ITEM 1. BUSINESS
Overview
We were formed as a corporation on August 28, 2008 under the Maryland General Corporation Law primarily with the purpose of acquiring single tenant properties that are essential to the tenant's business. We were taxed as a REIT for the taxable year ended December 31, 2010, and for each year thereafter, after satisfying both financial and non-financial requirements. Our year end is December 31.
We have no employees and are externally advised and managed by an affiliate, Griffin Capital Essential Asset Advisor, LLC, a Delaware limited liability company (the "Advisor"), which was formed on August 27, 2008. Griffin Capital Asset Management Company, LLC ("GAMCO," formerly known as Griffin Capital REIT Holdings, LLC) is the sole member of the Advisor, and Griffin Capital, LLC ("GC") is the sole member of GAMCO. We entered into an advisory agreement for the Public Offerings (as defined below) (as amended and restated, the "Advisory Agreement"), which states that the Advisor is responsible for managing our affairs on a day-to-day basis and identifying and making acquisitions and investments on our behalf. The officers of the Advisor are also officers of Griffin Capital Company, LLC, a Delaware limited liability company (the "Sponsor"). The Advisory Agreement has a one-year term, and it may be renewed for an unlimited number of successive one-year periods by our board of directors.
Griffin Capital Essential Asset Operating Partnership, L.P., a Delaware limited partnership (the "Operating Partnership"), was formed on August 29, 2008. Our Operating Partnership owns, directly or indirectly, all of the properties that we have acquired. Our Advisor purchased an initial 99% limited partnership interest in the Operating Partnership for $200,000, and we contributed the initial $1,000 capital contribution, received from our Advisor, to the Operating Partnership in exchange for a 1% general partnership interest.
From 2009 to 2014, we offered shares of common stock, pursuant to a private placement offering to accredited investors (the "Private Offering") and two public offerings, consisting of an initial public offering and a follow-on offering (together, the "Public Offerings"), which also included shares for sale pursuant to our distribution reinvestment plan ("DRP"). We issued 126,592,885 total shares of our common stock for gross proceeds of approximately $1.3 billion, pursuant to the Private Offering and Public Offerings.
On May 7, 2014, we filed a Registration Statement on Form S-3 with the SEC for the registration of $75.0 million in shares for sale pursuant to the DRP (the “2014 DRP Offering”). On September 22, 2015, we filed a Registration Statement on Form S-3 with the SEC for the registration of $100.0 million in shares for sale pursuant to the DRP (the “2015 DRP Offering” and together with the 2014 DRP Offering, the “DRP Offerings”) and terminated the 2014 DRP Offering. In connection with our DRP Offerings, we had issued 13,591,673 shares of our common stock for gross proceeds of approximately $139.5 million through December 31, 2016. The 2015 DRP Offering may be terminated at any time upon 10 days' prior written notice to stockholders.
We have a share redemption program ("SRP") that enables our stockholders to sell their stock to us in limited circumstances. Since inception and through December 31, 2016, we had redeemed 5,918,655 shares of common stock for approximately $58.8 million at a weighted average price per share of $9.93 pursuant to the SRP.
On October 24, 2016, our board, at the recommendation of our Nominating and Corporate Governance Committee comprised solely of independent directors, approved an estimated value per share of our common stock of $10.44 (unaudited) based on the estimated value of our assets less the estimated value of our liabilities, or net asset value ("NAV"), divided by the number of shares outstanding on a fully diluted basis, calculated as of June 30, 2016. We are providing this estimated value per share to assist broker dealers in connection with their obligations under applicable Financial Industry Regulatory Authority rules with respect to customer account statements. This valuation was performed in accordance with the methodology provided in Practice Guideline 2013-01, Valuations of Publicly Registered Non-Listed REITs, issued by the Investment Program Association in April 2013, in addition to guidance from the SEC. (Please see "Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" of this Form 10-K for more information regarding the determination of our NAV.)
Primary Investment Objectives
Our primary investment objectives are to invest in income-producing real property in a manner that allows us to qualify as a REIT for federal income tax purposes, provide regular cash distributions to our stockholders, preserve and protect
stockholders' invested capital, and achieve appreciation in the value of our properties over the long term. We cannot assure our stockholders that we will attain these primary investment objectives.
Exchange Listing and Other Liquidity Events
Our board of directors will determine when, and if, to apply to have our shares of common stock listed for trading on a national securities exchange, subject to satisfying then-existing applicable listing requirements. Our board of directors has begun to consider the appropriate timing for a liquidity event and has begun to weigh various strategic considerations. Subject to market conditions and the sole discretion of our board of directors, we may seek one or more of the following liquidity events:
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list our shares on a national securities exchange;
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merge, reorganize or otherwise transfer the company or its assets to another entity with listed securities;
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commence the sale of all of our properties and liquidate the company; or
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otherwise create a liquidity event for our stockholders.
However, we cannot assure our stockholders that we will achieve one or more of the above-described liquidity events. Our board of directors has the sole discretion to forego a liquidity event and continue operations if it deems such continuation to be in the best interests of our stockholders. Even if we accomplish one or more of these liquidity events, we cannot guarantee that a public market will develop for the securities listed or that such securities will trade at a price higher than what stockholders paid for their shares.
Investment Strategy
We operate a portfolio of predominantly single tenant business essential properties throughout the United States diversified by corporate credit, physical geography, product type and lease duration. Although we have no current intention to do so, we may also invest in single tenant business essential properties outside the United States. We acquire assets consistent with our single tenant acquisition philosophy by focusing primarily on properties:
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essential to the business operations of the tenant;
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located in primary, secondary, and certain select tertiary markets;
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leased to tenants with stable and/or improving credit quality; and
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subject to long-term leases with defined rental rate increases or with short-term leases with high-probability renewal prospects and potential for increasing rent.
Our investment objectives and policies may be amended or changed at any time by our board of directors. Although we have no plans at this time to change any of our investment objectives, our board of directors may change any and all such investment objectives, including our focus on single tenant business essential properties, if they believe such changes are in the best interests of our stockholders. In addition, we may invest in real estate properties other than single tenant business essential properties if the board of directors deems such investments to be in the best interests of our stockholders.
General Acquisition and Investment Policies
We seek to make investments that satisfy the primary investment objective of providing regular cash distributions to our stockholders. However, because a significant factor in the valuation of income-producing real property is its potential for future appreciation, some properties we acquire may have the potential both for growth in value and for providing regular cash distributions to our stockholders.
Our Advisor has substantial discretion with respect to the selection of specific properties. However, each acquisition will be approved by our board of directors. In selecting a potential property for acquisition, we and our Advisor consider a number of factors, including, but not limited to, tenant creditworthiness; essential nature of property to tenant; lease terms; geographic location and property type; proposed purchase price and terms and conditions; historical financial performance; projected net cash flow yield and internal rates of return; and potential for capital appreciation.
There is no limitation on the number, size, or type of properties that we may acquire, and such acquisitions will depend upon real estate market conditions and other circumstances existing at the time of acquisition and the funds available to us for the purchase of real estate.
Description of Leases
We primarily acquire predominantly single tenant properties with existing net leases. When spaces in a property become vacant, existing leases expire, or we acquire properties under development or requiring substantial refurbishment or renovation, we anticipate entering into “net” leases. “Net” leases mean leases that typically require tenants to pay all or a majority of the operating expenses, including real estate taxes, special assessments and sales and use taxes, utilities, insurance, common area maintenance charges, property services and building repairs related to the property, in addition to the lease payments. Under most commercial leases, tenants are obligated to pay a predetermined annual base rent. Some of the leases also will contain provisions that increase the amount of base rent payable at points during the lease term and/or that require the tenant to pay rent based upon a percentage of the tenant’s revenues. Percentage rent can be calculated based upon a number of factors. There are various forms of net leases, typically classified as triple-net or absolute triple-net. Triple-net leases typically require the tenant to pay all costs associated with a property in addition to the base rent and percentage rent, if any. However, often times in triple-net leases certain capital expenditure costs are not paid for by the tenants (such as roof and structure costs). Absolute triple-net leases are those that require tenants to pay for all the costs in a triple-net lease as well as all the capital costs associated with a property.
Typically, our tenants have lease terms of seven to 15 years at the time of the property acquisition. We may acquire properties under which the lease term has partially expired. We also may acquire properties with shorter lease terms if the property is located in a desirable location, is difficult to replace, or has other significant favorable real estate attributes.
Our Borrowing Strategy and Policies
We may incur our indebtedness in the form of bank borrowings, purchase money obligations to the sellers of properties, and publicly- or privately-placed debt instruments or financing from institutional investors or other lenders. We may obtain a credit facility or separate loans for each acquisition. Our indebtedness may be unsecured or may be secured by mortgages or other interests in our properties or underlying owner entities. We may use borrowing proceeds to finance acquisitions of new properties, to pay for capital improvements, repairs or buildouts, to refinance existing indebtedness, to pay distributions, to fund redemptions of our shares, or to provide working capital.
There is no limitation on the amount we can borrow for the purchase of any property. Our aggregate borrowings, secured and unsecured, must be reasonable in relation to our net assets and must be reviewed by our board of directors at least quarterly. At this time, we intend to maintain a leverage ratio of less than 50% to real estate net book value. However, our charter limits our borrowing to 300% of our net assets (equivalent to 75% of the cost of our assets) unless any excess borrowing is approved by a majority of our independent directors and is disclosed to our stockholders in our next quarterly report, along with the justification for such excess. Except as set forth in our charter regarding debt limits, we may re-evaluate and change our debt strategy and policies in the future without a stockholder vote. As of December 31, 2016, our leverage ratio (which we define as debt to total asset value) was approximately 49.5%.
Acquisition Structure
Although we are not limited as to the form our investments may take, our investments in real estate will generally constitute acquiring fee title or interests in joint ventures or similar entities that own and operate real estate.
We will make acquisitions of our real estate investments directly through our Operating Partnership, or indirectly through limited liability companies or limited partnerships, or through investments in joint ventures, partnerships, co-tenancies or other co-ownership arrangements with other owners of properties, affiliates of our Advisor, or other persons.
Insurance on Properties
Generally, our leases require each tenant to procure, at its own expense, commercial general liability insurance, as well as property insurance covering the building for the full replacement value and naming the ownership entity and the lender, if applicable, as the additional insured on the policy. As a precautionary measure, we may obtain, to the extent available, contingent liability and property insurance, as well as loss of rents insurance that covers one or more years of annual rent in the event of a rental loss. In addition, we maintain a pollution insurance policy for all of our properties to insure against the risk of environmental contaminants. However, we may decide not to obtain any or adequate earthquake or similar catastrophic insurance coverage because the premiums are too high, even in instances where it may otherwise be available.
Tenants are required to provide proof of insurance by furnishing a certificate of insurance to our Advisor on an annual basis. The insurance certificates are tracked and reviewed for compliance by our property managers.
Conditions to Closing Acquisitions
We obtain at least a Phase I environmental assessment and history for each property we acquire. In addition, we generally condition our obligation to close the purchase of any investment on the delivery and verification of certain documents from the seller or other independent professionals, including, but not limited to, where appropriate:
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property surveys and site audits;
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appraisal reports;
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lease agreements;
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building plans and specifications, if available;
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soil reports, seismic studies, flood zone studies, if available;
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licenses, permits, maps and governmental approvals;
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tenant estoppel certificates;
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tenant financial statements and information, as permitted;
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historical financial statements and tax statement summaries of the properties;
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proof of marketable title, subject to such liens and encumbrances as are acceptable to us; and
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liability and title insurance policies.
Joint Venture Investments
We may acquire properties in joint ventures, some of which may be entered into with affiliates of our Advisor. We may also enter into joint ventures, general partnerships, co-tenancies and other participations, such as Delaware Statutory Trusts (DSTs), with real estate developers, owners and others for the purpose of owning and leasing real properties. Among other reasons, we may want to acquire properties through a joint venture with third parties or affiliates in order to diversify our portfolio of properties in terms of geographic region or property type. Joint ventures may also allow us to acquire an interest in a property without requiring that we fund the entire purchase price. In addition, certain properties may be available to us only through joint ventures. In determining whether to recommend a particular joint venture, our Advisor will evaluate the real property which such joint venture owns or is being formed to own under the same criteria that the Advisor uses to evaluate other real estate investments.
We may enter into joint ventures with affiliates of our Advisor for the acquisition of properties, but only provided that a majority of our directors, including a majority of our independent directors, not otherwise interested in the transaction, approve the transaction as being fair and reasonable to us; and the investment by us and such affiliate are on substantially the same terms and conditions.
To the extent possible and if approved by our board of directors, including a majority of our independent directors, we will attempt to obtain a right of first refusal or option to buy the property held by the joint venture and allow such venture partners to exchange their interest for our Operating Partnership's units or to sell their interest to us in its entirety. In the event that the venture partner were to elect to sell property held in any such joint venture, however, we may not have sufficient funds to exercise our right of first refusal to buy the venture partner’s interest in the property held by the joint venture. Entering into joint ventures with affiliates of our Advisor will result in certain conflicts of interest.
Construction and Development Activities
From time to time, we may construct and develop real estate assets or render services in connection with these activities. We may be able to reduce overall purchase costs by constructing and developing a property versus purchasing a completed property. Developing and constructing properties would, however, expose us to risks such as cost overruns, carrying costs of projects under construction or development, availability and costs of materials and labor, weather conditions, and government regulation. To comply with the applicable requirements under federal income tax law, we intend to limit our construction and development activities to performing oversight and review functions, including reviewing the construction design proposals, negotiating and contracting for feasibility studies and supervising compliance with local, state or federal laws and regulations, negotiating contracts, overseeing construction, and obtaining financing. In addition, we may use taxable REIT subsidiaries or certain independent contractors to carry out these oversight and review functions. We will retain independent contractors to perform the actual construction work.
Government Regulations
The properties we acquire are subject to various federal, state and local regulatory requirements, including the Americans with Disabilities Act, environmental regulations, and other laws, such as zoning and state and local fire and life safety
requirements. Failure to comply with these requirements could result in the imposition of fines by governmental authorities or awards of damages to private litigants. We acquire properties that are in material compliance with all such regulatory requirements. However, we cannot assure stockholders that these requirements will not be changed or that new requirements will not be imposed which would require significant unanticipated expenditures by us and could have an adverse effect on our financial condition and results of operations.
Disposition Policies
We generally intend to hold each property we acquire for an extended period. However, we may sell a property at any time if, in our judgment, the sale of the property is in the best interests of our stockholders. The determination of whether a particular property should be sold or otherwise disposed of will generally be made after consideration of relevant factors, including prevailing economic conditions, other investment opportunities and considerations specific to the condition, value and financial performance of the property. To date we have sold four properties for an average hold time of 3.1 years.
Investment Limitations in Our Charter
Our charter places numerous limitations on us with respect to the manner in which we may invest our funds, most of which are those typically required by various provisions of the Statement of Policy Regarding Real Estate Investment Trusts published by the North American Securities Administrators Association ("NASAA REIT Guidelines"). So long as our shares are not listed on a national securities exchange, the NASAA REIT Guidelines apply to us.
Changes in Investment Policies and Limitations
Our charter requires that our independent directors review our investment policies at least annually to determine that the policies we are following are in the best interests of our stockholders. Each determination and the basis therefor are required to be set forth in the applicable meeting minutes. The methods of implementing our investment policies may also vary as new investment techniques are developed. The methods of implementing our investment objectives and policies, except as otherwise provided in our charter, may be altered by a majority of our directors, including a majority of our independent directors, without the approval of our stockholders. The determination by our board of directors that it is no longer in our best interests to continue to be qualified as a REIT shall require the concurrence of two-thirds of the board of directors. Investment policies and limitations specifically set forth in our charter, however, may only be amended by a vote of the stockholders holding a majority of our outstanding shares.
Investments in Mortgages
While we intend to emphasize equity real estate investments and, hence, operate as what is generally referred to as an “equity REIT,” as opposed to a “mortgage REIT,” we may invest in first or second mortgage loans, mezzanine loans secured by an interest in the entity owning the real estate or other similar real estate loans consistent with our REIT status. We may make such loans to developers in connection with construction and redevelopment of real estate properties. Such mortgages may or may not be insured or guaranteed by the Federal Housing Administration, the Veterans Benefits Administration or another third party. We may also invest in participating or convertible mortgages if our directors conclude that we and our stockholders may benefit from the cash flow or any appreciation in the value of the subject property. Such mortgages are similar to equity participation.
Affiliate Transaction Policy
Our board of directors has established a nominating and corporate governance committee, which reviews and approves all matters the board believes may involve a conflict of interest. This committee is composed solely of independent directors. This committee of our board of directors approves all transactions between us and our Advisor and its affiliates.
On June 24, 2013, our board of directors determined that we would not acquire any new properties in which our sponsor, or its executive officers, owns an economic interest in excess of 10% of the contract purchase price. To the extent management and the board of directors determine to acquire a property in which our sponsor owns an economic interest of 10% or less, the board of directors adopted certain procedures that they intend to apply consistently.
Tenant-in-common properties in which our sponsor owns a 10% economic interest or less. For these situations, we will require our sponsor to engage an independent third party real estate broker to market the property for sale. If we determine the price offered through such marketing efforts is a price at which we would have an interest in acquiring the property, we may submit a bid to acquire the same upon substantially the same terms and conditions otherwise dictated by the market. Should
the tenant-in-common owners elect to proceed with a transaction with us and our board approves the acquisition of the property upon such terms and conditions, we will obtain an independent third party appraisal. If the appraised value of the property is equal to or greater than the proposed purchase price, we may acquire the property. Investors in the seller of such property will have the option to either (a) elect to receive their pro-rata share of the net cash proceeds from such disposition, or (b) exchange their equity for limited partnership units in our operating partnership which amounts will be grossed-up by 10% since the exchange will not include sales commissions or a dealer manager fee.
Properties owned through a DST format where our sponsor, or its executive officers, owns a 10% economic interest or less. For these situations, we typically will have the option to acquire the balance of the interests in the DST from the other investors after one year from the initial sale to one of the DST investors. If our board determines to acquire those interests, we will obtain an independent third party appraisal on the property. We intend to acquire the interests in the DST based on such appraisal. The DST investors will have the option to either (a) elect to receive their pro-rata share of the net cash proceeds from such disposition, (b) exchange their DST interests for limited partnership units in our operating partnership, or (c) elect to retain their interest in the DST interests. In certain circumstances, the DST investors may only have options (a) and (b) available depending upon the nature and structure of the underlying transaction and the financing related thereto.
Investment Company Act and Certain Other Policies
We intend to operate in such a manner that we will not be subject to regulation under the Investment Company Act of 1940 (the "1940 Act"). Our Advisor will continually review our investment activity to attempt to ensure that we do not come within the application of the 1940 Act. Among other things, our Advisor will attempt to monitor the proportion of our portfolio that is placed in various investments so that we do not come within the definition of an “investment company” under the 1940 Act. If at any time the character of our investments could cause us to be deemed as an investment company for purposes of the 1940 Act, we will take all necessary actions to attempt to ensure that we are not deemed to be an “investment company.” In addition, we do not intend to underwrite securities of other issuers or actively trade in loans or other investments.
Subject to the restrictions we must follow in order to qualify to be taxed as a REIT, we may make investments other than as previously described, although we do not currently intend to do so. We have authority to purchase or otherwise reacquire our shares of common stock or any of our other securities. We have no present intention of repurchasing any of our shares of common stock except pursuant to our share redemption program, and we would only take such action in conformity with applicable federal and state laws and the requirements for qualifying as a REIT under the Internal Revenue Code of 1986, as amended (the "Code").
Employees
We have no employees. The employees of our Advisor and its affiliates provide management, acquisition, advisory and certain administrative services for us.
Competition
As we purchase properties for our portfolio, we are in competition with other potential buyers for the same properties, and may have to pay more to purchase the property than if there were no other potential acquirers or we may have to locate another property that meets our investment criteria. Although we intend to acquire properties subject to existing leases, the leasing of real estate is highly competitive in the current market, and we may experience competition for tenants from owners and managers of competing projects. As a result, we may have to provide free rent, incur charges for tenant improvements, or offer other inducements, or we might not be able to timely lease the space, all of which may have an adverse impact on our results of operations. At the time we elect to dispose of our properties, we will also be in competition with sellers of similar properties to locate suitable purchasers for our properties.
Industry Segments
We internally evaluate all of our properties and interests therein as one reportable segment.
ITEM 1A.
ITEM 1A. RISK FACTORS
Below are risks and uncertainties that could adversely affect our operations that we believe are material to stockholders. Other risks and uncertainties may exist that we do not consider material based on the information currently available to us at this time.
Risks Related to an Investment in Griffin Capital Essential Asset REIT, Inc.
We have paid a portion of our distributions from sources other than cash flow from operations; therefore, we will have fewer funds available for the acquisition of properties, and our stockholders’ overall return may be reduced.
In the event we do not have enough cash from operations to fund our distributions, we may borrow, issue additional securities or sell assets in order to fund the distributions. We are not prohibited from undertaking such activities by our charter, bylaws or investment policies, and we may use an unlimited amount from any source to pay our distributions. From inception and through December 31, 2016, we funded 91% of our cash distributions from cash flows provided by operating activities and 9% from offering proceeds. See Management's Discussion and Analysis of Financial Condition and Results of Operations - Distributions and Our Distribution Policy, below. If we continue to pay distributions from sources other than cash flow from operations, we will have fewer funds available for acquiring properties, which may reduce our stockholders’ overall returns. Additionally, to the extent distributions exceed cash flow from operations, a stockholder’s basis in our stock may be reduced and, to the extent distributions exceed a stockholder’s basis, the stockholder may recognize a capital gain.
We may be unable to pay or maintain cash distributions or increase distributions over time.
There are many factors that can affect the availability and timing of cash distributions to stockholders. Distributions will be based principally on distribution expectations of our potential investors and cash available from our operations. The amount of cash available for distribution will be affected by many factors, such as our ability to secure properties with leases or originate leases that generate rents to exceed our operating expense levels, as well as many other variables. Actual cash available for distribution may vary substantially from estimates. With limited prior operating history, we cannot assure our stockholders that we will be able to pay or maintain distributions or that distributions will increase over time, nor can we give any assurance that rents from the properties will increase, or that future acquisitions of real properties will increase our cash available for distribution to stockholders. Our actual results may differ significantly from the assumptions used by our board of directors in establishing the distribution rate to stockholders.
There is currently no public trading market for our shares and there may never be one; therefore, it will be difficult for our stockholders to sell their shares including under our share redemption program.
There is currently no public market for our shares and there may never be one. Our stockholders may not sell their shares unless the buyer meets applicable suitability and minimum purchase standards. Our charter also prohibits the ownership by any one individual of more than 9.8% of our stock, unless waived by our board of directors, which may inhibit large investors from desiring to purchase our stockholders’ shares. Moreover, our share redemption program includes numerous restrictions that would limit our stockholders’ ability to sell their shares to us, including a requirement that the shares have been held for at least one year. Redemption of shares, when requested, will generally be made quarterly. During any calendar year, we will not redeem in excess of 5% of the weighted average number of shares outstanding during the prior calendar year and redemptions will be funded solely from proceeds from our distribution reinvestment plan. Our board of directors could choose to amend, suspend or terminate our share redemption program upon 30 days’ notice. Therefore, it may be difficult for our stockholders to sell their shares promptly or at all. If our stockholders are able to sell their shares, they will likely have to sell them at a substantial discount to the price they paid for the shares. It also is likely that their shares would not be accepted as the primary collateral for a loan. Our stockholders should purchase the shares only as a long-term investment because of the illiquid nature of the shares.
In determining net asset value, or NAV, per share, we relied upon a valuation of our properties as of June 30, 2016. Valuations and appraisals of our properties are estimates of fair value and may not necessarily correspond to realizable value upon the sale of such properties, therefore our new asset value per share may not reflect the amount that would be realized upon a sale of each of our properties.
For the purposes of calculating our NAV per share, an independent third-party appraiser valued our properties as of June 30, 2016. The valuation methodologies used to value our properties involved certain subjective judgments. Ultimate realization of the value of an asset depends to a great extent on economic and other conditions beyond our control and the control of our Advisor and independent appraiser. Further, valuations do not necessarily represent the price at which an asset would sell, since market prices of assets can only be determined by negotiation between a willing buyer and seller. Therefore, the valuations of our properties and our investments in real estate related assets may not correspond to the timely realizable value upon a sale of those assets.
Our NAV per share is somewhat based upon subjective judgments, assumptions and opinions, which may or may not turn out to be correct. Therefore, our NAV per share may not reflect the precise amount that might be paid to stockholders for their shares in a market transaction.
Our net asset value per share was based on an estimate of the value of our properties - consisting principally of illiquid commercial real estate - as of June 30, 2016. The valuation methodologies used by the independent appraiser retained by our nominating and corporate governance committee to estimate the value of our properties as of June 30, 2016 involved subjective judgments, assumptions and opinions, which may or may not turn out to be correct. As a result, our net asset value per share may not reflect the precise amount that might be paid to stockholders for their shares in a market transaction.
If our Advisor loses or is unable to obtain key personnel, our ability to implement our investment objectives could be delayed or hindered, which could adversely affect our ability to make distributions and the value of our stockholders’ investment.
Our success depends to a significant degree upon the contributions of certain of our executive officers and other key personnel of our Advisor and sponsor, including Kevin A. Shields, Michael J. Escalante, Javier F. Bitar, Joseph E. Miller, David C. Rupert, Randy I. Anderson, Mary P. Higgins and Howard S. Hirsch, each of whom would be difficult to replace. Our Advisor does not have an employment agreement with any of these key personnel and we cannot guarantee that all, or any particular one, will remain affiliated with us and/or our Advisor. If any of our key personnel were to cease their affiliation with our Advisor, our operating results could suffer. Further, although our sponsor has obtained key person life insurance on some of these individuals, we do not intend to separately maintain key person life insurance on any of these individuals. We believe that our future success depends, in large part, upon our Advisor's ability to hire and retain highly skilled managerial, operational and marketing personnel. Competition for such personnel is intense, and we cannot assure stockholders that our Advisor will be successful in attracting and retaining such skilled personnel. If our Advisor loses or is unable to obtain the services of key personnel or does not establish or maintain appropriate strategic relationships, our ability to implement our investment strategies could be delayed or hindered, and the value of a stockholder's investment may decline.
Our ability to operate profitably will depend upon the ability of our Advisor to efficiently manage our day-to-day operations.
We will rely on our Advisor to manage our business and assets. Our Advisor will make all decisions with respect to our day-to-day operations. Thus, the success of our business will depend in large part on the ability of our Advisor to manage our operations. Any adversity experienced by our Advisor or problems in our relationship with our Advisor could adversely impact the operation of our properties and, consequently, our cash flow and ability to make distributions to our stockholders.
Cybersecurity risks and cyber incidents may adversely affect our business by causing a disruption to our operations, a compromise or corruption of our confidential information, and/or damage to our business relationships, all of which could negatively impact our financial results.
A cyber incident is considered to be any adverse event that threatens the confidentiality, integrity or availability of our information resources. These incidents may be an intentional attack or an unintentional event and could involve gaining unauthorized access to our information systems for purposes of misappropriating assets, stealing confidential information, corrupting data or causing operational disruption. The results of these incidents may include disrupted operations, misstated or unreliable financial data, financial loss, liability for stolen assets or information, increased cybersecurity protection and insurance costs, litigation, and damage to our tenant and investor relationships. As our reliance on technology increases, so will the risks posed to our information systems, both internal and those we outsource. There is no guarantee that any processes, procedures and internal controls we have implemented or will implement will prevent cyber intrusions, which could have a negative impact on our financial results, operations, business relationships or confidential information.
Risks Related to Conflicts of Interest
Our sponsor, Advisor, property manager and their officers and certain of their key personnel will face competing demands relating to their time, which may cause our operating results to suffer.
Our sponsor, Advisor, property manager and their officers and certain of their key personnel and their respective affiliates currently serve as key personnel, advisors, managers and sponsors or co-sponsors to some or all of 10 other real estate programs affiliated with our sponsor, including Griffin Capital Essential Asset REIT II, Inc. (“GCEAR II”), Griffin-American Healthcare REIT III, Inc. (“GAHR III”), and Griffin-American Healthcare REIT IV, Inc. (“GAHR IV”), each of which are publicly-registered, non-traded real estate investment trusts, Griffin-Benefit Street Partners BDC Corp. (“GB-BDC”), a non-traded business development company regulated under the 1940 Act, and Griffin Institutional Access Real Estate Fund (“GIA Real Estate Fund”) and Griffin Institutional Access Credit Fund ("GIA Credit Fund"), both of which are non-diversified, closed-end management investment companies that are operated as interval funds under the 1940 Act. Because these persons have competing demands on their time and resources, they may have conflicts of interest in allocating their time between our business and these other activities. During times of intense activity in other programs and ventures, they may devote less time and fewer resources to our business than is necessary or appropriate. If this occurs, the returns on our stockholders’ investment may suffer.
Our officers and one of our directors face conflicts of interest related to the positions they hold with affiliated entities, which could hinder our ability to successfully implement our investment objectives and to generate returns to our stockholders.
Our executive officers and one of our directors are also officers of our sponsor, our Advisor, our property manager, and other affiliated entities. As a result, these individuals owe fiduciary duties to these other entities and their owners, which fiduciary duties may conflict with the duties that they owe to our stockholders and us. Their loyalties to these other entities
could result in actions or inactions that are detrimental to our business, which could harm the implementation of our investment objectives. Conflicts with our business and interests are most likely to arise from involvement in activities related to (1) allocation of new investments and management time and services between us and the other entities, (2) our purchase of properties from, or sale of properties to, affiliated entities, (3) the timing and terms of the investment in or sale of an asset, (4) development of our properties by affiliates, (5) investments with affiliates of our Advisor, (6) compensation to our Advisor, and (7) our relationship with our property manager. If we do not successfully implement our investment objectives, we may be unable to generate cash needed to make distributions to our stockholders and to maintain or increase the value of our assets.
Our Advisor will face conflicts of interest relating to the purchase of properties, and such conflicts may not be resolved in our favor, which could adversely affect our investment opportunities.
We may be buying properties at the same time as one or more of the other programs currently managed by officers and key personnel of our Advisor. Our sponsor, Advisor and their affiliates are actively involved in 10 other affiliated real estate programs, including GCEAR II, GAHR III, and GAHR IV, tenant in common programs and other real estate programs and partnerships that may compete with us or otherwise have similar business interests. Our Advisor and our property manager will have conflicts of interest in allocating potential properties, acquisition expenses, management time, services and other functions between various existing enterprises or future enterprises with which they may be or become involved. There is a risk that our Advisor will choose a property that provides lower returns to us than a property purchased by another program sponsored by our sponsor. We cannot be sure that officers and key personnel acting on behalf of our Advisor and on behalf of these other programs will act in our best interests when deciding whether to allocate any particular property to us. Such conflicts that are not resolved in our favor could result in a reduced level of distributions we may be able to pay to our stockholders and a reduction in the value of our stockholders’ investment. If our Advisor or its affiliates breach their legal or other obligations or duties to us, or do not resolve conflicts of interest, we may not meet our investment objectives, which could reduce our expected cash available for distribution to our stockholders and the value of our stockholders’ investment.
We may face a conflict of interest when purchasing properties from affiliates of our Advisor.
As of December 31, 2016, we have acquired eight of our properties from certain affiliates of our sponsor, including our Chief Executive Officer and Chairman, Kevin A. Shields, our Executive Vice President, David C. Rupert and our Vice President - Acquisitions, Don Pescara, along with several third party investors. We may purchase properties from one or more affiliates of our Advisor in the future. A conflict of interest may exist in such an acquisition and affiliates of our Advisor may be entitled to fees on both sides of such a related party transaction. The business interests of our Advisor and its affiliates may be adverse to, or to the detriment of, our interests. Additionally, the prices we pay to affiliates of our Advisor for our properties may be equal to, or in excess of, the prices paid by them, plus the costs incurred by them relating to the acquisition and financing of the properties. These prices will not be the subject of arm’s-length negotiations, which could mean that the acquisitions may be on terms less favorable to us than those negotiated in an arm’s-length transaction. Even though we will use an independent third party appraiser to determine fair market value when acquiring properties from our Advisor and its affiliates, we may pay more for particular properties than we would have in an arm’s-length transaction, which would reduce our cash available for investment in other properties or distribution to our stockholders. Furthermore, because any agreement that we enter into with affiliates of our Advisor will not be negotiated in an arm’s-length transaction, and as a result of the affiliation between our Advisor and its affiliates, our Advisor may be reluctant to enforce the agreements against such entities. Our nominating and corporate governance committee of our board of directors approves all transactions between us and our Advisor and its affiliates. See Part I, Item 1, Business - Affiliate Transaction Policy.
We may face conflicts of interest when disposing of certain of our properties, which may cause us to make payments to the affiliated contributors of such properties pursuant to tax protection agreements.
In connection with the contribution of seven of our properties from certain affiliates of our sponsor and several other third party investors, we have entered into tax protection agreements with the contributors. These agreements obligate our Operating Partnership to reimburse the contributors for tax liabilities resulting from their recognition of income or gain if we cause our Operating Partnership to take certain actions with respect to the various properties, the result of which causes income or gain to the contributors for a period subsequent to the contribution of such property as specified in the tax protection agreement. As a result, we may face conflicts of interest if affiliates of our Advisor and sponsor recommend that we sell one of these properties, the result of which could cause our Operating Partnership to provide reimbursements under the tax protection agreements if we do not reinvest the proceeds of the sale pursuant to Section 1031 of the Code or any other tax deferred investment.
Our Advisor will face conflicts of interest relating to the incentive fee structure under our operating partnership agreement, which could result in actions that are not necessarily in the long-term best interests of our stockholders.
Our Advisor and its affiliates will perform services for us in connection with the selection, acquisition and management of our properties pursuant to our advisory agreement. In addition, our Advisor will be entitled to fees and distributions that are structured in a manner intended to provide incentives to our Advisor to perform in our best interests and in the best interests of our stockholders. The amount of such compensation has not been determined as a result of arm’s-length negotiations, and such
amounts may be greater than otherwise would be payable to independent third parties. While certain affiliates of our sponsor, including our Chief Executive Officer and Chairman, our Executive Vice President and our Vice President - Acquisitions, have an equity interest in our Operating Partnership through the contribution of certain of our properties, our Advisor is entitled to receive substantial minimum compensation regardless of performance. Therefore, our Advisor’s interests may not be wholly aligned with those of our stockholders. In that regard, our Advisor could be motivated to recommend riskier or more speculative investments in order for us to generate the specified levels of performance or sales proceeds that would entitle our Advisor to greater fees. In addition, our Advisor’s entitlement to fees upon the sale of our assets and to participate in sale proceeds could result in our Advisor recommending sales of our investments at the earliest possible time at which sales of investments would produce the level of return that would entitle our Advisor to compensation relating to such sales, even if continued ownership of those investments might be in our best long-term interest.
Our operating partnership agreement will require us to pay a performance-based termination distribution to our Advisor in the event that we terminate our Advisor prior to the listing of our shares for trading on an exchange or, absent such listing, in respect of its participation in net sale proceeds. To avoid paying this distribution, our independent directors may decide against terminating the advisory agreement prior to our listing of our shares or disposition of our investments even if, but for the termination distribution, termination of the advisory agreement would be in our best interest. In addition, the requirement to pay the distribution to our Advisor at termination could cause us to make different investment or disposition decisions than we would otherwise make in order to satisfy our obligation to pay the distribution to the terminated Advisor.
At the time it becomes necessary for our board of directors to determine which liquidity event, if any, is in the best interests of us and our stockholders, our Advisor may not agree with the decision of our board as to which liquidity event, if any, we should pursue if there is a substantial difference in the amount of subordinated distributions the Advisor may receive for each liquidity event. Our Advisor may prefer a liquidity event with higher subordinated distributions. If our board of directors decides to list our shares for trading on an exchange, our board may also decide to merge us with our Advisor in anticipation of the listing process. Such merger may result in substantial compensation to the Advisor which may create conflicts of interest.
Our Advisor will face conflicts of interest relating to joint ventures that we may form with affiliates of our Advisor, which conflicts could result in a disproportionate benefit to other joint venture partners at our expense.
We may enter into joint ventures with other programs sponsored by our sponsor, including other REITs, for the acquisition, development or improvement of properties. Our Advisor may have conflicts of interest in determining which program sponsored by our sponsor should enter into any particular joint venture agreement. The co-venturer may have economic or business interests or goals that are or may become inconsistent with our business interests or goals. In addition, our Advisor may face a conflict in structuring the terms of the relationship between our interests and the interest of the affiliated co-venturer and in managing the joint venture. Since our Advisor and its affiliates will control both the affiliated co-venturer, and, to a certain extent, us, agreements and transactions between the co-venturers with respect to any such joint venture will not have the benefit of arm’s-length negotiation of the type normally conducted between unrelated co-venturers, which may result in the co-venturer receiving benefits greater than the benefits that we receive. In addition, we may assume liabilities related to the joint venture that exceed the percentage of our investment in the joint venture, and this could reduce the returns on our stockholders investment.
There is no separate counsel for us and our affiliates, which could result in conflicts of interest.
Nelson Mullins Riley & Scarborough LLP ("Nelson Mullins") acts as legal counsel to us and also represents our sponsor, our Advisor, and some of their affiliates. There is a possibility in the future that the interests of the various parties may become adverse and, under the code of professional responsibility of the legal profession, Nelson Mullins may be precluded from representing any one or all of such parties. If any situation arises in which our interests appear to be in conflict with those of our Advisor or its affiliates, additional counsel may be retained by one or more of the parties to assure that their interests are adequately protected. Moreover, should a conflict of interest not be readily apparent, Nelson Mullins may inadvertently act in derogation of the interest of the parties which could affect our ability to meet our investment objectives.
Risks Related to Our Corporate Structure
The limit on the number of shares a person may own may discourage a takeover that could otherwise result in a premium price to our stockholders.
In order for us to continue to qualify as a REIT, no more than 50% of our outstanding stock may be beneficially owned, directly or indirectly, by five or fewer individuals (including certain types of entities) at any time during the last half of each taxable year. To ensure that we do not fail to qualify as a REIT under this test, our charter restricts ownership by one person or entity to no more than 9.8% in value or number, whichever is more restrictive, of any class of our outstanding stock. This restriction may have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all of our assets) that might provide a premium price for holders of our common stock.
Our charter permits our board of directors to issue stock with terms that may subordinate the rights of common stockholders or discourage a third party from acquiring us in a manner that might result in a premium price to our stockholders.
Our charter permits our board of directors to issue up to 900,000,000 shares of capital stock. In addition, our board of directors, without any action by our stockholders, may amend our charter from time to time to increase or decrease the aggregate number of shares or the number of shares of any class or series of stock that we have authority to issue. Our board of directors may classify or reclassify any unissued common stock or preferred stock and establish the preferences, conversion or other rights, voting powers, restrictions, limitations as to distributions, qualifications and terms or conditions of redemption of any such stock. Thus, our board of directors could authorize the issuance of preferred stock with terms and conditions that could have a priority as to distributions and amounts payable upon liquidation over the rights of the holders of our common stock. Preferred stock could also have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all of our assets) that might otherwise provide a premium price for holders of our common stock. In addition, our board can authorize the issuance of preferred units under our Operating Partnership which may have similar preferential rights as preferred stock. There is no limit on the amount of preferred units our Operating Partnership could issue.
We are not afforded the protection of Maryland law relating to business combinations.
Under Maryland law, “business combinations” between a Maryland corporation and an interested stockholder or an affiliate of an interested stockholder are prohibited for five years after the most recent date on which the interested stockholder becomes an interested stockholder. These business combinations include a merger, consolidation, share exchange, or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities. An interested stockholder is defined as:
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any person who beneficially owns 10% or more of the voting power of the corporation’s shares; or
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an affiliate or associate of the corporation who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10% or more of the voting power of the then outstanding voting stock of the corporation.
These prohibitions are intended to prevent a change of control by interested stockholders who do not have the support of our board of directors. Since our charter contains limitations on ownership of 9.8% or more of our common stock, we opted out of the business combinations statute in our charter. Therefore, we will not be afforded the protections of this statute and, accordingly, there is no guarantee that the ownership limitations in our charter would provide the same measure of protection as the business combinations statute and prevent an undesired change of control by an interested stockholder.
Our stockholders’ investment return may be reduced if we are required to register as an investment company under the Investment Company Act of 1940. If we become an unregistered investment company, we will not be able to continue our business.
We do not intend to register as an investment company under the 1940 Act. As of December 31, 2016, we owned 75 properties, and our intended investments in real estate will represent the substantial majority of our total asset mix, which would not subject us to registration under the 1940 Act. In order to maintain an exemption from regulation under the 1940 Act, we must engage primarily in the business of buying real estate. If we are unable to remain fully invested in real estate holdings, we may avoid being required to register as an investment company by temporarily investing any unused proceeds in government securities with low returns, which would reduce the cash available for distribution to investors and possibly lower our stockholders’ returns.
To maintain compliance with our 1940 Act exemption, we may be unable to sell assets we would otherwise want to sell and may need to sell assets we would otherwise wish to retain. In addition, we may be required to acquire additional income- or loss-generating assets that we might not otherwise acquire or forgo opportunities to acquire interests in companies that we would otherwise want to acquire. If we are required to register as an investment company but fail to do so, we would be
prohibited from engaging in our business, and criminal and civil actions could be brought against us. In addition, our contracts would be unenforceable unless a court required enforcement, and a court could appoint a receiver to take control of us and liquidate our business.
Our stockholders are bound by the majority vote on matters on which our stockholders are entitled to vote and, therefore, a stockholder’s vote on a particular matter may be superseded by the vote of other stockholders.
Stockholders may vote on certain matters at any annual or special meeting of stockholders, including the election of directors. However, stockholders will be bound by the majority vote on matters requiring approval of a majority of the stockholders even if they do not vote with the majority on any such matter.
If stockholders do not agree with the decisions of our board of directors, they only have limited control over changes in our policies and operations and may not be able to change such policies and operations, except as provided for in our charter and under applicable law.
Our board of directors determines our major policies, including our policies regarding investments, operations, capitalization, financing, growth, REIT qualification and distributions. Our board of directors may amend or revise these and other policies without a vote of our stockholders. Under the Maryland General Corporation Law and our charter, our stockholders have a right to vote only on the following:
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the election or removal of directors;
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any amendment of our charter, except that our board of directors may amend our charter without stockholder approval to increase or decrease the aggregate number of our shares, to increase or decrease the number of our shares of any class or series that we have the authority to issue, or to classify or reclassify any unissued shares by setting or changing the preferences, conversion or other rights, restrictions, limitations as to distributions, qualifications or terms and conditions of redemption of such shares, provided however, that any such amendment does not adversely affect the rights, preferences and privileges of the stockholders;
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our liquidation or dissolution; and
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any merger, consolidation or sale or other disposition of substantially all of our assets.
All other matters are subject to the discretion of our board of directors. Therefore, our stockholders are limited in their ability to change our policies and operations.
Our rights and the rights of our stockholders to recover claims against our officers, directors and our Advisor are limited, which could reduce our stockholders’ and our recovery against them if they cause us to incur losses.
Maryland law provides that a director has no liability in that capacity if he or she performs his or her duties in good faith, in a manner he or she reasonably believes to be in the corporation’s best interests and with the care that an ordinarily prudent person in a like position would use under similar circumstances. Our charter, in the case of our directors, officers, employees and agents, and the advisory agreement, in the case of our Advisor, requires us to indemnify our directors, officers, employees and agents and our Advisor and its affiliates for actions taken by them in good faith and without negligence or misconduct. Additionally, our charter limits the liability of our directors and officers for monetary damages to the maximum extent permitted under Maryland law. As a result, we and our stockholders may have more limited rights against our directors, officers, employees and agents, and our Advisor and its affiliates, than might otherwise exist under common law, which could reduce our stockholders’ and our recovery against them. In addition, we may be obligated to fund the defense costs incurred by our directors, officers, employees and agents of our Advisor in some cases which would decrease the cash otherwise available for distribution to our stockholders.
Our stockholders’ interest in us will be diluted as we issue additional shares.
Our stockholders will not have preemptive rights to any shares issued by us in the future. Subject to any limitations set forth under Maryland law, our board of directors may increase the number of authorized shares of stock (currently 900,000,000 shares), increase or decrease the number of shares of any class or series of stock designated, or reclassify any unissued shares without the necessity of obtaining stockholder approval. All of such shares may be issued in the discretion of our board of directors. Therefore, as we (1) sell additional shares in the future, including those issued pursuant to our DRP Offering, (2) sell securities that are convertible into shares of our common stock, (3) issue shares of our common stock in a private offering of securities to institutional investors, (4) issue shares of restricted common stock or stock options to our independent directors, (5) issue shares to our Advisor, its successors or assigns, in payment of an outstanding payment obligation as set forth under our operating partnership agreement, (6) issue shares of our common stock to sellers of properties acquired by us in connection with an exchange of limited partnership interests of our Operating Partnership, or (7) issue preferred units, existing stockholders and investors purchasing shares in our DRP Offering will experience dilution of their equity investment in us. Because the limited partnership interests of our Operating Partnership may, in the discretion of our board of directors, be exchanged for shares of our common stock, any merger, exchange or conversion between our Operating Partnership and
another entity ultimately could result in the issuance of a substantial number of shares of our common stock, thereby diluting the percentage ownership interest of other stockholders. As of December 31, 2016, we had 176,032,871 shares of common stock issued and outstanding, and we owned approximately 96% of the limited partnership units of the Operating Partnership. Our sponsor and certain of its affiliates owned approximately 2% of the limited partnership units of the Operating Partnership, and the remaining approximately 2% of the limited partnership units were owned by third parties. Because of these and other reasons described in this “Risk Factors” section, stockholders should not expect to be able to own a significant percentage of our shares.
In addition, the net book value per share of our common stock was approximately $7.30 as of December 31, 2016, as compared to our offering price per share pursuant to our DRP Offering of $10.44. Therefore, upon a purchase of our shares in the DRP Offering, stockholders will be immediately diluted based on the net book value. Net book value takes into account a deduction of commissions and/or expenses paid by us, and is calculated to include depreciated tangible assets, deferred financing costs, and amortized intangible assets, which include in-place market leases. Net book value is not an estimate of net asset value, or of the market value or other value of our common stock.
Payment of substantial fees and expenses to our Advisor and its affiliates will reduce cash available for investment and distribution.
Our Advisor and its affiliates will perform services for us in connection with the selection and acquisition of our investments, and the management of our properties. They will be paid substantial fees for these services, which will reduce the amount of cash available for investment in properties or distribution to stockholders.
We are uncertain of our sources of debt or equity for funding our future capital needs. If we cannot obtain funding on acceptable terms, our ability to make necessary capital improvements to our properties may be impaired or delayed.
To continue to qualify as a REIT, we generally must distribute to our stockholders at least 90% of our taxable income each year, excluding capital gains. Because of this distribution requirement, it is not likely that we will be able to fund a significant portion of our future capital needs from retained earnings. We have not identified all sources of debt or equity for future funding, and such sources of funding may not be available to us on favorable terms or at all. If, however, we do not have access to sufficient funding in the future, we may not be able to make necessary capital improvements to our properties, pay other expenses or expand our business.
Risks Related to Investments in Single Tenant Real Estate
Many of our properties depend upon a single tenant for all or a majority of their rental income, and our financial condition and ability to make distributions may be adversely affected by the bankruptcy or insolvency, a downturn in the business, or a lease termination of a single tenant, including those caused by the current economic downturn.
Most of our properties are occupied by only one tenant or will derive a majority of their rental income from one tenant and, therefore, the success of those properties is materially dependent on the financial stability of such tenants. A tenant at one or more of our properties may be negatively affected by an economic slowdown. Lease payment defaults by tenants, including those caused by an economic downturn, could cause us to reduce the amount of distributions we pay. A default of a tenant on its lease payments to us and the potential resulting vacancy would cause us to lose the revenue from the property and force us to find an alternative source of revenue to meet any mortgage payment and prevent a foreclosure if the property is subject to a mortgage. In the event of a default, we may experience delays in enforcing our rights as landlord and may incur substantial costs in protecting our investment and re-letting the property. If a lease is terminated or an existing tenant elects not to renew a lease upon its expiration, there is no assurance that we will be able to lease the property for the rent previously received or sell the property without incurring a loss. A default by a tenant, the failure of a guarantor to fulfill its obligations or other premature termination of a lease, or a tenant’s election not to extend a lease upon its expiration, could have an adverse effect on our financial condition and our ability to pay distributions.
A significant portion of our leases are due to expire around the same period of time, which may (i) cause a loss in the value of our stockholders’ investment until the affected properties are re-leased, (ii) increase our exposure to downturns in the real estate market during the time that we are trying to re-lease such space and (iii) increase our capital expenditure requirements during the releasing period (dollars in thousands unless otherwise noted).
(1)
Net rent is based on (a) the contractual base rental payments assuming the lease requires the tenant to reimburse us for certain operating expenses or the property is self-managed by the tenant and the tenant is responsible for all, or substantially all, of the operating expenses; or (b) contractual rent payments less certain operating expenses that are our responsibility for the 12-month period subsequent to December 31, 2016 and includes assumptions that may not be indicative of the actual future performance of a property, including the assumption that the tenant will perform its obligations under its lease agreement during the next 12 months.
We may experience similar concentrations of lease expiration dates in the future. As the expiration date of a lease for a single-tenant building approaches, the value of the property generally declines because of the risk that the building may not be re-leased upon expiration of the existing lease or may be re-leased on terms less favorable than those of the expiring leases. Therefore, if we were to list or liquidate our portfolio prior to the favorable re-leasing of the space, our stockholders may suffer a loss on their investment. Our stockholders may also suffer a loss (and a reduction in distributions) after the expiration of the lease terms if we are not able to re-lease such space on terms similar to or more favorable than the terms of the expiring lease. These expiring leases, therefore, increase our risk to real estate downturns during and approaching these periods of concentrated lease expirations. In addition, we may have to spend significant capital in order to ready the space for new tenants. To meet our need for cash at this time, we may have to increase borrowings or reduce our distributions, or both.
If a tenant declares bankruptcy, we may be unable to collect balances due under relevant leases.
Any of our tenants, or any guarantor of a tenant’s lease obligations, could be subject to a bankruptcy proceeding pursuant to Title 11 of the bankruptcy laws of the United States. Such a bankruptcy filing would bar all efforts by us to collect pre-bankruptcy debts from these entities or their properties, unless we receive an enabling order from the bankruptcy court. Post-bankruptcy debts would be paid currently. If a lease is assumed, all pre-bankruptcy balances owing under it must be paid in full. If a lease is rejected by a tenant in bankruptcy, we would have a general unsecured claim for damages. If a lease is rejected, it is unlikely we would receive any payments from the tenant because our claim is capped at the rent reserved under the lease, without acceleration, for the greater of one year or 15% of the remaining term of the lease, but not greater than three years, plus rent already due but unpaid. This claim could be paid only in the event funds were available, and then only in the same percentage as that realized on other unsecured claims.
A tenant or lease guarantor bankruptcy could delay efforts to collect past due balances under the relevant leases, and could ultimately preclude full collection of these sums. Such an event could cause a decrease or cessation of rental payments that would mean a reduction in our cash flow and the amount available for distributions to our stockholders. In the event of a bankruptcy, we cannot assure our stockholders that the tenant or its trustee will assume our lease. If a given lease, or guaranty of a lease, is not assumed, our cash flow and the amounts available for distributions to our stockholders may be adversely affected.
If a sale-leaseback transaction is recharacterized in a tenant’s bankruptcy proceeding, our financial condition could be adversely affected.
We may enter into sale-leaseback transactions, whereby we would purchase a property and then lease the same property back to the person from whom we purchased it. In the event of the bankruptcy of a tenant, a transaction structured as a sale-leaseback may be recharacterized as either a financing or a joint venture, either of which outcomes could adversely affect our business. If the sale-leaseback were recharacterized as a financing, we might not be considered the owner of the property, and as a result would have the status of a creditor in relation to the tenant. In that event, we would no longer have the right to sell or encumber our ownership interest in the property. Instead, we would have a claim against the tenant for the amounts owed under the lease, with the claim arguably secured by the property. The tenant/debtor might have the ability to propose a plan restructuring the term, interest rate and amortization schedule of its outstanding balance. If confirmed by the bankruptcy court, we could be bound by the new terms, and prevented from foreclosing our lien on the property. If the sale-leaseback were
recharacterized as a joint venture, our lessee and we could be treated as co-venturers with regard to the property. As a result, we could be held liable, under some circumstances, for debts incurred by the lessee relating to the property. Either of these outcomes could adversely affect our cash flow and the amount available for distributions to our stockholders.
Net leases may not result in fair market lease rates over time.
A large portion of our rental income is from net leases. Net leases are typically characterized by (1) longer lease terms; and (2) fixed rental rate increases during the primary term of the lease, and, thus, there is an increased risk that these contractual lease terms will fail to result in fair market rental rates. As a result, our income and distributions to our stockholders could be lower than they would otherwise be if we did not engage in net leases.
Our real estate investments may include special-use single tenant properties that may be difficult to sell or re-lease upon tenant defaults or early lease terminations.
We have investments in commercial and industrial properties, which may include manufacturing facilities and special-use single tenant properties. These types of properties are relatively illiquid compared to other types of real estate and financial assets. This illiquidity will limit our ability to quickly change our portfolio in response to changes in economic or other conditions. With these properties, if the current lease is terminated or not renewed or, in the case of a mortgage loan, if we take such property in foreclosure, we may be required to renovate the property or to make rent concessions in order to lease the property to another tenant or sell the property. In addition, in the event we are forced to sell the property, we may have difficulty selling it to a party other than the tenant or borrower due to the special purpose for which the property may have been designed. These and other limitations may affect our ability to sell or re-lease properties and adversely affect returns to our stockholders.
A high concentration of our properties in a particular geographic area, or that have tenants in a similar industry, would magnify the effects of downturns in that geographic area or industry.
In the event that we have a concentration of properties in any particular geographic area, any adverse situation that disproportionately affects that geographic area would have a magnified adverse effect on our portfolio. Similarly, if our tenants are concentrated in a certain industry or industries, any adverse effect to that industry generally would have a disproportionately adverse effect on our portfolio. As of December 31, 2016, approximately 15.7% and 14.0% of our annualized net rent for the 12-month period subsequent to December 31, 2016, was concentrated in the states of California and Texas, respectively. Additionally, as of December 31, 2016, approximately 18.1%, 11.3% and 10.4% of our annualized net rent for the 12-month period subsequent to December 31, 2016, was concentrated in the Capital Goods, Insurance, and Media industries, respectively.
General Risks Related to Investments in Real Estate
Our operating results will be affected by economic and regulatory changes that have an adverse impact on the real estate market in general, and we cannot assure our stockholders that we will be profitable or that we will realize growth in the value of our real estate properties.
Our operating results will be subject to risks generally incident to the ownership of real estate, including:
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changes in general economic or local conditions;
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changes in supply of or demand for similar or competing properties in an area;
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changes in interest rates and availability of permanent mortgage funds that may render the sale of a property difficult or unattractive;
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changes in tax, real estate, environmental and zoning laws;
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changes in property tax assessments and insurance costs; and
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increases in interest rates and tight debt and equity supply.
These and other reasons may prevent us from being profitable or from realizing growth or maintaining the value of our real estate properties.
We may obtain only limited warranties when we purchase a property.
The seller of a property will often sell such property in its “as is” condition on a “where is” basis and “with all faults,” without any warranties of merchantability or fitness for a particular use or purpose. In addition, purchase agreements may contain only limited warranties, representations and indemnifications that will only survive for a limited period after the closing. Also, certain sellers of real estate are single purpose entities without significant other assets. The purchase of properties with limited warranties or from undercapitalized sellers increases the risk that we may lose some or all of our invested capital in the property as well as the loss of rental income from that property.
Our inability to sell a property when we desire to do so could adversely impact our ability to pay cash distributions to our stockholders.
The real estate market is affected by many factors, such as general economic conditions, availability of financing, interest rates and other factors, including supply and demand, that are beyond our control. We cannot predict whether we will be able to sell any property for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We cannot predict the length of time needed to find a willing purchaser and to close the sale of a property. Real estate generally cannot be sold quickly. Also, the tax laws applicable to REITs require that we hold our properties for investment, rather than for sale in the ordinary course of business, which may cause us to forgo or defer sales of properties that otherwise would be in our best interest. Therefore, we may not be able to dispose of properties promptly, or on favorable terms, in response to economic or other market conditions, and this may adversely impact our ability to make distributions to our stockholders.
In addition, we may be required to expend funds to correct defects or to make improvements before a property can be sold. We cannot assure our stockholders that we will have funds available to correct such defects or to make such improvements.
In acquiring a property, we may agree to restrictions that prohibit the sale of that property for a period of time or impose other restrictions, such as a limitation on the amount of debt that can be placed or repaid on that property. These provisions would also restrict our ability to sell a property.
We may not be able to sell our properties at a price equal to, or greater than, the price for which we purchased such properties, which may lead to a decrease in the value of our assets.
We may be purchasing our properties at a time when cap rates are at historically low levels and purchase prices are high. Therefore, the value of our properties may not increase over time, which may restrict our ability to sell our properties, or in the event we are able to sell such property, may lead to a sale price less than the price that we paid to purchase the properties.
We may acquire or finance properties with lock-out provisions, which may prohibit us from selling a property, or may require us to maintain specified debt levels for a period of years on some properties.
Lock-out provisions are provisions that generally prohibit repayment of a loan balance for a certain number of years following the origination date of a loan. Such provisions are typically provided for by the Code or the terms of the agreement underlying a loan. Lock-out provisions could materially restrict us from selling or otherwise disposing of or refinancing properties. These provisions would affect our ability to turn our investments into cash and thus affect cash available for distribution to our stockholders. Lock-out provisions may prohibit us from reducing the outstanding indebtedness with respect to any properties, refinancing such indebtedness on a non-recourse basis at maturity, or increasing the amount of indebtedness with respect to such properties. Any mortgage debt that we place on our properties may also impose prepayment penalties upon the sale of the mortgaged property. If a lender invokes these penalties upon the sale of a property or prepayment of a mortgage on a property, the cost to us to sell the property could increase substantially.
Lock-out provisions could impair our ability to take actions during the lock-out period that would otherwise be in our stockholders’ best interests and, therefore, may have an adverse impact on the value of the shares, relative to the value that would result if the lock-out provisions did not exist. In particular, lock-out provisions could preclude us from participating in major transactions that could result in a disposition of our assets or a change in control even though that disposition or change in control might be in our stockholders’ best interests.
Adverse economic conditions may negatively affect our returns and profitability.
The following market and economic challenges may adversely affect our operating results:
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poor economic times may result in customer defaults under leases or bankruptcy;
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re-leasing may require reduced rental rates under the new leases; and
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increased insurance premiums, resulting in part from the increased risk of terrorism and natural disasters, may reduce funds available for distribution.
We are susceptible to the effects of adverse macro-economic events that can result in higher unemployment, shrinking demand for products, large-scale business failures and tight credit markets. Because our portfolio consists of single-tenant commercial and industrial properties, we are subject to risks inherent in investments in single tenant properties in which we rely on the payment of rent from an individual tenant, and our results of operations are sensitive to changes in overall economic conditions that impact the tenant's business and on-going cash flow that can cause the tenant to cease making rental payments. A continuation of, or slow recovery from, ongoing adverse domestic and foreign economic conditions, such as employment levels, business conditions, interest rates, tax rates, fuel and energy costs, could continue to negatively impact a tenant's business resulting in insufficient cash flow to continue as a going-concern and ultimately the vacating of the occupied property. Such circumstances will have a direct impact on our cash flow from operations and cause us to incur costs, such as on-going
maintenance during vacancy and leasing costs, that could have an impact on our ability to continue the payment of distributions to our stockholders.
If we suffer losses that are not covered by insurance or that are in excess of insurance coverage, we could lose invested capital and anticipated profits.
Material losses may occur in excess of insurance proceeds with respect to any property, as insurance may not be sufficient to fund the losses. However, there are types of losses, generally of a catastrophic nature, such as losses due to wars, acts of terrorism, earthquakes, floods, hurricanes, pollution or environmental matters, which are either uninsurable or not economically insurable, or may be insured subject to limitations, such as large deductibles or co-payments. In addition, we may decide not to obtain any or adequate earthquake or similar catastrophic insurance coverage because the premiums are too high even in instances where it may otherwise be available. Insurance risks associated with potential terrorism acts could sharply increase the premiums we pay for coverage against property and casualty claims. Additionally, mortgage lenders in some cases have begun to insist that commercial property owners purchase specific coverage against terrorism as a condition for providing mortgage loans. It is uncertain whether such insurance policies will be available, or available at reasonable cost, which could inhibit our ability to finance or refinance our potential properties. In these instances, we may be required to provide other financial support, either through financial assurances or self-insurance, to cover potential losses. We cannot assure our stockholders that will have adequate coverage for such losses. The Terrorism Risk Insurance Act of 2002 is designed for a sharing of terrorism losses between insurance companies and the federal government. We cannot be certain how this act will impact us or what additional cost to us, if any, could result. If such an event damaged or destroyed one or more of our properties, we could lose both our invested capital and anticipated profits from such property.
Delays in the acquisition, development and construction of properties may have adverse effects on our results of operations and returns to our stockholders.
Delays we encounter in the selection, acquisition and development of real properties could adversely affect our stockholders’ returns. Investments in unimproved real property, properties that are in need of redevelopment, or properties that are under development or construction will be subject to the uncertainties associated with the development and construction of real property, including those related to re-zoning land for development, environmental concerns of governmental entities and/or community groups and our builders’ ability to build in conformity with plans, specifications, budgets and timetables. If a builder fails to perform, we may resort to legal action to rescind the purchase or the construction contract or to compel performance. A builder’s performance may also be affected or delayed by conditions beyond the builder’s control.
Where properties are acquired prior to the start of construction or during the early stages of construction, it will typically take several months to complete construction and lease available space. Therefore, our stockholders could suffer delays in the receipt of cash distributions attributable to those particular real properties. We may incur additional risks when we make periodic progress payments or other advances to builders before they complete construction. These and other factors can result in increased costs of a project or loss of our investment. We also must rely on rental income and expense projections and estimates of the fair market value of a property upon completion of construction when agreeing upon a purchase price at the time we acquire the property. If our projections are inaccurate, we may pay too much for a property, and the return on our investment could suffer.
Costs of complying with governmental laws and regulations, including those relating to environmental matters, may adversely affect our income and the cash available for distribution.
All real property we acquire, and the operations conducted on real property are subject to federal, state and local laws and regulations relating to environmental protection and human health, safety and fire. These laws and regulations generally govern wastewater discharges, air emissions, the operation and removal of underground and above-ground storage tanks, the use, storage, treatment, transportation and disposal of solid and hazardous materials, and the remediation of contamination associated with disposals. Some of these laws and regulations may impose joint and several liability on tenants, owners or operators for the costs to investigate or remediate contaminated properties, regardless of fault or whether the acts causing the contamination were legal. This liability could be substantial. In addition, the presence of hazardous substances, or the failure to properly remediate these substances, may adversely affect our ability to sell, rent or pledge such property as collateral for future borrowings.
Some of these laws and regulations have been amended so as to require compliance with new or more stringent standards as of future dates. Compliance with new or more stringent laws or regulations or stricter interpretation of existing laws may require us to incur material expenditures. Future laws, ordinances or regulations may impose material environmental liability. Additionally, our tenants’ operations, the existing condition of land when we buy it, operations in the vicinity of our properties, such as the presence of underground storage tanks, or activities of unrelated third parties may affect our properties. Any material expenditures, fines, or damages we must pay will reduce our ability to make distributions to our stockholders and may reduce the value of our stockholders’ investment.
Further, we may not obtain an independent third party environmental assessment for every property we acquire. In addition, we cannot assure our stockholders that any such assessment that we do obtain will reveal all environmental liabilities or that a prior owner of a property did not create a material environmental condition not known to us. We cannot predict what other environmental legislation or regulations will be enacted in the future, how existing or future laws or regulations will be administered or interpreted, or what environmental conditions may be found to exist in the future. We cannot assure our stockholders that our business, assets, results of operations, liquidity or financial condition will not be adversely affected by these laws, which may adversely affect cash available for distribution, and the amount of distributions to our stockholders.
Our costs associated with complying with the Americans with Disabilities Act may affect cash available for distribution.
Our properties are subject to the Americans with Disabilities Act of 1990, or ADA. Under the ADA, all places of public accommodation are required to comply with federal requirements related to access and use by disabled persons. The ADA has separate compliance requirements for “public accommodations” and “commercial facilities” that generally require that buildings and services, including restaurants and retail stores, be made accessible and available to people with disabilities. The ADA’s requirements could require removal of access barriers and could result in the imposition of injunctive relief, monetary penalties, or, in some cases, an award of damages. We will attempt to acquire properties that comply with the ADA or place the burden on the seller or other third party to ensure compliance with the ADA. However, we cannot assure our stockholders that we will be able to acquire properties or allocate responsibilities in this manner. If we cannot, our funds used for ADA compliance may affect cash available for distribution and the amount of distributions to our stockholders.
If we sell properties by providing financing to purchasers, defaults by the purchasers would adversely affect our cash flows.
In some instances we may sell our properties by providing financing to purchasers. When we provide financing to purchasers, we will bear the risk that the purchaser may default, which could negatively impact our cash distributions to stockholders. Even in the absence of a purchaser default, the distribution of the proceeds of sales to our stockholders, or their reinvestment in other assets, will be delayed until the promissory notes or other property we may accept upon the sale are actually paid, sold, refinanced or otherwise disposed of. In some cases, we may receive initial down payments in cash and other property in the year of sale in an amount less than the selling price and subsequent payments will be spread over a number of years.
We will be subject to risks associated with the co-owners in our co-ownership arrangements that otherwise may not be present in other real estate investments.
We may enter into joint ventures or other co-ownership arrangements with respect to a portion of the properties we acquire. Ownership of co-ownership interests involves risks generally not otherwise present with an investment in real estate such as the following:
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the risk that a co-owner may at any time have economic or business interests or goals that are or become inconsistent with our business interests or goals;
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the risk that a co-owner may be in a position to take action contrary to our instructions or requests or contrary to our policies or objectives;
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the possibility that an individual co-owner might become insolvent or bankrupt, or otherwise default under the applicable mortgage loan financing documents, which may constitute an event of default under all of the applicable mortgage loan financing documents or allow the bankruptcy court to reject the tenants-in-common agreement or management agreement entered into by the co-owner owning interests in the property;
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the possibility that a co-owner might not have adequate liquid assets to make cash advances that may be required in order to fund operations, maintenance and other expenses related to the property, which could result in the loss of current or prospective tenants and may otherwise adversely affect the operation and maintenance of the property, and could cause a default under the mortgage loan financing documents applicable to the property and may result in late charges, penalties and interest, and may lead to the exercise of foreclosure and other remedies by the lender;
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the risk that a co-owner could breach agreements related to the property, which may cause a default under, or result in personal liability for, the applicable mortgage loan financing documents, violate applicable securities laws and otherwise adversely affect the property and the co-ownership arrangement; or
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the risk that a default by any co-owner would constitute a default under the applicable mortgage loan financing documents that could result in a foreclosure and the loss of all or a substantial portion of the investment made by the co-owner.
Any of the above might subject a property to liabilities in excess of those contemplated and thus reduce the amount available for distribution to our stockholders.
In the event that our interests become adverse to those of the other co-owners, we may not have the contractual right to purchase the co-ownership interests from the other co-owners. Even if we are given the opportunity to purchase such co-ownership interests in the future, we cannot guarantee that we will have sufficient funds available at the time to purchase co-ownership interests from the co-owners.
We might want to sell our co-ownership interests in a given property at a time when the other co-owners in such property do not desire to sell their interests. Therefore, we may not be able to sell our interest in a property at the time we would like to sell. In addition, we anticipate that it will be much more difficult to find a willing buyer for our co-ownership interests in a property than it would be to find a buyer for a property we owned outright.
Risks Associated with Debt Financing
If we breach covenants under our unsecured credit agreement with KeyBank, National Association ("KeyBank") and other syndication partners, or our loan agreements with certain other lenders, we could be held in default under such loans, which could accelerate our repayment date and materially adversely affect the value of our stockholders’ investment in us.
We entered into an unsecured credit facility with KeyBank and a syndicate of lenders partners under which we were provided with a $1.14 billion senior unsecured credit facility consisting of a $500.0 million senior unsecured revolver and a $640.0 million senior unsecured term loan.
The credit facility requires that we must maintain a pool of real properties, which is subject to the following requirements: (i) no less than 30 unencumbered asset pool properties at all times; (ii) no greater than 15% of the unencumbered asset pool value may be contributed by any single unencumbered asset pool property; (iii) no greater than 15% of the aggregate unencumbered asset pool value may be contributed by unencumbered asset pool properties subject to ground leases; (iv) no greater than 15% of the aggregate unencumbered asset pool value may be contributed by unencumbered asset pool properties that are under development; (v) a minimum weighted average occupancy of all unencumbered asset pool properties be no less than 90%; (vi) minimum weighted average remaining lease term for all unencumbered properties shall be no less than five years; and (vii) other limitations as determined by KeyBank upon further diligence of the unencumbered asset pool properties. Upon the occurrence of certain events described further in the KeyBank credit facility agreement, KeyBank may require the borrower to grant a first perfected mortgage/deed of trust lien on each of the unencumbered asset pool properties.
The credit facility includes a number of financial covenant requirements, including, but not limited to, a maximum consolidated leverage ratio (60% or, for a maximum of two consecutive quarters following a material acquisition, 65%), a minimum fixed charge ratio (1.5 to 1), a maximum secured debt ratio (40%), a maximum secured recourse debt ratio (5%), a maximum unhedged variable rate debt (30% of total asset value), and minimum tangible net worth of at least approximately $1.2 billion plus 75% of the net proceeds of any common or preferred share issuance after the effective date and 75% of the amount of units of limited partnership interest in our Operating Partnership issued in connection with the contribution of properties, a maximum payout ratio of 95% of distribution to core funds from operations, minimum unsecured interest coverage ratio (2 to 1).
If we were to default under the KeyBank credit facility agreement, the lenders could accelerate the date for our repayment of the loan, and could sue to enforce the terms of the loan. In addition, upon the occurrence of certain events described further in the KeyBank credit facility agreement, the lenders may have the ability to place a first mortgage on certain of the properties in the unencumbered asset pool, and could ultimately foreclose on such properties. Such foreclosure could result in a material loss for us and would adversely affect the value of our stockholders’ investment in us.
We have broad authority to incur debt, and high debt levels could hinder our ability to make distributions and could decrease the value of our stockholders’ investment.
Although, technically, our board may approve unlimited levels of debt, our charter generally limits us to incurring debt no greater than 300% of our net assets before deducting depreciation or other non-cash reserves (equivalent to 75% leverage), unless any excess borrowing is approved by a majority of our independent directors and disclosed to our stockholders in our next quarterly report, along with a justification for such excess borrowing. High debt levels would cause us to incur higher interest charges, would result in higher debt service payments, and could be accompanied by restrictive covenants. These factors could limit the amount of cash we have available to distribute and could result in a decline in the value of our stockholders’ investment.
We have incurred, and intend to continue to incur, mortgage indebtedness and other borrowings, which may increase our business risks.
We have placed, and intend to continue to place, permanent financing on our properties or obtain a credit facility or other similar financing arrangement in order to acquire properties. We may also decide to later further leverage our properties. We
may incur mortgage debt and pledge all or some of our real properties as security for that debt to obtain funds to acquire real properties. We may borrow if we need funds to pay a desired distribution rate to our stockholders. We may also borrow if we deem it necessary or advisable to assure that we maintain our qualification as a REIT for federal income tax purposes. If there is a shortfall between the cash flow from our properties and the cash flow needed to service mortgage debt, then the amount available for distribution to our stockholders may be reduced.
If we are unable to make our debt payments when required, a lender could foreclose on the property or properties securing such debt, which could reduce the amount of distributions we pay to our stockholders and decrease the value of our stockholders’ investment.
We may have a significant amount of acquisition indebtedness secured by first priority mortgages on our properties. In addition, some of our properties contain, and any future acquisitions we make may contain, mortgage financing. If we are unable to make our debt payments when required, a lender could foreclose on the property or properties securing such debt. In any such event, we could lose some or all of our investment in these properties, which would reduce the amount of distributions we pay to our stockholders and decrease the value of our stockholders’ investment.
Lenders may require us to enter into restrictive covenants relating to our operations, which could limit our ability to make distributions to our stockholders.
When providing financing, a lender could impose restrictions on us that affect our distribution and operating policies and our ability to incur additional debt. Loan documents we enter into may contain covenants that limit our ability to further mortgage the property, discontinue insurance coverage or replace our Advisor. These or other limitations may adversely affect our flexibility and limit our ability to make distributions to our stockholders.
Increases in interest rates would increase the amount of our debt payments and adversely affect our ability to make distributions to our stockholders.
We currently have outstanding debt payments which are indexed to variable interest rates. We may also incur additional debt or preferred equity in the future which rely on variable interest rates. Increases in these variable interest rates in the future would increase our interest costs, which would likely reduce our cash flows and our ability to make distributions to you. In addition, if we need to make payments on instruments which contain variable interest during periods of rising interest rates, we could be required to liquidate one or more of our investments in properties at times that may not permit realization of the maximum return on such investments.
Disruptions in the credit markets and real estate markets could have a material adverse effect on our results of operations, financial condition, and ability to pay distributions to our stockholders.
Future disruptions in domestic and international financial markets may severely impact the amount of credit available to us and may contribute to rising costs associated with obtaining or maintaining such credit. In such an instance, we may not be able to obtain new debt financing, or maintain our existing debt financing, on terms and conditions we find to be ideal. If disruptions in the credit markets occur and are ongoing, our ability to borrow monies to finance the purchase of, or other activities related to, real estate assets may be negatively impacted. In addition, if we pay fees to lock in a favorable interest rate, falling interest rates or other factors could require us to forfeit these fees. All of these events could have a material adverse effect on our results of operations, financial condition and ability to pay distributions.
In addition to volatility in the credit markets, the real estate market is subject to fluctuation and can be impacted by factors such as general economic conditions, supply and demand, availability of financing and interest rates. To the extent we purchase real estate in an unstable market, we are subject to the risk that if the real estate market ceases to attract the same level of capital investment in the future that it attracts at the time of our purchases, or the number of companies seeking to acquire properties decreases, the value of our investments may not appreciate or may decrease significantly below the amount we pay for these investments.
Federal Income Tax Risks
Failure to continue to qualify as a REIT would adversely affect our operations and our ability to make distributions, as we would incur additional tax liabilities.
We believe we operate in a manner that allows us to qualify as a REIT for U.S. federal income tax purposes under the Code. Qualification as a REIT involves highly technical and complex Code provisions for which there are only limited judicial and administrative interpretations. Our qualification as a REIT will depend upon our ability to meet, through investments, actual operating results, distributions and satisfaction of specific stockholder rules, the various tests imposed by the Code.
If we fail to qualify as a REIT for any taxable year, we will be subject to federal income tax and any applicable alternative minimum tax on our taxable income at regular corporate rates. In addition, we would generally be disqualified from treatment as a REIT for the four taxable years following the year of losing our REIT status. Losing our REIT status would reduce our net earnings available for investment or distribution to stockholders because of the additional tax liability. If this occurs, we might
be required to borrow funds or liquidate some investments in order to pay the applicable tax. In addition, distributions to stockholders would no longer qualify for the distributions paid deduction, and we would no longer be required to make distributions.
If our Operating Partnership fails to maintain its status as a partnership for federal income tax purposes, its income would be subject to taxation and our REIT status would be terminated.
If the IRS were to successfully challenge the status of our Operating Partnership as a partnership, it would be taxable as a corporation. In such event, this would reduce the amount of distributions that our Operating Partnership could make to us. This would also result in our losing REIT status and becoming subject to a corporate level tax on our own income. This would substantially reduce our cash available to pay distributions and the return on our stockholders’ investment. In addition, if any of the entities through which our Operating Partnership owns its properties, in whole or in part, loses its characterization as a partnership for federal income tax purposes, it would be subject to taxation as a corporation, thereby reducing distributions to our Operating Partnership. Such a recharacterization of our Operating Partnership or an underlying property owner could also threaten our ability to maintain REIT status.
Our stockholders may have tax liability on distributions they elect to reinvest in our common stock.
If stockholders participate in our distribution reinvestment plan, they will be deemed to have received, and for income tax purposes will be taxed on, the amount reinvested in common stock to the extent the amount reinvested was not a tax-free return of capital. As a result, unless stockholders are a tax-exempt entity, they may have to use funds from other sources to pay their tax liability on the value of the common stock received.
In certain circumstances, we may be subject to federal and state income taxes as a REIT, which would reduce our cash available for distribution to our stockholders.
Even if we qualify and maintain our status as a REIT, we may be subject to federal income taxes or state taxes. For example, net income from a “prohibited transaction” will be subject to a 100% tax. We may not be able to make sufficient distributions to avoid excise taxes applicable to REITs. We may also decide to retain income we earn from the sale or other disposition of our property and pay income tax directly on such income. In that event, our stockholders would be treated as if they earned that income and paid the tax on it directly. However, stockholders that are tax-exempt, such as charities or qualified pension plans, would have no benefit from their deemed payment of such tax liability. We may also be subject to state and local taxes on our income or property, either directly or at the level of the Operating Partnership or at the level of the other companies through which we indirectly own our assets. Any federal or state taxes we pay will reduce our cash available for distribution to our stockholders.
We may be required to pay some taxes due to actions of our taxable REIT subsidiary which would reduce our cash available for distribution to our stockholders.
Any net taxable income earned directly by our taxable REIT subsidiaries, or through entities that are disregarded for federal income tax purposes, which are wholly-owned by our taxable REIT subsidiaries, will be subject to federal and possibly state corporate income tax. We filed an election to treat Griffin Capital Essential Asset TRS, Inc. as a taxable REIT subsidiary, and we may elect to treat other subsidiaries as taxable REIT subsidiaries in the future. In this regard, several provisions of the laws applicable to REITs and their subsidiaries ensure that a taxable REIT subsidiary will be subject to an appropriate level of federal income taxation. For example, a taxable REIT subsidiary is limited in its ability to deduct certain interest payments made to an affiliated REIT. In addition, the REIT has to pay a 100% penalty tax on some payments that it receives or on some deductions taken by a taxable REIT subsidiary if the economic arrangements between the REIT, the REIT’s customers, and the taxable REIT subsidiary are not comparable to similar arrangements between unrelated parties. Finally, some state and local jurisdictions may tax some of our income even though as a REIT we are not subject to federal income tax on that income because not all states and localities follow the federal income tax treatment of REITs. To the extent that we and our affiliates are required to pay federal, state and local taxes, we will have less cash available for distributions to our stockholders.
Distributions to tax-exempt investors may be classified as unrelated business taxable income.
Neither ordinary nor capital gain distributions with respect to our common stock nor gain from the sale of common stock should generally constitute unrelated business taxable income (UBTI) to a tax-exempt investor. However, there are certain exceptions to this rule. In particular:
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part of the income and gain recognized by certain qualified employee pension trusts with respect to our common stock may be treated as UBTI if shares of our common stock are predominately held by qualified employee pension trusts, and we are required to rely on a special look-through rule for purposes of meeting one of the REIT share ownership tests, and we are not operated in a manner to avoid treatment of such income or gain as UBTI;
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part of the income and gain recognized by a tax exempt investor with respect to our common stock would constitute UBTI if the investor incurs debt in order to acquire the common stock; and
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part or all of the income or gain recognized with respect to our common stock by social clubs, voluntary employee benefit associations, supplemental unemployment benefit trusts and qualified group legal services plans which are exempt from federal income taxation under Sections 501(c)(7), (c)(9), (c)(17) or (c)(20) of the Code may be treated as UBTI.
Complying with the REIT requirements may cause us to forgo otherwise attractive opportunities.
To qualify as a REIT for federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of shares of our common stock. We may be required to make distributions to stockholders at disadvantageous times or when we do not have funds readily available for distribution, or we may be required to liquidate otherwise attractive investments in order to comply with the REIT tests. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.
Legislative or regulatory action could adversely affect investors.
Individuals with incomes below certain thresholds are subject to taxation at a 15% qualified dividend rate. For those with income above such thresholds, the qualified dividend rate is 20%. These tax rates are generally not applicable to distributions paid by a REIT, unless such distributions represent earnings on which the REIT itself has been taxed. As a result, distributions (other than capital gain distributions) we pay to individual investors generally will be subject to the tax rates that are otherwise applicable to ordinary income for federal income tax purposes, which currently are as high as 39.6%. This disparity in tax treatment may make an investment in our shares comparatively less attractive to individual investors than an investment in the shares of non-REIT corporations, and could have an adverse effect on the value of our common stock. Stockholders are urged to consult with their own tax advisors with respect to the impact of recent legislation on their investment in our common stock and the status of legislative, regulatory or administrative developments and proposals and their potential effect on an investment in our common stock.
Foreign purchasers of our common stock may be subject to the Foreign Investment in Real Property Tax Act (“FIRPTA”) upon the sale of their shares.
A foreign person disposing of a U.S. real property interest, including shares of a U.S. corporation whose assets consist principally of U.S. real property interests, is generally subject to a tax, known as FIRPTA tax, on the gain recognized on the disposition. Such FIRPTA tax does not apply, however, to the disposition of stock in a REIT if the REIT is “domestically controlled.” A REIT is “domestically controlled” if less than 50% of the REIT’s stock, by value, has been owned directly or indirectly by persons who are not qualifying U.S. persons during a continuous five-year period ending on the date of disposition or, if shorter, during the entire period of the REIT’s existence.
We cannot assure our stockholders that we will qualify as a “domestically controlled” REIT. If we were to fail to so qualify, gain realized by foreign investors on a sale of our shares would be subject to FIRPTA tax, unless our shares were traded on an established securities market and the foreign investor did not at any time during a specified testing period directly or indirectly own more than 10% of the value of our outstanding common stock.
Employee Retirement Income Security Act of 1974 (“ERISA”) Risks
There are special considerations that apply to employee benefit plans, IRAs or other tax-favored benefit accounts investing in our shares which could cause an investment in our shares to be a prohibited transaction which could result in additional tax consequences.
ERISA and the Code impose certain restrictions on (i) employee benefit plans (as defined in Section 3(3) of ERISA), (ii) plans described in Code Section 4975(e)(1), including IRAs and Keogh plans, (iii) any entities whose underlying assets include plan assets by reason of a plan’s investment in such entities, and (iv) persons who have certain specified relationships to such plans, i.e., parties-in-interest under ERISA and disqualified persons under the Code. If stockholders are investing the assets of such a plan or account in our common stock, they should satisfy themselves that, among other things:
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their investment is consistent with their fiduciary obligations under ERISA, the Code, or other applicable law;
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their investment is made in accordance with the documents and instruments governing their IRA, plan or other account, including any applicable investment policy;
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their investment satisfies the prudence and diversification requirements of ERISA or other applicable law;
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their investment will not impair the liquidity of the IRA, plan or other account;
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their investment will not produce UBTI for the IRA, plan or other account;
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they will be able to value the assets of the plan annually in accordance with the requirements of ERISA or other applicable law, to the extent applicable; and
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their investment will not constitute a prohibited transaction under Section 406 of ERISA or Section 4975 of the Code or constitute a violation of analogous provisions under other applicable law, to the extent applicable.
Persons investing the assets of employee benefit plans should consider ERISA risks of investing in the shares.
ERISA and Code Section 4975 prohibit certain transactions that involve (1) certain pension, profit-sharing, employee benefit, or retirement plans or individual retirement accounts and Keogh plans, and (2) any person who is a "party-in-interest" or "disqualified person" with respect to such a plan. Consequently, the fiduciary of a plan contemplating an investment in the shares should consider whether we, any other person associated with the issuance of the shares, or any of their affiliates is or might become a "party-in-interest" or "disqualified person" with respect to the plan and, if so, whether an exception from such prohibited transaction rules is applicable. In addition, the Department of Labor plan asset regulations provide that, subject to certain exceptions, the assets of an entity in which a plan holds an equity interest may be treated as assets of an investing plan, in which event the underlying assets of such entity (and transactions involving such assets) would be subject to the prohibited transaction provisions. We intend to take such steps as may be necessary to qualify us for one or more of the exceptions available, and thereby prevent our assets as being treated as assets of any investing plan.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not Applicable.
ITEM 2.
ITEM 2. PROPERTIES
As of December 31, 2016, we owned a fee simple interest in 75 properties, encompassing approximately 18.8 million rentable square feet and an 80% interest in an unconsolidated joint venture. See Part IV, Item 15. “Exhibits, Financial Statement Schedules-Schedule III-Real Estate and Accumulated Depreciation and Amortization,” of this Annual Report on Form 10-K for a detailed listing of our properties.
Revenue Concentration
No lessee or property, based on annualized net rent for the 12-month period subsequent to December 31, 2016, pursuant to the respective in-place leases, was greater than 7% as of December 31, 2016.
The percentage of annualized net rent for the 12-month period subsequent to December 31, 2016, by state, based on the respective in-place leases, is as follows (dollars in thousands):
(1)
All others account for less than 3% of total annualized net rent on an individual basis.
The percentage of annualized net rent for the 12-month period subsequent to December 31, 2016, by industry, based on the respective in-place leases, is as follows (dollars in thousands):
(1)
Industry classification based on the Global Industry Classification Standard.
(2)
All others account for less than 3% of total annualized net rent on an individual basis.
The tenant lease expirations, by year, based on annualized net rent for the 12-month period subsequent to December 31, 2016 are as follows (dollars in thousands):
(1)
Included in the annualized net rent amount is approximately 54,800 square feet related to a lease expiring in 2017 with the remaining square footage expiring in 2019. The Company included the lessee in the number of lessees in 2019.
Acquisition Indebtedness
For a discussion of our acquisitions and indebtedness, see Note 3, Real Estate, and Note 5, Debt, to the consolidated financial statements.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
(a)
From time to time, we may become subject to legal proceedings, claims and litigation arising in the ordinary course of our business. We are not a party to any material legal proceedings, nor are we aware of any pending or threatened litigation that would have a material adverse effect on our business, operating results, cash flows or financial condition should such litigation be resolved unfavorably.
(b)
None.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
As of March 10, 2017, we had approximately $1.4 billion in shares of common stock outstanding, including $170.6 million in shares issued pursuant to our distribution reinvestment plan, held by a total of approximately 39,100 stockholders of record. There is no established trading market for our common stock. Therefore, there is a risk that a stockholder may not be able to sell our stock at a time or price acceptable to the stockholder, or at all. Pursuant to the terms of our charter, certain restrictions are imposed on the ownership and transfer of shares.
Unless and until our shares are listed on a national securities exchange, it is not expected that a public market for our shares will develop. To assist fiduciaries of Plans (as defined below) subject to the annual reporting requirements of ERISA and Account (as defined below) trustees or custodians to prepare reports relating to an investment in our shares, we intend to provide reports in annual determinations of the current value of our net assets per outstanding share to those fiduciaries (including Account trustees and custodians) who identify themselves to us and request the reports.
For purposes of the preceding paragraphs, “Plans” include tax-qualified pension, stock bonus or profit-sharing plans, employee benefit plans described in Section 3(3) of ERISA, and annuities described in Section 403(a) or (b) of the Code, and “Accounts” include an individual retirement account or annuity described in Sections 408 or 408A of the Code (also known as IRAs), an Archer MSA described in Section 220(d) of the Code, a health savings account described in Section 223(d) of the Code, and a Coverdell education savings account described in Section 530 of the Code.
On October 10, 2016, our board of directors amended and restated our DRP to state that the purchase price for the shares pursuant to the DRP shall be equal to the most recently published estimated net asset value and to make certain other minor revisions. The amended and restated DRP was effective as of October 28, 2016. We are currently selling shares of our common stock to the public pursuant to the 2015 DRP Offering at a price of $10.44 per share (unaudited). Our board of directors established this share price following its receipt of a third-party report from an advisor to the board of directors regarding the determination of the Company's NAV as of June 30, 2016. See Determination of Estimated Value Per Share below.
Determination of Estimated Value Per Share
On October 24, 2016, our board of directors, including all our independent directors, approved an estimated value per share of our common stock of $10.44 based on the estimated value of our assets less the estimated value of our liabilities, or net asset value, divided by the approximate number of shares outstanding on a fully diluted basis, calculated as of June 30, 2016. We are providing this estimated value per share to assist broker dealers in connection with their obligations under applicable Financial Industry Regulatory Authority ("FINRA") rules with respect to customer account statements. This valuation was performed in accordance with the methodology provided in Practice Guideline 2013-01, Valuations of Publicly Registered Non-Listed REITs, issued by the Investment Program Association ("IPA") in April 2013 ("IPA Valuation Guidelines"), in addition to guidance from the SEC.
The estimated value per share was determined after consultation with our Advisor and Robert A. Stanger & Co, Inc. ("Stanger"), an independent third-party valuation firm not affiliated with our Advisor. Stanger was selected by our nominating and corporate governance committee to appraise the properties in our portfolio as of June 30, 2016. Stanger is actively engaged
in the business of appraising commercial real estate properties similar to those owned by us in connection with public securities offerings, private placements, business combinations, and similar transactions. Stanger collected reasonably available material information that it deemed relevant in appraising our real estate properties and relied in part on property-level information provided by our Advisor, including (i) property historical and projected operating revenues and expenses; (ii) property lease agreements and/or lease abstracts; and (iii) information regarding recent or planned capital expenditures. In determining an estimated value per share, our board of directors considered the reports provided by Stanger and information provided by our Advisor. Our goal in calculating an estimated value per share is to arrive at a value that is reasonable and supportable using what our board of directors deems to be appropriate valuation methodologies and assumptions.
Upon the board of director’s receipt and review of the reports, the recommendation of the nominating and corporate governance committee, and the recommendation of our Advisor, the board of directors approved $10.44 as the estimated value of our common stock as of June 30, 2016, which determinations are ultimately and solely the responsibility of the board of directors.
In conducting their investigation and analyses, Stanger took into account customary and accepted financial and commercial procedures and considerations as they deemed relevant; made numerous other assumptions as of various points in time with respect to industry performance, general business, economic, and regulatory conditions, and other matters, many of which are beyond their control and our control; and made assumptions with respect to certain factual matters. Furthermore, Stanger's analyses, opinions, and conclusions were necessarily based upon market, economic, financial, and other circumstances and conditions existing as of or prior to June 30, 2016, and any material change in such circumstances and conditions may affect Stanger's analyses and conclusions. Stanger's report contains other assumptions, qualifications, and limitations that qualify the analyses, opinions, and conclusions set forth therein.
Further, the value of our shares will fluctuate over time in response to developments related to individual assets in our portfolio and the management of those assets and in response to the real estate and finance markets. The estimated value per share does not reflect a discount for the fact that we are externally managed, nor does it reflect a real estate portfolio premium/discount versus the sum of the individual property values. The estimated value per share also does not take into account estimated disposition costs and fees for real estate properties that are not held for sale. As a result, our estimated value per share may not reflect the precise amount that might be paid to stockholders for their shares in a market transaction.
For additional information on the methodology used in calculating our estimated value per share, please refer to our Current Report on Form 8-K filed with the SEC on October 27, 2016.
Distributions
We elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended, for the year ended December 31, 2010, and for each year thereafter. To qualify as a REIT, we must meet certain organizational and operational requirements, and continue to adhere to these requirements for each subsequent year. As a REIT, we generally will not be subject to federal income tax on taxable income that we distribute to our stockholders. However, we may be subject to certain state and local taxes on our income and property, and federal income and excise taxes on our undistributed taxable income, if any. If we fail to qualify as a REIT in any taxable year, we will be subject to federal income taxes on our taxable income at regular corporate rates and will not be permitted to qualify for treatment as a REIT for federal income tax purposes for four years following the year during which qualification is lost unless the IRS grants us relief under certain statutory provisions. Such an event could materially adversely affect our net income and net cash available for distribution to stockholders. As of December 31, 2016, we satisfied the REIT requirements and distributed all of our taxable income.
Distributions to stockholders are characterized for federal income tax purposes as ordinary income, capital gains, non-taxable return of capital or a combination of the three. Distributions that exceed our current and accumulated earnings and profits (calculated for tax purposes) constitute a return of capital for tax purposes rather than a distribution and reduce the stockholders’ basis in our common shares. To the extent that a distribution exceeds both current and accumulated earnings and profits and the stockholders’ basis in the common shares, it will generally be treated as a capital gain. We will annually notify stockholders of the taxability of distributions paid during the preceding year. (See Note 9, Equity, for tax status of distributions per unit.)
Distributions for a given month are paid on or around the first day of the month following the month of distribution and are paid from operating cash flow generated from our properties or offering proceeds raised in future public offerings (if any). The following table shows the distributions we have declared and paid during each quarter in the years ended December 31, 2016 and 2015 (in thousands, except per share amounts):
(1)
Declared distributions are paid monthly in arrears.
(2)
Distributions declared per common share amounts are rounded to the nearest $0.01.
Securities Authorized for Issuance under Equity Compensation Plans
On February 12, 2009, our board of directors adopted our Employee and Director Long-Term Incentive Plan (the “Plan”) in order to (1) provide incentives to individuals who are granted awards because of their ability to improve our operations and increase profits; (2) encourage selected persons to accept or continue employment with us or with our Advisor or its affiliates that we deem important to our long-term success; and (3) increase the interest of our independent directors in our success through their participation in the growth in value of our stock. Pursuant to the Plan, we may issue stock-based awards to our directors and full-time employees (should we ever have employees), executive officers and full-time employees of our Advisor and its affiliates that provide services to us and who do not have any beneficial ownership of our Advisor and its affiliates, entities and full-time employees of entities that provide services to us, and certain consultants to us, our Advisor and its affiliates that provide services to us.
The term of the Plan is 10 years and the total number of shares of common stock reserved for issuance under the Plan is 10% of the outstanding shares of stock at any time, not to exceed 10,000,000 shares in the aggregate. Awards granted under the Plan may consist of stock options, restricted stock, stock appreciation rights and other equity-based awards. The stock-based payment will be measured at fair value and recognized as compensation expense over the vesting period. As of December 31, 2016, awards totaling 16,000 shares of restricted stock have been granted to our independent board members under the Plan.
Upon our reorganization, merger or consolidation with one or more corporations as a result of which we are not the surviving corporation, or upon sale of all or substantially all of our assets, that, in each case, is not an equity restructuring, appropriate adjustments as to the number and kind of shares and exercise prices will be made either by our compensation committee or by such surviving entity. Such adjustment may provide for the substitution of such awards with new awards of the successor entity or the assumption of such awards by such successor entity. Alternatively, rather than providing for the adjustment, substitution or assumption of awards, the compensation committee may either (1) shorten the period during which awards are exercisable, or (2) cancel an award upon payment to the participant of an amount in cash that the compensation committee determines is equivalent to the amount of the fair market value of the consideration that the participant would have received if the participant exercised the award immediately prior to the effective time of the transaction.
In the event that the compensation committee determines that any distribution, recapitalization, stock split, reorganization, merger, liquidation, dissolution or sale, transfer, exchange or other disposition of all or substantially all of our assets, or other similar corporate transaction or event, affects the stock such that an adjustment is appropriate in order to prevent dilution or enlargement of the benefits or potential benefits intended to be made available under the Plan or with respect to an award, then the compensation committee shall, in such manner as it may deem equitable, adjust the number and kind of shares or the exercise price with respect to any award.
The following table provides information about the common stock that may be issued under the Plan as of December 31, 2016:
(1)
The total number of shares of our common stock (or common stock equivalents) reserved for issuance under the Plan is equal to 10% of our outstanding shares of stock at any time, but not to exceed 10,000,000 shares in the aggregate. As of December 31, 2016, we had 176,032,871 outstanding shares of common stock, including shares issued pursuant to the distribution reinvestment plan, therefore the Plan was limited to the issuance of 10,000,000 shares.
Recent Sales of Unregistered Securities
During the fourth quarter of 2016, there were no sales of unregistered securities.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
Share Redemption Program
On February 20, 2009, our board of directors adopted a share redemption program, which enables our stockholders to have their shares redeemed by us, subject to certain significant conditions and limitations. Our share redemption program has no set termination date, but our ability to redeem shares under the program is limited.
On October 10, 2016, our board of directors amended our SRP to (i) revise the redemption price per share for shares purchased under the SRP, (ii) revise the redemption price per share in the event of death or qualifying disability, and (iii) make certain other clarifying changes regarding disability related redemptions. Pursuant to the amendment to the SRP, the redemption price per share shall be the lesser of (i) the amount paid for the shares or (ii) 95% of the NAV of the shares. The redemption price in connection with the death or qualifying disability of a stockholder shall be the greater of (i) the amount paid for the shares or (ii) 95% of the NAV of shares. The amendments to the SRP were effective as of November 14, 2016.
As of December 31, 2016 and 2015, $162.4 million and $110.2 million in shares of common stock, respectively, had been issued under the DRP, pursuant to the Private Offering, the Public Offerings, and the DRP Offerings, of which $11.6 million and $6.3 million in redemptions, respectively, were reclassified from redeemable common stock to accrued expenses and other liabilities in the consolidated balance sheets. During the year ended December 31, 2016, we redeemed 4,164,955 shares of common stock for approximately $41.4 million at a weighted average price per share of $9.95. Since inception and through December 31, 2016, we had redeemed 5,918,655 shares of common stock for approximately $58.8 million at a weighted average price per share of $9.93 pursuant to the SRP. As of December 31, 2016, there were 1,155,532 shares totaling $11.6 million subject to redemption requests. Our board of directors may choose to amend, suspend or terminate our share redemption program upon 30 days’ written notice at any time.
During the quarter ended December 31, 2016, we redeemed shares as follows:
(1)
A description of the maximum number of shares that may be purchased under our share redemption program is included in Note 9, Equity, to the consolidated financial statements.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial and operating information should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the financial statements and related notes thereto included elsewhere in this annual report on Form 10-K (in thousands, except per share data):
(1)
Amounts were reclassified to include the One Century property as held and used. (See note 3, Real Estate, for additional detail).
(2)
Effective December 31, 2015, the Company adopted new guidance on the presentation of debt issuance costs. This guidance was adopted retrospectively and all prior periods have been adjusted to reflect this change in accounting principle. (See note 2, Basis of Presentation and Summary of Significant Accounting Policies, for additional detail).
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following “Management’s Discussion and Analysis of Financial Condition and Result of Operations” should be read in conjunction with the financial statements and the notes thereto contained in this report.
Overview
We are a public, non-traded REIT that invests primarily in business essential properties significantly occupied by a single tenant, diversified by corporate credit, physical geography, product type and lease duration.
On August 28, 2008, our Advisor purchased 100 shares of common stock for $1,000 and became our initial stockholder. From 2009 to 2014, we offered shares of common stock, pursuant to a private placement offering to accredited investors (the "Private Offering") and two public offerings, consisting of an initial public offering and a follow-on offering (together, the "Public Offerings"), which also included shares for sale pursuant to the distribution reinvestment plan ("DRP"). We issued 181,951,526 total shares of our common stock for gross proceeds of approximately $1.4 billion, pursuant to the Private Offering and Public Offerings.
As of December 31, 2016, our real estate portfolio consisted of 75 properties in 20 states consisting substantially of office, warehouse, and manufacturing facilities and two land parcels held for future development with a combined acquisition value of approximately $3.0 billion, including the allocation of the purchase price to above and below-market lease valuation. Our annualized net rent for the 12-month period subsequent to December 31, 2016 was approximately $227.8 million with approximately 69.9% generated by properties leased to tenants and/or guarantors or whose non-guarantor parent companies have investment grade or equivalent ratings. Our portfolio, based on square footage, is approximately 97.5% leased as of December 31, 2016, with a weighted average remaining lease term of 7.1 years, average annual rent increases of approximately 2.0%, and a leverage ratio (which we define as debt to total asset value) of approximately 49.5%.
Acquisition Indebtedness
For a discussion of our acquisition indebtedness, see Note 3, Real Estate, and Note 5, Debt, to the consolidated financial statements.
Significant Accounting Policies and Estimates
We have established accounting policies which conform to generally accepted accounting principles (“GAAP”) as contained in the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (the “Codification” or "ASC"). The preparation of our consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. If our judgment or interpretation of the facts and circumstances relating to the various transactions had been different, it is possible that different estimates would have been applied, thus resulting in a different presentation of the financial statements. Additionally, other companies may use different estimates and assumptions that may impact the comparability of our financial condition and results of operations to those companies.
The following critical accounting policies discussion reflects what we believe are the most significant estimates, assumptions, and judgments used in the preparation of our consolidated financial statements. This discussion of our critical accounting policies is intended to supplement the description of our accounting policies in the footnotes to our consolidated financial statements and to provide additional insight into the information used by management when evaluating significant estimates, assumptions, and judgments. For further discussion on our significant accounting policies, see Note 2, Basis of Presentation and Summary of Significant Accounting Policies, to our consolidated financial statements included in this report.
Real Estate - Valuation and Purchase Price Allocation
When we acquire operating properties, we allocate the purchase price to the various components of the acquisition based upon the fair value of each component. The components typically include land, building and improvements, tenant improvements, intangible assets related to above and below market leases, intangible assets related to in-place leases, debt and other assumed assets and liabilities. Because of the timing or complexity of completing certain fair value adjustments, the initial purchase price allocation may be incomplete at the end of a reporting period, in which case we may record provisional purchase price allocation amounts based on information available at the acquisition date. Subsequent adjustments to provisional amounts are recognized during the measurement period, which cannot exceed one year from the date of acquisition.
We allocate the purchase price to the fair value of the tangible assets of a property by valuing the property as if it were vacant. This “as-if vacant” value is estimated using an income, or discounted cash flow, approach that relies upon Level 3 inputs, which are unobservable inputs based on our assumptions about the assumptions a market participant would use. These Level 3 inputs include discount rates, capitalization rates, market rents and comparable sales data for similar properties. Estimates of future cash flows are based on a number of factors including historical operating results, known and anticipated trends, and market and economic conditions.
In determining the fair value of intangible lease assets or liabilities, we also consider Level 3 inputs. Acquired above- and below-market leases are valued based on the present value of the difference between prevailing market rates and the in-place rates measured over a period equal to the remaining term of the lease for above-market leases and the initial term plus the term of any below-market fixed rate renewal options for below-market leases, if applicable. The estimated fair value of acquired in-place at-market tenant leases are the costs that would have been incurred to lease the property to the occupancy level of the property at the date of acquisition. Such estimates include the value associated with leasing commissions, legal and other costs, as well as the estimated period necessary to lease such property that would be incurred to lease the property to its occupancy level at the time of its acquisition. Acquisition costs associated with the business combination are expensed in the period they are incurred.
The difference between the fair value and the face value of debt assumed in connection with an acquisition is recorded as a premium or discount and amortized to “interest expense” over the life of the debt assumed. The valuation of assumed liabilities is based on our estimate of the current market rates for similar liabilities in effect at the acquisition date.
For acquisitions that do not meet the accounting criteria to be accounted for as a business combination, we allocate the cost of the acquisition, which includes any associated acquisition costs, to the individual assets (typically land and building) and liabilities assumed on a relative fair value basis.
Impairment of Real Estate and Related Intangible Assets and Liabilities
We continually monitor events and changes in circumstances that could indicate that the carrying amounts of real estate and related intangible assets may not be recoverable. When indicators of potential impairment are present that indicate that the carrying amounts of real estate and related intangible assets may not be recoverable, management will assess the recoverability of the assets by determining whether the carrying value of the assets will be recovered through the undiscounted future operating cash flows expected from the use of the assets and the eventual disposition. If based on this analysis we do not believe that we will be able to recover the carrying value of the asset, we will record an impairment loss to the extent the carrying value exceeds the estimated fair value of the asset.
Projections of expected future undiscounted cash flows require management to estimate future market rental income amounts subsequent to the expiration of current lease agreements, property operating expenses, discount rates, the number of months it takes to re-lease the property and the number of years the property is held for investment. As of December 31, 2016, we did not record any impairment charges related to our real estate assets or intangible assets.
Revenue Recognition
Leases associated with the acquisition and contribution of certain real estate assets have net minimum rent payment increases during the term of the lease and are recorded to rental revenue on a straight-line basis, commencing as of the contribution or acquisition date. If a lease provides for contingent rental income, we will defer the recognition of contingent rental income, such as percentage rents, until the specific target that triggers the contingent rental income is achieved.
Tenant reimbursement revenue, which is comprised of additional amounts collected from tenants for the recovery of certain operating expenses, including repair and maintenance, property taxes and insurance, and capital expenditures, to the extent allowed pursuant to the lease (collectively "Recoverable Expenses"), is recognized as revenue when the additional rent is due. Recoverable Expenses to be reimbursed by a tenant are determined based on our estimate of the property's operating expenses for the year, pro rated based on leased square footage of the property, and are collected in equal installments as additional rent from the tenant, pursuant to the terms of the lease. At the end of the calendar year, we reconcile the amount of additional rent paid by the tenant during the year to the actual amount of Recoverable Expenses incurred by us for the same period. The difference, if any, is either charged or credited to the tenant pursuant to the provisions of the lease. In certain instances, the lease may restrict the amount we can recover from the tenant such as a cap on certain or all property operating expenses.
Recently Issued Accounting Pronouncements
See Note 2, Basis of Presentation and Summary of Significant Accounting Policies, to the consolidated financial statements.
Results of Operations
We are not aware of any material trends or uncertainties, other than national economic conditions affecting real estate in general, that may reasonably be expected to have a material impact, favorable or unfavorable, on revenues or income from the acquisition, management, and operations of properties other than those listed in Part I, Item 1A. Risk Factors, of this Annual Report on Form 10-K.
Same Store Analysis
As of December 31, 2016, our "Same Store" portfolio consisted of 53 properties, encompassing approximately 11.6 million square feet, with an acquisition value of $1.8 billion and annual net rent of $144.0 million (for the 12-month period subsequent to December 31, 2016). The following table provides a comparative summary of the results of operations for the 53 properties for the years ended December 31, 2016 and 2015 (dollars in thousands):
Rental Income
The decrease in rental income is primarily due to three early terminations, which contributed to the acceleration of deferred rent and other intangibles of approximately $4.6 million and termination fees, in the prior year, of approximately $8.5 million.
Property Expense Recoveries
The increase in property expense recoveries is primarily the result of higher property tax recoveries due to reassessments and an increase in estimated expense recoveries.
Property Tax Expense
The increase in property tax expense of $2.6 million compared to the same period a year ago is primarily the result of reassessments and higher tax liability estimates.
As of December 31, 2015, our "Same Store" portfolio consisted of 38 properties, encompassing approximately 7.5 million square feet, with an acquisition value of $1.1 billion and annual net rent of $91.5 million (for the 12-month period subsequent to December 31, 2015). The following table provides a comparative summary of the results of operations for the 38 properties for the years ended December 31, 2015 and 2014 (dollars in thousands):
Rental Income
The increase in rental income is primarily due to (1) $0.5 million in additional rent related to a lease commencement at the One Century Place property in the prior period, for which there was a full year of rent recognized in the current period; (2) $1.2 million in additional rent related to a lease commencement on January 1, 2015 at the Northpointe Corporate Center II property; and (3) a $1.9 million net adjustment to straight-line rent and accelerated amortization of the in-place lease intangible at the Wells Fargo property (acquired in 2013), which resulted from the early lease termination effective December 31, 2015. For comparability purposes, the rental income for the year ended December 31, 2015 does not include the $9.0 million termination fee related to the Wells Fargo property, which is included in rental income on the consolidated statements of operations.
Property Expense Recoveries
The decrease in property expense recoveries is primarily due to (1) a $0.4 million decrease in expense recoveries for the Nokia property, which became self-managed in August 2014; and (2) a $1.5 million decrease in the current year expense recoveries as a result of the 2015 common area maintenance ("CAM") reconciliations primarily related to decreases in operating and tax expenses; offset by (3) a $1.2 million increase in property tax recoveries related to the Community Insurance, Travelers, and other properties.
Property Operating Expense
The decrease in property operating expense is primarily due to (1) $0.6 million related to the Nokia and Community Insurance properties, which became self-managed in August 2014 and December 2014, respectively; and (2) $0.7 million related to the Schlumberger, IBM, and One Century Place properties, primarily for utilities and repairs and maintenance.
Property Tax Expense
The decrease in property tax expense is primarily due to (1) a $1.1 million decrease in property taxes due to a successful 2014 tax appeal in September 2015 for the Nokia property and an additional payment made during the year ended December 31, 2014 as a result of a prior year reassessment for the JPMorgan Chase property; offset by (2) a $0.6 million increase related to property reassessments for the Northrop Grumman, Schlumberger, CHRISTUS Health, and United HealthCare properties.
Portfolio Analysis
As of December 31, 2015, we owned 74 properties, and as of December 31, 2016, we owned 75 properties. As of December 31, 2016, we have completed the offering stage of our life cycle, and may continue to deploy capital raised in our Public Offerings, along with draws from our Unsecured Credit Facility (July 2015), to acquire assets that adhere to our investment criteria. Therefore, our results of operations for our entire portfolio for the year ended December 31, 2016 are not directly comparable to those for the same period in the prior year as the variances are substantially the result of portfolio growth, specifically in rental income, operating expenses, acquisition fees and reimbursable expenses, and depreciation and amortization expenses. See Same Store analysis above for properties held for the same period of time.
Comparison of the Years Ended December 31, 2016 and 2015
The following table provides summary information about our results of operations for the years ended December 31, 2016 and 2015 (dollars in thousands):
Rental Income
Rental income for the year ended December 31, 2016 is comprised of base rent and adjustments to straight-line contractual rent, offset by in-place lease valuation amortization. Rental income for the year ended December 31, 2016 increased by $33.7 million compared to the same period in the prior year primarily as a result of (1) rental income related to real estate acquired and five leases commencing subsequent to January 1, 2015 of approximately $50.0 million and $2.2 million, respectively; offset by (2) three early lease terminations, in the prior year, that contributed to the acceleration of deferred rent and other intangibles and recognition of termination fees of approximately $4.6 million and $8.5 million, respectively; and (3) $5.6 million of decreased rental income due to the sale of two properties in the prior year.
Property Expense Recoveries
Also included as a component of revenue is the recovery of property operating expenses, including repairs and maintenance, property taxes and insurance, and certain capital expenses (collectively "Recoverable Expenses"), which increased by $16.6 million compared to the same period in the prior year primarily as a result of (1) approximately $14.7 million in property expense recoveries for properties acquired subsequent to January 1, 2015; and (2) $3.0 million in higher expected recoveries estimates for the current year; offset by (3) $0.7 million of property expense recoveries due to the sale of two properties in the prior period.
Management Fees (Asset and Property)
Asset management and property management fees include fees paid to affiliates to manage and monitor the performance of our investments. The total increase of approximately $6.3 million is primarily a result of $6.6 million related to properties acquired subsequent to January 1, 2015; offset by $0.7 million of decreased fees due to the sale of two properties in the prior year.
Property Operating Expense
Property operating expenses for the years ended December 31, 2016 and 2015 totaled $47.0 million and $37.9 million, respectively. Property operating expenses include insurance, repairs and maintenance, security, janitorial, landscaping, and other administrative expenses incurred to operate our properties. The total increase of $9.1 million compared to the same period a year ago is primarily a result of (1) $9.0 million in additional property operating expenses related to properties acquired subsequent to January 1, 2015; and (2) an increase of approximately $0.6 million related to increased occupancy, security and repair and maintenance at three properties acquired prior to 2015; offset by (3) $0.4 million related to the sale of two properties during 2015.
Property Tax Expense
Property tax expenses for the years ended December 31, 2016 and 2015 totaled $45.8 million and $34.7 million, respectively. The total increase of approximately $11.1 million compared to the same period a year ago is primarily a result of (1) $9.5 million in additional property tax expense related to properties acquired subsequent to January 1, 2015; (2) an increase
in property tax expenses of approximately $2.5 million for properties acquired prior to 2015 due to an increase in tax estimates; offset by (3) $1.0 million decrease related to the two properties sold in the prior year.
Acquisition Fees and Expenses
Real estate acquisition fees and expenses to non-affiliates and affiliates decreased by $33.2 million for the year ended December 31, 2016 compared to the same period a year ago due to decreased acquisition activity in the current period.
Depreciation and Amortization Expense
Depreciation and amortization expense for the year ended December 31, 2016 consisted of depreciation of building and building improvements of our properties of $56.7 million and amortization of the contributed and acquired values allocated to tenant origination and absorption costs of $74.1 million. The increase of $18.1 million as compared to the year ended December 31, 2015 is primarily the result of additional depreciation and amortization of (1) $25.6 million related to properties acquired subsequent to January 1, 2015; (2) $2.1 million related to a property reclassified as held and used during the current period, which required a catch up adjustment of depreciation and amortization expense and additional tenant improvements placed in service in the current year; offset by (3) $8.1 million of accelerated amortization related to lease terminations and a lease expiration; and (4) $2.6 million of depreciation and amortization related to two properties sold in the prior year.
Interest Expense
Interest expense for the year ended December 31, 2016 increased by $15.4 million compared to the same period in the prior year primarily due to the following: (1) $3.7 million in additional interest expense related to mortgages assumed for properties acquired subsequent to January 1, 2015; (2) $10.5 million increase in interest expense related to our unsecured credit agreement, which had a higher average outstanding balance and higher interest rate during the year ended December 31, 2016; (3) $5.1 million in interest expense related to our interest rate swaps, which became effective subsequent to June 30, 2015; (4) $0.9 million decrease in capitalized interest due to our development project being placed in service in August 2015; offset by (5) $2.7 million of interest expense not incurred in the current period as a result of multiple mortgage loan payoffs and the sale of one property in the prior period; and (6) $1.1 million decrease of deferred financing costs due to write-offs of unamortized deferred financing costs as a result of the unsecured credit facility restructuring on July 20, 2015.
Comparison of the Years Ended December 31, 2015 and 2014
The following table provides summary information about our results of operations for the years ended December 31, 2015 and 2014 (dollars in thousands):
Rental Income
Rental income for the year ended December 31, 2015 is comprised of base rent of $217.6 million, adjustments to straight-line contractual rent of $13.8 million, and in-place lease valuation amortization, net, of approximately $3.8 million. Rental income for the year ended December 31, 2015 increased by $70.7 million compared to the same period in the prior year primarily as a result of (1) $49.3 million of additional rental income related to the real estate acquired in the current period and a development project with WRRH Patterson, LLC, which was placed into service on August 15, 2015; (2) $18.7 million of additional rental income related to the real estate acquired during the year ended December 31, 2014, which includes a full year
of rental income for 2015; (3) a net increase of $1.9 million in termination income related to lease terminations at the SoftBank and Wells Fargo (acquired in 2013) properties effective August 31, 2015 and December 31, 2015, respectively, partially offset by the World Kitchen, LLC lease termination in the prior period; and (4) a $1.9 million net adjustment to straight-line rent and accelerated amortization of the in-place lease intangible at the Wells Fargo property, which resulted from the early lease termination; less (5) $3.4 million of decreased rental income due to the sale of the Eagle Rock and College Park properties on December 17, 2014 and February 20, 2015, respectively.
Property Expense Recoveries
Also included as a component of revenue is the recovery of property operating expenses, including repairs and maintenance, property taxes and insurance, and certain capital expenses (collectively "Recoverable Expenses"), which increased by $17.0 million compared to the same period in the prior year primarily as a result of (1) $14.1 million of additional expense recovery revenue related to properties acquired in the current period, net of the related common area maintenance adjustments; and (2) $3.0 million of additional expense recovery revenue related to the real estate acquired during the year ended December 31, 2014, which includes a full period of recoverable expenses for the year ended December 31, 2015, net of the related CAM adjustments.
Management Fees (Asset and Property)
Asset management and property management fees for the years ended December 31, 2015 and 2014 totaled $27.0 and $18.0 million, respectively. The total increase of $9.0 million compared to the same period a year ago is primarily the result of (1) approximately $4.5 million and $1.7 million in asset management and property management fees, respectively, related to the acquisitions made during the current year; and (2) approximately $2.5 million and $0.5 million in asset management and property management fees, respectively, related to the acquisitions made during the year ended December 31, 2014.
Property Operating Expense
Property operating expenses for the years ended December 31, 2015 and 2014 totaled $37.9 million and $30.6 million, respectively. Property operating expenses include insurance, repairs and maintenance, security, janitorial, landscaping, and other administrative expenses incurred to operate our properties. The total increase of $7.3 million compared to the same period a year ago is primarily a result of (1) $9.5 million in additional property operating expenses related to properties acquired during the current year; and (2) $1.2 million in additional property operating expenses related to properties acquired during the year ended December 31, 2014; offset by (3) a $3.4 million decrease in property operating expenses primarily related to the Eagle Rock and College Park properties, which were sold on December 17, 2014 and February 20, 2015, respectively, and certain properties which became self-managed in the prior year.
Property Tax Expense
Property tax expenses for the years ended December 31, 2015 and 2014 totaled $34.7 million and $24.9 million, respectively. The total increase of approximately $9.8 million compared to the same period a year ago is primarily a result of (1) $7.1 million in additional property tax expenses related to properties acquired during the current year; and (2) $3.7 million in additional property tax expenses related to properties acquired during the year ended December 31, 2014; offset by (3) a $0.7 decrease in property tax expenses related to the Eagle Rock and College Park properties, which were sold on December 17, 2014 and February 20, 2015, respectively; and (4) a $0.5 million decrease in property tax expenses for the Nokia property as a result of a successful 2014 tax appeal settled in September 2015.
Acquisition Fees and Expenses
Real estate acquisition fees and expenses to non-affiliates, which totaled $2.7 million for the year ended December 31, 2015, decreased by $1.5 million compared to the prior year due to decreased acquisition activity of individual properties in the current period. Acquisition fees and expenses to affiliates, which are based on the purchase price of each acquisition, increased by $7.9 million as a result of an increase in total purchase price of approximately $280.1 million compared to the prior year.
General and Administrative Expenses
General and administrative expenses for the year ended December 31, 2015 increased by $2.6 million compared to the same period a year ago due to increased operating activity. General and administrative expenses represent costs unrelated to property operations or transaction costs. These expenses primarily include corporate office expenses related to being a public company, including transfer agent fees, certain audit fees, regulatory fees, legal costs, and other professional fees. The $2.6 million increase is primarily due to the following: (1) an increase of $1.2 million in professional fees primarily for valuation services by third party providers and proxy campaign management services; (2) an increase of $0.7 million in allocated expenses for additional personnel and rent costs incurred by our Advisor, which is due in part to the growth in our portfolio; and (3) an increase of $0.6 million in transfer agent fees and insurance expense primarily due to increased fees related to the SOR Merger.
Depreciation and Amortization Expense
Depreciation and amortization expense for the year ended December 31, 2015 consisted of depreciation of building and building improvements of our properties of $43.3 million and amortization of the contributed and acquired values allocated to tenant origination and absorption costs of $69.4 million. The increase of $39.8 million as compared to the year ended December 31, 2014 is primarily the result of additional depreciation and amortization of (1) $24.4 million related to the acquisitions made during the year ended December 31, 2015; (2) $7.9 million related to the acquisitions made during the year ended December 31, 2014, which includes a full year of depreciation and amortization compared to partial months of activity during the year ended December 31, 2014; and (3) $12.7 million in additional amortization of absorption costs as a result of the early lease terminations at the SoftBank and Wells Fargo (acquired in 2013) properties, which were effective August 31, 2015 and December 31, 2015, respectively; less (4) $5.9 million in amortization of absorption costs primarily related to the lease termination at the Will Partners property, the sale of the Eagle Rock and College Park properties, which were sold on December 17, 2014 and February 20, 2015, respectively, and the expiration of certain leases at the Roush and One Century Place properties.
Interest Expense
Interest expense for the year ended December 31, 2015 increased by $8.8 million compared to the same period in 2014 primarily due to the following: (1) an $8.4 million increase in interest expense related to the Unsecured Credit Facility (May 2014) and the Unsecured Credit Facility (July 2015) as a result of borrowings utilized for the GE Aviation, Westgate III, DreamWorks, DynCorp, Mercedes-Benz, and Samsonite property acquisitions, preferred equity redemption, payoff of SOR debt on the merger date, and mortgage receivable entered into in the current year; (2) $3.1 million in interest expense related to the interest rate swaps entered into on July 9, 2015; and (3) an approximately $1.2 million increase in mortgage interest expense related to the AIG loan, TW Telecom loan, Ace Hardware mortgage loan, and the four mortgage loans assumed in the current year; offset by decreases of (4) $2.1 million in interest expense related to the KeyBank credit facility and the KeyBank term loan, which were terminated in conjunction with the execution of the Unsecured Credit Facility (May 2014) on May 8, 2014; (5) $0.8 million of capitalized interest related to the Restoration Hardware real estate development, which was substantially complete as of August 15, 2015; (6) $0.6 million of unused commitment fees; and (7) $0.3 million in amortization of deferred financing costs.
Funds from Operations and Modified Funds from Operations
Our management believes that historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values have historically risen or fallen with market conditions, many industry investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient. Additionally, publicly registered, non-listed REITs typically have a significant amount of acquisition activity and are substantially more dynamic during their initial years of investment and operation. While other start-up entities may also experience significant acquisition activity during their initial years, we believe that non-listed REITs are unique in that they have a limited life with targeted exit strategies within a relatively limited time frame after the acquisition activity ceases. Our board of directors is in the process of determining whether it is appropriate for us to achieve a liquidity event (i.e., listing of our shares of common stock on a national securities exchange, a merger or sale, the sale of all or substantially all of our assets, or another similar transaction). We do not intend to continuously purchase assets and intend to have a limited life. The decision whether to engage in any liquidity event is in the sole discretion of our board of directors.
In order to provide a more complete understanding of the operating performance of a REIT, the National Association of Real Estate Investment Trusts (“NAREIT”) promulgated a measure known as funds from operations (“FFO”). FFO is defined as net income or loss computed in accordance with GAAP, excluding extraordinary items, as defined by GAAP, and gains and losses from sales of depreciable operating property, adding back asset impairment write-downs, plus real estate related depreciation and amortization (excluding amortization of deferred financing costs and depreciation of non-real estate assets), and after adjustment for unconsolidated partnerships, joint ventures and preferred distributions. Because FFO calculations exclude such items as depreciation and amortization of real estate assets and gains and losses from sales of operating real estate assets (which can vary among owners of identical assets in similar conditions based on historical cost accounting and useful-life estimates), they facilitate comparisons of operating performance between periods and between other REITs. As a result, we believe that the use of FFO, together with the required GAAP presentations, provides a more complete understanding of our performance relative to our competitors and a more informed and appropriate basis on which to make decisions involving operating, financing, and investing activities. It should be noted, however, that other REITs may not define FFO in accordance with the current NAREIT definition or may interpret the current NAREIT definition differently than we do, making comparisons less meaningful.
The Investment Program Association (“IPA”) issued Practice Guideline 2010-01 (the “IPA MFFO Guideline”) on November 2, 2010, which extended financial measures to include modified funds from operations (“MFFO”). In computing MFFO, FFO is adjusted for certain non-operating cash items such as acquisition fees and expenses and certain non-cash items such as straight-line rent, amortization of in-place lease valuations, amortization of discounts and premiums on debt investments, nonrecurring impairments of real estate-related investments, mark-to-market adjustments included in net income (loss), and nonrecurring gains or losses included in net income (loss) from the extinguishment or sale of debt, hedges, foreign exchange, derivatives or securities holdings where trading of such holdings is not a fundamental attribute of the business plan, unrealized gains or losses resulting from consolidation from, or deconsolidation to, equity accounting, and after adjustments for consolidated and unconsolidated partnerships and joint ventures, with such adjustments calculated to reflect MFFO on the same basis.
Management is responsible for managing interest rate, hedge and foreign exchange risk. To achieve our objectives, we may borrow at fixed rates or variable rates. In order to mitigate our interest rate risk on certain financial instruments, if any, we may enter into interest rate cap agreements or other hedge instruments and in order to mitigate our risk to foreign currency exposure, if any, we may enter into foreign currency hedges. We view fair value adjustments of derivatives, impairment charges and gains and losses from dispositions of assets as non-recurring items or items which are unrealized and may not ultimately be realized, and which are not reflective of on-going operations and are therefore typically adjusted for when assessing operating performance.
Additionally, we believe it is appropriate to disregard impairment charges, as this is a fair value adjustment that is largely based on market fluctuations, assessments regarding general market conditions, and the specific performance of properties owned, which can change over time. No less frequently than annually, we evaluate events and changes in circumstances that could indicate that the carrying amounts of real estate and related intangible assets may not be recoverable. When indicators of potential impairment are present, we assess whether the carrying value of the assets will be recovered through the future undiscounted operating cash flows (including net rental and lease revenues, net proceeds on the sale of the property, and any other ancillary cash flows at a property or group level under GAAP) expected from the use of the assets and the eventual disposition. Investors should note, however, that determinations of whether impairment charges have been incurred are based partly on anticipated operating performance, because estimated undiscounted future cash flows from a property, including estimated future net rental and lease revenues, net proceeds on the sale of the property, and certain other ancillary cash flows, are taken into account in determining whether an impairment charge has been incurred. While impairment charges are excluded from the calculation of MFFO as described above, investors are cautioned that due to the fact that impairments are based on estimated future undiscounted cash flows and the relatively limited term of our operations, it could be difficult to recover any impairment charges through operational net revenues or cash flows prior to any liquidity event.
We adopted the IPA MFFO Guideline as management believes that MFFO is a beneficial indicator of our on-going portfolio performance and ability to sustain our current distribution level. More specifically, MFFO isolates the financial results of the REIT’s operations. MFFO, however, is not considered an appropriate measure of historical earnings as it excludes certain significant costs that are otherwise included in reported earnings. Further, since the measure is based on historical financial information, MFFO for the period presented may not be indicative of future results or our future ability to pay our dividends. By providing FFO and MFFO, we present information that assists investors in aligning their analysis with management’s analysis of long-term operating activities. MFFO also allows for a comparison of the performance of our portfolio with other REITs that are not currently engaging in acquisitions, as well as a comparison of our performance with that of other non-traded REITs, as MFFO, or an equivalent measure, is routinely reported by non-traded REITs, and we believe often used by analysts and investors for comparison purposes. As explained below, management’s evaluation of our operating performance excludes items considered in the calculation of MFFO based on the following economic considerations:
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Straight-line rent. Most of our leases provide for periodic minimum rent payment increases throughout the term of the lease. In accordance with GAAP, these periodic minimum rent payment increases during the term of a lease are recorded to rental revenue on a straight-line basis in order to reconcile the difference between accrual and cash basis accounting. As straight-line rent is a GAAP non-cash adjustment and is included in historical earnings, FFO is adjusted for the effect of straight-line rent to arrive at MFFO as a means of determining operating results of our portfolio.
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Amortization of in-place lease valuation. Acquired in-place leases are valued as above-market or below-market as of the date of acquisition based on the present value of the difference between (a) the contractual amounts to be paid pursuant to the in-place leases and (b) management's estimate of fair market lease rates for the corresponding in-place leases over a period equal to the remaining non-cancelable term of the lease for above-market leases. The above-market and below-market lease values are capitalized as intangible lease assets or liabilities and amortized as an adjustment to rental income over the remaining terms of the respective leases. As this item is a non-cash adjustment and is included in historical
earnings, FFO is adjusted for the effect of the amortization of in-place lease valuation to arrive at MFFO as a means of determining operating results of our portfolio.
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Acquisition-related costs. We were organized primarily with the purpose of acquiring or investing in income-producing real property in order to generate operational income and cash flow that will allow us to provide regular cash distributions to our stockholders. In the process, we incur non-reimbursable affiliated and non-affiliated acquisition-related costs, which in accordance with GAAP, are expensed as incurred and are included in the determination of income (loss) from operations and net income (loss). These costs have been and will continue to be funded with cash proceeds from our Public Offerings or included as a component of the amount borrowed to acquire such real estate. If we acquire a property after all offering proceeds from our Public Offerings have been invested, there will not be any offering proceeds to pay the corresponding acquisition-related costs. Accordingly, unless our Advisor determines to waive the payment of any then-outstanding acquisition-related costs otherwise payable to our Advisor, such costs will be paid from additional debt, operational earnings or cash flow, net proceeds from the sale of properties, or ancillary cash flows. In evaluating the performance of our portfolio over time, management employs business models and analyses that differentiate the costs to acquire investments from the investments’ revenues and expenses. Acquisition-related costs may negatively affect our operating results, cash flows from operating activities and cash available to fund distributions during periods in which properties are acquired, as the proceeds to fund these costs would otherwise be invested in other real estate related assets. By excluding acquisition-related costs, MFFO may not provide an accurate indicator of our operating performance during periods in which acquisitions are made. However, it can provide an indication of our on-going ability to generate cash flow from operations and continue as a going concern after we cease to acquire properties on a frequent and regular basis, which can be compared to the MFFO of other non-listed REITs that have completed their acquisition activity and have similar operating characteristics to ours. Management believes that excluding these costs from MFFO provides investors with supplemental performance information that is consistent with the performance models and analysis used by management.
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Financed termination fee. We believe that a fee received from a tenant for terminating a lease is appropriately included as a component of rental revenue and therefore included in MFFO. If, however, the termination fee is to be paid over time, we believe the recognition of such termination fee into income should not be included in MFFO. Alternatively, we believe that the periodic amount paid by the tenant in subsequent periods to satisfy the termination fee obligation should be included in MFFO.
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Gain or loss from the extinguishment of debt. We use debt as a partial source of capital to acquire properties in our portfolio. As a term of obtaining this debt, we will pay financing costs to the respective lender. Financing costs are presented on the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts and amortized into interest expense on a straight-line basis over the term of the debt. We consider the amortization expense to be a component of operations if the debt was used to acquire properties. From time to time, we may cancel certain debt obligations and replace these canceled debt obligations with new debt at more favorable terms to us. In doing so, we are required to write off the remaining capitalized financing costs associated with the canceled debt, which we consider to be a cost, or loss, on extinguishing such debt. Management believes that this loss is considered an event not associated with our operations, and therefore, deems this write off to be an exclusion from MFFO.
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Preferred units redemption premium. Preferred units were issued as a partial source of capital to acquire properties. As a term of the purchase agreement, we paid issuance costs to the investor that were capitalized as a component of equity on the consolidated balance sheets. Further, the purchase agreement allows us to exercise our right to redeem the outstanding preferred units, and, in doing so, we will be obligated to pay a redemption fee. In conjunction with the redemption, GAAP requires us to write off the issuance costs on a proportional basis of the redeemed preferred units to the total amount of preferred units issued. The write off of the issuance costs would be reflected on the statement of operations as a loss due to preferred unit redemptions. Management believes the loss, similar to the extinguishment of debt, is considered an isolated event not associated with our continuing operations, and therefore, deems it an exclusion from MFFO.
For all of these reasons, we believe the non-GAAP measures of FFO and MFFO, in addition to income (loss) from operations, net income (loss) and cash flows from operating activities, as defined by GAAP, are helpful supplemental performance measures and useful to investors in evaluating the performance of our real estate portfolio. However, a material limitation associated with FFO and MFFO is that they are not indicative of our cash available to fund distributions since other uses of cash, such as capital expenditures at our properties and principal payments of debt, are not deducted when calculating FFO and MFFO. Additionally, MFFO has limitations as a performance measure in an offering such as ours where the price of a share of common stock is a stated value. The use of MFFO as a measure of long-term operating performance on value is also limited if we do not continue to operate under our current business plan as noted above. MFFO is useful in assisting management and investors in assessing our on-going ability to generate cash flow from operations and continue as a going concern now that our Public Offerings have been completed and our portfolio is in place. Further, we believe MFFO is useful in comparing the sustainability of our operating performance now that our Public Offerings have been completed and we expect
our acquisition activity over the near term to be less vigorous, with the sustainability of the operating performance of other real estate companies that are not as involved in acquisition activities.
However, MFFO is not a useful measure in evaluating NAV because impairments are taken into account in determining NAV but not in determining MFFO. Therefore, FFO and MFFO should not be viewed as more prominent measures of performance than income (loss) from operations, net income (loss) or to cash flows from operating activities and each should be reviewed in connection with GAAP measurements.
Neither the SEC, NAREIT, nor any other applicable regulatory body has opined on the acceptability of the adjustments contemplated to adjust FFO in order to calculate MFFO and its use as a non-GAAP performance measure. In the future, the SEC or NAREIT may decide to standardize the allowable exclusions across the REIT industry, and we may have to adjust the calculation and characterization of this non-GAAP measure.
Our calculation of FFO and MFFO is presented in the following table for the years ended December 31, 2016, 2015 and 2014 (in thousands):
Liquidity and Capital Resources
Long-Term Liquidity and Capital Resources
On a long-term basis, our principal demands for funds will be for the payment of operating and capital expenses, including costs associated with re-leasing a property, distributions, and for the payment of debt service on our outstanding indebtedness, including repayment of the Unsecured Credit Facility (July 2015) (as defined below) and property secured mortgage loans. Generally, cash needs for items, other than property acquisitions, will be met from operations and the 2015 DRP Offering. Our Advisor will evaluate potential additional property acquisitions and engage in negotiations with sellers on our behalf. After a purchase contract is executed that contains specific terms, the property will not be purchased until the successful completion of due diligence, which includes review of the title insurance commitment, an appraisal and an environmental analysis. In some instances, the proposed acquisition will require the negotiation of final binding agreements, which may include financing documents. During this period, we may decide to repay debt as allowed under the loan agreements or temporarily invest in certain investments that could yield lower returns than the properties. These lower returns may affect our ability to make distributions.
Unsecured Credit Facility (July 2015)
On July 20, 2015, we, through our Operating Partnership, entered into a credit agreement (the "Unsecured Credit Agreement (July 2015)") with a syndicate of lenders, co-led by KeyBank, Bank of America, Fifth Third Bank ("Fifth Third"), and BMO Harris Bank, N.A. ("BMO Harris"), under which KeyBank serves as administrative agent and Bank of America, Fifth Third, and BMO Harris serve as co-syndication agents, and KeyBanc Capital Markets ("KeyBank Capital markets"), Merrill Lynch, Pierce, Fenner & Smith Incorporated ("Merrill Lynch"), Fifth Third, and BMO Capital Markets serve as joint bookrunners and joint lead arrangers. Pursuant to the Unsecured Credit Agreement (July 2015), we were provided with a $1.14 billion senior unsecured credit facility (the "Unsecured Credit Facility (July 2015)"), consisting of a $500.0 million senior unsecured revolver (the "Revolver Loan (July 2015)") and a $640.0 million senior unsecured term loan (the "Term Loan (July 2015)"). The Unsecured Credit Facility (July 2015) may be increased up to $860.0 million, in minimum increments of $50.0 million, for a maximum of $2.0 billion by increasing either the Revolver Loan (July 2015), the Term Loan (July 2015), or both. The Revolver Loan (July 2015) has an initial term of four years, maturing on July 20, 2019, and may be extended for a one-year period if certain conditions are met and upon payment of an extension fee. The Term Loan (July 2015) has a term of five years, maturing on July 20, 2020.
The Unsecured Credit Facility (July 2015) has an interest rate calculated based on LIBOR plus the applicable LIBOR margin or Base Rate plus the applicable Base Rate margin, both as provided in the Unsecured Credit Agreement (July 2015). The applicable LIBOR margin and Base Rate margin are dependent on whether the interest rate is calculated prior to or after we have received an investment grade senior unsecured credit rating of BBB-/Baa3 from Standard & Poors, Moody's, or Fitch, and we have elected to utilize the investment grade pricing list, as provided in the Unsecured Credit Agreement (July 2015). Otherwise, the applicable LIBOR margin will be based on a leverage ratio computed in accordance with our quarterly compliance package and communicated to KeyBank. The Base Rate is calculated as the greater of (i) the KeyBank Prime rate or (ii) the Federal Funds rate plus 0.50%. Payments under the Unsecured Credit Facility (July 2015) are interest only and are due on the first day of each quarter.
On March 29, 2016, we exercised our right to increase the total commitments, pursuant to the Unsecured Credit Agreement (July 2015). As a result, the total commitments on the Term Loan (July 2015) increased from $640.0 million to $715.0 million.
Derivative Instruments
As discussed in Note 6, Interest Rate Contracts, to the consolidated financial statements, on July 9, 2015, we executed three interest rate swap agreements to hedge the variable cash flows associated with certain existing or forecasted LIBO Rate-based variable-rate debt, including our Unsecured Credit Facility (July 2015). Three interest rate swaps are effective for the periods from July 9, 2015 to July 1, 2020, January 1, 2016 to July 1, 2018, and July 1, 2016 to July 1, 2018, and have notional amounts of $425.0 million, $300.0 million, and $100.0 million, respectively.
On March 24, 2016, we executed an interest rate swap agreement to hedge interest risk related to a future fixed-rate debt issuance. The forward-starting interest rate swap with a notional amount of $200.0 million became effective May 2016 and has a term of 10 years with a mandatory settlement date on November 30, 2016. On November 9, 2016, we paid approximately $1.3 million to settle the forward-starting interest rate swap, which is included in our comprehensive income/(loss) statement for the year ended December 31, 2016.
The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive loss ("AOCL") and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During 2016, such derivatives were used to hedge the variable cash flows associated with existing variable-rate debt and forecasted issuances of debt. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings.
The following table sets forth a summary of the interest rate swaps as of December 31, 2016 and 2015 :
Other Potential Future Sources of Capital
Other potential future sources of capital include proceeds from potential private or public offerings of our stock or limited partnership units of our Operating Partnership, proceeds from secured or unsecured financings from banks or other lenders, including debt assumed in a real estate acquisition transaction, proceeds from the sale of properties and undistributed funds from operations. If necessary, we may use financings or other sources of capital in the event of unforeseen significant capital expenditures. To the extent we are not able to secure additional financing in the form of a credit facility or other third party source of liquidity, we will be heavily dependent upon our current financing, our 2015 DRP Offering and our income from operations.
Contractual Commitments and Contingencies
The following is a summary of our contractual obligations as of December 31, 2016 (in thousands):
(1)
Amounts only include principal payments. The payments on our mortgage debt do not include the premium/discount or debt financing costs.
(2)
Projected interest payments are based on the outstanding principal amounts at December 31, 2016. Projected interest payments on the Revolver Loan (July 2015) and Term Loan (July 2015) are based on the contractual interest rate in effect at December 31, 2016.
(3)
The interest rate swaps contractual commitment was calculated based on the swap rate less the LIBOR.
(4)
Amount includes payment of the balance of the Plainfield and Ace Hardware property mortgage loans, both of which mature in 2017.
(5)
Amount includes payment of the balance of the TW Telecom loan, which matures in 2019.
(6)
Amount includes payment of the Term Loan (July 2015), which matures in 2020, and the Revolver Loan (July 2015), which matures in 2020, assuming the one-year extension is exercised.
(7)
Amount includes payment of the balances of:
•the Midland, Emporia Partners, Samsonite, and HealthSpring property mortgage loans, all of which mature in 2023,
•the Highway 94 property mortgage loan, which matures in 2024, and
•the AIG loan, which matures in 2029.
Short-Term Liquidity and Capital Resources
We expect to meet our short-term operating liquidity requirements with remaining proceeds raised in our 2015 DRP Offering, operating cash flows generated from our properties, and draws from our credit facility. All advances from our Advisor will be repaid, without interest, as funds are available after meeting our current liquidity requirements, subject to the limitations on reimbursement.
Our cash and cash equivalent balances increased by approximately $21.5 million during the year ended December 31, 2016 and were primarily used in or provided by the following:
Operating Activities. Cash flows provided by operating activities are primarily dependent on the occupancy level, the rental rates of our leases, the collectability of rent and recovery of operating expenses from our tenants, and the timing of acquisitions. During the year ended December 31, 2016, we generated $144.2 million compared to $92.5 million for the year ended December 31, 2015. Net cash provided by operating activities before changes in operating assets and liabilities for the year ended December 31, 2016 increased by approximately $49.7 million to approximately $146.4 million compared to $96.7 million during the same period in 2015. The increase is primarily related to the acquisition of 22 properties subsequent to January 1, 2015, partially offset by the sale of 3 non-strategic properties over the same period.
Investing Activities. During the year ended December 31, 2016, we generated approximately $61.1 million in cash provided by investing activities compared to $414.4 million used in investing activities during the same period in 2015. The $475.5 million increase in cash provided by investing activities is primarily related to the following:
•$393.5 million decrease in cash used for property acquisitions and deposits;
•$84.0 million related to proceeds that were held by a third party intermediary from the sale of four properties upon the completion of the tax-deferred real estate exchange, as permitted by Section 1031 of the Internal Revenue Code;
•$50.0 million repayment of a mortgage loan receivable from an affiliated party;
•$45.3 million decrease in payments for construction-in-progress and tenant improvements, mainly related to the Restoration Hardware project in the prior period;
offset by
•$90.3 million decrease in proceeds related to the sale of three properties during the prior period for which there were none during the year ended December 31, 2016; and
•$8.6 million in cash assumed through the Signature Office REIT, Inc. merger in the prior year.
Financing Activities. During the year ended December 31, 2016, we used approximately $183.8 million of cash in financing activities compared to approximately $274.9 million in cash provided by financing activities during the same period in 2015. The decrease in cash provided by financing activities of $458.8 million is primarily comprised of the following:
•$139.3 million increase in principal repayments on the Revolver Loan (July 2015);
•$490.1 million decrease in proceeds from borrowings on the prior year unsecured revolver;
•$991.6 million decrease in proceeds from borrowings under the Unsecured Credit Agreement (July 2015);
•$18.1 million increase in payments made to purchase the noncontrolling interest related to the Restoration Hardware project;
•$27.6 million increase in repurchases of common stock;
•$4.5 million increase in principal payoff of mortgage debt;
•$18.0 million increase in distribution payments to common stockholders and noncontrolling interests due to an increase in shares issued;
offset by
•$254.5 million decrease for the preferred units repurchased;
•$790.1 million decrease in principal repayments related to the prior year unsecured credit facility;
•$173.0 million decrease in principal payoff of secured indebtedness of the Signature Office REIT Inc. credit facility; and
•$10.9 million decrease in distributions paid on preferred units as a result of the full redemption in the prior year.
Distributions and Our Distribution Policy
Distributions will be paid to our stockholders as of the record date selected by our board of directors. We expect to continue to pay distributions monthly based on daily declaration and record dates. We expect to pay distributions regularly unless our results of operations, our general financial condition, general economic conditions, or other factors inhibit us from doing so. Distributions will be authorized at the discretion of our board of directors, which will be directed, in substantial part,
by its obligation to cause us to comply with the REIT requirements under the Internal Revenue Code. The funds we receive from operations that are available for distribution may be affected by a number of factors, including the following:
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our operating and interest expenses;
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the amount of distributions or dividends received by us from our indirect real estate investments;
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our ability to keep our properties occupied;
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our ability to maintain or increase rental rates;
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tenant improvements, capital expenditures, and reserves for such expenditures;
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the issuance of additional shares; and
•
debt maturity, financings, and refinancings.
Distributions may be funded with operating cash flow from our properties, offering proceeds raised in future public offerings (if any), or a combination thereof. From inception and through December 31, 2016, we funded 91% of our cash distributions from cash flows provided by operating activities and 9% from offering proceeds. To the extent that we do not have taxable income, distributions paid will be considered a return of capital to stockholders. The following table shows distributions declared, distributions paid, and cash flow provided by operating activities during the years ended December 31, 2016 and 2015:
(1)
Distributions are paid on a monthly basis in arrears. Distributions for all record dates of a given month are paid on or about the first business day of the following month. Total distributions declared but not paid as of December 31, 2016 were $6.4 million for common stockholders and noncontrolling interests.
(2)
Percentages were calculated by dividing the respective source amount by the total sources of distributions.
(3)
Allocation of total sources are calculated on a quarterly basis.
For the year ended December 31, 2016, we paid and declared distributions of approximately $121.8 million to common stockholders including shares issued pursuant to the DRP, and approximately $4.5 million to the limited partners of our Operating Partnership, as compared to FFO, adjusted for noncontrolling interest distributions, and MFFO to common stockholders for the year ended December 31, 2016 of $159.5 million and $149.9 million, respectively. The payment of distributions from sources other than FFO or MFFO may reduce the amount of proceeds available for investment and operations or cause us to incur additional interest expense as a result of borrowed funds.
Off-Balance Sheet Arrangements
As of December 31, 2016, we had no off-balance sheet transactions, nor do we currently have any such arrangements or obligations.
Subsequent Events
See Note 14, Subsequent Events, to the consolidated financial statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risks include risks that arise from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market-sensitive instruments. We expect that the primary market risk to which we will be exposed is interest rate risk, including the risk of changes in the underlying rates on our variable rate debt.
In order to modify and manage the interest rate characteristics of our outstanding debt and to limit the effects of interest rate risks on our operations, we may utilize a variety of financial instruments, including interest rate swap agreements, caps, floors, and other interest rate exchange contracts. The use of these types of instruments to hedge a portion of our exposure to changes in interest rates carries additional risks, such as counterparty credit risk and the legal enforceability of hedging contracts.
Our future earnings and fair values relating to financial instruments are primarily dependent upon prevalent market rates of interest, such as LIBO Rate. However, our interest rate swap agreements are intended to reduce the effects of interest rate changes. The effect of a 1% increase in interest rates, assuming a LIBO Rate floor of 0%, on our variable-rate debt, including
our unsecured credit facility and our mortgage loan, after considering the effect of our interest rate swap agreements would decrease our future earnings and cash flows by approximately $4.1 million annually.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary data filed as part of this annual report are set forth beginning on page of this report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As of the end of the period covered by this report, management, with the participation of our principal executive and principal financial officers, including our chief executive officer and chief financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures. Based upon, and as of the date of, the evaluation, our chief executive officer and chief financial officer concluded that the disclosure controls and procedures were effective as of the end of the period covered by this report to ensure that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported as and when required. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports we file and submit under the Exchange Act is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for us. Our management, including our chief executive officer and chief financial officer, evaluated, as of December 31, 2016, the effectiveness of our internal control over financial reporting using the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 1992. Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2016.
There have been no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
(a)
During the quarter ended December 31, 2016, there was no information required to be disclosed in a report on Form 8-K which was not disclosed in a report on Form 8-K.
(b)
During the quarter ended December 31, 2016, there were no material changes to the procedures by which security holders may recommend nominees to our board of directors.
PART III
We expect to file a definitive proxy statement for our 2017 Annual Meeting of Stockholders (the “2017 Proxy Statement”) with the SEC, pursuant to Regulation 14A, not later than 120 days after the end of our fiscal year. Accordingly, certain information required by Part III has been omitted under General Instruction G(3) to Form 10-K and is incorporated by reference to the 2017 Proxy Statement. Only those sections of the 2017 Proxy Statement that specifically address the items required to be set forth herein are incorporated by reference.
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this Item is incorporated by reference to the 2017 Proxy Statement to be filed with the SEC.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference to the 2017 Proxy Statement to be filed with the SEC.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this Item is incorporated by reference to the 2017 Proxy Statement to be filed with the SEC.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
The information required by this Item is incorporated by reference to the 2017 Proxy Statement to be filed with the SEC.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by this Item is incorporated by reference to the 2017 Proxy Statement to be filed with the SEC.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) List of Documents Filed.
1. The list of the financial statements contained herein is set forth on page hereof.
2. Schedule III - Real Estate and Accumulated Depreciation is set forth beginning on page S-1 hereof. All other schedules for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are not applicable and therefore have been omitted.
3. The Exhibits filed in response to Item 601 of Regulation S-K are listed on the Exhibit Index below.
(b) See (a) 3 above.
(c) See (a) 2 above.
EXHIBIT INDEX
The following exhibits are included in this Annual Report on Form 10-K for the year ended December 31, 2016 (and are numbered in accordance with Item 601 of Regulation S-K).
ITEM 16. FORM 10-K SUMMARY
None.
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, in the City of El Segundo, State of California, on March 14, 2017.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
By:
/s/ Kevin A. Shields
Kevin A. Shields
Chief Executive Officer and Chairman
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:
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of
Griffin Capital Essential Asset REIT, Inc.:
We have audited the accompanying consolidated balance sheets of Griffin Capital Essential Asset REIT, Inc. (the Company) as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive income (loss), equity, and cash flows for each of the three years in the period ended December 31, 2016. Our audits also included the financial statement schedule listed in the Index at Item 15. 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. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and 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 Griffin Capital Essential Asset REIT, Inc. at December 31, 2016 and 2015, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2016, 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.
As discussed in Note 2 to the consolidated financial statements, the Company changed its presentation of debt issuance costs as a result of the adoption of the amendment to the FASB Accounting Standards Codification resulting from Accounting Standards Update 2015-03 “Interest - Imputation of Interest - Simplifying the Presentation of Debt Issuance Costs” effective January 1, 2016.
/s/ Ernst & Young LLP
Los Angeles, California
March 14, 2017
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
See accompanying notes.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share amounts)
See accompanying notes.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
See accompanying notes.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
CONSOLIDATED STATEMENTS OF EQUITY
(in thousands, except share amounts)
See accompanying notes.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
See accompanying notes.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
1. Organization
Griffin Capital Essential Asset REIT, Inc., a Maryland corporation (the "Company"), was formed on August 28, 2008 under the Maryland General Corporation Law. The Company was organized primarily with the purpose of acquiring single tenant properties that are essential to the tenant’s business and used a substantial amount of the net proceeds from the Public Offerings (as defined below) to invest in these properties. The Company satisfied requisite financial and non-financial requirements and elected to be taxed as a REIT for each taxable year ended since December 31, 2010 and for each year thereafter. The Company’s year end is December 31.
Griffin Capital Company, LLC, a Delaware limited liability company (the "Sponsor"), has sponsored the Company’s Public Offerings. The Company’s Sponsor began operations in 1995, and was incorporated in 1996, to engage principally in acquiring and developing office and industrial properties. Kevin A. Shields, the Company's Chief Executive Officer and Chairman of the Company's board of directors, controls the Sponsor as the trustee of the trust entity that is the sole shareholder of the Sponsor.
Griffin Capital Essential Asset Advisor, LLC, a Delaware limited liability company (the "Advisor"), was formed on August 27, 2008. Griffin Capital Asset Management Company, LLC ("GAMCO," formerly known as Griffin Capital REIT Holdings, LLC) is the sole member of the Advisor, and Griffin Capital, LLC ("GC") is the sole member of GAMCO. The Company has entered into an advisory agreement for the Public Offerings (as amended and restated, the "Advisory Agreement"), which states that the Advisor is responsible for managing the Company’s affairs on a day-to-day basis and identifying and making acquisitions and investments on behalf of the Company. The officers of the Advisor are also officers of the Sponsor. The Advisory Agreement has a one-year term, and it may be renewed for an unlimited number of successive one-year periods by the Company's board of directors.
From 2009 to 2014, the Company offered shares of common stock, pursuant to a private placement offering to accredited investors (the "Private Offering") and two public offerings, consisting of an initial public offering and a follow-on offering (together, the "Public Offerings"), which also included shares for sale pursuant to the distribution reinvestment plan ("DRP"). The Company issued 126,592,885 total shares of its common stock for gross proceeds of approximately $1.3 billion, pursuant to the Private Offering and Public Offerings.
On May 7, 2014, the Company filed a Registration Statement on Form S-3 with the SEC for the registration of $75.0 million in shares for sale pursuant to the DRP (the "2014 DRP Offering"). On September 22, 2015, the Company filed a Registration Statement on Form S-3 with the SEC for the registration of $100.0 million in shares for sale pursuant to the DRP (the "2015 DRP Offering" and together with the 2014 DRP Offering, the "DRP Offerings") and terminated the 2014 DRP Offering. The 2015 DRP Offering may be terminated at any time upon 10 days’ prior written notice to stockholders.
As of December 31, 2016, the Company had issued 181,951,526 shares of common stock and received aggregate gross offering proceeds of approximately $1.4 billion from the sale of shares in the Private Offering, the Public Offerings, and the DRP Offerings. There were 176,032,871 shares outstanding at December 31, 2016, including shares issued pursuant to the DRP, less shares redeemed pursuant to the share redemption program. As of December 31, 2016 and 2015, the Company had issued approximately $162.4 million and $110.2 million, respectively, in shares pursuant to the DRP, which are classified on the consolidated balance sheets as common stock subject to redemption, net of redemptions paid of approximately $58.8 million and $17.3 million, respectively, and redemptions payable totaling approximately $11.6 million and $6.3 million, respectively, which are included in accrued expenses and other liabilities on the consolidated balance sheets. (See Note 9, Equity, for a discussion on the amendment of the Company's share redemption program.) Since inception and through December 31, 2016, the Company had redeemed 5,918,655 shares of common stock for approximately $58.8 million pursuant to the share redemption program.
Griffin Capital Securities, LLC (formerly known as Griffin Capital Securities, Inc., the "Dealer Manager") is an affiliate of the Sponsor, and is a wholly-owned subsidiary of GC. The Dealer Manager was responsible for marketing the Company’s shares offered during the Public Offerings. The dealer manager agreement was terminated in accordance with its terms upon the termination of the Follow-On Offering.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
Griffin Capital Essential Asset Operating Partnership, L.P., a Delaware limited partnership (the "Operating Partnership"), was formed on August 29, 2008. The Operating Partnership owns, directly or indirectly, all of the properties that the Company has acquired. The Advisor purchased an initial 99% limited partnership interest in the Operating Partnership for $200,000, and the Company contributed the initial $1,000 capital contribution, received from the Advisor, to the Operating Partnership in exchange for a 1% general partner interest. As of December 31, 2016, the Company owned approximately 96% of the limited partnership units of the Operating Partnership, and, as a result of the contribution of five properties to the Company, the Sponsor and certain of its affiliates, including the Company’s Chief Executive Officer and Chairman, Kevin A. Shields, and certain officers of the Company, owned approximately 2% of the limited partnership units of the Operating Partnership. The remaining approximately 2% of the limited partnership units were owned by third parties. No limited partnership units of the Operating Partnership have been redeemed during the years ended December 31, 2016 and 2015. The Operating Partnership may conduct certain activities through the Company’s taxable REIT subsidiary, Griffin Capital Essential Asset TRS, Inc., a Delaware corporation (the "TRS") formed on September 2, 2008, which is a wholly-owned subsidiary of the Operating Partnership. The TRS had no activity as of December 31, 2016.
The Company’s property manager is Griffin Capital Essential Asset Property Management, LLC, a Delaware limited liability company (the “Property Manager”), which was formed on August 28, 2008 to manage the Company’s properties. The Property Manager derives substantially all of its income from the property management services it performs for the Company.
2. Basis of Presentation and Summary of Significant Accounting Policies
The accompanying consolidated financial statements of the Company are prepared by management on the accrual basis of accounting and in accordance with principles generally accepted in the United States (“GAAP”) as contained in the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (the “Codification” or “ASC”), and in conjunction with rules and regulations of the SEC. The consolidated financial statements include accounts and related adjustments, which are, in the opinion of management, of a normal recurring nature and necessary for a fair presentation of the Company's financial position, results of operations and cash flows for the years ended December 31, 2016 and 2015. The consolidated financial statements include accounts of the Company, the Operating Partnership, and the TRS. All significant intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of the consolidated financial statements, in conformity with GAAP, requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could materially differ from those estimates.
Principles of Consolidation
The Company's financial statements, and the financial statements of the Company's operating partnership, including its wholly-owned subsidiaries, are consolidated in the accompanying consolidated financial statements. The portion of these entities not wholly-owned by the Company is presented as noncontrolling interests. All significant intercompany accounts and transactions have been eliminated in consolidation.
Consolidation Considerations
Current accounting guidance provides a framework for identifying a variable interest entity (“VIE”) and determining when a company should include the assets, liabilities, noncontrolling interests, and results of activities of a VIE in its consolidated financial statements. In general, a VIE is an entity or other legal structure used to conduct activities or hold assets that either (1) has an insufficient amount of equity to carry out its principal activities without additional subordinated financial support, (2) has a group of equity owners that are unable to make significant decisions about its activities, or (3) has a group of equity owners that do not have the obligation to absorb losses or the right to receive returns generated by its operations. Generally, a VIE should be consolidated if a party with an ownership, contractual, or other financial interest in the VIE (a variable interest holder) has the power to direct the VIE’s most significant activities and the obligation to absorb losses or right to receive benefits of the VIE that could be significant to the VIE. A variable interest holder that consolidates the VIE is called the primary beneficiary. Upon consolidation, the primary beneficiary generally must initially record all of the VIE’s assets,
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
liabilities, and noncontrolling interest at fair value and subsequently account for the VIE as if it were consolidated based on majority voting interest. See Note 4, Investments.
Cash and Cash Equivalents
The Company considers all short-term, highly liquid investments that are readily convertible to cash with a maturity of three months or less at the time of purchase to be cash equivalents. Cash and cash equivalents may include cash and short-term investments. Short-term investments are stated at cost, which approximates fair value. There were no cash equivalents, nor were there restrictions on the use of the Company’s cash balance as of December 31, 2016 and 2015.
The Company maintains its cash accounts with major financial institutions. The cash balances consist of business checking accounts. These accounts are insured by the Federal Deposit Insurance Corporation up to $250,000 at each institution. The Company has not experienced any losses with respect to cash balances in excess of government provided insurance. Management believes there was no significant concentration of credit risk with respect to these cash balances at December 31, 2016.
Change in Consolidated Financial Statements Presentation
Certain amounts in the Company's prior period consolidated financial statements have been reclassified to conform to the current period presentation. Corporate operating expenses to affiliates are presented separately from general and administrative expenses on the statement of operations for all periods presented. The Company decided to discontinue marketing the One Century Place property located in Nashville, Tennessee for sale. The One Century Place property, which was previously classified as held for sale and carried at the lower of its (i) carrying amount or (ii) fair value less costs to sell, was reclassified as held and used. As a result, assets and liabilities are presented as held and used on the consolidated balance sheets for all periods presented. See Note 3, Real Estate.
Real Estate Purchase Price Allocation
The Company applies the provisions in ASC 805-10, Business Combinations, to account for the acquisition of real estate, or real estate related assets, in which a lease, or other contract, is in place representing an active revenue stream, as a business combination. In accordance with the provisions of ASC 805-10, the Company recognizes the assets acquired, the liabilities assumed and any noncontrolling interest in the acquired entity at their fair values as of the acquisition date, on an “as if vacant” basis. Further, the Company recognizes the fair value of assets acquired, liabilities assumed and any noncontrolling interest in acquisitions of less than a 100% interest when the acquisition constitutes a change in control of the acquired entity. The accounting provisions have also established that acquisition-related costs and restructuring costs are considered separate and not a component of a business combination and, therefore, are expensed as incurred. For properties acquired in a sale-leaseback transaction or part of a development project, acquisition fees and acquisition expenses are included as part of the acquisition price.
Acquired in-place leases are valued as above-market or below-market as of the date of acquisition. The valuation is measured based on the present value (using an interest rate, which reflects the risks associated with the leases acquired) of the difference between (a) the contractual amounts to be paid pursuant to the in-place leases and (b) management’s estimate of fair market lease rates for the corresponding in-place leases over a period equal to the remaining non-cancelable term of the lease for above-market leases, taking into consideration below-market extension options for below-market leases. In addition, renewal options are considered and will be included in the valuation of in-place leases if (1) it is likely that the tenant will exercise the option, and (2) the renewal rent is considered to be sufficiently below a fair market rental rate at the time of renewal. The above-market and below-market lease values are capitalized as intangible lease assets or liabilities and amortized as an adjustment to rental income over the remaining terms of the respective leases.
The aggregate fair value of in-place leases includes direct costs associated with obtaining a new tenant, opportunity costs associated with lost rentals, which are avoided by acquiring an in-place lease, and tenant relationships. Direct costs associated with obtaining a new tenant include commissions, tenant improvements, and other direct costs and are estimated using methods similar to those used in independent appraisals and management’s consideration of current market costs to execute a similar lease. These direct costs are considered intangible lease assets and are included with real estate assets on the consolidated balance sheets. The intangible lease assets are amortized to expense over the remaining terms of the respective leases. The
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
value of opportunity costs is calculated using the contractual amounts to be paid, including real estate taxes, insurance, and other operating expenses, pursuant to the in-place leases over a market lease-up period for a similar lease. Customer relationships are valued based on management’s evaluation of certain characteristics of each tenant’s lease and the Company’s overall relationship with that respective tenant. Characteristics management will consider in allocating these values include the nature and extent of the Company’s existing business relationships with tenants, growth prospects for developing new business with the tenant, the tenant’s credit quality and expectations of lease renewals (including those existing under the terms of the lease agreement), among other factors. These intangibles will be included in intangible lease assets on the consolidated balance sheets and are amortized to expense over the remaining term of the respective leases.
The determination of the fair values of the assets and liabilities acquired requires the use of significant assumptions about current market rental rates, rental growth rates, discount rates and other variables.
Depreciation and Amortization
The purchase price of real estate acquired and costs related to development, construction, and property improvements are capitalized. Repairs and maintenance costs include all costs that do not extend the useful life of the real estate asset and are expensed as incurred. The Company considers the period of future benefit of an asset to determine the appropriate useful life. The Company anticipates the estimated useful lives of its assets by class to be generally as follows:
Buildings
25-40 years
Building Improvements
5-20 years
Land Improvements
15-25 years
Tenant Improvements
Shorter of estimated useful life or remaining contractual lease term
Tenant origination and absorption cost
Remaining contractual lease term
In-place lease valuation
Remaining contractual lease term with consideration as to below-market extension options for below-market leases
Assets Held for Sale
The Company accounts for properties held for sale in accordance with ASC Topic 360, Property, Plant, and Equipment, ("ASC Topic 360"), which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and Accounting Standards Update ("ASU") No. 2014-08, Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity ("ASU No. 2014-08"). Under ASU No. 2014-08, a discontinued operation is (i) a component of an entity or group of components that has been disposed of by sale, that has been disposed of other than by sale, or that is classified as held for sale that represents a strategic shift that has or will have a major effect on an entity's operations and financial results or (ii) an acquired business or nonprofit activity that is classified as held for sale on the date of the acquisition.
In accordance with ASC 205, a component of an entity or a group of components of an entity, or a business or nonprofit activity (the entity to be sold), shall be classified as held for sale in the period in which all of the required criteria are met.
In accordance with ASC Topic 360, upon being classified as held for sale, a property is carried at the lower of (i) its carrying amount or (ii) fair value less costs to sell. In addition, a property being held for sale ceases to be depreciated.
Assets Reclassified from Held for Sale to Held and Used
Upon the Company's determination to discontinue marketing properties for sale, the properties will no longer meet the held for sale criteria and are required to be reclassified as held and used at the lower of adjusted carrying value (carrying value of the properties prior to being classified as held for sale adjusted for any depreciation and/or amortization expense that would have been recognized had the properties been continuously classified as held and used) or its fair value at the date of the subsequent decision not to sell. If adjusted carrying value is determined to be lower, a catch up adjustment will be recorded. The depreciation and/or amortization expenses that would have been recognized had the properties been continuously classified as held and used will be included as a component of depreciation and amortization expense in the accompanying consolidated
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
statements of operations. If fair value is determined to be lower, the Company will record a gain or loss included in income or loss from continuing operations in the accompanying consolidated statements of operations. See Note 3, Real Estate.
Impairment of Real Estate and Related Intangible Assets
The Company continually monitors events and changes in circumstances that could indicate that the carrying amounts of real estate and related intangible assets may not be recoverable, including credit ratings of all tenants to stay abreast of any material changes in credit quality. The Company monitors tenant credit by (1) reviewing the credit ratings of tenants (or their parent companies or lease guarantors) that are rated by nationally recognized rating agencies; (2) reviewing financial statements and related metrics and information that are publicly available or that are required to be provided pursuant to the lease; (3) monitoring news reports and press releases regarding the tenants (or their parent companies or lease guarantors), and their underlying business and industry; and (4) monitoring the timeliness of rent collections.
When indicators of potential impairment are present that indicate that the carrying amounts of real estate and related intangible assets may not be recoverable, management assesses whether the carrying value of the assets will be recovered through the future undiscounted operating cash flows expected from the use of the assets and the eventual disposition. If, based on this analysis, the Company does not believe that it will be able to recover the carrying value of the asset, the Company will record an impairment charge to the extent the carrying value exceeds the net present value of the estimated future cash flows of the asset.
Projections of expected future undiscounted cash flows require management to estimate future market rental income amounts subsequent to the expiration of current lease agreements, property operating expenses, discount rates, the number of months it takes to re-lease the property and the number of years the property is held for investment. As of December 31, 2016 and 2015, the Company did not record any impairment charges related to its real estate assets or intangible assets.
Revenue Recognition
Leases associated with the acquisition and contribution of certain real estate assets (see Note 3, Real Estate), have net minimum rent payment increases during the term of the lease and are recorded to rental revenue on a straight-line basis, commencing as of the contribution or acquisition date. If a lease provides for contingent rental income, the Company will defer the recognition of contingent rental income, such as percentage rents, until the specific target that triggers the contingent rental income is achieved.
Tenant reimbursement revenue, which is comprised of additional amounts collected from tenants for the recovery of certain operating expenses, including repair and maintenance, property taxes and insurance, and capital expenditures, to the extent allowed pursuant to the lease (collectively "Recoverable Expenses"), is recognized as revenue when the additional rent is due. Recoverable Expenses to be reimbursed by a tenant are determined based on the Company's estimate of the property's operating expenses for the year, pro rated based on leased square footage of the property, and are collected in equal installments as additional rent from the tenant, pursuant to the terms of the lease. At the end of the calendar year, the Company reconciles the amount of additional rent paid by the tenant during the year to the actual amount of Recoverable Expenses incurred by the Company for the same period. The difference, if any, is either charged or credited to the tenant pursuant to the provisions of the lease. In certain instances, the lease may restrict the amount the Company can recover from the tenant such as a cap on certain or all property operating expenses. As of December 31, 2016, the Company estimated that approximately $2.4 million, net, was over collected from tenants throughout the year, and as a result, the Company recorded a liability to reflect the net over collections which will be refunded to the tenants either by a credit to contractual rent payments or as a disbursement from operating cash flow.
Derivative Instruments and Hedging Activities
FASB ASC Topic 815: Derivatives and Hedging ("ASC 815"), provides the disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how the entity accounts for derivative instruments and related hedged items, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Further, qualitative disclosures are required that explain the Company’s objectives and strategies for using derivatives, as well
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
as quantitative disclosures about the fair value of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.
As required by ASC 815, the Company recorded all derivatives on the consolidated balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, and whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. The Company may enter into derivative contracts that are intended to economically hedge certain risks, even though hedge accounting does not apply or the Company elects not to apply hedge accounting. See Note 6, Interest Rate Contracts.
Income Taxes
The Company elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”). To qualify as a REIT, the Company must meet certain organizational and operational requirements. The Company intends to adhere to these requirements and maintain its REIT status for the current year and subsequent years. As a REIT, the Company generally will not be subject to federal income taxes on taxable income that is distributed to stockholders. However, the Company may be subject to certain state and local taxes on its income and property, and federal income and excise taxes on its undistributed taxable income, if any. If the Company fails to qualify as a REIT in any taxable year, the Company will then be subject to federal income taxes on the taxable income at regular corporate rates and will not be permitted to qualify for treatment as a REIT for federal income tax purposes for four years following the year during which qualification is lost unless the Internal Revenue Service ("IRS") grants the Company relief under certain statutory provisions. Such an event could materially adversely affect net income and net cash available for distribution to stockholders. As of December 31, 2016, the Company satisfied the REIT requirements and distributed all of its taxable income.
Pursuant to the Code, the Company has elected to treat its corporate subsidiary as a taxable REIT subsidiary (“TRS”). In general, the TRS may perform non-customary services for the Company’s tenants and may engage in any real estate or non real estate-related business. The TRS will be subject to corporate federal and state income tax. As of December 31, 2016, the TRS had not commenced operations.
Per Share Data
The Company reports earnings per share for the period as (1) basic earnings per share computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding during the period, and (2) diluted earnings per share computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding, including common stock equivalents. As of December 31, 2016 and 2015, there were no material common stock equivalents that would have a dilutive effect on earnings (loss) per share for common stockholders.
Segment Information
ASC Topic 280, Segment Reporting, establishes standards for reporting financial and descriptive information about a public entity’s reportable segments. The Company internally evaluates all of the properties and interests therein as one reportable segment.
Unaudited Data
Any references to the number of buildings, square footage, number of leases, occupancy, and any amounts derived from these values in the notes to the consolidated financial statements are unaudited and outside the scope of the Company's
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
independent registered public accounting firm's audit of its consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board.
Recently Issued Accounting Pronouncements
In January 2017, the FASB issued ASU 2017-01, Business Combinations, that clarified the definition of a business. The ASU is effective for reporting periods beginning after December 15, 2017, with early adoption permitted. The Company is currently evaluating the potential impact of the pending adoption of this new guidance on its consolidated financial statements.
In November 2016, the FASB issued ASU 2016-18, Restricted Cash, that will require companies to include restricted cash and restricted cash equivalents with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The ASU will require a disclosure of a reconciliation between the statement of financial position and the statement of cash flows when the statement of financial position includes more than one line item for cash, cash equivalents, restricted cash, and restricted cash equivalents. Entities with material restricted cash and restricted cash equivalents balances will be required to disclose the nature of the restrictions. The ASU is effective for reporting periods beginning after December 15, 2017, with early adoption permitted, and will be applied retrospectively to all periods presented. The Company is currently evaluating the potential impact of the pending adoption of this new guidance on its consolidated financial statements.
In August 2016, the FASB issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments. ASU 2016-15 addresses eight specific cash flow issues with the objective of reducing diversity in practice. The cash flow issues include debt prepayment or debt extinguishment costs and proceeds from the settlement of insurance claims. The ASU is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2017. The Company does not expect the adoption of ASU No. 2016-15 to have a significant impact on its financial statements.
In June 2016, the FASB issued ASU 2016-13, Measurement of Credit Losses on Financial Instruments, that changes the impairment model for most financial instruments by requiring companies to recognize an allowance for expected losses, rather than incurred losses as required currently by the other-than-temporary impairment model. The ASU will apply to most financial assets measured at amortized cost and certain other instruments, including trade and other receivables, loans, held-to-maturity debt securities, net investments in leases, and off-balance-sheet credit exposures (e.g., loan commitments). The ASU is effective for reporting periods beginning after December 15, 2019, with early adoption permitted, and will be applied as a cumulative adjustment to retained earnings as of the effective date. The Company is currently evaluating the potential impact of the pending adoption of this new guidance on its consolidated financial statements.
In February 2016, the FASB issued ASU 2016-02, Leases ("ASU 2016-02"). ASU 2016-02 amends the existing accounting standards for lease accounting, including requiring lessees to recognize most leases on their balance sheets and making targeted changes to lessor accounting. ASU 2016-02 will be effective beginning in the first quarter of 2019. Early adoption of ASU 2016-02 as of its issuance is permitted. The new leases standard requires a modified retrospective transition approach for all leases existing at, or entered into after, the date of initial application, with an option to use certain transition relief. The Company is currently evaluating the impact of adopting the new leases standard on the consolidated financial statements.
In April 2015, the FASB issued ASU No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30) (“ASU 2015-03”) to amend the accounting guidance for the presentation of debt issuance costs. The standard requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. ASU 2015-03 is effective for public business entities for fiscal years beginning after December 15, 2015 and retrospective application is required. The Company has elected to adopt ASU 2015-03, beginning with the quarter ended March 31, 2016. As a result of the adoption of ASU 2015-03, the Company reclassified approximately $13.0 million of net debt issuance costs from an asset (previously recorded in the line item “Deferred financing costs, net” in the consolidated balance sheets) to a reduction in the carrying amount of the Company's debt as of December 31, 2015. ASU 2015-03 also expands disclosure requirements to include the face amount of the debt liability and the effective interest rate in the notes to the consolidated financial statements. See Note 5, Debt.
In February 2015, the FASB issued ASU No. 2015-02, Consolidation: Amendments to the Consolidation Analysis ("ASU No. 2015-02"), which amended the existing accounting standards for consolidation under both the variable interest model and
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
the voting model. Under ASU No. 2015-02, companies will need to re-evaluate whether an entity meets the criteria to be considered a Variable Interest Entity, whether companies still meet the definition of primary beneficiaries, and whether an entity needs to be consolidated under the voting model. ASU No. 2015-02 may be applied using a modified retrospective approach or retrospectively, and is effective for reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company adopted ASU No. 2015-02, beginning with the quarter ended March 31, 2016. There was no change to the Company's consolidated financial statements or notes as a result of adoption.
In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements (Subtopic 205-40), Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU No. 2014-15”). The amendments in ASU No. 2014-15 require management to evaluate, for each annual and interim reporting period, whether there are conditions or events, considered in the aggregate, that raise substantial doubt about an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued (or are available to be issued when applicable) and, if so, provide related disclosures. ASU No. 2014-15 is effective for annual periods ending after December 15, 2016, and interim periods within annual periods beginning after December 15, 2016. Early adoption is permitted for annual or interim reporting periods for which the financial statements have not previously been issued. There was no change to the Company's consolidated financial statements or notes as a result of adoption.
In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU No. 2014-09”). ASU No. 2014-09 replaces substantially all industry-specific revenue recognition requirements and converges areas under this topic with International Financial Reporting Standards. ASU No. 2014-09 implements a five-step process for customer contract revenue recognition that focuses on transfer of control, as opposed to transfer of risk and rewards. ASU No. 2014-09 also requires enhanced disclosures regarding the nature, amount, timing, and uncertainty of revenues and cash flows from contracts with customers. Other major provisions in ASU No. 2014-09 include capitalizing and amortizing certain contract costs, ensuring the time value of money is considered in the applicable transaction price, and allowing estimates of variable consideration to be recognized before contingencies are resolved in certain circumstances. ASU No. 2014-09 was originally effective for reporting periods beginning after December 31, 2016 (for public entities). On April 1, 2015, the FASB voted to defer the effective date of ASU No. 2014-09 by one year, to annual reporting periods beginning after December 15, 2017. On July 9, 2015, the FASB affirmed its proposal to defer the effective date to annual reporting periods beginning after December 15, 2017, although entities may elect to adopt the standard as of the original effective date. The Company is currently evaluating the potential impact of the pending adoption of this new guidance on its consolidated financial statements.
In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net). The amendments clarify how an entity should identify the unit of accounting (i.e., the specified good or service) for the principal versus agent evaluation, and how it should apply the control principle to certain types of arrangements, such as service transactions, by explaining what a principal controls before the specified good or service is transferred to the customer. The effective date and transition requirements for the amendments are the same as the effective date and transition requirements of ASU No. 2014-09. ASU No. 2014-09 was originally effective for reporting periods beginning after December 31, 2016 (for public entities). On April 1, 2015, the FASB voted to defer the effective date of ASU No. 2014-09 by one year, to annual reporting periods beginning after December 15, 2017. On July 9, 2015, the FASB affirmed its proposal to defer the effective date to annual reporting periods beginning after December 15, 2017, although entities may elect to adopt the standard as of the original effective date. The Company is currently evaluating the impact of adopting the standard on the consolidated financial statements.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
3. Real Estate
As of December 31, 2016, the Company’s real estate portfolio consisted of 75 properties in 20 states consisting substantially of office, warehouse, and manufacturing facilities with a combined acquisition value of approximately $3.0 billion, including the allocation of the purchase price to above and below-market lease valuation.
Depreciation expense for buildings and improvements for the years ended December 31, 2016, 2015, and 2014 was $56.7 million, $43.3 million, and $27.7 million, respectively. Amortization expense for intangibles, including but not limited to, tenant origination and absorption costs for the years ended December 31, 2016, 2015, and 2014 was $74.1 million, $69.4 million, and $45.2 million, respectively.
2016 Acquisitions
On March 17, 2016, the Company acquired two land parcels to be held for future development from an unaffiliated party. The aggregate purchase price of the acquisitions was approximately $2.8 million.
On April 27, 2016, the Company, through the Operating Partnership, acquired the remaining 90% beneficial interest of a two-building, single-story office campus located in Nashville, Tennessee (the “HealthSpring property”) for $37.2 million (total purchase price value of $41.3 million). The purchase price and other acquisition items for the land parcels and the property acquired during the year ended December 31, 2016 are shown below (see Note 4, Investments, for additional detail):
(1)
The Company acquired a 10% beneficial interest in April 2013, which is included in the total purchase price at fair value.
(2)
The Advisor is entitled to receive acquisition fees equal to 2.5% and acquisition expense reimbursement of up to 0.5% of the contract purchase price for each acquisition.
The following summarizes the purchase price allocations of the Highway 94 and HealthSpring properties acquired during the years ended December 31, 2016 and 2015, respectively:
(1)
The purchase price allocation of the Highway 94 property was finalized during the three months ended March 31, 2016.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
Pro Forma Financial Information (unaudited)
The following condensed pro forma operating information is presented as if the Company’s properties acquired in 2016 had been included in operations as of January 1, 2015. The pro forma operating information includes certain nonrecurring adjustments, such as acquisition fees and expenses incurred as a result of the assets acquired in the acquisitions:
(1)
Amount is net of net income (loss) attributable to noncontrolling interests and distributions to redeemable noncontrolling interests attributable to common stockholders.
The future minimum contractual rent payments pursuant to the lease terms, with lease expirations ranging from 2017 to 2036, are shown in the table below:
Assets Reclassified from Held for Sale to Held and Used
During September 2016, the Company decided to discontinue marketing the One Century Place property located in Nashville, Tennessee for sale. The One Century Place property, which was previously classified as held for sale, presented on the balance sheet as "Real estate assets and other assets held for sale, net" and carried at the lower of its (i) carrying amount or (ii) fair value less costs to sell was reclassified as held and used, and thus, included in total real estate and total liabilities as of September 30, 2016. In September 2016, the Company recorded a catch up adjustment for depreciation and amortization expense that would have been recognized had the property been continuously classified as held and used. No properties were classified as held for sale as of December 31, 2016.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
Intangibles
The Company allocated a portion of the acquired and contributed real estate asset value to in-place lease valuation and tenant origination and absorption cost, as discussed above and as shown below, net of the write-off of intangibles for the years ended December 31, 2016 and 2015. In-place leases were measured against comparable leasing information and the present value of the difference between the contractual, in-place rent, and the fair market rent was calculated using, as the discount rate, the capitalization rate utilized to compute the value of the real estate at acquisition or contribution.
The intangible assets are amortized over the remaining lease term of each property, which on a weighted-average basis, was approximately 7.1 years and 7.8 years as of December 31, 2016 and 2015, respectively. The amortization of the intangible assets and other leasing costs for the respective periods is as follows:
The following table sets forth the estimated annual amortization (income) expense for in-place lease valuation, net, tenant origination and absorption costs, ground leasehold improvements, and other leasing costs as of December 31, 2016 for the next five years:
Restricted Cash
In conjunction with acquisition of certain assets, as required by certain lease provisions or certain lenders in conjunction with an acquisition or debt financing, or credits received by the seller of certain assets, the Company assumed or funded reserves for specific property improvements and deferred maintenance, re-leasing costs, and taxes and insurance, which are included on the consolidated balance sheets as restricted cash. Additionally, an ongoing replacement reserve is funded by certain tenants
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
pursuant to each tenant’s respective lease as follows:
(1)
Additions represent tenant improvement reserves funded by the tenant and held by the lender. Deductions represent tenant improvement reimbursements made to certain tenants during the current period.
(2)
Represents a deferred maintenance reserve funded by the Company as part of the refinancing that occurred on February 28, 2013, whereby certain properties became collateral for the Midland mortgage loan.
(3)
Additions represent monthly funding of real estate taxes and insurance by the tenants during the current period. Deductions represent reimbursements to the tenant for payment of real estate taxes and insurance premiums made during the current period.
(4)
As part of the terms of the Midland mortgage loan, rent collections from the eight properties which serve as collateral thereunder are received in a designated cash collateral account which is controlled by the lender until the designated payment date, as defined in the loan agreement, and the excess cash is transferred to the operating account.
During January 2016, proceeds of $47.0 million from the sale of the Will Partners and LTI properties were released by the qualified intermediary. The funds were held by the qualified intermediary, as both properties were sold pursuant to a tax-deferred exchange.
4.
Investments
Investments in Unconsolidated Entities
HealthSpring Property
On April 10, 2013, a Delaware Statutory Trust ("DST") affiliated with the Sponsor acquired a two-building, single-story office campus located in Nashville, Tennessee (the "HealthSpring property") for a purchase price of $36.4 million. The DST was then syndicated for $39.6 million which consists of mortgage debt of $23.6 million and an equity contribution of $16.0 million. The HealthSpring property is leased in its entirety pursuant to a tripe-net lease to HealthSpring, Inc. ("HealthSpring"), obligating HealthSpring to all costs and expenses to operate and maintain the property, including certain capital expenditures. On the acquisition date, the remaining term was approximately nine years. On April 12, 2013, the Company, through the Operating Partnership, acquired a 10% beneficial ownership interest in the DST, net of a 10% discount associated with offering expenses. Pursuant to the private placement memorandum, the Operating Partnership was provided exchange rights in which it would be able to acquire the beneficial interests of other investors of the DST at fair value.
On April 27, 2016, the Company, through its Operating Partnership, exercised its exchange right and acquired the remaining 90% beneficial ownership interest in the HealthSpring property. The total purchase price of the property was $41.3 million, including the initial 10% interest of the Company. Approximately 70% of the beneficial owners of HealthSpring interests elected to exchange their interest in the DST for operating partnership units, and the remaining 30% elected to redeem their interest for cash. The issuance of approximately $11.9 million in limited partnership units of the operating partnership is included as a component of noncontrolling interest in the Company's permanent equity. The limited partnership units of the operating partnership were based on the Company's net asset valuation as of September 30, 2015, which was the most recent net asset valuation at the time of acquisition. The remaining balance of approximately $27.5 million consists of a mortgage loan of approximately $22.4 million, which was assumed by the Company in conjunction with the exchange, and a cash payment made to the unaffiliated third party investors of approximately $5.0 million. As a result of the acquisition of the remaining 90% interest, the Company consolidated the HealthSpring property as of the acquisition date and recognized a gain of approximately $0.7 million from the re-measurement of its initial 10% interest.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
In connection with the acquisition of the HealthSpring property, the Company was assigned and assumed a leasehold estate and the rights to a payment in lieu of taxes agreement (the “PILOT Program”) with the municipalities which own the underlying leased fee estate and subsequently leased the ground to the Company. The ground lease arrangements were put in place to provide the property operator with real estate tax abatements, which are facilitated through the issuance of municipal bonds. Payments on the bonds, which are owned by the Company, are funded solely from the payments on the ground leases, of which the Company is the lessee. Since the payments due from the municipality under the bond arrangement equals the rent payments, no payments are exchanged. The bonds can only be transferred to any successor to the Company, or any affiliate, as a lessee under the lease, including but not limited to any purchaser of the Company’s leasehold interest. Upon termination of the lease, the Company has the option to purchase the land for a nominal amount, which is a bargain purchase option. The bonds, ground lease obligations and purchase options were measured at fair value at acquisition in accordance with ASC 805 and, due to their inseparability, are presented as a component of land on the accompanying consolidated balance sheets.
Digital Realty Trust, Inc.
On September 9, 2014, the Company, through a special purpose entity ("SPE"), wholly-owned by the Operating Partnership, acquired an 80% interest in a joint venture with an affiliate of Digital Realty Trust, Inc. for $68.4 million, which was funded with equity proceeds raised in the Company's Public Offering. The gross acquisition value of the property was $187.5 million, plus closing costs, which was partially acquired with debt of $102.0 million. The joint venture was created for purposes of directly or indirectly acquiring, owning, financing, operating and maintaining a data center facility located in Ashburn, Virginia (the "Property"). The Property is approximately 132,300 square feet and consists of certain data processing and communications equipment that is fully leased to a social media company and a financial services company with an average remaining lease term of approximately six years.
The joint venture currently uses an interest rate swap to manage its interest rate risk associated with its variable rate debt. The interest rate swap is designated as an interest rate hedge of its exposure to the volatility associated with interest rates. As a result of the hedge designation and in satisfying the requirement for cash flow hedge accounting, the joint venture records changes in the fair value in accumulated other comprehensive loss. In conjunction with the investment in the joint venture discussed above, the Company recognized its 80% share, or approximately $0.2 million, of other comprehensive income for the year ended December 31, 2016.
The interests discussed above are deemed to be a variable interest in a variable interest entity ("VIE"), and, based on an evaluation of the variable interest against the criteria for consolidation, the Company determined that it is not the primary beneficiary of the investments, as the Company does not have power to direct the activities of the entity that most significantly affect its performance. As such, the interests in the VIEs are recorded using the equity method of accounting in the accompanying consolidated financial statements. Under the equity method, the investments in the unconsolidated entities are stated at cost and adjusted for the Company's share of net earnings or losses and reduced by distributions. Equity in earnings of real estate ventures is generally recognized based on the allocation of cash distributions upon liquidation of the investment at book value in accordance with the operating agreements.
As of December 31, 2016, the balance of the investments are shown below:
Investments in Consolidated Entities
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
Effective June 16, 2014, WRRH Patterson, LLC (an affiliate of Weeks Robinson Properties) and Griffin Capital JVII Patterson, LLC, a wholly-owned SPE of the Operating Partnership, entered into an operating agreement as Managing Member and Investor Member, respectively, for purposes of forming WR Griffin Patterson, LLC ("WR Griffin"). WR Griffin's purpose is to acquire, own, develop, construct, and otherwise invest and manage a development project located in Patterson, California (the "Project") in which a warehouse and distribution facility consisting of approximately 1.5 million square feet was subsequently constructed (the "Restoration Hardware property").
On June 20, 2014, the Company, through WR Griffin, entered into a real estate development agreement with Weeks Robinson Development & Management, LLC ("Weeks Robinson") to develop and construct the Restoration Hardware property. Concurrently, the land on which the property was to be constructed was purchased by WR Griffin for approximately $15.2 million, including closing costs.
The Restoration Hardware property is leased to Restoration Hardware, Inc. and Restoration Hardware Holdings, Inc. as co-tenants (collectively, "Restoration Hardware") pursuant to a 15-year triple-net lease, obligating Restoration Hardware to all costs and expenses to operate and maintain the property, including certain capital expenditures. The lease term commenced upon substantial completion of the project, which occurred on August 15, 2015.
During the construction of the Project, the business and affairs of WR Griffin were managed by the Managing Member. However, all major decisions, as provided in the operating agreement, were approved by both the Managing Member and Investor Member. Additionally, the Managing Member interest, pursuant to the purchase and sale agreement, has been assigned to the Investor Member in exchange for a mandatory redemption fee based on the fair value of the property at completion. The Project was deemed complete during January 2016, at which point the Company paid the $18.1 million mandatory redemption fee to the Managing Member. Upon payment and completion of the Project, the Managing Member transferred all membership interest to the Investor Member, pursuant to the operating agreement. Upon the transfer of the interest, the Managing Member had no further interest in WR Griffin or any of its assets and had no further obligations.
5. Debt
As of December 31, 2016 and 2015, the Company’s debt consisted of the following:
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
(1)
Including the effect of an interest rate swap agreement with a notional amount of $825.0 million, the weighted average interest rate as of December 31, 2016 was 3.2% for the Company's fixed-rate and variable-rate debt combined and approximately 3.5% for the Company's fixed-rate debt only.
(2)
Reflects the effective interest rate as of December 31, 2016 and includes the effect of amortization of discounts/premiums and deferred financing costs.
(3)
The LIBO Rate as of December 31, 2016 was 0.77%.
(4)
The Revolver Loan (July 2015) has an initial term of four years, maturing on July 20, 2019, and may be extended for a one-year period if certain conditions are met and upon payment of an extension fee. See discussion below.
(5)
Loan matures in October 2024. The interest rate of this loan resets on April 1, 2017 to the greater of (i) 8.9% or (ii) 500 basis points plus 10-year swap rate.
Unsecured Credit Facility (July 2015)
On July 20, 2015, the Company, through the Operating Partnership, entered into a credit agreement (the "Unsecured Credit Agreement (July 2015)") with a syndicate of lenders, co-led by KeyBank, Bank of America, Fifth Third Bank ("Fifth Third"), and BMO Harris Bank, N.A. ("BMO Harris"), under which KeyBank serves as administrative agent and Bank of America, Fifth Third, and BMO Harris serve as co-syndication agents, and KeyBanc Capital Markets ("KeyBank Capital markets"), Merrill Lynch, Pierce, Fenner & Smith Incorporated ("Merrill Lynch"), Fifth Third, and BMO Capital Markets serve as joint bookrunners and joint lead arrangers. Pursuant to the Unsecured Credit Agreement (July 2015), the Company was provided with a $1.14 billion senior unsecured credit facility (the "Unsecured Credit Facility (July 2015)"), consisting of a $500.0 million senior unsecured revolver (the "Revolver Loan (July 2015)") and a $640.0 million senior unsecured term loan (the "Term Loan (July 2015)"). The Unsecured Credit Facility (July 2015) may be increased up to $860.0 million, in minimum increments of $50.0 million, for a maximum of $2.0 billion by increasing either the Revolver Loan (July 2015), the Term Loan (July 2015), or both. The Revolver Loan (July 2015) has an initial term of four years, maturing on July 20, 2019, and may be extended for a one year period if certain conditions are met and upon payment of an extension fee. The Term Loan (July 2015) has a term of five years, maturing on July 20, 2020.
The Unsecured Credit Facility (July 2015) has an interest rate calculated based on LIBO Rate plus the applicable LIBO Rate margin or Base Rate plus the applicable Base Rate margin, both as provided in the Unsecured Credit Agreement (July 2015). The applicable LIBO Rate margin and Base Rate margin are dependent on whether the interest rate is calculated prior to or after the Company has received an investment grade senior unsecured credit rating of BBB-/Baa3 from Standard & Poors, Moody's, or Fitch, and the Company has elected to utilize the investment grade pricing list, as provided in the Unsecured Credit Agreement (July 2015). Otherwise, the applicable LIBO Rate margin will be based on a leverage ratio computed in accordance with the Company's quarterly compliance package and communicated to KeyBank. The Base Rate is calculated as the greater of (i) the KeyBank Prime rate or (ii) the Federal Funds rate plus 0.50%. Payments under the Unsecured Credit Facility (July 2015) are interest only and are due on the first day of each quarter.
On March 29, 2016, the Company exercised its right to increase the total commitments, pursuant to the Unsecured Credit Agreement (July 2015), by entering into the Increase Agreement. As a result, the total commitments on the Term Loan (July 2015) increased from $640.0 million to $715.0 million.
HealthSpring Mortgage Loan
As part of the acquisition of the remaining 90% beneficial interest in the HealthSpring property, the Company assumed a $22.4 million mortgage loan (the "HealthSpring mortgage loan") held with Barclays Bank PLC. The HealthSpring mortgage loan, which matures on April 6, 2023, has a fixed interest rate of 4.18% and requires monthly payments of principal and interest.
Debt Covenant Compliance
Pursuant to the terms of the Company's mortgage loans and Unsecured Credit Facility (July 2015), the Operating Partnership, in consolidation with the Company, is subject to certain loan compliance covenants. The Company was in compliance with all of its debt covenants as of December 31, 2016.
The following summarizes the future principal repayments of all loans as of December 31, 2016 per the loan terms discussed above:
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
(1)
Amount includes payment of the balance of the Plainfield and Ace Hardware property mortgage loans, which mature in 2017.
(2)
Amount includes payment of the balance of the TW Telecom loan, which matures in 2019.
(3)
Amount includes payment of the balances of:
•
the Term Loan (July 2015), which matures in 2020,
•
the Revolver Loan (July 2015), which matures in 2020, assuming the one-year extension is exercised,
•
the Midland, Emporia Partners, Samsonite, and HealthSpring property mortgage loans, all of which mature in 2023,
•
the Highway 94 property mortgage loan, which matures in 2024, and
•
the AIG loan, which matures in 2029.
6. Interest Rate Contracts
Risk Management Objective of Using Derivatives
The Company is exposed to certain risks arising from both business operations and economic conditions. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of debt funding and the use of derivative financial instruments. Specifically, the Company entered into derivative financial instruments to manage exposures that arise from business activities that result in the payment of future known and uncertain cash amounts, the value of which are determined by expected cash payments principally related to borrowings and interest rates. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. The Company does not use derivatives for trading or speculative purposes.
Derivative Instruments
On July 9, 2015, the Company executed three interest rate swap agreements to hedge the variable cash flows associated with certain existing LIBO Rate-based variable-rate debt, including the Company's Unsecured Credit Facility (July 2015). Three interest rate swaps are effective for the periods from July 9, 2015 to July 1, 2020, January 1, 2016 to July 1, 2018, and July 1, 2016 to July 1, 2018, and have notional amounts of $425.0 million, $300.0 million and $100.0 million, respectively.
On March 24, 2016, the Company executed an interest rate swap agreement to hedge interest risk related to a future fixed-rate debt issuance. The forward-starting interest rate swap with a notional amount of $200.0 million became effective May 2016 and has a term of 10 years with a mandatory settlement date on November 30, 2016. On November 9, 2016, the Company paid approximately $1.3 million to settle the forward-starting interest rate swap, which is included in the Company's comprehensive income (loss) statement for the year ended December 31, 2016.
The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive loss ("AOCL") and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During 2016, such derivatives were used to hedge the variable cash flows associated with existing variable-rate debt and forecasted issuances of debt. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings.
The following table sets forth a summary of the interest rate swaps as of December 31, 2016 and 2015 :
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
(1)
The Company records all derivative instruments on a gross basis in the consolidated balance sheets, and accordingly, there are no offsetting amounts that
net assets against liabilities. As of December 31, 2016, all of the derivatives were in a liability position, and as such, the fair value is included in the line item "Interest rate swap liability" in the consolidated balance sheets.
(2)
Represents the notional amount of swaps that are effective as of the balance sheet date of December 31, 2016 and 2015.
The following table sets forth the impact of the interest rate swap on the consolidated statements of operations for the periods presented:
During the next twelve months, the Company estimates that an additional $4.7 million will be recognized from AOCL into earnings.
Certain agreements with the derivative counterparties contain a provision where if the Company defaults on any of the Company's indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender within a specified time period, then the Company could also be declared in default on its derivative obligations.
As of December 31, 2016, the fair value of interest rate swaps in a net liability position, which excludes any adjustment for nonperformance risk related to these agreements, was approximately $3.1 million. As of December 31, 2016, the Company had not posted any collateral related to these agreements.
7.
Accrued Expenses and Other Liabilities
Accrued expenses and other liabilities consisted of the following as of December 31, 2016 and 2015:
8. Fair Value Measurements
The Company is required to disclose fair value information about all financial instruments, whether or not recognized in the consolidated balance sheets, for which it is practicable to estimate fair value. The Company measures and discloses the
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
estimated fair value of financial assets and liabilities utilizing a fair value hierarchy that distinguishes between data obtained from sources independent of the reporting entity and the reporting entity’s own assumptions about market participant assumptions. This hierarchy consists of three broad levels, as follows: (i) quoted prices in active markets for identical assets or liabilities, (ii) "significant other observable inputs," and (iii) "significant unobservable inputs." "Significant other observable inputs" can include quoted prices for similar assets or liabilities in active markets, as well as inputs that are observable for the asset or liability, such as interest rates, foreign exchange rates, and yield curves that are observable at commonly quoted intervals. "Significant unobservable inputs" are typically based on an entity’s own assumptions, since there is little, if any, related market activity. In instances in which the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level of input that is significant to the fair value measurement in its entirety. The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability. There were no transfers between the levels in the fair value hierarchy during the years ended December 31, 2016 and 2015.
The following tables set forth the liabilities that the Company measures at fair value on a recurring basis by level within the fair value hierarchy as of December 31, 2016:
Financial Instruments Disclosed at Fair Value
Financial instruments as of December 31, 2016 consisted of cash and cash equivalents, restricted cash, accounts receivable, accounts payable and other accrued expenses, and mortgage payable and other borrowings, as defined in Note 5, Debt. With the exception of the mortgage loans in the table below, the amounts of the financial instruments presented in the consolidated financial statements substantially approximate their fair value as of December 31, 2016 and 2015. The fair value of the three mortgage loans in the table below is estimated by discounting each loan’s principal balance over the remaining term of the mortgage using current borrowing rates available to the Company for debt instruments with similar terms and maturities. The Company determined that the mortgage debt valuation in its entirety is classified Level 2 of the fair value hierarchy, as the fair value is based on current pricing for debt with similar terms as the in-place debt.
(1)
The carrying values do not include the debt premium/(discount) or deferred financing costs as of December 31, 2016 and 2015. See Note 5, Debt, for details.
9. Equity
Common Equity
As of December 31, 2016, the Company had received aggregate gross offering proceeds of approximately $1.4 billion from the sale of shares in the Private Offering, the Public Offerings, and the DRP Offerings, as discussed in Note 1, Organization. There were 176,032,871 shares outstanding at December 31, 2016, including shares issued pursuant to the DRP, less shares redeemed pursuant to the share redemption plan discussed below.
Distribution Reinvestment Plan (DRP)
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
The Company has adopted the DRP, which allows stockholders to have dividends and other distributions otherwise distributable to them invested in additional shares of common stock. No sales commissions or dealer manager fee will be paid on shares sold through the DRP. The Company may amend or terminate the DRP for any reason at any time upon 10 days' prior written notice to stockholders.
On October 10, 2016, the Company's board of directors amended and restated the Company's DRP to state that the purchase price for the shares pursuant to the DRP shall be equal to the most recently published estimated net asset value and to make certain other minor revisions. The amended and restated DRP is effective as of October 28, 2016.
As of December 31, 2016 and 2015, $162.4 million and $110.2 million in shares of common stock, respectively, had been issued under the DRP, pursuant to the Private Offering, the Public Offerings, and the DRP Offerings.
Share Redemption Program
The Company has adopted a share redemption program ("SRP") that enables stockholders to sell their stock to the Company in limited circumstances. As long as the common stock is not listed on a national securities exchange or over-the-counter market, stockholders who have held their stock for at least one year may, under certain circumstances, be able to have all or any portion of their shares of stock redeemed by the Company. During any calendar year, the Company will not redeem more than 5.0% of the weighted average number of shares outstanding during the prior calendar year. The cash available for redemption will be limited to the proceeds from the sale of shares pursuant to the DRP.
On October 10, 2016, the Company's board of directors amended the Company's SRP to (i) revise the redemption price per share for shares purchased under the SRP, (ii) revise the redemption price per share in the event of death or qualifying disability, and (iii) make certain other clarifying changes regarding disability related redemptions. Pursuant to the amendment to the SRP, the redemption price per share shall be the lesser of (i) the amount paid for the shares or (ii) 95% of the NAV of the shares. The redemption price in connection with the death or qualifying disability of a stockholder shall be the greater of (i) the amount paid for the shares or (ii) 95% of the NAV of shares. The amendments to the SRP were effective as of November 14, 2016.
As the use of the proceeds from the DRP for redemptions is outside the Company’s control, the net proceeds from the DRP are considered to be temporary equity and are presented as common stock subject to redemption on the accompanying consolidated balance sheets. The cumulative proceeds from the DRP, net of any redemptions, will be computed at each reporting date and will be classified as temporary equity on the Company’s consolidated balance sheets. As noted above, the redemption is limited to proceeds from new permanent equity from the sale of shares pursuant to the DRP.
Redemption requests will be honored on or about the last business day of the month following the end of each quarter. Requests for redemption must be received on or prior to the end of the quarter in order for the Company to repurchase the shares as of the end of the following month. Since inception and through December 31, 2016, the Company had redeemed 5,918,655 shares of common stock for approximately $58.8 million at a weighted average price per share of $9.93 pursuant to the SRP. As of December 31, 2016, there were 1,155,532 shares totaling $11.6 million subject to redemption requests. The Company’s board of directors may choose to amend, suspend, or terminate the SRP upon 30 days' written notice at any time.
Distributions
Earnings and profits, which determine the taxability of distributions to stockholders, may differ from income reported for financial reporting purposes due to the differences for federal income tax purposes in the treatment of loss on debt, revenue recognition and compensation expense and in the basis of depreciable assets and estimated useful lives used to compute depreciation expense.
The following unaudited table summarizes the federal income tax treatment for all distributions for the years ended December 31, 2016, 2015, and 2014 reported for federal tax purposes and serves as a designation of capital gain distributions, if applicable, pursuant to Internal Revenue Code Section 857(b)(3)(C) and Treasury Regulation §1.857-6(e).
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
Share-Based Compensation
The Company has adopted an Employee and Director Long-Term Incentive Plan (the “Plan”) pursuant to which the Company may issue stock-based awards to its directors and full-time employees (should the Company ever have employees), executive officers and full-time employees of the Advisor and its affiliate entities that provide services to the Company, and certain consultants who provide significant services to the Company. The term of the Plan is 10 years and the total number of shares of common stock reserved for issuance under the Plan is 10% of the outstanding shares of stock at any time, not to exceed 10,000,000 shares in the aggregate. Awards granted under the Plan may consist of stock options, restricted stock, stock appreciation rights and other equity-based awards. The stock-based payment will be measured at fair value and recognized as compensation expense over the vesting period.
On March 3, 2014, the compensation committee of the board of directors authorized the issuance of 5,000 shares of restricted stock to each of the Company's independent directors. These restricted shares were immediately vested upon issuance. In addition, the compensation committee authorized the future issuance of 1,000 shares of restricted stock to each of the Company's independent directors for each 12-consecutive-month period during which each independent director continuously remains a director for the Company. The future shares granted will vest over a three year period, or will immediately vest upon a change in control of the Company. Upon re-election of each independent director at the June 12, 2014 annual stockholders' meeting, the Company measured and began recognizing director compensation expense for the 1,000 shares of restricted stock granted, subject to the vesting period.
Upon re-election of each independent director at the June 15, 2016 annual stockholders' meeting, the Company granted 1,000 shares of restricted common stock to each of the independent directors. The fair value of such issuance was estimated at $10.40 per share, the then current price paid to acquire a share of the Company's common stock pursuant to the 2015 DRP Offering. Immediately upon granting the restricted common shares, the Company measured and began recognizing director compensation expense, subject to the same vesting period discussed above.
One-third of the shares of restricted stock, or 1,333 shares, vested during the year ended December 31, 2016, which were part of the 2014 and 2015 grants. The fair value of the shares granted in 2014 was estimated at $10.28 per share; additionally, the fair value of the shares granted in 2015 and 2016 was $10.40, the then most recent price paid to acquire a share of the Company's common stock. All issuances of restricted stock are entitled to dividends upon vesting of the shares.
Noncontrolling Interests
Noncontrolling interests represent limited partnership interests in the Operating Partnership in which the Company is the general partner. General Partnership units and limited partnership units of the Operating Partnership were issued as part of the initial capitalization of the Operating Partnership, and limited partnership units were issued in conjunction with management's contribution of certain assets, as discussed in Note 1, Organization.
As of December 31, 2016, noncontrolling interests were approximately 3% of total shares outstanding and weighted average shares outstanding (both measures assuming limited partnership units were converted to common stock). The Company has evaluated the terms of the limited partnership interests in the Operating Partnership and as a result, has classified limited partnership interests issued in the initial capitalization and in conjunction with the contributed assets as noncontrolling interests, which are presented as a component of permanent equity, except as discussed below.
The Company evaluates individual noncontrolling interests for the ability to recognize the noncontrolling interest as permanent equity on the consolidated balance sheets at the time such interests are issued and on a continual basis. Any noncontrolling interest that fails to qualify as permanent equity has been reclassified as temporary equity and adjusted to the greater of (a) the carrying amount, or (b) its redemption value as of the end of the period in which the determination is made.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
As part of the acquisition of the remaining 90% beneficial interest in the HealthSpring property, the Company, through the Operating Partnership, issued approximately $11.9 million in limited partnership units of the Operating Partnership in April 2016, which is included in noncontrolling interest on the Company's balance sheet, as a component of permanent equity. (See Note 4, Investments, for additional detail.)
The Operating Partnership issued 6.6 million limited partnership units to affiliated parties and unaffiliated third parties in exchange for certain properties and 0.1 million limited partnership units to unaffiliated third parties unrelated to property contributions. To the extent the contributors should elect to redeem all or a portion of their Operating Partnership units, pursuant to the terms of the respective contribution agreement, such redemption shall be at a per unit value equivalent to the price at which the contributor acquired its limited partnership units in the respective transaction.
The limited partners of the Operating Partnership, other than those related to the Will Partners REIT, LLC contribution, will have the right to cause the general partner of the Operating Partnership, the Company, to redeem their limited partnership units for cash equal to the value of an equivalent number of shares, or, at the Company’s option, purchase their limited partnership units by issuing one share of the Company’s common stock for the original redemption value of each limited partnership unit redeemed. These rights may not be exercised under certain circumstances which could cause the Company to lose its REIT election. There were no redemption requests during the years ended December 31, 2016 and 2015.
The following summarizes the activity for noncontrolling interests recorded as equity for the years ended December 31, 2016, 2015, and 2014:
Noncontrolling interests subject to redemption
Operating partnership units issued pursuant to the Will Partners REIT, LLC contribution are not included in permanent equity on the consolidated balance sheets. The partners holding these units can cause the general partner to redeem the units for the cash value, as defined in the operating partnership agreement. As the general partner does not control these redemptions, these units are presented on the consolidated balance sheets as noncontrolling interest subject to redemption at their redeemable value. The net income (loss) and distributions attributed to these limited partners is allocated proportionately between common stockholders and other noncontrolling interests that are not considered redeemable.
10. Related Party Transactions
The following table summarizes the related party costs and fees incurred, paid and due to affiliates as of December 31, 2016 and 2015:
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
(1) Represents acquisition fees and expense reimbursements related to the land parcels and the HealthSpring property acquired during the previous quarters, as discussed in Note 3, Real Estate and Note 4, Investments.
Mortgage Receivable from Affiliate
On October 9, 2015, the Company entered into a mortgage receivable for approximately $26.0 million related to a 127,246 square foot, single-story office building located in Emeryville, CA. The borrowers are an affiliated tenant-in-common private program or LLC, each with the Sponsor as the asset manager. The mortgage receivable had a rate of 8% per annum and was funded with proceeds from the Unsecured Credit Facility (July 2015). The mortgage receivable was paid in full on January 15, 2016, and the Company recognized interest income of $1.2 million during the year ended December 31, 2016.
Advisory Agreement
The Company currently does not have nor does it expect to have any employees. The Advisor will be primarily responsible for managing the business affairs and carrying out the directives of the Company’s board of directors. The Company entered into an advisory agreement with the Advisor. The Advisory Agreement entitles the Advisor to specified fees and expense reimbursements upon the provision of certain services with regard to the Public Offerings and investment of funds in real estate properties, among other services, including as reimbursement for organizational and offering costs incurred by the Advisor on the Company’s behalf and reimbursement of certain costs and expenses incurred by the Advisor in providing services to the Company.
Management Compensation
The following table summarizes the compensation and fees the Company has paid or may pay to the Advisor, the Property Manager, and the Sponsor and other affiliates, including amounts to reimburse costs for providing services.
Type of Compensation
(Recipient)
Determination of Amount
Acquisition Fees and Expenses
(Advisor)
Under the Advisory Agreement, the Advisor receives acquisition fees equal to 2.5%, and reimbursement for actual acquisition related expenses incurred by the Advisor of up to 0.50% of the contract purchase price, as defined therein, of each property acquired by the Company, and reimbursement for actual acquisition expenses incurred on the Company's behalf, including certain payroll costs for acquisition-related efforts by the Advisor's personnel, as defined in the agreements. In addition, the Company pays acquisition expenses to unaffiliated third parties equal to approximately 0.60% of the purchase price of the Company's properties. The acquisition fee and acquisition expenses paid by the Company shall be reasonable and in no event exceed an amount equal to 6.0% of the contract purchase price, unless approved by a majority of the independent directors.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
Type of Compensation
(Recipient)
Determination of Amount
Disposition Fee
(Advisor)
In the event that the Company sells any or all of its properties (or a portion thereof), or all or substantially all of the business or securities of the Company are transferred or otherwise disposed of by way of a merger or other similar transaction, the Advisor will be entitled to receive a disposition fee if the Advisor or an affiliate provides a substantial amount of the services (as determined by a majority of the Company's directors, including a majority of the independent directors) in connection with such transaction. The disposition fee the Advisor or such affiliate shall be entitled to receive at closing will be equal to the lesser of: (1) 3% of the Contract Sales Price, as defined in the Advisory Agreement or (2) 50% of the Competitive Commission, as defined in the Advisory Agreement; provided, however, that in connection with certain types of transactions described further in the Advisory Agreement, the disposition fee shall be subordinated to Invested Capital (as defined in the operating partnership agreement). The disposition fee may be paid in addition to real estate commissions or other commissions paid to non-affiliates, provided that the total real estate commissions or other commissions (including the disposition fee) paid to all persons by the Company or the operating partnership shall not exceed an amount equal to the lesser of (i) 6% of the aggregate Contract Sales Price or (ii) the Competitive Commission.
Asset Management Fee
(Advisor)
The Advisor receives an annual asset management fee for managing the Company’s assets equal to 0.75% of the Average Invested Assets, defined as the aggregate carrying value of the assets invested before reserves for depreciation. The fee will be computed based on the average of these values at the end of each month. The asset management fees are earned monthly.
Operating Expenses
(Advisor)
The Advisor and its affiliates are entitled to reimbursement, at cost, for actual expenses incurred by them on behalf of the Company in connection with their provision of administrative services, including related personnel costs; provided, however, the Advisor must reimburse the Company for the amount, if any, by which total operating expenses (as defined), including advisory fees, paid during the previous 12 months then ended exceeded the greater of: (i) 2% of the Company’s average invested assets for that 12 months then ended; or (ii) 25% of the Company’s net income, before any additions to reserves for depreciation, bad debts or other expenses connected with the acquisition and disposition of real estate interests and before any gain from the sale of the Company’s assets, for that fiscal year, unless the Company’s board of directors has determined that such excess expenses were justified based on unusual and non-recurring factors.
Operating expenses for the year ended December 31, 2016 included approximately $0.4 million to reimburse the Advisor and its affiliates a portion of the compensation paid by the Advisor and its affiliates for the Company's principal financial officer, Javier F. Bitar, former principal financial officer, Joseph E. Miller, executive vice president, David C. Rupert, and vice president and general counsel, Mary P. Higgins, for services provided to the Company, for which the Company does not pay the Advisor a fee. In addition, the Company incurred approximately $0.1 million and $0.3 million for reimbursable expenses to the Advisor for services provided to the Company by certain of its other executive officers during the years ended December 31, 2016 and 2015. The reimbursable expenses include components of salaries, bonuses, benefits and other overhead charges and are based on the percentage of time each such executive officer spends on the Company's affairs.
Property Management Fees
(Property Manager)
The Property Manager is entitled to receive a fee for its services in managing the Company’s properties up to 3% of the gross monthly revenues from the properties plus reimbursement of the costs of managing the properties. The Property Manager, in its sole and absolute discretion, can waive all or a part of any fee earned. In the event that the Property Manager assists with the development or redevelopment of a property, the Company may pay a separate market-based fee for such services. In the event that the Company contracts directly with a non-affiliated third-party property manager with respect to a particular property, the Company will pay the Property Manager an oversight fee equal to 1% of the gross revenues of the property managed. In no event will the Company pay both a property management fee to the Property Manager and an oversight fee to the Property Manager with respect to a particular property.
In addition, the Company may pay the Property Manager or its designees a leasing fee in an amount equal to the fee customarily charged by others rendering similar services in the same geographic area. The Company may also pay the Property Manager or its designees a construction management fee for planning and coordinating the construction of any tenant directed improvements for which the Company is responsible to perform pursuant to lease concessions, including tenant-paid finish-out or improvements. The Property Manager shall also be entitled to a construction management fee of 5% of the cost of improvements.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
Type of Compensation
(Recipient)
Determination of Amount
Subordinated Share of Net Sale Proceeds (Advisor) (1)
Payable to the Advisor in cash upon the sale of a property after the Company's stockholders receive a return of capital plus a 6% cumulative, non-compounded return. The share of net proceeds from the sale of property is 5% if stockholders are paid a return of capital plus 6% to 8% annual cumulative non-compounding return, 10% if stockholders are paid a return of capital plus 8% to 10% annual cumulative non-compounding return, or 15% if stockholders are paid a return of capital plus 10% or more annual cumulative non-compounding return.
Subordinated Incentive Listing Distribution (Advisor) (1)
Payable to the Advisor no earlier than 7 months and no later than 19 months following a listing of the shares on a national securities exchange, based upon the market value of the Company's shares during a period of 30 trading days commencing after the first day of the 6th month, but no later than the last day of the 18th month following a listing, the commencement date of which shall be chosen by the Advisor in its sole discretion, and after the Company's stockholders receive a return of capital plus a 6% cumulative, non-compounded return. The distribution share is 5% if stockholders are paid a return of capital plus 6% to 8% annual cumulative non-compounding return, 10% if stockholders are paid a return of capital plus 8% to 10% annual cumulative non-compounding return, or 15% if stockholders are paid a return of capital plus 10% or more annual cumulative non-compounding return, and is payable in cash, shares of the Company's stock, units of limited partnership interest in the Operating Partnership, or a combination thereof.
Subordinated Distribution Due Upon Termination
(Advisor)
Payable to the Advisor (in cash, shares of the Company's stock, units of limited partnership interest in the Operating Partnership, or a combination thereof), 1/3rd within 30 days of the date of involuntary termination of the Advisory Agreement, 1/3rd upon the one year anniversary of such date, and 1/3rd upon the two year anniversary of such date. Calculated based upon appraised value of properties less the fair value of the underlying debt, and plus or minus net current assets or net current liabilities, respectively, and payable after the Company's stockholders receive a return of capital plus a 6% cumulative, non-compounded return. The distribution share is 5% if stockholders are paid a return of capital plus 6% to 8% annual cumulative non-compounding return, 10% if stockholders are paid a return of capital plus 8% to 10% annual cumulative non-compounding return, or 15% if stockholders are paid a return of capital plus 10% or more annual cumulative non-compounding return.
Upon a voluntary termination of the Advisory Agreement, the Advisor will not be entitled to receive the Subordinated Distribution Due Upon Termination but instead will be entitled to receive at the time of the applicable liquidity event a distribution equal to the applicable Subordinated Share of Net Sale Proceeds, Subordinated Incentive Listing Distribution, or Subordinated Distribution Due Upon Extraordinary Transaction.
Subordinated Distribution Due Upon Extraordinary Transaction
(Advisor) (1)
Payable to the Advisor upon the closing date of an Extraordinary Transaction (as defined in the Operating Partnership Agreement); payable in cash, shares of the Company's stock, units of limited partnership in the Operating Partnership, or a combination thereof after the Company's stockholders receive a return of capital plus a 6% cumulative, non-compounded return. The distribution share is 5% if stockholders are paid a return of capital plus 6% to 8% annual cumulative non-compounding return, 10% if stockholders are paid a return of capital plus 8% to 10% annual cumulative non-compounding return, or 15% if stockholders are paid a return of capital plus 10% or more annual cumulative non-compounding return.
Sponsor Break-Even Amount
(Sponsor)
In the event of a merger of the Advisor into the Company or one of its affiliates in anticipation of listing or a merger with an already-listed entity, any merger consideration paid to the Company's sponsor or its affiliates in excess of unreturned and unreimbursed capital invested by the Company's sponsor and its affiliates into the Company, the Advisor, the Company's dealer manager, or affiliates, relating in any way to the business organization of the Company, the Operating Partnership, or any offering of the Company, shall be subordinated to the return of stockholders' invested capital. Such excess merger consideration shall be paid in stock that may not be traded for one year from the date of receipt, and such stock shall be held in escrow pending the occurrence of certain conditions outlined further in the Operating Partnership Agreement.
(1)
The Advisor cannot earn more than one incentive distribution. Any receipt by the Advisor of subordinated share of net sale proceeds (for anything other than a sale of the entire portfolio) will reduce the amount of the subordinated distribution due upon termination, the subordinated incentive listing distribution and the subordinated distribution due upon extraordinary transaction.
Conflicts of Interest
The Sponsor, Advisor, Property Manager and their officers and certain of their key personnel and their respective affiliates currently serve as key personnel, advisors, managers and sponsors or co-sponsors to some or all of 10 other real estate programs affiliated with the Sponsor, including Griffin Capital Essential Asset REIT II, Inc. ("GCEAR II"), Griffin-American
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
Healthcare REIT III, Inc. ("GAHR III"), and Griffin-American Healthcare REIT IV, Inc. ("GAHR IV"), each of which are publicly-registered, non-traded real estate investment trusts, Griffin-Benefit Street Partners BDC Corp. ("GB-BDC"), a non-traded business development company regulated under the Investment Company Act of 1940 (the "1940 Act"), and Griffin Institutional Access Real Estate Fund (“GIA Real Estate Fund”) and Griffin Institutional Access Credit Fund ("GIA Credit Fund"), both of which are non-diversified, closed-end management investment companies that are operated as interval funds under the 1940 Act. Because these persons have competing demands on their time and resources, they may have conflicts of interest in allocating their time between the Company’s business and these other activities.
Some of the material conflicts that the Sponsor, Advisor, and Property Manager and their key personnel and their respective affiliates will face are (1) competing demand for time of the Advisor’s executive officers and other key personnel from the Sponsor and other affiliated entities; (2) determining if certain investment opportunities should be recommended to the Company or another program sponsored or co-sponsored by the Sponsor; and (3) influence of the fee structure under the Advisory Agreement and the distribution structure under the Operating Partnership Agreement that could result in actions not necessarily in the long-term best interest of the Company’s stockholders. The board of directors has adopted the Sponsor’s acquisition allocation policy as to the allocation of acquisition opportunities among the Company and GCEAR II, which is based on the following factors:
•the investment objectives of each program;
•the amount of funds available to each program;
•the financial impact of the acquisition on each program, including each program’s earnings and distribution ratios;
•various strategic considerations that may impact the value of the investment to each program;
•the effect of the acquisition on diversification of each program’s investments; and
•the income tax effects of the purchase to each program.
In the event all acquisition allocation factors have been exhausted and an investment opportunity remains equally suitable for the Company and GCEAR II, the Sponsor will offer the investment opportunity to the REIT that has had the longest period of time elapse since it was offered an investment opportunity.
If the Sponsor no longer sponsors the Company, then, in the event that an investment opportunity becomes available that is suitable, under all of the factors considered by the Advisor, for both GCEAR II and one or more other entities affiliated with the Sponsor, the Sponsor has agreed to present such investment opportunities to GCEAR II first, prior to presenting such opportunities to any other programs sponsored by or affiliated with the Sponsor. In determining whether or not an investment opportunity is suitable for more than one program, the Advisor, subject to approval by the board of directors, shall examine, among others, the following factors:
•anticipated cash flow of the property to be acquired and the cash requirements of each program;
•effect of the acquisition on diversification of each program’s investments;
•policy of each program relating to leverage of properties;
•income tax effects of the purchase to each program;
•size of the investment; and
•amount of funds available to each program and the length of time such funds have been available for investment.
Economic Dependency
The Company will be dependent on the Advisor for certain services that are essential to the Company, including the identification, evaluation, negotiation, purchase and disposition of properties and other investments, management of the daily operations of the Company’s real estate portfolio, and other general and administrative responsibilities. In the event that the Advisor is unable to provide the services, the Company will be required to obtain such services from other resources.
11. Commitments and Contingencies
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
Ground Lease Obligations
The Company acquired a property on January 16, 2014 that is subject to a ground lease with an expiration date of December 31, 2095. The Company incurred rent expense of approximately $0.5 million during the years ended December 31, 2016 and 2015, related to the ground lease. As of December 31, 2016, the remaining required payments under the terms of the ground lease are as follows:
Litigation
From time to time, the Company may become subject to legal proceedings, claims and litigation arising in the ordinary course of business. The Company is not a party to any material legal proceedings, nor is the Company aware of any pending or threatened litigation that would have a material adverse effect on the Company’s business, operating results, cash flows or financial condition should such litigation be resolved unfavorably.
12. Declaration of Distributions
During the quarter ended December 31, 2016, the Company paid distributions in the amount of $0.001895902 per day per share on the outstanding shares of common stock payable to stockholders of record at the close of business on each day during the period from October 1, 2016 through December 31, 2016. Such distributions were paid on a monthly basis, on or about the first day of the month, for the month then-ended.
On December 14, 2016, the Company’s board of directors declared distributions in the amount of $0.001901096 per day per share on the outstanding shares of common stock payable to stockholders of record at the close of business on each day during the period from January 1, 2017 through March 31, 2017. Such distributions payable to each stockholder of record during a month will be paid on such date of the following month as the Company’s Chief Executive Officer may determine.
13. Selected Quarterly Financial Data (Unaudited)
Presented below is a summary of the unaudited quarterly financial information for the years ended December 31, 2016 and 2015:
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2016
(Dollars in thousands unless otherwise noted)
14. Subsequent Events
Lease Termination
In January, 2017, the Company executed a termination agreement with Coca-Cola Refreshment USA, Inc., effective December 31, 2016, in which the Company agreed to a termination fee of approximately $12.8 million, which will be paid, quarterly, through December 2018.
Offering Status
As of March 10, 2017, the Company had issued approximately 14,381,443 shares of the Company’s common stock pursuant to the DRP Offerings for approximately $147.7 million.
Declaration of Distributions
On March 8, 2017, the Company’s board of directors declared distributions in the amount of $0.001901096 per day per share on the outstanding shares of common stock payable to stockholders of record at the close of business on each day during the period from April 1, 2017 through June 30, 2017. Such distributions payable to each stockholder of record during a month will be paid on such date of the following month as the Company’s Chief Executive Officer may determine.
Change in Director
On January 31, 2017, Timothy J. Rohner resigned his roles as an independent director member of the Company's board of directors, member and chairman of the audit committee, member of the nominating and corporate governance committee, and member of the compensation committee, effective as of the same date. Mr. Rohner's decision to resign was for health reasons and did not involve any disagreement with the Company, the Company's management, or the board of directors. Also on January 31, 2017, in accordance with the Company's bylaws and charter, the nominating and corporate governance committee and the board of directors appointed Ranjit M. Kripalani as an independent director member of the board of directors to fill the vacancy created by Mr. Rohner's resignation, as well as a member and chairman of the audit committee, a member of the nominating and corporate governance committee, and a member of the compensation committee. The board of directors has reviewed Mr. Kripalani's background and qualifications and has deemed him to be an "audit committee financial expert," as such term is defined by the rules and regulations of the SEC.
GRIFFIN CAPITAL ESSENTIAL ASSET REIT, INC.
SCHEDULE III
REAL ESTATE ASSETS AND ACCUMULATED DEPRECIATION AND AMORTIZATION
(Dollars in thousands)
S-1
S-2
S-3
(1)
The Company exercised its exchange right and acquired the remaining 90% beneficial ownership interest in the HealthSpring property during 2016 which was an affiliate of the Company. See Note 4, Investments, for additional discussion.
(2)
Amount does not include the net loan valuation premium of $0.1 million related to the debt assumed in the Ace Hardware, Highway 94, Samsonite and HealthSpring property acquisitions.
(3)
As of December 31, 2016, the aggregate cost of real estate the Company and consolidated subsidiaries own for federal income tax purposes was approximately $3.0 billion (unaudited).
S-4
S-5