The following "Management's Discussion and Analysis of Financial Condition and
Results of Operations" should be read in conjunction with our financial
statements and notes thereto contained elsewhere in this report. This section
contains forward-looking statements, including estimates, projections,
statements relating to our business plans, objectives and expected operating
results, and the assumptions upon which those statements are based. These
forward-looking statements generally are identified by the words "believes,"
"project," "expects," "anticipates," "estimates," "intends," "strategy," "plan,"
"may," "will," "would," "will be," "will continue," "will likely result," and
similar expressions. Forward-looking statements are based on current
expectations and assumptions that are subject to risks and uncertainties which
may cause actual results to differ materially from the forward-looking
statements. Forward-looking statements that were true at the time made may
ultimately prove to be incorrect or false. We undertake no obligation to update
or revise publicly any forward-looking statements, whether as a result of new
information, future events or otherwise. All forward-looking statements should
be read in light of the risks identified in Part II, Item 1A herein and Part I,
Item 1A of our annual report on Form 10-K for the year ended December 31, 2011
filed with the U.S. Securities and Exchange Commission (the "SEC").
Overview
We were incorporated on October 22, 2004 for the purpose of engaging in the
business of investing in and owning commercial real estate.As of June 30, 2012,
we had raised $167.1 million of gross proceeds from the sale of 20.9 million
shares of our common stock in our initial and follow-on public offerings and had
acquired thirteen properties, four of which were sold during 2011.
Our revenues, which are comprised largely of rental income, include rents
reported on a straight-line basis over the initial term of each lease. Our
growth depends, in part, on our ability to increase rental income and other
earned income from leases by increasing rental rates and occupancy levels and
controlling operating and other expenses. Our operations are impacted by
property-specific, market-specific, general economic and other conditions.
On November 23, 2010, we stopped soliciting and accepting offers to purchase
shares of our stock while our board of directors evaluates strategic
alternatives to maximize value and we informed our investors of several
decisions made by the board of directors for the health of our REIT.
Suspension of Distribution Reinvestment Plan. We suspended our distribution
reinvestment plan effective December 14, 2010. All distributions paid after
December 14, 2010 have been and will be made in cash.
Distributions. Effective December 1, 2010, our board of directors resolved to
reduce distributions on our common stock to an annualized rate of $0.08 per
share (1% based on a share price of $8.00), from the prior annualized rate of
$0.48 per share (6% based on a share price of $8.00), in order to preserve
capital that may be needed for capital improvements, debt repayment or other
corporate purposes. Distributions at this rate were declared for the first and
second quarters of 2011. In June 2011, the board of directors decided, based on
the financial position of the Company, to suspend the declaration of further
distributions and to defer the payment of the second quarter 2011 distribution
until the financial position improved. In the fourth quarter of 2011, we sold
the Arizona properties and paid the second quarter distributions. No
distributions have been declared for periods after June 30, 2011. The rate and
frequency of distributions is subject to the discretion of our board of
directors and may change from time to time based on our operating results and
cash flow.
27
Stock Repurchase Program. After careful consideration of the proceeds that were
available from our distribution reinvestment plan in 2010, and an assessment of
our expected capital expenditures, tenant improvement costs and other costs and
obligations related to our investments, our board of directors concluded that we
did not have sufficient funds available to prudently fund any stock redemptions
during 2011. Accordingly, our board of directors approved an amendment to our
stock repurchase program to suspend redemptions under the program effective
December 31, 2010. We can make no assurances as to whether and on what terms
redemptions will resume. The share redemption program may be amended, resumed,
suspended again, or terminated at any time.
Our board of directors continues to evaluate and implement strategic
alternatives to reposition the company and enhance shareholders' value.
Specifically, we sold the Goldenwest property in June 2011 for gross proceeds of
$9.4 million and made a principal payment of $7.8 million on the HSH Nordbank
credit facility. Additionally, we sold the Mack Deer Valley and Pinnacle Park
Business Center properties in November 2011 for gross proceeds of approximately
$23.9 million. The net proceeds were used, in part, to pay down the remaining
balance of the HSH Nordbank credit facility. In December 2011, we sold the 2111
South Industrial Park property for gross proceeds of $0.9 million. The proceeds
were used to pay down the Wells Fargo Bank, National Association ("Wells Fargo")
loan. Furthermore, in February 2012, we amended our loan agreement with Wells
Fargo. The amendment, executed upon our making a $7.5 million principal payment,
extended the maturity date of the loan from February 13, 2012 to February 13,
2014 and reduced the interest rate from 300 basis points over one-month LIBOR to
200 basis points over one-month LIBOR, with the LIBOR floor remaining fixed at
150 basis points. We are continuing to pursue options for repaying our debt,
including asset sales.
Market Outlook - Real Estate and Real Estate Finance Markets
Beginning in 2010, and continuing through 2011 and into 2012, significant and
widespread concerns about credit risk and access to capital experienced during
2009 began to subside. However, uncertainties created by a sluggish U.S. economy
and global economic problems have depressed real estate demand. Increased trade
volume in 2010 spurred some increase in leasing activity in select west coast
industrial markets. However, if economic uncertainty persists, we may continue
to experience significant vacancies and expect to be required to reduce rental
rates on occupied space.
Despite recent positive economic indicators, both the national and most global
economies have experienced continued volatility throughout 2011 and during the
first half of 2012. These conditions, combined with stagnant business activity
and low consumer confidence, have resulted in a challenging operating
environment.
As a result of the decline in general economic conditions, the U.S. commercial
real estate industry has experienced deteriorating fundamentals across most
major property types and most geographic markets. These market conditions have
and will likely continue to have a significant impact on our real estate
investments. In addition, these market conditions have impacted our tenants'
businesses, which makes it more difficult for them to meet current lease
obligations and places pressure on them to negotiate favorable lease terms upon
renewal in order for their businesses to remain viable. Increases in rental
concessions given to retain tenants and maintain our occupancy level, which are
vital to the continued success of our portfolio, have resulted in lower current
cash flows from operations. Projected future declines in rental rates, slower or
potentially negative net absorption of leased space and expectations of future
rental concessions, including free rent to retain tenants who are up for renewal
or to sign new tenants, are expected to result in additional decreases in cash
flows from operations.
Until market conditions are more stable, we expect to continue to limit capital
expenditures, focusing on those capital expenditures that preserve value and/or
generate rental revenue. However, if we experience an increase in vacancies, we
may incur costs to re-lease properties and pay leasing commissions.
Our board of directors is considering diversifying our investment objectives to
include healthcare-related, potential joint-ventures and other asset types as
well as industrial properties. In connection with such acquisitions, the board
of directors may consider acquiring assets with long-term financing in order to
leverage the capital available to us and increase our assets under management to
enable better diversification.
Healthcare-related properties include a wide variety of properties, including
senior housing facilities, medical office buildings, and skilled nursing
facilities. Senior housing facilities include independent living facilities,
assisted living facilities and continuing care retirement communities. Each of
these caters to different segments of the elderly population. Services provided
by operators or tenants in these facilities are primarily paid for by the
residents directly or through private insurance and are less reliant on
government reimbursement programs such as Medicaid and Medicare. Medical office
buildings ("MOBs") typically contain physicians' offices and examination rooms,
and may also include pharmacies, hospital ancillary service space, and
outpatient services such as diagnostic centers, rehabilitation clinics and
day-surgery operating rooms. While these facilities are similar to commercial
office buildings, they require more systems to accommodate special requirements.
MOBs are typically multi-tenant properties leased to multiple healthcare
providers (hospitals and physician practices) although there is a trend towards
net leases to doctors and hospitals. Skilled Nursing Facilities ("SNFs") offer
nursing care for people not requiring the more extensive and sophisticated
treatment available at hospitals. Sub-acute care services are provided to
residents beyond room and board. Certain skilled nursing facilities provide some
services on an outpatient basis. Skilled nursing services provided in these
facilities are primarily paid for either by private sources or through the
Medicare and Medicaid programs. SNFs are typically leased to single-tenant
operators under net lease structures.
28
Healthcare-related properties include a wide variety of lease structures. For
example, senior housing facilities are typically leased to an operator on a net
lease basis. Medical office buildings are typically leased to multiple tenants
although there is a trend towards net leases to doctor groups. Skilled nursing
facilities are typically leased to a single operator under a net lease
structure.
Critical Accounting Policies
There have been no material changes to our critical accounting policies as
previously disclosed in our Annual Report on Form 10-K for the year ended
December 31, 2011, as filed with the SEC.
Results of Operations
As of June 30, 2012, we owned nine properties. During 2011, we owned nine
properties for a full year, one property for five and one-half months, two
properties for eleven months, and one property for eleven and one-half months.
In June 2011, we sold the Goldenwest property for gross proceeds of $9.4
million. In November 2011, we sold the Mack Deer Valley and Pinnacle Park
Business Center properties for gross proceeds of $23.9 million. In December
2011, we sold the 2111 South Industrial Park property for gross proceeds of
$0.9
million.
In October 2011, we reclassified the Sherburne Commons property as held for sale
(see Note 10) and the results of its operations have been reported in
discontinued operations.
Three months ended June 30, 2012 and 2011
Three Months Ended
June 30, %
2012 2011 $ Change Change
Rental revenues, tenantreimbursements & other income $ 1,070,000 $ 1,152,000 $
(82,000 ) (7.1 )%
Property operating and
maintenance (440,000 ) (425,000 ) (15,000 ) 3.5 %
Net operating income(1) 630,000 727,000 (97,000 ) (13.3 )%
Interest income from notes
receivable 14,000 104,000 (90,000 ) (86.5 )%
General and administrative (698,000 ) (755,000 ) 57,000 (7.5 )%
Asset management fees and
expenses (207,000 ) (411,000 ) 204,000 (49.6 )%
Depreciation and amortization (389,000 ) (544,000 ) 155,000 (28.5 )%
Reserve for excess advisor
obligation (988,000 ) - (988,000 ) (0.0 )%
Interest expense (167,000 ) (320,000 ) 153,000 (47.8 )%
Impairment of notes receivable - (1,650,000 ) 1,650,000 (100.0 )%
Impairment of real estate - (23,219,000 ) 23,219,000 (100.0 )%
Loss from continuing operations (1,805,000 ) (26,068,000 ) 24,263,000 (93.1 )%
Loss from discontinued
operations (115,000 ) (18,871,000 ) 18,756,000 (99.4 )%
Net loss (1,920,000 ) (44,939,000 ) 43,019,000 (95.7 )%
Noncontrolling interests' share
in losses 225,000 52,000 173,000 332.7 %
Net loss applicable to common
shares $ (1,695,000 ) $ (44,887,000 ) $ 43,192,000 (96.2 )%
(1) Net operating income ("NOI") is a non-GAAP supplemental measure used to
evaluate the operating performance of real estate properties. We define NOI
as total rental revenues, tenant reimbursements and other income less
property operating and maintenance expenses. NOI excludes interest income
from notes receivable, general and administrative expense, asset management
fees and expenses, real estate acquisition costs, depreciation and
amortization, impairments, interest income, interest expense, and income from
discontinued operations. We believe NOI provides investors relevant and
useful information because it measures the operating performance of the
REIT's real estate at the property level on an unleveraged basis. We use NOI
to make decisions about resource allocations and to assess and compare
property-level performance. We believe that net income (loss) is the most
directly comparable GAAP measure to NOI. NOI should not be viewed as an
alternative measure of operating performance to net income (loss) as defined
by GAAP since it does not reflect the aforementioned excluded items.
Additionally, NOI as we define it may not be comparable to NOI as defined by
other REITs or companies, as they may use different methodologies for
calculating NOI. See Note 16 for a summary table reconciling NOI from net
loss.
29
Rental revenues, tenant reimbursements and other income decreased to
$1.1 million for the three months ended June 30, 2012 from $1.2 million for the
three months ended June 30, 2011. The decrease is primarily due to lower overall
occupancy rates, lower average lease rental rates and longer lease-up periods
for vacant space as a result of the current economic environment.
Property operating and maintenance expense was comparable at $0.4 million for
the three months ended June 30, 2012 and for the three months ended June 30,
2011.
Interest income from notes receivable decreased to $14,000 for the three months
ended June 30, 2012 from $0.1 million for the three months ended June 30, 2011
primarily due to the lower outstanding balance for the Servant Healthcare
Investments, LLC note (see Note 7) resulting in less interest income in 2012
compared to approximately $0.1 million in interest income for the three months
ended June 30, 2011.
General and administrative expenses decreased to $0.7 million for the three
months ended June 30, 2012 from $0.8 million for the three months ended June 30,
2011. The decrease is primarily due lower legal fees offset by increased audit
fees, professional fees, allocations and regulatory filing costs.
Asset management fees decreased to $0.2 million for the three months ended June
30, 2012 from $0.4 million for the three months ended June 30, 2011. The lower
asset management fees are attributed to the sale of four properties in 2011
combined with a reduction in the annual asset management fee basis from 1.0% to
0.75% of the Average Invested Assets (as defined in the Advisory Agreement).
Depreciation and amortization decreased to $0.4 million for the three months
ended June 30, 2012 from $0.5 million for the three months ended June 30, 2011
largely as a result of property impairments recorded in the second quarter
of
2011.
Reserve for excess advisor obligation represents the organizational and offering
costs incurred in excess of 3.5% of the gross proceeds from our Follow-on
Offering. Prior to June 10, 2012, approximately $1.0 million was reimbursed to
the Advisor in excess of 3.5% of the gross proceeds of our Follow-on offering.
Consistent with the limitations set forth in our charter, the advisory agreement
further provides that the Advisor will repay to the Company the excess (the
"Excess Reimbursement"). Consequently, in the second quarter of 2012, we
recorded a receivable from the Advisor of $1.0 million reflecting the Excess
Reimbursement. As a result of our evaluation related to the receivable's
collectability, we reserved for the full amount of the receivable as of June 30,
2012.
Interest expense decreased to $0.2 million for the three months ended June 30,
2012 from $0.3 million for the three months ended June 30, 2011. The decrease is
primarily due to lowering our overall outstanding principal balance of our debt
obligations as a result of the $13.1 million pay-off of the HSH Nordbank credit
facility in 2011 and principal repayments on the Wells Fargo Bank loan of $2.9
million during 2011 and $7.5 million during the first quarter of 2012, partially
offset by increasing interest rates during 2011 as a result of the HSH Nordbank
and Wells Fargo Bank note extensions and the related amortization of deferred
financing costs associated with each extension.
Impairment of note receivable decreased to $0 for three months ended June 30,
2012 compared to $1.65 million for the three months ended June 30, 2011. The
decrease relates to the Servant Healthcare note receivable which was determined
to be impaired due to events arising in the second quarter of 2011 and settled
in a forbearance agreement in December 22, 2011.
Impairment of real estate decreased to $0 for three months ended June 30, 2012
compared to $23.2 million for the three months ended June 30, 2011. The charge
during 2011 was a result of our assumption of shorter hold periods for each
property used in our impairment testing brought about by our board of directors
currently evaluating strategic alternatives to maximize shareholder value. These
alternatives include potentially selling additional properties to repay debt as
it becomes due.
The loss from discontinued operations represents the results of operations for
properties sold and/or classified as held for sale in accordance with ASC
360-10, Property, Plant and Equipment. Additionally, all prior periods presented
for these properties were reclassified to discontinued operations for
presentation purposes. During 2011, we sold our Goldenwest, Mack Deer Valley,
Pinnacle Park Business Center, and 2111 South Industrial Park properties to
third parties and classified our VIE as held for sale. The loss from
discontinued operations was $0.1 million for the three months ended June 30,
2012 compared to loss from discontinued operations of $18.9 million for the
three months ended June 30, 2011. The change is primarily attributed to
operating income reported in 2011 from the sold Arizona properties of $0.3
million offset a $19.1 million impairment of real estate compared to net loss
reported during the three months ended June 30, 2012.
30
Six months ended June 30, 2012 and 2011
Six Months Ended
June 30, %
2012 2011 $ Change Change
Rental revenues, tenant
reimbursements & other income $ 2,074,000 $ 2,257,000 $ (183,000 ) (8.1 )%
Property operating and
maintenance (794,000 ) (818,000 ) 24,000 (2.9 )%
Net operating income(1) 1,280,000 1,439,000 (159,000 ) (11.0 )%
Interest income from notes
receivable 27,000 263,000 (236,000 ) (89.7 )%
General and administrative (1,732,000 ) (1,371,000 ) (361,000 ) 26.3 %
Asset management fees and
expenses (422,000 ) (826,000 ) 404,000 (48.9 )%
Depreciation and amortization (770,000 ) (1,073,000 ) 303,000 (28.2 )%
Reserve for excess advisor
obligation (988,000 ) - (988,000 ) (0.0 )%
Interest expense (433,000 ) (611,000 ) 178,000 (29.1 )%
Impairment of notes receivable - (1,650,000 ) 1,650,000 (100.0 )%
Impairment of real estate - (23,219,000 ) 23,219,000 (100.0 )%
Loss from continuing operations (3,038,000 ) (27,048,000 ) 24,010,000 (88.8 )%
Loss from discontinued
operations (1,565,000 ) (18,663,000 ) 17,098,000 (91.6 )%
Net loss (4,603,000 ) (45,711,000 ) 41,108,000 (89.9 )%
Noncontrolling interests' share
in losses 528,000 52,000 476,000 915.4 %
Net loss applicable to common
shares $ (4,075,000 ) $ (45,659,000 ) $ 41,584,000 (91.1 )%
(1) Net operating income ("NOI") is a non-GAAP supplemental measure used to
evaluate the operating performance of real estate properties. We define NOI
as total rental revenues, tenant reimbursements and other income less
property operating and maintenance expenses. NOI excludes interest income
from notes receivable, general and administrative expense, asset management
fees and expenses, real estate acquisition costs, depreciation and
amortization, impairments, interest income, interest expense, and income from
discontinued operations. We believe NOI provides investors relevant and
useful information because it measures the operating performance of the
REIT's real estate at the property level on an unleveraged basis. We use NOI
to make decisions about resource allocations and to assess and compare
property-level performance. We believe that net income (loss) is the most
directly comparable GAAP measure to NOI. NOI should not be viewed as an
alternative measure of operating performance to net income (loss) as defined
by GAAP since it does not reflect the aforementioned excluded items.
Additionally, NOI as we define it may not be comparable to NOI as defined by
other REITs or companies, as they may use different methodologies for
calculating NOI. See Note 16 for a summary table reconciling NOI from net
loss.
Rental revenues, tenant reimbursements and other income decreased to
$2.1 million for the six months ended June 30, 2012 from $2.3 million for the
six months ended June 30, 2011. The decrease is primarily due to lower overall
occupancy rates, lower average lease rental rates and longer lease-up periods
for vacant space as a result of the current economic environment.
Property operating and maintenance expense was comparable at $0.8 million for
the six months ended June 30, 2012 and for the six months ended June 30, 2011.
Interest income from notes receivable decreased to $27,000 for the six months
ended June 30, 2012 from $0.3 million for the six months ended June 30, 2011
primarily due to the lower outstanding balance for the Servant Healthcare
Investments, LLC note (see Note 7) resulting in $173,000 less interest income
and non-payment of interest on the Nantucket Acquisition LLC loan in 2012
compared to approximately $63,000 in interest income for the six months ended
June 30, 2011.
General and administrative expenses increased to $1.7 million for the six months
ended June 30, 2012 from $1.4 million for the six months ended June 30, 2011.
The increase is primarily due to increased legal fees, audit fees, professional
fees, allocations, and regulatory filing costs.
Asset management fees decreased to $0.4 million for the six months ended June
30, 2012 from $0.8 million for the six months ended June 30, 2011. The lower
asset management fees are attributed to the sale of four properties in 2011
combined with a reduction in the annual asset management fee basis from 1.0% to
0.75% of the Average Invested Assets (as defined in the Advisory Agreement).
31
Depreciation and amortization decreased to $0.8 million for the six months ended
June 30, 2012 from $1.1 million for the six months ended June 30, 2011 largely
as a result of property impairments recorded in the second quarter of 2011.
Reserve for excess advisor obligation represents the organizational and offering
costs incurred in excess of 3.5% of the gross proceeds from our and Follow-on
Offering. Prior to June 10, 2012, approximately $1.0 million was reimbursed to
the Advisor in excess of 3.5% of the gross proceeds of our Follow-on Offering.
Consistent with the limitations set forth in our charter, the advisory agreement
further provides that the Advisor will repay to the Company the excess (the
"Excess Reimbursement"). Consequently, in the second quarter of 2012, we
recorded a receivable from the Advisor of $1.0 million reflecting the "Excess
Reimbursement." As a result of our evaluation related to the receivable's
collectability, we reserved for the full amount of the receivable as of June 30,
2012.
Interest expense experienced a small decrease for the six months ended June 30,
2012 from $0.4 million compared to $0.6 million for the six months ended June
30, 2011. The decrease is primarily due to lowering our overall outstanding
principal balance of our debt obligations as a result of the $13.1 million
pay-off of the HSH Nordbank credit facility in 2011 and principal repayments on
the Wells Fargo Bank loan of $2.9 million during 2011 and $7.5 million during
the second quarter of 2012, partially offset by increasing interest rates during
2011 as a result of the HSH Nordbank and Wells Fargo Bank note extensions and
related amortization of deferred financing costs associated with each extension.
Impairment of note receivable decreased to $0 for six months ended June 30, 2012
compared to $1.65 million for the six months ended June 30, 2011. The decrease
relates to the Servant Healthcare note receivable which was determined to be
impaired due to events arising in the second quarter of 2011 and settled in the
forbearance agreement in December 22, 2011.
Impairment of real estate decreased to $0 for six months ended June 30, 2012
compared to $23.2 million for the six months ended June 30, 2011. The charge
during 2011 was a result of our assumption of shorter hold periods for each
property used in our impairment testing brought about by our board of directors
currently evaluating strategic alternatives to maximize shareholder value. These
alternatives include potentially selling additional properties to repay debt as
it becomes due.
The loss from discontinued operations represents the results of operations for
properties sold and/or classified as held for sale in accordance with ASC
360-10, Property, Plant and Equipment. Additionally, all prior periods presented
for these properties were reclassified to discontinued operations for
presentation purposes. During 2011, we sold our Goldenwest, Mack Deer Valley,
Pinnacle Park Business Center, and 2111 South Industrial Park properties to
third parties and classified our VIE as held for sale. The loss from
discontinued operations was $1.6 million for the six months ended June 30, 2012
compared to income from discontinued operations of $18.7 million for the six
months ended June 30, 2011. The change is primarily due to 2012 losses incurred
by our VIE compared to income reported by our sold Arizona properties in 2011.
Additionally 2011 included $19.1 of impairments of real estate impairment
compared to 2012 where we recorded $1.1 million of impairments of real estate.
Liquidity and Capital Resources
On November 23, 2010, our board of directors made a decision to stop making or
accepting offers to purchase shares of our stock in our Follow-on Offering while
evaluating strategic alternatives to maximize value and preserve the capital of
our stockholders. On June 10, 2012, our Follow-on Offering was terminated. Going
forward, we expect our primary sources of cash to be rental revenues, tenant
reimbursements and interest income. In addition, we may receive sources of cash
through the sale of additional properties or borrowing against currently-owned
properties. We expect our primary uses of cash to be for the repayment of
principal on notes payable, funding of future acquisitions, payment of tenant
improvements and leasing commissions, operating expenses, interest expense on
outstanding indebtedness, advances to our VIE to fund operating shortfalls, and
cash distributions. Operating expenses are expected to exceed operating revenues
over the next twelve months. We plan to fund this operating shortfall from
available cash and the net proceeds from property sales and asset refinancings.
As of June 30 2012, we had $8.0 million in cash and cash equivalents on hand.
Credit Facilities and Loan Agreements
As of June 30, 2012, we had total debt obligations of $13.2 million that mature
in February and November of 2014. Of this amount, $6.7 million was outstanding
on a loan agreement with Wells Fargo and $6.5 million was outstanding on a loan
agreement with Transamerica Life Insurance Company.
On November 28, 2011, the HSH Nordbank credit facility was repaid in its
entirety with proceeds from the sale of the Mack Deer Valley and Pinnacle Park
Business Center properties (see Notes 14 and 16).
32
In February 2012, we amended our loan agreement with Wells Fargo to extend the
maturity date to February 13, 2014. In connection with this amendment, we made a
principal payment of $7.5 million, reducing the outstanding principal amount of
our obligations under the loan agreement from $14.3 million to $6.8 million as
of February 13, 2012, and paid fees and expenses totaling approximately $65,000.
The interest rate on the amended loan decreased from 300 basis points over
one-month LIBOR to 200 basis points over one-month LIBOR, with the one-month
LIBOR floor remaining fixed at 150 basis points. Any amounts repaid under the
loan agreement may not be re-borrowed. All other terms of the loan agreement
remain in full force and effect.
Short-Term Liquidity Requirements
In addition to the capital requirements for recurring capital expenditures,
tenant improvements and leasing commissions, we may incur expenditures for
future acquisitions and/or renovations of our existing properties, such as
increasing the size of the properties by developing additional rentable square
feet and/or making the space more appealing to potential industrial tenants.
We sold three properties in the fourth quarter of 2011 and currently have one
property listed for sale to monetize our interest in the VIE, and we amended our
loan agreement with Wells Fargo Bank in February 2012. We continue to pursue
options for repaying our debt obligations, including asset sales. We believe
that our cash and cash equivalents totaling $8.0 million as of June 30, 2012
will allow us to meet our obligations during the twelve months ending June 30,
2013. We expect to fund our short-term liquidity requirements primarily from
available cash and future net property sales proceeds.
In recent years, financial markets have experienced unusual volatility and
uncertainty and liquidity has tightened in all financial markets, including the
debt and equity markets. Our ability to repay or refinance debt could be
adversely affected by an inability to secure financing at reasonable terms,
if
at all.
Other than the financial market conditions discussed above and market conditions
discussed under the caption "Market Outlook-Real Estate and Real Estate Finance
Markets," we are not aware of any material trends or uncertainties, favorable or
unfavorable, affecting real estate generally, which we anticipate may have a
material impact on either capital resources or the revenues or income to be
derived from the operation of real estate properties.
Distributions
Effective December 1, 2010, our board of directors resolved to reduce
distributions on our common stock to an annualized rate of $0.08 per share (1%
based on a share price of $8.00), from the prior annualized rate of $0.48 per
share (6% based on a share price of $8.00), in order to preserve capital that
may be needed for capital improvements, debt repayment or other corporate
purposes. Distributions at this rate were declared for the first and second
quarters of 2011. In June 2011, the board decided, based on the financial
position of the Company, to suspend the declaration of further distributions and
to defer the payment of the second quarter 2011 distribution, which was paid in
December 2011. No distributions have been declared for periods after June 30,
2011. The rate and frequency of distributions is subject to the discretion of
our board of directors and may change from time to time based on our operating
results and cash flow.
The following table shows the distributions declared during the six months ended
June 30, 2012 and 2011:
Cash Flows
Provided by
(Used in)
Distributions Declared(2) Operating
Period Cash Reinvested Total Activities
First quarter 2011(1) $ 454,000 $ - $ 454,000 $ 481,000
Second quarter 2011(1) $ 468,000 $ - $ 468,000 $ (219,000 )
First quarter 2012 $ - $ - $ - $ (800,000 )
Second quarter 2012 $ - $ - $ - $ (953,000 )
(1) 100% of the distributions declared during the six months ended June 30, 2011
represented a return of capital for federal income tax purposes.
(2) In order to meet the requirements for being treated as a REIT under the
Internal Revenue Code, we must pay distributions to our shareholders each
taxable year equal to at least 90% of our net ordinary taxable income. Some
of our distributions have been paid from sources other than operating cash
flow, such as offering proceeds.
From our inception in October 2004 through June 30, 2012, we declared aggregate
distributions of $32.8 million. Our cumulative net loss and cumulative net cash
provided by operating activities during the same period were $72.8 million
and
$2.9 million, respectively.
Organization and offering costs
As of June 30, 2012, our Advisor and its affiliates had incurred on our behalf
organizational and offering costs totaling $5.6 million, including $0.1 million
of organizational costs that were expensed and $5.5 million of offering costs
which reduced the net proceeds of our combined offerings. Of this amount,
$4.4 million reduced the net proceeds of our initial public offering and $1.1
million reduced the net proceeds of our Follow-on Offering.
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On June 10, 2012, our Follow-on Offering was terminated. Under the Advisory
Agreement, within 60 days after the end of the month in which our Follow-on
Offering terminated, the Advisor is obligated to reimburse us to the extent that
the organization and offering expenses related to our Follow-on Offering borne
by us exceeded 3.5% of the gross proceeds of the Follow-on Offering. As of June
10, 2012, we had reimbursed our advisor a total of $1.1 million in
organizational and offering costs related to our Follow-on Offering, of which
$1.0 million was in excess of the contractual limit. Consequently, in the second
quarter of 2012, we recorded a receivable from the Advisor for $1.0 million
reflecting the Excess Reimbursement. As a result of our evaluation of various
factors related to collectability of this receivable, we recorded a reserve for
the full amount of the receivable as of June 30, 2012.
Funds from Operations and Modified Funds from Operations
Funds from operations ("FFO") is a non-GAAP supplemental financial measure that
is widely recognized as a measure of REIT operating performance. We compute FFO
in accordance with the definition outlined by the National Association of Real
Estate Investment Trusts ("NAREIT"). NAREIT defines FFO as net income (loss),
computed in accordance with GAAP, excluding extraordinary items, as defined by
the accounting principles generally accepted in the United States of America
("GAAP"), and gains or losses from sales of property, plus depreciation and
amortization on real estate assets, and after adjustments for unconsolidated
partnerships, joint ventures, noncontrolling interests and subsidiaries.
NAREIT recently issued updated reporting guidance that directs companies, for
their computation of NAREIT FFO, to exclude impairments of depreciable real
estate when write-downs are driven by measurable decreases in the fair value of
real estate holdings. Previously, the Company's calculation of FFO (consistent
with NAREIT's previous guidance) did not exclude impairments of, or related to,
depreciable real estate. Consistent with this current NAREIT reporting guidance,
the Company has restated its 2011 FFO amount.
Our FFO may not be comparable to FFO reported by other REITs that do not define
the term in accordance with the current NAREIT definition or that interpret the
current NAREIT definition differently than we do. We believe that FFO is helpful
to investors and our management as a measure of operating performance because it
excludes depreciation and amortization, gains and losses from property
dispositions, and extraordinary items, and as a result, when compared year to
year, reflects the impact on operations from trends in occupancy rates, rental
rates, operating costs, development activities, general and administrative
expenses, and interest costs, which is not immediately apparent from net income.
Historical cost accounting for real estate assets in accordance with GAAP
implicitly assumes that the value of real estate diminishes predictably over
time. Since real estate values have historically risen or fallen with market
conditions, many industry investors and analysts have considered the
presentation of operating results for real estate companies that use historical
cost accounting alone to be insufficient. As a result, our management believes
that the use of FFO, together with the required GAAP presentations, provide a
more complete understanding of our performance. Factors that impact FFO include
start-up costs, fixed costs, delays in buying assets, lower yields on cash held
in accounts pending investment, income from portfolio properties and other
portfolio assets, interest rates on acquisition financing and operating
expenses. FFO should not be considered as an alternative to net income (loss),
as an indication of our performance, nor is it indicative of funds available to
fund our cash needs, including our ability to make distributions.
Changes in the accounting and reporting rules under GAAP have prompted a
significant increase in the amount of non-cash and non-operating items included
in FFO, as defined. Therefore, we use modified funds from operations ("MFFO"),
which excludes from FFO real estate acquisition costs, amortization of above- or
below-market rents, and non-cash amounts related to straight-line rents and
impairment charges to further evaluate our operating performance. We compute
MFFO in accordance with the definition suggested by the Investment Program
Association (the "IPA"), the trade association for direct investment programs
(including non-traded REITs). However, certain adjustments included in the IPA's
definition are not applicable to us and are therefore not included in the
foregoing definition.
We believe that MFFO is an important supplemental measure of operating
performance because it excludes costs that management considers more reflective
of investing activities or non-operating changes. Accordingly, we believe that
MFFO can be a useful metric to assist management, investors and analysts in
assessing the sustainability of our operating performance. As explained below,
management's evaluation of our operating performance excludes these items in the
calculation based on the following considerations:
• Real estate acquisition costs. In evaluating investments in real estate,
including both business combinations and investments accounted for under the
equity method of accounting, management's investment models and analyses
differentiate costs to acquire the investment from the operations derived from
the investment. These acquisition costs have been funded from the proceeds of
our initial public offering and other financing sources and not from
operations. We believe by excluding expensed acquisition costs, MFFO provides
useful supplemental information that is comparable for each type of our real
estate investments and is consistent with management's analysis of the
investing and operating performance of our properties. Real estate acquisition
costs include those paid to our Advisor and to third parties.
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• Adjustments for amortization of above- or below-market rents. Similar to
depreciation and amortization of other real estate-related assets that are
excluded from FFO, GAAP implicitly assumes that the value of lease assets
diminishes predictably over time and that these charges be recognized
currently in revenue. Since real estate values and market lease rates in the
aggregate have historically risen or fallen with market conditions, management
believes that by excluding these charges, MFFO provides useful supplemental
information on the operating performance of our real estate.
• Adjustments for straight-line rents. Under GAAP, rental income recognition can
be significantly different from underlying contract terms. By adjusting for
these items, MFFO provides useful supplemental information on the economic
impact of our lease terms and presents results in a manner more consistent
with management's analysis of our operating performance.
• Impairment charges. Impairment charges relate to a fair value adjustment, which
is based on the impact of current market fluctuations and underlying
assessments of general market conditions and the specific performance of the
holding, which may not be directly attributable to our current operating
performance. As these losses relate to underlying long-term assets and
liabilities, excluding real estate, where we are not speculating or trading
assets, management believes MFFO provides useful supplemental information by
focusing on the changes in our core operating fundamentals rather than changes
that may reflect anticipated losses. In particular, because GAAP impairment
charges are not allowed to be reversed if the underlying fair values improve or
because the timing of impairment charges may lag the onset of certain operating
consequences, we believe MFFO provides useful supplemental information related
to the sustainability of rental rates, occupancy and other core operating
fundamentals.
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FFO and MFFO should not be considered as an alternative to net income (loss) or
as an indication of our liquidity, nor is it indicative of funds available to
fund our cash needs, including our ability to make distributions. Both FFO and
MFFO should be reviewed along with other GAAP measurements. Our FFO and MFFO, as
presented, may not be comparable to amounts calculated by other REITs. The
following is a reconciliation from net loss applicable to common shares, the
most direct comparable financial measure calculated and presented with GAAP, to
FFO and MFFO for the three and six months ended June 30, 2012 and 2011:
Three months ended Six months ended
June 30, June 30,
2012 2011 2012 2011
Net loss applicable to common
shares $ (1,695,000 ) $ (44,887,000 ) $ (4,075,000 ) $ (45,659,000 )
Adjustments:
Depreciation and amortization of
real estate assets:
Continuing operations 389,000 544,000 770,000 1,073,000
Discontinued operations - 173,000 - 476,000
Gain on sales of real estate,
net - 128,000 - 128,000
Impairment of real estate
assets:
Continuing operations - 23,219,000 - 23,219,000
Discontinued operations - 19,145,000 1,140,000 19,145,000
Noncontrolling interests' share
in losses (225,000 ) (52,000 ) (528,000 ) (52,000 )
Noncontrolling interests 'share
in FFO 225,000 - 528,000 -
FFO applicable to common shares $ (1,306,000 ) (1,730,000 ) (2,165,000 ) (1,670,000 )
Adjustments:
Amortization of (below-)
above-market rents (7,000 ) 2,000 (13,000 ) 6,000
Straight-line rents (49,000 ) (34,000 ) (39,000 ) (3,000 )
Reserve for excess advisor
obligation 988,000 - 988,000 -
Impairment of note receivable - 1,650,000 - 1,650,000
Amortization of deferred
financing costs 11,000 117,000 72,000 200,000
Modified funds from operations
(MMFO) applicable to common
shares $ (363,000 ) 5,000 (1,157,000 ) $ 183,000
Weighted-average number of
common shares
Outstanding - basic and diluted 23,028,284 23,521,838 23,028,284 23,473,816
FFO per weighted average common
shares $ (0.06 ) $ (0.07 ) $ (0.09 ) $ (0.07 )
MFFO per weighted average common
shares $ (0.02 ) $ 0.00 $ (0.05 ) $ 0.01
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Contractual Obligations
The following table reflects our contractual obligations as of June 30, 2012:
Payment due by period
Less than More than
Contractual Obligations Total 1 year 1-3 years 4-5 years 5 years
Notes payable(1) $ 13,235,000 $ 565,000 $ 12,670,000 $ - $ -
Interest expense related to
long-term debt(2) $ 1,233,000 $ 579,000 $ 654,000 $ - $ -
Below-market ground
lease(3)(4) $ 3,609,000 $ - $
9,000 $ 40,000 $ 3,560,000
(1) This represents the sum of loan agreements with Wells Fargo Bank, National
Association and Transamerica Life Insurance Company.
(2) Interest expense related to the loan agreement with Wells Fargo Bank,
National Association is calculated based on the loan balance outstanding at
June 30, 2012, one-month LIBOR at June 30, 2012, with a 150 basis point LIBOR
floor, plus a margin of 200 basis points. Interest expense related to the
loan agreement with Transamerica Life Insurance Company is based on a fixed
rate of 5.89% per annum.
(3) The below-market ground lease relates to the Sherburne Commons property, a
VIE for which we were deemed to be the primary beneficiary and began
consolidating as of June 30, 2011. As of October 19, 2011, the Sherburne
Commons property met the requirements for reclassification to real estate
held for sale. Consequently, at June 30, 2012, the related assets and
liabilities of the VIE are classified as assets of variable interest entity
held for sale and liabilities of variable interest entity held for sale,
respectively, on our condensed consolidated balance sheets.
(4) The below-market ground lease is a 50-year lease expiring in 2059 relating to
land on which the Sherburne Commons senior housing facility is located. The
land is leased from the town of Nantucket, Massachusetts with lease payments
totaling $1 per year for years one through four, one-half of one percent of
operating revenues, as defined in the ground lease, for years five through
seven, and one percent of operating revenues, as defined in the ground lease,
thereafter.
Subsequent Event
Acquisition of Health Care Properties
On August 3, 2012, through a wholly-owned subsidiary, we funded an investment in
a joint venture, Cornerstone Healthcare Partners, LLC, that concurrently
acquired a portfolio of two skilled nursing facilities located in the Portland,
Oregon metropolitan area from Sheridan Care Center LLC, Sheridan Properties LLC,
Fernhill Estates LLC and Fernhill Properties LLC (collectively, the "Sellers").
The Company contributed approximately $3.5 million to the joint venture, with
Cornerstone Healthcare Realty Fund ("CHREF"), an affiliate of our advisor,
contributing approximately $0.2 million as our joint venture partner. The
purchase price of the portfolio was $8.6 million in addition to acquisition
costs of $0.9 million. The portfolio, which includes the property at 411 SE
Sheridan Road, Sheridan Oregon and 5737 NE 37th Avenue, Portland Oregon
(collectively, the "Portland Properties") has a total of 102 beds.
We acquired our interest in the Portland Properties subject to a secured
loan. On August 1, 2012, we entered into a loan agreement with the Sellers for a
loan (the "Seller Loan") in the aggregate amount of approximately $5.8 million
secured by security interests in the Portland Properties. The Seller Loan, which
bears interest fixed at 5%, matures on March 15, 2013, at which time all
outstanding principal, accrued and unpaid interest and any other amounts due
under the loan agreement will become due. The Seller Loan is interest-only and
may be voluntarily prepaid in its entirety prior to the maturity date without
penalty. Interest payments on the Seller Loan are due monthly. Prior to the
maturity date of the Seller Loan, the Company intends to refinance the property
through a commercial lending institution. No financing fee was incurred in
connection with the Seller Loan.
The Portland Properties will be leased by the joint venture to the current
operator of the facilities, pursuant to a long-term triple net lease. The lease
term is fifteen years with a lessee option to renew for an additional five-year
period.
Additionally, the joint venture has acquired, for a fee of $348,000, the option
to purchase an additional property located at 14145 SW 105th Street, Tigard,
Oregon ("Tigard") for a purchase price of $8.2 million. The option gives the
joint venture the right, but not the obligation, to purchase Tigard from Pacific
Gardens Estates, LLC. Tigard is a 78 bed facility that is currently 77%
occupied.
In connection with the acquisition, we executed an amendment to our existing
advisory agreement with Cornerstone Realty Advisors (the "Advisor") in order to
revise certain advisory fees payable in connection with the acquisition,
management and leasing of the Portland Properties and other property that we may
acquire in the future. The amendment revises the acquisition fee payable to the
advisor from an amount equal to 2.0% of the gross proceeds from our public
offering to an amount not to exceed 2.0% of our pro rata portion of the contract
purchase price of the acquired property.
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We also executed a property management and leasing agreement with the Advisor
pursuant to which the Advisor will perform property management and leasing
services with respect to the Portland Properties and will receive property
management fees, payable monthly, of 3.0% of monthly gross revenues from the
Portland Properties and a one-time leasing fee with respect to the leasing of
the Portland Properties of 2.5% of the rent payable by the tenant during the
initial term of the lease, payable upon the execution of the lease.
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