Item 1.
Business
Archstone-Smith, an S&P 500 company, is a recognized leader in apartment investment and operations. The company owns and operates an unreplicated portfolio of high-rise and garden apartment communities concentrated in many of the most desirable neighborhoods in the greater Washington, D.C. Metropolitan Area, Southern California, the San Francisco Bay Area, the New York City Metropolitan Area, Boston, Chicago, Southeast Florida and Seattle. The company strives to continually upgrade the quality of its portfolio through the selective sale of assets, using proceeds to fund investments with higher anticipated growth prospects. Through our two customer-facing brands, Archstone and Charles E. Smith, we strive to provide great apartments and great service, all backed by our unconditional Seal of Servicetm guarantees.
As of December 31, 2005, we owned or had an ownership position in 257 communities, representing 86,930 units, including units under construction. At year-end, our operating portfolio was concentrated in protected locations in the following core markets, based on NOI for the three months ended December 31, 2005, excluding amounts owned by Ameriton or located in Germany:
The Company
Archstone-Smith is engaged primarily in the operation, development, redevelopment, acquisition and long-term ownership of apartment communities in the United States. We have elected REIT status and are structured as an UPREIT, with all property ownership and business operations conducted through the Operating Trust. We are the
sole trustee and owned 86.2% of the Operating Trust at December 31, 2005. Archstone-Smith Common Shares trade on the New York Stock Exchange (NYSE: ASN). Our principal focus is to maximize shareholder value by:
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Acquiring, developing, redeveloping and operating apartments in our core markets, which are characterized by: protected locations with limited land for new housing construction, expensive single-family home prices, and a strong, diversified economic base with significant employment growth potential;
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Generating long-term sustainable growth in operating cash flow;
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Increasing our Common Share dividend, as we have done for the last 15 consecutive years;
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Recruiting, training and retaining people whom we believe are the best and brightest in the apartment business;
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Building the dominant operating platform in the apartment industry, to produce an operating franchise that we believe is more efficient, more profitable and difficult to replicate. We do this by investing in technology to improve our operations and customer service delivery, strengthen our brand position and solidify our reputation for operational leadership; and
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Managing our invested capital through the selective sale of apartment communities in non-core locations and redeploying the proceeds to fund investments with higher anticipated growth prospects in outstanding locations in our core markets.
Accomplishments
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Archstone-Smith produced Same-Store revenue growth of 3.7% for the full year of 2005. The fourth quarter of 2005 was the seventh consecutive quarter of improving top-line revenue growth.
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Archstone-Smith’s reported Same-Store NOI outperformed our peer average by 970 basis points for the period from January 1, 2001 through December 31, 2005.(1)
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We completed the acquisition of a $1.5 billion portfolio from Oakwood Worldwide, comprising 35 communities and representing 12,696 units, significantly strengthening our dominant ownership presence in many of our core markets, including Southern California, the San Francisco Bay Area and the Washington, D.C. Metropolitan Area.
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In 2005 and through the first quarter of 2006, we significantly enhanced our presence in Manhattan through the acquisition of three high-rise apartment communities, totaling $624.6 million and 1,038 units. We also started construction on The Mosaic, a 627-unit joint venture community and our first development in Manhattan. At year-end 2005, our committed total expected investment in the New York City Metropolitan Area, including joint venture developments, totaled $1.2 billion.
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In December 2005, we completed our first acquisition in Europe with the purchase of an 11-building, 822-unit portfolio concentrated in Mannheim, Germany, for $44.5 million. We believe acquiring and operating these assets will help us research and understand this new market and help establish relationships with key market participants.
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In September 2005, we completed the successful sale of 12.1 million common shares, representing $500 million in gross proceeds. This equity offering, together with our incremental debt capacity, provides the financial flexibility to fund the completion of our $2.8 billion development pipeline.
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We completed the roll-out of MRI, a web-based, customer-centric property management system, to our national portfolio. MRI automates virtually all of our daily on-site leasing and reporting tasks, allows our site
(1) NOI performance is defined as cumulative same-store NOI growth for the period presented, relative to the average same-store NOI growth for our peer companies, which are BRE Properties, Inc.; United Dominion Realty; Essex Property Trust, Inc.; Camden Property Trust; Equity Residential; Avalon Bay Communities; Post Properties, Inc.; and excluding Archstone-Smith. Results are per Green Street Advisors 4Q05 Apartment REIT Update, except for Archstone-Smith figures, which are actual reported results.
teams to better track service requests from our customers, manage customer records and execute leases more efficiently - which we believe enhances our customers’ experience with us. MRI provides a seamless online interface with our customers via resident-only web sites, allowing customers 24/7 access to complete new and renewed leases, pay rent online, submit and track service requests and more.
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Archstone-Smith was recognized as one of the Top 50 Employers for Minorities by Fortune magazine in 2005.
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Forbes magazine ranked Archstone-Smith at 991 on the Forbes 2000 List for 2005, the magazine’s comprehensive ranking of the world’s largest corporations.
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We increased our 2006 annualized common share dividend level to $1.74, or $0.435 per quarter. This marks our 15th consecutive annual common share dividend increase and a total increase of 172% since 1991. Our first quarter 2006 common share dividend was paid in February 2006, representing our 122nd consecutive quarterly payment.
Investment Strategy
Capital Recycling Program. We believe that one of our most important responsibilities is to improve the quality of our portfolio with every transaction we complete. In 2005, we completed the disposition of $1.1 billion of non-core assets, excluding Ameriton, representing 8,558 units, generating GAAP gains of $446.7 million and an average unleveraged internal rate of return (IRR) of 14.2%. The cash gains on the sale of these assets was $302.4 million, or 38.8% of our cost basis. In addition, during 2005 we acquired $2.4 billion of assets, excluding Ameriton and German acquisitions, representing 15,446 units, and started development of $219.7 million of assets, representing 1,113 units, in markets that include Manhattan, Los Angeles and downtown San Francisco.
Focus on core markets. We focus our investment activities in our core markets, which are characterized by: (i) protected locations with limited land for new housing construction; (ii) expensive single-family home prices; and (iii) a strong, diversified economic base with significant employment growth potential.
Barriers to entry exist in areas where there is a very limited amount of land zoned and available for housing development, and where local municipalities are reluctant to zone additional land for new housing. We believe that the limited competition, expensive single family housing and diverse economic base typical of our core markets maximizes our ability to keep our occupancy relatively constant and produce sustainable long-term cash flow growth.
Our investment professionals generally live in our core markets, allowing them to thoroughly research and evaluate potential investments at the “street corner level of detail.” This locally based investment acumen guides our decisions in making investments, allowing us to continually upgrade the quality of our portfolio. As a result, our portfolio is concentrated in many of the most desirable neighborhoods in the Washington, D.C. Metropolitan Area, Southern California, the San Francisco Bay area, the New York City Metropolitan Area, Boston, Chicago, Southeast Florida and Seattle.
As of year-end 2005, approximately 93.4% of our portfolio was concentrated in our core markets. Our goal is to sell virtually all of our remaining non-core assets by the end of 2006.
Acquisition of the Oakwood Portfolio. In 2005, we completed the acquisition of a 35-community portfolio from Oakwood Worldwide, for $1.5 billion. This strategic transaction further strengthens Archstone-Smith’s dominant ownership presence in highly desirable neighborhoods in many of our most attractive submarkets: Marina del Rey; Toluca Hills; San Jose and La Jolla, California; the Rosslyn/Ballston corridor in the Washington, D.C. Metropolitan Area and downtown Boston. We expect to acquire two additional communities from Oakwood during the first half of 2006.
Developments. We place considerable emphasis on the value created through our development of new apartment properties. At December 31, 2005, we had $2.8 billion in total expected investment of assets in our development pipeline, including communities under construction and in planning in the REIT, Ameriton and through joint ventures. We completed $219.7 million of new REIT development properties during the year,
representing 1,113 units, in markets that include the Washington, D.C. Metropolitan Area, Boston and Southern California.
During the year, four REIT development properties achieved Stabilization, representing a Total Expected Investment of $213.3 million and adding a total of 1,113 units to Archstone-Smith’s operating portfolio.
We believe that our locally based development infrastructure creates a significant competitive advantage for identifying and completing very attractive investment opportunities in our core markets. As such, we expect our development capability to continue to be a key contributor to growth and to create significant value as properties are completed and stabilized at attractive yields during the next several years. Additionally, we generally utilize Guaranteed Maximum Price Contracts (GMAX) through qualified third-party contractors to reduce our development risk from a cost perspective.
Ameriton. Ameriton, our wholly owned subsidiary, continues to be a highly profitable franchise for our company. Utilizing our development, acquisition and operating expertise, Ameriton identifies under-managed operating communities, as well as development and redevelopment opportunities with a short-term ownership horizon of one to three years that have the potential to produce significant profits. Ameriton sold 11 communities in 2005 (including two joint venture transactions), contributing $62.5 million or $0.269 per share to Archstone-Smith’s 2005 earnings, $56.7 million, or $0.244 per share, to its 2005 FFO, and producing an average unleveraged pre-tax internal rate of return (IRR) of 24%.
Ameriton’s gains in 2005 were principally driven by the sale of newly developed communities in markets that include suburban Washington, D.C. and Houston. As of December 31, 2005, Ameriton has 20 communities representing 5,016 units under construction or in planning, including joint ventures. While nearly 60% of Ameriton’s development pipeline is located in our core markets, they are in locations that we deem to be non-core for ownership by the REIT.
A significant component of Ameriton’s successful development program is attributable to its creation of a successful business as a relationship-based financier of new, high-quality apartment communities that are built by other capable developers with whom we have fostered relationships over the past several years. Since 2003, Ameriton has completed seven of these transactions, realizing pre-tax gains of $28.3 million, or $0.122 per share, and funds from operations (FFO) of $21.5 million, or $0.093 per share, at an average leveraged IRR of 23.2%.
Leveraging our relationships with third-party apartment developers, we also created a related business that offers a compelling platform for long-term value creation: mezzanine debt financing. Our Ameriton investment team sources these transactions on behalf of the REIT, as the interest income is qualifying REIT income and therefore not subject to tax. Of the $129.2 million in mezzanine loan commitments we have made through December 31, 2005, $119.3 million were originated in 2005. During the year, we had two loans repaid in the amount of $34.5 million. We are encouraged by the opportunities to selectively invest capital at very attractive returns in this incremental area of our business.
Customer-focused Operations
We believe that our long-term cash flow growth is enhanced by the Archstone and Charles E. Smith brands, our goal to build the dominant operating platform in the apartment industry, robust and scalable technology, and continued investment in our associates.
Powerful brands. An essential component of our strategy is to consistently offer a higher level of service at our apartment communities. Through our Seal of Servicetm, we offer our residents convenience and flexibility all backed by written guarantees. We believe we are the only public apartment REIT with an established track record of offering customers flexible lease terms from two to 12 months as standard practice - and the only apartment company in the nation to offer fully transactional online leasing through Online Lease, our proprietary automated online leasing system.
Our expansion in the New York City Metropolitan Area underscores the embedded value of our customer-focused operating and branding strategy. We believe we are the only apartment owner and manager in Manhattan to provide all of the following services: (i) leasing offices that are open seven days a week; (ii) we will show
apartments without an appointment or a broker; (iii) we can process applications in 48 hours, compared to one week process time at most competitors; (iv) we offer innovative services and unconditional service guarantees through our Seal of Servicetm; and (v) we provide a technology platform that makes it easy for people to do business with us through online rent payment, online service requests and our Online Lease. Customers have demonstrated an overwhelming acceptance of this approach, allowing us to achieve a 15% increase in new move-in rents in our same-store operating communities in Manhattan in the fourth quarter of 2005 as compared to the same period in 2004.
Investing in technology.
Web-based property management system. We invest in technology to improve our core operations and make it easier for our customers to do business with us. In 2005, we completed the roll-out of MRI, our web-based property management system that provides the platform for virtually all of our customer-facing technology products. In addition, MRI’s automated work order solution allows us to manage and execute service requests more efficiently, in line with our 1-day Service Guarantee, through which we promise to respond to service requests within 24 hours. Equally important, MRI gives us the ability to accurately track resident histories to better understand and serve our customers.
Revenue management. In 2000, we pioneered the use of a sophisticated revenue management product, Lease Rent Options (LRO). LRO brings a tremendous amount of discipline to the pricing process, enabling us to more precisely forecast demand to optimize pricing and occupancy across our portfolio, thereby increasing revenues. In 2005, we continued to refine and improve LRO to better manage pricing, occupancy and lease expirations to make us less vulnerable to seasonal shifts in customer traffic.
We believe that pricing in the apartment industry is too reliant on on-site individuals who often use “gut instinct” to make what are ultimately arbitrary pricing decisions. To bring discipline and sophistication to pricing in the apartment industry, we began to actively market LRO to other apartment owners, making sales to two large apartment companies; several other apartment owners are currently pilot testing the software.
Resident web sites. MRI provides a seamless online presence with our customers via resident-only web sites, which we rolled out nationally in 2005, allowing customers 24/7 access to us to pay rent online, submit and track service requests, participate in periodic feedback surveys, review and update account information and more. In 2005, we collected approximately 115,000 online rent payments, representing revenue of $126.6 million and 11.2% of total rent collected. Online rent payments continued to accelerate throughout the year, with online rent payments in December 2005 totaling 18.1% of all rent collected.
Online Lease. We believe that we are the only national apartment company to be able to complete leases fully online through Online Lease, our proprietary automated online leasing system. Using Online Lease, customers can log on to any computer to search for a specific apartment, view real-time pricing and availability, select rentable amenities such as garages or additional storage, complete their credit application and finalize their lease - all online.
Fully launched in June of 2005, Online Lease has been well-accepted by our customers, representing approximately 9% of all leases transacted in the fourth quarter. Of those apartments that were leased online for the full year of 2005, 28% were leased sight-unseen by customers and 39% were leased by customers who only visited an Archstone-Smith community once. We believe Online Lease provides us with a meaningful competitive edge to better serve customers and improve our operating margins.
Internet marketing and lead management. Approximately 36% of all of our leases for the year ended December 31, 2005, were sourced through the Internet, with the vast majority of our customers beginning their apartment search online through third-party search vehicles such as Google and Yahoo! or Internet Listing Services (ILS) that include Apartments.com and RentNet.com as well as our branded web sites, ArchstoneApartments.com and SmithApartments.com. Because the acquisition cost for customers sourced through the Internet is dramatically lower than traditional marketing channels such as print advertising - we estimate the cost-per-lead is approximately $100 for those sourced through the Internet compared with an average of approximately $900 for traditional
print advertising - we continue to focus our marketing efforts on improving our online presence and lead management system.
In 2005, we established an Internet Lead Management (ILM) system in MRI, partnering with six ILSs with whom we have national contracts to provide customer lead information, which is automatically incorporated into MRI. Activated nationally in the third quarter of 2005, the ILM allows our site teams to be far more attentive and responsive to online customers, which we believe is critical to converting more customer leads into leases.
Driving renewals and referrals. We believe that we can create a distinct competitive advantage by identifying and implementing the best practices for our most critical processes and standardizing them at each of our communities to deliver a consistently superior resident experience that drives loyalty. We believe that loyalty is a key indicator of a resident’s likelihood to renew his or her lease or refer our apartment communities to friends and co-workers as a place to live.
To gain an understanding of our customers’ loyalty - and the drivers that would increase their potential to renew and refer - we engaged Satmetrix, a leading customer experience management company, to conduct and analyze random periodic online feedback surveys among existing residents as well as online surveys to new residents two weeks after move-in.
The principal objective of these surveys is to determine what actions are needed to improve renewals and referrals. The Satmetrix system also provides immediate feedback to correct specific resident issues before they impact brand satisfaction; compares our communities to identify best practices; and provides the mechanism by which to recognize excellent managers and provide development to those who need it.
In addition, our Core Process Project (CPP) team, established in 2004, focuses on three important customer touch-points that we believe are critical to customer acquisition, renewal and referral: (i) customer inquiries and leasing, (ii) the move-in experience, and (iii) renewal, transfer or move-out. To capture best practices, the CPP team conducts extensive field research with front-line associates to translate proven tactics into scalable tools that ensure consistency in our day-to-day customer interactions.
In 2005, the CPP team completed the roll-out of the Move-in Tracker, a tool that allows community teams to track all the customer-critical steps needed for a smooth move-in. As a result of the Move-in Tracker, we have received extremely favorable feedback from our customers via Satmetrix surveys about their move-in experiences. We believe that a smooth move-in increases the likelihood of a positive first impression of our company and our brands, helping to drive customer renewals and referrals. Other current projects led by the CPP team include improvements to our make-ready process and renewal program.
Investing in our associates. A critical component to ensuring the integrity of our brand offering is attracting, training and retaining the best professionals in our industry - and giving them the support and tools to provide an exceptional customer experience.
Associate engagement. In 2005, we contracted with Kenexa, a leading associate engagement consultancy, to measure our associates’ engagement and identify key drivers of engagement. It is our belief that associates who are fully engaged in their roles tend to contribute at a much higher level to the company and stay with us longer. Our initial results were extremely encouraging, with 75% of our associates taking part in the survey. Our results place us in the top quartile of responses among the companies with whom Kenexa works, including many of the “best in class” corporations in the United States, such as Home Depot, Kraft Foods, Molson Coors, REI, Starwood, FedEx Kinko’s and Blockbuster.
Incentive-based compensation. We made significant progress during the year on our incentive-based compensation (IBC) program, through which leasing associates take on a more traditional sales role, earning the majority of their compensation through leases “sold.” Previously, approximately 20% of our leasing associates’ income was based on leasing activity; with the IBC program, 65% of a leasing associate’s income is generated through leases they put in place. We believe that providing this performance-based income potential allows us to attract higher-caliber sales associates who are more vested in delivering a superior experience to our customers. Currently, the IBC program is in place at 83 of our larger communities with full roll-out expected in 2006.
Developing our leaders. In 2005, another 239 corporate and community managers attended The Practice of Leadership, our feedback-based training program for corporate managers, and Leading Teams at Archstone-Smith, a comparable three-day program for our on-site teams. These three-day programs focus on six leadership practices consistent with our company culture and values that we believe drive our success. This program is complemented by a feedback component, through which direct reports and peers evaluate corporate managers to identify strengths and opportunities for improvement to enhance their effectiveness as team leaders. To date, a total of 671 managers have participated in the program.
Conservative Balance Sheet Management
One of our primary financial objectives is to structure our balance sheet to enhance our financial flexibility in order to have access to capital when others in the industry do not. Archstone-Smith has a significant equity base, with equity market capitalization of $10.4 billion, including the value of the A-1 Common Units, as of December 31, 2005. Our investment-grade debt ratings from Standard & Poor’s (BBB+), Moody’s Investors Service (Baal) and Fitch, Inc. (BBB+) are indicative of our solid financial position.
In September 2005, we sold approximately 12.1 million Common Shares under our existing shelf registration statement filed with the Securities and Exchange Commission. The $500 million of gross proceeds was initially used to pay down our credit facilities, which had a total outstanding balance of $690 million when the transaction was announced. This equity offering, together with the incremental debt capacity it gave the company, provides the financial flexibility to fund approximately $1.0 billion needed to complete our $2.8 billion development pipeline.
In 2005, we increased our unencumbered asset base to $7.7 billion as of the end of the year. As of March 1, 2006, we had approximately $363.3 million of liquidity, including cash on hand, restricted cash in escrows and capacity on unsecured credit facilities. We believe this financial flexibility allows us to act more quickly on new investment opportunities as they arise. We also repurchased $56.5 million of our Common Shares in 2005, at prices ranging from $33.61 to $35.54 per share and at an average price of $34.31 per share.
We have structured our long-term debt maturities in a manner designed to avoid unmanageable repayment obligations in any year. We have only $92.5 million of long-term debt maturing in 2006, representing 0.6% of our total market capitalization. The following summarizes our long-term debt maturity profile for 2006 through 2010, and thereafter, as of December 31, 2005 (dollar amounts in millions):
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Total market capitalization as of December 31, 2005, represents the market capitalization based on the closing share price on the last trading day of the period for publicly traded securities, units and the liquidation value for private securities as well as the book value of total debt.
Consistent dividend growth. We raised our anticipated 2006 distribution level to $1.74 per share, marking our 15th consecutive annual common share dividend increase and a total increase of 172% since 1991.
Management
We have several senior executives who possess the leadership, operational, investment and financial skills and experience to oversee the overall operation of our Company. We believe several of our senior officers could serve as the principal executive officer and continue our strong performance. Our management team emphasizes active
training and organizational development initiatives for associates at all levels of our Company in order to build long-term management depth and facilitate succession planning.
Officers of Archstone-Smith
Certain Senior Officers, including all Executive Officers, of Archstone-Smith are:
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Executive Officers
Biographies of Senior Officers
R. Scot Sellers - 49 - Chairman and Chief Executive Officer from June 1997 to July 1998 and from December 1998 to the present, with overall responsibility for Archstone-Smith’s strategic direction, investments and operations; Co-Chairman and Chief Investment Officer from July 1998 to December 1998; Managing Director of Archstone-Smith from September 1994 to June 1997, where he had overall responsibility for investment strategy and implementation; Senior Vice President of Archstone-Smith from May 1994 to September 1994; member of the Executive Committee of the Board of Governors and current Chairman of NAREIT; member of the Executive Committee of the Board of Directors of the National Multi Housing Council; Director of the Christian International Scholarship Foundation; Director of CEO Forum; and Director of the Alliance for Choice in Education.
J. Lindsay Freeman - 60 - Chief Operating Officer since September 2002, with responsibility for managing all investment and operating activities for Archstone-Smith; President-East Division of Archstone-Smith from October 2001 to September 2002, with responsibility for all investments and operations of the East Division; from July 1998 to October 2001, Managing Director of Archstone-Smith, with responsibility for investments and operations in the East and Central Regions; Managing Director of Security Capital Atlantic Incorporated from December 1997 to July 1998; Senior Vice President of Security Capital Atlantic Incorporated from May 1994 to November 1997; previously, Senior Vice President and Operating Partner of Lincoln Property Company in Atlanta, Georgia, where he was responsible for acquisitions, financing, construction and management of apartment communities within the Atlantic region and oversaw operations of 16,000 apartment units.
Charles E. Mueller, Jr. - 42 - Chief Financial Officer of Archstone-Smith since December 1998, with responsibility for the planning and execution of the Company’s financial strategy, balance sheet management and corporate operations; Mr. Mueller oversees the Company’s accounting/financial reporting, corporate finance, investor relations, corporate and property tax, due diligence, risk management, human resources, national marketing and ancillary services functions. Vice President of Archstone-Smith from September 1996 to December 1998; prior thereto, he held various financial positions with Security Capital, where he provided financial services to Security Capital and its affiliates. He is a member of the National Multi-Housing Council Executive Committee and Board of Directors, the Real Estate Roundtable President’s Council and a Director of Denver K-Life.
Alfred G. Neely - 60 - President - Charles E. Smith Residential Division since February 2005; Chief Development Officer of Archstone-Smith since April 2003, with responsibility for the oversight and direction of all Archstone-Smith residential development projects; Executive Vice President of Archstone-Smith or Charles E. Smith Residential Realty, Inc. from April 1989 to April 2003 with responsibility for oversight and direction of
High-Rise residential development projects; Executive Vice President and Managing General Partner of the New Height Group from August 1981 to April 1989 with responsibility for the development and management of 2.5 million square feet of mixed-use property; General Manager of a 1,100-acre mixed-use business park from October 1973 to April 1981 where he managed the development of 3.5 million square feet of corporate user buildings.
Dana K. Hamilton - 37 - Managing Director - Europe with responsibility for research and development of European investment and operational opportunities since, February 2005; Executive Vice President-National Operations for Archstone-Smith from May 2001 to February 2005, with responsibility for corporate services, including human resources, training and development, marketing and corporate communications, and new business development; Senior Vice President of Archstone-Smith from December 1998 to May 2001; Vice President from December 1996 to December 1998, with responsibility for new product development and revenue enhancement through portfolio-wide initiatives.
Caroline Brower - 57 - General Counsel and Secretary of Archstone-Smith since September 1999, with responsibility for legal and corporate governance; from September 1998 to September 1999, President of Ameriton Properties Incorporated; prior thereto, Ms. Brower was a partner of Mayer, Brown & Platt (now Mayer, Brown, Rowe & Maw, LLP) where she practiced transaction and real estate law.
Daniel E. Amedro - 49 - Chief Information Officer of Archstone-Smith since January 1999, with primary responsibility for the Company’s information technology functions and initiatives; Chief Information Officer and Vice President from May 1998 to January 1999; from September 1996 to March 1998, Vice President of Information Services for American Medical Response, the largest private ambulance operation in the United States; prior thereto, Vice President of Information Services for Hyatt Hotels and Resorts, where he was responsible for all strategic information systems including Spirit, Hyatt’s worldwide reservation system, which supported over 50,000 users and was recognized as the leading reservations system in the hospitality industry.
Mark A. Schumacher - 47 - Chief Accounting Officer of Archstone-Smith since December 2004 and Senior Vice President and Controller of Archstone-Smith from January 2002 to December 2004, with principal responsibility for accounting and financial reporting; prior thereto, Vice President and Corporate Controller of Qwest Communications International (“Qwest”) from December 2000 to December 2001 where he had principal responsibility for accounting and financial reporting; from April 1991 to December 2000, held various senior and executive level positions in the accounting and financial reporting departments of US West; from April 1984 to April 1991 he held various managerial level positions in the accounting and financial reporting department of US West. On March 15, 2005, the Securities and Exchange Commission entered an administrative order and settled civil proceedings against Mr. Schumacher relating to his work at Qwest. The Securities and Exchange Commission alleged, among other things, that Mr. Schumacher was a cause of Qwest failing to properly record and report certain transactions in accordance with generally accepted accounting principles in violation of the Securities Exchange Act of 1934 (the “Exchange Act”). Pursuant to the terms of the consent decree, Mr. Schumacher settled all claims against him, agreed to cease and desist from violating various provisions of Section 13 of the Exchange Act and related rules thereunder, agreed not to engage in the future in any activity in violation of such provisions and paid a fine of $40,000.
Employees
We currently employ approximately 2,703 individuals, of whom approximately 2,106 are focused on the site-level operation of our garden communities and high-rise properties. Of the site-level associates, approximately 126 are subject to collective bargaining agreements with four unions in Illinois and New York. The balance are professionals who manage corporate and regional operations, including our investment program, property operations, financial activities and other support functions. We consider our relationship with our employees to be very good.
Insurance
We carry comprehensive general liability coverage on our owned communities, with limits of liability customary within the industry to insure against liability claims and related defense costs. Similarly, we are insured
against the risk of direct physical damage in amounts necessary to reimburse the company on a replacement cost basis for costs incurred to repair or rebuild each property, including loss of rental income during the reconstruction period. Our property policies for all operating and development communities include coverage for the perils of flood and earthquake shock with limits and deductibles customary in the industry. We also obtain title insurance policies when acquiring new properties, which insure fee title to our real properties. We currently have coverage for losses incurred in connection with both domestic and foreign terrorist-related activities. The terms of our property and general liability policies may exclude certain mold-related claims or other types of claims based on the specific circumstances and allegations. Should an uninsured loss arise against the company, we would be required to use our own funds to resolve the issue, including litigation costs. In addition, we self-insure certain portions of our insurance program through a wholly-owned captive insurance company, and therefore use our own funds to satisfy those limits, when applicable.
Competition
There are numerous commercial developers, real estate companies and other owners of real estate that we compete with in seeking land for development, apartment communities for acquisition and disposition and residents for apartment communities. All of our apartment communities are located in developed areas that include other apartment communities. The number of competitive apartment communities in a particular area could have a material adverse effect on our ability to lease units and on the rents charged. In addition, single-family homes and other residential properties provide housing alternatives to residents and potential residents of our apartment communities.
Available Information and Code of Ethics
Our web site is http://www.archstonesmith.com. We make available free of charge, on or through our web site, our annual, quarterly and current reports, as well as any amendments to these reports, as soon as reasonably practicable after electronically filing these reports with the Securities and Exchange Commission. The reference to our web site does not incorporate by reference the information contained in the web site and such information should not be considered a part of this report. We have adopted a code of ethics and business conduct applicable to our Board and officers and employees, including our principal executive officer, principal financial officer and principal accounting officer or controller. A copy of our code of ethics and business conduct is included as an exhibit to this report and is available through our web site. In addition, copies of the code of ethics and business conduct can be obtained, free of charge, upon written request to Investor Relations, 9200 East Panorama Circle, Suite 400, Englewood, Colorado 80112. Any amendments to or waivers of our code of ethics and business conduct that apply to the principal executive officer, principal financial officer and principal accounting officer or controller and that relate to any matter enumerated in Item 406(b) of Regulation S-K, will be disclosed on our web site. Any reference to our website in this Annual Report does not incorporate by reference the information contained in the website and such information should not be considered a part of this Annual Report.
Item 1A.
Item 1A.
Risk Factors
The following factors could affect our future financial performance:
We have restrictions on the sale of certain properties.
A taxable sale of any of the properties acquired in the Smith Merger prior to January 1, 2022, could result in increased costs to us in light of the tax-related obligations made to the former Smith Partnership Unitholders. Under the shareholders’ agreement between Archstone-Smith, the Operating Trust, Robert H. Smith and Robert P. Kogod, we are restricted from transferring specified high-rise properties located in the Crystal City area of Arlington, Virginia until October 31, 2016, without the consent of Messrs. Smith and Kogod, which could result in our inability to sell these properties at an opportune time and at increased costs to us. However, we are permitted to transfer these properties in connection with a non-taxable sale or a sale of all of the properties in a single transaction or pursuant to a bona fide mortgage of any or all of such properties in order to secure a loan or other financing.
We have similar restrictions with respect to the properties acquired from Oakwood Worldwide in 2005. The restrictions last until the earlier of (a) such time as 99% of the contributing partners have sold, redeemed or otherwise disposed of their A-1 Common Units in a taxable event and (b) the later to occur of (x) 10 years from the closing of the contribution of such properties and (y) the last to die of Howard Ruby and Ed Broida.
We depend on our key personnel.
Our success depends on our ability to attract and retain the services of executive officers, senior officers and company managers. There is substantial competition for qualified personnel in the real estate industry and the loss of several of our key personnel could have an adverse effect on us.
Debt financing could adversely affect our performance.
We are subject to risks associated with debt financing and preferred equity. These risks include the risks that we will not have sufficient cash flow from operations to meet required payments of principal and interest or to pay distributions on our securities at expected rates, that we will be unable to refinance current or future indebtedness, that the terms of any refinancing will not be as favorable as the terms of existing indebtedness, and that we will be unable to make necessary investments in new business initiatives due to lack of available funds. Increases in interest rates could increase interest expense, which would adversely affect net earnings and cash available for payment of obligations. If we are unable to make required payments on indebtedness that is secured by a mortgage on our property, the asset may be transferred to the lender with a consequent loss of income and value to us.
Additionally, our debt agreements contain customary covenants which, among other things, restrict our ability to incur additional indebtedness and, in certain instances, restrict our ability to engage in material asset sales, mergers, consolidations and acquisitions. These debt agreements also require us to maintain various financial ratios. Failure to comply with these covenants could result in a requirement to repay the indebtedness prior to its maturity, which could have an adverse effect on our operations and ability to make distributions to shareholders.
Some of our debt instruments bear interest at variable rates. Increases in interest rates would increase our interest expense under these instruments and would increase the cost of refinancing these instruments and issuing new debt. As a result, higher interest rates would adversely affect cash flow and our ability to service our indebtedness.
We had $5.3 billion in total debt outstanding as of December 31, 2005, of which $2.4 billion was secured by real estate assets and $1.4 billion was subject to variable interest rates, including $394.6 million outstanding on our short-term credit facilities.
We may not have access to equity capital.
A prolonged period in which we cannot effectively access the public equity markets may result in heavier reliance on alternative financing sources to undertake new investment activities. These alternative sources of financing may be more costly than raising funds in the public equity markets.
We could be subject to acts of terrorism.
Periodically, we receive alerts from government agencies that apartment communities could be the target of both domestic and foreign terrorism. Although we currently have insurance coverage for losses incurred in connection with terrorist-related activities, losses could exceed our coverage limits and have a material adverse affect on our operating results.
We are subject to risks inherent in ownership of real estate.
Real estate cash flows and values are affected by a number of factors, including changes in the general economic climate, local, regional or national conditions (such as an oversupply of communities or a reduction in rental demand in a specific area), the quality and philosophy of management, competition from other available properties and the ability to provide adequate property maintenance and insurance and to control operating costs. Real estate cash flows and values are also affected by such factors as government regulations, including zoning,
usage and tax laws, interest rate levels, the availability of financing, property tax rates, utility expenses, potential liability under environmental and other laws and changes in environmental and other laws. Although we seek to minimize these risks through our market research and property management capabilities, they cannot be totally eliminated.
We are subject to risks inherent in real estate development.
We have developed or commenced development on a substantial number of apartment communities and expect to develop additional apartment communities in the future. Real estate development involves risks in addition to those involved in the ownership and operation of established communities, including the risks that financing, if needed, may not be available on favorable terms, construction may not be completed on schedule, contractors may default, estimates of the costs of developing apartment communities may prove to be inaccurate, the costs and availability of materials may be adversely affected by global supply and demand, and communities may not be leased or rented on profitable terms or in the time frame anticipated. Timely construction may be affected by local weather conditions, local moratoria on construction, local or national strikes and local or national shortages in materials, building supplies or energy and fuel for equipment. These risks may cause the development project to fail to perform as expected.
Real estate investments are relatively illiquid and we may not be able to recover our investments.
Equity real estate investments are relatively illiquid, which may tend to limit our ability to react promptly to changes in economic or other market conditions. Our ability to dispose of assets in the future will depend on prevailing economic and market conditions. Furthermore, our mezzanine loans to real estate investors may not be recoverable if those investors are unable to monetize the underlying asset at underwritten amounts.
Compliance with laws and regulatory requirements may be costly.
We must comply with certain accessibility, environmental, building, and health and safety laws and regulations related to the ownership, operation, development and acquisition of apartments. Under those laws and regulations, we may be liable for, among other things, the costs of bringing our properties into compliance with the statutory and regulatory requirements. Non-compliance with certain of these laws and regulations may impose liability without regard to fault, and could give rise to actions brought against us by governmental entities and/or third parties who claim to be or have been damaged as a consequence of an apartment not being in compliance with the subject laws and regulations. As part of our due diligence procedures in connection with the acquisition of a property, whether it is an apartment community or land to be developed, we conduct an investigation of the property’s compliance with known laws and regulatory requirements with which we must comply once we acquire a property, which investigation includes performing a Phase I environmental assessment of the property and a Phase II assessment if recommended in the Phase I report. We cannot, however give any assurance that our investigations and these assessments have revealed all potential non-compliance issues or related liabilities.
Costs associated with moisture infiltration and resulting mold remediation may be costly.
As a general matter, concern about indoor exposure to mold continues as such exposure has been alleged to have a variety of adverse effects on health. As a result, there have been a number of lawsuits in our industry against owners and managers of apartment communities relating to moisture infiltration and resulting mold. We have implemented guidelines and procedures to address moisture infiltration and resulting mold issues if and when they arise. We believe that these measures will minimize the potential for any adverse effect on our residents. The terms of our property and general liability policies after June 30, 2002, may exclude certain mold-related claims. Should an uninsured loss arise against the company, we would be required to use our own funds to resolve the issue, including litigation costs. We can make no assurance that liabilities resulting from moisture infiltration and the presence of or exposure to mold will not have a future material impact on our financial results.
Changes in laws may result in increased cost.
We may not be able to pass on increased costs resulting from increases in real estate taxes, income taxes or other governmental requirements, such as the enactment of regulations relating to internal air quality, directly to our residents. Substantial increases in rents, as a result of those increased costs, may affect the ability of a resident to pay rent, causing increased vacancy.
Archstone-Smith’s failure to qualify as a REIT would have adverse consequences.
We believe that we have qualified for taxation as a REIT under the Internal Revenue Code and we plan to continue to meet the requirements for taxation as a REIT. We cannot, however, guarantee that we will continue to qualify in the future as a REIT. We cannot give any assurance that new legislation, regulations, administrative interpretations or court decisions will not significantly change the requirements relating to Archstone-Smith’s qualification. If we fail to qualify as a REIT, we would be subject to federal income tax at regular corporate rates. Also, unless the Internal Revenue Service granted us relief, we would remain disqualified as a REIT for four years following the year in which we failed to qualify. In the event that we failed to qualify as a REIT, we would be required to pay significant income taxes and would have less money available for operations and distributions to shareholders. This would likely have a significant adverse effect on the value of our securities and our ability to raise additional capital. In order to maintain our qualification as a REIT under the Internal Revenue Code, our declaration of trust limits the ownership of our shares by any person or group of related persons to 9.8%, unless special approval is granted by our Board.
The Operating Trust intends to qualify as a partnership, but we cannot guarantee that the Operating Trust will qualify.
The Operating Trust intends to qualify as a partnership for federal income tax purposes. However, the Operating Trust will be treated as an association taxable as a corporation for federal income tax purposes if it is deemed to be a publicly traded partnership, unless at least 90% of its income is qualifying income as defined in the tax code. Qualifying income for the 90% test generally includes passive income, such as real property rents, dividends and interest. The income requirements applicable to REITs and the definition of qualifying income for purposes of this 90% test are similar in most respects. We believe that the Operating Trust will meet this qualifying income test, but cannot guarantee that it will. If the Operating Trust were to be taxed as a corporation, it will incur substantial tax liabilities, Archstone-Smith would fail to qualify as a REIT for tax purposes and Archstone-Smith’s and the Operating Trust’s ability to raise additional capital would be impaired.
We are subject to losses that may not be covered by insurance.
There are certain types of losses (such as from war) that may be uninsurable or not economically insurable. Additionally, many of our communities in California are located in the general vicinity of active earthquake fault lines and many of our Southeast Florida assets are in coastal locations and subject to hurricanes. Although we maintain insurance to cover most reasonably likely risks, including earthquakes and hurricanes, if an uninsured loss or a loss in excess of insured limits occurs, we could lose both our invested capital in, and anticipated profits from, one or more communities. We may also be required to continue to repay mortgage indebtedness or other obligations related to such communities. The terms of our property and general liability policies after June 30, 2002, may exclude certain mold-related claims. We can make no assurance that liabilities resulting from moisture infiltration and the presence of or exposure to mold will not have a future material impact on our financial results. Should an uninsured loss arise against the company, we would be required to use our own funds to resolve the issue, including litigation costs. Any such loss could materially adversely affect our business, financial condition and results of operations.
We have a concentration of investments in certain markets.
As shown in the Geographic Distribution table below in “Item 2. Properties,” our most significant investment concentrations are in the Washington, D.C. Metropolitan Area, Southern California and the San Francisco Bay Area. Southern California is the geographic area comprising the Los Angeles County, San Diego, Orange County,
the Inland Empire, and Ventura County markets. We are, therefore, subject to increased exposure (positive or negative) from economic and other competitive factors specific to markets within these geographic areas.
Our business is subject to extensive competition.
There are numerous commercial developers, real estate companies and other owners of real estate that we compete with in seeking land for development, apartment communities for acquisition and disposition and residents for apartment communities. All of our apartment communities are located in developed areas that include other apartment communities. The number of competitive apartment communities in a particular area could have a material adverse effect on our ability to lease units and on the rents charged. In addition, single-family homes and other residential properties provide housing alternatives to residents and potential residents of our apartment communities.
Item 1B.
Item 1B.
Unresolved Staff Comments
Not Applicable.
Item 2.
Item 2.
Properties
Geographic Distribution
At December 31, 2005, the geographic distribution for our eight core markets based on NOI for the three months ended December 31, 2005, excluding properties owned by Ameriton or located in Germany, was as follows:
The following table summarizes the geographic distribution for 2005, 2004 and 2003, based on NOI:
(1)
Based on NOI for the fourth quarter of each calendar year, excluding NOI from communities disposed of during the period. See Item 7 under the caption “Property-level operating results” for a discussion on why we believe NOI is a meaningful measure and a reconciliation of NOI to Earnings from Operations.
(2)
Markets that represent 1.0% or less of NOI are included in Other.
Real Estate Portfolio
We are a leading multifamily company focused on the operation, development, redevelopment, acquisition, management and long-term ownership of apartment communities in protected markets throughout the United States. The following information summarizes our wholly owned real estate portfolio as of December 31, 2005 (dollar amounts in thousands). Additional information on our real estate portfolio is contained in “Schedule III, Real Estate and Accumulated Depreciation” and in our audited financial statements contained in this Annual Report:
(1)
Represents the percentage leased as of December 31, 2005. For communities in Lease-Up, the percentage leased is based on leased units divided by total number of units in the community (completed and under construction) as of December 31, 2005. The “N/A” for the Seattle market in the High-Rise operating community section indicates that the market is entirely comprised of Oakwood Master Lease communities. Oakwood Master Leased communities have been excluded from the Percentage Leased calculation for other markets that have both Oakwood Master Leased communities and communities with traditional resident leases. A “N/A” indicates markets with communities under construction where Lease-Up has not yet commenced.
(2)
Includes a 623 unit community which is undergoing redevelopment whose occupancy was 50.4% during the period indicated.
(3)
Includes land that is not In Planning and other real estate assets.
(4)
As of December 31, 2005, we had one investment representing 83 units classified as In Planning and Under Control. Our actual investment in these communities was $145,000, which is reflected in the “Other assets” caption of our Balance Sheet.
Item 3.
Item 3.
Legal Proceedings
During the second quarter of 2005, we entered into a full and final settlement in the United States District Court for the District of Maryland with three national disability organizations and agreed to make capital improvements in a number of our communities in order to make them fully compliant with the Fair Housing Act and Americans with Disabilities Act. The litigation, settled by this agreement, alleged lack of full compliance with certain design and construction requirements under the two federal statutes at 71 of the company’s communities. As part of the settlement, the three disability organizations all recognized that Archstone-Smith had no intention to build any of its communities in a manner inconsistent with the FHA or ADA.
The amount of the capital expenditures required to remediate the remaining communities named in the settlement is estimated at $47.2 million and was accrued as an addition to real estate during the fourth quarter of 2005. The settlement agreement approved by the court allows us to remediate each of the designated communities over a three year period, and also provides that we are not restricted from selling any of our communities during the remediation period. We agreed to pay damages totaling $1.4 million, which included legal fees and costs incurred by the plaintiffs. We accrued other expenses of $4.0 million during 2005, which included the settlement and all related legal and other expenses paid in 2005 or expected to be paid during 2006.
We are subject to various claims filed in 2002 and 2003 in connection with moisture infiltration and resulting mold issues at certain high-rise properties we once owned in Southeast Florida. These claims generally allege that water infiltration and resulting mold contamination resulted in the claimants having personal injuries and/or property damage. Although certain of these claims continue to be in various stages of litigation, with respect to the majority of these claims, we have either settled the claims and/or we have been dismissed from the lawsuits that had been filed. With respect to the lawsuits that have not been resolved, we continue to defend these claims in the normal course of litigation.
We are a party to various other claims and routine litigation arising in the ordinary course of business. We do not believe that the results of any such claims or litigation, individually or in the aggregate, will have a material adverse effect on our business, financial position or results of operations.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
None
PART II
Item 5.
Item 5.
Market for the Registrant’s Common Equity and Related Stockholder Matters
Our Common Shares are listed on the NYSE under the symbol “ASN.” The following table sets forth the high and low sales prices of our Common Shares, as reported on the NYSE Composite Tape, and cash distributions per Common Share for the periods indicated.
As of March 1, 2006, we had approximately 213,308,000 Common Shares outstanding, approximately 3,234 record holders of Common Shares and approximately 27,650 beneficial holders of Common Shares.
To qualify as a REIT, we are required to make annual shareholder distributions of 90% of our taxable income. The payment of distributions is also subject to the discretion of the Board and is dependent upon our strategy, financial condition and operating results. Our long-term objective is to increase annual distributions per Common Share while maximizing the amount of internally generated cash flow from operations to fund future investment opportunities.
We announce the following year’s projected annual distribution level after the Board’s annual budget review and approval. In January 2006 the Board announced an increase in the annual distribution level from $1.73 to $1.74 per Common Share and declared the first quarter 2005 distribution of $0.435 per Common Share payable on February 28, 2006, to shareholders of record on February 15, 2006. This dividend marks our 122nd consecutive quarter of dividends declared and paid. All future Common Share distributions are subject to approval by our Board of Trustees.
We are restricted from declaring or paying any distribution with respect to our Common Shares unless cumulative distributions on all Preferred Shares have been paid and sufficient funds have been set aside for Preferred Share distributions that have been declared and not paid. All of our declared distributions have been paid on schedule.
For federal income tax purposes, distributions may consist of ordinary income, capital gains, non-taxable return of capital or a combination thereof. Distributions that exceed our current and accumulated earnings and profits constitute a return of capital rather than ordinary income and reduce the shareholder’s basis in the Common
Shares. To the extent that a distribution exceeds both current and accumulated earnings and profits and the shareholder’s basis in the Common Shares, it will generally be treated as a gain from the sale or exchange of that shareholder’s Common Shares. We notify our shareholders annually of the taxability of distributions paid during the preceding year. The following table summarizes the taxability of cash distributions paid on the Common Shares in 2005 and 2004:
For federal income tax purposes, the following summaries reflect the taxability of dividends paid on our Preferred Shares:
(1)
Includes $1.00 per share special dividend paid in 2004.
(2)
The Series D Preferred Shares were redeemed in full plus accrued dividends during August 2004.
(3)
The Series H, K and L Preferred Shares were converted into Common Shares during May 2003, September 2004 and December 2004, respectively. The dividend paid on the Series H, K and L Preferred Shares prior to conversion was $1.27 per share, $2.55 per share and $3.40 per share, respectively. The taxability of which is proportionate to the amounts listed in the table above.
(4)
The Series I Preferred Shares have a par value of $100,000 per share.
Our tax return for the year ended December 31, 2005 has not been filed, and the taxability information for 2005 is based upon the best available data we have. Our tax returns for prior years have not been examined by the Internal Revenue Service and, therefore, the taxability of the dividends may be subject to change.
In 2005, 2004 and 2003 we issued 11,289,070, 374,921 and 1,955,908 A-1 Common Units of the Operating Trust as partial consideration for real estate, respectively. All units were issued in transactions exempt from registration under Section 4(2) of the Securities Act of 1933 and the rules thereunder.
The following table summarizes repurchases of our Common Shares (amounts in thousands):
(1)
Price includes amounts paid for commissions.
(2)
On April 22, 2005, the Board increased the total authorized for share repurchases to $255 million.
Item 6.
Item 6.
Selected Financial Data
The following table provides selected financial data relating to our historical financial condition and results of operations as of and for each of the years ending December 31, 2001 to 2005. This data is qualified in its entirety by, and should be read in conjunction with, “Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Results of Operations
Executive Summary
During the three years covered by this Form 10-K, we have continued to focus on two of our most important goals: (i) managing our invested capital through the selective sale of apartment communities in non-core locations and redeploying the proceeds to fund investments with higher anticipated growth prospects in outstanding locations in our core markets; and (ii) building the dominant operating platform in the apartment industry. The following graph illustrates the major redeployment of capital that has occurred during this time period, excluding properties owned by Ameriton, properties located in Germany and REIT joint ventures in which our economic interest is less than 50% (dollar amounts in millions).
ASN Capital Redeployment
(1)
Based on Total Expected Investment
(2)
Please refer to the Consolidated Statements of Cash Flows in Item 15 of this Annual Report for a reconciliation of disposition proceeds to cash flow from investing activities.
Although the full measure of success related to this strategy will be more fully reflected in future results, the increase in our diluted earnings per share, which includes gains from dispositions, have been encouraging.
Diluted Earnings Per Share
Other major factors that influenced our operating results over the last three years include the following:
•
Our Same-Store NOI growth has improved by 520 basis points from 2004 to growth of 3.6% in 2005 as compared to 2004. We believe the improvement in our Same-Store performance has resulted from both strengthening fundamentals in our core markets as well as benefits from the significant investments we have made in people and operating systems.
•
The significant disposition volume reflected in the respective charts above, resulted in REIT GAAP gains, net of disposition costs, of $446.7 million, $372.2 million and $310.9 million in 2005, 2004 and 2003, respectively.
•
Utilizing the REIT’s development, acquisition and operating expertise, Ameriton has identified under-managed operating communities, as well as development and redevelopment opportunities with a short-term ownership horizon of one to three years that have produced GAAP gains, net of dispositions costs, of $75.2 million, $65.1 million and $42.7 million in 2005, 2004 and 2003, respectively. The REIT and Ameriton disposition gains have contributed significantly to our diluted earnings per share in each year.
•
We recognized $56.0 million, $19.2 million and $19.3 million in other income during 2005, 2004 and 2003, respectively, related primarily to insurance-related reimbursements and interest income.
•
We recognized $72.2 million, $29.3 million and $54.8 million in other expense, including discontinued operations, during 2005, 2004 and 2003, respectively, related primarily to Ameriton income taxes, debt extinguishment costs and loss contingencies.
•
We recognized $28.8 million and $28.2 million in other non-operating income during 2005 and 2004, respectively, related primarily to gains from the sale of our Rent.com investment and other equity securities.
Reconciliation of Quantitative Summary to Consolidated Statements of Earnings
The following schedule is provided to reconcile our consolidated statements of earnings to the information presented in the “Quantitative Summary” provided in the next section:
Quantitative Summary
This summary is provided for reference purposes and is intended to support and be read in conjunction with the narrative discussion of our results of operations. This quantitative summary includes all operating activities, including those classified as discontinued operations for GAAP reporting purposes. This information is presented to correspond with the manner in which we analyze the business. We generally reinvest disposition proceeds into new developments and operating communities and therefore believe it is most useful to analyze continuing and discontinued operations on a combined basis. The impact of communities classified as “discontinued operations” for GAAP reporting purposes is discussed separately in a later section under the caption “Discontinued Operations Analysis.”
(1)
Reflects revenues and operating expenses for Same-Store communities that were owned on December 31, 2005 and fully operating during all three years in the comparison period.
(2)
Does not include occupancy associated with properties owned by Ameriton, located in Germany or operated under the Oakwood Master Leases.
Property-level operating results - 2005 compared to
We utilize NOI as the primary measure to evaluate the performance of our operating communities and for purposes of making decisions about resource allocations and assessing segment performance. We also believe NOI is a valuable means of comparing period-to-period property performance. In analyzing the performance of our operating portfolio, we evaluate Same-Store communities separately from Non Same-Store communities and other properties.
Same-Store Analysis
The following table reflects revenue, expense and NOI growth for Same-Store communities that were owned on December 31, 2005 and fully operating during both years.
Same-Store revenues were up in all core markets for both the garden and the high-rise portfolios, resulting primarily from higher rental income per unit and a slight improvement in the percentage of units occupied. We experienced revenue growth throughout 2005 as our markets strengthened and pricing power returned as new move-in rents, a leading indicator, continued to rise. In addition to improving operating fundamentals across our markets, we believe LRO, our revenue management system, has also enabled us to better manage lease expirations and produce higher revenues in the slow seasonal months. The Washington D.C. Metropolitan Area and Southern California, our two largest markets, reported revenue growth of 3.9% and 4.3%, respectively. The drivers of our year-over-year operating expenses were higher real estate taxes and personnel costs, as well as extraordinary snow removal and utility expenses in the first quarter of 2005. These increases were realized to a greater degree in high-rise. These revenue and expense increases resulted in overall portfolio Same-Store NOI growth of 3.6%, which was the major driver of the 1.4% margin increase recorded for the overall portfolio.
Non Same-Store and Other Analysis
The $29.4 million NOI increase in the non Same-Store portfolio is primarily attributable to (i) $52.7 million related to acquisitions; (ii) $16.0 million related to newly developed apartment communities, including lease-ups; (iii) $20.0 million related to the Oakwood Master Leases; and offset by (iv) $62.5 million related to community dispositions.
Ameriton
The $0.9 million NOI decrease from Ameriton apartment communities is primarily attributable to a $6.7 million decline related to community dispositions, including the sale of new developments, partially offset by $5.9 million increase from community acquisitions.
Non Multi-family
The $2.6 million NOI increase is primarily attributable to commercial/retail income associated with an asset purchased by Ameriton in 2005.
Property-level operating results - 2004 compared to
Same-Store Analysis
The following table reflects revenue, expense and NOI growth/(decline) for Same-Store communities that were owned on December 31, 2004 and fully operating during both years:
Overall Same-Store revenues were up slightly, driven primarily by increases in the Washington D.C. Metropolitan Area and Southern California, our two largest markets, which reported revenue growth of 1.9%
and 3.0%, respectively. These increases were offset primarily by revenue declines due to continuing weakness in the San Francisco Bay Area, Chicago and Atlanta, which decreased 3.6%, 3.3% and 3.8%, respectively. The primary drivers of our year-over-year operating expenses were higher site and regional personnel costs and real estate taxes, which were partially offset by lower ground lease expenses in high-rise. These revenue and expense increases resulted in an overall portfolio Same-Store NOI decline of 1.6%.
Non Same-Store Analysis
The $16.4 million NOI decrease in the non Same-Store portfolio is primarily attributable to $63.6 million related to community dispositions offset by $40.2 million related to community acquisitions and $10.6 million related to newly developed apartment communities, including lease-ups.
Ameriton
The $0.3 million NOI decrease from Ameriton apartment communities is primarily attributable to a $3.2 million increase from community acquisitions and $1.3 million related to newly developed apartment communities, including lease-ups, partially offset by a $4.4 million decrease attributable to community dispositions.
Other Income
The increase in other income during 2005 as compared to 2004 resulted primarily from (i) a $25.7 million increase from insurance recoveries related to moisture infiltration and mold litigation settlement costs associated with a previously owned community in southeast Florida; (ii) a $9.3 million increase in interest income on mezzanine loans to third parties and other interest bearing instruments; (iii) a $4.7 million increase in hurricane-related insurance reimbursements; and (iv) a $2.8 million insurance reimbursement for costs incurred in connection with our FHA and ADA settlement. These increases and other smaller insurance-related reimbursements recorded in 2005 were partially offset by a $4.7 million benefit related to the sale of CES and higher land gains in 2004.
There was no significant change in the amount of other income during 2004 as compared to 2003. Notable differences in the composition of other income were the collection and recognition of $3.1 million related to the settlement of a CES lawsuit during 2004, a $4.4 million decrease in the collection of indemnified CES accounts receivable over 120 days during 2004 as compared to 2003, a $3.2 million increase in gains related to the disposition of land during 2004 as compared to 2003, and $5.7 million of dividend income on stock investments in 2003.
Depreciation Expense
The depreciation increases in each year are primarily related to the increase in the size of the real estate portfolio. A few of the major drivers are (i) amortization of the value associated with in-place leases over the lease term on new acquisitions; (ii) disposition of assets with a lower depreciable basis at significant gains, and reinvestment of the proceeds into assets with a higher depreciable basis; partially offset by (iii) cessation of depreciation on assets sold or classified as held for sale.
Interest Expense
The increase in gross interest expense during 2005 as compared to 2004 is due to higher average debt levels associated with the increased size of the real estate portfolio combined with higher average interest rates on our unsecured credit facilities and other variable rate debt instruments. The Oakwood transaction was the most significant driver of the portfolio increase in 2005. Capitalized interest also increased significantly as a result of the increase in the size and number of communities under construction and, to a lesser extent, higher average interest rates in 2005.
The slight decrease in interest expense during 2004 as compared to 2003 is primarily the result of a reduction in weighted average debt interest rates and a decrease in the average outstanding mortgage balance during 2004 as compared to 2003, as we paid off secured debt during the year. This was partially offset by an increase in the average outstanding long-term debt balance in 2004 as compared to 2003. Capitalized interest decreased in 2004 as
compared to 2003 due to fewer communities under construction, which partially offset the overall decrease in gross interest expense.
General and Administrative Expenses
The increase in general and administrative expenses during 2005 as compared to 2004 is due to higher employee compensation-related costs, increased recruiting and relocation expenses and higher travel costs. These costs were partially offset by a smaller charge in 2005 as compared to 2004 pertaining to executive Common Share grants related to the achievement of total shareholder return performance targets.
The increase in general and administrative expenses during 2004 as compared to 2003 is due primarily to executive Common Share grants related to the achievement of total shareholder return performance targets associated with a three-year special incentive plan, an increase in audit and consulting fees associated with Sarbanes-Oxley compliance and the impact of the fourth quarter special dividend on DEUs earned on restricted share units and some employee share options. These expenses were partially offset by lower severance costs and payroll expense in 2004 as compared to 2003.
Other Expenses
The increase in other expenses during 2005 as compared to 2004 is primarily attributable to (i) $21.1 million increase in early debt extinguishment costs; (ii) $11.9 million in legal expenses and litigation settlement costs related to the settlement of the FHA and ADA lawsuit and other legal matters; (iii) a $4.3 million increase in hurricane related charges; (iv) a $2.8 million writeoff of a loan to a prior affiliate; and (v) a $1.5 million impairment related to a non-core asset.
The decrease in other expense during 2004 as compared to 2003 is primarily due to a $29.0 million expense associated with moisture infiltration and resulting mold recorded during 2003 at certain high-rise properties we previously owned in Southeast Florida. The moisture infiltration costs pertain to estimated and incurred legal fees and estimated settlement costs, additional residential property repair and replacement costs, and temporary resident relocation expenses.
Minority Interest
Minority interest increased in each successive period as a result of higher earnings and changes in the relative number of Common Units in each period, which averaged 12.1%, 10.9% and 11.8% of net earnings for 2005, 2004 and 2003, respectively. The percentage increase in 2005 was primarily attributable to the Oakwood transaction, which was partially funded with Common Units, whereas the percentage decrease in 2004 was primarily attributable to conversions of Common Units to Common Shares.
Equity in Income from Unconsolidated Entities
The increase in income from unconsolidated entities during 2005 as compared to 2004 is due primarily to an increase in disposition-related gains, including $6.6 million from Ameriton joint ventures and recognition of a $1.7 million incentive payment earned in connection with the final liquidation of a joint venture partnership in 2005. These increases were partially offset by recognition of $3.2 million of contingent proceeds from the expiration during the second quarter of 2004 of certain indemnifications related to the sale of CES.
Income from unconsolidated entities increased during 2004 as compared to 2003 primarily due to gains from the sale of joint venture operating communities and the recognition of contingent proceeds from the expiration of certain indemnifications related to the sale of CES.
Other Non-Operating Income
Other non-operating income during 2005 consists primarily of $25.9 million of gains from the sale of our Rent.com investment and $2.1 million from the sale of other equity securities.
Other non-operating income increased during 2004 as compared to 2003 due to the recognition of $24.9 million in gains from the sale and settlement of equity securities, and a $3.3 million gain from the sale of our property management business in 2004.
Gains on real estate dispositions
See “Discontinued Operations Analysis” below for discussion of gains.
Discontinued Operations Analysis
Included in the overall results discussed above are the following amounts associated with properties which have been sold or were classified as held for sale as of December 31, 2005 (dollars in thousands).
(1)
The portion of interest expense included in discontinued operations that is allocated to properties based on the company’s leverage ratio was $19.3 million, $44.2 million and $64.5 million for 2005, 2004 and 2003, respectively.
As a result of the execution of our strategy of managing our invested capital through the selective sale of apartment communities in non-core locations and redeploying the proceeds to fund investments with higher anticipated growth prospects in our core markets, we had significant disposition activity in all three years. The resulting gains, net of disposition costs, were the biggest driver of overall earnings from discontinued operations. The gains progressively increased in each successive year as communities with higher values were sold and the market for apartment communities improved. Our taxable REIT subsidiary gains also increased in each year primarily as a result of Ameriton community dispositions, which contributed significantly to our earnings in each year. The year-to-year changes in revenues and operating expenses associated with discontinued operations is primarily attributable to the market and number of communities sold during the period or held for sale at the end of the period. Changes in direct operating expenses and allocated interest expense generally relate to the overall revenue levels for each period. Income taxes fluctuate in relation to the taxable gains associated with communities sold by our taxable REIT subsidiaries, which increased in each successive year. The portion of earnings from discontinued operations allocated to minority interest increased each year due primarily to the higher income resulting from higher gains.
Preferred Share Dividend Analysis
Preferred Share distributions decreased by $7.1 million in 2005 as compared to 2004 and by $10.1 million in 2004 as compared to 2003. This decrease was primarily due to the conversion of Series H Preferred Shares into Common Shares in May 2003, the conversion of Series A Preferred Shares into Common Shares in December 2003, the redemption of our Series D Preferred Shares in August 2004, the conversion of Series K Preferred Shares into Common Shares in September 2004 and the early conversion of Series L Preferred Shares into Common Shares in December 2004. These savings were partially offset by the recognition of $1.7 million of issuance costs related to the Series D Preferred Shares in 2004. The decrease in Preferred Share distributions due to conversions was offset by an increase in Common Share dividends.
Liquidity and Capital Resources
We are committed to maintaining a strong balance sheet and preserving our financial flexibility, which we believe enhances our ability to capitalize on attractive investment opportunities as they become available. As a result of the significant cash flow generated by our operations, current cash positions, the available capacity under our unsecured credit facilities, gains from the disposition of real estate and our demonstrated ability to access the capital markets, we believe our liquidity and financial condition are sufficient to meet all of our reasonably anticipated cash flow needs during 2006.
Analysis of Historical Cash Flows
The following discussion of our historical cash flows is intended to be read in conjunction with the Consolidated Statements of Cash Flows found in Item 15 of this Annual Report.
Operating Activities
Net cash flow provided by operating activities increased $8.3 million in 2005 as compared to 2004 resulting primarily from an increase in NOI. This increase in cash flow from community operations in addition to proceeds from insurance reimbursements were largely offset by cash used to pay down accrued expenses and accounts payable and used to fund other operating needs, including increased interest, general and administrative expenses and other costs.
Net cash flow provided by operating activities increased $26.1 million in 2004 as compared to 2003. This increase was principally due to lower moisture infiltration and resulting mold-related expenses during 2004, lower interest expense due to a reduction in the average debt rates and a reduction in average debt balances during 2004, as well as higher investment income from marketable equity securities.
See Results of Operations for a more complete discussion of the factors impacting our operating performance in each year.
Investing and Financing Activities
The $1.5 billion net decrease in cash flows from investing activities in 2005 as compared to 2004 was primarily due to an increase in community acquisitions, including the Oakwood transaction, and a decrease in proceeds from community dispositions. In addition, proceeds from the sale of marketable equity securities decreased and we increased our funding of mezzanine loans to third parties during 2005.
Net cash flows provided by investing activities increased by $124.2 million in 2004 as compared to 2003. This was due primarily to an increase in net proceeds from the disposition of real estate assets during 2004 as compared to the same period of 2003, and proceeds from the sale of marketable securities in 2004 that were acquired in 2003, which is included in “Other, net” in the accompanying Condensed Consolidated Statement of Cash Flows. The increase was partially offset by higher spending on acquisitions and development activity during 2004 as compared to 2003.
Net cash flows provided by financing activities increased $1.1 billion in 2005 as compared to 2004, due primarily to issuance of additional long-term debt and Common Shares and additional borrowings under our unsecured credit facilities to finance real estate investments. Additionally, during 2004, we used $113.6 million
more cash to repurchase Common Shares, Preferred Shares and Series E and F Perpetual Preferred Units and paid a $1.00 per Common Share special dividend.
Net cash flows used in financing activities decreased by $55.3 million in 2004 as compared to 2003, due to increased borrowings to finance a net increase in real estate investments during 2004 as compared to the prior year, partially offset by an increase in cash used to repurchase Common and Preferred Shares and pay the $1.00 per share special dividend in 2004.
Significant non-cash investing and financing activities for the years ended December 31, 2005, 2004 and 2003 consisted of the following:
•
Issued $408.0 million, $10.8 million and $47.6 million of A-1 Common Units as partial consideration for properties acquired during 2005, 2004 and 2003, respectively;
•
Issued $250,000 of Series N-1 and N-2 Preferred Units ($125,000 each) as partial consideration for real estate during 2005;
•
Holders of Series K Preferred Shares and Series L Preferred Shares converted $25.0 million of each Series into Common Shares during 2004;
•
Holders of Series H Preferred Shares converted $71.5 million of their shares into Common Shares during 2003;
•
Holders of Series A Preferred Shares converted $71.9 million of their shares into Common Shares during 2003.
•
Redeemed $8.4 million, $47.9 million and $25.5 million A-1 Common Units for Common Shares during 2005, 2004 and 2003, respectively;
•
Assumed mortgage debt of $864.2 million, $113.6 million and $55.4 million during 2005, 2004 and 2003, respectively, in connection with the acquisition of apartment communities;
•
Recorded a $47.2 million accrual for anticipated capital spending to bring properties named in the FHA and ADA settlement into compliance in 2005; and
•
Recorded an accrual related to moisture infiltration and resulting mold remediation for $36.1 million at one of our high-rise properties in Southeast Florida during 2003.
Scheduled Debt Maturities and Interest Payment Requirements
We have structured our long-term debt maturities in a manner designed to avoid unmanageable repayment obligations in any year, which would negatively impact our financial flexibility. We have $92.5 million in scheduled maturities during 2006, and we have $552.6 million and $551.5 million of long-term debt maturing during 2007 and 2008, respectively. See Note 7 in our audited financial statements in this Annual Report for additional information on outstanding debt balances and scheduled debt maturities.
On March 1, 2006, we had $379.1 million borrowed on our unsecured credit facilities, $12.7 million outstanding under letters of credit and available borrowing capacity on our unsecured credit facilities of $308.2.
Our unsecured credit facilities, Long-Term Unsecured Debt and mortgages payable had effective weighted average interest rates of 4.21%, 5.85% and 5.15%, respectively, as of December 31, 2005. All of these rates give effect to debt issuance costs, fair value hedges, the amortization of fair market value purchase adjustments and other fees and expenses, as applicable.
Our debt instruments generally contain covenants common to the type of facility or borrowing, including financial covenants establishing minimum debt service coverage ratios and maximum leverage ratios. We were in compliance with all financial covenants pertaining to our debt instruments as of and for the year ended December 31, 2005.
Shareholder Dividend/Distribution Requirements
Based on anticipated distribution levels for 2006 and the number of shares and units outstanding as of December 31, 2005, we anticipate that we will pay the following dividends/distributions in 2006 (in thousands, except per share amounts):
(1)
Future distributions on Common Shares and Units are contingent upon approval by our Board of Trustees
(2)
See Note 10 in our audited financial statements in this Annual Report for more information on minority interests.
(3)
Series I Preferred Shares have a par value of $100,000 per share.
Planned Investments
Following is a summary of planned investments as of December 31, 2005, including Ameriton but excluding joint ventures (dollar amounts in thousands). The amounts labeled “Discretionary” represent future investments that we plan to make, although there is not a contractual commitment to do so. The amounts labeled “Committed” represent the approximate amount that we are contractually committed to fund for communities under construction in accordance with construction contracts with general contractors.
In addition to the planned investments noted above, we expect to make additional investments relating to planned expenditures on recently acquired communities as well as recurring expenditures to improve and maintain our established operating communities.
We anticipate completion of most of the communities that are currently under construction and the planned operating community improvements by the end of 2008. No assurances can be given that communities we do not currently own will be acquired or that planned developments will actually occur. In addition, actual costs incurred could be greater or less than our current estimates.
Funding Sources
We anticipate financing our planned investment and operating needs primarily with cash flow from operating activities, disposition proceeds from our capital recycling program, existing cash balances and borrowings under our unsecured credit facilities, prior to arranging additional long-term financing. We had $308.2 million in available
capacity on our unsecured credit facilities, $53.1 million of cash in tax-deferred exchange escrow and $2.0 million of cash on hand at March 1, 2006. In addition, we expect to complete the disposition of $1.1 - $1.4 billion of REIT operating communities during 2006.
As of March 1, 2006, the Operating Trust had $300 million available in shelf registered debt securities which can be issued subject to our ability to effect offerings on satisfactory terms based on prevailing market conditions. We anticipate filing registration statements for both Archstone-Smith and the Operating Trust to facilitate our future ability to issue additional securities.
Litigation and Contingencies
During the second quarter of 2005, we entered into a full and final settlement in the United States District Court for the District of Maryland with three national disability organizations and agreed to make capital improvements in a number of our communities in order to make them fully compliant with the Fair Housing Act and Americans with Disabilities Act. The litigation, settled by this agreement, alleged lack of full compliance with certain design and construction requirements under the two federal statutes at 71 of the company’s communities. As part of the settlement, the three disability organizations all recognized that Archstone-Smith had no intention to build any of its communities in a manner inconsistent with the FHA or ADA.
The amount of the capital expenditures required to remediate the remaining communities named in the settlement is estimated at $47.2 million and was accrued as an addition to real estate during the fourth quarter of 2005. The settlement agreement approved by the court allows us to remediate each of the designated communities over a three year period, and also provides that we are not restricted from selling any of our communities during the remediation period. We agreed to pay damages totaling $1.4 million, which included legal fees and costs incurred by the plaintiffs. We accrued other expenses of $4.0 million during 2005, which included the settlement and all related legal and other expenses paid in 2005 or expected to be paid during 2006.
During 2004 and 2005, we incurred losses associated with multiple hurricanes in Florida. As a result of this damage, we recorded charges for actual or estimated losses associated with both wholly owned and unconsolidated apartment communities and benefits for collected or estimated insurance recoveries. These estimates represent management’s best estimate of the probable and reasonably estimable costs and related recoveries and are based on the most current information available from our insurance adjustors.
We are subject to various claims filed in 2002 and 2003 in connection with moisture infiltration and resulting mold issues at certain high-rise properties we once owned in Southeast Florida. These claims generally allege that water infiltration and resulting mold contamination resulted in the claimants having personal injuries and/or property damage. Although certain of these claims continue to be in various stages of litigation, with respect to the majority of these claims, we have either settled the claims and/or we have been dismissed from the lawsuits that had been filed. With respect to the lawsuits that have not been resolved, we continue to defend these claims in the normal course of litigation.
We are a party to various other claims and routine litigation arising in the ordinary course of business. We do not believe that the results of any such claims or litigation, individually or in the aggregate, will have a material adverse effect on our business, financial position or results of operations.
Critical Accounting Policies
We define critical accounting policies as those accounting policies that require our management to exercise their most difficult, subjective and complex judgments. Our management has discussed the development and selection of all of these critical accounting policies with our audit committee, and the audit committee has reviewed the disclosure relating to these policies. Our critical accounting policies relate principally to the following key areas:
Internal Cost Capitalization
We have an investment organization that is responsible for development and redevelopment of apartment communities. Consistent with GAAP, all direct and certain indirect costs, including interest and real estate taxes,
incurred during development and redevelopment activities are capitalized. Interest is capitalized on real estate assets that require a period of time to get them ready for their intended use. The amount of interest capitalized is based upon the average amount of accumulated development expenditures during the reporting period. Included in capitalized costs are management’s estimates of the direct and incremental personnel costs and indirect project costs associated with our development and redevelopment activities. Indirect project costs consist primarily of personnel costs associated with construction administration and development accounting, legal fees, and various office costs that clearly relate to projects under development. Because the estimation of capitalizable internal costs requires management’s judgment, we believe internal cost capitalization is a “critical accounting estimate.”
If future accounting rules limit our ability to capitalize internal costs or if our development activity decreased significantly without a proportionate decrease in internal costs, there could be an increase in our operating expenses. For example, if hypothetically, we were to reduce our development and land acquisition activity by 25% with no corresponding decrease in internal costs, our net earnings per Common Share could decrease by approximately 1.2% or approximately $0.037 based on 2005 amounts.
Valuation of Real Estate
Long-lived assets to be held and used are carried at cost and evaluated for impairment when events or changes in circumstances indicate such an evaluation is warranted. We also evaluate assets for potential impairment when we deem them to be held for sale. Valuation of real estate is considered a “critical accounting estimate” because the evaluation of impairment and the determination of fair values involve a number of management assumptions relating to future economic events that could materially affect the determination of the ultimate value, and therefore, the carrying amounts of our real estate. Furthermore, decisions regarding when a property should be classified as held for sale under SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets,” requires significant management judgment. There are many phases to the disposition process ranging from the initial market research to being under contract with non-refundable earnest money. Deciding when management is committed to selling an asset is therefore highly subjective.
When determining if there is an indication of impairment, we estimate the asset’s NOI over the anticipated holding period on an undiscounted cash flow basis and compare this amount to its carrying value. Estimating the expected NOI and holding period requires significant management judgment. If it is determined that there is an indication of impairment for assets to be held and used, or if an asset is deemed to be held for sale, we then determine the fair value of the asset.
The apartment industry uses capitalization rates as the primary measure of fair value. Specifically, annual NOI for a community is divided by an estimated capitalization rate to determine the fair value of the community. Determining the appropriate capitalization rate requires significant judgment and is typically based on many factors including the prevailing rate for the market or submarket, as well as the quality and location of the properties. Further, capitalization rates can fluctuate up or down due to a variety of factors in the overall economy or within local markets. If the actual capitalization rate for a community is significantly different from our estimated rate, the impairment evaluation for an individual asset could be materially affected. For example, we would value a community with annual NOI of $10 million at $200 million using a 5.0% capitalization rate, whereas that same community would be valued at $166.7 million if the actual capitalization rate were 6.0%. Historically we have had limited and infrequent impairment charges, and the majority of our apartment community sales have produced gains. For example, we have sold approximately $3.8 billion of real estate assets over the 3 years covered by this Annual Report, which produced approximately $1.3 billion in gains. Over that same period, we have recorded $5.2 million in valuation-related impairments.
Capital Expenditures and Depreciable Lives
We incur costs relating to redevelopment initiatives, revenue enhancing and expense reducing capital expenditures, and recurring capital expenditures that are capitalized as part of our real estate. These amounts are capitalized and depreciated over estimated useful lives determined by management. We allocate the cost of newly acquired properties between net tangible and identifiable intangible assets. The primary intangible asset associated with an apartment community acquisition is the value of the existing lease agreements. When allocating
cost to an acquired property, we first allocate costs to the estimated intangible value of the existing lease agreements and then to the estimated value of the land, building and fixtures assuming the property is vacant. We estimate the intangible value of the lease agreements by determining the lost revenue associated with a hypothetical lease-up. We depreciate the building and fixtures based on the expected useful life of the asset and amortize the intangible value of the lease agreements over the average remaining life of the existing leases.
Determining whether expenditures meet the criteria for capitalization, the assignment of depreciable lives and determining the appropriate amounts to allocate between tangible and intangible assets for property acquisitions requires our management to exercise significant judgment and is therefore considered a “significant accounting estimate.”
Total capital expenditures were 1.5% and 1.0% of weighted average gross real estate as of December 31, 2005 and 2004, respectively. Additionally, depreciation expense as a percentage of depreciable real estate was 3.1%, 3.3% and 3.2% or $1.03, $0.99 and $1.04 per Share for the years ended December 31, 2005, 2004 and 2003, respectively. If the actual weighted average useful life were determined to be one year shorter or longer than management’s current estimate, our annual depreciation expense would increase or decrease approximately 3.1% or $0.03 per Common Share. See Note 1 in our audited financial statements in this Annual Report for additional detail on depreciable lives.
Pursuit Costs
We incur costs relating to the potential acquisition of real estate which we refer to as pursuit costs. To the extent that these costs are identifiable with a specific property and would be capitalized if the property were already acquired, the costs are accumulated by project and capitalized in the Other Asset section of the balance sheet. If these conditions are not met, the costs are expensed as incurred. Capitalized costs include but are not limited to earnest money, option fees, environmental reports, traffic reports, surveys, photos, blueprints, direct and incremental personnel costs and legal costs. Upon acquisition, the costs are included in the basis of the acquired property. When it becomes probable that a prospective acquisition will not be acquired, the accumulated costs for the property are charged to other expense on the statement of earnings in the period such a determination is made.
Because of the inherent judgment involved in evaluating whether a prospective property will ultimately be acquired, we believe capitalizable pursuit costs are a “critical accounting estimate.” If it were determined that 25% of accumulated costs relating to prospective acquisitions were deemed improbable as of December 31, 2005, net earnings for the year ended December 31, 2005 would decrease by approximately $0.017 per share, excluding refundable earnest money.
Consolidation vs. Equity Method of Accounting for Ventures
From time to time, we make co-investments in real estate ventures with third parties and are required to determine whether to consolidate or use the equity method of accounting for the venture. FASB Interpretation No. 46R, “Consolidation of Variable Interest Entities” (as revised) and Emerging Issues Task Force issued EITF No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights” are the two primary sources of accounting guidance in this area. Appropriate application of these relatively complex rules requires substantial management judgment, which we believe makes the choice of the appropriate accounting method for these ventures a “critical accounting estimate”.
For example, if we were to consolidate all of our equity-method joint ventures at December 31, 2005, our total assets and total liabilities would increase by approximately $1.3 billion (11%) and $1.0 billion (18%), respectively.
Off Balance Sheet Arrangements
Our real estate investments in entities that do not qualify as variable interest entities, variable interest entities where we are not the primary beneficiary and entities we do not control through majority economic interest, are not consolidated and are reported as investments in unconsolidated entities. Our investments in and advances to
unconsolidated entities at December 31, 2005, aggregated $132.7 million. Please refer Note 5 Investments in and Advances to Unconsolidated Entities for additional information.
As part of the Smith Merger and the Oakwood transaction, we are required to indemnify certain unitholders for any personal income tax expense resulting from the sale of properties identified in tax protection agreements.
Contractual Commitments
The following table summarizes information contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations and in our audited financial statements in this Annual Report regarding contractual commitments (amounts in millions):
(1)
The $600 million unsecured facility matures December 2007, with a one-year extension option available at our discretion.
(2)
Archstone-Smith, our subsidiaries and investees have not been required to perform on these guarantees, nor do we anticipate being required to perform on such guarantees. Since we believe that our risk of loss under these contingencies is remote, no accrual for potential loss has been made in the accompanying financial statements. We are still obligated for certain performance bond guarantees for SMC subsequent to their sale, but there are recourse provisions available to us to recover any potential future payments from the new owners of SMC.
(3)
Represents the estimated capital spending associated with the FHA and ADA settlement assuming 1/3 of the total will be spent in each of the next three years. Certain communities impacted by the settlement may be sold, which could impact the ultimate timing and amounts spent.
(4)
Lease commitments relate principally to ground lease payments as of December 31, 2005.
New Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (the FASB) issued SFAS No. 123R, “Share-Based Payment.” This Statement is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB No. 25, “Accounting for Stock Issued to Employees.” The Statement requires companies to recognize, in the income statement, the grant-date fair value of stock options and other equity based compensation issued to employees. This Statement is effective as of the beginning of the first interim or annual period that commences after January 1, 2006. We do not believe that the adoption of SFAS No. 123R will have a material impact on our financial position, net earnings or cash flows.
In June 2005, the Emerging Issues Task Force issued EITF No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights” (EITF No. 04-5). This Issue provides a framework for evaluating whether a general partner or group of general partners or managing members controls a limited partnership or limited liability company and therefore should consolidate the entity. The presumption that the general partner or group of general partners or managing members controls a limited liability partnership or limited liability company may be overcome if the limited partners
or members have (1) the substantive ability to dissolve the partnership without cause, or (2) substantive participating rights. EITF No. 04-5 became effective on June 30, 2005 for new or modified limited partnerships or limited liability companies and January 1, 2006 for all existing arrangements. We do not believe that the adoption of EITF No. 04-5 will have a material impact on our financial position, net earnings or cash flows.
In March 2005, the FASB issued Financial Interpretation No 47, “Accounting for Conditional Asset Retirement Obligations an interpretation of FASB Statement No. 143” (FIN 47). FIN 47 resulted in FASB Statement No. 143 (SFAS 143), “Accounting for Asset Retirement Obligations,” to be applied to more situations than many entities had previously applied it in practice. FIN 47 requires entities to recognize liabilities for conditional asset retirement obligations if a reasonable estimate of fair value can be made. Based on the premise that no tangible asset lasts forever, the obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or method of settlement. Accordingly, a company should recognize an asset retirement liability for a conditional asset retirement obligation with the offset to the asset itself in the period in which the obligation is incurred if the fair value of the liability can be reasonably estimated. The impact of FIN 47 is most discernable to the company related to asbestos exposure at certain of our real estate assets. FIN 47 became effective no later than the end of the fiscal years ending after December 15, 2005 and was adopted by the company for the year ended December 31, 2005. The adoption of FIN 47 did not have a material impact on our financial position or cash flows.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” (SFAS No. 154), as part of an effort to conform to international accounting standards. SFAS No. 154 requires that all voluntary changes in accounting principles are retrospectively applied to prior financial statements as if that principle had always been used, unless it is impracticable to do so. When it is impracticable to calculate the effects on all prior periods, SFAS No. 154 requires that the new principle be applied to the earliest period practicable. This statement is effective as of the first fiscal year beginning after December 15, 2005. We do not believe any voluntary changes in accounting principles, relating to the adoption of SFAS No. 154, would have a material effect on our financial position or results of operations.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Stock Investments
From time to time we make public and private investments in equity securities. The publicly traded equity securities are classified as “available for sale securities” and carried at fair value, with unrealized gains and losses reported as a separate component of shareholders’ equity. The private investments, for which we lack the ability to exercise significant influence, are accounted for at cost. Declines in the value of public and private investments that our management determines are other than temporary, are recorded as a provision for possible loss on investments. Our evaluation of the carrying value of these investments is primarily based upon a regular review of market valuations (if available), each company’s operating performance and assumptions underlying cash flow forecasts. In addition, our management considers events and circumstances that may signal the impairment of an investment.
Interest Rate Hedging Activities
We are exposed to the impact of interest rate changes and will occasionally utilize interest rate swaps and interest rate caps as hedges with the objective of lowering our overall borrowing costs. These derivatives are designated as either cash flow or fair value hedges. We do not use these derivatives for trading or other speculative purposes. Further, as a matter of policy, we only enter into contracts with major financial institutions based upon their credit ratings and other factors. When viewed in conjunction with the underlying and offsetting exposure that the derivatives are designed to hedge, we have not sustained, nor do we expect to sustain, a material loss from the use of these hedging instruments.
We formally assess, both at inception of the hedge and on an ongoing basis, whether each derivative is highly effective in offsetting changes in fair values or cash flows of the hedged item. We measure hedge effectiveness by comparing the changes in the fair value or cash flows of the derivative instrument with the changes in the fair value or cash flows of the hedged item. We assess effectiveness of purchased interest rate caps based on overall changes in the fair value of the caps. If a derivative ceases to be a highly effective hedge, we discontinue hedge accounting prospectively.
To determine the fair values of derivative and other financial instruments, we use a variety of methods and assumptions that are based on market value conditions and risks existing at each balance sheet date. These methods and assumptions include standard market conventions and techniques such as discounted cash flow analysis, option pricing models, replacement cost and termination cost. All methods of assessing fair value result in a general approximation of value, and therefore, are not necessarily indicative of the actual amounts that we could realize upon disposition.
During the years ended December 31, 2005, 2004 and 2003 we recorded an increase/(decrease) to interest expense of $(174,000), $33,000 and $101,000, for hedge ineffectiveness caused by a difference between the interest rate index on a portion of our outstanding variable rate debt and the underlying index of the associated interest rate swap. We pursue hedging strategies that we expect will result in the lowest overall borrowing costs and least degree of earnings volatility possible under the new accounting standards.
The following table summarizes the notional amount, carrying value and estimated fair value of our derivative financial instruments used to hedge interest rates, as of December 31, 2005 (dollar amounts in thousands). The notional amount represents the aggregate amount of a particular security that is currently hedged at one time, but does not represent exposure to credit, interest rate or market risks.
During 2004, we entered into interest rate swap transactions to mitigate the risk of changes in the interest-related cash outflows on a forecasted issuance of long-term unsecured debt. At inception, these swap transactions had an aggregate notional amount of $144 million and a fair value of zero. The long-term unsecured debt these swap transactions related to was issued in August 2004. The hedge was terminated when the debt was issued. The fair value of the cash flow hedge upon termination was a liability of approximately $2.5 million. This amount was deferred in accumulated other comprehensive income and will be reclassified out of accumulated other comprehensive income as additional interest expense as the hedged forecasted interest payments occur.
Foreign Currency Hedging Activities
We are exposed to foreign-exchange related variability and earnings volatility on our foreign investments. During 2005, we entered into a foreign currency forward contract with a notional amount of 8.5 million and designated the contract as a cash flow hedge. The fair value of this forward contract at December 31, 2005 was $(15,000).
Energy Contract Hedging Activities
We are exposed to price risk associated with the volatility of fuel oil and electricity rates. During 2005, we entered into contracts with several of our suppliers to fix our payments on set quantities of fuel oil and electricity. If the contract meets the criteria of a derivative, we designate these contracts as cash flow hedges of the overall changes in floating-rate payments made on our energy purchases. As of December 31, 2005, we had energy-related derivatives with aggregate notional amounts of $1.0 million and an estimated fair value and carrying amount of ($32,000). These contracts mature on or before December 31, 2006.
Equity Securities Hedging Activities
We are exposed to price risk associated with changes in the fair value of certain equity securities. During 2003, we entered into forward sale agreements with an aggregate notional amount, which represents the fair value of the underlying marketable securities, of approximately $128.5 million and an aggregate fair value of the forward sale agreements of approximately $486,000, to protect against a reduction in the fair value of these securities. We designated this forward sale as a fair value hedge.
During 2004, we settled all of the forward sales agreements for approximately 2.8 million shares, and sold 308,200 shares of marketable securities, which were not subject to forward sales agreements, resulting in an aggregate gain of approximately $24.9 million. The total net proceeds from the sale were $143.0 million, with the marketable securities basis determined using the average costs of the securities. The fair value of forward sales agreements at December 31, 2004 was $0.
Interest Rate Sensitive Liabilities
The table below provides information about our liabilities that are sensitive to changes in interest rates as of December 31, 2005. As the table incorporates only those exposures that existed as of December 31, 2005, it does not consider those exposures or positions that could arise after that date.
Moreover, because there were no firm commitments to actually sell these instruments at fair value as of December 31, 2005, the information presented herein is an estimate and has limited predictive value. As a result, our ultimate realized gain or loss, if any, will depend on the exposures that arise during future periods, hedging strategies, prevailing interest rates and other market factors existing at the time. The debt classification and interest rates shown below give effect to fair value hedges and other fees or expenses, where applicable (in thousands):
(1)
The estimated fair value for each of the liabilities listed was calculated by discounting the actual principal payment stream at prevailing interest rates (obtained from third party financial institutions) currently available on debt instruments with similar terms and features.
(2)
Reflects the weighted average nominal interest rate on the liabilities outstanding during each period, giving effect to principal payments and final maturities during each period, if any. The nominal rates for variable rate mortgages payable have been held constant during each period presented based on the actual variable rates as of December 31, 2005. The weighted average effective interest rate on the unsecured credit facilities, Long-Term Unsecured Debt and mortgages payable was 4.2%, 5.9% and 5.2%, respectively, as of December 31, 2005.
(3)
Represents unsecured tax-exempt bonds.
Item 8.
Item 8.
Financial Statements and Supplementary Data
Our Balance Sheets as of December 31, 2005 and 2004, and our Statements of Earnings, Shareholders’ Equity and Cash Flows for each of the years in the three-year period ended December 31, 2005, Schedule III - Real Estate and Accumulated Depreciation and Schedule IV - Mortgage Loans on Real Estate, together with the reports of KPMG LLP, Independent Registered Public Accounting Firm, are included under Item 15 of this Annual Report and are incorporated herein by reference. Selected quarterly financial data is presented in Note 13 of our audited financial statements in this Annual Report.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A.
Item 9A.
Controls and Procedures
An evaluation was carried out under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-14(c) under the Securities Exchange Act of 1934). Based on their evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were, to the best of their knowledge, effective as of December 31, 2005, to ensure that information required to be disclosed in reports that are filed or submitted under the Securities Exchange Act are recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. Subsequent to December 31, 2005, there were no significant changes in the company’s disclosure controls or in other factors that could significantly affect these controls, including any corrective actions with regard to significant deficiencies and material weaknesses.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2005. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. We have concluded that, as of December 31, 2005, our internal control over financial reporting was effective based on these criteria. Our independent registered public accounting firm, KPMG LLP, has issued an audit report on our assessment of our internal control over financial reporting, which is included herein.
Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of their inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Archstone-Smith have been detected.
/s/ R. Scot Sellers
R. Scot Sellers
Chairman of the Board, Chief Executive Officer and Trustee (principal executive officer)
/s/ Charles E. Mueller, Jr.
Charles E. Mueller, Jr.
Chief Financial Officer (principal financial officer)
Item 9B.
Item 9B.
Other Information
Not Applicable.
Part III
Item 10.
Item 10.
Trustees and Executive Officers of the Registrant
For information regarding certain senior officers, including all of our executive officers, see “Item 1. Business - Officers of Archstone-Smith.” For information on our Code of Ethics, see “Item 1. Business - Available Information and Code of Ethics.” The other information required by this Item 10 is incorporated herein by reference to the description under the captions “Election of Trustees,” “Section 16(a) Beneficial Ownership Reporting Compliance,” and “Report of the Audit Committee” in our definitive proxy statement for our annual meeting of shareholders (“2006 Proxy Statement”).
Item 11.
Item 11.
Executive Compensation
Incorporated herein by reference to the description under the captions “Election of Trustees” and “Executive Compensation” in the 2006 Proxy Statement.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management
Incorporated herein by reference to the description under the captions “Principal Shareholders” in the 2006 Proxy Statement.
Equity Compensation Plan Information
Item 13.
Item 13.
Certain Relationships and Related Transactions
Incorporated herein by reference to the description under the caption “Certain Relationships and Transactions” in the 2006 Proxy Statement.
Item 14.
Item 14.
Principal Accounting Fees and Services
Incorporated herein by reference to the description under the caption, “Ratification of Relationship with Independent Registered Public Accountants” in the 2006 Proxy Statement.
Part IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedules
The following documents are filed as part of this report:
(a)
Financial Statements and Schedule:
1.
Financial Statements
See Index to Financial Statements and Schedule on page 52 of this report, which is incorporated herein by reference.
2.
Financial Statement Schedule:
See Schedule III on page 93 of this report, which is incorporated herein by reference.
See Schedule IV on page 96 of this report, which is incorporated herein by reference.
All other schedules have been omitted since the required information is presented in the financial statements and the related notes or is not applicable.
3.
Exhibits
See Index to Exhibits on page 99 of this report, which is incorporated herein by reference.
(b)
Exhibits:
The Exhibits required by Item 601 of Registration S-K are listed in the Index to Exhibits on page 99 of this Annual Report, which is incorporated herein by reference.
INDEX TO FINANCIAL STATEMENTS AND SCHEDULE
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Trustees and Shareholders
Archstone-Smith Trust:
We have audited the accompanying consolidated balance sheets of Archstone-Smith Trust and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of earnings, shareholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of Archstone-Smith Trust’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Archstone-Smith Trust and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Archstone-Smith Trust’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 9, 2006, expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
Denver, Colorado
March 9, 2006
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Trustees and Shareholders
Archstone-Smith Trust:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that Archstone-Smith Trust maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Archstone-Smith Trust’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of Archstone-Smith Trust’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Archstone-Smith Trust maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Archstone-Smith Trust maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Archstone-Smith Trust and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of earnings, shareholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated March 9, 2006, expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Denver, Colorado
March 9, 2006
ARCHSTONE-SMITH TRUST
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
ARCHSTONE-SMITH TRUST
CONSOLIDATED STATEMENTS OF EARNINGS
(In thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
ARCHSTONE-SMITH TRUST
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME (LOSS)
Years Ended December 31, 2005, 2004 and 2003
(In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
ARCHSTONE-SMITH TRUST
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
These consolidated statements of cash flows combine cash flows from discontinued operations with cash flows from continuing operations. See Note 17 for supplemental information on non-cash investing and financing activities.
The accompanying notes are an integral part of these consolidated financial statements.
ARCHSTONE-SMITH TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
(The glossary included in this Annual Report is hereby incorporated by reference)
(1)
Description of Business and Summary of Significant Accounting Policies
Business
Our business is conducted primarily through our majority owned subsidiary, the Operating Trust. We are structured as an UPREIT under which all property ownership and business operations are conducted through the Operating Trust. We are the sole trustee and own approximately 86.2% of the Operating Trust’s outstanding A-1 Common Units; the remaining 13.8% are owned by minority interest holders. As used herein, “we,” “our” and the “company” refers to the Operating Trust and Archstone-Smith, collectively, except where the context otherwise requires. Archstone-Smith is an equity REIT organized under the laws of the State of Maryland. We focus on creating value for our shareholders by acquiring, developing, redeveloping and operating apartments in our core markets which are characterized by protected locations with limited land for new housing construction, expensive single-family home prices, and a strong, diversified economic base with significant employment growth potential.
Principles of Consolidation
The accounts of Archstone-Smith and its controlled subsidiaries are consolidated in the accompanying financial statements. All significant inter-company accounts and transactions have been eliminated. We use the equity method to account for investments that do not qualify as variable interest entities, variable interest entities where we are not the primary beneficiary and entities that we do not control, or where we do not own a majority of the economic interest, but have the ability to exercise significant influence over the operating and financial policies of the investee. For an investee accounted for under the equity method, our share of net earnings or losses of the investee is reflected in income as earned and dividends are credited against the investment as received.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect amounts reported in the financial statements and the related notes. Actual results could differ from management’s estimates. Estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the period they are determined to be necessary.
Discontinued Operations
For properties accounted for under SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets,” the results of operations for properties sold during the period or classified as held for sale at the end of the current period are required to be classified as discontinued operations in the current and prior periods. The property-specific components of net earnings that are classified as discontinued operations include rental revenue, rental expense, real estate tax, depreciation expense, minority interest and interest expense (actual interest expense for encumbered properties and a pro-rata allocation of interest expense for any unencumbered portion up to our weighted average leverage ratio). The net gain or loss and the related internal disposition costs on the eventual disposal of the held for sale properties are also classified as discontinued operations. Properties sold by our unconsolidated entities are not included in discontinued operations and related gains or losses are reported as a component of income from unconsolidated entities.
Cash and Cash Equivalents
Cash and cash equivalents consist of cash on hand, demand deposits with financial institutions and short-term, highly liquid investments. We consider all highly liquid instruments with maturities when purchased of three months or less to be cash equivalents.
ARCHSTONE-SMITH TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Restricted Cash in Tax-Deferred Exchange and Bond Escrow
In most cases, disposition proceeds are set aside and designated to fund future tax-deferred exchanges of qualifying real estate investments. If these proceeds are not redeployed to qualifying real estate investments within 180 days, these funds are redesignated as cash and cash equivalents. We generally decide if we are not going to do an exchange within 45 days and it is therefore rare for cash to remain in escrow for the full 180 days. Additionally, cash held in escrow to fund future developments costs and cash held as security deposits are classified as restricted cash.
Marketable Securities and Other Investments
All publicly traded equity securities are classified as “available for sale” and carried at fair value, with unrealized gains and losses reported as a separate component of shareholders’ equity. Private investments, for which we do not have the ability to exercise significant influence, are accounted for at cost. Declines in the value of public and private investments that management determines are other than temporary are recorded as a provision for loss on investments.
Real Estate and Depreciation
Real estate, other than properties held for sale, is carried at depreciated cost. Long-lived assets designated as being held for sale are reported at the lower of their carrying amount or estimated fair value less cost to sell, and thereafter are no longer depreciated.
We allocate the cost of newly acquired properties between net tangible and identifiable intangible assets. The primary intangible asset associated with an apartment community acquisition is the value of the existing lease agreements. When allocating cost to an acquired property, we first allocate costs to the estimated intangible value of the existing lease agreements and then to the estimated value of the land, building and fixtures assuming the property is vacant. We estimate the intangible value of the lease agreements by determining the lost revenue associated with a hypothetical lease-up. We depreciate the building and fixtures based on the expected useful life of the asset and amortize the intangible value of the lease agreements over the average remaining life of the existing leases. This amortization expense is included in depreciation on real estate investments in our consolidated statements of earnings
In accordance with SFAS No. 144, long-lived assets, such as property, plant, and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities classified as held for sale are presented separately in the appropriate asset and liability sections of the balance sheet.
We have an investment organization that is responsible for development and redevelopment of apartment communities. Consistent with GAAP, all direct and certain indirect costs, including interest and real estate taxes, incurred during development and redevelopment activities are capitalized. Interest is capitalized on real estate assets that require a period of time to get them ready for their intended use. The amount of interest capitalized is based upon the average amount of accumulated development expenditures during the reporting period. Included in capitalized costs are management’s estimates of the direct and incremental personnel costs and indirect project costs associated with our development and redevelopment activities. Indirect project costs consist primarily of personnel costs associated with construction administration and development accounting, legal fees, and various office costs that clearly relate to projects under development.
ARCHSTONE-SMITH TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Depreciation is computed over the expected useful lives of depreciable property on a straight-line basis as follows:
Interest
During 2005, 2004 and 2003, the total interest paid in cash on all outstanding debt was $263.5 million, $229.6 million and $244.8 million, respectively.
We capitalize interest during the construction period as part of the cost of apartment communities under development. Interest capitalized during 2005, 2004 and 2003 aggregated $39.1 million, $23.6 million and $26.9 million, respectively.
Cost of Raising Capital
Costs incurred in connection with the issuance of equity securities are deducted from shareholders’ equity. Costs incurred in connection with the issuance or renewal of debt are subject to the provisions of EITF 96-19. Accordingly, if the terms of the renewed or modified debt instrument are deemed to be substantially different (i.e., a 10 percent or more difference in the present value of the remaining cash flows), all unamortized loan costs associated with the extinguished debt are charged against earnings during the current period; otherwise, costs are capitalized as other assets and amortized into interest expense over the term of the related loan or the renewal period. The balance of any unamortized loan costs associated with retired debt is expensed upon retirement. We utilize the straight-line method to amortize debt issuance costs as it approximates the effective interest method required under SFAS No. 91. Amortization of loan costs included in interest expense for 2005, 2004 and 2003 was $4.2 million, $4.4 million and $4.5 million, respectively.
Moisture Infiltration and Mold Remediation Costs
We estimate and accrue costs related to the correction of moisture infiltration and related mold remediation when we anticipate incurring such remediation costs because of the assertion of a legal claim or threatened litigation. When we incur remediation costs at our own discretion, the cost is recognized as incurred. Costs of addressing moisture infiltration and resulting mold remediation issues are only capitalized, subject to recoverability, when it is determined by management that such costs also extend the life, increase the capacity, or improve the safety or efficiency of the property relative to when the community was originally constructed or acquired, if later. All other related costs are expensed.
Insurance Recoveries
We recognize insurance recovery proceeds as other income if the recovery is related to items that were originally expensed, such as, legal settlements, legal expenses and repairs that did not meet capitalization guidelines. For recoveries of property damages that were eligible for capitalization, we reduce the basis of the property or if the property has subsequently been sold, we recognize the proceeds as an additional gain on sale. We recognize insurance recoveries at such time that we believe the recovery is probable and we have sufficient information to make a reasonable estimate of proceeds, except in cases where we have to pursue recovery via litigation. In this circumstance, we recognize the recovery when we have a signed, legally binding agreement with the insurance carrier.
ARCHSTONE-SMITH TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Derivative Financial Instruments
We utilize derivative financial instruments to manage our interest rate risk, foreign currency exchange risk, exposure to changes in the fair value of certain investments in equity securities and exposure to volatile energy prices. During 2003, we adopted SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” Under SFAS No. 149, the resulting assets and liabilities associated with derivative financial instruments are carried on our financial statements at estimated fair value at the end of each reporting period. The changes in the fair value of a fair value hedge and the fair value of the items hedged are generally recorded in earnings for each reporting period. The change in the fair value of effective cash flow hedges and foreign currency hedges are carried on our financial statements as a component of accumulated other comprehensive income (loss). If effective, our hedges have little or no impact on our current earnings.
Revenue and Gain Recognition
We generally lease our apartment units under operating leases with terms of one year or less. Communities subject to the Oakwood Master Leases entered into in 2005 have a seven year term. Rental income related to leases is recognized in the period earned over the lease term in accordance with Statement of Financial Accounting Standards SFAS No. 13, “Accounting for Leases.” Rent concessions are recognized as an offset to revenues collected over the term of the underlying lease.
We use the full accrual method of profit recognition in accordance with SFAS No. 66 to record gains on sales of real estate. Accordingly, we evaluate the related GAAP requirements in determining the profit to be recognized at the date of each sale transaction (i.e., the profit is determinable and the earnings process is complete).
Rental Expenses
Rental expenses shown on the accompanying Statements of Earnings include costs associated with on-site and property management personnel, utilities (net of utility reimbursements from residents), repairs and maintenance, property insurance, marketing, landscaping and other on-site and related administrative costs.
Legal Fees
We generally recognize legal expenses as incurred; however, if such fees are related to the accrual for an estimated legal settlement, we accrue for the related incurred and anticipated legal fees at the same time we accrue the estimated cost of settlement.
Foreign Currency Translation
Assets and liabilities of the company’s foreign operations are translated into U.S. dollars at the exchange rate in effect at the balance sheet date. Revenue and expenses are translated at average rates in effect during the period. The resulting translation adjustment is reflected as accumulated other comprehensive income (loss), a separate component of shareholders’ equity on the consolidated balance sheets. The functional currency utilized for these subsidiaries is the local foreign currency.
Stock-Based Compensation
As of December 31, 2005, the company has one stock-based employee compensation plan. Effective January 1, 2003, the company adopted the fair value recognition provision of SFAS No. 123, “Accounting for Stock-Based Compensation,” prospectively to all employee awards granted, modified or settled after January 1, 2003, which results in expensing of options. During 2005, we granted approximately 313,000 Restricted Share Units and 515,000 stock options. During 2004, we granted approximately 300,000 Restricted Share Units and 648,000 stock options. For employee awards granted prior to January 1, 2003, the company accounted for this plan under the recognition and measurement provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and
ARCHSTONE-SMITH TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
related Interpretations. With respect to options granted under the plan prior to January 1, 2003, no stock-based employee compensation expense is reflected in the accompanying condensed consolidated statements of earnings, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net earnings and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period (dollar amounts in thousands, except per share amounts):
The following is a table of the assumptions used to value options for the respective grant year using the Black-Scholes model:
Income Taxes
We have made an election to be taxed as a REIT under the Internal Revenue Code of 1986, as amended, and we believe we qualify as a REIT and have made all required distributions of our taxable income. See Note 15 for more information on income taxes.
Income taxes for our taxable REIT subsidiaries are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date.
ARCHSTONE-SMITH TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Comprehensive Income
Comprehensive income, which is defined as net earnings and all other non-owner changes in equity, is displayed in the accompanying consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss). Other comprehensive income (loss) reflects unrealized holding gains and losses on the available-for-sale investments, changes in the fair value of effective cash flow hedges and gains and losses on long-term foreign currency transactions (see Derivative Financial Instruments).
Our accumulated other comprehensive income (loss) for the year ended December 31, 2005 was as follows (in thousands):
Per Share Data
Following is a reconciliation of basic EPS to diluted EPS for the periods indicated (in thousands):
(1)
Excludes the impact of potentially dilutive equity securities during periods in which they are anti-dilutive.
ARCHSTONE-SMITH TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Market Concentration Risk
Approximately 36.6%, 24.9% and 8.2% of our apartment communities are located in the Washington, D.C. Metropolitan Area, Southern California and the San Francisco Bay Area of California, based on NOI for the three months ended December 31, 2005. Southern California is the geographic area comprising the Los Angeles County, San Diego, Orange County, the Inland Empire and Ventura County markets. We are, therefore, subject to increased exposure (positive or negative) from economic and other competitive factors specific to markets within these geographic areas.
Preferred Share Redemptions
When redeeming preferred shares, we recognize share issuance costs as a charge to preferred share dividends in accordance with Financial Accounting Standards Board (“FASB”) - Emerging Issues Task Force (“EITF”) Topic D-42, “The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock.” In July 2003, the Securities and Exchange Commission (“SEC”) staff issued a clarification of the SEC’s position on the application of FASB-EITF Topic D-42. The SEC staff’s position, as clarified, is that in applying Topic D-42, the carrying value of preferred shares that are redeemed should be reduced by the amount of original issuance costs, regardless of where in shareholders’ equity those costs are reflected.
Reclassifications
Certain prior year amounts have been reclassified to conform to the current presentation.
New Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (the FASB) issued SFAS No. 123R, “Share-Based Payment.” This Statement is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB No. 25, “Accounting for Stock Issued to Employees.” The Statement requires companies to recognize, in the income statement, the grant-date fair value of stock options and other equity based compensation issued to employees. This Statement is effective as of the beginning of the first interim or annual period that commences after January 1, 2006. We do not believe that the adoption of SFAS No. 123R will have a material impact on our financial position, net earnings or cash flows.
In June 2005, the Emerging Issues Task Force issued EITF No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights” (EITF No. 04-5). This Issue provides a framework for evaluating whether a general partner or group of general partners or managing members controls a limited partnership or limited liability company and therefore should consolidate the entity. The presumption that the general partner or group of general partners or managing members controls a limited liability partnership or limited liability company may be overcome if the limited partners or members have (1) the substantive ability to dissolve the partnership without cause, or (2) substantive participating rights. EITF No. 04-5 became effective on June 30, 2005 for new or modified limited partnerships or limited liability companies and January 1, 2006 for all existing arrangements. We do not believe that the adoption of EITF No. 04-5 will have a material impact on our financial position, net earnings or cash flows.
In March 2005, the FASB issued Financial Interpretation No 47, “Accounting for Conditional Asset Retirement Obligations an interpretation of FASB Statement No. 143” (FIN 47). FIN 47 resulted in FASB Statement No. 143 (SFAS 143), “Accounting for Asset Retirement Obligations,” to be applied to more situations than many entities had previously applied it in practice. FIN 47 requires entities to recognize liabilities for conditional asset retirement obligations if a reasonable estimate of fair value can be made. Based on the premise that no tangible asset lasts forever, the obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or method of settlement. Accordingly, a company should recognize an asset retirement
ARCHSTONE-SMITH TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
liability for a conditional asset retirement obligation with the offset to the asset itself in the period in which the obligation is incurred if the fair value of the liability can be reasonably estimated. The impact of FIN 47 is most discernable to the company related to asbestos exposure at certain of our real estate assets. FIN 47 became effective no later than the end of the fiscal years ending after December 15, 2005 and was adopted by the company for the year ended December 31, 2005. The adoption of FIN 47 did not have a material impact on our financial position or cash flows.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” (SFAS No. 154), as part of an effort to conform to international accounting standards. SFAS No. 154 requires that all voluntary changes in accounting principles are retrospectively applied to prior financial statements as if that principle had always been used, unless it is impracticable to do so. When it is impracticable to calculate the effects on all prior periods, SFAS No. 154 requires that the new principle be applied to the earliest period practicable. This statement is effective as of the first fiscal year beginning after December 15, 2005. We do not believe any voluntary changes in accounting principles, relating to the adoption of SFAS No. 154, would have a material effect on our financial position or results of operations.
(2)
Real Estate
Investments in Real Estate
Investments in real estate, at cost, were as follows (dollar amounts in thousands):
(1)
Unit information is based on management’s estimates and has not been audited by our Independent Registered Public Accounting Firm.
(2)
Ameriton’s investment as of December 31, 2005 and 2004 for development communities Under Control was $145,000 (83 units) and $1.5 million (593 units), respectively. These amounts are reflected in the “Other assets” caption of our Consolidated Balance Sheets.
(3)
Includes land that is not In Planning and other real estate assets.
Capital Expenditures
In conjunction with the underwriting of each acquisition of an operating community, we prepare acquisition budgets that encompass the incremental capital needed to achieve our investment objectives. These expenditures, combined with the initial purchase price and related closing costs, are capitalized and classified as “acquisition-related” capital expenditures, as incurred.
As part of our operating strategy, we periodically evaluate each community’s physical condition relative to established business objectives and the community’s competitive position in its market. In conducting these evaluations, we consider our return on investment in relation to our long-term cost of capital as well as our research
ARCHSTONE-SMITH TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
and analysis of competitive market factors. Based on these factors, we make decisions on incremental capital expenditures, which are classified as either “redevelopment” or “recurring.”
The redevelopment category includes: (i) redevelopment initiatives, which are intended to reposition the community in the marketplace and include items such as significant upgrades to the interiors, exteriors, landscaping and amenities; (ii) revenue-enhancing expenditures, which include investments that are expected to produce incremental community revenues, such as building garages, carports and storage facilities or gating a community; and (iii) expense-reducing expenditures, which include items such as water submetering systems and xeriscaping that reduce future operating costs.
Recurring capital expenditures consist of significant expenditures for items having a useful life in excess of one year, which are incurred to maintain a community’s long-term physical condition at a level commensurate with our stringent operating standards. Examples of recurring capital expenditures include roof replacements, certain make-ready expenditures, parking lot resurfacing and exterior painting.
The change in investments in real estate, at cost, consisted of the following (in thousands):
At December 31, 2005, we had unfunded contractual commitments of $477.5 million related to communities under construction and under redevelopment.
(3)
Oakwood Asset Acquisition
During 2005 we acquired 35 communities, comprising 12,696 units, for a total purchase price of $1.5 billion from Oakwood Worldwide. We expect to acquire two additional communities from Oakwood during 2006. We funded the acquisitions with a combination of $362.8 million or 10.1 million A-1 Common Units, $250,000 or 1,000 N-1 and N-2 Preferred Units, $581.2 million of assumed mortgage debt and the remainder through cash. The purchase price of the assets was allocated to land, buildings and other assets as prescribed by SFAS 141 based on preliminary estimates and are subject to change as we obtain more complete information regarding land values and lease intangibles.
Thirteen of the communities acquired and one community we previously owned and operated were leased back to an affiliate of Oakwood Worldwide under the Oakwood Master Leases, which have seven-year terms, subject to Oakwood’s right to terminate individual leases under certain circumstances after the one-year anniversary of the acquisition, with one exception for which the right to terminate exists throughout the term. The initial aggregate annualized contractual base rent due under these leases is $62.1 million in the first year and is subject to annual
ARCHSTONE-SMITH TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
adjustments on January 1st of each year equal to the percentage change in the average same-store NOI growth for certain other specified properties. We are responsible for payment of real estate taxes, insurance and certain capital expenditures. We have engaged an affiliate of Oakwood to manage the retail portion of each community, if applicable. The real estate cost and net book value associated with the communities subject to the Oakwood Master Leases aggregated $915.5 million and $905.7 million, respectively, as of December 31, 2005. Approximately 6% of our annualized total rental revenue is expected to be derived from the Oakwood Master Leases.
(4)
Discontinued Operations
The results of operations for properties sold during the period or designated as held-for-sale at the end of the period are required to be classified as discontinued operations. The property specific components of net earnings that are classified as discontinued operations include rental revenues, rental expenses, real estate taxes, depreciation expense, minority interest, income taxes and interest expense (actual interest expense for encumbered properties and a pro-rata allocation of interest expense for any unencumbered property up to our weighted average leverage ratio), as well as the net gain or loss on the disposition of properties.
Consistent with our capital recycling program, we had 14 operating apartment communities, representing 4,585 units (unaudited), classified as held for sale under the provisions of SFAS No. 144, at December 31, 2005. Accordingly, we have classified the operating earnings from these 14 properties within discontinued operations for the years ended December 31, 2005, 2004 and 2003. During the twelve months ended December 31, 2005, 2004 and 2003 we sold 35, 30 and 48 Archstone-Smith and Ameriton operating communities, respectively. The operating results of these communities and the related gain/loss on sale are also included in discontinued operations for 2005, 2004 and 2003.
The following is a summary of net earnings from discontinued operations (in thousands):
(1)
The portion of interest expense included in discontinued operations that is allocated to properties based on the company’s leverage ratio was $19.3 million, $44.2 million and $64.5 million for 2005, 2004 and 2003, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(2)
Represents the direct and incremental compensation and related costs associated with the employees dedicated to our significant disposition activity.
The real estate and mortgage payable (if applicable) balances associated with operating communities classified as held for sale as of December 31, 2005 are reflected, for all periods presented, as “real estate - held for sale” and “mortgages payable - held for sale,” respectively, in the accompanying Consolidated Balance Sheets.
(5)
Investments in and Advances to Unconsolidated Entities
Real Estate Joint Ventures
At December 31, 2005, the REIT had investments in 11 real estate joint ventures. Our ownership percentage of economic interests ranges from 25% to 79%. Major decisions are generally subject to the approval of all members, and we generally handle day-to-day operations. At December 31, 2005, Ameriton had six real estate joint ventures in which the venture partners are the development/managing members. Major investment decisions are generally subject to the approval of all members, and our venture partners handle all day-to-day operational decisions. Ameriton generally contributes a majority of the GAAP equity. Economic interest in the ventures varies depending upon the ultimate return of the venture. The REIT and Ameriton joint ventures do not qualify as variable interest entities as neither partner is deemed to individually receive substantially all the benefits from the joint venture. Accordingly, we utilize the guidance provided by SOP 78-9, “Accounting for Investments in Real Estate Ventures,” when determining the basis of accounting for these ventures. Because we do not control the voting interest of these joint ventures, we account for these entities using the equity method. In the aggregate, these ventures own 13,445 units. At December 31, 2005, the investment balance consists of $102.6 million in REIT joint ventures and $30.1 million in Ameriton joint ventures. At December 31, 2004, the investment balance consists of $74.1 million in REIT joint ventures and $37.4 million in Ameriton joint ventures. Archstone-Smith and Ameriton’s combined weighted average percentage of ownership in joint ventures based on total assets at December 31, 2005 was 39.6%.
Summary Financial Information
Combined summary balance sheet data for our investments in unconsolidated entities presented on a stand-alone basis follows (in thousands):
(1)
The Operating Trust guarantees $194.5 million of the outstanding debt balance as of December 31, 2005 and is committed to guarantee another $93.5 million upon funding of additional debt.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Selected summary results of operations for our unconsolidated investees presented on a stand-alone basis follows (in thousands):
(1)
Includes gains associated with the disposition of REIT Joint Venture assets of $31.6 million, $32.4 million and $0 during 2005, 2004 and 2003, respectively.
(2)
Includes Ameriton’s share of pre-tax gains associated with the disposition of real estate joint venture assets. These gains totaled $14.2 million, $7.0 million and $7.4 million during 2005, 2004 and 2003, respectively.
Our income from unconsolidated entities differs from the stand-alone net earnings from the investees presented above due to various accounting adjustments made in accordance with GAAP. Examples of these differences include: (i) only recording our proportionate share of net earnings in the unconsolidated investees; (ii) the impact of certain eliminating inter-company transactions; and (iii) timing differences in income recognition due to deferral of gains on contribution of properties to joint ventures. Additionally, we have incurred certain joint venture formation costs at the investor level which we account for as outside basis as these costs are not reflected on the stand-alone financial statements of the joint venture. These amounts are reflected on our consolidated financial statements and are amortized over the life of the underlying assets.
Except as disclosed, we generally do not guarantee third party debt incurred by our unconsolidated investees. Investee third-party debt consists principally of mortgage notes payable. Generally, mortgages on real estate assets owned by our unconsolidated investees are secured by the underlying properties. Occasionally, the investees and/or Archstone-Smith are required to guarantee the mortgages along with all other venture partners. As of December 31, 2005, we have not been required to perform under any guarantees provided to our joint ventures.
(6)
Mezzanine Notes Receivable
During the twelve months ended December 31, 2005, we entered into eight mezzanine note agreements as a lender to third parties to fund certain real estate projects. As of December 31, 2005 and December 31, 2004, we had a total of $74.4 million and $8.7 million, respectively, in mezzanine notes receivable, which are reflected in other assets. Interest rates on these notes range from LIBOR plus 5% to a fixed rate of 18% and maturity dates range from 2007 to 2010. Outstanding principal plus accrued and unpaid interest is generally due on the maturity date unless specified as payable monthly in the loan agreement. Partial prepayment is required to the extent the borrower receives proceeds from the sale of constructed units in accordance with contracted terms. As of December 31, 2005, we had a commitment to fund an additional $19.9 million under existing agreements. Our rights to the underlying collateral in the event of default are subordinate to the primary mortgage lender. During the twelve months ended December 31, 2005 and 2004, we recognized a total of $7.2 million and $0.1 million, respectively in interest income associated with mezzanine notes receivable.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(7)
Borrowings
Unsecured Credit Facilities
In December 2004, we restructured our unsecured revolving credit facility provided by a group of financial institutions led by JPMorgan Chase Bank. The primary modifications were extending the maturity, reducing the pricing and lowering the capitalization rate used to value the operating portfolio. The $600 million facility matures in December 2007 and has a one-year extension feature, exercisable at our option. The facility bears interest at the greater of prime or the federal funds rate plus 0.50%, or at our option, LIBOR plus 0.50%. The spread over LIBOR can vary from LIBOR plus 0.425% to LIBOR plus 1.25% based upon the rating of our Long-Term Unsecured Debt. The facility contains an accordion feature that allows us to expand the commitment up to $900 million at any time during the life of the facility, subject to lenders providing additional commitments. Under the agreement, we pay a facility fee of 0.15% of the commitment, which can vary from 0.125% to 0.200% based upon the ratings of our Long-Term Unsecured Debt.
The following table summarizes our revolving credit facility borrowings under our line of credit (in thousands, except for percentages):
We also have a short-term unsecured borrowing agreement with JPMorgan Chase Bank, which provides for maximum borrowings of $100 million. The borrowings under the agreement bear interest at an overnight rate agreed to at the time of borrowing and ranged from 2.75% to 4.6% during 2005. There were $34.6 million of borrowings outstanding under the agreement at December 31, 2005 and no borrowings outstanding under this agreement at December 31, 2004.
Long-Term Unsecured Debt
In April 2005, the Operating Trust filed a shelf registration statement on Form S-3 to register an additional $300 million (for a total of $1 billion) in unsecured debt securities. This registration statement was declared effective in May 2005; subsequently, during May 2005, the Operating Trust issued $300 million in long-term unsecured ten-year senior notes with a coupon rate of 5.25% and an effective interest rate of 5.4% from its shelf registration statement. During July 2005, the Operating Trust issued $200 million in long-term unsecured ten-year senior notes with a coupon rate of 5.25% and an effective interest rate of 5.27% from its shelf registration statement; the notes were issued under a re-opening of the long-term unsecured ten-year senior notes issued in May 2005. During November 2005, the Operating Trust issued $200 million in long-term unsecured five-year senior notes with a coupon rate of 5.25% and an effective interest rate of 5.45% from its shelf registration statement. The Operating Trust redeemed $200 million of long-term unsecured ten-year senior notes with a coupon rate of 8.2% and an effective interest rate of 8.4% when the notes matured in July 2005.
In April 2004, the Operating Trust filed a shelf registration statement on Form S-3 to register an additional $450 million in unsecured debt securities. This registration statement was declared effective in April 2004. During August 2004, the Operating Trust issued $300 million in long-term unsecured ten-year notes with net proceeds of $297.1 million and a coupon rate of 5.6% and an effective interest rate of 5.8% from its shelf registration statement.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The proceeds were used to repay outstanding balances on the Operating Trust’s unsecured credit facilities. The notes were issued pursuant to a supplemental indenture with modified debt covenants, which are specific to these notes. The primary change pertains to the leverage covenant, which limits total debt to 65% of the market value of total assets as defined, using a capitalization rate of 7.5% to value stabilized operating assets.
The Operating Trust had $300 million available in shelf-registered debt securities as of December 31, 2005.
A summary of our Long-Term Unsecured Debt outstanding at December 31, 2005 and 2004 follows (dollar amounts in thousands):
(1)
Represents a fixed rate for the long-term unsecured notes and a variable rate for the unsecured tax-exempt bonds.
(2)
Includes the effect of fair value hedges, loan cost amortization and other ongoing fees and expenses, where applicable.
The $2.5 billion of Long-Term Unsecured Debt generally has semi-annual interest payments and either amortizing annual principal payments or balloon payments due at maturity. The unsecured tax-exempt bonds require semi-annual payments and are due upon maturity with $21.7 million maturing in 2008 and $55.4 million maturing in 2029. The notes are redeemable at our option, in whole or in part, and the unsecured tax-exempt bonds are redeemable at our option upon sale of the related property. The redemption price is generally equal to the sum of the principal amount of the notes being redeemed plus accrued interest through the redemption date plus a standard make-whole premium, if any.
Mortgages Payable
Our mortgages payable generally feature either monthly interest and principal payments or monthly interest-only payments with balloon payments due at maturity (see Scheduled Debt Maturities). Early repayment of mortgages is generally subject to prepayment penalties. A summary of mortgages payable outstanding for the years ending December 31, 2005 and 2004 follows (dollar amounts in thousands):
ARCHSTONE-SMITH TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(1)
Includes the unamortized fair market value adjustment associated with assumption of fixed rate mortgages in connection with real estate acquisitions. The unamortized balance aggregated $63.5 million and $48.4 million at December 31, 2005 and 2004 respectively, and is being amortized into interest expense over the life of the underlying debt.
(2)
Includes the effect of fair value hedges, credit enhancement fees, the amortization of fair market value purchase adjustment, and other related costs, where applicable.
The change in mortgages payable during 2005 and 2004 consisted of the following (in thousands):
Scheduled Debt Maturities
Approximate principal payments due during each of the next five calendar years and thereafter, are as follows (in thousands):
(1)
The average annual principal payments due from 2011 to 2024 are $184.0 million per year.
Other
The book value of total assets pledged as collateral for mortgage loans and other obligations at December 31, 2005 and 2004 is $4.6 billion and $3.8 billion, respectively. Our debt instruments generally contain covenants common to the type of facility or borrowing, including financial covenants establishing minimum debt service coverage ratios and maximum leverage ratios. We were in compliance with all financial covenants pertaining to our debt instruments at December 31, 2005. See Note 12 for a summary of derivative financial instruments used in connection with our debt instruments.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(8)
Dividends to Shareholders
To maintain our status as a REIT, we are generally required to distribute at least 90% of our taxable income. The payment of dividends is subject to the discretion of the Board and is dependent upon our strategy, financial condition and operating results. In January 2006, the Board announced an increase in the annual dividend from $1.73 to $1.74 per Common Share for calendar year 2006.
The following table summarizes the cash dividends paid per share on Common Shares and Preferred Shares during 2005, 2004 and 2003:
(1)
Includes a $1.00 per share special dividend issued to our Common Shareholders in December 2004.
(2)
The Series A Preferred Shares were called for redemption during the fourth quarter of 2003; of the 2.9 million Preferred Shares outstanding, 2.8 million were converted to Common Shares and the remaining were redeemed.
(3)
The Series D Preferred Shares were redeemed in August 2004.
(4)
The Series H Preferred Shares were converted into Common Shares in May 2003.
(5)
The Series I Preferred Shares have a par value of $100,000.
(6)
The Series K Preferred Shares were converted into Common Shares in September 2004.
(7)
The Series L Preferred Shares were converted to Common Shares in December 2004.
(9)
Shareholders’ Equity
Shares of Beneficial Interest
Our Declaration of Trust authorizes us to issue 450,000,000 shares with a par value of $0.01 per share. Our Declaration of Trust allows us to issue Common Shares, Preferred Shares and such other shares of beneficial interest as the Board may create and authorize from time to time. The Board may classify or reclassify any unissued shares from time to time by setting or changing the preferences, conversion rights, voting powers, restrictions, limitations as to distributions, qualifications of terms or conditions of redemption.
Preferred Share Redemption and Conversions
The Series A Preferred Shares were called for redemption during 2003. Of the 2.9 million Series A Preferred Shares outstanding, 2.8 million were converted to Common Shares and the remaining were redeemed. During May 2003, the Series H Preferred Shares were converted into Common Shares. In August 2004, the series D Preferred Shares were redeemed at liquidation value plus distributions for a total of $47.6 million. The Series K Preferred Shares were converted to Common Shares in September 2004 and the Series L Preferred Shares were converted to Common Shares in December 2004.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Common Share Repurchase and Issuances
In September 2005, we sold approximately 12.1 million Common Shares in an underwritten public offering under an existing shelf registration statement filed with the Securities and Exchange Commission. The $491.4 million in net proceeds were initially used to pay down the balance on our unsecured credit facilities.
During 2005, we repurchased 1,646,800 Common Shares for an average price of $34.31 per share, including commissions. In 2004, we repurchased 3,516,700 Common Shares for an average price of $27.93 per share.
Preferred Shares
A summary of our Perpetual Preferred Shares outstanding at December 31, 2005 and 2004, including their significant rights, preferences, and privileges follows (amounts in thousands):
(1)
Series I Preferred Shares may be redeemed for cash at our option, in whole or in part, at a redemption price equal to the liquidation price per share, plus accrued and unpaid dividends, if any, on or after the redemption date indicated.
The holders of our Preferred Shares do not have preemptive rights over the holders of Common Shares, but do have limited voting rights under certain circumstances. The Preferred Shares have no stated maturity, are not subject to any sinking fund requirements and we are not obligated to redeem or retire the shares. Holders of the Preferred Shares are entitled to receive cumulative preferential cash distributions, when and as declared and authorized by the Board, out of funds legally available for the payment of distributions. All Preferred Share distributions are cumulative from date of original issue and all series of Preferred Shares rank equally as to distributions and liquidation proceeds. All dividends due and payable on Preferred Shares have been accrued and paid as of the end of each fiscal year.
If six quarterly dividends payable (whether or not consecutive) on any series or class of Preferred Shares that are of equal rank with respect to dividends and any distribution of assets, shall not be paid in full, the number of Independent Trustees shall be increased by two and the holders of all such Preferred Shares voting as a class regardless of series or class, shall be entitled to elect the two additional Independent Trustees. Whenever all dividends in arrears have been paid, the right to elect the two additional Independent Trustees shall cease and the terms of such Independent Trustees shall terminate.
Dividend Reinvestment and Share Purchase Plan
Our Dividend Reinvestment and Share Purchase Plan was designed and implemented to increase ownership in the company by private investors. Under the plan, holders of Common Shares and A-1 Common Units have the ability to receive cash dividends or automatically reinvest their cash dividends to purchase additional Common Shares. We have the option of issuing new shares or acquiring shares through open market purchases or in negotiated transactions with third parties to satisfy our obligations under the plan. Common Shares acquired under the plan may be entitled to a discount.
Ownership Restrictions and Significant Shareholders
Our governing documents restrict beneficial ownership of our outstanding shares by a single person, or persons acting as a group, to 9.8% of the Common Shares and 25% of each series of Preferred Shares. For us to qualify as a
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
REIT under the Internal Revenue Code of 1986, as amended, not more than 50% in value of our outstanding capital shares may be owned by five or fewer individuals at any time during the last half of our taxable year. The provision permits five persons to acquire up to a maximum of 9.8% each of the Common Shares, or an aggregate of 49% of the outstanding Common Shares.
Common Shares owned by a person or group of persons in excess of the 9.8% limit are subject to redemption. The provision does not apply where a majority of the Board, in its sole and absolute discretion, waives such limit after determining that our eligibility to qualify as a REIT for federal income tax purposes will not be jeopardized or the disqualification as a REIT is advantageous to shareholders.
(10)
Minority Interest
Net earnings are allocated to minority interests based on the ownership percentage of the Operating Trust associated with Unitholders relative to Common Shareholders.
Minority interest consists of the following at December 31, 2005 and 2004 (in thousands):
The changes in the Minority Interest balance are as follows:
A-1 Common Units
As of December 31, 2005 and December 31, 2004, we owned an 86.2% and 89.1% majority interest in the Operating Trust, respectively. The A-1 Common units are redeemable at the option of the Unitholders. The Operating Trust has the option of redeeming the A-1 Common Units with cash or with Common Shares. The A-1 Common Units are entitled to the same dividend as Common Shares. The A-1 Common Unitholder’s aggregate minority interest in the Operating Trust was approximately 13.8% at December 31, 2005 and 10.9% at 2004. During 2005 and 2004, respectively, we redeemed 401,211 and 2,392,234 A-1 Common Units and issued 11,289,070 and
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
374,921 A-1 Common Units in exchange for real estate. The Common Units issued in 2005 related primarily to the Oakwood transaction described in note 3.
We revalue A-1 minority interest each quarter to maintain a proportional relationship between the book value of equity associated with Common Shareholders relative to that of holders of A-1 Common Units since both have equivalent rights and Units are convertible into Common Shares on a one-for-one basis.
Series M Preferred Unit
In December of 2004, the Operating Trust issued one Series M Preferred Unit in exchange for cash. This unit is redeemable at the option of the holder of such unit and/or the Operating Trust under certain circumstances. If the Operating Trust is required to redeem the Series M Preferred Unit, the redemption price will be paid in cash. If the holder of the Series M Preferred Unit requests redemption of the Series M Preferred Unit, the Operating Trust has the option of redeeming the Series M Preferred Unit with cash or with Common Shares. The redemption value under such circumstances is based on the performance of the related real estate asset, as outlined in the contribution agreement. The Series M Preferred Unit is entitled to a dividend equivalent to the same dividend paid on 263 Common Shares. The holder of the Series M Preferred Unit does not have preemptive rights over the holders of Common Shares and does not have any voting right except as required by law. The Series M Preferred Unit has no stated maturity and is not subject to any sinking fund requirements.
Series N-1 and N-2 Preferred Units
300 N-1 and 700 N-2 Preferred Units were issued as partial consideration for land acquired in one of the Oakwood acquisitions. If certain entitlements related to the land are obtained, the N-1 and N-2 units have the potential to convert to Common Units at a rate of $70,000 and $30,000, respectively, per entitled apartment unit. As of December 31, 2005, no entitlements have been obtained. The Series N-1 Preferred Units are entitled to a dividend equivalent to the same dividend paid on 11.58 Common Shares. The Series N-2 Preferred Units are entitled to a dividend equivalent to the same dividend paid on 4.96 Common Shares. The holders of the Series N-1 and N-2 Preferred Units do not have preemptive rights over the holders of Common Shares and do not have any voting rights except as required by law. The Series N-1 and N-2 Preferred Units have no stated maturity and are not subject to any sinking fund requirements.
Perpetual Preferred Units
At various dates, consolidated subsidiaries of Archstone-Smith issued Perpetual Preferred Units to limited partners in exchange for cash. During 2005, all remaining Perpetual Preferred Units were redeemed. Following is a summary of outstanding Perpetual Preferred Units as of December 31, 2005 and 2004 (amounts in thousands):
(1)
The shares were redeemed.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(2)
In August and November 2004, 520,000 and 400,000 Series E Perpetual Preferred Units were redeemed at liquidation value plus accrued dividends. In February 2005, the remaining 200,000 Series E Preferred Units were redeemed at liquidation value plus accrued dividends.
(3)
In March 2005, 600,000 Series G Preferred Units were redeemed at liquidation value plus accrued dividends.
(11)
Benefit Plans
Our long-term incentive plan was approved in 1997, and was modified in connection with the Smith Merger. There have been six types of awards under the plan: (i) options with a DEU feature (only awarded prior to 2000); (ii) options without the DEU feature (generally awarded after 1999); (iii) Restricted Share Unit awards with a DEU feature (awarded prior to 2006);(iv) Restricted Share Unit awards with a cash dividend payment feature (awarded after 2005) (v) employee share purchase program with matching options without the DEU feature, granted only in 1997 and 1998; and (vi) Common Shares issued to certain named executives under our Special Long-Term Incentive Plan.
No more than 20 million share or option awards in the aggregate may be granted under the plan and no individual may be awarded more than 1.0 million share or option awards in any one-year period. The plan has a 10-year term. As of December 31, 2005, Archstone-Smith had approximately 8,164,607 shares available for future grants. Non-qualified options constitute an important component of compensation for officers below the level of senior vice president and for selected employees.
Share Options, Trustee Options and Share Purchase Plan
The exercise price of each employee option granted is equal to the fair market value at the close of business on the day immediately preceding the date of grant. Options generally vest at the rate of 331/3% a year.
Additionally, Archstone-Smith has authorized 400,000 Common Units for issuance to its outside trustees. The exercise price under the equity plan is equal to the average of the high and low prices on the date of grant. All options granted before 1999 have been exercised or cancelled. The options issued between 1999 and 2001 have a DEU feature, a 10-year term and vest over a four-year period. Beginning in 2002 options are no longer issued to outside trustees.
During 1997, as part of the employee share purchase plan, certain officers and other employees purchased Common Shares of Archstone-Smith. The company financed 95% of the total purchase price by issuing notes representing approximately $17.1 million. Loans made to employees in connection with the employee share purchase plan are recourse loans and the associated receivable is recorded as a reduction of shareholders’/unitholders’ equity. As of December 31, 2005, the aggregate outstanding balances on these notes were approximately $359,278.
A summary of all options outstanding at December 31, 2005 follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
A summary of the status of Archstone-Smith Trust’s option plans as of December 31, 2005, 2004 and 2003, and changes during the years ended on those dates is presented below:
Restricted Share Unit Awards
Restricted Share Unit awards are granted at the market value of the underlying Common Shares on the date of grant. To compute the total compensation expense to be recognized, the fair value of each share on the grant date is multiplied by the number of shares granted. We then recognize this stock-based employee compensation expense over the vesting period, generally three years. The total expense recognized in connection with these awards, including the related DEUs for the years ending December 31, 2005, December 31, 2004 and December 31, 2003 was $6.6 million, $5.7 million, and $5.6 million, respectively.
All RSU grants awarded prior to 2006 had a DEU feature. During 2005, 2004 and 2003 Archstone-Smith awarded 312,933, 299,682 and 0 RSUs, respectively, to certain employees under the long-term incentive plan, of which 20,208 have been forfeited. A total of 40,504 RSUs with a DEU feature were awarded to trustees under the equity plan for outside trustees, none of which has been forfeited. Each RSU provides the holder with one Common Share upon settlement. The RSUs and related DEU feature vest at 331/3% per year over a three year period. We recognize the value of the awards and the related DEUs as compensation expense over the vesting period.
All RSU grants awarded after 2005 have a cash payment feature. Outstanding RSUs as of each dividend record date are entitled to a cash payment equal to the amount of the dividend paid on Common Shares. The payment may be deferred into the Archstone-Smith Deferred Compensation Plan.
Dividend Equivalent Units
Under the modified long-term incentive plan, participants who were awarded RSUs prior to 2006 were credited with DEUs equal to the amount of dividends paid on Common Shares with respect to such awards. The DEUs vest under substantially the same terms as the underlying share options or RSUs.
DEUs earned on options are calculated by taking the average number of options held at each record date and multiplying by the difference between the average annual dividend yield on Common Shares and the average dividend yield for the Standard & Poor’s 500 Stock Index. DEUs earned on RSUs are calculated by taking the
ARCHSTONE-SMITH TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
average number of RSUs held at each record date and multiplying by the average annual dividend yield on Common Shares. DEUs earned on existing DEUs are calculated by taking the number of DEUs at December 31 and multiplying by the average annual dividend yield on Common Shares.
As of December 31, 2005, there were a total of 327,891 DEUs outstanding awarded to 60 holders of options and RSUs. The outstanding DEUs are included in our diluted earnings per share calculation and were valued at $13.7 million on December 31, 2005 based upon market price of the Common Shares on that date. We recognize the value of the DEUs awarded over the vesting period with costs associated with unvested and vested awards charged to compensation expense and Common Share dividends, respectively. The matching options granted in connection with the 1997 employee purchase program and all of the employee options granted after 1999 (including the converted Smith Residential options) do not have a DEU feature.
Special Long-Term Incentive Plan
A special long-term incentive program related to the achievement of total shareholder return performance targets was established for certain of our executive officers. During 2005 and 2004, 76,226 and 205,602 performance units, which are exchangeable for Common Shares on a one-for-one basis, were paid under the plan. As a result of the application of variable plan accounting under SFAS 123, these awards resulted in an increase to general and administrative expense of $2.8 million, $4.9 million and $0.8 million in 2005, 2004 and 2003, respectively.
401(k) Plan and Nonqualified Deferred Compensation Plan
In December 1997, the Archstone-Smith Board established a 401(k) plan and a nonqualified savings plan, which both became effective on January 1, 1998. The 401(k) plan provides for matching employer contributions of fifty cents for every dollar contributed by the employee, up to 6% of the employees’ annual contribution. Contributions by employees to the 401(k) plan were subject to federal limitations of $14,000 during 2005. The matching employer contributions are made in Common Shares, which vest based on years of service at 20% per year. The Smith Residential nonqualified deferred compensation plan and the outside trustees deferred fee plan were merged into our existing nonqualified savings plan to form a new on-going nonqualified deferred compensation plan on January 1, 2002. Generally, the deferred compensation plan permits only deferrals of compensation by eligible employees and non-employee trustees. No employer contributions are currently being made to that plan. Amounts deferred under the deferred compensation plan are invested among a variety of investments as directed by the participants, and are generally deferred until termination of employment or service as a trustee.
Deferral of Fees by Non-Employee Trustees
Through December 31, 2005 and pursuant to the terms of the nonqualified deferred compensation plan, each non-employee member of our Board has had the opportunity to defer receipt of all or a portion of the service fees they otherwise would have been paid in cash. If a participant elected to have their fees deferred, the fees accrued in the form of phantom shares equal to the number of Common Shares that could have been purchased on the date the fee was credited. Dividends are calculated on the phantom shares and additional phantom shares are credited. Distribution of phantom shares may be deferred to a later date. Upon settlement, phantom shares convert into Common Shares on a 1-to-1 basis. Alternatively, the Trustee can elect to have his or her fees deferred and invested in one or more of the investment funds that are otherwise available under the deferred compensation plan. Upon settlement such investments are paid out in cash.
Beginning in 2006 each non-employee member of our Board will have the ability to defer their service fees into the Archstone-Smith Deferred Compensation Plan, rather than into phantom shares. The phantom shares already on account will continue to accrue additional phantom shares in lieu of dividends, as described in the preceding paragraph.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(12)
Financial Instruments and Hedging Activities
Fair Value of Financial Instruments
At December 31, 2005 and 2004, the fair values of cash and cash equivalents, restricted cash held in a tax-deferred exchange escrow accounts, receivables and accounts payable approximated their carrying values because of the short-term nature of these instruments. The estimated fair values of other financial instruments subject to fair value disclosures were determined based on available market information and valuation methodologies believed to be appropriate for these purposes. Considerable judgment and a high degree of subjectivity are involved in developing these estimates and, therefore, are not necessarily indicative of the actual amounts that we could realize upon disposition. The following table summarizes these financial instruments (in thousands):
All publicly traded equity securities are classified as “available for sale securities” and carried at fair value, with unrealized gains and losses reported as a separate component of shareholders’ equity. As of December 31, 2005 and 2004, our investments in publicly traded equity securities included in other assets were $4.6 million and $19.0 million, respectively. Private investments, for which we do not have the ability to exercise significant influence, are accounted for at cost. Declines in the value of public and private investments that management determines are other than temporary, are recorded as a provision for possible loss on investments. Our evaluation of the carrying value of these investments is primarily based upon a regular review of market valuations (if available), each company’s operating performance and assumptions underlying cash flow forecasts. In addition, management considers events and circumstances that may signal the impairment of an investment.
Interest Rate Hedging Activities
We are exposed to the impact of interest rate changes and will occasionally utilize interest rate swaps and interest rate caps as hedges with the objective of lowering our overall borrowing costs. These derivatives are designated as either cash flow or fair value hedges. We have interest rate caps that are not designated as a hedge that have immaterial fair value as of December 31, 2005. These caps were required by the loan agreement. We do not use these derivatives for trading or other speculative purposes. Further, as a matter of policy, we only enter into contracts with major financial institutions based upon their credit ratings and other factors. When viewed in conjunction with the underlying and offsetting exposure that the derivatives are designed to hedge, we have not, nor do we expect to sustain a material loss from the use of these hedging instruments.
We formally assess, both at inception of the hedge and on an ongoing basis, whether each derivative is highly effective in offsetting changes in fair values or cash flows of the hedged item. We measure hedge effectiveness by
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
comparing the changes in the fair value or cash flows of the derivative instrument with the changes in the fair value or cash flows of the hedged item. If a derivative ceases to be a highly effective hedge, we discontinue hedge accounting prospectively.
To determine the fair values of derivative and other financial instruments, we use a variety of methods and assumptions that are based on market value conditions and risks existing at each balance sheet date. These methods and assumptions include standard market conventions and techniques such as discounted cash flow analysis, option pricing models, replacement cost and termination cost. All methods of assessing fair value result in a general approximation of value, and therefore, are not necessarily indicative of the actual amounts that we could realize upon disposition.
During the years ended December 31, 2005, 2004 and 2003 we recorded an increase/(decrease) to interest expense of $(174,000), $33,000 and $101,000, for hedge ineffectiveness caused by a difference between the interest rate index on a portion of our outstanding variable rate debt and the underlying index of the associated interest rate swap. We pursue hedging strategies that we expect will result in the lowest overall borrowing costs and least degree of earnings volatility.
The following table summarizes the notional amount, carrying value and estimated fair value of our derivative financial instruments used to hedge interest rates, as of December 31, 2005 (dollar amounts in thousands). The notional amount represents the aggregate amount of a particular security that is currently hedged at one time, but does not represent exposure to credit, interest rate or market risks.
During 2004, we entered into interest rate swap transactions to mitigate the risk of changes in the interest-related cash outflows on a forecasted issuance of long-term unsecured debt. At inception, these swap transactions had an aggregate notional amount of $144 million and a fair value of zero. The long-term unsecured debt these swap transactions related to was issued in August 2004. The hedge was terminated when the debt was issued. The fair value of the cash flow hedge upon termination was a liability of approximately $2.5 million. This amount was deferred in accumulated other comprehensive income and will be amortized out of accumulated other comprehensive income as additional interest expense as the hedged forecasted interest payments occur.
Foreign Currency Hedging Activities
We are exposed to foreign-exchange related variability and earnings volatility on our foreign investments. As such, during 2005 we entered into a foreign currency forward contract with a notional amount of 8.5 million as a hedge against our exposure to variability in exchange rates on investment in foreign subsidiaries and designated the contract as a net investment hedge. The fair value of this forward contract at December 31, 2005 was $(15,000). To the extent effective, changes in fair value are recorded in the cumulative translation component of accumulated other comprehensive income (loss) and will subsequently be reclassified to income (expense) at the time that the
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hedge investment is sold or disposed of. The amount recorded in accumulated other comprehensive income (loss) is $15,000. The contract is scheduled to mature in December 2010.
Energy Contract Hedging Activities
We are exposed to price risk associated with the volatility of natural gas, fuel oil and electricity rates. During 2005, we entered into contracts with several of our suppliers to fix our payments on set quantities of fuel oil and electricity. If the contract meets the criteria of a derivative, we designate these contracts as cash flow hedges of the overall changes in floating-rate payments made on our energy purchases. As of December 31, 2005, we had energy-related derivatives with aggregate notional amounts of $1.0 million and an estimated fair value and carrying amount of $(32,000). These contracts mature on or before December 31, 2006.
Equity Securities Hedging Activities
We are exposed to price risk associated with changes in the fair value of certain equity securities. During 2003, we entered into forward sale agreements with an aggregate notional amount, which represents the fair value of the underlying marketable securities, of approximately $128.5 million and an aggregate fair value of the forward sale agreements of approximately $486,000, to protect against a reduction in the fair value of these securities. We designated this forward sale as a fair value hedge.
During 2004, we settled all of the forward sales agreements for approximately 2.8 million shares, and sold 308,200 shares of marketable securities, which were not subject to forward sales agreements, resulting in an aggregate gain of approximately $24.9 million. The total net proceeds from the sale were $143.0 million, with the marketable securities basis determined using the average costs of the securities. The fair value of forward sales agreements at December 31, 2005 and 2004 was $0.
(13)
Selected Quarterly Financial Data
Selected quarterly financial data (in thousands, except per share amounts) for 2005 and 2004 is summarized below. The sum of the quarterly earnings per Common Share amounts may not equal the annual earnings per Common Share amounts due primarily to changes in the number of Common Shares outstanding from quarter to quarter.
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(1)
Net earnings from discontinued operations have been reclassified for all periods presented.
(2)
Due to the quarterly pro-rata calculation of minority interest, the sum of the quarterly per share and dollar amounts do not equal the year-to-date totals.
(14)
Segment Data
We define our garden communities and high-rise properties each as individual operating segments. We have determined that each of our garden communities and each of our high-rise properties have similar economic characteristics and also meet the other GAAP criteria, which permit the garden communities and high-rise properties to be aggregated into two reportable segments. Additionally, we have defined the activity from Ameriton as an individual operating segment as its primary focus is the opportunistic acquisition, development and eventual disposition of real estate with a short term investment horizon. NOI is defined as rental revenues less rental expenses and real estate taxes. We rely on NOI for purposes of making decisions about resource allocations and assessing segment performance. We also believe NOI is a valuable means of comparing year-to-year property performance.
Following are reconciliations, which exclude the amounts classified as discontinued operations, of each reportable segment’s (i) revenues to consolidated revenues; (ii) NOI to consolidated earnings from operations; and (iii) assets to consolidated assets, for the periods indicated (in thousands):
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(1)
While rental revenue and NOI are the primary measures we use to evaluate the performance of our assets, management also utilizes gains from the disposition of real estate when evaluating the performance of Ameriton as its primary focus is the opportunistic acquisition, development and eventual disposition of real estate with a short term investment horizon. During 2005, 2004 and 2003, pre-tax gains, net of internal disposition costs, from the disposition of Ameriton real estate were $75.2 million, $65.1 million and $42.7 million, respectively. These gains are classified within discontinued operations. Ameriton assets are excluded from our Same-Store population as they are acquired or developed to achieve short-term opportunistic gains, and therefore, the average holding period is typically much shorter than the holding period of assets operated by the REIT.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Total capital expenditures for garden communities excluding communities sold or held for sale, were $42.9 million and $37.5 million for the years ended December 31, 2005 and 2004, respectively. Total capital expenditures for high-rise properties excluding communities sold or held for sale were $65.8 million and $45.1 million for the years ended December 31, 2005 and 2004, respectively. Total capital expenditures for Ameriton properties excluding communities sold or held for sale, were $1.4 million and $0.8 million for the years ended December 31, 2005 and 2004, respectively.
(15)
Income Taxes
Substantially all of our income is derived through the Operating Trust. The Operating Trust has elected to be treated as a partnership for federal income tax purposes. Accordingly, the Operating Trust’s income is not subject to federal income taxes. We have elected to be taxed as a REIT under the Internal Revenue Code. To qualify as a REIT, we must meet a number of organizational and operational requirements, including a requirement that we currently distribute at least 90% of our taxable income. As a REIT, we are generally not subject to corporate level federal income taxes on net income we distribute to our shareholders. Accordingly, no provision for income taxes is included in the accompanying Consolidated Statements of Earnings. If we fail to qualify as a REIT in any taxable year, then we will be subject to federal income taxes at regular corporate rates. Even as a REIT, we may be subject to certain state, local and REIT specific federal taxes on our income and property.
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The following table reconciles net earnings to taxable income subject to dividend distribution requirement for the years ended December 31 (in thousands):
(1)
We use accelerated depreciable lives for tax purposes. This results in higher depreciation expense on newly acquired assets for tax purposes relative to GAAP. This is offset by the Smith Merger in 2001 and the Oakwood transaction in 2005 as GAAP depreciation expense for the related assets is based on fair value and tax depreciation is based on a lower historical tax basis.
The following table provides a reconciliation between cash dividends paid and dividends paid deduction (in thousands):
(1)
Includes a special dividend of $221 million paid in December 2004, and reflects distribution of all ordinary income and capital gains.
The following table summarizes the taxability of our dividends for the past three years:
(1)
Includes 34.3%, 22.8% and 34.7% of unrecaptured section 1250 gains in 2005, 2004, and 2003, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As a taxable REIT subsidiary, Ameriton is subject to state and federal income taxes. Income tax expense consists of the following for the years ended December 31, 2005, 2004, and 2003 which is included in either other expense or discontinued operations (in thousands):
Income tax expense differed from the amounts computed by applying the U.S. federal income tax rate of 35% to pretax income as a result of the following for the years ended December 31, 2005, 2004, and 2003 (in thousands):
Deferred income taxes reflect the estimated net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the corresponding amounts for income tax purposes. Ameriton’s deferred tax assets and liabilities at December 31, 2005 and 2004 are presented below (in thousands).
(16)
Commitments and Contingencies
Commitments
At December 31, 2005 we had nine non-cancelable ground leases for certain apartment communities and buildings that expire between 2042 and 2077. Each ground lease generally provides for a fixed annual rental payment plus additional rental payments based on the properties’ operating results. Additionally, we lease certain office space under non-cancelable operating leases with fixed annual rental payments.
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The future minimum lease payments payable under non-cancelable leases are as follows at December 31, 2005 (in thousands):
See Note 2 for real estate-related commitments.
Guarantees and Indemnifications
We have extended performance bond guarantees relating to contracts entered into by SMC, which are customary to the type of business in which these entities engage. As of December 31, 2005, $1.3 million of these performance bond guarantees were still outstanding, based upon information we have been provided. Archstone-Smith, our subsidiaries and investees have not been required to perform on these guarantees, nor do we anticipate being required to perform on such guarantees. Since we believe that our risk of loss under these contingencies is remote, no accrual for potential loss has been made in the accompanying financial statements. There are recourse provisions available to us to recover any potential future payments from the new owners of SMC.
Investee third-party debt consists principally of mortgage notes payable. Generally, mortgages on real estate assets owned by our unconsolidated investees are secured by the underlying properties. We generally do not guarantee third party debt incurred by our unconsolidated investees; however, the investees and/or Archstone-Smith are occasionally required to guarantee the mortgages along with all other venture partners. We guarantee $194.5 million of the outstanding debt balance related to an unconsolidated development joint venture and are committed to guarantee another $93.5 million upon funding of additional debt. As of December 31, 2005 we have not been required to perform under any guarantees provided to our joint ventures.
As part of the Smith Merger and the Oakwood transaction, we are required to indemnify unitholders for any personal income tax expense resulting from the taxable sale of certain properties.
Litigation and Contingencies
During the second quarter of 2005, we entered into a full and final settlement in the United States District Court for the District of Maryland with three national disability organizations and agreed to make capital improvements in a number of our communities in order to make them fully compliant with the Fair Housing Act and Americans with Disabilities Act. The litigation, settled by this agreement, alleged lack of full compliance with certain design and construction requirements under the two federal statutes at 71 of the company’s communities. As part of the settlement, the three disability organizations all recognized that Archstone-Smith had no intention to build any of its communities in a manner inconsistent with the FHA or ADA.
The amount of the capital expenditures required to remediate the remaining communities named in the settlement is estimated at $47.2 million and was accrued as an addition to real estate during the fourth quarter of 2005. The settlement agreement approved by the court allows us to remediate each of the designated communities over a three year period, and also provides that we are not restricted from selling any of our communities during the remediation period. We agreed to pay damages totaling $1.4 million, which included legal fees and costs incurred by the plaintiffs. We accrued other expenses of $4.0 million during 2005, which included the settlement and all related legal and other expenses paid in 2005 or expected to be paid during 2006.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
During 2004 and 2005, we incurred losses associated with multiple hurricanes in Florida. As a result of this damage, we recorded charges for actual or estimated losses associated with both wholly owned and unconsolidated apartment communities and benefits for collected or estimated insurance recoveries. These estimates represent management’s best estimate of the probable and reasonably estimable costs and related recoveries and are based on the most current information available from our insurance adjustors.
We are subject to various claims filed in 2002 and 2003 in connection with moisture infiltration and resulting mold issues at certain high-rise properties we once owned in Southeast Florida. These claims generally allege that water infiltration and resulting mold contamination resulted in the claimants having personal injuries and/or property damage. Although certain of these claims continue to be in various stages of litigation, with respect to the majority of these claims, we have either settled the claims and/or we have been dismissed from the lawsuits that had been filed. With respect to the lawsuits that have not been resolved, we continue to defend these claims in the normal course of litigation.
We are a party to various other claims and routine litigation arising in the ordinary course of business. We do not believe that the results of any such claims or litigation, individually or in the aggregate, will have a material adverse effect on our business, financial position or results of operations.
(17)
Supplemental Cash Flow Information
Significant non-cash investing and financing activities for the years ended December 31, 2005, 2004 and 2003 consisted of the following:
•
Issued $408.0 million, $10.8 million and $47.6 million of A-1 Common Units as partial consideration for properties acquired during 2005, 2004 and 2003, respectively;
•
Issued $250,000 of Series N-1 and N-2 Preferred Units ($125,000 each) as partial consideration for real estate during 2005;
•
Holders of Series K Preferred Shares and Series L Preferred Shares converted $25.0 million of each Series into Common Shares during 2004;
•
Holders of Series H Preferred Shares converted $71.5 million of their shares into Common Shares during 2003;
•
Holders of Series A Preferred Shares converted $71.9 million of their shares into Common Shares during 2003;
•
Redeemed $8.4 million, $47.9 million and $25.5 million A-1 Common Units for Common Shares during 2005, 2004 and 2003, respectively;
•
Assumed mortgage debt of $864.2 million, $113.6 million and $55.4 million during 2005, 2004 and 2003, respectively, in connection with the acquisition of apartment communities;
•
Recorded a $47.2 million accrual for anticipated capital spending to bring properties named in the FHA and ADA settlement into compliance in 2005; and
•
Recorded an accrual related to moisture infiltration and resulting mold remediation for $36.1 million at one of our high-rise properties in Southeast Florida during 2003.
(18)
Related Party Transactions
Ameriton paid approximately $4.8 million, $3.2 million and $1.5 million to certain of Archstone-Smith’s officers and employees related to realized returns on investments sold during 2005, 2004 and 2003, respectively, none of which were made to members of Ameriton’s board. Four members of Ameriton’s board (James H. Polk, III,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
John C. Schweitzer, R. Scot Sellers and Charles E. Mueller, Jr.) are Trustees of Archstone-Smith or executive officers of Archstone-Smith and the Operating Trust.
During 1997, as part of an employee share purchase plan, certain officers and other employees purchased Common Shares of Archstone-Smith. Archstone-Smith financed 95% of the total purchase price by issuing notes representing approximately $17.1 million. As of December 31, 2005, the aggregate outstanding balances on these notes were approximately $335,755.
Archstone-Smith has the following business relationships with business entities or family members of Board of Trustee members Robert H. Smith and Robert P. Kogod:
On April 8, 2002, the Operating Trust entered into an Office Space Easement and Cost Sharing Arrangement with CESM, Inc. and others. CESM, Inc. is controlled by two of our trustees, Mr. Smith and Mr. Kogod. During 2005, CESM, Inc. paid to us a total of $59,316 for office services provided by us to CESM, Inc. and $33,662 for certain employee expenses. For that same period, we paid to CESM, Inc. $234,808 for a portion of the rent due for the executive suites that CESM, Inc. leases and which are utilized by Mr. Smith and Mr. Kogod while working for us, and $41,797 for certain employee expenses to support Mr. Smith and Mr. Kogod.
Mr. Smith owns a residence within a condominium in Crystal City, where Archstone-Smith staffs the property with doormen, maintenance, and administrative staff. We are contractually reimbursed by the condominium association for payroll and benefits costs, and receives a contractual monthly management fee of $1,800 for other Archstone-Smith management oversight. We do not have an ownership interest in this property. We billed $185,566 during 2005 for expenses incurred and management fees for this property.
Mr. Smith and Mr. Kogod have a 0.33% and 4.36% ownership interest, respectively, in two apartment communities in Washington D.C. We receive a contractual management fee of 4.5% of revenues to manage the property and perform all accounting functions. We do not have an ownership interest in this property. We billed $966,359 during the twelve months ended December 31, 2005 for expenses incurred and management fees for this property.
Mr. Smith’s daughter was employed with us and our predecessor, Smith Residential, from September 1980 through January 2006 as a Vice President in Marketing. During 2005, she received a salary and bonus of approximately $109,400, and received options grants with a face value of $237,000.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON
SUPPLEMENTARY INFORMATION
The Board of Trustees
Archstone-Smith Trust:
We have audited and reported separately herein on the consolidated balance sheets of Archstone-Smith Trust and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of earnings, shareholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2005.
Our audits were made for the purpose of forming an opinion on the consolidated financial statements of Archstone-Smith Trust and subsidiaries taken as a whole. The supplementary information included in Schedules III and IV is presented for purposes of additional analysis and is not a required part of the consolidated financial statements. Such information has been subjected to the auditing procedures applied in the audits of the consolidated financial statements and, in our opinion, is fairly stated in all material respects in relation to the consolidated financial statements taken as a whole.
(signed) KPMG LLP
Denver, Colorado
March 9, 2006
SCHEDULE III
ARCHSTONE-SMITH TRUST
REAL ESTATE AND ACCUMULATED DEPRECIATION
December 31, 2005
(Dollar amounts in thousands)
SCHEDULE III
The following is a reconciliation of the carrying amount and related accumulated depreciation of Archstone-Smith’s investment in real estate, at cost (in thousands):
(1)
Depreciation is net of $18.0 million and $16.4 million for intangible assets related to the value of leases in place for real estate acquired in 2005 and 2004, respectively.
SCHEDULE IV
ARCHSTONE-SMITH TRUST
MORTGAGE LOANS ON REAL ESTATE
December 31, 2005
(Dollar amounts in thousands)
(1)
Outstanding principal plus accrued and unpaid interest is generally due on the maturity date unless specified as payable monthly in the loan agreement. Partial prepayment is required to the extent the borrower receives proceeds from the sale of constructed units in accordance with contracted terms.
(2)
A portion of the accrued interest amount is added to the principal amount on a monthly basis on the majority of the loans.
(3)
Our rights to the underlying collateral in the event of default are subordinate to a primary mortgage lender.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Archstone-Smith Trust
By:
/s/ R. Scott Sellers
R. Scot Sellers
Chairman of the Board and
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated:
INDEX TO EXHIBITS
Certain of the following documents are filed herewith. Certain other of the following documents have been previously filed with the Securities and Exchange Commission and, pursuant to Rule 12b-32, are incorporated herein by reference:
INDEX TO EXHIBITS - (Continued)
INDEX TO EXHIBITS - (Continued)