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, 1999 OR / /Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 Commission file number: 1-14307 Great Lakes REIT (Exact name of Registrant as specified in its Charter) Maryland 36-4238056 (State or other jurisdiction (IRS employer identification no.) of incorporation or organization) 823 Commerce Drive, Suite 300, Oak Brook, IL 60523 (Address of principal executive offices) (Zip Code) (630) 368 - 2900 (Registrant's telephone number, including area code) 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 Number of shares of the registrant's common shares of beneficial interest, $.01 par value, outstanding as of November 2, 1999: 16,295,098. Great Lakes REIT Index to Form 10-Q September 30, 1999 Page Number Part I - Financial Information Item 1. Financial Statements (unaudited): Consolidated Balance Sheets as of September 30, 1999 and December 31, 1998 4 Consolidated Statements of Income for the three months ended September 30, 1999 and 1998 5 Consolidated Statements of Income for the nine months ended September 30, 1999 and 1998 6 Consolidated Statement of Changes in Shareholders' Equity for the nine months ended September 30, 1999 7 Consolidated Statements of Cash Flows for the nine months ended September 30, 1999 and 1998 8 Notes to Consolidated Financial Statements 9 Item 2. Management's Discussion and Analysis of Financial Condition And Results of Operations 11 Item 3. Quantitative and Qualitative Disclosures about Market Risk 14 Part II - Other Information Item 2. Changes in Securities 16 Item 6. Exhibits and Reports on Form 8-K 16 Great Lakes REIT Consolidated Balance Sheets (unaudited) (Dollars in Thousands) September 30, December 31, ------------------------------ 1999 1998 ---- ---- Assets Properties: Land $60,345 $60,960 Buildings, improvements, and equipment 399,760 388,068 ------------------------------ 460,105 449,028 Less accumulated depreciation 30,596 22,166 ------------------------------ 429,509 426,862 Cash and cash equivalents 9,825 2,466 Real estate tax escrows 225 619 Rents receivable 4,926 5,021 Deferred financing and leasing costs, net of accumulated amortization 6,011 6,067 Goodwill, net of accumulated amortization 1,228 1,284 Other assets 2,093 1,370 ------------------------------ Total assets $453,817 $443,689 ============================== Liabilities and shareholders' equity Bank loan payable $98,000 $84,291 Mortgage loans payable 100,713 104,532 Bonds payable 4,550 4,800 Accounts payable and accrued liabilities 6,473 4,338 Accrued real estate taxes 12,137 11,149 Prepaid rent 3,411 3,220 Security deposits 1,064 1,107 Distributions/dividends payable 5,603 ------------------------------ Total liabilities 231,951 213,437 ------------------------------ Minority interests 951 1,165 ------------------------------ Preferred shares of beneficial interest ($0.01 par value, 37,500 37,500 10,000,000 shares authorized; 1,500,000 9 3/4% Series A Cumulative Redeemable shares, with a $25.00 per share Liquidation Preference, issued and outstanding in 1999 and 1998) Common shares of beneficial interest ($0.01 par value, 178 175 60,000,000 shares authorized; 17,816,883 and 17,513,578 shares issued in 1999 and 1998, respectively) Paid-in-capital 227,907 223,414 Retained earnings (deficit) (4,946) (8,790) Employee share purchase loans (16,339) (11,967) Deferred compensation (27) (44) Treasury shares, at cost (1,521,785 and 743,184 shares in (23,358) (11,201) 1999 and 1998, respectively) ------------------------------ Total shareholders' equity 220,915 229,087 ------------------------------ Total liabilities and shareholders' $453,817 $443,689 equity ============================== The accompanying notes are an integral part of these financial statements. Great Lakes REIT Consolidated Statements of Income (unaudited) (Dollars in Thousands, except per share data) Three months ended September 30, ------------------------------------------ 1999 1998 ---- ---- Revenues: Rental $18,723 $16,685 Reimbursements 5,080 4,556 Interest and other 476 217 ------------------------------------------ Total revenues 24,279 21,458 ------------------------------------------ Expenses: Real estate taxes 3,683 3,332 Other property operating 6,364 5,523 General and administrative 1,210 1,393 Interest 3,593 3,440 Depreciation and amortization 4,063 3,505 ------------------------------------------ Total expenses 18,913 17,193 ------------------------------------------ Income before gain on sale of properties 5,366 4,265 Gain on sale of properties, net 3,203 ------------------------------------------ Income before allocation to minority interests 8,569 4,265 Minority interests 30 18 ------------------------------------------ Net income 8,539 4,247 Income allocated to preferred shareholders 914 ------------------------------------------ Net income applicable to common shares $7,625 $4,247 ========================================== Earnings per common share - basic $0.46 $0.25 ========================================== Weighted average common shares outstanding - basic 16,522,078 17,275,676 ========================================== Diluted earnings per common share $0.46 $0.24 ========================================== Weighted average common shares outstanding - diluted 16,602,010 17,406,102 ========================================== The accompanying notes are an integral part of these financial statements. Great Lakes REIT Consolidated Statements of Income (unaudited) (Dollars in Thousands, except per share data) Nine months ended September 30, ----------------------------------------- 1999 1998 ---- ---- Revenues: Rental $54,864 $44,854 Reimbursements 15,081 12,404 Interest and other 996 494 ----------------------------------------- Total revenues 70,941 57,752 ----------------------------------------- Expenses: Real estate taxes 11,828 9,072 Other property operating 18,377 14,840 General and administrative 3,424 3,643 Interest 10,349 8,354 Depreciation and amortization 11,812 9,426 ----------------------------------------- Total expenses 55,790 45,335 ----------------------------------------- Income before gain on sale of properties 15,151 12,417 Gain on sale of properties, net 8,061 ----------------------------------------- Income before allocation to minority interests 23,212 12,417 Minority interests 79 41 ----------------------------------------- Net income 23,133 12,376 Income allocated to preferred shareholders 2,742 ----------------------------------------- Net income applicable to common shares $20,391 $12,376 ========================================= Earnings per common share - basic $1.23 $0.74 ========================================= Weighted average common shares outstanding - basic 16,529,085 16,801,186 ========================================= Diluted earnings per common share $1.23 $0.73 ========================================= Weighted average common shares outstanding - diluted 16,609,017 17,015,289 ========================================= The accompanying notes are an integral part of these financial statements. Great Lakes REIT Consolidated Statement of Changes in Shareholders' Equity (unaudited) For the Nine Months Ended September 30, 1999 (Dollars in Thousands) 1999 - ------------------------------------------------------------------------- Preferred Shares Balance at beginning of period $37,500 Proceeds from the sale of preferred shares - ------------------------------------------------------------------------- Balance at end of period 37,500 Common Shares Balance at beginning of period 175 Exercise of share options 3 - ------------------------------------------------------------------------- Balance at end of period 178 Paid-in capital Balance at beginning of period 223,414 Exercise of share options 4,493 - ------------------------------------------------------------------------- Balance at end of period 227,907 Retained earnings (deficit) Balance at beginning of period (8,790) Net income 23,133 Distributions/dividends (19,289) - ------------------------------------------------------------------------- Balance at end of period (4,946) Employee share purchase loans Balance at beginning of period (11,967) Exercise of share options (4,372) - ------------------------------------------------------------------------- Balance at end of period (16,339) Deferred compensation Balance at beginning of period (44) Amortization of deferred compensation 17 - ------------------------------------------------------------------------- Balance at end of period (27) Treasury shares Balance at beginning of period (11,201) Purchase of treasury shares (12,157) - ------------------------------------------------------------------------- Balance at end of period (23,358) - ------------------------------------------------------------------------- Total shareholders' equity $220,915 ========================================================================= The accompanying notes are an integral part of these financial statements. Great Lakes REIT Consolidated Statements of Cash Flows (unaudited) (Dollars in Thousands) Nine Months Ended September 30, ---------------------------------- 1999 1998 ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES Net income $23,133 $12,376 Adjustments to reconcile net income to cash flows from operating activities Depreciation and amortization 11,812 9,426 Gain on sale of properties (8,061) Other non-cash items 96 63 Net changes in assets and liabilities: Rents receivable 95 (1,077) Real estate tax escrows and other assets 34 (669) Accounts payable, accrued expenses and other liabilities 2,141 2,629 Accrued real estate taxes 988 4,068 Payment of deferred leasing costs (1,545) (2,044) ---------------------------------- Net cash provided by operating activities 28,693 24,772 ---------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Purchase of properties (19,634) (128,793) Additions to buildings, improvements and equipment (8,918) (8,338) Proceeds from property sales, net 21,959 Other investing activities (362) 1,610 ---------------------------------- Net cash used by investing activities (6,955) (135,521) ---------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from sale of common and preferred shares 22,500 Payment of share offering costs (1,479) Proceeds from exercise of share options 124 13 Proceeds from bank and mortgage loans payable 29,775 189,035 Distributions / dividends paid (13,544) (15,542) Distributions to minority interests (37) Purchase of minority interests (256) Purchase of treasury shares (12,157) (6,452) Payment of bank and mortgage loans and bonds (18,055) (75,225) Payment of deferred financing costs (229) (1,402) ---------------------------------- Net cash provided by financing activities (14,379) 111,448 ---------------------------------- Net increase (decrease) in cash and cash equivalents 7,359 699 Cash and cash equivalents, beginning of year 2,466 1,437 ---------------------------------- Cash and cash equivalents, end of quarter $9,825 $2,136 ================================== Supplemental disclosure of cash flow: Interest paid $10,335 $7,581 ================================== Non-cash financing transactions: Employee share purchase loans $4,386 $6,515 ================================== Mortgage assumed by purchaser of property $2,079 ================================== Increase in preferred dividends payable $142 ================================== Issuance of shares and units to acquire properties $887 ================================== Mortgages assumed to acquire properties $12,435 ================================== The accompanying notes are an integral part of these financial statements. Great Lakes REIT Notes to Consolidated Financial Statements Dollars in thousands, except per share data (Unaudited) 1. Basis of Presentation Great Lakes REIT (the "Company") was formed in 1992 to invest in income-producing real property. In 1998, the Company changed its form of organization from a Maryland corporation to a Maryland real estate investment trust. The principal business of the Company is the ownership, management, leasing, renovation and acquisition of suburban office and office/service center properties primarily located in the Midwest. At September 30, 1999, the Company owned and operated 37 properties primarily located in suburban areas of Chicago, Detroit, Milwaukee, Columbus, Minneapolis, Denver and Cincinnati. The Company leases office and office/service center properties to over 550 tenants who are engaged in a variety of businesses. The Company conducts substantially all of its operations through Great Lakes REIT, L.P., of which the Company is the sole general partner. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries and controlled partnership. Intercompany accounts and transactions have been eliminated in consolidation. The accompanying consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with generally accepted accounting principles. These statements should be read in conjunction with the Company's most recent year-end audited financial statements contained in the Company's Annual Report on Form 10-K for the year ended December 31, 1998 (the "1998 10-K"). In the opinion of management, the financial statements contain all adjustments (which are normal and recurring) necessary for a fair statement of financial results for the interim periods. For further information, refer to the consolidated financial statements and notes thereto included in the 1998 10-K. 2. Segment Information The Company has three reportable segments distinguished by property type. The property types are office, office/service center, and industrial, and are primarily located in the Midwest. As of September 30, 1999, the properties were leased to more than 550 tenants, no single tenant accounted for more than 5% of the aggregate annualized base rent of the Company's portfolio and 20 tenants individually represented more than 1% of such aggregate annualized base rent. The Company evaluates performance and allocates resources based on property revenues (rental and reimbursement income) less property operating expenses and real estate taxes to arrive at net operating income. Net operating income is an industry measure of a property's performance. The following table summarizes the Company's segment information for the three and nine months ended September 30, 1999 and 1998. For the nine months ended For the three months ended September 30, September 30, 1999 1998 1999 1998 Revenues Office $64,328 $50,547 $21,839 $18,930 Office/service center 5,012 5,297 1,693 1,709 Industrial 172 255 91 Deferred rental revenues 433 1,159 271 511 Interest and other 996 494 476 217 ============================================================================== Total $70,941 $57,752 $24,279 $21,458 ============================================================================== Net operating income Office $35,939 $28,411 $12,274 $10,658 Office/service center 3,228 3,635 1,211 1,156 Industrial 140 141 61 ============================================================================== Total $39,307 $32,187 $13,485 $11,875 ============================================================================== Depreciation and amortization Office $10,440 $8,020 $3,580 $3,113 Office/service center 953 815 339 277 Industrial 33 62 19 Other 386 529 144 96 ============================================================================== Total $11,812 $9,426 $4,063 $3,505 ============================================================================== Interest expense Office $9,194 $7,334 $3,205 $3,080 Office/service center 1,085 858 388 302 Industrial 70 162 58 ============================================================================== Total $10,349 $8,354 $3,593 $3,440 ============================================================================== Additions to properties Office $27,816 $149,820 $2,656 $34,716 Office/service center 669 536 163 67 Industrial 36 37 37 Other 41 60 1 10 ============================================================================== Total $28,562 $150,453 $2,820 $34,830 ============================================================================== Income before allocation to minority interests and gains on sale of properties For the nine months ended For the three months ended September 30, September 30, 1999 1998 1999 1998 Office $16,305 $13,057 $5,489 $4,465 Office/service center 1,190 1,962 484 577 Industrial 37 (83) (16) Deferred rental revenues 433 1,159 271 511 Interest and other income 996 494 476 217 General and administrative (3,424) (3,643) (1,210) (1,393) Other depreciation (386) (529) (144) (96) ------------------------------------------------------------------------------ Total $15,151 $12,417 $5,366 $4,265 ============================================================================== Following is a summary of segment assets at September 30, 1999 and December 31, 1998: September 30, December 31, ---------------------------------------- 1999 1998 Assets Office $401,847 $394,607 Office/service center 31,132 31,841 Industrial 3,949 Other 20,838 13,292 ---------------------------------------- Total $453,817 $443,689 ======================================== 3. Property Acquisition On May 11, 1999, the Company acquired Burlington Office Center located in Ann Arbor, Michigan for a contract price of $19,650. The property contains three multi-story office buildings totaling 178,000 square feet. 4. Property Dispositions On April 21, 1999, the Company sold its Elgin, Illinois property for a contract price of $4,700 (including the assumption of $2,079 of mortgage debt) resulting in a net gain on sale of $658. The proceeds from this sale were reinvested in Burlington Office Center in a tax-deferred exchange (see note 3). On June 30, 1999, the Company sold its 2800 River Road, Des Plaines, Illinois, and 1251 Plum Grove Road, Schaumburg, Illinois, properties for a total contract price of $11,600 resulting in a total net gain on sale of $ 4,848. The Company expects to sell its Markham, Illinois property in the fourth quarter of 1999 at a disposition price ($514) that is less than the net book value of the property. Accordingly, the Company has recorded an anticipated net loss on sale of this property in an amount of $648 during the nine months ended September 30, 1999. On August 25, 1999, the Company sold its 565 Lakeview Parkway, Vernon Hills, Illinois property for $8,800 resulting in a net gain on sale of $3,203. 5. Long-term Debt In June 1999, the Company entered into an interest rate cap agreement with a major financial institution whereby the Company has limited the LIBOR interest rate on $50,000 of its variable rate debt to no more than 6% per annum until June 2001. The cost of this agreement to the Company was $209 and is being amortized to expense over the period of the agreement (24 months). 6. Commitments The Company has committed to acquire, upon completion, an office building under construction in Pewaukee, Wisconsin for a maximum contract price of $11,400. The Company expects to close this acquisition in December 1999. The Company has obtained a $500 letter of credit as a deposit towards the purchase of this property. ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Dollars in thousands except per share data) The following is a discussion and analysis of the consolidated financial condition and results of operations for the three and nine months ended September 30, 1999. The following should be read in conjunction with the consolidated financial statements and related notes appearing elsewhere herein and the consolidated financial statements and related notes contained in the 1998 10-K. Overview The principal business of the Company is the ownership, management, leasing, renovation, and acquisition of suburban office properties primarily located in the Midwest. At September 30, 1999, the Company owned and operated 37 properties primarily located in suburban areas of Chicago, Detroit, Milwaukee, Columbus, Minneapolis, Denver and Cincinnati. The Company leases space to over 550 tenants who are engaged in a variety of businesses. Growth in net income and funds from operations (FFO) for the three and nine months ended September 30, 1999 as compared to September 30, 1998 was due to a combination of improved operations of the Company's properties and the inclusion of the operating results of properties acquired in 1999 and 1998 from the dates of their respective acquisitions. On May 11, 1999, the Company acquired Burlington Office Center located in Ann Arbor, Michigan for a contract price of $19,650. The property contains three multi-story office buildings totaling 178,000 square feet. On April 21, 1999, the Company sold its Elgin, Illinois property for a contract price of $4,700 (including the assumption of $2,079 of mortgage debt) resulting in a net gain on sale of $658. The proceeds from this sale were reinvested in Burlington Office Center in a tax-deferred exchange. On June 30, 1999 the Company sold its 2800 River Road, Des Plaines, Illinois, and 1251 Plum Grove Road, Schaumburg, Illinois, properties for a total contract price of $11,600 resulting in a total net gain on sale of $4,848. On August 25, 1999, the Company sold its 565 Lakeview Parkway, Vernon Hills, Illinois property for $8,800 resulting in a net gain on sale of $3,203. See the 1998 10-K for a description of 1998 acquisition activity. The Company did not have material disposition activity in 1998. Three months ended September 30, 1999 compared to three months ended September 30, 1998 In analyzing the operating results for the quarter ended September 30, 1999, the changes in rental and reimbursement income, real estate taxes and property operating expenses from the same period in 1998 are due principally to the following factors: (1) the addition of operating results from properties acquired subsequent to September 30, 1998, (2) the addition of operating results from properties acquired in 1999, (3) operating results of properties sold in 1999 and (4) improved operations of properties during 1999 as compared to 1998. The Company acquired three properties during the third quarter of 1998 and one property subsequent to September 30, 1998. The operating results of these properties have been included in the Company's financial statements from the dates of their acquisitions. In addition, the Company sold four properties in 1999. A summary of these changes as they impact rental and reimbursement income, real estate taxes, and property operating expenses follows: Rental and Real estate Property reimbursement taxes operating income expenses Increase due to inclusion of results of properties acquired $1,520 $546 $332 in 1998 Increase due to properties acquired in 1999 754 119 282 Decrease due to property dispositions in 1999 (691) (113) (149) Improved operations in 1999 as compared to 1998 979 (201) 376 --------------------- ------------------ -------------- Total $2,562 $351 $841 ===================== ================== ============== Interest expense during the quarter ended September 30, 1999 increased by $153 as the Company had greater amounts of debt outstanding in 1999 as compared to 1998. Depreciation and amortization increased in 1999 by $558 as the Company had a gross book value of depreciable assets of $399,760 at September 30, 1999 as compared to $385,022 at September 30, 1998. The Company sold one property during the three months ended September 30, 1999 for a total net gain on sale of $3,203. The Company did not have any material dispositions during the same period of 1998. Nine months ended September 30, 1999 as compared to the nine months ended September 30, 1998 In analyzing the operating results for the nine months ended September 30, 1999, the changes in rental and reimbursement income, real estate taxes and property operating expenses, from 1998 are due principally to the following factors: (1) the addition of operating results from properties acquired in 1998, (2) the addition of operating results from properties acquired in 1999, (3) operating results of properties sold in 1999 and (4) improved operations of properties during 1999 as compared to 1998. The Company acquired three properties during the third quarter of 1998 and one property subsequent to September 30, 1998. The operating results of these properties have been included in the Company's financial statements from the dates of their acquisitions. In addition, the Company sold four properties in 1999. A summary of these changes as they impact rental and reimbursement income, real estate taxes, and property operating expenses follows: Rental and Real estate Property reimbursement taxes operating income expenses Increase due to inclusion of results of properties acquired $9,584 $1,920 $2,147 in 1998 Increase due to properties acquired in 1999 1,249 184 351 Decrease due to property dispositions in 1999 (259) (160) (102) Improved operations in 1999 as compared to 1998 2,113 812 1,141 --------------------- ------------------ -------------- Total $12,687 $2,756 $3,537 ===================== ================== ============== Interest expense during the nine months ended September 30, 1999 increased by $1,995 as the Company had greater amounts of debt outstanding in 1999 as compared to 1998. Depreciation and amortization increased in 1999 by $2,386 as the Company had a gross book value of depreciable assets of $399,760 at September 30, 1999 as compared to $385,022 at September 30, 1998. The Company sold four properties and recorded an anticipated loss on sale of $648 on its Markham, Illinois property during the nine months ended September 30, 1999 for a total net gain on sale of $8,061. The Company did not have any material dispositions during the same period of 1998. Liquidity and Capital Resources The Company expects to meet its short-term liquidity requirements principally through its working capital and net cash provided by operating activities. The Company considers its cash provided by operating activities to be adequate to meet operating requirements and to fund the payment of dividends in order to comply with federal income tax requirements applicable to real estate investment trusts ("REITs"). The Company expects to meet its liquidity requirements for property acquisitions and significant capital improvements through additional borrowings under its existing $150,000 unsecured bank credit facility, which matures in April 2001, and with proceeds from the sale of properties. The Company had $98,000 outstanding under its unsecured bank credit facility at September 30, 1999. The Company expects to meet its long-term liquidity requirements (such as scheduled mortgage debt maturities, property acquisitions and significant capital improvements) through long-term collateralized and uncollateralized borrowings, the issuance of debt or additional equity securities in the Company, and targeted property dispositions. In September 1998, the Company announced a 1,000,000 common share repurchase plan. During the nine months ended September 30, 1999, the Company purchased 278,601 common shares and completed the purchase of 1,000,000 common shares under this plan at an average cost to the Company of $15.34 per share. In March 1999, the Company announced that its board of trustees approved the repurchase of up to 500,000 common shares under a separate repurchase plan. As of September 30, 1999, the Company had repurchased 500,000 common shares as part of the new plan at an average cost to the Company of $15.50 per share. Common share repurchases totaled $12,157 for the nine months ended September 30, 1999 under the two plans. These common share repurchases were funded through borrowings under the Company's unsecured bank credit facility, proceeds from property dispositions and working capital. During the nine months ended September 30, 1999, the Company generated approximately $22,000 of net proceeds from property dispositions. These dispositions are consistent with the Company's strategy to seek to enhance shareholder value in part through strategic dispositions. The net proceeds from the sales were or will be used to repay borrowings under its unsecured bank credit facility, to repurchase common shares, to acquire additional investment properties and for working capital. The Company has signed a contract to sell its Markham, Illinois, property for $514. The Company anticipates closing this transaction in the fourth quarter of 1999. The Company has committed to acquire, upon completion, an office building under construction in Pewaukee, Wisconsin for a maximum contract price of $11,400. The Company expects to close this acquisition in December 1999. The Company has obtained a $500 letter of credit under its unsecured bank credit facility as a deposit towards the purchase of this property. Funds from Operations (FFO) The White Paper on Funds From Operations approved by the Board of Governors of the National Association of Real Estate Investment Trusts in March 1995 (the "White Paper") defines FFO as net income (loss) (computed in accordance with generally accepted accounting principles), excluding gains or losses from debt restructuring and sales of property, plus real estate depreciation and amortization and after adjustments for unconsolidated partnerships and joint ventures. Management considers FFO to be an appropriate measure of performance of an equity REIT because it is predicated on cash flow analyses. The Company computes FFO in accordance with standards established by the White Paper (except for the amortization of deferred compensation related to restricted stock awards). The Company's method of computing FFO may differ from the methodology for calculating FFO utilized by other equity REITs and, accordingly, may not be comparable to other equity REITs. FFO should not be considered as an alternative to net income (determined in accordance with generally accepted accounting principles) as an indicator of the Company's financial performance or to cash flow from operating activities (determined in accordance with generally accepted accounting principles) as a measure of the Company's liquidity. FFO is not indicative of funds available to fund the Company's working capital and other cash needs, including distributions to shareholders. FFO for the three and nine months ended September 30, 1999 and 1998 is as follows (dollars in thousands): Nine months ended Three months ended September 30, September 30, 1999 1998 1999 1998 Net income applicable to common shares $20,391 $12,376 $7,625 $4,247 Gain on sale of properties, net (8,061) (3,203) Depreciation and amortization 11,307 8,827 3,917 3,384 Minority interests 79 41 30 18 ----------------- ----------------- ---------------- --------------- FFO $23,716 $21,244 $8,369 $7,649 ================= ================= ================ =============== Forward-Looking Statements Certain statements in this document constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Acts of 1934, and the Company intends that such "forward-looking statements" be subject to the safe harbors created thereby. The words "believe", "expect" and "anticipate" and similar expressions identify forward-looking statements. In addition, statements regarding the Company's expectations with respect to its short-term and long-term liquidity requirements and related sources, statements regarding the anticipated timing and proceeds related to planned property dispositions and expenditures regarding the timing of property acquisitions are forward-looking statements. These forward-looking statements reflect the Company's current views with respect to future events and financial performance, but are subject to many uncertainties and factors relating to the Company's operations and business environment that may cause the actual results of the Company to be materially different from any future results expressed or implied by such forward-looking statements. Examples of such uncertainties include, but are not limited to, changes in interest rates, changes in the market value of the Company's equity securities, increased competition for acquisition of new properties, availability of alternative financing sources, changes in the timing of property sales and acquisitions, changes in the market value of properties expected to be sold, unanticipated expenses related to sale or acquisition transactions, or changes in occupancy rates and economic and business conditions in the markets in which the Company owns and operates properties. In addition, many of the statements below with respect to Year 2000 issues and status are forward-looking statements and are subject to the uncertainties expressed below. Year 2000 Issues and Status The Company recognizes the importance of Year 2000 issues and in 1998 initiated a program of evaluation, remediation and testing of the systems and equipment serving its business and properties for Year 2000 readiness. The Company is also assessing the readiness of external parties, including its suppliers, vendors, bankers, insurers and other service providers, as well as its tenants. The evaluation phase is intended to determine the readiness of internal systems and equipment as well as the readiness of third parties. The remediation phase includes computer software, hardware and operating equipment as well as identifying solutions to possible third party noncompliance. The testing phase includes integrated testing of all systems, including those that have been modified. Amounts incurred through September 30, 1999 for evaluation, remediation and testing costs were $178. The Company expects to incur an additional $180 of costs by December 31, 1999. The current status of the Company's state of readiness and expected completion dates for evaluation, remediation and testing related to Year 2000 issues are summarized below: Financial software: The evaluation of the Company's financial software is 100% complete. Because the Company believes this software is Year 2000 compliant, the Company believes that no remediation is required. The Company is testing whether the financial items are in fact Year 2000 compliant and expects to complete such testing in November 1999. Networking software: In the first quarter of 1999 the Company completed the upgrade of its internal computer networking software and hardware to a system that the Company believes is Year 2000 compliant. Building systems: Building systems include heating and air-conditioning control systems, elevator operating software, building security systems, telephone systems and alarm monitoring systems. The Company has contacted its significant vendors related to these systems in order to evaluate Year 2000 issues with respect to embedded technology related to these building systems. During the evaluation process the Company identified several building systems in certain of its properties that needed modification or replacement to be Year 2000 compliant. Based upon information the Company has received from its vendors and its own remediation and testing program, the Company believes that the impact of any system failure is not likely to be material. Tenants: The Company has contacted its tenants regarding their Year 2000 readiness, including whether the respective tenant's accounts payable systems will be able to make required payments on a timely basis which are due after December 31, 1999. Based upon the responses received to date the Company does not anticipate rent collections will be materially affected by Year 2000 compliance issues. The Company has received responses from 33 % (based on square feet occupied) of its tenants. These responses indicate that the tenants expect to make payments after December 31, 1999 on a timely basis. The Company believes that internal remediation and testing of financial and networking technology systems and building systems will be completed as indicated above and will not adversely affect the results of operations or financial condition of the Company. If any or all of these efforts are delayed, however, there could be disruption of the Company's financial, networking and building systems. Critical third party vendors, suppliers and service providers have been contacted to evaluate their Year 2000 readiness. However, not all external parties providing equipment, materials and services to the Company, including regional utilities, have assured the Company that their systems or products are fully Year 2000 compliant. There may be vendors, suppliers and tenants who will not be compliant on a timely basis or who will fail to become compliant with Year 2000 issues. Accordingly, there can be no assurance that the Company's operations will not be disrupted as a result of Year 2000 issues. The Company is in the process of developing contingency plans, as part of the remediation phases indicated above, in an effort to provide a continued supply of building services or to mitigate the effect of any service disruptions or equipment failures that may occur. These contingency plans are expected to be completed and implemented during the fourth quarter of 1999. The Company believes that, even in the most likely, worst case scenario, Year 2000 issues are not likely to have a material adverse effect on the Company's business, results of operations and financial condition. However, the economic consequences of real or anticipated disruptions related to Year 2000 issues, including a global economic slowdown, could have a material adverse effect on the Company's business, results of operations or financial condition. ITEM 3. MARKET RISK (Dollars in thousands) The Company's interest income is sensitive to changes in the general levels of U.S. short-term interest rates. The Company's interest expense is sensitive to changes in the general level of U.S. short-term and long-term interest rates as the Company has indebtedness outstanding at fixed and variable rates. The Company's variable rate debt bears interest at LIBOR plus 1% to 1.3% per annum depending on overall Company leverage. Increases in LIBOR rates would increase the Company's interest expense and reduce its cash flow. Conversely, declines in LIBOR rates would decrease its interest expense and increase its cash flow. The Company has entered into an interest rate cap agreement with a major financial institution whereby the Company limited the LIBOR interest rate on $50,000 of its variable rate debt to no more than 6% per annum until June 2001. The cost of this agreement to the Company was $209 and is being amortized to expense over the period of the agreement (24 months). The Company may, in the future, enter into additional interest rate swaps, interest rate caps or other derivative financial instruments to fix interest rates on its variable rate debt. The Company generally operates with variable rate debt representing less than 50% of total long-term debt. At September 30, 1999, the Company had $100,713 of fixed rate debt outstanding at an average rate of 6.96 %. If the general level of interest rates in the United States were to fall, the Company would not likely have the opportunity to refinance this fixed rate debt at lower interest rates due to prepayment restrictions and penalties on its fixed rate debt. In general, the Company believes long-term fixed rate debt is preferable as a financing vehicle for its operations due to the long-term fixed contractual rental income the Company receives from its tenants. As a result, 74% of the Company's long-term debt outstanding (including the interest rate cap agreement described above) at September 30, 1999, bears interest at fixed rates. The Company may, as market conditions warrant, incur additional long-term debt at fixed rates on either a secured or unsecured basis. A tabular presentation of interest rate sensitivity is as follows: Interest Rate Sensitivity Principal Amount by Expected Maturity Average Interest Rate 1999(1) 2000 2001 2002 2003 Thereafter Liabilities: Fixed Rate Mortgage loans payable $758 $2,484 $2,660 $2,851 $13,860 $78,100 Average interest rate 6.97% 6.97% 6.97% 6.97% 7.06% 6.94% Variable Rate Bank loan payable $98,000 Average interest rate(2) Bonds payable $280 $310 $340 $375 $3,245 Average interest rate (3) (3) (3) (3) (3) (3) (1) For the period October 1, 1999 to December 31, 1999. (2) The current interest rate on this debt is LIBOR + 1.3%. (3) The interest rate on the bonds payable is reset weekly. After factoring in credit enhancement costs for the bonds, the average interest rate for the nine months ended September 30, 1999 was 5.1%. Part II Other Information Item 2. Changes in Securities (Dollars in thousands) During the quarter ended September 30, 1999, the Company issued 3,518 unregistered common shares pursuant to the exercise of outstanding share options with an aggregate exercise price of $42. These shares were issued to the optionholders pursuant to the exemption from the registration requirements of the Securities Act of 1933, as amended (the "Act"), provided by Section 4(2) of the Act, including Rule 701 thereunder. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits The following exhibits are filed with this report: Exhibit Number Description of Document - ------ ----------------------- 27.1 Financial Data Schedule (b) Reports on Form 8-K: No reports on Form 8-K were filed during the quarter ended September 30, 1999. 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. Great Lakes REIT (Registrant) Date: November 12, 1999 /s/ James Hicks Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)