FSP 303 EAST WACKER DRIVE CORP. – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations.

    Real Estate Operations    

The Property was approximately 60% leased as of June 30, 2013 to a diverse group of tenants with staggered lease expirations. Management believes that any tenant that leases 10% or more of the Property's rentable space is material. As of June 30, 2013, 34 tenants were leasing space at the Property. As of June 30, 2013, the Property's largest tenant was AECOM Technology Corporation, which we refer to as AECOM. As of June 30, 2013, AECOM leased 105,990 square feet (approximately 12%) of the Property's rentable space through July 31, 2013. However, as previously reported, during the second quarter of 2012, AECOM signed a lease extension that allowed them to downsize at the Property commencing on August 1, 2013 and that extended AECOM's lease until 2024. Accordingly, effective August 1, 2013, AECOM's reduced space at the Property covered two floors, or approximately 58,424 square feet (approximately 6.8%) of the Property's rentable space. AECOM is a provider of professional, technical and management support services (NYSE: ACM).

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During the second quarter of 2013, we signed two new leases with McGraw Hill Global Education, a provider of digital educational solutions, for 15,104 square feet and with The University of Chicago for 13,210 square feet. As previously reported, during the first quarter of 2013, we signed a lease with Narrative Science, an information technology firm, for 8,657 square feet. Also, as previously reported, effective July 31, 2013, Groupon vacated the balance of its space (approximately 52,553 rentable square feet) at the Property and its lease expired.

Management believes that office buildings in the East Loop submarket of Chicago, where the Property is located, continue to struggle with high vacancy rates and disappointing net absorption. We believe that the office market in Chicago, and the East Loop in particular, has had difficulty stabilizing during the past five years, with several of its office properties losing anchor tenants and experiencing declining occupancies. We also believe that tenant improvement and leasing costs have risen during this time; and, consequently, the amount of capital necessary to attract good tenants to sign long-term leases has climbed significantly. Although the Property was approximately 60% leased at the conclusion of the second quarter of 2013, management continues to be encouraged by the tour activity in the market and positive feedback from prospective tenants regarding the first impression, overall appearance and condition of the Property. In addition, we believe that we have the capital to fund the estimated tenant improvement costs and leasing commissions necessary to re-lease the vacant space. We have been saving rental cash flow over the last few years by keeping dividend levels lower than in prior periods and we suspended dividend distributions for the past two quarters. We cannot guarantee the future payment of dividends or the amount of any such dividends. As of June 30, 2013, our existing cash reserves totaled approximately $19,000,000. In addition, in August 2011 we secured a $35,000,000 loan from John Hancock Life Insurance Company to be used for just such re-leasing costs. Approximately $26,800,000 of the loan amount was remaining and available as of June 30, 2013.

It is difficult for management to predict what will happen to occupancy and rents in the future because the need for space and the price tenants are willing to pay are tied to both the local economy and to the larger trends in the national economy, such as job growth, interest rates, the availability of credit and corporate earnings, which in turn are tied to even larger macroeconomic and political factors, such as recessionary concerns, volatility in energy pricing and the risk of terrorism. In addition to the difficulty of predicting macroeconomic factors, it is difficult to predict how our local market or tenants (existing and potential) will suffer or benefit from changes in the larger economy. In addition, because the Property is in a single geographical market, these macroeconomic trends may have a different effect on the Property and on its tenants (existing and potential), some of which may operate on a national level. Although we cannot predict how long it will take to lease vacant space at the Property or what the terms and conditions of any new leases will be, we expect to sign new leases at then-current market rates which may be below the expiring rates.

During the three months ended June 30, 2013, we believe that vacancy rates increased slightly and that rental rates were stable for buildings in Chicago'sEast Loop office market. These trends may continue, worsen or improve in the future. Management believes that the position of the Property within the East Loop office market is strong and management is optimistic that the existing vacant space will ultimately be leased to new tenants. In order to further improve the Property's position in Chicago's office market, management has implemented a number of lobby upgrades. If we can stabilize the Property at a high occupancy level with long-term quality rental income streams from credit-worthy tenants, we could create value for the holders of our Preferred Stock. If successful in re-leasing the existing vacant space under favorable terms, the opportunity for payment of dividends and/or a sale of the Property at an attractive price could be a real possibility. Of course, any sale of the Property would be subject to a number of conditions, including approval by our board of directors and a majority of the holders of our Preferred Stock. However, we may not be able to lease all of the remaining vacant space.

The potential for any of our tenants to default on its lease or to seek the protection of bankruptcy laws exists. If any of our tenants defaults on its lease, we may experience delays in enforcing our rights as a landlord and may incur substantial costs in protecting our investment. In addition, at any time, a tenant may seek the protection of bankruptcy laws, which could result in the rejection and termination of such tenant's lease and thereby cause a reduction in cash available for distribution to our stockholders. Bankruptcy or a material adverse change in the financial condition of a material tenant would likely have a material adverse effect on our results of operations.

Dividends, Future Tenant Improvement Costs and Leasing Commissions

Management believes that the Company will need to be able to quickly access cash in order to fund the potentially significant tenant improvements costs and leasing commissions that may be required to stabilize the occupancy and rent roll at the Property. We expect no or lower dividend distributions until occupancy levels at the Property recover and we have a better idea of the Property's actual future capital and leasing needs.

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In light of the amount of vacant space that needs to be leased at the Property and the potential for significant tenant improvement allowance costs and leasing commissions, on August 3, 2011, we entered into a mortgage note in favor of John Hancock Life Insurance Company (U.S.A.), which we refer to as the Lender, to evidence a loan, which we refer to as the Loan, in the original principal amount of $35,000,000 that matures on September 1, 2021. The proceeds of the Loan are being held by the Lender for our benefit in a restricted reserve account or accounts to be drawn upon by us from time to time for tenant improvement costs and leasing commissions at the Property upon satisfaction of certain conditions. The Loan bears interest at the fixed rate of 4.83% per annum. We are obligated to make monthly payments of interest only for the initial 60 months of the Loan. Thereafter, we are obligated to make monthly payments of principal and interest for the remaining 60 months, based on a 25-year amortization schedule, until the maturity date, when all outstanding amounts become due. The Loan is secured, in part, by a mortgage, assignment of leases and rents and security agreement, which we refer to as the Mortgage, from us in favor of the Lender. The Mortgage constitutes a lien against the Property and has been recorded in the land records of Cook County, Illinois. Subject to customary exceptions, the Loan is nonrecourse to the Company. As of June 30, 2013, we had made Lender advance requests of $8,200,000 from the proceeds of the Loan. Interest expense paid from the Loan for the six months ended June 30, 2013 and 2012 was $845,000. The documents evidencing and securing the Loan include restrictions on property liens and requires compliance with various financial covenants. Financial covenants include the requirement that we provide annual reporting. We were in compliance with the Loan covenants as of June 30, 2013 and December 31, 2012.

     10        Critical Accounting Policies 

We have certain critical accounting policies that are subject to judgments and estimates by our management and uncertainties of outcome that affect the application of these policies. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances. On an ongoing basis, we evaluate our estimates. In the event estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current information. The accounting policies that we believe are most critical to the understanding of our financial position and results of operations and that require significant management estimates and judgments are discussed in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2012.

Critical accounting policies are those that have the most impact on the reporting of our financial condition and results of operations and those requiring significant judgments and estimates. We believe that our judgments and estimates are consistently applied and produce financial information that fairly presents our results of operations.

No change to our critical accounting policies has occurred since the filing of our Annual Report on Form 10-K for the year ended December 31, 2012.

Results of Operations

As of June 30, 2013, the Property was approximately 60% leased to a diverse group of tenants with staggered lease expirations.

Comparison of the three months ended June 30, 2013 to the three months ended June 30, 2012

   Revenue   

Total revenue decreased by approximately $2.2 million to $3.6 million for the three months ended June 30, 2013, as compared to $5.8 million for the three months ended June 30, 2012. This decrease was primarily due to a decrease in rental income of $1.1 million, and a decrease in recoverable income of $1.1 million, both due to a decrease in occupancy.

   Expenses   

Total expenses decreased by approximately $0.7 million to $3.9 million for the three months ended June 30, 2013, as compared to $4.6 million for the three months ended June 30, 2012. The decrease is predominantly a result of a decrease in operating expenses of $0.5 million and a decrease in real estate taxes and insurance of $0.2 million.

Comparison of the six months ended June 30, 2013 to the six months ended June 30, 2012

    Revenue    

Total revenue decreased by approximately $4.6 million to $7.2 million for the six months ended June 30, 2013, as compared to $11.8 million for the six months ended June 30, 2012. This decrease was primarily due to a decrease in rental revenue of $2.3 million and a decrease in recoverable expenses of $2.3 million, both due to a decrease in occupancy.

   Expenses   

Total expenses decreased by approximately $1.8 million to $7.8 million for the six months ended June 30, 2013, as compared to $9.6 million for the six months ended June 30, 2012. The decrease is predominantly due to a decrease in operating expenses of $0.9 million, a decrease in depreciation and amortization of $0.3 million and a decrease in real estate taxes and insurance of $0.6 million.

Liquidity and Capital Resources

Cash and cash equivalents were $18.9 million at June 30, 2013 and $18.8 million at December 31, 2012. The $0.1 million increase for the six months ended June 30, 2013 is primarily attributable to approximately $0.5 million provided by operating activities, which was offset by approximately $0.5 million used for investing activities.

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Management believes that the existing cash and cash anticipated to be generated internally by operations will be sufficient to meet working capital requirements, any distributions required for us to maintain our status as a real estate investment trust and anticipated capital expenditures for at least the next 12 months.

    Operating Activities    

The cash provided by operating activities of $0.5 million for the six months ended June 30, 2013 was primarily attributable to a net loss of approximately $0.5 million, an increase in step rent receivable of $0.7 million and a decrease of $1.3 million by uses arising from other current accounts, which was offset by the add-back of $3.0 million for depreciation and amortization.

   Investing Activities   

The cash used for investing activities of approximately $0.5 million for the six months ended June 30, 2013 was attributable to the purchases of real estate assets of $5.5 million which was offset by the redemptions of the restricted investment of $5.0 million.

   Financing Activities   

There was no cash provided by or used for financing activities as of June 30, 2013.

    Sources and Uses of Funds    

The Company's principal demands on liquidity are cash for operations and distributions to equity holders. As of June 30, 2013, we had approximately $5.0 million in accrued liabilities. In the near term, liquidity is generated by cash from operations.

   Secured Debt   

On August 3, 2011, we entered into a mortgage note in favor of John Hancock Life Insurance Company (U.S.A.), which we refer to as the Lender, to evidence a loan, which we refer to as the Loan, in the original principal amount of $35,000,000 that matures on September 1, 2021. The proceeds of the Loan are being held by the Lender for our benefit in a restricted reserve account or accounts to be drawn upon by us from time to time for tenant improvement costs and leasing commissions at the Property upon satisfaction of certain conditions. The Loan bears interest at the fixed rate of 4.83% per annum. We are obligated to make monthly payments of interest only for the initial 60 months of the Loan. Thereafter, we are obligated to make monthly payments of principal and interest for the remaining 60 months, based on a 25-year amortization schedule, until the maturity date, when all outstanding amounts become due. The Loan is secured, in part, by a mortgage, assignment of leases and rents and security agreement, which we refer to as the Mortgage, from us in favor of the Lender. The Mortgage constitutes a lien against the Property and has been recorded in the land records of Cook County, Illinois. Subject to customary exceptions, the Loan is nonrecourse to the Company. Interest expense from the Loan for the six months ended June 30, 2013 and 2012 is $845,000.

The Loan agreement includes restrictions on property liens and requires compliance with various financial covenants. Financial covenants include the requirement that we provide annual reporting. We were in compliance with the Loan covenants as of June 30, 2013 and December 31, 2012.

   Contingencies   

We may be subject to various legal proceedings and claims that arise in the ordinary course of our business. Although occasional adverse decisions (or settlements) may occur, we believe that the final disposition of such matters will not have a material adverse effect on our financial position or results of operations.

    Related Party Transactions    Asset Management Agreement    

We have in the past engaged in and currently engage in transactions with a related party, Franklin Street, and its subsidiaries, FSP Investments LLC and FSP Property Management LLC, which we collectively refer to as FSP. We expect to continue to have related party transactions with FSP in the form of management fees paid to FSP to manage the Company on behalf of our stockholders. FSP Property Management LLC currently provides us with asset management and financial reporting services. The asset management agreement between us and FSP Property Management LLC requires us to pay FSP Property Management LLC a monthly fee equal to one-half of one percent (.5%) of the gross revenues of the Property. The asset management agreement between us and FSP Property Management LLC may be terminated by either party without cause at any time, upon at least thirty (30) days' written notice. For the six months ended June 30, 2013 and 2012, management fees paid were approximately $35,000 and $60,000, respectively.

 12      Investor Services Agreement   

On August 14, 2012, we entered into an Investor Services Agreement, which we refer to as the FSPI Agreement, with FSP Investments LLC for the provision of investor services to holders of our preferred stock. FSP Investments LLC is a wholly-owned subsidiary of Franklin Street, which is the sole holder of our one share of Common Stock that is issued and outstanding. FSP Investments LLC acted as a real estate investment firm and broker/dealer with respect to (a) our organization, (b) our acquisition of the Property and (c) the sale of our equity interests. The FSPI Agreement requires us to pay a monthly service fee of $500 for services performed under the FSPI Agreement, and to reimburse FSP Investments LLC for its reasonable out-of-pocket expenses incurred in connection with the FSPI Agreement. The FSPI Agreement may be terminated by either party with thirty days written notice or immediately upon certain events of default set forth in the FSPI Agreement. For the six months ended June 30, 2013 and 2012, investor services fees paid were approximately $7,000 and $0, respectively.

Ownership of Preferred Stock and Common Stock

On December 27, 2007, Franklin Street purchased 965.75 shares of the Preferred Stock (or approximately 43.7%), of the Company for consideration totaling $82,813,000. Prior to purchasing any shares of the Preferred Stock, Franklin Street agreed to vote any shares held by it on any matter presented to the holders of the Preferred Stock in a manner that approximates as closely as possible the votes cast in favor of and opposed to such matter by the holders of the Preferred Stock other than Franklin Street and its affiliates. For purposes of determining how Franklin Street votes its shares of the Preferred Stock, abstentions and non-votes by stockholders other than Franklin Street are not considered. Franklin Street is entitled to distributions that are declared on the Preferred Stock.

Franklin Street is the sole holder of the Company's one share of Common Stock that is issued and outstanding. Subsequent to the completion of the private placement of the Preferred Stock in December 2007, Franklin Street has not been entitled to share in our earnings or any dividend related to the Common Stock of the Company.

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