PRUDENTIAL VARIABLE CONTRACT REAL PROPERTY ACCOUNT – 10-Q – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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All of the assets of the Real Property Account are invested in the Partnership. Accordingly, the liquidity and capital resources and results of operations for the Real Property Account are contingent upon those of the Partnership. Therefore, this management's discussion and analysis addresses these items at the Partnership level. The general partners in the Partnership areThe Prudential Insurance Company of America ,Pruco Life Insurance Company , and Pruco Life Insurance Company ofNew Jersey , or collectively, the "Partners". The following discussion and analysis of the liquidity and capital resources and results of operations of the Partnership should be read in conjunction with the unaudited Consolidated Financial Statements of the Real Property Account and the Partnership and the related Notes included in this filing.
(a) Liquidity and Capital Resources
As ofSeptember 30, 2012 , the Partnership's liquid assets, consisting of cash and cash equivalents, were approximately$24.8 million , a decrease of approximately$2.6 million from$27.4 million as ofDecember 31, 2011 . The decrease was primarily due to the following activities: (a)$22.3 million for an acquisition of a 59-unit apartment property located inSeattle, Washington ; (b)$20.6 million for an acquisition of an 81,159 square foot retail property located inRoswell, Georgia ; (c)$5.0 million distribution to general partners' controlling interest; (d)$0.7 million of principal payments made on financed properties; and (e)$2.3 million paid for capital improvements. Partially offsetting this decrease was the (a) net cash flow generated from property operations of$6.4 million ; (b) net proceeds of$8.6 million from the final payment of the Capital Automotive Real Estate Services (or "CARS") preferred equity investment; (c)$11.7 million of loan proceeds associated with the apartment acquisition inSeattle, Washington ; (d)$12.5 million in a loan assumption associated with the retail acquisition inRoswell, Georgia ; (e)$7.4 million in proceeds from changes in financing arrangements on maturities of 90 days or less; and (f) contributions from noncontrolling interest of$1.7 million . The$2.3 million payment for capital improvements included the following items: (a)$0.5 million for building renovations at one of the office buildings inBrentwood, Tennessee ; (b)$0.4 million for tenant improvements and leasing costs at the office property inBeaverton, Oregon ; (c)$0.4 million for tenant improvements and leasing costs at the office building inLisle, Illinois ; (d)$0.3 million for roof replacements at the retail property inDunn, North Carolina ; (e)$0.2 million for exterior painting at the apartment property inRaleigh, North Carolina ; and (f)$0.5 million for capital improvements and transaction costs associated with leasing expenses at various properties. Sources of liquidity included net cash flow from property operations, capital redemptions, loans on properties, and interest from cash equivalents. The Partnership uses cash for its real estate investment activities and for its distributions to its partners. As ofSeptember 30, 2012 , approximately 9.9% of the Partnership's total assets consisted of cash and cash equivalents. 29
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(b) Results of Operations
The following is a comparison of the Partnership's results of operations for the nine and three month periods ended
Net Investment Income Overview The Partnership's net investment income attributable to the general partners' controlling interest for the nine months endedSeptember 30, 2012 was approximately$6.2 million , a$0.1 million increase from the prior year period. The increase in net investment income attributable to the general partners' controlling interest was primarily due to increases of$0.6 million ,$0.4 million and$0.1 million in the office, apartment and hotel sector investments' net investment income, respectively, from the prior year period. Partially offsetting the increase was a decrease of approximately$1.0 million from the prior year period in net investment income attributable to the general partners' controlling interest from the retail sector. The Partnership's net investment income attributable to the general partners' controlling interest for the three months endedSeptember 30, 2012 was approximately$2.4 million , an increase of approximately$0.4 million from the prior year period. The components of this net investment income and/or loss attributable to the general partners' controlling interest are discussed below by investment type. Valuation Overview The Partnership recorded a net recognized gain attributable to the general partner's controlling interest of$0.3 million for the nine month period endedSeptember 30, 2012 , compared with no recognized gains/losses for the prior year period. The net recognized gain attributable to the partner's controlling interest was due to the final payment of the CARS preferred equity investment. The Partnership recorded net unrealized gains attributable to the general partners' controlling interest of approximately$1.3 million for the nine month period endedSeptember 30, 2012 . This is compared with net unrealized gains attributable to the general partners' controlling interest of approximately$10.8 million for the prior year period. The net unrealized gains attributable to the general partners' controlling interest for the nine month period endedSeptember 30, 2012 were primarily due to valuation increases in the apartment and retail sector investments. Offsetting the net unrealized gains were net unrealized losses at the office and hotel sector investments. The Partnership recorded net unrealized gains attributable to the general partner's controlling interest of$1.5 million for the three month period endedSeptember 30, 2012 , compared with$3.3 million of unrealized gains for the prior year period. The components of these valuation gains and/or losses attributable to the general partners' controlling interest are discussed below by property type. 30
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The following table presents a comparison of the Partnership's sources of net investment income attributable to the general partners' controlling interest, and net recognized and unrealized gains or losses attributable to the general partners' controlling interest for the nine and three month periods endedSeptember 30, 2012 and 2011. Nine Months Ended September 30, Three Months Ended September 30, 2012 2011 2012 2011 Net Investment Income: Office properties $ 2,370,985 $ 1,795,162 $ 758,467 $ 583,520 Apartment properties 2,475,766 2,110,501 914,853 708,266 Retail properties 2,699,092 3,731,890 853,243 1,041,663 Hotel property 769,159 646,255 522,194 397,893 Other (including interest income, investment management fee, etc.) (2,085,622 ) (2,109,226 ) (686,748 ) (729,055 ) Total Net Investment Income $ 6,229,380 $
6,174,582 $ 2,362,009
Net Recognized Gain (Loss) on Real Estate Investments: Retail properties 348,760 - - - Net Recognized Gain (Loss) on Real Estate Investments 348,760 - - - Net Unrealized Gain (Loss) on Real Estate Investments: Office properties (1,331,202 ) 4,436,604 (1,095,681 ) 2,503,212 Apartment properties 1,566,482 3,053,940 1,288,311 1,263,906 Retail properties 1,212,894 3,158,682 1,630,929 (118,273 ) Hotel property (137,744 ) 169,795 (349,630 ) (313,969 ) Net Unrealized Gain (Loss) on Real Estate Investments 1,310,430 10,819,021 1,473,929 3,334,876
Net Recognized and Unrealized Gain (Loss) on Real Estate Investments $ 1,659,190 10,819,021 $ 1,473,929
3,334,876
Increase/(Decrease) in Net Assets $ 7,888,570
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Table of Contents OFFICE PROPERTIES Net Investment Net Investment Unrealized Unrealized Nine Months Ended Income/(Loss) Income/(Loss) Gain/(Loss) Gain/(Loss) Occupancy Occupancy September 30, 2012 2011 2012 2011 2012 2011 Property Lisle, IL $ 218,130 $ 233,343 $ (161,188 ) $ (67,058 ) 57 % 55 % Brentwood, TN 857,740 429,060 820,676 2,205,889 100 % 100 % Beaverton, OR 367,873 297,168 (701,598 ) 1,078,796 91 % 88 % Brentwood, TN 927,242 835,591 (1,289,092 ) 1,218,977 100 % 100 % $ 2,370,985 $ 1,795,162 $ (1,331,202 ) $ 4,436,604 Three Months Ended September 30, Property Lisle, IL $ 61,217 $ 93,684 $ (13,282 ) $ (20,298 ) Brentwood, TN 282,957 203,397 191,142 512,206 Beaverton, OR 119,294 27,329 (213,399 ) 856,298 Brentwood, TN 294,999 259,110 (1,060,142 ) 1,155,006 $ 758,467 $ 583,520 $ (1,095,681 ) $ 2,503,212 Net Investment Income Net investment income attributable to the general partners' controlling interest for the Partnership's office properties was approximately$2.4 million and$0.8 million for the nine and three month periods endedSeptember 30, 2012 , respectively, which represents an increase of approximately$0.6 million and$0.2 million , respectively, from the prior year period. The increase in net investment income attributable to the general partners' controlling interest for the nine and three month periods endedSeptember 30, 2012 were primarily due to rental rate increases from new and existing tenants at one of the properties inBrentwood, Tennessee and an increase in occupancy at the property inBeaverton, Oregon . Unrealized Gain/(Loss) The office properties owned by the Partnership recorded net unrealized losses attributable to the general partners' controlling interest of approximately$1.3 million and$1.1 million for the nine and three month periods endedSeptember 30, 2012 , respectively, compared with a net unrealized gain attributable to the general partners' controlling interest of approximately$4.4 million and$2.5 million , respectively, from the prior year period. The net unrealized losses attributable to the general partners' controlling interest for the nine and three month periods endedSeptember 30, 2012 were primarily due to (a) valuation loss at one of the properties inBrentwood, Tennessee due to the likelihood that the tenant will not renew upon lease expiration in 2015; (b) valuation loss at the property inBeaverton, Oregon due to a reconciliation of costs spent on tenant improvements and less favorable market leasing assumptions; and (c) increased capital expenditures related to leasing and tenant improvement costs and increased real estate taxes at the property inLisle, Illinois . Partially offsetting the decrease was an increase at one of theBrentwood, Tennessee properties due to increased contract rents and more favorable market leasing assumptions. 32
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Table of Contents APARTMENT PROPERTIES Net Investment Net Investment Unrealized Unrealized Nine Months Ended Income/(Loss) Income/(Loss) Gain/(Loss) Gain/(Loss) Occupancy Occupancy September 30, 2012 2011 2012 2011 2012 2011 Property Atlanta, GA (1) $ - $ (5,515 ) $ - $ - N/A N/A Raleigh, NC 828,222 754,609 763,444 1,395,582 98 % 98 % Austin, TX 1,053,301 933,254 652,776 987,489 97 % 98 % Charlotte, NC 503,784 428,153 263,750 670,869 99 % 97 % Seattle, WA 90,459 - (113,488 ) - 93 % N/A $ 2,475,766 $ 2,110,501 $
1,566,482 $ 3,053,940 Three Months Ended September 30, Property Atlanta, GA (1) $ - $ (312 ) $ - $ - Raleigh, NC 264,101 253,151 430,859 789,849 Austin, TX 359,167 315,456 998,701 494,415 Charlotte, NC 174,037 139,971 (27,762 ) (20,358 ) Seattle, WA 117,548 - (113,487 ) - $ 914,853 $ 708,266 $ 1,288,311 $ 1,263,906
(1) The
the nine and three month periods ended
post-closing adjustments. Net Investment Income Net investment income attributable to the general partners' controlling interest for the Partnership's apartment properties was approximately$2.5 million and$0.9 million for the nine and three month periods endedSeptember 30, 2012 , respectively, which represents increases of approximately$0.4 million and$0.2 million , respectively from the prior year period. The increase in net investment income attributable to the general partners' controlling interest for the nine and three month periods endedSeptember 30, 2012 was primarily due to increased rental rates and reduced concessions at the properties inRaleigh, North Carolina ,Austin, Texas , andCharlotte, North Carolina . Unrealized Gain/(Loss) The apartment properties owned by the Partnership recorded net unrealized gains attributable to the general partners' controlling interest of approximately$1.6 million and$1.3 million for the nine and three month periods endedSeptember 30, 2012 , respectively, compared with net unrealized gains attributable to the general partners' controlling interest of approximately$3.1 million and$1.3 million , respectively, for the prior year period. The net unrealized gains attributable to the general partners' controlling interest for the nine months endedSeptember 30, 2012 were generally due to favorable market leasing assumptions at the properties inCharlotte, North Carolina ;Raleigh, North Carolina andAustin, Texas . The net unrealized gains attributable to the general partners' controlling interest for the three months endedSeptember 30, 2012 were generally due to (a) more favorable market rents and decreased real estate taxes at the property inAustin, Texas ; and (b) more favorable market rents, decreased future capital expenditures and operating expenses at the property inRaleigh, North Carolina . 33
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Table of Contents RETAIL PROPERTIES Recognized/ Net Investment Net Investment Unrealized Unrealized Nine Months Ended Income/(Loss) Income/(Loss) Gain/(Loss) Gain/(Loss) Occupancy Occupancy September 30, 2012 2011 2012 2011 2012 2011 Property Roswell, GA(1) $ - $ 72,833 $ - $ - N/A N/A Hampton, VA 755,123 771,687 280,278 891,184 83 % 96 % Ocean City, MD 554,591 698,284 832,783 599,409 92 % 98 % Westminster, MD 986,090 1,000,351 397,327 597,074 98 % 100 % Dunn, NC 261,132 265,641 (297,494 ) (178,506 ) 36 % 35 % CARS Preferred Equity (2) 124,134 923,094 348,760 1,249,521 N/A N/A Roswell, GA 18,022 - - - 95 % N/A $ 2,699,092 $ 3,731,890 $ 1,561,654 $ 3,158,682 Three Months Ended September 30, Property Roswell, GA(1) $ - $ - $ - $ - Hampton, VA 253,939 275,110 (9,766 ) (6,456 ) Ocean City, MD 164,860 184,400 1,253,086 (181,529 ) Westminster, MD 321,975 359,825 398,011 (599 ) Dunn, NC 91,735 39,572 (10,402 ) (24,929 ) CARS Preferred Equity (2) 2,712 182,756 - 95,240 Roswell, GA 18,022 - - - $ 853,243 $ 1,041,663 $ 1,630,929 $ (118,273 )
(1) The
2011 is a result of post-closing adjustments.
(2) A partial capital redemption of the CARS preferred equity position was paid
on
on the position which is reflected as a recognized gain. Net Investment Income Net investment income attributable to the general partners' controlling interest for the Partnership's retail properties was approximately$2.7 million and$0.9 million for the nine and three month periods endedSeptember 30, 2012 , respectively, which represents a decrease of approximately$1.0 million and$0.2 million , respectively from the prior year period. The decrease in net investment income attributable to the general partners' controlling interest for the nine and three month periods endedSeptember 30, 2012 was largely due to (a) reduced interest income from the CARS preferred equity investment due to the final payment of the investment which occurred in the first quarter of 2012; and (b) increased interest expense as a result of refinancing the loan for theOcean City, Maryland property. Recognized and Unrealized Gain/(Loss) The retail properties owned by the Partnership recorded a net recognized gain and unrealized gains attributable to the general partners' controlling interest of approximately$1.6 million for the nine months endedSeptember 30, 2012 , compared with a net unrealized gain attributable to the general partners' controlling interest of approximately$3.2 million for the prior year period. The net recognized and unrealized gains attributable to the general partners' controlling interest for the nine months endedSeptember 30, 2012 were primarily due to (a) more favorable market rent assumptions for the property inOcean City, Maryland ; (b) increased rent at the property inWestminster, Maryland ; (c) recognized gains on the CARS preferred equity investment as a result of the sale of the investment; and (d) more favorable market leasing assumptions at the property inHampton, Virginia . Partially offsetting the gains was a loss at the property inDunn, North Carolina due to capital expenditures for roof replacements. The retail properties owned by the Partnership recorded net unrealized gains attributable to the general partners' interest of$1.6 million for the three months endedSeptember 30, 2012 , compared with net unrealized losses attributable to the general partners' controlling interest of approximately$0.1 million for the prior year period. The net unrealized gains attributable to the general partners' controlling interest for the three months endedSeptember 30, 2012 were primarily due to (a) more favorable market leasing assumptions and a reduction in future required capital expenditures at theOcean City, Maryland property; and (b) increased rent at the property inWestminster, Maryland . 34
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Table of Contents HOTEL PROPERTY Net Investment Net Investment Unrealized
Unrealized
Nine Months Ended Income/(Loss) Income/(Loss) Gain/(Loss)
Gain/(Loss) Occupancy Occupancy September 30, 2012 2011 2012 2011 2012 2011 Property Lake Oswego, OR $ 769,159 $ 646,255 $ (137,744 ) $ 169,795 83 % 80 % Three Months Ended September 30, Property Lake Oswego, OR $ 522,194 $ 397,893 $ (349,630 ) $ (313,969 ) Net Investment Income Net investment income attributable to the general partners' controlling interest for the Partnership's hotel property was approximately$0.8 million and$0.5 million for the nine and three month periods endedSeptember 30, 2012 , respectively, which represents an increase of approximately$0.2 million and$0.1 million from the prior year periods, respectively, due to an increase in average daily rate and occupancy. Unrealized Gain/(Loss) The Partnership's hotel property recorded a net unrealized loss attributable to the general partners' controlling interest of approximately$0.1 million for the nine months endedSeptember 30, 2012 , compared with a net unrealized gain attributable to the general partners' controlling interest of approximately$0.2 million for the prior year period. The unrealized loss attributable to the general partners' controlling interest for the nine months endedSeptember 30, 2012 was primarily due to a decrease in the growth rates applied to average daily rate projections. The Partnership's hotel property recorded a net unrealized loss attributable to the general partners' controlling interest of approximately$0.3 million for the three months endedSeptember 30, 2012 , which remained relatively unchanged from the prior year period. The unrealized loss attributable to the general partners' controlling interest for the three months endedSeptember 30, 2012 was primarily due to a decrease in the growth rates applied to the average daily rate projections.
Other
Other net investment loss mainly includes investment management fees, other portfolio level expenses and interest income. Other net investment loss attributable to the general partners' controlling interest was approximately
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(c) Inflation
A majority of the Partnership's leases with its commercial tenants provide for recoveries of expenses based upon the tenant's proportionate share of, and/or increases in, real estate taxes and certain operating costs, which may partially reduce the Partnership's exposure to increases in operating costs resulting from inflation. Critical Accounting Policies The preparation of financial statements in conformity with accounting principles generally accepted inthe United States of America , or "U.S. GAAP", requires the application of accounting policies that often involve a significant degree of judgment. Management reviews critical estimates and assumptions on an ongoing basis. If management determines, as a result of its consideration of facts and circumstances, that modifications in assumptions and estimates are appropriate, results of operations and financial position as reported in the unaudited Consolidated Financial Statements of the Real Property Account and the Partnership may change significantly. The following sections discuss those critical accounting policies applied in preparing the unaudited Consolidated Financial Statements of the Real Property Account and the Partnership that are most dependent on the application of estimates and assumptions.
Accounting Pronouncements Adopted
See Note 1B to the Partnership's unaudited Consolidated Financial Statements for a discussion of recently adopted accounting pronouncements.
Valuation of Investments
Real Estate Investments - Real estate investments are carried at fair value. Properties owned are initially recorded at the purchase price plus closing costs. Development costs and major renovations are capitalized as a component of cost, and routine maintenance and repairs are charged to expense as incurred. Real estate costs include the cost of acquired property, including all the tangible and intangible assets. Tangible assets include the value of all land, building and tenant improvements at the time of acquisition. Intangible assets include the value of any above and below market leases, in-place leases, and tenant relationships at the time of acquisition. In general, fair value estimates are based upon property appraisal reports prepared by independent real estate appraisers (members of theAppraisal Institute or an equivalent organization) within a reasonable amount of time following acquisition of the real estate and no less frequently than annually thereafter. The Chief Real Estate Appraiser ofPrudential Investment Management, Inc. ("PIM"), which is an indirectly owned subsidiary of Prudential Financial, Inc. ("PFI"), is responsible for assuring that the valuation process provides independent and reasonable property fair value estimates. An unaffiliated third party has been appointed by PIM to assist the Chief Real Estate Appraiser in maintaining and monitoring the independence and the accuracy of the appraisal process. The fair value of real estate investments does not reflect the transaction sale costs, which may be incurred upon disposition of the real estate investments. The purpose of an appraisal is to estimate the fair value of real estate as of a specific date. In accordance with FASB authoritative guidance on fair value measurements and disclosures, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The estimate of fair value is based on the conventional approaches to value, all of which require the exercise of subjective judgment. The three approaches are: (1) current cost of reproducing the real estate less deterioration and functional and economic obsolescence; (2) discounting a series of income streams and reversion at a specific yield or by directly capitalizing a single year income estimate by an appropriate factor; and (3) value indicated by recent sales of comparable real estate in the market. Key inputs and assumptions include rental income and expense amounts, related rental income and expense growth rates, discount rates and capitalization rates. In the reconciliation of these three approaches, the independent appraiser uses one or a combination of them, to determine the approximated value for the type of real estate in the market. The real estate investments consisting of real estate, improvements, and preferred equity investments are therefore classified as Level 3.
Cash equivalents include short term investments. Short term investments are generally valued using unadjusted quoted prices in active markets that are accessible for identical assets and primarily are classified as Level 1.
Other Estimates
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the unaudited Consolidated Financial Statements of the Real Property Account and the Partnership and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 36
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