Beginning in 2003, the Company implemented an upgrade to its subsidiary ledger for accounting for fixed assets. The Company completed this system upgrade in the first quarter of 2004. In conjunction with this system upgrade, the Company has determined that cumulative depreciation expense generated by consolidated or equity method rental properties was understated by approximately $2.1 million through December 31, 2003 and this amount was recorded during the quarter ended March 31, 2004. The Company does not believe that the correction is material to any previously reported financial statements and is not material to any consolidated earnings trends.
The Company believes that its operating results have largely been a result of its business strategy of investing in submarkets that provide the greatest potential for rental growth at the lowest relative risk. Essex believes that its market research process, which includes an analysis of both metropolitan statistical areas (MSA's) and submarkets, provides it with a distinct competitive advantage. Essex researches markets by reviewing data from private and government sources as well as information developed or verified by its field personnel. Essex then utilizes its proprietary research model to project market rent trends, allowing the Company to allocate capital to the markets with the best risk-adjusted return potential.
Essex's research process begins with a macro-economic analysis of various MSA's, followed by an evaluation of the submarkets within that MSA. The objective of the economic research department is to estimate the amount of new demand for housing, comparing it to the number of single family and multifamily homes being constructed within a submarket. Historically, markets with demand for multifamily housing that is greater than supply generate increasing occupancy levels and growth in rents.
Demographic trends: The Company evaluates areas with long-term positive immigration and demographic trends, and areas that provide an attractive quality of life.
Based on its evaluation of multifamily housing supply and demand factors, the Company forecasts the occupancy and rent trends for its targeted submarkets, and actively seeks to expand its multifamily portfolio in the submarkets with the greatest risk-adjusted return.
By region, the Company's operating results and investment strategy are as follows:
Southern California Region: At the time of the Company's 1994 initial public offering (IPO), the Company had ownership interests in this region representing 17% of its multifamily units. Following the IPO, the Company, using its research process, determined that various markets in the Southern California region were attractive for multifamily property investment and, the Company accordingly increased its ownership in such markets. As of March 31, 2005, we have ownership interests in this region representing 52% of our multifamily units. During the three months ended March 31, 2005 the region continued to perform well, with same store property revenues increasing by 4.9% versus the comparable period in 2004. Same store property revenues increased by 0.8% versus the immediately preceding quarter. The Company expects this region to generate positive rent growth of approximately 3.3% in 2005.
Northern California Region: As of March 31, 2005, the Company had ownership interests in this region representing 24% of its multifamily units. In the three months ended March 31, 2005, same store property revenues decreased slightly by 0.6% versus the comparable period in 2004 and increased by 1.0% versus the immediately preceding quarter. The Company expects market rents to increase by approximately 1% in 2005. The Company expects further recovery thereafter. As a result, the Company will begin to increase its investment focus in this region.
Pacific Northwest Region: As of March 31, 2005, the Company had ownership interests in this region representing 23% of its multifamily units. This region created jobs in 2004, and in the three months ended March 31, 2005, same store property revenues increased by 2.0% versus the comparable period in 2004 and increased by 2.2% versus the immediately preceding quarter. The Company expects continued job growth, leading to rental revenue growth of approximately 1.8% in 2005.
The preparation of consolidated financial statements, in accordance with accounting principles generally accepted in the United States of America, requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. We define critical accounting policies as those accounting policies that require our management to exercise their most difficult, subjective and complex judgments. Our critical accounting policies relate principally to the following key areas: (i) consolidation under applicable accounting standards of various entities; (ii) assessing the carrying values of our real estate properties and investments in and advances to joint ventures and affiliates;(iii) internal cost capitalization; (iiii) and qualification as a REIT. The Company bases its estimates on historical experience, current market conditions, and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from those estimates made by management.
The Company assesses each entity in which it has an investment or contractual relationship to determine if it may be deemed to be a VIE. If such an entity is a VIE, then the Company analyzes the expected losses and expected residual returns to determine who is the primary beneficiary. If the Company is the primary beneficiary, then the entity is consolidated. The analysis required to identify VIEs and primary beneficiaries is complex and judgmental, and the analysis must be applied to various types of entities and legal structures.
Rental properties are recorded at cost less accumulated depreciation. Depreciation components on rental properties have been provided over estimated useful lives ranging from 3 to 30 years using the straight-line method. Development costs include acquisition, direct and indirect construction costs, interest and real estate taxes incurred during the construction and property stabilizations periods. Maintenance and repair expenses that do not add to the value or prolong the useful life of the property are expensed as incurred. Asset replacements and improvements are capitalized and depreciated over their estimated useful lives.
The Company assesses the carrying value of its real estate investments by monitoring investment market conditions and performance compared to budget for operating properties and joint ventures, and by monitoring estimated costs for properties under development. Local market knowledge and data is used to assess carrying values of properties and the market value of acquisition opportunities. Whenever events or changes in circumstances indicate that the carrying amount of a property held for investment may not be fully recoverable, the carrying amount is evaluated. If the sum of the property’s expected future cash flows (undiscounted and without interest charges) is less than the carrying amount of the property, then the Company will recognize an impairment loss equal to the excess of the carrying amount over the fair value of the property. Adverse changes in market conditions or poor operating results of real estate investments could result in impairment charges. When the Company determines that a property is held for sale, it discontinues the periodic depreciation of that property. The criteria for determining when a property is held for sale requires judgment and has potential financial statement impact as depreciation would cease and an impairment loss could occur upon determination of held for sale status. Assets held for sale are reported at the lower of the carrying amount or estimated fair value less costs to sell. With respect to investments in and advances to joint ventures and affiliates, the Company looks to the underlying properties to assess performance and the recoverability of carrying amounts for those investments in a manner similar to direct investments in real estate properties. An impairment charge or investment valuation charge is recorded if the carrying value of the investment exceeds its fair value.
The Company capitalizes all direct and certain indirect costs, including interest and real estate taxes, incurred during development and redevelopment activities. Interest is capitalized on real estate assets that require a period of time to get them ready for their intended use. The amount of interest capitalized is based upon the average amount of accumulated development expenditures during the reporting period. Included in capitalized costs are management’s estimates of the direct and incremental personnel costs and indirect project costs associated with our development and redevelopment activities. Indirect project costs consist primarily of personnel costs associated with construction administration and development accounting, legal fees, and various office costs that clearly relate to projects under development.
The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may vary from those estimates and those estimates could be different under different assumptions or conditions..
General Background
The Company's property revenues are generated primarily from multifamily property operations, which accounted for 96% or more of its property revenues for each of the three months ended March 31, 2005 and 2004. The Company's properties ("the Properties") are located in Southern California (Los Angeles, Ventura, Orange, Riverside and San Diego counties), Northern California (the San Francisco Bay Area), the Pacific Northwest (the Seattle, Washington and Portland, Oregon metropolitan areas), and other areas (Houston, Texas).
Essex Apartment Value Fund, L.P. ("Fund I"), is an investment fund organized by the Company in 2001 to add value through rental growth and asset appreciation, utilizing the Company's development, redevelopment and asset management capabilities. An affiliate of the Company, Essex VFGP, L.P. ("VFGP"), is a 1% general partner and is a 20.4% limited partner. The Operating Partnership owns a 99% limited partnership interest in VFGP.
On September 27, 2004 the Company announced the final closing of partner equity commitments for Essex Apartment Value Fund II (“Fund II”). Fund II has eight institutional investors including the Company with combined partner equity commitments of $265.9 million. Essex had committed $75.0 million to Fund II, which represents a 28.2% interest as general partner and limited partner. Fund II expects to utilize leverage equal to approximately 65% of the estimated value of the underlying real estate. Fund II will invest in multifamily properties in the Company’s targeted West Coast markets with an emphasis on investment opportunities in Seattle and the San Francisco Bay Area. Subject to certain exceptions, Fund II will be Essex’s exclusive investment vehicle until October 31, 2006, or when Fund II’s committed capital has been invested, whichever occurs first. Consistent with Fund I, Essex will be compensated for its asset management, property management, development and redevelopment services and may receive promote distributions if Fund II exceeds certain financial return benchmarks.
The Company (excluding Fund I's development communities) has ownership interests in and is developing one multifamily residential community, with an aggregate of 275 multifamily units. In connection with these development projects, the Company has directly, or in some cases through its joint venture partners, entered into contractual construction related commitments with unrelated third parties and the total projected estimated cost for these projects is approximately $65.7 million. As of March 31, 2005, the remaining commitment to fund these projects is approximately $48.8 million.
Results of Operations
Comparison of the Three Months Ended March 31, 2005 to the Three Months Ended March 31, 2004
Average financial occupancy rates of the Company's multifamily “Quarterly Same Store Properties” (stabilized properties consolidated by the Company for each of the three months ended March 31, 2005 and 2004) was 96.4% and 95.8%, for the three months ended March 31, 2005 and 2004, respectively. "Financial occupancy" is defined as the percentage resulting from dividing actual rental revenue by total possible rental revenue. Actual rental revenue represents contractual rental revenue pursuant to leases without considering delinquency and concessions. Total possible rental revenue represents the value of all apartment units, with occupied units valued at contractual rental rates pursuant to leases and vacant units valued at estimated market rents. We believe that financial occupancy is a meaningful measure of occupancy because it considers the value of each vacant unit at its estimated market rate. Financial occupancy rates disclosed by other REIT’s may not be comparable to our calculation of financial occupancy.
The regional breakdown of average financial occupancy for the multifamily Quarterly Same Store Properties for the three months ended March 31, 2005 and 2004 is as follows:
| | Three months ended |
| | March 31, |
| | 2005 | | 2004 |
| Southern California | 96.2% | | 95.9% |
| Northern California | 96.9% | | 95.7% |
| Pacific Northwest | 96.7% | | 95.5% |
Total Property Revenues increased by $11,010,000 or 16.6% to $77,321,000 in the first quarter of 2005 from $66,311,000 in the first quarter of 2004. The following table sets forth a breakdown of these revenue amounts, including the revenues attributable to the Quarterly Same Store Properties.
| | | Number of | | Three months ended March 31, | | Dollar | | Percentage | |
| | | Properties | | 2005 | | 2004 | | Change | | Change | |
| Revenues: | | | | (Dollars in thousands) | | | |
| Property revenues - quarterly | | | | | | | | | | | | | | | | |
| Quarterly Same Store Properties | | | | | | | | | | | | | | | | |
| Southern California | | | 51 | | $ | 31,457 | | $ | 29,999 | | $ | 1,458 | | | 4.9 | % |
| Northern California | | | 18 | | | 13,052 | | | 13,127 | | | (75 | ) | | (0.6 | ) |
| Pacific Northwest | | | 26 | | | 12,017 | | | 11,783 | | | 234 | | | 2.0 | |
| Total property revenues | | | | | | | | | | | | | | | | |
| Same Store Properties | | | 95 | | | 56,526 | | | 54,909 | | | 1,617 | | | 2.9 | |
| Property revenues - properties | | | | | | | | | | | | | | | | |
| acquired or consolidated subsequent to | | | | | | | | | | | | | | | | |
| December 31, 2003 (1) | | | | | | 20,795 | | | 11,402 | | | 9,393 | | | 82.4 | |
| Total property revenues | | | | | $ | 77,321 | | $ | 66,311 | | $ | 11,010 | | | 16.6 | % |
(1) Also includes three office buildings, three recreational vehicle parks, one manufactured housing community, redevelopment and development communities.
As set forth in the above table, the $11,010,000 net increase in total property revenues was attributable to an increase of $9,393,000 primarily due to the acquisition of twelve multifamily properties (the "Quarterly Acquisition Properties"), the achievement of stabilized operations in two development communities, the sale of one multifamily community subsequent to December 31, 2003 and the increase in Quarterly Same Store Properties revenue of $1,617,000.
Property revenues from the Quarterly Same Store Properties increased by $1,617,000 or 2.9% to $56,526,000 in the first quarter of 2005 from $54,909,000 in the first quarter of 2004. The increase was attributable to the results of the 51 Quarterly Same Store Properties located in Southern California and the 26 Quarterly Same Store Properties located in the Pacific Northwest. The 51 Quarterly Same Store Properties located in Southern California increased by $1,458,000, or 4.9%, to $31,457,000 in the first quarter of 2005 from $29,999,000 in the first quarter of 2004. The $1,458,000 increase is primarily attributable to increases in occupancy and rental rates, and a decrease in property concessions. The property revenues of the Quarterly Same Store Properties in the Pacific Northwest increased by $234,000 or 2.0% to $12,017,000 in the first quarter of 2005 from $11,783,000 in the first quarter of 2004. The $234,000 increase is primarily attributable to increases in occupancy and rental rates, and a decrease in property concessions. These increases were offset by a decrease in revenues of $75,000, or 0.6%, in Northern California. Quarterly Same Store Properties for the first quarter of 2005 decreased to $13,052,000 from $13,127,000 in the first quarter of 2004.The decrease in revenue was primarily attributable to an increase in concessions. The Company expects market rents to increase in this region by approximately 1% in 2005.
Total Expenses increased by $10,905,000 or approximately 18.9% to $68,594,000 in the first quarter of 2005 from $57,689,000 in the first quarter of 2004. This increase was mainly due to an increase in property operating expenses, interest expense and general and administrative expenses. Property operating expenses increased $5,253,000 or 13.1% to $45,429,000 in the first quarter of 2005 from $40,176,000 in the first quarter of 2004. The increase of $5,253,000 was attributable to an increase in real estate taxes of $1,390,000, an increase in depreciation and amortization of $1,381,000, and an increase in maintenance and repairs of $1,277,000. All other property operating expenses increased $1,205,000. The increase in real estate taxes and maintenance and repairs was primarily attributable to the Quarterly Acquisition Properties. On a comparative basis, depreciation and amortization expense would have increased by $3,481,000 in the first quarter of 2005 from the amount for the first quarter of 2004 if a $2,100,000 correction to depreciation expense relating to 2003 were excluded. The $3,481,000 increase is primarily a result of the Quarterly Acquisition Properties. General and administrative expense increased by $1,612,000 or 55.0% to $4,542,000 in the first quarter of 2005 from $2,930,000 in the first quarter of 2004. This increase is primarily attributable to increases in headcount and related compensation expenses, and professional fees associated with Sarbanes-Oxley implementation. Interest expense increased by $3,837,000 or 26.8% to $18,147,000 in the first quarter of 2005 from $14,310,000 in the first quarter of 2004. The increase in interest expense was due to increases in the mortgage notes payable and line of credit balances, the majority of which relate to the Quarterly Acquisition Properties, increased rates on our variable rate debt, and a reduction in the amount of capitalized interest.
Gain on sale of real estate increased to $1,115,000 for the first quarter of 2005 as compared to $0 for the first quarter of 2004 due to the recognition of a portion of the deferred gain on the sale of The Essex at Lake Merritt, which was sold in the third quarter of 2004.
Interest and other income increased by $375,000 or 20.3% to $2,226,000 in the first quarter of 2005 from $1,851,000 in the first quarter of 2004. The increase primarily relates to increases in Fund II related fees, which were offset by the reduction in Fund I fee income.
Equity income in co-investments increased by $18,484,000 to $19,584,000 in the first quarter of 2005 from $1,100,000 in the first quarter of 2004. The increase relates to the Company’s ownership interest, through Fund I, in Coronado at Newport South, which resulted in the Company recognizing equity income from investments of $14,381,000. Additionally, the Company’s general partnership interest in Fund I provides for “promote distributions” upon attainment of certain financial return benchmarks. The Company recognized $4,873,000 of additional equity income associated with its promote distributions.
Minority interests increased by $946,000 or 17.1% to $6,476,000 in the first quarter of 2005 from $5,530,000 in the first quarter of 2004. This is primarily due to the increases in net income of the Operating Partnership and joint venture investments.
Discontinued operations increased by $1,294,000 to $1,701,000 in the first quarter of 2005 from $407,000 in the first quarter of 2004. The increase in discontinued operations was mainly due to a gain on sale of real estate of $668,000 and the recognition of deferred lease revenue of $955,000, net of minority interests related to the sales of the Riviera Recreational Vehicle Park and a Manufactured Home Park, located in Las Vegas, Nevada, and the sales of the two small office buildings located in San Diego, California.
Liquidity and Capital Resources
On July 26, 2004, Standard and Poor's publicly announced its existing issuer credit ratings of BBB/Stable for Essex Property Trust, Inc. and Essex Portfolio L.P., and issued a new rating of BBB- on its Senior Unsecured Debt for Essex Portfolio L.P.
At March 31, 2005 the Company had $12,517,000 of unrestricted cash and cash equivalents. The Company expects to meet its short-term liquidity requirements by using its working capital, cash generated from operations, and amounts available under lines of credit or other financings. The Company believes that its current net cash flows will be adequate to meet operating requirements and to provide for payment of dividends by the Company in accordance with REIT qualification requirements. The Company expects to meet its long-term liquidity requirements relating to property acquisitions and development (beyond the next 12 months) and balloon debt maturities by using a combination of some or all of the following sources: working capital, amounts available on lines of credit, net proceeds from public and private debt and equity issuances, refinancing of maturing loans, and proceeds from the disposition of properties that may be sold from time to time. There can, however, be no assurance that the Company will have access to the debt and equity markets in a timely fashion to meet such future funding requirements or that future working capital and borrowings under the lines of credit will be available, or if available, will be sufficient to meet the Company's requirements or that the Company will be able to dispose of properties in a timely manner and under terms and conditions that the Company deems acceptable.
Non-revenue generating capital expenditures are improvements and upgrades that extend the useful life of the property and are not related to preparing a multifamily property unit to be rented to a tenant. The Company expects to incur approximately $410 per weighted average occupancy unit in non-revenue generating capital expenditures for the year ended December 31, 2005. These expenditures do not include the improvements required as a condition to funding mortgage loans, expenditures for acquisition properties' renovations and improvements, which are expected to generate additional revenue, and renovation expenditures required pursuant to tax-exempt bond financings. The Company expects that cash from operations and/or its lines of credit will fund such expenditures. However, there can be no assurance that the actual expenditures incurred during 2005 and/or the funding thereof will not be significantly different than the Company's current expectations.
The Company is currently developing one multifamily residential project, with an aggregate of 275 multifamily units. The project involves certain risks inherent in real estate development. See "Other Matters/ Risk Factors--Risks that Development Activities Will be Delayed, Not Completed and/or Fail to Achieve Expected Results" in Item 1 of the Company's Annual Report on Form 10-K for the year ended December 31, 2004. In connection with this development project, the Company has directly, or in some cases through its joint venture partners, entered into contractual construction related commitments with unrelated third parties and the total projected estimated cost for these projects is approximately $65.7 million. As of March 31, 2005, the remaining commitment to fund this development project was approximately $48.8 million. The Company expects to fund this commitment by using a combination of some or all of the following sources: its working capital, amounts available on its lines of credit, net proceeds from public and private equity and debt issuances, and proceeds from the disposition of properties, if any.
On September 27, 2004 the Company announced the final closing of partner equity commitments for Essex Apartment Value Fund II (“Fund II”). Fund II has eight institutional investors including the Company with combined partner equity commitments of $265.9 million. Essex has committed $75.0 million to Fund II, which represents a 28.2% interest as general partner and limited partner. Fund II expects to utilize leverage equal to approximately 65% of the estimated value of the underlying real estate. Fund II will invest in multifamily properties in the Company’s targeted West Coast markets with an emphasis on investment opportunities in Seattle and the San Francisco Bay Area. Subject to certain exceptions, Fund II will be Essex’s exclusive investment vehicle until October 31, 2006, or when Fund II’s committed capital has been invested, whichever occurs first.
Consistent with Fund I, Essex will be compensated for its asset management, property management, development and redevelopment services and may receive promote distributions if Fund II exceeds certain financial return benchmarks.
The Company has an unsecured line of credit for an aggregate amount of $185,000,000. At March 31, 2005, the Company had $144,300,000 outstanding on this line of credit. At March 31, 2005, this line of credit bore an interest rate of approximately 4.1%. This facility matures in April 2007, with an option to extend it for one year thereafter. The underlying interest rate on this line is based on a tiered rate structure tied to the Company's corporate ratings and is currently LIBOR plus 1.0%. In addition, the Company has a $100 million credit facility from Freddie Mac secured by six of Essex's multifamily communities. At March 31, 2005, the Company had $93.7 million outstanding under this line of credit. At March 31, 2005, this line of credit bore an interest rate of approximately 3.1%. This facility matures in January 2009. The underlying interest rate on this line is between 55 and 59 basis points over the Freddie Mac Reference Rate. The Company expects to place an additional $80 million in long-term fixed rate debt in the second and third quarters of 2005, with the proceeds being used primarily to repay these lines of credit.
On February 23, 2005, Fund II obtained a credit facility for an aggregate amount of $50,0000,000. This line bears interest at LIBOR plus 0.875%, and matures in August 2005.
In addition to the Company's lines of credit, the Company had $1,079,920,000 mortgage notes payable at March 31, 2005. Such indebtedness consisted of $890,306,000 in fixed rate debt with interest rates varying from 4.25% to 8.18% and maturity dates ranging from 2006 to 2034. The indebtedness also includes $189,614,000 of tax-exempt variable rate demand bonds with interest rates, including credit enhancements and other fees, paid during the three months ended March 31, 2005 that average 3.6% and have maturity dates ranging from 2006 to 2034. The tax-exempt variable rate demand bonds are subject to interest rate caps.
The Company pays quarterly dividends from cash available for distribution. Until it is distributed, cash available for distribution is invested by the Company primarily in short-term investment grade securities or is used by the Company to reduce balances outstanding under its line of credit.
On February 16, 2005, the Company entered into a $50.0 million notional forward-starting swap with a commercial bank at a fixed rate of 4.927% and a settlement date on or around October 1, 2007. This derivative is used to hedge the cash flows associated with the forecasted issuance of debt expected to occur in 2007. The transaction is considered highly effective at offsetting changes in future cash flows for forecasted transactions and qualifies for hedge accounting. The increase in the derivative’s fair value in the first quarter of 2005 was $1.2 million, which is reflected in other assets and accumulated other comprehensive income in the Company’s consolidated financial statements.
As of March 31, 2005, the Company had the capacity pursuant to existing shelf registration statements to issue up to $219,455,250 in equity securities, and the Operating Partnership had the capacity pursuant to such registration statements to issue up to $250,000,000 of debt securities.
Certain of the Company's properties are located in areas that are subject to earthquake activity.The Company has obtained earthquake insurance for most the Properties. Most of the Properties are included in an earthquake insurance program that is subject to an aggregate limit of $80.0 million payable upon a covered loss in excess of a $15.0 million self-insured retention amount and a 5% deductible.
Off Balance Sheet Arrangements
As of March 31, 2005 the Company is involved with two VIEs in which the Company is not deemed to be the primary beneficiary. Total assets and liabilities of these entities as of March 31, 2005 were approximately $52.0 million and $29.6 million, respectively. The Company does not have a significant exposure to loss resulting from its involvement with these unconsolidated VIEs.
Contractual Obligations and Commercial Commitments
The following table summarizes our contractual obligations and other commitments at March 31, 2005, and the effect such obligations could have on our liquidity and cash flow in future periods:
| | | | | 2006 and | | 2008 and | | | | | |
(In thousands) | | 2005 | | 2007 | | 2009 | | Thereafter | | Total | |
| Mortgage notes payable | | $ | 16,069 | | $ | 150,189 | | $ | 168,532 | | $ | 745,130 | | $ | 1,079,920 | |
| Lines of credit | | | - | | | 144,300 | | | 93,735 | | | - | | | 238,035 | |
| Development commitments (1) | | | 24,400 | | | 24,400 | | | - | | | - | | | 48,800 | |
| Redevelopment commitments(2) | | | 14,269 | | | - | | | - | | | - | | | 14,269 | |
Essex Apartment Value Fund II, L.P.capital commitment (3) | | | 20,717 | | | 37,500 | | | - | | | - | | | 58,217 | |
| | | $ | 75,455 | | $ | 356,389 | | $ | 262,267 | | $ | 745,130 | | $ | 1,439,241 | |
__________
| | (1) | $5,127 of these commitments relate to actual contracts as of March 31, 2005. |
| | (2) | $8,511of these commitments relate to actual contracts as of March 31, 2005. |
| | (3) | The Company has a total commitment of $58,217, as of March 31, 2005. The amounts provided by year is management’s best estimate of the timing of the funding of such commitments. These estimates could change if the timing of Fund II’s acquisition of real estate changes. |
New Accounting Pronouncements Issued But Not Yet Adopted
In December 2004, the FASB issued SFAS No. 123 revised, “Share-Based Payment”. This statement is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation”, and supercedes APB No. 25, “Accounting for Stock Issued to Employees”. The Statement requires companies to recognize in the income statement the grant-date fair value of stock options and other equity based compensation issued to employees. This Statement is effective for fiscal years beginning after June 15, 2005. We do not believe that the adoption of SFAS No. 123 revised will have a material impact on our financial position, net earnings or cash flows.
In December 2004, the FASB issued SFAS No. 153, “Exchanges of Non-monetary Assets an amendment of APB No. 29”. This Statement amends APB Opinion No. 29, “Accounting for Non-monetary Transactions” to eliminate the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. That exception required that some non-monetary exchanges be recorded on a carryover basis versus this Statement, which requires that an entity record a non-monetary exchange at fair value and recognize any gain or loss if the transaction has commercial substance. This Statement is effective for fiscal years beginning after June 15, 2005. We do not believe that the adoption of SFAS No. 153 will have a material impact on our financial position, net earnings or cash flows.
Forward Looking Statements
Certain statements in this "Management's Discussion and Analysis of Financial Condition and Results of Operations," and elsewhere in this quarterly report on Form 10-Q which are not historical facts may be considered forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended, including statements regarding the Company's expectations, hopes, intentions, beliefs and strategies regarding the future. Forward looking statements include statements regarding the Company's expectations as to the timing of completion of current development and redevelopment projects and the stabilization dates of such projects, expectation as to the total projected costs and rental rates of acquisition and development projects, beliefs as to the adequacy of future cash flows to meet operating requirements and to provide for dividend payments in accordance with REIT requirements, expectations as to the amount of capital expenditures, expectations as to the amount of non-revenue generating capital expenditures, future acquisitions, developments, and redevelopment, the Company's anticipated development projects in 2005, the anticipated sale of the remaining property of the Essex Apartment Value Fund, L.P.("Fund I"), and estimate of the resulting incentive and promote interest, the anticipated performance of the second Essex Apartment Value Fund ("Fund II"), the anticipated performance of existing properties, anticipated results from various geographic regions and the Company's investment focus in such regions, statements regarding the Company's financing activities and the use of proceeds from such activities.
Such forward-looking statements involve known and unknown risks, uncertainties and other factors including, but not limited to, that the Company will fail to achieve its business objectives, that the actual completion of development projects will be subject to delays, that the stabilization dates of such projects will be delayed, that the total projected costs of current development projects will exceed expectations, that the Company's 2005 development strategy will change, that such development projects will not be completed, that development projects and acquisitions will fail to meet expectations, that estimates of future income from an acquired property may prove to be inaccurate, that future cash flows will be inadequate to meet operating requirements and/or will be insufficient to provide for dividend payments in accordance with REIT requirements, that the actual non-revenue generating capital expenditures will exceed the Company's current expectations, that the sale of the remaining property of Fund I will not occur or will generate proceeds that are less than anticipated, that the Company's partners in Fund II fail to fund capital commitments as contractually required, that there may be a downturn in the markets in which the Company's properties are located, that the terms of any refinancing may not be as favorable as the terms of existing indebtedness, as well as those risks, special considerations, and other factors discussed under the caption "Potential Factors Affecting Future Operating Results" below and those discussed under the caption "Other Matters/Risk Factors" in Item 1 of the Company's Annual Report on Form 10-K for the year ended December 31, 2004, and those other risk factors and special considerations set forth in the Company's other filings with the Securities and Exchange Commission (the "SEC") which may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. All forward-looking statements are made as of today, and the Company assumes no obligation to update this information.
Potential Factors Affecting Future Operating Results
Many factors affect the Company’s actual financial performance and may cause the Company’s future results to be different from past performance or trends. These factors include those set forth under the caption “Risk Factors” in Item I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 and the following:
Economic Environment and Impact on Operating Results
Both the national economy and the economies of the western states in which the Company owns, manages and develops properties, some of which are concentrated in high-tech sectors, have been and may be in an economic downturn. The impacts of such downturns on operating results can include, and are not limited to, reduction in rental rates, occupancy levels, property valuations and increases in operating costs such as advertising, turnover and repair and maintenance expense.
The Company's property type and diverse geographic locations provide some degree of risk moderation but are not immune to a prolonged down cycle in the real estate markets in which the Company operates. Although the Company believes it is well positioned to meet the challenges ahead, it is possible that reductions in occupancy and market rental rates will result in a reduction of rental revenues, operating income, cash flows, and market value of the Company's shares. Prolonged recession could also affect the Company's ability to obtain financing at acceptable rates of interest and to access funds from the refinance or disposition of properties at acceptable prices.
Development and Redevelopment Activities
The Company pursues multifamily residential properties and development and redevelopment projects from time to time. Development projects generally require various government and other approvals, the receipt of which cannot be assured. The Company's development and redevelopment activities generally entail certain risks, including the following:
| | · | funds may be expended and management's time devoted to projects that may not be completed; |
| | · | construction costs of a project may exceed original estimates possibly making the project economically unfeasible; |
| | · | projects may be delayed due to, among other things, adverse weather conditions; |
| | · | occupancy rates and rents at a completed project may be less than anticipated; and |
| | · | expenses at a completed development project may be higher than anticipated. |
These risks may reduce the funds available for distribution to the Company's stockholders. Further, the development and redevelopment of properties is also subject to the general risks associated with real estate investments.
Interest Rate Fluctuations
The Company monitors changes in interest rates and believes that it is well positioned from both a liquidity and interest rate risk perspective. However, current interest rates are at historic lows and potentially could increase rapidly to levels more in line with higher historical levels. The immediate effect of significant and rapid interest rate increases would result in higher interest expense on the Company's variable interest rate debt. The effect of prolonged interest rate increases could negatively impact the Company's ability to make acquisitions and develop properties at economic returns on investment and the Company's ability to refinance existing borrowings at acceptable rates. The Company expects to place an additional $80 million in long-term fixed rate debt in the second and third quarters of 2005, with the proceeds being used primarily to repay these lines of credit.
Inflation /Deflation
Substantial inflationary or deflationary pressures could have a negative effect on rental rates and property operating expenses. The Company believes it effectively manages its property and other expenses but understands that substantial annual rates of inflation or deflation could adversely impact operating results.
Funds from Operations
Funds from operations is a financial measure that is commonly used in the REIT industry. Essex presents funds from operations as a supplemental performance measure. Funds from operations is not used by Essex as, nor should it be considered to be, an alternative to net earnings computed under GAAP as an indicator of Essex’s operating performance or as an alternative to cash from operating activities computed under GAAP as an indicator of Essex’s ability to fund its cash needs.
Funds from operations is not meant to represent a comprehensive system of financial reporting and does not present, nor does Essex intend it to present, a complete picture of its financial condition and operating performance. Essex believes that net earnings computed under GAAP remain the primary measure of performance and that funds from operations is only meaningful when it is used in conjunction with net earnings. Further, Essex believes that its consolidated financial statements, prepared in accordance with GAAP, provide the most meaningful picture of its financial condition and its operating performance.
In calculating funds from operations, Essex follows the definition for this measure published by the National Association of REITs (“NAREIT”), which is a REIT trade association. Essex believes that, under the NAREIT funds from operation definition, the two most significant adjustments made to net income are (i) the exclusion of historical cost depreciation and (ii) the exclusion of gains and losses from the sale of previously depreciated properties. Essex agrees that these two NAREIT adjustments are useful to investors for the following reasons:
(a) historical cost accounting for real estate assets in accordance with GAAP assumes, through depreciation charges, that the value of real estate assets diminishes predictably over time. NAREIT stated in its White Paper on Funds from Operations “since real estate asset values have historically risen or fallen with market conditions, many industry investors have considered presentations of operating results for real estate companies that use historical cost accounting to be insufficient by themselves.” Consequently, NAREIT’s definition of funds from operations reflects the fact that real estate, as an asset class, generally appreciates over time and depreciation charges required by GAAP do not reflect the underlying economic realities.
(b) REITs were created as a legal form of organization in order to encourage public ownership of real estate as an asset class through investment in firms that were in the business of long-term ownership and management of real estate. The exclusion, in NAREIT’s definition of funds from operations, of gains and losses from the sales of previously depreciated operating real estate assets allows investors and analysts to readily identify the operating results of the long-term assets that form the core of a REIT’s activity and assists in comparing those operating results between periods.
Other REITs in calculating funds from operations may vary from the NAREIT definition for this measure, and thus their disclosure of funds from operations may not be comparable to Essex’s calculation. The following table sets forth the Company’s calculation of Funds from Operations for the three months ended March 31, 2005 and 2004.
