SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004. OR [ ] Transition pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 COMMISSION FILE NUMBER 1-12616 SUN COMMUNITIES, INC. (Exact Name of Registrant as Specified in its Charter) Maryland 38-2730780 (State of Incorporation) (I.R.S. Employer Identification No.) 27777 Franklin Rd. Suite 200 Southfield, Michigan 48034 (Address of Principal Executive Offices) (Zip Code) Registrant's telephone number, including area code: (248) 208-2500 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Number of shares of Common Stock, $.01 par value per share, outstanding as of September 30, 2004: 18,296,204 SUN COMMUNITIES, INC. INDEX PAGES ----- PART I Item 1. Financial Statements (Unaudited): Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003 3 Consolidated Statements of Operations for the periods ended September 30, 2004 and 2003 4 Consolidated Statements of Comprehensive Income (Loss) for the periods ended September 30, 2004 and 2003 5 Consolidated Statements of Cash Flows for the periods ended September 30, 2004 and 2003 6 Notes to Consolidated Financial Statements 7-14 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 15-24 Item 3. Quantitative and Qualitative Disclosures about Market Risk 25 Item 4. Controls and Procedures 26 PART II Item 2.(c) Changes in Securities and Use of Proceeds 27 Item 6. Exhibits required by Item 601 of Regulation S-K 27 Signatures 28 2 SUN COMMUNITIES, INC. CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 2004 AND DECEMBER 31, 2003 (AMOUNTS IN THOUSANDS) (UNAUDITED) SEPTEMBER 30, 2004 DECEMBER 31, 2003 ------------------ ----------------- ASSETS Investment in rental property, net $ 1,088,970 $ 1,010,484 Cash and cash equivalents 69,181 24,058 Inventory of manufactured homes 21,352 17,236 Investment in and advances to affiliate 50,810 50,667 Notes and other receivables 44,940 74,828 Other assets 56,105 44,301 --------------- --------------- Total assets $ 1,331,358 $ 1,221,574 =============== =============== LIABILITIES Line of credit $ - $ 99,000 Debt 999,793 674,328 Other liabilities 30,015 24,833 --------------- --------------- Total liabilities 1,029,808 798,161 --------------- --------------- Minority interests 85,311 96,803 --------------- --------------- STOCKHOLDERS' EQUITY Preferred stock, $.01 par value, 10,000 shares authorized, none issued - - Common stock, $.01 par value, 100,000 shares authorized, 19,495 and 19,192 issued in 2004 and 2003, respectively 195 192 Paid-in capital 455,248 446,211 Officer's notes (9,884) (10,299) Unearned compensation (13,104) (7,337) Accumulated comprehensive earnings (1,536) (1,294) Distributions in excess of accumulated earnings (171,214) (94,479) Treasury stock, at cost, 1,199 and 202 shares in 2004 and 2003, respectively (43,466) (6,384) --------------- --------------- Total stockholders' equity 216,239 326,610 --------------- --------------- Total liabilities and stockholders' equity $ 1,331,358 $ 1,221,574 =============== =============== The accompanying notes are an integral part of the consolidated financial statements 3 SUN COMMUNITIES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE PERIODS ENDED SEPTEMBER 30, 2004 AND 2003 (AMOUNTS IN THOUSANDS EXCEPT FOR PER SHARE DATA) (UNAUDITED) THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------- ------------- 2004 2003 2004 2003 ---- ---- ---- ---- REVENUES Income from rental property $ 40,960 $ 39,090 $ 124,329 $ 119,465 Revenue from home sales 4,837 4,357 14,893 14,072 Ancillary revenues, net 394 341 1,510 1,217 Interest and other income 1,937 3,769 5,744 9,331 ------------ ------------ ------------ ------------ Total revenues 48,128 47,557 146,476 144,085 ------------ ------------ ------------ ------------ COSTS AND EXPENSES Property operating and maintenance 10,738 10,091 31,034 29,640 Cost of home sales 3,812 3,282 12,074 9,468 Real estate taxes 3,520 2,937 10,039 8,805 General and administrative - rental property 3,173 2,581 8,619 7,458 General and administrative - home sales 1,413 1,353 4,474 4,364 Depreciation and amortization 10,987 11,036 33,076 32,486 Interest 11,812 7,377 31,177 26,684 Extinguishment of debt - - 51,643 - Deferred financing costs related to extinguished debt - - 5,557 - Florida storm damage 600 - 600 - ------------ ------------ ------------ ------------ Total expenses 46,055 38,657 188,293 118,905 ------------ ------------ ------------ ------------ Income (loss) before equity income (loss) from affiliate, discontinued operations, and minority interests 2,073 8,900 (41,817) 25,180 Equity income (loss) from affiliate 749 140 1,049 (174) ------------ ------------ ------------ ------------ Income (loss) from continuing operations before minority interests 2,822 9,040 (40,768) 25,006 Less income (loss) allocated to minority interests: Preferred OP Units 2,192 2,136 6,555 6,397 Common OP Units 76 816 (5,546) 2,284 ------------ ------------ ------------ ------------ Income (loss) from continuing operations 554 6,088 (41,777) 16,325 Income from discontinued operations - 333 - 978 ------------ ------------ ------------ ------------ Net income (loss) $ 554 $ 6,421 $ (41,777) $ 17,303 ============ ============ ============ ============ Weighted average common shares outstanding: Basic 18,100 18,504 18,480 18,065 ============ ============ ============ ============ Diluted 18,246 18,683 18,480 18,220 ============ ============ ============ ============ Basic earnings (loss) per share: Continuing operations $ 0.03 $ 0.33 $ (2.26) $ 0.91 Discontinued operations - 0.02 - 0.05 ------------ ------------ ------------ ------------ Net income (loss) $ 0.03 $ 0.35 $ (2.26) $ 0.96 ============ ============ ============ ============ Diluted earnings (loss) per share: Continuing operations $ 0.03 $ 0.32 $ (2.26) $ 0.90 Discontinued operations - 0.02 - 0.05 ------------ ------------ ------------ ------------ Net income (loss) $ 0.03 $ 0.34 $ (2.26) $ 0.95 ============ ============ ============ ============ The accompanying notes are an integral part of the consolidated financial statements 4 SUN COMMUNITIES, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) FOR THE PERIODS ENDED SEPTEMBER 30, 2004 AND 2003 (AMOUNTS IN THOUSANDS) (UNAUDITED) THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ --------------------- 2004 2003 2004 2003 ------- ------- --------- --------- Net income (loss) $ 554 $ 6,421 $(41,777) $ 17,303 Unrealized income (loss) on interest rate swaps (1,616) 2,033 (242) (347) ======= ======= ======== ======== Comprehensive income (loss) $(1,062) $ 8,454 $(42,019) $ 16,956 ======= ======= ======== ======== The accompanying notes are an integral part of the consolidated financial statements 5 SUN COMMUNITIES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003 (AMOUNTS IN THOUSANDS) (UNAUDITED) 2004 2003 --------- --------- CASH FLOWS FROM OPERATING ACTIVITIES: Net (loss) income $ (41,777) $ 17,303 Adjustments to reconcile net (loss) income to cash provided by operating activities: Income (loss) allocated to minority interests (5,546) 2,284 Income from discontinued operations allocated to minority interests - 136 Depreciation and amortization 34,399 32,486 Amortization of deferred financing costs 1,403 1,101 Extinguishment of debt 51,643 - Write off of deferred financing costs related to extinguished debt 5,557 - Equity (income) loss from affiliate (1,049) 174 Increase in inventory and other assets (14,307) (9,554) Increase in accounts payable and other liabilities 5,182 308 --------- --------- Net cash provided by operating activities 35,505 44,238 --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Investment in rental properties (118,392) (20,143) Investment in and advances to affiliate 988 (50,004) Proceeds from sale of installment loans on manufactured homes to Origen 12,463 61,994 Purchase of installment loans on manufactured homes from Origen - (74,206) Decrease in notes receivable and officers' notes, net 17,840 10,095 --------- --------- Net cash used in investing activities (87,101) (72,264) --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Net proceeds from issuance of common stock and OP units, net 7,927 25,210 Borrowings (repayments) on line of credit, net (99,000) 39,500 Payments to redeem notes payable and other debt (422,289) (133,432) Proceeds from notes payable and other debt 696,064 150,000 Payments for deferred financing costs (9,498) (1,995) Treasury stock purchases (37,082) - Distributions (39,403) (36,737) --------- --------- Net cash provided by financing activities 96,719 42,546 --------- --------- Net increase in cash and cash equivalents 45,123 14,520 Cash and cash equivalents, beginning of period 24,058 2,664 --------- --------- Cash and cash equivalents, end of period $ 69,181 $ 17,184 ========= ========= SUPPLEMENTAL INFORMATION: Cash paid for interest including capitalized amounts of $341 and $1,623 for the nine months ended September 30, 2004 and 2003, respectively $ 35,085 $ 24,343 Noncash investing and financing activities: Issuance of partnership units to retire capitalized lease obligations $ 4,725 $ 4,170 Unrealized losses on interest rate swaps $ 241 $ 347 The accompanying notes are an integral part of the consolidated financial statements 6 SUN COMMUNITIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION: These unaudited condensed consolidated financial statements of Sun Communities, Inc., a Maryland corporation, (the "Company") and all majority-owned and controlled subsidiaries including Sun Communities Operating Limited Partnership (the "Operating Partnership"), SunChamp LLC ("SunChamp"), and Sun Home Services, Inc. ("SHS"), have been prepared pursuant to the Securities and Exchange Commission ("SEC") rules and regulations and should be read in conjunction with the consolidated financial statements and notes thereto of the Company included in the Annual Report on Form 10-K for the year ended December 31, 2003. The following notes to consolidated financial statements present interim disclosures as required by the SEC. The accompanying consolidated financial statements reflect, in the opinion of management, all adjustments necessary for a fair presentation of the interim financial statements. All such adjustments are of a normal and recurring nature. Certain reclassifications have been made to prior periods' financial statements in order to conform with current period presentation. 2. RENTAL PROPERTY: The following summarizes rental property (amounts in thousands): SEPTEMBER 30, DECEMBER 31, 2004 2003 ---- ---- Land $ 111,513 $ 104,541 Land improvements and buildings 1,144,930 1,048,576 Furniture, fixtures, and equipment 33,683 33,080 Land held for future development 34,318 31,409 Property under development 2,141 2,799 ----------- ----------- 1,326,585 1,220,405 Less accumulated depreciation (237,615) (209,921) ----------- ----------- Rental property, net $ 1,088,970 $ 1,010,484 =========== =========== The Company acquired 5 properties for $66 million during the second quarter of 2004 consisting of 1,414 developed sites and an additional 570 sites available for development. The properties were acquired for cash and the assumption of $23 million of debt, which was immediately retired. During the third quarter of 2004, the Company acquired one manufactured housing community for $11.6 million consisting of 392 developed sites. The property was acquired for cash. Three communities located in northeast Atlanta, GA were purchased subsequent to quarter end comprising 1150 developed sites. The properties were purchased for $27.0 million cash and the assumption of $16.0 million of debt. 7 SUN COMMUNITIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 3. NOTES AND OTHER RECEIVABLES: The following table sets forth certain information regarding notes and other receivables (amounts in thousands): SEPTEMBER 30, DECEMBER 31, 2004 2003 ---- ---- Mortgage and other notes receivable, with interest payable at a weighted average interest rate of 7.08%, maturing at various dates through August 2008, substantially collateralized by manufactured home communities $ 18,499 $ 41,736 Installment loans on manufactured homes with interest payable monthly at a weighted average interest rate and maturity of 7.0% and 10 years, respectively. 15,182 24,802 Other receivables 11,259 8,290 ------------ ------------ $ 44,940 $ 74,828 ============ ============ At September 30, 2004, the maturities of mortgages and other notes receivable are approximately as follows: 2006-$3.8 million; 2008-$14.7 million. In February 2004, $12.3 million of the installment loans collateralized by manufactured homes were sold at book value (which approximated fair value) to Origen Financial, Inc. ("Origen, Inc."). Mortgage and other notes receivable of $24.0 million were repaid during the second quarter of 2004. Officer's notes, presented as a reduction to stockholders' equity in the balance sheet, are 10 year, LIBOR + 1.75% notes, with a minimum and maximum interest rate of 6% and 9%, respectively, collateralized by 352,206 shares of the Company's common stock and 127,794 OP Units with substantial personal recourse. The notes become due in three equal installments on each of December 2008, 2009 and 2010. 4. INVESTMENT IN AND ADVANCES TO AFFILIATE: Origen, Inc. is a real estate investment trust in the business of originating, acquiring and servicing manufactured home loans. In October 2003, the Company purchased 5,000,000 shares of common stock of Origen, Inc. for $50 million. The Company owns approximately 20% of Origen, Inc. at September 30, 2004 and its investment is accounted for using the equity method of accounting. Equity earnings recorded through September 30, 2004 are an estimate of the Company's portion of the anticipated earnings of Origen, Inc. through September 30, 2004, based on publicly available information. 8 SUN COMMUNITIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 5. DEBT: The following table sets forth certain information regarding debt (amounts in thousands): SEPTEMBER 30, DECEMBER 31, 2004 2003 ---- ---- Collateralized term loan, 7.010%, due September 9, 2007 $ 41,017 $ 41,547 Collateralized term loans - CMBS, 4.931-5.320%, due July 1, 2011-2016 496,031 - Collateralized term loans - FNMA, of which $77.4M is variable, due 2014 at the Company's option, interest at 3.406 - 4.705% and 3.244% at September 30, 2004 and December 31, 2003, respectively 329,254 152,363 Redeemable preferred OP units, average interest 6.795%, redeemable at various dates through January 2, 2014 62,123 58,148 Senior notes, 6.770%, due May 14, 2005 5,017 350,000 Capitalized lease obligation, 5.510%, matured in January, 2004 - 9,606 Mortgage notes, other 66,351 62,664 ------------- ------------- $ 999,793 $ 674,328 ============= ============= The collateralized term loans totaling $866.3 million at September 30, 2004 are secured by 93 properties comprising approximately 34,307 sites. The mortgage notes are collateralized by 12 communities comprising approximately 3,815 sites. A capitalized lease obligation matured as of January 1, 2004 and was paid by the issuance of 47,250 Preferred OP Units, cash of approximately $1.2 and the assumption of approximately $4.2 million of debt, which was immediately retired. In a prior quarter, the Company completed financings totaling $733 million consisting of Collateralized Mortgaged Back Securities (CMBS) of $496 million and additional FNMA financing of $237 million. As of September 30, 2004, $60 million of the additional FNMA financing remains undrawn. On September 30, 2004, the Company closed on a $90.0 million unsecured revolving line of credit bearing interest at LIBOR + 1.75%. Subsequent to quarter end, the line of credit was expanded an additional $25.0 million to a total of $115.0 million. The entire $115.0 million remains available for use. 9 SUN COMMUNITIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 6. INTEREST AND OTHER INCOME: The components of other income are as follows for the periods ended September 30, 2004 and 2003 (in thousands): THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------- ------------- 2004 2003 2004 2003 ---- ---- ---- ---- Interest income $ 1,744 $ 3,548 $ 4,993 $ 8,739 Brokerage commissions 209 174 717 586 Other income (loss) (16) 47 34 6 ---------- ---------- ---------- ---------- $ 1,937 $ 3,769 $ 5,744 $ 9,331 ========== ========== ========== ========== 7. SEGMENT REPORTING (AMOUNTS IN THOUSANDS): The consolidated operations of the Company can be segmented into manufactured home sales and property operations segments. Following is a presentation of selected financial information: THREE MONTHS ENDED SEPTEMBER 30, 2004 NINE MONTHS ENDED SEPTEMBER 30, 2004 ------------------------------------- ------------------------------------ PROPERTY MANUFACTURED PROPERTY MANUFACTURED OPERATIONS HOME SALES COMBINED OPERATIONS HOME SALES COMBINED ---------- ---------- -------- ---------- ---------- -------- Revenues $ 40,960 $ 4,837 $ 45,797 $ 124,329 $ 14,893 $ 139,222 Operating expenses/Cost of sales 14,258 3,812 18,070 41,073 12,074 53,147 ---------- ---------- ---------- ---------- ---------- ---------- Net operating income (1)/Gross profit 26,702 1,025 27,727 83,256 2,819 86,075 Adjustments to arrive at net loss: Other revenues 1,931 400 2,331 5,547 1,707 7,254 Selling, general and administrative (3,173) (1,413) (4,586) (8,619) (4,474) (13,093) Depreciation and amortization (10,598) (389) (10,987) (32,047) (1,029) (33,076) Interest expense (11,772) (40) (11,812) (31,085) (92) (31,177) Debt extinguishment costs - - - (51,643) - (51,643) Deferred financing costs related to extinguished debt - - - (5,557) - (5,557) Florida storm damage (600) - (600) (600) - (600) Equity income from affiliate 749 - 749 1,049 - 1,049 Income allocated to minority interest (2,268) - (2,268) (1,009) - (1,009) ---------- ---------- ---------- ---------- ---------- ---------- Net income (loss) $ 971 $ (417) $ 554 $ (40,708) $ (1,069) $ (41,777) ========== ========== ========== ========== ========== ========== THREE MONTHS ENDED SEPTEMBER 30, 2003 NINE MONTHS ENDED SEPTEMBER 30, 2003 ------------------------------------- ------------------------------------ PROPERTY MANUFACTURED PROPERTY MANUFACTURED OPERATIONS HOME SALES COMBINED OPERATIONS HOME SALES COMBINED ---------- ---------- -------- ---------- ------------ -------- Revenues $ 39,090 $ 4,357 $ 43,447 $ 119,465 $ 14,072 $ 133,537 Operating expenses 13,028 3,282 16,310 38,445 9,468 47,913 ---------- ---------- ---------- ---------- ---------- ---------- Net operating income (1)/Gross profit 26,062 1,075 27,137 81,020 4,604 85,624 Adjustments to arrive at net loss: Other revenues 1,871 2,239 4,110 4,967 5,581 10,548 Selling, general and administrative (2,581) (1,353) (3,934) (7,458) (4,364) (11,822) Depreciation and amortization (10,737) (299) (11,036) (31,736) (750) (32,486) Interest expense (7,353) (24) (7,377) (26,559) (125) (26,684) Equity income (loss) from affiliate 140 - 140 (174) - (174) Income allocated to minority interest (2,952) - (2,952) (8,681) - (8,681) Income from discontinued operations 333 - 333 978 - 978 ---------- ---------- ---------- ---------- ---------- ---------- Net income $ 4,783 $ 1,638 $ 6,421 $ 12,357 $ 4,946 $ 17,303 ========== ========== ========== ========== ========== ========== (1) Investors in and analysts following the real estate industry utilize net operating income ("NOI") as a supplemental performance measure. NOI is derived from revenues (determined in accordance with GAAP) minus property operating expenses and real estate taxes (determined in accordance with GAAP). NOI does not represent cash generated from operating activities in accordance with GAAP and should not be considered to be an alternative to net income (determined in accordance with GAAP) as an indication of the Company's financial performance or to be an alternative to cash flow from operating activities (determined in accordance with 10 SUN COMMUNITIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 7. SEGMENT REPORTING (AMOUNTS IN THOUSANDS), CONTINUED: GAAP) as a measure of the Company's liquidity; nor is it indicative of funds available for the Company's cash needs, including its ability to make cash distributions. The Company believes that net income is the most directly comparable GAAP measurement to net operating income. Because of the inclusion of items such as interest, depreciation and amortization, the use of net income as a performance measure is limited as these items may not accurately reflect the actual change in market value of a property, in the case of depreciation and in the case of interest, may not necessarily be linked to the operating performance of a real estate asset, as it is often incurred at a parent company level and not at a property level. The Company believes that net operating income is helpful to investors as a measure of operating performance because it is an indicator of the return on property investment, and provides a method of comparing property performance over time. The Company uses NOI as a key management tool when evaluating performance and growth of particular properties and/or groups of properties. The principal limitation of NOI is that it excludes depreciation, amortization and non-property specific expenses such as general and administrative expenses, all of which are significant costs, and therefore, NOI is a measure of the operating performance of the properties of the Company rather than of the Company overall. SEPTEMBER 30, 2004 DECEMBER 31, 2003 -------------------------------------- ------------------------------------ PROPERTY MANUFACTURED PROPERTY MANUFACTURED SELECTED BALANCE SHEET DATA OPERATIONS HOME SALES COMBINED OPERATIONS HOME SALES COMBINED - --------------------------- ---------- ----------- ---------- ---------- ---------- ---------- Identifiable assets: Investment in rental property, net $1,046,275 $ 42,695 $1,088,970 $ 980,149 $ 30,335 $1,010,484 Cash and cash equivalents 69,285 (104) 69,181 24,043 15 24,058 Inventory of manufactured homes - 21,352 21,352 - 17,236 17,236 Investments in and advances to affiliate 50,810 - 50,810 50,667 - 50,667 Notes and other receivables 43,389 1,551 44,940 61,534 13,294 74,828 Other assets 53,366 2,739 56,105 41,613 2,688 44,301 ---------- ----------- ---------- ---------- ---------- ---------- Total assets $1,263,125 $ 68,233 $1,331,358 $1,158,006 $ 63,568 $1,221,574 ========== =========== ========== ========== ========== ========== 8. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES (IN THOUSANDS): The Company has entered into four derivative contracts consisting of three interest rate swap agreements and an interest rate cap agreement. The Company's primary strategy in entering into derivative contracts is to minimize the variability that changes in interest rates could have on its future cash flows. The Company generally employs derivative instruments that effectively convert a portion of its variable rate debt to fixed rate debt and to cap the maximum interest rate on its variable rate borrowings. The Company does not enter into derivative instruments for speculative purposes. The swap agreements have the effect of fixing interest rates relative to a portion of a collateralized term loan due to FNMA. One swap matures in July 2009, with an effective fixed rate of 4.93 percent. A second swap matures in July 2012, with an effective fixed rate of 5.37 percent. The third swap matures in July 2007, with an effective fixed rate of 3.97 percent. The third swap is effective as long as 90-day LIBOR is 7 percent or lower. The three swaps have an aggregate notional amount of $75.0 million. The interest rate cap agreement has a cap rate of 9.49 percent, a notional amount of $152.4 million and a termination date of April 03, 2006. Each of the Company's derivative contracts is based upon 90-day LIBOR. The Company has designated the first two swaps and the interest rate cap as cash flow hedges for accounting purposes. These three hedges were highly effective and had minimal effect on income. The 11 SUN COMMUNITIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 8. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES (IN THOUSANDS), CONTINUED: third swap does not qualify as a hedge for accounting purposes and, accordingly, the entire change in valuation, whether positive or negative, is reflected as a component of interest expense. The valuation adjustment for the nine month period ended September 30, 2004 totals a negative $0.3 million. SFAS No. 133, the "Accounting for Derivative Instruments and Hedging Activities," requires all derivative instruments to be carried at fair value on the balance sheet. The fair value of the instruments approximates a liability of $1.4 million and $0.9 million as of September 30, 2004 and December 31, 2003, respectively. These valuation adjustments will only be realized if the Company terminates the swaps prior to maturity. If held to maturity, the valuation adjustments will approximate zero. 9. STOCK OPTIONS (IN THOUSANDS): The Company accounts for its stock options using the intrinsic value method contained in APB Opinion No. 25. "Accounting for Stock Issued to Employees." If the Company had accounted for options using the methods contained in FASB Statement No. 123, "Accounting for Stock-Based Compensation", net income (loss) and earnings (loss) per share would have been presented as follows for the periods ended September 30, 2004 and 2003: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------ ------------------------ 2004 2003 2004 2003 ---------- ---------- ---------- ---------- Net income (loss), as reported $ 554 $ 6,421 $ (41,777) $ 17,303 Stock-based compensation expense under fair value method (17) (47) (46) (227) ---------- ---------- ---------- ---------- Pro forma net income (loss) $ 537 $ 6,374 $ (41,823) $ 17,076 ========== ========== ========== ========== Earnings (loss) per share (Basic), as reported $ 0.03 $ 0.35 $ (2.26) $ 0.96 ========== ========== ========== ========== Earnings (loss) per share (Basic), pro forma $ 0.03 $ 0.34 $ (2.26) $ 0.95 ========== ========== ========== ========== Earnings (loss) per share (Diluted), as reported $ 0.03 $ 0.34 $ (2.26) $ 0.95 ========== ========== ========== ========== Earnings (loss) per share (Diluted), pro forma $ 0.03 $ 0.34 $ (2.26) $ 0.94 ========== ========== ========== ========== Stock options issued during the second quarter of 2004 were valued using the Binomial model rather than the Black-Scholes-Merton formula. The difference in valuation between the two methods was not material. 12 SUN COMMUNITIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 10. EARNINGS (LOSS) PER SHARE (IN THOUSANDS): THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ------------------- 2004 2003 2004 2003 ------- ------- -------- ------- Earnings (loss) used for basic and diluted earnings (loss) per share: Continuing operations $ 554 $ 6,088 $(41,777) $16,325 ======= ======= ======== ======= Discontinued operations $ - $ 333 $ - $ 978 ======= ======= ======== ======= Weighted average shares used for basic earnings (loss) per share 18,100 18,504 18,480 18,065 Dilutive securities: Stock options and other 146 179 - 155 ------- ------- -------- ------- Diluted weighted average shares 18,246 18,683 18,480 18,220 ======= ======= ======== ======= Diluted earnings per share reflect the potential dilution that would occur if dilutive securities were exercised or converted into common stock. The calculation of both basic and diluted earnings per share for the nine months ending September 30, 2004 is based upon weighted average shares prior to dilution, as the effect of including potentially dilutive securities in the calculation during this period would be anti-dilutive. The Company also has the following potentially convertible securities which, if converted, may impact dilution: NUMBER OF CONVERTIBLE SECURITIES UNITS ISSUED CONVERSION FEATURES ---------------------- ------------ ------------------- Series A Preferred OP Units 1,325,275 Convertible to common stock at $68 per share/unit. Mandatorily redeemable on 01/02/2014 Series B Preferred OP Units 35,637 On each of May 1, 2004, 2005, and 2006, holder may exchange Units for shares of common stock at exchange rate of 2.272727 ($44 per share) shares of common stock for each Series B Preferred Unit. Series B-2 Preferred OP Units 100,000 Convertible into Common OP Units after 01/31/2005 at $45 per share/unit. 13 SUN COMMUNITIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 11. RECENT ACCOUNTING PRONOUNCEMENTS: On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a proposed Statement, Share-Based Payment an Amendment of FASB Statements No. 123 and APB No. 95, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. Under the FASB's proposal, all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date. Current accounting guidance requires that the expense relating to so-called fixed plan employee stock options only be disclosed in the footnotes to the financial statements. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees for options granted after June 15, 2005. The Company has not assessed the impact of the proposed statement on its financial statements. 12. CONTINGENCIES: On April 9, 2003, T.J. Holdings, LLC ("TJ Holdings"), a member of Sun/Forest, LLC ("Sun/Forest") (which, in turn, owns an equity interest in SunChamp LLC), filed a complaint against the Company, SunChamp LLC, certain other affiliates of the Company and two directors of Sun Communities, Inc. in the Superior Court of Guilford County, North Carolina. The complaint alleges that the defendants wrongfully deprived the plaintiff of economic opportunities that they took for themselves in contravention of duties allegedly owed to the plaintiff and purports to claim damages of $13.0 million plus an unspecified amount for punitive damages. The Company believes the complaint and the claims threatened therein have no merit and will defend it vigorously. The Company is involved in various other legal proceedings arising in the ordinary course of business. All such proceedings, taken together, are not expected to have a material adverse impact on its results of operations or financial condition. 14 SUN COMMUNITIES, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The following discussion and analysis of the consolidated financial condition and results of operations should be read in conjunction with the consolidated financial statements and the notes thereto. Capitalized terms are used as defined elsewhere in this Form 10-Q. SIGNIFICANT ACCOUNTING POLICIES The Company had identified significant accounting policies that, as a result of the judgments, uncertainties, uniqueness and complexities of the underlying accounting standards and operations involved, could result in material changes to its financial condition or result of operations under different conditions or using different assumptions. Details regarding the Company's significant accounting policies are described fully in the Company's 2003 Annual Report filed with the Securities and Exchange Commission on Form 10-K. During the nine months ended September 30, 2004, there have been no material changes to the Company's significant accounting policies that impacted the Company's financial condition or results of operations. RESULTS OF OPERATIONS Comparison of the three months ended September 30, 2004 and 2003 For the three months ended September 30, 2004, income from continuing operations before minority interest decreased by $6.2 million from $9.0 million to $2.8 million, when compared to the three months ended September 30, 2003. The decrease was due to increased expenses of $6.8 million, costs related to Florida storm damage of $0.6 million, offset by increased revenues of $0.6 million and increased equity income from affiliates of $0.6 million as described in more detail below. Income from rental property increased by $1.9 million from $39.1 million to $41.0 million, or 4.9 percent, due primarily to acquisitions made during the nine months ended September 30, 2004, rent increases, and other community revenues. Interest and other income decreased by $1.9 million from $3.8 million to $1.9 million, or 50.0 percent, due primarily to a decrease in interest earning notes and receivables. The increase in revenue from home sales and increase in ancillary revenues relate to operations of the manufactured home sales segment which is discussed in detail below. Property operating and maintenance expenses increased by $0.6 million from $10.1 million to $10.7 million, or 5.9 percent. The increase was due to increases in utility costs ($0.2 million), payroll expense ($0.3 million), and other miscellaneous expenses ($0.1 million). Real estate taxes increased by $0.6 million from $2.9 million to $3.5 million, or 20.7 percent, due primarily to increases in assessments and tax rates. 15 SUN COMMUNITIES, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS, CONTINUED: General and administrative expenses for rental property increased by $0.6 million from $2.6 million to $3.2 million, or 23.0 percent, due to an increase in payroll and severance costs ($0.3 million), systems training costs ($0.1 million), and other miscellaneous expenses ($0.2 million). Interest expense increased by $4.4 million from $7.4 million to $11.8 million, or 59.5 percent, primarily due to increased debt levels somewhat offset by lower interest rates. Equity income from affiliate (Origen, Inc.) of $0.7 million in the quarter represents an estimate of the Company's pro-rata share of earnings for the nine months ended September 30, 2004 less amounts previously recognized. The cost of home sales increase of $0.5 million is discussed in detail below. Sun Home Services The following table summarizes certain financial and statistical data for Sun Home Services for the three months ended September 30, 2004 and 2003: THREE MONTHS ENDED SEPTEMBER 30, INCREASE/ PERCENT 2004 2003 (DECREASE) CHANGE ------- ------ --------- ------ New home sales revenues $2,613 $2,300 $ 313 13.6% Cost of sales 1,950 1,713 237 13.8% ------ ------ ------ ------ Gross profit 663 587 76 12.9% ====== ====== ====== ====== Pre-owned home sales revenues $2,224 $2,057 $ 167 8.1% Cost of sales 1,862 1,569 293 18.7% ------ ------ ------ ------ Gross profit 362 488 (126) - 25.8% ====== ====== ====== ====== Ancillary revenue, net $ 394 $ 341 $ 53 15.5% ====== ====== ====== ====== Home sales volumes: New homes 42 41 1 2.4% Pre-owned homes 100 109 (9) - 8.3% 16 SUN COMMUNITIES, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS, CONTINUED: Sun Home Services The margin on pre-owned home sales has declined as a result of a management strategy to reduce the inventory of pre-owned homes and increase revenue producing sites. The increase in ancillary revenue, net, is primarily due to increased activity in the Company's rental home program. Comparison of the nine months ended September 30, 2004 and 2003 For the nine months ended September 30, 2004, income from continuing operations before minority interest decreased by $65.8 million from $25.0 million to a loss of $40.8 million, when compared to the nine months ended September 30, 2003. The decrease was due to increased expenses of $11.6 million, debt extinguishment costs of $51.6 million, deferred financing costs related to the extinguished debt of $5.6 million, and Florida storm damage of $0.6 million, offset by increased revenues of $2.4 million and increased equity income from affiliates of $1.2 million as described in more detail below. Income from rental property increased by $4.8 million from $119.5 million to $124.3 million, or 4.0 percent, due to property acquisitions, rent increases, and other community revenues. Interest and other income decreased by $3.6 million from $9.3 million to $5.7 million, or 38.7 percent, due primarily to a decrease in interest earning notes and receivables. The increase in revenue from home sales and increase in ancillary revenues relate to operations of the manufactured home sales segment which is discussed in detail below. Property operating and maintenance expenses increased by $1.4 million from $29.6 million to $31.0 million, or 4.7 percent. The increase was due to increases in utility costs ($0.6 million), repair and maintenance expense ($0.1 million), payroll expense ($0.3 million), advertising costs ($0.1 million), and miscellaneous other expenses ($0.3 million). Real estate taxes increased by $1.2 million from $8.8 million to $10.0 million, or 13.6 percent, due primarily to increases in assessments and tax rates. 17 SUN COMMUNITIES, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS, CONTINUED: General and administrative expenses for rental property increased by $1.2 million from $7.5 million to $8.6 million, primarily due to training costs related to the Company's systems conversion and payroll costs. Depreciation and amortization increased by $0.6 million from $32.5 million to $33.1 million, or 1.8 percent, due to additional investment in rental property. Debt extinguishment costs of $51.6 million includes prepayment penalties, fees and other costs associated with extinguishing $345.0 million of unsecured notes. Deferred financing costs related to these notes and other debt repaid with the proceeds from $733.0 million of new secured financing were expensed. Equity income from affiliate of $1.0 million represents an estimate of the Company's prorata interest in the operations of Origen, Inc. for the nine months ended September 30, 2004. The remaining cost of home sales increase of $2.6 million is discussed in detail below. Sun Home Services The following table summarizes certain financial and statistical data for Sun Home Services for the nine months ended September 30, 2004 and 2003: NINE MONTHS ENDED SEPTEMBER 30, INCREASE/ PERCENT 2004 2003 (DECREASE) CHANGE ------- ------- --------- ------ New home sales revenues $ 8,150 $10,513 $(2,363) - 22.5% Cost of sales 6,370 6,995 (625) - 8.9% ------- ------- ------- ------ Gross profit 1,780 3,518 (1,738) - 49.4% ======= ======= ======= ====== Pre-owned home sales revenues $ 6,743 $ 3,559 $ 3,184 89.5% Cost of sales 5,704 2,473 3,231 130.7% ------- ------- ------- ------ Gross profit 1,039 1,086 (47) - 4.3% ======= ======= ======= ====== Ancillary revenue, net $ 1,510 $ 1,217 $ 293 24.1% ======= ======= ======= ====== Home sales volumes: New homes 139 198 (59) - 29.8% Pre-owned homes 308 200 108 54.0% The margin on pre-owned home sales has declined as a result of a management strategy to reduce the inventory of pre-owned homes and increase revenue producing sites. The increase in ancillary revenue, net, is primarily due to increased activity in the Company's rental home program. 18 SUN COMMUNITIES, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SAME PROPERTY INFORMATION The following table reflects property-level financial information as of and for the nine months ended September 30, 2004 and 2003. The "Same Property" data represents information regarding the operation of communities owned as of January 1, 2003 and September 30, 2004. Site, occupancy, and rent data for those communities is presented as of the last day of each period presented. The "Total Portfolio" column differs from the "Same Property" column by including financial and statistical information for new development and acquisition communities. SAME PROPERTY TOTAL PORTFOLIO ---------------------------- ---------------------------- 2004 2003 2004 2003 -------- -------- -------- -------- (in thousands) (in thousands) Income from rental property $109,736 $106,069 $124,329 $119,465 -------- -------- -------- -------- Property operating expenses: Property operating and maintenance 21,630 21,127 31,034 29,640 Real estate taxes 8,716 8,133 10,039 8,805 -------- -------- -------- -------- Property operating expenses 30,346 29,260 41,073 38,445 -------- -------- -------- -------- Property net operating income (2) $ 79,390 $ 76,809 $ 83,256 $ 81,020 ======== ======== ======== ======== Number of properties 108 108 133 130 Developed sites 39,706 39,744 45,726 44,542 Occupied sites 34,605 35,315 38,449 38,399 Occupancy % 88.4%(3) 90.4%(3) 84.7%(3) 87.2%(3) Weighted Average monthly rent per site $ 342 (3) $ 326 (3) $ 340 (3) $ 327 (3) Sites available for development 1,521 1,931 7,355 6,960 Sites planned for development in next year 5 5 5 5 (2) Investors in and analysts following the real estate industry utilize net operating income ("NOI") as a supplemental performance measure. NOI is derived from revenues (determined in accordance with GAAP) minus property operating expenses and real estate taxes (determined in accordance with GAAP). NOI does not represent cash generated from operating activities in accordance with GAAP and should not be considered to be an alternative to net income (determined in accordance with GAAP) as an indication of the Company's financial performance or to be an alternative to cash flow from operating activities (determined in accordance with GAAP) as a measure of the Company's liquidity; nor is it indicative of funds available for the Company's cash needs, including its ability to make cash distributions. The Company believes that net income is the most directly comparable GAAP measurement to net operating income. Because of the inclusion of items such as interest, depreciation and amortization, the use of net income as a performance measure is limited as these items may not accurately reflect the actual change in market value of a property, in the case of depreciation and in the case of interest, may not necessarily be linked to the operating performance of a real estate asset, as it is often incurred at a parent company level and not at a property level. The Company believes that net operating income is helpful to investors as a measure of operating performance because it is an indicator of the return on property investment, and provides a method of comparing property performance over time. The Company uses NOI as a key management tool when evaluating performance and growth of particular properties and/or groups of properties. The principal limitation of NOI is that it excludes depreciation, amortization and non-property specific expenses such as general and administrative expenses, all of which are significant costs, and therefore, NOI is a measure of the operating performance of the properties of the Company rather than of the Company overall. (3) Occupancy % and weighted average rent relates to manufactured housing sites, excluding recreational vehicle sites. 19 SUN COMMUNITIES, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SAME PROPERTY INFORMATION, CONTINUED On a same property basis, property net operating income increased by $2.6 million from $76.8 million to $79.4 million, or 3.4 percent. Income from property increased by $3.6 million from $106.1 million to $109.7 million, or 3.4 percent, due primarily to increases in rents including water and property tax pass through. Property operating expenses increased by $1.0 million from $29.3 million to $30.3 million, or 3.4 percent, due primarily to increases in real estate taxes and utility expenses. LIQUIDITY AND CAPITAL RESOURCES The Company's principal liquidity demands have historically been, and are expected to continue to be, distributions to the Company's stockholders and the unitholders of the Operating Partnership, property acquisitions, development and expansion of properties, capital improvements of properties, the purchase of new and pre-owned homes and debt repayment. The Company expects to meet its short-term liquidity requirements through its working capital provided by operating activities and through its $115.0 million line of credit. The Company considers its ability to generate cash from operations (anticipated to be approximately $50 to $60 million annually) to be adequate to meet all operating requirements, including recurring capital improvements, routinely amortizing debt and other normally recurring expenditures of a capital nature, pay dividends to its stockholders to maintain qualification as a REIT in accordance with the Internal Revenue Code and make distributions to the Operating Partnership's unitholders. The Company plans to invest approximately $5 to $10 million in developments consisting of expansions to existing communities and the development of new communities during 2004. The Company expects to finance these investments by using net cash flows provided by operating activities and by drawing upon its line of credit. Furthermore, the Company may invest substantial amounts in the acquisition of properties during the remainder of 2004, depending upon a number of factors. The Company will finance these investments using the proceeds from its secured financing transactions and through the assumption of existing debt on the properties. Cash and cash equivalents increased by $45.1 million to $69.2 million at September 30, 2004 compared to $24.1 million at December 31, 2003. Net cash provided by operating activities decreased by $8.7 million to $35.5 million for the nine months ended September 30, 2004 compared to $44.2 million for the nine months ended September 30, 2003. The Company's net cash flows provided by operating activities may be adversely impacted by, among other things: (a) the market and economic conditions in the Company's current markets generally, and specifically in metropolitan areas of the Company's current markets; (b) lower occupancy and rental rates of the Company's properties (the "Properties"); (c) increased operating costs, including insurance premiums, real estate taxes and utilities, that cannot be passed on to the Company's tenants; and (d) decreased sales of manufactured homes. See "Factors That May Affect Future Results" in the Company's Annual Report on Form 10-K for the year ended December 31, 2003. 20 SUN COMMUNITIES, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES CONTINUED: The Company anticipates meeting its long-term liquidity requirements, such as scheduled debt maturities, large property acquisitions, and Operating Partnership unit redemptions through the collateralization of a significant portion of its Properties. From time to time, the Company may also issue shares of its capital stock, issue equity units in the Operating Partnership or sell selected assets. The ability of the Company to finance its long-term liquidity requirements in such manner will be affected by numerous economic factors affecting the manufactured housing community industry at the time, including the availability and cost of mortgage debt, the financial condition of the Company, the operating history of the Properties, the state of the debt and equity markets, and the general national, regional and local economic conditions. See "Factors That May Affect Future Results" in the Company's Annual Report on Form 10-K for the year ended December 31, 2003. If the Company is unable obtain additional debt or equity financing on acceptable terms, the Company's business, results of operations and financial condition will be adversely impacted. At September 30, 2004, the Company's debt to total market capitalization approximated 53.6 percent (assuming conversion of all Common OP Units to shares of common stock). The debt has a weighted average maturity of approximately 8.8 years and a weighted average interest rate of 5.0 percent. Capital expenditures for the nine months ended September 30, 2004 and 2003 included recurring capital expenditures of $4.9 million and $4.7 million, respectively. Net cash used in investing activities increased by $14.8 million to $87.1 million for the nine months ended September 30, 2004 compared to $72.3 million used in investing activities for the nine months ended September 30, 2003. This increase was due to a $98.2 million increase in rental property investment activities and a $49.5 million decrease in sale of notes receivable to Origen, Inc., offset by a $51.0 million decrease in investment in and advances to an affiliate, a $74.2 million decrease in purchases of installments loans from Origen, Inc., and a $7.7 million decrease in notes receivable and officers' notes, net. Net cash provided by financing activities increased by $54.2 million to $96.7 million for the nine months ended September 30, 2004 from $42.5 million for the nine months ended September 30, 2003. This increase was primarily due to a $257.3 million increase in proceeds from notes payable and other debt, net, offset by a $17.3 million decrease of proceeds from issuance of common stock, $138.5 million increase in repayments on the line of credit, a $2.7 million increase in distributions, a $7.5 million increase in payments for deferred financing costs, and a $37.1 million increase in treasury stock purchase activities, representing 1,000,000 shares under a one million share buy back authorization. 21 SUN COMMUNITIES, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SUPPLEMENTAL MEASURE: Funds from operations ("FFO") is defined by the National Association of Real Estate Investment Trusts ("NAREIT") as net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of depreciable operating property, plus real estate-related depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. FFO is a non-GAAP financial measure that management believes is a useful supplemental measure of the Company's operating performance. Management generally considers FFO to be a useful measure for reviewing comparative operating and financial performance because, by excluding gains and losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization (which can vary among owners of identical assets in similar condition based on historical cost accounting and useful life estimates), FFO provides a performance measure that, when compared year over year, reflects the impact to operations from trends in occupancy rates, rental rates and operating costs, providing perspective not readily apparent from net income. Management believes that the use of FFO has been beneficial in improving the understanding of operating results of REITs among the investing public and making comparisons of REIT operating results more meaningful. Because FFO excludes significant economic components of net income including depreciation and amortization, FFO should be used as an adjunct to net income and not as an alternative to net income. The principal limitation of FFO is that it does not represent cash flow from operations as defined by GAAP and is a supplemental measure of performance that does not replace net income as a measure of performance or net cash provided by operating activities as a measure of liquidity. In addition, FFO is not intended as a measure of a REIT's ability to meet debt principal repayments and other cash requirements, nor as a measure of working capital. FFO only provides investors with an additional performance measure that, when combined with measures computed in accordance with GAAP such as net income, cash flow from operating activities, investing activities and financing activities, provide investors with an indication of the Company's ability to service debt and to fund acquisitions and other expenditures. Other REITS may use different methods for calculating FFO and, accordingly, the Company's FFO may not be comparable to other REITs. The following table reconciles net income to FFO and calculates FFO data for both basic and diluted purposes for the periods ended September 30, 2004 and 2003 (in thousands): 22 SUN COMMUNITIES, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SUPPLEMENTAL MEASURE, CONTINUED: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, -------------------- -------------------- 2004 2003 2004 2003 -------- -------- -------- -------- Net income (loss) $ 554 $ 6,421 $(41,777) $ 17,303 Adjustments: Depreciation and amortization 11,195 10,708 33,109 31,817 Valuation adjustment(4) (180) (1,949) 302 (1,274) Allocation of SunChamp losses(5) - 1,221 300 3,158 Income allocated to minority interest 76 860 (5,546) 2,420 -------- -------- --------- -------- Funds from operations $ 11,645 $ 17,261 $(13,612) $ 53,424 ======== ======== ========= ======== FFO - Continuing Operations $ 11,645 $ 16,775 $(13,612) $ 51,886 ======== ======== ========= ======== FFO - Discontinued Operations $ - $ 486 $ 0 $ 1,538 ======== ======== ========= ======== Weighted average common shares/OP Units outstanding: Basic 20,574 20,989 20,954 20,586 ======== ======== ========= ======== Diluted 20,720 21,168 20,954 20,741 ======== ======== ========= ======== Continuing Operations: FFO per weighted average Common Share/OP Unit - Basic $ 0.57 $ 0.80 $ (0.65) $ 2.52 ======== ======== ========= ======== FFO per weighted average Common Share/OP Unit - Diluted $ 0.56 $ 0.79 $ (0.65) $ 2.50 ======== ======== ========= ======== Discontinued Operations: FFO per weighted average Common Share/OP Unit - Basic $ - $ 0.02 $ - $ 0.08 ======== ======== ========= ======== FFO per weighted average Common Share/OP Unit - Diluted $ - $ 0.03 $ - $ 0.08 ======== ======== ========= ======== Total Operations: FFO per weighted average Common Share/OP Unit - Basic $ 0.57 $ 0.82 $ (0.65) $ 2.60 ======== ======== ========= ======== FFO per weighted average Common Share/OP Unit - Diluted $ 0.56 $ 0.82 $ (0.65) $ 2.58 ======== ======== ========= ======== (4) The Company entered into three interest rate swaps and an interest rate cap agreement. The valuation adjustment reflects the theoretical noncash profit and loss were those hedging transactions terminated at the balance sheet date. As the Company has no expectation of terminating the transactions prior to maturity, the net of these noncash valuation adjustments will be zero at the various maturities. As any imperfection related to hedging correlation in these swaps is reflected currently in cash as interest, the valuation adjustments reflect volatility that would distort the comparative measurement of FFO and on a net basis approximate zero. Accordingly, the valuation adjustments are excluded from Funds from Operations. The valuation adjustment is included in interest expense. (5) The Company acquired the equity interest of another investor in SunChamp in December 2002. Consideration consisted of a long-term note payable at net book value. Although the adjustment for the allocation of the SunChamp losses (based on SunChamp as a stand-alone entity) is not reflected in the accompanying financial statements, management believes that it is appropriate to provide for this adjustment because the Company's payment obligations with respect to the note are subordinate in all respects to the return of the members' equity (including the gross book value of the acquired equity) plus a preferred return. As a result, the losses that are allocated to the Company from SunChamp as a stand-alone entity under generally accepted accounting principles are effectively reallocated to the note for purposes of calculating Funds from Operations. A situation such as this is not contemplated in the NAREIT definition of FFO due to the unique circumstances of the transaction. Although not comparable to the precise NAREIT definition, the Company believes the inclusion of this item in its calculation of FFO to be appropriate as noted above. 23 SUN COMMUNITIES, INC. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SAFE HARBOR STATEMENT This Form 10-Q contains various "forward-looking statements" within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934, and the Company intends that such forward-looking statements will be subject to the safe harbors created thereby. For this purpose, any statements contained in this filing that relate to prospective events or developments are deemed to be forward-looking statements. Words such as "believes," "forecasts," "anticipates," "intends," "plans," "expects," "may", "will" and similar expressions are intended to identify forward-looking statements. These forward-looking statements reflect the Company's current views with respect to future events and financial performance, but involve known and unknown risks and uncertainties, both general and specific to the matters discussed in this filing. These risks and uncertainties may cause the actual results of the Company to be materially different from any future results expressed or implied by such forward looking statements. Such risks and uncertainties include the national, regional and local economic climates, the ability to maintain rental rates and occupancy levels, competitive market forces, changes in market rates of interest, the ability of manufactured home buyers to obtain financing, the level of repossessions by manufactured home lenders and those referenced under the headings entitled "Factors That May Affect Future Results" or "Risk Factors" contained in the Company's Annual Report on Form 10-K for the year ended December 31, 2003 and the Company's filings with the Securities and Exchange Commission. The forward-looking statements contained in this Form 10-Q speak only as of the date hereof and the Company expressly disclaims any obligation to provide public updates, revisions or amendments to any forward-looking statements made herein to reflect changes in the Company's expectations of future events. 24 SUN COMMUNITIES, INC. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The Company's principal market risk exposure is interest rate risk. The Company mitigates this risk by maintaining prudent amounts of leverage, minimizing capital costs and interest expense while continuously evaluating all available debt and equity resources and following established risk management policies and procedures, which include the periodic use of derivatives. The Company's primary strategy in entering into derivative contracts is to minimize the variability that changes in interest rates could have on its future cash flows. The Company generally employs derivative instruments that effectively convert a portion of its variable rate debt to fixed rate debt. The Company does not enter into derivative instruments for speculative purposes. The Company's variable rate debt totals $105.6 million and $207.7 million as of September 30, 2004 and 2003, respectively, which bears interest at various LIBOR/DMBS rates. If LIBOR/DMBS increased or decreased by 1.00 percent during the nine months ended September 30, 2004 and 2003, the Company believes its interest expense would have increased or decreased by approximately $1.9 million and $2.3 million based on the $190.9 million and $228.0 million average balance outstanding under the Company's variable rate debt facilities for the nine months ended September 30, 2004 and 2003, respectively. Additionally, the Company had $14.7 million and $31.6 million LIBOR based variable rate mortgage and other notes receivables as of September 30, 2004 and 2003, respectively. If LIBOR increased or decreased by 1.0 percent during the nine months ended September 30, 2004 and 2003, the Company believes interest income would have increased or decreased by approximately $0.2 million and $0.3 million based on the $20.9 million and $29.6 million average balance outstanding on all variable rate notes receivable for the nine months ended September 30, 2004 and 2003, respectively. The Company has entered into three separate interest rate swap agreements and an interest rate cap agreement. One of these swap agreements fixes $25 million of variable rate borrowings at 4.93 percent for the period April 2003 through July 2009, another of these swap agreements fixes $25 million of variable rate borrowings at 5.37 percent for the period April 2003 through July 2012 and the third swap agreement, which is only effective for so long as 90-day LIBOR is 7 percent or less, fixes $25 million of variable rate borrowings at 3.97 percent for the period April 2003 through July 2007. The interest rate cap agreement has a cap rate of 9.49 percent, a notional amount of $152.4 million and a termination date of April 13, 2006. Each of the Company's derivative contracts is based upon 90-day LIBOR. 25 SUN COMMUNITIES, INC. ITEM 4. CONTROLS AND PROCEDURES (a) Under the supervision and with the participation of the Company's management, including the Chief Executive Officer, Gary A. Shiffman, and Chief Financial Officer, Jeffrey P. Jorissen, the Company evaluated the effectiveness of the design and operation of the Company's disclosure controls and procedures as of the end of the period covered by this quarterly report, pursuant to Rule 13a-15 of the Securities Exchange Act of 1934 (the "Exchange Act"). Based upon that evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective to ensure that information the Company is required to disclose in its filings with the Securities and Exchange Commission under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms, and to ensure that information required to be disclosed by the Company in the reports that it files under the Exchange Act is accumulated and communicated to the Company's management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. (b) There have been no significant changes in the Company's internal control over financial reporting during the quarterly period ended September 30, 2004, that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. 26 SUN COMMUNITIES, INC. PART II ITEM 2. (c) - CHANGES IN SECURITIES AND USE OF PROCEEDS The Company announced a program to purchase up to 1,000,000 shares of its common stock on January 2, 2003. The results of this stock repurchase program for the three months ended September 30, 2004 are as follows: TOTAL NUMBER OF SHARES PURCHASED AS AVERAGE PART OF PUBLICLY MAXIMUM NUMBER OF SHARES THAT TOTAL NUMBER OF PRICE PAID ANNOUNCED PLANS OR MAY YET BE PURCHASED UNDER THE PERIOD SHARES PURCHASED PER SHARE PROGRAMS PLANS OR PROGRAMS ------ ---------------- --------- -------------------- ------------------------------- 07/01/04-07/31/04 260,400 $ 37.69 260,400 469,400 08/01/04-08/31/04 389,000 $ 38.11 389,000 80,400 09/01/04-09/30/04 80,400 $ 38.25 80,400 - ------- -------- ------- ------- Total 729,800 $ 37.98 729,800 - ------- -------- ------- ------- ITEM 6. - EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K See the attached Exhibit Index. 27 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Dated: November 5, 2004 SUN COMMUNITIES, INC. BY: /s/ Jeffrey P. Jorissen ------------------------------------------------------ Jeffrey P. Jorissen, Chief Financial Officer and Secretary (Duly authorized officer and principal financial officer) 28 SUN COMMUNITIES, INC. EXHIBIT INDEX EXHIBIT NO. DESCRIPTION - ----------- ----------- 10.1 Credit Agreement, dated September 30, 2004, among the Company, the Operating Partnership, Standard Federal Bank National Association, LaSalle Bank National Association and other lenders. 31.1 Certification of Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14(a)/15(d)-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a)/15(d)-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 29