UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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Form 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006
COMMISSION FILE NUMBER 1-8383
Mission West Properties, Inc.
(Exact name of registrant as specified in its charter)
Maryland 95-2635431
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(State or other jurisdiction of (I.R.S. Employer Identification
incorporation or organization) Number)
10050 Bandley Drive
Cupertino, California 95014-2188
(Address of principal executive offices)
Registrant's telephone number, including area code is (408) 725-0700
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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 a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Exchange Act Rule 12b-2). Yes [ ] No [X]
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:
19,397,287 shares outstanding as of October 31, 2006
Mission West Properties, Inc.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2006
INDEX
Page
Part I Financial Information
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as of September 30, 2006
and December 31, 2005 (unaudited).......................................................................2
Condensed Consolidated Statements of Operations for the three and
nine months ended September 30, 2006 and 2005 (unaudited)...............................................3
Condensed Consolidated Statements of Cash Flows for the
nine months ended September 30, 2006 and 2005 (unaudited)...............................................4
Notes to Condensed Consolidated Financial Statements (unaudited)........................................5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations....................................................................12
Item 3. Quantitative and Qualitative Disclosures about Market Risk.............................................23
Item 4. Controls and Procedures................................................................................24
Part II Other Information
Item 1. Legal Proceedings......................................................................................25
Item 1A. Risk Factors...........................................................................................25
Item 6. Exhibits...............................................................................................25
Signatures........................................................................................................26
Exhibits
Exhibit 31.1 - Certification Pursuant to Rule 13a-14(a) of the
Securities Exchange Act of 1934
Exhibit 31.2 - Certification Pursuant to Rule 13a-14(a) of the
Securities Exchange Act of 1934
Exhibit 31.3 - Certification Pursuant to Rule 13a-14(a) of the
Securities Exchange Act of 1934
Exhibit 32 - Certification of CEO and CFO Pursuant to 18 U.S.C.
ss. 1350, as Adopted Pursuant to ss. 906 of the
Sarbanes-Oxley Act of 2002
- 1 -
PART I - FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MISSION WEST PROPERTIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share and per share amounts)
(unaudited)
---------
September 30, 2006 December 31, 2005
--------------------- ----------------------
ASSETS
Real estate assets, at cost:
Land $ 272,222 $ 273,933
Buildings and improvements 753,668 766,457
Real estate related intangible assets 19,529 17,410
--------------------- ----------------------
Total investments in properties 1,045,419 1,057,800
Less accumulated depreciation and amortization (143,344) (130,419)
Assets held for sale, net 24,633 -
--------------------- ----------------------
Net investments in properties 926,708 927,381
Cash and cash equivalents 42,443 31,441
Restricted cash 6,893 16,712
Deferred rent receivable, net 18,170 19,218
Investment in unconsolidated joint venture 3,472 3,263
Other assets, net 25,537 25,362
--------------------- ----------------------
Total assets $1,023,223 $1,023,377
===================== ======================
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Mortgage notes payable $ 350,000 $ 357,481
Mortgage notes payable (related parties) 9,756 10,051
Interest payable 321 321
Security deposits 6,727 8,047
Deferred rental income 9,288 6,103
Liabilities related to assets held for sale 383 -
Dividends and distributions payable 16,741 16,725
Accounts payable and accrued expenses 13,694 8,952
--------------------- ----------------------
Total liabilities 406,910 407,680
--------------------- ----------------------
Commitments and contingencies (Note 9)
Minority interests 490,122 500,682
--------------------- ----------------------
Stockholders' equity:
Preferred stock, $.001 par value, 20,000,000 shares authorized,
none issued and outstanding - -
Common stock, $.001 par value, 200,000,000 shares authorized,
19,397,287 and 18,448,791 shares issued and outstanding
at September 30, 2006 and December 31, 2005 19 18
Paid-in-capital 148,993 138,038
Accumulated deficit (22,821) (23,041)
--------------------- ----------------------
Total stockholders' equity 126,191 115,015
--------------------- ----------------------
Total liabilities and stockholders' equity $1,023,223 $1,023,377
===================== ======================
The accompanying notes are an integral part of these
condensed consolidated financial statements.
- 2 -
MISSION WEST PROPERTIES, INC
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except share and per share amounts)
(unaudited)
---------
Three months ended September 30, Nine months ended September 30,
-------------------------------------- --------------------------------------
2006 2005 2006 2005
------------------ ------------------- -------------------- -----------------
Revenues:
Rental revenue from real estate $22,107 $23,935 $67,271 $73,753
Tenant reimbursements 3,274 3,779 9,424 10,722
Lease termination fees - - 16,068 478
Other income, including interest 1,047 423 2,862 2,530
------------------ ------------------- -------------------- -----------------
Total revenues 26,428 28,137 95,625 87,483
------------------ ------------------- -------------------- -----------------
Expenses:
Property operating, maintenance and real estate taxes 5,002 5,092 13,672 13,576
Interest 5,172 5,494 15,580 16,046
Interest (related parties) 188 229 569 779
General and administrative 531 424 1,803 1,542
Depreciation and amortization of real estate 5,569 5,111 16,161 15,432
------------------ ------------------- -------------------- -----------------
Total expenses 16,462 16,350 47,785 47,375
------------------ ------------------- -------------------- -----------------
Income before equity in earnings of unconsolidated
joint venture and minority interests 9,966 11,787 47,840 40,108
Equity in earnings of unconsolidated joint venture 857 291 1,538 677
Minority interests (8,714) (10,009) (40,170) (33,718)
------------------ ------------------- -------------------- -----------------
Income from continuing operations 2,109 2,069 9,208 7,067
------------------ ------------------- -------------------- -----------------
Discontinued operations, net minority interests:
Gain on disposal of discontinued operations - 291 - 305
(Loss)/income attributable to discontinued operations (3) 91 172 182
------------------ ------------------- -------------------- -----------------
(Loss)/income from discontinued operations (3) 382 172 487
------------------ ------------------- -------------------- -----------------
Net income available to common stockholders $2,106 $ 2,451 $ 9,380 $ 7,554
================== =================== ==================== =================
Net income available to minority interests $8,700 $11,541 $41,057 $35,823
================== =================== ==================== =================
Income per common share from continuing operations:
Basic $0.11 $0.11 $0.49 $0.39
================== =================== ==================== =================
Diluted $0.11 $0.11 $0.48 $0.39
================== =================== ==================== =================
Income per common share from discontinued operations:
Basic - $0.02 $0.01 $0.02
================== =================== ==================== =================
Diluted - $0.02 $0.01 $0.02
================== =================== ==================== =================
Net income per common share:
Basic $0.11 $0.13 $0.50 $0.41
================== =================== ==================== =================
Diluted $0.11 $0.13 $0.49 $0.41
================== =================== ==================== =================
Weighted average shares ofcommon stock outstanding(basic) 19,350,672 18,356,278 18,948,214 18,242,495
================== =================== ==================== =================
Weighted average shares of common stock outstanding(diluted)19,418,884 18,407,891 19,024,662 18,289,699
================== =================== ==================== =================
The accompanying notes are an integral part of these
condensed consolidated financial statements.
- 3 -
MISSION WEST PROPERTIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(unaudited)
---------
Nine months ended September 30,
--------------------------------------
2006 2005
------------------- ------------------
Cash flows from operating activities:
Net income $ 9,380 $ 7,554
Adjustments to reconcile net income to net cash provided by operating activities:
Minority interests 41,057 35,823
Minority interest distributions (41,057) (35,823)
Depreciation and amortization of real estate and in-place leases 16,632 16,321
Amortization of above market lease 1,416 1,416
Gain on sale of real estate - (1,408)
Equity in earnings of unconsolidated joint venture (1,538) (677)
Distributions from unconsolidated joint venture 1,330 765
Interest earned on restricted cash (314) -
Lease termination fee income related to restricted cash (6,748) -
Stock-based compensation expense 176 -
Other 35 -
Changes in operating assets and liabilities:
Deferred rent receivable 1,048 (791)
Other assets (175) (5,159)
Security deposits (1,300) (110)
Deferred rental income 3,185 653
Accounts payable and accrued expenses 5,048 4,346
------------------- ------------------
Net cash provided by operating activities 28,175 22,910
------------------- ------------------
Cash flows from investing activities:
Improvements to real estate assets (1,349) (871)
Proceeds from sale of real estate - 12,447
Purchase of real estate (15,959) (14,184)
Restricted cash used for purchase of real estate 13,447 -
Excess restricted cash 1,835 -
------------------- ------------------
Net cash used in investing activities (2,026) (2,608)
------------------- ------------------
Cash flows from financing activities:
Proceeds from mortgage loan - 150,800
Principal payments on mortgage notes payable (7,481) (5,021)
Principal payments on mortgage notes payable (related parties) (295) (274)
Net payments under line of credit (related parties) - (9,560)
Payment on mortgage loan payable - (78,710)
Net payments under revolving line of credit - (24,208)
Refund of appeal bond 1,551 -
Proceeds from exercised stock options 802 480
Distributions paid to minority interests in excess of earnings (717) (6,156)
Dividends paid (9,007) (8,729)
------------------- ------------------
Net cash (used in)/provided by financing activities (15,147) 18,622
------------------- ------------------
Net increase in cash and cash equivalents 11,002 38,924
Cash and cash equivalents, beginning of period 31,441 1,519
------------------- ------------------
Cash and cash equivalents, end of period $42,443 $40,443
=================== ==================
Supplemental information:
Cash paid for interest $15,944 $16,471
=================== ==================
Supplemental schedule of non-cash investing and financing activities:
Issuance of common stock upon conversion of O.P. units $ 9,977 $ 2,197
=================== ==================
The accompanying notes are an integral part of these
condensed consolidated financial statements.
- 4 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
1. ORGANIZATION AND FORMATION OF THE COMPANY
Mission West Properties, Inc. ("the Company") is a fully integrated,
self-administered and self-managed real estate company that acquires and
manages R&D/office properties in the portion of the San Francisco Bay Area
commonly referred to as Silicon Valley. In July 1998, the Company purchased
an approximate 12.11% of four existing limited partnerships (referred to
collectively as the "operating partnerships") and obtained control of these
partnerships by becoming the sole general partner in each one effective
July 1, 1998 for financial accounting and reporting purposes. All limited
partnership interests in the operating partnerships were converted into
59,479,633 operating partnership ("O.P.") units, which represented a
limited partnership ownership interest of approximately 87.89% of the
operating partnerships. The operating partnerships are the vehicles through
which the Company holds its real estate investments, makes real estate
acquisitions, and generally conducts its business.
On December 30, 1998, the Company was reincorporated under the laws of the
State of Maryland through a merger with and into Mission West Properties,
Inc. Accordingly, shares of the former company, Mission West Properties, a
California corporation (no par), which were outstanding at December 30,
1998, were converted into shares of common stock, $.001 par value per
share, on a one-for-one basis.
As of September 30, 2006, the Company owns a controlling general
partnership interest of 18.81%, 21.70%, 16.20% and 12.43% in Mission West
Properties, L.P., Mission West Properties, L.P. I, Mission West Properties,
L.P. II and Mission West Properties, L.P. III, respectively, which
represents an 18.12% general partnership interest in the operating
partnerships, taken as a whole, on a consolidated weighted average basis.
Through the operating partnerships, the Company owns interests in 110 R&D
properties, all of which are located in Silicon Valley.
The Company has elected to be taxed as a real estate investment trust
("REIT") under the Internal Revenue Code of 1986, as amended. Accordingly,
no provision has been made for income taxes for the three and nine months
ended September 30, 2006 and 2005.
BUSINESS SEGMENT INFORMATION
The Company's primary business is the ownership and management of
R&D/office real estate with a geographic concentration in the Silicon
Valley of the San Francisco Bay Area. Accordingly, the Company has
concluded it currently has a single reportable segment for Statement of
Financial Accounting Standards ("SFAS") No. 131, "Disclosures about
Segments of an Enterprise and Related Information," purposes.
2. BASIS OF PRESENTATION
PRINCIPLES OF CONSOLIDATION AND FINANCIAL STATEMENT PRESENTATION
The accompanying unaudited interim condensed consolidated financial
statements of the Company have been prepared in accordance with Rule 10-01
of Regulation S-X promulgated by the Securities and Exchange Commission
and, therefore, do not include all information and footnotes necessary for
a fair presentation of financial position, results of operations and cash
flows in conformity with accounting principles generally accepted in the
United States of America. In the opinion of the Company, however, the
accompanying unaudited interim condensed consolidated financial statements
contain all adjustments, consisting only of normal recurring adjustments,
necessary to present fairly the Company's consolidated financial position
as of September 30, 2006, their consolidated results of operations for the
three and nine months ended September 30, 2006 and 2005, and their cash
flows for the nine months ended September 30, 2006 and 2005. All
significant intercompany balances have been eliminated in consolidation.
The condensed consolidated financial statements as of September 30, 2006
and for the three and nine months ended September 30, 2006 and 2005 and
related footnote disclosures are unaudited. The results of operations for
the three and nine months ended September 30, 2006 are not necessarily
indicative of the results to be expected for the entire year.
The year-end condensed consolidated balance sheet data was derived from
audited financial statements, but does not include all disclosures required
by accounting principles generally accepted in the United States of
America.
The Company also consolidates all variable interest entities ("VIE") in
which it is deemed to be the primary beneficiary in accordance with FASB
Interpretation No. 46R ("FIN 46R"). As of September 30, 2006, the Company
consolidated one VIE in the accompanying condensed consolidated balance
sheet in connection with an assignment of a lease agreement with an
unrelated party, M&M Real Estate Control & Restructuring, LLC (see Note 4
for further discussion of this transaction).
- 5 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
STOCK-BASED OPTION COMPENSATION ACCOUNTING
In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment"
("SFAS No. 123R"), which addresses the accounting for employee and director
stock options. Statement 123R requires that the cost of all employee and
director stock options, as well as other equity-based compensation
arrangements, be reflected in the financial statements based on the
estimated fair value of the awards. SFAS No. 123R is an amendment to SFAS
No. 123 and supersedes Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25"). SFAS No. 123R is
applicable to any award that is settled or measured in stock, including
stock options, restricted stock, stock appreciation rights, stock units,
and employee stock purchase plans. At September 30, 2006, the Company had
one stock-based compensation plan. The Company has adopted the requirements
of SFAS No. 123R effective January 1, 2006 using the modified prospective
method of transition. Accordingly, prior periods have not been restated.
The adoption of this standard did not have a material effect on the
Company's condensed consolidated statements of operations, cash flows or
financial position.
The Company measures compensation cost for its stock options at fair value
on the date of grant and recognizes compensation expense relating to the
remaining unvested portion of outstanding stock options at the time of
adoption ratably over the vesting period, generally four years. The fair
value of the Company's stock options is determined using the Black-Scholes
option pricing model. Compensation expense related to the Company's
share-based awards is included in general and administrative expenses in
the Company's accompanying condensed consolidated statements of operations.
Under SFAS No. 123R, the Company recorded $59 and $176 of expense for
share-based compensation relating to grants of stock options for the three
and nine months ended September 30, 2006, respectively.
As of September 30, 2006, there was $150 of total unrecognized compensation
cost related to unvested share-based compensation arrangements granted
under the compensation plan. That cost is expected to be recognized over a
weighted-average period of 1.2 years.
For 2005 and all prior years, the Company had elected to follow APB 25 and
related interpretations in accounting for its employee and non-employee
director stock options. SFAS No. 123, "Accounting for Stock-Based
Compensation," encourages, but does not require, companies to record
compensation cost for stock-based employee compensation plans at fair value
prior to year 2006. Under APB 25, no compensation expense related to stock
options had been recognized because the exercise price of the granted
options equaled the market price of the underlying stock on the date of
grant. Although the Company had elected to follow APB 25 for previously
granted options prior to January 1, 2006, pro forma information regarding
net income and net income per share is required by SFAS No. 123R for all
periods presented prior to 2006. This information has been determined as if
the Company had accounted for stock options under the fair value method
under SFAS 123.
The following table illustrates the unaudited pro forma effect on
consolidated net income available to common stockholders and consolidated
earnings per share if the fair value method had been applied to all
outstanding and unvested stock options for the three and nine months ended
September 30, 2005.
Three Months Ended Nine Months Ended
September 30, 2005 September 30, 2005
--------------------------- ---------------------------
(dollars in thousands, except per share data)
Historical net income to common stockholders, as reported $2,451 $7,554
Add back compensation expense for stock options included
in historical net income to common stockholders - -
Deduct compensation expense for stock options determined
under fair value based method (51) (110)
Allocation of compensation expense to minority interests 42 91
--------------------------- ---------------------------
Pro forma net income to common stockholders $2,442 $7,535
=========================== ===========================
Earnings per share - basic:
Historical net income to common stockholders, as reported $0.13 $0.41
Pro forma net income to common stockholders $0.13 $0.41
Earnings per share - diluted:
Historical net income to common stockholders, as reported $0.13 $0.41
Pro forma net income to common stockholders $0.13 $0.41
MINORITY INTERESTS
Minority interests represent the separate private ownership of the
operating partnerships by the Berg Group (defined as Carl E. Berg, his
brother Clyde J. Berg, members of their respective immediate families, and
certain entities they control) and other non-affiliate interests. As of
September 30, 2006, these interests accounted for approximately 81.88% of
the ownership interests in the real estate operations of the Company on a
consolidated weighted average basis. Minority interests in net income is
calculated by taking the net income of the operating partnerships (on a
stand-alone basis) multiplied by the respective weighted average minority
interests ownership percentage.
- 6 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
Allocation of corporate general and administrative expenses to the
operating partnerships is performed based upon shares and operating
partnership units outstanding for each operating partnership in relation to
the total for all four operating partnerships.
RECLASSIFICATIONS
Certain reclassifications have been made to the previously reported 2005
condensed consolidated financial statements in order to conform to the 2006
presentation.
The following notes, which present interim disclosures as required by the
SEC, highlight significant changes to the notes to the Company's December
31, 2005 audited condensed consolidated financial statements and should be
read together with the condensed consolidated financial statements and
notes thereto included in the Company's 2005 Form 10-K filed on March 16,
2006.
3. RESTRICTED CASH
Restricted cash totaled $6,893 as of September 30, 2006. This amount
represents a balance that is consolidated due to the Company's adoption of
FIN 46R, "Consolidation of Variable Interest Entities." The Company does
not have possession or control over these funds or any right to receive
them except in accordance with the payment terms of the lease agreement
that has been assigned to the VIE. See Note 4 below for further discussion.
4. VARIABLE INTEREST ENTITY
In December 2003, the FASB issued FIN 46R, a revision to FIN 46, which was
issued in January 2003. Under FIN 46R, a variable interest entity must be
consolidated by a company if that company is subject to a majority of the
entity's expected losses or entitled to receive a majority of the entity's
expected residual returns or both. FIN 46R requires disclosures about
variable interest entities that a company is not required to consolidate,
but in which it has a significant variable interest.
In March 2006, one of the Company's tenants, JDS Uniphase ("JDS"), entered
into an assignment of lease agreement with an unrelated party, M&M Real
Estate Control & Restructuring, LLC ("M&M"), in connection with leases for
approximately 252,000 rentable square feet located in San Jose, California.
M&M assumed all of JDS's remaining obligations under these leases, acquired
certain personal property of JDS located on the premises and received a
payment of approximately $11,147. At the same time, the Company entered
into a consent for assignment of lease with both parties and a mutual
release agreement with JDS, pursuant to which all of the JDS's obligations
under these leases have been effectively transferred to M&M. M&M must
continue to perform all of the obligations under the assumed JDS leases and
has the right to sublease any or all of the 252,000 rentable square feet
vacated by JDS for the remainder of the current lease terms, which expire
in 2006 and 2007. Under the terms of the agreement, the Company will
receive monthly rent payments of approximately $733 from April 2006 through
December 2006, $545 from January 2007 through August 2007 and $330 from
September 2007 through November 2007. Based upon the provisions of FIN 46R,
the Company determined that M&M is a variable interest entity. The Company
further determined that the Company is the primary beneficiary of this
variable interest entity and therefore has consolidated this entity for
financial reporting purposes. Upon consolidation, the Company recognized a
lease termination fee of $11,147 in March 2006.
5. STOCK TRANSACTIONS
During the nine months ended September 30, 2006, stock options to purchase
65,000 shares of common stock were exercised at $8.25 per share and 26,600
shares of common stock were exercised at $10.00 per share. Total proceeds
to the Company were $802. During the same period, four limited partners
exchanged a total of 856,896 O.P. units for 856,896 shares of the Company's
common stock under the terms of the Exchange Rights Agreement among the
Company and all limited partners of the operating partnerships resulting in
a reclassification of $9,977 from minority interests to paid-in-capital.
Neither the Company nor the operating partnerships received any proceeds
from the issuance of the common stock in exchange for O.P. units.
6. REAL ESTATE ASSETS HELD FOR SALE/DISCONTINUED OPERATIONS
Effective January 1, 2002, the Company adopted SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets," which addresses
financial accounting and reporting for the impairment and disposal of long
lived assets. In general, income or loss attributable to the operations and
sale of property and the operations related to property held for sale is
classified as discontinued operations in the condensed consolidated
statements of operations. Prior period condensed consolidated statements of
operations presented in this report have been reclassified to reflect the
income or loss related to properties that were held for sale and presented
as discontinued operations during the three and nine months ended September
30, 2006. All periods presented in this report will likely require further
reclassification in future periods if there are properties held for sale or
property sales occur.
- 7 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
As of September 30, 2006, there were three properties under contract to be
sold or otherwise disposed of which would qualify as assets held for sale
or discontinued operations. The Company classified those three properties
as assets held for sale and discontinued operations because the Company
committed to an action to sell the properties, the properties had a buyer
and were available for immediate sale in their present condition (subject
to terms that are usual and customary for sales of such property), the sale
was probable and actions required to complete the plan indicated that it
was unlikely that significant changes to the plan would be made or that the
plan would be withdrawn. As of September 30, 2005, there was one property
under contract to be sold or otherwise disposed of which qualified as an
asset held for sale or discontinued operations. That property was sold for
$15,105 in October 2005. During the first quarter of 2005, the Company sold
two properties for a combined sales price of $12,750. Condensed results of
operations for these properties for the three and nine months ended
September 30, 2006 and 2005 are as follows:
Three Months Ended September 30, Nine Months Ended September 30,
2006 2005 2006 2005
------------- ------------- ------------ ------------
(dollars in thousands)
(unaudited)
Revenues
Rental revenue from real estate $254 $ 757 $1,734 $2,305
Tenant reimbursements 37 253 262 532
Other income 22 3 28 10
------------- ------------- ------------ ------------
Total revenues 313 1,013 2,024 2,847
------------- ------------- ------------ ------------
Expenses
Property operating, maintenance and real estate taxes 172 $210 494 775
Depreciation 158 234 471 889
------------- ------------- ------------ ------------
Total expenses 330 444 965 1,664
------------- ------------- ------------ ------------
(Loss)/income attributable to discontinued operations (17) 569 1,059 1,183
Gain on disposal of discontinued operations - 1,345 - 1,408
Minority interests in loss/(earnings) attributable to
discontinued operations 14 (1,532) (887) (2,104)
------------- ------------- ------------ ------------
(Loss)/income from discontinued operations (3) $ 382 $ 172 $ 487
============= ============= ============ ============
For the three and nine months ended September 30, 2006 and 2005, income and
loss from discontinued operations included results of operations from
assets held for sale at September 30, 2006 and three properties that were
sold in 2005.
A deferred gain of approximately $1,408 was recorded on one of the disposed
properties in 2005. The gain was recognized as revenue based on the
installment method of profit recognition because the purchaser of the
property did not make a sufficiently large down payment under SFAS No. 66,
"Accounting for Sales of Real Estate" ("SFAS No. 66"). SFAS No. 66
establishes accounting standards for recognizing profit or loss on sales of
real estate. Gain on the sale is recognized proportionately as the seller
receives payments from the purchaser. Interest income is recognized on an
accrual basis, when appropriate. The Company recorded a $63 gain in the
first quarter of 2005. In September 2005, the Company received the
remaining balance of the sales price from the purchaser and the remaining
gain of $1,345 was recognized in the third quarter of 2005.
7. NET INCOME PER SHARE
Basic operating net income per share is computed by dividing net income by
the weighted average number of common shares outstanding for the period.
Diluted operating net income per share is computed by dividing net income
by the sum of the weighted-average number of common shares outstanding for
the period plus the assumed exercise of all dilutive securities using the
treasury stock method.
The computation for weighted average shares is detailed below:
Three Months Ended September 30, Nine Months Ended September 30,
2006 2005 2006 2005
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (basic) 19,350,672 18,356,278 18,948,214 18,242,495
Incremental shares from assumed option exercise 68,212 51,613 76,448 47,204
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (diluted) 19,418,884 18,407,891 19,024,662 18,289,699
=============== ============== ============== ===============
Outstanding options to purchase 647,000 shares in 2006 and 2005 were
excluded from the computation of diluted net income per share under the
treasury stock method because the option exercise price was greater than
the weighted average exercise price of the Company's common stock during
the respective periods. The outstanding O.P. units, which are exchangeable
at the unit holder's option, subject to certain conditions, for shares of
common stock on a one-for-one basis have been excluded from the diluted net
income per share calculation, as there would be no effect on the
calculation after adding the minority interests' share of income back
- 8 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
to net income. The total number of O.P. units outstanding at September 30,
2006 and 2005 was 85,231,199 and 86,169,195, respectively.
8. RELATED PARTY TRANSACTIONS
As of September 30, 2006, the Berg Group owned 77,480,228 O.P. units. The
Berg Group's combined ownership of O.P. units and shares of common stock as
of September 30, 2006 represented approximately 74% of the total equity
interests, assuming conversion of the 85,231,199 O.P. units outstanding
into the Company's common stock.
As of September 30, 2006, debt in the amount of $9,756 was due the Berg
Group under a mortgage note established on May 15, 2000 in connection with
the acquisition of a 50% interest in Hellyer Avenue Limited Partnership,
the obligor under the mortgage note. The mortgage note bears interest at
7.65% and is due in June 2010 with principal payments amortized over 20
years. Interest expense incurred in connection with the Berg Group line of
credit, which was terminated in October 2005, and the mortgage note was
$188 and $229 for the three months ended September 30, 2006 and 2005,
respectively, and $569 and $779 for the nine months ended September 30,
2006 and 2005, respectively.
During the first nine months of 2006 and 2005, Carl E. Berg or entities
controlled by Mr. Berg held financial interests in several companies that
lease space from the operating partnerships, which include three companies
in which Mr. Berg has a greater than 10% ownership interest. These related
tenants occupy approximately 48,000 square feet and contributed $162 in
rental revenue during the three months ended September 30, 2006 and 2005,
and $486 and $570 in rental revenue during the nine months ended September
30, 2006 and 2005, respectively. Under the Company's charter, bylaws and
agreements with the Berg Group, the individual members of the Berg Group
are prohibited from acquiring or holding shares of the Company's common
stock if such acquisition would result in their beneficial ownership
percentage of the Company's common stock causing the Company to violate any
REIT qualification requirement.
In March 2006, the Company and Fujitsu Limited, or Fujitsu, agreed to the
termination of a lease for one building consisting of approximately 125,000
rentable square feet. Fujitsu is responsible for repairing damage to the
building and with the Company's Independent Directors Committee approval
has hired Berg & Berg Enterprises, LLC to perform the restoration work for
a total of approximately $4,500.
The Berg Group has an approximately $2,500 commitment to complete certain
tenant improvements in connection with the Company's 2002 acquisition of
5345 Hellyer Avenue in San Jose. The Company has recorded this portion of
the purchase price paid to the Berg Group as an "Other asset" on its
condensed consolidated balance sheets. The Berg Group plans to satisfy this
commitment to complete certain tenant improvements when requested by the
Company following the approval of the Independent Directors Committee.
The Berg Group has an approximately $7,500 commitment to complete an
approximately 75,000 to 90,000 square foot building in connection with the
Company's 2001 acquisition of 245 Caspian in Sunnyvale which is comprised
of approximately three acres of unimproved land. The Company has recorded
this portion of the purchase price paid to the Berg Group as an "Other
asset" on its condensed consolidated balance sheets. The Berg Group plans
to satisfy this commitment to construct a building when requested by the
Company following the approval of the Independent Directors Committee.
The Company currently leases office space owned by Berg & Berg Enterprises,
Inc., an affiliate of Carl E. Berg and Clyde J. Berg. Rental amounts and
overhead reimbursements paid to Berg & Berg Enterprises, Inc. were $23 for
each of the three-month periods ended September 30, 2006 and 2005 and $68
for each of the nine-month periods ended September 30, 2006 and 2005.
9. COMMITMENTS AND CONTINGENCIES
Neither the operating partnerships, the Company's properties nor the
Company are subject to any material litigation nor, to the Company's
knowledge, is any material litigation threatened against the operating
partnerships, the properties or the Company. From time to time, the Company
is engaged in legal proceedings arising in the ordinary course of business.
The Company does not expect any of such proceedings to have a material
adverse effect on its cash flows, financial condition or results of
operations. The Company is currently involved in the following legal
proceedings, and does not believe the ultimate outcome of any of these
proceedings will have a material adverse effect on its financial condition
or operating results.
Republic Properties Corporation ("RPC") v. Mission West Properties, L.P.
("MWP"), in the Circuit Court of Maryland for Baltimore City Case No.
24-C-00-005675. RPC is a former partner with Mission West Properties, L.P.
in the Hellyer Avenue Limited Partnership ("Hellyer LP"). In April 2004,
the Circuit Court for Baltimore City, Maryland issued a Memorandum Opinion
in the case and awarded damages of approximately $934 to the RPC
plaintiffs, which represented a liability of the Company or
- 9 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
MWP. The Company has a receivable from a Berg Group affiliate for the
amount of distributions it received as the successor to RPC's interest in
the Hellyer LP, which exceeds the amount of the damages awarded to the RPC
parties and would be used to pay those damages in the event the decision of
the Circuit Court is upheld ultimately. The Company has never accounted for
the 50% interest in Hellyer LP that is claimed by RPC as an asset of the
Company. In February 2001, the Company filed a suit against RPC in the
Superior Court of the State of California for the County of Santa Clara
Case No. CV 796249 which was stayed pending resolution of the Maryland
case. In March 2005, the Company voluntarily dismissed its California suit.
On March 1, 2005, the Maryland Appeals Court ruled in favor of Mission West
Properties, L.P., finding that the Circuit Court of Maryland lacked
personal jurisdiction over MWP. In April 2005, the decision of the Maryland
Appeals Court became final, and the Company obtained a court order for the
release of a $1,551 bond, which it posted to remove an attachment order
issued to RPC. In April 2005, RPC submitted a motion to the Superior Court
of the State of California effectively asking the court to prevent MWP from
dismissing the previously dismissed California suit. In April 2006 the
Maryland Supreme Court upheld an earlier Maryland Appeals Court ruling in
favor of MWP, finding that the Circuit Court of Maryland could not assert
personal jurisdiction over MWP in the RPC suit. All litigation in the
Maryland portion of this dispute over the Hellyer Avenue limited
partnership has been concluded in the Company's favor. The lawsuit in the
Santa Clara County, California Superior Court is still unresolved. However,
the California Superior Court ordered the release of the $1,551 bond in
June 2006. In an Order dated October 26, 2006, the Santa Clara Superior
Court granted MWP's demurrer to defendants' cross-complaint, ruling as
follows: Plaintiffs' demurrer to each cause of action in Defendants'
Cross-Complaint is granted with 20 days leave to amend on the ground of
defect of parties because Hellyer Avenue Limited Partnership and Berg &
Berg Enterprises as necessary parties must be added to the cross-complaint.
We intend to challenge the amended complaint.
In January 2004, the Global Crossing Estate Representative, for itself and
the Liquidating Trustee of the Global Crossing Liquidating Trust v. Mission
West Properties filed an action in United States Bankruptcy Court Southern
District of New York Case No. 02-40188 (REG) asserting that payments of
approximately $815 made in the ordinary course of business within 90 days
of the Global Crossing bankruptcy filing were preference payments. The
Company has engaged legal counsel to defend itself in this claim and intend
to vigorously contest the matter. On February 9, 2005, the Court held a
hearing to consider the objection filed with respect to Mission West
Properties' claim. In April 2005, the Company filed a motion for summary
judgment in the United States Bankruptcy Court Southern District of New
York requesting the Court to dismiss the preference claim. The motion for
summary judgment was denied. Discovery continues by both parties and no
trial date has been set.
GUARANTEES AND INDEMNITIES
Under its articles of incorporation and bylaws, the Company has agreed to
indemnify its officers and directors for certain events or occurrences
arising as a result of the officer or director's serving in such capacity.
The maximum potential amount of future payments the Company could be
required to make under these indemnification agreements is unlimited. The
Company believes the estimated fair value of these indemnification
agreements is minimal and has recorded no liabilities for these agreements
as of September 30, 2006.
The Company also enters into indemnification provisions under its
agreements with other companies in the ordinary course of business,
typically with lenders, joint venture partners, contractors, and tenants.
Under these provisions the Company typically agrees to indemnify and hold
harmless the indemnified party for losses suffered or incurred by the
indemnified party as a result of certain kinds of activities or inactions
of the Company. These indemnification provisions generally survive
termination of the underlying agreement. The maximum potential amount of
future payments the Company could be required to make under these
indemnification provisions is unlimited. To date, the Company has not
incurred material costs to defend lawsuits or settle claims related to
these indemnification agreements. As a result, the Company believes the
estimated fair value of these agreements is minimal. Accordingly, the
Company has recorded no liabilities for these agreements as of September
30, 2006.
SEISMIC ACTIVITY
The Company's properties are located in an active seismic area of Silicon
Valley. Insurance policies currently maintained by the Company do not cover
seismic activity, although they do cover losses from fires after an
earthquake.
ENVIRONMENTAL ISSUES
The environmental investigations that have been conducted on the Company's
properties have not revealed any environmental liability that the Company
believes would have a material adverse effect on its financial condition,
results of operations and assets, and the Company is not aware of any such
liability. Nonetheless, it is possible that there are material
environmental liabilities of which the Company is unaware. In addition, the
Company cannot assure that future laws, ordinances, or regulations will not
impose any material environmental liability, or that the current
environmental condition of the properties has not been, or will not be,
affected by tenants and occupants of the properties, by the condition of
properties in the vicinity of the properties, or by third parties unrelated
to the Company.
- 10 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
BERG LAND HOLDINGS OPTION AGREEMENT
In April 2005, the Berg Group disclosed the receipt of an offer from an
unrelated party to purchase a portion of the Piercy & Hellyer land
comprised of approximately 10 acres in San Jose, California that is subject
to the Berg Land Holdings Option Agreement with the Company. The
prospective purchaser has disclosed its intention to develop "for sale"
industrial type buildings. In light of the overcapacity in the Silicon
Valley R&D properties market and the Company's current inventory of
available buildings for lease in this submarket, the Independent Directors
Committee, which is responsible for reviewing, evaluating and authorizing
action with respect to any transaction between the Company and any member
of the Berg Group, has authorized removal of this approximately 10-acre
parcel of land from the scope of the Berg Land Holdings Option Agreement,
subject to the completion of the sale to the unrelated party. In making
this determination, the Independent Directors Committee considered a number
of factors, including risks and other potentially adverse consequences that
could be associated with acquiring undeveloped land for future development.
In the event this parcel of land is not sold to this prospective purchaser,
the parcel would not be deemed to be removed from the scope of the Berg
Land Holdings Option Agreement and would remain eligible for potential
future acquisition by the Company under the Berg Land Holdings Option
Agreement. In the third quarter of 2006, the Berg Group informed the
Company that the unrelated party referred to above has withdrawn its offer.
ASSET DISPOSITIONS SUBJECT TO CERTAIN CONDITIONS
The Company has entered into sale agreements with unrelated parties subject
to numerous material conditions, including but not limited to re-zoning of
the property and negotiating certain agreements with the local municipality
acceptable to the buyer. As a result of the conditions agreed to by the
Company and the respective buyers, these assets do not meet the criteria
set forth in SFAS No. 144 to be classified as assets held for sale. The
following summarizes the assets for which the Company has executed sales
contracts that are subject to material conditions as previously described:
Property Number of Building Rentable Square Feet Acre Sales Price
-------- ------------------ -------------------- ---- -----------
McCandless Drive
Milpitas, California (1) 3 162,000 13.03 $48,500
Morse Avenue
Sunnyvale, California 1 39,200 2.25 $8,250
(1) Due to the changing market conditions, in October 2006 the Company and
buyer agreed to an amendment to the purchase and sale agreement
reducing the number of acres to be sold in this transaction.
10. SUBSEQUENT EVENTS
On October 5, 2006, the Company paid dividends of $0.16 per share of common
stock to all common stockholders of record as of September 29, 2006. On the
same date, the operating partnerships paid a distribution of $0.16 per O.P.
unit to all holders of O.P. units. Aggregate dividends and distributions
amounted to approximately $16,741.
On October 31, 2006, the Company completed the sale of three R&D properties
consisting of approximately 235,000 rentable square feet at Samaritan Drive
in San Jose, California. A gain of approximately $18,110 will be recognized
in the fourth quarter of 2006 on the total sales price of $43,271.
- 11 -
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
This Management's Discussion and Analysis of Financial Condition and Results of
Operations should be read in conjunction with the accompanying condensed
consolidated financial statements and notes thereto contained herein and our
condensed consolidated financial statements and notes thereto contained in our
Annual Report on Form 10-K as of and for the year ended December 31, 2005. The
results for the three and nine months ended September 30, 2006 are not
necessarily indicative of the results to be expected for the entire fiscal year
ending December 31, 2006. The following discussion includes forward-looking
statements, including but not limited to, statements with respect to our future
financial performance, operating results, plans and objectives. Actual results
may differ materially from those currently anticipated depending upon a variety
of factors, including those described under the sub-heading, "Forward-Looking
Information."
FORWARD-LOOKING INFORMATION
This quarterly report contains forward-looking statements within the meaning of
the federal securities laws. We intend such forward-looking statements to be
covered by the safe harbor provisions for forward-looking statements contained
in the Private Securities Reform Act of 1995, and are including this statement
for purposes of complying with these safe harbor provisions. Forward-looking
statements, which are based on certain assumptions and describe future plans,
strategies and expectations of the Company, are generally identifiable by use of
the words "believe," "expect," "intend," "anticipate," "estimate," "project" or
similar expressions. Additionally, all disclosures under Part I, Item 3
constitute forward-looking statements. Our ability to predict results or the
actual effect of future plans or strategies is inherently uncertain.
Factors that could have a material adverse effect on our operations and future
prospects include, but are not limited to, the following:
- - economic conditions generally and the real estate market specifically,
- - legislative or regulatory provisions (including changes to laws governing
the taxation of REITs),
- - availability of capital,
- - interest rates,
- - competition,
- - supply of and demand for R&D, office and industrial properties in our
current and proposed market areas,
- - tenant defaults and bankruptcies,
- - lease term expirations and renewals, and
- - changes in general accounting principles, policies and guidelines
applicable to REITs.
In addition, the actual timing of development, construction, and leasing on any
projects that we believe we may acquire in the future under the Berg Land
Holdings Option Agreement is presently unknown, and reliance should not be
placed on estimates concerning these projects. These risks and uncertainties,
together with the other risks described under Part I, Item 1A -- "Risk Factors"
of our annual report on Form 10-K for 2005 and from time to time in our other
reports and documents filed with the Securities and Exchange Commission, should
be considered in evaluating forward-looking statements and undue reliance should
not be placed on such statements.
OVERVIEW
We acquire, market, lease, and manage R&D/office properties, primarily located
in the Silicon Valley portion of the San Francisco Bay Area. As of September 30,
2006, we owned and managed 110 properties totaling approximately 7.9 million
rentable square feet through four limited partnerships, or operating
partnerships, for which we are the sole general partner. This class of property
is designed for research and development and office uses and, in some cases,
includes space for light manufacturing operations with loading docks. We believe
that we have one of the largest portfolios of R&D/office properties in the
Silicon Valley. As of September 30, 2006, the four tenants who each leased in
excess of 300,000 rentable square feet from us were Microsoft Corporation, NEC
Electronics America, Inc. (a subsidiary of NEC Electronics Corporation), Ciena
Corporation and Apple Computer, Inc. For federal income tax purposes, we have
operated as a self-managed, self-administered and fully integrated real estate
investment trust ("REIT") since fiscal 1999.
Our acquisition, growth and operating strategy incorporates the following
elements:
- - working with the Berg Group to take advantage of their abilities and
resources to pursue development opportunities which we have an option to
acquire, on pre-negotiated terms, upon completion and leasing;
- - capitalizing on opportunistic acquisitions from third parties of
high-quality R&D/office properties that provide attractive initial yields
and significant potential for growth in cash-flow;
- - focusing on general purpose, single-tenant Silicon Valley R&D/office
properties for information technology companies in order to maintain low
operating costs, reduce tenant turnover and capitalize on our relationships
with these companies and our extensive knowledge of their real estate
needs; and
- 12 -
- - maintaining prudent financial management principles that emphasize current
cash flow while building long-term value, the acquisition of pre-leased
properties to reduce development and leasing risks and the maintenance of
sufficient liquidity to acquire and finance properties on desirable terms.
CURRENT ECONOMIC ENVIRONMENT
All of our properties are located in the Northern California area known as
Silicon Valley, which generally consists of portions of Santa Clara County,
Southwestern Alameda County, Southeastern San Mateo County and Eastern Santa
Cruz County. The Silicon Valley R&D property market has historically fluctuated
with the local economy. The Silicon Valley economy and business activity have
slowed markedly since 2001 after fast-paced growth in 1999 and 2000. According
to a recent report by NAI BT Commercial Real Estate (the "BT Report"), the
vacancy rate for Silicon Valley R&D property was approximately 19.6% in late
2005 and 18.2% at the end of the third quarter of 2006. Total vacant R&D square
footage in Silicon Valley at the end of the third quarter of 2006 amounted to
28.1 million square feet, of which 19.9%, or 5.6 million square feet, was being
offered under subleases. According to the BT Report, total positive net
absorption (which is the computation of gross square footage leased less gross
new square footage vacated for the period presented) in 2005 amounted to
approximately 3.6 million square feet. According to the BT Report, during the
first nine months of 2006, there was total positive net absorption of
approximately 2.1 million square feet. According to the BT Report, average
asking market rent per square foot at the end of the third quarter of 2006 was
$0.94 compared to $0.88 in late 2005, although individual properties within any
particular submarket presently may be leased above or below the current average
asking market rental rates within that submarket. The Silicon Valley R&D
property market has been characterized by a substantial number of submarkets,
with rent and vacancy rates varying by submarket and location within each
submarket.
Our occupancy rate at September 30, 2006 was 64.2% compared to 67.5% at
September 30, 2005. We believe that our occupancy rate could decline further
going forward if key tenants seek the protection of bankruptcy laws, consolidate
operations or discontinue operations. In addition, leases with respect to
approximately 160,000 rentable square feet are expiring prior to the end of
2006. The properties subject to these leases may take anywhere from 24 to 36
months or longer to re-lease. We believe that the average 2006 renewal rental
rates for our properties will be approximately equal to, or perhaps below,
current market rents, but we cannot give any assurance that leases will be
renewed or that available space will be re-leased at rental rates equal to or
above the current quoted market rates.
Despite our strategic focus on single tenant properties and leases, in order to
meet market conditions, we have been, and expect to continue leasing less than
the entire premises of some of our R&D properties to a single tenant from time
to time. Leasing our R&D properties, which generally have been built for single
tenant occupancy, to multiple tenants can increase our leasing costs and
operating expenses and reduce the profitability of our leasing activities.
If we are unable to lease a significant portion of any vacant space or space
subject to expiring leases; if we experience significant tenant defaults as a
result of the current economic downturn; if we are not able to lease space at or
above current market rates; if we restructure existing leases and lower existing
rents in order to retain tenants for an extended term; or if we increase our
lease costs and operating expenses substantially to accommodate multiple tenants
in our R&D properties, our results of operations and cash flows will be
adversely affected. Furthermore, in this event it is probable that our board of
directors will reduce the quarterly dividend on the common stock and the
outstanding O.P. units. Our operating results and ability to pay dividends at
current levels remain subject to a number of material risks, as indicated under
the caption "Forward-Looking Information" above and in the section entitled
"Risk Factors" in our most recent annual report on Form 10-K.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
We prepare the condensed consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
("GAAP"), which requires us to make certain estimates, judgments and assumptions
that affect the reported amounts in the accompanying condensed consolidated
financial statements, disclosure of contingent assets and liabilities and
related footnotes. Accounting and disclosure decisions with respect to material
transactions that are subject to significant management judgments or estimates
include impairment of long lived assets, deferred rent reserves, and allocation
of purchase price relating to property acquisitions and the related depreciable
lives assigned. Actual results may differ from these estimates under different
assumptions or conditions.
Critical accounting policies are defined as those that require management to
make estimates, judgments and assumptions, giving due consideration to
materiality, in certain circumstances that affect amounts reported in the
condensed consolidated financial statements, and potentially result in
materially different results under different conditions and assumptions. We
believe that the following best describe our critical accounting policies:
BUSINESS COMBINATIONS. Statement of Financial Accounting Standards ("SFAS") No.
141, "Business Combinations" ("SFAS No. 141"), was effective July 1, 2001. The
acquisition costs of each property acquired prior to July 1, 2001 were allocated
only to building, land and leasing commissions with building depreciation being
computed based on an estimated weighted average composite useful life of 40
years and leasing commission amortization being computed over the term of the
lease. Acquisitions of properties made subsequent to the
- 13 -
effective date of SFAS No. 141 are based on an allocation of the acquisition
cost to land, building, tenant improvements, and intangibles for at market,
including lease origination and lease up period costs, and above and below
market in place leases, and the determination of their useful lives are guided
by a combination of SFAS No. 141 and management's estimates. If we do not
appropriately allocate these components or we incorrectly estimate the useful
lives of these components, our computation of depreciation and amortization
expense may not appropriately reflect the actual impact of these costs over
future periods, which will affect net income.
IMPAIRMENT OF LONG-LIVED ASSETS. We review real estate assets for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable in accordance with SFAS No. 144, "Accounting for
the Impairment and Disposal of Long-Lived Assets" ("SFAS No. 144"). If the
carrying amount of the asset exceeds its estimated undiscounted net cash flow,
before interest, we will recognize an impairment loss equal to the difference
between its carrying amount and its estimated fair value. If impairment is
recognized, the reduced carrying amount of the asset will be accounted for as
its new cost. For a depreciable asset, the new cost will be depreciated over the
asset's remaining useful life. Generally, fair values are estimated using
discounted cash flow, replacement cost or market comparison analyses. The
process of evaluating for impairment requires estimates as to future events and
conditions, which are subject to varying market factors, such as the vacancy
rates, future rental rates, lease periods, deferred maintenance and operating
costs for R&D facilities in the Silicon Valley area and related submarkets.
Therefore, it is reasonably possible that a change in estimate resulting from
judgments as to future events could occur which would affect the recorded
amounts of the property.
ALLOWANCE FOR DOUBTFUL ACCOUNTS AND DEFERRED RENT. We must estimate the
uncollectibility of our accounts receivable based on the evaluation of our
tenants' financial position, analyses of accounts receivable and current
economic trends. We also make estimates for reserves against our deferred rent
receivable for existing tenants with the potential of early termination,
bankruptcy or ceasing operations. We charge or credit rental income for
increases or decreases to our deferred rent reserves. Our estimates are based on
our review of tenants' payment histories, the remaining lease term, whether or
not the tenant is currently occupying our building, publicly available financial
information and such additional information about their financial condition as
tenants provide to us. The information available to us might lead us to
overstate or understate these reserve amounts. The use of different estimates or
assumptions could produce different results. Moreover, actual future collections
of accounts receivable or reductions in future reported rental income due to
tenant bankruptcies or other business failures could differ materially from our
estimates.
CONSOLIDATED JOINT VENTURES. We, through an operating partnership, own three
properties that are in joint ventures of which we have controlling interests. We
manage and operate all three properties. The recognition of these properties and
their operating results are 100% reflected on our condensed consolidated
financial statements, with appropriate allocation to minority interests, because
we have operational and financial control of the investments. We make judgments
and assumptions about the estimated monthly payments made to our minority
interest joint venture partners, which are reported with our periodic results of
operations. Actual results may differ from these estimates under different
assumptions or conditions.
INVESTMENT IN UNCONSOLIDATED JOINT VENTURE. We, through an operating
partnership, have a 50% non-controlling limited partnership interest in one
unconsolidated joint venture. This investment is not consolidated because we do
not exercise significant control over major operating and financial decisions.
We account for this joint venture interest using the equity method of
accounting.
FAIR VALUE OF FINANCIAL INSTRUMENTS. Our financial instruments include cash and
cash equivalents, accounts receivable, accounts payable, and debt. Considerable
judgment is required in interpreting market data to develop estimates of fair
value. Our estimates of fair value are not necessarily indicative of the amounts
that we could realize in a current market exchange. The use of different market
assumptions and/or estimation methodologies may have a material effect on the
estimated fair value amounts. Cash and cash equivalents, accounts receivable,
and accounts payable are carried at amounts that approximate their fair values
due to their short-term maturities. The carrying amounts of our variable rate
debt approximate fair value since the interest rates on these instruments are
equivalent to rates currently offered to us. For fixed rate debt, we estimate
fair value by using discounted cash flow analyses based on borrowing rates for
similar kinds of borrowing arrangements.
STOCK-BASED COMPENSATION. In December 2004, the FASB issued SFAS No. 123R,
"Share-Based Payment" ("SFAS No. 123R"), which addresses the accounting for
employee and director stock options. Statement 123R requires that the cost of
all employee and director stock options, as well as other equity-based
compensation arrangements, be reflected in the financial statements based on the
estimated fair value of the awards. SFAS No. 123R is an amendment to SFAS No.
123 and supersedes APB Opinion 25 ("APB 25"). SFAS No. 123R is applicable to any
award that is settled or measured in stock, including stock options, restricted
stock, stock appreciation rights, stock units, and employee stock purchase
plans. We have adopted the requirements of SFAS No. 123R effective January 1,
2006 using the modified prospective method of transition. Accordingly, prior
periods have not been restated. The adoption of this standard did not have a
material effect on our condensed consolidated statements of operations or
financial position. Compensation cost under SFAS No. 123R may differ due to
different assumptions and treatment of forfeitures.
REVENUE RECOGNITION. Rental revenue is recognized on the straight-line method of
accounting required by GAAP under which contractual rent payment increases are
recognized evenly over the lease term, regardless of when the rent payments are
received by us. The difference between recognized rental income and rental cash
receipts is recorded as "Deferred rent receivable" on the condensed consolidated
balance sheets.
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Rental revenue is affected if existing tenants terminate or amend their leases.
We try to identify tenants who may be likely to declare bankruptcy, cease
operations or are likely to seek a negotiated settlement of their obligation. By
anticipating these events in advance, we expect to take steps to minimize their
impact on our reported results of operations through lease renegotiations,
reserves against deferred rent, and other appropriate measures. Our judgments
and estimations about tenants' capacity to continue to meet their lease
obligations will affect the rental revenue recognized. Material differences may
result in the amount and timing of our rental revenue for any period if we made
different judgments or estimations.
SFAS No. 66, "Accounting for Sales of Real Estate" ("SFAS No. 66"), establishes
accounting standards for recognizing profit or loss on sales of real estate. The
gain on the sale is only recognized proportionately as the seller receives
payments from the purchaser. Interest income is recognized on an accrual basis,
when appropriate.
Lease termination fees are recognized as other income when there is a signed
termination letter agreement, all of the conditions of the agreement have been
met, and when the tenant no longer has the right to occupy the property. These
fees are paid by tenants who want to terminate their lease obligations before
the end of the contractual term of the lease. We cannot predict or forecast the
timing or amounts of future lease termination fees.
We recognize income from rent, tenant reimbursements and lease termination fees
and other income once all of the following criteria are met in accordance with
SEC Staff Accounting Bulletin 104:
- - the agreement has been fully executed and delivered;
- - services have been rendered;
- - the amount is fixed and determinable; and
- - collectibility is reasonably assured.
With regard to critical accounting policies, where applicable, we have explained
and discussed the criteria for identification and selection, methodology in
application and impact on the financial statements with the Audit Committee of
our Board of Directors. The Audit Committee has reviewed the critical accounting
policies we identified.
- 15 -
RESULTS OF OPERATIONS
COMPARISON OF THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006 TO THE THREE
AND NINE MONTHS ENDED SEPTEMBER 30, 2005
As of September 30, 2006, through our controlling interests in the operating
partnerships, we owned 110 properties totaling approximately 7.9 million
rentable square feet compared to 108 properties totaling approximately 8.0
million rentable square feet owned by us as of September 30, 2005. This
represents a net decrease of approximately 1% in total rentable square footage,
as we acquired two R&D properties consisting of approximately 137,800 rentable
square feet and disposed of one R&D property consisting of approximately 239,000
rentable square feet since the third quarter of 2005.
Rental revenue from real estate for the three and nine months ended September
30, 2006 compared to the three- and nine-month periods in 2005 are as follows:
Three Months Ended September 30,
% Change by % of Total Net
2006 2005 $ Change Property Group Change
------------- -------------- --------------- --------------- ----------------
(dollars in thousands)
Same Property (1) $21,333 $23,935 ($2,602) (10.9%) (10.9%)
2006 Acquisitions 774 - 774 100.0% 3.3%
------------- -------------- --------------- ----------------
Total $22,107 $23,935 ($1,828) (7.6%) (7.6%)
============= ============== =============== ================
Nine Months Ended September 30,
% Change by % of Total Net
2006 2005 $ Change Property Group Change
------------- -------------- --------------- --------------- ----------------
(dollars in thousands)
Same Property (1) $65,833 $73,753 ($7,920) (10.7%) (10.7%)
2006 Acquisitions 1,438 - 1,438 100.0% 1.9%
------------- -------------- --------------- ----------------
Total $67,271 $73,753 ($6,482) (8.8%) (8.8%)
============= ============== =============== ================
(1) "Same Property" is defined as properties owned by us prior to 2006 that we
still owned as of September 30, 2006.
RENTAL REVENUE FROM REAL ESTATE FROM CONTINUING OPERATIONS
For the quarter ended September 30, 2006, rental revenue from real estate
decreased by approximately ($1.8) million, or 7.6%, from $23.9 million for the
three months ended September 30, 2005 to $22.1 million for the three months
ended September 30, 2006. For the nine months ended September 30, 2006, rental
revenue from real estate decreased by approximately ($6.5) million, or 8.8%,
from $73.8 million for the nine months ended September 30, 2005 to $67.3 million
for the nine months ended September 30, 2006. Rental revenue includes
approximately ($0.5) million in amortization expense for the three months ended
September 30, 2006 and 2005 and approximately ($1.4) million in amortization
expense for the nine months ended September 30, 2006 and 2005 for the
amortization of an above-market lease intangible asset pursuant to SFAS No. 141.
The decline in rental revenue was primarily a result of lower rental rates on
new leases and renewals and the loss of several tenants due to lease
terminations, bankruptcy, relocation or cessation of their operations since
September 30, 2005, all of which resulted from current adverse market
conditions. Our occupancy rate at September 30, 2006 was approximately 64.2%,
compared to approximately 67.5% at September 30, 2005. Due to an over supply of
R&D properties and competition from other landlords in the Silicon Valley, our
occupancy rate may drop further if existing leases for 160,000 rentable square
feet scheduled to expire during the remainder of 2006 are not renewed or those
properties are not re-leased.
EQUITY IN EARNINGS FROM UNCONSOLIDATED JOINT VENTURE
As of September 30, 2006, we had investments in three R&D buildings, totaling
466,600 rentable square feet, through an unconsolidated joint venture, TBI-MWP,
in which we acquired a 50% interest in January 2003 from the Berg Group under
the Berg Land Holdings Option Agreement. We have a non-controlling limited
partnership interest in this joint venture, which we account for using the
equity method of accounting. For the three months ended September 30, 2006, we
recorded equity in earnings from the unconsolidated joint venture of
approximately $0.86 million compared to equity in earnings of $0.29 million for
the same period in 2005. Our equity in earnings from this unconsolidated joint
venture increased in the third quarter of 2006 due to the sale of one R&D
property with approximately 126,400 rentable square feet for approximately $8.5
million. The total gain on the sale was approximately $0.88 million of which
$0.44 million was our share. For the nine-month periods ended September 30, 2006
and 2005, equity in earnings from the unconsolidated joint venture was
approximately $1.5 million and $0.68 million, respectively. The increase in
equity in earnings from unconsolidated joint venture for the nine-month period
ended September 30, 2006 resulted from the gain on sale of one R&D property and
the write-offs of leasing commission and tenant improvements in 2005 for a
tenant that terminated its lease agreement. The occupancy rate for the
properties owned by this joint venture at September 30, 2006 and 2005 was
approximately 100% and 78.7%, respectively.
- 16 -
LEASE TERMINATION INCOME FROM CONTINUING OPERATIONS
Lease termination fees for the nine months ended September 30, 2006 and 2005
were approximately $16.1 million and $0.5 million, respectively. These fees were
paid by tenants who terminated their lease obligations before the end of the
contractual term of the lease. We do not consider those transactions to be
recurring items.
OTHER INCOME FROM CONTINUING OPERATIONS
Other income of approximately $1.0 million for the three months ended September
30, 2006 included approximately $0.6 million from interest, $0.2 million from
management fee and $0.2 million from deposit forfeitures and miscellaneous
income. Other income of approximately $0.4 million for the three months ended
September 30, 2005 included approximately $0.2 million from management fee and
$0.2 million from interest. For the nine months ended September 30, 2006, other
income of approximately $2.9 million included approximately $1.5 million from
interest, $0.8 million from management fee and $0.6 million from settlement
claims, deposit forfeitures and miscellaneous income. For the nine months ended
September 30, 2005, other income of approximately $2.5 million included
approximately $0.7 million from management fee, $0.2 million from interest and
$1.6 million from settlement claims and miscellaneous income.
EXPENSES FROM CONTINUING OPERATIONS
Property operating expenses and real estate taxes during the third quarter of
2006 decreased by approximately ($0.1) million, or 2.4%, from $5.1 million to
$5.0 million for the three months ended September 30, 2005 and 2006,
respectively, due primarily to lower repair and maintenance services. Tenant
reimbursements decreased by approximately ($0.5) million, or 13.4%, from $3.8
million for the three months ended September 30, 2005 to $3.3 million for the
three months ended September 30, 2006 due to lower occupancy. Property operating
expenses and real estate taxes remained the same at approximately $13.6 million
for the nine months ended September 30, 2006 and 2005. Tenant reimbursements
decreased by approximately ($1.3) million, or 12.1%, from $10.7 million for the
nine months ended September 30, 2005 to $9.4 million for the nine months ended
September 30, 2006. The decrease in tenant reimbursements for the nine month
periods was due to lower occupancy. Certain expenses such as property insurance,
real estate taxes, and other fixed operating expenses are not recoverable from
vacant properties, however. General and administrative expenses increased by
approximately $0.1 million, or 25.2%, from $0.4 million to $0.5 million for the
three months ended September 30, 2005 and 2006, respectively. For the nine
months ended September 30, 2005 and 2006, general and administrative expenses
increased by approximately $0.3 million, or 16.9%, from $1.5 million to $1.8
million, respectively. The increase in general and administrative expenses for
the nine months ended September 30, 2006 was primarily a result of dividend
equivalent right compensation cost and stock option expensing, as well as fees
paid in connection with filing a registration statement for the resale of shares
of common stock to be acquired from time to time upon the exchange of O.P. units
for stock.
Depreciation and amortization expense of real estate increased by approximately
$0.5 million, or 9.0%, from $5.1 million to $5.6 million for the three months
ended September 30, 2005 and 2006, respectively. The increase was attributable
primarily to the write-offs of tenant improvements from lease terminations and
additional amortization expense relating to in-place lease value intangible
asset pursuant to SFAS No. 141 in connection with two R&D property acquisitions
during the first nine months of 2006. Depreciation and amortization expense of
real estate increased by approximately $0.7 million, or 4.7%, from $15.4 million
to $16.1 million for the nine months ended September 30, 2005 and 2006,
respectively. The increase for the nine months ended September 30, 2006 compared
to the same period in 2005 was attributable primarily for the same reasons
stated above comparing the three months ended September 30, 2006 to 2005.
Interest expense decreased by approximately ($0.3) million, or 5.9%, from $5.5
million for the three months ended September 30, 2005 to $5.2 million for the
three months ended September 30, 2006 due to lower total debt in 2006. Interest
expense (related parties) decreased by approximately ($41,000), or 17.9%, from
$229,000 for the three months ended September 30, 2005 to $188,000 for the three
months ended September 30, 2006 due to the termination of the Berg Group line of
credit in October 2005. Total debt outstanding, including amounts due related
parties, decreased by approximately ($10.3) million, or 2.8%, from $370.0
million as of September 30, 2005 to $359.7 million as of September 30, 2006.
Overall interest expense, including amounts paid to related parties, for the
quarter ended September 30, 2006 decreased by approximately ($0.4) million
compared to the same quarter a year ago, with the difference being primarily
attributable to the retirement of the higher rate Citicorp loan and the pay down
of the Santa Clara Valley National Bank (formerly known as Cupertino National
Bank) line of credit during the third quarter of 2005.
Interest expense decreased by approximately ($0.5) million, or 2.9%, from $16.1
million for the nine months ended September 30, 2005 to $15.6 million for the
nine months ended September 30, 2006. Interest expense (related parties)
decreased by approximately ($210,000), or 27.0%, from $779,000 for the nine
months ended September 30, 2005 to $569,000 for the nine months ended September
30, 2006.
- 17 -
INCOME/(LOSS) FROM DISCONTINUED OPERATIONS
The following table depicts income from discontinued operations for the three
and nine months ended September 30, 2006 and 2005.
Three Months Ended September 30, Nine Months Ended September 30,
2006 2005 2006 2005
----------- ------------ ------------ ------------
(dollars in thousands)
(unaudited)
Gain on disposal of discontinued operations - $1,345 - $1,408
(Loss)/income attributable to discontinued operations ($17) 569 $1,059 1,183
Minority interests in loss/(earnings) attributable to
discontinued operations 14 (1,532) (887) (2,104)
----------- ------------ ------------ ------------
(Loss)/income from discontinued operations ($ 3) $ 382 $ 172 $ 487
=========== ============ ============ ============
In accordance with our adoption of SFAS No. 144, at September 30, 2006 we
classified three properties consisting of 235,000 rentable square feet as assets
held for sale and discontinued operations, and in the first quarter of 2005 we
sold and classified as discontinued operations two properties consisting of
103,350 rentable square feet. In the third quarter of 2006, we classified three
properties as assets held for sale and discontinued operations because we
committed to an action to sell the properties, the properties had a buyer and
was available for immediate sale in their present condition (subject to terms
that are usual and customary for sales of such property), the sale was probable
and actions required to complete the plan indicated that it was unlikely that
significant changes to the plan would be made or that the plan would be
withdrawn. Net gains on sale and operating results of assets held for sale and
disposed properties were classified as discontinued operations. SFAS No. 144
requires prior period results of operations for these properties to be restated
and presented in discontinued operations in prior condensed consolidated
statements of operations.
In accordance with SFAS No. 66, in the third quarter of 2005 we received the
remaining balance owed on one of the properties disposed in the first quarter of
2005 and recorded the remaining gain of approximately $1.3 million.
The (loss)/income to common stockholders attributable to discontinued operations
from these properties for the three months ended September 30, 2006 and 2005 was
approximately ($3,000) and $0.4 million, respectively. The income to common
stockholders attributable to discontinued operations from these properties for
the nine months ended September 30, 2006 and 2005 was approximately $0.2 million
and $0.5 million, respectively.
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS AND NET INCOME AVAILABLE TO MINORITY
INTERESTS
Minority interest in net income has been calculated by taking the net income of
the operating partnerships (on a stand-alone basis) multiplied by the respective
minority interest ownership percentage. Minority interests represent the
ownership interest of all limited partners in the operating partnerships taken
as a whole, which was approximately 81% and 82% as of September 30, 2006 and
2005, respectively.
Net income available to common stockholders decreased by approximately ($0.3)
million, or 14.1%, from $2.4 million for the three months ended September 30,
2005 to $2.1 million for the same period in 2006. The minority interest portion
of income decreased by approximately ($2.8) million, or 24.6%, from $11.5
million for the three months ended September 30, 2005 to $8.7 million for the
three months ended September 30, 2006. The decline in the quarter's net income
for both common stockholders and minority interests was primarily due to lower
rental revenue and higher gain on disposal of discontinued operations in 2005.
For the nine months ended September 30, 2006 and 2005, the minority interest
portion of income was approximately $41.1 million and $35.8 million,
respectively, resulting in net income to common stockholders of approximately
$9.4 million and $7.6 million, respectively. The increase in net income for both
common stockholders and minority interests was primarily due to the realization
of higher lease termination fees in 2006.
CHANGES IN FINANCIAL CONDITION
The most significant changes in our financial condition during the three months
ended September 30, 2006 resulted from the acquisition of two R&D properties. In
addition, total stockholders' equity increased from the issuance of common
stocks for the exchange of O.P. units and stock option exercises.
At September 30, 2006, total investments in properties had a net increase of
approximately $17.4 million from December 31, 2005 primarily due to tenant
improvements and two R&D property acquisitions during the first nine months of
2006 consisting of approximately 137,800 rentable square feet located in the
Silicon Valley.
Total stockholders' equity, net, increased by approximately $11.2 million from
December 31, 2005 as we obtained additional capital from the issuance of 856,896
shares of our common stock for the exchange of O.P. units and 91,600 shares of
our common stock from stock option exercises and a decrease in accumulated
deficit of approximately $0.2 million due to the realization of higher lease
termination fees for the period. The newly issued shares increased additional
paid-in-capital by approximately $11.0 million.
- 18 -
LIQUIDITY AND CAPITAL RESOURCES
We expect a continued decline in operating cash flows from our operating
property portfolio in 2006 as compared to 2005. The reduction in cash flows
reflects the overall reduced demand for R&D properties, lower rental rates for
new and renewed leases, and an increase in vacant properties in 2006. In
addition, if we are unable to lease a significant portion of the approximately
160,000 rentable square feet scheduled to expire during the remainder of 2006 or
an equivalent amount of our currently available space of approximately 2.8
million rentable square feet, our operating cash flows may be affected
adversely. With the expectation of lower rental revenues for the remainder of
2006, we expect the properties' net operating income to continue to show year
over year declines when compared to 2005. As noted above, we expect cash flows
from operating activities to continue to show declines primarily driven by
excess capacity of commercial office and R&D space in the Silicon Valley, the
softening of the Company's market specifically, and the expected weaker
performance of our properties. We are also subject to risks of decreased
occupancy through tenant defaults and bankruptcies and potential reduction in
rental rates upon renewal of properties, which would result in reduced cash flow
from operations. It is reasonably likely that vacancy rates may continue to
increase and effective rental rates on new and renewed leases may continue to
decrease.
We expect our principal source of liquidity for distributions to stockholders
and O.P. unit holders, debt service, leasing commissions and recurring capital
expenditures to come from cash provided by operations and/or the borrowings
under the line of credit with Santa Clara Valley National Bank (formerly known
as Cupertino National Bank) ("SCVNB"). We expect these sources of liquidity to
be adequate to meet projected distributions to stockholders and other presently
anticipated liquidity requirements in 2006. We expect to meet our long-term
liquidity requirements for the funding of property development, property
acquisitions and other material non-recurring capital improvements through cash
and investments, long-term secured and unsecured indebtedness and the issuance
of additional equity securities by us. We have the ability to meet short-term
obligations or other liquidity needs based on a line of credit with SCVNB. We
expect our total interest expense to increase through new financing activities.
In the remainder of 2006, we will be obligated to make payments totaling
approximately $2.6 million of debt principal under mortgage notes without regard
to any debt refinancing or new debt obligations that we might incur, or optional
payments of debt principal.
Cash and cash equivalents increased by approximately $11.0 million from $31.4
million as of December 31, 2005 to $42.4 million as of September 30, 2006
primarily from cash flow from operations and excess remaining restricted cash
from a 1031 tax-deferred exchange transaction.
Restricted cash totaled $6.9 million as of September 30, 2006. This amount
represents a balance we consolidated due to our adoption of FIN 46R,
"Consolidation of Variable Interest Entities" (see Note 4 of Notes to Condensed
Consolidated Financial Statements in Part I, Item 1, above). We do not possess
or control these funds or have any rights to receive them except as provided in
the applicable agreements. Therefore, restricted cash is not available for
distribution to stockholders.
DISTRIBUTIONS
On October 5, 2006, we paid dividends of $0.16 per share of common stock to all
common stockholders of record as of September 29, 2006. On the same date, the
operating partnerships paid a distribution of $0.16 per O.P. unit to all holders
of O.P. units. Aggregate dividends and distributions amounted to approximately
$16.7 million. For the remainder of 2006, we expect to maintain our current
quarterly dividend payment rate to common stockholders and O.P. unit holders of
$0.16 per share. However, distributions are declared at the discretion of our
Board of Directors and are subject to actual cash available for distribution,
our financial condition, capital requirements and such other factors, as our
Board of Directors deems relevant.
DEBT
At September 30, 2006, we had total indebtedness of $359.8 million, including
$350.0 million of fixed rate mortgage debt and $9.8 million under the Berg Group
mortgage note (related parties), as detailed in the table below. The SCVNB loan
contains certain financial loan and reporting covenants as defined in the loan
agreements. As of September 30, 2006, we were in compliance with these loan
covenants.
CONTRACTUAL OBLIGATIONS
The following table identifies our contractual obligations as of September 30,
2006 that will impact our liquidity and cash flow in future periods:
------------ ------------- ------------ ------------ ------------- ------------ ------------
2006 2007 2008 2009 2010 Thereafter Total
------------ ------------- ------------ ------------ ------------- ------------ ------------
(dollars in thousands)
Long-Term Debt Obligations(1) $2,649 $11,028 $121,605 $9,580 $10,125 $204,769 $359,756
Operating Lease Obligations (2) 23 23 - - - - 46
------------ ------------- ------------ ------------ ------------- ------------ ------------
Total $2,672 $11,051 $121,605 $9,580 $10,125 $204,769 $359,802
============ ============= ============ ============ ============= ============ ============
(1) Our long-term debt obligations are set forth in detail in the schedule
below.
(2) Our operating lease obligations relate to a lease of our corporate office
facility from a related party.
- 19 -
The following table sets forth information regarding debt outstanding as of
September 30, 2006:
Maturity Interest
Debt Description Collateral Properties Balance Date Rate
- ----------------------------------------------- -------------------------------------- -------------------- ------------- ----------
(dollars in thousands)
Line of Credit:
Santa Clara Valley National Bank Not Applicable - 11/06 (3)
(fka Cupertino National Bank)
--------------------
Mortgage Notes Payable (related parties): 5300 & 5350 Hellyer Ave., San Jose, CA $ 9,756 6/10 7.65%
--------------------
Mortgage Notes Payable (1):
Prudential Insurance Company of America (2) 10300 Bubb Road, Cupertino, CA 115,582 10/08 6.56%
10500 N. De Anza Blvd, Cupertino, CA
4050 Starboard Drive, Fremont, CA
45700 Northport Loop, Fremont, CA
45738 Northport Loop, Fremont, CA
450 National Ave., Mountain View, CA
6311 San Ignacio Avenue, San Jose, CA
6321 San Ignacio Avenue, San Jose, CA
6325 San Ignacio Avenue, San Jose, CA
6331 San Ignacio Avenue, San Jose, CA
6341 San Ignacio Avenue, San Jose, CA
6351 San Ignacio Avenue, San Jose, CA
3236 Scott Boulevard, Santa Clara, CA
3560 Bassett Street, Santa Clara, CA
3570 Bassett Street, Santa Clara, CA
3580 Bassett Street, Santa Clara, CA
1135 Kern Avenue, Sunnyvale, CA
1212 Bordeaux Lane, Sunnyvale, CA
1230 E. Arques, Sunnyvale, CA
1250 E. Arques, Sunnyvale, CA
1170 Morse Avenue, Sunnyvale, CA
1600 Memorex Drive, Santa Clara, CA
1688 Richard Avenue, Santa Clara, CA
1700 Richard Avenue, Santa Clara, CA
3540 Bassett Street, Santa Clara, CA
3542 Bassett Street, Santa Clara, CA
3544 Bassett Street, Santa Clara, CA
3550 Bassett Street, Santa Clara, CA
Northwestern Mutual Life Insurance Company (4) 1750 Automation Parkway, San Jose, CA 88,965 1/13 5.64%
1756 Automation Parkway, San Jose, CA
1762 Automation Parkway, San Jose, CA
6320 San Ignacio Avenue, San Jose, CA
6540-6541 Via Del Oro, San Jose, CA
6385-6387 San Ignacio Avenue, San Jose, CA
2251 Lawson Lane, Santa Clara, CA
1325 McCandless Drive, Milpitas, CA
1650-1690 McCandless Drive, Milpitas, CA
20605-20705 Valley Green Drive, Cupertino, CA
Allianz Life Insurance Co. (Allianz Loan I)(5) 5900 Optical Court, San Jose, CA 24,723 8/25 5.56%
Allianz Life Insurance Co. (Allianz Loan II)(5) 5325-5345 Hellyer Avenue, San Jose, CA 120,730 8/25 5.22%
1768 Automation Parkway, San Jose, CA
2880 Scott Boulevard, Santa Clara, CA
2890 Scott Boulevard, Santa Clara, CA
2800 Scott Boulevard, Santa Clara, CA
20400 Mariani Avenue, Cupertino, CA
10450-10460 Bubb Road, Cupertino, CA
--------------------
350,000
--------------------
--------------------
TOTAL $359,756
====================
(1) Mortgage notes payable generally require monthly installments of interest
and principal ranging from $177,000 to $840,000 over various terms
extending through the year 2025. The weighted average interest rate of
mortgage notes payable was 5.84% at September 30, 2006.
(2) The Prudential Insurance loan is payable in monthly installments of
$827,000, which includes principal (based upon a 30-year amortization) and
interest. A limited partner who is not a member of the Berg Group has
guaranteed approximately $12.0 million of this debt. Costs and fees
incurred with obtaining this loan aggregated approximately $900,000, which
were deferred and amortized over the loan period.
(3) Interest rate equal to LIBOR plus 1.75%. The Santa Clara Valley National
Bank line of credit contains certain financial loan and reporting covenants
as defined in the loan agreements, including minimum tangible net worth and
debt service coverage ratio. As of September 30, 2006, the Company was in
compliance with these loan covenants.
(4) The Northwestern loan is payable in monthly installments of $696,000, which
includes principal (based upon a 20-year amortization) and interest. Costs
and fees incurred with obtaining this loan aggregated approximately
$675,000, which were deferred and amortized over the loan period.
(5) The Allianz loans are payable in monthly aggregate installments of
$1,017,000, which includes principal (based upon a 20-year amortization)
and interest. Costs and fees incurred with obtaining these loans aggregated
approximately $1,089,000, which were deferred and amortized over the loan
periods. The Allianz loans contain certain customary covenants as defined
in the loan agreements. As of September 30, 2006, the Company was in
compliance with these loan covenants.
At September 30, 2006, our debt to total market capitalization ratio, which is
computed as our total debt outstanding divided by the sum of total debt
outstanding plus the market value of common stock (based upon the closing price
of $11.40 per share on September 29, 2006) on a fully diluted basis, including
the conversion of all O.P. units into common stock, was approximately 23.2%. On
September 29, 2006, the last trading day for the quarter, total market
capitalization was approximately $1.55 billion.
- 20 -
At September 30, 2006, the outstanding balance remaining under certain notes
that we owed to the operating partnerships was $1.8 million. The due date of
these notes has been extended to September 30, 2007. The principal amount of
these notes, along with the interest expense, which is interest income to the
operating partnerships, is eliminated in consolidation and is not included in
the corresponding line items within the condensed consolidated financial
statements. However, the interest income earned by the operating partnerships,
which is interest expense to us, in connection with this debt, is included in
the calculation of minority interests as reported on the condensed consolidated
statement of operations, thereby reducing our net income by this same amount. At
present, our only means for repayment of this debt is through distributions that
we receive from the operating partnerships that are in excess of the amount of
dividends to be paid to our stockholders or by raising additional equity
capital.
HISTORICAL CASH FLOWS
COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 2006 TO THE NINE MONTHS ENDED
SEPTEMBER 30, 2005
Net cash provided by operating activities for the nine months ended September
30, 2006 was approximately $28.2 million compared to $22.9 million for the same
period in 2005. The increase resulted primarily from the cash receipts
associated with deferred rental income and rent payments from M&M, LLC (see Note
4 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1,
above) in 2006, and because we incurred higher leasing commission payments
(included in Other assets) in 2005, which amounted to approximately $4.0
million, compared to $0.8 million in 2006.
Net cash used in investing activities was approximately ($2.0) million and
($2.6) million for the nine months ended September 30, 2006 and 2005,
respectively. Cash used in investing activities during the nine months ended
September 30, 2006 related principally to the acquisition of the properties at
233 South Hillview Drive and 1875 Charleston Road for approximately $16.0
million. The 233 South Hillview Drive acquisition was completed as a
tax-deferred exchange transaction involving our former R&D property at 800
Embedded Way, San Jose, California. The remaining excess restricted cash of
approximately $1.8 million was transferred to our general cash account. Capital
expenditures relating to real estate improvements were approximately $1.3
million for the nine months ended September 30, 2006. Cash used in investing
activities during the nine months ended September 30, 2005 related principally
to the acquisition of the R&D property at 5521 Hellyer Avenue for $14.2 million
and the disposition of two R&D properties for a total of $12.4 million. Capital
expenditures relating to real estate improvements were approximately $0.9
million for the nine months ended September 30, 2005.
Net cash used in financing activities was approximately ($15.1) million for the
nine months ended September 30, 2006 compared to net cash provided by financing
activities of approximately $18.6 million for the nine months ended September
30, 2005. During the first nine months of 2006, we received $0.8 million from
stock option exercises, received $1.6 million from the refund of an appeal bond,
used $7.8 million to pay outstanding debt, paid $9.0 million to common
stockholders for dividends and paid $0.7 million to minority interests for
distributions in excess of earnings. During the same period in 2005, we received
$150.8 million from two new mortgage loans, received $0.5 million from stock
option exercises, used $117.8 million to pay outstanding debt, and paid $6.2
million to minority interests for distributions in excess of earnings and $8.7
million to common stockholders for dividends.
FUNDS FROM OPERATIONS ("FFO")
FFO is a non-GAAP financial measurement used by real estate investment trusts to
measure and compare operating performance. As defined by NAREIT, FFO represents
net income (loss) before minority interest of O.P. unit holders, computed in
accordance with GAAP, plus non-recurring events other than "extraordinary items"
under GAAP, excluding gains and losses from sales of depreciable operating
properties, plus real estate related depreciation and amortization, excluding
amortization of deferred financing costs and depreciation of non-real estate
assets, and after adjustments for unconsolidated partnerships and joint
ventures. FFO does include impairment losses for properties held for sale and
held for use. Management considers FFO to be an appropriate supplemental measure
of the Company's operating and financial performance because when compared year
over year, it reflects the impact to operations from trends in occupancy rates,
rental rates, operating costs, general and administrative expenses and interest
costs, providing a perspective not immediately apparent from net income. In
addition, management believes that FFO provides useful information about the
Company's financial performance when compared to other REITs since FFO is
generally recognized as the industry standard for reporting the operations of
REITs. In addition to the disclosure of operating earnings per share, we will
continue to use FFO as a measure of our performance. FFO should not be
considered as an alternative for net income as a measure of profitability nor is
it comparable to cash flows provided by operating activities determined in
accordance with GAAP, nor is FFO necessarily indicative of funds available to
meet our cash needs, including the need to make cash distributions to satisfy
REIT requirements. For example, FFO is not adjusted for payments of debt
principal required under our debt service obligations.
Our definition of FFO also assumes conversion at the beginning of the period of
all convertible securities, including minority interests that might be exchanged
for common stock. FFO does not represent the amount available for management's
discretionary use; as such funds may be needed for capital replacement or
expansion, debt service obligations or other commitments and uncertainties.
Furthermore, FFO is not comparable to similarly entitled items reported by other
REITs that do not define FFO exactly as we do.
- 21 -
FFO for the three and nine months ended September 30, 2006 and 2005, as
reconciled to net income available to common stockholders, are summarized in the
following tables:
Three Months Ended September 30, Nine Months Ended September 30,
2006 2005 2006 2005
------------------ ------------------ ------------------ ------------------
(dollars in thousands) (dollars in thousands)
Net income to common stockholders $ 2,106 $ 2,451 $ 9,380 $ 7,554
Add:
Minority interests (1) 8,566 11,414 40,676 35,441
Depreciation & amortization of real estate (2) 6,333 6,008 18,429 18,390
Less:
Gain on sale of JV real estate or real estate (438) (1,345) (438) (1,408)
------------------ ------------------ ------------------ ------------------
FFO $16,567 $18,528 $68,047 $59,977
================== ================== ================== ==================
(1) The minority interests for third parties totaling $134 and $127 for the
three months ended September 30, 2006 and 2005, respectively, and $382 for
the nine months ended September 30, 2006 and 2005 was deducted from total
minority interests in calculating FFO.
(2) Includes our portion of depreciation and amortization of real estate and
leasing commissions from our unconsolidated joint venture totaling $238 and
$210 for the three months ended September 30, 2006 and 2005, respectively,
and $660 and $774 for the nine months ended September 30, 2006 and 2005,
respectively. Also includes our amortization of leasing commissions of $368
and $453 for the three months ended September 30, 2006 and 2005,
respectively, and $1,138 and $1,295 for the nine months ended September 30,
2006 and 2005, respectively. Amortization of leasing commissions is
included in the property operating, maintenance and real estate taxes line
item in the Company's condensed consolidated statements of operations. For
the three months ended September 30, 2006 and 2005, depreciation and
amortization of real estate also includes approximately $158 and $234,
respectively, attributable to discontinued operations. For the nine months
ended September 30, 2006 and 2005, depreciation and amortization of real
estate also includes approximately $471 and $889, respectively,
attributable to discontinued operations.
DISTRIBUTION POLICY
Our board of directors determines the amount and timing of distributions to our
stockholders. The board of directors will consider many factors prior to making
any distributions, including the following:
- - the amount of cash available for distribution;
- - our financial condition;
- - whether to reinvest funds rather than to distribute such funds;
- - our committed and projected capital expenditures;
- - the amount of cash required for new property acquisitions, including
acquisitions under existing agreements with the Berg Group;
- - the amount of our annual debt service requirements;
- - prospects of tenant renewals and re-leases of properties subject to
expiring leases;
- - cash required for re-leasing activities;
- - the annual distribution requirements under the REIT provisions of the
federal income tax laws; and
- - such other factors as the board of directors deems relevant.
We cannot assure you that we will be able to meet or maintain our cash
distribution objectives.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
We do not believe recently issued accounting standards will materially impact
our financial position, results of operations, or cash flows.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections" ("SFAS No. 154"), to replace APB Opinion 20, "Reporting Accounting
Changes in Interim Financial Statements" ("APB 20"). SFAS No. 154 changes the
requirements for the accounting for and reporting of a change in accounting
principle and requires retrospective application to prior periods' financial
statements, unless it is impracticable to determine period specific effects or
the cumulative effect of the change. SFAS No. 154 will be effective for
accounting changes and corrections of errors made in fiscal years beginning
after December 15, 2005. The adoption of this statement is not expected to have
a material effect on our consolidated results of operations or financial
condition.
In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment" ("SFAS
No. 123R"), which addresses the accounting for employee and director stock
options. Statement 123R requires that the cost of all employee and director
stock options, as well as other equity-based compensation arrangements, be
reflected in the financial statements based on the estimated fair value of the
awards. SFAS No. 123R is an amendment to SFAS No. 123 and supersedes APB Opinion
No. 25 ("APB No. 25"). SFAS No. 123R is applicable to any award that is settled
or measured in stock, including stock options, restricted stock, stock
appreciation rights, stock units, and employee stock purchase plans. We have
adopted the requirements of SFAS No. 123R effective January 1, 2006 using the
modified prospective method of transition. Accordingly, prior periods have not
been restated. The adoption of this standard did not have a material effect on
our condensed consolidated statements of operations or financial position.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not generally hold market risk sensitive instruments for trading purposes.
We use fixed and variable rate debt to finance our operations. Our exposure to
market risk for changes in interest rates relates primarily to our current
variable rate debt and future debt obligations. We are vulnerable to significant
fluctuations of interest rates on our floating rate debt and pricing on our
future debt. We manage our market risk by monitoring interest rates where we try
to recognize the unpredictability of the financial markets and seek to reduce
potentially adverse effect on the results of our operations. This takes frequent
evaluation of available lending rates and examination of opportunities to reduce
interest expense through new sources of debt financing. Several factors
affecting the interest rate risk include governmental monetary and tax policies,
domestic and international economics and other factors that are beyond our
control. The following table provides information about the principal cash
flows, weighted average interest rates, and expected maturity dates for debt
outstanding as of September 30, 2006. The current terms of this debt are
described in Item 2, "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Liquidity and Capital Resources." For
fixed rate debt, we estimate fair value by using discounted cash flow analyses
based on borrowing rates for similar kinds of borrowing arrangements.
For fixed rate debt, the table presents the assumption that the outstanding
principal balance at September 30, 2006 will be paid according to scheduled
principal payments and that we will not prepay any of the outstanding principal
balance.
Three
Months Year Ending December 31,
Remaining ----------------------------------------------
2006 2007 2008 2009 2010 Thereafter Total Fair Value
----------------------------------------------------------------------------------------------
(dollars in thousands)
FIXED RATE DEBT:
Secured notes payable $2,649 $11,028 $121,605 $9,580 $10,125 $204,769 $359,756 $468,105
Weighted average interest rate 5.84% 5.84% 5.84% 5.84% 5.84% 5.84%
The primary market risks we face are interest rate fluctuations. Principal
amounts outstanding under the SCVNB line of credit, which had a zero balance at
September 30, 2006, is tied to a LIBOR based interest rate. As a result, we pay
lower rates of interest in periods of decreasing interest rates and higher rates
of interest in periods of increasing interest rates. All of our debt is
denominated in United States dollars. We had no interest rate caps or interest
rate swap contracts at September 30, 2006.
As of September 30, 2006, we had no interest rate risk since there was no
variable rate debt outstanding.
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ITEM 4. CONTROLS AND PROCEDURES
DISCLOSURE CONTROLS AND PROCEDURES
We strive to maintain disclosure controls and procedures that are designed to
ensure that information required to be disclosed in our Exchange Act reports is
recorded, processed, summarized and reported within the time periods specified
in the SEC's rules and forms, and that such information is accumulated and
communicated to our management, including our chief executive officer and chief
financial officer, as appropriate, to allow for timely decisions regarding
required disclosure. In designing and evaluating the disclosure controls and
procedures, management recognizes that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives and management necessarily is required
to apply its judgment in evaluating the cost-benefit relationship of possible
controls and procedures.
As required by SEC Rule 13a-15(b) we conducted an evaluation, under the
supervision and with the participation of our management, including our Chief
Executive Officer, President and Vice President of Finance, of the effectiveness
of the design and operation of our disclosure controls and procedures. Based
upon that evaluation, the Chief Executive Officer, President and Vice President
of Finance concluded that our disclosure controls and procedures (as defined in
Rule 13a-15(e) or Rule 15d-15(e)) were effective as of September 30, 2006.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
There was no material change in our internal control over financial reporting
during the last fiscal quarter that has materially affected, or is reasonably
likely to materially affect, our internal control over financial reporting.
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PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Legal proceedings are incorporated herein by reference from Part I "Item 1. -
Notes to Condensed Consolidated Financial Statements - Note 9 - Commitments and
Contingencies."
ITEM 1A. RISK FACTORS
While we attempt to identify, manage and mitigate risks and uncertainties
associated with our business to the extent practical under the circumstances,
some level of risk and uncertainty will always be present. In addition to the
other information contained in this report, you should carefully review the
factors discussed under Item 1A of our 2005 Form 10-K which describes some of
the risks and uncertainties associated with our business. These risks and
uncertainties have the potential to materially affect our business, financial
condition, results of operations, cash flows, and future prospects. Additional
risks and uncertainties not presently known to us or that we currently deem
immaterial also may impair our business operations.
ITEM 6. EXHIBITS
31.1 Section 1350 Certificate of CEO
31.2 Section 1350 Certificate of President & COO
31.3 Section 1350 Certificate of Principal Financial Officer
32 Certification pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
- 25 -
================================================================================
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 thereto duly authorized.
Mission West Properties, Inc.
(Registrant)
Date: November 6, 2006 By: /s/ Carl E. Berg
-----------------------------------------------
Carl E. Berg
Chief Executive Officer
Date: November 6, 2006 By: /s/ Wayne N. Pham
-----------------------------------------------
Wayne N. Pham
Vice President of Finance and Controller
(Principal Accounting Officer and Duly
Authorized Officer)
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