ITEM 1. BUSINESS
GENERAL
The Registrant, The Town and Country Trust (the "Trust" and, together with its consolidated subsidiaries and other controlled entities, the "Company"), is a self administered and self managed real estate investment trust ("REIT"), organized in Maryland in 1993. The Company operates in one industry segment, the ownership and operation of multifamily apartment communities. The Trust conducts substantially all of its operations through its operating partnership, The TC Operating Limited Partnership (the "Operating Partnership" or "TCOLP"), in which it holds an 88% general partnership interest at March 15, 2006. The remaining 12% limited partnership interest in the Operating Partnership is held by certain of the indirect predecessor owners of the Company's original 26 properties, including the successors of the late Alfred Lerner, the Trust's former Chairman, and Harvey Schulweis, the Trust's Chairman of the Board, President and Chief Executive Officer. At December 31, 2005, the Company owned 39 apartment communities (the "Properties") with 13,329 apartment units located in selected markets in the Mid-Atlantic region and Florida. The Company's headquarters are located at 300 East Lombard Street, Baltimore Maryland 21202 and its telephone number is (410) 539-7600.
The Registrant makes available free of charge, through its website (www.tctrust.com), its reports on Form 10-K, 10-Q and 8-K as soon as practicable after they are electronically filed with the Securities and Exchange Commission.
At December 31, 2005, approximately 37.5% of the Company's apartments were located in the greater Baltimore metropolitan area and an additional 25.4% were located in the greater Washington, D.C. metropolitan area.
The Company had continued to implement the ongoing program of reinvesting significant capital in its existing portfolio. During 2005, the Company began or continued renovations to seven of its communities containing 4,167 units. The renovations include the installation of new kitchens and baths, washers and dryers, new entranceways and windows. At several of these properties the renovations included the addition of a new clubhouse. Renovations at 884 units were completed during 2005, bringing the total completed to 2,756 units.
MERGER TRANSACTION
On December 19, 2005 we entered into an Agreement and Plan of Merger, by and among us, TCOLP, Magazine Acquisition GP LLC, Magazine Acquisition LP and Magazine Acquisition LLC, which we amended on February 16, 2006, pursuant to Amendment No. 1 to Agreement and Plan of Merger, by and among us, TCOLP, Magazine Acquisition GP LLC, Magazine Acquisition LP and Magazine Acquisition LLC ("Magazine Acquisition") (the Agreement and Plan of Merger, as amended, the "Merger Agreement"). Magazine Acquisition is a joint venture investment vehicle formed by affiliates of Morgan Stanley Real Estate and Onex Real Estate. Pursuant to the terms of the Merger Agreement, we will merge with and into Magazine Acquisition LP, with Magazine Acquisition LP continuing as the surviving entity, and Magazine Acquisition LLC will merge with and into TCOLP, with TCOLP continuing as the surviving entity (collectively referred to as "the merger").
Under the terms of the Merger Agreement, holders of our common shares of beneficial interest will receive $40.20 per share, without interest, plus a pro-rated dividend payable for the number of days since the end of the last fiscal quarter for which a dividend was declared and paid through the date of the closing of the merger ("the Merger Consideration"). Holders of limited partnership units in TCOLP will be entitled to receive $40.20 per unit, without interest, plus a pro-rated distribution payable for the number of days since the end of the last fiscal quarter for which a distribution was paid through the date of the closing of the merger. Also, in connection with the merger, any restrictions with respect to outstanding restricted shares awarded shall terminate and all holders of outstanding share options shall receive payment of the excess of the Merger Consideration over the exercise price per share of such options. Pursuant to the terms of the indenture for our 5.375% Convertible Senior Notes, due 2023, we are required to give public notice to the holders of such notes two days before the date that is fifteen days before the anticipated closing of the mergers (and mail notice to such holders ten days prior to such anticipated closing). Such holders may surrender their notes for conversion at any time from the date which is 15 days prior to the anticipated closing until 15 days after the actual closing.
The Board of Trustees unanimously approved the merger, the Merger Agreement and the other transactions contemplated by the Merger Agreement and declared the merger fair to, advisable and in the best interests of the trust, TCOLP, our shareholders and the holders of units of limited partnership in TCOLP. On March 9, 2006, the shareholders of the trust approved the merger and the other
transactions contemplated by the Merger Agreement by an affirmative vote in excess of two thirds of the votes that were entitled to be cast.
The merger is expected to occur during the first quarter of 2006. However, no assurance can be given that the merger will occur or as to the timing of its completion.
The foregoing description of the merger is qualified in its entirety by the full text of the Merger Agreement that has been filed with the Securities and Exchange Commission.
PROPERTY MANAGEMENT
Each of the apartment communities is managed by the Operating Partnership. The management staff for each community includes on-site management and maintenance personnel as well as off-site support staff. On-site staff performs leasing and rent collection functions and coordinates maintenance and resident services. Property management staffs are supervised by regional managers.
COMPETITION
All of the Company's apartments are located in developed areas and compete with numerous other apartment communities within their respective sub-markets. In many of the Company's apartment markets, the competition for residents is intense. Some competing communities are larger or newer than the Company's apartments and many offer features that the Company's communities do not have. The competitive position of each of the Company's apartment communities varies. Certain of the Company's competitors may have greater financial resources and other competitive advantages over the Company.
FINANCING
Thirty-eight of the thirty-nine of the Company's properties are encumbered by mortgage debt. Thirty-three properties are pledged as collateral for the Company's master credit facility with Fannie Mae. Five properties are encumbered by individual mortgage loans from Freddie Mac.
The Company has a credit facility with Fannie Mae of $488.2 million. This secured facility matures in 2008. At December 31, 2005, outstanding borrowings under the facility were $422.5 million, including amounts allocated to properties held for disposition. Of the $422.5 million, $300 million bears interest at a fixed rate of 6.91%. The remaining $122.5 million outstanding has a weighted-average variable rate of 4.45% at December 31, 2005 and can be converted to a fixed-rate term loan at the Company's option. The Company is party to floating-to-fixed interest rate swaps that effectively fix the interest rate on $40 million of this floating rate debt, changing the weighted average rate on its floating rate debts at December 31, 2005 to 4.69%.
Total outstanding borrowings under the facility at December 31, 2004 were $340 million. Of the $340 million, $300 million bears interest at a fixed rate of 6.91%. The remaining $40 million was outstanding at a weighted-average variable rate of 2.43% at December 31, 2004. After giving effect to the interest rate swaps, the weighted average interest rate on the $40 million was 4.66%.
The Company has a $50 million bank line of credit. Advances under the line bear interest at 120 basis points over LIBOR and are due on demand. Up to $10 million of the line may be used for working capital purposes and $40 million may be used to fund acquisitions. This line of credit matures in October 2006. The Company has the option to extend the line through October 2008. At December 31, 2005, no amounts were outstanding under the line. As of December 31, 2004, $2,000,000 was outstanding under the line.
The Company has $74.75 million aggregate principal amount of 5.375% Convertible Senior Notes outstanding. The notes mature on August 15, 2023 and are convertible into the Company's common shares under certain circumstances, provided that the share price exceeds $30.61 for a specified period of time. The initial conversion rate of the notes is 39.20185 shares per $1,000 principal amount of notes (equivalent to $25.51 per share). The conversion rate will be adjusted under certain circumstances, including stock splits, stock dividends and increases in the dividend rate over the current quarterly rate of $.43 per share. The shares would be considered in diluted earnings per share if the effect of including the conversion of debt were dilutive to earnings per share from continuing operations. The notes are redeemable at the Company's option for shares or cash at any time on or after August 21, 2010 and are subject to repurchase at the option of the holder on August 15, 2008, August 15, 2010, August 15, 2013 and August 15, 2018, or upon the occurrence of certain events. The notes are unsecured and unsubordinated obligations of the Company. Concurrent with the offering in 2003, the Company used approximately $15.0 million of the proceeds to purchase and retire 646,800 of its common shares ($23.19 per share) in privately negotiated transactions. The notes will become convertible for a period commencing on March 16,
2006 (which is 15 days prior to March 31, 2006, the anticipated effective date of the merger transaction discussed above) until 15 days after the actual effective date of the merger.
The Company uses interest rate protection agreements to reduce the potential impact of increases in interest rates as required by its secured credit facility. The Company maintains two interest rate protection agreements for $139 million and $49.2 million, capping the Company's exposure to LIBOR at 9.35% and 7.5%, respectively, through March 2007. In addition, the Company executed two $20 million floating to fixed interest rate swaps to effectively fix the interest rate on $40 million of floating rate debt under the secured credit facility at a blended rate of approximately 4.66%. The Company simultaneously sold two $20 million interest rate caps, capping the Company's exposure to LIBOR at 9.35%. These interest rate protection agreements hedge interest payments consistent with the Company's risk management objective and strategy to reduce exposure to variability in cash flows attributable to increases in LIBOR.
ENVIRONMENTAL MATTERS
Under various Federal, state and local laws, ordinances and regulations, a current or previous owner or operator of real estate may be liable for costs of removal or remediation of certain hazardous or toxic substances on, under or in such property. Such enactments often impose liability without regard to whether the owner knew of, or was responsible for, the presence of such hazardous or toxic substances. The presence of such substances, or the failure to properly remediate such substances, may affect adversely the owner's ability to sell or rent such property or to borrow using such property as collateral. Persons who arrange for the disposal or treatment of hazardous or toxic substances also may be liable for the costs of removal or remediation of such substances at the disposal or treatment facility, whether or not such facility is owned or operated by such person. Certain environmental laws impose liability for release of asbestos-containing materials ("ACMs") into the air and third parties may seek recovery from owners or operators of real property for personal injury associated with ACMs. In connection with its ownership and operation of the Properties, the Trust, the Operating Partnership, or any of their respective direct or indirect subsidiaries, as the case may be, potentially may be liable for such costs.
All of the Properties have been subjected to a Phase I or similar environmental assessment which generally does not involve invasive techniques such as soil or ground water sampling. These assessments have not revealed any environmental conditions that the Company believes will have a material adverse effect on its business, assets, financial condition or results of operations, nor is the Company aware of any material environmental liability.
EMPLOYEES
As of December 31, 2005, the Company had 428 employees.
ITEM 2.
ITEM 2. PROPERTIES.
The Properties consist of 39 multifamily properties comprising 13,329 apartment units located in suburban Baltimore, Maryland; suburban Washington, D.C. and northern Virginia; southeastern Pennsylvania; Delaware; and Florida.
The average occupancy rate for all Properties for fiscal 2005 and fiscal 2004 was 91.8% and 92.6%, respectively. Tenant leases are generally for one-year terms and often require security deposits. Approximately 96% of the apartments in the Properties are one-bedroom and two-bedroom apartments. The balance are three-bedroom apartments or townhomes. The Properties typically consist of two- and three-story buildings in a landscaped setting, many with amenities such as swimming pools, tennis courts, playgrounds and community buildings. All apartments offer air conditioning. The majority of such buildings are of brick construction and all of the Properties are located in mature, fully-developed neighborhoods.
The following table presents certain additional information concerning the Properties:
- ---------- (1) Average occupancy is defined as total market rent at 100% less market rent on vacant units divided by total market rent for the period, expressed as a percentage.
(2) Property held for disposition at December 31, 2005 and sold in January 2006.
(3) Property is undergoing major renovation.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
There were no legal proceedings pending at December 31, 2005 or as of the date of this report, except as noted below, to which the Registrant, the Operating Partnership or any of the separate general partnerships and limited liability companies which own the Properties is a party or to which the Properties are subject that are likely to have a material adverse impact on the Registrant's operations.
On February 2, 2006, an individual shareholder, Lee Foster, filed a putative class action, styled as Lee Foster v. The Town and Country Trust, et. al., in the Circuit Court for Baltimore City, Maryland, against us and each of our trustees. The complaint asserted that the trustees breached alleged fiduciary duties to plaintiff (and other shareholders) by entering into the December 19, 2005 merger agreement with Magazine Acquisition. The complaint sought, among other things, an injunction preventing Magazine Acquisition from acquiring us. By order dated February 21, 2006, the Court on our motion dismissed the complaint for failure to state a claim upon which relief may be granted, but allowed plaintiff 30 days within which to file an amended complaint.
Plaintiff filed his amended complaint on March 2, 2006. The amended complaint seeks disgorgement of benefits allegedly received by our trustees as a result of alleged breaches of duties, monetary damages, and an award of attorneys' fees, expenses and costs. The amended complaint alleges that our trustees breached their fiduciary duties to plaintiff (and other shareholders) by entering into the December 19, 2005 merger agreement with Magazine Acquisition without, according to plaintiff, having fully informed themselves about our "true value"; by agreeing to the initial $20 million break-up fee under such agreement; and by subsequently approving an amendment to the merger agreement on February 16, 2006 and agreeing to increase the break-up fee to $28 million in connection with the execution of the amendment. In addition, the amended complaint accuses our trustees of having favored their own interests over the interests of our shareholders. Finally, the amended complaint alleges that our trustees breached their fiduciary duties to plaintiff (and other shareholders) by allegedly not making full disclosure of all material facts in the proxy statement, dated January 26, 2006, which was mailed to shareholders on or around January 30, 2006, and the supplement to the proxy statement, dated February 24, 2006, which was mailed to shareholders on or around February 27, 2006.
We believe the amended complaint described above is without merit and we intend to vigorously defend against the claims and allegations in the complaint. However, there can be no assurance that the outcome will be favorable and defending this action may require the attention and resources of management and, regardless of the outcome, result in significant legal expenses.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.
EXECUTIVE OFFICERS OF THE REGISTRANT
Harvey Schulweis: Age 65. Mr. Schulweis has been the Chairman of the Board of the Trust since December 2002 and the Chief Executive Officer of the Trust since October 1997. Mr. Schulweis was President of the Trust from its formation in May 1993 until November 2004. Mr. Schulweis has been the President of Schulweis Realty, Inc., a private real estate investment and development firm, since 1991. Formerly a general partner of Lazard Freres & Co., he is a Certified Public Accountant and was a partner in a predecessor firm to Ernst & Young LLP, a major international accounting firm.
Thomas Brodie: Age 43. Mr. Brodie has served as President and Chief Operating Officer of the Registrant since November 2004. Prior thereto, he served as Executive Vice President--Co-Chief Operating Officer of the Registrant from February 2003 to November 2004. He served as Senior Vice President and Chief Investment Officer of the Registrant from May 2001 to February 2003. Mr. Brodie also has served as Managing Director of Schulweis Realty, Inc., a private real estate investment and development firm, since 1991. Prior to 1991, Mr. Brodie was a Senior Vice President of Lazard Realty, Inc.
Alan W. Lasker: Age 59. Mr. Lasker has served as Senior Vice President--Finance, Chief Financial Officer and Assistant Secretary of the Registrant since February 2003. Prior thereto, he served as Senior Vice President--Finance of the Registrant since February 2000 and Vice President--Finance of the Registrant since July 1997. Mr. Lasker also has served as Senior Vice President of Schulweis Realty, Inc., a private real estate investment and development firm, since 1991. Prior to 1991, Mr. Lasker was a Senior Vice President of Lazard Realty, Inc. Mr. Lasker is a Certified Public Accountant.
W. Daniel Brown: Age 55. Mr. Brown has served as Senior Vice President - Human Resources of the Registrant since May of 2001. Prior to joining the Company he held the same position at Prime Retail, LP beginning in 1998. From 1994 through 1998, Mr. Brown was a Vice President in Human Resources at T. Rowe Price Associates. Prior to joining T. Rowe Price, Mr. Brown was a member of the Principle Professional Staff of the Johns Hopkins University Applied Physics Laboratory (APL) from 1984 through 1994. Mr. Brown holds professional certifications in both human resources and compensation.
William J. Fishell: Age 51. Mr. Fishell has served as Vice President - Treasurer of the Registrant since February 2004. Previously, he served as Vice President - Controller of the Registrant since February 2003 and Vice President - Controller since the Registrant's initial public offering in 1993. He has been the Principal Accounting Officer of the Registrant since February 2003. Prior thereto, Mr. Fishell served as Assistant Vice President - Assistant Controller since 1979.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON SHARES OF BENEFICIAL INTEREST AND RELATED SHAREHOLDER MATTERS
The Company's common shares of beneficial interest are listed on the New York Stock Exchange under the trading symbol "TCT."
On February 3, 2006, a cash dividend for the quarter ended December 31, 2005 of $.43 per share was declared, payable March 10, 2006, to shareholders of record as of February 17, 2006.
At December 31, 2005, the approximate number of record holders of the Trust's shares was 437. This does not include beneficial owners for whom Cede & Co. or others act as nominee.
EQUITY COMPENSATION PLAN INFORMATION
The following table sets forth information concerning the Amended and Restated 1993 Long Term Incentive Plan and the 1997 Long Term Incentive Plan, both of which have been approved by the shareholders of the Trust. The figures shown are for the year ended December 31, 2005.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(1) Funds from operations ("FFO") is computed as net income (loss) (computed in accordance with U. S. generally accepted accounting principles) ("U.S. GAAP") excluding gains and losses from sales and involuntary conversions of operating properties, plus real estate depreciation and income allocated to minority interest. This computation of FFO is consistent with the formal definition promulgated by the National Association of Real Estate Investment Trusts (NAREIT). The reconciliation of FFO to Net Income, the most directly comparable financial measure calculated in accordance with GAAP, is included in the table above. Management generally considers FFO to be a useful measure for reviewing the comparative operating performance of the Trust between periods or as compared to other companies, without giving effect to real estate depreciation and amortization, which assumes that the value of real estate diminishes predictably over time and which can vary among owners of similar assets based upon historical cost and useful life estimates. FFO should not be considered an alternative to net income as a measure of performance nor does it represent cash generated from operating activities in accordance with GAAP and, therefore, it should not be considered indicative of cash available to fund cash needs.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
The Town and Country Trust owns an approximate 88% general partnership interest in The TC Operating Limited Partnership which, through wholly-owned subsidiary entities, holds the operating assets of the Company. The remaining 12% is owned by minority interest partners that hold limited partnership units, which are convertible by the holders into the Company's common shares of beneficial interest on a one-for-one basis. The general and limited partnership interests in the TC Operating Limited Partnership are represented by Operating Partnership units ("OP Units"). At December 31, 2005, the Company owned 17,655,222 OP Units and the minority interests held 2,466,535 OP Units.
On December 19, 2005 we entered into an Agreement and Plan of Merger, by and among us, TCOLP, Magazine Acquisition GP LLC, Magazine Acquisition LP and Magazine Acquisition LLC, which we amended on February 16, 2006, pursuant to Amendment No. 1 to Agreement and Plan of Merger, by and among us, TCOLP, Magazine Acquisition GP LLC, Magazine Acquisition LP and Magazine Acquisition LLC ("Magazine Acquisition") (the Agreement and Plan of Merger, as amended, the "Merger Agreement"). Magazine Acquisition is a joint venture investment vehicle formed by affiliates of Morgan Stanley Real Estate and Onex Real Estate. Pursuant to the terms of the Merger Agreement, we will merge with and into Magazine Acquisition LP, with Magazine Acquisition LP continuing as the surviving entity, and Magazine Acquisition LLC will merge with and into TCOLP, with TCOLP continuing as the surviving entity (collectively referred to as "the merger").
Under the terms of the Merger Agreement, holders of our common shares of beneficial interest will receive $40.20 per share, without interest, plus a pro-rated dividend payable for the number of days since the end of the last fiscal quarter for which a dividend was declared and paid through the date of the closing of the merger ("the Merger Consideration"). Holders of limited partnership units in TCOLP will be entitled to receive $40.20 per unit, without interest, plus a pro-rated distribution payable for the number of days since the end of the last fiscal quarter for which a distribution was paid through the date of the closing of the merger. Also, in connection with the merger, any restrictions with respect to outstanding restricted shares awarded shall terminate and all holders of outstanding share options shall receive payment of the excess of the Merger Consideration over the exercise price per share of such options. Pursuant to the terms of the indenture for our 5.375% Convertible Senior Notes, due 2023, we are required to give public notice to the holders of such notes two days before the date that is fifteen days before the anticipated closing of the mergers (and mail notice to such holders ten days prior to such anticipated closing). Such holders may surrender their notes for conversion at any time from the date which is 15 days prior to the anticipated closing until 15 days after the actual closing.
The Board of Trustees unanimously approved the merger, the Merger Agreement and the other transactions contemplated by the Merger Agreement and declared the merger fair to, advisable and in the best interests of the trust, TCOLP, our shareholders and the holders of units of limited partnership in TCOLP. On March 9, 2006, the shareholders of the trust approved the merger and the other transactions contemplated by the Merger Agreement by an affirmative vote in excess of two thirds of the votes that were entitled to be cast.
The merger is expected to occur during the first quarter of 2006. However, no assurance can be given that the merger will occur or as to the timing of its completion.
The foregoing description of the merger is qualified in its entirety by the full text of the Merger Agreement that has been filed with the Securities and Exchange Commission.
The Town and Country Trust, organized in 1993, is a real estate investment trust ("REIT") focused on the ownership and operation of multifamily apartment communities in selected markets in the Mid-Atlantic region of the U.S. and Florida. The Company owns 38 multifamily apartment communities with 13,182 apartment homes classified as real estate held for investment and one apartment community with 147 apartment homes classified as held for disposition in selected markets in the Mid-Atlantic region of the U. S. and Florida. In 2004, the Company exited the Charlotte, North Carolina market through the strategic disposition of its two apartment communities located there. On October 6, 2005, the Company acquired an apartment community consisting of 264 apartment homes and one townhome in Bear, Delaware for approximately $41.6 million including acquisition costs.
In October 2005, the Company entered into an agreement to sell an apartment community in Baltimore, Maryland. This community is currently classified as held for disposition on the Company's balance sheets. The sale was completed on January 19, 2006 for net proceeds of approximately $37.3 million and the Company expects to record a gain of approximately $17 million in the first quarter 2006.
The Company continues to aggressively reinvest in its existing portfolio. Renovation projects include modernization of kitchens and bathrooms, new building entrances and windows, new business and fitness centers, and the addition of washers and dryers inside apartment homes.
CRITICAL ACCOUNTING POLICIES
The Company's discussion and analysis of its financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.
The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.
IMPAIRMENT OF REAL ESTATE ASSETS The Company periodically evaluates its apartment communities for potential impairment indicators. Judgments regarding the existence of impairment indicators are based on legal factors, market conditions and operational performance of the apartment communities. Future events could cause management to conclude that impairment indicators exist and that the Company's portfolio of apartment communities is impaired. Any resulting impairment loss could have a material adverse impact on the Company's financial condition and results of operations.
REAL ESTATE The Company capitalizes expenditures made to acquire new assets, substantially improve the value of an existing asset or extend an asset's useful life. Any expenditure to repair or maintain an existing asset in normal operating condition is expensed as incurred.
Depreciation is computed on a straight-line basis over the estimated useful lives of the related assets. In assessing estimated useful lives, the Company makes assumptions based on historical experience acquired from both within and outside the Company.
The Company accounts for property acquisitions utilizing the purchase method, and accordingly, the results of the acquisition properties are included in the Company's results of operations from the date of acquisition. The Company allocates the purchase price to the acquired tangibles, consisting of land, building and improvements, and if material, to identified intangible assets and liabilities, consisting of above/below market leases and at-market leases in place based on their fair values.
REVENUE RECOGNITION Revenue from rental property is recognized on a straight-line basis over the terms of the lease. Leases are generally for one year or less.
Gains on sales of real estate assets are recognized pursuant to the provisions of SFAS No. 66, Accounting for Sales of Real Estate. The specific timing of the recognition of the sale and the related gain is measured against the various criteria in SFAS No. 66 related
to the terms of the transactions and the Company's continuing involvement, if any, associated with the assets sold. To the extent the sales criteria are not met, the Company defers gain recognition until the sales criteria are met.
DISCONTINUED OPERATIONS SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, requires that the assets and liabilities and the results of operations of any communities that have been sold since January 1, 2002, or otherwise qualify as held for sale, be presented as discontinued operations in the Company's Consolidated Financial Statements in both current and prior periods presented. The community specific components of net income that are presented as discontinued operations include net operating income, depreciation expense, minority interest, interest expense and gains or losses on involuntary conversion. In addition, the net gain or loss (including any impairment charge) on the disposition of communities held for sale is presented as discontinued operations. A change in presentation for discontinued operations would not have any impact on the Company's financial conditions or results of operations. Real estate assets held for sale are measured at the lower of the carrying amount or the fair value less costs to sell, and would be presented separately in the Consolidated Balance Sheet. Subsequent to classification of a community as held for sale, no further depreciation is recorded on the assets.
HEDGE ACCOUNTING The Company carries all derivative financial instruments as assets or liabilities on its balance sheets at fair value. Changes in fair value of these instruments, which qualify as cash flow hedges, are recorded as a component of other comprehensive income (loss). Any ineffective portion of the change in value is recorded to interest expense in current period earnings. Furthermore, should any change in management strategy, or other circumstance, cause an existing highly effective hedge to become entirely ineffective, the accumulated loss or gain in the value of the derivative instrument since its inception may be required to be immediately reclassified from the shareholders' equity section of the balance sheet to the income statement.
NEW ACCOUNTING PRONOUNCEMENT In December 2004, the Financial Accounting Standards Board (FASB) issued a revision to SFAS No. 123 (revised 2004), Share Based Payment ("Statement No.123(R)"). Statement No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recorded as an expense based on their fair values. The grant-date fair value of employee share options and similar instruments will be estimated using an option-pricing model adjusted for any unique characteristics of a particular instrument. If an equity award is modified after the grant date, incremental compensation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification. The Company will adopt the provisions of SFAS No. 123(R) during the first quarter 2006. The adoption of this new standard is not expected to have a material effect on the financial position or financial results of the Company.
RESULTS OF OPERATIONS
The Company's results include the results of both continuing and discontinued operations. Income from Discontinued Operations in the accompanying statement of operations for 2005 reflects the operations of a community under contract for sale in Baltimore, Maryland (147 apartment homes). Income from Discontinued Operations for 2004 and 2003 includes the property held for sale at December 31, 2005 as well as the apartment communities that were sold during 2004 and 2003 (580 and 2,325 apartment homes, respectively). The Company's results from continuing operations consist of both "Same Store" results and results of new acquisitions. "Same Store" results, as discussed in the comparison of 2005 to 2004, reflect results from 12,917 apartment homes owned and operated throughout both 2005 and 2004. "Same Store" results, as discussed in the comparison of 2004 to 2003, reflect results from 12,332 apartment homes owned and operated throughout both 2004 and 2003. Results for 2005 from new acquisitions include results from one community (265 apartment homes) acquired in October 2005.
YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004
Net income for 2005 was $5,192,000, or $0.30 per diluted share, an increase of $3,396,000 from $1,796,000, or $0.10 per diluted share, for the year ended December 31, 2004. Real estate depreciation in 2005 is $25,015,000 compared to $28,174,000 in 2004, a decrease of $3,159,000. Included in 2004 is a charge for additional depreciation of $6,493,000 relating to the Company's change in the estimated useful lives of certain depreciable assets, principally carpet, to more closely approximate their current economic lives based on experience. Net income for 2004 includes $1,672,000 of impairment charges offset by a $558,000 gain on involuntary conversion related to a fire on properties reported as discontinued operations. Net income for 2004 includes a separation charge of $1,533,000 related to the departure of two senior executives consisting primarily of cash payments that were paid during 2005 and will be paid in 2006. The results for 2004 also include expenses aggregating $573,000 relating to damage sustained in Florida during the 2004 hurricane season and $403,000 related to compensation expense recorded on the cashless exercise of certain stock options. The 2005 net income includes $2,540,000 in merger related fees and $2,211,000, of additional compensation expense associated with the accelerated vesting of certain restricted shares and the accelerated approval of bonuses by the compensation committee.
CONTINUING OPERATIONS
SAME STORE COMMUNITIES
Operating results for the Same Store communities are set forth in the table below:
A reconciliation between net income and Same Store net operating income is as follows:
The Company uses net operating income (NOI) to measure the operating results of its communities and to compare the operating performance of single assets or groups of assets. The Company defines NOI as property rental income less property operating expenses and does not include general and administrative expenses, interest expense, depreciation and amortization, discontinued operations, or gains/(losses) on sales of properties. Accordingly, this performance measure is not intended as a replacement for net income determined in accordance with U.S. GAAP. NOI is widely used by management and investors in the real estate industry in connection with the valuation of income-producing real estate and as a supplemental measure of operating performance. NOI measures presented by the Company may not be comparable to other similarly titled measures of other companies.
Same Store rental income for the year ended December 31, 2005, grew by $6,280,000 or 5.0%, reflecting an average rental rate increase of 5.9% despite a decline in occupancy of 80 basis points from 92.6% to 91.8%. Occupancy and average rent statistics for the Company's operating markets are as follows:
(1) Based on number of Same Store apartment homes
(2) Amounts have been restated for comparative purposes
Same Store operating expenses for the year ended December 31, 2005, increased 7.6% or $3,986,000, to $56,491,000 from $52,505,000 in 2004. Operating expenses reflect an increase in repairs and maintenance of $1,044,000 or 6.7%, to $16,697,000 from $15,653,000 due primarily to increased costs associated with the turnover process offset by $573,000 of hurricane damages sustained at our Florida properties in 2004. Utilities increased $975,000, or 13.3%, to $8,323,000 from $7,348,000 as a result of rate increases for the purchase of electric, natural gas and water. Specifically, $449,000 of the increase directly relates to rate increases associated with the purchase of natural gas. Marketing and advertising increased $543,000, or 11.6%, from $4,693,000 to $5,236,000, of which
$179,000 is related to the Company starting to use third party call centers as a first response to prospective customers and the remainder to increased print and Internet advertising. Other operating expenses increased $678,000, or 12.3%, to $6,177,000 from $5,499,000 as the Company accrued a $300,000 liability related to an unresolved resident complaint and experienced a $159,000 increase in professional fees associated with successful real estate tax appeals and $56,000 in cost related to the termination of a contract with a cable television provider. As a result, net operating income increased $2,294,000, or 3.2%, to $74,353,000 from $72,059,000.
ACQUISITIONS
The community acquired in October 2005 had net operating income of $550,000.
INTEREST EXPENSE
Interest expense increased $1,256,000, or 3.9%, to $33,702,000 from $32,446,000 last year. This is due principally to the amount of debt outstanding. The weighted average debt outstanding increased from $413.8 million at December 31, 2004 to $437.3 million at year end in 2005. The 6.40% weighted average interest rate in 2005 is flat compared to 6.42% last year.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased by $1,325,000, or 22.6% from $5,866,000 last year to $7,191,000 due primarily to $1,553,000 in additional compensation expense associated with the accelerated vesting of certain restricted shares and the accelerated approval of bonuses by the compensation committee. In 2004, the Company accrued $140,000 in state franchise taxes that relate to two of the Company's wholly owned subsidiaries and is discussed further in Note 13 to the Company's Consolidated Financial Statements.
DISCONTINUED OPERATIONS
For the year ended December 31, 2005, the Company recorded net income of $228,000 compared to a loss on discontinued operations of $656,000 for the year ended December 31, 2004. The loss from discontinued operations for the prior year includes $1,672,000 of impairment charges offset by a $558,000 gain on involuntary conversion related to a fire.
YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED DECEMBER 31, 2003
Net income for 2004 was $1,796,000, or $0.10 per diluted share, a decrease of $76,972,000 from $78,768,000 or $4.90 per diluted share, for the year ended December 31, 2003. Included in net income in 2003 is an $80,081,000 gain resulting from the sale of five communities in 2003. Included in net income for 2004 and 2003 is $1,672,000 and $4,000,000, respectively, of impairment charges recorded on properties that were sold during 2004. Net income for 2004 also includes a separation charge of $1,533,000 related to the departure of two senior executives consisting primarily of cash payments that will be paid during 2005 and 2006. During 2004, the Company revised the estimated useful lives of certain depreciable assets, principally carpet, to more closely approximate their current economic lives based upon the Company's capital improvement and renovation plans. This change in accounting estimate resulted in additional depreciation expense of $6,493,000.
CONTINUING OPERATIONS
SAME STORE COMMUNITIES
Operating results for the Same Store communities are set forth in the table below:
A reconciliation between net income and Same Store net operating income is as follows:
The Company uses net operating income (NOI) to measure the operating results of its communities and to compare the operating performance of single assets or groups of assets. The Company defines NOI as property rental income less property operating expenses and does not include general and administrative expenses, interest expense, depreciation and amortization, discontinued operations, or gains/losses on sales of properties. Accordingly, this performance measure is not intended as a replacement for net income determined in accordance with U.S. GAAP. NOI is widely used by management and investors in the real estate industry in connection with the valuation of income-producing real estate and as a supplemental measure of operating performance. NOI measures presented by the Company may not be comparable to other similarly titled measures of other companies.
Same Store rental income for the year ended December 31, 2004, grew by $3,050,000 or 2.7%, reflecting an average rental rate increase of 3.3% despite a decline in occupancy of 110 basis points from 93.6% to 92.5%. Occupancy and average rent statistics for the Company's operating markets are as follows:
(1) Based on number of Same Store apartment homes
Same Store operating expenses for the year ended December 31, 2004, increased 2.1% or $1,011,000, to $49,581,000 from $48,570,000 in 2003. Operating expenses reflect an increase in repairs and maintenance of $486,000 or 3.4%, to $14,811,000 from $14,325,000 as the Company experienced approximately $573,000 in damages sustained in the 2004 hurricane season and annual salary increases offset by reduced snow removal cost reflecting return to historical levels of snowfall in 2004 following the record snowfall experienced on the East Coast in early 2003. Marketing and advertising increased $433,000 or 10.9% to $4,395,000 from $3,962,000 related to increased leasing costs as well as increased advertising for newly renovated properties. As a result, Same Store net operating income increased $2,039,000 or 3.2% to $66,129,000 from $64,090,000.
ACQUISITIONS
During the year ended December 31, 2004, the two communities acquired in 2003 and included in continuing operations had net operating income of $5,930,000 compared to $2,557,000 for the prior year.
INTEREST EXPENSE
During 2003, the Company issued $74,750,000 of 5.375% Convertible Senior Notes due 2023. Interest expense for 2004 related to the notes was $4,106,000 compared to $1,659,000 for the year ended December 31, 2003. Interest expense on mortgage debt increased $1,737,000 or 6.4% to $28,863,000 from $27,126,000 in the prior year. Despite a decrease in average debt outstanding attributable to continuing operations, from $457 million to $421 million, the weighted average interest rate attributable to this debt, excluding the Convertible Senior Notes, was 6.42% compared to 5.67% for the prior year resulting in an increase to interest expense.
DISCONTINUED OPERATIONS
For the year ended December 31, 2004, the Company recorded a loss on discontinued operations of $656,000 compared to net income of $67,312,000 for the year ended December 31, 2003. The income from discontinued operations for the prior year includes an $80,081,000 gain related to the sale of five apartment communities containing 2,325 apartment homes in the Baltimore, Maryland suburbs. Discontinued operations for 2004 and 2003, included impairment charges of $1,672,000 and a $4,000,000, respectively, recorded on the Charlotte properties sold during 2004.
DISTRIBUTIONS TO MINORITY INTEREST IN EXCESS OF EARNINGS
U.S. GAAP requires that, for financial reporting purposes, an additional allocation of income be made to the minority interest account in an amount necessary to keep such balance from falling below zero since there is no requirement for the unit holders to make additional contributions. During 2003, earnings were in excess of distributions to minority interests and, therefore, the Company reallocated the $576,000 that had previously been so allocated to the minority interests.
FUNDS FROM OPERATIONS
Funds from operations ("FFO") is computed as net income (loss) (computed in accordance with U.S. GAAP) excluding gains and losses from sales and involuntary conversions of operating properties, plus real estate depreciation. This computation of FFO is consistent with the formal definition promulgated by the National Association of Real Estate Investment Trusts (NAREIT). The reconciliation of FFO to Net Income, the most directly comparable financial measure calculated in accordance with U.S. GAAP, is included in the table below. Management generally considers FFO to be a useful measure for reviewing the comparative operating performance of the Trust between periods or as compared to other companies, without giving effect to real estate depreciation and amortization, which assumes that the value of real estate diminishes predictably over time and which can vary among owners of similar assets based upon historical cost and useful life estimates. FFO should not be considered an alternative to net income as a measure of performance nor does it represent cash generated from operating activities in accordance with U.S. GAAP and, therefore, it should not be considered indicative of cash available to fund cash needs.
While the NAREIT definition of FFO does not specifically address involuntary conversions of operating properties, management believes that such conversions are, in substance, sales of property. Since the NAREIT definition of FFO excludes gains and losses on property sales, the reported gain on involuntary conversion has, likewise, been excluded from FFO.
A reconciliation between net income and FFO is as follows:
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET COMMITMENTS
The following table summarizes the Company's contractual obligations as of December 31, 2005:
See Note 6 to the Consolidated Financial Statements for a discussion of the Company's off-balance sheet obligations upon the exercise of the right of the holders of the 5.375% Convertible Senior Notes to convert their notes into common shares. In connection with the Company's improvement program discussed below, the Company currently has contracts pending that aggregate $9,520,000 for work to be performed over the next one to three years. However, these contracts contain certain provisions to allow for termination without significant penalties.
LIQUIDITY AND CAPITAL RESOURCES
A summary of the Company's cash flow activities is as follows:
Operating activities provided unrestricted cash for 2005 of $39,473,000 compared to $37,546,000 for 2004, and $43,107,000 for 2003. The increase in operating cash flow is primarily the result of an improvement in operating performance offset by increased interest
expense. Net cash flow used in investing activities has increased as compared to 2004 as a result of the purchase of an apartment community and as a result of the continued interior/exterior renovations programs at seven of the Company's communities. In 2004, cash flow from investing activities also included proceeds from the disposition of two properties. In 2005, financing activities provided cash flow of $46,391,000 as compared to net cash used of $31,326,000 for 2004, mainly as a result of net borrowings in 2005 compared to net repayment of mortgage debt in 2004 net of the additional funds received in connection with the share offering in 2004. The pending merger is anticipated to close before the end of the first quarter 2006. A prorated dividend, based on $0.43 per share, will be included as part of the merger consideration.
During 2005, the Company acquired an apartment community in Bear, Delaware a suburb of Wilmington, Delaware that contains 264 garden-style apartment homes and one townhome for approximately $41.6 million, including acquisition costs. The properties were acquired through an intermediary in anticipation of the completion of a like-kind exchange under Section 1031 of the Internal Revenue Code. The Company funded the acquisition using its existing credit facilities. In October 2005, the Company entered into an agreement to sell an apartment community in Baltimore, Maryland. This community is classified as held for disposition on the Company's balance sheets. This transaction, which occurred in January 2006, completed the like-kind exchange transaction discussed above. The Company expects to record a gain of approximately $17 million in the first quarter of 2006 as a result of the sale.
The Company makes capital improvements to certain of its properties. These capital improvements include expenditures that increase the value and extend the useful life of an asset. Expenditures for ordinary repairs and maintenance are expensed as incurred. Normal, recurring capital expenditures generally relate to items having economic lives of 10 years or less and include the replacement of appliances, carpeting and tile plus other routine capital expenditures such as landscaping, parking lot sealing and striping, HVAC equipment and various interior and exterior building improvements. The Company also makes certain expenditures that are considered to be non-recurring or revenue-enhancing in nature and generally relate either to (i) items having economic lives of more than 10 years or (ii) renovation projects such as the modernization of kitchen and bathrooms, new building entrances and windows, new business and fitness centers, and the addition of new appliances such as washers and dryers. In conjunction with certain of these renovation projects, the Company enters into commitments to purchase goods and services with vendors performing the work. The Company finances its capital improvements through a revolving credit facility and working capital. The following table details these expenditures for the year ended December 31, 2005 and 2004.
The Company has a credit facility with Fannie Mae of $488.2 million. This secured facility matures in 2008. At December 31, 2005, outstanding borrowings under the facility were $422.5 million, including amounts allocated to properties held for disposition. Of the $422.5 million, $300 million bears interest at a fixed rate of 6.91%. The remaining $122.5 million outstanding has a weighted-average variable rate of 4.45% at December 31, 2005 and can be converted to a fixed-rate term loan at the Company's option. The Company is party to floating-to-fixed interest rate swaps that effectively fix the interest rate on $40 million of this floating rate debt, changing the weighted average rate on its floating rate debts at December 31, 2005 to 4.69%.
Total outstanding borrowings under the facility at December 31, 2004 were $340 million. Of the $340 million, $300 million bears interest at a fixed rate of 6.91%. The remaining $40 million was outstanding at a weighted-average variable rate of 2.43% at December 31, 2004. After giving effect to the interest rate swaps, the weighted average interest rate on the $40 million was 4.67%.
The Company has a $50 million bank line of credit. Advances under the line bear interest at 120 basis points over LIBOR and are due on demand. Up to $10 million of the line may be used for working capital purposes and $40 million may be used to fund acquisitions. This line of credit matures in October 2006. The Company has the option to extend the line through October 2008. At December 31, 2005, no amounts were outstanding under the line. As of December 31, 2004, $2,000,000 was outstanding under the line.
The Company has $74.75 million aggregate principal amount of 5.375% Convertible Senior Notes outstanding. The notes mature on August 15, 2023 and are convertible into the Company's common shares under certain circumstances, provided that the share price exceeds $30.61 for a specified period of time. The initial conversion rate of the notes is 39.20185 shares per $1,000 principal amount of notes (equivalent to $25.51 per share). The conversion rate will be adjusted under certain circumstances, including stock splits, stock dividends and increases in the dividend rate over the current quarterly rate of $.43 per share. The shares would be considered in diluted earnings per share if the effect of including the conversion of debt were dilutive to earnings per share from continuing operations. The notes are redeemable at the Company's option for shares or cash at any time on or after August 21, 2010 and are subject to repurchase at the option of the holder on August 15, 2008, August 15, 2010, August 15, 2013 and August 15, 2018, or upon
the occurrence of certain events. The notes are unsecured and unsubordinated obligations of the Company. Concurrent with the offering in 2003, the Company used approximately $15.0 million of the proceeds to purchase and retire 646,800 of its common shares ($23.19 per share) in privately negotiated transactions. The notes will become convertible for a period commencing on March 16, 2006 (which is 15 days prior to March 31, 2006, the anticipated effective date of the merger transaction discussed above) until 15 days after the actual effective date of the merger.
The following table sets forth certain information regarding the Company's outstanding indebtedness as of December 31, 2005:
(1) The information shown for this debt gives effect to two interest rate swap agreements that have the effect of fixing the interest rate on $40 million of debt at approximately 4.66% from January 2003 to April 2007.
(2) Weighted average
The following table provides information about the Company's derivative financial instruments and other financial instruments that are sensitive to changes in interest rates. For debt obligations, the table presents principal cash flows and related weighted average interest rates by expected maturity dates. For interest rate swaps and caps, the table presents notional amounts and weighted average interest rates or strike rates by contractual maturity dates.
(1) Average variable interest rate is equivalent to the Fannie Mae MBS pass-through rate plus 49 basis points.
(2) Average receive rate is equivalent to LIBOR.
At December 31, 2004, the Company had fixed rate debt outstanding of $449,882,000, which had a fair value of $448,339,000.
The Company's primary market risk exposure relates to changes in interest rates associated with the variable rate portion of its secured credit facility and its bank line of credit. The Company had $82.5 million in variable rate debt outstanding at December 31, 2005, excluding amounts on which the interest rates are effectively fixed by floating to fix interest rate swap agreements. A hypothetical 100 basis point increase in interest rates in 2006 over the rates in effect during 2005 would result in an increase of interest expense and a corresponding decrease in income before discontinued operations and minority interest of approximately $709,000. This estimate incorporates only those exposures that exist as of December 31, 2005 and does not consider exposures that could arise after that date.
The Company uses interest rate protection agreements to reduce the potential impact of increases in interest rates as required by its secured credit facility. The Company maintains two interest rate protection agreements for $139 million and $49.2 million, capping the Company's exposure to LIBOR at 9.35% and 7.5%, respectively, through March 2007. In addition, the Company executed two $20 million floating to fixed interest rate swaps to effectively fix the interest rate on $40 million of floating rate debt under the secured facility at a blended rate of approximately 4.66%. The Company simultaneously sold two $20 million interest rate caps, capping the Company's exposure to LIBOR at 9.35%. These interest rate protection agreements hedge interest payments consistent with the Company's risk management objective and strategy to reduce exposure to variability in cash flows attributable to increases in LIBOR.
Debt agreements typically contain representations and financial or other covenants that must be adhered to in order for a borrower to avoid default on the agreement. The Company monitors its compliance with the covenants set forth in its debt agreements and does not believe that it will breach any of them in the ordinary course of business. A breach of a material covenant would normally result in the inability of the Company to maintain funds available until such breach is remedied or would allow the lender to require the Company to repay the debt obligation.
The Company has an effective shelf registration statement on file with the SEC that provides for the issuance of up to $75 million in securities. The Company believes that it is prudent to maintain shelf registration capacity in order to facilitate future capital raising activities. In February 2004, the Company sold 1,410,000 of its common shares pursuant to its shelf registration in a private sale at a negotiated price of $24.80 per share. After the sale, approximately $40 million in securities remains available under the shelf registration statement. The net proceeds of approximately $34.7 million from the sale, along with the proceeds of the debt offering in August 2003, were used to pay down floating rate debt.
Management believes that the Company has and will have access to the capital resources necessary to adequately fund its business. At December 31, 2005, the Company had $3,517,000 in cash and cash equivalents and $10 million available under its working capital line of credit. The Company also had $65.7 million in unused capacity on its secured credit facility which it intends to use primarily to fund acquisitions as well as its on-going capital improvements program. In addition, another $40 million is available for acquisitions on its bank line of credit. The Company expects that adequate cash will be available to fund its operating and administrative expenses, normal capital expenditures, debt service obligations and payments of dividends in the foreseeable future.
The Company believes that the direct effects of inflation upon its operations are immaterial. Substantially all of its apartment unit leases are for a term of one year or less, which enables the Company to seek increased rents upon renewal or reletting of apartment units. Such short-term leases minimize the risk of the adverse effects of inflation; however, as a general rule, such leases permit tenants to leave at the end of the lease term without penalty.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information in response to this Item is set forth under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Recourses" included in Item 7 of this Form 10-K and is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
(A) FINANCIAL STATEMENTS
THE TOWN AND COUNTRY TRUST CONSOLIDATED BALANCE SHEETS
See accompanying notes.
THE TOWN AND COUNTRY TRUST CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes.
THE TOWN AND COUNTRY TRUST CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT PER SHARE DATA)
See accompanying notes.
THE TOWN AND COUNTRY TRUST CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See accompanying notes.
THE TOWN AND COUNTRY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Significant Accounting Policies
Organization
The Town and Country Trust (the "Company" or the "Trust"), a Maryland real estate investment trust, is a self-administered and self-managed real estate investment trust ("REIT") organized in 1993 to own and operate a portfolio of multifamily residential properties. The Company conducts all of its business and owns all of its properties through The TC Operating Limited Partnership ("TCOLP"). At December 31, 2005, the Company owned 13,329 apartment homes in 39 apartment communities in selected markets in the Mid-Atlantic and Southeast.
On December 19, 2005, the Company entered into an Agreement and Plan of Merger, by and among us, TCOLP, Magazine Acquisition GP LLC, Magazine Acquisition LP and Magazine Acquisition LLC, which the Company amended on February 16, 2006, pursuant to Amendment No. 1 to Agreement and Plan of Merger, by and among the Company, TCOLP, Magazine Acquisition GP LLC, Magazine Acquisition LP and Magazine Acquisition LLC ("Magazine Acquisition") (the Agreement and Plan of Merger, as amended, the "Merger Agreement"). Magazine Acquisition is a joint venture investment vehicle formed by affiliates of Morgan Stanley Real Estate and Onex Real Estate. Pursuant to the terms of the Merger Agreement, the Company will merge with and into Magazine Acquisition LP, with Magazine Acquisition LP continuing as the surviving entity, and Magazine Acquisition LLC will merge with and into TCOLP, with TCOLP continuing as the surviving entity (collectively referred to as "the merger").
Under the terms of the Merger Agreement, holders of common shares of beneficial interest will receive $40.20 per share, without interest, plus a pro-rated dividend payable for the number of days since the end of the last fiscal quarter for which a dividend was declared and paid through the date of the closing of the merger ("the Merger Consideration"). Holders of limited partnership units in TCOLP will be entitled to receive $40.20 per unit, without interest, plus a pro-rated distribution payable for the number of days since the end of the last fiscal quarter for which a distribution was paid through the date of the closing of the merger. Also, in connection with the merger, any restrictions with respect to outstanding restricted shares awarded shall terminate and all holders of outstanding share options shall receive payment of the excess of the Merger Consideration over the exercise price per share of such options. Pursuant to the terms of the indenture for our 5.375% Convertible Senior Notes, due 2023, the Company is required to give public notice to the holders of such notes two days before the date that is fifteen days before the anticipated closing of the mergers (and mail notice to such holders ten days prior to such anticipated closing). Such holders may surrender their notes for conversion at any time from the date which is 15 days prior to the anticipated closing until 15 days after the actual closing.
The Board of Trustees unanimously approved the merger, the Merger Agreement and the other transactions contemplated by the Merger Agreement and declared the merger fair to, advisable and in the best interests of the Trust, TCOLP, the Company's shareholders and the holders of units of limited partnership in TCOLP. On March 9, 2006, the shareholders of the trust approved the merger and the other transactions contemplated by the Merger Agreement by an affirmative vote in excess of two thirds of the votes that were entitled to be cast.
The merger is expected to occur during the first quarter of 2006. However, no assurance can be given that the merger will occur or as to the timing of its completion. The Company had incurred approximately $2,540,000 in merger related costs as of December 31, 2005.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and accounts have been eliminated.
Real Estate Assets, Depreciation and Impairment
Real estate assets held for investment are carried at historical cost, less accumulated depreciation. Expenditures for repairs and maintenance are expensed as incurred. Significant expenditures for improvements, renovations and replacements are capitalized.
The Company accounts for the acquisitions of real estate in accordance with Statement of Financial Accounting Standards ("SFAS") No. 141, Business Combinations, utilizing the purchase method and includes the results of the acquisition properties in the Company's results of operations from the date of acquisition. The Company allocates the purchase price to the acquired tangibles, consisting of land, building and improvements, and, if material, identified intangible assets and liabilities consisting of above/below market leases and at-market leases in place based on their fair values.
If there is an event or change in circumstance that indicates an impairment in the value of an apartment community has occurred, the Company's policy is to assess any impairment in value by comparing the current and estimated future undiscounted operating cash flows of the community over its remaining useful life to the carrying amount of the asset. If such carrying amounts exceed the estimated projected operating cash flows of the community, the Company would recognize an impairment loss equal to the amount necessary to adjust the carrying amount of the asset to its estimated fair market value. The Company did not recognize any impairment losses in 2005, 2004 or 2003 on any of its properties held for investment. However, as discussed in Note 4, the Company recognized impairment losses in 2004 and 2003 related to the properties sold during 2004.
Depreciation is computed on a straight-line basis over the estimated useful lives of the related assets which are 27 1/2 to 40 years for buildings, 15 to 20 years for major improvements and 3 to 12 years for furniture, fixtures and equipment. Depreciation expense was $25,964,000, $29,398,000 and $20,871,000 for 2005, 2004 and 2003, respectively. Intangible assets relating to the value of in-place leases for community acquisitions are amortized over the remaining term of the tenant leases. Amortization expense for in-place leases was $60,000, $217,000 and $472,000 in 2005, 2004 and 2003, respectively.
During the year ended December 31, 2004, the Company revised the estimated useful life on certain depreciable assets, principally carpet, to more closely approximate their current economic lives based upon the Company's capital improvement and renovation plans. Consequently, in 2004 the Company recorded an additional depreciation charge of $6,493,000.
Discontinued Operations
SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, requires that the assets and liabilities and the results of operations of any communities which have been sold since January 1, 2002, or otherwise qualify as held for sale, be presented as discontinued operations in the Company's Consolidated Financial Statements in both current and prior periods presented. The community specific components of net income that are presented as discontinued operations include net operating income, depreciation expense, minority interest and interest expense. In addition, the net gain or loss (including any impairment charge) on the disposition of communities held for sale is presented as discontinued operations. A change in presentation for discontinued operations would not have any impact on the Company's financial conditions or results of operations. Real estate assets held for sale are measured at the lower of the carrying amount or the fair value less costs to sell, and are presented separately in the accompanying Consolidated Balance Sheet. Subsequent to classification of a community as held for sale, no further depreciation is recorded on the assets. Interest was allocated to discontinued operations based on the relative value of the collateral as determined by the lender.
Cash and Cash Equivalents
The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents.
Deferred Financing Costs
Deferred financing costs include certain fees and other external costs incurred in connection with debt financings and are amortized to interest expense using the straight-line method, which approximates the effective interest method, over the term of the related debt. Deferred financing costs at December 31, 2005 and 2004 are presented net of accumulated amortization of $5,429,000 and $4,283,000, respectively. Amortization of deferred financing costs are included in interest expense and totaled $1,195,000, $1,184,000 and $1,041,000, during 2005, 2004 and 2003, respectively.
Interest Rate Risk Management
SFAS No. 133, Accounting for Certain Derivative Instruments and Hedging Activities, as amended, establishes accounting and reporting standards requiring all derivative financial instruments to be carried in the balance sheet as either an asset or liability measured at its fair value. The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and on the type of hedge transaction. For derivative financial instruments that qualify as cash flow hedges, changes in fair value of the derivative instrument are reported as a component of other comprehensive income with a corresponding offset to other assets and reclassified into earnings during the same period or periods during which the hedged transaction affects earnings. For hedges where a change in the fair value of the derivative exceeds the change in the fair value of the hedged item or the notional amount of the hedge exceeds the expected proceeds under the debt agreements, the ineffective portion, if any, is recognized in other income/expense in current period earnings. The Company uses derivative financial instruments in the normal course of business to limit its exposure to fluctuations in interest rates. The Company does not enter into derivative instruments for speculative purposes.
To manage interest rate risk, the Company may employ interest rate swaps, caps and floors, options, forwards or a combination thereof, depending on the underlying exposure. Interest rate swaps and collars are contractual agreements between the Company and third parties to exchange fixed and floating interest payments periodically without the exchange of the underlying principal amounts (notional amounts). In the unlikely event that a counterparty fails to meet the terms of an interest rate swap contract or collar agreement, the Company's exposure would be limited to the interest rate differential on the notional amount. The Company does not
anticipate non-performance by any of its counterparties. Net interest differentials to be paid or received under a swap contract and/or collar agreement are accrued as interest expense as incurred or earned.
Revenue Recognition
Revenues from rental property are recognized on a straight-line basis over the term of the lease. Leases are generally for terms of one year or less.
Real Estate Sales
Gains on sales of real estate assets are recognized pursuant to the provisions of SFAS No. 66, Accounting for Sales of Real Estate. The specific timing of the recognition of the sale and the related gain are measured against the various criteria in SFAS No. 66 related to the terms of the transactions and any continuing involvement associated with the assets sold. To the extent the sales criteria are not met, the Company defers gain recognition until the sales criteria are met.
Advertising and Promotion Costs
Advertising and promotion costs are expensed as incurred. Total advertising and promotion expense for each of the years ended December 31, 2005, 2004 and 2003 was $1,616,000, $1,139,000 and $1,084,000, respectively.
Earnings Per Common Share
Basic earnings per common share is computed based upon the weighted average number of common shares outstanding during the year. Diluted earnings per common share is computed based upon common shares outstanding plus the effect of dilutive stock options and other potentially dilutive common stock equivalents. The dilutive effect of stock options and other potentially dilutive common stock equivalents is determined using the treasury stock method based on the Company's average stock price. The Company adopted Emerging Issues Task Force Issue No. 04-8, "The Effect of Contingently Convertible Instruments on Diluted Earnings per Share" which requires convertible debt or preferred stock to be included in diluted earnings per share computations if only one or more specified contingencies are required to occur, such as the underlying common stock achieving a specified price target, regardless of whether the market price trigger has been met. The adoption of this new pronouncement had no impact on the Company's diluted earnings per share for any year presented, as the effect was anti-dilutive to earnings per share from continuing operations.
Minority Interest
Minority interest is comprised of TCOLP common units that are not held by the Company. Minority interest is increased and decreased, respectively, for income and loss as well as distributions allocated to units held by outside interests. Periodically, the Company raises additional equity through the issuance of common shares and contributes the proceeds to TCOLP for an equivalent number of common units. The Company records adjustments to minority interest and shareholders' equity to reflect the Company's increased ownership in TCOLP. The minority interest represented 12.26% and 12.37% of the units in the partnership at December 31, 2005 and 2004, respectively.
As of December 31, 2005 and 2004, there were 2,466,535 common units of TCOLP that were not held by the Company. These units are exchangeable by the holders into the Company's common shares of beneficial interest on a one-for-one basis. This exchange right has not been considered in the computation of per share data, as it does not have a dilutive effect.
Use of Estimates
The Company's financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("U.S. GAAP"). The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, equity, revenues and expenses. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.
Stock Based Compensation
The Company accounts for its stock based employee compensation plans using the intrinsic value method under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Under APB No. 25, since the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, and other criteria are met, no compensation expense is recognized.
In December 2004, the Financial Accounting Standards Board (FASB) issued a revision to SFAS No. 123 (revised 2004), Share Based Payment ("Statement No.123(R)"). Statement No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recorded as an expense based on their fair values. The grant-date fair value of employee share options and similar instruments will be estimated using an option-pricing model adjusted for any unique characteristics of a particular instrument. If an equity award is modified after the grant date, incremental compensation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification.
The Company will adopt the provisions of FAS 123(R) during the first quarter 2006. The adoption of this new standard is not expected to have a material effect on the financial position or financial results of the Company. The Company accounts for compensation cost for restricted stock awards that are subject to acceleration of vesting upon retirement over the explicit service period. Upon adoption of FAS 123(R) on January 1, 2006, the Company will change the policy for all new restricted stock grants to record compensation cost over the period the employee is required to provide service. The impact on recognized compensation expense had the Company currently used the period the employee is required to provide service would have been $2,454,000.
Reclassifications
Certain previously reported amounts have been reclassified to conform to the current presentation.
2. Restricted Cash
The Company maintains certificates of deposit, all with maturities of three months or less, to cover the aggregate amount of resident security deposits retained by the respective communities in certain states.
3. Real Estate
The following is a reconciliation of the carrying amount of real estate held for investment:
The Company's operating properties are located in the Mid-Atlantic region and in Florida. The following is a summarization of the cost, accumulated depreciation and indebtedness of the Company's real estate held for investment by operating market.
(1) Carrying value consists of initial acquisition costs plus improvements subsequent to acquisition.
(2) 32 properties, including the properties held for disposition, are cross-collateralized with $422.5 million outstanding at December 31, 2005 under the Company's existing credit facility.
During October 2005, the Company acquired an apartment community in Bear, Delaware a suburb of Wilmington, Delaware that contains 264 garden-style apartment homes and one townhome for approximately $41.6 million, including acquisition costs. The property was acquired through an intermediary in anticipation of the completion of a like-kind exchange under Section 1031 of the Internal Revenue Code (see Note 4). The Company funded the acquisition using its existing credit facilities.
The Company accounted for the acquisition utilizing the purchase method, and accordingly, the results of the acquisition property is included in the Company's results of operations from the date of acquisition. The Company allocated the purchase price to the acquired tangibles, consisting of land, building and improvements, and, if material, identified intangible assets and liabilities consisting of above/below market leases and at-market leases in place based on their fair values, as follows (in thousands):
The following unaudited pro forma results of operations of the Company reflect the acquisition as if this transaction had occurred on January 1, 2005 and 2004, and 2003. Pro forma results for 2003 include results of the Company as if the properties acquired in 2003 had occurred on January 1, 2003.
4. Discontinued Operations
At December 31, 2005, the Company had one apartment community under contract for sale and classified in the Company's balance sheets as "Real estate and other assets held for disposition". The sale was completed on January 19, 2006 for net proceeds of approximately $37.3 million and the Company will record a gain of approximately $17 million in the first quarter 2006. The sale completed the like-kind exchange transaction under Section 1031 of the Internal Revenue Code discussed in Note 3 above. During 2004, the Company's two Charlotte communities were classified as held for disposition in the accompanying balance sheet as the Company made the strategic decision to exit the Charlotte, North Carolina market. The communities were sold during 2004 for net proceeds of approximately $31.1 million. Based on the carrying value of each community and the related net sales proceeds, the Company recorded impairment charges totaling approximately $1,672,000 during 2004 and $4,000,000 during 2003. During 2003, the Company sold five apartment communities containing 2,325 units for $117.2 million resulting in a gain on sales of $80.1 million. Also during 2004, the Company recorded a $558,000 gain on involuntary conversion relating to insurance proceeds received related to fires at two of these communities sold in 2003.
The results of operations for these properties are classified on the Consolidated Statements of Operations as, "Discontinued Operations" while the assets and liabilities of these properties are included in "Real estate and other assets held for disposition" and "Mortgage notes payable and other liabilities held for disposition" on the Company's Consolidated Balance Sheets until their respective date of sale. Unaudited condensed summary results of operations of the apartment communities is as follows:
(1) Interest was allocated to discontinued operations based on the relative value of the collateral as determined by the lender.
Assets and liabilities of the apartment communities held for disposition at December 31, 2005 and 2004 consisted of the following:
5. Mortgage Notes Payable and Notes Payable
The Company has a credit facility with Fannie Mae of $488.2 million. This secured facility matures in 2008. At December 31, 2005, outstanding borrowings under the facility were $422.5 million, including amounts allocated to properties held for disposition. Of the $422.5 million, $300 million bears interest at a fixed rate of 6.91%. The remaining $122.5 million outstanding has a weighted-average variable rate of 4.45% at December 31, 2005 and can be converted to a fixed-rate term loan at the Company's option. The
Company is party to floating-to-fixed interest rate swaps that effectively fix the interest rate on $40 million of this floating rate debt, changing the weighted average rate on its floating rate debts at December 31, 2005 to 4.69%.
Total outstanding borrowings under the facility at December 31, 2004 were $340 million. Of the $340 million, $300 million bears interest at a fixed rate of 6.91%. The remaining $40 million was outstanding at a weighted-average variable rate of 2.43% at December 31, 2004. After giving effect to the interest rate swaps, the weighted average interest rate on the $40 million was 4.67%.
The Company has a $50 million bank line of credit. Advances under the line bear interest at 120 basis points over LIBOR and are due on demand. Up to $10 million of the line may be used for working capital purposes and $40 million may be used to fund acquisitions. This line of credit matures in October 2006. The Company has the option to extend the line through October 2008. At December 31, 2005, no amounts were outstanding under the line. As of December 31, 2004, $2,000,000 was outstanding under the line.
The Company uses interest rate protection agreements to reduce the potential impact of increases in interest rates as required by the loan agreement covering its secured credit facility. The Company maintains two interest rate protection agreements for $139 million and $49.2 million, capping the Company's exposure to LIBOR at 9.35% and 7.5%, respectively, through March 2007. In addition, the Company executed two $20 million floating to fixed interest rate swaps to effectively fix the interest rate on $40 million of floating rate debt under the secured facility at a blended rate of approximately 4.66%. The Company simultaneously sold two $20 million interest rate caps, capping LIBOR at 9.35%. These interest rate protection agreements hedge interest payments consistent with the Company's risk management objective and strategy to reduce exposure to variability in cash flows attributable to increases in LIBOR. At December 31, 2005, the Company had an unrealized gain totaling $28,000.
The Company also has mortgages that were obtained in connection with the purchase or refinancing of certain properties. Information concerning these mortgages is summarized below (in thousands):
38 of the Company's 39 properties are secured by first and/or second priority mortgages. In connection with the mortgages, the Company maintains annually renewable bank letters of credit totaling $7,320,000 in lieu of maintaining real estate tax escrow deposits. Certain loan agreements contain restrictive covenants relating to the maintenance of specified financial performance ratios. As of December 31, 2005, the Company was in compliance with these covenants.
The following is a summary of scheduled debt maturities that includes the Company's mortgage notes payable, and convertible senior notes (see Note 5):
6. 5.375% Convertible Senior Notes
The Company has $74.75 million aggregate principal amount of 5.375% Convertible Senior Notes outstanding. The notes mature on August 15, 2023 and are convertible into the Company's common shares under certain circumstances, provided that the share price exceeds $30.61 for a specified period of time. The initial conversion rate of the notes is 39.20185 shares per $1,000 principal amount of notes (equivalent to $25.51 per share). The conversion rate will be adjusted under certain circumstances, including stock splits, stock dividends and increases in the dividend rate over the current quarterly rate of $.43 per share. The shares are considered in diluted earnings per share if the effect of including the conversion of debt is dilutive to earnings per share from continuing operations. The notes are redeemable at the Company's option for shares or cash at any time on or after August 21, 2010 and are subject to repurchase at the option of the holder on August 15, 2008, August 15, 2010, August 15, 2013 and August 15, 2018, or upon the occurrence of certain events. The notes are unsecured and unsubordinated obligations of the Company. The notes will become convertible for a period commencing on March 16, 2006 (which is 15 days prior to March 31, 2006, the anticipated effective date of the merger transaction discussed above) until 15 days after the actual effective date of the merger.
7. Income Taxes
Since its inception, the Company has elected to be taxed as a real estate investment trust ("REIT") under Sections 856 through 860 of the Internal Revenue Code. As a REIT, the Company generally is not subject to Federal income taxes provided that it meets certain conditions, including the requirement that it distributes at least 90% of its REIT taxable income to its shareholders. Management believes that the Company has qualified as a REIT for all years presented. Accordingly, no provision has been made for Federal income taxes. Although the Company qualifies for taxation as a REIT, it may be subject to certain state and local taxes on its income and property, and to Federal income and excise taxes on its undistributed income, if any.
TCOLP makes a number of special allocations for tax purposes only. In general, 100% of the interest deductions related to $232,000,000 of borrowings are allocated to the Trust and 85% of depreciation deductions related to certain communities are allocated to the minority interest ownership.
The following table reconciles GAAP net income to Federal taxable income for the years ended December 31, 2005, 2004 and 2003:
For income tax purposes, dividends to common shareholders consist of ordinary income and return of capital. For the years ended December 31, 2005, 2004 and 2003, dividends paid per share were taxable as follows:
8. Separation Expenses
During the fourth quarter of 2004, the Company recorded a charge of approximately $1.5 million, relating to the departure of two senior executives. The charge consists primarily of cash payments made to the executives in 2005 and cash payments to be made in 2006.
9. Employee Benefit Plans
Share Option Plans
In 1993 and 1997, the Company established long-term incentive plans for the purpose of attracting and retaining executive officers, other key employees and non-employee trustees (the "Plans"). The Plans provide for the granting of restricted shares and share options (incentive and non-qualified) to purchase up to 1,950,000 of the Company's common shares at a price not less than the fair market value at the date of grant.
Under the Plans, options generally become exercisable in equal installments over a three-year period, commencing with the first anniversary of the date of grant. All options expire ten years from the date of grant.
A summary of the Company's share option activity during the three years ended December 31, 2005 is as follows:
An additional 209,784 common shares have been authorized for issuance in future grants of options under the 1997 Plan as of December 31, 2005. The option price of future grants may not be less than the fair market value of the shares on the date of grant.
Pro forma information regarding net income and earnings per share as required by SFAS No. 148, which also requires that the information be determined as if the Company had accounted for its employee stock options granted subsequent to December 31, 1994 under the fair value method of that Statement, is set forth in the table below:
For purposes of the pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period.
The fair value for the options was estimated at the date of grant using Black-Scholes option valuation model with the following weighted-average assumptions:
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected share price volatility. Because the Company's employee share options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee share options.
The weighted average per share fair value of options granted during the years ended December 31, 2005, 2004 and 2003 was $1.43, $1.10, and $.87, respectively. The weighted average remaining contractual life of options granted is 5.32 years.
401(k) Plan
The Company has a 401(k) Plan that covers substantially all of its associates with more than six months of service. Participants may enter the Plan on January 1 or July 1 provided that they have reached six months of service and the age of 20 1/2. The 401(k) Plan complies with Internal Revenue Service requirements as a 401(k) Safe Harbor Plan whereby discretionary contributions made by the
Company are 100% vested. The aggregate cost of the Company's contributions to the 401(k) Plan was $464,000, $464,000, and $483,000 for the years ended December 31, 2005, 2004, and 2003, respectively.
Restricted Shares
From 1995 through 2004, the Company granted 554,000 restricted common shares to certain officers, pursuant to the 1993 and 1997 Plans. In February and December 2005, the Company granted an additional 64,500 and 81,250 restricted shares, respectively, under the 1997 Plan. The stock prices on the date of grant were $26.28 and $30.43, respectively. Under the terms of the grants issued prior to 2003, the shares become fully vested upon termination of the officer-shareholder's employment due to (i) retirement from the Company; (ii) death or disability; or (iii) a change of control, as defined in the Plans. Should an officer-shareholder leave the Company for any other reason, the restricted shares are subject to forfeiture. Under the terms of the subsequent grants, the shares generally become vested 20% per year in years four through eight of the restricted stock agreement. Should the officer-shareholder leave prior to full vesting, any unvested portion of the grant is subject to forfeiture. The market value of the shares awarded as of the dates of grant has been recorded as Unearned Compensation - Restricted Stock and the unamortized portion ($6,051,000 and $3,799,000 at December 31, 2005 and 2004, respectively) is reflected in the accompanying Balance Sheet as a separate component of Shareholders' Equity and is amortized into income as deferred compensation expense over the estimated vesting period. Such deferred compensation totaled $933,000, $897,000 and $738,000 for the years ended December 31, 2005, 2004, and 2003, respectively. In December 2005, the restriction on an aggregate of 45,950 shares for certain officers was lifted, resulting in a charge of $1,061,000 in additional compensation expense.
Supplemental Employees Retirement Plan
The Company has a split-dollar life insurance plan for certain officers. Through 2003, the Company advanced the premiums on life insurance policies for certain officers where such advances were not considered loans under the Sarbanes-Oxley Act of 2002. In 2004, the Company elected to discontinue paying premiums on all split- dollar policies. The policies are assigned to the Company. In the event of retirement or death, the Company will be repaid the aggregate amount of premiums paid from the cash surrender value at the time the benefits are paid. The remaining value is paid to the employee or beneficiary. The aggregate premiums advanced under the policies totaled $447,000 and are recorded as an asset to the Company. As part of the separation agreement for one of the senior officers, the Company agreed to defer collection of the amount due until the separated officer reaches the age of 65 or the policy is surrendered, during which time, the former officer will pay interest at 4.68% per annum.
10. Leases
The Company leases certain office facilities under noncancellable operating leases. The lease on the corporate office in Baltimore, Maryland contains escalating annual payments through December 31, 2014 with two five-year renewal options. Future minimum rental commitments under noncancellable leases with remaining terms in excess of one year are as follows at December 31, 2005:
Total rent expense for the years ended December 31, 2005, 2004, and 2003, was approximately $676,000, $559,000 and $552,000, respectively.
11. Dividend Reinvestment and Share Purchase Plan
Until February 16, 2006, the Company maintained a Dividend Reinvestment and Share Purchase Plan (the "Plan") pursuant to which shareholders could purchase additional shares of beneficial interest through reinvestment of dividends or by optional cash investment. Shares could have been acquired by the Plan either from the Company issuing new shares or by the Plan administrator acquiring shares in the open market. The Company had registered 750,000 common shares of beneficial interest for potential issuance under the Plan. At December 31, 2005, 592,540 shares remained available for future purchases under the Plan until the Plan's termination on February 16, 2006. The following is a summary of the Plan's activity for the years ended December 31, 2005 and 2004:
12. Distributions to Minority Interest Less than Earnings
During 2002, the amount reported under the caption "Minority interest" in the Balance Sheet was reduced to zero. U.S. GAAP requires that, for financial reporting purposes, an additional allocation of income be made to the minority interest account in an amount necessary to keep such balance from falling below zero since there is no requirement for the unit holders to make additional contributions. During 2003, earnings were in excess of distributions to the minority interests and, therefore, the Company reallocated the $576,000 that had previously been so allocated to the minority interests.
13. Contingencies
During 2004, the Company determined that two of its wholly owned subsidiaries were subject to filing requirements and franchise taxes in a state in which the Company owns property. The Company has prepared and filed these returns and paid approximately $84,000 of the original accrued provision for taxes of approximately $140,000. However, certain provisions of the state's regulations may be subject to varying interpretation as to their applicability to the Company's subsidiaries. The Company is seeking clarification from the state, which, if determined to be adverse to the Company, would subject the Company to additional taxes of approximately $860,000. The Company has made certain changes to its corporate structure such that it is no longer subject to such taxes.
There were no legal proceedings pending at December 31, 2005 or as of the date of this report, except as noted below, to which the Registrant, the Operating Partnership or any of the separate general partnerships and limited liability companies which own the Properties is a party or to which the Properties are subject that are likely to have a material adverse impact on the Registrant's operations.
On February 2, 2006, an individual shareholder, Lee Foster, filed a putative class action, styled as Lee Foster v. The Town and Country Trust, et. al., in the Circuit Court for Baltimore City, Maryland, against us and each of our trustees. The complaint asserted that the trustees breached alleged fiduciary duties to plaintiff (and other shareholders) by entering into the December 19, 2005 merger agreement with Magazine Acquisition. The complaint sought, among other things, an injunction preventing Magazine Acquisition from acquiring us. By order dated February 21, 2006, the Court on our motion dismissed the complaint for failure to state a claim upon which relief may be granted, but allowed plaintiff 30 days within which to file an amended complaint.
Plaintiff filed his amended complaint on March 2, 2006. The amended complaint seeks disgorgement of benefits allegedly received by our trustees as a result of alleged breaches of duties, monetary damages, and an award of attorneys' fees, expenses and costs. The amended complaint alleges that our trustees breached their fiduciary duties to plaintiff (and other shareholders) by entering into the December 19, 2005 merger agreement with Magazine Acquisition without, according to plaintiff, having fully informed themselves about our "true value"; by agreeing to the initial $20 million break-up fee under such agreement; and by subsequently approving an amendment to the merger agreement on February 16, 2006 and agreeing to increase the break-up fee to $28 million in connection with the execution of the amendment. In addition, the amended complaint accuses the trustees of having favored their own interests over the interests of the shareholders. Finally, the amended complaint alleges that the trustees breached their fiduciary duties to plaintiff (and other shareholders) by allegedly not making full disclosure of all material facts in the proxy statement, dated January 26, 2006, which was mailed to shareholders on or around January 30, 2006, and the supplement to the proxy statement, dated February 24, 2006, which was mailed to shareholders on or around February 27, 2006.
The Company believes the amended complaint described above is without merit and the Company intends to vigorously defend against the claims and allegations in the complaint. However, there can be no assurance that the outcome will be favorable and defending this action may require the attention and resources of management and, regardless of the outcome, result in significant legal expenses.
In addition, the Company is subject to various legal proceedings and claims arising in the ordinary course of business. During the year ended December 31, 2005, the Company recorded an accrual of $300,000 related to an unresolved resident complaint. The Company estimates its maximum liability in this matter to be $2.1 million. The Company cannot determine the ultimate liability with respect to such legal proceedings and claims at this time. The Company believes that such liability, to the extent not reimbursed, will not have a material adverse effect on the Company's financial condition, results of operations or cash flow.
14. Shareholders Equity
On February 3, 2004, the Company sold 1.41 million of its common shares of beneficial interest in a private sale at a negotiated price of $24.80 per share for net proceeds of approximately $34.7 million. The sale was made pursuant to the Company's existing shelf registration statement as previously filed with the Securities and Exchange Commission.
15. Financial Instruments
The following table presents the carrying amounts and estimated fair values of the Company's financial instruments as of December 31, 2005 and 2004. SFAS No. 107, Disclosures about Fair Value of Financial Instruments, defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties.
The carrying amounts shown in the above table are included in the accompanying Balance Sheet under the captions "Mortgage notes payable," "5.375% Convertible Senior Notes due 2023," "Notes payable," and "Mortgage notes payable and other liabilities held for disposition." The fair value of the fixed rate portion of the Company's mortgage notes payable is estimated by discounting expected cash flows based on the Company's incremental borrowing rate for similar types of borrowing arrangements. The floating rate portion of the Company's mortgage notes payable approximated market. Cash equivalents, other assets, accounts payable and other liabilities are carried at amounts that reasonably approximate their fair value.
The following table presents the fair value of outstanding derivative financial instruments, based on external market quotations as of December 31, 2005 and 2004.
The following is a summary of the derivative transactions for years ended December 31, 2005, 2004 and 2003.
The Company expects to reclassify approximately $448,000 of unrealized losses into earnings in the next twelve months.
16. Unaudited Quarterly Results of Operations
The following is a summary of quarterly results of operations for the years ended December 31, 2005 and 2004.
(1) Net income (loss) for the quarter ended December 31, 2005 includes $ 2,540,000 in merger related fees and $2,211,000 of additional compensation expense associated with the accelerated vesting of certain restricted shares and the accelerated approval of bonuses by the compensation committee.
Report of Independent Registered Public Accounting Firm
To The Board of Trustees and Shareholders The Town and Country Trust
We have audited the accompanying consolidated balance sheets of The Town and Country Trust (the "Company") as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of The Town and Country Trust at December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of The Town and Country 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 and our report dated March 10, 2006 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia March 10, 2006
SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION THE TOWN AND COUNTRY TRUST DECEMBER 31, 2005
NOTES TO SCHEDULE III THE TOWN AND COUNTRY TRUST (IN THOUSANDS)
(a) All properties are garden apartment communities with the exception of one commercial building included in the Howard Crossing/West Commercial Partnership.
(b) See description of mortgages payable in Note 5 of Notes to Consolidated Financial Statements of the Company.
(c) Initial cost for properties originally acquired from the Predecessor (see note (h) below) represents the historical cost as of August 23, 1993 plus the acquisition of non-controlled interests in the Predecessor on August 23, 1993. The initial cost of all other property acquisitions represents the cost to purchase the property at the date of acquisition.
(d) The aggregate cost of land, buildings and equipment on a Federal Income Tax basis is $699,204 at December 31, 2005.
(e) Reconciliation of Real Estate Properties
(f) Reconciliation of Accumulated Depreciation
(g) Depreciation is computed based upon the following estimated lives:
(h) Denotes property originally purchased in 1979 by the Predecessor.
(B) SUPPLEMENTARY DATA
Information in response to this Item is set forth in the financial statement schedules appearing on pages through of this Form 10-K.
ITEM 9.
ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
As of December 31, 2005, an evaluation was performed under the supervision and with the participation of the Company's management, including the CEO and CFO, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) or 15d-15(e) under the Exchange Act). Based on that evaluation, the Company's management, including the CEO and CFO, concluded that the Company's disclosure controls and procedures were effective as of December 31, 2005. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls subsequent to December 31, 2005.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of The Town and Country Trust (the "Company") is responsible for establishing and maintaining adequate internal controls over financial reporting and for the assessment of the effectiveness of internal controls over financial reporting. As defined by the Securities and Exchange Commission, internal control over financial reporting is a process designed by, or supervised by, the Company's principal executive and principal financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the consolidated financial statements in accordance with U.S generally accepted accounting principles.
The Company's internal controls over financial reporting are supported by written 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 Company's assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of the consolidated financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of the Company's management and trustees; 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 consolidated financial statements taken as a whole.
In connection with the preparation of the Company's annual consolidated financial statements, management has undertaken an assessment of the effectiveness of the Company's internal controls 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. Management's assessment included an evaluation of the design of the Company's internal controls over financial reporting and testing of the operational effectiveness of those controls.
Based on this assessment, management has concluded that the Company's internal controls over financial reporting were effective as of December 31, 2005.
Ernst & Young LLP, the independent registered public accounting firm that audited the Company's consolidated financial statements included in this report, have issued an attestation report on management's assessment of internal controls over financial reporting, a copy of which is included in this Annual Report on Form 10-K.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING
To The Board of Trustees and Shareholders The Town and Country Trust
We have audited management's assessment, included in the accompanying Management's Report on Internal Control over Financial Reporting that The Town and Country Trust (the "Company") 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 (the COSO criteria). The Company'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 the Company'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 trustees 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 The Town and Country Trust maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, The Town and Country Trust maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2005 consolidated financial statements of The Town and Country Trust and our report dated March 10, 2006, expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia March 10, 2006
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. TRUSTEES AND EXECUTIVE OFFICERS OF THE REGISTRANT
Certain information required by this item concerning the Registrant's Trustees and Executive Officers is set forth under the captions "Election of Trustees," "Board of Trustees; Committees of the Board of Trustees" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Registrant's 2006 Proxy Statement to be filed with the SEC which information is incorporated herein by reference. The information required by this Item in respect of the Registrant's Executive Officers who are not Trustees is set forth in Item 4 of this Form 10-K and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information in response to this Item is set forth under the caption "Compensation of Executive Officers" in the Registrant's 2006 Proxy Statement to be filed with the SEC which information is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information in response to this Item concerning security ownership of certain beneficial owners and management is set forth under the caption "Ownership of Common Shares of Beneficial Interest" in the Registrant's 2006 Proxy Statement to be filed with the SEC, which information is incorporated herein by reference. Information in response to this Item concerning equity compensation plan information is set forth in Item 5 of this Form 10-K and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information in response to this Item is set forth under the caption "Certain Related Transactions" in the Registrant's 2006 Proxy Statement to be filed with the SEC which information is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information in response to this Item concerning fees paid to the independent auditors is set forth under the caption "Selection of Accountants" in the Registrant's 2006 Proxy Statement to be filed with the SEC, which information is incorporated herein by reference. The Audit Committee of the Board of Trustees must pre-approve all auditing services and all non-audit services (including the fees and terms thereof) to be performed by the independent auditors. The Audit Committee may delegate to the Audit Committee Chairman the authority to grant pre-approvals for audit and permitted non-audit services to be performed for the Company by the independent auditor, provided that decisions of such members to grant pre-approvals shall be presented to the full Committee at its next regularly scheduled meeting.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
(3) Exhibits
* Compensation plan or arrangement required to be filed as an exhibit hereto.
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.
THE TOWN AND COUNTRY TRUST
By: /s/ Harvey Schulweis ------------------------------------ Harvey Schulweis Chairman of the Board and Chief Executive Officer
Dated: March 16, 2006
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 dates indicated.
- ---------- * Powers of attorney authorizing Harvey Schulweis to sign this annual report on Form 10-K on behalf of certain Trustees of the Registrant is being filed with the Securities and Exchange Commission herewith (Exhibit 24).