Item 1. Business.
The Company. Health and Retirement Properties Trust (the "Company") was organized on October 9, 1986 as a Maryland real estate investment trust. The Company primarily invests in nursing homes, retirement complexes and other income producing health care related real estate. The Company's investments, to date, have been principally in nursing homes and other long-term care facilities, assisted living facilities, retirement complexes and facilities that provide subacute services. In March 1995, in a one time transaction, the Company invested $179.4 million in 21 hotel properties managed by an affiliate of Marriott International, Inc. (Marriott). See "Developments since January 1, 1994". The facilities in which the Company has made investments by mortgage, purchase lease or merger transactions shall hereinafter be referred to individually as a "Property" and collectively as "Properties".
As of December 31, 1994, the Company owned 80 Properties acquired for an aggregate of $673.1 million and had mortgage investments in 61 Properties aggregating $133.5 million, for total real estate investments of approximately $806.6 million in 141 Properties located in 27 states. The Properties are described in "Business -- Developments Since January 1, 1994" and "Properties".
The Company's principal executive offices are located at 400 Centre Street, Newton, Massachusetts 02158, and its telephone number is (617) 332-3990.
Investment Policy and Method of Operation. The Company's investment goals are current income for distribution to shareholders, capital growth resulting from appreciation in the residual value of owned Properties, and preservation and protection of shareholders' capital. The Company's income is derived primarily from minimum rent and minimum interest payments under its leases and mortgages and from additional rent and additional interest payments based upon revenue increases at the leased and mortgaged Properties.
The Company's day-to-day operations are conducted by HRPT Advisors, Inc., the Company's investment advisor (the "Advisor"). The Advisor originates and presents investment opportunities to the Company's Board of Trustees (the "Trustees"). In evaluating potential investments, the Company considers such factors as: the adequacy of current and anticipated cash flow from the property to meet operational needs and financing obligations and to provide a competitive market return on investment to the Company; the growth, tax and regulatory environments of the community in which the property is located; the quality, experience, and credit worthiness of the property's operator; an appraisal of the property, if available; occupancy and demand for similar facilities in the same or nearby communities; the mix of private and government sponsored patients; the mix of cost-based and charge-based revenues; the construction quality, condition and design of the property; and the geographic area and type of property.
The Trustees have established a policy that the Company will not purchase or mortgage finance a facility for an amount which exceeds the appraised value of such facility. Prior to investing in properties, the Company obtains title commitments or policies of title insurance insuring that the Company holds title to or has mortgage interests in such properties, free of material liens and encumbrances.
The Company's investments may be structured using leases with minimum and additional rent and escalator provisions, loans with fixed or floating rates, joint ventures and partnerships with affiliated or unaffiliated parties, commitments or options to purchase interests in real estate, mergers or any combination of the foregoing that will best suit the particular investment.
In connection with its revolving credit facility, the Company has agreed to obtain bank approval before exceeding certain investment concentrations. Among these are that no more than 40% of its properties be operated by any single tenant or mortgagor, that investment in rehabilitation treatment, acute care and United Kingdom properties not exceed 40%, 15% and 10%, respectively, of total investments and that no new psychiatric care or hotel investments be made. In addition to these restrictions, the Trustees may establish limitations as they deem
appropriate from time to time. No limits have been set on the number of properties in which the Company will seek to invest, or on the concentration of investments involving any one facility or geographical area; however, the Trustees consider concentration of investments in determining whether to make new or increase existing investments. The Company's Declaration of Trust (the "Declaration") and operating policies provide that any investment in facilities owned or operated by the Advisor, persons expressly permitted under the Declaration to own more than 8.5% of the Company's shares, or any company affiliated with any of the foregoing must, however, be approved by a majority of the Trustees not affiliated with any of the foregoing (the "Independent Trustees").
The Company has in the past and may in the future consider, from time to time, the acquisition of or merger with other companies engaged in the same business as the Company; however, the Company has no present agreements or understandings concerning any such acquisition or merger. The Company has no intention of investing in the securities of others for the purpose of exercising control.
Borrowing Policy. In addition to the use of equity, the Company utilizes short-term and long-term borrowings to finance investments. During 1994, the Company obtained investment grade ratings on its long term debt from Moody's Investor Services ("Moody's"), Standard and Poor's Corporation ("S&P") and Fitch Investor Services, Inc. ("Fitch") in connection with the issuance of $200 million of floating rate notes. The notes were issued in two series. The Series A notes may be called, at the Company's option, beginning in April 1995. The Series B notes, which were issued at a discount, may be called, at the Companys option, beginning in July 1996. The notes bear interest at a spread over LIBOR and mature in July 1999. At December 31, 1994, the Company had a revolving credit facility available to it totalling $170 million. Availability under this revolver was increased to $200 million effective March 15, 1995. As of March 15, 1995, $10 million of this amount was outstanding, and $190 million was available to be drawn. All but $17.6 million of outstanding indebtedness is at variable interest rates determined by formulae based upon the London Interbank Offered Rate ("LIBOR"), prime or some other generally recognized interest rate standard. Fluctuations in interest rates on $200 million of variable rate outstanding term indebtedness have been limited by hedging arrangements so that the maximum average rates payable on the $200 million of indebtedness is 6.85% per annum. The maturities of the hedge agreements range from 1995 through 1998.
The Company's borrowing guidelines established by its Trustees and covenants in various debt agreements prohibit the Company from maintaining a debt to equity ratio of greater than 1 to 1. At December 31, 1994, the Company's debt to equity ratio was .36 to 1. The Declaration prohibits the Company from incurring secured and unsecured indebtedness which in the aggregate exceeds 300% of the net assets of the Company, unless approved by a majority of the Independent Trustees. There can be no assurance that debt capital will in the future be available at reasonable rates to fund the Company's operations or growth.
Developments Since January 1, 1994.
Horizon/Greenery Merger. In February 1994, the merger transaction (the "Horizon/Greenery Merger") between Horizon Healthcare Corporation ("Horizon") and Greenery Rehabilitation Group, Inc. ("Greenery") was consummated. In connection with this merger, the Company sold to Horizon for $28.4 million three facilities that had been leased to Greenery. The Company realized a gain of approximately $4.0 million on the sale of these properties. In addition, Horizon leased seven facilities previously leased to Greenery, on substantially similar terms except the leases were extended through 2005. The Company has also granted Horizon a ten year option to buy the seven leased facilities, at the rate of no more than one facility per consecutive twelve months. Also, the Company leased the three remaining Greenery facilities to a newly formed corporation, Connecticut Subacute Corporation, II ("CSC II"), an affiliate of the Advisor. These facilities are being managed by and the lease payments are guaranteed by Horizon for a term of up to five years. The terms of these lease arrangements are substantially similar to the original lease arrangements with Greenery.
On February 11, 1994, in connection with the Horizon-Greenery merger, the Company provided Horizon with $9.4 million first mortgage financing for two facilities. One of the facilities previously was owned by the Company and leased to Greenery. The mortgage notes bear interest at 11.5% per annum and mature December 31, 2000.
In January 1995, Horizon exercised its option and purchased one of the seven leased properties from the Company for $24.5 million resulting in a gain of $2.5 million. The Company provided Horizon a 16 year $19.5 million mortgage in connection with this sale in 1995.
New Revolving Credit Facility. During 1994 and early 1995, the Company amended its revolving credit facility from a syndicate of banks (the "Credit Facility"). The Credit Facility which allows borrowing of up to $200 million, will mature in 1998, unless extended by the parties. Borrowings on the Credit Facility will bear interest, at the Company's option, at prime or a spread over or LIBOR.
May Share Offering. During the second quarter of 1994, the Company sold 12,650,000 Shares in a public offering and received net proceeds of approximately $174 million. The proceeds were used, in part, to prepay $73 million in outstanding indebtedness and, in part, to fund the transactions described below.
July Floating Rate Note Offering. In July 1994, the Company issued $200 million floating rate notes in a public offering and received net proceeds after financing costs of approximately $197 million. The notes were issued in two series; Series A issued at par and Series B issued at a discount. The Series A and B notes mature in July 1999, but may be called, at the Company's option, beginning in April 1995 and July 1996, respectively. The notes bear interest at a spread over the three month LIBOR. The proceeds of the note offering were used, in part, to fund the Marriott retirement communities transaction described below.
Marriott Retirement Communities Transaction. On September 9, 1994, the Company completed its previously announced transaction with Host Marriott Corporation ("Host Marriott") to acquire 14 retirement communities containing 3,952 residences or beds for $320 million. These communities are triple net leased through December 31, 2013 to a wholly owned subsidiary of Marriott. The leases provide for fixed rent and additional rentals equal to a percentage of annual revenues from operations in excess of base amounts determined on a facility by facility basis. All of the leases are subject to cross default provisions and are guaranteed by Marriott. This transaction was funded from cash on hand, the proceeds of the equity offering discussed above, drawings under the Company's Credit Facility, assumption of $17.6 million of existing debt bearing interest at 7.75% and a portion of the proceeds from a floating rate note offering described above.
1995 Commitments; Hotel Transaction. Since January 1, 1995, the Company has made or committed to make real estate investments in four separate transactions involving 41 healthcare facilities totalling approximately $109 million. Of this amount, approximately $14 million represents mortgage financings and $95 million represents acquisitions of healthcare facilities.
In addition, the Company entered into a purchase and lease agreement with a subsidiary of Host Marriott for 21 Courtyard by Marriott hotel properties for approximately $179.4 million, subject to adjustment. The properties have been leased for an initial term of 12 years, with renewal options of an additional 37 years to a subsidiary of Host Marriott, and are being managed by a subsidiary of Marriott International. An amount equal to one year's rent was withheld from the purchase price to secure the tenant's obligations to the Company. The transaction closed in March 1995.
Although the Company's investments are no longer exclusively in healthcare, retirement and related properties, the Company's investment in hotel properties does not represent a change in the Company's strategy of focusing on investments in long term care and retirement facilities. Rather, this investment, structured as a triple net lease, will represent only approximately 15% of the Company's portfolio, including the commitments noted above as of March 24, 1995. The facilities are new, having been constructed within the last five years, and occupancy and cash flow coverage are strong. Following the announcement of this investment, Moody's downgraded the Company's debt rating and S&P and Fitch maintained their ratings. The Company believes, despite the negative reaction by Moody's, that this transaction will enhance the security and growth potential of its funds from operations.
The Advisor. The Advisor is wholly owned by Gerard M. Martin and Barry M. Portnoy. Messrs. Martin, Portnoy and Mark J. Finkelstein are the directors of the Advisor, Mr. Finkelstein is the President and Chief Executive Officer, David J. Hegarty is the Executive Vice President, Chief Financial Officer and Secretary and John G. Murray is the Treasurer of the Company. Effective April 1, 1995, Mr. Finkelstein will resign to pursue his interests in operating nursing homes and will become president of Subacute Management Corporation of America, Inc.
The Company's Board of Trustees has elected David J. Hegarty President, Chief Operating Officer and Secretary, John G. Murray, Executive Vice President and Chief Financial Officer and Ajay Saini, Treasurer. These officers of the Advisor are also officers of the Company. The Advisor provides management services and investment advice to the Company. The Advisor's principal executive offices are located at 400 Centre Street, Newton, Massachusetts 02158, and its telephone number is (617) 332-3990.
Employees. As of March 14, 1995, the Company had no employees. The Advisor, which administers the day-to-day operations of the Company, has 9 full-time employees and two active directors.
Regulation and Reimbursement; Competition. Compliance with federal, state and local statutes and regulations governing health care facilities is a prerequisite to continuation of health care operations at the Properties. In addition, the health care industry depends significantly upon federal and federal/state programs for revenues and, as a result, is vulnerable to the budgetary policies of both the federal and state governments.
Certificate of Need and Licensure. Most states in which the Company has or may invest require certificates of need ("CONs") prior to expansion of beds or services, certain capital expenditures, and in some states, a change in ownership. CON requirements are not uniform throughout the United States. Changes in CON requirements may affect competition, profitability of the Properties and the Company's opportunities for investment in health care facilities.
State licensure requirements, including regulations providing that commonly controlled facilities are subject to delicensure if one such facility is delicensed, also affect facilities in which the Company invests. The Company believes that each facility in which it has invested is appropriately licensed. Although each of the facilities may from time to time receive notices of non-compliance with certain standards, and certain facilities in Connecticut and Massachusetts are subject to provisional or probationary licenses, the Company believes that such actions have not, in fiscal year 1994 and through the date hereof, had any material adverse effect on the operations of the Company. Horizon's licenses to operate the Massachusetts facilities leased to it are probationary subject to certain conditions.
An increasing number of legislative proposals have been introduced in Congress that would effect major reforms of the health care system. Such proposals include universal health coverage, employer mandated insurance, and a single government health insurance plan. Following the failure of the Clinton administration's proposed Health Security Act or other major health care reform legislation to become law in 1994, legislative proposals for more incremental reforms have also been introduced, such as group health insurance plans for small businesses, health insurance industry reforms, health care anti-fraud legislation, and Medicare and Medicaid reforms and cost containment measures. The Company cannot predict whether any such legislative proposals will be adopted and, if adopted, what effect, if any, such proposals would have on the business of the lessees, the mortgagors or the Company. New regulations adopted by the Health Care Finance Administration governing
Medicare and Medicaid nursing facility surveys, certification, and enforcement, are scheduled to be effective on July 1, 1995. The regulations require the states to implement a wide range of enforcement remedies, and penalties for noncompliance with Medicare/Medicaid standards may increase in the future. An adverse determination concerning licensure or eligibility for government reimbursement of any operator could materially adversely affect that operator, its affiliates and the Company. In addition, federal and state civil and criminal anti-fraud and anti-kickback laws and regulations govern financial activities of health care providers and enforcement proceedings have increased. If any operator of the Company's Properties were to fail to comply with such laws or regulations, it, and therefore the Company, could be materially adversely affected unless and until any such property of properties were returned to compliance or the Company were able to re-lease or sell the affected Property or Properties on favorable terms.
Reimbursement. Reimbursement for health care services derives principally form the following sources: Medicare, a federal health insurance program for the aged and certain chronically disabled individuals; Medicaid, a medical assistance program for indigent persons operated by individual states with the financial participation of the federal government; health and other insurance plans, including health maintenance organizations; and private funds. These reimbursement sources are generally contingent upon compliance with state CON and licensure regulations and with extensive federal requirements for Medicare and Medicaid participation.
Medicaid programs provide significant current revenues of nursing facilities. Medicare is not presently a major source of revenue for the Company's lessees and mortgagors. The Medicaid program is subject to change and affected by state and federal budget shortfalls and funding restrictions which may materially decrease rates of payment or delay payment. There is no assurance that Medicaid or Medicare payments will remain constant or be sufficient to cover costs allocable to Medicare and Medicaid patients. The operators of the Properties appeal reimbursement rates from time to time. The Company cannot predict whether such appeals, if decided adversely, would have any material effect upon the respective financial positions of the operators.
Other. Federal law limits Medicare and Medicaid reimbursement for capital costs related to increases in the valuation of capital assets solely as a result of a change of ownership of nursing facilities, and numerous states use more restrictive standards to limit Medicaid reimbursement of capital costs. Effective in October of 1993, Medicare eliminated reimbursement of return on equity capital for Medicare skilled nursing homes. Some state Medicaid programs also do not provide for return on equity capital. In addition, a seller is liable to the Medicare program, and in certain states may also be liable to the Medicaid program, for recaptured depreciation. Such limitations may adversely affect the resale value of some Properties owned or financed by the Company.
Effective in October of 1992, DHHS issued final regulations which limit the amount of Medicare reimbursement available to a facility for
rental or lease expenses paid after a purchase lease transaction to that amount which would have been reimbursed as capital costs had the provider retained legal title to the facility. Limitations on rental expenses contained in the regulations may adversely affect the financial feasibility of future purchase lease transactions by denying Medicare and Medicaid reimbursement for additional rental expenses.
It is not possible to predict the content, scope or impact of future legislation, regulations or changes in reimbursement or insurance coverage policies which might affect the health care industry.
Competition. The Company is one of several REITs currently investing primarily in health care related real estate. The REITs compete with one another in that each is continually seeking attractive investment opportunities in health care facilities. The Company also competes with banks, non-bank finance companies, leasing companies and insurance companies.
In addition, the Company competes with the operators of its Properties in connection with the expansion of their businesses. Although each of the operators may offer investment opportunities to the Company, each of the operators or its affiliates will, in fact, compete with the Company (as well as with others) for investment opportunities. The operators may own facilities that are not mortgaged or leased to the Company. An operator, or an affiliate thereof, could preferentially place patients or operate special service programs in facilities other than those included among the Properties. Such preferential treatment and/or new programs could adversely affect the revenues derived by the Company under its mortgages and leases.
Federal Income Tax Considerations. The Company believes that it is and it intends to be and remain qualified as a real estate investment trust ("REIT") under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the "Code"). These Code provisions are highly technical and complex. Each shareholder therefore is urged to consult his own tax advisor with respect to the federal income tax and other tax consequences of the purchase, holding and sale of shares of beneficial interest of the Company.
The Company has obtained legal opinions that the Company has been organized in conformity with the requirements for qualification as a REIT, has qualified as a REIT for its 1987, 1988, 1989, 1990, 1991, 1992, 1993 and 1994 taxable years, and that its current and anticipated investments and its plan of operation will enable it to continue to meet the requirements for qualification and taxation as a REIT under the Code. Actual qualification of the Company as a REIT, however, will depend upon the Company's continued ability to meet, and its meeting, through actual annual operating results, the various qualification tests imposed under the Code. No assurance can be given that the actual results of the Company's operation for any one taxable year will satisfy such requirements.
Taxation of the Company. If the Company qualifies for taxation as a REIT and distributes to its shareholders at least 95% of its "real estate investment trust taxable income", it generally will not be
subject to federal corporate income taxes on the amount distributed. However, a REIT is subject to special taxes on the net income derived from "prohibited transactions." In addition, property acquired by the Company as the result of a default or imminent default on a lease or mortgage is classified as "foreclosure property". Certain net income from foreclosure property held by the Company for sale is taxable to it at the highest corporate marginal tax rate then prevailing.
Section 856(a) of the Code defines a REIT as a corporation, trust or association: (1) which is managed by one or more trustees or directors; (2) the beneficial ownership of which is evidenced by transferable shares or by transferable certificates of beneficial interest; (3) which would be taxable, but for Sections 856 through 859 of the Code, as a domestic corporation; (4) which is neither a financial institution nor an insurance company subject to certain provisions of the Code; (5) the beneficial ownership of which is held by 100 or more persons; (6) which is not closely held as determined under the personal holding company stock ownership test (as applied with one modification); and (7) which meets certain other tests, described below. Section 856(b) of the Code provides that conditions (1) to (4), inclusive, must be met during the entire taxable year and that condition (5) must be met during at least 335 days of a taxable year of 12 months, or during a proportionate part of a taxable year of less than 12 months. By reason of condition (6) above, the Company will fail to qualify as a REIT for a taxable year if at any time during the last half of such year more than 50% in value of its outstanding Shares are owned directly or indirectly by five or fewer individuals. To help maintain conformity with condition (6), the Company's Declaration of Trust (the "Declaration") contains certain provisions restricting share transfers and giving the Board of Trustees power to redeem shares involuntarily.
It is the expectation of the Company that it will have at least 100 shareholders during the requisite period for each of its taxable years. There can, however, be no assurance in this connection and, if the Company has fewer than 100 shareholders during the requisite period, condition (5) described above will not be satisfied, and the Company would not qualify as a REIT during such taxable year.
For taxable years beginning after 1993, the rule that an entity will fail to qualify as a REIT for a taxable year if at any time during the last half of such year more than 50% in value of its outstanding shares is owned directly or indirectly by five or fewer individuals has been liberalized in the case of a qualified pension trust owning shares in a REIT. Under the new rule, the requirement is applied by treating shares in a REIT held by such a pension trust as held directly by its beneficiaries in proportion to their actuarial interests in the pension trust. Consequently, five or fewer pension trusts could own more than 50% of the interests in an entity without jeopardizing its qualification as a REIT. However, if a REIT is a "pension-held REIT" as defined in the new law, each pension trust holding more than 10% of its shares (by value) generally will be taxable on a portion of the dividends it receives from the REIT, based on the ratio of the REIT's gross income for the year which would be unrelated trade or business income if the REIT were a qualified pension trust to the total gross income of the REIT for the year. A "pension-held REIT" is one in which at least one
qualified pension trust holds more than 25% (by value) of the interests by value, or a combination of qualified pension trusts each of which owns more than 10% by value of the REIT together holds more than 50% of the REIT interests by value.
To qualify as a REIT for a taxable year under the Code, the Company must elect to be so treated and must meet other requirements, certain of which are summarized below, including percentage tests relating to the sources of its gross income, the nature of the Company's assets, and the distribution of its income to shareholders. The Company has made such election for 1987 (its first full year of operations) and such election, assuming continuing compliance with the qualification tests discussed herein, continues in effect for subsequent years.
There are three gross income requirements. First, at least 75% of the Company's gross income (excluding gross income from certain sales of property held primarily for sale) must be derived directly or indirectly from investments relating to real property (including "rents from real property") or mortgages on real property. When the Company receives new capital in exchange for its shares (other than dividend reinvestment amounts) or in a public offering of five-year or longer debt instruments, income attributable to the temporary investment of such new capital in stock or a debt instrument, if received or accrued within one year of the Company's receipt of the new capital, is qualifying income under the 75% test. Second, at least 95% of the Company's gross income (excluding gross income from certain sales of property held primarily for sale) must be derived from such real property investments, dividends, interest, certain payments under interest rate swap or cap agreements, and gain from the sale or disposition of stock, securities, or real property or from any combination of the foregoing. Third, short-term gain from the sale or other disposition of stock or securities, including, without limitation, stock in other REITs, dispositions of interest rate swap or cap agreements, and gain from certain prohibited transactions or other dispositions of real property held for less than four years (apart from involuntary conversions and sales of foreclosure property) must represent less than 30% of the Company's gross income. (This rule does not apply for a year in which the REIT is completely liquidated, as to dispositions occurring after the adoption of a plan of complete liquidation.) For purposes of these rules, income derived from a "shared appreciation provision" is treated as gain recognized on the sale of the property to which it relates. Even though the Company's present mortgages do not contain shared appreciation provisions, the Company may make mortgage loans which include such provisions.
The Company temporarily invests working capital in short-term investments, including shares in other REITs. Although the Company will use its best efforts to ensure that its income generated by these investments will be of a type which satisfies the 75% and 95% gross income tests, there can be no assurance in this regard (see discussion above of the "new capital" rule under the 75% test). Moreover, the Company may realize short-term capital gain upon sale or exchange of such investments, and such short-term capital gain would be subject to the limitations imposed by the 30% gross income test.
In order to qualify as "rents from real property," the amount of rent received generally must not be determined from the income or profits of any person, but may be based on receipts or sales. The Code also provides that rents will not qualify as "rents from real property," in satisfying the gross income tests, if the REIT owns 10% or more of the tenant, whether directly or under certain attribution rules. The Company intends not to lease property to any party if rents from such property would not so qualify. Application of the 10% ownership rule is, however, dependent upon complex attribution rules provided in the Code and circumstances beyond the control of the Company. Ownership, directly or by attribution, by an unaffiliated third party of more than 10% of the Company's shares and more than 10% of the stock of a lessee would result in lessee rents not qualifying as "rents from real property". The Declaration provides that transfers or purported acquisitions, directly or by attribution, of shares that could result in disqualification of the Company as a REIT are null and void and permits the Trustees to repurchase shares to the extent necessary to maintain the Company's status as a REIT. Nevertheless, there can be no assurance such provisions in the Declaration will be effective to prevent the Company's REIT status from being jeopardized under the 10% rule. Furthermore, there can be no assurance that the Company will be able to monitor and enforce such restrictions, nor will shareholders necessarily be aware of share holdings attributed to them under the attribution rules.
In addition, the Company must not manage the property or furnish or render services to the tenants of such property, except through an independent contractor from whom the company derives no income. There is an exception to this rule permitting a REIT to perform certain customary tenant services of the sort which a tax-exempt organization could perform without being considered in receipt of "unrelated business taxable income."
If rent attributable to personal property leased in connection with a lease of real property is greater than 15% of the total rent received under the lease, then the portion of rent attributable to such personal property will not qualify as "rents from real property." The portion of rental income treated as attributable to personal property is determined according to the ratio of the tax basis of the personal property to the total tax basis of the property which is rented. If rent payments do not qualify, for the reasons discussed above, as rents from real property for the purposes of Section 856 of the Code, it will be more difficult for the Company to meet the 95% or 75% gross income tests and to qualify as a REIT. Finally, in order to qualify as mortgage interest on real property for purposes of the 75% test, interest must derive from a mortgage loan secured by real property with a fair market value at least equal to the amount of the loan. If the amount of the loan exceeds the fair market value of the real property, the interest will be treated as interest on a mortgage loan in a ratio equal to the ratio of the fair market value of the real property to the total amount of the mortgage loan.
If the Company fails to satisfy one or both of the 75% or 95% gross income tests for any taxable year, it may nevertheless qualify as a REIT for such year if its failure to meet such test was due to reasonable
cause and not due to willful neglect, it attaches a schedule of the sources of its income to its return, and any incorrect information on the schedule was not due to fraud with intent to evade tax. It is not possible, however, to state whether in all circumstances the Company would be entitled to the benefit of these relief provisions. If these relief provisions apply, a special tax generally equal to 100% is imposed upon the greater of the amount by which the Company failed the 75% test or the 95% test, less an amount which generally reflects the expenses attributable to earning the non-qualified income.
At the close of each quarter of the Company's taxable year, it must also satisfy three tests relating to the nature of its assets. First, at least 75% of the value of the Company's total assets must consist of real estate assets (including its allocable share of real estate assets held by joint ventures or partnerships in which the Company participates), cash, cash items and government securities. Second, not more than 25% of the Company's total assets may be represented by securities (other than those includable in the 75% asset class). Finally, of the investments included in the 25% asset class, the value of any one issuer's securities owned by the Company may not exceed 5% of the value of the Company's total assets, and the Company may not own more than 10% of any one issuer's outstanding voting securities.
Where a failure to satisfy the 25% asset test results from an acquisition of securities or other property during a quarter, the failure can be cured by disposition of sufficient non-qualifying assets within 30 days after the close of such quarter. The Company intends to maintain adequate records of the value of its assets to maintain compliance with the 25% asset test, and to take such action as may be required to cure any failure to satisfy the test within 30 days after the close of any quarter.
The Company, in order to qualify as a REIT, is required to distribute dividends (other than capital gain dividends) to its shareholders in an amount equal to or greater than the excess of (A) the sum of (i) 95% of the Company's "real estate investment trust taxable income" (computed without regard to the dividends paid deduction and the Company's net capital gain) and (ii) 95% of the net income, if any, (after tax) from foreclosure property, over (B) the sum of certain non-cash income (from certain imputed rental income and income from transactions inadvertently failing to qualify as like-king exchanges). These requirements may be waived by the IRS if the REIT establishes that it failed to meet them by reason of distributions previously made to meet the requirements of the 4% excise tax discussed below. To the extent that the Company does not distribute all of its net long-term capital gain and all of its "real estate investment trust taxable income", it will be subject to tax thereon. In addition, the Company will be subject to a 4% excise tax to the extent it fails within a calendar year to make "required distributions" to its shareholders of 85% of its ordinary income and 95% of its capital gain net income plus the excess, if any, of the "grossed up required distribution" for the preceding calendar year over the amount treated as distributed for such preceding calendar year. For this purpose, the term "grossed up required distribution" for any
calendar year is the sum of the taxable income of the Company for the calendar year (without regard to the deduction for dividends paid) and all amounts from earlier years that are not treated as having been distributed under the provision. Dividends declared in October, November, or December and paid during the following January will be treated as having been paid and received on December 31.
It is possible but highly unlikely, that the Company, from time to time, may not have sufficient cash or other liquid assets to meet the 95% distribution requirements, due to timing differences between the actual receipt of income and actual payment of deductible expenses or dividends on the one hand and the inclusion of such income and deduction of such expenses or dividends in arriving at "real estate investment trust taxable income" of the Company on the other hand. The problem of inadequate cash to make required distributions could also occur as a result of the repayment in cash of principal amounts due on the Company's outstanding debt, particularly in the case of "balloon" repayments or as a result of capital losses on short-term investments of working capital. Therefore, the Company might find it necessary to arrange for short-term, or possibly long-term, borrowing, or new equity financing. If the Company were unable to arrange such borrowing or financing as might be necessary to provide funds for required distributions, its REIT status could be jeopardized.
Under certain circumstances, the Company may be able to rectify a failure to meet the distribution requirement for a year by paying "deficiency dividends" to shareholders in a later year, which may be included in the Company's deduction for dividends paid for the earlier year. The Company may be able to avoid being taxed on amounts distributed as deficiency dividends; however, the Company may in certain circumstances remain liable for the 4% excise tax discussed above.
The Company is also required to request annually from record holders of certain significant percentages of its shares certain information regarding the ownership of such shares. Under the Declaration, shareholders are required to respond to such requests for information.
Federal Income Tax Treatment of Leases. The availability to the Company of, among other things, depreciation deductions with respect to the facilities owned and leased by the Company will depend upon the treatment of the Company as the owner of the facilities and the classification of the leases of the facilities as true leases, rather than as sales or financing arrangements, for Federal income tax purposes. As to the approximately 5% of the leased facilities which constitutes personal property, it is less clear that the Company will be treated as the owner of such personal property and that the leases will be treated as true leases with respect to such property. The Company plans to insure its compliance with the 95% distribution requirement (and the "required distribution" requirement) by making distributions on the assumption that it is not entitled to depreciation deductions for the 5% of the leased facilities which constitute personal property, but to report the amount of income taxable to its shareholders by taking into account such depreciation.
Other Issues. In the case of certain sale-leaseback arrangements, the IRS could assert that the Company realized prepaid rental income in the year of purchase to the extent that the value of a leased property exceeds the purchase price paid by the Company for that property. In litigated cases involving sale-leasebacks which have considered this issue, courts have concluded that buyers have realized prepaid rent where both parties acknowledged that the purported purchase price for the property was substantially less than fair market value and the purported rents were substantially less than the fair market rentals. Because of the lack of clear precedent, complete assurance cannot be given that the IRS could not successfully assert the existence of prepaid rental income.
Additionally, it should be noted that Code Section 467 (concerning leases with increasing rents) would apply to the leases because many of the leases provide for rents that increase from one period to the next. Section 467 provides that in the case of a so-called "disqualified leaseback agreement," rental income must be accrued at a constant rate. If such constant rent accrual were required, the Company would recognize rental income in excess of cash rents and, as a result, may fail to meet the 95% dividend distribution requirement. "Disqualified leaseback agreements" include leaseback transactions where a principal purpose for providing increasing rent under the agreement is the avoidance of Federal income tax. Because Section 467 directs the Treasury to issue regulations providing that rents will not be treated as increasing for tax avoidance purposes where the increases are based upon a fixed percentage of lessee receipts, the additional rent provisions of the leases should not cause the leases to be "disqualified leaseback agreements". In addition, the legislative history of Section 467 indicates that the Treasury should issue regulations under which leases providing for fluctuations in rents by no more than a reasonable percentage from the average rent payable over the term of the lease will be deemed not motivated by tax avoidance; this legislative history indicated that a standard allowing a 10% fluctuation in rents may be too restrictive for real estate leases.
Depreciation of Properties. For tax purposes, the Company's real property generally is depreciated on a straight-line basis over 40 years and personal property owned by the Company generally is depreciated over 12 years.
Failure to Qualify. If the Company fails to qualify for taxation as a REIT in any taxable year, and the relief provisions do not apply, the Company will be subject to tax on its taxable income at regular corporate rates (plus any applicable minimum tax). Distributions to shareholders in any year in which the Company fails to qualify will not be deductible by the Company nor will they be required to be made. In such event, to the extent of current and accumulated earnings and profits, all distributions to shareholders will be taxable as ordinary income and, subject to certain limitations in the Code, eligible for the 70% dividends received deduction for corporations. Unless entitled to relief under specific statutory provisions, the Company will also be disqualified from taxation as a REIT for the following four taxable years. It is not possible to state whether in all circumstances the Company would be entitled to statutory relief from such
disqualification. Failure to qualify for even one year could result in the Company's incurring substantial indebtedness (to the extent borrowings are feasible) or liquidating substantial investments in order to pay the resulting taxes.
Taxation of United States Shareholders--Generally. As long as the Company qualifies as a REIT, distributions (including reinvestments pursuant to the Company's dividend reinvestment plan) made to the Company's shareholders out of current or accumulated earnings and profits will be taken into account by them as ordinary income (which will not be eligible for the 70% dividends received deduction for corporations). Distributions that are designated as capital gain dividends will be taxed as long-term capital gains to the extent they do not exceed the Company's actual net capital gain for the taxable year although corporate shareholders may be required to treat up to 20% of any such capital gain dividend as ordinary income pursuant to Section 291 of the Code. For purposes of computing the Company's earnings and profits, depreciation on real estate is computed on a straight-line basis (over 40 years for property acquired after 1986). Distributions in excess of current or accumulated earnings and profits will not be taxable to a shareholder to the extent that they do not exceed the adjusted basis of the shareholder's shares, but will reduce the basis of the shareholder's shares. To the extent that such distributions exceed the adjusted basis of a shareholder's shares they will be included in income as long-term capital gain (or short-term capital gain if the shares have been held for not more than one year) assuming the shares are a capital asset in the hands of the shareholder. Shareholders may not include in their individual income tax returns any net operating losses or capital losses of the Company.
Dividends declared by the Company in October, November or December of a taxable year to shareholders of record on a date in such month, will be deemed to have been received by such shareholders on December 31, provided the Company actually pays such dividends during the following January. The Company has, however, generally declared dividends for the quarter ended December 31 in January of the following year and paid these dividends in the following February. As a result, for tax purposes, the dividend for any calendar year will generally include the dividends for the first three quarters of that year plus the dividend for the fourth quarter of the prior year. For tax purposes, dividends paid in 1987, 1988, 1989, 1990, 1991, 1992, 1993 and 1994 aggregated $1.085, $.840, $1.13, $1.16, $1.22, $1.25, $1.29 and $1.32 respectively, of which $.289, $.065, $.332, $.267, $.104, $.218, $.335 and $.081, respectively, represented a return of capital.
A sale of a share will result in recognition of gain or loss to the holder in an amount equal to the difference between the amount realized and its adjusted basis. Such a gain or loss will be capital gain or loss, provided the share is a capital asset in the hands of the seller. In general, any loss upon a sale or exchange of shares by a shareholder who has held such shares for not more than one year (after applying certain rules), will be treated as a long-term capital loss to the extent of distributions from the Company required to be treated by such shareholders as long-term capital gain.
Investors (other than certain corporations) who borrow funds to finance their acquisition of Shares in the Company could be limited in the amount of deductions allowed for the interest paid on the indebtedness incurred in such an arrangement. Under Code Section 163(d), interest paid or accrued on indebtedness incurred or continued to purchase or carry property held for investment is generally deductible only to the extent of the taxpayer's net investment income. An investor's net investment income will include the dividend and capital gain dividend distributions he receives from the Company; however, distributions treated as a nontaxable return of the shareholder's basis will not enter into the computation of net investment income.
In Revenue Ruling 66-106, the IRS ruled that amounts distributed by a real estate investment trust to a tax-exempt employee's pension trust did not constitute "unrelated business taxable income". Revenue rulings are interpretive in nature and subject to revocation or modification by the IRS. However, based upon Revenue Ruling 66-106 and the analysis therein, the Company has received an opinion of counsel that distributions by the Company to qualified pension plans (including individual retirement accounts) and other tax-exempt entities should not constitute "unrelated business taxable income," except as explained above in the case of a pension trust which holds more than 10% by value of a "pension-held REIT". This Revenue Ruling may not apply if a shareholder has borrowed money to acquire shares.
Under Section 469 of the Code, taxpayers (other than certain corporations) generally will not be entitled to deduct losses from so-called passive activities except to the extent of their income from passive activities. For purposes of these rules, distributions received by a shareholder from the Company will not be treated as income from a passive activity and thus will not be available to offset a shareholder's passive activity losses.
Tax preference and other items which are treated differently for regular and alternative minimum tax purposes are to be allocated between a REIT and its shareholders under regulations which are to be prescribed. It is likely that these regulations would require tax preference items to be allocated to the Company's shareholders with respect to any accelerated depreciation claimed by the Company, but the Company has not claimed accelerated depreciation with respect to its existing Properties.
Special Tax Considerations for Foreign Shareholders
The rules governing United States income taxation of nonresident alien individuals, foreign corporations, foreign partnerships, and foreign trusts and estates (collectively, "Non-U.S. Shareholders") are complex, and the following discussion is intended only as a summary of such rules. Prospective Non-U.S. Shareholders should consult with their own tax advisors to determine the impact of Federal, state, and local income
tax laws on an investment in the Company, including any reporting requirements.
In general, a Non-U.S. Shareholder will be subject to regular United States income tax with respect to its investment in the Company if such investment is "effectively connected" with the Non-U.S. Shareholder's conduct of a trade or business in the United States, or if the Non-U.S. Shareholder is a nonresident alien individual who is present in the United States for 183 days or more during the taxable year. A corporate Non-U.S. Shareholder that receives income that is (or is treated as) effectively connected with a U.S. trade or business may also be subject to the branch profits tax under Section 884 of the Code, which is payable in addition to regular United States corporate income tax. The following discussion will apply to Non-U.S. Shareholders whose investment in the Company is not so effectively connected.
A distribution by the Company that is not attributable to gain from the sale or exchange by the Company of a United States real property interest and that is not designated by the Company as a capital gain dividend will be treated as an ordinary income dividend to the extent that it is made out of current or accumulated earnings and profits. Generally, unless the dividend is effectively connected with the Non- U.S. Shareholder's conduct of a trade or business, such a dividend will be subject to a United States withholding tax equal to 30% of the gross amount of the dividend unless such withholding is reduced by an applicable tax treaty. A distribution of cash in excess of the Company's earnings and profits will be treated first as a nontaxable return of capital that will reduce a Non-U.S. Shareholder's basis in its shares (but not below zero) and then as gain from the disposition of such shares, the tax treatment of which is described under the rules discussed below with respect to disposition of shares. A distribution in excess of the Company's earnings and profits may be subject to 30% dividend withholding if at the time of the distribution it cannot be determined whether the distribution will be in an amount in excess of the Company's current and accumulated earnings and profits. If its subsequently determined that such distribution is, in fact, in excess of current and accumulated earnings and profits, the Non-U.S. Shareholder may seek a refund from the IRS. The Company expects to withhold United States income tax at the rate of 30% on the gross amount of any such distributions made to a Non-U.S. Shareholder unless (i) a lower tax treaty applies and the required form evidencing eligibility for that reduced rate is filed with the Company or (ii) the Non-U.S. Shareholder files IRS Form 4224 with the Company claiming that the distribution is "effectively connected" income.
For any year in which the Company qualifies as a REIT, distributions by the Company that are attributable to gain from the sale or exchange of a United States real property interest will be taxed to a Non-U.S. Shareholder in accordance with the Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA"). Under FIRPTA, such distributions are taxed to a Non-U.S. Shareholder as if such distributions were gains "effectively connected" with a United States trade or business. Accordingly, a Non-U.S. Shareholder will be taxed at the normal capital gain rates applicable to a U.S. Shareholder (subject to any applicable alternative minimum tax and a special alternative minimum tax in the
case of non-resident alien individuals). Distributions subject to FIRPTA may also be subject to a 30% branch profits tax in the hands of a foreign corporate shareholder that is not entitled to treaty exemption. The Company will be required to withhold from distributions to Non-U.S. Shareholders, and remit to the IRS, 35% of the amount of any distribution that could be designated as capital gain dividends.
Tax treaties may reduce the Company's withholding obligations. If the amount of tax withheld by the Company with respect to a distribution to a Non-U.S. Shareholder exceeds the shareholder's United States liability with respect to such distribution, the Non-U.S. Shareholder may file for a refund of such excess from the IRS. It should be noted that the 35% withholding tax rate on capital gain dividends corresponds to the maximum income tax rate applicable to corporations but is higher than the 28% maximum rate on capital gains of individuals.
If the Shares fail to constitute a "United States real property interest" within the meaning of FIRPTA, a sale of the Shares by a Non- U.S. Shareholder generally will not be subject to United States taxation unless (i) investment in the Shares is effectively connected with the Non-U.S. Shareholder's United States trade or business, in which case, as discussed above, the Non-U.S. Shareholder would be subject to the same treatment as U.S. Shareholders on such gain or (ii) the Non-U.S. Shareholder is a nonresident alien individual who was present in the United States for 183 days or more during the taxable year, in which case the nonresident alien individual will be subject to a 30% tax on the individual's capital gains.
The Shares will not constitute a United States real property interest if the Company is a "domestically controlled REIT". A domestically controlled REIT is a REIT in which at all times during a specified testing period less than 50% in value of its shares is held directly or indirectly by Non-U.S. Shareholders. It is currently anticipated that the Company will be a domestically controlled REIT, and therefore that the sale of Shares will not be subject to taxation under FIRPTA. However, because the Shares will be publicly traded, no assurance can be given that the Company will continue to be a domestically controlled REIT. If the Company did not constitute a domestically controlled REIT, whether a Non-U.S. Shareholder's sale of Shares would be subject to tax under FIRPTA as a sale of a United States real property interest would depend on whether the Shares were "regularly traded" (as defined by applicable Treasury Regulations) on an established securities market (e.g., the New York Stock Exchange, on which the Shares are listed) and on the size of the selling shareholder's interest in the Company. If the gain on the sale of the Shares were subject to taxation under FIRPTA, the Non-U.S. Shareholder would be subject to the same treatment as a U.S. Shareholder with respect to such gain (subject to applicable alternative minimum tax and a special alternative minimum tax in the case of nonresident alien individuals). In any event, a purchaser of Shares from a Non-U.S. Shareholder will not be required under FIRPTA to withhold on the purchase price if the purchased Shares are "regularly traded" on an established securities market or if the Company is a domestically controlled REIT. Otherwise, under FIRPTA, the purchaser of Shares may be required to withhold 10% of the purchase price and to remit such amount to the IRS.
Federal Estate Tax
Shares owned or treated as owned by an individual who is not a citizen or resident (as defined for United States federal estate tax purposes) of the United States at the time of death will be includible in the individual's gross estate for United States federal estate tax purposes unless an applicable estate tax treaty provides otherwise.
Backup Withholding and Information Reporting Requirements
The Company must report annually to the IRS and to each Non-U.S. Shareholder the amount of dividends paid to and the tax withheld with respect to such holder. These information reporting requirements apply regardless of whether withholding was reduced or eliminated by an applicable tax treaty. Copies of these information returns may also be made available under the provisions of a specific treaty or agreement to the tax authorities in the country in which the Non-U.S. Shareholder resides. United States backup withholding tax (which generally is a withholding tax imposed at the rate of 31% on certain payments to persons that fail to furnish the information required under the United States information reporting requirements) will generally not apply to dividends paid on Shares to a Non-U.S. Shareholder at an address outside the United States.
The payment of the proceeds from the disposition of Shares to or through the United States office of a broker will be subject to information reporting and backup withholding at a rate of 31% unless the owner, under penalties of perjury, certifies, among other things, its status as a Non-U.S. Shareholder, or otherwise establishes an exemption. The payment of the proceeds from the disposition of Shares to or through a non-U.S. office of a broker generally will not be subject to backup withholding and information reporting. In the case of proceeds from a disposition of Shares paid to or through a non-U.S. office of a U.S. broker or paid to or through a non-U.S. office of a non-U.S. broker that is (i) a "controlled foreign corporation" for United States federal income tax purposes or (ii) a person 50% or more of whose gross income from all sources for a certain three-year period was effectively connected with a United States trade or business, (a) backup withholding will not apply unless the broker has actual knowledge that the owner is not a Non-U.S. Shareholder, and (b) information reporting will not apply if the broker has documentary evidence in its files that the owner is a Non-U.S. Shareholder (unless the broker has actual knowledge to the contrary).
Any amounts withheld under the backup withholding rules from a payment to a Non-U.S. Shareholder will be refunded (or credited against the Non- U.S. Shareholder's United States federal income tax liability, if any), provided that the required information is furnished to the IRS.
Other Tax Consequences. The Company and its shareholders may be subject to state or local taxation in various state or local jurisdictions, including those in which it or they transact business or reside.
There may be other Federal, state, local or foreign income, or estate and gift, tax considerations applicable to the circumstances of a particular investor. Shareholders should consult their own tax advisors with respect to such matters.
ERISA Plans, Keogh Plans and Individual Retirement Accounts
General Fiduciary Obligations. Fiduciaries of a pension, profit-sharing or other employee benefit plan subject to Title I of the Employee Retirement Income Security Act of 1974 ("ERISA") ("ERISA Plan") must consider whether their investment in the Company's shares satisfies the diversification requirements of ERISA, whether the investment is prudent in light of possible limitations on the marketability of the shares, whether such fiduciaries have authority to acquire such shares under the appropriate governing instrument and Title I of ERISA, and whether such investment is otherwise consistent with their fiduciary responsibilities. Any ERISA Plan fiduciary should also consider ERISA's prohibition on improper delegation of control over or responsibility for "plan assets." Trustees and other fiduciaries of an ERISA plan may incur personal liability for any loss suffered by the plan on account of a violation of their fiduciary responsibilities. In addition, such fiduciaries may be subject to a civil penalty of up to 20% of any amount recovered by the plan on account of such a violation (the "Fiduciary Penalty"). Also, fiduciaries of any Individual Retirement Account ("IRA"), Keogh Plan or other qualified retirement plan not subject to Title I of ERISA because it does not cover common law employees ("Non-ERISA Plan") should consider that such an IRA or non-ERISA Plan may only make investments that are authorized by the appropriate governing instrument. Fiduciary shareholders should consult their own legal advisers if they have any concern as to whether the investment is inconsistent with any of the foregoing criteria.
Prohibited Transactions. Fiduciaries of ERISA Plans and persons making the investment decision for an IRA or other Non-ERISA Plan should also consider the application of the prohibited transaction provisions of ERISA and the Code in making their investment decision. Sales and certain other transactions between an ERISA Plan, IRA, or other Non-ERISA Plan and certain persons related to it are prohibited transactions. The particular facts concerning the sponsorship, operations and other investments of an ERISA Plan, IRA, or other Non-ERISA Plan may cause a wide range of other persons to be treated as disqualified persons or parties in interest with respect to it. A prohibited transaction, in addition to imposing potential personal liability upon fiduciaries of ERISA Plans, may also result in the imposition of an excise tax under the Code or a penalty under ERISA upon the disqualified person or party in interest with respect to the ERISA or Non-ERISA Plan or IRA. If the disqualified person who engages in the transaction is the individual on behalf of whom an IRA is maintained (or his beneficiary), the IRA may lose its tax-exempt status and its assets may be deemed to have been distributed to such individual in a taxable distribution (and no excise tax will be imposed) on account of the prohibited transaction. Fiduciary shareholders should consult their own legal advisers if they have any concern as to whether the investment is a prohibited transaction.
Special Fiduciary and Prohibited Transactions Considerations. On November 13, 1986 the Department of Labor ("DOL"), which has certain administrative responsibility over ERISA Plans as well as over IRAs and other Non-ERISA Plans, issued a final regulation defining "plan assets." The regulation generally provides that when an ERISA or non-ERISA Plan or IRA acquires a security that is an equity interest in an entity and that security is neither a "publicly offered security" nor a security issued by an investment company registered under the Investment Company Act of 1940, the ERISA or Non-ERISA Plan's or IRA's assets include both the equity interest and an undivided interest in each of the underlying assets of the entity, unless it is established either that the entity is an operating company or that equity participation in the entity by benefit plan investors is not significant.
The regulation defines a publicly offered security as a security that is "widely held," "freely transferable" and either part of a class of securities registered under the Securities Exchange Act of 1934, or sold pursuant to an effective registration statement under the Securities Act of 1933 (provided the securities are registered under the Securities Exchange Act of 1934 within 120 days after the end of the fiscal year of the issuer during which the offering occurred). The Company's shares have been registered under the Securities Exchange Act of 1934.
The regulation provides that a security is "widely held" only if it is part of a class of securities that is owned by 100 or more investors independent of the issuer and of one another. However, a security will not fail to be "widely held" because the number of independent investors falls below 100 subsequent to the initial public offering as a result of events beyond the issuer's control.
The regulation provides that whether a security is "freely transferable" is a factual question to be determined on the basis of all relevant facts and circumstances. The regulation further provides that, where a security is part of an offering in which the minimum investment is $10,000 or less, certain restrictions ordinarily will not, alone or in combination, affect a finding that such securities are freely transferable. The restrictions on transfer enumerated in the regulation as not affecting that finding include: any restriction on or prohibition against any transfer or assignment which would result in a termination or reclassification of the Company for Federal or state tax purposes, or would otherwise violate any state or Federal law or court order; any requirement that advance notice of a transfer or assignment be given to the Company and any requirement that either the transferor or transferee, or both, execute documentation setting forth representations as to compliance with any restrictions on transfer which are among those enumerated in the regulation as not affecting free transferability, including those described in the preceding clause of this sentence; any administrative procedure which establishes an effective date, or an event prior to which a transfer or assignment will not be effective; and any limitation or restriction on transfer or assignment which is not imposed by the issuer or a person acting on behalf of the issuer. The Company believes that the restrictions imposed under the Declaration on the transfer of shares do not result in the failure of the shares to be "freely transferable." Furthermore, the Company believes that at
present there exist no other facts or circumstances limiting the transferability of the shares which are not included among those enumerated as not affecting their free transferability under the regulation, and the Company does not expect or intend to impose in the future (or to permit any person to impose on its behalf) any limitations or restrictions on transfer which would not be among the enumerated permissible limitations or restrictions. However, the final regulation only establishes a presumption in favor of a finding of free transferability, and no guarantee can be given that the DOL or the Treasury Department will not reach a contrary conclusion.
Assuming that the shares will be "widely held" and that no other facts and circumstances exist which restrict transferability of the shares, the Company has received an opinion of counsel that the shares should not fail to be "freely transferable" for purposes of the regulation due to the restrictions on transfer of the shares under the Declaration and that under the regulation the shares are publicly offered securities and the assets of the Company will not be deemed to be "plan assets" of any ERISA Plan, IRA or other Non-ERISA Plan that invests in the shares.
If the assets of the Company are deemed to be plan assets under ERISA, (i) the prudence standards and other provisions of Part 4 of Title I of ERISA would be applicable to investments made by the Company; (ii) the person or persons having investment discretion over the assets of ERISA Plans which invest in the Company would be liable under the aforementioned Part 4 of Title I of ERISA for investments made by the Company which do not conform to such ERISA standards unless the Advisor registers as an investment adviser under the Investment Advisers Act of 1940 and certain other conditions are satisfied; and (iii) certain transactions that the Company might enter into in the ordinary course of its business and operation might constitute "prohibited transactions" under ERISA and the Code.
Item 2.
Item 2. Properties.
General. Approximately 77% of the Company's total investments are in nursing homes retirement centers and assisted living centers providing long-term care, 21% of the Company's total investments are in nursing homes with subacute and other specialty rehabilitation services and 2% are in other healthcare facilities. The Company believes that the physical plant of each of the facilities in which it has invested is suitable and adequate for its present and any currently proposed uses. At December 31, 1994, the Company had total real estate investments of approximately $807 million in 141 properties located in 27 states and with approximately 27 different lessees and mortgagors.
The following table summarizes certain information about the Properties as of December 31, 1994. All dollar figures are in thousands.
* Amounts represent or include notes receivable related to improvements to owned property, above.
Item 3.
Item 3. Legal Proceedings.
The Company may be subject to routine litigation in the ordinary course of business. It is not presently subject to any legal proceedings which would result in material losses to the Company. The Company knows of no proceedings contemplated by governmental authorities relating to the Company.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of shareholders during the fourth quarter of the year covered by this Form 10-K.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
The Company's Shares are traded on the New York Stock Exchange (symbol: HRP). The following table sets forth for the periods indicated the high and low sale prices for the Shares as reported in the New York Stock Exchange Composite Transactions reports.
High Low First Quarter........... 15 11 3/8 Second Quarter.......... 14 12 Third Quarter........... 15 1/8 12 1/2 Fourth Quarter.......... 16 3/4 14
First Quarter........... 16 3/8 14 3/8 Second Quarter.......... 15 3/8 14 Third Quarter........... 15 3/4 14 1/4 Fourth Quarter.......... 14 7/8 13
The closing price of the Shares on the New York Stock Exchange on March 3, 1995 was $14.50.
As of March 3, 1995, there were 3,815 holders of record of the Shares and the Company estimates that as of such date there were in excess of 60,000 beneficial owners of the Shares.
Dividends declared with respect to each period for the two most recent fiscal years and the amount of such dividends and the respective annualized rates are set forth in the following table.
Annualized Dividend Dividend Per Share Rate
First Quarter...... $.32 $1.28 Second Quarter..... .32 1.28 Third Quarter...... .33 1.32 Fourth Quarter..... .33 1.32
First Quarter...... .33 1.32 Second Quarter..... .33 1.32 Third Quarter...... .33 1.32 Fourth Quarter..... .34 1.36
All dividends declared have been paid. The Company intends to continue to declare and pay future dividends on a quarterly basis.
In order to qualify for the beneficial tax treatment accorded to REITs by Sections 856 through 860 of the Code, the Company is required to make distributions to shareholders which annually will be at least 95% of the Company's "real estate investment trust taxable income" (as defined in the Code). All distributions will be made by the Company at the discretion of the Board of Trustees and will depend on the earnings of the Company, funds from operations, the financial condition of the Company and such other factors as the Board of Trustees deems relevant. The Company has in the past distributed, and intends to continue to distribute, substantially all of its "real estate investment trust taxable income" to its shareholders.
Item 6.
Item 6. Selected Financial Data.
Set forth below are selected financial data for the Company for the periods and dates indicated. This data should be read in conjunction with, and is qualified in its entirety by reference to, the financial statements and accompanying notes included elsewhere in this Form 10-K. Amounts are in thousands, except per Share information.
(1) Funds from operations does not equal cash flow from operating activities as defined by generally accepted accounting principles and should not be considered an alternative to net income as an indication of the Company's performance or to cash as a measure of liquidity. Funds from operations means income before gain (loss) on sale of properties and extraordinary items plus depreciation and other non-cash items. Dividends in excess of net income generally constitute a return of capital.
Item 7.
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations.
Results of Operations
Year Ended December 31, 1994 compared to Year Ended December 31, 1993
Total revenues for the year ended December 31, 1994 were $86.7 million, an increase of $30.2 million or 53% over the year ended December 31, 1993. Rental income increased to $63.9 million from $46.1 million and interest income increased to $22.8 million from $10.4 million. Rental income increased as a result of new purchase and lease investments, primarily a $33.4 million transaction in December 1993 and the $320 million retirement community transaction with Marriott International, Inc. (Marriott) in 1994. The growth in interest income is primarily the result of the full year impact of three loan pool acquisitions in 1993 and a mortgage transaction of $26.6 million in December 1993.
Total expenses for 1994 increased to $28.8 million, from $18.7 million, in the comparable 1993 period. The increase of $10.1 million was due primarily to increases in interest of $2.7 million, advisory fees of $1.5 million, and depreciation and amortization of $5.6 million. The increases in advisory fees and depreciation and amortization are directly related to the Company's increased investments whereas interest increased due to both higher interest rates during the second half of 1994 and the issuance of $200 million senior notes in July 1994 in connection with the Marriott transaction.
Income before gain (loss) on sale of properties and extraordinary items for 1994 increased to $57.9 million, or $1.10 per share, from $37.7 million, or $1.10 per share, in 1993. Per share amounts remained flat reflecting the issuance of nine million new shares of the Company's stock in December 1993 and 13.3 million new shares in 1994, as well as negative interest arbitrage resulting from unusually high cash balances caused by timing differences between receipt of proceeds from the note offering and the investment of those proceeds in real estate.
Income before extraordinary items and net income in 1994 was $51.9 million ($.98 per share) and $49.9 million ($.95 per share), respectively, versus $37.7 million ($1.10 per share) and $33.4 million ($.97 per share), respectively, in 1993. On a per share basis, income before extraordinary items and net income decreased during 1994 primarily as a result of the new share issuances noted above and negative arbitrage noted above and the $10 million provision for the potential loss on the sale of two psychiatric hospitals. These two hospitals are HRP's only investments in the psychiatric industry and the loss is due to the general decline in value of such property.
The Company's business plan is to maximize funds from operations rather than net income. The Company's Board of Trustees considers funds from operations, among other factors, when determining dividends to be paid to shareholders. Funds from operations means net income excluding gains or losses from debt restructuring and sales of property, plus depreciation. Cash flow provided by operating activities may not necessarily equal funds from operations as the cash flow of the Company
is affected by other factors not included in the funds from operations calculation such as changes in assets and liabilities. Funds from operations for the year ended December 31, 1994, was $73.9 million, or $1.40 per share, versus $47.6 million, or $1.38 per share, in 1993. Funds from operations for 1994 increased $26.3 million or 55% over the prior year. However, funds from operations per share increased only slightly as a result of nine million new shares of the Company's stock issued in December 1993 and 13.3 million new shares issued in 1994 and the negative arbitrage from large cash balances previously discussed. Dividends declared for the years ended December 31, 1994 and 1993 were $1.33 per share and $1.30 per share, respectively. Dividends in excess of net income constitute a return of capital. For 1994, the return of capital portion reported was 6.1% of dividends and 12.6% of dividends was considered a long term capital gain.
Cash flow provided by (used for) operating, investing and financing activities were $78.3 million, ($261.8 million) and $229.4 million, respectively, for the year ended December 31, 1994 and $47.2 million, ($175.4 million) and $128.0 million, respectively in 1993.
Year Ended December 31, 1993 compared to Year Ended December 31, 1992
Total revenues for the year ended December 31, 1993 were $56.5 million, an increase of $7.8 million or 16% over the year ended December 31, 1992. Rental income increased to $46.1 million from $43.0 million and interest income increased to $10.4 million from $5.7 million. Rental income increased as a result of new purchase lease investments, increases in additional rent, and improvement financings during 1993. The growth in interest income is primarily the result of the acquisition since December 1, 1992, of four pools of performing mortgage loans for $133.7 million with a principal balance at the time of acquisition of approximately $148.2 million.
Net income for 1993 increased to $33.4 million, or $.97 per share, from $27.2 million, or $1.02 per share in the comparable 1992 period. The increase in net income of $6.2 million or 23% during the 1993 period was primarily the result of new investments discussed above and a decrease in total expenses of $2.7 million. On a per share basis, net income decreased slightly during 1993 primarily as a result of non- recurring charges related to the early extinguishment of debt. Debt was retired with the proceeds from the issuance of 10.35 million and nine million new shares of the Company's stock during the first and fourth quarters, respectively, of 1993. Total expenses for 1993 were $18.7 million, a decrease of 13% from $21.5 million for the comparable 1992 period. Interest expense decreased $3.2 million as a result of lower average bank borrowings and lower interest rates during the comparable periods. Depreciation and amortization expense remained flat reflecting the fact that the new mortgage investments occurred throughout the year and the significant purchase lease investments occurred near year end.
The Company's funds from operations for the years ended December 31, 1993, and 1992 was $47.6 million ($1.38 per share) and $36.9 million ($1.38 per share), respectively. Total funds from operations for 1993 increased $10.7 million or 29% over the prior year. However, on a per share basis, funds from operations remained unchanged, primarily as a result of the 19.4 million new shares of the Company's stock issued in 1993. Dividends declared for the years ended December 31, 1993 and 1992 were $1.30 per share and $1.26 per share, respectively. Dividends in excess of net income constitute a return of capital. For 1993, the return of capital portion was 26% of the dividends.
Cash flow provided by (used for) operations, investing and financing activities were $47.2 million, ($175.4 million) and $128.0 million, respectively, for the year ended December 31, 1993, and $42.0 million, ($71.9 million) and $1.9 million, respectively, for the year ended December 31, 1992.
Liquidity and Capital Resources
Assets increased to $840.2 million as of December 31, 1994, from $527.7 million as of December 31, 1993. The increase of $312.5 million or 59% is primarily attributable to the increases in real estate properties, net, and cash and cash equivalents of $283.7 million and $45.9 million, respectively, net of a decrease in real estate mortgages and notes, net, of $23.8 million. The increase in real estate properties is the net result of the acquisition of 14 retirement communities in connection with the Marriott transaction, and the sale of three properties in connection with the February 11, 1994 merger of Greenery Rehabilitation Group, Inc. (Greenery) into Horizon Healthcare Corporation (Horizon). Cash increased as a result of mortgage prepayments and excess proceeds from the July debt offering. Real estate mortgages and notes, net, decreased principally due to the prepayment of mortgage investments totalling $48.7 million, net of new mortgage financings of $14.5 million.
On February 11, 1994, in connection with the Horizon-Greenery merger, the Company sold to Horizon for $28.4 million three facilities that had been leased to Greenery. The Company realized a capital gain of approximately $4.0 million on the sale of these properties. In addition, Horizon has leased seven facilities previously leased to Greenery, on substantially similar terms except the leases were extended through 2005. The Company has granted Horizon a ten year option to buy the seven leased facilities, at the rate of no more than one facility per consecutive twelve months. The Company leased the three remaining Greenery facilities to a newly formed corporation, Connecticut Subacute Corporation, II (CSC II), an affiliate of HRPT Advisors, Inc. (Advisor). These facilities are being managed by and the lease payments are guaranteed by Horizon for a term of up to five years. The terms of these lease arrangements are substantially similar to the original lease arrangements with Greenery.
In January 1995 Horizon exercised its option and purchased one of the seven leased properties from the Company for $24.5 million resulting in a capital gain of $2.5 million. The Company provided Horizon a 16 year $19.5 million mortgage in connection with this sale in 1995.
On February 11, 1994, in connection with the Horizon-Greenery merger, the Company provided Horizon with $9.4 million first mortgage financing for two facilities. One of the facilities previously was owned by the Company and leased to Greenery. The mortgage notes bear interest at 11.5% per annum and mature December 31, 2000.
During 1994 the Company received net proceeds of approximately $182.4 million from the public offering of 13,251,500 shares of beneficial interest (including the underwriter's over-allotment). A portion of the proceeds were used to repay the outstanding balance of $73 million on the Company's revolving credit facility and the remainder was used to fund part of the Marriott transaction.
On September 9, 1994, the Company completed its acquisition of 14 retirement communities containing 3,952 residencies or beds for $320 million. These communities are triple net leased through December 31, 2013 to a wholly owned subsidiary of Marriott International Inc. The leases provide for fixed rent and additional rentals equal to a percentage of annual revenues from operations in excess of base amounts determined on a facility by facility basis. All of the leases are subject to cross default provisions and are guaranteed by Marriott. This transaction was funded from cash on hand, the proceeds of an equity offering discussed above, drawings under the Company's revolving credit facility, assumption of $17.6 million of existing debt bearing interest at 7.75% and a portion of the proceeds from a note offering described below.
On July 13, 1994, the Company received net proceeds of $197.3 million from the offering of $200 million floating rate senior notes due in 1999. The notes were issued in two series, A and B, which may be called by the Company beginning April 13, 1995 and July 13, 1996, respectively. The weighted average interest rate is LIBOR plus 84 basis points. A portion of these proceeds were used to fund part of the Marriott transaction and to repay $56 million in borrowings under the Company's revolving credit facility. The Company retained the balance to fund future real estate acquisitions. The Company has interest rate cap agreements which provide for maximum weighted average interest rates of approximately 6.85% on its variable rate debt.
This senior note offering was drawn under a shelf registration statement for the offering of up to $345 million of debt securities, preferred shares of beneficial interest, common shares of beneficial interest and common share warrants. An additional $145 million of securities may be issued under this registration statement.
At December 31, 1994, the Company had $59.8 million of cash and cash equivalents. The Company's $170 million revolving credit facility was undrawn at December 31, 1994. The facility matures in 1997 and bears interest at a spread over LIBOR.
As of December 31, 1994, the Company had extended commitments to provide financing totalling approximately $58.1 million. In addition to completing certain of these committed transactions in early 1995 as described below, the Company also entered into several additional commitments.
On January 24, 1995, the Company provided first mortgage financing of $11.5 million due in 2007, secured by four assisted living properties and operated by a newly created health care operating company. The borrower has provided a $1 million cash security deposit, to guarantee its obligations to the Company.
On January 31, 1995, the Company acquired nine nursing facilities for approximately $32 million. The facilities have been leased to two newly formed corporations which are affiliates of the Company. The purchase price paid was approximately $8.1 million in cash and 1.8 million shares of the Company's common stock.
The Company entered into a commitment to purchase and lease 11 nursing properties for $18 million and provide first mortgage financing of $2 million secured by three nursing properties, to a subsidiary of an existing tenant, on terms substantially similar to the Company's existing lease and mortgage agreements with that tenant. The acquisition is expected to close in April 1995.
The Company entered into an commitment to purchase and lease 14 nursing properties for approximately $45 million subject to adjustment, located in the United Kingdom, on terms substantially similar to the Company's existing lease agreements. The Company expects to fund this investment by borrowing in British sterling and has recently amended its bank credit facility to permit such borrowings. By borrowing in the same currency as it invests in, the Company believes it can reduce the impact of fluctuations in relative currency values. The acquisition is expected to close in installments beginning in April 1995 with the entire transaction being completed by December 1995.
The Company entered into a purchase and lease agreement with Host Marriott Corporation (Host Marriott) for 21 Courtyard by Marriott hotel properties for approximately $179.4 million, subject to adjustment. The properties are leased for an initial term of 12 years, with renewal options of an additional 37 years to a subsidiary of Host Marriott and are managed by a subsidiary of Marriott International. An amount equal to one year's rent was withheld from the purchase price to secure the tenant's obligations to the Company. The transaction closed in March 1995.
The Company funded and intends to fund these commitments with a combination of cash on hand, amounts available under its existing credit facilities, proceeds of mortgage prepayments, if any, and/or proceeds of other financings such as the possible issuance of additional securities in connection with the shelf registration statement described above.
The Company's investment in hotel properties does not represent a change in the Company's strategy of focusing on investments in long term care and retirement facilities. Rather, this investment, structured as a triple net lease, will represent only approximately 15% of the portfolio upon closing. The facilities are new, having been constructed within the last five years, and occupancy and cash flow coverage are strong. Following the announcement of this investment, Moody's downgraded the Company's debt rating and S&P and Fitch maintained their
ratings. The Company believes, despite the negative reaction by Moody's, that this transaction will enhance the security and growth potential of its funds from operations.
The Company continues to seek new investments to expand and diversify its portfolio of leased and mortgaged health care, retirement and related real estate. The Company believes that the transactions described above improve the security of its future cash flow and dividends. The Company intends to balance the use of debt and equity in such a manner that the long term cost of funds borrowed to acquire or mortgage finance facilities is appropriately matched, to the extent practicable, with the terms of the investments made with such borrowed funds. As of December 31, 1994, the Company's debt as a percentage of total capitalization was approximately 26%.
Impact of Inflation
Management believes that the Company is not adversely affected by inflation. In the real estate market, inflation tends to increase the value of the Company's underlying real estate which may be realized at the end of the lessees' fixed terms. In the health care and hotel industries, inflation increases the lessees' and mortgagors' revenues, thereby increasing the Company's additional rent or interest. At December 31, 1994, increases in interest rates on all of the Company's outstanding debt were capped by the use of interest rate cap agreements. The Company has interest rate cap agreements which provide for maximum weighted average interest rates of approximately 6.85% on its variable rate debt.
Item 8.
Item 8. Financial Statements and Supplementary Data
The financial statements and related notes and report of independent auditors for the Company are included following Part IV, beginning on page, and identified in the index appearing at Item 14(a). The financial statements for Marriott are incorporated by reference to Marriott's Annual Report on Form 10-K for the year ended December 30, 1994, Commission File No. 1-12188. The financial statements and financial statement schedules for Horizon are incorporated by reference to Horizon's Annual Report on Form 10-K for the year ended May 31, 1994, Commission File No. 1-9369 and Horizon's Quarterly Report on Form 10-Q for the quarter ended November 30, 1994, Commission File No. 1-9369. The financial statements and financial statement schedules for Grancare are incorporated by reference to Grancare's Annual Report on Form 10-K for the year ended December 31, 1994, Commission File No. 0- 19571.
Item 9.
Item 9. Changes in and Disagreements on Accounting and Financial Disclosure
Not applicable
PART III
The information in Part III (Items, 10, 11, 12 and 13) is incorporated by reference to the Company's definitive Proxy Statement, which will be filed not later than 120 days after the end of the Company's fiscal year.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) Index to Financial Statements and Financial Statement Schedules
HEALTH AND RETIREMENT PROPERTIES TRUST
Page
Report of Ernst & Young LLP, Independent Auditors Balance Sheets as of December 31, 1993 and 1994 Statements of Income for the years ended December 31, 1992, 1993 and 1994 Statements of Shareholders' Equity for the years ended December 31, 1992, 1993 and 1994 Statements of Cash Flows for the years ended December 31, 1992, 1993 and 1994 Notes to Financial Statements
The following financial schedules are included:
III -- Real Estate and Accumulated Depreciation IV -- Mortgage Loans on Real Estate
All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.
Exhibits:
3.1 - July 1994 Amended and Restated Declaration of Trust (3) 3.2 - Amended and Restated By-Laws (1) 4.1 - Form of Series A Note (2) 4.2 - Form of Series B Note (2) 4.3 - Shawmut Bank, N.A. Indenture dated as of June 1, 1994 (2) 4.4 - Supplemental Shawmut Bank, N.A., Indenture dated as of June 29, 1994 (2) 9.1 - AMS Voting Trust Agreement (9) 9.2 - Amended and Restated AMS Voting Trust Agreement (4) 10.1 - Advisory Agreement, as amended (10)(+) 10.2 - Second Amendment to Advisory Agreement (5)(+) 10.3 - Incentive Share Award Plan (6)(+) 10.4 - Master Lease Document (8) 10.5 - HRPT Shares Pledge Agreement (8) 10.6 - AMS Properties Security Agreement (8) 10.7 - AMS Subordination Agreement (8)
10.8 - AMS Guaranty (8) 10.9 - AMS Pledge Agreement (pledging shares of AMSP) (8) 10.10 - AMS Holding Co. Pledge Agreement (pledging shares of AMS) (7) 10.11 - Amended and Restated Renovation Funding Agreement (7) 10.12 - Amendment to AMS Transaction Documents (7) 10.13 - GCI Master Lease Document (6) 10.14 - Amended and Restated HRP Shares Pledge Agreement (6) 10.15 - Guaranty, Cross-Default and Cross-Collateralization Agreement (6) 10.16 - CSC $8,000,000 Working Capital Promissory Note (6) 10.17 - Marriott Senior Living Services Purchase and Sale Agreement (5) 10.18 - Connecticut Subacute Corporation II Lease Document Waterbury (1) 10.19 - Connecticut Subacute Corporation II Lease Document - Cheshire (1) 10.20 - Connecticut Subacute Corporation II Lease Document - New Haven (1) 10.21 - Vermont Subacute/New Hampshire Subacute Corporation Master Lease Agreement (Chapple) (1) 10.22 - Amended and Restated Agreement and Plan of Reorganization (Chapple) (1) 10.23 - March 1995 Second Amended and Restated Revolving Loan Agreement (1) 10.24 - Purchase Option Agreement (1) 12.1 - Earnings to Fixed Charges (1) 21.1 - Subsidiaries of the Registrant (1) 23.1 - Consent of Ernst & Young (1) 23.2 - Consent of Arthur Andersen LLP (Horizon) (1) 25.1 - Powers of Attorney (1) 27.1 - Financial Data Schedule (1)
(+) Management contract or compensatory plan or arrangement
(1) Filed herewith.
(2) Incorporated by reference to the Company's Registration Statement on Form 8-A dated July 11, 1994.
(3) Incorporated by reference to the Company's Current Report on Form 8-K dated July 1, 1994 and amendments thereto.
(4) Incorporated by reference to the Company's Registration Statement on Form S-3 dated June 2, 1994.
(5) Incorporated by reference to the Company's Annual Report on Form 10-K for its fiscal year ended December 31, 1993.
(6) Incorporated by reference to the Company's Registration Statement No. 33-55684 on Form S-11 dated December 23, 1992 and amendments thereto.
(7) Incorporated by reference to the Company's Annual Report on Form 10-K for its fiscal year ended December 31, 1991.
(8) Incorporated by reference to the Company's Current Report on Form 8-K dated December 28, 1990 and amendments thereto.
(9) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended September 30, 1990 and amendments thereto.
(10) Incorporated by reference to the Company's Registration Statement No. 33-16799 on Form S-11 dated August 27, 1987 and amendments thereto.
(b) Reports on Form 8-K
No reports on Form 8-K were filed during the last quarter of the period covered by this report.
REPORT OF INDEPENDENT AUDITORS
To the Trustees and Shareholders Health and Retirement Properties Trust
We have audited the accompanying balance sheets of Health and Retirement Properties Trust as of December 31, 1994 and 1993, and the related statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1994. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Health and Retirement Properties Trust at December 31, 1994 and 1993, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1994, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
ERNST & YOUNG LLP
Boston, Massachusetts February 9, 1995
See accompanying notes
See accompanying notes
See accompanying notes
See accompanying notes
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
Note 1. Organization
Health and Retirement Properties Trust (formerly known as Health and Rehabilitation Properties Trust), a Maryland real estate investment trust (the Company), was organized on October 9, 1986. The Company invests in income-producing real estate, primarily health care related properties.
Note 2. Summary of Significant Accounting Policies
Real estate properties and mortgages. Real estate properties and mortgages are recorded at cost. Depreciation is provided for on a straight-line basis over the estimated useful lives ranging up to 40 years. If the estimated net realizable value of an investment is less than the carrying value, an allowance for possible investment loss is established. The determination of net realizable value includes consideration of many factors including income to be earned from the investment, holding costs, estimated selling prices, and prevailing economic conditions.
Cash and cash equivalents. Cash, over-night repurchase agreements and short-term investments with maturities of three months or less at date of purchase are carried at cost plus accrued interest.
Deferred interest and finance costs. Costs incurred to secure certain borrowings are capitalized and amortized over the terms of their respective loans.
Interest rate hedging arrangements. The Company enters into interest rate hedging arrangements to limit the exposure to increasing interest rates with respect to its bank borrowings and notes payable. Their cost is included in interest expense ratably over the terms of the respective agreements. Amounts receivable from hedging arrangements are accrued as an adjustment to interest expense. The unamortized cost of these agreements is included in other assets.
Revenue recognition. Rental income from operating leases is recognized on a straight line basis over the life of the lease agreements. Interest income is recognized as earned over the terms of the real estate mortgages. Additional rent and interest revenue is recognized as earned.
Net income per share. Net income per share is computed using the weighted average number of shares outstanding during the period. Supplemental earnings per share for the years ended December 31, 1993 and 1994, was $.91 and $.93, respectively, based on the assumption that the issuance of shares in the Company's public offerings during 1993 and 1994, and the related repayment of outstanding bank borrowings, took place at the beginning of each year.
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
Reclassifications. Certain reclassifications have been made to the prior year financial statements to conform with the current year's presentation.
Federal income taxes. The Company is a real estate investment trust under the Internal Revenue Code of 1986, as amended. Accordingly, the Company expects not to be subject to federal income taxes on amounts distributed to shareholders provided it distributes at least 95% of its real estate investment trust taxable income and meets certain other requirements for qualifying as a real estate investment trust.
Note 3. Real estate properties.
The Company's real estate properties are leased pursuant to noncancellable, fixed term operating leases expiring from 1996 to 2013. The leases generally provide for renewal terms at existing rates followed by several market rate renewal terms. Each lease is a triple net lease and generally requires the lessee to pay minimum rent, additional rent based upon increases in net patient revenues and all operating costs associated with the leased property. Additional rent and interest for the years ended December 31, 1992, 1993 and 1994 were $1,809, $2,312, and $2,768, respectively.
During 1994, the Company acquired 14 retirement communities, two nursing properties and a medical laboratory building for an aggregate purchase price of approximately $326,350. The 14 retirement communities are leased to a subsidiary of Marriott International, Inc. (together with its subsidiaries, "Marriott") and the lease obligation is guaranteed by Marriott through the year 2013.
The obligations of Marriott are cross defaulted, cross guaranteed and cross secured. In the event Marriott's debt rating decreases to below "investment grade", Marriott is required to provide the Company a cash security deposit of approximately $6,911.
In addition, during 1994 the Company terminated the leases on thirteen properties. Seven of these properties have been leased to Horizon Healthcare Corporation (Horizon) on substantially similar terms, with the leases extended through 2005, and the Company has granted Horizon a ten year option to buy the seven properties, at the rate of no more than one property per consecutive twelve month period. Three of the properties have been leased to a newly formed corporation, an affiliate of HRPT Advisors, Inc. ("Advisor"), on substantially similar terms. These three properties are being managed by, and the lease payments are guaranteed by, Horizon for a term of up to five years. The three remaining properties were sold for approximately $28,400. The Company realized a gain of approximately $3,994 on the sale. In January, 1995, Horizon purchased one of the seven leased properties from
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
the Company for $24,500 and the Company realized a gain of approximately $2,476. The Company provided Horizon a $19,500 mortgage with a maturity of 2010 in connection with the sale of the property. The various leases and mortgages with another lessee, GranCare, Inc. (together with its subsidiaries, "GranCare") are secured by the pledge to the Company of 1,000,000 shares of the Company's common stock held by Grancare and substantially all the assets of the special operating subsidiaries. All obligations of GranCare are cross defaulted, cross guaranteed and cross secured.
The leases, mortgages and note due to the Company by Community Care of America ("CCA") and its subsidiaries are secured by a $3,800 cash security deposit, by a pledge of substantially all the assets of certain of the operating CCA subsidiaries and by a guarantee from the parent corporation. Substantially all of the CCA obligations are cross defaulted, cross guaranteed and cross secured.
The future minimum lease payments to be received by the Company during the current terms of the leases as of December 31, 1994, are approximately $70,422 in 1995, $70,397 in 1996, $65,305 in 1997, $65,046 in 1998, $60,640 in 1999 and $636,377 thereafter.
Note 4. Real Estate Mortgages and Notes, net
December 31, 1993 1994 Mortgage notes receivable, net of discounts of $11,951 and $5,817, respectively, due July 1995 through December 2016 $124,367 $ 92,560 Mortgage note receivable due December 2016 13,600 13,600 Amount due on investment held for sale, net of reserve of $10,000 - 9,947 Mortgage note receivable due December 2000 10,283 9,683 Secured note due December 2016 7,000 7,000 Other secured notes receivable 816 687 Loan to an affiliate 1,215 - $157,281 $133,477
At December 31, 1994, the interest rates on the mortgages range from 6.6% to 13.75%.
During 1994, the Company provided two mortgage loans secured by two properties for $9,400. One of these properties was previously owned by the Company. In addition, 23 mortgage loans, secured by 19 properties,
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
with outstanding principal balances aggregating approximately $48,667 were repaid.
In the fourth quarter of 1994, the Company agreed to sell its two psychiatric properties to the current operator, with a financial effect of September 1, 1994 ("Sale Date"). The sales price is being determined by a judicially supervised appraisal process and payments made to the Company, subsequent to Sale Date, on this investment, are being classified as interest and principal. Accordingly, at December 31, 1994, the Company has classified these properties as a mortgage receivable and has made a provision for a loss on this investment of approximately $10,000.
Note 5. Shareholders' Equity
During January 1994 and May 1994, the Company issued 601,500 and 12,650,000 common shares of beneficial interest, respectively, and received net proceeds of approximately $8,301 and $174,065, respectively.
In October, 1994, the Company adopted a Shareholders Rights Plan ("Plan") and declared a dividend of one right for each outstanding common share of beneficial interest ("Right"). Each Right entitles the holder to purchase one one-hundredth of a preferred share of beneficial interest, $.01 par value, or in certain circumstances, to receive cash, property, common shares or other securities of the Company, at a purchase price of $50 per one-hundredth of a preferred share, subject to adjustment. Upon the occurrence of certain events the holder of the Right will be entitled to acquire common shares at 50% of the then current market value of the shares. The Rights expire on October 17, 2004 and are redeemable at the Company's option at any time at $.01 per Right.
The Company has reserved 1,000,000 shares of the Company's stock, under the terms of the 1992 Incentive Share Award Plan ("Award Plan"). The Award Plan provides for the grant of the Company's stock to selected officers, Trustees and others rendering valuable services to the Company. During 1992, 1993 and 1994, 6,000, 6,000 and 11,000 shares, respectively, were granted to officers of the Company and certain employees of Advisors and 500 shares, annually, were granted to each of the three Independent Trustees, as part of their annual fee. The shares granted to the Trustees vest immediately. The shares granted to others vest over a three year period. At December 31, 1994, 972,500 shares of the Company remain reserved for issuance under the Award Plan.
Note 6. Financing Commitments
At December 31, 1994, the Company had total commitments aggregating $58,148, of which $8,603 is committed to finance improvements to certain
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
properties leased or mortgaged by the Company. During 1994, the Company funded approximately $11,088 of such improvements.
Note 7. Transactions With Affiliates
The Company has an agreement with the Advisor whereby the Advisor provides investment, management and administrative services to the Company. The Advisor is owned by Gerard M. Martin and Barry M. Portnoy. Messrs. Martin and Portnoy are directors of Horizon, shareholders of Connecticut Subacute Corporation ("CSC") and Connecticut Subacute Corporation II ("CSCII"), lessees of the Company, and are Managing- Trustees of the Company. The Company has extended a $4,000 line of credit to CSC until June 30, 1995. At December 31, 1994, there were no amounts outstanding under this agreement. Mr. Portnoy is a partner in the law firm which provides legal services to the Company and was a minority shareholder of the owner of Continuing Health Care Corporation, a company which formerly leased or mortgaged properties from the Company. Mr. Martin, until February 1994, was the majority shareholder of Greenery Rehabilitation Group, Inc. ("Greenery"), one of the Company's original sponsors and major tenant.
The Advisor is compensated at an annual rate equal to .7% of the Company's real estate investments up to $250 million and .5% of such investments thereafter. The Advisor is entitled to an incentive fee comprised of restricted shares of the Company's common stock based on a formula. Advisory fees for the years ended December 31, 1992, 1993 and 1994 were $2,231, $2,591 and $3,839, respectively. Incentive fees for 1994 were $239 which represents approximately 17,869 common shares. At December 31, 1994, the Advisor owned 996,250 common shares.
Amounts resulting from transactions with affiliates included in the accompanying statements of income, shareholders' equity and cash flows are as follows:
During 1994, the Company entered into a new revolving credit arrangement, aggregating $170,000, and repaid borrowings then outstanding. In connection with the prepayments, the Company terminated certain interest rate hedge arrangements, wrote off certain deferred costs related to the prepayment and recorded an extraordinary charge of approximately $1,953. In addition, the Company received net proceeds
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
after financing costs of $197,270 from the issuance of $200,000 Series A and Series B Senior Notes, issued at par and at a discount, respectively. The Series A notes may be called, at the Company's option, beginning in April 1995. The Series B notes may be called, at the Company's option, beginning in July 1996.
In association with the purchase of the Marriott properties, the Company assumed bonds payable of $17,620. These notes are secured by first mortgage liens on two retirement communities having an aggregate net book value of $67,997 at December 31, 1994, and by a $17,802 letter of credit.
At December 31, 1994, the Company had interest rate hedge agreements which cap interest rates on up to $200,000 of borrowings. The maximum average rates payable on such borrowings under these arrangements is 6.85% per annum over the terms of the agreements. The maturities of the hedge agreements range from 1995 through 1998.
The required principal payments for the next five years of $200,000 are due in 1999.
Note 9. Concentration of credit risk
Substantially all of the Company's assets are invested in income producing health care related real estate. At December 31, 1994, the Company's significant lessees and mortgagors are as follows:
Note 10. Fair value of financial instruments.
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
At December 31, 1994, the carrying amounts and fair values of the Company's financial instruments are as follows:
Cash and cash equivalents, security deposits and financing commitments approximate fair values. Interest rate hedging agreements are based on quoted market prices. The fair values of notes and bonds payable are based on estimates using discounted cash flow analysis and currently prevailing rates. The fair value of the letter of credit is based on fees currently charged to enter into similar agreements taking into account the remaining term and the counter party's credit standing.
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
Note 11. Selected Quarterly Financial Data (Unaudited)
The following is a summary of the unaudited quarterly results of operations of the Company for 1993 and 1994.
Note 12. Subsequent Events and Pro Forma Information (Unaudited)
On January 24, 1995, the Company provided first mortgage financing of $11,500, due in 2007, secured by four assisted living properties and operated by a newly created health care operating company. The borrower has provided a $1,000 cash security deposit to guarantee its obligations to the Company.
In addition, on January 31, 1995, the Company acquired nine nursing facilities for approximately $32,000. The facilities have been leased to a newly formed corporation which is an affiliate of the Company. The purchase price paid was approximately $8,132 in cash and 1,777,768 shares of the Company's common stock.
The Company entered into a commitment to purchase and lease 11 nursing properties for $18,000 and provide first mortgage financing of $2,045, secured by three nursing properties, to a subsidiary of an existing tenant, on terms substantially similar to the Company's existing lease and mortgage agreements. The acquisition is expected to close on or about April 1, 1995.
The Company has entered into a commitment of approximately $45,000, subject to adjustment, to purchase and lease 14 nursing properties located in the United Kingdom, on terms substantially similar to the Company's existing lease agreements. This investment will be funded in British Sterling. The acquisition is expected to close in installments beginning in April 1995 with the entire transaction completed by December 31, 1995.
The Company entered into a purchase and lease agreement with a subsidiary of Host Marriott Corporation ("Host Marriott") for 21 Courtyard by Marriott hotel properties for approximately $179,400, subject to adjustment. The properties will be leased for an initial term of 12 years, with renewal options of an additional 37 years to a subsidiary of Host Marriott, and will be managed by a subsidiary of
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
Marriott International. A portion of the purchase price equal to one year's rent will be withheld by the Company to guarantee the rent obligations to the Company. The acquisition is expected to close in March 1995.
The following summarized Pro Forma Statements of Income assume that the 1994 transactions described in Notes 3 and 4, the issuance of the Company's common shares and senior notes during 1994 and the transactions described above had occurred on January 1, 1993, and give effect to the Company's borrowing rates throughout the periods indicated.
The summarized Pro Forma Balance Sheet is intended to present the financial position of the Company as if the transactions described in Note 14 had occurred on December 31, 1994.
These pro forma statements are not necessarily indicative of the expected results of operations or the Company's financial position for any future period. Differences could result from, but are not
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
limited to, additional property investments, changes in interest rates and changes in the debt and/or equity structure of the Company.
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
HEALTH AND RETIREMENT PROPERTIES TRUST NOTES TO FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
HEALTH AND RETIREMENT PROPERTIES TRUST
By:/S/ David J. Hegarty David J. Hegarty Executive Vice President and Chief Financial Officer Dated: March 30, 1995
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons, or by their attorney-in-fact, in the capacities and on the dates indicated.