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 JUNE 30, 2007
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
Indicatethe number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date:
19,640,087 shares outstanding as of July 31, 2007
Mission West Properties, Inc.
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2007
INDEX
Page
Part I Financial Information
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as of June 30, 2007
and December 31, 2006 (unaudited).......................................................................2
Condensed Consolidated Statements of Operations for the three
and six months ended June 30, 2007 and 2006 (unaudited).................................................3
Condensed Consolidated Statements of Cash Flows for the
six months ended June 30, 2007 and 2006 (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)
---------
June 30, 2007 December 31, 2006
--------------------- ----------------------
ASSETS
Real estate:
Land $ 307,903 $ 272,223
Buildings and improvements 766,515 756,596
Real estate related intangible assets 6,422 19,529
--------------------- ----------------------
Total investments in properties 1,080,840 1,048,348
Less accumulated depreciation and amortization (152,107) (149,459)
--------------------- ----------------------
Total investments in real estate, net 928,733 898,889
Cash and cash equivalents 39,053 33,785
Restricted cash 1,640 48,245
Deferred rent receivable, net 16,788 18,489
Investment in unconsolidated joint venture 2,914 3,468
Other assets, net 26,015 24,611
--------------------- ----------------------
Total assets $1,015,143 $1,027,487
===================== ======================
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Mortgage notes payable $ 342,879 $ 348,101
Mortgage notes payable (related parties) 9,443 9,654
Interest payable 1,343 1,375
Security deposits 6,595 6,977
Deferred rental income 6,891 6,874
Dividends and distributions payable 16,745 16,745
Accounts payable and accrued expenses 7,346 7,601
--------------------- ----------------------
Total liabilities 391,242 397,327
--------------------- ----------------------
Commitments and contingencies (Note 10)
Minority interests 493,004 501,282
--------------------- ----------------------
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,
19,640,087 and 19,443,587 shares issued and outstanding
at June 30, 2007 and December 31, 2006 20 19
Paid-in capital 152,463 149,541
Accumulated deficit (21,586) (20,682)
--------------------- ----------------------
Total stockholders' equity 130,897 128,878
--------------------- ----------------------
Total liabilities and stockholders' equity $1,015,143 $1,027,487
===================== ======================
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 June 30, Six months ended June 30,
2007 2006 2007 2006
------------------ ------------------- -------------------- ------------------
Revenues:
Rental revenue from real estate $21,283 $22,060 $42,621 $46,108
Above market lease intangible asset amortization - (472) (4,091) (944)
Tenant reimbursements 3,254 2,954 6,482 6,151
Lease termination fees 168 12 10,277 16,068
Other income, including interest 959 1,085 4,014 1,814
------------------ ------------------- -------------------- ------------------
Total revenues 25,664 25,639 59,303 69,197
------------------ ------------------- -------------------- ------------------
Expenses:
Property operating, maintenance and real estate taxes 4,616 4,164 9,161 8,671
Interest 5,046 5,193 10,115 10,408
Interest (related parties) 182 190 366 381
General and administrative 673 637 1,387 1,272
Depreciation and amortization of real estate 5,454 5,269 11,664 10,591
------------------ ------------------- -------------------- ------------------
Total expenses 15,971 15,453 32,693 31,323
------------------ ------------------- -------------------- ------------------
Income before equity in earnings of unconsolidated
joint venture and minority interests 9,693 10,186 26,610 37,874
Equity in earnings of unconsolidated joint venture 350 351 687 682
Minority interests (8,039) (8,505) (21,918) (31,456)
------------------ ------------------- -------------------- ------------------
Income from continuing operations 2,004 2,032 5,379 7,100
------------------ ------------------- -------------------- ------------------
Discontinued operations, net of minority interests:
Income attributable to discontinued operations - 89 - 174
------------------ ------------------- -------------------- ------------------
Income from discontinued operations - 89 - 174
------------------ ------------------- -------------------- ------------------
Net income to common stockholders $2,004 $2,121 $ 5,379 $ 7,274
================== =================== ==================== ==================
Net income to minority interests $8,039 $8,968 $21,918 $32,358
================== =================== ==================== ==================
Income per common share from continuing operations:
Basic $0.10 $0.11 $0.27 $0.38
================== =================== ==================== ==================
Diluted $0.10 $0.11 $0.27 $0.38
================== =================== ==================== ==================
Income per common share from discontinued operations:
Basic - - - $0.01
================== =================== ==================== ==================
Diluted - - - $0.01
================== =================== ==================== ==================
Net income per common share to common stockholders:
Basic $0.10 $0.11 $0.27 $0.39
================== =================== ==================== ==================
Diluted $0.10 $0.11 $0.27 $0.39
================== =================== ==================== ==================
Weighted average shares of
common stock outstanding (basic) 19,639,928 19,028,240 19,611,515 18,743,649
================== =================== ==================== ==================
Weighted average shares of
common stock outstanding (diluted) 20,020,596 19,123,945 19,956,752 18,824,340
================== =================== ==================== ==================
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)
---------
Six months ended June 30,
2007 2006
------------------- -------------------
Cash flows from operating activities:
Net income $ 5,379 $ 7,274
Adjustments to reconcile net income to net cash provided by operating activities:
Minority interests income 21,918 32,358
Minority interest distributions (21,918) (27,931)
Depreciation and amortization of real estate and in-place leases 11,664 10,904
Amortization of above market lease 4,091 944
Equity in earnings of unconsolidated joint venture (687) (682)
Distributions from unconsolidated joint venture 1,100 510
Interest earned on restricted cash (592) (121)
Lease termination fee income related to restricted cash 3,264 (8,948)
Stock-based compensation expense 316 118
Other 131 35
Changes in operating assets and liabilities:
Deferred rent receivable 1,701 830
Other assets (1,263) 334
Interest payable (32) -
Security deposits (389) (1,366)
Deferred rental income 17 3,743
Accounts payable and accrued expenses (266) 1,795
------------------- -------------------
Net cash provided by operating activities 24,434 19,797
------------------- -------------------
Cash flows from investing activities:
Improvements to real estate assets (2,409) (163)
Purchase of real estate (43,191) (15,959)
Restricted cash released for purchase of real estate 43,191 13,447
Excess restricted cash 630 1,835
------------------- -------------------
Net cash used in investing activities (1,779) (840)
------------------- -------------------
Cash flows from financing activities:
Principal payments on mortgage notes payable (5,222) (4,966)
Principal payments on mortgage notes payable (related parties) (211) (195)
Net proceeds from exercise of stock options - 145
Minority interest distributions in excess of earnings (5,703) -
Dividends paid to common stockholders (6,251) (5,912)
------------------- -------------------
Net cash used in financing activities (17,387) (10,928)
------------------- -------------------
Net increase in cash and cash equivalents 5,268 8,029
Cash and cash equivalents, beginning of period 33,785 31,441
------------------- -------------------
Cash and cash equivalents, end of period $39,053 $39,470
=================== ===================
Supplemental information:
Cash paid for interest $4,199 $10,653
=================== ===================
Supplemental schedule of non-cash investing and financing activities:
Issuance of common stock upon conversion of O.P. units $2,606 $ 9,925
=================== ===================
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 per share and per square footage)
(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 June 30, 2007, the Company owns a controlling general partnership
interest of 20.06%, 21.78%, 16.26% and 12.48% 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 18.74%
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 six months
ended June 30, 2007 and 2006.
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
("SEC") 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 June 30, 2007, their consolidated
results of operations for the three and six months ended June 30, 2007 and
2006, and their cash flows for the six months ended June 30, 2007 and 2006.
All significant inter-company balances have been eliminated in
consolidation. The condensed consolidated financial statements as of June
30, 2007 and for the three and six months ended June 30, 2007 and 2006 and
related footnote disclosures are unaudited. The results of operations for
the three and six months ended June 30, 2007 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 consolidates all variable interest entities ("VIE") in which it
is deemed to be the primary beneficiary in accordance with FASB
Interpretation No. 46R, "Consolidation of Variable Interest Entities" ("FIN
46R"). As of June 30, 2007, the Company consolidated one VIE in the
accompanying condensed consolidated balance sheets in connection with an
assignment of a lease agreement with an unrelated party, M&M Real Estate
Control & Restructuring, LLC. See Note 5 for further discussion of this
transaction.
- 5 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
STOCK-BASED OPTION COMPENSATION ACCOUNTING
In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment"
("SFAS 123R"), which addresses the accounting for stock options. SFAS 123R
requires that the cost of all employee, director and consultant 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 123R is an amendment to SFAS 123, "Accounting for
Stock-Based Compensation," and supersedes Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). SFAS
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 June 30, 2007, the Company had
one stock-based compensation plan. The Company adopted the requirements of
SFAS 123R effective January 1, 2006 using the modified prospective method
of transition. 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.
In the first quarter of 2007, stock options to purchase 710,000 shares of
common stock were granted to four employees, three non-employee directors
and four consultants, which options vest monthly for 48 months from date of
grant, subject to continued employment or other service to the Company.
Each option grant has a term of six years from the date of grant subject to
earlier termination in certain events related to termination of employment.
The options were granted at an exercise price of $12.09 per share. The
estimated fair value of the options granted in 2007 was $1.45 per share on
the date of grant using the Black-Scholes option pricing model with the
following assumptions: dividend yield of 5.3%, volatility of 18.94%, risk
free rates of 4.5% and an expected life of six years. All options were
granted at the fair market value at the date of grant.
The following table shows the activity and detail for the 2004 Equity
Incentive Plan.
Weighted Average
2004 Equity Option Price
Incentive Plan Per Share
--------------- ------------------
Balance, December 31, 2006 1,037,100 $10.48
Options granted 710,000 $12.09
Options exercised -
Options cancelled -
---------------
Balance, June 30, 2007 1,747,100 $11.13
===============
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 123R, the Company recorded approximately $157 and $59 of expense
for the three months ended June 30, 2007 and 2006, respectively, and $316
and $118 of expense for share-based compensation relating to grants of
stock options for the six months ended June 30, 2007 and 2006,
respectively.
As of June 30, 2007, there was approximately $807 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 3.3 years.
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
June 30, 2007, these interests accounted for approximately 81.26% 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.
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 2006
condensed consolidated financial statements in order to conform to the 2007
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, 2006 audited consolidated financial statements and should be read
together with the consolidated financial statements and notes thereto
included in the Company's 2006 Annual Report on Form 10-K filed on March
15, 2007.
- 6 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
3. REAL ESTATE
On April 20, 2007, the Company acquired three office/R&D buildings
comprised of approximately 149,000 rentable square feet at Montague
Expressway in Milpitas, California for approximately $15,351. The
acquisition was funded from a portion of the proceeds received from the
Samaritan property sale, which was classified as restricted cash as of
March 31, 2007. With the exception of one lease, the property was purchased
without any long-term tenants.
On April 27, 2007, the Company acquired approximately five acres of vacant
land in Morgan Hill, California, which could support approximately 73,000
rentable square feet of space. The land is currently zoned for industrial
use. The acquisition price for this property was approximately $2,297 and
was funded from the remaining proceeds received from the Samaritan property
sale, which was classified as restricted cash as of March 31, 2007.
4. RESTRICTED CASH
Restricted cash totaled approximately $1,640 as of June 30, 2007. This
amount represents cash held by the Company's consolidated VIE. 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.
5. 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.
Under FIN 46R, for an entity to qualify as a VIE one or more of the
following three characteristics must exist:
1. The equity investment at risk is not sufficient to permit the entity
to finance its activities without additional subordinated financial
support by any parties, including the equity holders.
2. The equity investors lack one or more of the following essential
characteristics of a controlling financial interest:
a. The direct or indirect ability to make decisions about the
entity's activities through voting or similar rights.
b. The obligation to absorb the expected loss of the entity.
c. The right to receive the expected residual returns of the entity.
3. The equity investors have voting rights that are not proportionate to
their economic interests, and the activities of the entity involve or
are conducted on behalf of an investor with a disproportionately small
voting 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 approximately $11,147 in March 2006.
Factors considered by the Company in determining whether M&M should be
considered a VIE for financial reporting purposes included the following:
- No equity was contributed by the partners in the formation of M&M.
- At present, the assignment of a lease is the only property under
management by M&M.
- Because M&M is a newly formed entity it does not have an operating
history that demonstrates its ability to finance its activities
without additional subordinated financial support.
- 7 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
- All revenues, other than interest income, are generated by M&M from
the Company in the form of fees or commissions.
The Company remains at risk because if M&M's operating expenses exceed its
interest income, fees and commissions there would be insufficient funds to
meet the assigned lease obligation without additional financial support
from equity holders or other parties. The Company, which had released the
original tenant from its obligations under the lease, would have to absorb
the majority of any loss, making it the primary beneficiary of M&M's
activities.
6. STOCK TRANSACTIONS
During the six months ended June 30, 2007, two limited partners exchanged a
total of 196,500 O.P. units for 196,500 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 approximately $2,606 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.
7. DISCONTINUED OPERATIONS
Effective January 1, 2002, the Company adopted SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), 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 sold and
presented as discontinued operations in 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.
The Company classified three R&D properties as assets held for sale in the
third quarter of 2006 and sold them in the fourth quarter of 2006, which
qualified as discontinued operations. Condensed results of operations for
these properties for the three and six months ended June 30, 2006 are as
follows:
Three Months Ended June 30, Six Months Ended June 30,
2007 2006 2007 2006
------------- ------------- ------------ ------------
(dollars in thousands)
(unaudited)
Revenues
Rental revenue from real estate - $ 740 - $1,479
Tenant reimbursements - 112 - 224
Other income - 3 - 7
------------- ------------- ------------ ------------
Total revenues - 855 - 1,710
------------- ------------- ------------ ------------
Expenses
Property operating, maintenance and real
estate taxes - 147 - 321
Depreciation of real estate - 156 - 313
------------- ------------- ------------ ------------
Total expenses - 303 - 634
------------- ------------- ------------ ------------
Income from discontinued operations - 552 - 1,076
Minority interest in earnings attributable to
discontinued operations - (463) - (902)
------------ ------------ ------------ ------------
Income from discontinued operations - $ 89 - $ 174
============= ============= ============ ============
8. 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 June 30, Six Months Ended June 30,
2007 2006 2007 2006
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (basic) 19,639,928 19,028,240 19,611,515 18,743,649
Incremental shares from assumed option exercise 380,668 95,705 345,237 80,691
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (diluted) 20,020,596 19,123,945 19,956,752 18,824,340
=============== ============== ============== ===============
- 8 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
Outstanding options to purchase 647,000 shares in 2006 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 period. 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 to net income. The total number of O.P.
units outstanding at June 30, 2007 and 2006 was 85,009,699 and 85,235,999,
respectively.
9. RELATED PARTY TRANSACTIONS
As of June 30, 2007, the Berg Group owned 77,378,148 O.P. units. The Berg
Group's combined ownership of O.P. units and shares of common stock as of
June 30, 2007 represented approximately 74% of the total equity interests,
assuming conversion of all O.P. units outstanding into the Company's common
stock.
As of June 30, 2007, debt in the amount of approximately $9,443 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 mortgage
note was approximately $182 and $190 for the three months ended June 30,
2007 and 2006, respectively, and $366 and $381 for the six months ended
June 30, 2007 and 2006, respectively.
During the first six months of 2007 and 2006, Carl E. Berg or entities
controlled by Mr. Berg held financial interests in several companies that
lease space from the operating partnerships, which include companies where
Mr. Berg has a greater than 10% ownership interest. These related tenants
contributed approximately $361 and $162 in rental revenue during the three
months ended June 30, 2007 and 2006, respectively, and $721 and $324 in
rental revenue during the six months ended June 30, 2007 and 2006,
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, which is substantially complete.
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 in "Other assets" on its
condensed consolidated balance sheets. The Berg Group is in the process of
satisfying this commitment to complete certain tenant improvements.
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 in "Other assets"
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, for the Company's
headquarters. Rental amounts and overhead reimbursements paid to Berg &
Berg Enterprises, Inc. were approximately $24 and $23 for the three months
ended June 30, 2007 and 2006, respectively, and $47 and $45 for the six
months ended June 30, 2007 and 2006, respectively.
10. 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.
- 9 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
Mission West Properties, L.P. v. Republic Properties Corporation, et al.
Santa Clara County Superior Court, Case No. CV 796249. Republic Properties
Corporation ("RPC") is a former 50% partner with Mission West Properties,
L.P. in the Hellyer Avenue Limited Partnership ("Hellyer LP"), which was
formed in July 2000. Under the terms of the Hellyer LP partnership
agreement and other related contracts, Mission West Properties, L.P.
("MWP") had the right to obtain RPC's entire interest in Hellyer LP in the
event of certain payment defaults which occurred in August 2000. Therefore,
on September 1, 2000, MWP, as the general partner of Hellyer LP, ceased all
allocations of income and cash flow to RPC and exercised the right under
the partnership agreement to cancel RPC's entire interest in the
partnership. Following discussions with and approval by the Independent
Directors Committee, the Company authorized the transfer of RPC's interest
in Hellyer LP to Berg & Berg Enterprises, Inc. Under the Berg Land Holdings
Option Agreement and the Acquisition Agreement dated as of May 14, 1998,
the Independent Directors Committee had the right, but not the obligation,
to reacquire the property interest and the related distributions related to
the property interest at any time. The transfer was effective as of
September 1, 2000. On November 20, 2000, RPC commenced a lawsuit against
MWP in the Circuit Court of Maryland for Baltimore City. After lengthy
litigation, which included a trial on the merits and subsequent appeals, in
April 2006 Maryland's highest 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. The Court
vacated the judgment and decision in the trial court and dismissed the
entire Maryland suit. In February 2001, while the Maryland case was
pending, the Company filed a suit against RPC in the Superior Court of the
State of California for the County of Santa Clara. The case was stayed
pending resolution of the Maryland case, and the Company dismissed its suit
on March 4, 2005. In April 2005, RPC submitted a motion asking the Superior
Court to reinstate the case, which the Court granted on May 25, 2005. On
July 5, 2006, RPC filed a cross-complaint in the case seeking partnership
distributions to which the Company demurred. The Court sustained the
Company's demurrer with leave to amend. Subsequently, RPC filed an amended
complaint and the Company submitted another demurrer seeking dismissal of
the claims on statute of limitations grounds. On February 20, 2007, the
Court overruled the Company's demurrer. The Company is in the process of
seeking a writ from the California State Court of Appeal for the Sixth
District directing the Superior Court to sustain the demurrer.
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 Hellyer LP.
Furthermore, the Company has never accounted for the 50% interest of RPC as
its asset, and if it is ultimately determined that RPC should have retained
that interest or it reacquires that interest, the Company's balance sheet
and financial condition would not be impacted. Although to date, the
Company has consolidated the assets, liabilities and operating results of
Hellyer LP and allocated 50% of the operating income to the minority
interest holder.
In January 2004, the Global Crossing Estate Representative, for Itself and
the Liquidating Trustee of the Global Crossing Liquidating Trust v. Mission
West Properties L.P. 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 avoidable
preference payments. During the course of settlement discussions with
Global Crossing's representative, the Company learned that it would receive
only 2-3% of its unsecured claim of approximately $16,711 for unpaid rent
from the final distribution of the assets and proceeds of bankruptcy
estate. On February 21, 2007, the Company and the Liquidating Trustee
entered into a settlement agreement under which the $815 claim against the
Company was dismissed and the Company agreed to accept a payment of
approximately $301 as a final settlement of its unsecured claim for unpaid
rent.
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 June 30, 2007.
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 June 30,
2007.
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.
- 10 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
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.
ASSET DISPOSITIONS SUBJECT TO CERTAIN CONDITIONS
The Company has entered into sales 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 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 Buildings Rentable Square Feet Acres Sales Prices
-------- ------------------- -------------------- ----- ------------
Morse Avenue
Sunnyvale, California 1 39,200 2.25 $8,300
McCandless Drive
Milpitas, California 8 427,000 23.03 $76,500
Northport Loop
Fremont, California 1 48,400 3.32 $7,700
11. SUBSEQUENT EVENTS
On July 5, 2007, the Company paid dividends of $0.16 per share of common
stock to all common stockholders of record as of June 29, 2007. 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 $16,745.
- 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 under Part I, Item 1 of this
Report and our audited consolidated financial statements and notes thereto
contained in our Annual Report on Form 10-K as of and for the year ended
December 31, 2006. The results for the three and six months ended June 30, 2007
are not necessarily indicative of the results to be expected for the entire
fiscal year ending December 31, 2007. 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," below.
FORWARD-LOOKING INFORMATION
This quarterly report on Form 10-Q 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,
- - the occupancy rates of the properties,
- - rental rates on new and renewed leases,
- - 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 2006 Annual Report on Form 10-K and from time to time in our other
reports and documents filed with the Securities and Exchange Commission ("SEC"),
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 June 30,
2007, we owned and managed 110 properties totaling approximately 7.8 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 June 30, 2007, 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 the beginning of 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 18.3% in late
2006 and 17.6% at the end of the second quarter of 2007. Total vacant R&D square
footage in Silicon Valley at the end of the second quarter of 2007 amounted to
27.1 million square feet, of which 17.7%, or 4.8 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 2006 amounted to
approximately 1.9 million square feet, but in the first six months of 2007,
there was total positive net absorption of approximately 1.3 million square
feet. According to the BT Report, the average asking market rent per square foot
at the end of the second quarter of 2007 was $1.14 compared to $0.99 in late
2006. 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, however, and individual properties
within any particular submarket presently may be leased above or below the
current average asking market rental rates within that submarket.
Our occupancy rate at June 30, 2007 was 67.8% compared to 63.0% at June 30,
2006. 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
372,000 rentable square feet are expiring prior to the end of 2007. The
properties subject to these leases may take anywhere from 24 to 36 months or
longer to re-lease. We believe that the average 2007 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 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 effective date of SFAS
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 141 and
management's estimates. Amortization expense of above and below
- 13 -
market lease intangible asset is offset against rental revenue in the revenue
section while amortization of in-place lease value intangible asset is included
in depreciation and amortization of real estate in the expense section of our
condensed consolidated statements of operations. 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 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 123R, which
addresses the accounting for stock options. SFAS 123R requires that the cost of
all employee, director and consultant 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 123R is an amendment to
SFAS 123 and supersedes APB 25. SFAS 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 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 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.
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
- 14 -
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 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 SIX MONTHS ENDED JUNE 30, 2007 TO THE THREE AND SIX
MONTHS ENDED JUNE 30, 2006
As of June 30, 2007, through our controlling interests in the operating
partnerships, we owned 110 properties totaling approximately 7.8 million
rentable square feet compared to 110 properties totaling approximately 7.9
million rentable square feet owned by us as of June 30, 2006. This represents a
net decrease of approximately 1.3% in total rentable square footage, as we
acquired three R&D properties consisting of approximately 148,600 rentable
square feet and sold three R&D properties consisting of approximately 235,100
rentable square feet since the second quarter of 2006. Included in the 7.8
million rentable square feet are approximately 894,000 rentable square feet (or
17 buildings), which are in the process of being rezoned for residential
development.
Rental revenue from real estate for the three and six months ended June 30, 2007
compared to the same three- and six-month periods in 2006 are as follows:
Three Months Ended June 30,
% Change by
2007 2006 $ Change Property Group
------------- -------------- --------------- ---------------
(dollars in thousands)
Same Property (1) $20,708 $21,506 ($798) (3.7%)
2006 Acquisitions 554 554 - -
2007 Acquisitions 21 - 21 100%
------------- -------------- ---------------
Total $21,283 $22,060 ($777) (3.5%)
============= ============== ===============
Six Months Ended June 30,
% Change by
2007 2006 $ Change Property Group
------------- -------------- --------------- ---------------
(dollars in thousands)
Same Property (1) $41,492 $45,443 ($3,951) (8.7%)
2006 Acquisitions 1,108 665 443 66.6%
2007 Acquisitions 21 - 21 100%
------------- -------------- ---------------
Total $42,621 $46,108 ($3,487) (7.6%)
============= ============== ===============
(1) "Same Property" is defined as properties owned by us prior to 2007
that we still owned as of June 30, 2007.
RENTAL REVENUE FROM REAL ESTATE FROM CONTINUING OPERATIONS
For the quarter ended June 30, 2007, rental revenue from real estate decreased
by approximately ($0.8) million, or 3.5%, from $22.1 million for the three
months ended June 30, 2006 to $21.3 million for the three months ended June 30,
2007. For the six months ended June 30, 2007, rental revenue from real estate
decreased by approximately ($3.5) million, or 7.6%, from $46.1 million for the
six months ended June 30, 2006 to $42.6 million for the six months ended June
30, 2007. The decline in rental revenue resulted primarily from the loss of
several tenants due to lease terminations, bankruptcy, relocation or cessation
of their operations since June 30, 2006, all of which resulted from current
adverse market conditions. Rental revenue was offset by amortization expense of
approximately ($0.5) million for the three months ended June 30, 2006, and
($4.1) million and ($0.9) million for the six months ended June 30, 2007 and
2006, respectively, for an above-market lease intangible asset. The increase was
attributable to a lease termination. Our occupancy rate at June 30, 2007 was
approximately 67.8%, compared to approximately 63.0% at June 30, 2006.
EQUITY IN EARNINGS FROM UNCONSOLIDATED JOINT VENTURE
As of June 30, 2007, 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 June 30, 2007, we recorded equity in
earnings from the unconsolidated joint venture of approximately $0.35 million
compared to equity in earnings of $0.35 million for the same period in 2006. For
the six-month periods ended June 30, 2007 and 2006, equity in earnings from the
unconsolidated joint venture was approximately $0.69 million and $0.68 million,
respectively. The occupancy rate for the properties owned by this joint venture
at June 30, 2007 and 2006 was 100% and approximately 86.6%, respectively.
LEASE TERMINATION INCOME
Lease termination fees for the three months ended June 30, 2007 and 2006 were
approximately $0.2 million and $12,000, respectively. Lease termination fees for
the six months ended June 30, 2007 and 2006 were approximately $10.3 million and
$16.1 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 June 30,
2007 included approximately $0.5 million from interest, $0.3 million from
management fees and $0.2 million from security deposit forfeitures and
miscellaneous income. Other income of
- 16 -
approximately $1.1 million for the three months ended June 30, 2006 included
approximately $0.5 million from interest, $0.3 million from management fees and
$0.3 million from the settlement of claims and miscellaneous income. For the six
months ended June 30, 2007, other income of approximately $4.0 million included
approximately $1.6 million from a forfeited deposit under a contract for the
sale of property, $1.3 million from interest, $0.6 million from management fees,
$0.3 million from a bankruptcy settlement claim and $0.2 million from security
deposit forfeitures and miscellaneous income. For the six months ended June 30,
2006, other income of approximately $1.8 million included approximately $0.9
million from interest, $0.5 million from management fees and $0.4 million from
bankruptcy settlement claims and miscellaneous income.
EXPENSES FROM CONTINUING OPERATIONS
Property operating expenses and real estate taxes during the second quarter of
2007 increased by approximately $0.4 million, or 10.9%, from $4.2 million to
$4.6 million for the three months ended June 30, 2006 and 2007, respectively, as
in 2006 we benefited from real estate tax refunds of $0.6 million that did not
reoccur in the same period of 2007. Tenant reimbursements increased by
approximately $0.3 million, or 10.2%, from $3.0 million for the three months
ended June 30, 2006 to $3.3 million for the three months ended June 30, 2007 due
to higher occupancy. Certain expenses such as property insurance, real estate
taxes, and other fixed operating expenses are not recoverable from vacant
properties, however. For the six months ended June 30, 2007, property operating
expenses and real estate taxes increased by approximately $0.5 million, or 5.7%,
from $8.7 million for the six months ended June 30, 2006 to $9.2 million for the
six months ended June 30, 2007. General and administrative expenses increased by
approximately $0.1 million, or 5.7%, from $0.6 million to $0.7 million for the
three months ended June 30, 2006 and 2007, respectively. For the six months
ended June 30, 2006 and 2007, general and administrative expenses increased by
approximately $0.1 million, or 9.0%, from $1.3 million to $1.4 million,
respectively. The increase in general and administrative expenses was primarily
a result of higher salaries and wages and stock-based compensation expense.
Real estate depreciation and amortization expense increased by approximately
$0.2 million, or 3.5%, from $5.3 million to $5.5 million for the three months
ended June 30, 2006 and 2007, respectively. Real estate depreciation and
amortization expense increased by approximately $1.1 million, or 10.1%, from
$10.6 million to $11.7 million for the six months ended June 30, 2006 and 2007,
respectively. The increase was attributable primarily to the write-offs of
additional amortization expense relating to in-place lease value intangible
asset pursuant to SFAS 141 in connection with two lease terminations and
additional tenant improvements.
Interest expense decreased by approximately ($0.1) million, or 2.8%, from $5.2
million for the three months ended June 30, 2006 to $5.1 million for the three
months ended June 30, 2007 due to lower total debt in 2007. Interest expense
(related parties) was approximately $0.2 million in both three-month periods
ended June 30, 2007 and 2006. Total debt outstanding, including amounts due
related parties, decreased by approximately ($10.0) million, or 2.8%, from
$362.4 million as of June 30, 2006 to $352.3 million as of June 30, 2007.
Overall interest expense, including amounts paid to related parties, for the
quarter ended June 30, 2007 decreased by approximately ($0.2) million compared
to the same quarter a year ago.
Interest expense decreased by approximately ($0.3) million, or 2.8%, from $10.4
million for the six months ended June 30, 2006 to $10.1 million for the six
months ended June 30, 2007. Interest expense (related parties) did not change
significantly for the six months ended June 30, 2007 compared to the same period
in 2006.
INCOME FROM DISCONTINUED OPERATIONS
The following table depicts the amounts of income from discontinued operations
for the three and six months ended June 30, 2006.
Three Months Ended June 30, Six Months Ended June 30,
2007 2006 2007 2006
----------- ------------ ------------ ------------
(dollars in thousands)
(unaudited)
Income attributable to discontinued operations - $552 - $1,076
Minority interests in earnings attributable to
discontinued operations - (463) - (902)
----------- ------------ ------------ ------------
Income from discontinued operations - $ 89 - $ 174
=========== ============ ============ ============
In accordance with our adoption of SFAS 144, in the third quarter of 2006 we
classified three R&D properties as assets held for sale and sold them in the
fourth quarter of 2006 and classified them as discontinued operations. The
income to common stockholders and minority interests attributable to
discontinued operations from these three R&D properties for the three months
ended June 30, 2006 was approximately $0.1 million and $0.5 million,
respectively. The income to common stockholders and minority interests
attributable to discontinued operations from these three R&D properties for the
six months ended June 30, 2006 was approximately $0.2 million and $0.9 million,
respectively.
NET INCOME TO COMMON STOCKHOLDERS AND NET INCOME TO MINORITY INTERESTS
Net income to common stockholders decreased by approximately ($0.1) million, or
5.5%, from $2.1 million for the three months ended June 30, 2006 to $2.0 million
for the same period in 2007. The minority interest portion of income decreased
by approximately ($0.9) million, or 10.4%, from $8.9 million for the three
months ended June 30, 2006 to $8.0 million for the three months ended June 30,
2007. The decline in the quarter's net income for both common stockholders and
minority interests was primarily due to lower rental income and higher operating
expenses in the second quarter of 2007. For the six months ended June 30, 2007
and 2006, the minority interest portion of income was approximately $21.9
million and $32.4 million, respectively, and net income to common stockholders
was
- 17 -
approximately $5.4 million and $7.3 million, respectively. The decrease in net
income for both common stockholders and minority interests in the first half of
2007 was primarily from the combination of lower rental income for the June 30,
2007 period and the realization of higher lease termination fees in the same
period in 2006.
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 June 30, 2007 and 2006,
respectively.
CHANGES IN FINANCIAL CONDITION
The most significant changes in our financial condition during the three months
ended June 30, 2007 resulted from the acquisition of three R&D properties and
approximately five acres of vacant land. In addition, total stockholders' equity
increased from the issuance of common stock upon the exchange of O.P. units.
At June 30, 2007, total investments in properties increased on a net basis by
approximately $32.5 million from December 31, 2006 primarily due to three R&D
property acquisitions consisting of approximately 149,000 rentable square feet
located in the Silicon Valley, the acquisition of 55 acres of vacant land
located in the Silicon Valley and the construction of additional tenant
improvements.
Total stockholders' equity, net, increased by approximately $2.0 million from
December 31, 2006 as we obtained additional capital from the issuance of 196,500
shares of our common stock for the exchange of O.P. units, offset with an
increase in accumulated deficit of approximately ($0.9) million. The newly
issued shares of common stock increased additional paid-in capital by
approximately $2.9 million.
LIQUIDITY AND CAPITAL RESOURCES
We expect an increase in operating cash flows from our operating property
portfolio in 2007 as compared to 2006. The increase in cash flows is resulting
from early lease terminations. If we are unable to lease a significant portion
of the approximately 372,000 rentable square feet scheduled to expire during the
remainder of 2007 or an equivalent amount of our currently available space of
approximately 2.5 million rentable square feet, our operating cash flows may be
affected adversely. With the expectation of lower rental revenues for the
remainder of 2007, we expect our properties' net operating income to show a year
over year decline when compared to 2006 driven by excess capacity of commercial
office and R&D space in the Silicon Valley. 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. Cash flows from lease terminations are
non-recurring and to maintain or increase cash flows in the future we must
re-lease our vacant properties.
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 borrowings under
the line of credit with Santa Clara Valley 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 2007. 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 the
line of credit with SCVNB. We expect our total interest expense to increase
through new financing activities. In the remainder of 2007, we will be obligated
to make payments totaling approximately $5.6 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 $5.3 million from $33.8
million as of December 31, 2006 to $39.1 million as of June 30, 2007 primarily
from lease termination fees.
Restricted cash totaled approximately $1.6 million as of June 30, 2007. This
amount represents cash held by our VIE from a lease termination in 2006. We
include this in our restricted cash under the principles of FIN 46R. We do not
possess or control these funds or have any rights to receive them except as
provided in the applicable agreements, however. The restricted cash is not
available for distribution to stockholders.
DISTRIBUTIONS
On July 5, 2007, we paid dividends of $0.16 per share of common stock to all
common stockholders of record as of June 29, 2007. 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 2007, 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.
- 18 -
DEBT
At June 30, 2007, we had total indebtedness of approximately $352.3 million,
including $342.9 million of fixed rate mortgage debt and $9.4 million under the
Berg Group mortgage note (related parties), as detailed in the table below. The
Allianz and SCVNB loans contain certain financial loan and reporting covenants
as defined in the loan agreements. As of June 30, 2007, we were in compliance
with these loan covenants.
CONTRACTUAL OBLIGATIONS
The following table identifies the contractual obligations as of June 30, 2007
that will impact our liquidity and cash flow in future periods:
------------ ------------ ------------- ------------ ------------- ------------ ------------
2007 2008 2009 2010 2011 Thereafter Total
------------ ------------ ------------- ------------ ------------- ------------ ------------
(dollars in thousands)
Long-Term Debt Obligations (1) $5,578 $121,589 $9,561 $10,105 $10,681 $194,808 $352,322
Operating Lease Obligations (2) 48 24 - - - - 72
------------ ------------ ------------- ------------ ------------- ------------ ------------
Total $5,626 $121,613 $9,561 $10,105 $10,681 $194,808 $352,394
============ ============ ============= ============ ============= ============ ============
(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 June
30, 2007:
Maturity Interest
Debt Description Collateral Properties Balance Date Rate
- ----------------------------------------- -------------------------------------- -------------------- ------------- ------------
(dollars in thousands)
Line of Credit:
Santa Clara Valley National Bank Not Applicable - 12/07 (3)
--------------------
Mortgage Notes Payable(related parties): 5300 & 5350 Hellyer Ave., San Jose, CA $ 9,443 6/10 7.65%
--------------------
Mortgage Notes Payable(1):
Prudential Ins. Co. of America(2) 10300 Bubb Road, Cupertino, CA 113,789 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 Ins. Co.(4) 1750 Automation Parkway, San Jose, CA 86,702 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 Ave., San Jose, CA
2251 Lawson Lane, Santa Clara, CA
1325 McCandless Drive, Milpitas, CA
1650-1690 McCandless Dr., Milpitas, CA
20605-20705 Valley Green Dr., Cupertino, CA
Allianz Life Ins. Co.(Allianz Loan I)(5) 5900 Optical Court, San Jose, CA 24,217 8/25 5.56%
Allianz Life Ins. Co.(Allianz Loan II)(5) 5325-5345 Hellyer Avenue, San Jose, CA 118,171 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
--------------------
342,879
--------------------
--------------------
TOTAL $352,322
====================
(1) Mortgage notes payable generally require monthly installments of principal
and interest ranging from approximately $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 June 30, 2007.
(2) The Prudential Insurance loan is payable in monthly installments of
approximately $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 June 30, 2007, the Company was in
compliance with these loan covenants.
(4) The Northwestern loan is payable in monthly installments of approximately
$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
approximately $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 June 30, 2007,
the Company was in compliance with these loan covenants.
At June 30, 2007, 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 $13.94 per share on June 29, 2007) on a fully diluted basis, including the
conversion of all O.P. units into common stock, was approximately 19.4%. On June
29, 2007, the last trading day for the quarter, total market capitalization was
approximately $1.82 billion.
- 20 -
At June 30, 2007, the outstanding balance remaining under certain notes that we
owed to the operating partnerships was approximately $1.9 million. The due date
of these notes has been extended to September 30, 2008. 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 SIX MONTHS ENDED JUNE 30, 2007 TO THE SIX MONTHS ENDED JUNE
30, 2006
Net cash provided by operating activities for the six months ended June 30, 2007
was approximately $24.4 million compared to $19.8 million for the same period in
2006. Cash flow increases came primarily from lease termination fees, a
forfeited deposit under a contract for the sale of property, and rent payments
from M&M, LLC in 2007 (see Note 5 of Notes to Condensed Consolidated Financial
Statements in Part I, Item 1, above). Higher leasing commission payments
(included in other assets) in 2007 compared to 2006 reduced the amount of the
overall increase in cash flows.
Net cash used in investing activities was approximately ($1.8) million and
($0.8) million for the six months ended June 30, 2007 and 2006, respectively.
Cash used in investing activities during the six months ended June 30, 2007
related principally to the acquisition of 50 acres of vacant land at the Morgan
Hill Ranch in Morgan Hill, California for approximately $25.5 million, the
acquisition of five acres of vacant land at the Morgan Hill Ranch in Morgan
Hill, California for approximately $2.3 million and the acquisition of three R&D
properties at Montague Expressway in Milpitas, California for approximately
$15.4 million. All three acquisitions were completed as a tax-deferred exchange
transaction involving our former R&D properties at 2033-2243 Samaritan Drive in
San Jose, California. The remaining excess restricted cash of approximately $0.6
million was transferred to our general cash account. Capital expenditures for
real estate improvements were approximately $2.4 million for the six months
ended June 30, 2007.
Net cash used in investing activities during the six months ended June 30, 2006
related principally to the acquisition of the property at 233 South Hillview
Drive in Milpitas, California for approximately $13.5 million, pursuant to a
tax-deferred exchange transaction involving our former R&D property at 800
Embedded Way in San Jose, California. Excess restricted cash of approximately
$1.8 million from the sale of 800 Embedded Way was transferred to our general
cash account. Capital expenditures for real estate improvements were
approximately $0.2 million for the six months ended June 30, 2006.
Net cash used in financing activities was approximately ($17.4) million for the
six months ended June 30, 2007 compared to approximately ($10.9) million for the
six months ended June 30, 2006. During the first six months of 2007, we used
approximately $5.4 million to pay outstanding debt, paid approximately $6.3
million of dividends to common stockholders and paid $5.7 million to minority
interests for distributions in excess of earnings. During the same period in
2006, we received approximately $0.2 million from stock option exercises, used
approximately $5.2 million to pay outstanding debt and paid approximately $5.9
million of dividends to common stockholders.
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 our 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 our financial
performance when compared to other REITs because 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 represented by O.P.
Units 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.
- 21 -
Furthermore, FFO is not comparable to similarly entitled items reported by other
REITs that do not define FFO exactly as we do.
FFO for the three and six months ended June 30, 2007 and 2006, as reconciled to
net income to common stockholders, are summarized in the following table:
Three Months Ended June 30, Six Months Ended June 30,
2007 2006 2007 2006
------------------ ------------------ ------------------ ------------------
(dollars in thousands) (dollars in thousands)
Net income to common stockholders $ 2,004 $ 2,121 $ 5,379 $ 7,274
Add:
Minority interests(1) 7,922 8,855 21,677 32,110
Depreciation & amortization of real estate(2) 6,028 5,978 12,803 12,096
------------------ ------------------ ------------------ ------------------
FFO $15,954 $16,954 $39,859 $51,480
================== ================== ================== ==================
(1) 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. The
minority interests for third parties totaling approximately $117 and $113
for the three months ended June 30, 2007 and 2006, respectively, and $241
and $248 for the six months ended June 30, 2007 and 2006, respectively, 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
approximately $189 and $211 for the three months ended June 30, 2007 and
2006, respectively, and $379 and $422 for the six months ended June 30,
2007 and 2006, respectively. Also includes our amortization of leasing
commissions of approximately $384 and $342 for the three months ended June
30, 2007 and 2006, respectively, and $760 and $770 for the six months ended
June 30, 2007 and 2006, 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.
The decline in FFO year-over-year was primarily due to lower rental and
termination fee income and higher amortization expense for an above-market lease
intangible asset in 2007 compared to 2006.
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 June 2006, the FASB issued Interpretation 48, "Accounting for Uncertainty in
Income Taxes" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in
income taxes recognized in our financial statements in accordance with SFAS No.
109, "Accounting for Income Taxes." The provisions of FIN 48 are effective for
our fiscal year beginning January 1, 2007. The adoption of FIN 48 on January 1,
2007 is not expected to have a significant impact on our consolidated results of
operations or financial position.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements"
("SFAS 157"). SFAS 157 defines fair value, establishes a framework for measuring
fair value in generally accepted accounting principles, and expands disclosures
about fair value measurements. The provisions of SFAS 157 are effective for our
fiscal year beginning January 1, 2008. We are currently evaluating the impact of
the provisions of SFAS 157 and currently cannot estimate the impact to our
consolidated results of operations or financial position.
- 22 -
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 June 30, 2007. 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 June 30, 2007 will be paid according to scheduled principal
payments and that we will not prepay any of the outstanding principal balance.
Six Months Year Ending December 31,
Remaining -----------------------------------------------
2007 2008 2009 2010 2011 Thereafter Total Fair Value
----------------------------------------------------------------------------------------------
(dollars in thousands)
Fixed Rate Debt:
Secured notes payable $5,578 $121,589 $9,561 $10,105 $10,681 $194,808 $352,322 $458,653
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. 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 June 30, 2007.
As of June 30, 2007, 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 June 30, 2007.
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 10 - 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 2006 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
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================================================================================
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: August 8, 2007 By: /s/ Carl E. Berg
------------------------------------------
Carl E. Berg
Chief Executive Officer
Date: August 8, 2007 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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