UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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Form 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004
COMMISSION FILE NUMBER 1-8383
MISSION WEST PROPERTIES, INC.
(Exact name of registrant as specified in its charter)
Maryland 95-2635431
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(State or other jurisdiction of (I.R.S. Employer Identification
incorporation or organization) Number)
10050 Bandley Drive
Cupertino, California 95014-2188
(Address of principal executive offices)
Registrant's telephone number, including area code is (408) 725-0700
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [ ] NO [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [X] No [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date:
18,072,691 shares outstanding as of July 31, 2004
Mission West Properties, Inc.
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2004
INDEX
PAGE
PART I FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited):
Consolidated Balance Sheets as of June 30, 2004
and December 31, 2003 ..................................................................................2
Consolidated Statements of Operations for the
three and six months ended June 30, 2004 and 2003 (As Restated).........................................3
Consolidated Statements of Cash Flows for the
six months ended June 30, 2004 and 2003 (As Restated)...................................................4
Notes to Consolidated Financial Statements..............................................................5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations....................................................................10
Item 3. Quantitative and Qualitative Disclosures about Market Risk.............................................21
Item 4. Controls and Procedures................................................................................22
PART II OTHER INFORMATION
Item 1. Legal Proceedings......................................................................................23
Item 6. Exhibits and Reports on Form 8-K.......................................................................23
Signatures...........................................................................................................24
Exhibit Index
Certifications
Section 1350 Certification
- 1 -
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
MISSION WEST PROPERTIES, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share and per share amounts)
(Unaudited)
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June 30, 2004 December 31, 2003
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ASSETS
Real estate assets, at cost:
Land $ 275,707 $ 275,707
Buildings and improvements 779,556 779,636
Real estate related intangible assets 18,283 19,651
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Total investments in properties 1,073,546 1,074,994
Less accumulated depreciation and amortization (100,035) (89,243)
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Net investments in properties 973,511 985,751
Cash and cash equivalents 1,857 4,129
Deferred rent receivable, net of $2,000 allowance
at June 30, 2004 and December 31, 2003 18,822 18,970
Investment in unconsolidated joint venture 2,504 2,285
Other assets (net of accumulated amortization of $6,144 and $4,211
at June 30, 2004 and December 31, 2003, respectively) 21,868 21,497
--------------------- ----------------------
Total assets $1,018,562 $1,032,632
===================== ======================
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Line of credit (related parties) $ 1,603 $ 6,320
Revolving line of credit 22,513 23,965
Mortgage notes payable 297,250 299,858
Mortgage notes payable (related parties) 10,594 10,762
Interest payable 330 332
Security deposits 9,900 10,248
Deferred rental income 14,181 12,723
Dividend/distribution payable 25,076 25,031
Accounts payable and accrued expenses 5,647 5,085
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Total liabilities 387,094 394,324
Commitments and contingencies
Minority interests 517,359 524,918
Stockholders' equity:
Preferred stock, $.001 par value, 20,000,000 shares
authorized, none issued and outstanding - -
Common stock, $.001 par value, 200,000,000 shares
authorized, 18,063,691 and 17,894,691 shares issued and
outstanding at June 30, 2004 and December 31, 2003, respectively 18 18
Paid-in-capital 134,196 132,136
Accumulated deficit (20,105) (18,764)
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Total stockholders' equity 114,109 113,390
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Total liabilities and stockholders' equity $ 1,018,562 $ 1,032,632
===================== ======================
The accompanying notes are an integral part of these
consolidated financial statements.
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MISSION WEST PROPERTIES, INC
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except share and per share amounts)
(Unaudited)
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Three months ended June 30, Six months ended June 30,
2004 2003 2004 2003
(As Restated) (As Restated)
------------------ ------------------- ----------------- ------------------
Revenues:
Rental revenue from real estate $ 29,901 $ 32,722 $ 61,477 $ 64,154
Tenant reimbursements 3,738 4,990 7,956 9,565
Other income, including lease terminations,
settlements and interest 4,613 569 5,007 1,303
------------------ ------------------- ----------------- ------------------
38,252 38,281 74,440 75,022
------------------ ------------------- ----------------- ------------------
Expenses:
Property operating, maintenance and real estate taxes 5,195 5,459 10,696 10,181
Interest 4,220 4,355 8,583 7,761
Interest (related parties) 252 257 504 550
General and administrative 885 322 1,233 679
Depreciation and amortization of real estate 5,694 5,067 11,216 9,777
------------------ ------------------- ----------------- ------------------
16,246 15,460 32,232 28,948
------------------ ------------------- ----------------- ------------------
Income before equity in earnings of unconsolidated joint
venture and minority interests 22,006 22,821 42,208 46,074
Equity in earnings of unconsolidated joint venture,
including $1,400 gain on sale of property acquired
from related party 627 2,023 1,218 2,759
Minority interests 18,838 20,733 36,108 40,733
------------------ ------------------- ----------------- ------------------
Income from operations 3,795 4,111 7,318 8,100
------------------ ------------------- ----------------- ------------------
Net income to common stockholders $ 3,795 $ 4,111 $ 7,318 $ 8,100
================== =================== ================= ==================
Net income to minority interests $ 18,838 $ 20,733 $ 36,108 $ 40,733
================== =================== ================= ==================
Net income per share to common stockholders:
Basic $0.21 $0.23 $0.41 $0.46
================== =================== ================= ==================
Diluted $0.21 $0.23 $0.40 $0.46
================== =================== ================= ==================
Weighted average shares of
common stock outstanding (basic) 18,016,356 17,701,999 17,992,886 17,669,808
================== =================== ================= ==================
Weighted average shares of
common stock outstanding (diluted) 18,079,139 17,762,773 18,075,734 17,728,638
================== =================== ================= ==================
The accompanying notes are an integral part of these
consolidated financial statements.
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MISSION WEST PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(Unaudited)
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Six months ended June 30,
2004 2003
(As Restated)
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Cash flows from operating activities:
Net income $ 7,318 $ 8,100
Adjustments to reconcile net income to net cash provided by operating activities:
Minority interests 36,108 40,733
Depreciation and amortization of real estate 11,216 9,777
Amortization of above market rent intangible asset 944 472
Equity in earnings of unconsolidated joint venture (1,218) (2,759)
Distributions from unconsolidated joint venture 1,000 1,000
Other - 9
Changes in operating assets and liabilities, net of liabilities assumed:
Deferred rent receivable 148 (450)
Other assets (21) 840
Interest payable (2) (2)
Security deposits (348) (520)
Deferred rental income 1,458 4,181
Accounts payable and accrued expenses 644 (286)
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Net cash provided by operating activities 57,247 61,095
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Cash flows from investing activities:
Improvements to real estate assets (370) (991)
Purchase of real estate - (110,008)
Net proceeds from sale of TBI unconsolidated joint venture real estate - 1,400
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Net cash used in investing activities (370) (109,599)
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Cash flows from financing activities:
Principal payments on mortgage notes payable (2,608) (2,709)
Proceeds from mortgage loan payable - 180,000
Principal payments on mortgage notes payable (related parties) (168) (155)
Net payments under line of credit (related parties) (4,619) (54,607)
Payment on loan payable - (20,000)
Payment on revolving line of credit (1,452) (5,408)
Financing costs - (863)
Proceeds from stock options exercised 165 560
Minority interest distributions (41,849) (41,614)
Dividends (8,618) (8,434)
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Net cash used in financing activities (59,149) (46,770)
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Net decrease in cash and cash equivalents (2,272) (1,734)
Cash and cash equivalents, beginning of period 4,129 4,479
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Cash and cash equivalents, ending of period $ 1,857 $ 2,745
=================== ===================
Supplemental information:
Cash paid for interest $ 8,934 $ 8,158
=================== ===================
Supplemental schedule of non-cash investing and financing activities:
Issuance of common stock upon conversion of O.P units $ 1,895 $ 1,574
=================== ===================
Assumption of other liabilities in connection with property acquisition $ - $ 783
=================== ===================
Issuance of operating partnership units in connection with joint venture acquisition $ - $ 1,800
=================== ===================
The accompanying notes are an integral part of these
consolidated financial statements.
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MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except share, per share, O.P units and per
square footage amounts)
(Unaudited)
The Company's consolidated financial statements have been prepared pursuant
to the Securities and Exchange Commission's ("SEC") rules and regulations.
The following notes, which present interim disclosures as required by the
SEC, highlight significant changes to the notes to the Company's December
31, 2003 audited consolidated financial statements and should be read
together with the financial statements and notes thereto included in the
Company's Form 10-K. The results of operations for the three and six months
ended June 30, 2004 are not necessarily indicative of the results to be
expected for the entire year.
1. ORGANIZATION AND FORMATION OF THE COMPANY
Mission West Properties, Inc. ("the Company") is a fully integrated,
self-administered and self-managed real estate company that acquires and
manages R&D/office properties in the portion of the San Francisco Bay Area
commonly referred to as Silicon Valley. In July 1998, the Company purchased
an approximate 12.11% of four existing limited partnerships (referred to
collectively as the "operating partnerships") and obtained control of these
partnerships by becoming the sole general partner in each one effective
July 1, 1998 for financial accounting and reporting purposes. The Company
purchased an approximate 12.11% interest in each of the operating
partnerships. All limited partnership interests in the operating
partnerships were converted into 59,479,633 operating partnership ("O.P.")
units, which represented a limited partnership ownership interest of
approximately 87.89% of the operating partnerships. The operating
partnerships are the vehicles through which the Company holds its real
estate investments, makes real estate acquisitions, and generally conducts
its business.
On December 30, 1998, the Company was reincorporated under the laws of the
State of Maryland through a merger with and into Mission West Properties,
Inc. Accordingly, shares of the former company, Mission West Properties, a
California corporation (no par), which were outstanding at December 30,
1998, were converted into shares of common stock ($.001 par value per
share) on a one-for-one basis.
As of June 30, 2004, the Company owns a general partnership interest of
17.11%, 21.63%, 16.12% and 12.38% in Mission West Properties, L.P., Mission
West Properties, L.P. I, Mission West Properties, L.P. II and Mission West
Properties, L.P. III, respectively, for a 17.29% general partnership
interest in the operating partnerships, taken as a whole, on a weighted
average basis.
Through the operating partnerships, the Company owns interests in 109 R&D
properties, all of which are located in Silicon Valley.
The Company has elected to be taxed as a real estate investment trust
("REIT") under the Internal Revenue Code of 1986, as amended. Accordingly,
no provision has been made for income taxes for the three and six months
ended June 30, 2004.
BUSINESS SEGMENT INFORMATION
The Company's primary business is the ownership and management of
R&D/office real estate with a geographic concentration in the Silicon
Valley of the San Francisco Bay Area. Accordingly, the Company has
concluded it currently has a single reportable segment for SFAS No. 131
purposes.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION AND FINANCIAL STATEMENT PRESENTATION
The accompanying consolidated financial statements include the accounts of
Mission West Properties, Inc. and its controlled subsidiaries, including
the operating partnerships. All significant intercompany balances have been
eliminated in consolidation. The consolidated financial statements as of
and for the three and six months ended June 30, 2004 and 2003 and related
footnote disclosures are unaudited. In the opinion of management, such
financial statements reflect all adjustments necessary for a fair
presentation of the results of the interim periods. All such adjustments
are of a normal recurring nature.
USE OF ESTIMATES
The Company prepares the consolidated financial statements in conformity
with accounting principles generally accepted in the United States of
America ("GAAP"), which requires it to make certain estimates, judgments
and assumptions that affect the reported amounts in the accompanying
consolidated financial statements, disclosure of contingent assets and
liabilities and related footnotes. Accounting and disclosure decisions with
respect to material transactions that are subject to significant management
judgments or estimates include impairment of long lived assets, deferred
rent reserves, and allocation of purchase price relating to property
acquisitions and the related depreciable lives assigned. Actual results may
differ from these estimates under different assumptions or conditions.
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MINORITY INTERESTS
Minority interest represents the separate private ownership of the
operating partnerships by the Berg Group (defined as Carl E. Berg, his
brother Clyde J. Berg, members of their respective immediate families, and
certain entities they control) and other non-affiliate interests. In total,
these interests account for approximately 83% of the ownership interests in
the real estate operations of the Company as of June 30, 2004. Minority
interest in net income is calculated by taking the net income of the
operating partnerships (on a stand-alone basis) multiplied by the
respective minority interest ownership percentage.
RECLASSIFICATIONS
Certain reclassifications have been made to the previously reported 2003
statements in order to conform to the 2004 presentation.
ACCOUNTING FOR STOCK-BASED COMPENSATION
SFAS No. 123, "Accounting for Stock-Based Compensation," encourages, but
does not require companies to record compensation cost for stock-based
employee compensation plans at fair value. The Company has chosen to
continue to account for stock-based compensation using the intrinsic value
method prescribed in Accounting Principles Board Opinion ("APB") No. 25,
"Accounting for Stock Issued to Employees" and related interpretations.
Accordingly, compensation cost for stock options is measured as the excess,
if any, of the quoted market price of the Company's stock at the date of
the grant over the amount an employee must pay to acquire the stock.
The following table illustrates the unaudited pro forma effect on
consolidated net income available to common shareholders and consolidated
earnings per share if the fair value method had been applied to all
outstanding and unvested stock options for the three and six months ended
June 30, 2004 and 2003.
Three Months Ended June 30, Six Months Ended June 30,
2004 2003 2004 2003
(As Restated) (As Restated)
--------------- --------------- --------------- ---------------
(dollars in thousands, except per share data)
Historical net income to common stockholders $3,795 $4,111 $7,318 $8,100
Deduct compensation expense for stock options
determined under fair value based method (44) (59) (88) (117)
Allocation of expense to minority interest 36 49 73 94
--------------- --------------- --------------- ---------------
Pro forma net income to common stockholders
$3,787 $4,101 $7,303 $8,077
=============== =============== =============== ===============
Earnings per share - basic:
Historical net income to common stockholders $0.21 $0.23 $0.41 $0.46
Pro forma net income to common stockholders $0.21 $0.23 $0.41 $0.46
Earnings per share - diluted:
Historical net income to common stockholders $0.21 $0.23 $0.40 $0.46
Pro forma net income to common stockholders $0.21 $0.23 $0.40 $0.46
No stock options were granted during the first six months of 2004.
3. STOCK TRANSACTIONS
During the six months ended June 30, 2004, stock options to purchase 20,000
shares of common stock were exercised at $8.25 per share. Total proceeds to
the Company were approximately $165. In 2004, one limited partner exchanged
100,000 O.P. units for 100,000 shares of the Company's common stock under
the terms of the December 1998 Exchange Rights Agreement among the Company
and all limited partners of the operating partnerships. In 2004, Carl E.
Berg gave 49,000 O.P. units to charitable institutions that exchanged them
for 49,000 shares of the Company's common stock pursuant to the December
1998 Exchange Rights Agreement.
4. NET INCOME PER SHARE
Basic operating net income per share is computed by dividing net income by
the weighted average number of common shares outstanding for the period.
Diluted operating net income per share is computed by dividing net income
by the sum of the weighted-average number of common shares outstanding for
the period plus the assumed exercise of all dilutive securities using the
treasury stock method.
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The computation for weighted average shares is detailed below:
Three Months Ended June 30, Six Months Ended June 30,
2004 2003 2004 2003
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (basic) 18,016,356 17,701,999 17,992,886 17,669,808
Incremental shares from assumed option exercise 62,783 60,774 82,848 58,830
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (diluted) 18,079,139 17,762,773 18,075,734 17,728,638
=============== ============== ============== ===============
The outstanding O.P. units, which are exchangeable at the unit holder's
option, subject to certain conditions, for shares of common stock on a
one-for-one basis have been excluded from the diluted net income per share
calculation, as there would be no effect on the calculation after adding
the minority interests' share of income back to net income. The total
number of O.P. units outstanding at June 30, 2004 and 2003 was 86,418,195
and 86,498,064, respectively.
5. RELATED PARTY TRANSACTIONS
As of June 30, 2004, the Berg Group owned 77,586,528 O.P. units. The Berg
Group's ownership as of June 30, 2004 represented approximately 74% of the
equity interests, assuming conversion of the 86,418,195 O.P. units
outstanding into the Company's common stock.
The Berg Group $20,000 line of credit bears interest at LIBOR plus 1.30%,
which was 3.24% as of June 30, 2004, and matures in March 2005. The Company
believes that the terms of the Berg Group line of credit are more favorable
than those available from commercial lenders. As of June 30, 2004, debt in
the amount of $1,603 was due the Berg Group under the line of credit, and
debt in the amount of $10,594 was due the Berg Group under a mortgage note
established May 15, 2000 in connection with the acquisition of a 50%
interest in Hellyer Avenue Limited Partnership, the obligor under the
mortgage note. The mortgage note bears interest at 7.65% and is due June
2010 with principal payments amortized over 20 years. Interest expense
incurred in connection with the Berg Group line of credit and mortgage note
was $252 and $257 for the three months ended June 30, 2004 and 2003,
respectively, and $504 and $550 for the six months ended June 30, 2004 and
2003, respectively.
During the first six months of June 30, 2004 and 2003, Carl E. Berg or
entities controlled by Mr. Berg have financial interests in several
companies that lease space from the operating partnerships, which include
three companies where Mr. Berg has a greater than 10% ownership interest.
These related tenants occupy approximately 48,000 square feet and
contributed $217 and $232 in rental revenue during the first three months
of 2004 and 2003, respectively, and $433 and $471 in rental revenue during
the first six months of 2004 and 2003, respectively. Under the Company's
charter, bylaws and agreements with the Berg Group, the individual members
of the Berg Group are prohibited from acquiring shares of the Company's
common stock if such acquisition would result in their beneficial ownership
percentage of the Company's common stock causing it to violate any REIT
qualification requirement.
The Berg Group has an approximately $2,500 commitment to complete certain
tenant improvements in connection with the Company's 2002 acquisition of
5345 Hellyer Avenue in San Jose. The Company recorded this portion of its
purchase consideration paid to the Berg Group as an Other Asset on its
Consolidated Balance Sheets. The Berg Group plans to satisfy this
commitment to complete certain tenant improvements when requested by the
Company following the approval of the Independent Directors Committee.
The Berg Group has an approximately $7,500 commitment to complete an
approximately 75,000 to 90,000 square foot building in connection with the
Company's 2001 acquisition of 245 Caspian in Sunnyvale which is comprised
of approximately three acres of unimproved land. The Company recorded this
portion of its purchase consideration paid to the Berg Group as an Other
Asset on its Consolidated Balance Sheets. The Berg Group plans to satisfy
this commitment to construct a building when requested by the Company
following the approval of the Independent Directors Committee.
The Company currently leases office space owned by Berg & Berg Enterprises,
Inc., an affiliate of Carl E. Berg and Clyde J. Berg. Rental amounts and
overhead reimbursements paid to Berg & Berg Enterprises, Inc. were $23 for
each of the three-month periods ended June 30, 2004 and 2003 and $45 for
each of the six-month periods ended June 30, 2004 and 2003.
In January 2003, the Company acquired a 50% interest in an unconsolidated
joint venture from the Berg Group under the Berg Land Holdings Option
Agreement for $1,800. The Company financed this acquisition by issuing
181,032 O.P. units to various members of the Berg Group. In April 2003, the
Company, through the joint venture, acquired a property from the Berg Group
under the Berg Land Holdings Agreement and sold it to an unrelated third
party. The Company received a net distribution and recorded a gain of
$1,400 from the sale.
6. COMMITMENTS AND CONTINGENCIES
Neither the operating partnerships, the properties nor the Company are
subject to any material litigation nor, to the Company's knowledge, is any
material litigation threatened against the operating partnerships, the
properties or the Company. From time to time, the Company is engaged in
legal proceedings arising in the ordinary course of business. The Company
does not expect any of such proceedings to have a material adverse effect
on its cash flows, financial condition or results of operations. The
Company is
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currently involved in or has recently concluded the following legal
proceedings, which it believes the ultimate outcome will have no material
adverse effect on its consolidated financial statements.
Republic Properties Corporation ("RPC") v. Mission West Properties, L.P.
("MWP"), in the Circuit Court of Maryland for Baltimore City Case No.
24-C-00-005675. RPC is a former partner with Mission West Properties, L.P.
in the Hellyer Avenue Limited Partnership ("Hellyer LP"). In April 2004 the
Circuit Court for Baltimore City, Maryland issued a Memorandum Opinion in
the case and awarded damages of approximately $934 to the RPC plaintiffs,
which must be paid by the Company or MWP. The court denied all requests by
MWP, including a declaration that all of RPC's interests in Heller L.P.
were validly converted to limited partnership interests and transferred to
MWP or its designee in accordance with the terms of the Hellyer L.P.
partnership agreement. The court also denied RPC's request for an
injunction ordering the reinstatement of RPC's partnership interests in
Hellyer L.P. The Company has appealed the decision to the Maryland Appeals
Court. Under the pre-appeal hearing procedures, the Maryland Appeals Court
requires a mediation hearing before the parties can appear before the
Appeals Court. No date has been set for such a hearing. The Company does
not believe that any further court decisions in this case, for or against
it and MWP, will have a material adverse effect on its business. The
Company has a receivable from a Berg Group affiliate for the amount of
distributions it received as the successor to RPC's interest in the Hellyer
LP which exceeds the amount of the damages awarded to the RPC parties and
would be used to pay for those damages in the event the decision of the
Circuit Court is upheld ultimately. Furthermore, the Company has never
accounted for the 50% interest of RPC as its asset and if RPC is deemed to
have retained that interest or reacquires that interest, the Company's
balance sheet and financial condition would not be impacted. In February
2001, the Company filed a suit against RPC in Superior Court of the State
of California for the County of Santa Clara Case No. CV 796249 which has
been stayed pending resolution of the Maryland case. In July 2004, RPC
attached the Company's bank account for approximately $1,100. Following a
July 2004 hearing in Superior Court of the State of California for the
County of Santa Clara, the parties agreed that the Company will post a
$1,500 bond and RPC will remove the attachment of the Company's bank
account until final resolution of the appeal in Maryland.
In January 2004, the Global Crossing Estate Representative, for Itself and
the Liquidating Trustee of the Global Crossing Liquidating Trust v. Mission
West Properties filed an action in United States Bankruptcy Court Southern
District of New York Case No. 02-40188 (REG) asserting that payments of
approximately $815 made in the ordinary course of business within 90 days
of the Global Crossing bankruptcy filing were preference payments. The
Company has engaged legal counsel to defend itself in this claim and intend
to vigorously contest the matter.
In December 2003, Craig R. Jalbert Liquidating CEO, as representative of
the Estate of the Consolidated Debtors for ACT Manufacturing, Inc v.
Mission West Properties, L.P. filed an action in United States Bankruptcy
Court District of Massachusetts Case No. 01-47641 (JBR) asserting that
payments of approximately $482 made in the ordinary course of business
within 90 days of the ACT bankruptcy filing were preference payments. The
Company has engaged legal counsel to defend itself in this claim and intend
to vigorously contest the matter.
GUARANTEES
Under its certificate of incorporation and bylaws, the Company has agreed
to indemnify its officers and directors for certain events or occurrences
arising as a result of the officer or director's serving in such capacity.
The maximum potential amount of future payments the Company could be
required to make under these indemnification agreements is unlimited. The
Company believes the estimated fair value of these indemnification
agreements is minimal and has no liabilities recorded for these agreements
as of June 30, 2004.
The Company also enters into indemnification provisions under (i) its
agreements with other companies in its ordinary course of business,
typically with lenders, joint venture partners, contractors, and tenants.
Under these provisions the Company generally indemnifies and holds harmless
the indemnified party for losses suffered or incurred by the indemnified
party as a result of the Company's activities. These indemnification
provisions generally survive termination of the underlying agreement. The
maximum potential amount of future payments the Company could be required
to make under these indemnification provisions is unlimited. The Company
has not incurred material costs to defend lawsuits or settle claims related
to these indemnification agreements. As a result, the Company believes the
estimated fair value of these agreements is minimal. Accordingly, the
Company has no liabilities recorded for these agreements as of June 30,
2004.
SEISMIC ACTIVITY
The Company's properties are located in an active seismic area of Silicon
Valley. Insurance policies currently maintained by the Company do not cover
seismic activity, although they do cover losses from fires after an
earthquake.
ENVIRONMENTAL ISSUES
The environmental investigations that have been conducted on the Company's
properties have not revealed any environmental liability that it believes
would have a material adverse effect on its financial condition, results of
operations and assets, and it is not aware of any such liability.
Nonetheless, it is possible that there are material environmental
liabilities of which the Company is unaware. The Company cannot assure that
future laws, ordinances, or regulations will not impose any material
environmental liability, or that the current environmental condition of the
properties has not been, or will not be, affected by tenants and occupants
of the properties, by the condition of properties in the vicinity of the
properties, or by third parties unrelated to the Company.
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7. RESTATEMENTS
The Company has restated its previously reported quarterly information for
the three and six months ended June 30, 2003. The restated consolidated
financial statements were reported and are further discussed in the
Company's 2003 Form 10-K filed on July 30, 2004. The items that the Company
restated for are as follows:
- The Company recorded additional amortization expense relating to
certain leasing commissions, which were originally being amortized
over a 40-year period. The additional amortization expense resulted
from changing the amortization period of commissions from 40 years to
the term of the lease and the write-off of certain unamortized leasing
commissions in connection with tenant bankruptcies.
- The Company corrected the purchase accounting originally applied to
its 2002 acquisition of the Orchard-Trimble property. In accordance
with Statement of Financial Accounting Standards (SFAS) No. 141,
Business Combinations, which became effective July 1, 2001, the
Company allocated a portion of the purchase price to in-place lease
intangible assets and recorded additional amortization expense from
changing the amortization period of these intangible assets from 40
years to the term of the lease.
- The Company recorded additional depreciation expense relating to the
reclassification of certain real estate assets from a 40-year
depreciable life to a 7- and 25-year depreciable life.
- The Company reclassified the amortization of the above-market lease
intangible asset relating to the 2003 acquisition of the San Thomas
Technology Park from amortization expense to an offset to rental
revenue from real estate.
The aggregate net impact of all restatement items on the Company's
Consolidated Statements of Operations for the three and six months ended
June 30, 2003 resulted in a decrease in net income to common stockholders
compared to previously reported amounts of $45 ($0.00 per diluted share)
and $90 ($0.00 per diluted share), respectively. The effects of the
restatement items described above on the Company's net income to common
stockholders for the three and six months ended June 30, 2003 are as
follows:
Three Months Ended Six Months Ended
June 30, 2003 June 30, 2003
-------------------- -------------------
(dollars in thousands)
Net income to common stockholders, as previously reported $4,156 $8,190
Impact of adjustments for:
Leasing commission amortization (128) (256)
Intangible asset amortization (137) (274)
Depreciation of real estate assets (5) (14)
-------------------- -------------------
Total adjustments (270) (544)
-------------------- -------------------
Minority interest portion of adjustments 225 454
-------------------- -------------------
Net income to common stockholders, as restated $4,111 $8,100
==================== ===================
8. SUBSEQUENT EVENTS
On May 10, 2004, the audit committee appointed BDO Seidman, LLP ("BDO") as
the Company's new independent registered accounting firm. Upon the
appointment of BDO, the American Stock Exchange ("AMEX") granted the
Company an extension to comply with their listing standards. To become
compliant with the AMEX continued listing standards, the Company must file
its quarterly reports on Form 10-Q for the first and second quarter of 2004
as soon as practicable following the July 30, 2004 filing of its Form 10-K
for 2003, but no later than August 16, 2004.
On July 8, 2004, the Company paid dividends of $0.24 per share of common
stock to all common stockholders of record as of June 30, 2004. On the same
date, the operating partnerships paid a distribution of $0.24 per O.P. unit
to all holders of O.P. units.
In July 2004, a $40,000 loan with Cupertino National Bank ("CNB") was
scheduled to mature. CNB has granted an extension until September 2, 2004
pending the completion of the Company's Form 10-K filing for 2003, which
was filed on July 30, 2004. The Company is in the process of renegotiating
the terms and extending the $40,000 loan for an additional two-year period.
The Company does not believe that the terms of the extended loan will
differ materially from its current terms.
- 9 -
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and Results of
Operations should be read in conjunction with the accompanying consolidated
financial statements and notes thereto contained herein and our consolidated
financial statements and notes thereto contained in our Annual Report on Form
10-K as of and for the year ended December 31, 2003. The results for the three
and six months ended June 30, 2004 are not necessarily indicative of the results
to be expected for the entire fiscal year ending December 31, 2004. The
following discussion includes forward-looking statements, including but not
limited to, statements with respect to our future financial performance,
operating results, plans and objectives. Actual results may differ materially
from those currently anticipated depending upon a variety of factors, including
those described under the sub-heading, "Forward-Looking Information."
FORWARD-LOOKING INFORMATION
This quarterly report contains forward-looking statements within the meaning of
the federal securities laws. We intend such forward-looking statements to be
covered by the safe harbor provisions for forward-looking statements contained
in the Private Securities Reform Act of 1995, and is including this statement
for purposes of complying with these safe harbor provisions. Forward-looking
statements, which are based on certain assumptions and describe future plans,
strategies and expectations of the Company, are generally identifiable by use of
the words "believe," "expect," "intend," "anticipate," "estimate," "project" or
similar expressions. Additionally, all disclosures under Part I, Item 3
constitute forward-looking statements. Our ability to predict results or the
actual effect of future plans or strategies is inherently uncertain.
Factors that could have a material adverse effect on our operations and future
prospects include, but are not limited to, the following:
- - economic conditions generally and the real estate market specifically,
- - legislative or regulatory provisions (including changes to laws governing
the taxation of REITs),
- - availability of capital
- - interest rates,
- - competition,
- - supply of and demand for R&D, office and industrial properties in our
current and proposed market areas,
- - tenant defaults and bankruptcies,
- - lease term expirations and renewals, and
- - general accounting principles, policies and guidelines applicable to REITs.
In addition, the actual timing of development, construction, and leasing on any
projects that we believe we may acquire in the future under the Berg Land
Holdings Option Agreement is presently unknown, and reliance should not be
placed on the estimates concerning these projects. These risks and
uncertainties, together with the other risks described from time to time in our
reports and other documents filed with the Securities and Exchange Commission,
should be considered in evaluating forward-looking statements and undue reliance
should not be placed on such statements.
OVERVIEW
We acquire, market, lease, and manage R&D/office properties, primarily located
in the Silicon Valley portion of the San Francisco Bay Area. As of June 30,
2004, we owned and managed 109 properties totaling approximately 7.9 million
rentable square feet through four limited partnerships, or operating
partnerships, for which we are the sole general partner. This class of property
is designed for research and development and office uses and, in some cases,
includes space for light manufacturing operations with loading docks. We believe
that we have one of the largest portfolios of R&D/office properties in the
Silicon Valley. As of June 30, 2004, the six tenants who each leased in excess
of 300,000 rentable square feet from us were Microsoft Corporation, Fujitsu
America (a subsidiary of Fujitsu Limited), JDS Uniphase Corporation, NEC
Electronics America, Inc. (a subsidiary of NEC Electronics Corporation), Ciena
Corporation and Apple Computer, Inc. For federal income tax purposes, we have
operated as a self-managed, self-administered and fully integrated real estate
investment trust ("REIT") since fiscal 1999.
Our acquisition, growth and operating strategy incorporates the following
elements:
- - working with the Berg Group to take advantage of their abilities and
resources to pursue development opportunities which we have an option to
acquire, on pre-negotiated terms, upon completion and leasing;
- - capitalizing on opportunistic acquisitions from third parties of
high-quality R&D/office properties that provide attractive initial yields
and significant potential for growth in cash-flow;
- - focusing on general purpose, single-tenant Silicon Valley R&D/office
properties for information technology companies in order to maintain low
operating costs, reduce tenant turnover and capitalize on our relationships
with these companies and our extensive knowledge of their real estate
needs; and
- 10 -
- - maintaining prudent financial management principles that emphasize current
cash flow while building long-term value, the acquisition of pre-leased
properties to reduce development and leasing risks and the maintenance of
sufficient liquidity to acquire and finance properties on desirable terms.
CURRENT ECONOMIC ENVIRONMENT
All of our properties are located in the Northern California area known as
Silicon Valley, which generally consists of portions of Santa Clara County,
Southwestern Alameda County, Southeastern San Mateo County and Eastern Santa
Cruz County. The Silicon Valley economy and business activity have slowed
markedly since 2001 after fast-paced growth in 1999 and 2000. The Silicon Valley
R&D property market has historically fluctuated with the local economy.
According to a recent report by BT Commercial Real Estate, vacancy rates for
Silicon Valley R&D property increased from approximately 22.5% in late 2003 to
23% at the end of the second quarter 2004. Total vacant R&D square footage in
Silicon Valley at the end of the second quarter of 2004 amounted to 35.5 million
square feet, of which 28.2%, or 10 million square feet, was being offered under
subleases. Total negative net absorption (which is the computation of gross
square footage leased less gross new square footage vacated for the period
presented) in 2003 amounted to approximately (3.0) million square feet. During
the first six months of 2004, there was total negative net absorption of
approximately (0.7) million square feet. The impact of the rental market decline
has not been uniform throughout the area, however. The Silicon Valley R&D
property market has been characterized by a substantial number of submarkets,
with rent and vacancy rates varying by submarket and location within each
submarket.
Our physical occupancy rate at June 30, 2004 was 71.6%, which is a significant
decline from the occupancy rate of 80.2% at June 30, 2003. We believe that our
physical occupancy rate could decline further going forward if key tenants seek
the protection of bankruptcy laws, consolidate operations or discontinue
operations. In addition, leases with respect to approximately 210,000 rentable
square feet are expiring prior to the end of 2004. The properties subject to
these leases may take anywhere from 12 to 18 months or longer to re-lease. We
believe that the average 2004 renewal rental rates for our properties will be
approximately equal to, or perhaps, below current rents. If we are unable to
lease a significant portion of any vacant space or space subject to expiring
leases; if we experience significant tenant defaults as a result of the current
economic downturn; or if we are not able to lease space at or above current
market rates, our results of operations and cash flows will be adversely
affected. Our operating results and ability to pay dividends at current levels
remain subject to a number of material risks, as indicated under the caption
"Forward-Looking Information" above and in the section entitled "Risk Factors"
in our most recent annual report on Form 10-K.
IMPACT OF RESTATEMENTS
We have restated our previously reported quarterly information for the three and
six months ended June 30, 2003. The restated consolidated financial statements
were reported and are further discussed in our 2003 Form 10-K filed on July 30,
2004. The items that we restated for are as follows:
- - We recorded additional amortization expense relating to certain leasing
commissions, which were originally being amortized over a 40-year period.
The additional amortization expense resulted from changing the amortization
period of commissions from 40 years to the term of the lease and the
write-off of certain unamortized leasing commissions in connection with
tenant bankruptcies.
- - We corrected the purchase accounting originally applied to our 2002
acquisition of the Orchard-Trimble property. In accordance with Statement
of Financial Accounting Standards (SFAS) No. 141, Business Combinations,
which became effective July 1, 2001, we allocated a portion of the purchase
price to in-place lease intangible assets and recorded additional
amortization expense from changing the amortization period of these
intangible assets from 40 years to the term of the lease.
- - We recorded additional depreciation expense relating to the
reclassification of certain real estate assets from a 40-year depreciable
life to a 7- and 25-year depreciable life.
- - We reclassified the amortization of the above-market lease intangible asset
relating to the 2003 acquisition of the San Thomas Technology Park from
amortization expense to an offset to rental revenue from real estate.
The aggregate net impact of all restatement items on our Consolidated Statements
of Operations for the three and six months ended June 30, 2003 resulted in a
decrease in net income to common stockholders compared to previously reported
amounts of $45,000 ($0.00 per diluted share) and $90,000 ($0.00 per diluted
share), respectively.
- 11 -
The effects of the restatement items described above on our net income to common
stockholders for the three and six months ended June 30, 2003 are as follows:
Three Months Ended Six Months Ended
June 30, 2003 June 30, 2003
-------------------- -------------------
(dollars in thousands)
Net income to common stockholders, as previously reported $4,156 $8,190
Impact of adjustments for:
Leasing commission amortization (128) (256)
Intangible asset amortization (137) (274)
Depreciation of real estate assets (5) (14)
-------------------- -------------------
Total adjustments (270) (544)
-------------------- -------------------
Minority interest portion of adjustments 225 454
-------------------- -------------------
Net income to common stockholders, as restated $4,111 $8,100
==================== ===================
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
We prepare the consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America ("GAAP"), which
requires us to make certain estimates, judgments and assumptions that affect the
reported amounts in the accompanying consolidated financial statements,
disclosure of contingent assets and liabilities and related footnotes.
Accounting and disclosure decisions with respect to material transactions that
are subject to significant management judgments or estimates include impairment
of long lived assets, deferred rent reserves, and allocation of purchase price
relating to property acquisitions and the related depreciable lives assigned.
Actual results may differ from these estimates under different assumptions or
conditions.
Critical accounting policies are defined as those that require management to
make estimates, judgments and assumptions, giving due consideration to
materiality, in certain circumstances that affect amounts reported in the
consolidated financial statements, and potentially result in materially
different results under different conditions and assumptions. We believe that
the following best describe our critical accounting policies:
BUSINESS COMBINATIONS. Statement of financial Accounting Standards No. 141
("SFAS No. 141"), Business Combinations, was effective July 1, 2001. The
acquisition costs of each property acquired prior to July 1, 2001were allocated
only to building, land and leasing commissions with building depreciation being
computed based on an estimated weighted average composite useful life of 40
years and leasing commissions amortization being computed over the term of the
lease. Acquisitions of properties made subsequent to the effective date of SFAS
No. 141 are based on an allocation of the acquisition cost to land, building,
tenant improvements, and intangibles for at market and above market in place
leases, and the determination of their useful lives are guided by a combination
SFAS No. 141 and management's estimates. If we do not appropriately allocate
these components or we incorrectly estimate the useful lives of these
components, our computation of depreciation and amortization expense may not
appropriately reflect the actual impact of these costs over future periods,
which will affect net income.
IMPAIRMENT OF LONG-LIVED ASSETS. We review real estate assets for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable in accordance with Statement of Financial
Accounting Standards No. 144 ("SFAS No. 144"), Accounting for the Impairment and
Disposal of Long-Lived Assets. If the carrying amount of the asset exceeds its
estimated undiscounted net cash flow, before interest, we will recognize an
impairment loss equal to the difference between its carrying amount and its
estimated fair value. If impairment is recognized, the reduced carrying amount
of the asset will be accounted for as its new cost. For a depreciable asset, the
new cost will be depreciated over the asset's remaining useful life. Generally,
fair values are estimated using discounted cash flow, replacement cost or market
comparison analyses. The process of evaluating for impairment requires estimates
as to future events and conditions, which are subject to varying market factors,
such as the vacancy rates, future rental rates and operating costs for R&D
facilities in the Silicon Valley area and related submarkets. Therefore, it is
reasonably possible that a change in estimate resulting from judgments as to
future events could occur which would affect the recorded amounts of the
property. To date we have not recognized an impairment of any long-lived assets.
ALLOWANCE FOR DOUBTFUL ACCOUNTS AND DEFERRED RENT. The preparation of the
consolidated financial statements requires us to make estimates and assumptions.
As such, we must make estimates of the uncollectability of our accounts
receivable based on the evaluation of our tenants' financial position, analyses
of accounts receivable and current economic trends. We also make estimates for a
straight-line adjustment reserve for existing tenants with the potential of
early termination, bankruptcy or ceasing operations. Our estimates are based on
our review of tenants' payment histories, publicly available financial
information and such additional information about their financial condition as
tenants provide to us. The information available to us might lead us to
overstate or understate these reserve amounts. The use of different estimates or
assumptions could produce different results. Moreover, actual future collections
of accounts receivable or reductions in future reported rental income due to
tenant bankruptcies or other business failures could differ materially from our
estimates.
- 12 -
CONSOLIDATED JOINT VENTURES. We, through an operating partnership, own three
properties that are in joint ventures of which we have controlling interests. We
manage and operate all three properties. The recognition of these properties and
their operating results are 100% reflected on our consolidated financial
statements, with appropriate allocation to minority interest, because we have
operational and financial control of the investments. We make judgments and
assumptions about the estimated monthly payments made to our minority interest
joint venture partners, which are reported with our periodic results of
operations. Actual results may differ from these estimates under different
assumptions or conditions.
INVESTMENT IN UNCONSOLIDATED JOINT VENTURE. We, through an operating
partnership, have a 50% non-controlling limited partnership interest in one
unconsolidated joint venture. This investment is not consolidated because the we
do not exercise significant control over major operating and financial
decisions. We account for the joint venture using the equity method of
accounting.
FAIR VALUE OF FINANCIAL INSTRUMENTS. Our financial instruments include cash and
cash equivalents, accounts receivable, accounts payable, and debt. Considerable
judgment is required in interpreting market data to develop estimates of fair
value. These estimates presented herein are not necessarily indicative of the
amounts that we could realize in a current market exchange. The use of different
market assumptions and/or estimation methodologies may have a material effect on
the estimated fair value amounts. Cash and cash equivalents, accounts
receivable, and accounts payable are carried at amounts that approximate their
fair values due to their short-term maturities. The carrying amounts of our
variable rate debt approximate fair value since the interest rates on these
instruments are equivalent to rates currently offered to us. For fixed rate
debt, we estimate fair value by using discounted cash flow analyses based on
borrowing rates for similar kinds of borrowing arrangements. The fair value of
our fixed rate debt at June 30, 2004 was approximately $241 million.
REVENUE RECOGNITION. Rental revenue is recognized on the straight-line method of
accounting required by GAAP under which contractual rent payment increases are
recognized evenly over the lease term, regardless of when the rent payments are
received by us. The difference between recognized rental income and rental cash
receipts is recorded as Deferred Rent Receivable on the consolidated balance
sheets.
Certain lease agreements contain terms that provide for additional rents based
on reimbursement of certain costs. These additional rents are reflected on the
accrual basis.
Rental revenue is affected if existing tenants terminate or amend their leases.
We try to identify tenants who may be likely to declare bankruptcy or cease
operations. By anticipating these events in advance, we expect to take steps to
minimize their impact on our reported results of operations through lease
renegotiations, reserves against deferred rent, and other appropriate measures.
Our judgments and estimations about tenants' capacity to continue to meet their
lease obligations will affect the rental revenue recognized. Material
differences may result in the amount and timing of our rental revenue for any
period if we made different judgments or estimations.
Lease termination fees are included in other income. These fees are paid by
tenants who want to terminate their lease obligations before the end of the
contractual term of the lease. There is no way of predicting or forecasting the
timing or amounts of future lease termination fees.
We recognize income from rent, tenant reimbursements and lease termination fees
and other income once all of the following criteria are met in accordance with
SEC Staff Accounting Bulletin 104:
- - the agreement has been fully executed and delivered;
- - services have been rendered;
- - the amount is fixed and determinable; and
- - collectability is reasonably assured.
- 13 -
RESULTS OF OPERATIONS
COMPARISON OF THE THREE AND SIX MONTHS ENDED JUNE 30, 2004 TO THE THREE AND SIX
MONTHS ENDED JUNE 30, 2003
As of June 30, 2004, through our controlling interests in the operating
partnerships, we owned 109 properties totaling approximately 7.9 million
rentable square feet compared to 108 properties totaling approximately 7.8
million rentable square feet owned by us as of June 30, 2003. This represents a
net increase of approximately 1% in total rentable square footage, which is
primarily attributable to our acquisition in December 2003 of one property
located in San Jose, California consisting of approximately 129,000 rentable
square feet from the Berg Group.
Rental revenue from real estate for the three and six months ended June 30, 2004
compared to the three- and six-month periods in 2003 are as follows:
Three Months Ended June 30,
% Change by % of Total Net
2004 2003 $ Change Property Group Change
-------------- -------------- -------------- --------------- -----------------
(dollars in thousands)
Same Property (1) $26,983 $30,259 ($3,276) (10.8%) (10.0%)
2003 Acquisitions (2) 2,918 2,463 455 18.5% 1.4%
-------------- -------------- -------------- -----------------
$29,901 $32,722 ($2,821) (8.6%) (8.6%)
============== ============== ============== =================
Six Months Ended June 30,
% Change by % of Total Net
2004 2003 $ Change Property Group Change
-------------- -------------- -------------- --------------- -----------------
(dollars in thousands)
Same Property (1) $55,641 $61,690 ($6,049) (9.8%) (9.4%)
2003 Acquisitions (2) 5,836 2,464 3,372 137% 5.2%
-------------- -------------- -------------- -----------------
$61,477 $64,154 ($2,677) (4.2%) (4.2%)
============== ============== ============== =================
(1) "Same Property" is defined as properties owned by us prior to 2003 that we
still owned as of June 30, 2004.
(2) Operating rental revenue for 2003 Acquisitions does not reflect a full 12
months of operations in 2003 because these properties were acquired at
various times during 2003. 2003 acquisition amount for the three months
ended June 30, 2004 and 2003 each includes approximately $0.5 million of
above market rent amortization against rental revenue from real estate in
connection with the implementation of SFAS No. 141. 2003 acquisition amount
for the six months ended June 30, 2004 and 2003 includes approximately $0.9
million and $0.5 million, respectively, of above market rent amortization
against rental revenue from real estate in connection with the
implementation of SFAS No. 141.
RENTAL REVENUE FROM REAL ESTATE
For the quarter ended June 30, 2004, rental revenue from real estate decreased
by approximately ($2.8) million, or 8.6%, from $32.7 million for the three
months ended June 30, 2003 to $29.9 million for the same period of 2004. The net
decrease resulted from a decline of ($3.3) million in our "Same Property"
portfolio and an increase of $0.5 million from properties acquired in 2003.
Rental revenue decreased by approximately ($2.7) million, or 4.2%, from $64.2
million for the six months ended June 30, 2003 to $61.5 million for the same
period of 2004. Of the ($2.7) million decrease in rental revenue, ($6.0) million
resulted from our "Same Property" portfolio and $3.3 million were generated by
properties acquired in 2003. The overall decline in rental revenue was a result
of adverse market conditions and the loss of several tenants due to their
bankruptcy, relocation or cessation of operations since June 30, 2003. Our
physical occupancy rate at June 30, 2004 was approximately 72%, compared to
approximately 80% at June 30, 2003.
EQUITY IN EARNINGS FROM UNCONSOLIDATED JOINT VENTURE
As of June 30, 2004, we had investments in four R&D buildings, totaling 593,000
rentable square feet, through an unconsolidated joint venture, TBI-MSW, which we
acquired a 50% interest in January 2003 from the Berg Group under the Berg Land
Holdings Option Agreement. We have a non-controlling limited partnership
interest in this joint venture, which we account for using the equity method of
accounting. For the three months ended June 30, 2004, we recorded equity in
earnings from the unconsolidated joint venture of approximately $0.6 million
compared to $2.0 million for the same period in 2003. For the six-month periods
ended June 30, 2004 and 2003, equity in earnings from the unconsolidated joint
venture was approximately $1.2 million and $2.8 million, respectively. Included
in equity in earnings of unconsolidated joint venture for the three- and
six-month periods ended June 30, 2003 is $1.4 million relating to a gain from
the sale of real estate. Our interest in the property was acquired by the
unconsolidated joint venture from a related party. This type of transaction did
not recur in 2004.
OTHER INCOME
Other income increased to approximately $4.6 million for the three months ended
June 30, 2004 from $0.6 million for the second quarter of 2003. For the six
months ended June 30, 2004 and 2003, other income was $5.0 million and $1.3
million, respectively. Lease termination fees of approximately $2.6 million and
tenant bankruptcy settlement income of approximately $1.1 million represented
most of the 2004 increase. We do not consider these transactions to be recurring
items.
- 14 -
EXPENSES
Property operating expenses and real estate taxes during the second quarter of
2004 decreased by approximately ($0.3) million, or 5.5%, from $5.5 million to
$5.2 million for the three months ended June 30, 2003 and 2004, respectively,
due to lower property tax expense from the reductions in assessed property
values on existing properties. Tenant reimbursements decreased by approximately
($1.3) million, or 26%, from $5.0 million for the three months ended June 30,
2003 to $3.7 million for the three months ended June 30, 2004. Property
operating expenses and real estate taxes increased by approximately $0.5
million, or 4.9%, from $10.2 million to $10.7 million for the six months ended
June 30, 2003 and 2004, respectively, due to higher insurance, repair and
maintenance expenses to our existing properties. Tenant reimbursements decreased
by approximately ($1.6) million, or 16.7%, from $9.6 million for the six months
ended June 30, 2003 to $8.0 million for the six months ended June 30, 2004. The
decrease in tenant reimbursements for both periods ended June 30, 2004 as
compared to the same periods in 2003 was due to lower occupancy. Certain
expenses such as property insurance, real estate taxes, and other fixed expenses
are not recoverable from vacant properties. At June 30, 2004, our physical
occupancy rate was 72% compared to 80% at June 30, 2003. General and
administrative expenses increased by approximately $0.6 million, or 200%, from
$0.3 million to $0.9 million for the three months ended June 30, 2003 and 2004,
respectively. For the six months ended June 30, 2003 and 2004, general and
administrative expenses increased by approximately $0.5 million, or 71.4%, from
$0.7 million to $1.2 million, respectively. The increase in general and
administrative expenses for the quarter and the six months ended June 30, 2004
was a result of incurring additional legal and accounting expenses in connection
with the resignation of PricewaterhouseCoopers LLP, our former independent
accountants and the need to re-audit consolidated financial statements for years
2001 and 2002 and audit 2003 results.
Depreciation and amortization expense of real estate increased by approximately
$0.6 million, or 11.8%, from $5.1 million to $5.7 million for the three months
ended June 30, 2003 and 2004, respectively, reflecting the amortization expense
of in-place leases in connection with the implementation of SFAS No. 141
relating to the acquisition of the San Tomas Technology Park. Included in the
$0.6 million is the write-off of the remaining in-place lease intangible asset
amounting to approximately $0.3 million due to a lease termination of one tenant
at the Orchard-Trimble property. Depreciation and amortization expense of real
estate increased by approximately $1.4 million, or 14.3%, from $9.8 million to
$11.2 million for the six months ended June 30, 2003 and 2004, respectively,
reflecting the newly acquired San Tomas Technology Park and the amortization
expense of in-place leases in connection with the implementation of SFAS No.
141. The $5.1 million and the $9.8 million of such expense for the three and six
months ended June 30, 2003, respectively, include $0.14 million and $0.29
million, respectively, that resulted from the reclassification of assets and the
resulting restatement described in Note 7 of Notes to Consolidated Financial
Statements in Part I, Item 1, above.
Interest expense decreased by approximately ($0.1) million, or 2.3%, from $4.3
million for the three months ended June 30, 2003 to $4.2 million for the three
months ended June 30, 2004. Interest expense (related parties) remained
relatively stable for the current three-month period compared to the same period
one year ago. Total debt outstanding, including amounts due related parties,
decreased by approximately ($3.9) million, or 1.2%, from $335.9 million as of
June 30, 2003 to $332.0 million as of June 30, 2004. Overall interest expense,
including amounts paid to related parties, for the quarter ended June 30, 2004
decreased by approximately ($0.1) million compared to the same quarter a year
ago.
Interest expense increased by approximately $0.8 million, or 10.3%, from $7.8
million for the six months ended June 30, 2003 to $8.6 million for the six
months ended June 30, 2004. The increase in interest expense resulted
principally from a new $80 million mortgage loan from Citicorp USA, Inc.
obtained in early April 2003. Interest expense (related parties) decreased by
approximately ($46,000), or 8.4%, from $550,000 for the six months ended June
30, 2003 to $504,000 for the six months ended June 30, 2004 due to a lower
balance owed on the Berg Group line of credit. Overall interest expense,
including amounts paid to related parties, for the six months ended June 30,
2004 increased by approximately $0.8 million compared to the six months ended
June 30, 2003 due to the new Citicorp USA, Inc. loan discussed above and the
substitution of new debt at slightly higher interest rates for the loan under
the Berg Group line of credit.
Interest expense for the six-month period in 2004 increased as a result of new
debt. In addition to the higher amount of debt, the new debt carries a higher
interest rate than the Berg Group line of credit which it mainly replaced.
Management expects additional increases in interest expense as new debt is
incurred in connection with property acquisitions, we draw on the Cupertino
National Bank revolving line of credit, and we seek alternative sources of
credit.
NET INCOME TO COMMON STOCKHOLDERS AND NET INCOME TO MINORITY INTEREST
Minority interest in net income has been calculated by taking the net income of
the operating partnerships (on a stand-alone basis) multiplied by the respective
minority interest ownership percentage.
Net income to common stockholders decreased by approximately ($0.3) million, or
7.3%, from $4.1 million for the three months ended June 30, 2003 to $3.8 million
for the same period in 2004. The minority interest portion of income decreased
by approximately ($1.9) million, or 9.2%, from $20.7 million for the three
months ended June 30, 2003 to $18.8 million for the three months ended June 30,
2004. For the six months ended June 30, 2004 and 2003, the minority interest
portion of income was approximately $36.1 million and $40.7 million,
respectively, resulting in net income to stockholders of approximately $7.3
million and $8.1 million, respectively. The decline in net income and minority
interest portion of income was primarily due to reduced rental revenue,
un-reimbursable operating expenses from vacant properties and a $1.4 million
gain on sale of property by the unconsolidated joint venture in 2003 that did
not recur in 2004. Minority interest represents the ownership interest of all
limited partners in the operating partnerships taken as a whole, which was
approximately 83% as of June 30, 2004 and 2003.
- 15 -
CHANGES IN FINANCIAL CONDITION
At June 30, 2004, total stockholders' equity, net, increased by approximately
$0.7 million from December 31, 2003 as we obtained additional capital from stock
option exercises and the exchange of O.P. units for shares of our common stock
while incurring a deficit of approximately ($1.3) million due to dividends
declared in excess of net income for the period. During the six months ended
June 30, 2004, stock options to purchase 20,000 shares of common stock were
exercised at $8.25 per share. Total proceeds were approximately $0.17 million.
During the first six months of 2004, one limited partner exchanged 100,000 O.P.
units for 100,000 shares of our common stock and Carl E. Berg gave 49,000 O.P.
units to charitable institutions that exchanged them for 49,000 shares of our
common stock under the Exchange Rights Agreement among us and the limited
partners in the operating partnerships. The newly issued shares increased
additional paid in capital by approximately $2.1 million.
LIQUIDITY AND CAPITAL RESOURCES
We expect our principal source of liquidity for distributions to stockholders
and O.P. unit holders, debt service, leasing commissions and recurring capital
expenditures to come from cash provided by operations and/or the borrowings
under the lines of credit with the Berg Group and Cupertino National Bank. We
expect these sources of liquidity to be adequate to meet projected distributions
to stockholders and other presently anticipated liquidity requirements in 2004.
We expect to meet our long-term liquidity requirements for the funding of
property development, property acquisitions and other material non-recurring
capital improvements through long-term secured and unsecured indebtedness and
the issuance of additional equity securities by us. We have the ability to meet
short-term obligations or other liquidity needs based on lines of credit with
the Berg Group and Cupertino National Bank, assuming renewal of our existing $40
million line of credit which expires in September 2004. Despite the current
weakness in the economy, we expect our total interest expense to increase as
interest rates rise and as we incur debt through acquisitions of new properties
and financing activities. In the remainder of 2004, we will be obligated to make
payments totaling approximately $105.3 million of debt principal under mortgage
notes without regard to any debt refinancing or new debt obligations that we
might incur, or optional payments of debt principal. We anticipate renewing
these obligations, primarily to Cupertino National Bank and Citicorp USA, as
described below. If we are not able to extend our loans from Cupertino National
Bank and Citicorp, however, we will be required to finance these loan payments
through other sources that may not be readily available to us on favorable
terms. Our operating results and financial condition could be affected
adversely, as a result.
DISTRIBUTIONS
On July 8, 2004, we paid dividends of $0.24 per share of common stock to all
common stockholders of record as of June 30, 2004. On the same date, the
operating partnerships paid a distribution of $0.24 per O.P. unit to all holders
of O.P. units.
CONTRACTUAL OBLIGATIONS
The following table identifies our contractual obligations as of June 30, 2004
that will impact liquidity and cash flow in future periods:
Six Months Year Ending December 31,
Remaining ------------------------------------------------------
2004 2005 2006 2007 2008 Thereafter Total
-------------------------------------------------------------------------------------------------
(dollars in thousands)
Debt Obligations (1) $105,348 $7,580 $6,245 $6,350 $116,674 $89,763 $331,960
Operating Lease Obligations (2) 45 90 90 23 - - 248
--------------- ------------ ------------- ------------- ------------- ------------ -------------
Total $105,393 $7,670 $6,335 $6,373 $116,674 $89,763 $332,208
=============== ============ ============= ============= ============= ============ =============
(1) Debt obligations are set forth in detail in the schedule below. The amount
due in 2004 does not reflect the planned two-year extension of the Citicorp
USA, Inc. and Cupertino National Bank loans described in Liquidity and
Capital Resources above.
(2) Operating lease obligations relate to a lease of our corporate office
facility from a related party.
At June 30, 2004, we had total indebtedness of $332.0 million, including $217.3
million of fixed rate mortgage debt, $10.6 million under the Berg Group mortgage
note (related parties), $80 million under the Citicorp USA mortgage loan, $22.5
million under the Cupertino National Bank line of credit, and $1.6 million under
the Berg Group line of credit (related parties), as detailed in the table below.
The $80 million short-term mortgage loan from Citicorp USA, Inc. ("Citicorp
Loan"), which we obtained in April 2003, was originally scheduled to mature on
March 29, 2004. We and Citicorp extended the loan to May 27, 2004 and again to
September 6, 2004. The mortgage loan is collateralized by seven properties. The
extension of this loan is subject to our providing additional collateral valued
at not less than $7.6 million, which we have proposed to Citicorp, and Citicorp
is currently appraising it. In July 2004, the $40 million line of credit with
Cupertino National Bank was scheduled to mature. Cupertino National Bank and
Citicorp USA, Inc. have granted extensions of the loans to September 2, 2004 and
September 6, 2004, respectively (the "Loan Extension Period"). We are in the
process of renegotiating the terms and extending these loans for an additional
two-year period. We do not believe that the terms of the extended loans will
differ materially from their current terms. We are the borrower under the
Cupertino National Bank line of credit which is guaranteed by Mission West
Properties, L.P. and Mission West Properties, L.P. II. Mission West Properties,
L.P. is the borrower under the Citicorp USA mortgage loan which is guaranteed by
Carl E. Berg, Mission West Properties, L.P. I, Mission West Properties L.P. II
and Mission West Properties L.P. III. The Cupertino National Bank line of credit
and Citicorp USA, Inc. mortgage loan contain certain loan covenants. We were not
in compliance with one
- 16 -
covenant pertaining to our late filing of the Form 10-K for the year ending
December 31, 2003 and Form 10-Q for the period ending March 31, 2004 (the
"Financial Reporting Covenants"). Each bank elected not to enforce the Financial
Reporting Covenants during the Loan Extension Period, and neither of such
lenders declared a default as a result of our failure to timely perform the
Financial Reporting Covenants. Compliance with the Financial Reporting Covenants
is a condition of the renewal for both loans.
- 17 -
The following table sets forth information regarding debt outstanding as of June
30, 2004:
Maturity Interest
Debt Description Collateral Properties Balance Date Rate
- ----------------------------------------------- -------------------------------------- -------------------- ------------- ----------
(dollars in thousands)
LINE OF CREDIT:
Berg Group (related parties) 2033-2043 Samaritan Drive, San Jose, CA $ 1,603 3/05 (1)
2133 Samaritan Drive, San Jose, CA --------------------
2233-2243 Samaritan Drive, San Jose, CA
1310-1450 McCandless Drive, Milpitas, CA
1795-1845 McCandless Drive, Milpitas, CA
Cupertino National Bank Not Applicable 22,513 9/04 (4)
--------------------
Mortgage Notes Payable (related parties): 5300 & 5350 Hellyer Avenue, San Jose, CA 10,594 6/10 7.650%
--------------------
Mortgage Notes Payable (2):
Prudential Capital Group 20400 Mariani Avenue, Cupertino, CA 611 10/06 8.750%
Washington Mutual (Home Savings & Loan Assoc.) 10460 Bubb Road, Cupertino, CA 187 12/06 9.500%
Prudential Insurance Company of America (3) 10300 Bubb Road, Cupertino, CA 120,464 10/08 6.560%
10500 N. De Anza Boulevard, Cupertino, CA
4050 Starboard Drive, Fremont, CA
45700 Northport Loop, Fremont, CA
45738 Northport Loop, Fremont, CA
450 National Avenue, Mountain View, CA
6311 San Ignacio Avenue, San Jose, CA
6321 San Ignacio Avenue, San Jose, CA
6325 San Ignacio Avenue, San Jose, CA
6331 San Ignacio Avenue, San Jose, CA
6341 San Ignacio Avenue, San Jose, CA
6351 San Ignacio Avenue, San Jose, CA
3236 Scott Boulevard, Santa Clara, CA
3560 Bassett Street, Santa Clara, CA
3570 Bassett Street, Santa Clara, CA
3580 Bassett Street, Santa Clara, CA
1135 Kern Avenue, Sunnyvale, CA
1212 Bordeaux Lane, Sunnyvale, CA
1230 E. Arques, Sunnyvale, CA
1250 E. Arques, Sunnyvale, CA
1170 Morse Avenue, Sunnyvale, CA
1600 Memorex Drive, Santa Clara, CA
1688 Richard Avenue, Santa Clara, CA
1700 Richard Avenue, Santa Clara, CA
3540 Bassett Street, Santa Clara, CA
3542 Bassett Street, Santa Clara, CA
3544 Bassett Street, Santa Clara, CA
3550 Bassett Street, Santa Clara, CA
Northwestern Mutual Life Insurance Company (5) 1750 Automation Parkway, San Jose, CA 95,988 1/13 5.640%
1756 Automation Parkway, San Jose, CA
1762 Automation Parkway, San Jose, CA
6320 San Ignacio Avenue, San Jose, CA
6540-6541 Via Del Oro, San Jose, CA
6385-6387 San Ignacio Avenue, San Jose, CA
2251 Lawson Lane, Santa Clara, CA
1325 McCandless Drive, Milpitas, CA
1650-1690 McCandless Drive, Milpitas, CA
20605-20705 Valley Green Drive, Cupertino, CA
Citicorp USA, Inc. 2001 Walsh Avenue, Santa Clara, CA 80,000 9/04 (4)
2880 Scott Boulevard, Santa Clara, CA
2890 Scott Boulevard, Santa Clara, CA
2770-2800 Scott Boulevard, Santa Clara, CA
2300 Central Expressway, Santa Clara, CA
2220 Central Expressway, Santa Clara, CA
2330 Central Expressway, Santa Clara, CA
--------------------
Mortgage Notes Payable Subtotal 297,250
--------------------
Total $331,960
====================
(1) The debt owed to the Berg Group under the line of credit carries a variable
interest rate equal to LIBOR plus 1.30% and is payable in full in March
2005. The interest rate at June 30, 2004 was 3.24%.
(2) Mortgage notes payable generally require monthly installments of interest
and principal over various terms extending through the year 2013. The
weighted average interest rate of mortgage notes payable was 6.23% at June
30, 2004.
(3) The Prudential Insurance loan is payable in monthly installments of $827,
which includes principal (based upon a 30-year amortization) and interest.
John Kontrabecki, one of the limited partners, has guaranteed approximately
$12,000 of this debt. Costs and fees incurred with obtaining this loan
aggregated approximately $900.
(4) Interest rate equal to LIBOR plus 2%. The interest rates for the Cupertino
National Bank line of credit and the Citicorp USA, Inc. mortgage loan at
June 30, 2004 were 3.11% and 3.21%, respectively.
(5) The Northwestern loan is payable in monthly installments of $696, which
includes principal (based upon a 20-year amortization) and interest. Costs
and fees incurred with obtaining this loan aggregated approximately $675.
- 18 -
At June 30, 2004, our debt to total market capitalization ratio, which is
computed as our total debt outstanding divided by the sum of total debt
outstanding plus the market value of common stock (based upon the closing price
of $12.11 per share on June 30, 2004) on a fully diluted basis, including the
conversion of all O.P. units into common stock, was approximately 20.8%. On June
30, 2004, the last trading day for the year, total market capitalization was
approximately $1.6 billion.
At June 30, 2004, the outstanding balance remaining under certain demand notes
that we owed to the operating partnerships was $1.5 million. The due date of the
demand notes has been extended to September 30, 2005. The principal of the
demand notes, along with the interest expense, which is interest income to the
operating partnerships, is eliminated in consolidation and is not included in
the corresponding line items within the consolidated financial statements.
However, the interest income earned by the operating partnerships, which is
interest expense to us, in connection with this debt, is included in the
calculation of minority interest as reported on the consolidated statement of
operations, thereby reducing our net income by this same amount. At present, our
only means for repayment of this debt is through distributions that we receive
from the operating partnerships that are in excess of the amount of dividends to
be paid to our stockholders or raising additional equity capital.
HISTORICAL CASH FLOWS
COMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2004 TO THE SIX MONTHS ENDED JUNE
30, 2003
Net cash provided by operating activities for the six months ended June 30, 2004
was $57.2 million compared to $61.1 million for the same period in 2003. The
decline resulted from the decrease in rental revenue from our current portfolio
of property due to tenant lease obligation defaults, tenant re-location and
lower rent renewal rates during the last half of 2003 and the first half of
2004.
Net cash used in investing activities was ($0.4) million and ($109.6) million
for the six months ended June 30, 2004 and 2003, respectively. Cash used in
investing activities during the first six months of 2003 related principally to
the acquisition of the San Tomas Technology Park for $110 million.
Net cash used in financing activities was ($59.1) million for the six months
ended June 30, 2004 compared to ($46.8) million used in financing activities for
the same period in 2003. Of the ($59.1) million net cash used in financing
activities during 2004, ($8.8) million was used to pay outstanding debt, ($41.8)
million for minority interest distributions and ($8.6) million for dividends.
During the six months ended June 30, 2003, financing activities included two new
collateralized mortgage loans aggregating $180 million, of which $100 million
was utilized towards the payment of short-term debt and the Berg Group line of
credit and $80 million was utilized towards the acquisition of the San Tomas
Technology Park as discussed above. Additionally, during 2003, we used ($82.9)
million to pay outstanding debt, ($41.6) million for minority interest
distributions and ($8.4) million for dividends.
FUNDS FROM OPERATIONS ("FFO")
FFO is a non-GAAP financial measurement used by real estate investment trusts to
measure and compare operating performance. As defined by NAREIT, FFO represents
net income (loss) before minority interest of O.P. unit holders, computed in
accordance with GAAP, including non-recurring events other than "extraordinary
items" under GAAP and gains and losses from sales of depreciable operating
properties, plus real estate related depreciation and amortization, excluding
amortization of deferred financing costs and depreciation of non-real estate
assets, and after adjustments for unconsolidated partnerships and joint
ventures. Management considers FFO an appropriate measure of performance of an
equity REIT because, along with cash flows from operating activities, financing
activities and investing activities, it provides investors with an understanding
of our ability to incur and service debt and make capital expenditures. With the
emphasis on the disclosure of operating earnings per share, we will still
continue to use FFO as a measure of our performance. FFO should not be
considered as an alternative for net income as a measure of profitability nor is
it comparable to cash flows provided by operating activities determined in
accordance with GAAP, nor is FFO necessarily indicative of funds available to
meet our cash needs, including the need to make cash distributions to satisfy
REIT requirements. For example, FFO is not adjusted for payments of debt
principal required under our debt service obligations.
Our definition of FFO also assumes conversion at the beginning of the period of
all convertible securities, including minority interests that might be exchanged
for common stock. FFO does not represent the amount available for management's
discretionary use; as such funds may be needed for capital replacement or
expansion, debt service obligations or other commitments and uncertainties.
Furthermore, FFO is not comparable to similarly entitled items reported by other
REITs that do not define FFO exactly as we do.
We have revised our FFO computations for 2003 for the inclusion of the
amortization of leasing commissions in depreciation and amortization of real
estate in order to be comparable to our 2004 FFO presentation in accordance with
NAREIT guidelines and to more closely conform to the NAREIT's FFO definition.
Additionally, our FFO calculation includes our portion of the depreciation and
amortization of real estate from our unconsolidated joint venture.
- 19 -
FFO for the three and six months ended June 30, 2004 and 2003, as reconciled to
net income to common stockholders, are summarized in the following tables:
Three Months Ended June 30, Six Months Ended June 30,
2004 2003 2004 2003
(As Restated) (As Restated)
--------------- --------------- --------------- ---------------
(dollars in thousands) (dollars in thousands)
Net income to common stockholders (1) $ 3,795 $ 4,111 $ 7,318 $ 8,100
Add:
Minority interests (2) 18,706 20,574 35,850 40,402
Depreciation & amortization of real estate (3) 6,240 5,634 12,650 10,842
Less:
Gain on sale of unconsolidated joint venture asset - 1,400 - 1,400
--------------- --------------- --------------- ---------------
FFO (4) $28,741 $28,919 $55,818 $57,944
=============== =============== =============== ===============
(1) As restated for the three and six months ended June 30, 2003 described in
Note 7 of Notes to Consolidated Financial Statements under Part I, Item 1
above.
(2) Excludes minority interest for third parties.
(3) Includes depreciation and amortization of real estate from our
unconsolidated joint venture and amortization of leasing commissions.
(4) As restated for the three and six months ended June 30, 2003. As originally
reported for that quarter, FFO was $28,952. As originally reported for the
six months ended June 30, 2003, FFO was $57,607.
DISTRIBUTION POLICY
Our board of directors will determine the amount and timing of distributions to
our stockholders. The board of directors will consider many factors prior to
making any distributions, including the following:
- - the amount of cash available for distribution;
- - our financial condition;
- - whether to reinvest funds rather than to distribute such funds;
- - our committed and projected capital expenditures;
- - the amount of cash required for new property acquisitions, including
acquisitions under existing agreements with the Berg Group;
- - prospects of tenant renewals and re-leases of properties subject to
expiring leases;
- - cash required for re-leasing activities;
- - the annual distribution requirements under the REIT provisions of the
federal income tax laws; and
- - such other factors as the board of directors deems relevant.
We cannot assure you that we will be able to meet or maintain our cash
distribution objectives.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
We do not believe recently issued accounting standards will materially impact
our financial position, results of operations, or cash flows.
In December 2003, the FASB issued FIN 46R, "Consolidation of Variable Interest
Entities," a revision to FIN 46, which was issued in January 2003. Under FIN
46R, a variable interest entity must be consolidated by a company if that
company is subject to a majority of the entity's expected losses or entitled to
receive a majority of the entity's expected residual returns or both. FIN 46R
requires disclosures about variable interest entities that a company is not
required to consolidate, but in which it has a significant variable interest.
The consolidation requirements apply to existing entities in the first reporting
period that ends after March 15, 2004. We adopted the consolidation requirements
of FIN 46R in the first quarter of 2004. There was no significant effect on the
consolidated financial position, results of operations or cash flows as a result
of the initial adoption of this standard in regard to existing variable interest
entities; however, newly formed entities could meet these requirements and will
be recorded as appropriate.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity. This Statement
establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its scope
as a liability (or an asset in some circumstances). SFAS No. 150 was effective
beginning in the third quarter of 2003. The FASB deferred the implementation of
SFAS No. 150 as applied to certain minority interests in finite life entities,
however. We adopted the requirements of SFAS No. 150 in the third quarter of
2003, and considering the aforementioned deferral, it did not impact our
financial position, results of operations or cash flows.
- 20 -
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not generally hold market risk sensitive instruments for trading purposes.
We use fixed and variable rate debt to finance our operations. Our exposure to
market risk for changes in interest rates relates primarily to our current and
future debt obligations. We are vulnerable to significant fluctuations of
interest rates on our floating rate debt and pricing on our future debt. We
manage our market risk by monitoring interest rates where we try to recognize
the unpredictability of the financial markets and seek to reduce potentially
adverse effect on the results of our operations. This takes frequent evaluation
of available lending rates and examination of opportunities to reduce interest
expense through new sources of debt financing. Several factors affecting the
interest rate risk include governmental monetary and tax policies, domestic and
international economics and other factors that are beyond our control. The
following table provides information about the principal cash flows, weighted
average interest rates, and expected maturity dates for debt outstanding as of
June 30, 2004. The current terms of this debt are described in Item 2,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources."
For variable rate debt, the table presents the assumption that the outstanding
principal balance at June 30, 2004 will be paid upon maturity.
For fixed rate debt, the table presents the assumption that the outstanding
principal balance at June 30, 2004 will be paid according to scheduled principal
payments and that we will not prepay any of the outstanding principal balance.
Six Months
Remaining Year Ending December 31,
----------------------------------------------
2004 2005 2006 2007 2008 Thereafter Total Fair Value
-----------------------------------------------------------------------------------------------
(dollars in thousands)
VARIABLE RATE DEBT:
Secured and unsecured debt $102,513 $1,603 - - - - $104,116 $104,116
Weighted average interest rate 3.19% 2.71%
FIXED RATE DEBT:
Secured notes payable $2,835 $5,977 $6,245 $6,350 $116,674 $89,763 $227,844 $240,719
Weighted average interest rate 6.23% 6.23% 6.23% 6.23% 6.23% 6.23%
The primary market risk we face is the risk of interest rate fluctuations.
Principal amounts outstanding under the Berg Group line of credit, the Cupertino
National Bank line of credit and the Citicorp USA, Inc. mortgage loan, which are
tied to a LIBOR based interest rate, were approximately $1.6 million, $22.5
million, and $80.0 million, or 0.5%, 6.8% and 24.1%, respectively, of the total
$332.0 million of outstanding debt as of June 30, 2004. As a result, we pay
lower rates of interest in periods of decreasing interest rates and higher rates
of interest in periods of increasing interest rates. All of the debt is
denominated in United States dollars. We had no interest rate caps or interest
rate swap contracts at June 30, 2004.
The following discussion of market risk is based solely on a possible
hypothetical change in future market conditions related to our variable-rate
debt. It includes "forward-looking statements," as previously defined, regarding
market risk, but we are not forecasting the occurrence of these market changes.
Based on the amount of variable debt outstanding as of June 30, 2004, a 1%
increase or decrease in interest rates on our $104.1 million of floating rate
debt would decrease or increase, respectively, six months earnings and cash
flows by approximately $0.52 million, as a result of the increased or decreased
interest expense associated with the change in rate, and would not have an
impact on the fair value of the floating rate debt. This amount is determined by
considering the impact of hypothetical interest rates on our borrowing cost. Due
to the uncertainty of fluctuations in interest rates and the specific actions
that might be taken by us to mitigate of such fluctuations and their possible
effects, the foregoing sensitivity analysis assumes no changes to our financial
structure.
- 21 -
ITEM 4. CONTROLS AND PROCEDURES
We strive to maintain disclosure controls and procedures that are designed to
ensure that information required to be disclosed in our Exchange Act reports is
recorded, processed, summarized and reported within the time periods specified
in the SEC's rules and forms, and that such information is accumulated and
communicated to our management, including our chief executive officer and chief
financial officer, as appropriate, to allow for timely decisions regarding
required disclosure. In designing and evaluating the disclosure controls and
procedures, management recognizes that any controls and procedures, no matter
how well designated and operated, can provide only reasonable assurance of
achieving the desired control objectives and management necessarily is required
to apply its judgment in evaluating the cost-benefit relationship of possible
controls.
Until their resignation on January 26, 2004, our independent registered
accounting firm was PricewaterhouseCoopers LLP. In May 2004, we hired new
independent accountants, BDO Seidman, LLP who conducted audits of our financial
statements for 2001, 2002 and 2003. In connection with the issuance of its
report of independent registered public accounting firm, BDO Seidman, LLP
reported to our audit committee a "material weakness" under standards
established by the Public Company Accounting Oversight Board of the American
Institute regarding some elements of our system of internal controls. They noted
a material weakness with respect to our review and oversight of our application
of purchase accounting relating to the amortization of leasing commissions on
acquired buildings, as a result of which we amortized such commissions over the
40-year term of the acquired building rather than the lease term. In addition,
due to our total head count of four, they have also identified certain
segregation of duties issues without compensating controls.
In the view of BDO Seidman, LLP this material weakness led to certain accounting
adjustments for 2003, principally pertaining to purchase accounting errors
related to leasing commissions and to a much smaller extent, to correct
depreciable lives for tenant improvements and base interior improvements. The
error in accounting for lease commissions necessitated a significant portion of
the restatements described elsewhere in this report and resulted in adjustments
to our 2003 financial statements upon audit. We have conducted a review of the
errors requiring restatement, including a separate review by our audit committee
to determine what remedial measures were necessary. We believe our management
has taken or is in the process of taking the steps necessary to correct the
errors and avoid similar errors in the future. One important measure is to have
our President also become involved in the review of our internal controls and
procedures.
As required by SEC Rule 13a-15(b) we conducted an evaluation, under the
supervision and with the participation of our management, including our Chief
Executive Officer, President and Vice President of Finance, of the effectiveness
of the design and operation of our disclosure controls and procedures. Based
upon that evaluation, the Chief Executive Officer, President and Vice President
of Finance concluded that our disclosure controls and procedures are effective
in timely alerting them to material information relating to us (including our
subsidiaries) required to be included in our periodic SEC filings.
While we have taken or are in the process of taking the foregoing steps in order
to address the adequacy of our disclosure controls and procedures, and, in
addition, to develop and implement a formal set of internal controls and
procedures for financial reporting in accordance with SEC's proposed rules to
adopt the internal control report requirements included in Section 404 of the
Sarbanes-Oxley Act of 2002, the efficacy of the steps we have taken to date and
the steps we are still in the process of completing is subject to continued
management review supported by confirmation and testing by our internal and
external auditors. As a result, it is likely that additional changes will be
made to our internal controls and procedures.
CHANGES IN INTERNAL CONTROLS
Other than the foregoing initiatives, there were no significant changes in our
internal controls or to our knowledge, in other factors that could significantly
affect such internal controls subsequent to the date of their evaluation.
- 22 -
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Legal proceedings are incorporated herein by reference from Part 1 "Item 1. -
Financial Statements - Note 6 - Commitments and Contingencies."
ITEM 6. EXHIBITS AND REPORTS ON FROM 8-K
a. Exhibits
31.1 Section 1350 Certificate of CEO
31.2 Section 1350 Certificate of President & COO
31.3 Section 1350 Certificate of Principal Financial Officer
32 Certification pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
b. Reports on Form 8-K
We filed a Current Report on Form 8-K on April 15, 2004,
regarding our results of operations and financial condition for
the first quarter of 2004.
We filed a Current Report on Form 8-K on May 12, 2004, regarding
the appointment of BDO Seidman, LLP as our new independent
registered accounting firm and the announcement of our plan for
reaching the AMEX compliance.
- 23 -
================================================================================
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereto duly authorized.
MISSION WEST PROPERTIES, INC.
(Registrant)
Date: August 12, 2004 By: /s/ Carl E. Berg
------------------------------------------------
Carl E. Berg
Chief Executive Officer
Date: August 12, 2004 By: /s/ Wayne N. Pham
------------------------------------------------
Wayne N. Pham
Vice President of Finance and Controller
(Principal Accounting Officer and Duly
Authorized Officer)
- 24 -
EXHIBIT 31.1
CERTIFICATE PURSUANT TO
RULE 13a-14 THE SECURITIES EXCHANGE ACT OF 1934
I, Carl E. Berg, certify that:
1. I have reviewed this Form 10-Q of Mission West Properties, Inc. for
the quarterly period ended June 30, 2004;
2. Based on my knowledge, this report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this
report;
4. The registrant's other certifying officer(s) and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the
registrant and have:
(a) Designed such disclosure controls and procedures, or caused
such disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made
known to us by others within those entities, particularly during
the period in which this report is being prepared;
(b) Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure controls
and procedures, as of the end of the period covered by this
report based on such evaluation; and
(c) Disclosed in this report any change in the registrant's
internal control over financial reporting that occurred during or
subsequent to the period ended June 30, 2004 and prior to the
date of this certificate that has materially affected, or is
reasonably likely to materially affect, the registrant's internal
control over financial reporting; and
5. The registrant's other certifying officer(s) and I have disclosed,
based on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of the
registrant's board of directors (or persons performing the equivalent
functions):
(a) All significant deficiencies and material weaknesses in the
design or operation of internal control over financial reporting
which are reasonably likely to adversely affect the registrant's
ability to record, process, summarize and report financial
information; and
(b) Any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal control over financial reporting.
Carl E. Berg
Chairman and CEO
August 12, 2004
EXHIBIT 31.2
CERTIFICATE PURSUANT TO
RULE 13a-14 THE SECURITIES EXCHANGE ACT
OF 1934
I, Raymond V. Marino, certify that:
1. I have reviewed this Form 10-Q of Mission West Properties, Inc. for
the quarterly period ended June 30, 2004;
2. Based on my knowledge, this report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this
report;
4. The registrant's other certifying officer(s) and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the
registrant and have:
(a) Designed such disclosure controls and procedures, or caused
such disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made
known to us by others within those entities, particularly during
the period in which this report is being prepared;
(b) Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure controls
and procedures, as of the end of the period covered by this
report based on such evaluation; and
(c) Disclosed in this report any change in the registrant's
internal control over financial reporting that occurred during or
subsequent to the period ended June 30, 2004 and prior to the
date of this certificate that has materially affected, or is
reasonably likely to materially affect, the registrant's internal
control over financial reporting; and
5. The registrant's other certifying officer(s) and I have disclosed,
based on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of the
registrant's board of directors (or persons performing the equivalent
functions):
(a) All significant deficiencies and material weaknesses in the
design or operation of internal control over financial reporting
which are reasonably likely to adversely affect the registrant's
ability to record, process, summarize and report financial
information; and
(b) Any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal control over financial reporting.
Raymond V. Marino
President and Chief Operating Officer
August 12, 2004
EXHIBIT 31.3
CERTIFICATE PURSUANT TO
RULE 13a-14 THE SECURITIES EXCHANGE ACT OF 1934
I, Wayne N. Pham, certify that:
1. I have reviewed this Form 10-Q of Mission West Properties, Inc. for
the quarterly period ended June 30, 2004;
2. Based on my knowledge, this report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this
report;
4. The registrant's other certifying officer(s) and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the
registrant and have:
(a) Designed such disclosure controls and procedures, or caused
such disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made
known to us by others within those entities, particularly during
the period in which this report is being prepared;
(b) Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure controls
and procedures, as of the end of the period covered by this
report based on such evaluation; and
(c) Disclosed in this report any change in the registrant's
internal control over financial reporting that occurred during or
subsequent to the period ended June 30, 2004 and prior to the
date of this certificate that has materially affected, or is
reasonably likely to materially affect, the registrant's internal
control over financial reporting; and
5. The registrant's other certifying officer(s) and I have disclosed,
based on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of the
registrant's board of directors (or persons performing the equivalent
functions):
(a) All significant deficiencies and material weaknesses in the
design or operation of internal control over financial reporting
which are reasonably likely to adversely affect the registrant's
ability to record, process, summarize and report financial
information; and
(b) Any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal control over financial reporting.
Wayne N. Pham
Vice President of Finance and Controller
August 12, 2004
EXHIBIT 32
CERTIFICATION OF CEO AND CFO PURSUANT TO
18 U.S.C. ss. 1350,
AS ADOPTED PURSUANT TO
ss. 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report on Form 10-Q of Mission West
Properties, Inc. (the "Company") for the quarterly period ended June 30, 2004 as
filed with the Securities and Exchange Commission on the date hereof (the
"Report"), each of Carl E. Berg, Chairman of the Board and Chief Executive
Officer of the Company, and Wayne N. Pham, Vice President of Finance and
Controller of the Company, hereby certify, pursuant to 18 U.S.C. ss. 1350, as
adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, to the best of
his knowledge, that:
(1) The Report fully complies with the requirements of Section 13(a) or
15(d) of the Securities Exchange Act of 1934, as amended; and
(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and result of operations of the
Company.
- ----------------------------------------------------
Carl E. Berg
Chairman of the Board and Chief Executive Officer
August 12, 2004
- ----------------------------------------------------
Wayne N. Pham
Vice President of Finance and Controller
August 12, 2004
This certification accompanies this Report pursuant to ss. 906 of the
Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by the
Sarbanes-Oxley Act of 2002, or otherwise required, be deemed filed by the
Company for purposes of ss. 18 of the Securities Exchange Act of 1934, as
amended.