Whitestone REIT - FORM 10-Q - November 6, 2018

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EX-32.2 - EXHIBIT 32.2 - Whitestone REITexhibit322certificationofc.htm
EX-32.1 - EXHIBIT 32.1 - Whitestone REITexhibit321certificationofc.htm
EX-31.2 - EXHIBIT 31.2 - Whitestone REITexhibit312certificationofc.htm
EX-31.1 - EXHIBIT 31.1 - Whitestone REITexhibit311certificationofc.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q
 
(Mark One)
[x]
QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2018

OR

[ ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________ to ____________

Commission File Number 001-34855
WHITESTONE REIT
(Exact Name of Registrant as Specified in Its Charter)
 
Maryland
 
76-0594970
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)

2600 South Gessner, Suite 500
Houston, Texas
 
77063
(Address of Principal Executive Offices)
 
(Zip Code)

(713) 827-9595
(Registrant's Telephone Number, Including Area Code)
 
N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

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.  ýYes     ¨No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).  ýYes    ¨No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer ¨                                                                                      Accelerated filer ý
Non-accelerated filer ¨                            Smaller reporting company ¨

Emerging growth company ¨

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨Yes   ý No

As of November 5, 2018, there were 39,773,002 common shares of beneficial interest, $0.001 par value per share, outstanding.


PART I - FINANCIAL INFORMATION


PART II - OTHER INFORMATION




PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.
Whitestone REIT and Subsidiaries
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)

 
 
September 30, 2018
 
December 31, 2017
 
 
(unaudited)
 
 
ASSETS
Real estate assets, at cost
 
 
 
 
Property
 
$
1,146,951

 
$
1,149,454

Accumulated depreciation
 
(145,807
)
 
(131,034
)
Total real estate assets
 
1,001,144

 
1,018,420

Cash and cash equivalents
 
9,389

 
5,005

Restricted cash
 
91

 
205

Marketable securities
 
—

 
32

Investment in real estate partnership
 
2,770

 
4,095

Escrows and acquisition deposits
 
7,702

 
7,916

Accrued rents and accounts receivable, net of allowance for doubtful accounts
 
21,906

 
21,140

Unamortized lease commissions and loan costs
 
6,847

 
7,157

Prepaid expenses and other assets
 
10,597

 
6,198

Total assets
 
$
1,060,446

 
$
1,070,168

 
 
 
 
 
LIABILITIES AND EQUITY
Liabilities:
 
 
 
 
Notes payable
 
$
666,624

 
$
659,068

Accounts payable and accrued expenses
 
32,846

 
35,536

Tenants' security deposits
 
5,920

 
5,694

Dividends and distributions payable
 
11,600

 
11,466

Total liabilities
 
716,990

 
711,764

Commitments and contingencies:
 
—

 
—

Equity:
 
 
 
 
Preferred shares, $0.001 par value per share; 50,000,000 shares authorized; none issued and outstanding as of September 30, 2018 and December 31, 2017, respectively
 
—

 
—

Common shares, $0.001 par value per share; 400,000,000 shares authorized; 39,772,105 and 39,221,773 issued and outstanding as of September 30, 2018 and December 31, 2017, respectively
 
38

 
38

Additional paid-in capital
 
525,780

 
521,314

Accumulated deficit
 
(198,199
)
 
(176,684
)
Accumulated other comprehensive gain
 
7,034

 
2,936

Total Whitestone REIT shareholders' equity
 
334,653

 
347,604

Noncontrolling interest in subsidiary
 
8,803

 
10,800

Total equity
 
343,456

 
358,404

Total liabilities and equity
 
$
1,060,446

 
$
1,070,168



See accompanying notes to Consolidated Financial Statements.


1

Whitestone REIT and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(Unaudited)
(in thousands, except per share data)

 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Property revenues
 
 
 
 
 
 
 
 
Rental revenues
 
$
25,256

 
$
24,891

 
$
74,852

 
$
69,197

Other revenues
 
9,340

 
8,762

 
26,412

 
22,931

Total property revenues
 
34,596

 
33,653

 
101,264

 
92,128

 
 
 
 
 
 
 
 
 
Property expenses
 
 
 
 
 
 
 
 
Property operation and maintenance
 
6,374

 
6,104

 
17,920

 
16,973

Real estate taxes
 
5,253

 
5,181

 
14,395

 
13,588

Total property expenses
 
11,627

 
11,285

 
32,315

 
30,561

 
 
 
 
 
 
 
 
 
Other expenses (income)
 
 
 
 
 
 
 
 
General and administrative
 
4,959

 
5,581

 
17,897

 
17,598

Depreciation and amortization
 
7,483

 
7,247

 
22,100

 
19,936

Interest expense
 
6,951

 
6,376

 
20,306

 
17,158

Interest, dividend and other investment income
 
(84
)
 
(142
)
 
(302
)
 
(381
)
Total other expense
 
19,309

 
19,062

 
60,001

 
54,311

 
 
 
 
 
 
 
 
 
Income before gain (loss) on sale or disposal of properties or assets and income taxes
 
3,660

 
3,306

 
8,948

 
7,256

 
 
 
 
 
 
 
 
 
Provision for income taxes
 
(115
)
 
(126
)
 
(328
)
 
(296
)
Gain on sale of properties
 
4,380

 
—

 
4,646

 
16

Profit sharing expense
 
(73
)
 
(63
)
 
(276
)
 
(228
)
Loss on sale or disposal of assets
 
(15
)
 
(40
)
 
(286
)
 
(135
)
 
 
 
 
 
 
 
 
 
Net income
 
7,837

 
3,077

 
12,704

 
6,613

 
 
 
 
 
 
 
 
 
Less: Net income attributable to noncontrolling interests
 
193

 
84

 
326

 
201

 
 
 
 
 
 
 
 
 
Net income attributable to Whitestone REIT
 
$
7,644

 
$
2,993

 
$
12,378

 
$
6,412






See accompanying notes to Consolidated Financial Statements.

2

Whitestone REIT and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(Unaudited)
(in thousands, except per share data)

 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Basic Earnings Per Share:
 
 
 
 
 
 
 
 
Net income attributable to common shareholders, excluding amounts attributable to unvested restricted shares
 
$
0.19

 
$
0.07

 
$
0.31

 
$
0.18

Diluted Earnings Per Share:
 
 
 
 
 
 
 
 
Net income attributable to common shareholders, excluding amounts attributable to unvested restricted shares
 
$
0.19

 
$
0.07

 
$
0.30

 
$
0.17

 
 
 
 
 
 
 
 
 
Weighted average number of common shares outstanding:
 
 
 
 
 
 
 
 
Basic
 
39,327

 
37,992

 
39,200

 
34,406

Diluted
 
40,635

 
38,589

 
40,541

 
35,211

 
 
 
 
 
 
 
 
 
Distributions declared per common share / OP unit
 
$
0.2850

 
$
0.2850

 
$
0.8550

 
$
0.8550

 
 
 
 
 
 
 
 
 
Consolidated Statements of Comprehensive Income
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
7,837

 
$
3,077

 
$
12,704

 
$
6,613

 
 
 
 
 
 
 
 
 
Other comprehensive gain
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Unrealized gain on cash flow hedging activities
 
605

 
172

 
4,163

 
124

Unrealized gain (loss) on available-for-sale marketable securities
 
—

 
(7
)
 
18

 
26

 
 
 
 
 
 
 
 
 
Comprehensive income
 
8,442

 
3,242

 
16,885

 
6,763

 
 
 
 
 
 
 
 
 
Less: Net income attributable to noncontrolling interests
 
193

 
84

 
326

 
201

Less: Comprehensive gain attributable to noncontrolling interests
 
15

 
5

 
107

 
5

 
 
 
 
 
 
 
 
 
Comprehensive income attributable to Whitestone REIT
 
$
8,234

 
$
3,153

 
$
16,452

 
$
6,557




See accompanying notes to Consolidated Financial Statements.

3

Whitestone REIT and Subsidiaries
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
(Unaudited)
(in thousands)

 
 
 
 
 
 
 
 
 
 
Accumulated
 
 
 
 
 
 
 
 
 
 
Additional
 
 
 
Other
 
Total
 
Noncontrolling
 
 
 
 
Common Shares
 
Paid-In
 
Accumulated
 
Comprehensive
 
Shareholders'
 
Interests
 
Total
 
 
Shares
 
Amount
 
Capital
 
Deficit
 
Gain
 
Equity
 
Units
 
Dollars
 
Equity
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2017
 
39,222

 
$
38

 
$
521,314

 
$
(176,684
)
 
$
2,936

 
$
347,604

 
1,084

 
$
10,800

 
$
358,404

Exchange of noncontrolling interest OP units for common shares
 
155

 
—

 
1,545

 
—

 
—

 
1,545

 
(155
)
 
(1,545
)
 
—

Exchange offer costs
 
—

 
—

 
(128
)
 
—

 
—

 
(128
)
 
—

 
—

 
(128
)
Issuance of shares under dividend reinvestment plan
 
8

 
—

 
101

 
—

 
—

 
101

 
—

 
—

 
101

Repurchase of common shares (1)
 
(139
)
 
—

 
(1,699
)
 
—

 
—

 
(1,699
)
 
—

 
—

 
(1,699
)
Share-based compensation
 
526

 
—

 
4,647

 
—

 
—

 
4,647

 
—

 
—

 
4,647

Distributions
 
—

 
—

 
—

 
(33,893
)
 
—

 
(33,893
)
 
—

 
(861
)
 
(34,754
)
Unrealized gain on change in value of cash flow hedge
 
—

 
—

 
—

 
—

 
4,056

 
4,056

 
—

 
107

 
4,163

Unrealized gain on change in fair value of available-for-sale marketable securities
 
—

 
—

 
—

 
—

 
18

 
18

 
—

 
—

 
18

Reallocation of ownership between parent and subsidiary
 
—

 
—

 
—

 
—

 
24

 
24

 
—

 
(24
)
 
—

Net income
 
—

 
—

 
—

 
12,378

 
—

 
12,378

 
—

 
326

 
12,704

Balance, September 30, 2018
 
39,772

 
$
38

 
$
525,780

 
$
(198,199
)
 
$
7,034

 
$
334,653

 
929

 
$
8,803

 
$
343,456


(1) 
During the nine months ended September 30, 2018, the Company acquired common shares held by employees who tendered owned common shares to satisfy the tax withholding on the lapse of certain restrictions on restricted common shares.



See accompanying notes to Consolidated Financial Statements.


4

Whitestone REIT and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)
 
 
Nine Months Ended
 
 
September 30,
 
 
2018
 
2017
Cash flows from operating activities:
 
 
 
 
Net income
 
$
12,704

 
$
6,613

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
22,100

 
19,936

Amortization of deferred loan costs
 
976

 
953

Amortization of notes payable discount
 
—

 
447

Loss (gain) on sale of marketable securities
 
20

 
(5
)
Loss (gain) on sale or disposal of assets and properties
 
(4,360
)
 
119

Bad debt expense
 
1,123

 
1,442

Share-based compensation
 
4,894

 
7,347

Changes in operating assets and liabilities:
 
 
 
 
Escrows and acquisition deposits
 
214

 
(2,683
)
Accrued rent and accounts receivable
 
(1,736
)
 
(3,307
)
Unamortized lease commissions
 
(1,394
)
 
(1,837
)
Prepaid expenses and other assets
 
618

 
71

Accounts payable and accrued expenses
 
(2,924
)
 
(1,441
)
Tenants' security deposits
 
226

 
488

Net cash provided by operating activities
 
32,461

 
28,143

Cash flows from investing activities:
 
 
 
 
Acquisitions of real estate
 
—

 
(124,557
)
Additions to real estate
 
(11,300
)
 
(13,499
)
Proceeds from sales of properties
 
12,574

 
26

Investment in real estate partnership
 
843

 
(1,533
)
Proceeds from sales of marketable securities
 
30

 
306

Net cash provided by (used in) investing activities
 
2,147

 
(139,257
)
Cash flows from financing activities:
 
 
 
 
Distributions paid to common shareholders
 
(33,642
)
 
(29,494
)
Distributions paid to OP unit holders
 
(890
)
 
(932
)
Proceeds from issuance of common shares, net of offering costs
 
—

 
107,619

Payments of exchange offer costs
 
(128
)
 
—

Net proceeds from credit facility
 
9,000

 
40,600

Repayments of notes payable
 
(2,949
)
 
(2,788
)
Payments of loan origination costs
 
(30
)
 
(695
)
Repurchase of common shares
 
(1,699
)
 
(1,987
)
Net cash provided by (used in) financing activities
 
(30,338
)
 
112,323

 
 
 
 
 
Net increase in cash, cash equivalents and restricted cash
 
4,270

 
1,209

Cash, cash equivalents and restricted cash at beginning of period
 
5,210

 
2,988

Cash, cash equivalents and restricted cash at end of period
 
$
9,480

 
$
4,197


See accompanying notes to Consolidated Financial Statements.

5

Whitestone REIT and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)

 
 
Nine Months Ended
 
 
September 30,
 
 
2018
 
2017
Supplemental disclosure of cash flow information:
 
 
 
 
Cash paid for interest
 
$
19,879

 
$
16,311

Cash paid for taxes
 
$
392

 
$
329

Non cash investing and financing activities:
 
 
 
 
Disposal of fully depreciated real estate
 
$
963

 
$
995

Financed insurance premiums
 
$
1,273

 
$
1,115

Value of shares issued under dividend reinvestment plan
 
$
101

 
$
95

Value of common shares exchanged for OP units
 
$
1,545

 
$
206

Change in fair value of available-for-sale securities
 
$
18

 
$
26

Change in fair value of cash flow hedge
 
$
4,163

 
$
124

Reallocation of ownership percentage between parent and subsidiary
 
$
24

 
$
9








See accompanying notes to Consolidated Financial Statements.


6
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

The use of the words “we,” “us,” “our,” “Company” or “Whitestone” refers to Whitestone REIT and our consolidated subsidiaries, except where the context otherwise requires.

1.  INTERIM FINANCIAL STATEMENTS
 
The consolidated financial statements included in this report are unaudited; however, amounts presented in the consolidated balance sheet as of December 31, 2017 are derived from our audited consolidated financial statements as of that date.  The unaudited financial statements as of and for the period ended September 30, 2018 have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information on a basis consistent with the annual audited consolidated financial statements and with the instructions to Form 10-Q.
 
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 Whitestone and our subsidiaries as of September 30, 2018, and the results of operations for the three and nine month periods ended September 30, 2018 and 2017, the consolidated statements of changes in equity for the nine month period ended September 30, 2018 and cash flows for the nine month periods ended September 30, 2018 and 2017.  All of these 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 the notes thereto which are included in our Annual Report on Form 10-K for the year ended December 31, 2017.
 
Business.  Whitestone was formed as a real estate investment trust (“REIT”) pursuant to the Texas Real Estate Investment Trust Act on August 20, 1998.  In July 2004, we changed our state of organization from Texas to Maryland pursuant to a merger where we merged directly with and into a Maryland REIT formed for the sole purpose of the reorganization and the conversion of each of the outstanding common shares of beneficial interest of the Texas entity into 1.42857 common shares of beneficial interest of the Maryland entity.  We serve as the general partner of Whitestone REIT Operating Partnership, L.P. (the “Operating Partnership”), which was formed on December 31, 1998 as a Delaware limited partnership.  We currently conduct substantially all of our operations and activities through the Operating Partnership.  As the general partner of the Operating Partnership, we have the exclusive power to manage and conduct the business of the Operating Partnership, subject to certain customary exceptions.  As of September 30, 2018 and December 31, 2017, Whitestone owned or held a majority interest in 71 and 73 commercial properties, respectively, in and around Austin, Chicago, Dallas-Fort Worth, Houston, Phoenix and San Antonio.

These properties consist of:

Operating Portfolio

•
51 wholly-owned properties that meet our Community Centered Properties® strategy; and

•
through our 81.4% interest in Pillarstone Capital REIT Operating Partnership LP (“Pillarstone OP”), an interest in 14 properties that do not meet our Community Centered Properties® strategy. See Note 6 for additional information regarding our investment in real estate partnerships.

Redevelopment, New Acquisitions Portfolio

•
six parcels of land held for future development.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Consolidation.  We are the sole general partner of the Operating Partnership and possess full legal control and authority over the operations of the Operating Partnership. As of September 30, 2018 and December 31, 2017, we owned a majority of the partnership interests in the Operating Partnership. Consequently, the accompanying consolidated financial statements include the accounts of the Operating Partnership.

Noncontrolling 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 or loss is allocated

7
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

to noncontrolling interests based on the weighted-average percentage ownership of the Operating Partnership during the period. Issuance of additional common shares of beneficial interest in Whitestone (the “common shares”) and units of limited partnership interest in the Operating Partnership that are convertible into cash or, at our option, common shares on a one-for-one basis (the “OP units”) changes the percentage of ownership interests of both the noncontrolling interests and Whitestone.

Profit-sharing Method. In accordance with the Financial Accounting Standards Board's (“FASB”) guidance applicable to sales of real estate or interests therein, specifically FASB Accounting Standards Codification (“ASC”) 360-20, “Real Estate Sales,” ASC 606, “Revenue from Contracts with Customers” and ASC 610, “Other Income–Gains and Losses from the Derecognition of Nonfinancial Assets,” we have not recognized the sale of assets to Pillarstone OP and are accounting for the transaction under the profit-sharing method. Until we otherwise meet the requirements to recognize the sale as defined, we will continue to recognize Pillarstone OP's real estate assets and notes payables in our consolidated balance sheets, for all periods following the transaction. Additionally, the profits and losses of Pillarstone OP not attributable to the Company are reported as profit sharing expense. See Note 6 for additional disclosure on Pillarstone OP.
  
Basis of Accounting.  Our financial records are maintained on the accrual basis of accounting whereby revenues are recognized when earned and expenses are recorded when incurred.
 
Use of Estimates.   The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates that we use include the estimated fair values of properties acquired, the estimated useful lives for depreciable and amortizable assets and costs, the estimated allowance for doubtful accounts, the estimated fair value of interest rate swaps and the estimates supporting our impairment analysis for the carrying values of our real estate assets.  Actual results could differ from those estimates.
 
Reclassifications.  We have reclassified certain prior period amounts in the accompanying consolidated financial statements in order to be consistent with the current period presentation. Other than the effects noted below, these reclassifications had no effect on net income, total assets, total liabilities or equity.

Immaterial Error Correction. During the second quarter of 2018, we determined that certain prior period amounts contained errors due to our initial determination that we were the primary beneficiary of a variable interest entity (“VIE”), Pillarstone OP. See Note 6 for additional disclosure on Pillarstone OP. Management evaluated the materiality of the errors quantitatively and qualitatively, and concluded that they were not material to the financial statements of any period presented, and elected to correct them in the accompanying prior period consolidated financial statements.

The following table presents the effects of the immaterial error correction on the consolidated statements of operations and comprehensive income for the three and nine months ended September 30, 2017 (in thousands):
 
 
For the Three Months Ended September 30, 2017
 
 
As Reported
 
Correction of Error
 
As Adjusted
Net income
 
$
3,140

 
$
(63
)
 
$
3,077

Net income attributable to noncontrolling interests
 
147

 
(63
)
 
84

 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30, 2017
 
 
As Reported
 
Correction of Error
 
As Adjusted
Net income
 
$
6,841

 
$
(228
)
 
$
6,613

Net income attributable to noncontrolling interests
 
429

 
(228
)
 
201

 
Restricted Cash. We classify all cash pledged as collateral to secure certain obligations and all cash whose use is limited as restricted cash. During 2015, pursuant to the terms of our $15.1 million 4.99% Note, due January 6, 2024 (see Note 7), which is collateralized by our Anthem Marketplace property, we were required by the lenders thereunder to establish a cash

8
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

management account controlled by the lenders to collect all amounts generated by our Anthem Marketplace property in order to collateralize such promissory note.

Derivative Instruments and Hedging Activities. We utilize derivative financial instruments, principally interest rate swaps, to manage our exposure to fluctuations in interest rates. We have established policies and procedures for risk assessment, and the approval, reporting and monitoring of derivative financial instruments. We recognize our interest rate swaps as cash flow hedges with the effective portion of the changes in fair value recorded in comprehensive income and subsequently reclassified into earnings in the period that the hedged transaction affects earnings. Any ineffective portion of a cash flow hedges' change in fair value is recorded immediately into earnings. Our cash flow hedges are determined using Level 2 inputs under ASC 820. Level 2 inputs represent quoted prices in active markets for similar assets or liabilities; quoted prices in markets that are not active; and model-derived valuations whose inputs are observable. As of September 30, 2018, we consider our cash flow hedges to be highly effective.
        
Development Properties. Land, buildings and improvements are recorded at cost. Expenditures related to the development of real estate are carried at cost which includes capitalized carrying charges and development costs. Carrying charges (interest, real estate taxes, loan fees, and direct and indirect development costs related to buildings under construction), are capitalized as part of construction in progress. The capitalization of such costs ceases when the property, or any completed portion, becomes available for occupancy. For the three months ended September 30, 2018, approximately $149,000 and $145,000 in interest expense and real estate taxes, respectively, were capitalized, and for the nine months ended September 30, 2018, approximately $440,000 and $274,000 in interest expense and real estate taxes, respectively, were capitalized. For the three months ended September 30, 2017, approximately $146,000 and $96,000 in interest expense and real estate taxes, respectively, were capitalized, and for the nine months ended September 30, 2017, approximately $302,000 and $189,000 in interest expense and real estate taxes, respectively, were capitalized.

Real Estate Held for Sale and Discontinued Operations. We consider a commercial property to be held for sale when it meets all of the criteria established under ASC 205, “Presentation of Financial Statements.” For commercial properties classified as held for sale, assets and liabilities are presented separately for all periods presented.

In accordance with ASC 205, a discontinued operation may include a component of an entity or a group of components of an entity. A disposal of a component of an entity or a group of components of an entity is reported in discontinued operations if the disposal represents a strategic shift that has (or will have) a major effect on an entity's operations and financial results when the component of an entity or group of components of an entity is classified as held for sale, disposed of by sale or disposed of other than by sale. In addition, ASC 205 requires us to provide additional disclosures about both discontinued operations and the disposal of an individually significant component of an entity that does not meet the criteria for a discontinued operation.

Share-Based Compensation.   From time to time, we grant nonvested restricted common share awards or restricted common share unit awards, which may be converted into common shares, to executive officers and employees under our 2008 Long-Term Equity Incentive Ownership Plan (the “2008 Plan”).  The vast majority of the granted shares and units vest when certain performance conditions are met.  We recognize compensation expense when achievement of the performance conditions is probable based on management's most recent estimates using the fair value of the shares as of the grant date. We recognized $1,497,000 and $2,704,000 in share-based compensation for the three months ended September 30, 2018 and 2017, respectively, and we recognized $4,894,000 and $7,545,000 in share-based compensation for the nine months ended September 30, 2018 and 2017, respectively.

Noncontrolling Interests.  Noncontrolling interests is the portion of equity in a subsidiary not attributable to a parent.  The ownership interests not held by the parent are considered noncontrolling interests.  Accordingly, we have reported noncontrolling interests in equity on the consolidated balance sheets but separate from Whitestone's equity.  On the consolidated statements of operations, subsidiaries are reported at the consolidated amount, including both the amount attributable to Whitestone and noncontrolling interests.  The consolidated statement of changes in equity is included for quarterly financial statements, including beginning balances, activity for the period and ending balances for shareholders' equity, noncontrolling interests and total equity.
 
See our Annual Report on Form 10-K for the year ended December 31, 2017 for further discussion on significant accounting policies.

9
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

 
Recent Accounting Pronouncements.  In May 2014, the FASB issued guidance, as amended in subsequent updates, establishing a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and superseding most of the existing revenue recognition guidance. The standard also requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services and also requires certain additional disclosures. This guidance became effective for the reporting periods beginning on or after December 15, 2017, and interim periods within those fiscal years. We adopted this guidance on a modified retrospective basis beginning January 1, 2018, and the adoption of this guidance did not have a material impact on our consolidated financial statements.

In February 2016, the FASB issued guidance requiring lessees to recognize a lease liability and a right-of-use asset for all leases. Lessor accounting will remain largely unchanged with the exception of changes related to costs which qualify as initial direct costs. The guidance will also require new qualitative and quantitative disclosures to help financial statement users better understand the timing, amount and uncertainty of cash flows arising from leases. This guidance will be effective for reporting periods on or after December 15, 2018, with early adoption permitted. We will adopt this guidance on a modified retrospective basis beginning January 1, 2019, and such adoption will result in certain costs (primarily legal costs related to lease negotiations) being expensed rather than capitalized. We capitalized $24,000 in legal related costs for the nine months ended September 30, 2018.

In March 2016, the FASB issued guidance simplifying the accounting for share-based payment transactions, including the income tax consequences, balance sheet classification of awards and the classification on the statement of cash flows. We adopted this guidance as of January 1, 2017. The main provision regarding excess tax benefits did not have an impact on our consolidated financial statements due to our status as a REIT for federal income tax purposes. We have elected to continue estimating the number of shares expected to vest in order to determine compensation cost, and we will continue to classify cash paid by us for employee taxes when common shares were repurchased to cover minimum statutory requirements under cash flows from financing activities.

In November 2016, the FASB issued guidance requiring that the statement of cash flows explain the change during the period in the total cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. This guidance became effective for the reporting periods beginning on or after December 15, 2017, and interim periods within those fiscal years. We adopted this guidance effective January 1, 2018, and we have reconciled cash and cash equivalents and restricted cash and restricted cash equivalents on a retrospective basis, whereas under the previous guidance, we reported restricted cash and restricted cash equivalents under cash flows from financing activities.

In January 2017, the FASB issued guidance clarifying the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or dispositions) of assets or businesses. This guidance became effective for the reporting periods beginning on or after December 15, 2017, and interim periods within those fiscal years. We adopted this guidance on a prospective basis beginning January 1, 2018 and believe the majority of our future acquisitions will qualify as asset acquisitions and the associated transaction costs will be capitalized as opposed to expensed under previous guidance.

In February 2017, the FASB issued guidance clarifying the scope of asset derecognition guidance, adding guidance for partial sales of nonfinancial assets and clarifying recognizing gains and losses from the transfer of nonfinancial assets in contracts with noncustomers. This guidance became effective for the reporting periods beginning on or after December 15, 2017, and interim periods within those fiscal years. We adopted this guidance on a modified retrospective basis beginning January 1, 2018, and the adoption of this guidance did not have a material impact on our consolidated financial statements.


10
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

3. MARKETABLE SECURITIES

In January 2018, we sold all of our remaining marketable securities and had no marketable securities as of September 30, 2018. All of our marketable securities were classified as available-for-sale securities as of December 31, 2017. Available-for-sale securities consisted of the following as of December 31, 2017 (in thousands):

 
 
December 31, 2017
 
 
Amortized Cost
 
Gains in Accumulated Other Comprehensive Income
 
Losses in Accumulated Other Comprehensive Income
 
Estimated Fair Value
Real estate sector common stock
 
$
50

 
$
—

 
$
(18
)
 
$
32

Total available-for-sale securities
 
$
50

 
$
—

 
$
(18
)
 
$
32


During the nine months ended September 30, 2018, available-for-sale securities were sold for total proceeds of $30,000. The gross realized loss on these sales during the nine months ended September 30, 2018 was $20,000. During the three months ended September 30, 2017, available-for-sale securities were sold for total proceeds of $306,000. The gross realized gain on these sales during the three months ended September 30, 2017 was $5,000. For purposes of determining gross realized gains and losses, the cost of securities sold is based on specific identification. A net unrealized holding loss on available-for-sale securities in the amount of $111,000 for the nine months ended September 30, 2017 has been included in accumulated other comprehensive income.

4. ACCRUED RENTS AND ACCOUNTS RECEIVABLE, NET

Accrued rents and accounts receivable, net consists of amounts accrued, billed and due from tenants, allowance for doubtful accounts and other receivables as follows (in thousands):

 
 
September 30, 2018
 
December 31, 2017
 
 
 
 
 
Tenant receivables
 
$
15,558

 
$
14,128

Accrued rents and other recoveries
 
15,482

 
15,620

Allowance for doubtful accounts
 
(9,291
)
 
(8,608
)
Other receivables
 
157

 
—

Total
 
$
21,906

 
$
21,140



11
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

5. UNAMORTIZED LEASE COMMISSIONS, LEGAL FEES AND LOAN COSTS

Costs which have been deferred consist of the following (in thousands):
 
 
September 30, 2018
 
December 31, 2017
 
 
 
 
 
Leasing commissions
 
$
8,649

 
$
7,861

Deferred legal cost
 
410

 
386

Deferred financing cost
 
4,076

 
4,071

Total cost
 
13,135

 
12,318

Less: leasing commissions accumulated amortization
 
(3,398
)
 
(3,046
)
Less: deferred legal cost accumulated amortization
 
(111
)
 
(52
)
Less: deferred financing cost accumulated amortization
 
(2,779
)
 
(2,063
)
Total cost, net of accumulated amortization
 
$
6,847

 
$
7,157


6. INVESTMENT IN REAL ESTATE PARTNERSHIP

On December 8, 2016, we, through our Operating Partnership, entered into a Contribution Agreement (the “Contribution Agreement”) with Pillarstone OP and Pillarstone Capital REIT (“Pillarstone REIT”) pursuant to which we contributed all of the equity interests in four of our wholly-owned subsidiaries: Whitestone CP Woodland Ph. 2, LLC, a Delaware limited liability company (“CP Woodland”); Whitestone Industrial-Office, LLC, a Texas limited liability company (“Industrial-Office”); Whitestone Offices, LLC, a Texas limited liability company (“Whitestone Offices”); and Whitestone Uptown Tower, LLC, a Delaware limited liability company (“Uptown Tower,” and together with CP Woodland, Industrial-Office and Whitestone Offices, the “Entities”) that own 14 non-core properties that do not fit our Community Centered Property® strategy (the “Pillarstone Properties”), to Pillarstone OP for aggregate consideration of approximately $84 million, consisting of (1) approximately $18.1 million of Class A units representing limited partnership interests in Pillarstone OP (“Pillarstone OP Units”), issued at a price of $1.331 per Pillarstone OP Unit; and (2) the assumption of approximately $65.9 million of liabilities, consisting of (a) approximately $15.5 million of our liability under the Facility (as defined in Note 7); (b) an approximately $16.3 million promissory note of Uptown Tower under the Loan Agreement, dated as of September 26, 2013, between Uptown Tower, as borrower, and U.S. Bank, National Association, as successor to Morgan Stanley Mortgage Capital Holdings LLC, as lender; and (c) an approximately $34.1 million promissory note (the “Industrial-Office Promissory Note”) of Industrial-Office issued under the Loan Agreement, dated as of November 26, 2013 (the “Industrial-Office Loan Agreement”), between Industrial-Office, as borrower, and Jackson National Life Insurance Company, as lender (collectively, the “Contribution”).

In connection with the Contribution, on December 8, 2016, the Operating Partnership entered into an OP Unit Purchase Agreement (the “OP Unit Purchase Agreement”) with Pillarstone REIT and Pillarstone OP pursuant to which the Operating Partnership agreed to purchase up to an aggregate of $3.0 million of Pillarstone OP Units at a price of $1.331 per Pillarstone OP Unit over the two-year term of the OP Unit Purchase Agreement on the terms set forth therein. The OP Unit Purchase Agreement contains customary closing conditions and the parties have made certain customary representations, warranties and indemnifications to each other in the OP Unit Purchase Agreement. In addition, pursuant to the OP Unit Purchase Agreement, in the event of a Change of Control (as defined therein) of the Company, Pillarstone OP shall have the right, but not the obligation, to repurchase the Pillarstone OP Units issued thereunder from the Operating Partnership at their initial issue price of $1.331 per Pillarstone OP Unit.


12
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

In connection with the Contribution, (1) with respect to each Pillarstone Property (other than Uptown Tower), Whitestone TRS, Inc., a subsidiary of the Company (“Whitestone TRS”), entered into a Management Agreement with the Entity that owns such Pillarstone Property and (2) with respect to Uptown Tower, Whitestone TRS entered into a Management Agreement with Pillarstone OP (collectively, the “Management Agreements”). Pursuant to the Management Agreements with respect to each Pillarstone Property (other than Uptown Tower), Whitestone TRS agreed to provide certain property management, leasing and day-to-day advisory and administrative services to such Pillarstone Property in exchange for (x) a monthly property management fee equal to 5.0% of the monthly revenues of such Pillarstone Property and (y) a monthly asset management fee equal to 0.125% of GAV (as defined in each Management Agreement as, generally, the purchase price of the respective Pillarstone Property based upon the purchase price allocations determined pursuant to the Contribution Agreement, excluding all indebtedness, liabilities or claims of any nature) of such Pillarstone Property. Pursuant to the Management Agreement with respect to Uptown Tower, Whitestone TRS agreed to provide certain property management, leasing and day-to-day advisory and administrative services to Pillarstone OP in exchange for (x) a monthly property management fee equal to 3.0% of the monthly revenues of Uptown Tower and (y) a monthly asset management fee equal to 0.125% of GAV of Uptown Tower. The initial term of each Management Agreement expired on December 31, 2017, after which each Management Agreement became automatically renewable on a month to month basis; provided that each Management Agreement can be terminated by either party thereto upon not less than thirty days' prior written notice to the other party. None of the Management Agreements had been terminated as of September 30, 2018.

In connection with the Contribution, on December 8, 2016, the Operating Partnership entered into a Tax Protection Agreement with Pillarstone REIT and Pillarstone pursuant to which Pillarstone agreed to indemnify the Operating Partnership for certain tax liabilities resulting from its recognition of income or gain prior to December 8, 2021 if such liabilities result from a transaction involving a direct or indirect taxable disposition of all or a portion of the Pillarstone Properties or if Pillarstone fails to maintain and allocate to the Operating Partnership for taxation purposes minimum levels of liabilities as specified in the Tax Protection Agreement, the result of which causes such recognition of income or gain and the Company incurs taxes that must be paid to maintain its REIT status for federal income tax purposes.

As of September 30, 2018, we owned approximately 81.4% of the total outstanding units of Pillarstone OP. Additionally, certain of our officers and trustees serve as officers and trustees of Pillarstone REIT. In connection with the Contribution, in December 2016, we determined that we were the primary beneficiary of Pillarstone OP, through our power to direct the activities of Pillarstone OP, additional working capital required by Pillarstone OP under the OP Unit Purchase Agreement and our obligation to absorb losses and receive benefits based on our ownership percentage. Accordingly, we accounted for Pillarstone OP as a VIE and fully consolidated it in our consolidated financial statements for the year ended December 31, 2016 and in the subsequent periods.

In November 2017, we received a comment letter from the Staff of the Division of Corporation Finance of the SEC (the “Staff”) relating to our Annual Report on Form 10-K for the year ended December 31, 2016. In their letter, the Staff requested that we provide them with an analysis to support our determination that Pillarstone OP is a VIE of which we are the primary beneficiary and that Pillarstone OP should be consolidated in our financial statements in accordance with GAAP. In response to the Staff’s comment, we provided the Staff with our analysis of our accounting and financial reporting obligations relating to our interest in Pillarstone. After communicating our analysis and conclusions to the Staff and responding to additional questions from the Staff relating to this matter, the Staff did not object to or otherwise take exception to our initial determinations at the time of the consummation of the Contribution in December 2016 but provided a verbal reminder that the determination of the primary beneficiary of a VIE should be continually reassessed, noting that the initial terms of the Management Agreements expired in December 2017, and suggesting that we consider pre-clearing future accounting treatment of Pillarstone OP with the Staff of the Office of the Chief Accountant (“OCA”).


13
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

In connection with the preparation and review of our financial statements for the quarter ended March 31, 2018, we concluded, in accordance with the Staff’s recommendation, and after consultation with our outside accounting advisors, that it would be prudent to seek the pre-clearance of the OCA of our proposed treatment of Pillarstone OP in our financial statements for such quarter. Accordingly, in April 2018, we submitted a letter to the OCA seeking their concurrence with our determinations that we maintained our status as the primary beneficiary of Pillarstone OP and, accordingly, should continue to consolidate Pillarstone in our financial statements for the quarter ended March 31, 2018 in accordance with GAAP. After further correspondence, including telephonic meetings between us, our advisors and the OCA, the OCA informed us that it objected to our conclusions that we were the primary beneficiary of Pillarstone OP and were required to consolidate it in our financial statements since the Contribution in December 2016 and during the subsequent periods. We respectfully disagreed with the OCA's determination and made a formal appeal to the Chief Accountant of the SEC.

On July 30, 2018, the Chief Accountant of the SEC informed us that our formal appeal was denied and that the OCA objected to our consolidation of Pillarstone OP in our financial statements under the VIE accounting guidance since the contribution in December 2016. As a result, we should not have consolidated Pillarstone OP in our financial statements under VIE accounting guidance in our historical financial statements for the years ended December 31, 2016 and 2017 and the interim periods. After consideration of the OCA's objection to our original accounting, we determined that the Contribution did not meet the requirements for derecognition of the underlying assets, and we have revised our accounting treatment accordingly. Management evaluated the materiality of the errors relating to our prior consolidation of Pillarstone OP quantitatively and qualitatively, and concluded that they were not material to the financial statements of any period presented, and elected to correct them in the accompanying prior period consolidated financial statements. See Note 2 for additional disclosure on our revised accounting treatment and the correction of an immaterial error as a result.

The carrying amounts and classification of certain assets and liabilities for Pillarstone OP are now reflected in our consolidated balance sheets according to the profit sharing method as of September 30, 2018 and December 31, 2017 and consisted of the following (in thousands):
 
 
September 30, 2018
 
December 31, 2017
Real estate assets, at cost
 
 
 
 
  Property
 
$
97,260

 
$
95,146

  Accumulated depreciation
 
(38,643
)
 
(35,980
)
    Total real estate assets
 
58,617

 
59,166

 
 
 
 
 
Investment in real estate partnership
 
2,770

 
4,095

 
 
 
 
 
Liabilities
 
 
 
 
  Notes payable(1)
 
$
(47,939
)
 
$
(48,840
)
 
 
 
 
 
Net carrying value
 
$
13,448

 
$
14,421


(1) 
Excludes approximately $14.5 million and $15.5 million in notes payable due to Whitestone as of September 30, 2018 and December 31, 2017, respectively.

The Company's maximum exposure to loss relating to Pillarstone OP is limited to its investment in Pillarstone OP and its guarantee of promissory notes issued to Pillarstone OP. Since the date of the Contribution, the Company has not provided financial support to Pillarstone OP that it was not previously contractually required to provide under the Management Agreements or OP Unit Purchase Agreement. The Company's maximum exposure to loss relating to Pillarstone OP as of September 30, 2018 and December 31, 2017 is as follows (in thousands):

14
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

 
 
September 30, 2018
 
December 31, 2017
Net carrying value
 
$
13,448

 
$
14,421

OP Unit Purchase Agreement
 
3,000

 
3,000

Notes payable (1)
 
62,412

 
64,313

Maximum exposure to loss
 
$
78,860

 
$
81,734


(1) 
Includes approximately $14.5 million and $15.5 million of Whitestone's liability under the Facility as of September 30, 2018 and December 31, 2017, respectively.
 

7. DEBT

Certain subsidiaries of Whitestone are the borrowers under various financing arrangements. These subsidiaries are separate legal entities, and their respective assets and credit are not available to satisfy the debt of Whitestone or any of its other subsidiaries.

Debt consisted of the following as of the dates indicated (in thousands):
Description
 
September 30, 2018
 
December 31, 2017
Fixed rate notes
 
 
 
 
$10.5 million, LIBOR plus 2.00% Note, due September 24, 2020 (1)
 
$
9,560

 
$
9,740

$50.0 million, 1.75% plus 1.35% to 1.90% Note, due October 30, 2020 (2)
 
50,000

 
50,000

$50.0 million, 1.50% plus 1.35% to 1.90% Note, due January 29, 2021 (3)
 
50,000

 
50,000

$100.0 million, 1.73% plus 1.65% to 2.25% Note, due October 30, 2022 (4)
 
100,000

 
100,000

$80.0 million, 3.72% Note, due June 1, 2027
 
80,000

 
80,000

$37.0 million 3.76% Note, due December 1, 2020 (5)
 
32,359

 
33,148

$6.5 million 3.80% Note, due January 1, 2019
 
5,704

 
5,842

$19.0 million 4.15% Note, due December 1, 2024
 
19,000

 
19,000

$20.2 million 4.28% Note, due June 6, 2023
 
19,089

 
19,360

$14.0 million 4.34% Note, due September 11, 2024
 
13,776

 
13,944

$14.3 million 4.34% Note, due September 11, 2024
 
14,300

 
14,300

$16.5 million 4.97% Note, due September 26, 2023 (5)
 
15,870

 
16,058

$15.1 million 4.99% Note, due January 6, 2024
 
14,700

 
14,865

$2.6 million 5.46% Note, due October 1, 2023
 
2,441

 
2,472

$1.3 million 3.47% Note, due November 28, 2018
 
255

 
—

Floating rate notes
 
 
 
 
Unsecured line of credit, LIBOR plus 1.40% to 1.95%, due October 30, 2019 (6)
 
241,200

 
232,200

Total notes payable principal
 
668,254

 
660,929

Less deferred financing costs, net of accumulated amortization
 
(1,630
)
 
(1,861
)
Total notes payable
 
$
666,624

 
$
659,068


(1) 
Promissory note includes an interest rate swap that fixed the interest rate at 3.55% through September 24, 2018 and 4.85% beginning September 24, 2018 through September 24, 2020.

(2) 
Promissory note includes an interest rate swap that fixed the LIBOR portion of Term Loan 1 (as defined below) at 0.84% through February 3, 2017 and 1.75% beginning February 3, 2017 through October 30, 2020.


15
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

(3) 
Promissory note includes an interest rate swap that fixed the LIBOR portion of Term Loan 2 (as defined below) at 1.50%.

(4) 
Promissory note includes an interest rate swap that fixed the LIBOR portion of Term Loan 3 (as defined below) at 1.73%,

(5) 
Promissory notes were assumed by Pillarstone OP in December 2016 and included in our consolidated balance sheets under the profit-sharing method of accounting as discussed in Note 2.

(6) 
Unsecured line of credit includes certain Pillarstone Properties (as defined and described in more detail below) in determining the amount of credit available under the Facility (as defined and described in more detail below).

On May 26, 2017, we, through our subsidiary, Whitestone Houston BLVD Place LLC, a Delaware limited liability company, issued an $80.0 million promissory note to American General Life Insurance Company (the “BLVD Note”). The BLVD Note has a fixed interest rate of 3.72% and a maturity date of June 1, 2027. Proceeds from the BLVD Note were used to fund a portion of the purchase price of the acquisition of BLVD Place (see Note 15 below).

On November 7, 2014, we, through our Operating Partnership, entered into an unsecured revolving credit facility (the “2014 Facility”) with the lenders party thereto, with BMO Capital Markets, Wells Fargo Securities, LLC, Merrill Lynch, Pierce, Fenner & Smith Incorporated, and U.S. Bank, National Association, as co-lead arrangers and joint book runners, and Bank of Montreal, as administrative agent (the “Agent”). The 2014 Facility amended and restated our previous unsecured revolving credit facility. On October 30, 2015, we, through our Operating Partnership, entered into the First Amendment to the 2014 Facility (the “First Amendment”) with the guarantors party thereto, the lenders party thereto and the Agent. We refer to the 2014 Facility, as amended by the First Amendment, as the “Facility.”

Pursuant to the First Amendment, the Company made the following amendments to the 2014 Facility:

•
extended the maturity date of the $300 million unsecured revolving credit facility under the 2014 Facility (the “Revolver”) to October 30, 2019 from November 7, 2018;

•
converted $100 million of outstanding borrowings under the Revolver to a new $100 million unsecured term loan under the 2014 Facility (“Term Loan 3”) with a maturity date of October 30, 2022;

•
extended the maturity date of the first $50 million unsecured term loan under the 2014 Facility (“Term Loan 1”) to October 30, 2020 from February 17, 2017; and

•
extended the maturity date of the second $50 million unsecured term loan under the 2014 Facility (“Term Loan 2” and together with Term Loan 1 and Term Loan 3, the “Term Loans”) to January 29, 2021 from November 7, 2019.
    
Borrowings under the Facility accrue interest (at the Operating Partnership's option) at a Base Rate or an Adjusted LIBOR plus an applicable margin based upon our then existing leverage. The applicable margin for Adjusted LIBOR borrowings ranges from 1.40% to 1.95% for the Revolver and 1.35% to 2.25% for the Term Loans. Base Rate means the higher of: (a) the Agent's prime commercial rate, (b) the sum of (i) the average rate quoted by the Agent by two or more federal funds brokers selected by the Agent for sale to the Agent at face value of federal funds in the secondary market in an amount equal or comparable to the principal amount for which such rate is being determined, plus (ii) 1/2 of 1.00%, and (c) the LIBOR rate for such day plus 1.00%. Adjusted LIBOR means LIBOR divided by one minus the Eurodollar Reserve Percentage. The Eurodollar Reserve Percentage means the maximum reserve percentage at which reserves are imposed by the Board of Governors of the Federal Reserve System on eurocurrency liabilities.

We serve as the guarantor for funds borrowed by the Operating Partnership under the Facility. The Facility contains customary terms and conditions, including, without limitation, affirmative and negative covenants such as information reporting requirements, maximum secured indebtedness to total asset value, minimum EBITDA (earnings before interest, taxes, depreciation, amortization or extraordinary items) to fixed charges, and maintenance of a minimum net worth. The Facility also contains customary events of default with customary notice and cure, including, without limitation, nonpayment, breach of covenant, misrepresentation of representations and warranties in a material respect, cross-default to other major indebtedness, change of control, bankruptcy and loss of REIT tax status.


16
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

The Facility includes an accordion feature that will allow the Operating Partnership to increase the borrowing capacity to $700 million, upon the satisfaction of certain conditions, including new commitments from lenders. As of September 30, 2018, $441.2 million was drawn on the Facility, and our remaining borrowing capacity was $58.8 million. Proceeds from the Facility were used for general corporate purposes, including property acquisitions, debt repayment, capital expenditures, the expansion, redevelopment and retenanting of properties in our portfolio and working capital. We intend to use any additional proceeds from the Facility for general corporate purposes, including property acquisitions, debt repayment, capital expenditure, the expansion, redevelopment and re-tenanting of properties in our portfolio and working capital.

On December 8, 2016, in connection with the Contribution, the Operating Partnership entered into the Second Amendment to the Facility and Reaffirmation of Guaranties (the “Second Amendment”) with Pillarstone OP, the Company and the other Guarantors party thereto, the lenders party thereto and the Agent. Pursuant to the Second Amendment, following the Contribution, Whitestone Offices, LLC and Whitestone CP Woodland Ph. 2, LLC were permitted to remain Material Subsidiaries (as defined in the Facility) and Guarantors under the Facility and their respective Pillarstone Properties were each permitted to remain an Eligible Property (as defined in the Facility) and be included in the Borrowing Base (as defined in the Facility) under the Facility. In addition, on December 8, 2016, Pillarstone OP entered into the Limited Guarantee (the “Limited Guarantee”) with the Agent, pursuant to which Pillarstone OP agreed to be joined as a party to the Facility to provide a limited guarantee up to the amount of availability generated by the Pillarstone Properties owned by Whitestone Offices, LLC and Whitestone CP Woodland Ph. 2, LLC. As of September 30, 2018, Pillarstone accounted for approximately $14.5 million of the total amount drawn on the Facility.

As of September 30, 2018, our $226.8 million in secured debt was collateralized by 19 properties with a carrying value of $322.1 million.  Our loans contain restrictions that would require the payment of prepayment penalties for the acceleration of outstanding debt and are secured by deeds of trust on certain of our properties and by assignment of the rents and leases associated with those properties.  As of September 30, 2018, our tangible Net Worth (as defined in the Facility) was $343.4 million and, as a result, we were not in compliance with respect to the tangible Net Worth covenant in the Facility, which states that the tangible Net Worth of the Company shall not be less than the sum of $217.0 million plus 85% of the aggregate net proceeds received by the Company after December 8, 2016 in connection with any offering of stock or stock equivalents, or $350.6 million as of September 30, 2018. We have received two waivers as of September 30, 2018 and can make no assurances that we will be in compliance with this covenant or other covenants under the Facility in future periods or, if we are not in compliance, that we will be able to obtain another waiver. Had we been unable to obtain a waiver or other suitable relief from the lenders under the Facility, an Event of Default (as defined in the Facility) would have occurred, permitting the lenders holding a majority of the commitments under the Facility to, among other things, accelerate the outstanding indebtedness, which would make it immediately due and payable. We are working with the lenders on an amendment to the Facility that would reset at a new threshold and change the definition of Net Worth to add back accumulated depreciation. We expect to have the amendment completed by December 31, 2018.

Scheduled maturities of our outstanding debt as of September 30, 2018 were as follows (in thousands):
Year
 
Amount Due
 
 
 
2018
 
$
1,032

2019
 
249,489

2020
 
92,087

2021
 
51,918

2022
 
102,007

Thereafter
 
171,721

Total
 
$
668,254

 

17
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

8.  DERIVATIVES AND HEDGING ACTIVITIES

The fair value of our interest rate swaps is as follows (in thousands):
 
 
Balance Sheet Location
 
Estimated Fair Value
Interest rate swaps:
 
 
 
 
September 30, 2018
 
Prepaid expenses and other assets
 
$
7,198

December 31, 2017
 
Prepaid expenses and other assets
 
$
3,036


On November 19, 2015, we, through our Operating Partnership, entered into an interest rate swap with Bank of Montreal that fixed the LIBOR portion of Term Loan 3 under the Facility at 1.725%. In the fourth quarter of 2015, pursuant to the terms of the agreement governing the interest rate swap, Bank of Montreal assigned $35.0 million of the swap to U.S. Bank, National Association, and $15.0 million of the swap to SunTrust Bank. See Note 7 for additional information regarding the Facility. The swap began on November 30, 2015 and will mature on October 28, 2022. We have designated the interest rate swap as a cash flow hedge with the effective portion of the changes in fair value to be recorded in comprehensive income and subsequently reclassified into earnings in the period that the hedged transaction affects earnings. The ineffective portion of the change in fair value, if any, will be recognized directly in earnings.

On November 19, 2015, we, through our Operating Partnership, entered into an interest rate swap with Bank of Montreal that fixed the LIBOR portion of Term Loan 1 under the Facility at 1.75%. In the fourth quarter of 2015, pursuant to the terms of the agreement governing the interest rate swap, Bank of Montreal assigned $3.8 million of the swap to Regions Bank, $6.5 million of the swap to U.S. Bank, National Association, $14.0 million of the swap to Wells Fargo Bank, National Association, $14.0 million of the swap to Bank of America, N.A., and $5.0 million of the swap to SunTrust Bank. See Note 7 for additional information regarding the Facility. The swap began on February 3, 2017 and will mature on October 30, 2020. We have designated the interest rate swap as a cash flow hedge with the effective portion of the changes in fair value to be recorded in comprehensive income and subsequently reclassified into earnings in the period that the hedged transaction affects earnings. The ineffective portion of the change in fair value, if any, will be recognized directly in earnings.

On November 19, 2015, we, through our Operating Partnership, entered into an interest rate swap with Bank of Montreal that fixed the LIBOR portion of Term Loan 2 under the Facility at 1.50%. In the fourth quarter of 2015, pursuant to the terms of the agreement governing the interest rate swap, Bank of Montreal assigned $3.8 million of the swap to Regions Bank, $6.5 million of the swap to U.S. Bank, National Association, $14.0 million of the swap to Wells Fargo Bank, National Association, $14.0 million of the swap to Bank of America, N.A., and $5.0 million of the swap to SunTrust Bank. See Note 7 for additional information regarding the Facility. The swap began on December 7, 2015 and will mature on January 29, 2021. We have designated the interest rate swap as a cash flow hedge with the effective portion of the changes in fair value to be recorded in comprehensive income and subsequently reclassified into earnings in the period that the hedged transaction affects earnings. The ineffective portion of the change in fair value, if any, will be recognized directly in earnings.

A summary of our interest rate swap activity is as follows (in thousands):
 
 
Amount Recognized as Comprehensive Income (Loss)
 
Location of Income (Loss) Recognized in Earnings
 
Amount of Income (Loss) Recognized in Earnings (1)
Three months ended September 30, 2018
 
$
606

 
Interest expense
 
$
231

Three months ended September 30, 2017
 
$
172

 
Interest expense
 
$
(317
)
 
 
 
 
 
 
 
Nine months ended September 30, 2018
 
$
4,163

 
Interest expense
 
$
335

Nine months ended September 30, 2017
 
$
124

 
Interest expense
 
$
(1,266
)

(1) 
There was no ineffective portion of our interest rate swaps to recognize in earnings for the three and nine months ended September 30, 2018 and 2017.


18
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

9.  EARNINGS PER SHARE
 
Basic earnings per share for our common shareholders is calculated by dividing income from continuing operations excluding the net income attributable to unvested restricted common shares and the net income attributable to noncontrolling interests, by our weighted average common shares outstanding during the period.  Diluted earnings per share is computed by dividing the net income attributable to common shareholders, excluding the net income attributable to unvested restricted common shares and the net income attributable to noncontrolling interests, by the weighted average number of common shares including any dilutive unvested restricted common shares.
 
Certain of our performance-based restricted common shares are considered participating securities that require the use of the two-class method for the computation of basic and diluted earnings per share.  During the three months ended September 30, 2018 and 2017, 1,002,026 and 1,083,647 OP units, respectively, were excluded from the calculation of diluted earnings per share because their effect would be anti-dilutive, and during the nine months ended September 30, 2018 and 2017, 1,039,147 and 1,089,876 OP units, respectively, were excluded from the calculation of diluted earnings per share because their effect would be anti-dilutive.
 
For the three months ended September 30, 2018 and 2017, distributions of $121,000 and $152,000, respectively, were made to holders of certain restricted common shares, $4,000 of which were charged against earnings in each period, and for the nine months ended September 30, 2018 and 2017, distributions of $237,000 and $356,000, respectively, were made to holders of certain restricted common shares, $12,000 of which were charged against earnings in each period. See Note 12 for information related to restricted common shares under the 2008 Plan.

 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
(in thousands, except per share data)
 
2018
 
2017
 
2018
 
2017
Numerator:
 
 
 
 
 
 
 
 
Net income
 
$
7,837

 
$
3,077

 
$
12,704

 
$
6,613

Less: Net income attributable to noncontrolling interests
 
(193
)
 
(84
)
 
(326
)
 
(201
)
Distributions paid on unvested restricted shares
 
(117
)
 
(148
)
 
(225
)
 
(344
)
Net income attributable to common shareholders excluding amounts attributable to unvested restricted shares
 
$
7,527

 
$
2,845

 
$
12,153

 
$
6,068

 
 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
 
Weighted average number of common shares - basic
 
39,327

 
37,992

 
39,200

 
34,406

Effect of dilutive securities:
 
 
 
 
 
 
 
 
Unvested restricted shares
 
1,308

 
597

 
1,341

 
805

Weighted average number of common shares - dilutive
 
40,635

 
38,589

 
40,541

 
35,211

 
 
 
 
 
 
 
 
 
Earnings Per Share:
 
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
 
Net income attributable to common shareholders excluding amounts attributable to unvested restricted shares
 
$
0.19

 
$
0.07

 
$
0.31

 
$
0.18

Diluted:
 
 
 
 
 
 
 
 
Net income attributable to common shareholders excluding amounts attributable to unvested restricted shares
 
$
0.19

 
$
0.07

 
$
0.30

 
$
0.17



19
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

10. INCOME TAXES
 
With the exception of our taxable REIT subsidiaries, federal income taxes are generally not provided because we intend to and believe we continue to qualify as a REIT under the provisions of the Internal Revenue Code of 1986, as amended (the “Code”), and because we have distributed and intend to continue to distribute all of our taxable income to our shareholders.  As a REIT, we must distribute at least 90% of our REIT taxable income to our shareholders and meet certain income sources and investment restriction requirements.  In addition, REITs are subject to a number of organizational and operational requirements.  If we fail to qualify as a REIT in any taxable year, we will be subject to federal income tax (including any applicable alternative minimum tax) on our taxable income at regular corporate tax rates.
 
We are subject to the Texas Margin Tax, which is computed by applying the applicable tax rate (0.75% for us) to the profit margin, which generally will be determined for us as total revenue less a 30% standard deduction.  Although the Texas Margin Tax is not an income tax, FASB ASC 740, “Income Taxes” applies to the Texas Margin Tax.  For the three months ended September 30, 2018 and 2017, we recognized approximately $113,000 and $122,000 in margin tax provision, respectively, and for the nine months ended September 30, 2018 and 2017, we recognized approximately $330,000 and $292,000 in margin tax provision, respectively.

11.  EQUITY

Common Shares    

Under our declaration of trust, as amended, we have authority to issue up to 400,000,000 common shares of beneficial interest, $0.001 par value per share, and up to 50,000,000 preferred shares of beneficial interest, $0.001 par value per share.
  
Equity Offerings

On April 25, 2017, we completed the sale of 8,018,500 common shares, including 1,018,500 common shares purchased by the underwriters upon exercise of their option to purchase additional common shares, at a public offering price per share of $13.00 (the “April 2017 Offering”). Total net proceeds from the April 2017 Offering, after deducting offering expenses, were approximately $99.9 million, which we contributed to the Operating Partnership in exchange for OP units. The Operating Partnership used the net proceeds from the April 2017 Offering to repay a portion of the Facility and for general corporate purposes, including funding a portion of the purchase price of BLVD Place and Eldorado Plaza.

On June 4, 2015, we entered into six amended and restated equity distribution agreements for an at-the-market equity distribution program (the “2015 equity distribution agreements”). Pursuant to the terms and conditions of the 2015 equity distribution agreements, we can issue and sell up to an aggregate of $50 million of our common shares. Actual sales will depend on a variety of factors to be determined by us from time to time, including (among others) market conditions, the trading price of our common shares, capital needs and our determinations of the appropriate sources of funding for us, and will be made in transactions that will be deemed to be “at-the-market” offerings as defined in Rule 415 under the Securities Act of 1933, as amended. We have no obligation to sell any of our common shares, and can at any time suspend offers under the 2015 equity distribution agreements or terminate the 2015 equity distribution agreements. We did not sell any common shares under the 2015 equity distribution agreements during the three and nine months ended September 30, 2018. During the three months ended September 30, 2017, we did not sell any common shares under the 2015 equity distribution agreements. During the nine months ended September 30, 2017, we sold 567,302 common shares under the 2015 equity distribution agreements, with net proceeds to us of approximately $7.7 million. In connection with such sales, we paid compensation of approximately $139,000 to the sales agents.

Operating Partnership Units 

Substantially all of our business is conducted through our Operating Partnership.  We are the sole general partner of the Operating Partnership.  As of September 30, 2018, we owned a 97.7% interest in the Operating Partnership.
 

20
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

Limited partners in the Operating Partnership holding OP units have the right to redeem their OP units for cash or, at our option, common shares at a ratio of one OP unit for one common share.  Distributions to OP unit holders are paid at the same rate per unit as distributions per share to holders of Whitestone common shares.  As of September 30, 2018 and December 31, 2017, there were 40,579,890 and 40,184,532 OP units outstanding, respectively.  We owned 39,651,283 and 39,100,951 OP units as of September 30, 2018 and December 31, 2017, respectively. The balance of the OP units is owned by third parties, including certain members of our board of trustees.  Our weighted average share ownership in the Operating Partnership was approximately 97.5% and 97.3% for the three months ended September 30, 2018 and 2017, respectively and approximately 97.4% and 97.0% for the nine months ended September 30, 2018 and 2017, respectively. During the three months ended September 30, 2018 and 2017, 79,565 and zero OP units, respectively, were redeemed for an equal number of common shares, and during the nine months ended September 30, 2018 and 2017, 154,974 and 18,989 OP units, respectively, were redeemed for an equal number of common shares.

 Distributions
 
The following table summarizes the cash distributions paid or payable to holders of common shares and to holders of noncontrolling OP units during each quarter of 2017 and the nine months ended September 30, 2018 (in thousands, except per share/per OP unit data):
 
 
Common Shares
 
Noncontrolling OP Unit Holders
 
Total
Quarter Paid
 
Distributions Per Common Share
 
Amount Paid
 
Distributions Per OP Unit
 
Amount Paid
 
 Amount Paid
2018
 
 
 
 
 
 
 
 
 
 
Third Quarter
 
$
0.2850

 
$
11,294

 
$
0.2850

 
$
286

 
$
11,580

Second Quarter
 
0.2850

 
11,203

 
0.2850

 
295

 
11,498

First Quarter
 
0.2850

 
11,145

 
0.2850

 
309

 
11,454

Total
 
$
0.8550

 
$
33,642

 
$
0.8550

 
$
890


$
34,532

 
 
 
 
 
 
 
 
 
 
 
2017
 
 
 
 
 
 
 
 
 
 
Fourth Quarter
 
$
0.2850

 
$
11,002

 
$
0.2850

 
$
309

 
$
11,311

Third Quarter
 
0.2850

 
10,948

 
0.2850

 
309

 
11,257

Second Quarter
 
0.2850

 
10,093

 
0.2850

 
310

 
10,403

First Quarter
 
0.2850

 
8,429

 
0.2850

 
313

 
8,742

Total
 
$
1.1400

 
$
40,472

 
$
1.1400

 
$
1,241

 
$
41,713


12.  INCENTIVE SHARE PLAN
 
On July 29, 2008, our shareholders approved the 2008 Plan. On December 22, 2010, our board of trustees amended the 2008 Plan to allow for awards in or related to Class B common shares pursuant to the 2008 Plan. On June 27, 2012, our Class B common shares were redesignated as “common shares.” The 2008 Plan, as amended, expired on July 29, 2018 and provided that awards may be made with respect to common shares of Whitestone or OP units, which may be redeemed for cash or, at our option, common shares of Whitestone. The maximum aggregate number of common shares issuable under the 2008 Plan was increased upon each issuance of common shares by Whitestone so that at any time the maximum number of common shares issuable under the 2008 Plan equaled 12.5% of the aggregate number of common shares of Whitestone and OP units issued and outstanding (other than common shares and/or OP units issued to or held by Whitestone).

The Compensation Committee of our board of trustees administered the 2008 Plan, except with respect to awards to non-employee trustees, for which the 2008 Plan was administered by our board of trustees.  The Compensation Committee is authorized to grant share options, including both incentive share options and non-qualified share options, as well as share appreciation rights, either with or without a related option. The Compensation Committee is also authorized to grant restricted common shares, restricted common share units, performance awards and other share-based awards. 


21
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

On April 2, 2014, the Compensation Committee approved the modification of the vesting provisions with respect to awards of an aggregate of 633,704 restricted common shares and restricted common share units granted under the 2008 Plan to certain of our employees. The modified time-based shares vested annually in three equal installments. The modified performance-based restricted common shares and restricted common share units were modified to include performance-based vesting based on achievement of certain absolute financial goals, as well as one to two years of time-based vesting post achievement of financial goals. Continued employment was required through the applicable vesting date. Additionally, 2,049,116 restricted performance-based common share units were granted with the same vesting conditions as the modified performance-based grants described above. If the performance targets are not met prior to December 31, 2018, any unvested performance-based restricted common shares and restricted common share units will be forfeited.

The Compensation Committee approved the grant of an aggregate of 320,000 and 143,000 time-based restricted common share units under the 2008 Plan on June 30, 2016 and 2015, respectively, to James C. Mastandrea and David K. Holeman.

On September 6, 2017, the Compensation Committee approved the grant of an aggregate of 267,783 performance-based restricted common share units under the 2008 Plan with market-based vesting conditions (the “TSR Units”) to certain of our employees. Vesting is contingent upon achieving Total Shareholder Return relative to the peer group defined in the TSR Unit award agreements over a three-year performance period. At the end of the performance period, the number of common shares awarded for each vested TSR Unit will vary from 0% to 200% depending on the Company's ranking in the peer group (the “TSR Peer Group Ranking”). Continued employment is required through the vesting date. The grant date fair value for each TSR Unit of $12.37 was determined using the Monte Carlo simulation method and is being recognized as share-based compensation expense ratably from the September 30, 2017 grant date to the end of the performance period, December 31, 2019. The Monte Carlo simulation model utilizes multiple input variables that determine the probability of satisfying the market condition stipulated in the award grant and calculates the fair value of the award. Expected volatilities utilized in the model were estimated using a historical period consistent with the performance period of approximately three years. The risk-free interest rate was based on the United States Treasury rate for a term commensurate with the expected life of the grant.

On September 6, 2017, the Compensation Committee approved the grant of an aggregate of 965,000 performance-based restricted common share units under the 2008 Plan which only vest immediately prior to the consummation of a Change in Control (as defined in the 2008 Plan) that occurs on or before September 30, 2024 (the “CIC Units”) to certain of our employees. Continued employment is required through the vesting date. If a Change in Control does not occur on or before September 30, 2024, the CIC Units shall be immediately forfeited. The Company considers a Change in Control on or before September 30, 2024 to be improbable, and no expense has been recognized for the CIC Units. If a Change in Control occurs, any outstanding CIC Units would be expensed immediately on the date of the Change in Control using the grant date fair value. The grant date fair value for each CIC Unit of $13.05 was determined based on the Company's closing share price on the grant date.

On March 16, 2018, the Compensation Committee approved the grant of an aggregate of 387,499 time-based restricted common share units under the 2008 Plan, which vest annually in three equal installments, and 4,300 performance-based restricted common share units to certain of our employees.

A summary of the share-based incentive plan activity as of and for the nine months ended September 30, 2018 is as follows:
 
 
Shares
 
Weighted Average
Grant Date
Fair Value
Non-vested at January 1, 2018
 
2,481,331

 
$
13.60

Granted
 
391,799

 
8.74

Vested
 
(400,690
)
 
14.34

Forfeited
 
(108,983
)
 
12.82

Non-vested at September 30, 2018
 
2,363,457

 
$
12.71

Available for grant at September 30, 2018
 
3,433,831

 
 

22
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)


A summary of our non-vested and vested shares activity for the nine months ended September 30, 2018 and years ended December 31, 2017 and 2016 is presented below:
 
 
Shares Granted
 
Shares Vested
 
 
Non-Vested Shares Issued
 
Weighted Average Grant-Date Fair Value
 
Vested Shares
 
Total Vest-Date Fair Value
 
 
 
 
 
 
 
 
(in thousands)
Nine Months Ended September 30, 2018
 
391,799

 
$
8.74

 
(400,690
)
 
$
5,744

Year Ended December 31, 2017
 
1,354,534

 
$
12.92

 
(881,710
)
 
$
12,829

Year Ended December 31, 2016
 
545,778

 
$
14.85

 
(734,261
)
 
$
10,577

    
Total compensation recognized in earnings for share-based payments was $1,497,000 and $2,704,000 for the three months ended September 30, 2018 and 2017, respectively, and $4,894,000 and $7,545,000 for the nine months ended September 30, 2018 and 2017, respectively.

Based on our current financial projections, we expect approximately 62% of the unvested awards, exclusive of 920,000 CIC Units, to vest over the next 30 months. As of September 30, 2018, there was approximately $1.7 million in unrecognized compensation cost related to outstanding non-vested TSR Units, which are expected to vest over a period of 15 months, and approximately $3.5 million in unrecognized compensation cost related to outstanding non-vested time-based shares, which are expected to be recognized over a period of approximately 30 months beginning on October 1, 2018.

We expect to record approximately $6.0 million in non-cash share-based compensation expense in 2018 and $4.1 million subsequent to 2018. The unrecognized share-based compensation cost is expected to vest over a weighted average period of 21 months. The dilutive impact of the performance-based shares will be included in the denominator of the earnings per share calculation beginning in the period that the performance conditions are expected to be met. The dilutive impact of the TSR Units is based on the Company's TSR Peer Group Ranking as of the reporting date and weighted according to the number of days outstanding in the period. As of September 30, 2018, the TSR Peer Group Ranking called for 200% attainment. The dilutive impact of the CIC Units is based on the probability of a Change in Control. Because the Company considers a Change in Control on or before September 30, 2024 to be improbable, no CIC Units are included in the Company's dilutive shares.

At our annual meeting of shareholders on May 11, 2017, our shareholders voted to approve the 2018 Long-Term Equity Incentive Ownership Plan (the “2018 Plan”). The 2018 Plan provides for the issuance of up to 3,433,831 common shares and OP units pursuant to awards under the 2018 Plan. The 2018 Plan became effective on July 30, 2018, which was the day after the 2008 Plan expired.
    
The Compensation Committee of our board of trustees administers the 2018 Plan, except with respect to awards to non-employee trustees, for which the 2018 Plan is administered by our board of trustees.  The Compensation Committee is authorized to grant share options, including both incentive share options and non-qualified share options, as well as share appreciation rights, either with or without a related option. The Compensation Committee is also authorized to grant restricted common shares, restricted common share units, performance awards and other share-based awards.


13. GRANTS TO TRUSTEES

On December 12, 2017, each of our six independent trustees and one trustee emeritus were granted 3,000 common shares, which vested immediately and were prorated based on date appointed. The 16,281 common shares granted to our trustees had a grant date fair value of $14.46 per share. On December 12, 2017, three of our independent trustees each elected to receive a total of 2,320 common shares with a grant date fair value of $14.46 in lieu of cash for board fees. The fair value of the shares granted were determined using quoted prices available on the date of grant.


23
WHITESTONE REIT AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2018
(Unaudited)

14. SEGMENT INFORMATION

Historically, our management has not differentiated results of operations by property type or location and, therefore, does not present segment information.

15. REAL ESTATE

Property acquisitions. On May 26, 2017, we acquired BLVD Place, a property that meets our Community Centered Property® strategy, for $158.0 million, including $80.0 million of asset level mortgage financing and $78.0 million in cash and net prorations using borrowings under our Facility and a portion of the net proceeds from the April 2017 Offering. BLVD Place, a 216,944 square foot property, was 99% leased at the time of purchase and is located in Houston, Texas. Included in the purchase of BLVD Place is approximately 1.43 acres of developable land.
    
On May 3, 2017, we acquired Eldorado Plaza, a property that meets our Community Centered Property® strategy, for $46.6 million in cash and net prorations using borrowings under our Facility and a portion of the net proceeds from the April 2017 Offering. Eldorado Plaza, a 221,577 square foot property, was 96% leased at the time of purchase and is located in McKinney, Texas, a suburb of Dallas, Texas.
        
Development properties. As of March 31, 2017, we had substantially completed construction at our Pinnacle of Scottsdale Phase II property. As of September 30, 2018, we had incurred approximately $5.3 million in construction costs, including approximately $0.6 million in previously capitalized interest and real estate taxes. The 27,063 square foot Community Centered Property® was 91% leased as of September 30, 2018 and is located in Scottsdale, Arizona, adjacent to our Pinnacle of Scottsdale retail center.

On December 31, 2016, we had substantially completed construction at our Shops at Starwood Phase III property. As of September 30, 2018, we had incurred approximately $8.4 million in construction costs, including approximately $1.1 million in previously capitalized interest and real estate taxes. The 35,351 square foot Community Centered Property® was 72% leased as of September 30, 2018 and is located in Frisco, Texas, a northern suburb of Dallas, Texas, adjacent to our Shops at Starwood retail center.

Property dispositions. On September 24, 2018, we completed the sale of Torrey Square, located in Houston, Texas, for $8.7 million. We recorded a gain on sale of $4.4 million. We have not included Torrey Square in discontinued operations as it did not meet the definition of discontinued operations.

On February 27, 2018, we completed the sale of Bellnott Square, located in Houston, Texas, for $4.7 million. We recorded a gain on sale of $0.3 million. We have not included Bellnott Square in discontinued operations as it did not meet the definition of discontinued operations.     

    
 


24

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations.

You should read the following discussion of our financial condition and results of operations in conjunction with our unaudited consolidated financial statements and the notes thereto included in this Quarterly Report on Form 10-Q (the “Report”), and the consolidated financial statements and the notes thereto and “Management's Discussion and Analysis of Financial Condition and Results of Operations” contained in our Annual Report on Form 10-K for the year ended December 31, 2017.  For more detailed information regarding the basis of presentation for the following information, you should read the notes to the unaudited consolidated financial statements included in this Report.

This Report contains forward-looking statements within the meaning of the federal securities laws, including discussion and analysis of our financial condition, pending acquisitions and the impact of such acquisitions on our financial condition and results of operations, anticipated capital expenditures required to complete projects, amounts of anticipated cash distributions to our shareholders in the future and other matters.  These forward-looking statements are not historical facts but are the intent, belief or current expectations of our management based on its knowledge and understanding of our business and industry.  Forward-looking statements are typically identified by the use of terms such as “may,” “will,” “should,” “potential,” “predicts,” “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates” or the negative of such terms and variations of these words and similar expressions, although not all forward-looking statements include these words.  These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond our control, are difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements.
     
Forward-looking statements that were true at the time made may ultimately prove to be incorrect or false.  You are cautioned not to place undue reliance on forward-looking statements, which reflect our management's view only as of the date of this Report.  We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results.  Factors that could cause actual results to differ materially from any forward-looking statements made in this Report include:

•
the imposition of federal income taxes if we fail to qualify as a real estate investment trust (“REIT”) in any taxable year or forego an opportunity to ensure REIT status;
•
uncertainties related to the national economy, the real estate industry in general and in our specific markets;
•
legislative or regulatory changes, including changes to laws governing REITs and the impact of the legislation commonly known as the Tax Cuts and Jobs Act;
•
adverse economic or real estate developments or natural disasters in Texas, Arizona or Illinois;
•
increases in interest rates, operating costs or general and administrative expenses, including those incurred in connection with the nomination of trustees by a shareholder;
•
availability and terms of capital and financing, both to fund our operations and to refinance our indebtedness as it matures;
•
decreases in rental rates or increases in vacancy rates;
•
litigation risks;
•
lease-up risks, including leasing risks arising from exclusivity and consent provisions in leases with significant tenants;
•
our inability to renew tenant leases or obtain new tenant leases upon the expiration of existing leases;
•
our inability to generate sufficient cash flows due to market conditions, competition, uninsured losses, changes in tax or other applicable laws;
•
the need to fund tenant improvements or other capital expenditures out of operating cash flow;
•
the risk that we are unable to raise capital for working capital, acquisitions or other uses on attractive terms or at all; and
•
our ability to regain compliance and to continue to comply with all covenants under the Facility.
 
The forward-looking statements should be read in light of these factors and the factors identified in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2017, as previously filed with the Securities and Exchange Commission (“SEC”) and of this Report below.
 
Overview

We are a fully-integrated real estate company that owns and operates commercial properties in culturally diverse markets in major metropolitan areas. Founded in 1998, we are internally managed with a portfolio of commercial properties in Texas, Arizona and Illinois.


25

In October 2006, our current management team joined the Company and adopted a strategic plan to acquire, redevelop, own and operate Community Centered Properties®.  We define Community Centered Properties® as visibly located properties in established or developing culturally diverse neighborhoods in our target markets. We market, lease and manage our centers to match tenants with the shared needs of the surrounding neighborhood.  Those needs may include specialty retail, grocery, restaurants and medical, educational and financial services.  Our goal is for each property to become a Whitestone-branded retail community that serves a neighboring five-mile radius around our property.  We employ and develop a diverse group of associates who understand the needs of our multicultural communities and tenants.

We serve as the general partner of Whitestone REIT Operating Partnership, L.P. (the “Operating Partnership”), which was formed on December 31, 1998 as a Delaware limited partnership. We currently conduct substantially all of our operations and activities through the Operating Partnership. As the general partner of the Operating Partnership, we have the exclusive power to manage and conduct the business of the Operating Partnership, subject to certain customary exceptions.

As of September 30, 2018, we owned or had a majority interest in 71 commercial properties consisting of:

Operating Portfolio

•
51 wholly-owned properties that meet our Community Centered Properties® strategy containing approximately 4.8 million square feet of gross leasable area (“GLA”) and having a total carrying amount (net of accumulated depreciation) of $924.7 million;

•
an interest in 14 properties that do not meet our Community Centered Properties® strategy containing approximately 1.5 million square feet of GLA and having a total carrying amount (net of accumulated depreciation) of $59.0 million; and

Redevelopment, New Acquisitions Portfolio

•
six parcels of land held for future development having a total carrying value of $17.4 million.

As of September 30, 2018, we had an aggregate of 1,690 tenants.  We have a diversified tenant base with our largest tenant comprising only 2.6% of our annualized rental revenues for the nine months ended September 30, 2018.  Lease terms for our properties range from less than one year for smaller tenants to over 15 years for larger tenants.  Our leases include minimum monthly lease payments and generally provide for tenant reimbursements for payment of taxes, insurance and maintenance. We completed 339 new and renewal leases during the nine months ended September 30, 2018, totaling 945,957 square feet and approximately $78.9 million in total lease value.  This compares to 272 new and renewal leases totaling 727,223 square feet and approximately $56.4 million in total lease value during the same period in 2017.

We employed 96 full-time employees as of September 30, 2018.  As an internally managed REIT, we bear our own expenses of operations, including the salaries, benefits and other compensation of our employees, office expenses, legal, accounting and investor relations expenses and other overhead costs.

Pillarstone

In November 2017, we received a comment letter from the Staff of Division of Corporation Finance of the SEC (the “Staff”) relating to our Annual Report on Form 10-K for the year ended December 31, 2016. In their letter, the Staff requested that we provide them with an analysis to support our determination that Pillarstone OP is a VIE of which we are the primary beneficiary and that Pillarstone OP should be consolidated in our financial statements in accordance with GAAP. In response to the Staff’s comment, we provided the Staff with our analysis of our accounting and financial reporting obligations relating to our interest in Pillarstone. After communicating our analysis and conclusions to the Staff and responding to additional questions from the Staff relating to this matter, the Staff did not object to or otherwise take exception to our initial determinations at the time of the consummation of the Contribution in December 2016 but provided a verbal reminder that the determination of the primary beneficiary of a VIE should be continually reassessed, noting that the initial terms of the Management Agreements expired in December 2017, and suggesting that we consider pre-clearing future accounting treatment of Pillarstone OP with the Office of the Chief Accountant (“OCA”).


26

In connection with the preparation and review of our financial statements for the quarter ended March 31, 2018, we concluded, in accordance with the Staff’s recommendation, and after consultation with our outside accounting advisors, that it would be prudent to seek the pre-clearance of the OCA of our proposed treatment of Pillarstone OP in our financial statements for such quarter. Accordingly, in April 2018, we submitted a letter to the OCA seeking their concurrence with our determinations that we maintained our status as the primary beneficiary of Pillarstone OP and, accordingly, should continue to consolidate Pillarstone in our financial statements for the quarter ended March 31, 2018 in accordance with GAAP. After further correspondence, including telephonic meetings between us, our advisors and the OCA, the OCA informed us that it objected to our conclusions that we were the primary beneficiary of Pillarstone OP and were required to consolidate it in our financial statements since the Contribution in December 2016 and during the subsequent periods. We respectfully disagreed with the OCA’s determination and made a formal appeal to the Chief Accountant of the SEC.

On July 30, 2018, the Chief Accountant of the SEC informed us that our formal appeal was denied and that the OCA objected to our consolidation of Pillarstone OP in our financial statements under the VIE accounting guidance since the contribution in December 2016. As a result, we should not have consolidated Pillarstone OP in our financial statements under VIE accounting guidance in our historical financial statements for the years ended December 31, 2016 and 2017 and the interim periods. After consideration of the OCA’s objection to our original accounting, we determined that the Contribution did not meet the requirements for derecognition of the underlying assets, and we have revised our accounting treatment accordingly, pursuant to which we did not recognize the sale of assets to Pillarstone OP and accounted for the transaction under the profit-sharing method. Management evaluated the materiality of the errors relating to our prior consolidation of Pillarstone OP quantitatively and qualitatively, and concluded that they were not material to the financial statements of any period presented, and elected to correct them in the accompanying prior period consolidated financial statements.    
    
For more information, see Note 2 (Summary of Significant Accounting Policies—Profit-sharing Method) and Note 6 (Investment in Real Estate Partnership) to the accompanying consolidated financial statements.

April 2017 Offering

On April 25, 2017, we completed the sale of 8,018,500 common shares, including 1,018,500 common shares purchased by the underwriters upon exercise of their option to purchase additional common shares, at a public offering price per share of $13.00 (the “April 2017 Offering”). Total net proceeds from the April 2017 Offering, after deducting offering expenses, were approximately $99.9 million, which we contributed to the Operating Partnership in exchange for OP units. The Operating Partnership used the net proceeds from the April 2017 Offering to repay a portion of the Facility and for general corporate purposes, including funding a portion of the purchase price of BLVD Place and Eldorado Plaza.

How We Derive Our Revenue
 
Substantially all of our revenue is derived from rents received from leases at our properties. We had rental income and tenant reimbursements of approximately $34.6 million and $33.7 million for the three months ended September 30, 2018 and 2017, respectively, and $101.3 million and $92.1 million for the nine months ended September 30, 2018 and 2017, respectively.


Known Trends in Our Operations; Outlook for Future Results
 
Rental Income
 
We expect our rental income to increase year-over-year due to the addition of properties and rent increases on renewal leases. The amount of net rental income generated by our properties depends principally on our ability to maintain the occupancy rates of currently leased space and to lease currently available space, newly acquired properties with vacant space, and space available from unscheduled lease terminations. The amount of rental income we generate also depends on our ability to maintain or increase rental rates in our submarkets. Over the past three years, we have seen modest improvement in the overall economy in our markets, which has allowed us to maintain overall occupancy rates, with slight increases in occupancy at certain of our properties, and to recognize modest increases in rental rates. We expect this trend to continue in the foreseeable future. Rental income may decrease once the sale of the Pillarstone Properties is complete but will not have a material financial impact.
 

27

Scheduled Lease Expirations
 
We tend to lease space to smaller businesses that desire shorter term leases. As of September 30, 2018, approximately 20% of our GLA was subject to leases that expire prior to December 31, 2019.  Over the last three years, we have renewed expiring leases with respect to approximately 78% of our GLA. We routinely seek to renew leases with our existing tenants prior to their expiration and typically begin discussions with tenants as early as 24 months prior to the expiration date of the existing lease. Inasmuch as our early renewal program and other leasing and marketing efforts target these expiring leases, we hope to re-lease most of that space prior to expiration of the leases. In the markets in which we operate, we obtain and analyze market rental rates through review of third-party publications, which provide market and submarket rental rate data and through inquiry of property owners and property management companies as to rental rates being quoted at properties that are located in close proximity to our properties and we believe display similar physical attributes as our nearby properties. We use this data to negotiate leases with new tenants and renew leases with our existing tenants at rates we believe to be competitive in the markets for our individual properties. Due to the short term nature of our leases, and based upon our analysis of market rental rates, we believe that, in the aggregate, our current leases are at market rates. Market conditions, including new supply of properties, and macroeconomic conditions in our markets and nationally affecting tenant income, such as employment levels, business conditions, interest rates, tax rates, fuel and energy costs and other matters, could adversely impact our renewal rate and/or the rental rates we are able to negotiate. We continue to monitor our tenants' operating performances as well as overall economic trends to evaluate any future negative impact on our renewal rates and rental rates, which could adversely affect our cash flow and ability to make distributions to our shareholders.
 
General and Administrative Expenses

On December 29, 2017, a shareholder of the Company notified us of its intention to nominate three trustees to our board of trustees at our 2018 Annual Meeting of Shareholders, which process concluded in our favor in May 2018. The process resulted in an increase of $2.5 million in our general and administrative expenses.

Acquisitions
 
We seek to grow our GLA through the acquisition of additional properties, and we expect to actively pursue and consummate additional acquisitions in the foreseeable future. We believe that over the next few years we will continue to have excellent opportunities to acquire quality properties at historically attractive prices. We have extensive relationships with community banks, attorneys, title companies and others in the real estate industry, which we believe enables us to take advantage of these market opportunities and maintain an active acquisition pipeline.
 
Property Acquisitions, Dispositions and Development
 
We seek to acquire commercial properties in high-growth markets. Our acquisition targets are properties that fit our Community Centered Properties® strategy.  We may acquire properties in other high-growth cities in the future.

Property Dispositions. On September 24, 2018, we completed the sale of Torrey Square, located in Houston, Texas, for $8.7 million. We recorded a gain on sale of $4.4 million. We have not included Torrey Square in discontinued operations as it did not meet the definition of discontinued operations.     

On February 27, 2018, we completed the sale of Bellnott Square, located in Houston, Texas, for $4.7 million. We recorded a gain on sale of $0.3 million. We have not included Bellnott Square in discontinued operations as it did not meet the definition of discontinued operations.

    


28

On December 8, 2016, we, through our Operating Partnership, entered into a Contribution Agreement (the “Contribution Agreement”) with Pillarstone OP and Pillarstone Capital REIT (“Pillarstone REIT”) pursuant to which we contributed all of the equity interests in four of our wholly-owned subsidiaries: Whitestone CP Woodland Ph. 2, LLC, a Delaware limited liability company (“CP Woodland”); Whitestone Industrial-Office, LLC, a Texas limited liability company (“Industrial-Office”); Whitestone Offices, LLC, a Texas limited liability company (“Whitestone Offices”); and Whitestone Uptown Tower, LLC, a Delaware limited liability company (“Uptown Tower,” and together with CP Woodland, Industrial-Office and Whitestone Offices, the “Entities”) that own 14 non-core properties that do not fit our Community Centered Property® strategy (the “Pillarstone Properties”), to Pillarstone for aggregate consideration of approximately $84 million, consisting of (1) approximately $18.1 million Class A units representing limited partnership interests in Pillarstone (“Pillarstone OP Units”), issued at a price of $1.331 per Pillarstone OP Unit; and (2) the assumption of approximately $65.9 million of liabilities, consisting of (a) approximately $15.5 million of our liability under the Facility (as defined below)(see Note 7 (Debt) to the accompanying consolidated financial statements); (b) an approximately $16.3 million promissory note of Uptown Tower under the Loan Agreement, dated as of September 26, 2013, between Uptown Tower, as borrower, and U.S. Bank, National Association, as successor to Morgan Stanley Mortgage Capital Holdings LLC, as lender; and (c) an approximately $34.1 million promissory note (the “Industrial-Office Promissory Note”) of Industrial-Office issued under the Loan Agreement, dated as of November 26, 2013 (the “Industrial-Office Loan Agreement”), between Industrial-Office, as borrower, and Jackson National Life Insurance Company, as lender (collectively, the “Contribution”).

In connection with the Contribution, on December 8, 2016, the Operating Partnership entered into an OP Unit Purchase Agreement (the “OP Unit Purchase Agreement”) with Pillarstone REIT and Pillarstone pursuant to which the Operating Partnership agreed to purchase up to an aggregate of $3.0 million of Pillarstone OP Units at a price of $1.331 per Pillarstone OP Unit over the two-year term of the OP Unit Purchase Agreement on the terms set forth therein. The OP Unit Purchase Agreement contains customary closing conditions and the parties have made certain customary representations, warranties and indemnifications to each other in the OP Unit Purchase Agreement. In addition, pursuant to the OP Unit Purchase Agreement, in the event of a Change of Control (as defined therein) of the Company, Pillarstone shall have the right, but not the obligation, to repurchase the Pillarstone OP Units issued thereunder from the Operating Partnership at their initial issue price of $1.331 per Pillarstone OP Unit.

In connection with the Contribution, (1) with respect to each Pillarstone Property (other than Uptown Tower), Whitestone TRS, Inc., a subsidiary of the Company (“Whitestone TRS”), entered into a Management Agreement with the Entity that owns such Pillarstone Property and (2) with respect to Uptown Tower, Whitestone TRS entered into a Management Agreement with Pillarstone (collectively, the “Management Agreements”). Pursuant to the Management Agreements with respect to each Pillarstone Property (other than Uptown Tower), Whitestone TRS agreed to provide certain property management, leasing and day-to-day advisory and administrative services to such Pillarstone Property in exchange for (x) a monthly property management fee equal to 5.0% of the monthly revenues of such Pillarstone Property and (y) a monthly asset management fee equal to 0.125% of GAV (as defined in each Management Agreement as, generally, the purchase price of the respective Pillarstone Property based upon the purchase price allocations determined pursuant to the Contribution Agreement, excluding all indebtedness, liabilities or claims of any nature) of such Pillarstone Property. Pursuant to the Management Agreement with respect to Uptown Tower, Whitestone TRS agreed to provide certain property management, leasing and day-to-day advisory and administrative services to Pillarstone in exchange for (x) a monthly property management fee equal to 3.0% of the monthly revenues of Uptown Tower and (y) a monthly asset management fee equal to 0.125% of GAV of Uptown Tower. The initial term of each Management Agreement expired on December 31, 2017, after which each Management Agreement became automatically renewable on a month to month basis; provided that each Management Agreement can be terminated by either party thereto upon not less than thirty days' prior written notice to the other party. None of the Management Agreements had been terminated as of September 30, 2018.

In connection with the Contribution, on December 8, 2016, the Operating Partnership entered into a Tax Protection Agreement with Pillarstone REIT and Pillarstone pursuant to which Pillarstone agreed to indemnify the Operating Partnership for certain tax liabilities resulting from its recognition of income or gain prior to December 8, 2021 if such liabilities result from a transaction involving a direct or indirect taxable disposition of all or a portion of the Pillarstone Properties or if Pillarstone fails to maintain and allocate to the Operating Partnership for taxation purposes minimum levels of liabilities as specified in the Tax Protection Agreement, the result of which causes such recognition of income or gain and the Company incurs taxes that must be paid to maintain its REIT qualification for federal income tax purposes.


29

As of September 30, 2018, we owned approximately 81.4% of the total outstanding Pillarstone OP Units. Additionally, certain of our officers and trustees serve as officers and trustees of Pillarstone REIT. In connection with Contribution, in December 2016 we determined that we were the primary beneficiary of a VIE, Pillarstone OP, through our power to direct the activities of Pillarstone OP, additional working capital required by Pillarstone OP under the OP Unit Purchase Agreement and our obligation to absorb losses and receive benefits based on our ownership percentage. Accordingly, we accounted for Pillarstone OP as a VIE and fully consolidated it in our consolidated financial statements for the year ended December 31, 2016 and in the subsequent periods.
  
During the second quarter of 2018, we determined that certain prior period amounts contained errors due to our initial determination that we were the primary beneficiary of a variable interest entity, Pillarstone OP. We have revised our accounting treatment accordingly, pursuant to which we did not recognize the sale of assets to Pillarstone OP and accounted for the transaction under the profit-sharing method. See Note 2 (Summary of Significant Accounting Policies—Profit-sharing Method) and Note 6 (Investment in Real Estate Partnership) to the accompanying consolidated financial statements for additional disclosure on Pillarstone OP. Management evaluated the materiality of the errors quantitatively and qualitatively, and concluded that they were not material to the financial statements of any period presented, and elected to correct them in the accompanying prior period consolidated financial statements.

Property Acquisitions. On May 26, 2017, we acquired BLVD Place, a property that meets our Community Centered Property® strategy, for $158.0 million, including $80.0 million of asset level mortgage financing and $78.0 million in cash and net prorations using borrowings under our Facility and a portion of the net proceeds from the April 2017 Offering. BLVD Place, a 216,944 square foot property, was 99% leased at the time of purchase and is located in Houston, Texas. Included in the purchase of BLVD Place is approximately 1.43 acres of developable land.

On May 3, 2017, we acquired Eldorado Plaza, a property that meets our Community Centered Property® strategy, for $46.6 million in cash and net prorations using borrowings under our Facility and a portion of the net proceeds from the April 2017 Offering. Eldorado Plaza, a 221,577 square foot property, was 96% leased at the time of purchase and is located in McKinney, Texas, a suburb of Dallas, Texas.

Development Properties. As of March 31, 2017, we had substantially completed construction at our Pinnacle of Scottsdale Phase II property. As of September 30, 2018, we had incurred approximately $5.3 million in construction costs, including approximately $0.6 million in previously capitalized interest and real estate taxes. The 27,063 square foot Community Centered Property® was 91% leased as of September 30, 2018 and is located in Scottsdale, Arizona, adjacent to our Pinnacle of Scottsdale retail center.

On December 31, 2016, we had substantially completed construction at our Shops at Starwood Phase III property. As of September 30, 2018, we had incurred approximately $8.4 million in construction costs, including approximately $1.1 million in previously capitalized interest and real estate taxes. The 35,351 square foot Community Centered Property® was 72% leased as of September 30, 2018 and is located in Frisco, Texas, a northern suburb of Dallas, Texas, adjacent to our Shops at Starwood retail center.


30

Leasing Activity
    
As of September 30, 2018, we owned or held a majority interest in 71 properties with 6,373,380 square feet of GLA and our occupancy rate for all properties was approximately 89% and 87% occupied as of September 30, 2018 and 2017, respectively. The following is a summary of the Company's leasing activity for the nine months ended September 30, 2018:

 
 
Number of Leases Signed
 
GLA Signed
 
Weighted Average Lease Term (2)
 
TI and Incentives per Sq. Ft. (3)
 
Contractual Rent Per Sq. Ft (4)
 
Prior Contractual Rent Per Sq. Ft. (5)
 
Straight-lined Basis Increase Over Prior Rent
Comparable (1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
   Renewal Leases
 
186

 
457,671

 
3.8

 
$
3.10

 
$
16.60

 
$
15.87

 
12.8
%
   New Leases
 
45

 
92,851

 
4.8

 
7.45

 
18.21

 
18.41

 
8.9
%
   Total
 
231

 
550,522

 
4.0

 
$
3.83

 
$
16.87

 
$
16.30

 
12.1
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Number of Leases Signed
 
GLA Signed
 
Weighted Average Lease Term (2)
 
TI and Incentives per Sq. Ft. (3)
 
Contractual Rent Per Sq. Ft (4)
 
 
 
 
Non-Comparable
 
 
 
 
 
 
 
 
 
 
 
 
 
 
   Renewal Leases
 
2

 
22,296

 
4.2

 
$
7.69

 
$
17.16

 
 
 
 
   New Leases
 
106

 
373,139

 
4.8

 
10.72

 
14.83

 
 
 
 
   Total
 
108

 
395,435

 
4.8

 
$
10.55

 
$
14.96

 
 
 
 

(1)
Comparable leases represent leases signed on spaces for which there was a former tenant within the last twelve months and the new or renewal square footage was within 25% of the expired square footage.

(2) 
Weighted average lease term is determined on the basis of square footage.

(3) 
Estimated amount per signed leases. Actual cost of construction may vary. Does not include first generation costs for tenant improvements (“TI”) and leasing commission costs needed for new acquisitions or redevelopment of a property to bring to operating standards for its intended use.

(4) 
Contractual minimum rent under the new lease for the first month, excluding concessions.

(5) 
Contractual minimum rent under the prior lease for the final month.

Capital Expenditures

The following is a summary of the Company's capital expenditures for the three and nine months ended September 30, 2018 and 2017 (in thousands):

 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
 
 
2018
 
2017
 
2018
 
2017
Capital expenditures:
 
 
 
 
 
 
 
 
    Tenant improvements and allowances
 
$
1,784

 
$
1,944

 
$
4,233

 
$
4,821

    Developments / redevelopments
 
643

 
2,608

 
3,769

 
5,548

    Leasing commissions and costs
 
887

 
869

 
1,874

 
2,407

    Maintenance capital expenditures
 
1,307

 
668

 
3,298

 
3,130

      Total capital expenditures
 
$
4,621

 
$
6,089

 
$
13,174

 
$
15,906



31

Critical Accounting Policies

In preparing the consolidated financial statements, we have made estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenue and expenses during the reported periods. Actual results may differ from these estimates.  A summary of our critical accounting policies is included in our Annual Report on Form 10-K for the year ended December 31, 2017, under “Management's Discussion and Analysis of Financial Condition and Results of Operations.”  There have been no significant changes to these policies during the nine months ended September 30, 2018.  For disclosure regarding recent accounting pronouncements and the anticipated impact they will have on our operations, please refer to Note 2 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2017.


32




Results of Operations

Comparison of the Three Months Ended September 30, 2018 and 2017
 
The following table provides a summary comparison of our results of operations and other metrics for the three months ended September 30, 2018 and 2017 (dollars in thousands, except per share and per OP unit amounts):

 
 
Three Months Ended September 30,
 
 
2018
 
2017
Number of properties wholly-owned and operated
 
57

 
58

Aggregate GLA (sq. ft.)(1)
 
4,843,519

 
5,023,215

Ending occupancy rate - wholly-owned operating portfolio(1)
 
92
%
 
90
%
Ending occupancy rate - all wholly-owned properties
 
92
%
 
90
%
 
 
 
 
 
Number of properties managed
 
14

 
14

Aggregate GLA (sq. ft.)
 
1,529,861

 
1,531,737

Ending occupancy rate - managed operating portfolio
 
80
%
 
80
%
 
 
 
 
 
Total property revenues
 
$
34,596

 
$
33,653

Total property expenses
 
11,627

 
11,285

Total other expenses
 
19,309

 
19,062

Provision for income taxes
 
115

 
126

Gain on sale of properties
 
(4,380
)
 
—

Profit sharing expense
 
73

 
63

Loss on disposal of assets
 
15

 
40

Net income
 
7,837

 
3,077

Less:  Net income attributable to noncontrolling interests
 
193

 
84

Net income attributable to Whitestone REIT
 
$
7,644

 
$
2,993

 
 
 
 
 
Funds from operations (2)
 
$
10,694

 
$
10,129

Funds from operations core (3)
 
12,191

 
13,097

Property net operating income (4)
 
22,969

 
22,368

Distributions paid on common shares and OP units
 
11,580

 
11,257

Distributions per common share and OP unit
 
$
0.2850

 
$
0.2850

Distributions paid as a percentage of funds from operations core
 
95
%
 
86
%

(1)  
Excludes (i) new acquisitions, through the earlier of attainment of 90% occupancy or 18 months of ownership, and (ii) properties that are undergoing significant redevelopment or re-tenanting.

(2)  
For a reconciliation of funds from operations to net income, see “—Reconciliation of Non-GAAP Financial Measures—Funds From Operations (“FFO”)” below.

(3)  
For a reconciliation of funds from operations core to net income, see “—Reconciliation of Non-GAAP Financial Measures—FFO Core” below.

(4)  
For a reconciliation of property net operating income to net income, see “—Reconciliation of Non-GAAP Financial Measures—Property Net Operating Income (“NOI”)” below.


33

Property revenues. We had rental income and tenant reimbursements of approximately $34,596,000 for the three months ended September 30, 2018 as compared to $33,653,000 for the three months ended September 30, 2017, an increase of $943,000, or approximately 3%. The three months ended September 30, 2018 included $234,000 in increased revenues from the Pillarstone OP properties and $108,000 in decreased revenues from Non Same Stores. We define “Non-Same Stores” as properties acquired since the beginning of the period being compared and properties that have been sold, but not classified as discontinued operations. The decrease in Non-Same Store revenues is attributable to the disposal of Torrey Square on September 24, 2018. Same Store revenues increased $817,000 for the three months ended September 30, 2018 as compared to the same period in the prior year. We define “Same Stores” as properties that have been owned for the entire period being compared. For purposes of comparing the three months ended September 30, 2018 to the three months ended September 30, 2017, Same Stores include properties owned during the entire period from July 1, 2017 to September 30, 2018. Same Store revenue increased $373,000 for the three months ended September 30, 2018 as compared to the three months ended September 30, 2017 as the result of an increase in the average leased square feet to 4,438,000 from 4,382,000. The Same Store average revenue per leased square foot increased $0.40 for the three months ended September 30, 2018 to $27.20 per leased square foot as compared to the average revenue per leased square foot of $26.80 for the three months ended September 30, 2017, resulting in an increase of Same Store revenues of $444,000.

Property expenses.  Our property expenses were approximately $11,627,000 for the three months ended September 30, 2018 as compared to $11,285,000 for the three months ended September 30, 2017, an increase of $342,000, or approximately 3%.  The primary components of property expenses are detailed in the table below (in thousands, except percentages):

 
 
Three Months Ended September 30,
 
 
 
 
Overall Property Expenses
 
2018
 
2017
 
Change
 
% Change
Real estate taxes
 
$
5,253

 
$
5,181

 
$
72

 
1
 %
Utilities
 
1,731

 
1,594

 
137

 
9
 %
Contract services
 
2,097

 
1,930

 
167

 
9
 %
Repairs and maintenance
 
1,156

 
1,119

 
37

 
3
 %
Bad debt
 
354

 
535

 
(181
)
 
(34
)%
Labor and other
 
1,036

 
926

 
110

 
12
 %
Total property expenses
 
$
11,627

 
$
11,285

 
$
342

 
3
 %

 
 
Three Months Ended September 30,
 
 
 
 
Same Store Property Expenses
 
2018
 
2017
 
Change
 
% Change
Real estate taxes
 
$
4,302

 
$
4,189

 
$
113

 
3
 %
Utilities
 
1,350

 
1,318

 
32

 
2
 %
Contract services
 
1,832

 
1,626

 
206

 
13
 %
Repairs and maintenance
 
879

 
917

 
(38
)
 
(4
)%
Bad debt
 
372

 
460

 
(88
)
 
(19
)%
Labor and other
 
834

 
671

 
163

 
24
 %
Total property expenses
 
$
9,569

 
$
9,181

 
$
388

 
4
 %

 
 
Three Months Ended September 30,
 
 
 
 
Non-Same Store Property Expenses
 
2018
 
2017
 
Change
 
% Change
Real estate taxes
 
$
77

 
$
91

 
$
(14
)
 
Not meaningful
Utilities
 
25

 
22

 
3

 
Not meaningful
Contract services
 
7

 
21

 
(14
)
 
Not meaningful
Repairs and maintenance
 
7

 
24

 
(17
)
 
Not meaningful
Bad debt
 
(71
)
 
15

 
(86
)
 
Not meaningful
Labor and other
 
16

 
37

 
(21
)
 
Not meaningful
Total property expenses
 
$
61

 
$
210

 
$
(149
)
 
Not meaningful

34


Real estate taxes.  Real estate taxes increased approximately $72,000, or 1%, during the three months ended September 30, 2018 as compared to the same period in 2017. The real estate tax increase was comprised of an increase of $113,000, or 3%, in our Same Store properties, offset by decreases of $27,000 and $14,000 in Pillarstone OP and Non-Same Store properties, respectively. Many of the tax assessments on our properties are still under protest for 2018, and we expect to achieve further reductions through the litigation process. We actively work to keep our valuations and resulting taxes low because a majority of these taxes are charged to our tenants through triple net leases, and we strive to keep these charges to our tenants as low as possible.

Utilities. Utilities expenses increased approximately $137,000, or 9%, during the three months ended September 30, 2018 as compared to the same period in 2017. The utilities expense increase was comprised of increases of $102,000, $32,000 and $3,000 in Pillarstone OP, Same Store properties and Non-Same Store properties, respectively.

Contract services.  Contract services expenses increased approximately $167,000, or 9%, during the three months ended September 30, 2018 as compared to the same period in 2017. The contract services expenses increase was comprised of a $206,000 increase in our Same Store properties, offset by decreases of $25,000 and $14,000 in our Pillarstone OP and Non-Same Store properties, respectively. The Same Store increase of $206,000 was primarily comprised of landscaping costs for our Arizona properties.
  
Repairs and maintenance. Repairs and maintenance expenses increased approximately $37,000, or 3%, during the three months ended September 30, 2018 as compared to the same period in 2017. The repairs and maintenance expenses increase was comprised of a $92,000 increase in the Pillarstone OP properties and partially offset by decreases of $38,000 and $17,000 in our Same Store properties and Non-Same Store properties, respectively. The $92,000 increase in the Pillarstone OP properties was primarily comprised of roof repairs.
 
Bad debt.  Bad debt expenses decreased $181,000, or 34% during the three months ended September 30, 2018 as compared to the same period in 2017. The decrease in bad debt expenses was comprised of a $88,000, $86,000 and $7,000 in Same Store, Non-Same Store and Pillarstone OP properties, respectively.

Labor and other.  Labor and other expenses increased approximately $110,000, or 12%, during the three months ended September 30, 2018 as compared to the same period in 2017. The increased labor and other expense was comprised of $163,000 of increases in Same Store properties, offset by decreases of $32,000 and $21,000 in Pillarstone OP and Non-Same Store properties, respectively.

35


Same Store, Non-Same Store and Pillarstone OP net operating income. The components of Same Store, Non-Same Store, Pillarstone OP and total property net operating income and net income are detailed in the table below (in thousands):

 
 
Three Months Ended September 30,
 
 
 
Percent
 
 
2018
 
2017
 
Change
 
Change
Same Store (51 properties, exclusive of land held for development)
 
 
 
 
 
 
 
 
Property revenues
 
 
 
 
 
 
 
 
Rental revenues
 
$
21,781

 
$
21,413

 
$
368

 
2
 %
Other revenues
 
8,395

 
7,946

 
449

 
6
 %
Total property revenues
 
30,176

 
29,359

 
817

 
3
 %
 
 
 
 
 
 
 
 
 
Property expenses
 
 
 
 
 
 
 
 
Property operation and maintenance
 
5,267

 
4,992

 
275

 
6
 %
Real estate taxes
 
4,302

 
4,189

 
113

 
3
 %
Total property expenses
 
9,569

 
9,181

 
388

 
4
 %
 
 
 
 
 
 
 
 
 
Total Same Store net operating income
 
20,607

 
20,178

 
429

 
2
 %
 
 
 
 
 
 
 
 
 
Non-Same Store (2 Properties, exclusive of land held for development)
 
 
 
 
 
 
 
 
Property revenues
 
 
 
 
 
 
 
 
Rental revenues
 
184

 
262

 
(78
)
 
Not meaningful

Other revenues
 
96

 
126

 
(30
)
 
Not meaningful

Total property revenues
 
280

 
388

 
(108
)
 
Not meaningful

 
 
 
 
 
 
 
 
 
Property expenses
 
 
 
 
 
 
 
 
Property operation and maintenance
 
(16
)
 
119

 
(135
)
 
Not meaningful

Real estate taxes
 
77

 
91

 
(14
)
 
Not meaningful

Total property expenses
 
61

 
210

 
(149
)
 
Not meaningful

 
 
 
 
 
 
 
 
 
Total Non-Same Store net operating income
 
219

 
178

 
41

 
Not meaningful

 
 
 
 
 
 
 
 
 
Pillarstone OP properties (14 Properties)
 
 
 
 
 
 
 
 
Property revenues
 
 
 
 
 
 
 
 
Rental revenues
 
3,291

 
3,216

 
75

 
2
 %
Other revenues
 
849

 
690

 
159

 
23
 %
Total property revenues
 
4,140

 
3,906

 
234

 
6
 %
 
 
 
 
 
 
 
 
 
Property expenses
 
 
 
 
 
 
 
 
Property operation and maintenance
 
1,123

 
993

 
130

 
13
 %
Real estate taxes
 
874

 
901

 
(27
)
 
(3
)%
Total property expenses
 
1,997

 
1,894

 
103

 
5
 %
 
 
 
 
 
 
 
 
 
Total Pillarstone OP properties net operating income
 
2,143

 
2,012

 
131

 
7
 %
 
 
 
 
 
 
 
 
 
Total property net operating income
 
22,969

 
22,368

 
601

 
3
 %
 
 
 
 
 
 
 
 
 
Less total other expenses, provision for income taxes, gain on sale of properties, profit sharing expense and gain (loss) on disposal of assets
 
15,132

 
19,291

 
(4,159
)
 
(22
)%
 
 
 
 
 
 
 
 
 
Net income
 
$
7,837

 
$
3,077

 
$
4,760

 
155
 %


36

Other expenses.  Our other expenses were approximately $19,309,000 for the three months ended September 30, 2018, as compared to $19,062,000 for the three months ended September 30, 2017, an increase of $247,000, or 1%.  The primary components of other expenses are detailed in the table below (in thousands, except percentages):

 
 
Three Months Ended
 
 
 
 
 
 
September 30,
 
 
 
 
 
 
2018
 
2017
 
Change
 
% Change
General and administrative
 
$
4,959

 
$
5,581

 
$
(622
)
 
(11
)%
Depreciation and amortization
 
7,483

 
7,247

 
236

 
3
 %
Interest expense
 
6,951

 
6,376

 
575

 
9
 %
Interest, dividend and other investment income
 
(84
)
 
(142
)
 
58

 
(41
)%
Total other expenses
 
$
19,309

 
$
19,062

 
$
247

 
1
 %

General and administrative. General and administrative expenses decreased approximately $622,000, or 11%, for the three months ended September 30, 2018 as compared to the same period in 2017. The decrease was comprised of $1,207,000 in decreased share-based compensation expense, offset by increases of $228,000 in professional fees, $217,000 in salaries and benefits, net of allocated costs, $47,000 in information system costs, $42,000 in marketing costs and $51,000 in other expenses.

Total compensation recognized in earnings for share-based payments was $1,497,000 and $2,704,000 for the three months ended September 30, 2018 and 2017, respectively.
    
Depreciation and amortization. Depreciation and amortization increased $236,000, or 3%, for the three months ended September 30, 2018 as compared to the same period in 2017. Depreciation for improvements to Same Store properties increased $152,000 for the three months ended September 30, 2018 as compared to the same period in 2017. Depreciation for Non-Same Store properties decreased $44,000 and depreciation for Pillarstone OP properties increased $54,000. Lease commission amortization and depreciation of corporate assets increased $74,000 for the three months ended September 30, 2018 as compared to the same period in 2017.

Interest expense. Interest expense increased approximately $575,000, or 9%, for the three months ended September 30, 2018 as compared to the same period in 2017. The increase in interest expense is comprised of approximately $34,000 in increased interest expense resulting from a $3,693,000 increase in our average notes payable balance, a $546,000 increase in interest expense resulting from an increase in the average effective interest rate on our average notes payable from 3.64% to 3.96% and offset by a decrease in amortized loan fees included in interest expense of $5,000.

Interest, dividend and other investment income. Interest, dividend and other investment income decreased approximately $58,000, or 41%, for the three months ended September 30, 2018 as compared to the same period in 2017. The decrease in interest, dividend and other investment income for the three months ended September 30, 2018 as compared to the same period in 2017 is comprised of approximately $50,000 in decreased interest income, $5,000 in decreased gains on sales of available-for-sale securities and $3,000 in decreased dividend income.


37

Results of Operations

Comparison of the Nine Months Ended September 30, 2018 and 2017
 
The following table provides a summary comparison of our results of operations and other metrics for the nine months ended September 30, 2018 and 2017 (dollars in thousands, except per share and per OP unit amounts):

 
 
Nine Months Ended September 30,
 
 
2018
 
2017
Number of properties wholly-owned and operated
 
57

 
58

Aggregate GLA (sq. ft.)(1)
 
4,843,519

 
5,023,215

Ending occupancy rate - wholly-owned operating portfolio(1)
 
92
%
 
90
%
Ending occupancy rate - all wholly-owned properties
 
92
%
 
90
%
 
 
 
 
 
Number of properties managed
 
14

 
14

Aggregate GLA (sq. ft.)
 
1,529,861

 
1,531,737

Ending occupancy rate - managed operating portfolio
 
80
%
 
80
%
 
 
 
 
 
Total property revenues
 
$
101,264

 
$
92,128

Total property expenses
 
32,315

 
30,561

Total other expenses
 
60,001

 
54,311

Provision for income taxes
 
328

 
296

Gain on sale of properties
 
(4,646
)
 
(16
)
Profit sharing expense
 
276

 
228

Loss on disposal of assets
 
286

 
135

Net income
 
12,704

 
6,613

Less:  Net income attributable to noncontrolling interests
 
326

 
201

Net income attributable to Whitestone REIT
 
$
12,378

 
$
6,412

 
 
 
 
 
Funds from operations (2)
 
$
29,667

 
$
25,982

Funds from operations core (3)
 
37,095

 
34,925

Property net operating income (4)
 
68,949

 
61,567

Distributions paid on common shares and OP units
 
34,532

 
30,426

Distributions per common share and OP unit
 
$
0.8550

 
$
0.8550

Distributions paid as a percentage of funds from operations core
 
93
%
 
87
%

(1)  
Excludes (i) new acquisitions, through the earlier of attainment of 90% occupancy or 18 months of ownership, and (ii) properties that are undergoing significant redevelopment or re-tenanting.

(2)  
For a reconciliation of funds from operations to net income, see “—Reconciliation of Non-GAAP Financial Measures—Funds From Operations (“FFO”)” below.

(3)  
For a reconciliation of funds from operations core to net income, see “—Reconciliation of Non-GAAP Financial Measures—FFO Core” below.

(4)  
For a reconciliation of property net operating income to net income, see “—Reconciliation of Non-GAAP Financial Measures—Property Net Operating Income (“NOI”)” below.


38

Property revenues. We had rental income and tenant reimbursements of approximately $101,264,000 for the nine months ended September 30, 2018 as compared to $92,128,000 for the nine months ended September 30, 2017, an increase of $9,136,000, or 10%. The nine months ended September 30, 2018 included $7,268,000 in increased revenues from Non-Same Store operations resulting from the acquisitions in May 2017 of BLVD Place and Eldorado Plaza and $480,000 in increased revenues from Pillarstone OP. We define “Non-Same Stores” as properties acquired since the beginning of the period being compared and properties that have been sold, but not classified as discontinued operations. Same Store revenues increased $1,388,000 for the nine months ended September 30, 2018 as compared to the same period in the prior year. We define “Same Stores” as properties that have been owned for the entire period being compared. For purposes of comparing the nine months ended September 30, 2018 to the nine months ended September 30, 2017, Same Stores include properties owned during the entire period from January 1, 2017 to September 30, 2018. Same Store revenue increased $1,000,000 for the nine months ended September 30, 2018 as compared to the nine months ended September 30, 2017 as the result of an increase in the average leased square feet to 4,003,000 from 3,948,000. The Same Store average revenue per leased square foot increased $0.13 for the nine months ended September 30, 2018 to $24.50 per leased square foot as compared to the average revenue per leased square foot of $24.37 for the nine months ended September 30, 2017, resulting in an increase of Same Store revenues of $390,000.

Property expenses.  Our property expenses were approximately $32,315,000 for the nine months ended September 30, 2018 as compared to $30,561,000 for the nine months ended September 30, 2017, an increase of $1,754,000, or 6%.  The primary components of property expenses are detailed in the table below (in thousands, except percentages):

 
 
Nine Months Ended September 30,
 
 
 
 
Overall Property Expenses
 
2018
 
2017
 
Change
 
% Change
Real estate taxes
 
$
14,395

 
$
13,588

 
$
807

 
6
 %
Utilities
 
4,526

 
4,091

 
435

 
11
 %
Contract services
 
6,041

 
5,361

 
680

 
13
 %
Repairs and maintenance
 
3,368

 
3,212

 
156

 
5
 %
Bad debt
 
1,123

 
1,442

 
(319
)
 
(22
)%
Labor and other
 
2,862

 
2,867

 
(5
)
 
—
 %
Total property expenses
 
$
32,315

 
$
30,561

 
$
1,754

 
6
 %

 
 
Nine Months Ended September 30,
 
 
 
 
Same Store Property Expenses
 
2018
 
2017
 
Change
 
% Change
Real estate taxes
 
$
9,823

 
$
9,994

 
$
(171
)
 
(2
)%
Utilities
 
2,957

 
2,939

 
18

 
1
 %
Contract services
 
4,189

 
4,044

 
145

 
4
 %
Repairs and maintenance
 
2,344

 
2,568

 
(224
)
 
(9
)%
Bad debt
 
990

 
1,212

 
(222
)
 
(18
)%
Labor and other
 
2,057

 
2,009

 
48

 
2
 %
Total property expenses
 
$
22,360

 
$
22,766

 
$
(406
)
 
(2
)%

 
 
Nine Months Ended September 30,
 
 
 
 
Non-Same Store Property Expenses
 
2018
 
2017
 
Change
 
% Change
Real estate taxes
 
$
2,375

 
$
1,426

 
$
949

 
Not meaningful
Utilities
 
615

 
264

 
351

 
Not meaningful
Contract services
 
1,045

 
433

 
612

 
Not meaningful
Repairs and maintenance
 
343

 
97

 
246

 
Not meaningful
Bad debt
 
(20
)
 
108

 
(128
)
 
Not meaningful
Labor and other
 
203

 
163

 
40

 
Not meaningful
Total property expenses
 
$
4,561

 
$
2,491

 
$
2,070

 
Not meaningful

39


Real estate taxes.  Real estate taxes increased approximately $807,000, or 6%, during the nine months ended September 30, 2018 as compared to the same period in 2017. The real estate tax increase was comprised of increases of $949,000 and $29,000 in our Non-Same Store and Pillarstone OP properties, respectively, offset by a decrease of $171,000 in our Same Store properties. Many of the tax assessments on our properties are still under protest for 2018, and we expect to achieve further reductions through the litigation process. We actively work to keep our valuations and resulting taxes low because a majority of these taxes are charged to our tenants through triple net leases, and we strive to keep these charges to our tenants as low as possible.

Utilities. Utilities expenses increased approximately $435,000, or 11%, during the nine months ended September 30, 2018 as compared to the same period in 2017. Utility expenses increased $351,000, $66,000 and $18,000 in our Non-Same Store, Pillarstone OP and Same Store properties, respectively.

Contract services.  Contract services expenses increased approximately $680,000, or 13%, during the nine months ended September 30, 2018 as compared to the same period in 2017. The contract services expenses increase was comprised of $612,000 and $145,000 of increases in our Non-Same Store and Same Store properties, respectively, partially offset by a decrease of $77,000 in Pillarstone OP properties.
  
Repairs and maintenance. Repairs and maintenance expenses increased approximately $156,000, or 5%, during the nine months ended September 30, 2018 as compared to the same period in 2017. The repairs and maintenance expenses increase was comprised of increases of $246,000 and $134,000 in our Non-Same Store and Pillarstone OP properties, respectively, offset by a decrease of $224,000 in our Same Store properties.
 
Bad debt.  Bad debt expenses decreased $319,000, or 22% during the nine months ended September 30, 2018 as compared to the same period in 2017. The decrease in bad debt expenses was comprised of decreases of $222,000 and $128,000 in our Same Store and Non-Same store properties, respectively, partially offset by an increase of $31,000 from Pillarstone OP properties.

Labor and other.  Labor and other expenses decreased approximately $5,000, or 0%, during the nine months ended September 30, 2018 as compared to the same period in 2017. The decreased labor and other expense was comprised of $93,000 in our Pillarstone OP properties and partially offset by increases of $48,000 and $40,000 in our Same Store properties and Non-Same Store properties, respectively.

40


Same Store, Non-Same Store and Pillarstone OP net operating income. The components of Same Store, Non-Same Store, Pillarstone OP and total property net operating income and net income are detailed in the table below (in thousands):

 
 
Nine Months Ended September 30,
 
 
 
Percent
 
 
2018
 
2017
 
Change
 
Change
Same Store (49 properties, exclusive of land held for development)
 
 
 
 
 
 
 
 
Property revenues
 
 
 
 
 
 
 
 
Rental revenues
 
$
54,313

 
$
53,753

 
$
560

 
1
 %
Other revenues
 
19,243

 
18,415

 
828

 
4
 %
Total property revenues
 
73,556

 
72,168

 
1,388

 
2
 %
 
 
 
 
 
 
 
 
 
Property expenses
 
 
 
 
 
 
 
 
Property operation and maintenance
 
12,537

 
12,772

 
(235
)
 
(2
)%
Real estate taxes
 
9,823

 
9,994

 
(171
)
 
(2
)%
Total property expenses
 
22,360

 
22,766

 
(406
)
 
(2
)%
 
 
 
 
 
 
 
 
 
Total Same Store net operating income
 
51,196

 
49,402

 
1,794

 
4
 %
 
 
 
 
 
 
 
 
 
Non-Same Store (4 Properties, exclusive of land held for development)
 
 
 
 
 
 
 
 
Property revenues
 
 
 
 
 
 
 
 
Rental revenues
 
10,707

 
5,815

 
4,892

 
Not meaningful

Other revenues
 
4,946

 
2,570

 
2,376

 
Not meaningful

Total property revenues
 
15,653

 
8,385

 
7,268

 
Not meaningful

 
 
 
 
 
 
 
 
 
Property expenses
 
 
 
 
 
 
 
 
Property operation and maintenance
 
2,186

 
1,065

 
1,121

 
Not meaningful

Real estate taxes
 
2,375

 
1,426

 
949

 
Not meaningful

Total property expenses
 
4,561

 
2,491

 
2,070

 
Not meaningful

 
 
 
 
 
 
 
 
 
Total Non-Same Store net operating income
 
11,092

 
5,894

 
5,198

 
Not meaningful

 
 
 
 
 
 
 
 
 
Pillarstone OP properties (14 Properties)
 
 
 
 
 
 
 
 
Property revenues
 
 
 
 
 
 
 
 
Rental revenues
 
9,832

 
9,629

 
203

 
2
 %
Other revenues
 
2,223

 
1,946

 
277

 
14
 %
Total property revenues
 
12,055

 
11,575

 
480

 
4
 %
 
 
 
 
 
 
 
 
 
Property expenses
 
 
 
 
 
 
 
 
Property operation and maintenance
 
3,197

 
3,136

 
61

 
2
 %
Real estate taxes
 
2,197

 
2,168

 
29

 
1
 %
Total property expenses
 
5,394

 
5,304

 
90

 
2
 %
 
 
 
 
 
 
 
 
 
Total Pillarstone OP properties net operating income
 
6,661

 
6,271

 
390

 
6
 %
 
 
 
 
 
 
 
 
 
Total property net operating income
 
68,949

 
61,567

 
7,382

 
12
 %
 
 
 
 
 
 
 
 
 
Less total other expenses, provision for income taxes, gain on sale of properties, profit sharing expense and gain (loss) on disposal of assets
 
56,245

 
54,954

 
1,291

 
2
 %
 
 
 
 
 
 
 
 
 
Net income
 
$
12,704

 
$
6,613

 
$
6,091

 
92
 %



41

Other expenses.  Our other expenses were approximately $60,001,000 for the nine months ended September 30, 2018, as compared to $54,311,000 for the nine months ended September 30, 2017, an increase of $5,690,000, or 10%.  The primary components of other expenses are detailed in the table below (in thousands, except percentages):

 
 
Nine Months Ended
 
 
 
 
 
 
September 30,
 
 
 
 
 
 
2018
 
2017
 
Change
 
% Change
General and administrative
 
$
17,897

 
$
17,598

 
$
299

 
2
 %
Depreciation and amortization
 
22,100

 
19,936

 
2,164

 
11
 %
Interest expense
 
20,306

 
17,158

 
3,148

 
18
 %
Interest, dividend and other investment income
 
(302
)
 
(381
)
 
79

 
(21
)%
Total other expenses
 
$
60,001

 
$
54,311

 
$
5,690

 
10
 %

General and administrative. General and administrative expenses increased approximately $299,000, or 2%, for the nine months ended September 30, 2018 as compared to the same period in 2017. The increase was comprised of increases of $2,534,000 in professional fees and other expenses incurred in connection with our 2018 Annual Meeting of Shareholders, $617,000 of salaries and benefits, net of allocated costs and $36,000 of other expenses. The increases were partially offset by decreases of $2,651,000 in share-based compensation expense and $237,000 in acquisition costs.

Total compensation recognized in earnings for share-based payments was $4,894,000 and $7,545,000 for the nine months ended September 30, 2018 and 2017, respectively.

Depreciation and amortization. Depreciation and amortization increased $2,164,000, or 11%, for the nine months ended September 30, 2018 as compared to the same period in 2017. Depreciation for improvements to Same Store properties increased $551,000 for the nine months ended September 30, 2018 as compared to the same period in 2017. Depreciation for Non-Same Store properties increased $1,239,000 and depreciation for Pillarstone OP properties increased $155,000. Lease commission amortization and depreciation of corporate assets increased $219,000 for the nine months ended September 30, 2018 as compared to the same period in 2017.

Interest expense. Interest expense increased approximately $3,148,000, or 18%, for the nine months ended September 30, 2018 as compared to the same period in 2017. The increase in interest expense is comprised of approximately $1,574,000 in increased interest expense resulting from a $59,071,000 increase in our average notes payable balance, a $1,549,000 increase in interest expense resulting from an increase in the average effective interest rate on our average notes payable from 3.55% to 3.86% and an increase in amortized loan fees included in interest expense of $25,000.

Interest, dividend and other investment income. Interest, dividend and other investment income decreased approximately $79,000, or 21%, for the nine months ended September 30, 2018 as compared to the same period in 2017. The decrease in interest, dividend and other investment income for the nine months ended September 30, 2018 as compared to the same period in 2017 is comprised of approximately $43,000 in decreased interest income, $25,000 in realized losses from sales of available-for-sale securities, and $11,000 in decreased dividend income.


42

Reconciliation of Non-GAAP Financial Measures

Funds From Operations (“FFO”)
 
The National Association of Real Estate Investment Trusts (“Nareit”) defines FFO as net income (loss) available to common shareholders computed in accordance with U.S. GAAP, excluding gains or losses from sales of operating real estate assets, impairment charges on properties held for investment and extraordinary items, plus depreciation and amortization of operating properties, including our share of unconsolidated real estate joint ventures and partnerships.  We calculate FFO in a manner consistent with the Nareit definition.
 
Management uses FFO as a supplemental measure to conduct and evaluate our business because there are certain limitations associated with using U.S. GAAP net income (loss) alone as the primary measure of our operating performance. Historical cost accounting for real estate assets in accordance with U.S. GAAP implicitly assumes that the value of real estate assets diminishes predictably over time.  Because real estate values instead have historically risen or fallen with market conditions, management believes that the presentation of operating results for real estate companies that use historical cost accounting is insufficient by itself.  In addition, securities analysts, investors and other interested parties use FFO as the primary metric for comparing the relative performance of equity REITs.  

FFO should not be considered as an alternative to net income or other measurements under U.S. GAAP, as an indicator of our operating performance or to cash flows from operating, investing or financing activities as a measure of liquidity.  FFO does not reflect working capital changes, cash expenditures for capital improvements or principal payments on indebtedness. Although our calculation of FFO is consistent with that of Nareit, there can be no assurance that FFO presented by us is comparable to similarly titled measures of other REITs.

Funds From Operations Core (“FFO Core”)

Management believes that the computation of FFO in accordance with Nareit's definition includes certain items
that are not indicative of the results provided by our operating portfolio and affect the comparability of our period-over-period performance. These items include, but are not limited to, non-cash share-based compensation expense, proxy contest professional fees and acquisition costs. Therefore, in addition to FFO, management uses FFO Core, which we define to exclude such items. Management believes that these adjustments are appropriate in determining FFO Core as they are not indicative of the operating performance of our assets. In addition, we believe that FFO Core is a useful supplemental measure for the investing community to use in comparing us to other REITs as many REITs provide some form of adjusted or modified FFO. However, there can be no assurance that FFO Core presented by us is comparable to the adjusted or modified FFO of other REITs.

Below are the calculations of FFO and FFO Core and the reconciliations to net income, which we believe is the most comparable U.S. GAAP financial measure (in thousands):
 
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
FFO and FFO CORE
 
2018
 
2017
 
2018
 
2017
Net income attributable to Whitestone REIT
 
$
7,644

 
$
2,993

 
$
12,378

 
$
6,412

  Adjustments to reconcile to FFO:(1)
 
 
 
 
 
 
 
 
Depreciation and amortization of real estate assets
 
7,224

 
7,015

 
21,325

 
19,255

(Gain) loss on sale or disposal of assets and properties, net
 
(4,367
)
 
37

 
(4,362
)
 
114

Net income attributable to noncontrolling interests
 
193

 
84

 
326

 
201

FFO
 
10,694

 
10,129

 
29,667

 
25,982

 
 
 
 
 
 
 
 
 
  Adjustments to reconcile to FFO Core:
 
 
 
 
 
 
 
 
Share-based compensation expense
 
1,497

 
2,704

 
4,894

 
7,545

Proxy contest professional fees
 
—

 
—

 
2,534

 
—

Acquisition costs
 
—

 
264

 
—

 
1,398

FFO Core
 
$
12,191

 
$
13,097

 
$
37,095

 
$
34,925

(1) 
Includes pro-rata share attributable to assets held by Pillarstone OP.

43


Property Net Operating Income (“NOI”)

Management believes that NOI is a useful measure of our property operating performance and is useful to securities analysts in estimating the relative net asset values of REITs. We define NOI as operating revenues (rental and other revenues) less property and related expenses (property operation and maintenance and real estate taxes). Other REITs may use different methodologies for calculating NOI and, accordingly, our NOI may not be comparable to other REITs. Because NOI excludes general and administrative expenses, depreciation and amortization, involuntary conversion, interest expense, interest income, provision for income taxes and gain or loss on sale or disposition of assets, it provides a performance measure that, when compared year over year, reflects the revenues and expenses directly associated with owning and operating commercial real estate properties and the impact to operations from trends in occupancy rates, rental rates and operating costs, providing perspective not immediately apparent from net income. We use NOI to evaluate our operating performance since NOI allows us to evaluate the impact that factors such as occupancy levels, lease structure, lease rates and tenant base have on our results, margins and returns. In addition, management believes that NOI provides useful information to the investment community about our property and operating performance when compared to other REITs since NOI is generally recognized as a standard measure of property performance in the real estate industry. However, NOI should not be viewed as a measure of our overall financial performance since it does not reflect general and administrative expenses, depreciation and amortization, involuntary conversion, interest expense, interest income, provision for income taxes and gain or loss on sale or disposition of assets, the level of capital expenditures and leasing costs necessary to maintain the operating performance of our properties.

Below is the calculation of NOI and the reconciliations to net income, which we believe is the most comparable U.S. GAAP financial measure (in thousands):

 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
PROPERTY NET OPERATING INCOME
 
2018
 
2017
 
2018
 
2017
Net income attributable to Whitestone REIT
 
$
7,644

 
$
2,993

 
$
12,378

 
$
6,412

General and administrative expenses
 
4,959

 
5,581

 
17,897

 
17,598

Depreciation and amortization
 
7,483

 
7,247

 
22,100

 
19,936

Interest expense
 
6,951

 
6,376

 
20,306

 
17,158

Interest, dividend and other investment income
 
(84
)
 
(142
)
 
(302
)
 
(381
)
Provision for income taxes
 
115

 
126

 
328

 
296

Gain on sale of properties
 
(4,380
)
 
—

 
(4,646
)
 
(16
)
Profit sharing expense
 
73

 
63

 
276

 
228

Loss on disposal of assets
 
15

 
40

 
286

 
135

Net income attributable to noncontrolling interests
 
193

 
84

 
326

 
201

NOI
 
$
22,969

 
$
22,368

 
$
68,949

 
$
61,567


Liquidity and Capital Resources
 
Our short-term liquidity requirements consist primarily of distributions to holders of our common shares and OP units, including those required to maintain our REIT status and satisfy our current quarterly distribution target of $0.2850 per share and OP unit, recurring expenditures, such as repairs and maintenance of our properties, non-recurring expenditures, such as capital improvements and tenant improvements, debt service requirements, and, potentially, acquisitions of additional properties.

     During the nine months ended September 30, 2018, our cash provided from operating activities was $32,461,000 and our total distributions were $34,532,000.  Therefore, we had distributions in excess of cash flow from operations of approximately $2,071,000. We anticipate that cash flows from operating activities and our borrowing capacity under our unsecured revolving credit facility will provide adequate capital for our working capital requirements, anticipated capital expenditures and scheduled debt payments in the short term. 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 for federal income tax purposes.


44

We had approximately $58.8 million in borrowing capacity under our Facility as of September 30, 2018. Our long-term capital requirements consist primarily of maturities under our longer-term debt agreements, development and redevelopment costs, and potential acquisitions. We expect to meet our long-term liquidity requirements with net cash from operations, long-term indebtedness, sales of common shares, issuance of OP units, sales of underperforming properties and non-core properties and other financing opportunities, including debt financing. We believe we have access to multiple sources of capital to fund our long-term liquidity requirements, including the incurrence of additional debt and the issuance of additional equity. However, our ability to incur additional debt will be dependent on a number of factors, including our degree of leverage, the value of our unencumbered assets and borrowing restrictions that may be imposed by lenders. As of September 30, 2018, our tangible Net Worth (as defined in the Facility) was $343.4 million and, as a result, we were not in compliance with respect to the tangible Net Worth covenant in the Facility, which states that the tangible Net Worth of the Company shall not be less than the sum of $217.0 million plus 85% of the aggregate net proceeds received by the Company after December 8, 2016 in connection with any offering of stock or stock equivalents, or $350.6 million as of September 30, 2018. We have received two waivers as of September 30, 2018 and can make no assurances that we will be in compliance with this covenant or other covenants under the Facility in future periods or, if we are not in compliance, that we will be able to obtain another waiver. Had we been unable to obtain a waiver or other suitable relief from the lenders under the Facility, an Event of Default (as defined in the Facility) would have occurred, permitting the lenders holding a majority of the commitments under the Facility to, among other things, accelerate the outstanding indebtedness, which would make it immediately due and payable. We are working with the lenders on an amendment to the Facility that would reset at a new threshold and change the definition of Net Worth to add back accumulated depreciation. We expect to have the amendment completed by December 31, 2018.

We expect that our rental income will increase as we continue to acquire additional properties, subsequently increasing our cash flows generated from operating activities. We intend to continue acquiring such additional properties that meet our Community Centered Property® strategy through equity issuances and debt financing. For example, on April 25, 2017, we completed the April 2017 Offering. On May 3, 2017, we acquired Eldorado Plaza. We funded the purchase price of Eldorado Plaza and related transaction expenses with borrowings under our Facility and a portion of the net proceeds from the April 2017 Offering. On May 26, 2017, we acquired BLVD Place. We funded the purchase price of BLVD Place and related transaction expenses through a combination of borrowings under our Facility and the BLVD Note (as defined below) and a portion of the net proceeds from the April 2017 Offering. Included in the purchase of Eldorado Plaza was approximately 1.86 acres of developable land that will give us the ability to build an estimated 24,000 square feet of additional leasable space for an estimated cost to acquire and develop the land parcel of approximately $4.0 million, based on current plans. Further, included in the purchase of BLVD Place was approximately 1.43 acres of developable land. We currently intend to develop a six-story, 137,000 square foot mixed-use building, which we refer to as the BLVD Phase II-B development, on the developable land at BLVD Place, for an estimated cost to acquire and develop the land parcel of $55 million, including the $10.5 million of the aggregate purchase price of BLVD Place allocated to the acquisition of the land parcel.

As discussed in Note 11 (Equity) to the accompanying consolidated financial statements, on June 4, 2015, we entered into the 2015 equity distribution agreements.  Pursuant to the terms and conditions of the 2015 equity distribution agreements, we can issue and sell up to an aggregate of $50 million of our common shares into the existing trading market at current market prices or at negotiated prices through the placement agents over a period of time and from time to time. We did not sell any common shares under the 2015 equity distribution agreements during the three and nine months ended September 30, 2018. During the three months ended September 30, 2017, we sold 176,576 common shares under the 2015 equity distribution agreements, with net proceeds to us of approximately $2.4 million. In connection with such sales, we paid compensation of approximately $27,000 to the sales agents. During the nine months ended September 30, 2017, we sold 567,302 common shares under the 2015 equity distribution agreements, with net proceeds to us of approximately $7.7 million. In connection with such sales, we paid compensation of approximately $139,000 to the sales agents. We have used and anticipate using net proceeds from common shares issued pursuant to the 2015 equity distribution agreements for general corporate purposes, which may include acquisitions of additional properties, the repayment of outstanding indebtedness, capital expenditures, the expansion, redevelopment and/or re-tenanting of properties in our portfolio, working capital and other general purposes.

Our capital structure includes non-recourse mortgage debt that we have assumed or originated on certain properties. We may hedge the future cash flows of certain variable rate debt transactions principally through interest rate swaps with major financial institutions. See Note 8 (Derivatives and Hedging Activities) to the accompanying consolidated financial statements for a description of our current cash flow hedges.


45

As discussed in Note 7 (Debt) to the accompanying consolidated financial statements, on May 26, 2017, we, through our subsidiary, Whitestone Houston BLVD Place LLC, a Delaware limited liability company, issued a $80.0 million promissory note to American General Life Insurance Company (the “BLVD Note”). The BLVD Note has a fixed interest rate of 3.72% and a maturity date of June 1, 2027. The BLVD Notes requires interest only payments with all principal repayable upon maturity. The BLVD Note is a non-recourse loan secured by the real property located at BLVD Place, including the related equipment, fixtures, personal property and other assets, with a limited carve-out guarantee by the Operating Partnership. Proceeds from the BLVD Note were used to fund a portion of the BLVD Place acquisition.

As discussed in Note 2 (Summary of Significant Accounting Policies) to the accompanying consolidated financial statements, pursuant to the terms of our $15.1 million 4.99% Note, due January 6, 2024 (see Note 7 (Debt) to the accompanying consolidated financial statements), which is collateralized by our Anthem Marketplace property, we were required by the lenders thereunder to establish a cash management account controlled by the lenders to collect all amounts generated by our Anthem Marketplace property in order to collateralize such promissory note. Amounts in the cash management account are classified as restricted cash.
  
Cash, Cash Equivalents and Restricted Cash
 
We had cash, cash equivalents and restricted cash of approximately $9,480,000 as of September 30, 2018, as compared to $5,210,000 on December 31, 2017.  The increase of $4,270,000 was primarily the result of the following:
 
Sources of Cash
 
•
Cash flow from operations of $32,461,000 for the nine months ended September 30, 2018;

•
Net proceeds of $9,000,000 from the Facility;

•
Proceeds of $12,574,000 from sale of property;

•
Our investment in real estate partnership of $843,000;

•
Proceeds of $30,000 from sale of marketable securities;

Uses of Cash

•
Payment of distributions to common shareholders and OP unit holders of $34,532,000;

•
Additions to real estate of $11,300,000;

•
Repurchase of common shares of $1,699,000;

•
Payments of notes payable of $2,949,000;

•
Payments of exchange offer costs of $128,000; and

•
Payments of loan origination costs of $30,000.

     We place all cash in short-term, highly liquid investments that we believe provide appropriate safety of principal.


46

Debt

Debt consisted of the following as of the dates indicated (in thousands):
Description
 
September 30, 2018
 
December 31, 2017
Fixed rate notes
 
 
 
 
$10.5 million, LIBOR plus 2.00% Note, due September 24, 2020 (1)
 
$
9,560

 
$
9,740

$50.0 million, 1.75% plus 1.35% to 1.90% Note, due October 30, 2020 (2)
 
50,000

 
50,000

$50.0 million, 1.50% plus 1.35% to 1.90% Note, due January 29, 2021 (3)
 
50,000

 
50,000

$100.0 million, 1.73% plus 1.65% to 2.25% Note, due October 30, 2022 (4)
 
100,000

 
100,000

$80.0 million, 3.72% Note, due June 1, 2027
 
80,000

 
80,000

$37.0 million 3.76% Note, due December 1, 2020 (5)
 
32,359

 
33,148

$6.5 million 3.80% Note, due January 1, 2019
 
5,704

 
5,842

$19.0 million 4.15% Note, due December 1, 2024
 
19,000

 
19,000

$20.2 million 4.28% Note, due June 6, 2023
 
19,089

 
19,360

$14.0 million 4.34% Note, due September 11, 2024
 
13,776

 
13,944

$14.3 million 4.34% Note, due September 11, 2024
 
14,300

 
14,300

$16.5 million 4.97% Note, due September 26, 2023 (5)
 
15,870

 
16,058

$15.1 million 4.99% Note, due January 6, 2024
 
14,700

 
14,865

$2.6 million 5.46% Note, due October 1, 2023
 
2,441

 
2,472

$1.3 million 3.47% Note, due November 28, 2018
 
255

 
—

Floating rate notes
 
 
 
 
Unsecured line of credit, LIBOR plus 1.40% to 1.95%, due October 30, 2019 (6)
 
241,200

 
232,200

Total notes payable principal
 
668,254

 
660,929

Less deferred financing costs, net of accumulated amortization
 
(1,630
)
 
(1,861
)
 
 
$
666,624

 
$
659,068


(1) 
Promissory note includes an interest rate swap that fixed the interest rate at 3.55% through September 24, 2018 and 4.85% beginning September 24, 2018 through September 24, 2020.

(2) 
Promissory note includes an interest rate swap that fixed the LIBOR portion of Term Loan 1 (as defined below) at 0.84% through February 3, 2017 and 1.75% beginning February 3, 2017 through October 30, 2020.

(3) 
Promissory note includes an interest rate swap that fixed the LIBOR portion of Term Loan 2 (as defined below) at 1.50%.

(4) 
Promissory note includes an interest rate swap that fixed the LIBOR portion of Term Loan 3 (as defined below) at 1.73%,

(5) 
Promissory notes were assumed by Pillarstone OP in December 2016 and included in our consolidated balance sheets under the profit-sharing method of accounting as discussed in Note 2 (Summary of Significant Accounting Policies) to the accompanying consolidated financial statements.

(6) 
Unsecured line of credit includes certain Pillarstone Properties described in more detail below in determining the amount of credit available under the Facility.

On May 26, 2017, we, through our subsidiary, Whitestone Houston BLVD Place LLC, issued the BLVD Note. The BLVD Note has a fixed interest rate of 3.72% and a maturity date of June 1, 2027. Proceeds from the BLVD Note were used to fund a portion of the purchase price of the acquisition of BLVD Place.
    

47

On November 7, 2014, we, through our Operating Partnership, entered into an unsecured revolving credit facility (the “2014 Facility”) with the lenders party thereto, with BMO Capital Markets, Wells Fargo Securities, LLC, Merrill Lynch, Pierce, Fenner & Smith Incorporated, and U.S. Bank, National Association, as co-lead arrangers and joint book runners, and Bank of Montreal, as administrative agent (the “Agent”). The 2014 Facility amended and restated our previous unsecured revolving credit facility. On October 30, 2015, we, through our Operating Partnership, entered into the First Amendment to the 2014 Facility (the “First Amendment”) with the guarantors party thereto, the lenders party thereto and the Agent. We refer to the 2014 Facility, as amended by the First Amendment, as the “Facility.”

Pursuant to the First Amendment, the Company made the following amendments to the 2014 Facility:

•
extended the maturity date of the $300 million unsecured revolving credit facility under the 2014 Facility (the “Revolver”) to October 30, 2019 from November 7, 2018;

•
converted $100 million of outstanding borrowings under the Revolver to a new $100 million unsecured term loan under the 2014 Facility (“Term Loan 3”) with a maturity date of October 30, 2022;

•
extended the maturity date of the first $50 million unsecured term loan under the 2014 Facility (“Term Loan 1”) to October 30, 2020 from February 17, 2017; and

•
extended the maturity date of the second $50 million unsecured term loan under the 2014 Facility (“Term Loan 2” and together with Term Loan 1 and Term Loan 3, the “Term Loans”) to January 29, 2021 from November 7, 2019.
    
Borrowings under the Facility accrue interest (at the Operating Partnership's option) at a Base Rate or an Adjusted LIBOR plus an applicable margin based upon our then existing leverage. The applicable margin for Adjusted LIBOR borrowings ranges from 1.40% to 1.95% for the Revolver and 1.35% to 2.25% for the Term Loans. Base Rate means the higher of: (a) the Agent's prime commercial rate, (b) the sum of (i) the average rate quoted by the Agent by two or more federal funds brokers selected by the Agent for sale to the Agent at face value of federal funds in the secondary market in an amount equal or comparable to the principal amount for which such rate is being determined, plus (ii) 1/2 of 1.00%, and (c) the LIBOR rate for such day plus 1.00%. Adjusted LIBOR means LIBOR divided by one minus the Eurodollar Reserve Percentage. The Eurodollar Reserve Percentage means the maximum reserve percentage at which reserves are imposed by the Board of Governors of the Federal Reserve System on eurocurrency liabilities.

We serve as the guarantor for funds borrowed by the Operating Partnership under the Facility. The Facility contains customary terms and conditions, including, without limitation, affirmative and negative covenants such as information reporting requirements, maximum secured indebtedness to total asset value, minimum EBITDA (earnings before interest, taxes, depreciation, amortization or extraordinary items) to fixed charges, and maintenance of a minimum net worth. The Facility also contains customary events of default with customary notice and cure, including, without limitation, nonpayment, breach of covenant, misrepresentation of representations and warranties in a material respect, cross-default to other major indebtedness, change of control, bankruptcy and loss of REIT tax status.

The Facility includes an accordion feature that will allow the Operating Partnership to increase the borrowing capacity to $700 million, upon the satisfaction of certain conditions, including new commitments from lenders. As of September 30, 2018, $441.2 million was drawn on the Facility, and our remaining borrowing capacity was $58.8 million. Proceeds from the Facility were used for general corporate purposes, including property acquisitions, debt repayment, capital expenditures, the expansion, redevelopment and retenanting of properties in our portfolio and working capital. We intend to use any additional proceeds from the Facility for general corporate purposes, including property acquisitions, debt repayment, capital expenditure, the expansion, redevelopment and re-tenanting of properties in our portfolio and working capital.

On December 8, 2016, in connection with the Contribution, the Operating Partnership entered into the Second Amendment to the Facility and Reaffirmation of Guaranties (the “Second Amendment”) with Pillarstone OP, the Company and the other Guarantors party thereto, the lenders party thereto and the Agent. Pursuant to the Second Amendment, following the Contribution, Whitestone Offices, LLC and Whitestone CP Woodland Ph. 2, LLC were permitted to remain Material Subsidiaries (as defined in the Facility) and Guarantors under the Facility and their respective Pillarstone Properties were each permitted to remain an Eligible Property (as defined in the Facility) and be included in the Borrowing Base (as defined in the Facility) under the Facility. In addition, on December 8, 2016, Pillarstone OP entered into the Limited Guarantee (the “Limited Guarantee”) with the Agent, pursuant to which Pillarstone OP agreed to be joined as a party to the Facility to provide a limited guarantee up to the amount of availability generated by the Pillarstone Properties owned by Whitestone Offices, LLC and Whitestone CP Woodland Ph. 2, LLC. As of September 30, 2018, Pillarstone OP accounted for approximately $14.5 million of the total amount drawn on the Facility.

48


As of September 30, 2018, our $226.8 million in secured debt was collateralized by 19 properties with a carrying value of $322.1 million.  Our loans contain restrictions that would require the payment of prepayment penalties for the acceleration of outstanding debt and are secured by deeds of trust on certain of our properties and by assignment of the rents and leases associated with those properties.

Scheduled maturities of our outstanding debt as of September 30, 2018 were as follows (in thousands):
 
 
 
Year
 
Amount Due
 
 
 
2018
 
$
1,032

2019
 
249,489

2020
 
92,087

2021
 
51,918

2022
 
102,007

Thereafter
 
171,721

Total
 
$
668,254


Capital Expenditures
 
We continually evaluate our properties’ performance and value. We may determine it is in our shareholders’ best interest to invest capital in properties that we believe have potential for increasing value. We also may have unexpected capital expenditures or improvements for our existing assets. Additionally, we intend to continue investing in similar properties outside of the markets on which we focus in cities with exceptional demographics to diversify market risk, and we may incur significant capital expenditures or make improvements in connection with any properties we may acquire.

Contractual Obligations

During the nine months ended September 30, 2018, there were no material changes outside of the ordinary course of business to the information regarding specified contractual obligations contained in our Annual Report on Form 10-K for the year ended December 31, 2017.


49

Distributions
 
The following table summarizes the cash distributions paid or payable to holders of our common shares and noncontrolling OP units during each quarter of 2017 and the nine months ended September 30, 2018 (in thousands, except per share data):

 
 
Common Shares
 
Noncontrolling OP Unit Holders
 
Total
Quarter Paid
 
Distributions Per Common Share
 
 Amount Paid
 
Distributions Per OP Unit
 
 Amount Paid
 
Amount Paid
2018
 
 
 
 
 
 
 
 
 
 
Third Quarter
 
$
0.2850

 
$
11,294

 
$
0.2850

 
$
286

 
$
11,580

Second Quarter
 
0.2850

 
11,203

 
0.2850

 
295

 
11,498

First Quarter
 
0.2850

 
11,145

 
0.2850

 
309

 
11,454

Total
 
$
0.8550

 
$
33,642

 
$
0.8550

 
$
890

 
$
34,532

 
 
 
 
 
 
 
 
 
 
 
2017
 
 
 
 
 
 
 
 
 
 
Fourth Quarter
 
$
0.2850

 
$
11,002

 
$
0.2850

 
$
309

 
$
11,311

Third Quarter
 
0.2850

 
10,948

 
0.2850

 
309

 
11,257

Second Quarter
 
0.2850

 
10,093

 
0.2850

 
310

 
10,403

First Quarter
 
0.2850

 
8,429

 
0.2850

 
313

 
8,742

Total
 
$
1.1400

 
$
40,472

 
$
1.1400

 
$
1,241

 
$
41,713


Taxes
 
We elected to be taxed as a REIT under the 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 a manner to qualify and be taxed as a REIT, and we intend to operate so as to remain qualified as a REIT for federal income tax purposes.

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.

Off-Balance Sheet Arrangements
 
We had no significant off-balance sheet arrangements as of September 30, 2018 and December 31, 2017.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk.

Our future income, cash flows and fair value relevant to our financial instruments depend upon prevailing market interest rates. Market risk refers to the risk of loss from adverse changes in market prices and interest rates. Based upon the nature of our operations, we are not subject to foreign exchange rate or commodity price risk. The principal market risk to which we are exposed is the risk related to interest rate fluctuations. Many factors, including governmental monetary and tax policies, domestic and international economic and political considerations, and other factors that are beyond our control contribute to interest rate risk. Our interest rate risk objective is to limit the impact of interest rate fluctuations on earnings and cash flows and to lower our overall borrowing costs. To achieve this objective, we manage our exposure to fluctuations in market interest rates for our borrowings through the use of fixed rate debt instruments to the extent that reasonably favorable rates are obtainable.

All of our financial instruments were entered into for other than trading purposes.

50


Fixed Interest Rate Debt

As of September 30, 2018, $427.1 million, or approximately 64% of our outstanding debt, was subject to fixed interest rates, which limit the risk of fluctuating interest rates. Although a change in the market interest rates affects the fair market value of our fixed interest rate debt, it does not impact net income to shareholders or cash flows. Our total outstanding fixed interest rate debt had an average effective interest rate as of September 30, 2018 of approximately 3.9% per annum with scheduled maturities ranging from 2018 to 2027 (see Note 7 (Debt) to the accompanying consolidated financial statements for further detail). Holding other variables constant, a 1% increase or decrease in interest rates would cause a $14.9 million decline or increase, respectively, in the fair value for our fixed rate debt.

Variable Interest Rate Debt

As of September 30, 2018, $241.2 million, or approximately 36% of our outstanding debt, was subject to floating interest rates of LIBOR plus 1.40% to 1.95% and not currently subject to a hedge. The impact of a 1% increase or decrease in interest rates on our non-hedged variable rate debt would result in a decrease or increase of annual net income of approximately $2.4 million, respectively.

Item 4.  Controls and Procedures.

Evaluation of Disclosure Controls and Procedures
 
The management of Whitestone REIT, under the supervision and with the participation of our principal executive and financial officers, has evaluated the effectiveness of our disclosure controls and procedures in ensuring that the information required to be disclosed in our filings under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, including ensuring that such information is accumulated and communicated to Whitestone REIT's management, as appropriate, to allow timely decisions regarding required disclosure. Based on such evaluation, our principal executive and financial officers have concluded that such disclosure controls and procedures were effective as of September 30, 2018 (the end of the period covered by this Report).

Changes in Internal Control Over Financial Reporting

During the three months ended September 30, 2018, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


51

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

We are subject to 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, management believes the final outcome of such matters will not have a material adverse effect on our financial position, results of operations or liquidity.

Item 1A. Risk Factors.
 
There have been no material changes from the risk factors disclosed in the “Risk Factors” section of Whitestone's Annual Report on Form 10-K for the year ended December 31, 2017 and Quarterly Report on Form 10-Q for the period ended June 30, 2018.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

(a)
During the period covered by this Form 10-Q, we did not sell any equity securities that were not registered under the Securities Act of 1933, as amended.

(b)
Not applicable.

(c)
During the three months ended September 30, 2018, certain of our employees tendered owned common shares to satisfy the tax withholding on the lapse of certain restrictions on restricted common shares issued under the 2008 Plan. The following table summarizes all of these repurchases during the three months ended September 30, 2018.

Period
 
Total Number of Shares Purchased (1)
 
Average Price Paid Per Share
 
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
 
Maximum Number of Shares that May Yet be Purchased Under the Plans or Programs
July 1, 2018 through July 31, 2018
 
—

 
$
—

 
N/A
 
N/A
August 1, 2018 through August 31, 2018
 
—

 
—

 
N/A
 
N/A
September 1, 2018 through September 30, 2018
 
46,142

 
13.88

 
N/A
 
N/A
      Total
 
46,142

 
$
13.88

 
 
 
 

(1)    The number of shares purchased represents common shares held by employees who tendered owned common shares to satisfy the tax withholding on the lapse of certain restrictions on restricted common shares issued under the 2008 Plan. With respect to these shares, the price paid per share is based on the fair market value at the time of tender.

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Mine Safety Disclosures.

Not applicable.

Item 5. Other Information.

None.


52

Item 6. Exhibits.

The exhibits listed on the accompanying Exhibit Index are filed, furnished and incorporated by reference (as stated therein) as part of this Report.


53

EXHIBIT INDEX
Exhibit No.
Description
101.INS***
XBRL Instance Document
 
 
101.SCH***
XBRL Taxonomy Extension Schema Document
 
 
101.CAL***
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
101.LAB***
XBRL Taxonomy Extension Label Linkbase Document
 
 
101.PRE***
XBRL Taxonomy Extension Presentation Linkbase Document
 
 
101.DEF***
XBRL Taxonomy Extension Definition Linkbase Document
 ________________________
 
*       Filed herewith.
**     Furnished herewith.
***    The following financial information of the Registrant for the quarter ended September 30, 2018, formatted in XBRL (eXtensible Business Reporting Language): (i) the Consolidated Balance Sheets as of September 30, 2018 (unaudited) and December 31, 2017, (ii) the Consolidated Statements of Operations and Comprehensive Income for the three and nine months ended September 30, 2018 and 2017 (unaudited), (iii) the Consolidated Statements of Changes in Equity for the nine months ended September 30, 2018 (unaudited), (iv) the Consolidated Statement of Cash Flows for the nine months ended September 30, 2018 and 2017 (unaudited) and (v) the Notes to the Consolidated Financial Statements (unaudited).
    
Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.


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 thereunto duly authorized.


 
 
 
 
 
WHITESTONE REIT
 
 
 
Date:
November 6, 2018
 
 
/s/ James C. Mastandrea 
 
 
 
 
James C. Mastandrea
 
 
 
 
Chief Executive Officer
 
 
 
 
(Principal Executive Officer)
 
Date:
November 6, 2018
 
 
/s/ David K. Holeman
 
 
 
 
David K. Holeman
 
 
 
 
Chief Financial Officer
 
 
 
 
(Principal Financial and Principal Accounting Officer)


55

Whitestone REIT Reports