Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

HARTMAN COMMERCIAL PROPERTIES REIT
(Exact name of registrant as specified in its charter)

1450 W. Sam Houston Parkway N., Suite 100
Houston, Texas 77057
(Address of principal executive offices)

Registrant’s telephone number, including area code: (713) 467-2222

                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 S                                   No ¨

                Indicated by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨                                    No S

                The number of the registrant’s Common Shares of Beneficial Interest outstanding at August 13, 2004 was 7,010,146.

PART I – FINANCIAL INFORMATION

Item 1.  Financial Statements

Hartman Commercial Properties REIT and Subsidiary

Consolidated Balance Sheets

See notes to consolidated financial statements.
2

See notes to consolidated financial statements.
3

Hartman Commercial Properties REIT and Subsidiary

Consolidated Statements of Income

(Unaudited)

See notes to consolidated financial statements.
4

Hartman Commercial Properties REIT and Subsidiary

Consolidated Statements of Changes in Shareholders’ Equity

(Unaudited)

See notes to consolidated financial statements.
5

Hartman Commercial Properties REIT and Subsidiary

Consolidated Statements of Cash Flows

(Unaudited)

See notes to consolidated financial statements.
6

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 1   -  Summary of Significant Accounting Policies

The consolidated financial statements included in this report are unaudited; however, amounts presented in the balance sheet as of December 31, 2003 are derived from the audited financial statements of the Company included in Amendment No. 3 to the Company’s registration statement on Form S-11 filed with the U.S. Securities and Exchange Commission on July 29, 2004.  The unaudited financial statements at June 30, 2004 have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information on a basis consistent with the annual audited consolidated financial statements and with the instructions to Form 10-Q.  Accordingly, they do not include the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  The consolidated financial statements presented herein reflect all adjustments which, in the opinion of management, are necessary for a fair presentation of the financial position of Hartman Commercial Properties REIT (“HCP”) as of June 30, 2004 and results of operations for the three and six month periods ended June 30, 2004 and 2003 and cash flows for the six month periods ended June 30, 2004 and 2003.  All such adjustments are of a normal recurring nature.  The results of operations for the interim periods are not necessarily indicative of the results expected for a full year.  The statements should be read in conjunction with the audited consolidated financial statements and footnotes thereto included in HCP’s registration statement on Form S-11 referred to above.

The consolidated statements of income for the three months and six months ended June 30, 2003 and related notes to the consolidated financial statements have been adjusted retroactively to reflect the recapitalization discussed in Note 9.

Description of business and nature of operations

HCP was formed as a real estate investment trust, pursuant to the Texas Real Estate Investment Trust Act on August 20, 1998 to consolidate and expand the real estate investment strategy of Allen R. Hartman (“Hartman”) in acquiring and managing office and retail properties (see Note 9).  Hartman, HCP’s Chairman of the Board of Trust Managers, has been engaged in the ownership, acquisition, and management of commercial properties in the Houston, Texas, metropolitan area for over 20 years.  HCP serves as the general partner of Hartman REIT Operating Partnership, L.P. (the “Operating Partnership” or “HROP”), which was formed on December 31, 1998 as a Delaware limited partnership.  HCP and the Operating Partnership are collectively referred to herein as the “Company.”  HCP currently conducts substantially all of its operations and activities through the Operating Partnership.  As the general partner of the Operating Partnership, HCP has the exclusive power to manage and conduct the business of the Operating Partnership, subject to certain customary exceptions.  Hartman Management, L.P. (the “Management Company”), a company wholly-owned by Hartman, provides a full range of real estate services for the Company, including leasing and property management, accounting, asset management and investor relations.  As of June 30, 2004 and December 31, 2003, the Company owned and operated 33 office and retail properties in and around Houston and San Antonio, Texas.

Basis of consolidation

HCP is the sole general partner of the Operating Partnership and possesses full legal control and authority over the operations of the Operating Partnership.  As of June 30, 2004 and December 31, 2003, HCP owned a majority of the partnership interests in the Operating Partnership.  Consequently, the accompanying consolidated financial statements of the Company include the accounts of the Operating Partnership.  All significant intercompany balances have been eliminated.  Minority interest in the accompanying consolidated financial statements represents the share of equity and earnings of the Operating Partnership allocable to holders of partnership interests other than the Company.  Net income is allocated to minority interests based on the weighted-average percentage ownership of the Operating Partnership during the year.  Issuance of additional common shares of beneficial interest in HCP (“common shares”) and units of limited partnership interest in the Operating Partnership (“OP Units”) changes the ownership interests of both the minority interests and HCP.

7

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 1   -  Summary of Significant Accounting Policies (Continued)

Basis of accounting

The financial records of the Company are maintained on the accrual basis of accounting whereby revenues are recognized when earned and expenses are recorded when incurred.

 Cash and cash equivalents

The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.  Cash and cash equivalents at June 30, 2004 and December 31, 2003 consist of demand deposits at commercial banks and money market funds.

Investment securities

The Company sold all of its investment securities during the quarter ended June 30, 2003 for an immaterial gain.  The Company classified all investment securities as available-for-sale.  Securities classified as available-for-sale are reported at fair value and unrealized gains and losses are excluded from income and reported separately as a component of other comprehensive income within shareholders’ equity.  Realized gains and losses on the sale of securities available-for-sale are determined using the specific identification method.

Due from affiliates

Due from affiliates includes amounts owed to the Company from Hartman operated limited partnerships and other entities.

Escrows and acquisition deposits

Escrow deposits include escrows established pursuant to certain mortgage financing arrangements for real estate taxes, insurance, maintenance and capital expenditures.  Acquisition deposits include earnest money deposits on future acquisitions.

Real estate

Real estate properties are recorded at cost, net of accumulated depreciation.  Improvements, major renovations and certain costs directly related to the acquisition, improvement and leasing of real estate are capitalized.  Expenditures for repairs and maintenance are charged to operations as incurred.  Depreciation is computed using the straight-line method over the estimated useful lives of five to 39 years for the buildings and improvements.  Tenant improvements are depreciated using the straight-line method over the life of the lease.

8

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 1   -  Summary of Significant Accounting Policies (Continued)

Real estate (continued)

Management reviews its properties for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets, including accrued rental income, may not be recoverable through operations.  Management determines whether an impairment in value has occurred by comparing the estimated future cash flows (undiscounted and without interest charges), including the estimated residual value of the property, with the carrying cost of the property.  If impairment is indicated, a loss will be recorded for the amount by which the carrying value of the property exceeds its fair value.  Management has determined that there has been no impairment in the carrying value of the Company’s real estate assets as of June 30, 2004 and December 31, 2003.

Deferred costs

Deferred costs consist primarily of leasing commissions paid to the Management Company and deferred financing costs.  Leasing commissions are amortized on the straight-line method over the terms of the related lease agreements.  Deferred financing costs are amortized on the straight-line method over the terms of the loans, which approximates the interest method.  Costs allocated to in-place leases whose terms differ from market terms related to acquired properties are amortized over the remaining life of the respective leases.

Revenue recognition

All leases on properties held by the Company are classified as operating leases, and the related rental income is recognized on a straight-line basis over the terms of the related leases.  Differences between rental income earned and amounts due per the respective lease agreements are capitalized or charged, as applicable, to accrued rent receivable.  Percentage rents are recognized as rental income when the thresholds upon which they are based have been met.  Recoveries from tenants for taxes, insurance, and other operating expenses are recognized as revenues in the period the corresponding costs are incurred.  The Company provides an allowance for doubtful accounts against the portion of tenant accounts receivable which is estimated to be uncollectible. 

Federal income taxes

The Company is qualified as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986 and is therefore not subject to Federal income taxes provided it meets all conditions specified by the Internal Revenue Code for retaining its REIT status.  The Company believes it has continuously met these conditions since reaching 100 shareholders in 1999 (see Note 7).

9

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 1   -  Summary of Significant Accounting Policies (Continued)

Use of estimates

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Significant estimates used by the Company include the estimated useful lives for depreciable and amortizable assets and costs, and the estimated allowance for doubtful accounts receivable.  Actual results could differ from those estimates.

Fair value of financial instruments

The Company’s financial instruments consist primarily of cash, cash equivalents, accounts receivable and accounts and notes payable.  The carrying value of cash, cash equivalents, accounts receivable and accounts payable are representative of their respective fair values due to the short-term nature of these instruments.  Investment securities are carried at fair market value or at amounts which approximate fair market value.  The fair value of the Company’s debt obligations is representative of its carrying value based upon current rates offered for similar types of borrowing arrangements.

Concentration of risk

Substantially all of the Company’s revenues are obtained from office, office/warehouse and retail locations in the Houston, Texas and San Antonio, Texas metropolitan areas.

The Company maintains cash accounts in major financial institutions in the United States.  The terms of these deposits are on demand to minimize risk.  The balances of these accounts occasionally  exceed the federally insured limits, although no losses have been incurred in connection with such cash balances.

Comprehensive income

The Company follows Statement of Financial Accounting Standards (“SFAS”) No. 130, “Reporting Comprehensive Income”, which establishes standards for reporting and display for comprehensive income and its components.  For the periods presented, the Company did not have significant amounts of comprehensive income.

10

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 2   -  Real Estate

During 2003, the Company acquired from an unrelated party one multi-tenant retail center comprising approximately 192,458 square feet of gross leasable area (GLA).  The property was acquired for cash and assumption of debt of $6,550,000 for a total consideration of approximately $13,100,000.

The purchase prices the Company paid for the properties were determined by, among other procedures, estimating the amount and timing of expected cash flows from the acquired properties, discounted at market rates.  This process in general also results in the assessment of fair value for each property.

The Company allocates the purchase price of real estate to the acquired tangible assets, consisting of land, building and tenant improvements, and identified intangible assets and liabilities, generally consisting of the value of above-market and below-market leases, other value of in-place leases and value of tenant relationships, based in each case on management’s estimates of their fair values.

Management estimates the fair value of acquired tangible assets by valuing the acquired property as if it were vacant. The “as-if-vacant” value (limited to the purchase price) is allocated to land, building, and tenant improvements based on management’s determination of the relative fair values of these assets.

Above-market and below-market in-place lease values for owned properties is recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) management’s estimate of fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining non-cancelable term of the lease. The capitalized above-market lease values are amortized as a reduction of rental income over the remaining non-cancelable terms of the respective leases. The capitalized below-market lease values are amortized as an increase to rental income over the initial term and any fixed-rate renewal periods in the respective leases.

The aggregate value of other intangible assets acquired is measured based on the difference between (i) the property valued with existing in-place leases adjusted to market rental rates and (ii) the property valued as if vacant. Management’s estimates of value are made using methods similar to those used by independent appraisers, primarily discounted cash flow analysis. Factors considered by management in its analysis include an estimate of carrying costs during hypothetical expected lease-up periods considering current market conditions, and costs to execute similar leases. The Company also considers information obtained about each property as a result of its pre-acquisition due diligence, marketing and leasing activities in estimating the fair value of the tangible and intangible assets acquired. In estimating carrying costs, management also includes real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, which generally range from four to 18 months, depending on specific local market conditions. Management also estimates costs to execute similar leases including leasing commissions, legal and other related expenses to the extent that such costs are not already incurred in connection with a new lease origination as part of the transaction.

11

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 2   -  Real Estate (Continued)

The total amount of other intangible assets acquired is further allocated to in-place lease values and customer relationship intangible values based on management’s evaluation of the specific characteristics of each tenant’s lease and the Company’s overall relationship with that respective tenant. Characteristics considered by management in allocating these values include the nature and extent of the Company’s existing business relationships with the tenant, growth prospects for developing new business with the tenant, the tenant’s credit quality, and expectations of lease renewals (including those existing under the terms of the lease agreement), among other factors.

The value of in-place leases, if any, is amortized to expense over the remaining initial term of the respective leases, which, for leases with allocated intangible value, are expected to range generally from five to 10 years. The value of customer relationship intangibles is amortized to expense over the remaining initial term and any renewal periods in the respective leases, but in no event does the amortization period for intangible assets exceed the remaining depreciable life of the building. Should a tenant terminate its lease, the unamortized portion of the in-place lease value and customer relationship intangibles are charged to expense.

At June 30, 2004 and December 31, 2003, the Company owned and operated 33 commercial properties in the Houston, Texas and San Antonio, Texas areas comprising approximately 2,540,000 square feet of gross leasable area. 

Note 3   -  Investment in Real Estate Partnership

During January 2004, HROP contributed approximately $9,100,000 to Hartman Gulf Plaza Acquisitions LP, a Texas limited partnership, in which it is a limited partner with a 73.11% percentage interest.  On January 30, 2004, the partnership purchased Gulf Plaza, a 120,651 square foot office building located in Houston, Texas.  The purpose of the partnership is to acquire and sell tenant-in-common interests in the building.

Note 4   -   Note Receivable

In January 2003, the Company partially financed the sale of a property it had previously sold and for which it had taken a note receivable of $420,000 as part of the consideration.  The Company advanced $290,000 and renewed and extended the balance of $420,000 still due from the original sale.

The original principal amount of the note receivable, dated January 10, 2003, is $710,000.  The note is payable in monthly installments of $6,382, including interest at 7% per annum, for the first two years of the note.  Thereafter, monthly installments of $7,489 are due with interest at 10% per annum.  The note is fully amortizing with the final payment due January 10, 2018.

12

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 5   -  Debt

Notes Payable

Mortgages and other notes payable consist of the following:

In December 2002, the Company refinanced substantially all of its mortgage debt with a $34,440,000 three-year floating rate mortgage loan collateralized by 18 of the Company’s properties and a maturity date of January 1, 2006.  The loan bears interest at 2.5% over a LIBOR rate (3.82% at June 30, 2004 and December 31, 2003) computed on the basis of a 360 day year and has a two-year extension option.  Interest only payments are due monthly for the first 30 month period after the origination date, after which, the loan may be repaid in full or in $100,000 increments, with a final balloon payment due upon maturity.  The Company capitalized loan costs of $1,271,043 financed from the proceeds of the refinancing.  The security documents related to the mortgage loan contain a covenant which requires Hartman REIT Operating Partnership II, L.P., a wholly owned subsidiary of the Company, to maintain adequate capital in light of its contemplated business operations.  This covenant and the other restrictions provided for in the credit facility do not affect Hartman REIT Operating Partnership II, L.P.’s ability to make distributions to the Company.

On June 30, 2003, the Company entered into a $25,000,000 loan agreement with a bank pursuant to which the Company may, subject to the satisfaction of certain conditions, borrow funds to acquire additional income producing properties.  The revolving loan agreement terminates in June, 2005 and provides for interest payments at a rate, adjusted monthly, of either (at the Company’s option) 30-day LIBOR plus 225 basis points, or the bank’s prime rate less 50 basis points, with either rate subject to a floor of 3.75% per annum.  The loan is secured by currently owned and otherwise unencumbered properties and may also be secured by properties acquired with the proceeds drawn from the facility.  As of June 30, 2004, the Company had borrowed $8,126,000 under this credit facility.  The Company is required to make monthly payments of interest only, with the principal and all accrued unpaid interest being due at maturity of the loan.  The loan may be prepaid at any time without penalty.

In connection with the purchase of the Windsor Park property in December 2003, the Company assumed a note payable in the amount of $6,550,000 secured by the property.  The balance at June 30, 2004 was $6,309,526.  The note is payable in equal monthly installments of principal and interest of $80,445, with interest at the rate of 8.34% per annum.  The balance of the note is payable in full on December 1, 2006.

13

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 5   -  Debt (Continued)

The Company financed its comprehensive insurance premium with a note in the amount of  $299,778 payable in nine equal monthly installments of $33,308, which includes interest at 4.5%.  The note is secured by unearned insurance premiums and will be paid in full in November 2004.

As of  June 30, 2004, annual maturities of notes payable, including the revolving loan, are as follows:

Note Payable to Affiliate

In November 2002, the Company issued a $3,278,000 note payable bearing interest at 4.25% per annum to Houston R.E. Income Properties XVI, Ltd., a related party operated by Hartman.  The note was secured by property and was due upon demand with interest only payments due monthly.  The note was repaid in the second quarter of 2003.

Supplemental Cash Flow Information

The Company made cash payments for interest on debt of $581,295 and $343,931 for the three months ended June 30, 2004 and 2003, respectively, and $1,214,695 and $703,588 for the six months ended June 30, 2004 and 2003, respectively.

Note 6   -  Earnings Per Share

Basic earnings per share is computed using net income to common shareholders and the weighted average number of common shares outstanding.  Diluted earnings per share reflects common shares issuable from the assumed conversion of OP units convertible into common shares.  Only those items that have a dilutive impact on basic earnings per share are included in the diluted earnings per share.  Accordingly, because conversion of OP units into common shares is antidilutive, no OP units were included in the diluted earnings per share calculations.

14

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 7   -  Federal Income Taxes

Federal income taxes are not provided because the Company intends to and believes it qualifies as a REIT under the provisions of the Internal Revenue Code.  Shareholders of the Company include their proportionate taxable income in their individual tax returns.  As a REIT, the Company must distribute at least 90% of its ordinary taxable income to its shareholders and meet certain income sources and investment restriction requirements.  In addition, REITs are subject to a number of organizational and operational requirements.  If the Company fails to qualify as a REIT in any taxable year, the Company will be subject to federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate tax rates.

Taxable income differs from net income for financial reporting purposes principally due to differences in the timing of recognition of interest, real estate taxes, depreciation and rental revenue.

For Federal income tax purposes, the cash dividends distributed to shareholders are characterized as follows for the year ended December 31, 2003:

Note 8   -  Related-Party Transactions

In January 1999, the Company entered into a property management agreement with the Management Company.  In consideration for supervising the management and performing various day-to-day affairs, the Company pays the Management Company a management fee of 5% and a partnership management fee of 1% based on Effective Gross Revenues from the properties, as defined.  The Company incurred total management and partnership fees of $345,807 and $315,319 for the three months ended June 30, 2004 and 2003, respectively, and $669,945 and $658,128 for the six months ended June 30, 2004 and 2003, respectively.  Such fees in the amounts of $97,972 and $93,006 were payable at June 30, 2004 and December 31, 2003, respectively.

During April 2003, the Company amended certain terms of its Declaration of Trust.  Under the amended terms, the Management Company may be required to reimburse the Company for operating expenses exceeding certain limitations determined at the end of each fiscal quarter.  Reimbursements, if any, from the Management Company are recorded on a quarterly basis as a reduction in management fees.

Under the provisions of the property management agreement, costs incurred by the Management Company for the management and maintenance of the properties are reimbursable to the Management Company.  At June 30, 2004 and December 31, 2003, $290,566 and $288,305, respectively, were payable to the Management Company related to these reimbursable costs.

15

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 8   -  Related-Party Transactions (Continued)

In consideration of managing and leasing the properties, the Company also pays the Management Company leasing commissions of 6% for leases originated by the Management Company and 4% for expansions and renewals of existing leases based on Effective Gross Revenues from the properties.  The Company incurred total leasing commissions to the Management Company of $257,329 and $312,407 for the three months ended June 30, 2004 and 2003, respectively, and $431,542 and $553,939 for the six months ended June 30, 2004 and 2003, respectively.  At June 30, 2004 and December 31, 2003, $157,123 and $175,725, respectively, were payable to the Management Company relating to leasing commissions.

The Management Company paid $26,856 and  $21,150 to the Company for office space during the three months ended June 30, 2004 and 2003, respectively, and $53,112 and $40,942 for the six months ended June 30, 2004 and 2003, respectively.  Such amounts are included in rental income in the consolidated statements of income.

In conjunction with the acquisition of certain properties, the Company assumed liabilities payable to the Management Company.  At June 30, 2004 and December 31, 2003, $200,415 was payable to the Management Company related to these liabilities.

The Company’s day-to-day operations are strategically directed by the Board of Trust Managers and implemented through the Management Company.  Hartman is the Company’s Board Chairman and sole owner of the Management Company.  Hartman was owed $47,251 and $41,306 in dividends payable on his common shares at June 30, 2004 and December 31, 2003, respectively.  Hartman owned 3.9% and 3.4% of the issued and outstanding common shares of the Company as of  June 30, 2004 and December 31, 2003, respectively.

The Company was a party to various other transactions with related parties which are reflected in due to/from affiliates in the accompanying consolidated balance sheets and also disclosed in Notes 5 and 9.

16

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 9   -  Shareholders’ Equity

In July 2004, the Company changed its state of organization from Texas to Maryland pursuant to a merger of the Company directly with and into a Maryland real estate investment trust formed for the sole purpose of the reorganization and the conversion of each outstanding common share of beneficial interest of the Texas entity into 1.42857 common shares of beneficial interest of the Maryland entity.  Under its Articles of Amendment and Restatement in effect, the Company has authority to issue 400,000,000 common shares of beneficial interest, $0.001 par value per share, and 50,000,000 preferred shares of beneficial interest, $0.001 par value per share.  All capital stock amounts, share and per share information in the accompanying consolidated financial statements and the related notes to consolidated financial statements have been adjusted to retroactively reflect this recapitalization.

Prior to June 2004, the Charter and Bylaws of the Company authorized the Company to issue up to 100,000,000 common shares at $0.001 par value per share, and 10,000,000 Preferred Shares at $0.001 par value per share.  The Company commenced a private offering (the “Offering”) in May 1999 to sell 2,500,000 common shares, par value $.001 per share, at a price of $10 per common share for a total Offering of $25,000,000.  The Company intended that the Offering be exempt from the registration requirements of the Securities Act of 1933, as amended, pursuant to Regulation D promulgated thereunder.  The common shares are “restricted securities” and are not transferable unless they subsequently are registered under the 1933 Act and applicable state securities laws or an exemption from such registration is available.  The Offering was directed solely to “accredited investors” as such term is defined in Regulation D.  Pursuant to the Offering, the Company sold  for cash or issued in exchange for property or OP Units, 4,907,107 (7,010,146 after the reorganization) shares as of June 30, 2004 and December 31, 2003.  HCP conducts substantially all of its operations through the Operating Partnership.  All net proceeds of the Offering were contributed by HCP to the Operating Partnership in exchange for OP Units.  The Operating Partnership used the proceeds to acquire additional commercial properties and for general working capital purposes.  HCP received one OP Unit for each $10 contributed to the Operating Partnership.  OP Units were valued at $10 per unit because they are convertible on a one-for-one basis to common shares which were being sold in the Offering for $10 per common share.

Operating Partnership units

Limited partners in the Operating Partnership holding OP Units have the right to convert their OP Units into common shares at a ratio of one OP Unit for one common share.  In connection with the reorganization discussed above, OP Unit holders received 1.42857 OP Units for each OP Unit previously held.  Subject to certain restrictions, OP Units are not convertible into common shares until the later of one year after acquisition or an initial public offering of the common shares.  As of June 30, 2004 and December 31, 2003, after giving effect to the recapitalization, there were 12,456,995 OP Units outstanding.  HCP owned 6,648,658 Units as of June 30, 2004 and December 31, 2003.  HCP’s weighted-average share ownership in the Operating Partnership was approximately 53.37% during the six months and three months ended June 30, 2004 and 2003.

17

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 9  -   Shareholders’ Equity (Continued)

Dividends and distributions

The following tables summarize the cash dividends/distributions payable to holders of common shares and holders of OP Units (after giving effect to the recapitalization) related to the six months ended June 30, 2004 and the year ended December 31, 2003.

18

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 9  -   Shareholders’ Equity (Continued)

Dividends and distributions (continued)

Note 10 - Commitments and Contingencies

The Company is a participant in various legal proceedings and claims that arise in the ordinary course of business.  These matters are generally covered by insurance.  While the resolution of these matters cannot be predicted with certainty, the Company believes that the final outcome of such matters will not have a material effect on the financial position, results of operations, or cash flows of the Company.

Note 11 - Segment Information

The operating segments presented are the segments of the Company for which separate financial information is available, and operating performance is evaluated regularly by senior management in deciding how to allocate resources and in assessing performance.  The Company evaluated the performance of its operating segments based on net operating income that is defined as total revenues less operating expenses and ad valorem taxes.  Management does not consider gains or losses from the sale of property in evaluating ongoing operating performance.

19

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 11 - Segment Information (continued)

The retail segment is engaged in the acquisition, development and management of real estate, primarily anchored neighborhood and community shopping centers located in the Houston, Texas and San Antonio, Texas metropolitan areas.  The customer base includes supermarkets and other retailers who generally sell basic necessity-type commodities.  The office/warehouse segment is engaged in the acquisition, development and management of office and warehouse centers located in the Houston, Texas metropolitan area and has a diverse customer base.  The office segment is engaged in the acquisition, development and management of commercial office space.  Included in “Other” are corporate related items, insignificant operations and costs that are not allocated to the reportable segments.

Information concerning the Company’s reportable segments for the three months ended June 30 is as follows:

20

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 11 - Segment Information (Continued)

Net operating income reconciles to income before minority interests shown on the consolidated statements of income for the three months ended June 30 as follows:

Information concerning the Company’s reportable segments for the six months ended June 30 is as follows:

21

Hartman Commercial Properties REIT and Subsidiary

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2004

Note 11 - Segment Information (Continued)

Net operating income reconciles to income before minority interests shown on the consolidated statements of income for the six months ended June 30 as follows:

Note 12 - Pro Forma Financial Information

During December 2003 the Company acquired a retail center for approximately $13,100,000.  The pro forma financial information for the three months ended June 30, 2003 is based on the historical statements of the Company after giving effect to the acquisition as if such acquisition took place on January 1, 2003.

The pro forma financial information shown below is presented for information purposes only and may not be indicative of results that would have actually occurred if the acquisition had been in effect at the date indicated, nor does it purport to be indicative of the results that may be achieved in the future.

22

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operation

You should read the following discussion of our financial condition and results of operations in conjunction with our financial statements and the notes thereto included in this report.  For more detailed information regarding the basis of presentation for the following information, you should read the notes to the consolidated financial statements included in this report.

Forward-Looking Statements

This report on Form 10-Q includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Statements included in this quarterly report that are not historical facts (including any statements concerning plans and objectives of management for future operations or economic performance, or assumptions or forecasts related thereto), including, without limitation, the information set forth in this “Management's Discussion and Analysis of Financial Condition and Results of Operations,” are forward-looking statements.  These statements can be identified by the use of forward-looking terminology, including “forecast,” “may,” “believe,” “will,” “expect,” “anticipate,” “estimate,” “continue” or other similar words.  These statements discuss future expectations, contain projections of results of operations or of financial condition or state other “forward-looking” information.  We and our representatives may from time to time make other oral or written statements that are also forward-looking statements.

These forward-looking statements are made based upon management’s current plans, expectations, estimates, assumptions and beliefs concerning future events impacting us and therefore involve a number of risks and uncertainties.  While we believe that the assumptions concerning future events are reasonable, we caution that there are inherent difficulties in anticipating or predicting certain important factors.  Such factors are discussed in our other filings, including but not limited to, our Annual Report on Form 10-K and our registration statement on Form S-11, as amended, as filed with the Securities and Exchange Commission.  We disclaim any intention or obligation to revise any forward-looking statements, including financial estimates, whether as a result of new information, future events or otherwise. 

Overview

We own 33 commercial properties, consisting of 18 retail centers, 12 office/warehouse properties and three office buildings.  All of our properties are located in the Houston, Texas and San Antonio, Texas metropolitan areas.  As of June 30, 2004, we had 607 total tenants.  No individual lease or tenant is material to our business.  Revenues from our largest lease constituted 2.16% of our total revenues for the three months ended June 30, 2004.  Leases for our properties range from one year for our smaller spaces to over ten years for larger tenants.  Our leases generally include minimum monthly lease payments and tenant reimbursements for payment of taxes, insurance and maintenance.

We have no employees and we do not manage our properties.  Our properties and day-to-day operations are managed by the Management Company under a management agreement.  Under this agreement, we pay the Management Company the following amounts:

• a management fee of 5% of our “Effective Gross Revenues” to manage our properties;

• a leasing fee of 6% of the Effective Gross Revenues from leases originated by the Management Company and a fee of 4% of the Effective Gross Revenues from expansions or renewals of existing leases;

• an administrative fee of 1% of our Effective Gross Revenues for day-to-day supervisory and general administration services; and

• the reimbursement of all reasonable and necessary expenses incurred or funds advanced in connection with the management and operation of our properties, including expenses and costs relating to maintenance and construction personnel incurred on behalf of our properties; provided, however, that we will not reimburse the Management Company for its overhead, including salaries and expenses of centralized employees other than salaries of certain maintenance and construction personnel.

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Our management agreement defines “Effective Gross Revenues” as all payments actually collected from tenants and occupants of our properties, exclusive of:

• security payments and deposits (unless and until such deposits have been applied to the payment of current or past due rent); and

• payments received from tenants in reimbursement of the expense of repairing damage caused by tenants. 

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements.  We prepared these financial statements in conformity with U.S generally accepted accounting principles.  The preparation of these financial statements required us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods.  We based our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances.  Our results may differ from these estimates.  Currently, we believe that our accounting policies do not require us to make estimates using assumptions about matters that are highly uncertain.  You should read Note 1, Summary of Significant Accounting Policies, to our financial statements in conjunction with this Management’s Discussion and Analysis of Financial Condition and Results of Operations. 

We have described below the critical accounting policies that we believe could impact our consolidated financial statements most significantly.

Basis of Consolidation.  We are the sole general partner of the Operating Partnership and possess full legal control and authority over its operations.  As of June 30, 2004 and December 31, 2003, we owned a majority of the partnership interests in the Operating Partnership.  Consequently, our consolidated financial statements include the accounts of the Operating Partnership.  All significant intercompany balances have been eliminated.  Minority interest in the accompanying consolidated financial statements represents the share of equity and earnings of the Operating Partnership allocable to holders of partnership interests other than us.  Net income is allocated to minority interests based on the weighted-average percentage ownership of the Operating Partnership during the year.  Issuance of additional common shares and OP Units changes our ownership interests as well as those of minority interests.

Real Estate.  We record real estate properties at cost, net of accumulated depreciation.  We capitalize improvements, major renovations and certain costs directly related to the acquisition, improvement and leasing of real estate.  We charge expenditures for repairs and maintenance to operations as they are incurred.  We calculate depreciation using the straight-line method over the estimated useful lives of 5 to 39 years of our buildings and improvements.  We depreciate tenant improvements using the straight-line method over the life of the lease.

We review our properties for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets, including accrued rental income, may not be recoverable through our operations.  We determine whether an impairment in value has occurred by comparing the estimated future cash flows (undiscounted and without interest charges), including the estimated residual value of the property, with the carrying cost of the property.  If impairment is indicated, we record a loss for the amount by which the carrying value of the property exceeds its fair value.  We have determined that there has been no impairment in the carrying value of our real estate assets as of June 30, 2004 and December 31, 2003.

Purchase Price Allocation.  We record above-market and below-market in-place lease values for owned properties based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) management’s estimate of fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining non-cancelable term of the lease. We amortize the capitalized above-market lease values as a reduction of rental income over the remaining non-cancelable terms of the respective leases. We amortize the capitalized below-market lease values as an increase to rental income over the initial term and any fixed-rate renewal periods in the respective leases. Because most of our leases are relatively short term, have inflation or other scheduled rent escalations, and cover periods during which there have been few, and generally insignificant, pricing changes in the specific properties’ markets, the properties we have acquired have not been subject to leases with terms materially different than then-existing market-level terms.

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We measure the aggregate value of other intangible assets acquired based on the difference between (i) the property valued with existing in-place leases adjusted to market rental rates and (ii) the property valued as if vacant. Our management’s estimates of value are made using methods similar to those used by independent appraisers, primarily discounted cash flow analysis. Factors considered by management in its analysis include an estimate of carrying costs during hypothetical expected lease-up periods considering current market conditions, and costs to execute similar leases. We also consider information obtained about each property as a result of our pre-acquisition due diligence, marketing and leasing activities in estimating the fair value of the tangible and intangible assets acquired. In estimating carrying costs, management will also include real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, which we expect to primarily range from four to 18 months, depending on specific local market conditions. Our management also estimates costs to execute similar leases including leasing commissions, legal and other related expenses to the extent that such costs are not already incurred in connection with a new lease origination as part of the transaction.

The total amount of other intangible assets acquired is further allocated to in-place lease values and customer relationship intangible values based on our management’s evaluation of the specific characteristics of each tenant’s lease and our overall relationship with that respective tenant. Characteristics considered by our management in allocating these values include the nature and extent of our existing business relationships with the tenant, growth prospects for developing new business with the tenant, the tenant’s credit quality and expectations of lease renewals (including those existing under the terms of the lease agreement), among other factors.

We amortize the value of in-place leases, if any, to expense over the remaining initial terms of the respective leases, which, for leases with allocated intangible value, we expect to range generally from five to 10 years. The value of customer relationship intangibles is amortized to expense over the remaining initial terms and any renewal periods in the respective leases, but in no event does the amortization period for intangible assets exceed the remaining depreciable life of the building. Should a tenant terminate its lease, the unamortized portion of the in-place lease value and customer relationship intangibles are charged to expense.

Revenue Recognition.  All leases on properties we hold are classified as operating leases, and we recognize the related rental income on a straight-line basis over the terms of the related leases.  We capitalize or charge to accrued rent receivable, as applicable, differences between rental income earned and amounts due per the respective lease agreements.  Percentage rents are recognized as rental income when the thresholds upon which they are based have been met.  Recoveries from tenants for taxes, insurance, and other operating expenses are recognized as revenues in the period the corresponding costs are incurred.  We provide an allowance for doubtful accounts against the portion of tenant accounts receivable which we estimate to be uncollectible.

Liquidity and Capital Resources

General.  During the year ended December 31, 2003 and the six-month period ended June 30, 2004, our properties generated sufficient cash flow to cover our operating expenses and to allow us to pay quarterly distributions.  We generally lease our properties on a triple-net basis or on bases which provide for tenants to pay for increases in operating expenses over a base year or set amount, which means that tenants are required to pay for all repairs and maintenance, property taxes, insurance and utilities, or increases thereof, applicable to their space.  We anticipate that cash flows from operating activities and our borrowing capacity will continue to provide adequate capital for our working capital requirements, anticipated capital expenditures and scheduled debt payments during the next 12 months.  We also believe that cash flows from operating activities and our borrowing capacity will allow us to make all distributions required for us to continue to qualify to be taxed as a REIT.  We also believe that our properties are adequately covered by insurance. 

Cash and Cash Equivalents.  We had cash and cash equivalents of $641,857 on June 30, 2004 as compared to $578,687 on December 31, 2003 for operations and to purchase marketable securities.  The increase was relatively insignificant because we try to keep cash balances to a minimum by either buying properties, improving properties, reducing debt or making distributions to shareholders.  We place all cash in short-term, highly liquid investments that we believe provide appropriate safety of principal. 

In December 2002, we refinanced most of our debt with a new credit facility from GMAC Commercial Mortgage Corporation.  The loan is secured by, among other things, 18 of our properties, which are held by Hartman REIT Operating Partnership II, L.P., a wholly-owned subsidiary formed for the purpose of this credit facility, and the improvements, personal property and fixtures on the properties, all reserves, escrows and deposit accounts held by Hartman REIT Operating Partnership II, L.P., all intangible assets specific to or used in connection with the

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properties, and an assignment of rents related to such properties.  We believe the fair market value of these properties was approximately $62,000,000 at the time the loan was put in place.  We may prepay the loan after July 1, 2005 without penalty.  We must pay a prepayment fee equal to one percent of the outstanding principal balance under the facility if we prepay the note prior to July 1, 2005.  As of June 30, 2004, the outstanding principal balance under this facility was $34,440,000. 

We are required to make monthly interest payments under this credit facility.  During the initial term of the note, indebtedness under the credit facility will bear interest at LIBOR plus 2.5% computed on the basis of a 360 day year, adjusted monthly.  The interest rate was 3.82% as of June 30, 2004.  We are not required to make any principal payments prior to the loan’s maturity.  The credit facility will mature on January 1, 2006, though we have the option, subject to certain conditions, of extending the facility for an additional two-year period.  In no event shall the interest rate be lower than 3.82% during the initial term or lower than 4.32% during the extension term. 

In addition, Hartman REIT Operating Partnership II, L.P. entered into certain covenants pursuant to the credit facility which, among other things, require it to maintain specified levels of insurance and use the properties securing the note only for retail, light industrial, office, warehouse and commercial office uses.  The facility also limits, without the approval of the lender, this wholly-owned subsidiary’s ability to:

• acquire additional material assets;

• merge or consolidate with any other entity;

• engage in any other business or activity other than the ownership, operation and maintenance of the properties securing the note;

• make certain investments;

• incur, assume or guarantee additional indebtedness;

• grant certain liens; and

• loan money to others.

The security documents related to the note contain a covenant which requires Hartman REIT Operating Partnership II, L.P. to maintain adequate capital in light of its contemplated business operations.  We believe that this covenant and the other restrictions provided for in our credit facility will not affect or limit Hartman REIT Operating Partnership II, L.P.’s ability to make distributions us.  The note and the security documents related thereto also contain customary events of default, including, without limitation, payment defaults, bankruptcy-related defaults and breach of covenant defaults.  These covenants only apply to Hartman REIT Operating Partnership II, L.P. and do not impact the other operations of the Operating Partnership, including the operation of our 14 properties which do not secure this debt.

Upon the closing of this financing, we repaid approximately $24,800,000 of existing debt, placed approximately $2,800,000 in escrows established at the closing for taxes, insurance, agreed capital improvement and other uses required by the lender and paid fees and expenses of approximately $600,000 incurred in connection with the credit facility.  The remaining proceeds, approximately $6,200,000, were available for general working capital purposes.  We used the loan proceeds to repay debt and the remainder to pay accrued real estate taxes and other operating expenses.

On June 30, 2003, the Operating Partnership entered into a $25,000,000 loan agreement with Union Planter’s Bank, N.A. pursuant to which the Operating Partnership may, subject to the satisfaction of certain conditions, borrow funds to acquire additional income producing properties.  The revolving loan agreement terminates in June, 2005 and provides for interest payments at a rate, adjusted monthly, of either (at the Operating Partnership’s option) 30-day LIBOR plus 225 basis points, or Union Planter’s Bank, N.A.’s prime rate less 50 basis points, with either rate subject to a floor of 3.75% per annum.  The loan will be secured by unencumbered properties currently directly owned by the Operating Partnership as well as those to be acquired with the proceeds drawn from the facility and all improvements, equipment, fixtures, building materials, consumer goods, furnishings, inventory and articles of personal property related thereto, together with all water rights, timber crops and mineral interests pertaining to the acquired properties, all deposits, bank accounts, instruments arising in virtue of transactions related

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to the acquired properties, all proceeds from insurance, takings or litigation arising out of the acquired properties and all leases, rents, royalties and profits or other benefits of the acquired properties.  As of August 5, 2004, we had borrowed $8,126,000 under this credit facility; at June 30, 2004, the loan balance was $8,126,000.  We are required to make monthly payments of interest only, with the principal and all accrued unpaid interest being due at maturity of the loan.  The loan may be prepaid at any time without penalty.

In addition, the Operating Partnership entered into certain covenants pursuant to the loan agreement which, among other things, require it to maintain specified levels of insurance.  The facility also limits, among other things, the Operating Partnership’s ability to, without the approval of the lender:

• declare or pay any distribution during the continuance of a default or event of default;

• acquire, consolidate with or merge into any other entity;

• permit a material change in the management group;

• engage in any other business or activity other than the ownership, operation and maintenance of the properties securing the note;

• change the general character of its business;

• materially change accounting practices, methods or standards;

• sell, lease, transfer, convey or otherwise dispose of a material part of its assets other than in the ordinary course of business;

• form any new subsidiary or acquire all of the assets of a third party;

• permit the combined occupancy of the properties securing the loan to be less than 86%;

• make certain investments;

• incur, assume, guarantee or alter the terms of certain additional indebtedness;

• grant certain liens; and

• loan money to others.

The loan agreement and the security documents related thereto also contain customary events of default, including, without limitation, payment defaults, bankruptcy-related defaults, environmental defaults, material uninsured judgment defaults and defaults for breaches of covenant or representations.

In connection with the purchase of the Windsor Park property in December 2003, the Company assumed a note payable in the amount of $6,550,000 secured by the property.  The balance at June 30, 2004 was $6,309,526.  The note is payable in equal monthly installments of principal and interest of $80,445, with interest at the rate of 8.34% per annum.  The balance of the note is payable in full on December 1, 2006.

In August 2002, we entered into $2,000,000 line of credit with First Bank & Trust.  The collateral was released and the loan agreement was terminated during the quarter ended September 30, 2003.  There was no amount outstanding at the time the loan agreement was terminated and at no time during 2003 did we have any amounts outstanding under this line of credit.  This line of credit was secured by our Bellnot Square property. 

In November 2002, we borrowed $3,278,000 from Houston R.E. Income Properties XVI, L.P.  This debt was evidenced by a promissory note and accrued interest at a rate of 4.25%.  The note was secured by our Corporate Park Northwest property and was payable at any time upon the demand of Houston XVI.  We used these borrowed funds to repay existing debt.  Mr. Hartman controls the general partner of Houston XVI.  We were only required to make monthly interest payments under the note.  This note was repaid in full in the second quarter of 2003.

Capital Expenditures.  We currently do not expect to make significant capital expenditures or any significant improvements to any of our properties during the next 12 months.  However, we may have unexpected capital expenditures or improvements on our existing assets.  Additionally, we may incur significant capital expenditures or make significant improvements in connection with any properties we may acquire.

Total Contractual Cash Obligations.  A summary of our contractual cash obligations, as of June 30, 2004 is as follows:

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We have no commercial commitments such as lines of credit or guarantees that might result from a contingent event that would require our performance pursuant to a funding commitment.

Property Acquisitions.  During 2003, we acquired from an unrelated party one multi-tenant retail center comprising approximately 192,458 square feet of GLA.  The property was acquired for cash and assumption of debt of $6,550,000 for a total consideration of approximately $13,100,000.

Common Share Distributions.  We declared the following distributions to our shareholders during 2003 and 2004: 

               The following sets forth the tax status of the amounts we distributed to shareholders during 1999 through 2003:

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OP Unit Distributions.  The Operating Partnership declared the following distributions to holders of its OP Units, including HCP, during 2003 and 2004:

Results of Operations

Quarter Ended June 30, 2004 Compared to Quarter Ended June 30, 2003

General.

The following table provides a general comparison of our results of operations for the quarters ended June 30, 2003 and June 30, 2004:

Revenues.

We had rental income and tenant reimbursements of $6,095,742 for the three months ended June 30, 2004, as compared to revenues of $5,485,617 for the three months ended June 30, 2003, an increase of $610,125, or 11%.  Substantially all of our revenues are derived from rents received from the use of our properties.  The increase in our revenues during the second quarter of 2004 as compared to the second quarter of 2003 was due primarily to an adjustment made in the second quarter of 2004 to an estimate of accrued tenant reimbursements partially offset by a decrease in occupancy from 2003 to 2004.  A similar adjustment to accrued tenant reimbursements was reflected in the first quarter of 2003.  Also, the increase is attributable to the acquisition of an additional property, Windsor Park, in December 2003.  Our occupancy rate at June 30, 2004 was 87%, as compared to 89% at June 30, 2003 and our average annualized revenue was $9.75 per square foot in the second quarter of 2004, as compared to an average annualized revenue of $9.34 per square foot in the second quarter of 2003.

We had interest and other income of $166,402 for the three months ended June 30, 2004, as compared to $167,030 for the three months ended June 30, 2003, a decrease of $628, or .4%.  We hold all revenues and proceeds

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we receive from offerings and loans in money market accounts and other short-term, highly liquid investments.  The decrease in interest and other income during the second quarter of 2004 as compared to 2003 was insignificant.

Expenses.

Our total operating expenses, including interest expense and depreciation and amortization expense, were $4,303,615 for the three months ended June 30, 2004, as compared to $3,518,456 for the three months ended June 30, 2003, an increase of $785,159, or 22%.  We expect that the dollar amount of operating expenses will increase as we acquire additional properties and expand our operations.  However, we expect that general and administrative expenses as a percentage of total revenues will decline as we acquire additional properties.

The increase in our operating expenses during the second quarter of 2004 was a result of increased maintenance, real estate taxes, and depreciation and amortization expenses.  This increase included an increase in real estate tax expense.  We settled several property tax disputes during the second quarter of 2003 which resulted in a $415,000 reduction of accrued property taxes as of December 31, 2002.  We accrued $138,000 in legal fees and $95,000 in possible tenant reimbursement reductions related to the settlements for a net positive impact of $182,000 on income before minority interests for the second quarter of 2003. 

The amount we pay the Management Company under our management agreement is based on our revenues and the number of leases the Management Company originates.  As a result of our increased revenues in the second quarter of  2004, management fees were $345,807 in the second quarter of  2004, as compared to $315,319 in the second quarter of  2003, an increase of $30,488, or 10%.  Our interest expense increased by $249,991, or 75%, in the second quarter of 2004 as compared to the second quarter of 2003.  Our average outstanding debt increased from $37,992,146 in the second quarter of 2003 compared to $51,178,302 in the second quarter of 2004 and the average interest rate associated with this debt increased from 3.83% in the second quarter of 2003 to 4.51% in the second quarter of 2004.  Finally, general and administrative expenses decreased $42,039, or 12%, in the second quarter of 2004 as compared to the second quarter of 2003 primarily as the result of a decrease in professional fees.

Net Income.

Income before minority interests was $1,792,127 for the quarter ended June 30, 2004, as compared to $1,967,161 for the quarter ended June 30, 2003, a decrease of $175,034, or 9%.  Net income for the quarter ended June 30, 2004 was $956,521, as compared to $1,050,005 for the quarter ended June 30, 2003, a decrease of $93,484, or 9%. 

Six Months Ended June 30, 2004 Compared to Six Months June 30, 2003

General.

The following table provides a general comparison of our results of operations for the six months ended June 30, 2003 and June 30, 2004:

Revenues.

We had rental income and tenant reimbursements of $11,582,168 for the six months ended June 30, 2004, as compared to revenues of $11,022,756 for the six months ended June 30, 2003, an increase of $559,412, or 5%.  Substantially all of our revenues are derived from rents received from the use of our properties.  The increase in our revenues for the six months ended June 30, 2004 as compared to the six months ended June 30, 2003 was due to an increase in the amount of rent charged at some locations and the acquisition of an additional property, Windsor Park, in December 2003.  Our occupancy rate at June 30, 2004 was 87%, as compared to 89% at June 30, 2003, and our

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average annualized revenue was $9.12 per square foot for the six months ended June 30, 2004, as compared to an average annualized revenue of $9.39 per square foot for the six months ended June 30, 2003.

We had interest and other income of $303,277 for the six months ended June 30, 2004, as compared to $302,700 for the six months ended June 30, 2003, an increase of $577, or .2%.  We hold all revenues and proceeds we receive from offerings in money market accounts and other short-term, highly liquid investments.  In 2003, we had proceeds from the loan refinancing we completed in December, 2002 that earned interest.  The increase in interest and other income for the six months ended June 30, 2004 as compared to the six months ended June 30, 2003 was insignificant.

Expenses.

Our total operating expenses, including interest expense and depreciation and amortization expense, were $8,405,234 for the six months ended June 30, 2004, as compared to $7,351,231 for the six months ended June 30, 2003, an increase of $1,054,003, or 14%.  We expect that the dollar amount of operating expenses will increase as we acquire additional properties and expand our operations.  However, we expect that general and administrative expenses as a percentage of total revenues will decline as we acquire additional properties.

The increase in our operating expenses during the six months ended June 30, 2004 was a result of increased maintenance, real estate taxes,  general and administrative and depreciation and amortization expenses.  Real estate taxes increased significantly for the period because in 2003, we settled several lawsuits against an appraisal district which resulted in a reduction of previously accrued property taxes. 

The amount we pay the Management Company under our management agreement is based on our revenues and the number of leases the Management Company originates.  As a result of our increased revenues for the six months ended June 30, 2004, management fees were $669,945 for the six months ended June 30, 2004, as compared to $658,128 for the six months ended June 30, 2003, an increase of $11,817, or 2%.  Our interest expense increased by $481,022, or 72%, for the six months ended June 30, 2004 as compared to the six months ended June 30, 2003.  Our average outstanding debt increased from $37,855,073 for the six months ended June 30, 2003 compared to $52,707,385 for the six months ended June 30, 2004, and the average interest rate associated with this debt increased from 3.84%  for the six months ended June 30, 2003 to 4.34% for the six months ended June 30, 2004.  Finally, general and administrative expenses increased $29,728, or 5%, for the six months ended June 30, 2004 as compared to the six months ended June 30, 2003,  primarily as the result of an increase in professional fees.

Net Income.

Income before minority interests was $3,176,934 for the six months ended June 30, 2004, as compared to $3,671,525 for the six months ended June 30, 2003, a decrease of $494,591, or 13%.  Net income for the six months ended June 30, 2004 was $1,695,639, as compared to $1,959,707 for the six months ended June 30, 2003, a decrease of $264,068, or 13%. 

Taxes

We elected to be taxed as a REIT under the Internal Revenue Code beginning with our taxable year ended December 31, 1999.  As a REIT, we generally are not subject to federal income tax on income that we distribute to our shareholders.  If we fail to qualify as a REIT in any taxable year, we will be subject to federal income tax on our taxable income at regular corporate rates.  We believe that we are organized and operate in such a manner as to qualify to be taxed as a REIT, and we intend to operate so as to remain qualified as a REIT for federal income tax purposes.

Inflation

We anticipate that our leases will continue to be triple-net leases or otherwise provide that tenants pay for increases in operating expenses and will contain provisions that we believe will mitigate the effect of inflation.  In addition, many of our leases are for terms of less than five years, which allows us to adjust rental rates to reflect inflation and other changing market conditions when the leases expire.  Consequently, increases due to inflation, as well as ad valorem tax rate increases, generally do not have a significant adverse effect upon our operating results.

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Environmental Matters

Our properties are subject to environmental laws and regulations adopted by various governmental authorities in the jurisdictions in which our operations are conducted.  From our inception, we have incurred no significant environmental costs, accrued liabilities or expenditures to mitigate or eliminate future environmental contamination. 

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

Market risk is the risk of loss arising from adverse changes in market rates and prices.  The principal market risk to which we are exposed is the risk related to interest rate fluctuations.  We will be exposed to changes in interest rates as a result of our credit facilities which have floating interest rates.  As of June 30, 2004, we had $42,566,000 of indebtedness outstanding under these facilities.  The impact of a 1% increase in interest rates on our debt would result in an increase in interest expense and a decrease in income before minority interests of approximately $425,660 annually. 

Item 4.  Controls and Procedures

In accordance with Rules 13a-15 and 15d-15 under the Securities and Exchange Act, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2004 to provide reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the Securities and Exchange Commission's rules and forms.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

From time to time, we are subject to certain legal proceedings claims and disputes that arise in the ordinary course of our business.  Although we cannot predict the outcomes of these legal proceedings, we do not believe these actions, in the aggregate, will have a material adverse impact on our financial position, results of operations or liquidity.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

In June 2004, our shareholders approved a proposal to change the Company’s state of organization from Texas to Maryland pursuant to a merger of the Company with and into a Maryland real estate investment trust formed for the sole purpose of the reorganization.  The reorganization was consummated on July 28, 2004.  In conjunction with the reorganization, each outstanding common share of beneficial interest of the Company was converted into 1.42857 common shares of beneficial interest of the surviving Maryland entity.  In addition, the Company filed Articles of Amendment and Restatement to its Declaration of Trust, pursuant to which the rights of the holders of the Company’s common shares of beneficial interest have been modified.  The purpose for this amendment was to bring the Company’s Declaration of Trust in compliance with the guidelines set forth in the Statement of Policy Regarding Real Estate Programs of the North American Securities Administrators Association, Inc. as well as similar policy statements incorporated in the securities laws of individual states.  As a result of the Articles of Amendment and Restatement to our Declaration of Trust:

• a majority of our board of trustees must be independent trustees;

• the independent trustees have specific authority and responsibility over the approval and monitoring of any transactions or relationships between us, our affiliates, and other affiliates of Allen R. Hartman or Hartman Management, L.P., as well as any other “conflict of interest” transactions;

• our board of trustees must have a minimum of three members;

• our trustees may be removed by a majority vote of our outstanding common shares;

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• we have established limits on the amount of fees we are allowed to pay the management company, the term of any management agreement and the termination rights related to any management agreement; and

• our independent trustees must periodically monitor and review our management company’s performance.

Item 3.  Defaults Upon Senior Securities

None.

Item 4.  Submission of Matters to a Vote of Security Holders

We held our annual meeting on June 4, 2004 at the Radisson Hotel West, 10655 Katy Freeway, Houston, Texas 77024.  The annual meeting was held to elect all of the members of our board of trustees and to consider and vote on a proposal to reorganize the Company as a Maryland real estate investment trust and the related conversion of each outstanding common share of beneficial interest of the Company into 1.42857 common shares of the surviving Maryland entity. 

At the meeting, our shareholders elected Allen R. Hartman, Robert W. Engel, Sam Hathorn, Jack L. Mahaffey, Chris A. Minton and Chand Vyas to our board of trustees.  We had no other trustees whose term of office continued after the meeting.  The shareholders elected each individual nominee as follows:

The shareholders also voted to approve the reorganization of the Company as a Maryland real estate investment trust pursuant to a merger of the Company with and into a Maryland real estate investment trust formed by us for the sole purpose of the reorganization, as well as the conversion of each outstanding common share of beneficial interest into 1.42857 common shares of beneficial interest of the surviving Maryland entity.  Regarding the vote on this matter, 3,996,621 shares voted in favor of the proposal, 24,001 voted against the proposal and 10,000 shares abstained from voting on the matter. 

Item 5.  Other Information

None.

Item 6.  Exhibits and Reports on Form 8-K

(a)           Exhibits

*Filed herewith

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(b)           Reports on Form 8-K

On May 11, 2004, Hartman Commercial Properties REIT filed a Current Report on Form 8-K which included its press release as Exhibit 99.1 announcing its financial results for the quarter ended March 31, 2004.  On August 2, 2004, Hartman Commercial Properties REIT filed a Current Report on Form 8-K which included its press release as Exhibit 99.1 announcing its financial results for the quarter ended June 30, 2004.

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SIGNATURE

                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 thereunto duly authorized.