may not be well suited to enforce our rights under the terms of the advisory agreement or to seek a new advisor.
•We could enter into transactions with other Pacific Oak-sponsored programs, such as property sales, acquisitions or financing arrangements. Such transactions might entitle Pacific Oak Capital Advisors or its affiliates to fees and other compensation from both parties to the transaction. For example, acquisitions from other Pacific Oak-sponsored programs might entitle Pacific Oak Capital Advisors or its affiliates to disposition fees and possible subordinated incentive fees in connection with its services for the seller in addition to acquisition and origination fees and other fees that we might pay to Pacific Oak Capital Advisors in connection with such transaction. Similarly, property sales to other Pacific Oak-sponsored programs might entitle Pacific Oak Capital Advisors or its affiliates to acquisition and origination fees in connection with its services to the purchaser in addition to disposition and other fees that we might pay to Pacific Oak Capital Advisors in connection with such transaction. Decisions of our board of directors and the conflicts committee regarding the terms of those transactions may be influenced by our board’s and the conflicts committee’s loyalties to such other Pacific Oak-sponsored programs.
•A decision of our board of directors or the conflicts committee regarding the timing of a debt or equity offering could be influenced by concerns that such offering would compete with an offering of other Pacific Oak-sponsored programs.
•A decision of our board of directors or the conflicts committee regarding the timing of property sales could be influenced by concerns that the sales would compete with those of other Pacific Oak-sponsored programs.
•A decision of our board of directors or the conflicts committee regarding whether and when we seek to list our shares of common stock on a national securities exchange could be influenced by concerns that such listing could adversely affect the sales efforts for other Pacific Oak-sponsored programs, depending on the price at which our shares trade.
Risks Related to Our Corporate Structure
Our charter limits the number of shares a person may own, which may discourage a takeover that could otherwise result in a premium price to our stockholders.
Our charter, with certain exceptions, authorizes our directors to take such actions as are necessary and desirable to preserve our qualification as a REIT. To help us comply with the REIT ownership requirements of the Internal Revenue Code, our charter prohibits a person from directly or constructively owning more than 9.8% of our outstanding shares, unless exempted by our board of directors. This restriction may have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all of our assets) that might provide a premium price for holders of our common stock.
Our charter permits our board of directors to issue stock with terms that may subordinate the rights of our common stockholders or discourage a third party from acquiring us in a manner that could result in a premium price to our stockholders.
Our board of directors may classify or reclassify any unissued common stock or preferred stock and establish the preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends and other distributions, qualifications and terms or conditions of redemption of any such stock. Thus, our board of directors could authorize the issuance of preferred stock with priority as to distributions and amounts payable upon liquidation over the rights of the holders of our common stock. Such preferred stock could also have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all of our assets) that might provide a premium price to holders of our common stock.
Our bylaws designate the Circuit Court for Baltimore City, Maryland as the sole and exclusive forum for certain types of actions and proceedings that may be initiated by our stockholders, which could limit our stockholders’ ability to obtain a favorable judicial forum for disputes with us or our directors, officers or employees.
Our bylaws provide that, unless we consent in writing to the selection of an alternative forum, the Circuit Court for Baltimore City, Maryland shall be the sole and exclusive forum for certain types of actions and proceedings that may be initiated by our stockholders with respect to our company, our directors, our officers or our employees (we note we currently have no employees). This choice of forum provision may limit a stockholder’s ability to bring a claim in a judicial forum that the stockholder believes is favorable for disputes with us or our directors, officers or employees, which may discourage meritorious claims from being asserted against us and our directors, officers and employees. Alternatively, if a court were to find this provision of our bylaws inapplicable to, or unenforceable in respect of, one or more of the specified types of actions or proceedings, we may incur additional costs associated with resolving such matters in other jurisdictions, which could adversely affect our business, financial condition or results of operations. We adopted this provision because we believe it makes it less likely that we will be forced to incur the expense of defending duplicative actions in multiple forums and less likely that plaintiffs’ attorneys will be able to employ such litigation to coerce us into otherwise unjustified settlements, and we believe the risk of a court declining to enforce this provision is remote, as the General Assembly of Maryland has specifically amended the Maryland General Corporation Law to authorize the adoption of such provisions.
Our stockholders’ investment return may be reduced if we are required to register as an investment company under the Investment Company Act; if we or our subsidiaries become an unregistered investment company, we could not continue our business.
Neither we nor any of our subsidiaries intend to register as investment companies under the Investment Company Act. If we or our subsidiaries were obligated to register as investment companies, we would have to comply with a variety of substantive requirements under the Investment Company Act that impose, among other things:
•limitations on capital structure;
•restrictions on specified investments;
•prohibitions on transactions with affiliates; and
•compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly increase our operating expenses.
Under the relevant provisions of Section 3(a)(1) of the Investment Company Act, an investment company is any issuer that:
•pursuant to Section 3(a)(1)(A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities (the “primarily engaged test”); or
•pursuant to Section 3(a)(1)(C) is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire “investment securities” having a value exceeding 40% of the value of such issuer’s total assets (exclusive of U.S. government securities and cash items) on an unconsolidated basis (the “40% test”). “Investment securities” excludes U.S. government securities and securities of majority-owned subsidiaries that are not themselves investment companies and are not relying on the exception from the definition of investment company under Section 3(c)(1) or Section 3(c)(7) (relating to private investment companies).
We believe that neither we nor our Operating Partnership will be required to register as an investment company based on the following analyses. With respect to the 40% test, most of the entities through which we and our Operating Partnership own our assets will be majority-owned subsidiaries that will not themselves be investment companies and will not be relying on the exceptions from the definition of investment company under Section 3(c)(1) or Section 3(c)(7).
With respect to the primarily engaged test, we and our Operating Partnership will be holding companies and do not intend to invest or trade in securities ourselves. Rather, through the majority-owned subsidiaries of our Operating Partnership, we and our Operating Partnership will be primarily engaged in the non-investment company businesses of these subsidiaries, namely the business of purchasing or otherwise acquiring real estate and real estate-related assets.
If any of the subsidiaries of our Operating Partnership fail to meet the 40% test, we believe they will usually, if not always, be able to rely on Section 3(c)(5)(C) of the Investment Company Act for an exception from the definition of an investment company. (Otherwise, they should be able to rely on the exceptions for private investment companies pursuant to Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act.) As reflected in no-action letters, the SEC staff’s position on Section 3(c)(5)(C) generally requires that an issuer maintain at least 55% of its assets in “mortgages and other liens on and interests in real estate,” or qualifying assets; at least 80% of its assets in qualifying assets plus real estate-related assets; and no more than 20% of the value of its assets in other than qualifying assets and real estate-related assets, which we refer to as miscellaneous assets. To constitute a qualifying asset under this 55% requirement, a real estate interest must meet various criteria based on no-action letters. We expect that any of the subsidiaries of our Operating Partnership relying on Section 3(c)(5)(C) will invest at least 55% of its assets in qualifying assets, and approximately an additional 25% of its assets in other types of real estate-related assets. If any subsidiary relies on Section 3(c)(5)(C), we expect to rely on guidance published by the SEC staff or on our analyses of guidance published with respect to types of assets to determine which assets are qualifying real estate assets and real estate-related assets.
To maintain compliance with the Investment Company Act, our subsidiaries may be unable to sell assets we would otherwise want them to sell and may need to sell assets we would otherwise wish them to retain. In addition, our subsidiaries may have to acquire additional assets that they might not otherwise have acquired or may have to forego opportunities to make investments that we would otherwise want them to make and would be important to our investment strategy. Moreover, the SEC or its staff may issue interpretations with respect to various types of assets that are contrary to our views and current SEC staff interpretations are subject to change, which increases the risk of non-compliance and the risk that we may be forced to make adverse changes to our portfolio. In this regard, we note that in 2011 the SEC issued a concept release indicating that the SEC and its staff were reviewing interpretive issues relating to Section 3(c)(5)(C) and soliciting views on the application of Section 3(c)(5)(C) to companies engaged in the business of acquiring mortgages and mortgage related instruments. If we were required to register as an investment company but failed to do so, we would be prohibited from engaging in our business and criminal and civil actions could be brought against us. In addition, our contracts would be unenforceable unless a court required enforcement and a court could appoint a receiver to take control of us and liquidate our business. For more information related to compliance with the Investment Company Act, see “Investment Objectives and Criteria-Investment Limitations Under the Investment Company Act of 1940.”
Rapid changes in the values of our assets may make it more difficult for us to maintain our qualification as a REIT or our exception from the definition of an investment company under the Investment Company Act.
If the market value or income potential of our qualifying real estate assets changes as compared to the market value or income potential of our non-qualifying assets, or if the market value or income potential of our assets that are considered “real estate-related assets” under the Investment Company Act or REIT qualification tests changes as compared to the market value or income potential of our assets that are not considered “real estate-related assets” under the Investment Company Act or REIT qualification tests, whether as a result of increased interest rates, prepayment rates or other factors, we may need to modify our investment portfolio in order to maintain our REIT qualification or exception from the definition of an investment company. If the decline in asset values or income occurs quickly, this may be especially difficult, if not impossible, to accomplish. This difficulty may be exacerbated by the illiquid nature of many of the assets that we may own. We may have to make investment decisions that we otherwise would not make absent REIT and Investment Company Act considerations.
Our stockholders have limited control over changes in our policies and operations, which increases the uncertainty and risks our stockholders face.
Our board of directors determines our major policies, including our policies regarding financing, growth, debt capitalization, REIT qualification and distributions. Our board of directors may amend or revise these and other policies without a vote of the stockholders. Under Maryland General Corporation Law and our charter, our stockholders have a right to vote only on limited matters. Our board’s broad discretion in setting policies and our stockholders’ inability to exert control over those policies increases the uncertainty and risks stockholders face.
Because our charter does not require our listing or liquidation by a specified date, or at all, investors should only purchase our shares as a long-term investment and be prepared to hold them for an indefinite period of time.
We may seek to list our shares of common stock on a national securities exchange if our independent directors believe listing would be in the best interest of our stockholders. If we do not list our shares of common stock on a national securities exchange within ten years from commencement of our initial public offering, our charter requires that we either seek stockholder approval of the liquidation of the company; or postpone the decision of whether to liquidate the company, if a majority of the conflicts committee determines that liquidation is not then in the best interests of the stockholders. If a majority of the conflicts committee does determine that liquidation is not then in the best interests of our stockholders, our charter requires that the conflicts committee revisit the issue of liquidation at least annually. Further postponement of listing or stockholder action regarding liquidation would only be permitted if a majority of the conflicts committee again determined that liquidation would not be in the best interest of our stockholders. If we sought and failed to obtain stockholder approval of our liquidation, our charter would not require us to list or liquidate and would not require the conflicts committee to revisit the issue of liquidation, and we could continue to operate as before. Because our charter does not require our listing or liquidation by a specified date, or at all, investors should only purchase our shares as a long-term investment and be prepared to hold them for an indefinite period of time.
If funds are not available from our dividend reinvestment plan offering for general corporate purposes, then we may have to use a greater proportion of our cash flow from operations to meet our general cash requirements, which would reduce cash available for distributions and limit our ability to redeem shares under our share redemption program.
We depend on the proceeds from our dividend reinvestment plan offering for general corporate purposes, including, but not limited to, the repurchase of shares under our share redemption program; reserves required by any financings of our investments; future funding obligations under any real estate loan receivable we acquire or originate; the acquisition or origination of assets, which would include payment of acquisition and origination fees to our advisor; the repayment of debt; and expenses relating to our investments, such as purchasing a loan senior to ours to protect our junior position in the event of a default by the borrower on the senior loan, making protective advances to preserve collateral securing a loan, or making capital and tenant improvements or paying leasing costs and commissions related to real property. We cannot predict with any certainty how much, if any, dividend reinvestment plan proceeds will be available for general corporate purposes. If such funds are not available from our dividend reinvestment plan offering, then we may have to use a greater proportion of our cash flow from operations to meet our general cash requirements, which would reduce cash available for distributions and could limit our ability to redeem shares under our share redemption program.
The estimated NAV per share of our common stock may not reflect the value that stockholders will receive for their investment and does not take into account how developments subsequent to the valuation date related to individual assets, the financial or real estate markets or other events may have increased or decreased the value of our portfolio.
On December 17, 2019, our board of directors approved an estimated NAV per share of our common stock of $10.25 based on the estimated value of the our assets less the estimated value of our liabilities, or NAV, divided by the number of shares outstanding, all as of September 30, 2019, with the exception of the following adjustments: (i) our consolidated investments in real estate properties were valued as of October 31, 2019; (ii) an adjustment to reduce cash for the amount of capital expenditures incurred in October 2019; (iii) an adjustment for disposition costs and fees incurred in connection with the disposition of 2200 Paseo Verde. Other than the adjustments, there were no material changes between September 30, 2019 and December 17, 2019 that impacted the overall estimated NAV per share. We are providing this estimated NAV per share to assist broker-dealers that participated in our initial public offering in meeting their customer account statement reporting obligations under National Association of Securities Dealers Conduct Rule 2340 as required by the Financial Industry Regulatory Authority (“FINRA”). This valuation was performed in accordance with the provisions of and also to comply with Practice Guideline 2013–01, Valuations of Publicly Registered, Non-Listed REITs, issued by the Institute for Portfolio Alternatives (formerly known as the Investment Program Association) (“IPA”) in April 2013 (the “IPA Valuation Guidelines”).
As with any valuation methodology, the methodologies used are based upon a number of estimates and assumptions that may not be accurate or complete.
Different parties with different assumptions and estimates could derive a different estimated NAV per share of our common stock and this difference could be significant, nor does it represent a liquidation value of our assets and liabilities or the price at which our shares of common stock would trade on a national securities exchange. The estimated NAV per share is not audited and does not represent the fair value of our assets less the fair value of our liabilities according to GAAP.
Accordingly, with respect to our estimated NAV per share, we can give no assurance that:
•a stockholder would be able to resell his or her shares at our estimated NAV per share;
•a stockholder would ultimately realize distributions per share equal to our estimated NAV per share upon liquidation of our assets and settlement of our liabilities or a sale of our company;
•our shares of common stock would trade at our estimated NAV per share on a national securities exchange;
•a third party would offer our estimated NAV per share in an arm’s-length transaction to purchase all or substantially all of our shares of common stock;
•another independent third-party appraiser or third-party valuation firm would agree with our estimated NAV per share; or
•the methodology used to determine our estimated NAV per share would be acceptable to FINRA for compliance with ERISA reporting requirements.
For a full description of the methodologies and assumptions used to value our assets and liabilities in connection with the calculation of the estimated value per share, see Part II, Item 5, “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities — Market Information.”
Payment of fees to Pacific Oak Capital Advisors and its affiliates reduces cash available for distribution and increases the risk that stockholders will not be able to recover the amount of an investment in our shares.
Pacific Oak Capital Advisors and its affiliates perform services for us in connection with the selection, acquisition, origination, management, and administration of our investments. We pay them substantial fees for these services, which will result in immediate dilution to the value of an investment in us and reduce the amount of cash available for distribution to stockholders. Compensation to be paid to our advisor may be increased without stockholder approval, which would further dilute our stockholders’ investment and reduce the amount of cash available for distribution to stockholders.
We may also pay significant fees during our listing/liquidation stage. Although most of the fees payable during our listing/liquidation stage are contingent on our investors first enjoying agreed-upon investment returns, the investment-return thresholds may be reduced subject to approval by our conflicts committee and the other limitations in our charter.
These fees increase the risk that the amount of cash available for distribution to common stockholders upon a liquidation of our portfolio would be less than the estimated NAV per share. These substantial fees and other payments also increase the risk that our stockholders will not be able to resell their shares at a profit, even if our shares are listed on a national securities exchange.
Failure to procure adequate capital and funding would negatively impact our results and may, in turn, negatively affect our ability to pay distributions to our stockholders.
We will depend upon the availability of adequate funding and capital for our operations. The failure to secure acceptable financing could reduce our taxable income, as our investments would no longer generate the same level of net interest income due to the lack of funding or increase in funding costs. A reduction in our net income could reduce our liquidity and our ability to pay distributions to our stockholders. We cannot assure our stockholders that any, or sufficient, funding or capital will be available to us in the future on terms that are acceptable to us. Therefore, in the event that we cannot obtain sufficient funding on acceptable terms, there may be a negative impact on our ability to pay distributions.
Stockholders may be more likely to sustain a loss on their investment because our sponsors do not have as strong an economic incentive to avoid losses as do sponsors who have made significant equity investments in their companies.
KBS Capital Advisors has only invested $200,000 in us through the purchase of 21,739 shares of our Class A common stock at $9.20 per share. In addition, Messrs. Hall and McMillan, through their ownership interest in Willowbrook Capital Group LLC have invested $2,000,000 in us through the purchase of 240,211 shares of our Class A common stock at $8.33 per share. Therefore, our former sponsor and current sponsor have have little exposure to loss in the value of our shares. Without this exposure, our stockholders may be at a greater risk of loss because our sponsors do not have as much to lose from a decrease in the value of our shares as do those sponsors who make more significant equity investments in their companies.
Although we will not currently be afforded the protection of the Maryland General Corporation Law relating to deterring or defending hostile takeovers, our board of directors could opt into these provisions of Maryland law in the future, which may discourage others from trying to acquire control of us and may prevent our stockholders from receiving a premium price for their stock in connection with a business combination.
Under Maryland law, “business combinations” between a Maryland corporation and certain interested stockholders or affiliates of interested stockholders are prohibited for five years after the most recent date on which the interested stockholder becomes an interested stockholder. These business combinations include a merger, consolidation, share exchange, or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities. Also under Maryland law, control shares of a Maryland corporation acquired in a control share acquisition have no voting rights except to the extent approved by a vote of two-thirds of the votes entitled to be cast on the matter. Shares owned by the acquirer, an officer of the corporation or an employee of the corporation who is also a director of the corporation are excluded from the vote on whether to accord voting rights to the control shares. Should our board of directors opt into these provisions of Maryland law, it may discourage others from trying to acquire control of us and increase the difficulty of consummating any offer. Similarly, provisions of Title 3, Subtitle 8 of the Maryland General Corporation Law could provide similar anti-takeover protection.
Our charter includes an anti-takeover provision that may discourage a stockholder from launching a tender offer for our shares.
Our charter provides that any tender offer made by a stockholder, including any “mini-tender” offer, must comply with most provisions of Regulation 14D of the Securities Exchange Act of 1934, as amended. The offering stockholder must provide our company notice of such tender offer at least 10 business days before initiating the tender offer. If the offering stockholder does not comply with these requirements, all tendering stockholders will have the ability to rescind the tender of their shares. In addition, the noncomplying stockholder shall be responsible for all of our company’s expenses in connection with that stockholder’s noncompliance. This provision of our charter may discourage a stockholder from initiating a tender offer for our shares and prevent our stockholders from receiving a premium price for their shares in such a transaction.
Risks Related to Our Investments
Our investments will be subject to the risks typically associated with real estate.
We intend to invest in a portfolio of real estate-related loans, opportunistic real estate, real estate equity securities and other real estate-related investments, including direct investments in opportunistic real estate. Each of these investments will be subject to the risks typically associated with real estate. Our loans held for investment will generally be directly or indirectly secured by a lien on real property (or the equity interests in an entity that owns real property) that, upon the occurrence of a default on the loan, could result in our acquiring ownership of the property. We will not know whether the values of the properties ultimately securing our loans will remain at the levels existing on the dates of origination or acquisition of those loans. If the values of the properties securing the loans drop, our risk will increase because of the lower value of the security associated with such loans. In this manner, real estate values could impact the values of our loan investments. Our investments in residential and commercial mortgage-backed securities, collateralized debt obligations and other real estate-related investments may be similarly affected by real estate property values. The value of real estate may be adversely affected by a number of risks, including:
•natural disasters such as hurricanes, earthquakes, floods and pandemics;
•acts of war or terrorism, including the consequences of terrorist attacks, such as those that occurred on September 11, 2001;
•adverse changes in national and local economic and real estate conditions;
•an oversupply of (or a reduction in demand for) space in the areas where particular properties are located and the attractiveness of particular properties to prospective tenants;
•changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance therewith and the potential for liability under applicable laws;
•costs of remediation and liabilities associated with environmental conditions affecting properties; and
•the potential for uninsured or under insured property losses.
The value of each property is affected significantly by its ability to generate cash flow and net income, which in turn depends on the amount of rental or other income that can be generated net of expenses required to be incurred with respect to the property. Many expenditures associated with properties (such as operating expenses and capital expenditures) cannot be reduced when there is a reduction in income from the properties. These factors may have a material adverse effect on the ability of our borrowers to pay their loans and our tenants to pay their rent, as well as on the value that we can realize from other real estate-related assets we originate, own or acquire.
Investments in non-performing real estate assets involve greater risks than investments in stabilized, performing assets and make our future performance more difficult to predict.
Traditional performance metrics of real estate assets are generally not meaningful for non-performing real estate. Non-performing properties, for example, do not have stabilized occupancy rates to provide a useful measure of revenue. Similarly, non-performing loans do not have a consistent stream of loan servicing or interest payments to provide a useful measure of revenue. In addition, for non-performing loans, often there is no expectation that the face amount of the note will be paid in full. Appraisals may provide a sense of the value of the investment, but any appraisal of the property or property securing the loan will be based on numerous estimates, judgments and assumptions that significantly affect the appraised value of the property securing the loan. Further, an appraisal of a nonstabilized property, in particular, involves a high degree of subjectivity due to high vacancy levels and uncertainties with respect to future market rental rates and timing of lease-up and stabilization. Accordingly, different assumptions may materially change the appraised value of the property. In addition, the value of the property will change over time.
We may pursue more than one strategy to create value in a non-performing real estate investment. With respect to a property, these strategies may include development, redevelopment, or lease-up of such property. With respect to a loan, these strategies may include negotiating with the borrower for a reduced payoff, restructuring the terms of the loan or enforcing our rights as lender under the loan and foreclosing on the collateral securing the loan.
The factors described above make it challenging to evaluate non-performing investments.
We are dependent on the third-party managers of our hotels.
We currently own two hotel properties. In order to qualify as a REIT, we are not able to operate any hotel properties or participate in the decisions affecting the daily operations of our hotels. We will lease any hotels we acquire to a taxable REIT subsidiary (“TRS”) in which we may own up to a 100% interest. Our TRS will enter into management agreements with eligible independent contractors that are not our subsidiaries or otherwise controlled by us to manage the hotels. Thus, independent hotel operators, under management agreements with our TRS, will control the daily operations of our hotels.
We depend on these independent management companies to adequately operate our hotels as provided in the management agreements. We will not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel (for instance, setting room rates). Thus, even if we believe our hotels are being operated inefficiently or in a manner that does not result in satisfactory occupancy rates, revenue per available room and average daily rates, we may not be able to force the management company to change its method of operation of our hotels. We can only seek redress if a management company violates the terms of the applicable management agreement with the TRS, and then only to the extent of the remedies provided for under the terms of the management agreement. In the event that we need to replace our management company, we may be required by the terms of the management agreement to pay substantial termination fees and may experience significant disruptions at the affected hotel.
We may have to make significant capital expenditures to maintain our hotels.
Hotels have an ongoing need for renovations and other capital improvements, including replacements of furniture, fixtures and equipment. Generally, we will be responsible for the costs of these capital improvements, which gives rise to the following risks:
•cost overruns and delays;
•renovations can be disruptive to operations and can displace revenue at the hotels, including revenue lost while rooms under renovation are out of service;
•the cost of funding renovations and the possibility that financing for these renovations may not be available on attractive terms; and
•the risk that the return on our investment in these capital improvements will not be what we expect.
If we have insufficient cash flow from operations to fund needed capital expenditures, then we will need to obtain financing or use proceeds from our initial public offering to fund future capital improvements.
General economic conditions and discretionary consumer spending may affect our hotels and lower the return on our stockholders’ investment.
The operations of our hotels will depend upon a number of factors relating to discretionary consumer spending. Unfavorable local, regional or national economic developments or uncertainties regarding future economic prospects as a result of terrorist attacks, military activity or natural disasters could reduce consumer spending in the markets in which we own hotels and adversely affect the operation of any hotels we may acquire. Consumer spending on luxury goods, travel and other leisure may decline as a result of lower consumer confidence levels, even if prevailing economic conditions are favorable. In an economic downturn, consumer discretionary spending levels generally decline, at times resulting in disproportionately large reductions in expenditures on luxury goods, travel and other leisure activities. Certain of the classes of properties that we may acquire may be unable to maintain their profitability during periods of adverse economic conditions or low consumer confidence, which could in turn affect the ability of operators to make scheduled rent payments to us.
Seasonal revenue variations in our hotels require the operators of such assets to manage cash flow properly over time to meet their non-seasonal scheduled rent payments to us.
Certain of our hotels may be seasonal in nature. For example, the typical beach season begins in early May and runs through August, during which time beach resorts generate the vast majority of their annual revenues. Revenues and profits at beach resorts and their related properties are substantially lower and historically result in losses during the winter months due to the weather. As a result of the seasonal nature of certain industries that may be conducted on properties we acquire, these businesses will experience seasonal variations in revenues that may require our operators to supplement revenue at their properties in order to be able to make scheduled rent payments to us. The failure of an operator or a tenant to manage its cash flow properly may result in such operator or tenant having insufficient cash on hand to make its scheduled payments to us during seasonally slow periods, which may adversely affect our cash available for distribution to stockholders.
Adverse weather conditions may affect operations of our hotels or reduce our operators’ ability to make scheduled rent payments to us, which could reduce our cash flow from such investments.
Adverse weather conditions may disrupt operations and influence revenues at our hotels. These adverse weather conditions include heavy snowfall (or lack thereof), hurricanes, tropical storms, high winds, heat waves, frosts, drought (or merely reduced rainfall levels), excessive rain and floods. In particular, Springmaid Beach Resort Hotel, which represented 10% of our total assets as of December 31, 2019 is located in Myrtle Beach, South Carolina, an area that sustained significant damage from Hurricane Matthew in October 2016, which resulted in a number of rooms being offline during the year ended December 31, 2017. As of December 31, 2017, no rooms remained out of service. The pier was destroyed and certain restaurants and stores had been closed. The Company’s insurance policy provides coverage for property damage and business interruption subject to a deductible of up to 3% of replacement cost per incident.
Certain properties, such as Springmaid Beach Resort, are susceptible to damage from weather conditions such as hurricanes, which damage (including but not limited to property damage and loss of revenue) is not generally insurable at commercially reasonable rates. Thus, poor weather conditions and may adversely affect both the value of our tenants and operators to make their scheduled rent payments to us.
We may not have control over properties under construction.
We may acquire properties under development, such as 210 West 31st Street, as well as hotels that require extensive renovation, such as Springmaid Beach Resort. If we acquire a property for development or renovation, we may be subject to the risk that we cannot control construction costs and the timing of completion of construction or a developer’s ability to build in conformity with plans, specifications and timetables.
We are subject to the risk of increased hotel operating expenses.
We are subject to the risk of increased hotel operating expenses, including, but not limited to, the following cost elements:
•wage and benefit costs;
•repair and maintenance expenses;
•employee liabilities;
•energy costs;
•property taxes;
•insurance costs;
•other operating expenses; and
•the risk that the return on our investment in these capital improvements will not be what we expect.
Any increases in one or more of these operating expenses could have a significant adverse impact on our results of operations, cash flows and financial position.
We are subject to the risk of potentially significant tax penalties in case our leases with our TRS do not qualify for tax purposes as arm’s length.
Any TRSs we form will incur taxes or accrue tax benefits consistent with a “C” corporation. If the leases between us and any of our TRSs were deemed by the IRS to not reflect arm’s length transactions for tax purposes, we may be subject to severe tax penalties as the lessor that will increase our lodging operating expenses and adversely impact our profitability and cash flows.
There may be operational limitations associated with management and franchise agreements affecting our hotels and these limitations may prevent us from using these properties to their best advantage for our stockholders.
Our TRSs will lease and hold some of our hotels and may enter into franchise or license agreements with nationally recognized hotel brands. These franchise agreements may contain specific standards for, and restrictions and limitations on, the operation and maintenance of any hotels we may acquire in order to maintain uniformity within the franchiser system. We expect that franchisers will periodically inspect our properties to ensure that we maintain their standards. We do not know whether those limitations may restrict our business plans tailored to each property and to each market.
The standards are subject to change over time, in some cases at the direction of the franchiser, and may restrict our TRS’s ability, as franchisee, to make improvements or modifications to a property without the consent of the franchiser. Conversely, as a condition to the maintenance of a franchise license, a franchiser could also require us to make capital expenditures, even if we do not believe the capital improvements are necessary, desirable, or likely to result in an acceptable return on our investment. Action or inaction on our part or by our TRS could result in a breach of those standards or other terms and conditions of the franchise agreements and could result in the loss or termination of a franchise license.
In connection with terminating or changing the franchise affiliation of a property, we may be required to incur significant expenses or capital expenditures. Moreover, the loss of a franchise license could have a material adverse effect upon the operations or the underlying value of the property covered by the franchise because of the loss of associated name recognition, marketing support and centralized reservation systems provided by the franchiser. A loss of a franchise license for one or more lodging properties could materially and adversely affect our results of operations, financial condition and cash flows, including our ability to service debt and pay distributions to our stockholders.
Newly constructed and existing multifamily rental properties or other properties that compete with any properties we may acquire in any particular location could adversely affect the operating results of our properties and our cash available for distribution.
We may acquire properties in locations that experience increases in construction of multifamily rental or other properties that compete with our properties. This increased competition and construction could:
•make it more difficult for us to find residents to lease units in our apartment communities;
•force us to lower our rental prices in order to lease units in our apartment communities; or
•substantially reduce our revenues and cash available for distribution.
Our efforts to upgrade multifamily rental properties to increase occupancy and raise rental rates through redevelopment and repositioning may fail, which may reduce our net income and the cash available for distributions.
The success of our ability to upgrade our multifamily rental properties and realize capital gains and current income for our investors on these investments materially depends upon the status of the economy where the multifamily rental property is located. Our revenues will be lower if the rental market cannot bear the higher rental rate that accompanies the upgraded multifamily rental property due to job losses or other economic hardships. Should the local market be unable to support a higher rental rate for a multifamily rental property that we upgraded, we may not realize the premium rental we had assumed by a given upgrade and we may realize reduced rental income or a reduced gain or even loss upon the sale of the property. These events could cause us to reduce the cash available for distributions.
Short-term multifamily leases expose us to the effects of declining market rent, which could adversely impact our ability to make cash distributions.
We expect that substantially all of our apartment leases will be for a term of one year or less. Because these leases generally permit the residents to leave at the end of the lease term or earlier in certain situations, such as when a resident loses his/her job, without penalty, our rental revenues may be impacted by declines in market rents more quickly than if our leases were for longer terms.
Retail properties or mixed-use properties with a retail component may be affected by an economic downturn in the United States, which may have an adverse impact on the retail industry generally. Slow or negative growth in the retail industry may result in defaults by retail tenants, which could have an adverse impact on our results of operations.
Economic conditions in the United States have had an adverse impact on the retail industry generally. As a result, the retail industry is facing reductions in sales revenues and increased bankruptcies throughout the United States. The continuation of adverse economic conditions may result in an increase in distressed or bankrupt retail companies, which in turn would result in an increase in defaults by tenants at our commercial properties. Additionally, slow economic growth is likely to hinder new entrants into the retail market which may make it difficult for us to fully lease space at any retail properties we may acquire. Tenant defaults and decreased demand for retail space would have an adverse impact on the value of any retail properties we acquire and our results of operations.
Any retail tenants we have will face competition from numerous retail channels, which may reduce our profitability and ability to pay distributions.
Retailers will face continued competition from discount or value retailers, factory outlet centers, wholesale clubs, mail order catalogues and operators, television shopping networks and shopping via the Internet. If retail tenants’ rent payments are based on the amount of sales revenue that they generate, such competition could adversely affect our tenants and, consequently, our revenues and funds available for distribution.
Hedging against interest rate exposure may adversely affect our earnings, limit our gains or result in losses, which could adversely affect cash available for distribution to our stockholders.
We may enter into interest rate swap agreements or pursue other interest rate hedging strategies. Our hedging activity will vary in scope based on the level of interest rates, the type of portfolio investments held, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:
•interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;
•available interest rate hedging products may not correspond directly with the interest rate risk for which protection is sought;
•the duration of the hedge may not match the duration of the related liability or asset;
•the amount of income that a REIT may earn from hedging transactions to offset losses due to fluctuations in interest rates is limited by federal tax provisions governing REITs;
•the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction;
•the party owing money in the hedging transaction may default on its obligation to pay; and
•we may purchase a hedge that turns out not to be necessary, i.e., a hedge that is out of the money.
Any hedging activity we engage in may adversely affect our earnings, which could adversely affect cash available for distribution to our stockholders. Therefore, while we may enter into such transactions to seek to reduce interest rate risks, unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions. In addition, the degree of correlation between price movements of the instruments used in a hedging strategy and price movements in the investments being hedged or liabilities being hedged may vary materially. Moreover, for a variety of reasons, we may not seek to establish a perfect correlation between such hedging instruments and the interest rate risk sought to be hedged. Any such imperfect correlation may prevent us from achieving the intended accounting treatment and may expose us to risk of loss.
Hedging instruments often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities and involve risks and costs.
The cost of using hedging instruments increases as the period covered by the instrument increases and during periods of rising and volatile interest rates. We may increase our hedging activity and thus increase our hedging costs during periods when interest rates are volatile or rising and hedging costs have increased. In addition, hedging instruments involve risk since they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities. Consequently, there are no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions. Furthermore, the enforceability of agreements underlying derivative transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in a default. Default by a party with whom we enter into a hedging transaction may result in the loss of unrealized profits and force us to cover our resale commitments, if any, at the then current market price. Although generally we will seek to reserve the right to terminate our hedging positions, it may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. We cannot be certain that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.
We will assume the credit risk of our counterparties with respect to derivative transactions.
We may enter into derivative contracts for risk management purposes to hedge our exposure to cash flow variability caused by changing interest rates on our future variable rate real estate loans receivable and variable rate notes payable. These derivative contracts generally are entered into with bank counterparties and are not traded on an organized exchange or guaranteed by a central clearing organization. We would therefore assume the credit risk that our counterparties will fail to make periodic payments when due under these contracts or become insolvent. If a counterparty fails to make a required payment, becomes the subject of a bankruptcy case, or otherwise defaults under the applicable contract, we would have the right to terminate all outstanding derivative transactions with that counterparty and settle them based on their net market value or replacement cost. In such an event, we may be required to make a termination payment to the counterparty, or we may have the right to collect a termination payment from such counterparty. We assume the credit risk that the counterparty will not be able to make any termination payment owing to us. We may not receive any collateral from a counterparty, or we may receive collateral that is insufficient to satisfy the counterparty’s obligation to make a termination payment. If a counterparty is the subject of a bankruptcy case, we will be an unsecured creditor in such case unless the counterparty has pledged sufficient collateral to us to satisfy the counterparty’s obligations to us.
We will assume the risk that our derivative counterparty may terminate transactions early.
If we fail to make a required payment or otherwise default under the terms of a derivative contract, the counterparty would have the right to terminate all outstanding derivative transactions between us and that counterparty and settle them based on their net market value or replacement cost. In certain circumstances, the counterparty may have the right to terminate derivative transactions early even if we are not defaulting. If our derivative transactions are terminated early, it may not be possible for us to replace those transactions with another counterparty, on as favorable terms or at all.
We may be required to collateralize our derivative transactions.
We may be required to secure our obligations to our counterparties under our derivative contracts by pledging collateral to our counterparties. That collateral may be in the form of cash, securities or other assets. If we default under a derivative contract with a counterparty, or if a counterparty otherwise terminates one or more derivative contracts early, that counterparty may apply such collateral toward our obligation to make a termination payment to the counterparty. If we have pledged securities or other assets, the counterparty may liquidate those assets in order to satisfy our obligations. If we are required to post cash or securities as collateral, such cash or securities will not be available for use in our business. Cash or securities pledged to counterparties may be repledged by counterparties and may not be held in segregated accounts. Therefore, in the event of a counterparty insolvency, we may not be entitled to recover some or all collateral pledged to that counterparty, which could result in losses and have an adverse effect on our operations.
There can be no assurance that the direct or indirect effects of the Dodd-Frank Act and other applicable non-U.S. regulations will not have an adverse effect on our interest rate hedging activities.
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) imposed additional regulations on derivatives markets and transactions. Such regulations and, to the extent we trade with counterparties organized in non-US jurisdictions, any applicable regulations in those jurisdictions, are still being implemented, and will affect our interest rate hedging activities. While the full impact of the regulation on our interest rate hedging activities cannot be fully assessed until all final rules and regulations are implemented, such regulation may affect our ability to enter into hedging or other risk management transactions, may increase our costs in entering into such transactions, and/or may result in us entering into such transactions on less favorable terms than prior to implementation of such regulation. For example, but not by way of limitation, the Dodd-Frank Act and the rule-making thereunder provides for significantly increased regulation of the derivative transactions used to affect our interest rate hedging activities, including: (i) regulatory reporting, (ii) subject to an exemption for end-users of swaps upon which we and our subsidiaries generally rely, mandated clearing of certain derivatives transactions through central counterparties and execution on regulated exchanges or execution facilities and, (iii) to the extent we are required to clear any such transactions, margin and collateral requirements. The imposition, or the failure to comply with, any of the foregoing requirements may have an adverse effect on our business and our stockholders’ return.
Our investments in preferred and common equity securities will be subject to the specific risks relating to the particular issuer of the securities and may involve greater risk of loss than secured debt financings.
Our investments in preferred and common equity securities will involve special risks relating to the particular issuer of the securities, including the financial condition and business outlook of the issuer. Issuers that are REITs and other real estate companies are subject to the inherent risks associated with real estate and real estate-related investments discussed in our prospectus. Issuers that are debt finance companies are subject to the inherent risks associated with structured financing investments also discussed in our prospectus. Furthermore, preferred and common equity securities may involve greater risk of loss than secured debt financings due to a variety of factors, including that such investments are generally unsecured and may also be subordinated to other obligations of the issuer. As a result, investments in preferred and common equity securities are subject to risks of (i) substantial market price volatility resulting from changes in prevailing interest rates, (ii) subordination to the senior claims of banks and other lenders to the issuer, (iii) the operation of mandatory sinking fund or call/redemption provisions during periods of declining interest rates that could cause the issuer to reinvest redemption proceeds in lower yielding assets, (iv) the possibility that earnings of the issuer may be insufficient to meet its distribution obligations and (v) the declining creditworthiness and potential for insolvency of the issuer during periods of rising interest rates and economic downturn. These risks may adversely affect the value of outstanding preferred and common equity securities and the ability of the issuers thereof to make distribution payments to us.
We may make investments in non-U.S. dollar denominated securities, which will be subject to currency rates exposure.
We may purchase real estate-related securities denominated in foreign currencies. A change in foreign currency exchange rates may have an adverse impact on returns on our non-U.S. dollar denominated investments. Although we may hedge our foreign currency risk subject to the REIT income qualification tests, we may not be able to do so successfully and may incur losses on these investments as a result of exchange rate fluctuations.
Investments in properties or other real estate investments outside the United States subject us to foreign currency risks, which may adversely affect distributions and our REIT status.
Revenues generated from any properties or other real estate investments we acquire or ventures we enter into relating to transactions involving assets located in markets outside the United States likely will be denominated in the local currency. Therefore, any investments we make outside the United States may subject us to foreign currency risk due to potential fluctuations in exchange rates between foreign currencies and the U.S. dollar. As a result, changes in exchange rates of any such foreign currency to U.S. dollars may affect our revenues, operating margins and distributions and may also affect the book value of our assets and the amount of stockholders’ equity.
Changes in foreign currency exchange rates used to value a REIT’s foreign assets may be considered changes in the value of the REIT’s assets. These changes may adversely affect our status as a REIT. Further, bank accounts in foreign currency which are not considered cash or cash equivalents may adversely affect our status as a REIT.
Inflation in foreign countries, along with government measures to curb inflation, may have an adverse effect on our investments.
Certain countries have in the past experienced extremely high rates of inflation. Inflation, along with governmental measures to curb inflation, coupled with public speculation about possible future governmental measures to be adopted, has had significant negative effects on these international economies in the past and this could occur again in the future. The introduction of governmental policies to curb inflation can have an adverse effect on our business. High inflation in the countries where we purchase real estate or make other investments could increase our expenses and we may not be able to pass these increased costs on to our tenants.
Concerns regarding the European debt crisis and market perceptions concerning the instability of the euro could adversely affect our business, results of operations and financing.
Concerns persist regarding the debt burden of certain Eurozone countries and their ability to meet future financial obligations, the overall stability of the euro and the suitability of the euro as a single currency given the diverse economic and political circumstances in individual Eurozone countries. These concerns could lead to the re-introduction of individual currencies in one or more Eurozone countries, or, in more extreme circumstances, the possible dissolution of the euro currency entirely. Should the euro dissolve entirely, the legal and contractual consequences for holders of euro-denominated obligations would be determined by laws in effect at such time. These potential developments, or market perceptions concerning these and related issues, could materially adversely affect the value of any euro-denominated assets and obligations we may acquire.
Our dependence on the management of other entities in which we invest may adversely affect our business.
We will not control the management, investment decisions or operations of the companies in which we may invest. Management of those enterprises may decide to change the nature of their assets, or management may otherwise change in a manner that is not satisfactory to us. We will have no ability to affect these management decisions and we may have only limited ability to dispose of our investments.
Many of our investments will be illiquid and we may not be able to vary our portfolio in response to changes in economic and other conditions.
Certain of the real estate-related securities that we may purchase in connection with privately negotiated transactions will not be registered under the relevant securities laws, resulting in a prohibition against their transfer, sale, pledge or other disposition except in a transaction that is exempt from the registration requirements of, or is otherwise in accordance with, those laws. Some of the CMBS and RMBS that we may purchase may be traded in private, unregistered transactions and are therefore subject to restrictions on resale or otherwise have no established trading market. The mezzanine and bridge loans we may purchase or originate will be particularly illiquid investments due to their short life, their unsuitability for securitization and the greater difficulty of recoupment in the event of a borrower’s default. This illiquidity may limit our ability to vary our portfolio in response to changes in economic and other conditions, which could increase the likelihood that the value of the stockholders’ investment in us will decrease as a result of such changes in economic and other conditions.
Declines in the market values of our investments may adversely affect periodic reported results of operations and credit availability, which may reduce earnings and, in turn, cash available for distribution to our stockholders.
We expect that a substantial portion of our assets will be classified for accounting purposes as “available-for-sale.” These investments are carried at estimated fair value and temporary changes in the market values of those assets will be directly charged or credited to stockholders’ equity without impacting net income on the income statement. Moreover, if we determine that a decline in the estimated fair value of an available-for-sale security below its amortized value is other-than-temporary, we will recognize a loss on that security on the income statement, which will reduce our earnings in the period recognized.
A decline in the market value of our assets may adversely affect us particularly in instances where we have borrowed money based on the market value of those assets. If the market value of those assets declines, the lender may require us to post additional collateral to support the loan. If we were unable to post the additional collateral, we may have to sell assets at a time when we might not otherwise choose to do so. A reduction in available credit may reduce our earnings and, in turn, cash available for distribution to stockholders.
Further, credit facility providers may require us to maintain a certain amount of cash reserves or to set aside unleveraged assets sufficient to maintain a specified liquidity position, which would allow us to satisfy our collateral obligations. If the market value of our investments declines, we may not be able to leverage our assets as fully as we would choose, which could reduce our return on equity. In the event that we are unable to meet these contractual obligations, our financial condition could deteriorate rapidly.
Market values of our real estate-related investments may decline for a number of reasons, such as changes in prevailing market rates, increases in defaults related to the collateral, increases in voluntary prepayments for our investments that are subject to prepayment risk, widening of credit spreads and downgrades of ratings of the securities by ratings agencies and global recession or significant declines in the overall economy.
Some of our investments will be carried at an estimated fair value and we will be required to disclose the fair value of other investments quarterly. The estimated fair value will be determined by us and, as a result, there may be uncertainty as to the value of these investments.
Some of our investments will be in the form of securities that are recorded at fair value but that have limited liquidity or are not publicly traded. In addition, we must disclose the fair value of our investments in loans each quarter. Such estimates are inherently uncertain. The fair value of securities and other investments, including loans that have limited liquidity or are not publicly traded, may not be readily determinable. We will estimate the fair value of these investments on a quarterly basis. Because such valuations are inherently uncertain, may fluctuate over short periods of time and may be based on numerous estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. The value of our common stock could be adversely affected if our determinations regarding the fair value of these investments are materially higher than the values that we ultimately realize upon their disposal.
Our joint venture partners could take actions that decrease the value of an investment to us and lower our stockholders’ overall return.
We have entered into, and may continue to enter into, joint ventures with third parties to make investments. We may also make investments in partnerships or other co-ownership arrangements or participations. Such investments may involve risks not otherwise present with other methods of investment, including, for example, the following risks:
•that our co-venturer or partner in an investment could become insolvent or bankrupt;
•that such co-venturer or partner may at any time have economic or business interests or goals that are or that become inconsistent with our business interests or goals;
•that such co-venturer or partner may be in a position to take action contrary to our instructions or requests or contrary to our policies or objectives; or
•that disputes between us and our co-venturer or partner in an investment could result in litigation, thereby increasing our expenses and preventing our executive officers and directors from focusing available time and effort on our ongoing business operations.
Any of the above might subject us to liabilities and thus reduce our returns on our investment with that co-venturer or partner.
Properties that have significant vacancies could be difficult to sell, which could diminish the return on these properties.
A property may incur vacancies either by the expiration of tenant leases or the continued default of tenants under their leases. If vacancies continue for a long period of time, we may suffer reduced revenues resulting in less cash available to distribute to our stockholders. In addition, because a property’s market value depends principally upon the value of the leases associated with that property, the resale value of a property with high or prolonged vacancies could suffer, which could further reduce our returns. Such a reduction in the resale value of a property could also reduce the value of our stockholders’ investment.
We depend on tenants for a portion of our revenue, and lease defaults or terminations could reduce our net income and limit our ability to pay distributions to our stockholders.
The success of our real estate investments materially depends on the financial stability of our tenants. A default or termination by a significant tenant on its lease payments to us would cause us to lose the revenue associated with such lease and could require us to find an alternative source of revenue to meet mortgage payments and prevent a foreclosure, if the property is subject to a mortgage. In the event of a tenant default or bankruptcy, we may experience delays in enforcing our rights as landlord and may incur substantial costs in protecting our investment and re-leasing our property.
If a tenant defaults on or terminates a significant lease, we may be unable to lease the property for the rent previously received or sell the property without incurring a loss. These events could cause us to reduce the amount of distributions to our stockholders.
Our inability to sell a property at the time and on the terms we want could limit our ability to pay cash distributions to our stockholders.
Many factors that are beyond our control affect the real estate market and could affect our ability to sell properties for the price, on the terms or within the time frame that we desire. These factors include general economic conditions, the availability of financing, interest rates and other factors, including supply and demand. Because real estate investments are relatively illiquid, we have a limited ability to vary our portfolio in response to changes in economic or other conditions. Further, before we can sell a property on the terms we want, it may be necessary to expend funds to correct defects or to make improvements. However, we can give no assurance that we will have the funds available to correct such defects or to make such improvements. We may be unable to sell our properties at a profit. Our inability to sell properties at the time and on the terms we want could reduce our cash flow and limit our ability to pay distributions to our stockholders and could reduce the value of our shares.
Our revenue and net income may vary significantly from one period to another due to investments in opportunity-oriented properties and portfolio acquisitions, which could increase the variability of our cash available for distributions.
Our opportunistic property acquisition strategy may include investments in properties in various phases of development, redevelopment or repositioning and portfolio acquisitions, which may cause our revenues and net income to fluctuate significantly from one period to another. Projects do not produce revenue while in development or redevelopment. During any period when our projects in development or redevelopment or those with significant capital requirements increase without a corresponding increase in stable revenue-producing properties, our revenues and net income will likely decrease. Many factors may have a negative impact on the level of revenues or net income produced by our portfolio of properties and projects, including higher than expected construction costs, failure to complete projects on a timely basis, failure of the properties to perform at expected levels upon completion of development or redevelopment, and increased borrowings necessary to fund higher than expected construction or other costs related to the project. Further, our net income and stockholders’ equity could be negatively affected during periods with large portfolio acquisitions, which generally require large cash outlays and may require the incurrence of additional financing. Any such reduction in our revenues and net income during such periods could cause a resulting decrease in our cash available for distributions during the same periods.
If we sell a property by providing financing to the purchaser, we will bear the risk of default by the purchaser, which could delay or reduce the distributions available to our stockholders.
In some instances, we may sell our properties by providing financing to purchasers. When we provide financing to a purchaser, we will bear the risk that the purchaser may default, which could reduce our cash distributions to stockholders. Even in the absence of a purchaser default, the distribution of the proceeds of the sale to our stockholders, or the reinvestment of the proceeds in other assets, will be delayed until the promissory note or other property we may accept upon a sale are actually paid, sold, refinanced or otherwise disposed.
Our operating results may be negatively affected by potential development and construction delays and result in increased costs and risks, which could diminish our stockholders’ return on their investment in us.
We may invest some of the proceeds available for investment in the acquisition, development and/or redevelopment of properties upon which we will develop and construct improvements. We could incur substantial capital obligations in connection with these types of investments. We will be subject to risks relating to uncertainties associated with rezoning for development and environmental concerns of governmental entities and/or community groups and our builder’s ability to control construction costs or to build in conformity with plans, specifications and timetables. The builder’s failure to perform may necessitate legal action by us to rescind the purchase or the construction contract or to compel performance. Performance may also be affected or delayed by conditions beyond the builder’s control. Delays in completion of construction could also give tenants the right to terminate preconstruction leases for space at a newly developed project. We may incur additional risks when we make periodic progress payments or other advances to such builders prior to completion of construction. These and other such factors can result in increased costs of a project or loss of our investment. Substantial capital obligations could delay our ability to pay distributions. In addition, we will be subject to normal lease-up risks relating to newly constructed projects. Furthermore, we must rely upon projections of rental income and expenses and estimates of the fair market value of property upon completion of construction when agreeing upon a price to be paid for the property at the time of acquisition of the property. If our projections are inaccurate, we may pay too much for a property, and the return on our investment could suffer.
In addition, we may invest in unimproved real property. Returns from development of unimproved properties are also subject to risks and uncertainties associated with rezoning the land for development and environmental concerns of governmental entities and/or community groups. Although our intention is to limit any investment in unimproved property to property we intend to develop, our stockholders’ investment nevertheless is subject to the risks associated with investments in unimproved real property.
If the properties related to our investments are concentrated by type or geographic area, then we will be exposed to increased risk with respect to those property types or that geographic area.
Our investments may at times be concentrated in certain property types that are subject to a higher risk of foreclosure. In addition, our investments may be secured by properties concentrated in a limited number of geographic locations. Adverse conditions in the areas where the properties securing or otherwise underlying our investments are located (including business layoffs or downsizing, industry slowdowns, changing demographics and other factors) and local real estate conditions (such as oversupply or reduced demand) may have an adverse effect on the value of the properties securing the loans our investments. A material decline in demand or the ability of tenants to pay rent or of a buyer to consummate a purchase in these geographic areas may result in a material decline in our cash available for distribution.
Costs imposed pursuant to governmental laws and regulations may reduce our net income and the cash available for distributions to our stockholders.
Real property and the operations conducted on real property are subject to federal, state and local laws and regulations relating to protection of the environment and human health. We could be subject to liability in the form of fines, penalties or damages for noncompliance with these laws and regulations. These laws and regulations generally govern wastewater discharges, air emissions, the operation and removal of underground and above-ground storage tanks, the use, storage, treatment, transportation and disposal of solid and hazardous materials, the remediation of contamination associated with the release or disposal of solid and hazardous materials, the presence of toxic building materials, and other health and safety-related concerns.
Some of these laws and regulations may impose joint and several liability on the tenants, owners or operators of real property for the costs to investigate or remediate contaminated properties, regardless of fault, whether the contamination occurred prior to purchase, or whether the acts causing the contamination were legal. Activities of our tenants, the condition of properties at the time we buy them, operations in the vicinity of our properties, such as the presence of underground storage tanks, or activities of unrelated third parties may affect our properties.
The presence of hazardous substances, or the failure to properly manage or remediate these substances, may hinder our ability to sell, rent or pledge such property as collateral for future borrowings. Any material expenditures, fines, penalties, or damages we must pay will reduce our ability to pay distributions and may reduce the value of our shares.
The costs of defending against claims of environmental liability, of complying with environmental regulatory requirements, of remediating any contaminated property, or of paying personal injury or other damage claims could reduce the cash available for distribution to our stockholders.
Under various federal, state and local environmental laws, ordinances and regulations, a current or previous real property owner or operator may be liable for the cost of removing or remediating hazardous or toxic substances on, under or in such property. These costs could be substantial. Such laws often impose liability whether or not the owner or operator knew of, or was responsible for, the presence of such hazardous or toxic substances. Environmental laws also may impose liens on property or restrictions on the manner in which property may be used or businesses may be operated, and these restrictions may require substantial expenditures or prevent us from entering into leases with prospective tenants that may be impacted by such laws. Environmental laws provide for sanctions for noncompliance and may be enforced by governmental agencies or, in certain circumstances, by private parties. Certain environmental laws and common law principles could be used to impose liability for the release of and exposure to hazardous substances, including asbestos-containing materials and lead-based paint. Third parties may seek recovery from real property owners or operators for personal injury or property damage associated with exposure to released hazardous substances and governments may seek recovery for natural resource damage. The costs of defending against claims of environmental liability, of complying with environmental regulatory requirements, of remediating any contaminated property, or of paying personal injury claims could reduce the cash available for distribution to our stockholders.
Costs associated with complying with the Americans with Disabilities Act may decrease cash available for distribution.
Our properties may be subject to the Americans with Disabilities Act of 1990, as amended, or the Disabilities Act. Under the Disabilities Act, all places of public accommodation are required to comply with federal requirements related to access and use by disabled persons. The Disabilities Act has separate compliance requirements for “public accommodations” and “commercial facilities” that generally require that buildings and services be made accessible and available to people with disabilities. The Disabilities Act’s requirements could require removal of access barriers and could result in the imposition of injunctive relief, monetary penalties or, in some cases, an award of damages. Any funds used for Disabilities Act compliance will reduce our net income and the amount of cash available for distribution to our stockholders.
Uninsured losses relating to real property or excessively expensive premiums for insurance coverage could reduce our cash flow from operations and the return on our stockholders’ investment in us.
There are types of losses, generally catastrophic in nature, such as losses due to wars, acts of terrorism, earthquakes, floods, hurricanes, pollution or environmental matters, that are uninsurable or not economically insurable, or may be insured subject to limitations, such as large deductibles or co-payments. Insurance risks associated with potential acts of terrorism could sharply increase the premiums we pay for coverage against property and casualty claims. Additionally, mortgage lenders in some cases may insist that commercial property owners purchase coverage against terrorism as a condition to providing mortgage loans. Such insurance policies may not be available at reasonable costs, if at all, which could inhibit our ability to finance or refinance our properties. In such instances, we may be required to provide other financial support, either through financial assurances or self-insurance, to cover potential losses. We may not have adequate coverage for such losses. If any of our properties incurs a casualty loss that is not fully insured, the value of our assets will be reduced by any such uninsured loss, which will reduce the value of our stockholders’ investment in us. In addition, other than any working capital reserve or other reserves we may establish, we have limited sources of funding to repair or reconstruct any uninsured property. Also, to the extent we must pay unexpectedly large amounts for insurance, we could suffer reduced earnings that would result in lower distributions to our stockholders.
Terrorist attacks and other acts of violence or war may affect the markets in which we plan to operate, which could delay or hinder our ability to meet our investment objectives and reduce our stockholders’ overall return.
Terrorist attacks or armed conflicts may directly impact the value of our properties through damage, destruction, loss or increased security costs. We may not be able to obtain insurance against the risk of terrorism because it may not be available or may not be available on terms that are economically feasible. The terrorism insurance that we obtain may not be sufficient to cover loss for damages to our properties as a result of terrorist attacks. The inability to obtain sufficient terrorism insurance or any terrorism insurance at all could limit our investment, financing and refinancing options as some mortgage lenders have begun to insist that specific coverage against terrorism be purchased by commercial owners as a condition to providing loans.
Risks Related to Our Financing Strategy
We have obtained mortgage indebtedness and other borrowings, which increases our risk of loss due to potential foreclosure.
We have obtained long-term financing that are secured by our real estate investments. In some instances, we may acquire real properties by financing a portion of the price of the properties and mortgaging or pledging some or all of the properties purchased as security for that debt. We may also incur mortgage debt on properties that we already own in order to obtain funds to acquire additional properties, to fund property improvements and other capital expenditures, to pay distributions and for other purposes. In addition, we may borrow as necessary or advisable to ensure that we maintain our qualification as a REIT for federal income tax purposes, including borrowings to satisfy the REIT requirement that we distribute at least 90% of our annual REIT taxable income to our stockholders (computed without regard to the dividends-paid deduction and excluding net capital gain). However, we can give our stockholders no assurance that we will be able to obtain such borrowings on satisfactory terms or at all.
If we do mortgage a property and there is a shortfall between the cash flow generated by that property and the cash flow needed to service mortgage debt on that property, then the amount of cash available for distribution to our stockholders may be reduced. In addition, incurring mortgage debt increases the risk of loss of a property since defaults on indebtedness secured by a property may result in lenders initiating foreclosure actions. In that case, we could lose the property securing the loan that is in default, reducing the value of our stockholders’ investment. For tax purposes, a foreclosure of any of our properties would be treated as a sale of the property for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the property, we would recognize taxable income on foreclosure even though we would not necessarily receive any cash proceeds. We may give full or partial guaranties to lenders of mortgage or other debt on behalf of the entities that own our properties. When we give a guaranty on behalf of an entity that owns one of our properties, we will be responsible to the lender for satisfaction of all or a part of the debt or other amounts related to the debt if it is not paid by such entity. If any mortgages contain cross-collateralization or cross-default provisions, a default on a mortgage secured by a single property could affect mortgages secured by other properties.
We may also obtain recourse debt to finance our acquisitions and meet our REIT distribution requirements. If we have insufficient income to service our recourse debt obligations, our lenders could institute proceedings against us to foreclose upon our assets. If a lender successfully forecloses upon any of our assets, our ability to pay cash distributions to our stockholders will be limited and our stockholders could lose all or part of their investment.
High mortgage rates or changes in underwriting standards may make it difficult for us to finance or refinance properties, which could reduce the number of properties we can acquire, our cash flow from operations and the amount of cash available for distribution to our stockholders.
If mortgage debt is unavailable at reasonable rates, we may not be able to finance the purchase of properties. If we place mortgage debt on a property, we run the risk of being unable to refinance part or all of the debt when it becomes due or of being unable to refinance on favorable terms. If interest rates are higher when we refinance properties subject to mortgage debt, our income could be reduced. We may be unable to refinance or may only be able to partly refinance properties if underwriting standards, including loan to value ratios and yield requirements, among other requirements, are more strict than when we originally financed the properties. If any of these events occurs, our cash flow could be reduced and/or we might have to pay down existing mortgages. This, in turn, would reduce cash available for distribution to our stockholders, could cause us to require additional capital and may hinder our ability to raise capital by issuing more stock or by borrowing more money.
High mortgage rates may make it difficult for us to finance or refinance properties, which could reduce the number of properties we can acquire, our net income and the amount of cash distributions we can make.
If mortgage debt is unavailable at reasonable rates, we may not be able to finance the purchase of real properties. For the mortgage debt we place on properties, we run the risk of being unable to refinance our indebtedness when the loans become due, or of being unable to refinance our indebtedness on favorable terms. If interest rates are higher when we refinance the properties, our income could be reduced. We may be unable to refinance properties. If any of these events occurs, our cash flow would be reduced. This, in turn, would reduce cash available for distribution to our stockholders and may hinder our ability to raise more capital by issuing more stock or by borrowing more money.
Lenders may require us to enter into restrictive covenants relating to our operations, which could limit our ability to pay distributions to our stockholders.
When providing financing, a lender may impose restrictions on us that affect our distribution and operating policies and our ability to incur additional debt. Loan agreements into which we may enter may contain covenants that limit our ability to further mortgage a property or that prohibit us from discontinuing insurance coverage or replacing Pacific Oak Capital Advisors as our advisor. These or other limitations would decrease our operating flexibility and our ability to achieve our operating objectives.
In a period of rising interest rates, our interest expense could increase while the interest we earn on our fixed-rate assets would not change, which would adversely affect our profitability.
Our operating results will depend in large part on differences between the income from our assets, net of credit losses and financing costs. Income from our assets may respond more slowly to interest rate fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net income. Increases in these rates will tend to decrease our net income and market value of our assets. Interest rate fluctuations resulting in our interest expense exceeding our interest income would result in operating losses for us and may limit our ability to pay distributions to our stockholders. We have incurred debt and increases in interest rates will increase the cost of that debt, which could reduce our cash flow from operations and the cash we have available for distribution to our stockholders. In addition, if we need to repay existing debt during periods of rising interest rates, we could be required to liquidate one or more of our investments at times that may not permit realization of the maximum return on such investments.
Changes to the LIBOR settling process and potential phasing out of LIBOR after 2021 could adversely affect our ability to make distributions to our stockholders.
As of December 31, 2019, we have $329.6 million variable rate debt outstanding for which we pay interest based on the London Interbank Offered Rate (“LIBOR”). LIBOR and certain other interest “benchmarks” may be subject to regulatory guidance and/or reform that could cause interest rates under our current or future debt agreements to perform differently than in the past or cause other unanticipated consequences. The United Kingdom’s Financial Conduct Authority, which regulates LIBOR, has announced that it intends to stop encouraging or requiring banks to submit rates for the calculation of LIBOR rates after 2021, and it is unclear whether new methods of calculating LIBOR will be established, such that LIBOR may continue to exist after 2021. While there is no consensus on what rate or rates may become accepted alternatives to LIBOR, the Alternative Reference Rates Committee, a steering committee comprised of U.S. financial market participants, selected the Secured Overnight Finance Rate (“SOFR”) as an alternative to LIBOR. SOFR is a broad measure of the cost of borrowing cash in the overnight U.S. treasury repo market, and the Federal Reserve Bank of New York started to publish the SOFR in May 2018. At this time, it is impossible to predict whether the SOFR or another reference rate will become an accepted alternative to LIBOR. The discontinuation, reform or replacement of LIBOR or any other benchmark rates may have an unpredictable impact on contractual mechanics in the credit markets or cause disruption to the broader financial markets, and could have an adverse effect on LIBOR-based interest rates on our current or future debt obligations.
We have broad authority to incur debt and high debt levels could hinder our ability to pay distributions and decrease the value of an investment in us.
Although we expect that once we have fully invested the proceeds of our initial public offering, our debt financing and other liabilities will be 60% or less of the cost of our tangible assets (before deducting depreciation and other non-cash reserves), our debt financing and other liabilities may exceed this level during our offering stage. Our charter limits our total liabilities to 75% of the cost of our tangible assets (before deducting depreciation and other non-cash reserves); however, we may exceed this limit with the approval of the conflicts committee of our board of directors. During the early stages of our initial public offering, and to the extent financing in excess of this limit is available on attractive terms, the conflicts committee may approve debt such that our total liabilities would exceed this limit. High debt levels would cause us to incur higher interest charges and higher debt service payments and could also be accompanied by restrictive covenants. These factors could limit the amount of cash we have available to distribute and could result in a decline in the value of an investment in us.
We may not be able to access financing sources on attractive terms, which could adversely affect our ability to execute our business plan.
We may finance our assets over the long-term through a variety of means, including repurchase agreements, credit facilities, issuances of commercial mortgage-backed securities and other structured financings. Our ability to execute this strategy will depend on various conditions in the markets for financing in this manner that are beyond our control, including lack of liquidity and greater credit spreads. We cannot be certain that these markets will remain an efficient source of long-term financing for our assets. If our strategy is not viable, we will have to find alternative forms of long-term financing for our assets, as secured revolving credit facilities and repurchase agreements may not accommodate long-term financing. This could subject us to more recourse indebtedness and the risk that debt service on less efficient forms of financing would require a larger portion of our cash flow, thereby reducing cash available for distribution to our stockholders and funds available for operations as well as for future business opportunities.
Federal Income Tax Risks
Failure to qualify as a REIT would reduce our net earnings available for investment or distribution.
Our qualification as a REIT will depend upon our ability to meet requirements regarding our organization and ownership, distributions of our income, the nature and diversification of our income and assets and other tests imposed by the Internal Revenue Code. If we fail to qualify as a REIT for any taxable year after electing REIT status, we will be subject to federal income tax on our taxable income at corporate rates (a maximum rate of 35% applied through 2017, with a 21% rate beginning 2018). In addition, we would generally be disqualified from treatment as a REIT for the four taxable years following the year in which we lost our REIT status. Losing our REIT status would reduce our net earnings available for investment or distribution to stockholders because of the additional tax liability. In addition, distributions to stockholders would no longer qualify for the dividends-paid deduction and we would no longer be required to pay distributions. If this occurs, we might be required to borrow funds or liquidate some investments in order to pay the applicable tax.
Failure to qualify as a REIT would subject us to U.S. federal income tax, which would reduce the cash available for distribution to our stockholders.
We believe that we have operated and will continue to operate in a manner that will allow us to continue to qualify as a REIT for federal income tax purposes, commencing with the taxable year ended December 31, 2014. However, the U.S. federal income tax laws governing REITs are extremely complex, and interpretations of the U.S. federal income tax laws governing qualification as a REIT are limited. Qualifying as a REIT requires us to meet various tests regarding the nature of our assets and our income, the ownership of our outstanding stock, and the amount of our distributions on an ongoing basis. Accordingly, we cannot be certain that we will be successful in operating so we can remain qualified as a REIT. While we intend to continue to operate so that we will qualify as a REIT, given the highly complex nature of the rules governing REITs, the ongoing importance of factual determinations, including the tax treatment of certain investments we may make, and the possibility of future changes in our circumstances, no assurance can be given that we will so qualify for any particular year. If we fail to qualify as a REIT in any calendar year and we do not qualify for certain statutory relief provisions, we would be required to pay U.S. federal income tax on our taxable income at regular corporate rates, and distributions to our stockholders would not be deductible by us in determining our taxable income. In such a case, we might need to borrow money or sell assets to pay that tax. Our payment of income tax would decrease the amount of our income available for distribution to our stockholders. Furthermore, if we fail to maintain our qualification as a REIT and we do not qualify for certain statutory relief provisions, we no longer would be required to distribute substantially all of our REIT taxable income to our stockholders. Unless our failure to qualify as a REIT were excused under federal tax laws, we would be disqualified from taxation as a REIT for the four taxable years following the year during which qualification was lost.
Our stockholders may have current tax liability on distributions they elect to reinvest in our common stock.
If our stockholders participate in our dividend reinvestment plan, they will be deemed to have received, and for income tax purposes will be taxed on, the amount reinvested in shares of our common stock to the extent the amount reinvested was not a tax-free return of capital. In addition, our stockholders will be treated for tax purposes as having received an additional distribution to the extent the shares are purchased at a discount to fair market value, if any. As a result, unless our stockholders are tax-exempt entities, they may have to use funds from other sources to pay their tax liability on the value of the shares of common stock received.
Even if we qualify as a REIT for U.S. federal income tax purposes, we may be subject to federal, state, local or other tax liabilities that reduce our cash flow and our ability to pay distributions to our stockholders.
Even if we qualify as a REIT for U.S. federal income tax purposes, we may be subject to some federal, state and local taxes on our income or property. For example:
•In order to qualify as a REIT, we must distribute annually at least 90% of our REIT taxable income to our stockholders (which is determined without regard to the dividends-paid deduction or net capital gain). To the extent that we satisfy the distribution requirement but distribute less than 100% of our REIT taxable income, we will be subject to federal corporate income tax on the undistributed income.
•We will be subject to a 4% nondeductible excise tax on the amount, if any, by which distributions we pay in any calendar year are less than the sum of 85% of our ordinary income, 95% of our capital gain net income and 100% of our undistributed income from prior years.
•If we elect to treat property that we acquire in connection with a foreclosure of a mortgage loan or certain leasehold terminations as “foreclosure property,” we may avoid the 100% tax on the gain from a resale of that property, but the income from the sale or operation of that property may be subject to corporate income tax at the highest applicable rate.
•If we sell an asset, other than foreclosure property, that we hold primarily for sale to customers in the ordinary course of business, our gain would be subject to the 100% “prohibited transaction” tax unless such sale were made by one of our taxable REIT subsidiaries or the sale met certain “safe harbor” requirements under the Internal Revenue Code.
•Any domestic taxable REIT subsidiary, or TRS, of ours will be subject to U.S. federal corporate income tax on its income, and on any non-arm’s-length transactions between us and any TRS, for instance, excessive rents charged to a TRS could be subject to a 100% tax. We may be subject to tax on income from certain activities conducted as a result of taking title to collateral.
•We may be subject to state or local income, property and transfer taxes, such as mortgage recording taxes.
REIT distribution requirements could adversely affect our ability to execute our business plan.
We generally must distribute annually at least 90% of our REIT taxable income, subject to certain adjustments and excluding any net capital gain, in order for federal corporate income tax not to apply to earnings that we distribute. To the extent that we satisfy this distribution requirement, but distribute less than 100% of our REIT taxable income, we will be subject to federal corporate income tax on our undistributed REIT taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our stockholders in a calendar year is less than a minimum amount specified under federal tax laws. We also may decide to retain net capital gain we earn from the sale or other disposition of our property and pay U.S. federal income tax directly on such income. In that event, our stockholders would be treated as if they earned that income and paid the tax on it directly. However, stockholders that are tax-exempt, such as charities or qualified pension plans, would have no benefit from their deemed payment of such tax liability unless they file U.S. federal income tax returns and thereon seek a refund of such tax. We also will be subject to corporate tax on any undistributed REIT taxable income. We intend to make distributions to our stockholders to comply with the REIT requirements of the Internal Revenue Code.
From time to time, we may generate taxable income greater than our income for financial reporting purposes, or our taxable income may be greater than our cash flow available for distribution to stockholders (for example, where a borrower defers the payment of interest in cash pursuant to a contractual right or otherwise). If we do not have other funds available in these situations we could be required to borrow funds, sell investments at disadvantageous prices or find another alternative source of funds to pay distributions sufficient to enable us to pay out enough of our taxable income to satisfy the REIT distribution requirements and to avoid corporate income tax and the 4% excise tax in a particular year. These alternatives could increase our costs or reduce our equity. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.
To maintain our REIT status, we may be forced to forego otherwise attractive business or investment opportunities, which may delay or hinder our ability to meet our investment objectives and reduce our stockholders’ overall return.
To qualify as a REIT, we must satisfy certain tests on an ongoing basis concerning, among other things, the sources of our income, nature of our assets and the amounts we distribute to our stockholders. We may be required to pay distributions to stockholders at times when it would be more advantageous to reinvest cash in our business or when we do not have funds readily available for distribution. Compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits and reduce the value of our stockholders’ investment.
If our operating partnership fails to maintain its status as a partnership for U.S. federal income tax purposes, its income would be subject to taxation and our REIT status would be terminated.
We intend to maintain the status of our operating partnership as a partnership for U.S. federal income tax purposes. However, if the Internal Revenue Service (“Internal Revenue Service” or “IRS”) were to successfully challenge the status of our operating partnership as a partnership, it would be taxable as a corporation. In such event, this would reduce the amount of distributions that our operating partnership could make to us. This would also result in our losing REIT status and becoming subject to a corporate level tax on our own income. This would substantially reduce our cash available to pay distributions and the return on your investment. In addition, if any of the entities through which our operating partnership owns its properties, in whole or in part, loses its characterization as a partnership for U.S. federal income tax purposes, the underlying entity would become subject to taxation as a corporation, thereby reducing distributions to our operating partnership and jeopardizing our ability to maintain REIT status.
Potential characterization of distributions or gain on sale may be treated as unrelated business taxable income to tax-exempt investors.
If (i) all or a portion of our assets are subject to the rules relating to taxable mortgage pools, (ii) we are a “pension-held REIT,” (iii) a tax-exempt stockholder has incurred debt to purchase or hold our common stock, or (iv) the residual Real Estate Mortgage Investment Conduit interests, or REMICs, we buy (if any) generate “excess inclusion income,” then a portion of the distributions to and, in the case of a stockholder described in clause (iii), gains realized on the sale of common stock by such tax-exempt stockholder may be subject to U.S. federal income tax as unrelated business taxable income under the Internal Revenue Code.
The tax on prohibited transactions will limit our ability to engage in transactions that would be treated as sales for U.S. federal income tax purposes.
A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of assets, other than foreclosure property, deemed held primarily for sale to customers in the ordinary course of business. We might be subject to this tax if we were to dispose of loans in a manner that was treated as a sale of the loans for U.S. federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans at the REIT level, and may limit the structures we utilize for our securitization transactions, even though the sales or structures might otherwise be beneficial to us.
It may be possible to reduce the impact of the prohibited transaction tax by conducting certain activities through taxable REIT subsidiaries. However, to the extent that we engage in such activities through taxable REIT subsidiaries, the income associated with such activities may be subject to full corporate income tax.
Our acquisition of debt or securities investments may cause us to recognize income for U.S. federal income tax purposes even though no cash payments have been received on the debt investments.
We may acquire debt or securities investments in the secondary market for less than their face amount. The amount of such discount will generally be treated as a “market discount” for U.S. federal income tax purposes. If these debt or securities investments provide for “payment-in-kind” interest, we may recognize “original issue discount,” or OID, for U.S. federal income tax purposes. Moreover, we may acquire distressed debt investments that are subsequently modified by agreement with the borrower. If the amendments to the outstanding debt constitute “significant modifications” under the applicable Department of the Treasury regulations (“Treasury Regulations”), the modified debt may be considered to have been reissued to us in a debt-for-debt exchange with the borrower. In that event, if the debt is considered to be “publicly traded” for U.S. federal income tax purposes, the modified debt in our hands may be considered to have been issued with OID to the extent the fair market value of the modified debt is less than the principal amount of the outstanding debt. In the event the debt is not considered to be “publicly traded” for U.S. federal income tax purposes, we may be required to recognize taxable income to the extent that the principal amount of the modified debt exceeds our cost of purchasing it. Also, certain loans that we originate and later modify and certain previously modified debt we acquire in the secondary market may be considered to have been issued with the OID at the time it was modified.
In general, we will be required to accrue OID on a debt instrument as taxable income in accordance with applicable federal income tax rules even though no cash payments may be received on such debt instrument on a current basis.
In the event a borrower with respect to a particular debt instrument encounters financial difficulty rendering it unable to pay stated interest as due, we may nonetheless be required to continue to recognize the unpaid interest as taxable income. Similarly, we may be required to accrue interest income with respect to subordinate mortgage-backed securities at the stated rate regardless of when their corresponding cash payments are received.
In order to meet the REIT distribution requirements, it might be necessary for us to arrange for short-term, or possibly long-term borrowings, or to pay distributions in the form of our shares or other taxable in-kind distributions of property. We may need to borrow funds at times when the market conditions are unfavorable. Such borrowings could increase our costs and reduce the value of your investment. In the event in-kind distributions are made, your tax liabilities associated with an investment in our common stock for a given year may exceed the amount of cash we distribute to you during such year.
Complying with REIT requirements may force us to liquidate otherwise attractive investments.
To qualify as a REIT, we must ensure that at the end of each calendar quarter, at least 75% of the value of our assets consists of cash, cash items, government securities and qualified REIT real estate assets, including certain mortgage loans and residential and commercial mortgage-backed securities. The remainder of our investment in securities (other than government securities and qualified real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of our assets (other than government securities and qualified real estate assets) can consist of the securities of any one issuer, no more than 20% (25% for taxable years before 2018) of the value of our total assets can be represented by securities of one or more taxable REIT subsidiaries and no more than 25% of the value of our total assets can be represented by “non-qualified publicly offered REIT debt instruments.” If we fail to comply with these requirements at the end of any calendar quarter, we must correct the failure within 30 days after the end of the calendar quarter or qualify for certain statutory relief provisions to avoid losing our REIT qualification and suffering adverse tax consequences. As a result, we may be required to liquidate from our portfolio otherwise attractive investments. These actions could have the effect of reducing our income and amounts available for distribution to our stockholders.
Liquidation of assets may jeopardize our REIT qualification.
To qualify as a REIT, we must comply with requirements regarding our assets and our sources of income. If we are compelled to liquidate our investments to repay obligations to our lenders, we may be unable to comply with these requirements, ultimately jeopardizing our qualification as a REIT, or we may be subject to a 100% tax on any resultant gain if we sell assets that are treated as dealer property or inventory.
Complying with REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Internal Revenue Code may limit our ability to hedge our assets and operations. Under these provisions, any income that we generate from transactions intended to hedge our interest rate, inflation and/or currency risks will be excluded from gross income for purposes of the REIT 75% and 95% gross income tests if the purpose of the instrument is to (i) hedge interest rate risk on liabilities incurred to carry or acquire real estate, (ii) hedge risk of currency fluctuations with respect to any item of income or gain that would be qualifying income under the REIT 75% or 95% gross income tests, or (iii) manage risk with respect to the termination of certain prior hedging transactions described in (i) and/or (ii) above and, in each case, such instrument is properly identified under applicable Treasury Regulations. Income from hedging transactions that do not meet these requirements will generally constitute nonqualifying income for purposes of both the REIT 75% and 95% gross income tests. As a result of these rules, we may have to limit our use of hedging techniques that might otherwise be advantageous, which could result in greater risks associated with interest rate or other changes than we would otherwise incur.
Our ownership of and relationship with our taxable REIT subsidiaries will be limited and a failure to comply with the limits would jeopardize our REIT status and may result in the application of a 100% excise tax.
A REIT may own up to 100% of the stock of one or more taxable REIT subsidiaries. A taxable REIT subsidiary may earn income that would not be qualifying income if earned directly by the parent REIT. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a taxable REIT subsidiary. A corporation of which a taxable REIT subsidiary directly or indirectly owns more than 35% of the voting power or value of the stock will automatically be treated as a taxable REIT subsidiary. Overall, no more than 20% (25% for taxable years before 2018) of the value of a REIT’s assets may consist of stock or securities of one or more taxable REIT subsidiaries. A domestic taxable REIT subsidiary will pay federal, state and local income tax at regular corporate rates on any income that it earns. In addition, the taxable REIT subsidiary rules limit the deductibility of interest paid or accrued by a taxable REIT subsidiary to its parent REIT to assure that the taxable REIT subsidiary is subject to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a taxable REIT subsidiary and its parent REIT that are not conducted on an arm’s-length basis. We cannot assure our stockholders that we will be able to comply with the 20% value limitation on ownership of taxable REIT subsidiary stock and securities on an ongoing basis so as to maintain REIT status or to avoid application of the 100% excise tax imposed on certain non-arm’s length transactions.
Our qualification as a REIT may depend upon the accuracy of legal opinions or advice rendered or given or statements by the issuers of assets we acquire.
When purchasing securities, we may rely on opinions or advice of counsel for the issuer of such securities, or statements made in related offering documents, for purposes of determining, among other things, whether such securities represent debt or equity securities for U.S. federal income tax purposes, the value of such securities, and also to what extent those securities constitute qualified real estate assets for purposes of the REIT asset tests and produce qualified income for purposes of the 75% gross income test. The inaccuracy of any such opinions, advice or statements may adversely affect our ability to qualify as a REIT and result in significant corporate-level tax.
Our charter limits the number of shares a person may own, which may discourage a takeover that could otherwise result in a premium price paid to you.
Our charter, with certain exceptions, authorizes our board of directors to take such actions as are necessary and desirable to preserve our qualification as a REIT. To help us comply with the REIT ownership requirements of the Internal Revenue Code, among other purposes, our charter prohibits a person from directly or constructively owning more than 9.8% in value of the aggregate of the outstanding shares of our stock of any class or series or more than 9.8% in value or number of shares, whichever is more restrictive, of the aggregate of the outstanding shares of our common stock, unless exempted (prospectively or retroactively) by our board of directors. This restriction may have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all of our assets) that might otherwise provide a premium price for holders of our shares of common stock.
The ability of our board of directors to revoke our REIT qualification without stockholder approval may subject us to U.S. federal income tax and reduce distributions to our stockholders.
Our charter provides that our board of directors may revoke or otherwise terminate our REIT election, without the approval of our stockholders, if it determines that it is no longer in our best interest to continue to qualify as a REIT. While we intend to elect and qualify to be taxed as a REIT, we may not elect to be treated as a REIT or may terminate our REIT election if we determine that qualifying as a REIT is no longer in our best interests. If we cease to be a REIT, we would become subject to U.S. federal income tax on our taxable income and would no longer be required to distribute most of our taxable income to our stockholders, which may have adverse consequences on our total return to our stockholders and on the market price of our common stock.
Changes recently made to the U.S. tax laws could have a negative impact on our business.
The President signed a tax reform bill into law on December 22, 2017 (the “Tax Cuts and Jobs Act”). Among other things, the Tax Cuts and Jobs Act:
•Reduces the corporate income tax rate from 35% to 21% (including with respect to a taxable REIT subsidiary);
•Reduces the rate of U.S. federal withholding tax on distributions made to non-U.S. stockholders by a REIT that are attributable to gains from the sale or exchange of U.S. real property interests from 35% to 21%;
•If elected, allows an immediate 100% deduction of the cost of certain capital asset investments (generally excluding real estate assets), subject to a phase-down of the deduction percentage over time;
•Changes the recovery periods for certain real property and building improvements (for example, to 15 years for qualified improvement property under the modified accelerated cost recovery system if a technical correction is passed, and to 30 years (previously 40 years) for residential real property and 20 years (previously 40 years) for qualified improvement property under the alternative depreciation system);
•Restricts the deductibility of interest expense by businesses (generally, to 30% of the business’ adjusted taxable income) except, among others, real property businesses electing out of such restriction; we have not yet determined whether we and/or our subsidiaries can and/or will make such an election;
•Requires the use of the less favorable alternative depreciation system to depreciate real property in the event a real property business elects to avoid the interest deduction restriction above;
•Restricts the benefits of like-kind exchanges that defer capital gains for tax purposes to exchanges of real property;
•Permanently repeals the “technical termination” rule for partnerships, meaning sales or exchanges of the interests in a partnership will be less likely to, among other things, terminate the taxable year of, and restart the depreciable lives of assets held by, such partnership for tax purposes;
•Requires accrual method taxpayers to take certain amounts in income no later than the taxable year in which such income is taken into account as revenue in an applicable financial statement prepared under GAAP, which, with respect to certain leases, could accelerate the inclusion of rental income;
•Eliminates the federal corporate alternative minimum tax;
•Reduces the highest marginal income tax rate for individuals to 37% from 39.6% (excluding, in each case, the 3.8% Medicare tax on net investment income);
•Generally allows a deduction for individuals equal to 20% of certain income from pass-through entities, including ordinary dividends distributed by a REIT (excluding capital gain dividends and qualified dividend income), generally resulting in a maximum effective U.S. federal income tax rate applicable to such dividends of 29.6% compared to 37% (excluding, in each case, the 3.8% Medicare tax on net investment income); and
•Limits certain deductions for individuals, including deductions for state and local income taxes, and eliminates deductions for miscellaneous itemized deductions (including certain investment expenses).
Many of the provisions in the Tax Cuts and Jobs Act, in particular those affecting individual taxpayers, expire at the end of 2025.
As a result of the changes to U.S. federal tax laws implemented by the Tax Cuts and Jobs Act, our taxable income and the amount of distributions to our stockholders required in order to maintain our REIT status, and our relative tax advantage as a REIT, could change. As a REIT, we are required to distribute at least 90% of our taxable income to our stockholders annually.
The Tax Cuts and Jobs Act is a complex revision to the U.S. federal income tax laws with various impacts on different categories of taxpayers and industries, and will require subsequent rulemaking and interpretation in a number of areas. The long-term impact of the Tax Cuts and Jobs Act on the overall economy, government revenues, our tenants, us, and the real estate industry cannot be reliably predicted at this time. Furthermore, the Tax Cuts and Jobs Act may negatively impact certain of our tenants’ operating results, financial condition, and future business plans. The Tax Cuts and Jobs Act may also result in reduced government revenues, and therefore reduced government spending, which may negatively impact some of our tenants that rely on government funding. There can be no assurance that the Tax Cuts and Jobs Act will not negatively impact our operating results, financial condition, and future business operations.
Dividends payable by REITs do not qualify for the reduced tax rates.
In general, the maximum tax rate for dividends payable to domestic stockholders that are individuals, trusts and estates is 20%. Dividends payable by REITs, however, are generally not eligible for this reduced rate; provided under current law, individuals may be able to deduct 20% of income received as ordinary REIT dividends, thus reducing the maximum effective U.S. federal income tax rate on such dividend. In addition, Treasury Regulations impose a minimum holding period for the 20% deduction that was not set forth in the Internal Revenue Code. Under the Treasury Regulations, in order for a REIT dividend with respect to a share of REIT stock to be treated as a qualified REIT dividend, the U.S. stockholder (i) must have held the share for more than 45 days during the 91-day period beginning on the date which is 45 days before the date on which such share becomes ex-dividend with respect to such dividend and (ii) cannot have been under an obligation to make related payments with respect to positions in substantially similar or related property, e.g., pursuant to a short sale. While this tax treatment does not adversely affect the taxation of REITs or dividends paid by REITs, the more favorable rates applicable to regular corporate dividends could cause investors who are individuals, trusts or estates to perceive investments in REITs to be relatively less attractive than investments in stock of non-REIT corporations that pay dividends, which could adversely affect the value of the stock of REITs, including our common stock.
Qualifying as a REIT involves highly technical and complex provisions of the Internal Revenue Code.
Qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which only limited judicial and administrative authorities exist. Even a technical or inadvertent violation could jeopardize our REIT qualification. Our continued qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis. In addition, our ability to satisfy the requirements to qualify as a REIT depends in part on the actions of third parties over which we have no control or only limited influence, including in cases where we own an equity interest in an entity that is classified as a partnership for U.S. federal income tax purposes.
The taxation of distributions to our stockholders can be complex; however, distributions that we make to our stockholders generally will be taxable as ordinary income, which may reduce your anticipated return from an investment in us.
Distributions that we make to our taxable stockholders to the extent of our current and accumulated earnings and profits (and not designated as capital gain dividends or qualified dividend income) generally will be taxable as ordinary income. However, a portion of our distributions may (i) be designated by us as capital gain dividends generally taxable as long-term capital gain to the extent that they are attributable to net capital gain recognized by us, (ii) be designated by us as qualified dividend income generally to the extent they are attributable to dividends we receive from non-REIT corporations, such as our taxable REIT subsidiaries, or (iii) constitute a return of capital generally to the extent that they exceed our current and accumulated earnings and profits as determined for U.S. federal income tax purposes. A return of capital distribution is not taxable, but has the effect of reducing the basis of a stockholder’s investment in our common stock.
We may be required to pay some taxes due to actions of a taxable REIT subsidiary which would reduce our cash available for distribution to you.
Any net taxable income earned directly by a taxable REIT subsidiary, or through entities that are disregarded for U.S. federal income tax purposes as entities separate from our taxable REIT subsidiaries, will be subject to federal and possibly state corporate income tax. In this regard, several provisions of the laws applicable to REITs and their subsidiaries ensure that a taxable REIT subsidiary will be subject to an appropriate level of U.S. federal income taxation. For example, a taxable REIT subsidiary may be limited in its ability to deduct certain interest payments made to an affiliated REIT. In addition, the REIT has to pay a 100% penalty tax on some payments that it receives or on some deductions taken by a taxable REIT subsidiary if the economic arrangements between the REIT, the REIT's customers, and the taxable REIT subsidiary are not comparable to similar arrangements between unrelated parties. Finally, some state and local jurisdictions may tax some of our income even though as a REIT we are not subject to U.S. federal income tax on that income because not all states and localities follow the U.S. federal income tax treatment of REITs. To the extent that we and our affiliates are required to pay federal, state and local taxes, we will have less cash available for distributions to you.
We may distribute our common stock in a taxable distribution, in which case you may sell shares of our common stock to pay tax on such distributions, and you may receive less in cash than the amount of the dividend that is taxable.
We may make taxable distributions that are payable in cash and common stock. The IRS has issued private letter rulings to other REITs treating certain distributions that are paid partly in cash and partly in stock as taxable distributions that would satisfy the REIT annual distribution requirement and qualify for the dividends paid deduction for U.S. federal income tax purposes. Those rulings may be relied upon only by taxpayers to whom they were issued, but we could request a similar ruling from the IRS. Accordingly, it is unclear whether and to what extent we will be able to make taxable distributions payable in cash and common stock. If we made a taxable dividend payable in cash and common stock, taxable stockholders receiving such distributions will be required to include the dividend as taxable income to the extent of our current and accumulated earnings and profits, as determined for U.S. federal income tax purposes. As a result, you may be required to pay income tax with respect to such distributions in excess of the cash distributions received. If a U.S. stockholder sells the common stock that it receives as a dividend in order to pay this tax, the sales proceeds may be less than the amount recorded in earnings with respect to the dividend, depending on the market price of our common stock at the time of the sale. Furthermore, with respect to certain non-U.S. stockholders, we may be required to withhold U.S. federal income tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in common stock.
Investments in other REITs and real estate partnerships could subject us to the tax risks associated with the tax status of such entities.
We may invest in the securities of other REITs and real estate partnerships. Such investments are subject to the risk that any such REIT or partnership may fail to satisfy the requirements to qualify as a REIT or a partnership, as the case may be, in any given taxable year. In the case of a REIT, such failure would subject such entity to taxation as a corporation, may require such REIT to incur indebtedness to pay its tax liabilities, may reduce its ability to make distributions to us, and may render it ineligible to elect REIT status prior to the fifth taxable year following the year in which it fails to so qualify. In the case of a partnership, such failure could subject such partnership to an entity level tax and reduce the entity’s ability to make distributions to us. In addition, such failures could, depending on the circumstances, jeopardize our ability to qualify as a REIT.
Non-U.S. stockholders will be subject to U.S. federal withholding tax and may be subject to U.S. federal income tax on distributions received from us and upon the disposition of our shares.
Subject to certain exceptions, distributions received from us will be treated as dividends of ordinary income to the extent of our current or accumulated earnings and profits. Such dividends ordinarily will be subject to U.S. withholding tax at a 30% rate, or such lower rate as may be specified by an applicable income tax treaty, unless the distributions are treated as “effectively connected” with the conduct by the non-U.S. stockholder of a U.S. trade or business. Pursuant to the Foreign Investment in Real Property Tax Act of 1980, or FIRPTA, capital gain distributions attributable to sales or exchanges of “U.S. real property interests,” or USRPIs, generally (subject to certain exceptions for “qualified foreign pension funds” and certain “qualified shareholders”) will be taxed to a non-U.S. stockholder (other than a qualified foreign pension plan, entities wholly owned by a qualified foreign pension plan and certain publicly traded foreign entities) as if such gain were effectively connected with a U.S. trade or business unless FIRPTA provides an exemption. However, a capital gain dividend will not be treated as effectively connected income if (i) the distribution is received with respect to a class of stock that is regularly traded on an established securities market located in the United States and (ii) the non-U.S. stockholder does not own more than 10% of the class of our stock at any time during the one-year period ending on the date the distribution is received. We do not anticipate that our shares will be “regularly traded” on an established securities market for the foreseeable future, and therefore, this exception is not expected to apply.
Gain recognized by a non-U.S. stockholder upon the sale or exchange of our common stock generally will not be subject to U.S. federal income taxation unless such stock constitutes a USRPI under FIRPTA (subject to specific FIRPTA exemptions for certain non-U.S. stockholders). Our common stock will not constitute a USRPI so long as we are a “domestically-controlled qualified investment entity.” A domestically-controlled qualified investment entity includes a REIT if at all times during a specified testing period, less than 50% in value of such REIT’s stock is held directly or indirectly by non-U.S. stockholders. We believe, but cannot assure you, that we will be a domestically-controlled qualified investment entity.
Even if we do not qualify as a domestically-controlled qualified investment entity at the time a non-U.S. stockholder sells or exchanges our common stock, gain arising from such a sale or exchange would not be subject to U.S. taxation under FIRPTA as a sale of a USRPI if: (a) our common stock is “regularly traded,” as defined by applicable Treasury Regulations, on an established securities market, and (b) such non-U.S. stockholder owned, actually and constructively, 10% or less of our common stock at any time during the five-year period ending on the date of the sale. However, it is not anticipated that our common stock will be “regularly traded” on an established market. We encourage you to consult your tax advisor to determine the tax consequences applicable to you if you are a non-U.S. stockholder.
We may be subject to adverse legislative or regulatory tax changes.
At any time, the U.S. federal income tax laws or regulations governing REITs or the administrative interpretations of those laws or regulations may be amended. We cannot predict when or if any new U.S. federal income tax law, regulation or administrative interpretation, or any amendment to any existing U.S. federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation or interpretation may take effect retroactively. We and our stockholders could be adversely affected by any such change in, or any new, U.S. federal income tax law, regulation or administrative interpretation.
Retirement Plan Risks
If the fiduciary of an employee benefit plan subject to ERISA (such as a profit sharing, Section 401(k) or pension plan) or an owner of a retirement arrangement subject to Section 4975 of the Internal Revenue Code (such as an IRA) fails to meet the fiduciary and other standards under ERISA or the Internal Revenue Code as a result of an investment in our stock, the fiduciary could be subject to penalties and other sanctions.
There are special considerations that apply to employee benefit plans subject to ERISA (such as profit sharing, Section 401(k) or pension plans) and other retirement plans or accounts subject to Section 4975 of the Internal Revenue Code (such as an IRA) that are investing in our shares. Fiduciaries and IRA owners investing the assets of such a plan or account in our common stock should satisfy themselves that:
•the investment is consistent with their fiduciary and other obligations under ERISA and the Internal Revenue Code;
•the investment is made in accordance with the documents and instruments governing the plan or IRA, including the plan’s or account’s investment policy;
•the investment satisfies the prudence and diversification requirements of Sections 404(a)(1)(B) and 404(a)(1)(C) of ERISA and other applicable provisions of ERISA and the Internal Revenue Code;
•the investment in our shares, for which no public market currently exists, is consistent with the liquidity needs of the plan or IRA;
•the investment will not produce an unacceptable amount of “unrelated business taxable income” for the plan or IRA;
•our stockholders will be able to comply with the requirements under ERISA and the Internal Revenue Code to value the assets of the plan or IRA annually; and
•the investment will not constitute a prohibited transaction under Section 406 of ERISA or Section 4975 of the Internal Revenue Code.
With respect to the annual valuation requirements described above, we will provide an estimated value for our stock annually. We can make no claim whether such estimated value will satisfy the applicable annual valuation requirements under ERISA and the Internal Revenue Code. The Department of Labor or the Internal Revenue Service may determine that a plan fiduciary or an IRA custodian is required to take further steps to determine the value of our common stock. In the absence of an appropriate determination of value, a plan fiduciary or an IRA custodian may be subject to damages, penalties or other sanctions.
Failure to satisfy the fiduciary standards of conduct and other applicable requirements of ERISA and the Internal Revenue Code may result in the imposition of civil and criminal penalties and could subject the fiduciary to claims for damages or for equitable remedies, including liability for investment losses. In addition, if an investment in our shares constitutes a prohibited transaction under ERISA or the Internal Revenue Code, the fiduciary or IRA owner who authorized or directed the investment may be subject to the imposition of excise taxes with respect to the amount invested. In addition, the investment transaction must be undone. In the case of a prohibited transaction involving an IRA owner, the IRA may be disqualified as a tax-exempt account and all of the assets of the IRA may be deemed distributed and subjected to tax. ERISA plan fiduciaries and IRA owners should consult with counsel before making an investment in our common stock.
If our assets are deemed to be plan assets, our advisor and we may be exposed to liabilities under Title I of ERISA and the Internal Revenue Code.
In some circumstances where an ERISA plan holds an interest in an entity, the assets of the entity are deemed to be ERISA plan assets unless an exception applies. This is known as the “look-through rule.” Under those circumstances, the obligations and other responsibilities of plan sponsors, plan fiduciaries and plan administrators, and of parties in interest and disqualified persons, under Title I of ERISA or Section 4975 of the Internal Revenue Code, may be applicable, and there may be liability under these and other provisions of ERISA and the Internal Revenue Code. We believe that our assets should not be treated as plan assets because the shares should qualify as “publicly-offered securities” that are exempt from the look-through rules under applicable Treasury Regulations. We note, however, that because certain limitations are imposed upon the transferability of shares so that we may qualify as a REIT, and perhaps for other reasons, it is possible that this exemption may not apply. If that is the case, and if we or our advisor are exposed to liability under ERISA or the Internal Revenue Code, our performance and results of operations could be adversely affected. Stockholders should consult with their legal and other advisors concerning the impact of ERISA and the Internal Revenue Code on their investment and our performance.
Risks Related to the Merger
The merger consideration would not be adjusted in the event of any change in the relative values of the common stock of POSOR or us.
Upon the consummation of the Merger, each outstanding share of our common stock will be converted automatically into the right to receive 0.9643 shares of POSOR common stock. The exchange ratio will not be adjusted before or after consummation of the Merger. Except as expressly contemplated in the Merger Agreement, no change in the Merger consideration will be made for any reason, including the following (which may occur prior to consummation of the Merger or any time thereafter):
•changes in the respective businesses, operations, assets, liabilities and prospects of POSOR or us;
•changes in the estimated value per share of either the shares of POSOR common stock or our common stock;
•interest rates, general market and economic conditions, market and economic conditions in specific geographic regions, and other factors generally affecting the businesses of POSOR and us;
•federal, state and local legislation, governmental regulation and legal developments in the businesses in which POSOR and we operate;
•dissident stockholder activity, including any stockholder litigation challenging the transaction; and
•acquisitions, disposals or new development opportunities.
Completion of the Merger is subject to many conditions and if these conditions are not satisfied or waived, the Merger will not be completed, which could result in the expenditure of significant unrecoverable transaction costs.
The Merger Agreement is subject to many conditions, which must be satisfied or waived in order to complete the Merger. The mutual conditions of the parties include, among others, the approval by our stockholders of the Merger and an amendment to our charter. In addition, each party’s obligation to consummate the Merger is subject to certain other conditions, including, among others: (a) the accuracy of the other party’s representations and warranties (subject to customary materiality qualifiers and other customary exceptions); (b) the other party’s compliance with its covenants and agreements contained in the Merger Agreement (subject to customary materiality qualifiers); (c) the absence of any change, event, circumstance or development arising during the period from the date of the Merger Agreement until the effective time of the Merger that has had or would have a material adverse effect on the other party; (d) the receipt of an opinion of counsel of the other party to the effect that such party has been organized and has operated in conformity with the requirements for qualification and taxation as a REIT; and (e) the receipt of an opinion of counsel of each party to the effect that the Merger will qualify as a reorganization within the meaning of Section 368(a) of the Code.
There can be no assurance that the conditions to closing of the Merger will be satisfied or waived or that the Merger will be completed. Failure to consummate the Merger may adversely affect POSOR’s or our results of operations and business prospects for the following reasons, among others: (i) each of POSOR and we have incurred and will continue to incur certain transaction costs, regardless of whether the Merger closes, which could adversely affect each company’s financial condition, results of operations and ability to make distributions to its stockholders; and (ii) the Merger, whether or not it closes, will divert the attention of certain management and other key employees of POSOR and us from ongoing business activities, including the pursuit of other opportunities that could be beneficial to POSOR or us, respectively. In addition, POSOR or we may terminate the Merger Agreement under certain circumstances, including, among other reasons, if the Merger is not completed by the November 19, 2020 (the “Outside Date”).
Failure to complete the Merger could negatively impact our future business and financial results.
If the Merger is not completed, our ongoing business could be materially and adversely affected and we will be subject to a variety of risks associated with the failure to complete the Merger, including the following:
•our being required to pay to POSOR a termination fee of up to $9.28 million and up to $3 million as reimbursement for POSOR’s expenses in the event of termination of the Merger Agreement under certain circumstances;
•our having to pay certain costs relating to the proposed merger, such as legal, accounting, financial advisor, filing, printing and mailing fees; and
•the diversion of our management focus and resources from operational matters and other strategic opportunities while working to implement the Merger.
If the Merger is not completed, these risks could materially affect our business and financial results.
The pendency of the Merger, including as a result of the restrictions on the operation of POSOR’s and our business during the period between signing the Merger Agreement and the completion of the Merger, could adversely affect the business and operations of POSOR, us, or both.
In connection with the pending Merger, some business partners or vendors of each of POSOR and ours may delay or defer decisions, which could negatively impact the revenues, earnings, cash flows and expenses of POSOR and us, regardless of whether the Merger is completed. In addition, due to operating covenants in the Merger Agreement, each of POSOR and we may be unable, during the pendency of the Merger, to pursue certain strategic transactions, undertake certain significant capital projects, undertake certain significant financing transactions and otherwise pursue other actions that are not in the ordinary course of business, even if such actions would prove beneficial.
We are seeking approval of its stockholders of an amendment to our charter, which would remove substantive and procedural protections relating to Roll-Up Transactions such as the Merger.
We are seeking approval of its stockholders of an amendment to our charter. If adopted, this proposal would remove substantive and procedural protections relating to Roll-Up Transactions. A “Roll-up Transaction” is a transaction involving the acquisition, merger, conversion or consolidation, directly or indirectly, of us and the issuance of securities of an entity that is created or would survive after the successful completion of a Roll-up Transaction. The proposed charter amendment would eliminate certain protections that would have applied to the Merger. For example, the our charter provides that prior to conducting a Roll-Up Transaction, we would be required to obtain an appraisal of our assets. In addition, as part of the Roll-Up Transaction, we would be required to provide stockholders certain rights including the right to remain as a stockholder of us and preserve their interests therein on the same terms and conditions as existed previously, or to receive cash in an amount equal to the stockholders pro rata share of our appraised value of the net assets, even if the our board of directors concludes that transaction would be in our best interests. Because the Merger is conditioned on approval of the amendment to our charter, our stockholders will not be entitled to the benefit of these protections in connection with the Merger.
The Merger Agreement prohibits us from soliciting proposals after the Go Shop Period End Time, and places conditions on its ability to negotiate and accept a Superior Proposal, which may adversely affect our stockholders.
In the Merger Agreement, we agreed that, beginning as of 11:59 p.m. April 4, 2020 (the “Go Shop Period End Time”), we will be subject to restrictions relating to, among other things, the initiation, solicitation, knowing encouragement or facilitation of any inquiries, offers, or other actions that constitute or may reasonably be expected to lead to an Acquisition Proposal (as such term is defined under the Merger Agreement). After that date, under certain circumstances, if we receive an Acquisition Proposal from any person that did not result from a breach of its obligations and if our special committee determines that such Acquisition Proposal is or is reasonably expected to lead to a Superior Proposal (as such term is defined under the Merger Agreement), our special committee may take certain actions, including furnishing non-public information with respect to us (subject to compliance with certain matters). We may, upon our board of directors making certain determinations relating to its duties, disclose to our stockholders any information required to be disclosed under applicable law.
Pursuant to the Merger Agreement, our board of directors may also, upon making certain determinations, to make an Adverse Recommendation Change (as such term is defined under the Merger Agreement), terminate the Merger Agreement, pay a termination fee to POSOR and enter into an agreement relating to a Superior Proposal. The limitations, requirements and conditions described above may make it more unlikely that after the Go Shop Period End Time, a proposal relating to an alternative business combination transaction would emerge for us and may make it more difficult and expensive for us to accept a proposal relating to an alternative business combination transaction that the our special committee determines to be superior to the Merger.
The Merger Agreement contains provisions that could discourage a potential competing acquirer of us or could result in a competing Acquisition Proposal being at a lower price than it might otherwise be.
Except for a 45-day go shop period that expires at the Go Shop Period End Time, the Merger Agreement contains provisions that, subject to limited exceptions, restrict our ability to solicit, initiate or knowingly facilitate or encourage any Acquisition Proposal. With respect to any written, bona fide Acquisition Proposal that we receive, POSOR generally has an opportunity to offer to modify the terms of the Merger Agreement in response to such proposal before our board of directors may change, withdraw, or modify its recommendation to stockholders in response to such Acquisition Proposal or terminate the Merger Agreement to enter into an agreement with respect to such Acquisition Proposal. Upon termination of the Merger Agreement under certain circumstances relating to an Acquisition Proposal, we would have to pay POSOR a termination fee of $9.28 million in connection with a transaction initiated after the go shop process and, in addition, up to $3 million as reimbursement for POSOR’s expenses.
These provisions could discourage a potential competing acquirer that might have an interest in acquiring all or a significant part of our business from considering or making a competing Acquisition Proposal, even if the potential competing acquirer was prepared to pay consideration with a higher per share cash value than that market value proposed to be received or realized in the Merger, or might cause a potential competing acquirer to propose to pay a lower price than it might otherwise have proposed to pay because of the added expense of the termination fee that may become payable in certain circumstances under the Merger Agreement.
Some of the directors and executive officers of POSOR I and POSOR II have interests in seeing the Merger completed that are different from, or in addition to, those of the POSOR I and POSOR II stockholders.
Some of the directors and executive officers of POSOR I and POSOR II have interests in seeing the Merger completed that are different from, or in addition to, those of the POSOR I and POSOR II stockholders. Specifically, Keith D. Hall and Peter McMillan III control and indirectly own Pacific Oak Holding Group, LLC, our sponsor and POSOR I’s sponsor since November 1, 2019. Pacific Oak Holding is the sole owner of Pacific Oak Capital Advisors, LLC, our advisor and POSOR I’s advisor since November 1, 2019. Messrs. Hall and McMillan are also two of our executive officers and directors and two of POSOR I’s executive officers and directors. Pacific Oak Capital Advisors earns fees from our advisory agreement with them and from POSOR II’s advisory agreement with them. The Merger may make it more likely that Pacific Oak Capital Advisors will continue to earn fees under the advisory agreement with respect to our and POSOR II’s assets, as compared to other strategic alternatives for us or POSOR I (such as a sale of our assets to a third party for cash).
In certain circumstances, either of POSOR or we may terminate the Merger Agreement.
POSOR or we may terminate the Merger Agreement if the Merger has not been consummated by the Outside Date. Also, the Merger Agreement may be terminated if a final and non-appealable order is entered prohibiting or disapproving the transaction, upon a material uncured breach by the other party that would cause the closing conditions not to be satisfied, or upon the failure to obtain receipt of approvals of the our stockholders. In addition, we have the right to terminate the Merger Agreement at any time prior to obtaining the necessary approvals of the our stockholders in order to enter into an Alternative Acquisition Agreement (as such term is defined under the Merger Agreement) with respect to a Superior Proposal. Finally, POSOR has the right to terminate the Merger Agreement at any time prior to obtaining the approvals of the our stockholders, upon an Adverse Recommendation Change (as such term is defined under the Merger Agreement) or upon the commencement of a tender offer.
POSOR and we each expect to incur substantial expenses related to the Merger.
POSOR and we each expect to incur substantial expenses in connection with completing the Merger and integrating our properties and operations with those of POSOR. While POSOR and we each have assumed that a certain level of transaction expenses would be incurred, there are a number of factors beyond the control of each company that could affect the total amount or the timing of such expenses. Many of the expenses that will be incurred, by their nature, are difficult to estimate accurately at the present time. As a result, the transaction expenses associated with the Merger could, particularly in the near term, exceed the savings that POSOR expects to achieve from the elimination of duplicative expenses and the realization of economies of scale and cost savings following the completion of the Merger.
The ownership positions of POSOR and our stockholders will be diluted by the Merger.
The Merger will dilute the ownership position of POSOR stockholders and result in our stockholders having an ownership stake in the combined company (“Combined Company”) that is smaller than their current stake in us. Upon completion of the Merger, based on the number of shares of POSOR common stock and our common stock outstanding on March 23, 2020, continuing POSOR stockholders will own approximately 69.4% of the issued and outstanding shares of Combined Company common stock, and our stockholders will own approximately 30.6% of the issued and outstanding shares of common stock of the Combined Company. Consequently, POSOR stockholders and our stockholders, as a general matter, will have less influence over the management and policies of the Combined Company following the Merger than each currently exercise over the management and policies of POSOR and us, as applicable.
Litigation challenging the Merger may increase transaction costs and prevent the Merger from becoming effective or from becoming effective within the expected timeframe.
If any stockholder files a lawsuit challenging the Merger, POSOR and we can provide no assurances as to the outcome of any such lawsuit, including the costs associated with defending these claims or any other liabilities that may be incurred in connection with the litigation or settlement of these claims. If plaintiffs are successful in obtaining an injunction prohibiting the parties from completing the Merger on the agreed-upon terms, such an injunction may prevent the completion of the Merger in the expected time frame, or may prevent it from being completed altogether. Whether or not any such plaintiffs’ claims are successful, this type of litigation is often expensive and diverts management’s attention and resources, which could adversely affect the operations of each company’s business.
Risks Related to the Combined Company Following the Merger
The Combined Company will have substantial indebtedness upon completion of the Merger.
In connection with the Merger, the Combined Company will assume and/or refinance certain indebtedness of ours and will be subject to risks associated with debt financing. As of December 31, 2019, POSOR had $678.1 million of outstanding debt, comprised of $385.4 million of variable interest and $292.7 million of fixed interest loans. After giving effect to the Merger, the Combined Company’s total pro forma consolidated indebtedness will increase. Taking into account our existing indebtedness, transaction expenses, and the assumption and/or refinancing of indebtedness in the Merger, the Combined Company’s pro forma consolidated indebtedness as of December 31, 2019, after giving effect to the Merger, would be approximately $1.0 billion. The indebtedness of the Combined Company will be comprised of $715.0 million of variable interest loans and $292.7 million of fixed interest loans.
The Combined Company’s indebtedness could have important consequences to holders of its common stock, including our stockholders who receive POSOR common stock in the Merger, including:
•vulnerability of the Combined Company to general adverse economic and industry conditions;
•limiting the Combined Company’s ability to obtain additional financing to fund future working capital, capital expenditures and other general corporate requirements;
•requiring the use of a substantial portion of the Combined Company’s cash flow from operations for the payment of principal and interest on its indebtedness, thereby reducing its ability to use its cash flow to fund working capital, acquisitions, capital expenditures and general corporate requirements;
•limiting the Combined Company’s flexibility in planning for, or reacting to, changes in its business and its industry; and
•putting the Combined Company at a disadvantage compared to its competitors with less indebtedness;
If the Combined Company defaults under a mortgage loan, it would automatically be in default under any other loan that has cross-default provisions, and it may lose the properties securing these loans.
Following the consummation of the Merger, our stockholders will receive a lower dollar amount per share in monthly distributions if the Combined Company continues to pay distributions at POSOR’s current rate.
POSOR’s distributions are currently equivalent to a 0.00258% annualized distribution rate based on a purchase price of $10.00 per share, or $0.0258 per share annually. Our distributions are currently equivalent to a 0.0112% annualized distribution rate based on $10.00 per share, or $0.112 per share annually. Based on the merger consideration of 0.9643 shares of POSOR common stock for each share of our common stock, annual distributions post-merger are expected to be approximately $0.0258 per share at the current POSOR distribution rate. There is no guarantee that the Combined Company will continue to pay distributions at this rate, if at all, and all decisions regarding future distributions will remain entirely at the discretion of the Combined Company’s board of directors.
Stockholders of the Combined Company will have no contractual or other legal right to distributions that have not been authorized by the Combined Company’s board of directors and declared by the Combined Company.
The Combined Company may incur adverse tax consequences if prior to the Merger, POSOR or we failed to qualify as a REIT for U.S. federal income tax purposes.
Each of POSOR and we have operated in a manner that it believes has allowed it to qualify as a REIT for U.S. federal income tax purposes under the Code and intends to continue to do so through the time of the Merger, and the Combined Company intends to continue operating in such a manner following the Merger. None of POSOR or we have requested or plans to request a ruling from the Internal Revenue Service, or the IRS, that it qualifies as a REIT. Qualification as a REIT involves the application of highly technical and complex Code provisions for which there are only limited judicial and administrative interpretations. The complexity of these provisions and of the applicable Treasury Regulations is greater in the case of a REIT, like each of POSOR and us, that holds its assets through a partnership. The determination of various factual matters and circumstances not entirely within the control of POSOR or us may affect its ability to qualify as a REIT. In order to qualify as a REIT, each of POSOR and we must satisfy a number of requirements, including requirements regarding the ownership of its stock and the composition of its gross income and assets. Also, a REIT must make distributions to stockholders aggregating annually at least 90% of its REIT taxable income, excluding any net capital gains.
If POSOR or our company (or, following the Merger, the Combined Company) loses its REIT status, or is determined to have lost its REIT status in a prior year, it will face serious tax consequences that would substantially reduce its cash available for distribution, including cash available to pay dividends to its stockholders, because:
•it would be subject to U.S. federal corporate income tax on its net income for the years it did not qualify for taxation as a REIT (and, for such years, would not be allowed a deduction for dividends paid to stockholders in computing its taxable income);
•it could be subject to the federal alternative minimum tax for taxable years prior to January 1, 2018 and possibly increased state and local taxes for such periods;
•unless it is entitled to relief under applicable statutory provisions, neither it nor any “successor” company could elect to be taxed as a REIT until the fifth taxable year following the year during which it was disqualified; and
•for five years following re-election of REIT status, upon a taxable disposition of an asset owned as of such re-election, it could be subject to corporate level tax with respect to any built-in gain inherent in such asset at the time of re-election.
As a result of all these factors, any of POSOR, our or the Combined Company’s failure to qualify as a REIT could impair the Combined Company’s ability to expand its business and have other material adverse effects on the Combined Company. In addition, for years in which the Combined Company does not qualify as a REIT, it would not otherwise be required to make distributions to stockholders.
In certain circumstances, even if the Combined Company qualifies as a REIT, it and its subsidiaries may be subject to certain U.S. federal, state, and other taxes, which would reduce the Combined Company’s cash available for distribution to its stockholders.
Even if the Combined Company has qualified and continues to qualify as a REIT, it may be subject to some U.S. federal, state and local taxes on its income or property and, in certain cases, a 100% penalty tax, in the event it sells property as a dealer. Any U.S. federal, state or other taxes the Combined Company pays will reduce its cash available for distribution to stockholders.
If the Merger does not qualify as a tax-free reorganization, there may be adverse tax consequences.
The Merger is intended to qualify as a tax-free reorganization within the meaning of Section 368(a) of the Code. The closing of the Merger is conditioned on the receipt by each of POSOR and us of an opinion of its counsel to the effect that the Merger will qualify as a tax-free reorganization within the meaning of Section 368(a) of the Code. However, these legal opinions will not be binding on the IRS or on the courts. If, for any reason, the Merger were to fail to qualify as a tax-free reorganization, then each of our stockholders generally would recognize gain or loss, as applicable, equal to the difference between (i) the merger consideration (i.e. the fair market value of the shares of POSOR common stock) received by our stockholders in the Merger; and (ii) our stockholder’s adjusted tax basis in our common stock.
The Combined Company may have difficulty providing liquidity to stockholders through its share redemption program and/or tender offers.
The Merger is not a liquidity event for our stockholders or those of POSOR I. Both we and POSOR have had recent difficulty in satisfying redemption requests under our respective share redemption programs. In January 2019, we exhausted funds available for redemptions under our share redemption program, other than special redemption requests submitted in connection with a stockholder’s death, “qualifying disability” or “determination of incompetence.” As a result, in 2019, we redeemed a total of 277,452 shares in connection with ordinary redemption requests. In January 2020, we again exhausted funds available for redemptions other than special redemptions. We currently have outstanding and unfulfilled ordinary redemption requests representing 808,172 shares. With respect to POSOR, other than special redemption requests, for the first, second, third and fourth quarters of 2019, it had unfulfilled requests to redeem 3,294,070, 3,782,675, 4,595,566 and 5,813,699 shares, respectively, or 94.2%, 94.9%, 95.7% and 96.8%, respectively, of the shares submitted for redemption, due to funding limitations. It currently has $0.8 million available for redemptions in 2020, all of which is reserved exclusively for special redemptions.
We cannot predict the demand for liquidity by stockholders of the Combined Company following the Merger, but if it simply remains at 2019 and 2020 levels, the Combined Company will need to provide additional funding compared to prior years in order to meet demand. We may not have sufficient funding to satisfy the demand for liquidity. The Combined Company’s primary source for funding is currently expected to be a portion of the net proceeds from new ongoing public offerings as an NAV REIT and potential Israeli offerings, but we cannot guarantee that the net proceeds raised will be sufficient to satisfy the demand for liquidity and our other capital needs, such as capital expenditures and funds for new investments. If future redemption requests exceed the amount of funding available under the Combined Company’s share redemption program and any additional funding made available under one or more self-tender offers, the number of rejected redemption or repurchase requests will increase over time.
ITEM 1B. UNRESOLVED STAFF COMMENTS
We have no unresolved staff comments.
ITEM 2. PROPERTIES
As of December 31, 2019, we owned two hotel properties, three office properties and one apartment property. Additionally, as of December 31, 2019, we had entered into a consolidated joint venture to develop one office/retail property.
Hotel Properties
The following table provides summary information regarding our hotel properties as of December 31, 2019:
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Property
Location of Property | | Date Acquired | | Number of Rooms | | Occupancy | | Average Daily Rate | | Average Revenue per Available Room | | Ownership % |
Springmaid Beach Resort
Myrtle Beach, SC | | 12/30/2014 | | 453 | | | 65.0 | % | | $ | 138.06 | | | $ | 89.80 | | | 90.0% | |
Q&C Hotel
New Orleans, LA | | 12/17/2015 | | 196 | | | 73.3 | % | | $ | 165.37 | | | $ | 121.13 | | | 90.0% | |
TRS Leases
Our hotels are leased by the respective joint venture owners of each hotel (the “Hotel Owner Joint Venture”) to a second joint venture (the “Hotel Operations Joint Venture”) we have formed between each hotel’s respective joint venture partner and an indirect wholly owned subsidiary we have formed with respect to each hotel that we have elected to treat as a TRS.
Each lease agreement provides for a five-year term with the right for the respective Hotel Operations Joint Venture to extend the term of the lease for up to three additional terms of three years each; provided, however, that the Hotel Owner Joint Venture has the right to terminate the lease upon the sale of the hotel or any members of the Hotel Owner Joint Venture buying out any other member, as well as upon the occurrence of an event of default under the respective lease agreement.
Pursuant to the lease agreements, the Hotel Operations Joint Venture will pay to the Hotel Owner Joint Venture, on a monthly basis, an annual base rent. The annual base rent will be adjusted as set forth in the lease agreements beginning in 2016 as well as prorated for any partial years. For the Springmaid Beach Resort, the annual base rent was $3.1 million for 2019 and is $3.2 million for 2020. For the Q&C Hotel the annual base rent was $3.5 million for 2019 and is $3.6 million for 2020.
In addition to annual base rent, each respective Hotel Operations Joint Venture will pay a monthly percentage rent to the respective Hotel Owner Joint Venture equal to (i) an agreed percentage of year-to-date gross revenue that exceeds certain annual threshold amounts, less (ii) all prior percentage rent payments. Each respective Hotel Operations Joint Venture is also required to establish and fund a repairs and replacement reserve for the periodic refurbishment, replacements and non-routine repairs of all tangible personal property owned by the respective Hotel Owner Joint Venture. For each lease, the reserve is a percentage of gross receipts as set forth in the lease agreement. For Springmaid Beach Resort, this percentage ranges from 1% to 4%. For Q&C Hotel, this percentage ranges from 2% to 5%. In addition, the lease agreements require each Hotel Operations Joint Venture to pay all income taxes, rent, and all costs and expenses and utility and other charges incurred in the operations of the respective hotel.
Management Agreements
For us to qualify as a REIT, we cannot directly or indirectly operate any of our hotels. Third parties must operate our hotels. As described above, our hotels are leased to TRS lessees, which in turn have engaged property managers to manage our hotels pursuant to a hotel management agreement.
Springmaid Beach Resort
The Springmaid Hotel Operations Joint Venture has entered a management agreement with Doubletree Management LLC, an independent third-party hotel operator (“Doubletree”) pursuant to which Doubletree will manage and operate the Springmaid Beach Resort. The hotel was branded a DoubleTree by Hilton in September 2016 (the “Brand Commencement Date”).
The management agreement requires us to maintain a minimum working capital reserve for the Springmaid Beach Resort. In addition, the Springmaid Hotel Owner Joint Venture is responsible for providing funds to meet the cash needs for the hotel operations if at any time the funds available from hotel operations are insufficient to meet the financial requirements of the hotel. The management agreement expires on December 31 of the 20th full year following the Brand Commencement Date. Upon mutual agreement, the parties may extend the term of the agreement for two successive periods of five years each. If an event of default occurs and continues beyond any applicable notice and cure periods set forth in the management agreement, the non-defaulting party generally has, among other remedies, the option of terminating the management agreement upon written notice to the defaulting party with no termination fee payable to Doubletree. In addition, we have the right to terminate the management agreement without the payment of a termination fee if Doubletree fails to achieve certain criteria relating to the performance of the hotel for any two consecutive years following the Brand Commencement Date. Under certain circumstances following a casualty or condemnation event, either party may terminate the management agreement provided Doubletree receives a termination fee an amount equal to two years of the base fee. We are permitted to terminate the management agreement upon a sale, lease or other transfer of the Springmaid Beach Resort any time so long as the buyer is approved for, and enters into a DoubleTree by Hilton franchise agreement for the balance of the agreement’s term. Finally, we are restricted in our ability to assign the management agreement upon a sale, lease or other transfer the Springmaid Beach Resort unless the transferee is approved by Doubletree to assume the management agreement.
Pursuant to the management agreement Doubletree receives the following fees:
•a base fee, which is a percentage of total operating revenue that starts at 2.5% and increases to 2.75% in the second year following the Brand Commencement Date and further increases in the third year following the Brand Commencement Date and thereafter to 3.0%;
•a campground area management fee, which is 2% of any campground revenue;
•an incentive fee, which is 15% of operating cash flow (after deduction for capital renewals reserve and the Springmaid Hotel Owner Joint Venture’s priority, which is 12% of the Springmaid Hotel Owner Joint Venture’s total investment);
•an additional services fee in the amount reasonably determined by Doubletree from time to time; and
•a brand services fee in the amount of 4% of total rooms revenue, and an other brand services fee in an amount determined by Doubletree from time to time.
Q&C Hotel
A wholly owned subsidiary of the Q&C Hotel Operations Joint Venture (“Q&C Hotel Operations”) has entered a management agreement with Encore Hospitality, LLC (“Encore Hospitality”), an affiliate of the Q&C JV Partner, pursuant to which Encore Hospitality will manage and operate the Q&C Hotel. The management agreement expires on December 17, 2035. Subject to certain conditions, Encore Hospitality may extend the term of the agreement for a period of five years. Q&C Hotel Operations may terminate the management agreement upon (1) the occurrence of an event of default that continues beyond any applicable notice and cure periods, (2) a sale of the Q&C Hotel, (3) a change of control of Encore Hospitality without Q&C Hotel Operations’ approval, (4) a failure of Encore Hospitality to meet certain performance thresholds, (5) a sale of the Q&C Joint Venture Partner’s interest in the joint venture to us, and (6) if Q&C Hotel Operations is required to do so pursuant to the terms of the loan documents or the franchise agreement. Pursuant to the management agreement Encore Hospitality will receive a base fee, which is 4.0% of gross revenue (as defined in the management agreement).
Q&C Hotel Operations has also entered a franchise agreement with Marriott International (“Marriott”) pursuant to which Marriott has granted Q&C Hotel Operations a limited, non-exclusive license to establish and operate the Q&C Hotel using certain of Marriott’s proprietary marks and systems and the hotel was branded as a Marriott Autograph Collection hotel on May 25, 2016. The franchise agreement will expire on May 25, 2041 with no renewal options. Marriott may terminate the franchise agreement immediately upon certain defaults and after an opportunity to cure with respect to certain other defaults. Pursuant to the franchise agreement, commencing on May 25, 2016, Q&C Hotel Operations will pay Marriott a monthly franchise fee equal to a percent of gross room sales on a sliding scale that is initially 2% and increases to 5% after the third anniversary of the opening date and a monthly marketing fund contribution fee equal to 1.5% of the Q&C Hotel’s gross room sales. In addition, the franchise agreement requires the maintenance of a reserve account to fund all renovations at the hotel based on a percentage of gross revenues which starts at 2% of gross revenues and increases to 5% of gross revenues after May 25, 2019. Q&C Hotel Operations will also be responsible for the payment of certain other fees, charges and costs as set forth in the agreement.
In addition, in connection with the execution of the franchise agreement, Pacific Oak SOR US Properties II LLC (“SOR US Properties II”), our indirect wholly owned subsidiary, is providing an unconditional guarantee that all Q&C Hotel Operations’ obligations under the franchise agreement will be punctually paid and performed. Finally, certain transfers of the Q&C Hotel or an ownership interest therein are subject to a notice and consent requirement, and the franchise agreement further provides Marriott with a right of first refusal with respect to a sale of the hotel to a competitor of Marriott.
Office Properties
The following table provides summary information regarding our office properties as of December 31, 2019:
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Property
Location of Property | | Date Acquired | | Property Type | | Rentable Square Feet | | Total Real Estate at Cost
(in thousands) | | Occupancy | | Annualized Base Rent (1) (in thousands) | | Average Annualized Base Rent per Square Foot (2) | | Average Remaining Lease Term in Years | | Ownership % |
Lincoln Court
Campbell, CA | | 05/20/2016 | | Office | | 123,529 | | | $ | 52,810 | | | 81.0% | | | $ | 5,291 | | | $ | 52.87 | | | 2.7 | | | 100.0% | |
Oakland City Center
Oakland, CA | | 08/18/2017 | | Office | | 368,595 | | | 174,748 | | | 82.2% | | | 13,529 | | | 44.68 | | | 3.2 | | | 100.0% | |
Madison Square
Phoenix, AZ | | 10/03/2017 | | Office | | 313,991 | | | 35,350 | | | 47.1% | | | 3,182 | | | 21.50 | | | 5.0 | | | 90.0% | |
| | | | | | 806,115 | | | $ | 262,908 | | | 68.3% | | | $ | 22,002 | | | $ | 39.94 | | | 3.3 | | | |
_____________________
(1) Annualized base rent represents annualized contractual base rental income as of December 31, 2019, adjusted to straight-line any contractual tenant concessions (including free rent), rent increases and rent decreases from the lease’s inception through the balance of the lease term.
(2) Average annualized base rent per square foot is calculated as the annualized base rent divided by the leased square feet.
As of December 31, 2019, there were no tenants occupying 10% or more of our total rentable square footage. As of December 31, 2019, our real estate portfolio’s highest tenant industry concentrations (greater than 10% of annualized base rent) were as follows:
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| Industry | | Number of Tenants | | Annualized Base Rent (1) (in thousands) | | Percentage of
Annualized Base Rent |
| Legal Services | | 13 | | | $ | 4,547 | | | 20.7 | % |
| Public Administration | | 6 | | | 3,589 | | | 16.3 | % |
| Professional, Scientific, and Technical Services | | 12 | | | 3,123 | | | 14.2 | % |
| | | | | | |
| | | | $ | 11,259 | | | 51.2 | % |
_____________________
(1) Annualized base rent represents annualized contractual base rental income as of December 31, 2019, adjusted to straight-line any contractual tenant concessions (including free rent), rent increases and rent decreases from the lease’s inception through the balance of the lease term.
Portfolio Lease Expiration
The following table reflects lease expirations of our office properties as of December 31, 2019:
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| Year of Expiration | | Number of Leases
Expiring | | Annualized Base Rent (in thousands) (1) | | % of Portfolio Annualized Base Rent
Expiring | | Leased Rentable Square Feet
Expiring | | % of Portfolio Rentable Square Feet
Expiring |
| | | | | | | | | | |
| 2020 | | 18 | | | $ | 3,987 | | | 18.1 | % | | 103,568 | | | 18.9 | % |
| 2021 | | 15 | | | 3,603 | | | 16.4 | % | | 79,692 | | | 14.5 | % |
| 2022 | | 19 | | | 3,899 | | | 17.7 | % | | 92,529 | | | 16.9 | % |
| 2023 | | 15 | | | 3,141 | | | 14.3 | % | | 60,407 | | | 11.0 | % |
| 2024 | | 7 | | | 1,435 | | | 6.5 | % | | 31,623 | | | 5.8 | % |
| 2025 | | 15 | | | 4,522 | | | 20.6 | % | | 138,086 | | | 25.2 | % |
| 2026 | | 5 | | | 910 | | | 4.1 | % | | 32,502 | | | 5.9 | % |
| 2027 | | 2 | | | 267 | | | 1.2 | % | | 5,145 | | | 0.9 | % |
| 2028 | | 2 | | | 238 | | | 1.1 | % | | 5,170 | | | 0.9 | % |
| | | | | | | | | | |
| | | | | | | | | | |
| Total | | 98 | | | $ | 22,002 | | | 100 | % | | 548,722 | | | 100 | % |
_____________________
(1) Annualized base rent represents annualized contractual base rental income as of December 31, 2019, adjusted to straight-line any contractual tenant concessions (including free rent), rent increases and rent decreases from the lease’s inception through the balance of the lease term.
Apartment Property
The following table provides summary information regarding our apartment property as of December 31, 2019:
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Property
Location of Property | | Date Acquired | | Property Type | | Number of Units | | Monthly Rent (1) | | Occupancy (2) | | Average Monthly Rent per Leased Unit (3) | | Ownership % |
Lofts at NoHo Commons
North Hollywood, CA | | 11/16/2016 | | Apartment | | 292 | | | $ | 692,000 | | | 93.5 | % | | $ | 2,535 | | | 90.0% | |
_____________________
(1) Monthly rent is based on the aggregate contractual rent from tenant leases in effect as of December 31, 2019, adjusted to reflect any contractual tenant concessions.
(2) Occupancy percentage is calculated as the number of occupied units divided by the total number of units of the property as of December 31, 2019.
(3) Average monthly rent per leased unit is calculated as the aggregate contractual rent from leases in effect as of December 31, 2019, adjusted to reflect any
contractual tenant concessions, divided by the number of leased units.
Development Property
On December 1, 2016, we, through a joint venture (the “210 West 31st Street Joint Venture”), acquired a leasehold interest to develop one office/retail property in 210 West 31st Street, New York, New York (“210 West 31st Street”). The leasehold interest for 210 West 31st Street expires January 31, 2114. We own an 80% equity interest in the 210 West 31st Street Joint Venture.
210 West 31st Street is located in New York, New York and consists of an 8,637 square foot development site located directly across the street from Madison Square Garden and Penn Station. As of December 31, 2019, the book value of our construction project was $55.2 million.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we are party to legal proceedings that arise in the ordinary course of our business. Management is not aware of 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 government agencies.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Stockholder Information
As of March 23, 2020, we had 17,842,301 and 12,222,529 shares of Class A and Class T common stock, respectively, outstanding held by a total of approximately 3,200 and 2,600 stockholders, respectively. The number of stockholders is based on the records of DST Systems, Inc., who serves as our transfer agent.
Market Information
No public market currently exists for our shares of common stock, and we currently have no plans to list our shares on a national securities exchange. Until our shares are listed, if ever, our stockholders may not sell their shares unless the buyer meets applicable suitability and minimum purchase requirements. In addition, our charter prohibits the ownership of more than 9.8% of our stock, unless exempted by our board of directors. Consequently, there is the risk that our stockholders may not be able to sell their shares at a time or price acceptable to them.
We provide an estimated value per share to assist broker-dealers that participate in our initial public offering in meeting their customer account statement reporting obligations under National Association of Securities Dealers Conduct Rule 2340 as required by the Financial Industry Regulatory Authority (“FINRA”). This valuation was performed in accordance with the provisions of and also to comply with Practice Guideline 2013-01, Valuations of Publicly Registered, Non-Listed REITs issued by the Institute for Portfolio Alternatives (formerly known as the Investment Program Association) (“IPA”) in April 2013 (the “IPA Valuation Guidelines”). For this purpose, we estimated the value of the shares of our common stock as $10.25 per share as of December 31, 2019. This estimated value per share is based on our board of directors’ approval on December 17, 2019 of an estimated value per share of our common stock of $10.25 based on the estimated value of our assets less the estimated value of our liabilities, or NAV, divided by the number of shares outstanding, all as of September 30, 2019, with the exception of the following adjustments: (i) our consolidated investments in real estate properties were valued as of October 31, 2019; (ii) an adjustment to reduce cash for the amount of capital expenditures incurred in October 2019; (iii) an adjustment for disposition costs and fees incurred in connection with the disposition of 2200 Paseo Verde (collectively the "Adjustments"). Other than the Adjustments, there were no material changes between September 30, 2019 and December 17, 2019 that impacted the overall estimated NAV per share.
Our conflicts committee, composed solely of all of our independent directors, is responsible for the oversight of the valuation process used to determine the estimated NAV per share of our common stock, including the review and approval of the valuation and appraisal processes and methodologies used to determine our estimated NAV per share, the consistency of the valuation and appraisal methodologies with real estate industry standards and practices and the reasonableness of the assumptions used in the valuations and appraisals. The estimated NAV per share was based upon the recommendation and valuation prepared by our advisor. Our advisor's valuation of our consolidated investments in real estate properties was based on (i) appraisals of all but one property (“Appraised Properties”) performed by the independent third-party real estate valuation firm Duff & Phelps, LLC (“Duff & Phelps”) and (ii) the contractual sale price less estimated selling credits for an office property located in Henderson, Nevada (2200 Paseo Verde) which was sold on November 4, 2019. Duff & Phelps prepared appraisal reports, summarizing key inputs and assumptions for each of the Appraised Properties. Our advisor performed valuations of our cash, restricted cash, investment in real estate equity securities, investment in an unconsolidated entity, other assets, mortgage debt and other liabilities. The methodologies and assumptions used to determine the estimated value of our assets and the estimated value of our liabilities are described further below.
Our advisor used the appraised values of the Appraised Properties and in the case of 2200 Paseo Verde, the contractual sales price less estimated selling credits, together with its estimated value of each of our other assets and liabilities to calculate and recommend an estimated NAV per share of our common stock. Based on (i) the conflicts committee’s receipt and review of our advisor's valuation report, including our advisor's summary of the appraisal reports prepared by Duff & Phelps and our advisor's estimated value of each of our other assets and liabilities, (ii) the conflicts committee’s review of the reasonableness of our estimated NAV per share resulting from our advisor’s valuation process, and (iii) other factors considered by the conflicts committee and the conflicts committee’s own extensive knowledge of our assets and liabilities, the conflicts committee concluded that the estimated NAV per share proposed by our advisor was reasonable and recommended to our board of directors that it adopt $10.25 as the estimated NAV per share of our common stock. The board of directors unanimously agreed to accept the recommendation of the conflicts committee and approved $10.25 as the estimated NAV per share of our common stock, which determination is ultimately and solely the responsibility of the board of directors.
The table below sets forth the calculation of our estimated NAV per share as of December 17, 2019, as well as the calculation of our estimated NAV per share as of December 6, 2018. Duff & Phelps is not responsible for the determination of the estimated NAV per share as of December 17, 2019 or December 6, 2018.
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| | December 17, 2019
Estimated NAV per Share | | | December 6, 2018 Estimated NAV per Share (1) | | Change in Estimated
NAV per Share | |
Real estate properties (2) | | $ | 21.76 | | | $ | 20.54 | | | $ | 1.22 | |
Real estate equity securities (3) | | 0.33 | | | 0.23 | | | 0.10 | |
| Investment in unconsolidated entity | | 0.02 | | | 0.17 | | | (0.15) | |
| Cash | | 0.95 | | | 0.90 | | | 0.05 | |
| Other assets | | 0.35 | | | 0.42 | | | (0.07) | |
Mortgage debt (4) | | (11.65) | | | (11.02) | | | (0.63) | |
| Other liabilities | | (0.42) | | | (0.41) | | | (0.01) | |
| Non-controlling interests | | (1.09) | | | (1.18) | | | 0.09 | |
| Estimated NAV per share | | $ | 10.25 | | | $ | 9.65 | | | $ | 0.60 | |
| Estimated enterprise value premium | | None assumed | | None assumed | | None assumed |
| Total estimated NAV per share | | $ | 10.25 | | | $ | 9.65 | | | $ | 0.60 | |
_____________________
(1) The December 6, 2018 estimated value per share was based upon the recommendation and valuation of our former external advisor, KBS Capital Advisors LLC ("KBS Capital Advisors"). We engaged Duff & Phelps to provide appraisals of our consolidated investments in real properties and KBS Capital Advisors performed valuations of our cash, restricted cash, investment in an unconsolidated entity, other assets, mortgage debt and other liabilities. For more information relating to the December 6, 2018 estimated NAV per share and the assumptions and methodologies used by Duff & Phelps and KBS Capital Advisors, see ou Current Report on Form 8-K filed with the SEC on December 11, 2018.
(2) The increase in the estimated value of real estate properties was due to increases in fair values of our real estate properties.
(3) The increase in the estimated value of real estate equity securities was due to acquisitions of real estate equity securities as well as unrealized gains on the securities.
(4) The increase in mortgage debt was primarily due to borrowings for future capital needs and to fund capital expenditures on real estate.
The increase in our estimated NAV per share from the previous estimate was primarily due to the items noted below, which reflect the significant contributors to the increase in the estimated NAV per share from $9.65 to $10.25. The changes are not equal to the change in values of each real each asset and liability group presented in the table above due to real estate property acquisitions, debt financings and other factors, which caused the value of certain asset or liability groups to change with no impact to our fair value of equity or the overall estimated NAV per share.
| | | | | | | | |
| | Change in Estimated NAV per Share |
| December 6, 2018 estimated NAV per share (after stock distributions) | | $ | 9.65 | |
| Changes to estimated NAV per share | | |
| Investments | | |
| Real estate | | 1.47 | |
| Investment in unconsolidated entity | | 0.02 | |
| Investment in equity securities | | 0.03 | |
| Capital expenditures on real estate | | (0.61) | |
| Total change related to investments | | 0.91 | |
Operating cash flow shortfall compared to distributions declared (1) | | (0.14) | |
Selling and financing costs (2) | | (0.11) | |
Advisor disposition fees (3) | | (0.01) | |
| Notes payable | | 0.04 | |
| Other changes | | 0.01 | |
| Total change in estimated NAV per share | | 0.70 | |
| Stock distributions | | (0.10) | |
| December 17, 2019 estimated NAV per share | | $ | 10.25 | |
_____________________
(1) Operating cash flow reflects modified funds from operations (“MFFO”) adjusted to (i) deduct certain capitalized interest expense related to a development project, (ii) add back the amortization of deferred financing costs and (iii) deduct income from business interruption insurance recoveries. We compute MFFO in accordance with the definition included in the practice guideline issued by IPA in November 2010.
(2) Selling and financing costs include approximately, $0.7 million, or $0.02 per share, for the selling costs incurred subsequent to September 30, 2019 in connection with the 2200 Paseo Verde sale subsequent to September 30, 2019.
(3) Advisor fees include approximately, $0.3 million, or $0.01 per share, for the disposition of 2200 Paseo Verde, subsequent to September 30, 2019.
As with any valuation methodology, the methodologies used are based upon a number of estimates and assumptions that may not be accurate or complete. Different parties using different assumptions and estimates could derive a different estimated NAV per share of our common stock, and this difference could be significant. The estimated NAV per share is not audited and does not represent the fair value of our assets less the fair value of our liabilities according to U.S. generally accepted accounting principles (“GAAP”), nor does it represent a liquidation value of our assets and liabilities or the price at which our shares of common stock would trade on a national securities exchange. The estimated NAV per share does not reflect a discount for the fact that we are externally managed, nor does it reflect a real estate portfolio premium/discount versus the sum of the individual property values. The estimated NAV per share also does not take into account estimated disposition costs and fees for real estate properties or debt prepayment penalties that could apply upon the prepayment of certain of our debt obligations, the impact of restrictions on the assumption of debt or swap breakage fees that may be incurred upon the termination of certain of our swaps prior to expiration. The estimated NAV per share does not take into consideration acquisition-related costs and financing costs related to future acquisitions. As of September 30, 2019, we had no potentially dilutive securities outstanding that would impact the estimated NAV per share of our common stock.
Our estimated NAV per share takes into consideration any potential liability related to a subordinated participation in cash flows our advisor is entitled to upon meeting certain stockholder return thresholds in accordance with our advisory agreement. For purposes of determining the estimated NAV per share, our advisor calculated the potential liability related to this incentive fee based on a hypothetical liquidation of our assets and liabilities at their estimated fair values, after considering the impact of any potential closing costs and fees related to the disposition of real estate properties, and determined that there would be no liability related to the subordinated participation in cash flows.
Methodology
Our goal for the valuation was to arrive at a reasonable and supportable estimated NAV per share, using a process that was designed to be in compliance with the IPA Valuation Guidelines and using what we and our advisor deemed to be appropriate valuation methodologies and assumptions. The following is a summary of the valuation and appraisal methodologies, assumptions and estimates used to value our assets and liabilities:
Real Estate
Independent Valuation Firm
Duff & Phelps(1) was selected by our advisor and approved by our conflicts committee and board of directors to appraise each of the Appraised Properties. Duff & Phelps is engaged in the business of appraising commercial real estate properties and is not affiliated with us or our advisor. The compensation we paid to Duff & Phelps was based on the scope of work and not on the appraised values of the Appraised Properties. The appraisals were performed in accordance with the Code of Ethics and the Uniform Standards of Professional Appraisal Practice, or USPAP, the real estate appraisal industry standards created by The Appraisal Foundation, as well as the requirements of the state where each real property is located. Each appraisal was reviewed, approved and signed by an individual with the professional designation of MAI (Member of the Appraisal Institute). The use of the reports is subject to the requirements of the Appraisal Institute relating to review by its duly authorized representatives.
Duff & Phelps collected all reasonably available material information that it deemed relevant in appraising the Appraised Properties. Duff & Phelps obtained property-level information from our advisor, including (i) property historical and projected operating revenues and expenses; (ii) property lease agreements; and (iii) information regarding recent or planned capital expenditures. Duff & Phelps reviewed and relied in part on the property-level information provided by our advisor and considered this information in light of its knowledge of each property’s specific market conditions.
_____________________
(1) Duff & Phelps is actively engaged in the business of appraising commercial real estate properties similar to those owned by us in connection with public securities offerings, private placements, business combinations and similar transactions. We engaged Duff & Phelps to prepare appraisal reports for each of the Appraised Properties and Duff & Phelps received fees upon the delivery of such reports. In addition, we have agreed to indemnify Duff & Phelps against certain liabilities arising out of this engagement. In the three years prior to December 17, 2019, Duff & Phelps and its affiliates have provided a number of commercial real estate, appraisal, valuation and financial advisory services for our affiliates and have received fees in connection with such services. Duff & Phelps and its affiliates may from time to time in the future perform other commercial real estate, appraisal, valuation and financial advisory services for us and our affiliates in transactions related to the properties that are the subjects of the appraisals, so long as such other services do not adversely affect the independence of the applicable Duff & Phelps appraiser as certified in the applicable appraisal report.
In conducting its investigation and analyses, Duff & Phelps took into account customary and accepted financial and commercial procedures and considerations as it deemed relevant. Although Duff & Phelps reviewed information supplied or otherwise made available by us or our advisor for reasonableness, it assumed and relied upon the accuracy and completeness of all such information and of all information supplied or otherwise made available to it by any other party and did not independently verify any such information. With respect to operating or financial forecasts and other information and data provided to or otherwise reviewed by or discussed with Duff & Phelps, Duff & Phelps assumed that such forecasts and other information and data were reasonably prepared in good faith on bases reflecting the best currently available estimates and judgments of our management, board of directors and/or our advisor. Duff & Phelps relied on us or our advisor to advise it promptly if any information previously provided became inaccurate or was required to be updated during the period of its review.
In performing its analyses of the Appraised Properties, Duff & Phelps made numerous other assumptions as of various points in time with respect to industry performance, general business, economic and regulatory conditions and other matters, many of which are beyond its and our control, as well as certain factual matters. For example, unless specifically informed to the contrary, Duff & Phelps assumed that we had clear and marketable title to each of the Appraised Properties, that no title defects existed, that any improvements were made in accordance with law, that no hazardous materials were present or had been present previously, that no deed restrictions existed, and that no changes to zoning ordinances or regulations governing use, density or shape were pending or being considered. Furthermore, Duff & Phelps’ analyses, opinions and conclusions were necessarily based upon market, economic, financial and other circumstances and conditions existing as of or prior to the date of the appraisals, and any material change in such circumstances and conditions may affect Duff & Phelps’ analyses and conclusions. Duff & Phelps’ appraisal reports contain other assumptions, qualifications and limitations that qualify the analyses, opinions and conclusions set forth therein. Furthermore, the prices at which the Appraised Properties may actually be sold could differ from their appraised values.
Although Duff & Phelps considered any comments to its appraisal reports received from us or our advisor, the appraised values of the Appraised Properties were determined by Duff & Phelps. The appraisal reports for the Appraised Properties are addressed solely to us to assist in the determination of the estimated NAV per share of our common stock. The appraisal reports are not addressed to the public and may not be relied upon by any other person to establish an estimated NAV per share of our common stock and do not constitute a recommendation to any person to purchase or sell any shares of our common stock. In preparing its appraisal reports, Duff & Phelps did not solicit third-party indications of interest for the Appraised Properties and did not, and was not requested to, solicit third-party indications of interest for our common stock in connection with possible purchases thereof or the acquisition of all or any part of us. While Duff & Phelps is responsible for providing appraisals of the Appraised Properties, Duff & Phelps is not responsible for, did not calculate, and did not participate in, the determination of our estimated NAV per share.
The foregoing is a summary of the standard assumptions, qualifications and limitations that generally apply to Duff & Phelps’ appraisal reports. All of the Duff & Phelps appraisal reports, including the analyses, opinions and conclusions set forth in such reports, are qualified by the assumptions, qualifications and limitations set forth in the respective appraisal reports.
Real Estate Valuation
As of October 31, 2019, we owned two hotel properties, four office properties, one apartment building and one retail development property
We obtained appraisals for two hotel properties, three office properties, one apartment building and one retail development property. As of October 31, 2019, the total appraised value of the consolidated real estate properties, excluding 2200 Paseo Verde, as provided by Duff & Phelps using the appraisal methods described below was $638.2 million. The estimated value of 2200 Paseo Verde, based on the sales price less selling credits, was $18.7 million. Based on the appraisal and valuation methodologies described above, the total estimated value of our consolidated real estate properties was $656.9 million. The total cost basis of these properties as of October 31, 2019 was $570.1 million. This amount includes the acquisition cost of $492.5 million, $60.5 million in capital expenditures, leasing commissions and other capitalized costs and $17.0 million of acquisition fees and expenses. The total estimated value of our consolidated real estate properties, compared to the total purchase price (exclusive of acquisition fees and acquisition expenses) of our consolidated real estate properties plus subsequent capital expenditures, leasing commissions and other capitalized costs in our consolidated real estate properties through October 31, 2019, results in an overall increase in the value of the Appraised Properties of approximately 18.8%.
Income-Generating Properties
As of October 31, 2019, the Appraised Properties were appraised by Duff & Phelps and consisted of two hotel properties, three office properties and one apartment building. Duff & Phelps appraised each of these income-generating properties using various methodologies including the direct capitalization approach, discounted cash flow analysis and sales comparison approach and relied primarily on 10-year discounted cash flow analyses for the final appraisal of the these properties. Duff & Phelps calculated the discounted cash flow value of each of these income-generating properties using property-level cash flow estimates, terminal capitalization rates and discount rates that fall within ranges it believes would be used by similar investors to value the properties, based on recent comparable market transactions adjusted for unique properties and market-specific factors.
The total appraised value of these income-generating properties using the appraisal methodologies described above was $591.0 million, compared to a total cost basis of $497.9 million. This amount includes the acquisition price of $431.2 million, $52.1 million in capital expenditures, leasing commissions and tenant improvements and $14.6 million of acquisition fees and expenses.
The following table summarizes the key assumptions that Duff & Phelps used in the discounted cash flow analyses to arrive at the appraised value of these income-generating properties:
| | | | | | | | | | | |
| Range in Values | | Weighted-Average Basis |
| Terminal capitalization rate | 4.50% to 7.50% | | 5.99% | |
| Discount rate | 6.00% to 9.50% | | 7.11% | |
Net operating income compounded annual growth rate (1) | 2.18% to 19.64% | | 5.28% | |
_____________________
(1) The net operating income compounded annual growth rates (“CAGRs”) reflect both the contractual and market rents and reimbursements (in cases where the contractual lease period is less than the valuation period of the property) net of expenses over the valuation period. The range of CAGRs shown is the constant annual rate at which the net operating income is projected to grow to reach the net operating income in the final year of the hold period for each of the properties.
While we believe that Duff & Phelps’ assumptions and inputs are reasonable, a change in these assumptions and inputs would significantly impact the appraised value of the income-generating properties and thus, our estimated NAV per share. The table below illustrates the impact on our estimated NAV per share; including an adjustment to non-controlling interest, if the terminal capitalization rates or discount rates Duff & Phelps used to appraise the income generating properties were adjusted by 25 basis points, assuming all other factors remain unchanged. Additionally, the table below illustrates the impact on our estimated NAV per share if these terminal capitalization rates or discount rates were adjusted by 5% in accordance with the IPA Valuation Guidelines, assuming all other factors remain unchanged:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Increase (Decrease) on the Estimated NAV per Share due to | | | | | | | | | | |
| Decrease of 25 basis points | | | Increase of 25 basis points | | | Decrease of 5% | | | Increase of 5% | |
| Terminal capitalization rate | $ | 0.41 | | | $ | | (0.40) | | | $ | 0.48 | | | $ | | (0.46) | |
| Discount Rate | | 0.28 | | | | (0.29) | | | | 0.39 | | | | (0.40) | |
Development Property
As of October 31, 2019, we had invested in a retail development project. Duff & Phelps considered various valuation methodologies including the cost approach, income capitalization approach and sales comparison approach and relied on a sales comparison approach for the final appraisal of this investment. Duff & Phelps gathered data on reasonably substitutable properties and adjusted for unique property and market-specific factors to arrive at a market value. The appraised value of our retail development project using the appraisal methodology described above was $47.2 million, compared to a total cost basis, including acquisition fees and expenses, capital expenditures and other capitalized costs through October 31, 2019 of $56.0 million.
Finally, a 1% increase in the appraised value of the Appraised Properties would result in an increase of $0.17 to our estimated NAV per share and a 1% decrease in the appraised value of the Appraised Properties would result in a decrease of $0.18 to our estimated NAV per share, assuming all other factors remain unchanged.
Real Estate Equity Securities
As of September 30, 2019, we owned an investment in real estate equity securities. The estimated value of our real estate equity securities is equal to the GAAP fair value disclosed in our Quarterly Report on Form 10-Q for the period ended September 30, 2019, which also equals the book value of the real estate equity securities in accordance with GAAP. As of September 30, 2019, we owned 1,160,591 shares of Franklin Street Properties Corp. The fair values of these real estate equity securities were based on quoted prices in an active market on a major stock exchange. As of September 30, 2019, the fair value and carrying value of our real estate equity securities was $9.8 million.
Investment in Unconsolidated Entity
As of September 30, 2019, we had originated a participating loan facility in an amount up to €2.6 million ($3.0 million as of September 30, 2019). As September 30, 2019, we had funded the participating loan facility €2.1 million ($2.4 million as of September 30, 2019). The proceeds were used to fund a 5% general partner interest in a joint venture acquiring a portfolio of light industrial properties located throughout France. Under the terms of the participating loan facility, we participate in the expected residual profits of the portfolio and the terms are structured in a manner such that the risks and rewards of the arrangement are similar to those associated with an investment in a real estate joint venture. Accordingly, the participating loan facility is accounted for under the equity method of accounting. The estimated value of our investment in this participating loan facility was estimated by our advisor based on its estimate of the final distribution to be received by us in the next one to two quarters, pursuant to the terms of the participating loan facility. The fair value and carrying value of our investment in the participating loan facility is $0.5 million and $0.5 million, respectively.
Non-controlling Interest
We have an ownership interest in five consolidated joint ventures as of September 30, 2019. As we consolidate these joint ventures, the entire amount of the underlying assets and liabilities of each joint venture is reflected at fair value in the corresponding line items of the estimated NAV per share determination. Given this and the October 31, 2019 appraisal date for the real estate, we also must consider the fair value of any non-controlling interest liability as of October 31, 2019. In determining this fair value, we considered the various profit participation thresholds in each of the joint ventures that must be measured in determining the fair value of our non-controlling interest liability. We used the real estate appraisals provided by Duff & Phelps and calculated the amount that the joint venture partners would receive in a hypothetical liquidation of the underlying real estate properties (including all current assets and liabilities) at their current appraised values and the payoff of any related debt at its fair value, based on the profit participation thresholds contained in the joint venture agreements. The estimated payment to the joint venture partners was then reflected as the non-controlling interest liability in our determination of our estimated NAV per share.
Notes Payable
The estimated values of the Company’s notes payable are equal to the GAAP fair values disclosed in our Quarterly Report on Form 10-Q for the period ended September 30, 2019, but do not equal the book value of the loans in accordance with GAAP. Our advisor estimated the values of our notes payable using a discounted cash flow analysis. The discounted cash flow analysis was based on projected cash flow over the remaining loan terms, including extensions we expect to exercise, and management’s estimates of current market interest rates for instruments with similar characteristics, including remaining loan term, loan-to-value ratio and type of collateral.
As of September 30, 2019, the GAAP fair value and the carrying value of our notes payable were $351.8 million and $347.5 million, respectively. The weighted-average discount rate applied to the future estimated debt payments, was approximately 4.56%. Our notes payable have a weighted-average remaining term of 1.9 years.
The table below illustrates the impact on our estimated NAV per share if the discount rates our advisor used to value our notes payable were adjusted by 25 basis points, assuming all other factors remain unchanged. Additionally, the table below illustrates the impact on our estimated NAV per share if these discount rates were adjusted by 5% in accordance with the IPA Valuation Guidelines, assuming all other factors remain unchanged:
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Increase (Decrease) on the Estimated NAV per Share due to | | | | | | |
| | Decrease of 25 basis points | | Increase of 25 basis points | | Decrease of 5% | | Increase of 5% |
| Discount rate | | $ | (0.04) | | | $ | 0.04 | | | $ | (0.03) | | | $ | 0.03 | |
Other Assets and Liabilities
The carrying values of a majority of our other assets and liabilities are considered to equal their fair value due to their short maturities or liquid nature. Certain balances, such as straight-line rent receivables, lease intangible assets and liabilities, deferred financing costs, unamortized lease commissions and unamortized lease incentives, have been eliminated for the purpose of the valuation due to the fact that the value of those balances was already considered in the valuation of the related asset or liability. Our advisor has also excluded redeemable common stock as temporary equity does not represent a true liability to us and the shares that this amount represents are included in our total outstanding shares of common stock for purposes of determining our estimated NAV per share.
Limitations of Estimated NAV per Share
As mentioned above, we are providing this estimated NAV per share to assist broker dealers that participated in our initial public offering in meeting their customer account statement reporting obligations. This valuation was performed in accordance with the provisions of the IPA Valuation Guidelines. As with any valuation methodology, the methodologies used are based upon a number of estimates and assumptions that may not be accurate or complete. Different parties with different assumptions and estimates could derive a different estimated NAV per share of our common stock and this difference could be significant. The estimated NAV per share is not audited and does not represent the fair value of our assets less the fair value of our liabilities according to GAAP.
Accordingly, with respect to our estimated NAV per share, we can give no assurance that:
•a stockholder would be able to resell his or her shares at our estimated NAV per share;
•a stockholder would ultimately realize distributions per share equal to our estimated NAV per share upon liquidation of our assets and settlement of our liabilities or a sale of our company;
•our shares of common stock would trade at our estimated NAV per share on a national securities exchange;
•a third party would offer our estimated NAV per share in an arm’s-length transaction to purchase all or substantially all of our shares of common stock;
•another independent third-party appraiser or third-party valuation firm would agree with our estimated NAV per share; or
•the methodology used to determine our estimated NAV per share would be acceptable to FINRA or for compliance with ERISA reporting requirements.
Further, the estimated NAV per share is based on the estimated value of our assets less the estimated value of our liabilities, divided by the number of shares outstanding, all as of September 30, 2019, after giving effect to the Adjustments. As of September 30, 2019, there were 17,934,013 and 12,255,327 shares of Class A and Class T common stock issued and outstanding, respectively. The value of our shares will fluctuate over time in response to developments related to the performance of individual assets in our portfolio, the management of those assets and in response to the real estate and finance markets. The estimated NAV per share does not reflect a discount for the fact that we are externally managed, nor does it reflect a real estate portfolio premium/discount versus the sum of the individual property values. The estimated NAV per share does not take into account estimated disposition costs and fees for real estate properties that are not held for sale or under contract for sale, debt prepayment penalties that could apply upon the prepayment of certain of our debt obligations or the impact of restrictions on the assumption of debt. The estimated NAV per share does consider any participation or incentive fees that would be due to our advisor based on our aggregate net asset value, which would be payable in a hypothetical liquidation as of the valuation date in accordance with the terms of our advisory agreement. We currently expects to utilize our advisor and/or an independent valuation firm to update the estimated NAV per share no later than December 2020.
Historical Estimated NAV per Share
The historical reported estimated NAV per share of our common stock approved by our board of directors is set forth below:
| | | | | | | | | | | | | | |
| Estimated NAV per Share | | Effective Date of Valuation | | Filing with the Securities and Exchange Commission |
| $9.65 | | | December 6, 2018 | | Current Report on Form 8-K, filed December 11, 2018 |
| $9.05 | | | June 6, 2017 | | Current Report on Form 8-K, filed June 7, 2017 |
Distribution Information
We declare stock dividends and cash distributions when our board of directors determines we have sufficient cash flow from operations, investment activities and/or strategic financings. This policy reflects our focus on acquiring an investment portfolio with a total return profile that is composed of a combination of assets that have potential for long-term appreciation and/or stabilized cash flow from operations upon lease-up or other enhancement.
We currently expect our board of directors to authorize, declare and pay cash distributions on a monthly basis. We expect that we will fund these cash distributions from dividend, rental and other income on our investments. We may also utilize strategic refinancings to fund cash distributions for investments that have appreciated in value after our acquisition. Generally, our distribution policy is not to pay cash distributions from sources other than cash flow from operations, investment activities and strategic financings. However, we may fund cash distributions from any source and there are no limits to the amount of distributions that we may pay from any source, including proceeds from the issuance of securities in the future, other third party borrowings, advances from our advisor or sponsors or from our advisor’s deferral of its fees under the advisory agreement. Distributions paid from sources other than current or accumulated earnings and profits may constitute a return of capital. From time to time, we may generate taxable income greater than our taxable income for financial reporting purposes, or our taxable income may be greater than our cash flow available for distribution to stockholders. In these situations we may pay distributions in excess of our cash flow from operations, investment activities and strategic financings to satisfy the REIT distribution requirement described above. In such an event, we would look first to other third party borrowings to fund these distributions.
As a REIT, we will generally have to hold our assets for two years in order to meet the safe harbor to avoid a 100% prohibited transactions tax, unless such assets are held through a TRS or other taxable corporation. At such time as we have assets that we have held for at least two years, we anticipate that we may authorize and declare distributions based on gains on asset sales, to the extent we close on the sale of one or more assets and the board of directors does not determine to reinvest the proceeds of such sales.
To maintain our qualification as a REIT, we must make aggregate annual distributions to our stockholders of at least 90% of our REIT taxable income (which is computed without regard to the dividends paid deduction or net capital gain and which does not necessarily equal net income as calculated in accordance with GAAP). If we meet the REIT qualification requirements, we generally will not be subject to federal income tax on the income that we distribute to our stockholders each year. In general, we anticipate making distributions to our stockholders of at least 100% of our REIT taxable income so that none of our income is subject to federal income tax. Our board of directors may authorize distributions in excess of those required for us to maintain REIT status depending on our financial condition and such other factors as our board of directors deems relevant.
We have not established a minimum distribution level, and our charter does not require that we pay distributions to our stockholders. Distributions declared during 2019 and 2018, aggregated by quarter, are as follows (dollars in thousands, except per share amounts):
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| 2019 | | | | | | | | |
| 1st Quarter | | 2nd Quarter | | 3rd Quarter | | 4th Quarter | | Total |
| Total Distributions Declared | $ | 1,206 | | | $ | 724 | | | $ | 724 | | | $ | 725 | | | $ | 3,379 | |
| Distributions Declared Per Class A Share | $ | 0.040 | | | $ | 0.024 | | | $ | 0.024 | | | $ | 0.024 | | | $ | 0.112 | |
| Distributions Declared Per Class T Share | $ | 0.040 | | | $ | 0.024 | | | $ | 0.024 | | | $ | 0.024 | | | $ | 0.112 | |
| | | | | | | | | |
| 2018 | | | | | | | | |
| 1st Quarter | | 2nd Quarter | | 3rd Quarter | | 4th Quarter | | Total |
| Total Distributions Declared | $ | 1,082 | | | $ | 1,124 | | | $ | 1,349 | | | $ | 1,452 | | | $ | 5,007 | |
| Distributions Declared Per Class A Share | $ | 0.047 | | | $ | 0.048 | | | $ | 0.048 | | | $ | 0.048 | | | $ | 0.191 | |
| Distributions Declared Per Class T Share | $ | 0.024 | | | $ | 0.025 | | | $ | 0.041 | | | $ | 0.048 | | | $ | 0.138 | |
The tax composition of our cash distributions paid during the years ended December 31, 2019 and 2018 was as follows:
| | | | | | | | | | | | | | |
| | 2019 | | 2018 |
| Ordinary Income | | — | % | | — | % |
| Return of Capital | | 100 | % | | 100 | % |
| Capital Gain | | — | % | | — | % |
| Total | | 100 | % | | 100 | % |
Commencing March 2015, the Company’s board of directors has declared and issued stock dividends on shares of the Company’s common stock through December 31, 2019 as follows:
| | | | | | | | | | | | | | |
| Year Ended December 31, | | Amount Declared per Share Outstanding (1) | | Total Shares Issued |
| 2015 | | 0.100000 shares | | | 765,604 | |
| 2016 | | 0.035003 shares | | | 513,723 | |
| 2017 | | 0.020004 shares | | | 493,463 | |
| 2018 | | 0.018337 shares | | | 584,377 | |
| 2019 | | — | | | — | |
_____________________
(1) Amount declared per share outstanding includes one-time stock dividends, quarterly dividends and monthly dividends and assumes each share was issued and outstanding for the entire periods presented. Stock dividends are issued in the same class of shares as the shares for which such stockholder received the stock dividend.
Stock dividends are non-taxable to stockholders at the time of issuance. During our offering stage and through November 2018, our board of directors declared stock dividends on a set monthly basis based on monthly record dates. We currently do not expect our board of directors to declare additional monthly stock dividends.
For more information with respect to our distributions paid, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Distributions.”
Unregistered Sales of Equity Securities
During the year ended December 31, 2019, we did not sell any equity securities that were not registered under the Securities Act of 1933. During the year ended December 31, 2018, we sold the following equity securities that were not registered under the Securities Act of 1933. On February 13, 2018, we issued 10,935 of Class A shares of common stock for $9.15 per share (or an aggregate purchase price of $0.1 million) to a business associate of Keith D. Hall and Peter McMillan III. The shares were issued in private transactions exempt from the registration requirements pursuant to Section 4(a)(2) of the Securities Act of 1933. We did not pay selling commissions or dealer manager fees with respect to this sale. The purchase price reflects a $0.85 discount to the $10.00 per share offering price in our now-terminated initial public offering, reflecting that no selling commissions or dealer manager fees were paid on the sale.
Share Redemption Program
We have adopted a share redemption program that may enable stockholders to sell their shares to us in limited circumstances.
Pursuant to the share redemption program there are several limitations on our ability to redeem shares:
•Unless the shares are being redeemed in connection with a stockholder’s death, “qualifying disability” or “determination of incompetence” (each as defined under the share redemption program), we may not redeem shares until the stockholder has held the shares for one year.
•During each calendar year, the share redemption program limits the number of shares we may redeem to those that we could purchase with the amount of the net proceeds from the issuance of shares under the dividend reinvestment plan during the prior calendar year. In 2020, the share redemption program also provides that in any calendar year, the last $0.5 million of net proceeds from the dividend reinvestment plan during the prior year is reserved exclusively for shares redeemed in connection with a stockholder’s death, “qualifying disability,” or “determination of incompetence” with any excess funds being available to redeem shares not requested in connection with a stockholder’s death, “qualifying disability,” or “determination of incompetence” during the December redemption date in the current year. We may, however, increase or decrease the funding available for the redemption of shares pursuant to the program upon ten business days’ notice to our stockholders.
•During any calendar year, we may redeem no more than 5% of the weighted-average number of shares outstanding during the prior calendar year.
•We have no obligation to redeem shares if the redemption would violate the restrictions on distributions under Maryland law, which prohibits distributions that would cause a corporation to fail to meet statutory tests of solvency.
Pursuant to our share redemption program, redemptions made in connection with a stockholder’s death, qualifying disability, or determination of incompetence are made at a price per share equal to the most recent NAV per share as of the applicable redemption date. The price at which we redeem all other shares eligible for redemption is as follows:
•For those shares held by the redeeming stockholder for at least one year, 92.5% of our most recent estimated NAV per share as of the applicable redemption date;
•For those shares held by the redeeming stockholder for at least two years, 95.0% of our most recent estimated NAV per share as of the applicable redemption date;
•For those shares held by the redeeming stockholder for at least three years, 97.5% of our most recent estimated NAV per share as of the applicable redemption date; and
•For those shares held by the redeeming stockholder for at least four years, 100% of our most recent estimated NAV per share as of the applicable redemption date.
For purposes of determining the time period a redeeming stockholder has held each share, the time period begins as of the date the stockholder acquired the share; provided, that shares purchased by the redeeming stockholder pursuant to our dividend reinvestment plan and shares received as a stock dividend will be deemed to have been acquired on the same date as the initial share to which the dividend reinvestment plan shares or stock dividend shares relate. The date of the share’s original issuance by us is not determinative. In addition, as described above, the shares owned by a stockholder may be redeemed at different prices depending on how long the stockholder has held each share submitted for redemption.
We expect to update our estimated NAV per share annually.
The terms of our share redemption program with respect to redemptions sought upon a stockholder’s death, qualifying disability or determination of incompetence are as follows:
•There is no one-year holding requirement;
•Effective in January 2019, funds from our dividend reinvestment plan in an amount of $500,000 are reserved for redemption (during 2018, additional funds in an amount up to $500,000 were available for redemptions); and
•The redemption price is the estimated NAV of the shares, as determined by our board of directors.
Upon a transfer of shares any pending redemption requests with respect to such transferred shares will be canceled as of the date we accept the transfer. Stockholders wishing to continue to have a redemption request related to any transferred shares considered by us must resubmit their redemption request.
Our board may amend, suspend or terminate the share redemption program upon 10 business days’ notice to stockholders. We also may increase or decrease the funding available for the redemption of shares pursuant to the share redemption program upon 10 business days’ notice to stockholders.
Effective beginning with the month of February 2020, we have suspended (a) redemptions requested under the share redemption program in connection with a stockholder’s death, “qualifying disability” or “determination of incompetence”, until we and POSOR I file with the SEC a Registration Statement on Form S-4 containing a Joint Proxy Statement/Prospectus for the proposed Merger, and (b) all other redemptions under the share redemption program until after the Merger closes.
During the year ended December 31, 2019, we fulfilled redemption requests and redeemed shares pursuant to the share redemption program as follows:
| | | | | | | | | | | | | | | | | | | | |
| Month | | Total Number of Shares Redeemed | | Average Price Paid Per Share (1) | | Approximate Dollar Value of Shares Available That
May Yet Be Redeemed Under the Program |
| January 2019 | | 260,234 | | | $ | 9.50 | | | (2) |
| February 2019 | | 2,277 | | | $ | — | | | (2) |
| March 2019 | | — | | | $ | — | | | (2) |
| April 2019 | | — | | | $ | — | | | (2) |
| May 2019 | | 23,534 | | | $ | 9.65 | | | (2) |
| June 2019 | | 1,144 | | | $ | 9.65 | | | (2) |
| July 2019 | | — | | | $ | — | | | (2) |
| August 2019 | | 13,059 | | | $ | 9.65 | | | (2) |
| September 2019 | | 7,056 | | | $ | 9.65 | | | (2) |
| October 2019 | | 575 | | | $ | 9.65 | | | (2) |
| November 2019 | | — | | | $ | — | | | (2) |
| December 2019 | | 11,559 | | | $ | 10.11 | | | (2) |
| | 319,438 | | | | | |
_____________________
(1) Pursuant to the program, as amended, we redeem shares at the purchase prices described above. Redemptions for January 2019 through November 2019 were processed based on our estimated NAV per share of $9.65 as established by our board of directors on December 6, 2018. December 2019 redemptions were processed based on our estimated NAV per share of $10.25 as established by our board of directors on December 17, 2019.
(2) We limit the dollar value of shares that may be redeemed under the program as described above. During the year ended December 31, 2019, we redeemed $3.0 million of common stock. In January 2019, we exhausted all funds available for redemption of shares in 2019 in connection with redemption requests not made upon a stockholder's death, "qualifying disability", or determination of incompetence. As of December 31, 2019, we had $8.7 million outstanding and unfulfilled redemption requests representing 863,378 shares due to the limitations described above. We recorded $2.2 million of redeemable common stock payable on our balance sheet as of December 31, 2019, which represents the amount available to be redeemed in 2020 based on the net proceeds from the sale of shares under of distribution reinvestment plan as of December 31, 2019.
In addition to the redemptions under the share redemption program described above, during the year ended December 31, 2019, we repurchased 2,286 shares of our common stock at $8.89 per share for an aggregate price of approximately $20,000.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data as of December 31, 2019, 2018, 2017, 2016 and 2015 and for the years ended December 31, 2019, 2018, 2017, 2016 and 2015 should be read in conjunction with the accompanying consolidated financial statements and related notes thereto and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (in thousands, except share and per share amounts):
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| As of December 31, | | | | | | | | |
| 2019 | | 2018 | | 2017 | | 2016 | | 2015 |
| Balance sheet data | | | | | | | | | |
| Total real estate and real estate-related investments, net | $ | 503,617 | | | $ | 518,836 | | | $ | 533,940 | | | $ | 320,765 | | | $ | 113,345 | |
| Total assets | 543,483 | | | 562,478 | | | 582,515 | | | 383,214 | | | 139,729 | |
| Total notes payable, net | 325,995 | | | 326,543 | | | 328,351 | | | 208,581 | | | 60,836 | |
| Total liabilities | 353,241 | | | 358,040 | | | 360,606 | | | 221,125 | | | 67,895 | |
| Redeemable common stock | — | | | — | | | 2,611 | | | 2,121 | | | 1,092 | |
| Total equity | 190,242 | | | 204,438 | | | 219,298 | | | 159,968 | | | 70,742 | |
| | | | | | | | | |
| For the Years Ended December 31, | | | | | | | | |
| Operating data | 2019 | | 2018 | | 2017 | | 2016 | | 2015 |
| Total revenues | $ | 68,741 | | | $ | 70,282 | | | $ | 51,968 | | | $ | 31,320 | | | $ | 17,025 | |
| Class A Common Stock: | | | | | | | | | |
| Net loss attributable to common stockholders | (4,458) | | | (13,729) | | | (1,480) | | | (5,421) | | | (1,861) | |
| Net loss per common share - basic and diluted | (0.25) | | | (0.77) | | | (0.09) | | | (0.41) | | | (0.25) | |
| Class T Common Stock: | | | | | | | | | |
| Net loss attributable to common stockholders | (3,041) | | | (9,779) | | | (1,792) | | | (1,069) | | | (195) | |
| Net loss per common share - basic and diluted | (0.25) | | | (0.82) | | | (0.18) | | | (0.45) | | | (0.38) | |
| Other data | | | | | | | | | |
| Cash flows (used in) provided by operating activities | $ | (95) | | | $ | 4,615 | | | $ | 8,829 | | | $ | 704 | | | $ | 434 | |
| Cash flows provided by (used in) investing activities | 5,398 | | | (20,042) | | | (203,399) | | | (221,728) | | | (69,467) | |
| Cash flows (used in) provided by financing activities | (8,685) | | | 7,232 | | | 182,497 | | | 242,784 | | | 80,598 | |
| Distributions declared | 3,379 | | | 5,007 | | | 3,920 | | | 1,027 | | | — | |
| Distributions declared per common share - Class A | $ | 0.112 | | | $ | 0.191 | | | 0.191
| | | $ | 0.202 | | | $ | 0.120 | |
| Distributions declared per common share - Class T | $ | 0.112 | | | $ | 0.138 | | | $ | 0.098 | | | $ | 0.123 | | | $ | — | |
| Stock dividends declared per common share | — | | | 0.018 | | | 0.020 | | | 0.035 | | | 0.100 | |
Weighted-average number of common shares
outstanding, basic and diluted - Class A | 17,949,301 | | | 17,775,503 | | | 16,096,216 | | | 13,158,129 | | | 7,553,934 | |
Weighted-average number of common shares
outstanding, basic and diluted - Class T | 12,241,271 | | | 11,864,178 | | | 9,797,325 | | | 2,377,436 | | | 509,329 | |
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with the “Selected Financial Data” above and our accompanying consolidated financial statements and the notes thereto. Also, see “Forward-Looking Statements” preceding Part I of this Annual Report on Form 10-K.
Overview
We were formed on February 6, 2013 as a Maryland corporation and elected to be taxed as a real estate investment trust (“REIT”) beginning with the taxable year ending December 31, 2014. On July 3, 2013, we commenced a private placement offering exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”), to offer a maximum of $105,000,000 of shares of common stock for sale to certain accredited investors, of which $5,000,000 of shares were offered pursuant to our dividend reinvestment plan. We ceased offering shares in our private offering on August 11, 2014. KBS Capital Markets Group LLC, an affiliate of our former advisor, served as the dealer manager of the offering pursuant to a dealer manager agreement and was responsible for marketing our shares in the offering.
On November 14, 2013, we filed a registration statement on Form S-11 with the Securities and Exchange Commission (the “SEC”) to register for sale to the public a maximum of 180,000,000 shares of common stock, of which 80,000,000 shares were to be offered pursuant to our dividend reinvestment plan. The SEC declared our registration statement effective on August 12, 2014 and we retained KBS Capital Markets Group LLC to serve as the dealer manager of the initial public offering pursuant to a dealer manager agreement. On February 11, 2016, we filed an amended registration statement on Form S-11 with the SEC to offer a second class of common stock designated as Class T shares and to designate our initially offered and outstanding common stock as Class A shares. Pursuant to the amended registration statement, we were offering to sell any combination of Class A and Class T shares in our primary offering and dividend reinvestment plan offering but in no event could we sell more than 180,000,000 of shares of our common stock pursuant to the offering. We commenced offering our Class T shares of our common stock for sale to the public on February 17, 2016. The dealer manager was responsible for marketing our shares in the initial public offering. We ceased offering shares of common stock in our initial public primary offering on July 31, 2018 and terminated our initial public primary offering on September 28, 2018. We continue to offer shares of common stock under our dividend reinvestment plan. In some states, we will need to renew the registration statement annually or file a new registration statement to continue our dividend reinvestment plan offering. We may terminate our dividend reinvestment plan offering at any time.
We have used substantially all of the net proceeds from our offerings to invest in and manage a portfolio of opportunistic real estate, real estate-related loans, real estate equity securities and other real estate-related investments located in the United States and Europe. As of December 31, 2019, we had invested in two hotel properties, three office properties, one apartment building, two investments in an unconsolidated entities and an investment in real estate equity securities. Additionally, as of December 31, 2019, we had entered into a consolidated joint venture to develop one office/retail property.
We sold 11,977,758 and 11,537,701 shares of Class A and Class T common stock, respectively, for aggregate gross offering proceeds of $228.6 million in our initial public primary offering. As of December 31, 2019, we had sold 723,641 and 333,841 shares of Class A and Class T common stock, respectively, under our dividend reinvestment plan for aggregate gross offering proceeds of $9.8 million. Also as of December 31, 2019, we had redeemed 718,962 and 107,945 shares of Class A and Class T common stock, respectively, for $7.4 million.
We sold 3,619,851 shares of Class A common stock for gross offering proceeds of $32.2 million in our private offering. Additionally, on each of April 2, 2014 and July 31, 2014, we issued 120,106 shares of Class A common stock to an entity affiliated with two of our officers and affiliated directors for $1.0 million in separate private transactions exempt from the registration requirements of the Securities Act. On July 14, 2017 and February 13, 2018, we issued 214,175 shares and 10,935 shares, respectively, of Class A common stock to a business associate of two of our officers and affiliated directors for $2.0 million and $0.1 million, respectively, in a separate private transaction exempt from the registration requirements of the Securities Act.
We have no employees and KBS Capital Advisors LLC (“KBS Capital Advisors”) had served as our external advisor since commencement of the private offering. On October 31, 2019, KBS Capital Advisors ceased to serve as our advisor or have any advisory responsibility to us immediately following the filing of our Quarterly Report on Form 10-Q for the period ending September 30, 2019 with the SEC. On November 1, 2019, we entered into a new advisory agreement with Pacific Oak Capital Advisors, LLC (“Pacific Oak Capital Advisors”). The new advisory agreement is effective as of November 1, 2019 through November 1, 2020; however we may terminate the advisory agreement without cause or penalty upon providing 30 days’ written notice and Pacific Oak Capital Advisors may terminate the advisory agreement without cause or penalty upon providing 90 days’ written notice. The terms of the advisory agreement are consistent with those of the advisory agreement that was previously in effect with KBS Capital Advisor. As our advisor, Pacific Oak Capital Advisors manages our day-to-day operations and managed our portfolio of real estate properties and real estate-related investments. Pacific Oak Capital Advisors also provides asset-management, marketing, investor-relations and other administrative services on our behalf.
On February 19, 2020, we, Pacific Oak Strategic Opportunity REIT, Inc. (“POSOR I”), and Pacific Oak SOR II, LLC, an indirect subsidiary of POSOR I (“Merger Sub”), entered into an Agreement and Plan of Merger (the “Merger Agreement”). Subject to the terms and conditions of the Merger Agreement, we will merge with and into Merger Sub (the “Merger”), with Merger Sub surviving the Merger (the “Surviving Entity”), such that following the Merger, the Surviving Entity will continue as an indirect subsidiary of POSOR I. In accordance with the applicable provisions of the Maryland General Corporation Law, the separate existence of our company shall cease. At the effective time of the Merger and subject to the terms and conditions of the Merger Agreement, each issued and outstanding share of our common stock will be converted into the right to receive 0.9643 shares of POSOR I common stock. The combined company after the Merger will retain the name “Pacific Oak Strategic Opportunity REIT, Inc.” The Merger is intended to qualify as a “reorganization” under, and within the meaning of, Section 368(a) of the Internal Revenue Code of 1986, as amended. See “Proposed Merger” in Item Part I, Item 1 of this Annual Report on Form 10-K for more information.
Market Outlook - Real Estate and Real Estate Finance Markets
Volatility in global financial markets and changing political environments can cause fluctuations in the performance of the U.S. commercial real estate markets. Possible future declines in rental rates, slower or potentially negative net absorption of leased space and expectations of future rental concessions, including free rent to renew tenants early, to retain tenants who are up for renewal or to attract new tenants, may result in decreases in cash flows from investment properties. Increases in the cost of financing due to higher interest rates may cause difficulty in refinancing debt obligations prior to or at maturity or at terms as favorable as the terms of existing indebtedness. Further, increases in interest rates would increase the amount of our debt payments on our variable rate debt to the extent the interest rates on such debt are not limited by interest rate caps. Market conditions can change quickly, potentially negatively impacting the value of real estate investments. Management continuously reviews our investment and debt financing strategies to optimize our portfolio and the cost of our debt exposure. The recent global outbreak of COVID-19 (more commonly known as the Coronavirus) has significantly disrupted economic markets and impacted commercial activity worldwide, including the US, and the prolonged economic impact is uncertain.
Liquidity and Capital Resources
Our principal demand for funds during the short and long-term is and will be for the payment of operating expenses, capital expenditures and general and administrative expenses; payments under debt obligations; redemptions of common stock; capital commitments and development expenses under our joint venture agreements; and payments of distributions to stockholders.
To date, we have had five primary sources of capital for meeting our cash requirements:
•Proceeds from the primary portion of our initial public offering;
•Proceeds from our dividend reinvestment plan;
•Proceeds from the sale of real estate and the repayment of a real estate loan receivable;
•Debt financings; and
•Cash flow generated by our real estate investments.
We had sold 11,977,758 and 11,537,701 shares of Class A and Class T common stock, respectively, for aggregate gross offering proceeds of $228.6 million in our initial public offering. Additionally, we sold 3,619,851 shares of common stock in our private offering for gross offering proceeds of $32.2 million. We ceased offering shares of common stock in our initial public primary offering on July 31, 2018 and terminated our initial public primary offering on September 28, 2018.
To date, we have invested a significant amount of the proceeds from the primary public offering in real estate and do not anticipate making additional real estate acquisitions due to the termination of the primary portion of our initial public offering on July 31, 2018. We intend to use our cash on hand, cash flow generated by our real estate operations and proceeds from our dividend reinvestment plan as our primary sources of immediate and long-term liquidity.
As of December 31, 2019, we had invested in two hotel properties, three office properties, one apartment building, two investments in unconsolidated entities and an investment in real estate equity securities. Additionally, as of December 31, 2019, we had entered into a consolidated joint venture to develop one office/retail property.
Our office and apartment properties generate cash flow in the form of rental revenues and tenant reimbursements, which are reduced by operating expenditures, capital expenditures, debt service payments, the payment of asset management fees and corporate general and administrative expenses. Cash flow from operations from office and apartment properties is primarily dependent upon the occupancy level of our properties, the net effective rental rates on our leases, the collectibility of rent and operating recoveries from our tenants and how well we manage our expenditures. As of December 31, 2019, we owned three office properties that were 68% occupied and one apartment property that was 93% occupied.
Our hotel properties generate cash flow in the form of room, food, beverage and convention services, campground and other revenues, which are reduced by hotel expenses, capital expenditures, debt service payments, the payment of asset management fees and corporate general and administrative expenses. Cash flow from operations from our hotel properties are primarily dependent upon the occupancy levels of our hotels, the average daily rates and how well we manage our expenditures. The following table provides summary information regarding our hotel properties for the year ended December 31, 2019 and 2018:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | Percentage Occupied for the Year Ended | | | | Average Daily Rate for the Year Ended | | | | Average Revenue per Available Room for the Year Ended | | |
| Property | | Number of Rooms | | 2019 | | 2018 | | 2019 | | 2018 | | 2019 | | 2018 |
| Springmaid Beach Resort | | 453 | | | 65.0% | | | 60.6% | | | $138.06 | | | $157.47 | | | $89.80 | | | $95.47 | |
| Q&C Hotel | | 196 | | | 73.3% | | | 77.8% | | | $165.37 | | | $158.92 | | | $121.13 | | | $123.69 | |
Investments in real estate equity securities generate cash flow in the form of dividend income, which is reduced by asset management fees. As of December 31, 2019, we had an investment in real estate equity securities outstanding with a total book value of $9.9 million.
As of December 31, 2019, we had mortgage debt obligations in the aggregate principal amount of $329.6 million, with a weighted-average remaining term of 2.0 years. As of December 31, 2019, an aggregate amount of $47.2 million was available under our mortgage loans for future disbursements to be used for capital improvement costs, tenant improvement costs, leasing commissions and expenses and operating/interest shortfall, subject to certain terms and conditions contained in the loan documents.
We expect to use our capital resources to make certain payments to our advisor in connection with the management of our assets and costs incurred by our advisor in providing services to us. Our currently effective advisory agreement expires November 1, 2020 and may be renewed for an unlimited number of successive one-year periods upon the mutual consent of our advisor and our conflicts committee.
Among the fees payable to our advisor is an asset management fee. We pay our advisor a monthly fee equal to the lesser of one-twelfth of (i) 1.0% of the cost of our investments and (ii) 2.0% of the sum of the cost of our investments, less any debt secured by or attributable to the investments. The cost of the real property investments is calculated as the amount paid or allocated to acquire the real property, including the cost of any subsequent development, construction or improvements to the property and including fees and expenses related thereto (but excluding acquisition fees paid or payable our advisor). The cost of the loans and any investments other than real property is calculated as the lesser of (x) the amount actually paid or allocated to acquire or fund the loan or other investment, including fees and expenses related thereto (but excluding acquisition fees paid or payable to our advisor) and (y) the outstanding principal amount of such loan or other investment, including fees and expenses related to the acquisition or funding of such investment (but excluding acquisition fees paid or payable to our advisor) as of the time of calculation. In the case of investments made through joint ventures, the asset management fee is determined based on our proportionate share of the underlying investment.
We elected to be taxed and to operate as a REIT beginning with our taxable year ended December 31, 2014. To maintain our qualification as a REIT, we will be required to make aggregate annual distributions to our stockholders of at least 90% of our REIT taxable income (computed without regard to the dividends paid deduction and excluding net capital gain). Our board of directors may authorize distributions in excess of those required for us to maintain REIT status depending on our financial condition and such other factors as our board of directors deems relevant. We have not established a minimum distribution level.
Under our charter, we are required to limit our total operating expenses to the greater of 2% of our average invested assets or 25% of our net income for the four most recently completed fiscal quarters, as these terms are defined in our charter, unless the conflicts committee has determined that such excess expenses were justified based on unusual and non-recurring factors. Total operating expenses for the four fiscal quarters ended December 31, 2019 did not exceed the charter imposed limitation.
Cash Flows from Operating Activities
We commenced operations on September 4, 2014 in connection with our first investment. As of December 31, 2019, we had invested in two hotel properties, three office properties, one apartment building, two investments in unconsolidated entities and an investment in real estate equity securities. Additionally, as of December 31, 2019, we had entered into a consolidated joint venture to develop one office/retail property. During the year ended December 31, 2019, net cash used in operating activities was $0.1 million. We expect that our cash flows from operating activities will generally increase in future years as a result of leasing additional space that is currently unoccupied and owning real estate equity securities acquired during 2019 for an entire period.
Cash Flows from Investing Activities
Net cash provided by investing activities was $5.4 million for the year ended December 31, 2019 and primarily consisted of the following:
•$17.7 million of disposition of real estate;
•$14.1 million of improvements to real estate;
•$5.1 million of distribution of capital from unconsolidated joint venture; and
•$2.9 million of investment in an unconsolidated joint venture.
Cash Flows from Financing Activities
Net cash used in financing activities was $8.7 million for the year ended December 31, 2019 and primarily consisted of the following:
•$2.4 million of net cash used in debt and other financings as a result of principal payments on notes payable of $179.4 million and payments of deferred financing costs of $3.2 million, partially offset by proceeds from notes payable of $180.2 million;
•$3.0 million of cash used for redemptions of common stock;
•$1.9 million of distributions to noncontrolling interest;
•$1.4 million of net cash distributions, after giving effect to distributions reinvested by stockholders of $2.2 million;
•$0.2 million of noncontrolling interest contributions; and
•$0.2 million of principal payments on capital lease obligations.
In order to execute our investment strategy, we utilize secured debt and we may, to the extent available, utilize unsecured debt, to finance a portion of our investment portfolio. Management remains vigilant in monitoring the risks inherent with the use of debt in our portfolio and is taking actions to ensure that these risks, including refinancing and interest risks, are properly balanced with the benefit of using leverage. We expect our debt financing will be 60% or less of the cost of our tangible assets (before deducting depreciation or other non-cash reserves). There is no limitation on the amount we may borrow for any single investment. Our charter limits our total liabilities such that our total liabilities may not exceed 75% of the cost of our tangible assets (before deducting depreciation or other non-cash reserves); however, we may exceed that limit if a majority of the Conflicts Committee approves each borrowing in excess of our charter limitation and we disclose such borrowing to our common stockholders in our next quarterly report with an explanation from the conflicts committee of the justification for the excess borrowing. As of December 31, 2019, our borrowings and other liabilities were approximately 60% of the cost (before depreciation and other noncash reserves) and book value (before depreciation) of our tangible assets.
Contractual Commitments and Contingencies
The following is a summary of our contractual obligations as of December 31, 2019 (in thousands):
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| | | | Payments Due During the Years Ending December 31, | | | | | | |
| Contractual Obligations | | Total | | 2020 | | 2021-2022 | | 2023-2024 | | Thereafter |
Outstanding debt obligations (1) | | $ | 329,595 | | | $ | 79,931 | | | $ | 249,664 | | | $ | — | | | $ | — | |
Interest payments on outstanding debt obligations (2) | | 28,048 | | | 13,076 | | | 14,972 | | | — | | | — | |
| Finance lease obligations | | 56,251 | | | 740 | | | 1,670 | | | 885 | | | 52,956 | |
_____________________
(1) Amounts include principal payments only.
(2) Projected interest payments are based on the outstanding principal amounts and interest rates in effect at December 31, 2019. We incurred interest expense of $18.0 million, excluding amortization of deferred financing costs of $1.8 million and unrealized loss on interest rate cap of $0.1 million for the year ended December 31, 2019.
Results of Operations
Overview
As of December 31, 2019, we had invested in two hotel properties, three office properties, one apartment building, an investment in real estate equity securities and we had entered into a consolidated joint venture to develop one office/retail property. We also invested in two investments in unconsolidated entities, with one investment acquired during the year ended December 31, 2019. We funded the acquisitions of these investments with proceeds from our terminated offerings and debt financing. Our results of operations for the year ended December 31, 2019 are not indicative of those in future periods as we expect that our revenue and expenses related to our portfolio will increase in future periods as the occupancies at our properties stabilize as discussed below. Our investment objectives include acquiring properties with significant possibilities for short-term capital appreciation, such as non-stabilized properties, properties with moderate vacancies or near-term lease rollovers, poorly managed and positioned properties, properties owned by distressed sellers and built-to-suit properties. As of December 31, 2019, the occupancy in our properties has not been stabilized. However, due to the amount of near-term lease expirations, we do not put significant emphasis on quarterly changes in occupancy (positive or negative) in the short run. Our underwriting and valuations are generally more sensitive to “terminal values” that may be realized upon the disposition of the assets in the portfolio and less sensitive to ongoing cash flows generated by the portfolio in the years leading up to an eventual sale. There are no guarantees that occupancies of our assets will increase, or that we will recognize a gain on the sale of our assets. In general, we expect that our income and expenses related to our portfolio will increase in future periods as a result of leasing additional space and improving our properties but decrease due to disposition activity.
As of December 31, 2018, we had invested in two hotel properties, four office properties, one apartment building, an investment in real estate equity securities and we had entered into a consolidated joint venture to develop one office/retail property. We also invested in an investment in an unconsolidated entity. We funded the acquisitions of these investments with proceeds from our terminated offerings and debt financing.
Comparison of the year ended December 31, 2019 versus the year ended December 31, 2018
The following table provides summary information about our results of operations for the years ended December 31, 2019 and 2018 (dollar amounts in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Years Ended December 31, | | | | Increase (Decrease) | | Percentage Change | | $ Change Due to Acquisitions/Repayments (1) | | $ Change Due to Investments Held Throughout Both Periods (2) |
| | 2019 | | 2018 | | | | | | | | |
| Hotel revenues | $ | 31,381 | | | $ | 32,666 | | | $ | (1,285) | | | (4) | % | | $ | — | | | $ | (1,285) | |
| Office revenues | 28,830 | | | 29,941 | | | (1,111) | | | (4) | % | | (215) | | | (896) | |
| Apartment revenues | 8,112 | | | 7,469 | | | 643 | | | 9 | % | | — | | | 643 | |
| Dividend income from real estate equity securities | 418 | | | 196 | | | 222 | | | 113 | % | | — | | | 222 | |
| Interest income from real estate loan receivable | — | | | 10 | | | (10) | | | (100) | % | | (10) | | | — | |
| Hotel expenses | 22,770 | | | 22,907 | | | (137) | | | (1) | % | | — | | | (137) | |
| Office expenses | 13,705 | | | 12,322 | | | 1,383 | | | 11 | % | | (19) | | | 1,402 | |
| Apartment expenses | 3,554 | | | 3,779 | | | (225) | | | (6) | % | | — | | | (225) | |
| Asset management fees to affiliate | 4,093 | | | 3,985 | | | 108 | | | 3 | % | | (38) | | | 146 | |
| General and administrative expenses | 3,475 | | | 2,866 | | | 609 | | | 21 | % | | n/a | | | n/a | |
| Depreciation and amortization | 20,236 | | | 20,405 | | | (169) | | | (1) | % | | (109) | | | (60) | |
| Interest expense | 19,876 | | | 14,663 | | | 5,213 | | | 36 | % | | (11) | | | 5,224 | |
| Impairment charges on real estate | — | | | 14,745 | | | (14,745) | | | (100) | % | | — | | | (14,745) | |
| Other interest income | 305 | | | 367 | | | (62) | | | (17) | % | | n/a | | | n/a | |
| Equity in income of unconsolidated entity | 2,800 | | | 339 | | | 2,461 | | | 726 | % | | — | | | 2,461 | |
| Gain (loss) on real estate equity securities | 2,704 | | | (1,924) | | | 4,628 | | | (241) | % | | 4,628 | | | — | |
| Gain on sale of real estate | 4,178 | | | — | | | 4,178 | | | n/a | | | 4,178 | | | — | |
| | | | | | | | | | | |
_____________________
(1) Represents the dollar amount increase (decrease) for the year ended December 31, 2019 compared to the year ended December 31, 2018 related to real estate and real estate-related investments acquired, repaid or disposed on or after January 1, 2018.
(2) Represents the dollar amount increase (decrease) for the year ended December 31, 2019 compared to the year ended December 31, 2018 with respect to real estate and real estate-related investments owned by us during the entirety of both periods presented.
Hotel revenues decreased from $32.7 million for the year ended December 31, 2018 to $31.4 million for the year ended December 31, 2019 primarily due to a decrease in hotel room revenues collected as a result of a decrease in average daily rate at Springmaid Beach Resort and a decrease in occupancy at Q&C Hotel. The average daily rate at Springmaid Beach Resort decreased from $157.47 for the year ended December 31, 2018 to $138.06 for the year ended December 31, 2019. Springmaid Beach Resort occupancy increased from 60.6% for the year ended December 31, 2018 to 65.0% for the year ended December 31, 2019. Q&C Hotel occupancy decreased from 77.8% for the year ended December 31, 2018 to 73.3% for the year ended December 31, 2019. We expect hotel revenues to vary in future periods based on occupancy and room rates.
Office revenues decreased from $29.9 million for the year ended December 31, 2018 to $28.8 million for the year ended December 31, 2019 primarily due to a decrease in average occupancy to 68.3% for the year ended December 31, 2019 compared to 70% for the year ended December 31, 2018 and the disposition of 2200 Paseo Verde. We expect office revenues to vary in future periods based on occupancy rates and rental rates of our office properties, but to decrease to the extent we dispose of properties.
Apartment revenues increased from $7.5 million for the year ended December 31, 2018 to $8.1 million for the year ended December 31, 2019 primarily due to overall increase in rent per unit. We expect apartment revenues to vary in future periods depending on occupancy rates and rental rates.
Dividend income from real estate equity securities increased from $0.2 million for the year ended December 31, 2018 to $0.4 million for the year ended December 31, 2019 due to the acquisition of real estate equity securities. We expect dividend income from real estate equity securities to vary in future periods as a result of declaration of dividends and to the extent we buy or sell any securities.
Hotel expenses remained consistent at $22.9 million for the years ended December 31, 2018 and 2019. Office expenses increased from $12.3 million for the year ended December 31, 2018 to $13.7 million for year ended December 31, 2019 primarily as a result of (i) approximately $1.2 million of 210 West 31st Street expenses incurred during the year ended December 31, 2019, which were previously capitalized to building and improvements prior to the development being placed on hold on October 1, 2018. We expect total expenses to vary in future periods based on occupancy rates.
Asset management fees to affiliate increased from $4.0 million for the year ended December 31, 2018 to $4.1 million for year ended December 31, 2019 primarily as a result of improvements made at our properties. We expect asset management fees to increase in future periods as a result of any improvements we make to our properties but to decrease to the extent we dispose of properties. Approximately $0.6 million of asset management fees incurred were payable as of December 31, 2019.
General and administrative expenses increased from $2.9 million for the year ended December 31, 2018 to $3.5 million for year ended December 31, 2019 primarily due to an increase in legal costs. We expect general and administrative expenses to fluctuate in future periods based on our legal expenses and investment and disposition activity.
Depreciation and amortization expenses decreased from $20.4 million for the year ended December 31, 2018 to $20.2 million for the year ended December 31, 2019 primarily due to disposition of 2200 Paseo Verde. We expect depreciation and amortization expenses to vary in future periods as a result of a decrease in amortization related to fully amortized tenant origination and absorption costs and increase as a result of improvements to real estate.
Interest expense increased from $14.7 million for the year ended December 31, 2018 to $19.9 million for the year ended December 31, 2019, primarily as a result of approximately $3.8 million of 210 West 31st Street interest expense incurred during the year ended December 31, 2019, which was previously capitalized to building and improvements prior to the development being placed on hold on October 1, 2018. Excluded from interest expense was $3.9 million of interest capitalized to building and improvements during the years ended December 31, 2018. Our interest expense in future periods will vary based on our level of future borrowings, which will depend on the availability and cost of debt financing. The increase in interest expense due to increases in LIBOR rates would be minimized somewhat to the extent rates are above the strike rates on our interest rate cap instruments.
During the year ended December 31, 2018, we recorded impairment charges in the aggregate of $14.7 million to write-down the carrying value of 210 West 31st Street, a development property located in New York, New York, to its estimated fair value of $54.9 million due to a change in the projected hold period and related decrease in projected cash flows. We purchased 210 West 31st Street for $48.0 million plus $1.8 million of closing costs. Since acquisition in December 2016, we have capitalized $6.8 million related to a finance lease asset, $3.8 million in development costs and $9.2 million of other certain costs such as financing costs, real estate taxes and insurance costs that have been capitalized to building and improvements.
During the year ended December 31, 2019, we recognized $2.8 million of equity income from unconsolidated entity as a result of the liquidation of the underlying portfolio related to our STAM investment.
Gain on real estate equity securities was $2.7 million during the year ended December 31, 2019, primarily as a result of a increase in share price of our investment in real estate equity securities. Loss on real estate equity securities was $1.9 million during the year ended December 31, 2018, primarily as a result of a decrease in share price of our investment in real estate equity securities We expect gain (loss) on real estate equity securities to fluctuate in future periods as a result of changes in the share price of our investment in real estate equity securities.
Gain on sale of real estate was $4.2 million for the year ended December 31, 2019, due to the disposition of 2200 Paseo Verde.
Funds from Operations, Modified Funds from Operations and Adjusted Modified Funds from Operations
We believe that funds from operations (“FFO”) is a beneficial indicator of the performance of an equity REIT. We compute FFO in accordance with the current National Association of Real Estate Investment Trusts (“NAREIT”) definition. FFO represents net income, excluding gains and losses from sales of operating real estate assets (which can vary among owners of identical assets in similar conditions based on historical cost accounting and useful-life estimates), impairment losses on real estate assets, depreciation and amortization of real estate assets, and adjustments for unconsolidated partnerships and joint ventures. In addition, we elected the option to exclude mark-to-market changes in value recognized on equity securities in the calculation of FFO. We believe FFO facilitates comparisons of operating performance between periods and among other REITs. However, our computation of FFO may not be comparable to other REITs that do not define FFO in accordance with the NAREIT definition or that interpret the current NAREIT definition differently than we do. Our management believes that historical cost accounting for real estate assets in accordance with U.S. generally accepted accounting principles (“GAAP”) implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values have historically risen or fallen with market conditions, many industry investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. As a result, we believe that the use of FFO, together with the required GAAP presentations, provides a more complete understanding of our performance relative to our competitors and provides a more informed and appropriate basis on which to make decisions involving operating, financing, and investing activities.
Changes in accounting rules have resulted in a substantial increase in the number of non-operating and non-cash items included in the calculation of FFO. As a result, our management also uses modified funds from operations (“MFFO”) as an indicator of our ongoing performance as well as our dividend sustainability. MFFO excludes from FFO: acquisition fees and expenses (to the extent that such fees and expenses have been recorded as operating expenses); adjustments related to contingent purchase price obligations; amounts relating to straight-line rents and amortization of above- and below-market intangible lease assets and liabilities; accretion of discounts and amortization of premiums on debt investments; amortization of closing costs relating to debt investments; impairments of real estate-related investments; mark-to-market adjustments included in net income; and gains or losses included in net income for the extinguishment or sale of debt or hedges. We compute MFFO in accordance with the definition of MFFO included in the practice guideline issued by the Institute for Portfolio Alternatives (“IPA”) in November 2010 as interpreted by management. Our computation of MFFO may not be comparable to other REITs that do not compute MFFO in accordance with the current IPA definition or that interpret the current IPA definition differently than we do.
In addition, our management uses an adjusted MFFO (“Adjusted MFFO”) as an indicator of our ongoing performance as well as our dividend sustainability. Adjusted MFFO provides adjustments to reduce MFFO related to operating expenses that are capitalized with respect to certain of our investments in undeveloped land.
We believe that MFFO and Adjusted MFFO are helpful as measures of ongoing operating performance because they exclude costs that management considers more reflective of investing activities and other non-operating items included in FFO. Management believes that excluding acquisition costs (to the extent that such costs have been recorded as operating expenses) from MFFO and Adjusted MFFO provides investors with supplemental performance information that is consistent with management’s analysis of the operating performance of the portfolio over time, including periods after our acquisition stage. MFFO and Adjusted MFFO also exclude non-cash items such as straight-line rental revenue. Additionally, we believe that MFFO and Adjusted MFFO provide investors with supplemental performance information that is consistent with the performance indicators and analysis used by management, in addition to net income and cash flows from operating activities as defined by GAAP, to evaluate the sustainability of our operating performance. MFFO provides comparability in evaluating the operating performance of our portfolio with other non-traded REITs which typically have limited lives with short and defined acquisition periods and targeted exit strategies. MFFO, or an equivalent measure, is routinely reported by non-traded REITs, and we believe often used by analysts and investors for comparison purposes.
FFO, MFFO and Adjusted MFFO are non-GAAP financial measures and do not represent net income as defined by GAAP. Net income as defined by GAAP is the most relevant measure in determining our operating performance because FFO, MFFO and Adjusted MFFO include adjustments that investors may deem subjective, such as adding back expenses such as depreciation and amortization and the other items described above. Accordingly, FFO, MFFO and Adjusted MFFO should not be considered as alternatives to net income as an indicator of our current and historical operating performance. In addition, FFO, MFFO and Adjusted MFFO do not represent cash flows from operating activities determined in accordance with GAAP and should not be considered an indication of our liquidity. We believe FFO, MFFO and Adjusted MFFO, in addition to net income and cash flows from operating activities as defined by GAAP, are meaningful supplemental performance measures.
Although MFFO includes other adjustments, the exclusion of straight-line rent, the amortization of above- and below-market leases and mark-to-market adjustments included in net income are the most significant adjustments for the periods presented. We have excluded these items based on the following economic considerations:
•Adjustments for straight-line rent. These are adjustments to rental revenue as required by GAAP to recognize contractual lease payments on a straight-line basis over the life of the respective lease. We have excluded these adjustments in our calculation of MFFO to more appropriately reflect the current economic impact of our in-place leases, while also providing investors with a useful supplemental metric that addresses core operating performance by removing rent we expect to receive in a future period or rent that was received in a prior period;
•Amortization of above- and below-market leases. Similar to depreciation and amortization of real estate assets and lease related costs that are excluded from FFO, GAAP implicitly assumes that the value of intangible lease assets and liabilities diminishes predictably over time and requires that these charges be recognized currently in revenue. Since market lease rates in the aggregate have historically risen or fallen with local market conditions, management believes that by excluding these charges, MFFO provides useful supplemental information on the realized economics of the real estate; and
•Mark to Market adjustments included in net income. These are fair value adjustments to derivative instruments. We have excluded these adjustments in our calculation of MFFO to more appropriately reflect core operating performance.
Adjusted MFFO includes adjustments to reduce MFFO related to real estate taxes, property insurance and financing costs which are capitalized with respect to certain renovation projects. We have included adjustments for the costs incurred necessary to bring these investments to their intended use, as these costs are recurring operating costs that are capitalized in accordance with GAAP and not reflected in our net income (loss), FFO and MFFO.
Our calculation of FFO, which we believe is consistent with the calculation of FFO as defined by NAREIT, is presented in the following table, along with our calculations of MFFO and Adjusted MFFO, for the years ended December 31, 2019, 2018 and 2017 (in thousands). No conclusions or comparisons should be made from the presentation of these periods.
| | | | | | | | | | | | | | | | | |
| For the Years Ended December 31, | | | | | |
| 2019 | | 2018 | | 2017 |
| Net loss attributable to common stockholders | $ | (7,499) | | | $ | (23,508) | | | $ | (3,272) | |
| Depreciation of real estate assets | 14,433 | | | 13,219 | | | 9,039 | |
| Amortization of lease-related costs | 5,803 | | | 7,186 | | | 5,390 | |
| Gain on sale of real estate | (4,178) | | | — | | | — | |
| Impairment charges on real estate | — | | | 14,745 | | | — | |
| (Gain) loss on real estate equity securities | (2,704) | | | 1,924 | | | — | |
Adjustments for noncontrolling interests (1) | (985) | | | (3,302) | | | (758) | |
Adjustments for investment in unconsolidated entity (2) | (2,800) | | | (26) | | | — | |
FFO attributable to common stockholders (3) | 2,070 | | | 10,238 | | | 10,399 | |
| Straight-line rent and amortization of above- and below-market leases | (3,221) | | | (4,845) | | | (2,802) | |
| Loss on extinguishment of debt | 105 | | | — | | | — | |
| Amortization of discounts and closing costs | — | | | — | | | (58) | |
| Unrealized loss (gain) on derivative instruments | 5 | | | (124) | | | 175 | |
| | | | | |
| | | | | |
Adjustments for noncontrolling interests (1) | (25) | | | (22) | | | (21) | |
MFFO attributable to common stockholders (3) | (1,066) | | | 5,247 | | | 7,693 | |
Other capitalized operating expenses (4) | — | | | (998) | | | (641) | |
Casualty-related income, net (5) | 87 | | | — | | | (1,614) | |
Adjustments for noncontrolling interests - consolidated entity (1) | (9) | | | — | | | 161 | |
Adjusted MFFO attributable to common stockholders (3) | $ | (988) | | | $ | 4,249 | | | $ | 5,599 | |
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(1) Reflects adjustments to eliminate the noncontrolling interest holders’ share of the adjustments to convert our net income (loss) attributable to common stockholders to FFO, MFFO and Adjusted MFFO.
(2) Reflects adjustments to add back our noncontrolling interest share of the adjustments to convert our net (loss) income attributable to common stockholders to FFO for our equity investment in an unconsolidated entity.
(3) FFO, MFFO and Adjusted MFFO includes $5.8 million of business interruption insurance recovery for the year ended December 31, 2017.
(4) Reflects real estate taxes, property insurance and financing costs that are capitalized with respect to certain renovation projects but excluding development projects. During the time in which we are incurring costs necessary to bring these investments to their intended use, certain financing costs are capitalized in accordance with GAAP and not reflected in our net loss, FFO and MFFO.
(5) Reflects property damages and insurance recoveries related to the impact of Hurricane Matthew at the Springmaid Beach Resort. We exclude them from Adjusted MFFO to more appropriately present the ongoing operating perfor,mance of our real estate investments on a comparative basis. We believe this exclusion is useful to investors as it allows investors to more accurately evaluate the sustainability of our operating performance.
FFO, MFFO and Adjusted MFFO may also be used to fund all or a portion of certain capitalizable items that are excluded from FFO, MFFO and Adjusted MFFO, such as tenant improvements, building improvements and deferred leasing costs. We expect FFO, MFFO and Adjusted MFFO to improve in future periods to the extent that we continue to lease up vacant space and acquire additional assets. We expect FFO, MFFO and Adjusted MFFO to increase as a result of stabilizing occupancies at our properties.
Organization and Offering Costs
Our organization and offering costs (other than selling commissions, dealer manager fees and the stockholder servicing fee) were paid by our advisor, the dealer manager or their affiliates on our behalf or paid directly by us. These offering costs include all expenses incurred in connection with our offerings. Organization costs include all expenses incurred in connection with our formation, including but not limited to legal fees and other costs to incorporate.
We recorded $1.0 million of offering costs (other than selling commissions and dealer manager fees) related to our private offering, all of which were initially paid by our advisor or its affiliates on our behalf and subsequently reimbursed by us. In addition, we paid $1.9 million in selling commissions and dealer manager fees related to our private offering.
During our initial public offering, pursuant to the advisory agreement and dealer manager agreement, we were obligated to reimburse our advisor, the dealer manager or their affiliates, as applicable, for organization and other offering costs paid by them on behalf of us, provided that no reimbursements made by us to our advisor or the dealer manager could cause total organization and offering expenses incurred by us in connection with our initial public offering (including selling commissions, dealer manager fees and the stockholder servicing fees) to exceed 15% of the aggregate gross proceeds from our initial public offering as of the date of reimbursement. In addition, our advisor and its affiliates reimbursed us to the extent that the organization and other offering expenses (which exclude selling commissions, dealer manager fees and stockholder servicing fees) paid directly or reimbursed by us in connection with the primary portion of our initial public offering, regardless of when incurred, exceeded 1.0% of gross offering proceeds from the primary portion of our initial public offering. Our advisor and its affiliates are responsible for any organization and other offering expenses related to the primary portion of our initial public offering to the extent they exceed 1.0% of gross proceeds from the primary portion of the public offering as of the termination of the primary portion of our initial public offering.
Through December 31, 2019, our advisor and its affiliates had incurred organization and other offering costs (which exclude selling commissions dealer manager fees and stockholder servicing fees) on our behalf in connection with our initial public offering of approximately $11.4 million. As of December 31, 2019, we had recorded $16.4 million in selling commissions and dealer manager fees and $1.7 million of stockholder servicing fees. As of December 31, 2019, we had recorded $2.8 million of other organization and offering expenses, which amounts represent our maximum liability for organization and other offering costs as of December 31, 2019 based on the 1.0% limitation described above.
Distributions
To maintain our qualification as a REIT, we must make aggregate annual distributions to our stockholders of at least 90% of our REIT taxable income (which is computed without regard to the dividends paid deduction or net capital gain and which does not necessarily equal net income as calculated in accordance with GAAP). If we meet the REIT qualification requirements, we generally will not be subject to federal income tax on the income that we distribute to our stockholders each year. In general, we anticipate making distributions to our stockholders of at least 100% of our REIT taxable income so that none of our income is subject to federal income tax. Our board of directors may authorize distributions in excess of those required for us to maintain REIT status depending on our financial condition and such other factors as our board of directors deems relevant.
From time to time during our operational stage we may not pay distributions solely from our cash flow from operating activities, in which case distributions may be paid in whole or in part from debt financing. Distributions declared, distributions paid and cash flow provided by operations during 2019 were as follows (in thousands, except per share amounts):
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Distributions Declared (1) | | Distributions Declared Per Class A Share (1) (2) | | Distributions Declared Per Class T Share (1) (2) | | Distributions Paid (3) | | | | | | Cash Flows (Used in) Provided by Operations |
| Period | | | | | | | | Cash | | Reinvested | | Total | | |
| First Quarter 2019 | | $ | 1,206 | | | $ | 0.040 | | | $ | 0.040 | | | $ | 550 | | | $ | 899 | | | $ | 1,449 | | | $ | (3,111) | |
| Second Quarter 2019 | | 724 | | | 0.024 | | | 0.024 | | | 276 | | | 448 | | | 724 | | | 2,899 | |
| Third Quarter 2019 | | 724 | | | 0.024 | | | 0.024 | | | 285 | | | 439 | | | 724 | | | 2,065 | |
| Fourth Quarter 2019 | | 725 | | | 0.024 | | | 0.024 | | | 292 | | | 432 | | | 724 | | | (1,948) | |
| | $ | 3,379 | | | $ | 0.112 | | | $ | 0.112 | | | $ | 1,403 | | | $ | 2,218 | | | $ | 3,621 | | | $ | (95) | |
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(1) Distributions for the period from January 2019 through February 2019 were based on monthly record dates and were calculated at a rate of $0.01598333 per share per month. Distributions for March 2019 through December 2019 were based on the monthly record date and were calculated at a rate of $0.00799167 per share on the outstanding shares of all classes of its common stock as of monthly record dates.
(2) Assumes share was issued and outstanding each day that was a record date for distributions during the period presented.
(3) Distributions are paid on a monthly basis. Distributions for all record dates of a given month are paid on or about the first business day of the following month.
For the year ended December 31, 2019, we paid aggregate distributions of $3.6 million, including $1.4 million distributions paid in cash and $2.2 million of distributions reinvested through our dividend reinvestment plan. Our net loss attributable to common stockholders for the year ended December 31, 2019 was $7.5 million and cash flow used in operations was $0.1 million. We funded our total distributions paid, which includes net cash distributions and dividends reinvested by stockholders, with $3.6 million of prior period cash flow from operating activities in excess of distributions paid. For purposes of determining the source of our distributions paid, we assume first that we use cash flow from operating activities from the relevant or prior periods to fund distribution payments.
To the extent that we pay distributions from sources other than our cash flow from operating activities, we will have less funds available, the overall return to our stockholders may be reduced and subsequent investors will experience dilution.
Going forward we expect our board of directors to continue to authorize and declare monthly cash distributions. Cash distributions will be determined by our board of directors based on our financial condition and such other factors as our board of directors deems relevant. Our board of directors has not pre-established a percentage rate of return for cash distributions to stockholders. We have not established a minimum distribution level, and our charter does not require that we make distributions to our stockholders.
We expect that we will fund these cash distributions from rental and other income on our real property investments and dividend income from real estate equity securities. We may also utilize strategic refinancings to fund cash distributions for investments that have appreciated in value after our acquisition. Generally, our distribution policy is not to pay cash distributions from sources other than cash flow from operations, investment activities and strategic financings. However, we may fund cash distributions from any source and there are no limits to the amount of distributions that we may pay from any source, including proceeds from our public offering or the proceeds from the issuance of securities in the future, other third party borrowings, advances from our advisor or sponsors or from our advisor’s deferral of its fees under the advisory agreement. Distributions paid from sources other than current or accumulated earnings and profits may constitute a return of capital. From time to time, we may generate taxable income greater than our net income for financial reporting purposes, or our taxable income may be greater than our cash flow available for distribution to stockholders. In these situations we may make distributions in excess of our cash flow from operations, investment activities and strategic financings to satisfy the REIT distribution requirement. In such an event, we would look first to other third party borrowings to fund these distributions.
Critical Accounting Policies
Below is a discussion of the accounting policies that management considers critical in that they involve significant management judgments and assumptions, require estimates about matters that are inherently uncertain and because they are important for understanding and evaluating our reported financial results. These judgments will affect the reported amounts of assets and liabilities and our 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. With different estimates or assumptions, materially different amounts could be reported in our 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.
Revenue Recognition
Effective January 1, 2018, we adopted ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU No. 2014-09”), using the modified retrospective approach, which requires a cumulative effect adjustment as of the date of our adoption. Under the modified retrospective approach, an entity may also elect to apply this standard to either (i) all contracts as of January 1, 2018 or (ii) only to contracts that were not completed as of January 1, 2018. A completed contract is a contract for which all (or substantially all) of the revenue was recognized under legacy GAAP that was in effect before the date of initial application. We elected to apply this standard only to contracts that were not completed as of January 1, 2018.
Based on our evaluation of contracts within the scope of ASU No. 2014-09, revenue that is impacted by ASU No. 2014-09 includes revenue generated by other operating income and tenant reimbursements for substantial services earned at our office properties and hotel revenues. The recognition of such revenue will occur when the services are provided and the performance obligations are satisfied.
Hotel Revenue
We recognize revenue for hotels as hotel revenue when earned. Revenues are recorded net of any sales or occupancy tax collected from our guests. Additionally, some of our hotel rooms are booked through independent internet travel intermediaries. If the guest pays the independent internet travel intermediary directly, revenue for the room is booked by us at the price we sold the room to the independent internet travel intermediary, less any discount or commission paid. If the guest pays us directly, revenue for the room is booked by us on a gross basis. We participate in frequent guest programs sponsored by the brand owners of our hotels and we expense the charges associated with those programs, as incurred. Hotel operating revenues are disaggregated in the real estate footnote into the categories of rooms revenue, food, beverage and convention services revenue, campground revenue and other revenue to demonstrate how economic factors affect the nature, amount, timing, and uncertainty of revenue and cash flows.
Room revenue is generated through contracts with customers whereby the customer agrees to pay a daily rate for the right to use a hotel room. Our contract performance obligations are fulfilled at the end of the day that the customer is provided the room and revenue is recognized daily at the contract rate. Payment from the customer is secured at the end of the contract upon check-out by the customer from our hotel. We record contract liabilities in the form of advanced deposits when a customer or group of customers provides a deposit for a future stay at our hotels. Advanced deposits for room revenue are included in the balance of other liabilities on the consolidated balance sheet. Advanced deposits are recognized as revenue at the time of the guest’s stay. We note no significant judgments regarding the recognition of rooms revenue.
Food, beverage and convention revenue is generated through contracts with customers whereby the customer agrees to pay a contract rate for restaurant dining services or convention services. Our contract performance obligations are fulfilled at the time that the meal is provided to the customer or when the convention facilities and related dining amenities are provided to the customer. We recognize food and beverage revenue upon the fulfillment of the contract with the customer. We record contract liabilities in the form of advanced deposits when a customer or group of customers provides a deposit for a future banquet event at our hotels. Advanced deposits for food and beverage revenue are included in the balance of other liabilities on the consolidated balance sheet. Advanced deposits for banquet services are recognized as revenue following the completion of the banquet services. We note no significant judgments regarding the recognition of food and beverage revenue.
Campground revenue is recognized on a straight-line basis over the term of the lease when collectability is reasonably assured.
Office and Apartment Revenues
We recognize minimum rent, including rental abatements, lease incentives and contractual fixed increases attributable to operating leases, on a straight-line basis over the term of the related leases when collectibility is reasonably assured and will record amounts expected to be received in later years as deferred rent receivable. If the lease provides for tenant improvements, we will determine whether the tenant improvements, for accounting purposes, are owned by the tenant or us. When we are the owner of the tenant improvements, the tenant is not considered to have taken physical possession or have control of the physical use of the leased asset until the tenant improvements are substantially completed. When the tenant is the owner of the tenant improvements, any tenant improvement allowance (including amounts that can be taken in the form of cash or a credit against the tenant’s rent) that is funded is treated as a lease incentive and amortized as a reduction of revenue over the lease term. Tenant improvement ownership is determined based on various factors including, but not limited to:
•whether the lease stipulates how a tenant improvement allowance may be spent;
•whether the amount of a tenant improvement allowance is in excess of market rates;
•whether the tenant or landlord retains legal title to the improvements at the end of the lease term;
•whether the tenant improvements are unique to the tenant or general purpose in nature; and
•whether the tenant improvements are expected to have any residual value at the end of the lease.
We record property operating expense reimbursements due from tenants for common area maintenance, real estate taxes, and other recoverable costs in the period the related expenses are incurred.
We lease apartment units under operating leases with terms generally of one year or less. Generally, credit investigations will be performed for prospective residents and security deposits will be obtained. We recognize rental revenue, net of concessions, on a straight-line basis over the term of the lease, when collectibility is reasonably assured.
We make estimates of the collectibility of our tenant receivables related to base rents, including deferred rent, expense reimbursements and other revenue or income. We will specifically analyze accounts receivable, deferred rents receivable, historical bad debts, customer creditworthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. In addition, with respect to tenants in bankruptcy, we will make estimates of the expected recovery of pre-petition and post-petition claims in assessing the estimated collectibility of the related receivable. In some cases, the ultimate resolution of these claims can exceed one year. When a tenant is in bankruptcy, we will record a bad debt reserve for the tenant’s receivable balance and generally will not recognize subsequent rental revenue until cash is received or until the tenant is no longer in bankruptcy and has the ability to make rental payments.
Real Estate Equity Securities
Our real estate equity securities are carried at their estimated fair value based on quoted market prices for the security. Transaction costs that are directly attributable to the acquisition of real estate equity securities are capitalized to its cost basis. Upon adoption of ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU No. 2016-01”) on January 1, 2018, unrealized gains and losses on real estate equity securities are recognized in earnings.
Dividend income from real estate equity securities is recognized on an accrual basis based on eligible shares as of the ex-dividend date.
Real Estate
Depreciation and Amortization
Real estate costs related to the acquisition and improvement of properties are capitalized and depreciated over the expected useful life of the asset on a straight-line basis. Repair and maintenance costs are charged to expense as incurred and significant replacements and betterments are capitalized. Repair and maintenance costs will include all costs that do not extend the useful life of the real estate asset. We consider the period of future benefit of an asset to determine its appropriate useful life. Expenditures for tenant improvements will be capitalized and amortized over the shorter of the tenant’s lease term or expected useful life. We anticipate the estimated useful lives of our assets by class to be generally as follows:
| | | | | |
| Land | N/A |
| Buildings | 25-40 years |
| Building improvements | 10-25 years |
| Tenant improvements | Shorter of lease term or expected useful life |
| Tenant origination and absorption costs | Remaining term of related leases, including below-market renewal periods |
| Real estate subsidies & tax abatements | Remaining term of agreement |
| Furniture, fixtures & equipment | 3-12 years |
Real Estate Acquisition Valuation
As a result of our adoption of ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business, acquisitions of real estate beginning January 1, 2017 could qualify as asset acquisitions (as opposed to business combinations). We record the acquisition of income-producing real estate or real estate that will be used for the production of income as a business combination or an asset acquisition. If substantially all of the fair value of the gross assets acquired are concentrated in a single identifiable asset or group of similar identifiable assets, then the set is not a business. For purposes of this test, land and buildings can be combined along with the intangible assets for any in-place leases and accordingly, most acquisitions of investment properties would not meet the definition of a business and would be accounted for as an asset acquisition. To be considered a business, a set must include an input and a substantive process that together significantly contributes to the ability to create an output. All assets acquired and liabilities assumed in a business combination are measured at their acquisition date fair values. For asset acquisitions, the cost of the acquisition is allocated to individual assets and liabilities on a relative fair value basis. Acquisition costs associated with business combinations are expensed as incurred. Acquisition costs associated with asset acquisitions are capitalized.
Intangible assets include the value of in place leases, which represents the estimated value of the net cash flows of the in place leases to be realized, as compared to the net cash flows that would have occurred had the property been vacant at the time of acquisition and subject to lease up. Acquired in place lease values are amortized to expense over the average remaining non-cancelable terms of the respective in place leases, including any below-market renewal periods. Intangible assets also include the estimated value of subsidy receipts for apartments, which are recorded at a discounted present value based on estimated collectibility and are amortized on a straight-line basis over the period the amounts are expected to be collected.
We assess the acquisition date fair values of all tangible assets, identifiable intangibles and assumed liabilities using methods similar to those used by independent appraisers generally utilizing a discounted cash flow analysis that applies appropriate discount and/or capitalization rates and available market information. Estimates of future cash flows will be based on a number of factors, including historical operating results, known and anticipated trends, and market and economic conditions. The fair value of tangible assets of an acquired property considers the value of the property as if it were vacant.
We record above-market and below-market in-place lease values for acquired properties based on the present value (using an interest rate that reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) management’s estimate of fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining non-cancelable term of above-market in-place leases and for the initial term plus any extended term for any leases with below-market renewal options. We amortize any recorded above-market or below-market lease values as a reduction or increase, respectively, to rental income over the remaining non-cancelable terms of the respective lease, including any below-market renewal periods.
We estimate the value of tenant origination and absorption costs by considering the estimated carrying costs during hypothetical expected lease up periods, considering current market conditions. In estimating carrying costs, we include real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease up periods.
We amortize the value of tenant origination and absorption costs to depreciation and amortization expense over the remaining non-cancelable term of the leases.
Subsequent to the acquisition of a property, we may incur and capitalize costs necessary to get the property ready for its intended use. During that time, certain costs such as legal fees, real estate taxes and insurance and financing costs are also capitalized.
Estimates of the fair values of the tangible assets, identifiable intangibles and assumed liabilities require us to make significant assumptions 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.
Impairment of Real Estate and Related Intangible Assets and Liabilities
We continually monitor events and changes in circumstances that could indicate that the carrying amounts of our real estate and related intangible assets and liabilities may not be recoverable or realized. When indicators of potential impairment suggest that the carrying value of real estate and related intangible assets and liabilities may not be recoverable, we assess the recoverability by estimating whether we will recover the carrying value of the real estate and related intangible assets and liabilities through its undiscounted future cash flows and its eventual disposition. If, based on this analysis, we do not believe that we will be able to recover the carrying value of the real estate and related intangible assets and liabilities, we would record an impairment loss to the extent that the carrying value exceeds the estimated fair value of the real estate and related intangible assets and liabilities.
Projecting future cash flows involves estimating expected future operating income and expenses related to the real estate and its related intangible assets and liabilities as well as market and other trends. Using inappropriate assumptions to estimate cash flows could result in incorrect fair values of the real estate and its related intangible assets and liabilities and could result in the overstatement of the carrying values of our real estate and related intangible assets and liabilities and an overstatement of our net income.
Construction in Progress
Direct investments in undeveloped land or development properties without leases in place at the time of acquisition are accounted for as an asset acquisition and not as a business combination. Acquisition fees and expenses are capitalized into the cost basis of an asset acquisition. Additionally, during the time in which we are incurring costs necessary to bring these investments to their intended use, certain costs such as legal fees, real estate taxes and insurance and financing costs are also capitalized. Once construction in progress is substantially completed, the amounts capitalized to construction in progress are transferred to land and buildings and improvements and are depreciated over their respective useful lives.
Derivative Instruments
We enter into derivative instruments for risk management purposes to hedge our exposure to cash flow variability caused by changing interest rates on our variable rate notes payable. We record these derivative instruments at fair value on the accompanying consolidated balance sheets. The changes in fair value for derivative instruments that are not designated as a hedge or that do not meet the hedge accounting criteria are recorded as a component of interest expense on the accompanying consolidated statements of operations. Derivative instruments designated and qualifying as a hedge of the exposure to variability in expected future cash flows or other types of forecasted transactions are considered cash flow hedges. The change in fair value of the effective portion of a derivative instrument that is designated as a cash flow hedge is recorded as other comprehensive income (loss) on the accompanying consolidated statements of comprehensive income (loss) and consolidated statements of equity.
With respect to derivative instruments designated as a hedge, we will formally document all relationships between hedging instruments and hedged items, as well as its risk-management objectives and strategy for undertaking various hedge transactions. This process includes designating all derivative instruments that are part of a hedging relationship to specific forecasted transactions or recognized obligations on the consolidated balance sheets. We also assess and document, both at the hedging instrument’s inception and on a quarterly basis thereafter, whether the derivative instruments that are used in hedging transactions are highly effective in offsetting changes in cash flows associated with the respective hedged items. When we determine that a derivative instrument ceases to be highly effective as a hedge, or that it is probable the underlying forecasted transaction will not occur, we discontinue hedge accounting prospectively and reclassify amounts recorded in accumulated other comprehensive income (loss) to earnings.
The termination of a cash flow hedge prior to the maturity date may result in a net derivative instrument gain or loss that continues to be reported in accumulated other comprehensive income (loss) and is reclassified into earnings over the period of the original forecasted hedged transaction (i.e., LIBOR based debt service payments) unless it is probable that the original forecasted hedged transaction will not occur by the end of the originally specified time period (as documented at the inception of the hedging relationship) or within an additional two-month period of time thereafter. If it is probable that the hedged forecasted transaction will not occur either by the end of the originally specified time period or within the additional two-month period of time, that derivative instrument gain or loss reported in accumulated other comprehensive income (loss) shall be reclassified into earnings immediately.
Fair Value Measurements
Under GAAP, we are required to measure certain financial instruments at fair value on a recurring basis. In addition, we are required to measure other non-financial and financial assets at fair value on a non-recurring basis (e.g., carrying value of impaired real estate loans receivable and long lived assets). Fair value is defined as the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The GAAP fair value framework uses a three tiered approach. Fair value measurements are classified and disclosed in one of the following three categories:
•Level 1: unadjusted quoted prices in active markets that are accessible at the measurement date for identical assets or liabilities;
•Level 2: quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model derived valuations in which significant inputs and significant value drivers are observable in active markets; and
•Level 3: prices or valuation techniques where little or no market data is available that requires inputs that are both significant to the fair value measurement and unobservable.
When available, we will utilize quoted market prices from an independent source to determine fair value and will classify such items in Level 1 or Level 2. In instances where the market for a financial instrument is not active, regardless of the availability of a nonbinding quoted market price, observable inputs might not be relevant and could require us to make a significant adjustment to derive a fair value measurement. Additionally, in an inactive market, a market price quoted from an independent third party may rely more on models with inputs based on information available only to that independent third party. When we determine the market for a financial instrument owned by us to be illiquid or when market transactions for similar instruments do not appear orderly, we will use several valuation sources (including internal valuations, discounted cash flow analysis and quoted market prices) and will establish a fair value by assigning weights to the various valuation sources. Additionally, when determining the fair value of liabilities in circumstances in which a quoted price in an active market for an identical liability is not available, we will measure fair value using (i) a valuation technique that uses the quoted price of the identical liability when traded as an asset or quoted prices for similar liabilities when traded as assets or (ii) another valuation technique that is consistent with the principles of fair value measurement, such as the income approach or the market approach.
Changes in assumptions or estimation methodologies can have a material effect on these estimated fair values. In this regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, may not be realized in an immediate settlement of the instrument.
We consider the following factors to be indicators of an inactive market: (i) there are few recent transactions, (ii) price quotations are not based on current information, (iii) price quotations vary substantially either over time or among market makers (for example, some brokered markets), (iv) indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability, (v) there is a significant increase in implied liquidity risk premiums, yields, or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with our estimate of expected cash flows, considering all available market data about credit and other nonperformance risk for the asset or liability, (vi) there is a wide bid ask spread or significant increase in the bid ask spread, (vii) there is a significant decline or absence of a market for new issuances (that is, a primary market) for the asset or liability or similar assets or liabilities, and (viii) little information is released publicly (for example, a principal to principal market).
We consider the following factors to be indicators of non-orderly transactions: (i) there was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities under current market conditions, (ii) there was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant, (iii) the seller is in or near bankruptcy or receivership (that is, distressed), or the seller was required to sell to meet regulatory or legal requirements (that is, forced), and (iv) the transaction price is an outlier when compared with other recent transactions for the same or similar assets or liabilities.
Income Taxes
We elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended. To qualify as a REIT, we must continue to meet certain organizational and operational requirements, including a requirement to distribute at least 90% of our annual REIT taxable income to our stockholders (which is computed without regard to the dividends paid deduction or net capital gain and which does not necessarily equal net income as calculated in accordance with GAAP). As a REIT, we generally will not be subject to federal income tax to the extent we distribute qualifying dividends to our stockholders. If we fail to qualify as a REIT in any taxable year, we will be subject to federal income tax on our taxable income at regular corporate income tax rates and generally will not be permitted to qualify for treatment as a REIT for federal income tax purposes for the four taxable 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 and 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.
Subsequent Events
We evaluate subsequent events up until the date the consolidated financial statements are issued.
Cash Distributions Paid
On January 2, 2020, we paid distributions of $0.2 million related to a monthly distribution in the amount of $0.00799167 per share on the outstanding shares of all classes of our common stock as of December 19, 2019.
Proposed Merger
On February 19, 2020, we, Pacific Oak Strategic Opportunity REIT, Inc. (“POSOR I”), and Pacific Oak SOR II, LLC, an indirect subsidiary of POSOR I (“Merger Sub”), entered into an Agreement and Plan of Merger (the “Merger Agreement”). Subject to the terms and conditions of the Merger Agreement, we will merge with and into Merger Sub (the “Merger”), with Merger Sub surviving the Merger (the “Surviving Entity”), such that following the Merger, the Surviving Entity will continue as an indirect subsidiary of POSOR I. In accordance with the applicable provisions of the Maryland General Corporation Law, the separate existence of our company shall cease. At the effective time of the Merger and subject to the terms and conditions of the Merger Agreement, each issued and outstanding share of our common stock will be converted into the right to receive 0.9643 shares of POSOR I common stock. The combined company after the Merger will retain the name “Pacific Oak Strategic Opportunity REIT, Inc.” The Merger is intended to qualify as a “reorganization” under, and within the meaning of, Section 368(a) of the Internal Revenue Code of 1986, as amended. See “Proposed Merger” in Item Part I, Item 1 of this Annual Report on Form 10-K for more information.
COVID-19
The recent global outbreak of COVID-19 (more commonly known as the Coronavirus) has significantly disrupted economic markets and impacted commercial activity worldwide, including the US, and the prolonged economic impact is uncertain. Customers and potential customers of the properties we own could be adversely affected by the disruption to business caused by the global outbreak of the Coronavirus. This could lead to similar negative impacts on our business.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to the effects of interest rate changes as a result of borrowings used to maintain liquidity and to fund the financing of our real estate investment portfolio and operations. We are also exposed to the effects of foreign currency changes in the Euro with respect to our €2.1 million participating loan facility. Foreign currency exchange rate risk is the possibility that our financial results could be better or worse than planned because of changes in foreign currency exchange rates. Our profitability and the value of our investment portfolio may be adversely affected during any period as a result of interest rate changes and foreign currency changes. Our interest rate risk management objectives are to limit the impact of interest rate changes on earnings, prepayment penalties and cash flows and to lower overall borrowing costs. We may manage interest rate risk by maintaining a ratio of fixed rate, long-term debt such that floating rate exposure is kept at an acceptable level. In addition, we may utilize a variety of financial instruments, including interest rate caps, floors, and swap agreements, in order to limit the effects of changes in interest rates on our operations. When we use these types of derivatives to hedge the risk of interest-earning assets or interest-bearing liabilities, we may be subject to certain risks, including the risk that losses on a hedge position will reduce the funds available for payments to holders of our common stock and that the losses may exceed the amount we invested in the instruments.
The table below summarizes the outstanding principal balance and the weighted average interest rates for our notes payable for each category as of December 31, 2019 based on the maturity dates and the notional amount and average interest strike rates of our derivative instrument as of December 31, 2019 based on maturity date (dollars in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Maturity Date | | | | | | | | | | | | Total Value or
Notional Amount | | |
| | 2020 | | 2021 | | 2022 | | 2023 | | 2024 | | Thereafter | | | | Fair Value |
| Assets | | | | | | | | | | | | | | | | |
| Derivative instruments | | | | | | | | | | | | | | | | |
| Interest rate caps, notional amount | | $ | 34,125 | | | $ | 142,950 | | | $ | — | | | $ | — | | | $ | — | | | $ | — | | | $ | 177,075 | | | $ | — | |
Average interest strike rate (1) | | 3.0 | % | | 3.7 | % | | — | | | — | | | — | | | — | | | 3.6 | % | | |
| Liabilities | | | | | | | | | | | | | | | | |
| Notes Payable, principal outstanding | | | | | | | | | | | | | | | | |
| Variable rate | | $ | 78,208 | | | $ | 73,862 | | | $ | 177,525 | | | $ | — | | | $ | — | | | $ | — | | | $ | 329,595 | | | $ | 330,687 | |
Average interest rate (2) | | 4.5 | % | | 3.9 | % | | 4.3 | % | | — | | | — | | | — | | | 4.3 | % | | |
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(1) The average interest strike rate represents the weighted-average cap on one-month LIBOR on the applicable notional amounts.
(2) Average interest rate is the weighted-average interest rate. Weighted-average interest rate as of December 31, 2019 is calculated as the actual interest rate in effect at December 31, 2019 (consisting of the contractual interest rate), using interest rate indices at December 31, 2019, where applicable.
Movements in interest rates on variable rate debt would change our future earnings and cash flows, but would not significantly affect the fair value of those instruments. However, changes in required risk premiums would result in changes in the fair value of floating rate instruments. As of December 31, 2019, we were exposed to market risks related to fluctuations in interest rates on $329.6 million of variable rate debt outstanding. As of December 31, 2019, we have also entered into four interest rate cap agreements with an aggregate notional value of $177.1 million, which effectively cap one-month LIBOR at a range of 3.00%-4.00%. The weighted-average remaining term of the interest rate caps is 1.5 years. Based on interest rates as of December 31, 2019, if interest rates were 100 basis points higher or lower during the 12 months ending December 31, 2019, interest expense on our variable rate debt would increase or decrease, respectively, by $3.3 million and $3.3 million, respectively.
The weighted-average interest rate of our variable rate debt as of December 31, 2019 was 4.3%. The weighted-average interest rate represents the actual interest rate in effect as of December 31, 2019 (consisting of the contractual interest rate and the effect of interest rate caps, if applicable), using interest rate indices as of December 31, 2019 where applicable.
We are exposed to financial market risk with respect to our real estate equity securities. Financial market risk is the risk that we will incur economic losses due to adverse changes in our real estate equity security prices. Our exposure to changes in real estate equity security prices is a result of our investment in these types of securities. Market prices are subject to fluctuation and, therefore, the amount realized in the subsequent sale of an investment may significantly differ from the reported market value. Fluctuation in the market prices of a real estate equity security may result from any number of factors, including perceived changes in the underlying fundamental characteristics of the issuer, the relative price of alternative investments, interest rates, default rates and general market conditions. In addition, amounts realized in the sale of a particular security may be affected by the relative quantity of the real estate equity security being sold. We do not currently engage in derivative or other hedging transactions to manage our real estate equity security price risk. As of December 31, 2019, we owned real estate equity securities with a book value of $9.9 million. Based solely on the prices of real estate equity securities as of December 31, 2019, if prices were to increase or decrease by 10%, our net income would increase or decrease, respectively, by approximately $1.0 million.
For a discussion of the interest rate risks related to the current capital and credit markets, see Part I, Item 1A, “Risk Factors.”
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See the Index to Financial Statements at page F-1 of this Annual Report on Form 10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As of the end of the period covered by this report, management, including our principal executive officer and principal financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures. Based upon, and as of the date of, the evaluation, our principal executive officer and principal financial officer concluded that the disclosure controls and procedures were effective as of the end of the period covered by this report to ensure that information required to be disclosed in the reports we file and submit under the Exchange Act is recorded, processed, summarized and reported as and when required. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports we file and submit under the Exchange Act 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.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Exchange Act.
In connection with the preparation of our Form 10-K, our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2019. In making that assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013).
Based on its assessment, our management believes that, as of December 31, 2019, our internal control over financial reporting was effective based on those criteria.
Changes in Internal Control over Financial Reporting
On November 1, 2019, we entered into an advisory agreement with a new external advisor, Pacific Oak Capital Advisors, LLC, and as a result, all processes have been affected by this change. In most cases, the accounting functions are the same but performed by new personnel. Effective November 1, 2019, Michael A. Bender was appointed to serve as our Executive Vice President, Treasurer, Secretary and Chief Financial Officer-Elect and on November 8, 2019 became Chief Financial Officer. The new external advisor has transitioned most accounting functions to a service provider during our last fiscal quarter, and this resulted in a change to our processes and control environment. There were no other changes to our internal control over financial reporting during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B. OTHER INFORMATION
As of the year ended December 31, 2019, all items required to be disclosed under Form 8-K were reported under Form 8-K.
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
We have provided below certain information about our executive officers and directors.
| | | | | | | | | | | | | | |
| Name | | Position(s) | | Age* |
| Keith D. Hall | | Chief Executive Officer and Director | | 60 | |
| Peter McMillan III | | Chairman of the Board, President and Director | | 61 | |
| Michael A. Bender | | Chief Financial Officer, Treasurer and Secretary | | 60 | |
| John P. Joliet | | Independent Director | | 50 | |
| Laurent Degryse | | Independent Director | | 53 | |
| Kenneth G. Yee | | Independent Director | | 60 | |
_____________________
* As of March 1, 2020.
Keith D. Hall is our Chief Executive Officer and one of our directors, positions he has held since February 2013 and October 2008, respectively. He is also the Chief Executive Officer and a director of Pacific Oak Strategic Opportunity REIT, positions he has held since December 2008 and October 2008, respectively. He is a former Executive Vice President of KBS REIT II, KBS REIT III and KBS Growth & Income REIT. Mr. Hall was Executive Vice President of KBS Real Estate Investment Trust, Inc (“KBS REIT I”) from June 2005 until its liquidation in December 2018. Mr. Hall owns and controls a 50% interest in Pacific Oak Holding, which is the sole owner of our current advisor. Mr. Hall also owns and controls a 50% interest in GKP Holding LLC. GKP Holding owns a 33 1/3% interest in KBS Holdings LLC, which is the sole owner of our former advisor (KBS Capital Advisors) and our former dealer manager (KBS Capital Markets Group). KBS Holdings is a sponsor of our company, and is or was a sponsor of KBS REIT I, KBS REIT II, KBS REIT III, KBS Legacy Partners Apartment REIT, Inc. (“KBS Legacy Partners Apartment REIT”), Pacific Oak Strategic Opportunity REIT and KBS Growth & Income REIT, which were formed in 2008, 2005, 2007, 2009, 2009, 2008 and 2015, respectively. Mr. Hall is also a member of the investment committee formed by our advisor to evaluate and recommend new investment opportunities for us.
Mr. Hall is affiliated with Willowbrook Capital Group, LLC, an asset management company. Mr. Hall is also a founder of Pacific Oak Capital Group, a real estate asset management company formed in 2018, and its family of companies. Prior to commencing his affiliation with Willowbrook in 2000, Mr. Hall was a Managing Director at CS First Boston, where he managed the distribution strategy and business development for the Principal Transaction Group’s $18.0 billion real estate securities portfolio. Mr. Hall’s two primary business unit responsibilities were Mezzanine Lending and Commercial Real Estate Development. Before joining CS First Boston in 1996, he served as a Director in the Real Estate Products Group at Nomura Securities, with responsibility for the company’s $6.0 billion annual pipeline of fixed-income, commercial mortgage-backed securities. During the 1980s, Mr. Hall was a Senior Vice President in the High Yield Department of Drexel Burnham Lambert’s Beverly Hills office, where he was responsible for distribution of the group’s high-yield real estate securities. Mr. Hall received a Bachelor of Arts Degree with honors in Finance from California State University, Sacramento.
Our board of directors has concluded that Mr. Hall is qualified to serve as one of our directors for reasons including his expertise in the real estate finance markets and his expertise with real estate-related investments. With over 30 years of experience investing in and managing real estate-related investments, Mr. Hall has the depth and breadth of experience to implement our business strategy. As an executive officer and principal of our advisor, Mr. Hall is able to direct the board of directors to the critical issues facing our company.
Peter McMillan III is our President, the Chairman of the Board and one of our directors, positions he has held since February 2013. He is also President, Chairman of the Board and a director of Pacific Oak Strategic Opportunity REIT, positions he has held since December 2008. Mr. McMillan has previously served as an Executive Vice President, the Treasurer and Secretary and a director of KBS Growth & Income REIT and KBS REIT III. From June 2005 until its liquidation in December 2018, Mr. McMillan was Executive Vice President, Treasurer, Secretary and a director of KBS REIT I. From August 2007 through August 2018 he served as Executive Vice President, Treasurer and Secretary of KBS REIT II and from August 2007 through February 2019 he was also a director of KBS REIT II. From August 2009 until its liquidation in December 2018, Mr. McMillan was Executive Vice President of KBS Legacy Partners Apartment REIT. Mr. McMillan owns and controls a 50% interest in Pacific Oak Holding, which is the sole owner of our current advisor. Mr. McMillan also owns and controls a 50% interest in GKP Holding LLC. GKP Holding owns a 33 1/3% interest in KBS Holdings LLC, which is the sole owner of our former advisor (KBS Capital Advisors) and our former dealer manager (KBS Capital Markets Group). KBS Holdings is a sponsor of our company, and is or was a sponsor of KBS REIT I, KBS REIT II, KBS REIT III, Pacific Oak Strategic Opportunity REIT II, KBS Legacy Partners Apartment REIT and KBS Growth & Income REIT, which were formed in 2008, 2005, 2007, 2009, 2009, 2013 and 2015, respectively. Mr. McMillan is also a member of the investment committee formed by our advisor to evaluate and authorize new investment opportunities for us.
Mr. McMillan is a Partner and co-owner of Temescal Canyon Partners LP, an investment advisor formed in 2013 to manage a multi-strategy hedge fund on behalf of investors. Mr. McMillan is also a founder of Pacific Oak Capital Group, a real estate asset management company formed in 2018, and its family of companies. Mr. McMillan is also a co-founder and the Managing Partner of Willowbrook Capital Group, LLC, an asset management company. In addition, since November 2017, Mr. McMillan has served as Chairman and a director for Keppel Pacific Oak-US REIT Management Pte. Ltd., which is the Manager of Keppel Pacific Oak US REIT. Prior to forming Willowbrook in 2000, Mr. McMillan served as an Executive Vice President and Chief Investment Officer of SunAmerica Investments, Inc., which was later acquired by AIG. As Chief Investment Officer, he was responsible for over $75.0 billion in assets, including residential and commercial mortgage-backed securities, public and private investment grade and non-investment grade corporate bonds and commercial mortgage loans and real estate investments. Before joining SunAmerica in 1989, he served as Assistant Vice President for Aetna Life Insurance and Annuity Company with responsibility for the company’s $6.0 billion fixed income portfolios. Mr. McMillan received his Master of Business Administration in Finance from the Wharton Graduate School of Business at the University of Pennsylvania and his Bachelor of Arts Degree with honors in Economics from Clark University. Mr. McMillan is a member of the board of directors of TCW Funds, Inc. and TCW Strategic Income Fund, Inc., and is a member of the board of trustees of Metropolitan West Funds.
Our board of directors has concluded that Mr. McMillan is qualified to serve as one of our directors and the Chairman of the Board for reasons including his expertise in real estate finance and with real estate-related investments. With over 30 years of experience investing in and managing real estate-related debt investments, Mr. McMillan offers insights and perspective with respect to our real estate-related investment portfolio as well as our real estate portfolio. As one of our executive officers and a principal of our advisor, Mr. McMillan is also able to direct our board of directors to the critical issues facing our company. Further, his experiences as a director of Pacific Oak Strategic Opportunity REIT II, TCW Mutual Funds, and Metropolitan West Funds and as a former director of KBS REIT I, KBS REIT II, KBS REIT III, KBS Growth & Income REIT, TCW Alternative Funds and Steinway Musical Instruments, Inc. provide him with an understanding of the requirements of serving on a public company board and qualify him to serve as the chairman of our board of directors.
Michael A. Bender has served as our Executive Vice President, Chief Financial Officer, Treasurer and Secretary since November 2019. Mr. Bender has also served in the same roles for Pacific Oak Strategic Opportunity REIT since November 2019. Mr. Bender has served as Chief Financial Officer of Pacific Oak Capital Advisors since July 2019. Prior to joining our advisor in 2019, Mr. Bender was self-employed as a private consultant primarily engaged in commercial real estate finance from January 2017 to July 2019. From January 2016 to January 2017, Mr. Bender served as Chief Financial Officer for Kamal Osman Janjoom Group LLC, a Dubai-based retail company focused in the Middle East, where he was responsible for all aspects of accounting, reporting, control, corporate finance and treasury. From October 2007 to January 2016, Mr. Bender was Chief Financial Officer and Chief Accounting Officer for Spirit Realty Capital, Inc., a NYSE-traded commercial property REIT. During his eight years at Spirit Realty Capital, Mr. Bender was in charge of accounting, reporting, control, corporate finance and treasury.
Before joining Spirit Realty Capital, Inc. in 2007, Mr. Bender held positions including Assistant Corporate Controller for Allied Waste, Inc., Vice President of Global External Reporting for American Express Corporation, Chief Financial Officer for FINOVA Realty Capital and senior manager for Deloitte & Touche, LLP. Mr. Bender earned a Bachelor of Science Degree in Accounting and a Master of Business Administration from Arizona State University. He is a Certified Public Accountant.
John P. Joliet is one of our independent directors, a position he has held since August 2017. He has been a Partner at American Discovery Capital, an independent merchant banking firm focused on principal investments in leading family-owned and middle-market companies in selected high-growth sectors, since he founded the company in 2016. Prior to founding American Discovery Capital Mr. Joliet was a Partner and Managing Director at Moelis & Company where he was responsible for leading the firm’s global investment banking activities in the Enterprise Software sector. Prior to joining Moelis &Co., Mr. Joliet spent ten years at UBS Investment Bank where he was a Managing Director and Global Head of Software Investment Banking, as well as the Head of the Los Angeles office. Mr. Joliet began his investment banking career with Donaldson, Lufkin & Jenrette (“DLJ”), and remained with DLJ until its sale to Credit Suisse in 2000. Before he began his investment banking career, Mr. Joliet spent four years as a consultant with Coopers & Lybrand in Boston, London UK, and Chicago, and was licensed as a Certified Public Accountant.
Mr. Joliet studied at the University of Pennsylvania’s Wharton School and the Ross School of Business at the University of Michigan,where he earned a Bachelor of Business Administration. He earned a Master of Business Administration, with honors, from the University of Chicago’s Booth School of Business.
Our board of directors has concluded that Mr. Joliet is qualified to serve as one of our independent directors for reasons including his nearly 25 years as an investment banker and corporate finance consultant. With his strong back ground in mergers and acquisitions and capital markets, he is well-positioned to advise the board with respect to strategic alternatives.
Laurent Degryse is one of our independent directors, a position he has held since April 2014. Mr. Degryse has been involved in the real estate development industry for over 20 years with a focus on real estate activities in Belgium. For the past five years he has been self-employed and engaged in real estate development and venture capital activities. In 2002, Mr. Degryse founded Urbis Development, a real estate development company located in Luxembourg, and served as its Managing Director until, in 2008, it created a joint venture with another real estate company, Herpain SA, and became Herpain Urbis.
From December 2007 through December 2015, he has served as the Managing Director of Hunza Ventures and Managing Partner of Hunza Management, affiliated venture capital companies based in Luxemburg that invest in technology and life science projects. In connection with his position at Hunza Ventures, he serves as a member of the supervisory board of Hunza Ventures II SCA SICAR, a fund raised by Hunza Ventures that is investing and raising capital for venture investments; and from December 2007 through June 2012 he served as a member of the supervisory board of Hunza Ventures SCA SPF, a fund that raised and fully invested €15 million in 14 venture investments. Mr. Degryse also manages his own portfolio of investments in Europe, Asia and the United States.
In addition, Mr. Degryse has served as the chairman of the board of SoftKinetic International SA from 2008 to 2015. He was a director of Herpain Urbis Retail (from 2008 to 2015) and a director of Herpain Urbis (from 2007 to 2013) and Herpain Enterprise (from 2008 to 2013). Herpain Urbis Retail, Herpain Urbis and Herpain Enterprise are related companies with expertise in real estate development and construction for office, residential and commercial real estate in Belgium. In addition, from March 2007 through March 2012 he served as a member of the supervisory board of Urbis SCA. Mr. Degryse was a member of the board of trustees and member of the finance and the audit committee of MOCA, the Museum of Contemporary Art in Los Angeles, California. Mr. Degryse is a graduate of the Solvay Business School at the University of Brussels, Belgium where he received a Master in Business Engineering.
Our board of directors has concluded that Mr. Degryse is qualified to serve as one of our independent directors for reasons including his expertise in the real estate development business. With over 20 years of experience in the real estate industry, with a particular focus on investments in Belgium, Mr. Degryse offers insights and perspective with respect to our investment portfolio and our focus on European investment opportunities.
Kenneth G. Yee is one of our independent directors and is the Chairman of the Audit Committee, positions he has held since April 2017 and May 2017, respectively. He is also an independent director and Chairman of the Audit Committee of Pacific Oak Strategic Opportunity REIT, positions he has held since April 2017 and May 2017, respectively. Since 2000, Mr. Yee has been the President and Chief Executive Officer of Ridgecrest Capital, Inc., a real estate financial advisory services and structured finance firm. Mr. Yee previously served in the same positions for Ridgecrest Capital, Inc. from 1992 to 1997. From 2007 to June 2011, Mr. Yee was also the managing director of Cappello Capital Corp., where he was responsible for sourcing, evaluating, structuring and placing transactions relating to domestic and international real estate equity and debt, and small and middle market corporate capital raising and mergers and acquisitions. Mr. Yee served as Senior Vice President of Acquisitions for Imperial Credit Commercial Mortgage Investment Corp from 1998 to 1999. From 1990 to 1991, Mr. Yee served as Vice President and Controller for Secured Capital Corp. (now known as Eastdil Secured LLC, formerly a division of Wells Fargo), a real estate advisory and investment banking firm. Prior to that, he was a Vice President at Drexel Burnham Lambert from 1987 to 1990. From 1986 to 1987, Mr. Yee was an associate consultant for Kenneth Leventhal & Company, a real estate consulting and public accounting firm. Mr. Yee was a financial analyst with Deseret Pacific Mortgage from 1985 to 1986 and he was a senior accountant with Ernst & Whinney, a public accounting firm, from 1982 to 1985.
Mr. Yee received Bachelor of Science in Business Administration, Master of Business Administration and Master of Business Taxation degrees from the University of Southern California. He also received a Master of Science in Real Estate Development degree from the Massachusetts Institute of Technology and a Juris Doctor degree from the University of California, Los Angeles. Mr. Yee is a Chartered Financial Analyst, a Certified Public Accountant, a licensed attorney and a licensed real estate broker.
Our board of directors has concluded that Mr. Yee is qualified to serve as one of our independent directors for reasons including his expertise with respect to real estate equity and debt transactions and accounting matters. With more than 25 years of experience with real estate equity and debt transactions, Mr. Yee is well-positioned to advise the board with respect to potential investment opportunities and investment management. In addition, with over 30 years of experience as a Certified Public Accountant, Mr. Yee provides our board of directors with substantial expertise regarding real estate accounting and financial reporting matters
The Audit Committee
Our board of directors has established an audit committee. The audit committee’s function is to assist our board of directors in fulfilling its responsibilities by overseeing (i) the integrity of our financial statements, (ii) our compliance with legal and regulatory requirements, (iii) the independent auditors’ qualifications and independence, and (iv) the performance of the independent auditors and our internal audit function. The members of the audit committee are Kenneth G. Yee (chairman), Laurent Degryse and John P. Joliet. All of the members of the audit committee are “independent” as defined by the New York Stock Exchange. All members of the audit committee have significant financial and/or accounting experience, and our board of directors has determined that all members of the audit committee satisfy the SEC’s requirements for an “audit committee financial expert.”
Code of Conduct and Ethics
We have adopted a Code of Conduct and Ethics that applies to all of our executive officers and directors, including but not limited to, our principal executive officer, principal financial officer and principal accounting officer. Our Code of Conduct and Ethics can be found at http://www.pacificoakcmg.com/offering/reit-ii.
ITEM 11. EXECUTIVE COMPENSATION
Compensation of Executive Officers
Our executive officers do not receive compensation directly from us for services rendered to us. Our executive officers are officers and/or employees of, or hold an indirect ownership interest in, our advisor, and/or its affiliates, and our executive officers are compensated by these entities, in part, for their services to us. See Part III, Item 13, “Certain Relationships and Related Transactions and Director Independence –Report of the Conflicts Committee” for a discussion of the fees paid to our advisor and its affiliates.
Compensation of Directors
If a director is also one of our executive officers, we do not pay any compensation to that person for services rendered as a director. The amount and form of compensation payable to our independent directors for their service to us is determined by our conflicts committee, based upon recommendations from our advisor. Two of our executive officers, Messrs. Hall and McMillan, manage and control our advisor, and through our advisor, they are involved in recommending and setting the compensation to be paid to our independent directors.
We have provided below certain information regarding compensation earned by or paid to our directors during fiscal year 2019.
| | | | | | | | | | | | | | | | | | | | |
| Name | | Fees Earned in 2019 or Paid in Cash | | All Other Compensation | | Total |
| John P. Joliet | | $ | 133,333 | | | $ | — | | | $ | 133,333 | |
| Laurent Degryse | | 149,333 | | | — | | | 149,333 | |
| Kenneth G. Yee | | 97,333 | | | — | | | 97,333 | |
Peter McMillan (2) | | — | | | — | | | — | |
Keith D. Hall (2) | | — | | | — | | | — | |
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(1) Fees Earned in 2019 or Paid in Cash include meeting fees earned in: (i) 2018 but paid or reimbursed in 2019 as follows: Mr. Degryse $10,333, Mr. Yee $11,333 and Mr. Joliet $9,333; and (ii) 2019 and paid or to be paid in 2020 as follows: Mr. Degryse $3,333, Mr. Yee $3,333 and Mr. Joliet $3,333.
(2) Directors who are also our executive officers do not receive compensation for services rendered as a director.
Cash Compensation
We will compensate each of our independent directors with an annual retainer of $40,000. In addition, we will pay independent directors for attending board and committee meetings as follows:
•$2,500 in cash for each board meeting attended;
•$2,500 in cash for each committee meeting attended, except that the committee chairman is paid $3,000 for each committee meeting attended;
•$2,000 in cash for each teleconference board meeting attended; and
•$2,000 in cash for each teleconference committee meeting attended, except that the committee chairman is paid $3,000 for each teleconference committee meeting attended.
All directors will receive reimbursement of reasonable out-of-pocket expenses incurred in connection with attendance at board of directors meetings and committee meetings.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Stock Ownership
The following table shows, as of March 1, 2020, the amount of our Class A common stock and Class T common stock beneficially owned (unless otherwise indicated) by (i) any person who is known by us to be the beneficial owner of more than 5% of the outstanding shares of each of our Class A common stock and Class T common stock, (ii) our directors, (iii) our executive officers, and (iv) all of our directors and executive officers as a group.
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| Name and Address of Beneficial Owner of Class A and Class T Shares, as indicated | | Amount and Nature of Beneficial Ownership of Class A Shares | | | Percent of all Class A Shares | | Amount and Nature of Beneficial Ownership of Class T Shares | | Percent of all Class T Shares |
| Keith D. Hall, Chief Executive Officer and Director | | 334,535 | | (1)(2) | | 1.9% | | | — | | | —% | |
| Peter McMillan III, Chairman of the Board, President and Director | | 334,535 | | (1)(2) | | 1.9% | | | — | | | —% | |
| Michael A. Bender, Chief Financial Officer, Treasurer and Secretary | | — | | | | — | | | — | | | —% | |
| John P. Joliet, Independent Director | | — | | | | — | | | — | | | —% | |
| Laurent Degryse, Independent Director | | — | | | | — | | | — | | | —% | |
| Kenneth G. Yee, Independent Director | | — | | | | — | | | — | | | —% | |
| All directors and executive officers as a group | | 334,535 | | (1)(2) | | 1.9% | | | — | | | —% | |
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(1) Includes 25,785 Class A shares owned by KBS Capital Advisors, which is indirectly owned and controlled by Keith D. Hall and Peter McMillan III. None of the shares are pledged as security. The address of this beneficial owner is 800 Newport Center Drive, Suite 700, Newport Beach, California 92660.
(2) Includes 307,984 Class A shares owned by Willowbrook Capital Group, an entity owned and controlled by Keith D. Hall and Peter McMillan III. None of the shares are pledged as security. The address of this beneficial owner is 11150 Santa Monica Blvd., Suite 400, Los Angeles, California 90025.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Director Independence
A majority of our board of directors, Messrs. Degryse, Joliet, and Yee, meet the independence criteria as specified in our charter, as set forth on Appendix A attached hereto. In addition, and although our shares are not listed for trading on any national securities exchange, a majority of our directors, and all of the members of the audit committee and the conflicts committee, are “independent” as defined by the New York Stock Exchange. The New York Stock Exchange standards provide that to qualify as an independent director, in addition to satisfying certain bright-line criteria, our board of directors must affirmatively determine that a director has no material relationship with us (either directly or as a partner, stockholder or officer of an organization that has a relationship with us). Our board of directors has affirmatively determined that Kenneth G. Yee, John P. Joliet and Laurent Degryse each satisfies the New York Stock Exchange independence standards. Kenneth G. Yee also serves as independent director of POSOR I. None of these directors has ever served as (or is related to) an employee of ours or any of our predecessors or acquired companies or received or earned any compensation from us or any such entities except for compensation directly related to service as a director of us. Therefore, we believe that all of these directors are independent directors.
Report of the Conflicts Committee
Review of Our Policies
The conflicts committee has reviewed our policies and determined that they are in the best interest of our stockholders. Set forth below is a discussion of the basis for that determination.
Offering Policy. We conducted an initial primary public offering from August 12, 2014 through July 31, 2018. We are continuing to offer shares of our common stock pursuant to our dividend reinvestment plan offering at a purchase price equal to our estimated net asset value per share. We may continue to offer shares under the dividend reinvestment plan until we have sold an aggregate of 76,366,006 shares of our Class A and Class T common stock through the reinvestment of distributions. In some states, we will need to renew the registration statement annually or file a new registration statement to continue our dividend reinvestment plan offering. We may terminate our dividend reinvestment plan offering at any time.
For the year ended December 31, 2019, the costs of raising capital in our primary initial public offering and our dividend reinvestment plan offering represented less than 1% of the capital raised.
Acquisition and Investment Policies. We have invested a significant amount of the net proceeds of our now-terminated primary initial public offering and do not anticipate making additional real estate acquisitions. As of January 31, 2020, we had invested in two hotel properties, three office properties, one apartment building, two investments in unconsolidated entities and an investment in real estate equity securities. Additionally, as of January 31, 2020, we had entered into a joint venture to develop one office/retail property.
Borrowing Policies. In order to execute our investment strategy, we have utilized secured debt and we may, to the extent available, utilize unsecured debt, to finance a portion of our investment portfolio. Management remains vigilant in monitoring the risks inherent with the use of debt in our portfolio and is taking actions to ensure that these risks, including refinancing and interest risks, are properly balanced with the benefit of using leverage. We expect our debt financing will be 60% or less of the cost of our tangible assets (before deducting depreciation or other non-cash reserves). There is no limitation on the amount we may borrow for any single investment. Our charter limits our total liabilities such that our total liabilities may not exceed 75% of the cost of our tangible assets (before deducting depreciation or other non-cash reserves); however, we may exceed that limit if a majority of the conflicts committee approves each borrowing in excess of our charter limitation and we disclose such borrowing to our common stockholders in our next quarterly report with an explanation from the conflicts committee of the justification for the excess borrowing.
We do not intend to exceed this leverage limit. Careful use of debt will help us to achieve our diversification goals because we will have more funds available for investment. However, high levels of debt could cause us to incur higher interest charges and higher debt service payments, which would decrease the amount of cash available for distribution to our stockholders, and could also be accompanied by restrictive covenants. High levels of debt could also increase the risk of being unable to refinance when loans become due, or of being unable to refinance on favorable terms, and the risk of loss with respect to assets pledged as collateral for loans.
Except with respect to the borrowing limits contained in our charter, we may reevaluate and change our debt policy in the future without a stockholder vote. Factors that we would consider when reevaluating or changing our debt policy include: then-current economic conditions, the relative cost and availability of debt and equity capital, any investment opportunities, the ability of our investments to generate sufficient cash flow to cover debt service requirements and other similar factors. Further, we may increase or decrease our ratio of debt to book value in connection with any change of our borrowing policies.
As of January 31, 2020, our borrowings and other liabilities were both approximately 60% of the cost (before deducting depreciation and other noncash reserves) and book value (before deducting depreciation) of our tangible assets, respectively.
Disposition Policies. The period that we will hold our investments in opportunistic real estate, real estate-related loans, real estate equity securities and other real estate-related investments will vary depending on the type of asset, interest rates and other factors. Our advisor develops a well-defined exit strategy for each investment we make and continually performs a hold-sell analysis on each asset in order to determine the optimal time to hold the asset and generate a strong return for our stockholders. Economic and market conditions may influence us to hold our investments for different periods of time. We may sell an asset before the end of the expected holding period if we believe that market conditions have maximized its value to us or the sale of the asset would otherwise be in the best interests of our stockholders.
We disposed of one office building, 2200 Paseo Verde, during the year ended December 31, 2019.
Policy Regarding Working Capital Reserves. We establish an annual budget for capital requirements and working capital reserves each year that we update periodically during the year. We may set aside proceeds from our primary initial public offering for working capital purposes. We may also use proceeds from our dividend reinvestment plan offering, debt proceeds and cash flow from operations to meet our needs for working capital and to build a moderate level of cash reserves. In addition, contractual obligations may require us to maintain a minimum working capital reserve related to our properties.
Policies Regarding Operating Expenses. Under our charter, we are required to limit our total operating expenses to the greater of 2% of our average invested assets or 25% of our net income for the four most recently completed fiscal quarters, as these terms are defined in our charter, unless the conflicts committee has determined that such excess expenses were justified based on unusual and non-recurring factors. For the four consecutive quarters ended December 31, 2019, total operating expenses represented approximately 1% and 676% of average invested assets and our net income, respectively.
Our Policy Regarding Transactions with Related Persons. Our charter requires the conflicts committee to review and approve all transactions between us and our advisor, and any of our officers or directors or any of their affiliates. Prior to entering into a transaction with a related party, a majority of the conflicts committee must conclude that the transaction is fair and reasonable to us and on terms and conditions not less favorable to us than those available from unaffiliated third parties. In addition, our Code of Conduct and Ethics lists examples of types of transactions with related parties that would create prohibited conflicts of interest and requires our officers and directors to be conscientious of actual and potential conflicts of interest with respect to our interests and to seek to avoid such conflicts or handle such conflicts in an ethical manner at all times consistent with applicable law. Our executive officers and directors are required to report potential and actual conflicts to the Compliance Officer, currently our Chief Financial Officer, via the Ethics Hotline, or directly to the audit committee chair, as appropriate.
Certain Transactions with Related Persons. The conflicts committee has reviewed the material transactions between our affiliates and us since the beginning of 2019 as well as any such currently proposed material transactions. Set forth below is a description of such transactions and the conflicts committee’s report on their fairness.
As described further below, we have entered into agreements with certain affiliates pursuant to which they provide services to us. Keith D. Hall and Peter McMillan III control and indirectly own Pacific Oak Holding Group, LLC, our sponsor since November 1, 2019. Pacific Oak Holding is the sole owner of Pacific Oak Capital Advisors, LLC, our advisor since November 1, 2019. Messrs. Hall and McMillan are also two of our executive officers and directors.
In addition, along with Charles J. Schreiber, Jr., Keith D. Hall and Peter McMillan III control and indirectly own KBS Holdings LLC, our sponsor prior to November 1, 2019. KBS Holdings is the sole owner of KBS Capital Advisors LLC, our advisor prior to November 1, 2019, and KBS Capital Markets Group LLC, the entity that acted as the dealer manager of our now-terminated primary initial public offering.
Our Relationships with KBS Capital Advisors and Pacific Oak Capital Advisors. From our inception through October 31, 2019, KBS Capital Advisors provided day-to-day management of our business. Among the services provided by KBS Capital Advisors under the terms of the KBS Capital Advisors advisory agreement were the following:
•finding, presenting and recommending to us real estate investment opportunities consistent with our investment policies and objectives;
•structuring the terms and conditions of our investments, sales and joint ventures;
•acquiring properties and other investments on our behalf in compliance with our investment objectives and policies;
•sourcing and structuring our loan originations and acquisitions;
•arranging for financing and refinancing of our properties and our other investments;
•entering into leases and service contracts for our properties;
•supervising and evaluating each property manager’s performance;
•reviewing and analyzing the properties’ operating and capital budgets;
•assisting us in obtaining insurance;
•generating an annual budget for us;
•reviewing and analyzing financial information for each of our assets and our overall portfolio;
•formulating and overseeing the implementation of strategies for the administration, promotion, management, operation, maintenance, improvement, financing and refinancing, marketing, leasing and disposition of our properties and other investments;
•performing investor-relations services;
•maintaining our accounting and other records and assisting us in filing all reports required to be filed with the SEC, the IRS and other regulatory agencies;
•engaging in and supervising the performance of our agents, including our registrar and transfer agent; and
•performing any other services reasonably requested by us.
KBS Capital Advisors was subject to the supervision of the board of directors and only had such authority as we delegated to it as our agent. The advisory agreement with KBS Capital Advisors terminated on October 31, 2019, and we hired Pacific Oak Capital Advisors under substantially the same terms on November 1, 2019. Our advisory agreement with Pacific Oak Capital Advisors has a one-year term subject to an unlimited number of successive one-year renewals upon the mutual consent of the parties. From January 1, 2019 through the most recent date practicable, which was January 31, 2020, we compensated our then-current advisor as set forth below.
Our advisor or its affiliates have paid our organization and other offering expenses (other than selling commissions, dealer manager fees and the stockholder servicing fee with respect to Class T shares sold in our primary initial public offering) related to our primary initial public offering in excess of 1.0% of gross proceeds from our primary initial public offering.
We incur acquisition and origination fees payable to our advisor equal to a percentage of the cost of investments acquired or originated by us, or the amount to be funded by us to acquire or originate loans, including acquisition and origination expenses and any debt attributable to such investments plus significant capital expenditures related to the development, construction or improvement of the investment budgeted as of the date of acquisition. Acquisition and origination fees relate to services provided in connection with the selection and acquisition or origination of real estate investments. For investments acquired or originated with proceeds raised in our offerings on or prior to February 16, 2016, this percentage is 1.5%. For investments acquired or originated with proceeds raised in our initial public offering after February 16, 2016, this percentage is 2.6%. Acquisition and origination fees from January 1, 2019 through January 31, 2020 totaled approximately $29,000.
In addition to acquisition and origination fees, we reimburse our advisor for customary acquisition and origination expenses, whether or not we ultimately acquire the asset. From January 1, 2019 through January 31, 2020, our advisor and its affiliates did not incur any such costs on our behalf.
For asset management services, we pay our advisor a monthly fee equal to the lesser of one-twelfth of (i) 1.0% of the cost of our investments and (ii) 2.0% of the sum of the cost of our investments, less any debt secured by or attributable to the investments. The cost of the real property investments is calculated as the amount paid or allocated to acquire the real property, including the cost of any subsequent development, construction or improvements to the property and including fees and expenses related thereto (but excluding acquisition fees paid or payable to our advisor). The cost of the loans and any investments other than real property is calculated as the lesser of (x) the amount actually paid or allocated to acquire or fund the loan or other investment, including fees and expenses related thereto (but excluding acquisition fees paid or payable to our advisor), and (y) the outstanding principal amount of such loan or other investment, including fees and expenses related to the acquisition or funding of such investment (but excluding acquisition fees paid or payable to our advisor), as of the time of calculation. In the case of investments made through joint ventures, the asset management fee is determined based on our proportionate share of the underlying investment. From January 1, 2019 through January 31, 2020, our asset management fees totaled $4.4 million.
Under the advisory agreement our advisor and its affiliates have the right to seek reimbursement from us for all costs and expenses they incur in connection with their provision of services to us, including our allocable share of our advisor’s overhead, such as rent, employee costs, utilities, accounting software and cybersecurity costs. Our advisor may seek reimbursement for employee costs under the advisory agreement. At this time, our advisor only expects to seek reimbursement for our allocable portion of the salaries, benefits and overhead of internal audit department personnel providing services to us. In the future, if our advisor seeks reimbursement for additional employee costs, such costs may include our proportionate share of the salaries of persons involved in the preparation of documents to meet SEC reporting requirements. We do not reimburse our advisor or its affiliates for employee costs in connection with services for which our advisor earns acquisition or origination fees or disposition fees (other than reimbursement of travel and communication expenses) or for the salaries and benefits our advisor or its affiliates may pay to our executive officers. From January 1, 2019 through January 31, 2020, we had reimbursed our advisor for $0.3 million of operating expenses, including $0.3 million of employee costs.
The conflicts committee considers our relationship with our advisor during 2018 and 2019 to be fair. The conflicts committee believes that the amounts paid or payable to our advisor under the advisory agreement are similar to those paid by other publicly offered, unlisted, externally advised REITs and that this compensation is necessary in order for our advisor to provide the desired level of services to us and our stockholders.
Our Relationship with KBS Capital Markets Group. We entered a dealer manager agreement with our dealer manager on August 12, 2014 in connection with the launch of our initial public offering which agreement was amended and restated on February 17, 2016 and terminated effective December 31, 2019. Pursuant to our dealer manager agreement, through February 16, 2017, our dealer manager was entitled to receive selling commissions of up to 6.5% and dealer manager fees of up to 3.0% of the purchase price for shares of our common stock sold in our primary offering. Effective February 17, 2016, our dealer manager was entitled to receive selling commissions of up to 6.5% of the purchase price for Class A shares of our common stock sold in the primary offering and up to 3.0% of the purchase price of our Class T shares of common stock sold in the primary offering, as well as a dealer manager fee of up to 2.0% of the purchase price of each class of shares of our common stock sold in the primary offering. All or a portion of the selling commissions were not charged with regard to shares sold to certain categories of purchasers. A reduced dealer manager fee was payable with respect to certain volume discount sales. The dealer manager reallowed 100% of selling commissions to broker-dealers participating in our initial public offering. From its dealer manager fee, our dealer manager generally reallowed to any participating broker-dealer up to 1.0% of the gross offering proceeds attributable to that participating broker-dealer as a marketing fee (in select cases, up to 1.5% of the gross primary offering proceeds).
From January 1, 2019 through January 31, 2020, we did not incur any selling commissions or dealer manager fees.
In addition, our dealer manager received an annual stockholder servicing fee of 1.0% of the purchase price per share (ignoring any discounts that may be available to certain categories of purchasers) of Class T common stock sold in our primary initial public offering solely to the extent there was a broker-dealer of record with respect to such Class T share that had entered into a currently effective selected dealer agreement or servicing agreement that provided for the payment to such broker-dealer of the stockholder servicing fee with respect to such Class T share, and such broker-dealer of record was in compliance with the applicable terms of such selected dealer agreement or servicing agreement related to such payment. To the extent payable, the stockholder servicing fee accrued daily and was paid monthly in arrears, and our dealer manager reallowed 100% of the stockholder servicing fee to such broker-dealer of record for services provided to Class T stockholders after the initial sale of the Class T share.
No stockholder servicing fee was paid with respect to Class T shares purchased through our dividend reinvestment plan offering or issued pursuant to a stock dividend. We ceased accruing for stockholder servicing fees after July 31, 2018.
Subordinated Participation in Net Cash Flows.
Upon a merger or listing of our common stock on a national securities exchange, we may pay Pacific Oak Capital Advisors an incentive fee. Upon a listing this fee will equal 15% of the amount by which (i) the market value of our outstanding stock plus the total of all distributions paid by us to stockholders from inception until the date market value is determined (regardless of the source used to fund such distributions and including distributions that may constitute a return of capital for federal income tax purposes and excluding any stock dividend) exceeds (ii) the sum of our stockholders’ gross investment amount, which is the amount calculated by multiplying the total number of shares purchased by stockholders by the issue price, reduced by the total number of shares repurchased by us (excluding shares received as a stock dividend which we subsequently repurchased) multiplied by the weighted average issue price of the shares sold in the primary offering, and the amount of cash flow necessary to generate a 7.0% per year cumulative, noncompounded return on our stockholders’ gross investment amount from our inception through the date the market value is determined.
Upon a merger this fee will equal 15% of the amount by which (i) the merger consideration amount plus the total of all distributions paid or declared by us to stockholders from inception until the closing of the merger (regardless of the source used to fund such distributions and including distributions that may constitute a return of capital for federal income tax purposes and excluding any stock dividend) exceeds (ii) the sum of our stockholders’ gross investment amount, which is the amount calculated by multiplying the total number of shares purchased by stockholders by the issue price, reduced by the total number of shares repurchased by us (excluding shares received as a stock dividend which we subsequently repurchased) multiplied by the weighted average issue price of the shares sold in the primary offering, and the amount necessary to generate a 7.0% per year cumulative, noncompounded return on our stockholders’ gross investment amount from our inception through the closing of the merger.
If our advisor receives a subordinated incentive fee, the fee will not be separately reduced by the prior payment to our advisor of a participation in our net cash flows as the calculation of the subordinated incentive fee takes into account any prior payment to our advisor of this participation. In addition, if Pacific Oak Capital Advisors is entitled to receive the subordinated incentive fee upon a listing, Pacific Oak Capital Advisors will no longer participate in our net cash flows as described above.
The 7.0% per year cumulative, noncompounded return on gross investment amount is calculated on a daily basis. In making this calculation, gross investment amount is determined for each day during the period for which the 7.0% per year cumulative, noncompounded return is being calculated, including a daily adjustment to reflect shares repurchased by us (excluding shares received as a stock dividend which we subsequently repurchased). In addition, gross investment amount is reduced by the following: (i) distributions from net sales proceeds, (ii) distributions from net financing proceeds, and (iii) distributions paid from cash flow from operations in excess of a cumulative, noncompounded, annual return of 7.0%. Gross investment amount is only reduced as described above; it is not reduced simply because a distribution constitutes a return of capital for federal income tax purposes. The 7.0% per year cumulative, noncompounded return is not based on the return provided to any individual stockholder but rather is based on total distributions paid on all outstanding shares relative to total gross investment amount invested by all stockholders. Accordingly, it is not necessary for each of our stockholders to have received any minimum return in order for Pacific Oak Capital Advisors to receive the subordinated incentive fee. In fact, if Pacific Oak Capital Advisors is entitled to receive the subordinated incentive fee, the returns of our stockholders will differ, and some may be less than a 7.0% per year cumulative, noncompounded return.
Sub-Advisory Agreement.
KBS Capital Advisors entered a sub-advisory agreement with STAM Europe (“STAM”), a real estate operating company based in Paris, France, pursuant to which STAM would provide real estate acquisition and portfolio management services to our advisor in connection with investments in Europe. For investments in Europe we make directly and for which our ownership interest is 100%, our advisor would compensate STAM for its services in sourcing and managing these investments from the fees it earns from us under the advisory agreement with us and we will pay STAM no additional compensation. Effective April 17, 2019, STAM terminated the sub-advisory agreement with KBS Capital Advisors.
Insurance.
On January 6, 2014, we, together with KBS Real Estate Investment Trust, Inc. (“KBS REIT I”), KBS Real Estate Investment Trust II, Inc. (“KBS REIT II”), KBS Real Estate Investment Trust III Inc. (“KBS REIT III”), KBS Legacy Partners Apartment REIT, Inc. (“KBS Legacy Partners Apartment REIT”), POSOR I, our former dealer manager, our former advisor and other KBS-affiliated entities, entered into an errors and omissions and directors and officers liability insurance program where the lower tiers of such insurance coverage are shared. The cost of these lower tiers was allocated by KBS Capital Advisors and its insurance broker among each of the various entities covered by the program, and was billed directly to each entity. In June 2015, KBS Growth & Income REIT, Inc. ("KBS Growth & Income REIT") was added to the insurance program at terms similar to those described above. At renewal in June 2018, we, along with POSOR I and KBS Legacy Partners Apartment REIT elected to cease participation in the program and obtain separate insurance coverage. We, together with POSOR I, entered into an errors and omissions and directors and officers liability insurance program where the lower tiers of such insurance coverage are shared. The cost of these lower tiers is or was allocated by our applicable advisor and its insurance broker among each REIT covered by the program, and is billed directly to each REIT. The program is effective through June 30, 2020.
Pacific Oak Opportunity Zone Fund I.
On December 31, 2019, we made a $2.9 million investment in the Pacific Oak Opportunity Zone Fund I, LLC. Pacific Oak Opportunity Zone Fund I is sponsored by Pacific Oak Holding. Pacific Oak Capital Advisors is entitled to certain fees in connection with the fund. The fund will pay an acquisition fee equal to 1.5% of the purchase price of each asset (including any debt incurred or assumed and significant capital improvement costs budgeted as of the date of acquisition) with a purchase price less than or equal to $25.0 million plus 1.0% of the purchase price in excess of $25.0 million; a quarterly asset management fee equal to 0.25% of the total purchase price of all assets (including any debt incurred or assumed and significant capital improvement costs budgeted as of the date of acquisition) as of the end of the applicable quarter; and a financing fee equal to 0.5% of the original principal amount of any indebtedness they incur (reduced by any financing fee previously paid with respect to indebtedness being refinanced). In the case of investments made through joint ventures, the fees above will be determined based on our proportionate share of the investment. Pacific Oak is also entitled to certain distributions paid by the Pacific Oak Opportunity Zone Fund I after the Class A Members have received their preferred return. These fees and distributions have been waived for our $2.9 million investment.
Currently Proposed Transactions.
On February 19, 2020, Pacific Oak Strategic Opportunity REIT II, Inc. (the “Company” or “POSOR II”), Pacific Oak Strategic Opportunity REIT, Inc. (“POSOR I”), and Pacific Oak SOR II, LLC, an indirect subsidiary of POSOR I (“Merger Sub”), entered into an Agreement and Plan of Merger (the “Merger Agreement”). Subject to the terms and conditions of the Merger Agreement, POSOR II will merge with and into Merger Sub (the “Merger”), with Merger Sub surviving the Merger (the “Surviving Entity”), such that following the Merger, the Surviving Entity will continue as an indirect subsidiary of ours. In accordance with the applicable provisions of the Maryland General Corporation Law, the separate existence of POSOR II shall cease. At the effective time of the Merger and subject to the terms and conditions of the Merger Agreement, each issued and outstanding share of POSOR II’s common stock (or a fraction thereof), $0.01 par value per share (the “POSOR II Common Stock”), will be converted into the right to receive 0.9643 shares of our common stock, par value $0.01 per share. The combined company after the Merger (the “Combined Company”) will retain the name “Pacific Oak Strategic Opportunity REIT, Inc.” The Merger is intended to qualify as a “reorganization” under, and within the meaning of, Section 368(a) of the Internal Revenue Code of 1986, as amended. See “Proposed Merger” in Item Part I, Item 1 of this Annual Report on Form 10-K for more information.
Conflicts Committee Determination. The conflicts committee has examined the fairness of the transactions described above, and has determined that all such transactions are fair and reasonable to us. The conflicts committee has also determined that the policies set forth in this Report of the Conflicts Committee are in the best interests of our stockholders because they provide us with the highest likelihood of achieving our investment objectives.
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| March 25, 2020 | | The Conflicts Committee of the Board of Directors: |
| | Laurent Degryse (Chairman), John P. Joliet, and Kenneth G. Yee |
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Independent Registered Public Accounting Firm
During the year ended December 31, 2019, Ernst & Young LLP served as our independent registered public accounting firm and provided certain tax and other services. Ernst & Young has served as our independent registered public accounting firm since our formation.
Pre-Approval Policies
In order to ensure that the provision of such services does not impair the auditors’ independence, the audit committee charter imposes a duty on the audit committee to pre-approve all auditing services performed for us by our independent auditors, as well as all permitted non-audit services. In determining whether or not to pre-approve services, the audit committee considers whether the service is a permissible service under the rules and regulations promulgated by the SEC. The audit committee may, in its discretion, delegate to one or more of its members the authority to pre-approve any audit or non-audit services to be performed by our independent auditors, provided any such approval is presented to and approved by the full audit committee at its next scheduled meeting.
For the years ended December 31, 2019 and 2018, all services rendered by Ernst & Young were pre-approved in accordance with the policies and procedures described above.
Principal Independent Registered Public Accounting Firm Fees
The audit committee reviewed the audit and non-audit services performed by Ernst & Young, as well as the fees charged by Ernst & Young for such services. In its review of the non-audit service fees, the audit committee considered whether the provision of such services is compatible with maintaining the independence of Ernst & Young. The aggregate fees billed to us for professional accounting services, including the audit of our annual financial statements by Ernst & Young for the years ended December 31, 2019 and 2018, are set forth in the table below.
| | | | | | | | | | | | | | |
| | 2019 | | 2018 |
| Audit Fees | | $ | 505,000 | | | $ | 509,000 | |
| Audit-related fees | | — | | | — | |
| Tax fees | | 152,000 | | | 126,000 | |
| All other fees | | — | | | 2,000 | |
| Total | | $ | 657,000 | | | $ | 637,000 | |
For purposes of the preceding table, Ernst & Young’s professional fees are classified as follows:
•Audit fees - These are fees for professional services performed for the audit of our annual financial statements and the required review of quarterly financial statements and other procedures performed by Ernst & Young in order for them to be able to form an opinion on our consolidated financial statements. These fees also cover services that are normally provided by independent auditors in connection with statutory and regulatory filings or engagements.
•Audit-related fees - These are fees for assurance and related services that traditionally are performed by independent auditors that are reasonably related to the performance of the audit or review of our financial statements, such as due diligence related to acquisitions and dispositions, attestation services that are not required by statute or regulation, internal control reviews and consultation concerning financial accounting and reporting standards.
•Tax fees - These are fees for all professional services performed by professional staff in our independent auditor’s tax division, except those services related to the audit of our financial statements. These include fees for tax compliance, tax planning and tax advice, including federal, state and local issues. Services may also include assistance with tax audits and appeals before the IRS and similar state and local agencies, as well as federal, state and local tax issues related to due diligence.
•All other fees - These are fees for any services not included in the above-described categories.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) Financial Statement Schedules
See the Index to Financial Statements at page F-1 of this report.
The following financial statement schedule is included herein at pages F-42 through F-43 of this report:
Schedule III - Real Estate Assets and Accumulated Depreciation and Amortization
(b) Exhibits
| | | | | | | | |
| Ex. | | Description |
| | |
| 2.1 | | |
| | |
| 3.1 | | |
| | |
| 3.2 | | |
| | |
| 3.3 | | |
| | |
| 3.4 | | |
| | |
| 3.5 | | |
| | |
| 4.1 | | |
| | |
| 4.2 | | |
| | |
| 4.3 | | |
| | |
| 4.4 | | |
| | |
| 10.1 | | |
| | |
| 10.2 | | |
| | |
| 10.3 | | Deed of Trust, Assignment of Leases and Rents and Security Agreement and Fixture Filing and Financing Statement, by and between NOHO Commons Pacific Owner LLC, Fidelity National Tile Company and Invesco CMI Investments, L.P., dated August 30, 2019, incorporated by reference to Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 2019, filed November 8, 2019 |
| | |
| 10.4 | | |
| | |
| 10.5 | | |
| | |
| | | | | | | | |
| Ex. | | Description |
| 10.6 | | |
| | |
| 21.1 | | |
| | |
| 23.1 | | |
| | |
| 31.1 | | |
| | |
| 31.2 | | |
| | |
| 32.1 | | |
| | |
| 32.2 | | |
| | |
| 99.1 | | |
| | |
| 99.2 | | |
| | |
| | |
| 101.INS | | Inline XBRL Instance Document |
| | |
| 101.SCH | | Inline XBRL Taxonomy Extension Schema |
| | |
| 101.CAL | | Inline XBRL Taxonomy Extension Calculation Linkbase |
| | |
| 101.DEF | | Inline XBRL Taxonomy Extension Definition Linkbase |
| | |
| 101.LAB | | Inline XBRL Taxonomy Extension Label Linkbase |
| | |
| 101.PRE | | Inline XBRL Taxonomy Extension Presentation Linkbase |
| | |
| 104 | | Cover Page Interactive Data File (formatted as inline XBRL and contained in Exhibit 101) |
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
| | | | | |
| Consolidated Financial Statements | |
| |
| |
| |
| |
| |
| |
| |
| |
| Financial Statement Schedule | |
| |
All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and the Board of Directors of
Pacific Oak Strategic Opportunity REIT II, Inc.
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Pacific Oak Strategic Opportunity REIT II, Inc. (formerly known as KBS Strategic Opportunity REIT II, Inc.) (the “Company”) as of December 31, 2019 and 2018, the related consolidated statements of operations, comprehensive income (loss), equity and cash flows for each of the three years in the period ended December 31, 2019, and the related notes and financial statement schedule listed in the Index at Item 15(a), Schedule III - Real Estate Assets and Accumulated Depreciation and Amortization (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with U.S. generally accepted accounting principles.
Basis for Opinion
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ Ernst & Young LLP
We have served as the Company’s auditor since 2013.
Irvine, California
March 26, 2020
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
| | | | | | | | | | | | | | |
| | | December 31, | | |
| | | 2019 | | 2018 |
| Assets | | | | |
| Real estate, net | | $ | 493,683 | | | $ | 511,606 | |
| Real estate equity securities | | 9,934 | | | 7,230 | |
| | | | |
| Total real estate and real estate-related investments, net | | 503,617 | | | 518,836 | |
| Cash and cash equivalents | | 17,500 | | | 21,063 | |
| Restricted cash | | 5,976 | | | 5,795 | |
| Investment in unconsolidated joint ventures | | 3,468 | | | 2,868 | |
| Rents and other receivables | | 4,648 | | | 5,612 | |
| Above-market leases, net | | 44 | | | 65 | |
| Prepaid expenses and other assets | | 8,230 | | | 8,239 | |
| Total assets | | $ | 543,483 | | | $ | 562,478 | |
| Liabilities and equity | | | | |
| Notes payable, net | | $ | 325,995 | | | $ | 326,543 | |
| Accounts payable and accrued liabilities | | 6,684 | | | 7,226 | |
| Due to affiliates | | 649 | | | 235 | |
| Distributions payable | | 242 | | | 484 | |
| Below-market leases, net | | 4,677 | | | 7,348 | |
| Other liabilities | | 12,776 | | | 13,176 | |
| Redeemable common stock payable | | 2,218 | | | 3,028 | |
| Total liabilities | | 353,241 | | | 358,040 | |
| Commitments and contingencies (Note 12) | | | | |
| Redeemable common stock | | — | | | — | |
| Equity | | | | |
| Pacific Oak Strategic Opportunity REIT II, Inc. stockholders’ equity | | | | |
| Preferred stock, $.01 par value per share; 10,000,000 shares authorized, 0 shares issued and outstanding | | — | | | — | |
| Class A common stock, $.01 par value per share; 500,000,000 shares authorized, 17,949,194 and 18,103,437 shares issued and outstanding as of December 31, 2019 and 2018, respectively | | 179 | | | 181 | |
| Class T common stock, $.01 par value per share; 500,000,000 shares authorized, 12,272,927 and 12,208,242 shares issued and outstanding as of December 31, 2019 and 2018, respectively | | 123 | | | 122 | |
| Additional paid-in capital | | 266,310 | | | 266,339 | |
| Cumulative distributions and net losses | | (84,339) | | | (73,461) | |
| Accumulated other comprehensive income | | — | | | 89 | |
| Total Pacific Oak Strategic Opportunity REIT II, Inc. stockholders’ equity | | 182,273 | | | 193,270 | |
| Noncontrolling interests | | 7,969 | | | 11,168 | |
| Total equity | | 190,242 | | | 204,438 | |
| Total liabilities and equity | | $ | 543,483 | | | $ | 562,478 | |
See accompanying notes to consolidated financial statements.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share amounts)
| | | | | | | | | | | | | | | | | |
| Years Ended December 31, | | | | |
| 2019 | | 2018 | | 2017 |
| Revenues: | | | | | |
| Hotel revenues | $ | 31,381 | | | $ | 32,666 | | | $ | 28,994 | |
| Office revenues | 28,830 | | | 29,941 | | | 15,607 | |
| Apartment revenues | 8,112 | | | 7,469 | | | 6,980 | |
| Dividend income from real estate equity securities | 418 | | | 196 | | | — | |
| Interest income from real estate loan receivable | — | | | 10 | | | 387 | |
| Total revenues | 68,741 | | | 70,282 | | | 51,968 | |
| Expenses: | | | | | |
| Hotel expenses | 22,770 | | | 22,907 | | | 19,187 | |
| Office expenses | 13,705 | | | 12,322 | | | 5,372 | |
| Apartment expenses | 3,554 | | | 3,779 | | | 3,624 | |
| Asset management fees to affiliate | 4,093 | | | 3,985 | | | 2,775 | |
| | | | | |
| | | | | |
| General and administrative expenses | 3,475 | | | 2,866 | | | 3,199 | |
| Depreciation and amortization | 20,236 | | | 20,405 | | | 14,429 | |
| Interest expense | 19,876 | | | 14,663 | | | 8,814 | |
| Impairment charges on real estate | — | | | 14,745 | | | — | |
| Total expenses | 87,709 | | | 95,672 | | | 57,400 | |
| Other (loss) income: | | | | | |
| Other interest income | 305 | | | 367 | | | 514 | |
| Equity in income of unconsolidated entity | 2,800 | | | 339 | | | 54 | |
| Gain (loss) on real estate equity securities | 2,704 | | | (1,924) | | | — | |
| Casualty-related income, net | — | | | — | | | 1,614 | |
| Gain on sale of real estate | 4,178 | | | — | | | — | |
| Loss on extinguishment of debt | (105) | | | — | | | — | |
| Total other income (loss) | 9,882 | | | (1,218) | | | 2,182 | |
| Net loss before income taxes | (9,086) | | | (26,608) | | | (3,250) | |
| Income tax benefit (expense) | — | | | 9 | | | (48) | |
| Net loss | (9,086) | | | (26,599) | | | (3,298) | |
| Net loss attributable to noncontrolling interests | 1,587 | | | 3,091 | | | 26 | |
| Net loss attributable to common stockholders | $ | (7,499) | | | $ | (23,508) | | | $ | (3,272) | |
| | | | | |
| Class A Common Stock: | | | | | |
| Net loss attributable to common stockholders | $ | (4,458) | | | $ | (13,729) | | | $ | (1,480) | |
| Net loss per common share, basic and diluted | $ | (0.25) | | | $ | (0.77) | | | $ | (0.09) | |
| Weighted-average number of common shares outstanding, basic and diluted | 17,949,301 | | | 17,775,503 | | | 16,096,216 | |
| | | | | |
| Class T Common Stock: | | | | | |
| Net loss attributable to common stockholders | $ | (3,041) | | | $ | (9,779) | | | $ | (1,792) | |
| Net loss per common share, basic and diluted | $ | (0.25) | | | $ | (0.82) | | | $ | (0.18) | |
| Weighted-average number of common shares outstanding, basic and diluted | 12,241,271 | | | 11,864,178 | | | 9,797,325 | |
See accompanying notes to consolidated financial statements.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
| | | | | | | | | | | | | | | | | |
| | Years Ended December 31, | | | | |
| 2019 | | 2018 | | 2017 |
| Net loss | $ | (9,086) | | | $ | (26,599) | | | $ | (3,298) | |
| Other comprehensive (loss) income: | | | | | |
| Foreign currency translation (loss) gain | (25) | | | (113) | | | 313 | |
| Reclassification adjustment for amounts recognized in net loss | (64) | | | — | | | — | |
| Total other comprehensive (loss) income | (89) | | | (113) | | | 313 | |
| Total comprehensive loss | (9,175) | | | (26,712) | | | (2,985) | |
| Total comprehensive loss attributable to noncontrolling interests | 1,587 | | | 3,091 | | | 26 | |
| Total comprehensive loss attributable to common stockholders | $ | (7,588) | | | $ | (23,621) | | | $ | (2,959) | |
See accompanying notes to consolidated financial statements.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
CONSOLIDATED STATEMENTS OF EQUITY
(dollars in thousands)
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Common Stock | | | | | | | | Additional Paid-in Capital | | Cumulative Distributions and Net Losses | | Accumulated Other Comprehensive (Loss) Income | | Total Stockholders’ Equity | | Noncontrolling Interests | | Total Equity |
| Class A | | | | Class T | | | | | | | | | | | | | | |
| | Shares | | Amounts | | Shares | | Amounts | | | | | | | | | | | | |
| Balance, December 31, 2016 | 14,074,793 | | | $ | 140 | | | 6,046,591 | | | $ | 61 | | | $ | 176,021 | | | $ | (27,817) | | | $ | (111) | | | $ | 148,294 | | | $ | 11,674 | | | $ | 159,968 | |
| Net loss | — | | | — | | | — | | | — | | | — | | | (3,272) | | | — | | | (3,272) | | | (26) | | | (3,298) | |
| Other comprehensive loss | — | | | — | | | — | | | — | | | — | | | — | | | 313 | | | 313 | | | — | | | 313 | |
| Issuance of common stock | 2,641,090 | | | 27 | | | 4,822,456 | | | 48 | | | 71,841 | | | — | | | — | | | 71,916 | | | — | | | 71,916 | |
| Stock dividends issued | 308,857 | | | 3 | | | 184,606 | | | 2 | | | 4,643 | | | (4,648) | | | — | | | — | | | — | | | — | |
| Redemptions of common stock | (135,800) | | | (1) | | | (21,758) | | | (1) | | | (1,357) | | | — | | | — | | | (1,359) | | | — | | | (1,359) | |
| Transfers to redeemable common stock | — | | | — | | | — | | | — | | | (490) | | | — | | | — | | | (490) | | | — | | | (490) | |
| Distributions declared | — | | | — | | | — | | | — | | | — | | | (3,920) | | | — | | | (3,920) | | | — | | | (3,920) | |
| Commissions on stock sales, dealer manager fees and stockholder servicing fees to affiliate | — | | | — | | | — | | | — | | | (4,913) | | | — | | | — | | | (4,913) | | | — | | | (4,913) | |
| Other offering costs | — | | | — | | | — | | | — | | | (668) | | | — | | | — | | | (668) | | | — | | | (668) | |
| Noncontrolling interests contributions | — | | | — | | | — | | | — | | | — | | | — | | | — | | | — | | | 1,774 | | | 1,774 | |
| Distributions to noncontrolling interests | — | | | — | | | — | | | — | | | — | | | — | | | — | | | — | | | (25) | | | (25) | |
| Balance, December 31, 2017 | 16,888,940 | | | $ | 169 | | | 11,031,895 | | | $ | 110 | | | $ | 245,077 | | | $ | (39,657) | | | $ | 202 | | | $ | 205,901 | | | $ | 13,397 | | | $ | 219,298 | |
| Net loss | — | | | — | | | — | | | — | | | — | | | (23,508) | | | — | | | (23,508) | | | (3,091) | | | (26,599) | |
| Other comprehensive loss | — | | | — | | | — | | | — | | | — | | | — | | | (113) | | | (113) | | | — | | | (113) | |
| Issuance of common stock | 1,100,169 | | | 11 | | | 984,685 | | | 10 | | | 19,974 | | | — | | | — | | | 19,995 | | | — | | | 19,995 | |
| Stock dividends issued | 350,547 | | | 3 | | | 233,830 | | | 2 | | | 5,284 | | | (5,289) | | | — | | | — | | | — | | | — | |
| Redemptions of common stock | (236,219) | | | (2) | | | (42,168) | | | — | | | (2,439) | | | — | | | — | | | (2,441) | | | — | | | (2,441) | |
| Transfers to redeemable common stock | — | | | — | | | — | | | — | | | (417) | | | — | | | — | | | (417) | | | — | | | (417) | |
| Distributions declared | — | | | — | | | — | | | — | | | — | | | (5,007) | | | — | | | (5,007) | | | — | | | (5,007) | |
| Commissions on stock sales, dealer manager fees and stockholder servicing fees to affiliate | — | | | — | | | — | | | — | | | (965) | | | — | | | — | | | (965) | | | — | | | (965) | |
| Other offering costs | — | | | — | | | — | | | — | | | (175) | | | — | | | — | | | (175) | | | — | | | (175) | |
| Noncontrolling interests contributions | — | | | — | | | — | | | — | | | — | | | — | | | — | | | — | | | 1,362 | | | 1,362 | |
| Distributions to noncontrolling interests | — | | | — | | | — | | | — | | | — | | | — | | | — | | | — | | | (500) | | | (500) | |
| Balance, December 31, 2018 | 18,103,437 | | | $ | 181 | | | 12,208,242 | | | $ | 122 | | | $ | 266,339 | | | $ | (73,461) | | | $ | 89 | | | $ | 193,270 | | | $ | 11,168 | | | $ | 204,438 | |
| Net loss | — | | | — | | | — | | | — | | | — | | | (7,499) | | | — | | | (7,499) | | | (1,587) | | | (9,086) | |
| Other comprehensive loss | — | | | — | | | — | | | — | | | — | | | — | | | (89) | | | (89) | | | — | | | (89) | |
| Issuance of common stock | 121,175 | | | 1 | | | 108,704 | | | 1 | | | 2,216 | | | — | | | — | | | 2,218 | | | — | | | 2,218 | |
| | | | | | | | | | | | | | | | | | | |
| Redemptions of common stock | (275,418) | | | (3) | | | (44,019) | | | — | | | (3,045) | | | — | | | — | | | (3,048) | | | — | | | (3,048) | |
| Transfers from redeemable common stock | — | | | — | | | — | | | — | | | 810 | | | — | | | — | | | 810 | | | — | | | 810 | |
| Distributions declared | — | | | — | | | — | | | — | | | — | | | (3,379) | | | — | | | (3,379) | | | — | | | (3,379) | |
| | | | | | | | | | | | | | | | | | | |
| Other offering costs | — | | | — | | | — | | | — | | | (10) | | | — | | | — | | | (10) | | | — | | | (10) | |
| Noncontrolling interests contributions | — | | | — | | | — | | | — | | | — | | | — | | | — | | | — | | | 239 | | | 239 | |
| Distributions to noncontrolling interests | — | | | — | | | — | | | — | | | — | | | — | | | — | | | — | | | (1,851) | | | (1,851) | |
| Balance, December 31, 2019 | 17,949,194 | | | $ | 179 | | | 12,272,927 | | | $ | 123 | | | $ | 266,310 | | | $ | (84,339) | | | $ | — | | | $ | 182,273 | | | $ | 7,969 | | | $ | 190,242 | |
See accompanying notes to consolidated financial statements.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
| | | | | | | | | | | | | | | | | |
| For the Years Ended December 31, | | | | |
| 2019 | | 2018 | | 2017 |
| Cash Flows from Operating Activities: | | | | | |
| Net loss | $ | (9,086) | | | $ | (26,599) | | | $ | (3,298) | |
| Adjustment to reconcile net loss to net cash (used in) provided by operating activities | | | | | |
| Equity in income of unconsolidated entity | (2,800) | | | (339) | | | (54) | |
| Distribution of earnings from unconsolidated joint venture | — | | | 56 | | | 54 | |
| | | | | |
| Casualty-related income, net | — | | | — | | | (1,614) | |
| Depreciation and amortization | 20,236 | | | 20,405 | | | 14,429 | |
| Impairment charges on real estate | — | | | 14,745 | | | — | |
| (Gain) loss on real estate equity securities | (2,704) | | | 1,924 | | | — | |
| Gain on real estate sale | (4,178) | | | — | | | — | |
| Noncash interest income on real estate-related investment | — | | | — | | | (58) | |
| Loss on extinguishment of debt | 105 | | | — | | | — | |
| Deferred rents | (567) | | | (1,428) | | | (774) | |
| Bad debt expense | — | | | 344 | | | 152 | |
| Amortization of above- and below-market leases, net | (2,654) | | | (3,417) | | | (2,028) | |
| Amortization of deferred financing costs | 1,763 | | | 1,207 | | | 910 | |
| Foreign currency translation gain | (64) | | | — | | | — | |
| Unrealized loss (gain) on derivative instruments | 5 | | | (124) | | | 175 | |
| Changes in operating assets and liabilities: | | | | | |
| Rents and other receivables | 1,076 | | | (1,480) | | | (804) | |
| Prepaid expenses and other assets | (1,394) | | | (1,738) | | | 2,123 | |
| Accounts payable and accrued liabilities | (192) | | | 136 | | | (783) | |
| Due to affiliates | 563 | | | (7) | | | 27 | |
| Other liabilities | (204) | | | 930 | | | 372 | |
| Net cash (used in) provided by operating activities | (95) | | | 4,615 | | | 8,829 | |
| Cash Flows from Investing Activities: | | | | | |
| Acquisitions of real estate | — | | | — | | | (193,146) | |
| Proceeds from sale of real estate, net | 17,697 | | | — | | | — | |
| Improvements to real estate | (14,145) | | | (8,914) | | | (9,744) | |
| Investment in real estate securities | — | | | (9,150) | | | — | |
| Payments for construction costs | (445) | | | (5,699) | | | (5,575) | |
| Payoff of real estate loan receivable | — | | | 3,500 | | | — | |
| Contributions to unconsolidated joint venture | (2,900) | | | — | | | — | |
| Distribution of capital from unconsolidated joint venture | 5,104 | | | — | | | — | |
| Proceeds from insurance claims | — | | | 237 | | | 5,080 | |
| Purchase of interest rate cap agreement | (58) | | | (16) | | | (14) | |
| Proceeds from termination of derivative instrument | 145 | | | — | | | — | |
| Net cash provided by (used in) investing activities | 5,398 | | | (20,042) | | | (203,399) | |
| Cash Flows from Financing Activities: | | | | | |
| Proceeds from notes payable | 180,164 | | | 2,278 | | | 120,025 | |
| Principal payments on notes payable | (179,383) | | | (5,499) | | | — | |
| Payments of deferred financing costs | (3,197) | | | (254) | | | (1,782) | |
| Principal payments on finance lease obligations | (196) | | | (175) | | | (166) | |
| Proceeds from issuance of common stock | — | | | 17,184 | | | 70,090 | |
| Payments to redeem common stock | (3,048) | | | (2,441) | | | (1,359) | |
| Payments of commissions on stock sales, dealer manager fees and stockholder servicing fees | — | | | (1,645) | | | (4,607) | |
| Payments of other offering costs | (10) | | | (1,217) | | | — | |
| Distributions paid | (1,403) | | | (1,861) | | | (1,453) | |
| Noncontrolling interest contributions | 239 | | | 1,362 | | | 1,774 | |
| Distributions to noncontrolling interest | (1,851) | | | (500) | | | (25) | |
| Net cash (used in) provided by financing activities | (8,685) | | | 7,232 | | | 182,497 | |
| Net decrease in cash, cash equivalents and restricted cash | (3,382) | | | (8,195) | | | (12,073) | |
| Cash, cash equivalents and restricted cash, beginning of period | 26,858 | | | 35,053 | | | 47,126 | |
| Cash, cash equivalents and restricted cash, end of period | $ | 23,476 | | | $ | 26,858 | | | $ | 35,053 | |
| Supplemental Disclosure of Cash Flow Information: | | | | | |
| Interest paid, net of capitalized interest of $0, $3,920 and $4,075 for the years ended December 31, 2019, 2018 and 2017, respectively | $ | 17,574 | | | $ | 12,427 | | | $ | 6,390 | |
| Supplemental Disclosure of Noncash Investing and Financing Activities: | | | | | |
| Distributions paid to common stockholders through common stock issuances pursuant to the dividend reinvestment plan | $ | 2,218 | | | $ | 3,028 | | | $ | 2,375 | |
| Redemptions payable | $ | 2,218 | | | $ | 3,028 | | | $ | — | |
| Accrued improvements to real estate | $ | 1,158 | | | $ | 1,381 | | | $ | 805 | |
| Other offering costs due to affiliates | $ | — | | | $ | — | | | $ | 1,042 | |
| Distributions payable | $ | 242 | | | $ | 484 | | | $ | 366 | |
| Acquisition fees due to affiliates | $ | 29 | | | $ | 178 | | | $ | 77 | |
| Construction cost payable | $ | — | | | $ | 400 | | | $ | 426 | |
| Stock dividends issued | $ | — | | | $ | 5,289 | | | $ | 4,648 | |
| | | | | |
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| | | | | |
See accompanying notes to consolidated financial statements.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2019
1. ORGANIZATION
Pacific Oak Strategic Opportunity REIT II, Inc. (formerly known as KBS Strategic Opportunity REIT II, Inc.) (the “Company”) was formed on February 6, 2013 as a Maryland corporation that elected to be taxed as a real estate investment trust (“REIT”) beginning with the taxable year ended December 31, 2014 and intends to continue to operate in such a manner. The Company’s business is conducted through Pacific Oak Strategic Opportunity Limited Partnership II (the “Operating Partnership”), a Delaware limited partnership formed on February 7, 2013. The Company is the sole general partner of, and owns a 0.1% partnership interest in, the Operating Partnership. Pacific Oak Strategic Opportunity Holdings II LLC (“REIT Holdings”), a Delaware limited liability company formed on February 7, 2013, owns the remaining 99.9% partnership interest in the Operating Partnership and is the sole limited partner. The Company is the sole member and manager of REIT Holdings. The Company has 3 wholly owned taxable REIT subsidiaries (“TRS”), 2 of which lease the Company’s hotel properties and in turn contract with independent hotel management companies that manage the day-to-day operations of the Company’s hotels; the third consolidates the Company’s wholly owned TRSs. The Company’s TRSs are subject to federal and state income tax at regular corporate tax rates.
Subject to certain restrictions and limitations, the business of the Company was externally managed by KBS Capital Advisors LLC (“KBS Capital Advisors”), an affiliate of the Company, since July 2013 pursuant to an advisory agreement the Company renewed with KBS Capital Advisors on September 26, 2019. KBS Capital Advisors conducted the Company’s operations and managed its portfolio of real estate loans, opportunistic real estate and other real estate-related investments. On October 31, 2019, KBS Capital Advisors ceased to serve as the Company's advisor or have any advisory responsibility to the Company immediately following the filing of the Company's Quarterly Report on Form 10-Q for the period ended September 30, 2019 (filed November 8, 2019) with the Securities and Exchange Commission (the “SEC”). On November 1, 2019, the Company entered into an advisory agreement (the “Advisory Agreement”) with Pacific Oak Capital Advisors, LLC (the “Advisor”). The Advisory Agreement is effective as of November 1, 2019 through November 1, 2020; however the Company may terminate the Advisory Agreement without cause or penalty upon providing 30 days’ written notice and the Advisor may terminate the Advisory Agreement without cause or penalty upon providing 90 days’ written notice. The terms of the Advisory Agreement are consistent with those of the advisory agreement that was previously in effect with KBS Capital Advisors. KBS Capital Advisors previously entered into a sub-advisory agreement with STAM Europe (“STAM”), a real estate operating company based in Paris, France, to provide real estate acquisition and portfolio management services to KBS Capital Advisors in connection with any investments the Company may make in value-added real estate, distressed debt, and real estate-related investments in Europe. Effective April 17, 2019, STAM terminated the sub-advisory agreement with KBS Capital Advisors.
The Company has invested in and manages a portfolio of opportunistic real estate, real estate equity securities and other real estate-related investments located in the United States and Europe. As of December 31, 2019, the Company had invested in 2 hotel properties, 3 office properties, 1 apartment building, 2 investments in unconsolidated joint ventures and an investment in real estate equity securities. Additionally, as of December 31, 2019, the Company had entered into a consolidated joint venture to develop 1 office/retail property.
From July 3, 2013 to August 11, 2014, the Company conducted a private placement offering (the “Private Offering”) exempt from registration under Regulation D of the Securities Act of 1933, as amended (the “Act”). The Company sold 3,619,851 shares of common stock for gross offering proceeds of $32.2 million in the Private Offering.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
On November 14, 2013, the Company filed a registration statement on Form S-11 with the Securities and Exchange Commission (the “SEC”) to offer a maximum of 180,000,000 shares of common stock for sale to the public (the “Public Offering”), of which 100,000,000 shares were registered in a primary offering and 80,000,000 shares were registered to be sold under the Company’s dividend reinvestment plan. The SEC declared the Company’s registration statement effective on August 12, 2014. On February 11, 2016, the Company filed an amended registration statement on Form S-11 with the SEC to offer a second class of common stock designated as Class T shares and to designate its initially offered and outstanding common stock as Class A shares. Pursuant to the amended registration statement, the Company offered to sell any combination of Class A and Class T shares in the Public Offering but in no event may the Company sell more than 180,000,000 of shares of its common stock pursuant to the Public Offering. The Company commenced offering Class T shares of common stock for sale to the public on February 17, 2016. KBS Capital Markets Group LLC (the “Dealer Manager”), an affiliate of our former advisor, serves as the dealer manager of the Public Offering pursuant to a dealer manager agreement originally dated August 12, 2014 and amended and restated February 17, 2016 (the “Dealer Manager Agreement”). Previously the Dealer Manager served as dealer manager for the Private Offering. The Dealer Manager was responsible for marketing the Company’s shares. The Company ceased offering shares of common stock in the primary portion of the Public Offering on July 31, 2018 and terminated the primary portion of the Public Offering on September 28, 2018. The Company continues to offer shares of common stock under its dividend reinvestment plan. In some states, the Company will need to renew the registration statement annually or file a new registration statement to continue its dividend reinvestment plan offering. The Company may terminate its dividend reinvestment plan offering at any time.
The Company sold 11,977,758 and 11,537,701 shares of Class A and Class T common stock, respectively, in the Public Offering for aggregate gross offering proceeds of $228.6 million. As of December 31, 2019, the Company had sold 723,641 and 333,841 shares of Class A and Class T common stock, respectively, under its dividend reinvestment plan for aggregate gross offering proceeds of $9.8 million. Also as of December 31, 2019, the Company had redeemed 718,962 and 107,945 shares of Class A and Class T common stock, respectively, for $7.4 million.
In addition, the Company raised $4.2 million in separate private transactions exempt from the registration requirements of the Act pursuant to Section 4(2) of the Act.
On July 3, 2013, the Company issued 21,739 shares of its Class A common stock to KBS Capital Advisors at a purchase price of $9.20 per share. On each of April 2, 2014 and July 31, 2014, the Company issued 120,106 shares of Class A common stock to Willowbrook Capital Group LLC, an entity owned and controlled by Keith D. Hall, one of the Company’s directors and the Company’s Chief Executive Officer, and Peter McMillan III, also one of the Company’s directors and the Company’s President, for $1.0 million. On July 14, 2017 and February 13, 2018, the Company issued 214,175 shares and 10,935 shares, respectively, of Class A common stock to a business associate of Keith D. Hall and Peter McMillan III for approximately $2.0 million and $0.1 million, respectively. The Company issued these shares of common stock in a private transaction exempt from the registration requirements of the Act pursuant to Section 4(2) of the Act.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation and Basis of Presentation
The consolidated financial statements include the accounts of the Company, REIT Holdings, the Operating Partnership and their direct and indirect wholly owned subsidiaries and joint ventures in which the Company has a controlling interest. All significant intercompany balances and transactions are eliminated in consolidation.
The consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) as contained within the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) and the rules and regulations of the SEC.
Use of Estimates
The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could materially differ from those estimates.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Reclassifications
Certain amounts in the Company’s prior period consolidated financial statements have been reclassified to conform to the current period presentation. These reclassifications have not changed the results of operations of prior periods. Upon adoption of the lease accounting standards of Topic 842 on January 1, 2019 (described below), the Company accounted for tenant reimbursements for property taxes, insurance and common area maintenance as variable lease payments and recorded these amounts as rental income. For the year ended December 31, 2018, the Company reclassified $2.5 million and $22,000 of tenant reimbursement revenue for property taxes, insurance, and common area maintenance to office revenues and apartment revenues, respectively, for comparability purposes. For the year ended December 31, 2017, the Company reclassified $0.9 million and $24,000 of tenant reimbursement revenue for property taxes, insurance, and common area maintenance to office revenues and apartment revenues, respectively, for comparability purposes.
In addition, upon adoption of the lease accounting standards of Topic 842, the Company’s 2 ground leases which were classified as capital leases under ASC 840 were reclassified as finance leases under ASC 842. The existing capital lease assets were reclassified as right-of-use assets and the existing obligation as lease liabilities as of January 1, 2019. The reclassification of these ground leases did not have a material impact to the Company’s financial statements as the accounting and presentation of the related assets and liabilities on the Company’s balance sheet as of December 31, 2019 was consistent with the previous period. The Company’s 2 ground leases had an aggregate right-of-use asset of $8.7 million and an aggregate lease liability of $8.2 million as of December 31, 2019, which are included in total real estate, net and other liabilities, respectively, on the Company’s consolidated balance sheet.
Revenue Recognition
Effective January 1, 2018, the Company adopted ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU No. 2014-09”), using the modified retrospective approach, which requires a cumulative effect adjustment as of the date of the Company’s adoption. Under the modified retrospective approach, an entity may also elect to apply this standard to either (i) all contracts as of January 1, 2018 or (ii) only to contracts that were not completed as of January 1, 2018. A completed contract is a contract for which all (or substantially all) of the revenue was recognized under legacy GAAP that was in effect before the date of initial application. The Company elected to apply this standard only to contracts that were not completed as of January 1, 2018.
Based on the Company’s evaluation of contracts within the scope of ASU No. 2014-09, revenue that is impacted by ASU No. 2014-09 includes revenue generated by other operating income and tenant reimbursements for substantial services earned at the Company’s office properties and hotel revenues. The recognition of such revenue will occur when the services are provided and the performance obligations are satisfied.
Hotel Revenue
The Company recognizes revenue for hotels as hotel revenue when earned. Revenues are recorded net of any sales or occupancy tax collected from the Company’s guests. Additionally, some of the Company’s hotel rooms are booked through independent internet travel intermediaries. If the guest pays the independent internet travel intermediary directly, revenue for the room is booked by the Company at the price the Company sold the room to the independent internet travel intermediary, less any discount or commission paid. If the guest pays the Company directly, revenue for the room is booked by the Company on a gross basis. The Company participates in frequent guest programs sponsored by the brand owners of the Company’s hotels and the Company expenses the charges associated with those programs, as incurred. Hotel operating revenues are disaggregated in the real estate footnote into the categories of rooms revenue, food, beverage and convention services revenue, campground revenue and other revenue to demonstrate how economic factors affect the nature, amount, timing, and uncertainty of revenue and cash flows.
Room revenue is generated through contracts with customers whereby the customer agrees to pay a daily rate for the right to use a hotel room. The Company’s contract performance obligations are fulfilled at the end of the day that the customer is provided the room and revenue is recognized daily at the contract rate. The Company records contract liabilities in the form of advanced deposits when a customer or group of customers provides a deposit for a future stay at the Company’s hotels. Advanced deposits for room revenue are included in the balance of other liabilities on the consolidated balance sheet. Advanced deposits are recognized as revenue at the time of the guest’s stay.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Food, beverage and convention revenue is generated through contracts with customers whereby the customer agrees to pay a contract rate for restaurant dining services or convention services. The Company’s contract performance obligations are fulfilled at the time that the meal is provided to the customer or when the convention facilities and related dining amenities are provided to the customer. The Company recognizes food and beverage revenue upon the fulfillment of the contract with the customer. The Company records contract liabilities in the form of advanced deposits when a customer or group of customers provides a deposit for a future banquet event at the Company’s hotels. Advanced deposits for food and beverage revenue are included in the balance of other liabilities on the consolidated balance sheet. Advanced deposits for banquet services are recognized as revenue following the completion of the banquet services.
Campground revenue is recognized on a straight-line basis over the term of the lease when collectability of the lease payments is probable.
Office and Apartment Revenues
On January 1, 2019, the Company adopted the lease accounting standards under Topic 842 including the package of practical expedients for all leases that commenced before the effective date of January 1, 2019. Accordingly, the Company (i) did not reassess whether any expired or existing contracts are or contain leases, (ii) did not reassess the lease classification for any expired or existing lease, and (iii) did not reassess initial direct costs for any existing leases. The Company did not elect the practical expedient related to using hindsight to reevaluate the lease term. In addition, the Company adopted the practical expedient for land easements and did not assess whether existing or expired land easements that were not previously accounted for as leases under the lease accounting standards of Topic 840 are or contain a lease under Topic 842.
In addition, Topic 842 provides an optional transition method to allow entities to apply the new lease accounting standards at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings. The Company adopted this transition method upon its adoption of the lease accounting standards of Topic 842, which did not result in a cumulative effect adjustment to the opening balance of retained earnings on January 1, 2019. The Company’s comparative periods presented in the financial statements will continue to be reported under the lease accounting standards of Topic 840.
In accordance with Topic 842, tenant reimbursements for property taxes and insurance are included in the single lease component of the lease contract (the right of the lessee to use the leased space) and therefore are accounted for as variable lease payments and are recorded as rental income on the Company’s statement of operations beginning January 1, 2019. In addition, the Company adopted the practical expedient available under Topic 842 to not separate nonlease components from the associated lease component and instead to account for those components as a single component if the nonlease components otherwise would be accounted for under the new revenue recognition standard (Topic 606) and if certain conditions are met, specifically related to tenant reimbursements for common area maintenance which would otherwise be accounted for under the revenue recognition standard. The Company believes the two conditions have been met for tenant reimbursements for common area maintenance as (i) the timing and pattern of transfer of the nonlease components and associated lease components are the same and (ii) the lease component would be classified as an operating lease. Accordingly, tenant reimbursements for common area maintenance are also accounted for as variable lease payments and recorded as rental income on the Company’s statement of operations beginning January 1, 2019.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
The Company recognizes minimum rent, including rental abatements, lease incentives and contractual fixed increases attributable to operating leases, on a straight-line basis over the term of the related leases when collectibility is probable and records amounts expected to be received in later years as deferred rent receivable. If the lease provides for tenant improvements, the Company determines whether the tenant improvements, for accounting purposes, are owned by the tenant or the Company. When the Company is the owner of the tenant improvements, the tenant is not considered to have taken physical possession or have control of the physical use of the leased asset until the tenant improvements are substantially completed. When the tenant is the owner of the tenant improvements, any tenant improvement allowance (including amounts that can be taken in the form of cash or a credit against the tenant’s rent) that is funded is treated as a lease incentive and amortized as a reduction of rental revenue over the lease term. Tenant improvement ownership is determined based on various factors including, but not limited to:
•whether the lease stipulates how a tenant improvement allowance may be spent;
•whether the lessee or lessor supervises the construction and bears the risk of cost overruns;
•whether the amount of a tenant improvement allowance is in excess of market rates;
•whether the tenant or landlord retains legal title to the improvements at the end of the lease term;
•whether the tenant improvements are unique to the tenant or general purpose in nature; and
•whether the tenant improvements are expected to have any residual value at the end of the lease.
The Company leases apartment units under operating leases with terms generally of one year or less. Generally, credit investigations will be performed for prospective residents and security deposits will be obtained. The Company recognizes rental revenue, net of concessions, on a straight-line basis over the term of the lease, when collectibility is determined to be probable.
In accordance with Topic 842, the Company makes a determination of whether the collectibility of the lease payments in an operating lease is probable. If the Company determines the lease payments are not probable of collection, the Company would fully reserve for any contractual lease payments, deferred rent receivable, and variable lease payments and would recognize rental income only if cash is received. Beginning January 1, 2019, these changes to the Company’s collectibility assessment are reflected as an adjustment to rental income included in office revenues and apartment revenues in the Company’s consolidated statement of operations. Prior to January 1, 2019, bad debt expense related to uncollectible accounts receivable and deferred rent receivable was included in office expenses and apartment expenses in the Company’s consolidated statement of operations. Any subsequent changes to the collectibility of the allowance for doubtful accounts as of December 31, 2018, which was recorded prior to the adoption of Topic 842, are recorded in office expenses and apartment expenses in the Company’s consolidated statement of operations.
Beginning January 1, 2019, the Company, as a lessor, records costs to negotiate or arrange a lease that would have been incurred regardless of whether the lease was obtained, such as legal costs incurred to negotiate an operating lease, as an expense and classify such costs as operating, maintenance, and management expense, which is included in office expenses in the Company’s consolidated statement of operations, as these costs are no longer capitalizable under the definition of initial direct costs under Topic 842.
Sale of Real Estate
The Company adopted the guidance of ASC 610-20, Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets (“ASC 610-20”), which applies to sales or transfers to noncustomers of nonfinancial assets or in substance nonfinancial assets that do not meet the definition of a business. Generally, the Company’s sales of real estate would be considered a sale of a nonfinancial asset as defined by ASC 610-20.
ASC 610-20 refers to the revenue recognition principles under ASU No. 2014-09. Under ASC 610-20, if the Company determines it does not have a controlling financial interest in the entity that holds the asset and the arrangement meets the criteria to be accounted for as a contract, the Company would derecognize the asset and recognize a gain or loss on the sale of the real estate when control of the underlying asset transfers to the buyer. The Company sold 1 office building during the years ended December 31, 2019 and recognized a gain of $4.2 million. There were 0 sales of real estate during the years ended 2018 and 2017.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Real Estate Equity Securities
The Company’s real estate equity securities are carried at their estimated fair value based on quoted market prices for the security. Transaction costs that are directly attributable to the acquisition of real estate equity securities are capitalized to its cost basis. Unrealized gains and losses on real estate equity securities are recognized in earnings.
Dividend income from real estate equity securities is recognized on an accrual basis based on eligible shares as of the ex-dividend date.
Real Estate Loans Receivable
Interest income on the Company’s real estate loans receivable is recognized on an accrual basis over the life of the investment using the interest method. Direct loan origination or acquisition fees and costs, as well as acquisition premiums or discounts, are amortized over the term of the loan as an adjustment to interest income. The Company places loans on non-accrual status when any portion of principal or interest is 90 days past due, or earlier when concern exists as to the ultimate collection of principal or interest. When a loan is placed on non-accrual status, the Company reserves for any unpaid accrued interest and generally does not recognize subsequent interest income until cash is received, or the loan returns to accrual status. The Company will resume the accrual of interest if it determines the collection of interest, according to the contractual terms of the loan, is probable.
The Company generally recognizes income on impaired loans on either a cash basis, where interest income is only recorded when received in cash, or on a cost-recovery basis, where all cash receipts are applied against the carrying value of the loan. The Company considers the collectibility of the loan’s principal balance in determining whether to recognize income on impaired loans on a cash basis or a cost-recovery basis.
Cash and Cash Equivalents
The Company recognizes interest income on its cash and cash equivalents as it is earned and records such amounts as other interest income.
Real Estate
Depreciation and Amortization
Real estate costs related to the acquisition and improvement of properties are capitalized and depreciated over the expected useful life of the asset on a straight-line basis. Repair and maintenance costs are charged to expense as incurred and significant replacements and betterments are capitalized. Repair and maintenance costs include all costs that do not extend the useful life of the real estate asset. The Company considers the period of future benefit of an asset to determine its appropriate useful life. Expenditures for lessor owned tenant improvements are capitalized and amortized over the shorter of the tenant’s lease term or expected useful life. The Company anticipates the estimated useful lives of its assets by class to be generally as follows:
| | | | | |
| Land | N/A |
| Buildings | 25-40 years |
| Building improvements | 10-25 years |
| Tenant improvements | Shorter of lease term or expected useful life |
| Tenant origination and absorption costs | Remaining term of related leases, including below-market renewal periods |
| Real estate subsidies & tax abatements | Remaining term of agreement |
| Furniture, fixtures & equipment | 3-12 years |
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Real Estate Acquisition Valuation
The Company records the acquisition of income-producing real estate or real estate that will be used for the production of income as a business combination or an asset acquisition. If substantially all of the fair value of the gross assets acquired are concentrated in a single identifiable asset or group of similar identifiable assets, then the set is not a business. For purposes of this test, land and buildings can be combined along with the intangible assets for any in-place leases and accordingly, most acquisitions of investment properties would not meet the definition of a business and would be accounted for as an asset acquisition. To be considered a business, a set must include an input and a substantive process that together significantly contributes to the ability to create an output. All assets acquired and liabilities assumed in a business combination are measured at their acquisition-date fair values. For asset acquisitions, the cost of the acquisition is allocated to individual assets and liabilities on a relative fair value basis. Acquisition costs associated with business combinations are expensed as incurred. Acquisition costs associated with asset acquisitions are capitalized.
Intangible assets include the value of in-place leases, which represents the estimated value of the net cash flows of the in-place leases to be realized, as compared to the net cash flows that would have occurred had the property been vacant at the time of acquisition and subject to lease-up. Acquired in-place lease values are amortized to expense over the average remaining non-cancelable terms of the respective in-place leases, including any below-market renewal periods. Intangible assets also include the estimated value of subsidy receipts for apartments, which are recorded at a discounted present value based on estimated collectibility and are amortized on a straight-line basis over the period the amounts are expected to be collected.
The Company assesses the acquisition-date fair values of all tangible assets, identifiable intangibles and assumed liabilities using methods similar to those used by independent appraisers, generally utilizing a discounted cash flow analysis that applies appropriate discount and/or capitalization rates and available market information. Estimates of future cash flows are based on a number of factors, including historical operating results, known and anticipated trends, and market and economic conditions. The fair value of tangible assets of an acquired property considers the value of the property as if it were vacant.
The Company records above-market and below-market in-place lease values for acquired properties based on the present value (using a discount rate that reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) management’s estimate of fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining non-cancelable term of above-market in-place leases and for the initial term plus any extended term for any leases with below-market renewal options. The Company amortizes any recorded above-market or below-market lease values as a reduction or increase, respectively, to rental income over the remaining non-cancelable terms of the respective lease, including any below-market renewal periods.
The Company estimates the value of tenant origination and absorption costs by considering the estimated carrying costs during hypothetical expected lease-up periods, considering current market conditions. In estimating carrying costs, the Company includes real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods. The Company amortizes the value of tenant origination and absorption costs to depreciation and amortization expense over the remaining non-cancelable term of each respective lease.
Subsequent to the acquisition of a property, the Company may incur and capitalize costs necessary to get the property ready for its intended use. During that time, certain costs such as legal fees, real estate taxes and insurance and financing costs are also capitalized.
Estimates of the fair values of the tangible assets, identifiable intangibles and assumed liabilities require the Company to make significant assumptions 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.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Impairment of Real Estate and Related Intangible Assets and Liabilities
The Company continually monitors events and changes in circumstances that could indicate that the carrying amounts of its real estate and related intangible assets and liabilities may not be recoverable or realized. When indicators of potential impairment suggest that the carrying value of real estate and related intangible assets and liabilities may not be recoverable, the Company assesses the recoverability by estimating whether the Company will recover the carrying value of the real estate and related intangible assets and liabilities through its undiscounted future cash flows and its eventual disposition. If, based on this analysis, the Company does not believe that it will be able to recover the carrying value of the real estate and related intangible assets and liabilities, the Company will record an impairment loss to the extent that the carrying value exceeds the estimated fair value of the real estate and related intangible assets and liabilities. The Company did 0t record impairment charges on its real estate and related intangible assets during the years ended December 31, 2019 and 2017. The Company recorded impairment charges in the aggregate on real estate of $14.7 million during the year ended December 31, 2018. See note 3, “Real Estate” for a further discussion on the Company’s impairment of real estate.
Projecting future cash flows involves estimating expected future operating income and expenses related to the real estate and its related intangible assets and liabilities as well as market and other trends. Using inappropriate assumptions to estimate cash flows could result in incorrect fair values of the real estate and its related intangible assets and liabilities and could result in the overstatement of the carrying values of the Company’s real estate and related intangible assets and liabilities and an overstatement of its net income.
Insurance Proceeds for Property Damages
The Company maintains an insurance policy that provides coverage for property damages and business interruption. Losses due to physical damages are recognized during the accounting period in which they occur, while the amount of monetary assets to be received from the insurance policy is recognized when receipt of insurance recoveries is probable. Losses, which are reduced by the related probable insurance recoveries, are recorded as casualty-related income/(loss), net on the accompanying consolidated statements of operations. Anticipated proceeds in excess of recognized losses would be considered a gain contingency and recognized when the contingency related to the insurance claim has been resolved. Anticipated recoveries for lost revenue due to property damages are also considered to be a gain contingency and recognized when the contingency related to the insurance claim has been resolved.
Construction in Progress
Direct investments in development properties without leases in place at the time of acquisition are accounted for as an asset acquisition and not as a business combination. Acquisition fees and expenses are capitalized into the cost basis of an asset acquisition. Additionally, during the time in which the Company is incurring costs necessary to bring these investments to their intended use, certain costs such as legal fees, real estate taxes and insurance and financing costs are also capitalized. Once construction in progress is substantially completed, the amounts capitalized to construction in progress are transferred to land and buildings and improvements and are depreciated over their respective useful lives.
Cash and Cash Equivalents
The Company 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. Cash and cash equivalents are stated at cost, which approximates fair value. The Company’s cash and cash equivalents balance exceeded federally insurable limits as of December 31, 2019 and 2018. The Company mitigates this risk by depositing funds with a major financial institution; however, these cash balances could be impacted if the underlying financial institutions fail or are subject to other adverse conditions in the financial markets.
Restricted Cash
Restricted cash is comprised of lender impound reserve accounts on the Company’s borrowings for security deposits, property taxes, insurance, debt service obligations and capital improvements and replacements.
Rents and Other Receivables
The Company periodically evaluates the collectibility of amounts due from hotel guests and will maintain an allowance for doubtful accounts for estimated losses resulting from the inability of hotel guests to make required payments under the terms of hotel agreements. The Company will exercise judgment in establishing these allowances and will consider payment history and current credit status in developing these estimates.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Derivative Instruments
The Company enters into derivative instruments for risk management purposes to hedge its exposure to cash flow variability caused by changing interest rates on its variable rate notes payable. The Company records these derivative instruments at fair value on the accompanying consolidated balance sheets. Derivative instruments designated and qualifying as a hedge of the exposure to variability in expected future cash flows or other types of forecasted transactions are considered cash flow hedges. The change in fair value of the effective portion of a derivative instrument that is designated as a cash flow hedge is recorded as other comprehensive income (loss) on the accompanying consolidated statements of comprehensive income (loss) and consolidated statements of equity. The changes in fair value for derivative instruments that are not designated as a hedge or that do not meet the hedge accounting criteria are recorded as a component of interest expense in the accompanying consolidated statements of operations.
The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objectives and strategy for undertaking various hedge transactions. This process includes designating all derivative instruments that are part of a hedging relationship to specific forecasted transactions or recognized obligations on the consolidated balance sheets. The Company also assesses and documents, both at the hedging instrument’s inception and on a quarterly basis thereafter, whether the derivative instruments that are used in hedging transactions are highly effective in offsetting changes in cash flows associated with the respective hedged items. When the Company determines that a derivative instrument ceases to be highly effective as a hedge, or that it is probable the underlying forecasted transaction will not occur, the Company discontinues hedge accounting prospectively and reclassifies amounts recorded to accumulated other comprehensive income (loss) to earnings.
Deferred Financing Costs
Deferred financing costs represent commitment fees, loan fees, legal fees and other third-party costs associated with obtaining financing and are presented on the balance sheet as a direct deduction from the carrying value of the associated debt liability. These costs are amortized over the terms of the respective financing agreements using the effective interest method. Unamortized deferred financing costs are generally expensed when the associated debt is refinanced or repaid before maturity unless specific rules are met that would allow for the carryover of such costs to the refinanced debt. Deferred financing costs incurred before an associated debt liability is recognized are included in prepaid expenses and other assets on the balance sheet. Costs incurred in seeking financing transactions that do not close are expensed in the period in which it is determined that the financing will not close.
Fair Value Measurements
Under GAAP, the Company is required to measure certain financial instruments at fair value on a recurring basis. In addition, the Company is required to measure other non-financial and financial assets at fair value on a non-recurring basis (e.g., carrying value of impaired real estate loans receivable and long-lived assets). Fair value is defined as the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The GAAP fair value framework uses a three-tiered approach. Fair value measurements are classified and disclosed in one of the following three categories:
•Level 1: unadjusted quoted prices in active markets that are accessible at the measurement date for identical assets or liabilities;
•Level 2: quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model derived valuations in which significant inputs and significant value drivers are observable in active markets; and
•Level 3: prices or valuation techniques where little or no market data is available that requires inputs that are both significant to the fair value measurement and unobservable.
When available, the Company utilizes quoted market prices from an independent third-party source to determine fair value and classify such items in Level 1 or Level 2.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
The Company would classify items as Level 3 in instances where the market for a financial instrument is not active, regardless of the availability of a nonbinding quoted market price, observable inputs might not be relevant and could require the Company to make a significant adjustment to derive a fair value measurement. Additionally, in an inactive market, a market price quoted from an independent third party may rely more on models with inputs based on information available only to that independent third party. When the Company determines that the market for a financial instrument owned by the Company is illiquid or when market transactions for similar instruments do not appear orderly, the Company uses several valuation sources (including internal valuations, discounted cash flow analysis and quoted market prices) and establishes a fair value by assigning weights to the various valuation sources. Additionally, when determining the fair value of liabilities in circumstances in which a quoted price in an active market for an identical liability is not available, the Company measures fair value using (i) a valuation technique that uses the quoted price of the identical liability when traded as an asset or quoted prices for similar liabilities when traded as assets or (ii) another valuation technique that is consistent with the principles of fair value measurement, such as the income approach or the market approach.
Changes in assumptions or estimation methodologies can have a material effect on these estimated fair values. In this regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, may not be realized in an immediate settlement of the instrument.
The Company considers the following factors to be indicators of an inactive market: (i) there are few recent transactions, (ii) price quotations are not based on current information, (iii) price quotations vary substantially either over time or among market makers (for example, some brokered markets), (iv) indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability, (v) there is a significant increase in implied liquidity risk premiums, yields, or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the Company’s estimate of expected cash flows, considering all available market data about credit and other nonperformance risk for the asset or liability, (vi) there is a wide bid-ask spread or significant increase in the bid-ask spread, (vii) there is a significant decline or absence of a market for new issuances (that is, a primary market) for the asset or liability or similar assets or liabilities, and (viii) little information is released publicly (for example, a principal-to-principal market).
The Company considers the following factors to be indicators of non-orderly transactions: (i) there was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities under current market conditions, (ii) there was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant, (iii) the seller is in or near bankruptcy or receivership (that is, distressed), or the seller was required to sell to meet regulatory or legal requirements (that is, forced), and (iv) the transaction price is an outlier when compared with other recent transactions for the same or similar assets or liabilities.
Cash and cash equivalents, restricted cash, rent and other receivables and accounts payable and accrued liabilities: These balances approximate their fair values due to the short maturities of these items.
Real estate equity securities: The Company’s real estate equity securities are presented at fair value on the accompanying consolidated balance sheet. The fair values of real estate equity securities were based on a quoted price in an active market on a major stock exchange. The Company classifies these inputs as Level 1 inputs.
Derivative instruments: The Company’s derivative instruments are presented at fair value on the accompanying consolidated balance sheets. The valuation of these instruments are determined using a proprietary model that utilizes observable inputs. As such, the Company classifies these inputs as Level 2 inputs. The proprietary model uses the contractual terms of the derivatives, including the period to maturity, as well as observable market-based inputs, including interest rate curves and volatility. The fair value of interest rate caps (floors) are determined using the market standard methodology of discounting the future expected cash payments (receipts) which would occur if variable interest rates rise above (below) the strike rate of the caps (floors). The variable interest rates used in the calculation of projected payments (receipts) on the cap (floor) are based on an expectation of future interest rates derived from observed market interest rate curves and volatilities.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Notes payable: The fair value of the Company’s notes payable are estimated using a discounted cash flow analysis based on management’s estimates of current market interest rates for instruments with similar characteristics, including remaining loan term, loan-to-value ratio, type of collateral and other credit enhancements. Additionally, when determining the fair value of liabilities in circumstances in which a quoted price in an active market for an identical liability is not available, the Company measures fair value using (i) a valuation technique that uses the quoted price of the identical liability when traded as an asset or quoted prices for similar liabilities or similar liabilities when traded as assets or (ii) another valuation technique that is consistent with the principles of fair value measurement, such as the income approach or the market approach. The Company classifies these inputs as Level 3 inputs.
Redeemable Common Stock
On July 3, 2013, in connection with launching the Private Offering, the Company’s board of directors adopted a share redemption program that may enable stockholders to sell their shares to the Company in limited circumstances. The share redemption program has been amended and restated at various points thereafter: June 26, 2014, May 12, 2015, February 16, 2016 and December 6, 2018. The share redemption program, as amended is referred to herein as the “Share Redemption Program” and the terms of the Share Redemption Program described below are the terms of the program as currently in effect.
There are several limitations on the Company’s ability to redeem shares under the Share Redemption Program:
•Unless the shares are being redeemed in connection with a stockholder’s death, “qualifying disability” or “determination of incompetence” (each as defined under the Share Redemption Program and collectively “Special Redemptions”), the Company may not redeem shares until the stockholder has held the shares for one year.
•During each calendar year, the Share Redemption Program limits the number of shares the Company may redeem to those that the Company could purchase with the amount of the net proceeds from the issuance of shares under the dividend reinvestment plan during the prior calendar year. In 2020, the Share Redemption Program also provides that in any calendar year, the last $0.5 million of net proceeds from the dividend reinvestment plan during the prior year is reserved exclusively for shares redeemed in connection with a stockholder’s death, “qualifying disability,” or “determination of incompetence” with any excess funds being available to redeem shares not requested in connection with a stockholder’s death, “qualifying disability,” or “determination of incompetence” during the December redemption date in the current year. The Company may, however, increase or decrease the funding available for the redemption of shares pursuant to the program upon 10 business days’ notice to the stockholders.
•During any calendar year, the Company may redeem no more than 5% of the weighted average number of shares outstanding during the prior calendar year.
•The Company has no obligation to redeem shares if the redemption would violate the restrictions on distributions under Maryland law, which prohibits distributions that would cause a corporation to fail to meet statutory tests of solvency.
Pursuant to the Share Redemption Program, unless the shares were redeemed in connection with a Special Redemption, the price at which the Company redeemed the shares through the May 2017 redemption date was as follows:
•For those shares held by the redeeming stockholder for at least one year, 92.5% of the price paid to acquire the shares from the Company;
•For those shares held by the redeeming stockholder for at least two years, 95.0% of the price paid to acquire the shares from the Company;
•For those shares held by the redeeming stockholder for at least three years, 97.5% of the price paid to acquire the shares from the Company; and
•For those shares held by the redeeming stockholder for at least four years, 100% of the price paid to acquire the shares from the Company.
Special Redemptions through the May 2017 redemption date were redeemed at the price paid to acquire the shares from the Company.
Notwithstanding the foregoing, stock dividends were initially redeemed at the “net investment amount” per share, which was based on the “amount available for investment/net investment amount” percentage shown in the Company’s estimated use of proceeds table in the prospectus for the Public Offering. For each class of shares, this amount was initially equal to $9.01 per share for redemptions of shares received as a result of a stock dividend.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Effective for the June 30, 2017 redemption date, redemptions made in connection with a stockholder’s death, qualifying disability, or determination of incompetence are made at a price per share equal to the most recent estimated net asset value (“NAV”) per share as of the applicable redemption date. The price at which we redeem all other shares eligible for redemption is as follows:
•For those shares held by the redeeming stockholder for at least one year, 92.5% of the Company’s most recent NAV per share as of the applicable redemption date;
•For those shares held by the redeeming stockholder for at least two years, 95.0% of the Company’s most recent NAV per share as of the applicable redemption date;
•For those shares held by the redeeming stockholder for at least three years, 97.5% of the Company’s most recent NAV per share as of the applicable redemption date; and
•For those shares held by the redeeming stockholder for at least four years, 100% of the Company’s most recent NAV per share as of the applicable redemption date.
For purposes of determining the time period a redeeming stockholder has held each share, the time period begins as of the date the stockholder acquired the shares; provided, that shares purchased by the redeeming stockholder pursuant to the Company’s dividend reinvestment plan and shares received as a stock dividend will be deemed to have been acquired on the same date as the initial share to which the dividend reinvestment plan shares or stock dividend shares relate. The date of the share’s original issuance by the Company is not determinative. In addition, as described above, the shares owned by a stockholder may be redeemed at different prices depending on how long the stockholder has held each share submitted for redemption.
On June 6, 2017, the Company established a NAV per share of common stock of $9.05 (unaudited). The estimated value per share became effective for the June 2017 redemption date.
On December 6, 2018, the Company established a NAV per share of common stock of $9.65 (unaudited). The estimated value per share became effective for the December 2018 redemption date.
On December 17, 2019, the Company established a NAV per share of common stock of $10.25 (unaudited). The estimated value per share became effective for the December 2019 redemption date.
Upon a transfer of shares any pending redemption requests with respect to such transferred shares will be canceled as of the date the Company accepts the transfer. Stockholders wishing to continue to have a redemption request related to any transferred shares considered by the Company must resubmit their redemption request.
The board may amend, suspend or terminate the Share Redemption Program upon 10 days’ notice to stockholders, provided that the Company may increase or decrease the funding available for the redemption of shares pursuant to the share redemption program upon 10 business days’ notice.
The Company records amounts that are redeemable under the Share Redemption Program as redeemable common stock in its consolidated balance sheets because the shares are mandatorily redeemable at the option of the holder and therefore their redemption is outside the control of the Company. The maximum amount redeemable under the Company’s Share Redemption Program is limited to the number of shares the Company could redeem with the amount of the net proceeds from the sale of shares under the dividend reinvestment plan during the prior calendar year. However, because the amounts that can be redeemed is determinable and only contingent on an event that is likely to occur (e.g., the passage of time) the Company presents the net proceeds from the current year and prior year dividend reinvestment plan, net of current year redemptions, as redeemable common stock in its consolidated balance sheets.
The Company classifies as liabilities financial instruments that represent a mandatory obligation of the Company to redeem shares. The Company’s redeemable common shares are contingently redeemable at the option of the holder. When the Company determines it has a mandatory obligation to repurchase shares under the Share Redemption Program, it reclassifies such obligations from temporary equity to a liability based upon their respective settlement values.
The Company limits the dollar value of shares that may be redeemed under the program as described above. During the year ended December 31, 2019, the Company redeemed $3.0 million of common stock. The Company processed all redemption requests received in good order and eligible for redemption through the December 2019 redemption date, except for 863,378 shares totaling $8.7 million due to the limitations described above. The Company recorded $2.2 million of redeemable common stock payable on the Company’s balance sheet as of December 31, 2019, which represents the amount available to be redeemed in 2020 based on the net proceeds from the sale of shares under of distribution reinvestment plan as of December 31, 2019.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Effective beginning with the month of February 2020, the Company temporarily suspended the Share Redemption Program in light of the proposed merger with Pacific Oak Strategic Opportunity REIT, Inc. See note 15 "Subsequent Events" for further details.
Related Party Transactions
Pursuant to the advisory agreements with KBS Capital Advisors and the Advisor, Dealer Manager Agreement and the dealer manager agreement entered in connection with the Private Offering, the Company was or is obligated to pay KBS Capital Advisors or the Advisor and the Dealer Manager specified fees upon the provision of certain services related to the Public Offering and the Private Offering, the investment of funds in real estate and real estate-related investments, management of the Company’s investments and for other services (including, but not limited to, the disposition of investments). The Company was or is also obligated to reimburse KBS Capital Advisors or the Advisor and Dealer Manager for organization and offering costs incurred by KBS Capital Advisors or the Advisor and the Dealer Manager on behalf of the Company, and the Company is obligated to reimburse KBS Capital Advisors or is obligated to pay the Advisor for acquisition and origination expenses and certain operating expenses incurred on behalf of the Company or incurred in connection with providing services to the Company. In addition, the Advisor is entitled to certain other fees, including an incentive fee upon achieving certain performance goals, as detailed in the Advisory Agreement.
The Company records all related party fees as incurred, subject to any limitations described in the applicable advisory agreement. The Company had not incurred any subordinated participation in net cash flows or subordinated incentive fees payable to KBS Capital Advisors or the Advisor through December 31, 2019.
Acquisition and Origination Fees
The Company pays the applicable advisor acquisition and origination fees equal to 2.6% percentage of the cost of investments acquired or originated by the Company, or the amount to be funded by the Company to acquire or originate loans, including acquisition and origination expenses and any debt attributable to such investments plus significant capital expenditures related to the development, construction or improvement of the investment budgeted as of the date of acquisition.
The Company reimburses the applicable advisor or its affiliates for customary acquisition and origination expenses (including expenses relating to potential investments that do not close), such as legal fees and expenses (including fees of independent contractor in-house counsel that are not employees of KBS Capital Advisors or the Advisor, as applicable), costs of due diligence (including, as necessary, updated appraisals, surveys and environmental site assessments), travel and communication expenses, accounting fees and expenses and other closing costs and miscellaneous expenses relating to the acquisition or origination of opportunistic real estate, real estate-related loans, real estate equity securities and other real estate-related investments.
Asset Management Fee
The Company paid KBS Capital Advisors or will pay the Advisor a monthly fee equal to the lesser of one-twelfth of (i) 1.0% of the cost of its investments and (ii) 2.0% of the sum of the cost of its investments, less any debt secured by or attributable to the investments. The cost of the real property investments is calculated as the amount paid or allocated to acquire the real property, including the cost of any subsequent development, construction or improvements to the property and including fees and expenses related thereto (but excluding acquisition fees paid or payable to KBS Capital Advisors or the Advisor). The cost of the loans and any investments other than real property is calculated as the lesser of (x) the amount actually paid or allocated to acquire or fund the loan or other investment, including fees and expenses related thereto (but excluding acquisition fees paid or payable to KBS Capital Advisors or the Advisor) and (y) the outstanding principal amount of such loan or other investment, including fees and expenses related to the acquisition or funding of such investment (but excluding acquisition fees paid or payable to KBS Capital Advisors or the Advisor) as of the time of calculation. In the case of investments made through joint ventures, the asset management fee is determined based on the Company’s proportionate share of the underlying investment.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Disposition Fee
For substantial assistance in connection with the sale of investments, the Company would pay KBS Capital Advisors or will pay the Advisor, as applicable, or its affiliates a percentage of the contract sales price of each loan, debt-related security, real property or other investment sold (including residential or commercial mortgage-backed securities or collateralized debt obligations issued by a subsidiary of ours as part of a securitization transaction) as a disposition fee. For dispositions with a contract sales price less than or equal to $50 million, the disposition fee will equal 1.5% of the contract sales price. For dispositions with a contract sales price greater than $50 million, the disposition fee will equal the sum of $750,000 (which amount is 1.5% of $50 million), plus 1.0% of the amount of the contract sales price in excess of $50 million. The disposition fee is determined in a per transaction basis and is not cumulative. Disposition fees may be paid, in addition to commissions paid to non-affiliates, provided that the total commissions (including such disposition fee) paid to affiliates and non-affiliates do not exceed an amount equal to the lesser of (i) 6.0% if the aggregate contract sales price or (ii) the competitive real estate commission. The Company will not pay a disposition fee upon the maturity, prepayment or workout of a loan or other debt-related investment, provided that if the Company negotiates a discounted payoff with the borrower it will pay a disposition fee and if the Company takes ownership of a property as a result of a workout or foreclosure of a loan, it will pay a disposition fee upon the sale of such property.
Subordinated Participation in Net Cash Flows
After the Company’s common stockholders have received, together as a collective group, aggregate distributions (regardless of the source used to fund such distributions and including distributions that may constitute a return of capital for federal income tax purposes) sufficient to provide (i) a return of their gross investment amount, which is the amount calculated by multiplying the total number of shares purchased by stockholders by the issue price, reduced by the total number of shares repurchased by the Company (excluding shares received as a stock dividend which the Company subsequently repurchased) multiplied by the weighted average issue price of the shares sold in a primary offering, and (ii) a 7.0% per year cumulative, noncompounded return on such gross investment amount, the Advisor is entitled to receive 15% of the Company’s net cash flows, whether from continuing operations, net sales proceeds, net financing proceeds, or otherwise. This fee is only payable if the Company is not listed on an exchange.
Subordinated Incentive Fee
Upon a merger or listing of the Company’s common stock on a national securities exchange, the Advisor or its affiliates will receive an incentive fee. Upon a listing this fee will equal 15% of the amount by which (i) the market value of the Company’s outstanding stock, as defined in the Advisory Agreement, plus the total of all distributions paid by the Company to stockholders from inception until the date market value is determined (regardless of the source used to fund such distributions and including distributions that may constitute a return of capital for federal income tax purposes and excluding any stock dividend) exceeds (ii) the sum of stockholders’ gross investment amount, or the amount calculated by multiplying the total number of shares purchased by stockholders by the issue price, reduced by the total number of shares repurchased by the Company (excluding shares received as a stock dividend which the Company subsequently repurchased) multiplied by the weighted average issue price of the shares sold in the primary portion of an offering, and the amount of cash flow necessary to generate a 7.0% per year cumulative, noncompounded return on stockholders’ gross investment amount from the Company’s inception through the date the market value is determined.
Upon a merger this fee will equal 15% of the amount by which (i) the merger consideration amount plus the total of all distributions paid or declared by the Company to stockholders from inception until the closing of the merger (regardless of the source used to fund such distributions and including distributions that may constitute a return of capital for federal income tax purposes and excluding any stock dividend) exceeds (ii) the sum of stockholders’ gross investment amount, or the amount calculated by multiplying the total number of shares purchased by stockholders by the issue price, reduced by the total number of shares repurchased by the Company (excluding shares received as a stock dividend which the Company subsequently repurchased) multiplied by the weighted average issue price of the shares sold in the primary portion of an offering, and the amount necessary to generate a 7.0% per year cumulative, noncompounded return on the Company’s stockholders’ gross investment amount from the Company’s inception through the closing of the merger.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Foreign Currency Translation
The Company had a participating loan facility funded in Euros which is accounted for under the equity method of accounting and recorded as an investment in unconsolidated entity in the accompanying balance sheets. The Company’s reporting currency is the U.S. dollar, however the functional currency of the unconsolidated entity is the Euro. At the end of each reporting period, before determining the Company’s share of its equity investment, the results of operations of the unconsolidated entity is translated into U.S. dollars using the average currency rates of exchange in effect during the period, and the assets and the liabilities of the unconsolidated entity are translated using the currency exchange rate in effect at the end of the period. The resulting foreign currency translation adjustment is recorded as other comprehensive income (loss) on the accompanying consolidated statements of comprehensive income (loss) and consolidated statements of equity.
Income Taxes
The Company elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended with its taxable year ended December 31, 2014. To continue to qualify as a REIT, the Company must meet certain organizational and operational requirements, including a requirement to distribute at least 90% of the Company’s annual REIT taxable income to its stockholders (which is computed without regard to the dividends paid deduction or net capital gain and which does not necessarily equal net income as calculated in accordance with GAAP). As a REIT, the Company generally will not be subject to federal income tax to the extent it distributes qualifying dividends to its stockholders. If the Company fails to qualify as a REIT in any taxable year, it will be subject to federal income tax on its taxable income at regular corporate income tax rates and generally will not be permitted to qualify for treatment as a REIT for federal income tax purposes for the four taxable years following the year during which qualification is lost unless the Internal Revenue Service grants the Company relief under certain statutory provisions. Such an event could materially and adversely affect the Company’s net income and net cash available for distribution to stockholders. However, the Company intends to organize and operate in such a manner as to qualify for treatment as a REIT.
The Company accounts for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective income tax bases, and for net operating loss, capital loss and tax credit carryforwards. The deferred tax assets and liabilities are measured using the enacted income tax rates in effect for the year in which those temporary differences are expected to be realized or settled. The effect on the deferred tax assets and liabilities from a change in tax rates is recognized in earnings in the period when the new rate is enacted. However, deferred tax assets are recognized only to the extent that it is more likely than not that they will be realized based on consideration of all available evidence, including the future reversals of existing taxable temporary differences, future projected taxable income and tax planning strategies. Valuation allowances are provided if, based upon the weight of the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
The Company has concluded that there are no significant uncertain tax positions requiring recognition in its financial statements. Neither the Company nor its subsidiaries have been assessed interest or penalties by any major tax jurisdictions.The Company’s evaluations were performed for all open tax years through December 31, 2019. As of December 31, 2019, returns for the calendar year 2015 through 2018 remain subject to examination by major tax jurisdictions.
The Company’s hotel properties are leased to wholly-owned taxable REIT subsidiaries, which in turn contracts with an independent hotel management company that manages the day-to-day operations of the Company’s hotels. Lease revenue generated from the taxable REIT subsidiary is eliminated in consolidation.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Segments
The Company has invested in opportunistic real estate investments, real estate equity securities and originated a loan secured by a non-stabilized real estate asset, which was repaid on January 12, 2018. In general, the Company intends to hold its investments in opportunistic real estate, real estate equity securities and other real estate-related assets for capital appreciation. Traditional performance metrics of opportunistic real estate and other real estate-related assets may not be meaningful as these investments are generally non-stabilized and do not provide a consistent stream of interest income or rental revenue. These investments exhibit similar long-term financial performance and have similar economic characteristics. These investments typically involve a higher degree of risk and do not provide a constant stream of ongoing cash flows. As a result, the Company’s management views opportunistic real estate and other real estate-related assets as similar investments. Substantially all of its revenue and net income (loss) is from opportunistic real estate and other real estate-related assets, and therefore, the Company currently aggregates its operating segments into one reportable business segment. In addition, the Company has invested in a participating loan facility secured by a portfolio of light industrial properties located in Europe. However, based on the Company’s investment portfolio and future investment focus, the Company does not believe that its investment in the European asset is a reportable segment.
Per Share Data
Basic net income (loss) per share of common stock is calculated by dividing net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock issued and outstanding for each class of share outstanding during such period. Diluted net income (loss) per share of common stock equals basic net income (loss) per share of common stock as there were 0 potentially dilutive securities outstanding during the years ended December 31, 2019, 2018 and 2017. For the purpose of determining the weighted average number of shares outstanding, stock dividends issued are adjusted retroactively and treated as if they were issued and outstanding for all periods presented.
Commencing March 2015, the Company’s board of directors has declared and issued stock dividends on shares of the Company’s common stock through December 31, 2019 as follows:
| | | | | | | | | | | | | | |
| Year Ended December 31, | | Amount Declared per Share Outstanding (1) | | Total Shares Issued |
| 2015 | | 0.100000 shares | | | 765,604 | |
| 2016 | | 0.035003 shares | | | 513,723 | |
| 2017 | | 0.020004 shares | | | 493,463 | |
| 2018 | | 0.018337 shares | | | 584,377 | |
| 2019 | | — | | | — | |
_____________________
(1) Amount declared per share outstanding includes one-time stock dividends, quarterly dividends and monthly dividends and assumes each share was issued and outstanding for the entire periods presented. Stock dividends are issued in the same class of shares as the shares for which such stockholder received the stock dividend.
Stock dividends are non-taxable to stockholders at the time of issuance. During the Company’s offering stage and through November 2018, the Company’s board of directors declared stock dividends on a set monthly basis based on monthly record dates. The Company currently does not expect its board of directors to declare additional monthly stock dividends.
Until the Company established a NAV per share of common stock on June 6, 2017, for the purpose of calculating the dollar amount of the Class A and Class T stock dividends issued, the Company used the Class A and Class T primary offering price at the time of issuance.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Cash distributions declared per share of Class A common stock were $0.112, $0.191 and 0.191 for the years ended December 31, 2019, 2018 and 2017, respectively. Cash distributions declared per share of Class T common stock were $0.112, $0.138 and $0.098 for the years ended December 31, 2019, 2018 and 2017, respectively. Until the Company ceased offering shares of common stock in the Public Offering on July 31, 2018, the declared rate of cash distributions for Class T Shares was different than the rate declared for the Class A Shares by an amount equivalent to any applicable daily stockholder servicing fees. On March 7, 2019, the Company's board of directors declared a monthly cash distribution in the amount of $0.00799167 per share on the outstanding shares of all classes of its common stock as of March 18, 2019 and through December 31, 2019. On December 6, 2018, the Company’s board of directors declared a monthly cash distribution in the amount of $0.01598333 per share on the outstanding shares of all classes of its common stock as of December 20, 2018 and through February 2019. Distributions declared per share of Class A common stock assumes each share was issued and outstanding each day that was a record date during the 11 months ended November 30, 2018 and during the year ended December 31, 2017. Distributions declared per share of Class T common stock assumes each share was issued and outstanding each day that was a record date from January 1, 2017 through November 30, 2018. Each day during the period from January 1, 2017 through November 30, 2018 was a record date for distributions. Distributions for January 1, 2017 through November 30, 2018 were calculated based on stockholders of record each day during the period at a rate of $0.00052548 per share per day, all of which were reduced by the applicable daily stockholder servicing fees accrued for and allocable to any class of common stock, divided by the number of shares of common stock of such class outstanding as of the close of business on each respective record date.
The Company uses the two-class method to calculate earnings per share. Basic earnings per share is calculated based on dividends declared (“distributed earnings”) and the rights of common shares and participating securities in any undistributed earnings, which represents net income remaining after deduction of dividends declared during the period. The undistributed earnings are allocated to all outstanding common shares based on the relative percentage of each class of shares to the total number of outstanding shares. The Company does not have any participating securities outstanding other than Class A Common Stock and Class T Common stock during the periods presented.
The Company’s calculated earnings per share for the years ended December 31, 2019, 2018 and 2017 were as follows (in thousands, except per share amounts):
| | | | | | | | | | | | | | | | | | | | |
| | Years Ended December 31, | | | | |
| | 2019 | | 2018 | | 2017 |
| | | | | | |
| Net loss attributable to common stockholders | | (7,499) | | | (23,508) | | | (3,272) | |
| Less: Class A Common Stock cash distributions declared | | 2,010 | | | 3,372 | | | 2,991 | |
| Less: Class T Common Stock cash distributions declared | | 1,369 | | | 1,635 | | | 929 | |
| Undistributed net loss attributable to common stockholders | | $ | (10,878) | | | $ | (28,515) | | | $ | (7,192) | |
| | | | | | |
| Class A Common Stock: | | | | | | |
| Undistributed net loss attributable to common stockholders | | (6,468) | | | (17,101) | | | (4,471) | |
| Class A Common Stock cash distributions declared | | 2,010 | | | 3,372 | | | 2,991 | |
| Net loss attributable to common stockholders | | $ | (4,458) | | | $ | (13,729) | | | $ | (1,480) | |
| Net loss per common share, basic and diluted | | $ | (0.25) | | | $ | (0.77) | | | $ | (0.09) | |
| Weighted-average number of common shares outstanding, basic and diluted | | 17,949,301 | | | 17,775,503 | | | 16,096,216 | |
| | | | | | |
| Class T Common Stock: | | | | | | |
| Undistributed net loss attributable to common stockholders | | $ | (4,410) | | | $ | (11,414) | | | $ | (2,721) | |
| Class T Common Stock cash distributions declared | | 1,369 | | | 1,635 | | | 929 | |
| Net loss attributable to common stockholders | | $ | (3,041) | | | $ | (9,779) | | | $ | (1,792) | |
| Net loss per common share, basic and diluted | | $ | (0.25) | | | $ | (0.82) | | | $ | (0.18) | |
| Weighted-average number of common shares outstanding, basic and diluted | | 12,241,271 | | | 11,864,178 | | | 9,797,325 | |
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Square Footage, Occupancy and Other Measures
Square footage, occupancy, average revenue per available room, average daily rate and other measures including annualized base rents and annualized base rents per square foot used to describe real estate and real-estate related investments included in these Notes to Consolidated Financial Statements are presented on an unaudited basis.
Recently Issued Accounting Standards Updates
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses of Financial Instruments (“ASU No. 2016-13”). ASU No. 2016-13 affects entities holding financial assets and net investments in leases that are not accounted for at fair value through net income. The amendments in ASU No. 2016-13 require a financial asset (or a group of financial assets) measured at amortized cost basis to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset(s) to present the net carrying value at the amount expected to be collected on the financial asset. ASU No. 2016-13 also amends the impairment model for available-for-sale securities. An entity will recognize an allowance for credit losses on available-for-sale debt securities as a contra-account to the amortized cost basis rather than as a direct reduction of the amortized cost basis of the investment, as is currently required. ASU No. 2016-13 also requires new disclosures. For financial assets measured at amortized cost, an entity will be required to disclose information about how it developed its allowance for credit losses, including changes in the factors that influenced management’s estimate of expected credit losses and the reasons for those changes. For financing receivables and net investments in leases measured at amortized cost, an entity will be required to further disaggregate the information it currently discloses about the credit quality of these assets by year of the asset’s origination for as many as five annual periods. For available for sale securities, an entity will be required to provide a roll-forward of the allowance for credit losses and an aging analysis for securities that are past due. ASU No. 2016-13 is effective for annual periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. During October 2019, the FASB announced that certain entities. including smaller reporting companies, will be allowed additional implementation time with the standard becoming effective for annual periods beginning after December 15, 2022, including interim periods within those fiscal years. The Company is still evaluating the impact of adopting ASU No. 2016-13 on its financial statements, but does not expect the adoption of ASU No. 2016-13 to have a material impact on its financial statements.
3. REAL ESTATE
As of December 31, 2019, the Company’s real estate portfolio was composed of 2 hotel properties, 3 office properties and 1 apartment building. In addition, as of December 31, 2019, the Company has entered into a consolidated joint venture to develop 1 office/retail property. The following table summarizes the Company’s real estate as of December 31, 2019 and 2018, respectively (in thousands):
| | | | | | | | | | | | | | |
| | December 31, 2019 | | December 31, 2018 |
| Land | | $ | 102,288 | | | $ | 104,138 | |
| Buildings and improvements | | 427,696 | | | 425,989 | |
| Tenant origination and absorption costs | | 15,422 | | | 17,183 | |
Total real estate, cost and net of impairment charges (1) | | 545,406 | | | 547,310 | |
| Accumulated depreciation and amortization | | (51,723) | | | (35,704) | |
| Total real estate, net | | $ | 493,683 | | | $ | 511,606 | |
_____________________
(1) See “ – Impairment of Real Estate” below.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
The following table provides summary information regarding the Company’s real estate as of December 31, 2019 (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Property | | Date Acquired | | City | | State | | Property Type | | Land | | Building and Improvements (1) | | Tenant Origination and Absorption | | Total Real Estate, at Cost and Net of Impairment Charges | | Accumulated Depreciation and Amortization | | Total Real Estate, Net | | Ownership % |
| Springmaid Beach Resort | | 12/30/2014 | | Myrtle Beach | | SC | | Hotel | | $ | 27,438 | | | $ | 37,822 | | | $ | — | | | $ | 65,260 | | | $ | (10,314) | | | $ | 54,946 | | | 90.0% | |
| Q&C Hotel | | 12/17/2015 | | New Orleans | | LA | | Hotel | | 1,232 | | | 53,233 | | | — | | | 54,465 | | | (8,315) | | | 46,150 | | | 90.0% | |
| Lincoln Court | | 05/20/2016 | | Campbell | | CA | | Office | | 14,706 | | | 35,978 | | | 2,126 | | | 52,810 | | | (5,641) | | | 47,169 | | | 100.0% | |
| Lofts at NoHo Commons | | 11/16/2016 | | North Hollywood | | CA | | Apartment | | 26,222 | | | 81,307 | | | — | | | 107,529 | | | (6,576) | | | 100,953 | | | 90.0% | |
210 West 31st Street (2) | | 12/01/2016 | | New York | | NY | | Retail | | — | | | 55,244 | | | — | | | 55,244 | | | — | | | 55,244 | | | 80.0% | |
| Oakland City Center | | 08/18/2017 | | Oakland | | CA | | Office | | 22,150 | | | 142,102 | | | 10,496 | | | 174,748 | | | (17,493) | | | 157,255 | | | 100.0% | |
Madison Square (3) | | 10/03/2017 | | Phoenix | | AZ | | Office | | 10,540 | | | 22,010 | | | 2,800 | | | 35,350 | | | (3,384) | | | 31,966 | | | 90.0% | |
| | | | | | | | | | $ | 102,288 | | | $ | 427,696 | | | $ | 15,422 | | | $ | 545,406 | | | $ | (51,723) | | | $ | 493,683 | | | |
_____________________
(1) Building and improvements includes construction costs for the Company’s project that was under development.
(2) The Company acquired the rights to a leasehold interest with respect to this property, which was accounted for as a finance lease. The Company applied a 6.1% discount rate to the finance lease and the lease expires on January 31, 2114. As of December 31, 2019, the finance lease right-of-use asset had a carrying value of $6.8 million included in building and improvements. NaN depreciation or amortization was recorded to this property as of December 31, 2019.
(3) The Company acquired the rights to a leasehold interest with respect to the land at this property, which was accounted for as a finance lease. The Company applied a 5.4% discount rate to the finance lease and as of December 31, 2019, the finance lease had a weighted average remaining lease term of 2.6 years. As of December 31, 2019, the capital lease asset had a carrying value of $1.9 million included in land. This property was formerly known as Grace Court and was re-named Madison Square in connection with the Company’s re-branding strategy for this property.
Hotel Properties
As of December 31, 2019, the Company owned 2 hotel properties. The following table provides detailed information regarding the Company’s hotel revenues and expenses for the years ended December 31, 2019, 2018 and 2017 (in thousands):
| | | | | | | | | | | | | | | | | | | | |
| | For the Years Ended December 31, | | | | | |
| | 2019 | | 2018 | | 2017 |
| Hotel revenues: | | | | | | |
| Room | | $ | 23,513 | | | $ | 24,620 | | | $ | 17,216 | |
| Food, beverage and convention services | | 5,030 | | | 5,263 | | | 3,761 | |
| Campground | | 1,105 | | | 1,176 | | | 1,127 | |
Other (1) | | 1,733 | | | 1,607 | | | 6,890 | |
| Hotel revenues | | $ | 31,381 | | | $ | 32,666 | | | $ | 28,994 | |
| | | | | | |
| Hotel expenses: | | | | | | |
| Room | | $ | 5,984 | | | $ | 6,157 | | | $ | 4,759 | |
| Food, beverage and convention services | | 4,023 | | | 4,077 | | | 3,179 | |
| General and administrative | | 2,917 | | | 2,919 | | | 2,357 | |
| Sales and marketing | | 3,260 | | | 3,069 | | | 2,642 | |
| Repairs and maintenance | | 2,099 | | | 2,362 | | | 1,815 | |
| Utilities | | 1,173 | | | 1,207 | | | 1,033 | |
| Property taxes and insurance | | 1,743 | | | 1,749 | | | 1,799 | |
| Other | | 1,571 | | | 1,367 | | | 1,603 | |
| Hotel expenses | | $ | 22,770 | | | $ | 22,907 | | | $ | 19,187 | |
_____________________
(1) Hotel revenues - other includes $5.8 million of business interruption insurance recovery for the year ended December 31, 2017 related to the impact of Hurricane Matthew in October 2016, the result of which placed certain rooms at Springmaid Beach Resort out of service during the year ended December 31, 2017.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Contract liabilities
The following table summarizes the Company’s contract liabilities, which are included in other liabilities in the accompanying consolidated balance sheets, as of December 31, 2019 and December 31, 2018 (in thousands):
| | | | | | | | | | | | | | |
| | December 31, 2019 | | December 31, 2018 |
| Contract liability | | $ | 500 | | | $ | 324 | |
| Revenue recognized in the period from: | | | | |
| Amounts included in contract liability at the beginning of the period | | $ | 281 | | | $ | 304 | |
Office Properties
As of December 31, 2019, the Company owned 3 office properties encompassing in the aggregate 806,115 rentable square feet which were 68% occupied. The following table provides detailed information regarding the Company’s office revenues and expenses for the years ended December 31, 2019, 2018 and 2017 (in thousands):
| | | | | | | | | | | | | | | | | | | | |
| | For the Years Ended December 31, | | | | | |
| | 2019 | | 2018 | | 2017 |
| Office revenues: | | | | | | |
| Rental income | | $ | 27,978 | | | $ | 29,104 | | | $ | 15,204 | |
Other income (1) | | 852 | | | 837 | | | 403 | |
| Office revenues | | $ | 28,830 | | | $ | 29,941 | | | $ | 15,607 | |
| | | | | | |
| Office expenses: | | | | | | |
Operating, maintenance, and management (2) | | $ | 9,349 | | | $ | 8,362 | | | $ | 3,636 | |
Real estate taxes and insurance (2) | | 4,356 | | | 3,960 | | | 1,736 | |
| Office expenses | | $ | 13,705 | | | $ | 12,322 | | | $ | 5,372 | |
_____________________
(1) For the years ended December 31, 2018 and 2017, the Company reclassified $2.5 million, and $0.9 million of tenant reimbursement revenue for property taxes, insurance, and common area maintenance to rental income. See note 2, “Summary of Significant Accounting Policies” for a further discussion on this reclassification.
(2) On October 1, 2018, the Company placed the development of 210 West 31st Street on hold and began expensing certain costs that were previously capitalized. Included in office expenses for the year ended December 31, 2019 is $0.7 million of operating, maintenance and management and $0.5 million of real estate taxes and insurance for 210 West 31st Street.
Operating Leases
The Company’s office properties are leased to tenants under operating leases for which the terms and expirations vary. As of December 31, 2019, the leases had remaining terms, excluding options to extend, of up to 8.7 years with a weighted-average remaining term of 3.3 years. Some of the leases may have provisions to extend the term of the lease, options for early termination for all or a part of the leased premises after paying a specified penalty and other terms and conditions as negotiated. The Company retains substantially all of the risks and benefits of ownership of the real estate assets leased to tenants. Generally, upon the execution of a lease, the Company requires a security deposit from the tenant in the form of a cash deposit and/or a letter of credit. The amount required as a security deposit varies depending upon the terms of the respective lease and the creditworthiness of the tenant, but generally is not a significant amount. Therefore, exposure to credit risk exists to the extent that a receivable from a tenant exceeds the amount of its security deposit. Security deposits received in cash related to office tenant leases are included in other liabilities in the accompanying consolidated balance sheets and totaled $1.1 million and $1.3 million as of December 31, 2019 and 2018, respectively.
During the years ended December 31, 2019, 2018 and 2017, the Company recognized deferred rent from tenants of $0.6 million, $1.4 million and $0.8 million, respectively, net of lease incentive amortization. As of December 31, 2019 and 2018, the cumulative deferred rent receivable balance, including unamortized lease incentive receivables, was $2.9 million and $2.8 million, respectively, and is included in rents and other receivables on the accompanying balance sheets. The cumulative deferred rent balance included $0.2 million of unamortized lease incentives as of December 31, 2019 and 2018.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
As of December 31, 2019, the future minimum rental income from the Company’s office properties under its non-cancelable operating leases was as follows (in thousands):
| | | | | |
| 2020 | $ | 21,600 | |
| 2021 | 19,985 | |
| 2022 | 16,287 | |
| 2023 | 13,245 | |
| 2024 | 10,802 | |
| Thereafter | 33,323 | |
| $ | 115,242 | |
As of December 31, 2019, the Company’s commercial real estate properties were leased to approximately 80 tenants over a diverse range of industries and geographic areas. As of December 31, 2019, the highest tenant industry concentrations (greater than 10% of annualized base rent) in the Company’s portfolio were as follows:
| | | | | | | | | | | | | | | | | | | | |
| Industry | | Number of Tenants | | Annualized Base Rent (1) (in thousands) | | Percentage of
Annualized Base Rent |
| Legal Services | | 13 | | | $ | 4,547 | | | 20.7 | % |
| Public Administration | | 6 | | | 3,589 | | | 16.3 | % |
| Professional, Scientific, and Technical Services | | 12 | | | 3,123 | | | 14.2 | % |
| | | | $ | 11,259 | | | 51.2 | % |
_____________________
(1) Annualized base rent represents annualized contractual base rental income as of December 31, 2019, adjusted to straight-line any contractual tenant concessions (including free rent), rent increases and rent decreases from the lease’s inception through the balance of the lease term.
No other tenant industries accounted for more than 10% of annualized base rent. No tenant accounted for more than 10% of annualized base rent. No material tenant credit issues have been identified at this time. During the year ended December 31, 2019, the Company recorded a $9,000 adjustment to office revenues for lease payments deemed not probable of collection. During the years ended December 31, 2019, 2018 and 2017, the Company recorded bad debt expense of $0.1 million, $0.3 million and $0.2 million, respectively, which were included in office expenses in the accompanying consolidated statements of operations.
Apartment Property
As of December 31, 2019, the Company owned 1 apartment property with 292 units which was 93% occupied. The following table provides detailed information regarding the Company’s apartment revenues and expenses for the years ended December 31, 2019, 2018 and 2017 (in thousands):
| | | | | | | | | | | | | | | | | | | | |
| | For the Years Ended December 31, | | | | | |
| | 2019 | | 2018 | | 2017 |
| Apartment revenues: | | | | | | |
Rental income (1) | | $ | 7,503 | | | $ | 6,861 | | | $ | 6,539 | |
| Other income | | 609 | | | 608 | | | 441 | |
| Apartment revenues | | $ | 8,112 | | | $ | 7,469 | | | $ | 6,980 | |
| | | | | | |
| Apartment expenses: | | | | | | |
| Operating, maintenance, and management | | $ | 2,177 | | | $ | 2,423 | | | $ | 2,278 | |
| Real estate taxes and insurance | | 1,377 | | | 1,356 | | | 1,346 | |
| Apartment expenses | | $ | 3,554 | | | $ | 3,779 | | | $ | 3,624 | |
_____________________
(1) For the years ended December 31, 2018 and 2017, the Company reclassified $22,000 and $24,000, respectively, of tenant reimbursement revenue for property taxes, insurance, and common area maintenance to rental income. See note 2, “Summary of Significant Accounting Policies” for a further discussion on this reclassification.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Geographic Concentration Risk
As of December 31, 2019, the Company’s real estate investments in California represented 56.2% of the Company’s total assets. As a result, the geographic concentration of the Company’s portfolio makes it particularly susceptible to adverse economic developments in the California real estate market. Any adverse economic or real estate developments in this market, such as business layoffs or downsizing, industry slowdowns, relocations of businesses, changing demographics and other factors, or any decrease in demand for office space resulting from the local business climate, could adversely affect the Company’s operating results and its ability to make distributions to stockholders.
Disposition of Real Estate
During the year ended December 31, 2019, the Company disposed of 1 office building and there were 0 dispositions during the year ended December 31, 2018.
On November 4, 2019, the Company, through an indirect wholly owned subsidiary, sold 2200 Paseo Verde to a purchaser unaffiliated with the Company or the Advisor for a sales price, net of closing credits of $18.7 million, excluding closing costs. The carrying value of 2200 Paseo Verde as of the disposition date was $13.5 million, which was net of $2.0 million of accumulated depreciation and amortization. The Company recognized a gain on sale of $4.2 million related to the disposition of 2200 Paseo Verde.
The following summary presents the major components of assets and liabilities related to real estate held for sale as December 31, 2019 and 2018 (in thousands):
| | | | | | | | | | | | | | |
| | December 31,
2019 | | December 31,
2018 |
| Assets related to disposition | | | | | | |
| Real estate, cost | | $ | — | | | $ | 14,119 | |
| Accumulated depreciation and amortization | | — | | | (1,455) | |
| Real estate, net | | — | | | 12,664 | |
| Other assets | | — | | | 738 | |
| Total assets related to disposition | | $ | — | | | $ | 13,402 | |
| Liabilities related to disposition | | | | | |
| Notes payable, net | | — | | | 7,914 | |
| | | | |
| Total liabilities related to disposition | | $ | — | | | $ | 7,914 | |
The operations of this property and gain on sales are included in continuing operations on the accompanying statements of operations. The following table summarizes certain revenue and expenses related to this property for the years ended December 31, 2019, 2018 and 2017 (in thousands):
| | | | | | | | | | | | | | | | | | | | |
| | For the Years Ended December 31, | | | | |
| | 2019 | | 2018 | | 2017 |
| Revenues | | | | | | |
| Rental income | | $ | 1,315 | | | $ | 1,534 | | | $ | 1,206 | |
| Other operating income | | 32 | | | 27 | | | 35 | |
| Total revenues | | $ | 1,347 | | | $ | 1,561 | | | $ | 1,241 | |
| Expenses | | | | | | | | |
| Operating, maintenance, and management | | $ | 313 | | | $ | 261 | | | $ | 312 | |
| Real estate taxes and insurance | | 69 | | | 78 | | | 76 | |
| Asset management fees to affiliate | | 97 | | | 133 | | | 127 | |
| Depreciation and amortization | | 562 | | | 671 | | | 608 | |
| Interest expense | | 352 | | | 363 | | | 343 | |
| Total expenses | | $ | 1,393 | | | $ | 1,506 | | | $ | 1,466 | |
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Impairment of Real Estate
During the year ended December 31, 2018, the Company recorded impairment charges in the aggregate of $14.7 million to write-down the carrying value of 210 West 31st Street, a development property located in New York, New York, to its estimated fair value of $54.9 million due to a change in the projected hold period and related decrease in projected cash flows. The Company purchased 210 West 31st Street for $48.0 million plus $1.8 million of closing costs. Since acquisition in December 2016, the Company has capitalized $6.8 million related to a finance lease asset, $3.8 million in development costs and $9.2 million of other certain costs such as financing costs, real estate taxes and insurance costs that have been capitalized to building and improvements. On October 1, 2018, the Company placed the development on hold and ceased capitalizing expenses.
4. TENANT ORIGINATION AND ABSORPTION COSTS, ABOVE-MARKET LEASE ASSETS AND BELOW-MARKET LEASE LIABILITIES
As of December 31, 2019 and 2018, the Company’s tenant origination and absorption costs, above-market lease assets and below-market lease liabilities (excluding fully amortized assets and liabilities and accumulated amortization) were as follows (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Tenant Origination and
Absorption Costs | | | | Above-Market
Lease Assets | | | | Below-Market
Lease Liabilities | | |
| | | December 31,
2019 | | December 31,
2018 | | December 31,
2019 | | December 31,
2018 | | December 31,
2019 | | December 31,
2018 |
| Cost | | $ | 15,422 | | | $ | 17,183 | | | $ | 72 | | | $ | 99 | | | $ | (10,802) | | | $ | (11,526) | |
| Accumulated Amortization | | (7,954) | | | (6,163) | | | (28) | | | (34) | | | 6,125 | | | 4,178 | |
| Net Amount | | $ | 7,468 | | | $ | 11,020 | | | $ | 44 | | | $ | 65 | | | $ | (4,677) | | | $ | (7,348) | |
Increases (decreases) in net income as a result of amortization of the Company’s tenant origination and absorption costs, above-market lease assets and below-market lease liabilities for the years ended December 31, 2019, 2018 and 2017 were as follows (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Tenant Origination and
Absorption Costs | | | | | | Above-Market Lease Assets | | | | | | Below-Market Lease Liabilities | | | | |
| | For the Years Ended December 31, | | | | | | For the Years Ended December 31, | | | | | | For the Years Ended December 31, | | | | |
| | | 2019 | | 2018 | | 2017 | | 2019 | | 2018 | | 2017 | | 2019 | | 2018 | | 2017 |
| Amortization | | $ | (3,492) | | | $ | (4,513) | | | $ | (3,892) | | | $ | (17) | | | $ | (18) | | | $ | (10) | | | $ | 2,671 | | | $ | 3,435 | | | $ | 2,038 | |
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
The remaining unamortized balance for these outstanding intangible assets and liabilities as of December 31, 2019 will be amortized for the years ending December 31 as follows (in thousands):
| | | | | | | | | | | | | | | | | | | | |
| | Tenant Origination and
Absorption Costs | | Above-Market
Lease Assets | | Below-Market
Lease Liabilities |
| 2020 | | $ | (2,518) | | | $ | (12) | | | $ | 1,750 | |
| 2021 | | (1,815) | | | (12) | | | 973 | |
| 2022 | | (1,181) | | | (12) | | | 744 | |
| 2023 | | (882) | | | (8) | | | 595 | |
| 2024 | | (656) | | | — | | | 389 | |
| Thereafter | | (416) | | | — | | | 226 | |
| | $ | (7,468) | | | $ | (44) | | | $ | 4,677 | |
| Weighted-Average Remaining Amortization Period | | 4.0 years | | 3.6 years | | 3.9 years |
As of December 31, 2019 and 2018, the Company had recorded a housing subsidy intangible asset, net of amortization, which is included in prepaid expenses and other assets in the accompanying balance sheets, of $2.3 million and $2.4 million, respectively. As of December 31, 2019, the housing subsidy intangible asset has a remaining amortization period of 28.7 years. During the years ended December 31, 2019, 2018 and 2017, the Company recorded in depreciation and amortization, expense of $0.1 million, $0.1 million and $0.1 million, respectively, related to the housing subsidy intangible asset.
Additionally, as of December 31, 2019 and 2018, the Company had recorded property tax abatement intangible assets, net of amortization, which are included in prepaid expenses and other assets in the accompanying balance sheets, of $1.8 million and $2.3 million, respectively. As of December 31, 2019, the property tax abatement intangible assets had a weighted-average remaining amortization period of 3.8 years. During the years ended December 31, 2019, 2018 and 2017, the Company recorded in depreciation and amortization expense, of $0.5 million, $0.5 million and $0.1 million, respectively, related to the property tax abatement intangible asset.
5. REAL ESTATE EQUITY SECURITIES
The Company’s real estate equity securities are carried at their estimated fair value based on quoted market prices for the security. Transaction costs that are directly attributable to the acquisition of real estate equity securities are capitalized to its cost basis. Unrealized gains and losses on real estate equity securities are recognized in earnings. As of December 31, 2019 and 2018, the Company owned 1,160,591 shares of common stock of Franklin Street Properties Corp. (NYSE Ticker: FSP).
As of December 31, 2019 and 2018, the total book value of the Company’s real estate equity securities was $9.9 million and $7.2 million, respectively. During the year ended December 31, 2019 and 2018, the Company recorded a $2.7 million gain and a $1.9 million loss on real estate equity securities and recognized $0.4 million and $0.2 million of dividend income from real estate equity securities, respectively.
6. INVESTMENT IN UNCONSOLIDATED JOINT VENTURES
On June 28, 2016, the Company originated a participating loan facility in an amount up to €2.6 million ($2.9 million at closing). The Company funded approximately €2.1 million ($2.3 million at closing). The proceeds were used by STAM to fund a 5% general partner interest in a joint venture acquiring a portfolio of light industrial properties located throughout France. The total acquisition cost of the portfolio was approximately €95.5 million ($105.6 million at closing). Under the terms of the participating loan facility, the Company participates in the expected residual profits of the portfolio and the terms are structured in a manner such that the risks and rewards of the arrangement are similar to those associated with an investment in a real estate joint venture. Accordingly, the participating loan facility is accounted for under the equity method of accounting. In addition to the amount funded at closing, the Company also capitalized an additional $0.2 million of acquisition costs and fees. During the years ended December 31, 2019, 2018 and 2017, the Company recognized $2.8 million, $0.3 million and $0.1 million, respectively, of income with respect to this investment.
During the year ended December 31, 2019, STAM completed the liquidation of the portfolio and the Company recognized $2.8 million of equity in income of unconsolidated entity with respect to this investment. On May 9, 2019, the Company received a distribution in the amount of €4.5 million or $5.1 million. As of December 31, 2019, the Company’s investment in unconsolidated entity was $0.5 million.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
On December 31, 2019, the Company acquired 13 Class A Units for $2.9 million in Pacific Oak Opportunity Zone Fund I, LLC (“Pacific Oak Opportunity Zone Fund I”). As of December 31, 2019, Pacific Oak Opportunity Zone Fund I consolidated 2 joint ventures with real estate under development. As of December 31, 2019, the Company has concluded that Pacific Oak Opportunity Zone Fund I qualifies as a Variable Interest Entity (“VIE”) because there is insufficient equity at risk to finance the entity’s activities and the entity is structured with non-substantive voting rights. The Company concluded it is not the primary beneficiary of this VIE since it does not have the power to direct the activities that most significantly impact the entity’s economic performance and will account for its investment under the equity method of accounting.
The Company’s maximum exposure to loss as a result of its involvement with this VIE is limited to the carrying value of the investment in Pacific Oak Opportunity Zone Fund I which totaled $2.9 million as of December 31, 2019.
7. NOTES PAYABLE
As of December 31, 2019 and 2018, the Company’s notes payable consisted of the following (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Book Value as of December 31, 2019 | | Book Value as of December 31, 2018 | | Contractual Interest Rate (1) | | Effective Interest Rate (1) | | Payment Type | | Maturity Date |
Springmaid Beach Resort Mortgage Loan (2) | | $ | 56,536 | | | $ | 37,280 | | | One-month LIBOR +2.25% (2) | | 5.75% | | | Principal & Interest | | 08/10/2022 |
Q&C Hotel Mortgage Loan (3) | | 25,000 | | | 23,551 | | | One-month LIBOR + 2.50% (3) | | 4.50% | | | Principal & Interest | | 12/23/2022 |
2200 Paseo Verde Mortgage Loan (4) | | — | | | 7,947 | | | (4) | | (4) | | (4) | | (4) |
| Lincoln Court Mortgage Loan | | 34,615 | | | 33,500 | | | One-month LIBOR + 1.75% | | 3.44% | | | Interest Only | | 06/01/2020 |
Lofts at NoHo Commons Mortgage Loan (5) | | 73,862 | | | 72,100 | | | One-month LIBOR + 2.18% | | 3.93% | | | Interest Only | | 09/09/2021 |
210 West 31st Street Mortgage Loan (6) | | 20,000 | | | 38,041 | | | One-month LIBOR + 3.00% | | 4.71% | | | Interest Only | | 12/16/2020 (6) |
Oakland City Center Mortgage Loan (7) | | 95,989 | | | 94,500 | | | One-month LIBOR + 1.75% | | 3.44% | | | Interest Only (7) | | 09/01/2022 |
Madison Square Mortgage Loan (8) | | 23,593 | | | 21,895 | | | One-month LIBOR + 4.05% (8) | | 5.79% | | | Interest Only | | 10/09/2020 |
| Total notes payable principal outstanding | | 329,595 | | | 328,814 | | | | | | | | | |
| Deferred financing costs, net | | (3,600) | | | (2,271) | | | | | | | | | |
| Total notes payable, net | | $ | 325,995 | | | $ | 326,543 | | | | | | | | | |
_____________________
(1) Contractual interest rate represents the interest rate in effect under the loan as of December 31, 2019. Effective interest rate is calculated as the actual interest rate in effect as of December 31, 2019 (consisting of the contractual interest rate, contractual floor rates and the effects of interest rate caps, if applicable), using interest rate indices at December 31, 2019, where applicable.
(2) As of December 31, 2019, $56.5 million had been disbursed to the Company and up to $10.5 million was available for future disbursements, subject to certain terms and conditions contained in the loan documents. The interest rate is variable at the higher of one-month LIBOR + 2.25% or 5.75%.
(3) On December 23, 2019, the Company closed the refinancing of the Q&C Hotel Mortgage Loan and the maturity date was extended to December 23, 2022. The new interest rate is variable at the higher of one-month LIBOR + 2.5% or 4.5%.
(4) On November 4, 2019, in connection with the disposition of 2200 Paseo Verde, the Company repaid the $8.7 million outstanding principal balance due under the 2200 Paseo Verde Mortgage Loan.
(5) As of December 31, 2019, $73.9 million had been disbursed to the Company and up to $2.1 million is available for future disbursements to be used for tenant improvements and leasing commissions, subject to certain terms and conditions contained in the loan documents.
(6) On December 16, 2019, the Company closed the refinancing of the 210 West 31st Street Mortgage Loan and the maturity date was extended to December 16, 2020. The previous loan amount was fully repaid and the new loan amount was $20.0 million.
(7) As of December 31, 2019, $96.0 million had been disbursed to the Company and up to $7.4 million is available for future disbursements to be used for tenant improvements and leasing commissions, subject to certain terms and conditions contained in the loan documents. Beginning October 1, 2020, monthly payments will include principal and interest with principal payments of $110,000 or, in the event the Company repays any principal of the loan amount, with principal payments calculated using an amortization schedule of 30 years and an annual interest rate of 6.0%, subject to certain terms and conditions contained in the loan documents.
(8) As of December 31, 2019, $23.6 million had been disbursed to the Company and up to $10.5 million is available for future disbursements to be used for tenant improvements and leasing expenses, subject to certain terms and conditions contained in the loan documents. The Madison Square Mortgage Loan bears interest at a floating rate of 405 basis points over one-month LIBOR, but at no point shall the interest rate be less than 5.05%. The property securing this mortgage loan was formerly known as Grace Court and was re-named Madison Square in connection with the Company’s re-branding strategy of the property.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
During the years ended December 31, 2019, 2018 and 2017, the Company incurred $19.9 million, $14.7 million and $8.8 million, respectively, of interest expense. Included in interest expense was: (i) the amortization of deferred financing costs of $1.8 million, $1.7 million and $1.6 million for the years ended December 31, 2019, 2018 and 2017, respectively, (ii) the capitalization of interest to building and improvements related to its redevelopment project at 210 West 31st Street of $0, $3.9 million and $4.1 million for the years ended December 31, 2019, 2018 and 2017, and (iii) unrealized losses of $63,000, $23,000 and $0.1 million on interest rate cap agreements for the years ended December 31, 2019, 2018 and 2017. As of December 31, 2019 and 2018, the Company’s interest payable was $0.8 million and $1.4 million, respectively, which is included in accounts payable and accrued liabilities in the accompanying consolidated balance sheets.
The following is a schedule of maturities, including principal amortization payments, for all notes payable outstanding as of December 31, 2019 (in thousands):
| | | | | | | | |
| 2020 | | $ | 79,931 | |
| 2021 | | 76,575 | |
| 2022 | | 173,089 | |
| | |
| | $ | 329,595 | |
The Company’s notes payable contain financial and non-financial debt covenants. As of December 31, 2019, the Company was in compliance with all debt covenants, except that the borrower under the Madison Square Mortgage Loan was out of debt service coverage compliance. Such non-compliance does not constitute an event of default under the loan agreement. As a result of such non-compliance, the Company is required to maintain an interest shortfall reserve.
The Company’s note payable with respect to the Springmaid Beach Resort Mortgage Loan requires the Company to maintain a minimum working capital reserve in an amount sufficient to fund the working capital requirements of the Springmaid Beach Resort through the off-peak season, which amount shall be reduced by any amounts for working capital reserved by the third-party hotel operator. The working capital reserve was included in restricted cash on the accompanying consolidated balance sheets.
8. DERIVATIVE INSTRUMENTS
The Company enters into derivative instruments for risk management purposes to hedge its exposure to cash flow variability caused by changing interest rates. The primary goal of the Company’s risk management practices related to interest rate risk is to prevent changes in interest rates from adversely impacting the Company’s ability to achieve its investment return objectives. The Company does not enter into the derivatives for speculative purposes.
Interest Rate Caps
The Company enters into interest rate caps to mitigate its exposure to rising interest rates on its variable rate notes payable. The values of interest rate caps are primarily impacted by interest rates, market expectations about interest rates, and the remaining life of the instrument. In general, increases in interest rates, or anticipated increases in interest rates, will increase the value of interest rate caps. As the remaining life of an interest rate cap decreases, the value of the instrument will generally decrease towards zero. As of December 31, 2019, the Company had 4 interest rate caps outstanding, with a total notional value of $177.1 million, which were not designated as hedging instruments.
During the years ended December 31, 2019, 2018 and 2017, the Company recorded unrealized losses of $63,000, $23,000 and $0.1 million, respectively, on interest rate cap agreements, which were included in interest expense on the accompanying consolidated statements of operations.
Foreign Currency Contracts
The Company enters into foreign currency forward contracts to mitigate its exposure to foreign currency exchange rate movements on its investment in unconsolidated entity. The foreign currency forward contract is a commitment to deliver a certain amount of currency at a certain price on a specific date in the future. On May 9, 2019, the Company terminated its $2.1 million foreign currency forward contract and received $0.1 million in connection with the termination.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
During the year ended December 31, 2019, the Company recorded a foreign currency gain of $0.1 million on the foreign currency forward contract, which is included as an offset to general and administrative expenses on the accompanying consolidated statements of operations. During the year ended December 31, 2018, the Company recorded a foreign currency gain of $0.1 million on the foreign currency forward contract, which is included an offset to general and administrative expenses on the accompanying consolidated statements of operations. The fair value of the foreign currency forward contract was $0 as of December 31, 2019. The fair value of the foreign currency forward contract was $0.1 million asset as of December 31, 2018 and was included in other assets on the accompanying balance sheets.
9. FAIR VALUE DISCLOSURES
The following were the face value, carrying amount and fair value of the Company’s financial instruments as of December 31, 2019 and 2018, which carrying amounts do not approximate the fair values (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | December 31, 2019 | | | | | | December 31, 2018 | | | | |
| | Face Value | | Carrying Amount | | Fair Value | | Face Value | | Carrying Amount | | Fair Value |
| | | | | | | | | | | | |
| | | | | | | | | | | | |
| Financial liability: | | | | | | | | | | | | |
| Notes payable | | $ | 329,595 | | | $ | 325,995 | | | $ | 330,687 | | | $ | 328,814 | | | $ | 326,543 | | | $ | 329,588 | |
Disclosure of the fair value of financial instruments is based on pertinent information available to the Company as of the period end and requires a significant amount of judgment. Despite increased capital market and credit market activity, transaction volume for certain financial instruments remains relatively low. This has made the estimation of fair values difficult and, therefore, both the actual results and the Company’s estimate of value at a future date could be materially different.
As of December 31, 2019, the Company measured the following assets at fair value on a recurring basis (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | Fair Value Measurements Using | | | | |
| | Total | | Quoted Prices in Active Markets for Identical Assets
(Level 1) | | Significant Other Observable Inputs
(Level 2) | | Significant Unobservable Inputs
(Level 3) |
| Recurring Basis: | | | | | | | | |
| Real estate equity securities | | $ | 9,934 | | | $ | 9,934 | | | $ | — | | | $ | — | |
| Asset derivatives - interest rate caps | | $ | — | | | $ | — | | | $ | — | | | $ | — | |
| | | | | | | | |
As of December 31, 2018, the Company measured the following assets at fair value on a recurring basis (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | Fair Value Measurements Using | | | | |
| | Total | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | Significant Other Observable Inputs (Level 2) | | Significant Unobservable Inputs (Level 3) |
| Recurring Basis: | | | | | | | | |
| Real estate equity securities | | $ | 7,230 | | | $ | 7,230 | | | $ | — | | | $ | — | |
| Asset derivatives - interest rate caps | | $ | 6 | | | $ | — | | | $ | 6 | | | $ | — | |
| Asset derivative - foreign currency forward contract | | $ | 68 | | | $ | — | | | $ | 68 | | | $ | — | |
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
As of December 31, 2018, the Company measured the following asset at fair value on a nonrecurring basis (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | Fair Value Measurements Using | | | | |
| | Total | | Quoted Prices in Active Markets for Identical Assets
(Level 1) | | Significant Other Observable Inputs
(Level 2) | | Significant Unobservable Inputs
(Level 3) |
| Nonrecurring Basis: | | | | | | | | |
Impaired real estate (1) | | $ | 54,927 | | | $ | — | | | $ | — | | | $ | 54,927 | |
| | | | | | | | |
_____________________
(1) Amount represents the fair value for a real estate asset impacted by impairment charges during the year ended December 31, 2018, as of the date that the fair value measurement was made. The carrying value for the real estate asset may have subsequently increased or decreased from the fair value reflected due to activity that has occurred since the measurement date.
During the year ended December 31, 2018, one of the Company’s real estate properties was measured at its estimated fair value based on a sales comparison approach. As a result, this property was impaired and the carrying value was adjusted due to a change in the projected hold period and related decrease in projected cash flows. See note 3, “Real Estate – Impairment of Real Estate” for a further discussion on the impaired real estate property.
10. RELATED PARTY TRANSACTIONS
As described further below, the Company has entered into agreements with certain affiliates pursuant to which they provide services to the Company. Keith D. Hall and Peter McMillan III control and indirectly own Pacific Oak Holding Group, LLC, the Company’s sponsor since November 1, 2019. Pacific Oak Holding is the sole owner of Pacific Oak Capital Advisors, LLC, the Company’s advisor since November 1, 2019. Messrs. Hall and McMillan are also two of the Company’s executive officers and directors.
In addition, along with Charles J. Schreiber, Jr., Keith D. Hall and Peter McMillan III control and indirectly own KBS Holdings LLC, the Company’s sponsor prior to November 1, 2019. KBS Holdings is the sole owner of KBS Capital Advisors LLC, the Company’s advisor prior to November 1, 2019, and KBS Capital Markets Group LLC, the entity that acted as the dealer manager of the Company’s now-terminated primary initial public offering.
From the Company’s inception through October 31, 2019, KBS Capital Advisors provided day-to-day management of the Company’s business. The advisory agreement with KBS Capital Advisors terminated on October 31, 2019, and the Company hired Pacific Oak Capital Advisors under substantially the same terms on November 1, 2019. The advisory agreement with Pacific Oak Capital Advisors has a one year term subject to an unlimited number of successive one year renewals upon the mutual consent of the parties.
The Company entered the Dealer Manager Agreement with the Dealer Manager on August 12, 2014 in connection with the launch of its initial public offering which agreement was amended and restated on February 17, 2016 and terminated effective December 31, 2019. Pursuant to the Dealer Manager Agreement, through February 16, 2017, the Dealer Manager was entitled to receive selling commissions of up to 6.5% and dealer manager fees of up to 3.0% of the purchase price for shares of the Company’s common stock sold in its primary offering. Effective February 17, 2016, the Dealer Manager was entitled to receive selling commissions of up to 6.5% of the purchase price for Class A shares of the Company’s common stock sold in the primary offering and up to 3.0% of the purchase price of the Company’s Class T shares of common stock sold in the primary offering, as well as a dealer manager fee of up to 2.0% of the purchase price of each class of shares of the Company’s common stock sold in the primary offering. All or a portion of the selling commissions were not charged with regard to shares sold to certain categories of purchasers. A reduced dealer manager fee was payable with respect to certain volume discount sales. The Dealer Manager reallowed 100% of selling commissions to broker-dealers participating in the Company’s initial public offering. From its dealer manager fee, the Dealer Manager generally reallowed to any participating broker-dealer up to 1.0% of the gross offering proceeds attributable to that participating broker-dealer as a marketing fee (in select cases, up to 1.5% of the gross primary offering proceeds).
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
In addition, the Dealer Manager received an annual stockholder servicing fee of 1.0% of the purchase price per share (ignoring any discounts that may be available to certain categories of purchasers) of Class T common stock sold in the Company’s primary initial public offering solely to the extent there was a broker-dealer of record with respect to such Class T share that had entered into a currently effective selected dealer agreement or servicing agreement that provided for the payment to such broker-dealer of the stockholder servicing fee with respect to such Class T share, and such broker-dealer of record was in compliance with the applicable terms of such selected dealer agreement or servicing agreement related to such payment. To the extent payable, the stockholder servicing fee accrued daily and was paid monthly in arrears, and the Dealer Manager reallowed 100% of the stockholder servicing fee to such broker-dealer of record for services provided to Class T stockholders after the initial sale of the Class T share.
NaN stockholder servicing fee was paid with respect to Class T shares purchased through the Company’s dividend reinvestment plan offering or issued pursuant to a stock dividend.
In addition to selling commissions, dealer manager fees and the stockholder servicing fee, and subject to the limitations on organization and offering expenses described above, the Company was also obligated to reimburse the Dealer Manager and its affiliates for certain offering-related expenses that they incurred on the Company’s behalf. These expenses included, among others, the cost of bona fide training and education meetings held by the Company (primarily the travel, meal and lodging costs of registered representatives of broker-dealers), attendance and sponsorship fees payable to participating broker-dealers hosting retail seminars and travel, meal and lodging costs for registered persons associated with our dealer manager and officers and employees of our affiliates to attend retail seminars conducted by broker-dealers, legal fees of the Dealer Manager and promotional items. The Company reimbursed the Dealer Manager for such underwriting compensation incurred in connection with our initial public offering as discussed in the prospectus for its initial public offering. The Company also directly paid or reimbursed the Dealer Manager for bona fide invoiced due diligence expenses of broker-dealers.
Pursuant to the terms of these agreements, summarized below are the related-party costs incurred by the Company for the years ended December 31, 2019, 2018 and 2017, respectively, and any related amounts payable as of December 31, 2019 and 2018 (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Incurred in the Years Ended December 31, | | | | | | Payable as of December 31, | | |
| 2019 | | 2018 | | 2017 | | 2019 | | 2018 |
| Expensed | | | | | | | | | |
| Asset management fees | 4,093 | | | 3,985 | | | 2,775 | | | 620 | | | 22 | |
Reimbursable operating expenses (1) | 315 | | | 477 | | | 339 | | | — | | | 35 | |
Disposition fee (2) | 281 | | | — | | | — | | | — | | | — | |
| Capitalized | | | | | | | | | | |
| Acquisition fees | 29 | | | 228 | | | 4,943 | | | 29 | | | 178 | |
| Asset management fees | — | | | — | | | 67 | | | — | | | — | |
| Additional Paid-in Capital | | | | | | | | | | |
| Sales commissions | — | | | 614 | | | 2,412 | | | — | | | — | |
| Dealer manager fees | — | | | 337 | | | 1,352 | | | — | | | — | |
Stockholder servicing fees (3) | — | | | 14 | | | 1,149 | | | — | | | — | |
Reimbursable other offering costs (4) | — | | | 175 | | | 668 | | | — | | | — | |
| $ | 4,718 | | | $ | 5,830 | | | $ | 13,705 | | | $ | 649 | | | $ | 235 | |
_____________________
(1) Reimbursable operating expenses primarily consists of internal audit personnel costs, accounting software and cyber security related expenses incurred by the applicable advisor under the applicable advisory agreement. The Company has reimbursed the applicable advisor for the Company’s allocable portion of the salaries, benefits and overhead of internal audit department personnel providing services to the Company. These amounts totaled $260,000, $389,000 and $335,000 for the years ended December 31, 2019, 2018 and 2017, respectively, and were the only employee costs reimbursed under the applicable advisory agreement for the years ended December 31, 2019, 2018 and 2017. The applicable advisor may seek reimbursement for certain other employee costs under the applicable advisory agreement. The Company will not reimburse for employee costs in connection with services for which the applicable advisor earns acquisition or origination fees or disposition fees (other than reimbursement of travel and communication expenses) or for the salaries or benefits the applicable advisor or its affiliates may pay to the Company’s executive officers. In addition to the amounts above, the Company reimburses the applicable advisor for certain of the Company’s direct costs incurred from third parties that were initially paid by the applicable advisor on behalf of the Company.
(2) Disposition fees with respect to real estate sold are included in the gain on sale of real estate in the accompanying consolidated statements of operations.
(3) Reflects the stockholder servicing fee paid based on the terms of the Class T Shares. Pursuant to the terms of the Class T shares as set forth in the Articles Supplementary and Multiple Class Plan of the Company, the Company ceased accruing for stockholder servicing fees after July 31, 2018.
(4) See “Other Offering Costs” below.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
During the year ended December 31, 2018, KBS Capital Advisors reimbursed the Company $35,000 for property insurance rebates. During the year ended December 31, 2017, KBS Capital Advisors reimbursed the Company $0.1 million for legal and professional fees, travel expenses and property insurance rebates.
Other Offering Costs
Organization and offering costs (other than selling commissions, dealer manager fees and the stockholder servicing fee) of the Company may be paid by KBS Capital Advisors, the Dealer Manager or their affiliates on behalf of the Company or may be paid directly by the Company. These offering costs include all expenses incurred by the Company in connection with the Private Offering and the Public Offering. Organization costs include all expenses incurred by the Company in connection with the formation of the Company, including but not limited to legal fees and other costs to incorporate the Company.
The Company recorded $1.0 million of offering costs (other than selling commissions and dealer manager fees) related to the Private Offering, all of which was initially paid by KBS Capital Advisors or its affiliates on behalf of the Company and subsequently reimbursed by the Company. In addition, the Company paid $1.9 million in selling commissions and dealer manager fees related to the Private Offering.
During the Public Offering, pursuant to the advisory agreement with KBS Capital Advisors and the Dealer Manager Agreement, the Company is obligated to reimburse KBS Capital Advisors, the Dealer Manager or their affiliates, as applicable, for organization and other offering costs paid by them on behalf of the Company, provided that no reimbursements made by the Company to KBS Capital Advisors or the Dealer Manager may cause total organization and offering expenses incurred by the Company in connection with the Public Offering (including selling commissions, dealer manager fees and the stockholder servicing fee) to exceed 15% of the aggregate gross proceeds from the Public Offering as of the date of reimbursement. In addition, KBS Capital Advisors and its affiliates reimbursed the Company to the extent that the organization and other offering expenses (which exclude selling commissions, dealer manager fees and stockholder servicing fees) paid directly or reimbursed by the Company in connection with the primary portion of the Public Offering, regardless of when incurred, exceeded 1.0% of gross offering proceeds from the primary portion of the Public Offering. KBS Capital Advisors and its affiliates are responsible for any organization and other offering expenses related to the primary portion of the Public Offering to the extent they exceed 1.0% of gross proceeds from the primary portion of the Public Offering.
Through December 31, 2019, KBS Capital Advisors and its affiliates had incurred organization and other offering costs (which exclude selling commissions dealer manager fees and stockholder servicing fees) on the Company’s behalf in connection with the Public Offering of approximately $11.4 million. As of December 31, 2019, the Company had recorded $14.5 million in selling commissions and dealer manager fees and $1.7 million of stockholder servicing fees. As of December 31, 2019, the Company had recorded $2.3 million of other organization and offering expenses, which amounts represent the Company’s maximum liability for organization and other offering costs as of December 31, 2019 based on the 1.0% limitation described above.
In addition, as of December 31, 2019, KBS Capital Advisors had incurred $0.1 million in organization and offering costs on behalf of the Company in connection with a proposed follow-on offering the Company filed with the SEC on August 10, 2017. On December 18, 2018, the Company withdrew the proposed follow-on offering.
Insurance.
On January 6, 2014, the Company, together with KBS Real Investment Trust, Inc. ("KBS REIT I"), KBS Real Estate Investment Trust II, Inc. ("KBS REIT II"), KBS Real Estate Investment Trust, Inc. ("KBS REIT III"), KBS Legacy Partners Apartment REIT, Inc. ("KBS Legacy Partners Apartment REIT"), POSOR I, the Dealer Manager, KBS Capital Advisors and other KBS-affiliated entities, entered into an errors and omissions and directors and officers liability insurance program where the lower tiers of such insurance coverage are shared. The cost of these lower tiers was allocated by KBS Capital Advisors and its insurance broker among each of the various entities covered by the program, and was billed directly to each entity. In June 2015, KBS Growth & Income REIT, Inc. ("KBS Growth & Income REIT") was added to the insurance program at terms similar to those described above. At renewal in June 2018, the Company, along with POSOR I and KBS Legacy Partners Apartment REIT elected to cease participation in the program and obtain separate insurance coverage. The Company, together with POSOR I, entered into an errors and omissions and directors and officers liability insurance program where the lower tiers of such insurance coverage are shared. The cost of these lower tiers is or was allocated by the Company’s applicable advisor and its insurance broker among each REIT covered by the program, and is billed directly to each REIT. The program is effective through June 30, 2020.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Pacific Oak Opportunity Zone Fund I.
On December 31, 2019, the Company made a $2.9 million investment in the Pacific Oak Opportunity Zone Fund I. Pacific Oak Opportunity Zone Fund I is sponsored by Pacific Oak Holding. Pacific Oak Capital Advisors is entitled to certain fees in connection with the fund. The fund will pay an acquisition fee equal to 1.5% of the purchase price of each asset (including any debt incurred or assumed and significant capital improvement costs budgeted as of the date of acquisition) with a purchase price less than or equal to $25.0 million plus 1.0% of the purchase price in excess of $25.0 million; a quarterly asset management fee equal to 0.25% of the total purchase price of all assets (including any debt incurred or assumed and significant capital improvement costs budgeted as of the date of acquisition) as of the end of the applicable quarter; and a financing fee equal to 0.5% of the original principal amount of any indebtedness they incur (reduced by any financing fee previously paid with respect to indebtedness being refinanced). In the case of investments made through joint ventures, the fees above will be determined based on our proportionate share of the investment. Pacific Oak is also entitled to certain distributions paid by the Pacific Oak Opportunity Zone Fund I after the Class A Members have received their preferred return. These fees and distributions have been waived for the Company’s $2.9 million investment.
11. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Presented below is a summary of the unaudited quarterly financial information for the year ended December 31, 2019 and 2018 (in thousands, except share and per share amounts):
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | 2019 | | | | | | |
| | First Quarter | | Second Quarter | | Third Quarter | | Fourth Quarter |
| Revenues | | $ | 15,196 | | | $ | 19,336 | | | $ | 18,747 | | | $ | 15,462 | |
| | | | | | | | |
| Class A Common Stock: | | | | | | | | |
| Net loss attributable to common stockholders | | $ | (914) | | | $ | (1,537) | | | $ | (1,519) | | | $ | (488) | |
| Net loss per common share, basic and diluted | | $ | (0.05) | | | $ | (0.09) | | | $ | (0.08) | | | $ | (0.03) | |
| Cash distributions declared per common share | | $ | 0.040 | | | $ | 0.024 | | | $ | 0.024 | | | $ | 0.024 | |
| | | | | | | | |
| Class T Common Stock: | | | | | | | | |
| Net loss attributable to common stockholders | | $ | (621) | | | $ | (1,048) | | | $ | (1,038) | | | $ | (334) | |
| Net loss per common share, basic and diluted | | $ | (0.05) | | | $ | (0.09) | | | $ | (0.08) | | | $ | (0.03) | |
| Cash distributions declared per common share | | $ | 0.040 | | | $ | 0.024 | | | $ | 0.024 | | | $ | 0.024 | |
| | | | | | | | |
| | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | 2018 | | | | | | |
| | First Quarter | | Second Quarter | | Third Quarter | | Fourth Quarter |
| Revenues | | $ | 14,835 | | | $ | 19,463 | | | $ | 19,993 | | | $ | 15,991 | |
| | | | | | | | |
| Class A Common Stock: | | | | | | | | |
| Net loss attributable to common stockholders | | $ | (1,573) | | | $ | (22) | | | $ | (2,914) | | | $ | (9,183) | |
| Net loss per common share, basic and diluted | | $ | (0.09) | | | $ | — | | | $ | (0.16) | | | $ | (0.51) | |
| Cash distributions declared per common share | | $ | 0.047 | | | $ | 0.048 | | | $ | 0.048 | | | $ | 0.048 | |
| | | | | | | | |
| Class T Common Stock: | | | | | | | | |
| Net loss attributable to common stockholders | | $ | (1,294) | | | $ | (282) | | | $ | (2,049) | | | $ | (6,191) | |
| Net loss per common share, basic and diluted | | $ | (0.11) | | | $ | (0.02) | | | $ | (0.17) | | | $ | (0.51) | |
| Cash distributions declared per common share | | $ | 0.024 | | | $ | 0.025 | | | $ | 0.041 | | | $ | 0.048 | |
| | | | | | | | |
| Stock dividends declared per common share - Classes A and T | | 0.005 | | | 0.005 | | | 0.005 | | | 0.003 | |
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
12. COMMITMENTS AND CONTINGENCIES
Management Agreement
Springmaid Beach Resort
The consolidated joint venture entity through which the Company leases the operations for Springmaid Beach Resort has entered into a management agreement with Doubletree Management LLC, an independent third-party hotel operator (the “Operator”) pursuant to which the Operator will manage and operate the Springmaid Beach Resort. The hotel was branded a DoubleTree by Hilton in September 2016 (the “Brand Commencement Date”).
The management agreement expires on December 31 of the 20th full year following the Brand Commencement Date. Upon mutual agreement, the parties may extend the term of the agreement for two successive periods of five years each. If an event of default occurs and continues beyond any applicable notice and cure periods set forth in the management agreement, the non-defaulting party generally has, among other remedies, the option of terminating the management agreement upon written notice to the defaulting party with no termination fee payable to Doubletree. In addition, the Company has the right to terminate the management agreement without the payment of a termination fee if Doubletree fails to achieve certain criteria relating to the performance of the hotel for any two consecutive years following the Brand Commencement Date. Under certain circumstances following a casualty or condemnation event, either party may terminate the management agreement provided Doubletree receives a termination fee an amount equal to two years of the base fee. The Company is permitted to terminate the management agreement upon a sale, lease or other transfer of the Springmaid Beach Resort any time so long as the buyer is approved for, and enters into a DoubleTree by Hilton franchise agreement for the balance of the agreement’s term. Finally, the Company is restricted in its ability to assign the management agreement upon a sale, lease or other transfer the Springmaid Beach Resort unless the transferee is approved by Doubletree to assume the management agreement.
Pursuant to the management agreement the Operator receives the following fees:
•a base fee, which is a percentage of total operating revenue that starts at 2.5% and increases to 2.75% in the second year following the Brand Commencement Date and further increases in the third year following the Brand Commencement Date and thereafter to 3.0%;
•a campground area management fee, which is 2% of any campground revenue;
•an incentive fee, which is 15% of operating cash flow (after deduction for capital renewals reserve and the joint venture owner’s priority, which is 12% of the joint venture owner’s total investment);
•an additional services fee in the amount reasonably determined by the Operator from time to time; and
•a brand services fee in the amount of 4% of total rooms revenue, and an other brand services fee in an amount determined by the Operator from time to time.
The management agreement contains specific standards for the operation and maintenance of the hotel, which allows the Operator to maintain uniformity in the system created by the Operator’s franchise. Such standards generally regulate the appearance of the hotel, quality and type of goods and services offered, signage and protection of trademarks. Compliance with the management agreement will require the Company to make significant expenditures for capital improvements.
During the years ended December 31, 2019, 2018 and 2017, the Company incurred $0.6 million, $0.6 million and $0.3 million, respectively, of fees related to the management agreement, which are included in hotel expenses on the accompanying consolidated statements of operations.
Q&C Hotel
A wholly owned subsidiary of the joint venture through which the Company leases the operations of the Q&C Hotel (“Q&C Hotel Operations”) has entered into a management agreement with Encore Hospitality, LLC (“Encore Hospitality”), an affiliate of the joint venture partner, pursuant to which Encore Hospitality will manage and operate the Q&C Hotel. The management agreement expires on December 17, 2035. Subject to certain conditions, Encore Hospitality may extend the term of the agreement for a period of five years. Pursuant to the management agreement Encore Hospitality will receive a base fee, which is 4.0% of gross revenue (as defined in the management agreement). During the years ended December 31, 2019, 2018 and 2017, the Company incurred $0.4 million, $0.4 million and $0.4 million, respectively, of fees related to the management agreement, which are included in hotel expenses on the accompanying consolidated statements of operations.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Q&C Hotel Operations has also entered into a franchise agreement with Marriott International (“Marriott”) pursuant to which Marriott has granted Q&C Hotel Operations a limited, non-exclusive license to establish and operate the Q&C Hotel using certain of Marriott’s proprietary marks and systems and the hotel was branded as a Marriott Autograph Collection hotel on May 25, 2016. The franchise agreement will expire on May 25, 2041. Pursuant to the franchise agreement, Q&C Hotel Operations pays Marriott a monthly franchise fee equal to a percent of gross room sales on a sliding scale that is initially 2% and increases to 5% on May 25, 2019 and a monthly marketing fund contribution fee equal to 1.5% of the Q&C Hotel’s gross room sales. In addition, the franchise agreement requires the maintenance of a reserve account to fund all renovations at the hotel based on a percentage of gross revenues which starts at 2% of gross revenues and increases to 5% of gross revenues on May 25, 2019. Q&C Hotel Operations is also responsible for the payment of certain other fees, charges and costs as set forth in the agreement. During the years ended December 31, 2019, 2018 and 2017, the Company incurred $0.7 million, $1.0 million and $0.9 million, respectively, of fees related to the Marriott franchise agreement.
In addition, in connection with the execution of the franchise agreement, SOR US Properties II is providing an unconditional guarantee that all Q&C Hotel Operations’ obligations under the franchise agreement will be punctually paid and performed. Finally, certain transfers of the Q&C Hotel or an ownership interest therein are subject to a notice and consent requirement, and the franchise agreement further provides Marriott with a right of first refusal with respect to a sale of the hotel to a competitor of Marriott.
Lease Obligations
As of December 31, 2019, the Company had leasehold interests expiring on various expiration dates between 2020 and 2114. Future minimum lease payments owed by the Company under the finance leases as of December 31, 2019 are as follows (in thousands):
| | | | | | | | |
| 2020 | | $ | 740 | |
| 2021 | | 735 | |
| 2022 | | 935 | |
| 2023 | | 525 | |
| 2024 | | 360 | |
| Thereafter | | 52,956 | |
| Total expected minimum lease obligations | | 56,251 | |
Less: Amount representing interest (1) | | (48,044) | |
Present value of net minimum lease payments (2) | | $ | 8,207 | |
_____________________
(1) Interest includes the amount necessary to reduce the total expected minimum lease obligations to present value calculated at the Company’s incremental borrowing rate at acquisition.
(2) The present value of net minimum lease payments are presented in other liabilities in the accompanying consolidated balance sheets.
Economic Dependency
The Company is dependent on the Advisor for certain services that are essential to the Company, including the identification, evaluation, negotiation, origination, acquisition and disposition of investments; management of the daily operations of the Company’s investment portfolio; and other general and administrative responsibilities. In the event that the Advisor is unable to provide these services, the Company will be required to obtain such services from other sources.
Environmental
As an owner of real estate, the Company is subject to various environmental laws of federal, state and local governments. Although there can be no assurance, the Company is not aware of any environmental liability that could have a material adverse effect on its financial condition or results of operations as of December 31, 2019. However, changes in applicable environmental laws and regulations, the uses and conditions of properties in the vicinity of the Company’s properties, the activities of its tenants and other environmental conditions of which the Company is unaware with respect to the properties could result in future environmental liabilities.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 2019
Legal Matters
From time to time, the Company is a party to legal proceedings that arise in the ordinary course of its business. Management is not aware of any legal proceedings of which the outcome is probable or reasonably possible to have a material adverse effect on the Company’s results of operations or financial condition, which would require accrual or disclosure of the contingency and the possible range of loss. Additionally, the Company has not recorded any loss contingencies related to legal proceedings in which the potential loss is deemed to be remote.
13. SUBSEQUENT EVENTS
The Company evaluates subsequent events up until the date the consolidated financial statements are issued.
Cash Distributions Paid
On January 2, 2020, we paid distributions of $0.2 million related to a monthly distribution in the amount of $0.00799167 per share on the outstanding shares of all classes of our common stock as of December 19, 2019.
Proposed Merger
On February 19, 2020, the Company, POSOR I, and Pacific Oak SOR II, LLC, an indirect subsidiary of POSOR I (“Merger Sub”), entered into an Agreement and Plan of Merger (the “Merger Agreement”). Subject to the terms and conditions of the Merger Agreement, the Company will merge with and into Merger Sub (the “Merger”), with Merger Sub surviving the Merger (the “Surviving Entity”), such that following the Merger, the Surviving Entity will continue as an indirect subsidiary of POSOR I. In accordance with the applicable provisions of the Maryland General Corporation Law, the separate existence of the Company shall cease. At the effective time of the Merger and subject to the terms and conditions of the Merger Agreement, each issued and outstanding share of the Company's common stock will be converted into the right to receive 0.9643 shares of POSOR I common stock. The combined company after the Merger will retain the name “Pacific Oak Strategic Opportunity REIT, Inc.”
Concurrently with the entry into the Merger Agreement, POSOR I and the Advisor entered into the Amended and Restated Advisory Agreement (the “Amended Advisory Agreement”). The Amended Advisory Agreement amended POSOR I’s existing advisory agreement to provide that no acquisition fees will be paid in connection with the Merger and to set the “issue price” ($10.63 per share) of the shares issued in the Merger for purposes of calculating the Advisor’s incentive fee. The Merger itself will not trigger an incentive fee to the Advisor by POSOR I or the Company.
Concurrently with the entry into the Merger Agreement, the Company and the Advisor entered into a termination letter agreement (the “Termination Agreement”), effective as of February 19, 2020. Pursuant to the Termination Agreement, the advisory agreement between the Company and the Advisor (the “POSOR II Advisory Agreement”) will be terminated at the effective time of the Merger. Also pursuant to the Termination Agreement, the Advisor waived any disposition fee it otherwise would be entitled to receive from the Company with respect to the Merger. If, however, the Company is ultimately sold to another bidder, then the Advisor may be entitled to a disposition fee from the Company in an amount as set forth in the POSOR II Advisory Agreement.
COVID-19
The recent global outbreak of COVID-19 (more commonly known as the Coronavirus) has significantly disrupted economic markets and impacted commercial activity worldwide, including the US, and the prolonged economic impact is uncertain. Customers and potential customers of the properties we own could be adversely affected by the disruption to business caused by the global outbreak of the Coronavirus. This could lead to similar negative impacts on our business.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
SCHEDULE III
REAL ESTATE ASSETS AND ACCUMULATED DEPRECIATION AND AMORTIZATION
December 31, 2019
(dollar amounts in thousands)
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | Initial Cost to Company | | | | | | | | Gross Amount at which Carried at Close of Period | | | | | | | | | | |
| Description | | Location | | Ownership Percent | | Encumbrances | | Land | | Building and Improvements (1) | | Total | | Cost Capitalized Subsequent to Acquisition (2) | | Land | | Building and Improvements (1) | | Total (3) | | Accumulated Depreciation and Amortization | | Original Date of Construction | | Date Acquired |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| Springmaid Beach Resort | | Myrtle Beach, SC | | 90.0% | | | $ | 56,536 | | | $ | 27,340 | | | $ | 12,727 | | | $ | 40,067 | | | $ | 25,193 | | | $ | 27,438 | | | $ | 37,822 | | | $ | 65,260 | | | $ | (10,314) | | | 1948/1980/1992/1995/2001 | | 12/30/2014 |
| Q&C Hotel | | New Orleans, LA | | 90.0% | | | 25,000 | | | 1,232 | | | 49,452 | | | 50,684 | | | 3,781 | | | 1,232 | | | 53,233 | | | 54,465 | | | (8,315) | | | 1913 | | 12/17/2015 |
| Lincoln Court | | Campbell, CA | | 100.0% | | | 34,615 | | | 14,706 | | | 38,080 | | | 52,786 | | | 24 | | | 14,706 | | | 38,104 | | | 52,810 | | | (5,641) | | | 1985 | | 05/20/2016 |
| Lofts at NoHo Commons | | North Hollywood, CA | | 90.0% | | | 73,862 | | | 26,222 | | | 73,750 | | | 99,972 | | | 7,557 | | | 26,222 | | | 81,307 | | | 107,529 | | | (6,576) | | | 2007 | | 11/16/2016 |
210 West 31st Street (4) | | New York, NY | | 80.0% | | | 20,000 | | | — | | | 50,141 | | | 50,141 | | | 5,103 | | | — | | | 55,244 | | | 55,244 | | | — | | | (5) | | 12/01/2016 |
| Oakland City Center | | Oakland, CA | | 100.0% | | | 95,989 | | | 22,150 | | | 148,495 | | | 170,645 | | | 4,103 | | | 22,150 | | | 152,598 | | | 174,748 | | | (17,493) | | | 1985/1990 | | 08/18/2017 |
Madison Square (6) | | Phoenix, AZ | | 90.0% | | | 23,593 | | | 10,540 | | | 22,684 | | | 33,224 | | | 2,126 | | | 10,540 | | | 24,810 | | | 35,350 | | | (3,384) | | | 1911/2003/2007/2008 | | 10/03/2017 |
| | Total Properties | | | | | | $ | 102,190 | | | $ | 395,329 | | | $ | 497,519 | | | $ | 47,887 | | | $ | 102,288 | | | $ | 443,118 | | | $ | 545,406 | | | $ | (51,723) | | | | | |
____________________
(1) Building and improvements includes tenant origination and absorption costs and construction costs for the Company’s project that was under development.
(2) Costs capitalized subsequent to acquisition is net of impairments and write-offs of fully depreciated/amortized assets.
(3) The aggregate cost of real estate for federal income tax purposes was $552.9 million (unaudited) as of December 31, 2019.
(4) The Company acquired the rights to a leasehold interest with respect to this property. The leasehold interest expires January 31, 2114.
(5) 210 West 31st Street is a development property.
(6) The Company acquired the rights to a leasehold interest with respect to the land at this property.
PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC.
SCHEDULE III
REAL ESTATE ASSETS AND ACCUMULATED DEPRECIATION AND AMORTIZATION (CONTINUED)
December 31, 2019
(dollars in thousands)
| | | | | | | | | | | | | | | | | | | | |
| | 2019 | | 2018 | | 2017 |
| Real Estate: | | | | | | |
| Balance at the beginning of the year | | $ | 547,310 | | | $ | 549,086 | | | $ | 324,176 | |
| Acquisitions | | — | | | — | | | 203,869 | |
| Improvements | | 13,744 | | | 9,577 | | | 10,075 | |
| Construction in progress | | 317 | | | 5,940 | | | 13,280 | |
| Write-off of fully depreciated and fully amortized assets | | (1,343) | | | (2,548) | | | (2,314) | |
| Disposition | | (14,622) | | | — | | | — | |
| Impairments | | — | | | (14,745) | | | — | |
| Balance at the end of the year | | $ | 545,406 | | | $ | 547,310 | | | $ | 549,086 | |
| | | | | | |
| Accumulated depreciation and amortization: | | | | | | |
| Balance at the beginning of the year | | $ | 35,704 | | | $ | 18,646 | | | $ | 6,853 | |
| Depreciation and amortization expense | | 19,326 | | | 19,606 | | | 14,107 | |
| Write-off of fully depreciated and fully amortized assets | | (1,343) | | | (2,548) | | | (2,314) | |
| Disposition | | (1,964) | | | — | | | — | |
| Balance at the end of the year | | $ | 51,723 | | | $ | 35,704 | | | $ | 18,646 | |
ITEM 16. FORM 10-K SUMMARY
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, in the City of Los Angeles, State of California, on March 26, 2020.
| | | | | | | | |
| | PACIFIC OAK STRATEGIC OPPORTUNITY REIT II, INC. | |
| | |
| By: | /s/ KEITH D. HALL |
| | | Keith D. Hall |
| | | Chief Executive Officer and Director
(principal executive officer) |
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
| | | | | | | | | | | | | | |
| Name | | Title | | Date |
| | | | |
| /s/ KEITH D. HALL | | Chief Executive Officer and Director
(principal executive officer) | | March 26, 2020 |
| Keith D. Hall | | | | |
| /s/ PETER MCMILLAN III | | Chairman of the Board, President and Director | | March 26, 2020 |
| Peter McMillan III | | | | |
| /s/ MICHAEL A. BENDER | | Chief Financial Officer
(principal financial officer) | | March 26, 2020 |
| Michael A. Bender | | | | |
| /s/ LAURENT DEGRYSE | | Director | | March 26, 2020 |
| Laurent Degryse | | | | |
| /s/ JOHN P. JOLIET | | Director | | March 26, 2020 |
| John P. Joliet | | | | |
| /s/ KENNETH G. YEE | | Director | | March 26, 2020 |
| Kenneth G. Yee | | | | |
