 |
   |
 |
The discussion that follows is based primarily on our consolidated financial
statements as of December 31, 2002 and 2001, and for the years ended December
31, 2002, 2001 and 2000 and should be read along with the consolidated
financial statements and related notes. The ability to compare one period
to another may be significantly affected by acquisitions completed, development
properties placed in service and dispositions made during those years.
The number of operating office buildings that we owned and were consolidated
in the financial statements were 260 in 2002, 254 in 2001 and 252 in 2000.
General
During 2002, we completed the following significant transactions:
- We issued $400.0 million of 7.125% senior unsecured notes in January 2002, $50.0 million of 5.261% senior unsecured notes in November 2002 and $175.0 million of 5.25% senior unsecured notes in November 2002.
- We entered into interest rate swap agreements with notional amounts of $150.0 million and $175.0 million which hedge certain senior unsecured notes, effectively converting this fixed rate debt to variable rate debt.
- We repurchased and redeemed an aggregate of approximately 5.8 million shares of our preferred stock for approximately $145.5 million.
- We repurchased approximately 1.4 million shares of our common stock for approximately $35.9 million.
- We acquired five operating properties for an aggregate purchase price of approximately $216.1 million, including assumed debt.
- We disposed of four operating properties (one owned through a joint venture) for aggregate net proceeds of approximately $176.1 million.
During 2001, we completed the following significant transactions:
- We disposed of seven operating properties, one property under development and three parcels of land held for development.
- We entered into a three-year, $500.0 million unsecured credit facility with J.P. Morgan Chase, as agent for a group of banks.
- We repurchased approximately 14.7 million shares of our common stock for approximately $428.3 million, including 9.2 million shares repurchased from Security Capital.
Critical Accounting Policies and Estimates
Critical accounting policies and estimates are those that are both
important to the presentation of our financial condition and
results of operations
and require management’s most difficult, complex or subjective
judgments. Our critical accounting policies and estimates relate
to evaluating the
impairment of long-lived assets, our investment in HQ Global and
other investments, assessing our probable liability under lease
guarantees
for HQ Global and evaluating the collectibility of accounts and
notes receivable.
If events or changes in circumstances indicate that the carrying
value of a rental property to be held and used or land held
for development may be impaired, we perform a recoverability
analysis
based on estimated
undiscounted
cash flows to be generated from the property in the future.
If the analysis indicates that the carrying value is not recoverable
from
future cash flows,
the property and related assets such as tenant improvements
and
lease commissions, are written down to estimated fair value
and an impairment
loss is recognized.
If we decide to sell rental properties or land holdings, we
evaluate the recoverability of the carrying amounts of the
assets. If
the evaluation
indicates that the carrying value is not recoverable from estimated
net
sales proceeds, the property is written down to estimated fair
value less costs to sell and an impairment loss is recognized.
Our estimates
of cash
flows and fair values of the properties are based on current
market conditions and consider matters such as rental rates
and occupancies
for comparable
properties, recent sales data for comparable properties and,
where applicable, contracts or the results of negotiations
with purchasers
or prospective
purchasers. For 2002 and 2001, we recognized impairment losses
of $2.5 million and $1.5 million, respectively, on land held
for development.
Changes in estimated future cash flows due to changes in our
plans or views of
market and economic conditions could result in recognition
of additional impairment losses which, under applicable accounting
guidance,
could be substantial.
If events or circumstances indicate that the fair value of
an investment accounted for using the equity or cost method
(such
as our investments
in HQ Global and essention) has declined below its carrying
value and we consider the decline to be “other than temporary,” the investment
is written down to fair value and an impairment loss is recognized. For
example, our evaluation of impairment of our investment in HQ Global in
2001was based on a number of factors. These factors included: analysis
of the financial condition and operating results for HQ Global; the inability
of HQ Global to remain in compliance with provisions of its debt agreements
and its failure to reach an agreement with lenders on a restructuring of
its debt prior to the expiration of a forbearance period in December 2001;
the losses of key board members and executives by HQ Global, particularly
in the last half of 2001; and the announcement by FrontLine Capital Group,
HQ Global’s controlling shareholder, in November 2001 that it had
recognized an impairment in the value of intangible assets relating to
HQ Global. Based on our evaluation, we determined in the fourth quarter
of 2001 that our investment in HQ Global was impaired on an “other
than temporary” basis and that our investment in HQ Global had
no value. Accordingly, we wrote down the carrying value of our investment
to zero and recognized the loss in continuing operations. In the fourth
quarter of 2002, we concluded that our investment in essention was partially
impaired and wrote down the carrying value of our investment by $0.5
million
to $1.2 million.
As a result of the bankruptcy of HQ Global, we were required
to make estimates regarding our probable liability under guarantees
of HQ
Global’s
performance under four office leases. After carefully evaluating the
facts and circumstances of each property and developments in the bankruptcy
proceedings,
we accrued a loss of $8.7 million in 2002, our best estimate of the probable
liability related to these guarantees. Circumstances may change in the
future which could cause us to reevaluate our liability under these guarantees
and adjust our estimate as appropriate.
Our allowance for doubtful accounts receivable is established
based on analysis of the risk of loss on specific accounts.
The analysis
places
particular emphasis on past-due accounts and considers information
such as the nature and age of the receivable, the payment history
of the tenant
or other debtor, the financial condition of the tenant and
our assessment of its ability to meet its lease obligations,
the
basis for any disputes
and the status of related negotiations, etc. Our estimate of
the required allowance, which is reviewed on a quarterly basis,
is
subject to revision
as these factors change and is sensitive to the effects of
economic and market conditions on our tenants, particularly
in our largest
markets (i.e.,
the San Francisco Bay and Washington, D.C. Metro areas). For
example, due to economic conditions and analysis of our accounts
and notes
receivable, we increased our allowance for uncollectible accounts
(including related
accrued straight-line rents) by approximately $7.1 million
in 2002, $5.5
million in 2001 and $2.9 million in 2000.
Results of Operations
Property Operations Revenue
Property operations revenue is summarized as follows:
| For the Year Ended | Variance | ||||||||||
 |
|
||||||||||
| December 31, | 2002 vs. | 2001 vs. | |||||||||
|
|
|
|||||||||
| (In millions) | 2002 | 2001 | 2000 | 2001 | 2000 | ||||||
|
|||||||||||
| Minimum base rent | $ | 422.2 | $ | 419.0 | $ | 439.4 | $ | 3.2 | $ | (20.4 | ) |
| Recoveries from | |||||||||||
| tenants | 67.4 | 63.9 | 64.7 | 3.5 | (0.8 | ) | |||||
| Parking and other | |||||||||||
| tenant charges | 13.6 | 11.9 | 19.4 | 1.7 | (7.5 | ) | |||||
Property operations revenue is composed of minimum base rent from our office buildings, revenue from the recovery of operating expenses from our tenants and other revenue such as parking and termination fees. Occupancy rates in our buildings began to decline in most of our markets in late 2001 and continued to decline in 2002. This decline has negatively affected our operating revenue in both years. Occupancy in stabilized buildings (buildings in operation more than one year) by market as of December 31, 2002, 2001 and 2000 was as follows:
| December 31, | December 31, | December 31, | ||||
| 2002 | 2001 | 2000 | ||||
|
||||||
| Rentable | Rentable | Rentable | ||||
| Square | Percent | Square | Percent | Square | Percent | |
| Market | Footage | Leased | Footage | Leased | Footage | Leased |
|
||||||
| Washington, | ||||||
| DC Metro | 3,522,714 | 96.7 | 2,929,089 | 99.1 | 2,929,052 | 99.4 |
| Chicago | 1,237,565 | 86.4 | 1,227,656 | 91.8 | 1,227,710 | 91.8 |
| Atlanta | 1,774,263 | 83.4 | 1,770,836 | 89.3 | 1,770,706 | 95.3 |
| Dallas | 1,007,309 | 86.6 | 1,611,951 | 97.0 | 1,611,068 | 97.3 |
| Austin | 432,083 | 88.0 | 626,278 | 83.5 | 431,048 | 99.9 |
| Denver | 815,529 | 97.8 | 815,788 | 97.1 | 723,369 | 93.2 |
| Phoenix | 532,506 | 100.0 | 532,506 | 100.0 | 1,365,906 | 92.2 |
| Portland | 275,193 | 80.7 | 275,193 | 90.8 | 275,193 | 99.0 |
| Seattle | 1,501,368 | 96.8 | 1,501,679 | 97.6 | 1,501,679 | 99.2 |
| Salt Lake City | 630,029 | 92.7 | 702,117 | 98.0 | 624,249 | 97.0 |
| San Francisco | ||||||
| Bay Area | 5,507,607 | 94.7 | 5,416,697 | 96.5 | 5,168,715 | 99.9 |
| Orange County/ | ||||||
| Los Angeles | 1,812,764 | 84.2 | 1,813,732 | 93.3 | 1,817,129 | 96.1 |
| San Diego | 1,254,095 | 95.8 | 1,069,709 | 93.5 | 992,816 | 98.8 |
|
|
|
|
|
|
|
| Total | 20,303,025 | 92.3 | 20,293,231 | 95.3 | 20,438,640 | 97.4 |
|
|
|
|
|
|
|
As a result of the ongoing weak economic climate, the
real estate markets have been materially affected. The sustained lack of job
growth has
reduced demand
for office space and overall vacancy rates for office properties
have increased in most of our markets. In reviewing various outlooks
for
the economy,
we believe that the vacancy rates will not improve in any material
fashion until
at least
2004. During 2002, our markets weakened significantly and our operations
in those markets were adversely impacted. The occupancy in our
portfolio of stabilized
operating properties decreased to 92.3% at December 31, 2002 compared
to 95.3% at December 31, 2001 and 97.4% at December 31, 2000. Market
rental
rates have
declined in most markets from peak levels and we believe there
will be additional declines in some markets in 2003. Rental rates on space
that
was re-leased
in 2002 decreased an average of 12.1% in comparison to rates that
were in effect
under expiring leases.
Minimum Base Rent
Minimum base rent increased $3.2 million (0.8%) in 2002 compared
to 2001 and decreased $20.4 million (4.6%) in 2001 as compared
to 2000.
The increase
in minimum
base rent in 2002 was due primarily to higher base rents from
buildings we acquired in 2002 compared to the buildings we sold
in 2002, partially
offset
by higher
vacancies. The decrease in 2001 from 2000 was due primarily to
the dispositions of properties, including the contribution of
properties
to a joint venture
(Carr Office Park, L.L.C.) in August 2000 and higher vacancies.
We expect minimum base
rent to continue to decline in 2003 as a result of releasing
space at lower rates than those that were in effect under expiring
leases.
Our lease rollover by square footage and rent at December
31, 2002 is as follows:
| Leased | ||
| Square | Rent | |
| Footage1 | ($000) | |
|
||
| 2003 | 2,615,646 | 51,023 |
| 2004 | 2,878,686 | 67,727 |
| 2005 | 2,672,617 | 58,991 |
| 2006 | 2,342,458 | 57,956 |
| 2007 | 2,690,661 | 57,044 |
| 2008 | 1,758,065 | 38,976 |
| 2009 | 1,395,697 | 27,628 |
| 2010 | 551,498 | 15,852 |
| 2011 | 396,797 | 7,575 |
| 2012 | 962,044 | 24,665 |
| 2013 and thereafter | 472,804 | 13,282 |
|
|
|
| 18,736,973 | 420,719 | |
|
|
|
| 1. Does not include 1.6 million sq. ft. of vacant space | ||
Recoveries from Tenants
Recoveries from tenants increased $3.5 million (5.5%) in 2002 from
2001. The increase was due primarily to higher recoveries of
real estate taxes
and insurance
expense which increased significantly in 2002 for the reasons
discussed below. Recoveries from tenants decreased $0.8 million (1.2%)
in 2001
from 2000 due
to dispositions of properties, including the properties contributed
to Carr Office
Park, L.L.C., partially offset by development properties placed
in service.
Parking and Other Tenant Charges
Parking and other tenant charges increased $1.7 million (14.3%)
in 2002 from 2001. This increase was due primarily to higher
lease termination
fees. Parking
and other tenant charges decreased $7.5 million (38.7%) in
2001 from 2000 due primarily to lower lease termination fees. Lease
termination
fees are
paid by
a tenant in exchange for our agreement to terminate the lease.
Other tenant charges included $4.4 million, $2.5 million and
$6.7 million
of
termination
fees in 2002,
2001 and 2000, respectively.
Property Expenses
Property expenses are summarized as follows:
| For the Year Ended | Variance | ||||||||||
|
|
||||||||||
| December 31, | 2002 vs. | 2001 vs. | |||||||||
|
|
|
|||||||||
| (In millions) | 2002 | 2001 | 2000 | 2001 | 2000 | ||||||
|
|||||||||||
| Property operating | |||||||||||
| expenses | $ | 127.9 | $ | 123.4 | $ | 123.4 | $ | 4.5 | $ | – | |
| Real estate taxes | 44.7 | 39.3 | 45.9 | 5.4 | (6.6 | ) | |||||
Property operating expenses increased $4.5 million (3.6%)
in 2002 from 2001 as a result of higher insurance expense ($5.0 million)
and higher
security
costs
($0.9 million). The increase in insurance expense was due primarily
to general increases in insurance premiums and the cost of terrorism
coverage.
These
increases were partially offset by lower rent expense ($2.2 million)
resulting from the
termination of a master lease on a property in the Washington,
D.C. Metro market. Property operating expenses did not change in 2001
from 2000.
Real estate taxes increased $5.4 million (13.7%) in 2002
from 2001 due primarily to higher taxes in the Washington, D.C. Metro market.
Real
estate taxes decreased
$6.6 million (14.4%) in 2001 from 2000 due to dispositions of properties,
including properties contributed to Carr Office Park, L.L.C.
Property Operating Margin
Property operating margin, defined as property operations
revenue less property expenses, is summarized as follows:
| For the Year Ended | Variance | |||||||||||
|
|
|||||||||||
| December 31, | 2002 vs. | 2001 vs. | ||||||||||
|
|
|
||||||||||
| (In millions) | 2002 | 2001 | 2000 | 2001 | 2000 | |||||||
|
||||||||||||
| Property operating | ||||||||||||
| margin | $ | 330.6 | $ | 332.0 | $ | 354.4 | $ | (1.4 | ) | $ | (22.4 | ) |
| Property operating | ||||||||||||
| margin percent | 65.7% | 67.1% | 67.8% | |||||||||
Property operating margin decreased $1.4 million (0.4%)
in 2002 compared to 2001. Property operating margin as a percentage of property
operations
revenue declined
to 65.7% in 2002 from 67.1% in 2001. These decreases are due primarily
to increased vacancies. Property operating margin decreased to
$332.0 million in 2001 from
$354.4 million in 2000; however, property operating margin as a
percentage of property operations revenue remained relatively unchanged at 67.1%
in 2001 compared
to 67.8% in 2000. The decrease in property operating margin in
2001
was due
primarily to the dispositions of properties.
Real Estate Service Revenue
Real estate service revenue, which includes our third party
property management services and our development services,
decreased $6.5
million (20.9%) in
2002 from 2001. The decrease occurred primarily because
we earned one-time incentive
fees related to the development of properties in 2001 ($5.2
million) and because leasing activity related to properties
we manage
for others decreased
as a result
of the economic and rental market conditions discussed
above. Real estate service revenue increased $4.8 million
in 2001
from 2000 due
to the one-time
development
incentive fees discussed above.
Interest Expense
Interest expense increased $15.3 million (18.3%) in 2002
from 2001. This increase was due primarily to higher debt
levels
to finance
our repurchase
of preferred
stock in the third quarter of 2002 and our repurchase of
common shares in late 2001 (which we financed with a $400.0
million
public debt
offering in
the first
quarter of 2002) and two additional public debt offerings
aggregating $225.0 million in the fourth quarter of 2002.
The effect of
these increases was
partially offset by a decrease in short-term interest rates
on our variable rate line of
credit, our interest rate swap agreements and repayment
of higher rate mortgages. We have several interest rate
swap
agreements with an aggregate
notional
amount of $325.0 million under which we pay a variable
rate of
interest. During 2002,
these swaps resulted in lower interest expense of $3.1
million.
Interest expense decreased $16.5 million (16.5%) in 2001
from 2000 due primarily to the repayment of debt and lower interest rates on
our variable
rate debt.
General and Administrative Expense
General and administrative expenses decreased $7.8 million
(15.8%) in 2002 from 2001. This decrease was due primarily
to lower costs
as a result
of
the savings
derived from completing the implementation of our Shared
Service Center and completing portions of our internal
process improvement
efforts,
reductions in incentive
compensation and cost containment efforts.
General and administrative expenses increased $6.7 million
(15.7%) in 2001 from 2000. This increase was due to expanded development
activity for third
parties,
principally joint ventures in which we have an interest, expanded
property management operations and the cost associated with our
internal process
improvement efforts
including the implementation of our Shared Service Center and other
initiatives.
Depreciation and Amortization
Depreciation and amortization increased $6.2 million (5.1%)
in 2002 from 2001. The increase was due primarily to the
acquisition of properties
and development
properties placed in service and the write-off of tenant
improvement balances for defaulting tenants, partially
offset by property
dispositions.
Depreciation and amortization decreased $3.1 million
(2.5%) in 2001 compared to 2000. The decrease was due primarily to the disposition
of the Phoenix
properties and the contribution of interests in properties to Carr
Office Park, L.L.C.,
partially offset by properties placed in service.
Gain on Sales of Assets and Other Provisions, Net, and Discontinued
Property Operations
We dispose of assets (sometimes using tax-deferred exchanges) that
are inconsistent with our long-term strategic or return
objectives or where
market conditions
for sale are favorable. The proceeds from the sales are
redeployed into other properties or used to fund development operations
or to support
other corporate
needs.
During 2002, we disposed of four operating properties
(including one property in which we held an interest through an unconsolidated
entity),
recognizing
a gain of $34.7 million, including a gain of $4.9 million relating
to our share
of gain on a sale of property in which we held an interest through
an unconsolidated entity. Approximately $19.1 million of the gain
relates to our Commons
at Las Colinas property with which we have no continuing involvement
after the
sale.
Accordingly, the gain and the results of operations of the property
are
classified as discontinued operations. The balance of the gain
relates
to properties
we continue to manage under management agreements. Accordingly,
the gains on these
sales and the operating results of the properties are not classified
as discontinued operations due to our continuing involvement. We
also recognized
impairment
losses of $2.5 million on land holdings.
During 2001, we disposed of seven operating properties,
one property under development and three parcels of land held for development.
We recognized
a gain of $4.5
million on these transactions. We also recognized an impairment
loss
of $1.5 million on land holdings.
During 2000, we disposed of 16 operating properties (including
one property in which we held an interest through an unconsolidated entity)
and four
parcels of land held for development. We recognized a gain of $24.1
million on these
transactions, net of taxes of $5.6 million, including a gain of
$8.8 million relating to our share of gain on a sale of property in which
we held an
interest through an unconsolidated entity.
On August 17, 2000, we closed on a joint venture transaction with
New York State Teachers’ Retirement System (“NYSTRS”).
At closing, we and some affiliates contributed properties to the
joint venture, Carr Office
Park,
L.L.C., and NYSTRS contributed cash of approximately $255.1 million.
The joint venture encompasses five suburban office parks (including
26 rental properties
and land held for development of additional properties) in four
markets. We received approximately $249.6 million and a 35% interest
in the
joint venture
in exchange
for the properties contributed and recognized a gain on the partial
sale of $20.1 million, net of taxes of $13.1 million.
Other provisions for 2000 included an impairment loss
of $7.9 million for land held for development that we decided to sell. For various
reasons, we determined
that we would not proceed with planned development of rental properties
on certain of our land holdings and decided to market the land
for
sale. As
a result, we
evaluated the recoverability of the carrying amounts of the land.
We determined
that the carrying amounts would not be recovered from estimated
net sale proceeds in certain cases and, in those cases, we recognized
impairment losses.
Other Income and Expense
Other income (expense) was $(0.9) million, $(29.9) million
and $12.0 million in 2002, 2001 and 2000, respectively.
Equity in
earnings
from unconsolidated
entities decreased $2.1 million in 2002 from 2001. This
decrease was due primarily to decreased earnings of Carr
Office Park,
L.L.C. as
a result
of higher interest
expense. In June 2001, Carr Office Park, L.L.C. obtained
third-party financing increasing its leverage and reducing
our equity in
earnings from the venture.
Equity in earnings of unconsolidated entities increased
$1.7 million in 2001 from 2000. This increase was due primarily
to a full year
earnings from our
investment in Carr Office Park, L.L.C. which was formed
in
August 2000.
In 2002, we accrued losses related to lease guarantees
associated with HQ Global of $8.7 million. In 2001, we recognized an impairment
loss
of $42.2
million related
to our investment in HQ Global (see Liquidity and Capital Resources
for additional discussion of these losses).
Consolidated Cash Flows
Consolidated cash flow information is summarized as follows:
| For the Year Ended | Variance | ||||||||||||||
|
|
||||||||||||||
| December 31, | 2002 vs. | 2001 vs. | |||||||||||||
|
|
|
|||||||||||||
| (In millions) | 2002 | 2001 | 2000 | 2001 | 2000 | ||||||||||
|
|||||||||||||||
| Cash provided by | |||||||||||||||
| operating activities | $ | 213.0 | $ | 217.7 | $ | 179.1 | $ | (4.7) | $ | 38.6 | |||||
| Cash (used by) | |||||||||||||||
| provided by | |||||||||||||||
| investing activities | (44.1 | ) | 101.2 | 567.5 | (145.3 | ) | (466.3 | ) | |||||||
| Cash used by | |||||||||||||||
| financing activities | (171.0 | ) | (338.6 | ) | (773.7 | ) | 167.6 | 435.1 | |||||||
Operations generated $213.0 million of net cash in 2002
compared to $217.7 million in 2001 and $179.1 million in 2000. The changes
in cash
flow
from operating activities
were primarily the result of factors discussed above in the analysis
of operating results. The level of net cash provided by operating
activities is also affected
by the timing of receipt of revenues and payment of expenses, including
in 2001 income taxes relating to sales of properties and discontinued
operations
completed
in 2000.
Our investing activities used net cash of $44.1 million
in 2002 and provided net cash of $101.2 million in 2001 and $567.5 million in
2000. The change
in cash flows from investing activities in 2002 is due primarily
to increased acquisition
and development of operating properties ($151.3 million). There
were
decreases in cash used for construction of properties ($24.7 million)
and land acquisitions
($35.6 million) in 2002 due to lower levels of internal development
activity. Distributions from unconsolidated entities also decreased
in 2002, as
2001 included a distribution from Carr Office Park, L.L.C. ($77.9
million) of
proceeds from
third-party financing of its properties.
The decrease in net cash provided by investing activities
in 2001 from 2000 is due primarily to the fact that in 2000, we sold our
investment
in HQ Global,
generating $377.3 million of cash. Proceeds from sales of properties
were also
higher in 2000 ($372.7 million) due primarily to the Carr Office
Park, L.L.C. transaction. The effect of these decreases on net
cash provided
by investing
activities was partially offset by a reduction in development activities
($64.6 million), receipt of a distribution from Carr Office Park,
L.L.C. from proceeds
of a third party financing of properties ($77.9 million) and a
release of restricted deposits ($34.9 million) in connection with the acquisition
of
a property.
Our financing activities used net cash of $171.0 million
in 2002, $338.6 million in 2001 and $773.7 million in 2000. The decrease in
net cash
used by financing
activities in 2002 is due primarily to lower dividend payments
($11.3 million) and decreased stock repurchases ($246.9 million), partially
offset by decreased
net borrowings ($89.4 million).
During 2001, we repurchased $428.3 million of our common
stock generally using our credit line to finance the purchases. In 2001, we had
net
borrowings on our
credit line of $281.0 million. In 2000, we decreased our debt significantly.
Net debt repayments during 2000 totaled $546.3 million including
net repayment of credit facility borrowings of $307.5 million and
retirement
of $150.0
million of senior unsecured notes. We also repurchased $90.2 million
of our common stock
in 2000.
Liquidity and Capital Resources
General
As of December 31, 2002, we had approximately $3.0 million
in avail-able cash and cash equivalents. As a REIT, we
are required
to distribute
at least 90% of
our taxable income to our stockholders on an annual basis.
In addition, we and our affiliates regularly require
capital to
invest in our
existing portfolio
of operating assets for capital projects. These capital
projects include such
things as large-scale renovations, routine capital improvements,
deferred maintenance on properties we have recently acquired
and leasing-related
matters, including
tenant improvements, allowances and leasing commissions.
The amounts of the leasing-related expenditures can vary
significantly
depending
on negotiations
with tenants and
the willingness of tenants to pay higher base rents over
the life of the leases.
We derive substantially all of our revenue from tenants
under leases at our properties. Our operating cash flow therefore depends materially
on
the rents
that we are
able to charge to our tenants, and the ability of these tenants
to
make their rental payments. Although our top 25 tenants accounted
for approximately
35.1% of our annualized minimum base rents, we believe that the
diversity of our tenant
base (no tenant accounted for more than 5% of annualized minimum
base rents as of December 31, 2002) helps insulate us from the
negative impact of
tenant
defaults
and bankruptcies. However, general economic downturns, or economic
downturns in one or more of our markets, could materially adversely
impact the
ability of our tenants to make lease payments and our ability to
re-lease
space
on favorable terms as leases expire. In either of these cases,
our cash flow
and therefore
our ability to meet our capital needs would be adversely affected.
As a result of the ongoing weak economic climate, the
real estate markets have been materially affected. The sustained lack of job
growth has
reduced demand
for office space and overall vacancy rates for office properties
have increased in most of our markets. In reviewing various outlooks
for
the economy,
we believe that the vacancy rates will not improve in any material
fashion until
at least
2004. During 2002, our markets weakened significantly and our operations
in those markets were adversely impacted. The occupancy in our
portfolio of stabilized
operating properties decreased to 92.3% at December 31, 2002 compared
to 95.3% at December 31, 2001 and 97.4% at December 31, 2000. Market
rental
rates have
declined in most markets from peak levels and we believe there
will be additional declines in some markets in 2003. Rental rates on space
that
was re-leased
in 2002 decreased an average of 12.1% in comparison to rates that
were in effect
under expiring leases.
In the future, if, as a result of general economic downturns,
a credit rating downgrade or otherwise, our properties do not perform as expected,
or we
cannot raise the expected funds from the sale of properties and/or
if we are unable
to obtain capital from other sources, we may not be able to make
required principal and interest payments or make necessary routine
capital improvements
with respect
to our existing portfolio of operating assets. While we believe
that
we would continue to have sufficient funds to pay our operating
expenses and
debt
service and our regular quarterly dividends, our ability to expand
our development activity
or to fund acquisition of new properties could be adversely affected.
In addition, if a property is mortgaged to secure payment of indebtedness
and we are unable
to meet mortgage payments, the holder of the mortgage could foreclose
on
the property, resulting in loss of income and asset value. An unsecured
lender could
also attempt to foreclose on some of our assets in order to receive
payment. In most cases, very little of the principal amount that
we borrow is
repaid prior to the maturity of the loan. We generally expect to
refinance that
debt when
it matures, although in some cases we may pay off the loan. If
principal amounts due at maturity cannot be refinanced, extended or paid with
proceeds of other
capital transactions, such as new equity capital, our cash flow
may
be insufficient to repay all maturing debt. Prevailing interest
rates or
other factors at
the time of a refinancing (such as possible reluctance of lenders
to make commercial
real estate loans) may result in higher interest rates and increased
interest expense.
Our ability to raise funds through sales of debt and
equity securities is dependent on, among other things, general economic conditions,
general market
conditions
for REITs, rental rates, occupancy levels, market perceptions about
us, our debt rating and the current trading price of our stock.
We
will continue
to analyze
which source of capital is most advantageous to us at any particular
point in time, but the capital markets may not consistently be
available on terms
that
are attractive.
Capital Structure
We manage our capital structure to reflect a long-term
investment approach, generally seeking to match the stable
return nature
of our assets with
a mix of equity
and various debt instruments. We expect that our capital
structure will allow us to obtain additional capital
from diverse sources
that could
include additional
equity offerings of common stock and/or preferred stock,
public and private debt financings and possible asset
dispositions. Our management
believes,
but there
can be no assurance, that we will have access to the
capital resources necessary to expand and develop our
business,
to fund our operating
and administrative
expenses, to continue to meet our debt service obligations,
to pay dividends in accordance with REIT requirements,
to acquire
additional
properties
and land and to pay for construction in progress.
Debt Financing
We generally use fixed rate debt instruments in order
to match the returns from our real estate assets. We
also
utilize variable
rate
debt for short-term
financing
purposes or to protect against the risk, at certain times,
that fixed rates may overstate our long-term costs of
borrowing if
assumed inflation
or
growth in
the economy implicit in higher fixed interest rates do
not materialize. At times, our mix of variable and fixed
rate
debt may not suit
our needs. At
those times,
we use derivative financial instruments including interest
rate swaps and caps, forward interest rate options or
interest rate
options
in order to
assist us
in managing our debt mix. We either will hedge our variable
rate debt to give it a fixed interest rate or hedge fixed
rate debt
to give it
a variable
interest
rate.
We have three investment grade ratings. As of December 31, 2002,
Fitch Rating Services and Standard & Poors have each assigned
their BBB rating to our prospective senior unsecured debt offerings
and their BBB- rating to our prospective
cumulative preferred stock offerings. Moody’s Investor Service
has assigned its Baa2 rating with a negative outlook to our prospective
senior unsecured
debt offerings and its Baa3 rating to our prospective cumulative
preferred stock offerings.
A downgrade in rating by any one of these rating agencies could
result from, among other things, a change in our financial position
or a
downturn in general
economic conditions. Any such downgrade could adversely affect
our ability to obtain future financing or could increase the interest
rates on our existing
variable rate debt. However, we have no debt instruments under
which
the principal maturity would be accelerated upon a downward change
in our debt rating.
Our total debt at December 31, 2002 is summarized as
follows:
| (In thousands) | |||
|
|||
| Fixed rate mortgages | $ | 419,356 | |
| Unsecured credit facility | 88,000 | ||
| Senior unsecured notes | 1,100,000 | ||
| 1,607,356 | |||
| Unamortized discount and fair value adjustment, net | (3,407 | ) | |
|
|
||
| $ | 1,603,949 | ||
|
|
||
Our fixed rate mortgage debt bore an effective weighted
average interest rate of 7.98% at December 31, 2002 and had a weighted average
maturity
of 6.5 years.
$88.0 million (5.5%) of our total debt at December 31, 2002 bore
a LIBOR-based variable interest rate and $325.0 million (20.2%)
was subject
to variable
interest rates through interest rate swap agreements. The interest
rate on borrowings
on our unsecured credit facility at December 31, 2002 was 2.1%.
Our primary external source of liquidity is our credit
facility. We have a three-year, $500 million unsecured credit facility expiring
in June
2004 with J.P. Morgan
Chase, as agent for a group of banks. We can extend the life of
the
facility an additional year at our option. The facility carries
an interest rate
of 70 basis points over 30-day LIBOR, or 2.1% as of December 31,
2002.
As of
December
31, 2002, $88.0 million was drawn on the credit facility, $1.2
million in letters of credit were outstanding and we had $410.8 million available
for
borrowing.
Our unsecured credit facility contains financial and
other covenants with which we must comply. Some of
these covenants
include:
- A minimum ratio of annual EBITDA (earnings before interest, taxes, depreciation and amortization) to interest expense;
- A minimum ratio of annual EBITDA to fixed charges;
- A maximum ratio of aggregate unsecured debt to unencum-bered assets;
- A maximum ratio of total debt to tangible fair market value of our assets; and
- Restrictions on our ability to make dividend distributions in excess of 90% of funds from operations.
Availability
under the unsecured credit facility is also limited to a specified
percentage of the fair value of our unmortgaged properties.
We are currently
in compliance with all the financial covenants of our credit
facility. Failure to comply with these or any of the other covenants
under
our unsecured credit
facility or other debt instruments could result in a default
under one
or more of our debt instruments. This could cause our lenders
to accelerate the timing
of payments and would therefore have a material adverse effect
on
our business, operations, financial condition or liquidity.
We have senior unsecured notes outstanding at December 31, 2002
as follows:
| Fair | |||||||||||
| Note | Unamortized | Value | |||||||||
| (In thousands) | Principal | Discount | Adjustment | Total | |||||||
|
|||||||||||
| 7.20% notes due in 2004 | $ | 150,000 | $ | (338 | ) | $ | 5,333 | $ | 154,995 | ||
| 6.625% notes due in 2005 | 100,000 | (1,381 | ) | – | 98,619 | ||||||
| 7.375% notes due in 2007 | 125,000 | (653 | ) | – | 124,347 | ||||||
| 5.261% notes due in 2007 | 50,000 | (50 | ) | – | 49,950 | ||||||
| 5.25% notes due in 2007 | 175,000 | (1,440 | ) | 2,235 | 175,795 | ||||||
| 6.875% notes due in 2008 | 100,000 | (2,137 | ) | – | 97,863 | ||||||
| 7.125% notes due in 2012 | 400,000 | (4,976 | ) | – | 395,024 | ||||||
|
|
||||||||||
| $ | 1,100,000 | $ | (10,975 | ) | $ | 7,568 | $ | 1,096,593 | |||
|
|
||||||||||
Of our senior
unsecured notes, $625.0 million was issued in 2002. In January 2002,
we issued $400.0 million of senior unsecured
notes. The
notes bear
interest at 7.125% per annum payable semi-annually beginning
on July 15, 2002. The notes
mature on January 15, 2012. In November 2002, we issued $50.0
million of 5.261% and $175.0 million of 5.25% senior unsecured
notes. Interest
on
these notes is
payable semi-annually beginning May 30, 2003. The notes mature
November 30, 2007. All of the notes are unconditionally guaranteed
by CarrAmerica
Realty,
L.P.,
one of our subsidiaries.
Our senior unsecured notes also contain covenants with which
we must comply. These include:
- Limits on our total indebtedness on a consolidated basis;
- Limits on our secured indebtedness on a consolidated basis;
- Limits on our required debt service payments; and
- Compliance with the financial covenants of our credit facility.
Derivative
Financial Instruments
On May 8, 2002, we entered into interest rate swap agreements with
JP Morgan Chase and Bank of America, N.A. (both rated
A+ by Standard & Poors), hedging
$150.0 million of 7.2% senior unsecured notes due July 2004. We receive interest
at a fixed rate of 7.2% and pay interest at a variable rate of six-month LIBOR
in arrears plus 2.72%. The interest rate swaps mature at the same time the
notes are due. The swaps qualify as fair value hedges for accounting purposes.
Net
semi-annual settlement payments are recognized as increases or decreases to
interest expense. The fair value of the interest rate swaps is recognized on
our balance
sheet and the carrying value of the senior unsecured notes is increased or
decreased by an offsetting amount. As of December 31, 2002, the fair value
of the interest
rate swaps was approximately $5.3 million. We recognized a reduction in interest
expense for 2002 of approximately $2.7 million related to the swaps. As of
December 31, 2002, taking into account the effect of the interest rate swaps,
the effective
interest rate on the notes was reduced to 4.2%.
In conjunction with the issuance of the $175.0 million
of 5.25% senior unsecured notes, in November 2002,
we entered into interest
rate
swap agreements with
JP Morgan Chase, Bank of America, N.A. and Goldman
Sachs & Co. (all rated A+
by Standard & Poors). Under the swap agreements,
we receive interest at a fixed rate of 5.25% and pay
interest at a variable rate of six-month LIBOR
in
arrears plus 1.405%. The interest rate swaps mature
at the same time the notes are due. The swaps qualify
as fair value hedges for accounting purposes. Net
semi-annual settlement payments are recognized as increases
or decreases to interest expense. The fair value of
the interest rate swaps is recognized on
our balance
sheet and the carrying value of the senior unsecured
notes is increased or decreased by an offsetting amount.
As of December 31, 2002, the fair value
of the interest
rate swaps was approximately $2.2 million. We recognized
a reduction in interest expense for 2002 of approximately
$0.4 million related to the swaps. As of
December 31, 2002, taking into account the effect of
the interest rate swaps, the effective
interest rate on the notes was reduced to 3.1%.
As part of the assumption of $63.5 million of debt
associated with the purchase of two operating properties
in August
2002, we also
purchased interest rate
caps with a notional amount of $97.0 million and a
6.75% cap on LIBOR. The fair value
of the interest rate caps was not material at December
31, 2002.
Stock Repurchases
On September 7, 2002, we redeemed 4.0 million shares
of our Series B Cumulative Redeemable Preferred Stock
at a
redemption
price
of $25.00 per share plus
accrued and unpaid dividends for the period from September
1, 2002 through
and including
the redemption date, without interest. Additionally,
during 2002, we repurchased 1.8 million shares of our
preferred
stock for
approximately $45.5 million.
Our unsecured credit facility contained a financial
covenant requiring us to maintain at least $1.1 billion
of tangible
net worth (as
defined by the
facility).
After giving effect to the proposed redemption of our
Series B Preferred Stock, we would have been in violation
of that
covenant. Therefore,
on July 29, 2002
we entered into an amendment to the facility, reducing
the minimum tangible net worth requirement to $800.0
million.
Our Board of Directors has authorized us to spend up
to $400.0 million to repurchase our common stock, preferred
stock and
debt securities,
excluding the 9.2 million
shares repurchased from Security Capital in November
2001
and our preferred stock redemption of 4.0 million shares
in September
2002,
which were
separately approved.
Since the start of this program in mid-2000 through
December 31, 2002, we
have acquired approximately 10.1 million of our common
shares for an aggregate purchase
price of approximately $289.0 million including approximately
1.4 million shares for $35.9 million in 2002. We continue
to monitor
market conditions
and other
alternative investments in order to evaluate whether
repurchase of our securities is appropriate.
We pay dividends quarterly. The maintenance of these
dividends is subject to various factors, including
the discretion
of the Board
of Directors,
the ability
to pay dividends under Maryland law, the avail-ability
of cash to make the necessary dividend payments and
the effect
of REIT
distribution
requirements, which require
at least 90% of our taxable income to be distributed
to stockholders. In addition, under our line of credit,
we
generally are restricted
from paying
dividends that
would exceed 90% of our funds from operations during
any four-quarter period.
Capital Commitments
We will require capital for development projects currently
underway and in the future. As of December 31, 2002,
we had approximately
70,000 rentable
square
feet of office space in two wholly-owned development
projects in progress. Our total expected investment
on these projects
is $9.5
million. Through
December
31, 2002, we had invested $7.4 million or 77.9% of
the total expected investment for these projects. We
also
have a residential
project
under development.
We undertook this wholly-owned project in conjunction
with an office development project in a joint venture.
Our total
investment
in
the residential project
is
expected to be $19.9 million. As of December 31, 2002,
we had invested $5.4
million in this project with the remainder expected
to be incurred during 2003. As of
December 31, 2002, we also had 608,000 rentable square
feet of office space under construction in two joint
venture projects
in which we
own minority
interests.
These projects are expected to cost $188.3 million,
of which our total investment is expected to be approximately
$57.7
million.
Through December
31, 2002,
approximately $101.2 million or 53.7% of total project
costs had
been expended on these projects.
We have financed our investment in both our wholly-owned
and our joint venture projects under construction at
December 31,
2002
primarily from borrowings
under our credit facility. We expect that our credit
facility and project-specific
financing of selected assets will provide the additional
funds required to complete
existing development projects and to finance the costs
of additional projects we may undertake. As a result
of market
conditions,
we believe we will
be limiting our development activities in the near
future
and expect to concentrate
our growth
efforts on the acquisition of properties.
Below is a summary of certain obligations that will
require significant capital:
| (In thousands) | Payments due by Period | |||||||||
|
||||||||||
| Contractual | Less than | 1-3 | 3-5 | After 5 | ||||||
| Obligations | Total | 1 year | Years | Years | Years | |||||
|
||||||||||
| Long-term debt | $ | 1,607,356 | $ | 39,903 | $ | 417,137 | $ | 377,842 | $ | 772,474 |
| Operating | ||||||||||
| leases–land | 281,320 | 4,201 | 8,402 | 8,402 | 260,315 | |||||
| Operating | ||||||||||
| leases–building | 5,834 | 796 | 1,592 | 1,592 | 1,854 | |||||
| Estimated | ||||||||||
| development | ||||||||||
| commitments | 20,098 | 19,224 | 874 | – | – | |||||
Unconsolidated Investments and Joint Ventures
We have minority investments in two non-real estate
operating companies, AgilQuest and essention, which
we account
for using the cost method.
These are startup
entities in which we invested $2.8 million and $1.7
million, respectively. To date, neither company has
had any substantial
earnings. In the
fourth quarter
of 2002, we recognized an impairment of $500,000
on our investment in essention because we believe the
value
of our investment
was partially impaired.
In the future, additional impairment charges related
to our investments may
be required.
We have investments in real estate joint ventures in
which we hold 15%–50%
interests. These investments are accounted for using
the equity or cost method, as appropriate, and therefore
the assets and liabilities of the joint ventures
are not included in our consolidated financial statements.
Most of these joint ventures own and operate office
buildings financed by non-recourse debt obligations
that are secured only by the real estate and other
assets of the joint ventures.
We have no obligation to repay this debt and the lenders
have no recourse to our other assets. As of December
31, 2002, we guaranteed $26.5 million of debt
related to a joint venture and have provided completion
guarantees related to three joint venture projects
for which total costs are anticipated to be
$370.0
million, of which $277.0 million had been expended
to date. We have not funded any amounts under these
guarantees and do not expect any funding will be required
in the future.
Our investments in these joint ventures are subject
to risks not inherent in our majority owned properties,
including:
- Absence of exclusive control over the development, financing, leasing, management and other aspects of the project;
- Possibility
that our co-venturer or partner might:
- become bankrupt;
- have interests or goals that are inconsistent with ours;
- take action contrary to our instructions, requests or interests (including those related to our qualification as a REIT for tax purposes); or
- otherwise impede our objectives; and
- Possibility that we, together with our partners, may be required to fund losses of the investee.
In addition
to making investments in these ventures, we provide construction management,
leasing and property
management,
development and architectural
and other services to them. We earned fees for these
services
of $8.0 million in
2002, $14.2 million in 2001 and $8.9 million in 2000.
Accounts receivable from joint ventures and other affiliates
were
$1.7 million at December
31, 2002 and
$3.2 million at December 31, 2001.
Guarantee Obligations
Our obligations under guarantee agreements at December
31, 2002 are summarized as follows:
| Type of | Project | Maximum | Carrying | ||||
| Guarantee | Relationship | Term | Exposure | Value | |||
|
|||||||
| Loan1 | 575 7th Street | Apr-05 | $ | 26,500,000 | $ | – | |
| Loan2 | Atlantic Building | Dec-03 | 21,000,000 | – | |||
| Lease3 | HQ Global | Jan-13 | 18,150,000 | 8,837,714 | |||
| Indemnification4 | HQ Global | – | – | ||||
1. Loan
guarantee relates to a joint venture in which we have a 30% interest
and for which we are the developer.
It is a
payment guaranty
to the lender
on behalf of the joint venture. If the joint venture
defaults
on
the loan, we may
be required to perform under the guarantee. We
have a reimbursement guarantee from the other joint venture
partner to repay
us their proportionate share (70%) of any monies
we pay
under
the guarantee.
2. Loan guarantee relates to a third party project
for which we are the developer. It is a payment
guarantee to the lender.
If
the third
party
defaults on the
loan, we may be required to perform under the guarantee.
We have a security interest
in the third party’s interest in the underlying
property. In the event of a default, we can exercise
our rights under the security agreement to take
title to the property and sell the property to
mitigate our exposure under
the guarantee.
3. We have guaranteed leases related to HQ Global
Workplaces, Inc. (for further discussion, see HQ
Global Workplaces,
Inc. below).
4. See Item 3: Legal Proceedings for further discussion.
In the normal course of business, we guarantee our
performance of services or indemnify third parties
against our negligence.
Insurance
Although we believe our properties are adequately
covered by insurance, we cannot predict at this
time if we
will be able
to obtain full
coverage at
a reasonable
cost in the future. The costs associated with our
June 30, 2002 property and casualty insurance renewals
were
higher
than anticipated.
Although
we have an
excellent claims history and safety record, all
lines of coverage were affected by higher premiums,
in
part because
insurance
companies have
experienced a loss of income on their investments,
underwriting results have been poor
and also
as a result of the events of September 11, 2001.
Our insurance renewal on June 30, 2002 increased
premiums from the prior year approximately 155%.
The property
insurance deductible
increased from $5,000 to
$10,000 per claim. Since reinsurance treaties renew
twice each year
(January
and July), our property and casualty insurance renewal
date has been changed from June 30 to May 15 to enable
underwriters
to
concentrate on the insurance
proposals well ahead of treaty renewal.
In December 2002, three major corporate insurance
policies were renewed for another annual term. The
policies
were the Directors
and Officers
Liability, Employment
Practices Liability and the Professional (Errors
and Omissions) Liability. As had been expected, the
insurance
markets
were not favorable to
the buyer due
mainly to insurance industry conditions. The increases
in premiums were 44%
for Directors and Officers Liability, 76% for Employment
Practices Liability and
45% for Professional (Errors and Omissions) Liability.
The deductible for the Directors and Officers Liability
policy
changed from
$250,000 for each
claim
to $500,000 for securities claims and $250,000 for
all other claims. The deductible for the Employment
Practices
Liability
increased
from $50,000
per claim to $250,000
per claim.
In 2002, all risk property insurers began attaching
terrorism exclusions to insurance policies. As a
result of the
Terrorism Risk Insurance
Act of 2002, terrorism
insurance must now be priced separately within the
property insurance coverage. Unlike earthquake exposure,
insurers
do not yet have
a means of modeling
the terrorism risk.
During 2002, we completed an in-depth evaluation
of our terrorism exposure as well as our lender requirements.
Upon our renewal
date for insurance
of June
30, 2002, we purchased terrorism coverage with limits
of $200 million per occurrence and in the aggregate,
with
a deductible
of $1.0
million per
claim, at a cost
of approximately $2.2 million per year. The policy
covers
only physical damage and our amount of coverage may
not be enough
for all damages
that could result
from a terrorist attack. Coverage does not include
losses due to biological, chemical or radioactive
contamination.
The lack
of
coverage for such
contamination could have a material adverse effect
on
our financial results if a building
we own becomes uninhabitable as a result of biological,
chemical, radioactive or
other contamination. We do not anticipate purchasing
any additional terrorism coverage before May 15,
2003, our
insurance renewal
date.
HQ Global Workplaces, Inc.
In 1997, we began making investments in HQ Global
Workplaces, Inc. (“HQ
Global”), a provider of executive office suites. On June 1, 2000, we,
along with HQ Global, VANTAS Incorporated (VANTAS) and FrontLine Capital Group
(FrontLine),
consummated several transactions including (i) the merger of VANTAS with and
into HQ Global, (ii) the acquisition by FrontLine of shares of HQ Global common
stock from us and other stockholders of HQ Global, and (iii) the acquisition
by VANTAS of our debt and equity interests in OmniOffices (UK) Limited and
OmniOffices LUX 1929 Holding Company S.A. We received $377.3 million in cash
in connection
with these transactions. In addition, $140.5 million of debt which we had guaranteed
was repaid with a portion of the cash proceeds. Following the transaction,
we owned approximately 16% of the equity of HQ Global on a diluted basis and
our
investment had a carrying value of $42.2 million.
FrontLine, the majority stockholder of HQ Global,
announced in October 2001 that HQ Global was in default
with
respect to certain
covenant
and payment
obligations
under its senior and mezzanine term indebtedness,
was in a forbearance period with HQ Global lenders
and
was actively
negotiating with
those lenders. In
November 2001, FrontLine disclosed that it had recognized
an
impairment in the value of
intangible assets relating to HQ Global due to HQ
Global’s trend of operating
losses and its inability to remain in compliance
with the terms of its debt arrangements. Based on
these factors, our analysis of the financial condition
and operating
results of HQ Global (which deteriorated significantly
during 2001 as the economic
slowdown reduced the demand for temporary office
space, particularly from technology-related tenants)
and the losses of key board members and executives
by HQ Global, particularly
in the last half of 2001, we determined in the fourth
quarter of 2001, that our investment in HQ Global
was impaired. We recorded a $42.2 million impairment
charge, reducing the carrying value of our remaining
investment in HQ Global
to zero.
On March 13, 2002, HQ Global filed for bankruptcy
protection under Chapter 11 of the federal bankruptcy
laws. During
1997 and 1998,
to assist HQ
Global as
it grew its business, we provided guarantees of HQ
Global’s performance
under four office leases. To our knowledge, all monthly
rental payments were made by HQ Global under two
of these leases through January 2002, and rental
payments under the other two leases were made through
February 2002. In connection with the June 2000 merger
transaction, FrontLine agreed to indemnify us against
any losses incurred with respect to guarantees of
the four office leases. However,
on June 12, 2002, FrontLine also filed for bankruptcy
protection under Chapter 11 of the federal bankruptcy
laws, and therefore it is unlikely that we will
recover any resulting losses from FrontLine under
this indemnity.
In the course of its bankruptcy proceedings, HQ Global
has filed motions to reject two of these four leases.
One lease
is for
space in San Jose,
California. This
lease is for approximately 22,000 square feet of
space at two adjacent buildings and runs through
October
2008. Total
aggregate
remaining
lease payments under
this lease as of February 1, 2002 were approximately
$6.2 million (approximately $0.7 million of which
was payable
in 2002);
however, our liability
under this guarantee was limited to approximately
$2.0 million. We reached
an agreement with the landlord of this lease pursuant
to which we paid $1.75
million in
full
satisfaction of the guarantee in January 2003. We
recognized this expense in 2002.
The second lease that was rejected by HQ Global is
a sublease for space in downtown Manhattan. This
lease is for approximately
26,000
square
feet of
space and runs
through March 2008, with total aggregate remaining
lease
payments as of February 1, 2002 of approximately
$5.4 million (approximately
$0.8
million
of which
was payable in 2002). In June 2002, we received a
demand for payment of the full
amount of the guarantee. However, we believe that
we have defenses to payment under this guarantee
available
to us
and joined
with HQ Global
in filing
suit on July 24, 2002 in HQ Global’s bankruptcy
proceedings asking the bankruptcy court to declare
that the lease was terminated by the landlord of
the sublease
not later than February 28, 2002. On July 26, 2002,
the landlord under the sublease filed suit in federal
court in New York seeking payment from us under
this guarantee.
In light of our defenses and these proceedings, we
have not accrued any expense relating to this guarantee;
however, there can be no assurance as to the outcome
of the pending litigation or that we will not incur
expense or be required
to make cash payments relating to this guarantee
up to the full amount of the guarantee.
As of December 31, 2002, we had not made any payments
under this guarantee.
HQ Global has not filed a motion seeking to reject
the remaining two leases that we have guaranteed,
although it could do
so in the future.
Even if
the leases
are not rejected, we may ultimately be liable to
the lessors for payments due under the leases. In
one case,
the lease
is for approximately
25,000
square feet
of space in midtown Manhattan, and our liability
is currently
capped at approximately $0.5 million, which liability
reduces over the
life of the
lease until its
expiration in September 2007. As of December 31,
2002, we have not accrued any expense related
to or made any payments under this guarantee.
The remaining lease is for space in San Mateo, California.
This lease is for approximately 19,000 square feet
of space and runs
through
January 2013, with
total aggregate remaining lease payments as of March
1, 2002 of approximately $10.4 million (approximately
$0.6
million
of which
was payable in
2002). We initially recognized an expense of $0.4
million under this guarantee
in the
first quarter
of 2002 based on a tentative agreement with HQ Global
under which HQ Global
would not reject this lease obligation and we would
fund HQ Global’s
operating losses at this location for a limited period
of time. Due to deteriorating conditions
in the local commercial real estate market, HQ Global
subsequently determined that the tentative agreement
was not in its best interest. HQ Global indicated
to us that it intended to reject this lease unless
its rent was reduced to
current market rates. As an interim measure, we entered
into an agreement with HQ Global
as of June 30, 2002 to fund operating losses at this
location up to an aggregate amount of $130,000 in
exchange for HQ Global forbearing from rejecting
this
lease until September 15, 2002, or if it obtained
from the bankruptcy court an extension
of time within which to reject leases, November 1,
2002. Because the bankruptcy court has since twice
extended the time period within which HQ Global may
reject
this lease to May 9, 2003, we have twice extended
the existing forbearance agreement in exchange for
funding operating losses up to an additional aggregate
amount
of $245,000. As a result of our efforts to mitigate
our exposure under this
guarantee, we entered into agreements with HQ Global
in January 2003 under which HQ Global
assigned its interest as a tenant in this lease to
us and we in turn subleased the space back to HQ
Global at current market rates. These agreements
remain
subject to approval by both the bankruptcy court
and the landlord under the lease. In addition, these
agreements will not be enforceable if HQ Global fails
to successfully
reorganize and emerge from the bankruptcy proceedings.
There can be no assurance
that the necessary approvals will be granted, that
material changes to the agreements will not be required
to gain approvals, or that HQ Global will successfully
reorganize
and emerge from the bankruptcy proceedings. We increased
our provision for
loss under this guarantee to $6.9 million in the
second quarter of 2002 and this continues
to represent the amount we have determined to be
our likely exposure under this guarantee as of December
31, 2002. However, there can be no assurance
that we
will not be required to further increase our provision
or make cash payments related to this guarantee in
future periods up to, in the aggregate, the full
amount of the guarantee. As of December 31, 2002,
we had not made any payments under this guarantee.
New Accounting Pronouncements
In November 2002, the FASB issued Interpretation
No. 45, “Guarantor’s
Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees
of the Indebtedness of Others.” For 2002, the Interpretation requires
certain disclosures which we have included in the footnotes to the financial
statements.
Beginning in 2003, the Interpretation requires recognition of liabilities at
their fair market value for newly issued guarantees. We do not anticipate that
adoption of Interpretation No. 45 will have a material effect on our financial
statements.
In December 2002, the FASB issued SFAS No. 148, “Accounting for
Stock-Based Compensation—Transition and Disclosure.” SFAS
No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS
No. 148 provides alternative methods of transition for a voluntary change
to the fair
value based method of accounting for stock-based
compensation and requires disclosure in both annual and interim financial
statements about the method
of accounting
for stock-based compensation and the effect of the
method used on reported results. We have adopted the disclosure provisions
of SFAS No. 148. Beginning
January
1, 2003, we will adopt the prospective transition
method for all new stock compensation awards. We do not anticipate that
adoption of SFAS No. 148 will
have a material
effect on our financial statements.
In January 2003, the FASB issued Interpretation No.
46, “Consolidation
of Variable Interest Entities.” This Interpretation
clarifies the application of Accounting Research
Bulletin No. 51, “Consolidated Financial Statements”,
to certain entities in which equity investors do
not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk
for the entity to finance its activities without
additional subordinated financial
support from other parties. We do not anticipate
that adoption of Interpretation No. 46 will have
a material effect on our financial statements.
Funds from Operations
We believe that funds from operations is helpful
to investors as a measure of the operating performance
of an equity
REIT. Based
on our
experience,
funds from
operations, along with information about cash flows
from operating activities, investing activities
and financing
activities,
provides investors with
an indication of our ability to incur and service
debt,
to make capital expenditures
and to
fund other cash needs. Funds from operations is
defined by the National Association of Real Estate
Investment
Trusts (NAREIT) as follows:
- Net income (loss)—computed in accordance with accounting principles generally accepted in the United States of America (GAAP);
- Less gains (or plus losses) from sales of depreciable operating properties and items that are classified as extraordinary items under GAAP;
- Plus depreciation and amortization of assets uniquely significant to the real estate industry;
- Plus or minus adjustments for unconsolidated partnerships and joint ventures (to reflect funds from operations on the same basis).
Our funds
from operations may not be comparable to funds from operations reported
by other REITs. These
other
REITs may not
define the
term in accordance with
the current NAREIT definition or may interpret
the current NAREIT definition differently than us. Funds
from operations
does not
represent net income
or cash flow generated from operating activities
in accordance with GAAP. As such, it
should not be considered an alternative to net
income as an indication of our performance or to cash flows
as a measure
of
our liquidity
or our ability
to
make distributions.
The following table provides the calculation of
our funds from operations and a reconciliation
of funds
from operations
to
income from continuing
operations for the years presented:
| (In thousands) | 2002 | 2001 | 2000 | ||||||
|
|||||||||
| Income from operations before | |||||||||
| minority interest | $ | 104,021 | $ | 88,492 | $ | 163,308 | |||
| Adjustments to derive funds | |||||||||
| from operations: | |||||||||
| Add: | |||||||||
| Depreciation and amortization | 137,245 | 131,909 | 128,861 | ||||||
| Deduct: | |||||||||
| Minority interests (non-Unitholders | |||||||||
| share of depreciation, amortization | |||||||||
| and net income) | (1,159 | ) | (755 | ) | (1,084 | ) | |||
| Gain on sale of assets and other | |||||||||
| provisions, net | (13,156 | ) | (2,964 | ) | (36,371 | ) | |||
|
|
||||||||
| Funds from operations before allocation | |||||||||
| to the minority Unitholders | 226,951 | 216,682 | 254,714 | ||||||
| Less funds from operations allocable | |||||||||
| to the minority Unitholders | (17,884 | ) | (16,901 | ) | (16,342 | ) | |||
|
|
||||||||
| Funds from operations allocable to | |||||||||
| CarrAmerica Realty Corporation | 209,067 | 199,781 | 238,372 | ||||||
| Less preferred stock dividends | (30,055 | ) | (34,719 | ) | (35,206 | ) | |||
|
|
||||||||
| Funds from operations allocable to | |||||||||
| common shareholders | 179,012 | 165,062 | 203,166 | ||||||
|
|
||||||||
| Less: | |||||||||
| Depreciation and amortization | (136,086 | ) | (131,154 | ) | (127,777 | ) | |||
| Discontinued property operations | (4,166 | ) | (7,208 | ) | (4,275 | ) | |||
| Minority interest in income | (13,801 | ) | (9,431 | ) | (16,149 | ) | |||
| Add: | |||||||||
| Gain on sale of assets and other | |||||||||
| provisions, net | 13,156 | 2,964 | 36,371 | ||||||
| Minority interest adjustment | 17,884 | 16,901 | 16,342 | ||||||
| Preferred stock dividends | 30,055 | 34,719 | 35,206 | ||||||
|
|
||||||||
| Income from continuing operations | $ | 86,054 | $ | 71,853 | $ | 142,884 | |||
|
|
||||||||
Quantitative and Qualitative Disclosures about Market Risk
Our future earnings and cash flows and the fair values of our financial
instruments are dependent upon prevailing market
rates. Market risk associated with financial
instruments and derivative and commodity instruments
is the risk of loss from adverse changes in market prices or
rates. We
manage
our risk by
matching projected
cash inflows from operating activities, financing
activities and investing
activities with projected cash outflows to fund
debt payments, acquisitions, capital expenditures,
distributions and other cash requirements. We
may also use derivative
financial instruments at times to limit market
risk. Interest rate protection agreements
may be used to convert variable rate debt to
a fixed rate basis, to convert fixed rate debt to a variable
rate basis
or to
hedge anticipated financing
transactions.
We use derivative financial instruments only
for hedging purposes,
and not for speculation or trading purposes.
On May 8, 2002, we entered into interest rate swap
agreements with JP Morgan Chase and Bank of America,
N.A. hedging
$150.0 million
of senior
unsecured
notes due July 2004. We receive interest at a
fixed rate of 7.2% and pay interest at
a variable rate of six-month LIBOR in arrears
plus 2.72%. The interest rate swaps mature at the same
time the notes
are due.
The swaps
qualify as fair
value hedges
for accounting purposes. Net semi-annual settlement
payments are recognized as increases or decreases
to interest
expense. The fair
value of the
interest rate
swaps is recognized on our balance sheet and
the carrying value of the senior unsecured notes is
increased or
decreased by
an offsetting amount.
As of
December 31, 2002, the fair value of the interest
rate swaps was approximately $5.3 million.
We recognized a reduction in interest expense
for 2002 of approximately $2.7 million related to the
swaps.
As of December
31, 2002,
taking into account the effect of the interest
rate swaps, the effective interest rate on the
notes was
reduced to 4.2%.
In conjunction with the issuance of $175.0 million
of senior unsecured notes in November 2002, we
entered into
interest
rate swap agreements
with JP Morgan
Chase, Bank of America, N.A. and Goldman Sachs & Co.
We receive interest at a fixed rate of 5.25%
and pay interest at a variable rate of six-month
LIBOR
in arrears plus 1.405%. The interest rate swaps
mature at the same time the
notes are due. The swaps qualify as fair value
hedges for accounting purposes. Net
semi-annual settlement payments are recognized
as increases or decreases to interest expense.
The fair value of the interest rate swaps is
recognized on
our balance
sheet and the carrying value of the senior unsecured
notes is increased or decreased by an offsetting
amount. As of December 31, 2002, the fair value
of the interest
rate swaps was approximately $2.2 million. We
recognized a reduction in interest
expense for 2002 of approximately $0.4 million
related to the swaps. As of December 31, 2002,
taking into account the effect of the interest
rate swaps,
the effective
interest rate on the notes was reduced to 3.1%.
As part of the assumption of $63.5 million of debt
associated with the purchase of two operating
properties in August
2002, we also
purchased two interest
rate caps with a notional amount of $97.0 million
and a 6.75% cap to LIBOR. As of
December 31, 2002, the fair market value of these
interest rate caps was not material.
If the market rates of interest on our credit facility
change by 10% (or approximately 21 basis points),
our annual interest
expense
would
change
by approximately $0.2
million. This assumes the amount outstanding
under our credit facility remains at $88.0 million, our
balance at December
31, 2002. The
book value of our
credit facility approximates market value at
December 31, 2002.
If the market rates of interest on our interest
rate swap agreements change by 10% (or approximately
19
basis points),
our annual
interest expense
would change
by approximately $0.5 million.
A change in interest rates generally does not impact
future earnings and cash flows for fixed-rate
debt instruments, except for those
senior notes
which have
been hedged with interest rate swaps. As fixed-rate
debt matures, and additional debt is incurred
to fund the
repayments
of maturing
loans,
future earnings
and cash flows may be impacted by changes in
interest rates. This impact would be
realized in the periods subsequent to debt maturities.
The following is a summary of the fixed rate
mortgages and senior
unsecured
debt maturities at December
31, 2002:
| (In thousands) | ||
|
||
| 2003 | $ | 39,903 |
| 2004 | 171,426 | |
| 2005 | 157,711 | |
| 2006 | 20,580 | |
| 2007 | 357,262 | |
| 2008 & thereafter | 772,474 | |
|
|
|
| $ | 1,519,356 | |
|
|
|
If we assume the repayments of fixed rate borrowings
are made in accordance with the terms and conditions
of the
respective credit
arrangements,
a 10 percent
change in the market interest rate for the respective
fixed rate debt instruments would change the fair
market value
of
our fixed
rate debt
by approximately
$12.8 million. The estimated fair market value
of the fixed rate debt instruments and
the senior unsecured notes at December 31, 2002
was $438.5 million and $1,182.1 million, respectively.
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