UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 2016
OR
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 000-54691
PHILLIPS EDISON GROCERY CENTER REIT I, INC.
(Exact Name of Registrant as Specified in Its Charter)
Maryland | 27-1106076 |
(State or Other Jurisdiction of Incorporation or Organization) | (I.R.S. Employer Identification No.) |
11501 Northlake Drive Cincinnati, Ohio | 45249 |
(Address of Principal Executive Offices) | (Zip Code) |
(513) 554-1110
(Registrant’s Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class | Name of Each Exchange on Which Registered | |
None | None | |
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.01 par value per share
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No þ
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No þ
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes þ No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment of this Form 10-K. þ
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large Accelerated Filer | ¨ | Accelerated Filer | ¨ |
Non-Accelerated Filer | þ (Do not check if a smaller reporting company) | Smaller reporting company | ¨ |
Indicate by check mark whether the Registrant is a shell company (as defined in rule 12b-2 of the Securities Exchange Act). Yes ¨ No þ
There is no established public market for the Registrant’s shares of common stock. On April 14, 2016, the board of directors of the Registrant approved an estimated value per share of the Registrant’s common stock of $10.20 based substantially on the estimated market value of its portfolio of real estate properties as of March 31, 2016. For a full description of the methodologies used to establish the estimated value per share, see Part II, Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities - Market Information, of this Form 10-K. As of June 30, 2016, the last business day of the Registrant’s most recently completed second fiscal quarter, there were approximately 183.3 million shares of common stock held by non-affiliates.
As of February 28, 2017, there were 182.1 million outstanding shares of common stock of the Registrant.
Documents Incorporated by Reference: None
PHILLIPS EDISON GROCERY CENTER REIT I, INC.
FORM 10-K
TABLE OF CONTENTS
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Cautionary Note Regarding Forward-Looking Statements
Certain statements contained in this Annual Report on Form 10-K of Phillips Edison Grocery Center REIT I, Inc. (“we,” the “Company,” “our,” or “us”) other than historical facts may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We intend for all such forward-looking statements to be covered by the applicable safe harbor provisions for forward-looking statements contained in those acts. Such statements include, in particular, statements about our plans, strategies, and prospects and are subject to certain risks and uncertainties, including known and unknown risks, which could cause actual results to differ materially from those projected or anticipated. Therefore, such statements are not intended to be a guarantee of our performance in future periods. Such forward-looking statements can generally be identified by our use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “anticipate,” “estimate,” “believe,” “continue,” or other similar words. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date this report is filed with the U.S. Securities and Exchange Commission (“SEC”). We make no representations or warranties (expressed or implied) about the accuracy of any such forward-looking statements contained in this Annual Report on Form 10-K, and we do not intend to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
Any such forward-looking statements are subject to risks, uncertainties, and other factors and are based on a number of assumptions involving judgments with respect to, among other things, future economic, competitive, and market conditions, all of which are difficult or impossible to predict accurately. To the extent that our assumptions differ from actual conditions, our ability to accurately anticipate results expressed in such forward-looking statements, including our ability to generate positive cash flows from operations, make distributions to stockholders, and maintain the value of our real estate properties, may be significantly hindered. See Item 1A. Risk Factors, herein, for a discussion of some of the risks and uncertainties, although not all of the risks and uncertainties, that could cause actual results to differ materially from those presented in our forward-looking statements. Except as required by law, we do not undertake any obligation to update or revise any forward-looking statements contained in this Form 10-K. Important factors that could cause actual results to differ materially from the forward-looking statements are disclosed in Item 1A. Risk Factors, Item 1. Business, and Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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PART I
ITEM 1. BUSINESS
Overview
Phillips Edison Grocery Center REIT I, Inc. (“we,” the “Company,” “our,” or “us”) was formed as a Maryland corporation in October 2009 and qualified as a real estate investment trust (“REIT”) for the year ended December 31, 2010, and each year thereafter. We invest primarily in well-occupied, grocery-anchored neighborhood and community shopping centers having a mix of creditworthy national and regional retailers selling necessity-based goods and services in strong demographic markets throughout the United States. As of December 31, 2016, we owned fee simple interests in 153 real estate properties acquired from third parties unrelated to us or Phillips Edison NTR LLC (“PE-NTR”).
Substantially all of our business is conducted through Phillips Edison Grocery Center Operating Partnership I, L.P. (“Operating Partnership”), a Delaware limited partnership formed in December 2009. We are a limited partner of the Operating Partnership, and our wholly owned subsidiary, Phillips Edison Grocery Center OP GP I LLC, is the sole general partner of the Operating Partnership.
Our advisor is PE-NTR, which is directly or indirectly owned by Phillips Edison Limited Partnership (“Phillips Edison sponsor”). Under the terms of the advisory agreement between PE-NTR and us (“PE-NTR Agreement”), PE-NTR is responsible for the management of our day-to-day activities and the implementation of our investment strategy. The PE-NTR Agreement has a one-year term, but may be renewed for an unlimited number of successive one-year periods upon the mutual consent of the parties and approval of the independent members of our board of directors.
Segment Data
We internally evaluate the operating performance of our portfolio of properties and currently do not differentiate properties by geography, size, or type. Each of our investment properties is considered a separate operating segment, as each property earns revenue and incurs expenses, individual operating results are reviewed, and discrete financial information is available. However, the properties are aggregated into one reportable segment as they have similar economic characteristics, we provide similar services to the tenants at each of our properties, and we evaluate the collective performance of our properties. Accordingly, we did not report any other segment disclosures in 2016.
Tax Status
We elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”) beginning with the tax year ended December 31, 2010. Because we qualify for taxation as a REIT, we generally will not be subject to federal income tax on taxable income that is distributed to stockholders. If we fail to qualify as a REIT in any taxable year, without the benefit of certain relief provisions, we will be subject to federal (including any applicable alternative minimum tax) and state income tax on our taxable income at applicable corporate tax rates. Even if we qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income, property, or net worth, and to federal income and excise taxes on our undistributed income.
Competition
We are subject to significant competition in seeking real estate investments and tenants. We compete with many third parties engaged in real estate investment activities including other REITs, specialty finance companies, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, lenders, hedge funds, governmental bodies, and other entities. Some of these competitors, including larger REITs, have substantially greater financial resources than we do and generally enjoy significant competitive advantages that result from, among other things, increased access to capital, lower cost of capital, and enhanced operating efficiencies.
Employees
While we have officers of the Company, we do not have any employees. In addition, all of our executive officers are also officers of our Phillips Edison sponsor or one or more of its affiliates and are compensated by those entities, in part, for their service rendered to us. We do not separately compensate our executive officers for their service as officers.
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Environmental Matters
As an owner of real estate, we are subject to various environmental laws of federal, state, and local governments. Compliance with federal, state, and local environmental laws has not had a material, adverse effect on our business, assets, results of operations, financial condition, and ability to pay distributions, and we do not believe that our existing portfolio will require us to incur material expenditures to comply with these laws and regulations.
Access to Company Information
We electronically file our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Proxy and Information statements, and all amendments to those reports with the Securities and Exchange Commission (“SEC”). The public may read and copy any of the reports that are filed with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549, on official business days during the hours of 10:00 AM to 3:00 PM. The public may obtain information on the operation of the Public Reference Room by calling the SEC at (800) SEC-0330. The SEC maintains an Internet site at www.sec.gov that contains the reports, proxy and information statements, and other information regarding issuers, including ours that are filed electronically. The contents of our website are not incorporated by reference.
We make available, free of charge, by responding to requests addressed to our investor relations group, the Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports on our website, www.grocerycenterREIT1.com. These reports are available as soon as reasonably practicable after such material is electronically filed or furnished to the SEC.
ITEM 1A. RISK FACTORS
The factors described below represent our principal risks. The occurrence of any of the risks discussed below could have a material adverse effect on our business, financial condition, results of operations, and ability to pay distributions to our stockholders. Potential investors and our stockholders may be referred to as “you” or “your” in this Item 1A. Risk Factors, section.
Risks Related to an Investment in Us
Because no public trading market for our shares currently exists, it is difficult for our stockholders to sell their shares and, if our stockholders are able to sell their shares, it may be at a discount to the public offering price.
There is no public market for our shares. Until our shares are listed, if ever, stockholders may not sell their shares unless the buyer meets the applicable suitability and minimum purchase standards. Under the share repurchase program (“SRP”), we repurchase shares at a price in place at the time of the repurchase and not based on the price at which you initially purchased your shares. It is likely we will repurchase fewer shares than have been requested to be repurchased due to lack of readily available funds under the SRP. While we have a limited SRP, in its sole discretion, our board of directors could amend, suspend or terminate our SRP upon 30 days’ notice. Further, the SRP includes numerous restrictions that would limit a stockholder’s ability to sell his or her shares to us. These restrictions have limited us from repurchasing shares submitted to us under the SRP in the past and may do so again in the future.
Therefore, it is difficult for our stockholders to sell their shares promptly or at all. If a stockholder is able to sell his or her shares, it may be at a discount to the public offering price of such shares. It is also likely that our shares would not be accepted as the primary collateral for a loan.
Because of the illiquid nature of our shares, investors should purchase our shares only as a long-term investment and be prepared to hold them for an indefinite period of time.
If we decide to list our common stock on a national securities exchange, we may wish to lower our distribution rate in order to optimize the price at which our shares would trade.
Our board of directors has the option to effect a liquidity event by listing our common stock on a national securities exchange. If such an election were to occur, a reduction in our distribution rate could occur with or in advance of a listing, as the public market for listed REITs appears to reward those that have a more conservative distribution policy.
The actual value of shares that we repurchase under our SRP may be less than what we pay.
We repurchase shares under our SRP at $10.20 per share, which is the estimated value per share of our common stock. This value is likely to differ from the price at which a stockholder could resell his or her shares. Thus, when we repurchase shares of our common stock, the repurchase may be dilutive to our remaining stockholders.
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Our stockholders may not be able to sell their shares under our SRP and, if they are able to sell their shares under the program, they may not be able to recover the amount of their investment in our shares.
Our SRP includes numerous restrictions that limit our stockholders’ ability to sell their shares. During any calendar year, we may repurchase no more than 5% of the weighted-average number of shares outstanding during the prior calendar year. Our stockholders must hold their shares for at least one year in order to participate in the SRP, except for repurchases sought upon a stockholder’s death or “qualifying disability.” The cash available for redemption on any particular date is generally limited to the proceeds from the dividend reinvestment plan (“DRIP”) during the period consisting of the preceding four fiscal quarters, less any cash already used for redemptions since the start of the same period; however, subject to the limitations described above, we may use other sources of cash at the discretion of our board of directors. These limitations do not, however, apply to repurchases sought upon a stockholder’s death or “qualifying disability.” Only those stockholders who purchased their shares from us or received their shares from us (directly or indirectly) through one or more non-cash transactions may be able to participate in the SRP. In other words, once our shares are transferred for value by a stockholder, the transferee and all subsequent holders of the shares are not eligible to participate in the SRP. These limits may prevent us from accommodating all repurchase requests made in any year. For example, in the fourth quarter of 2016, repurchase requests exceeded the funding limits provided under the SRP, and we were unable to repurchase all of the shares submitted to us. These restrictions would severely limit our stockholders’ ability to sell their shares should they require liquidity and would limit their ability to recover the value they invested. Our board is free to amend, suspend or terminate the SRP upon 30 days’ notice.
If we pay distributions from sources other than our cash flows from operations, we may not be able to sustain our distribution rate, we may have fewer funds available for investment in properties and other assets, and our stockholders’ overall returns may be reduced.
Our organizational documents permit us to pay distributions from any source without limit. To the extent we fund distributions from borrowings or the net proceeds from the issuance of securities, as we have done, we will have fewer funds available for investment in real estate properties and other real estate-related assets, and our stockholders’ overall returns may be reduced.
At times, we may be forced to borrow funds to pay distributions during unfavorable market conditions or during periods when funds from operations are needed to make capital expenditures and pay other expenses, which could increase our operating costs. Furthermore, if we cannot cover our distributions with cash flows from operations, we may be unable to sustain our distribution rate. For the year ended December 31, 2016, we paid gross distributions to our common stockholders of $123.1 million, including distributions reinvested through the DRIP of $58.9 million. For the year ended December 31, 2016, our net cash provided by operating activities was $103.1 million, which represents a shortfall of $20.0 million, or 16.3%, of our distributions paid, while our funds from operations (“FFO”) were $108.8 million, which represents a shortfall of $14.3 million, or 11.6%, of the distributions paid. The shortfall was funded by proceeds from borrowings. For the year ended December 31, 2015, we paid distributions of $123.2 million, including distributions reinvested through the DRIP of $63.8 million. For the year ended December 31, 2015, our net cash provided by operating activities was $106.1 million, which represents a shortfall of $17.1 million, or 13.9%, of our distributions paid, while our FFO was $113.4 million, which represents a shortfall of $9.8 million, or 8.0% of our distributions paid. The shortfall was funded by proceeds from borrowings.
We may change our targeted investments without stockholder consent.
Our portfolio is primarily invested in well-occupied, grocery-anchored neighborhood and community shopping centers leased to a mix of national, creditworthy retailers selling necessity-based goods and services in strong demographic markets throughout the United States. Though this is our current target portfolio, we may make adjustments to our target portfolio based on real estate market conditions and investment opportunities, and we may change our targeted investments and investment guidelines at any time without the consent of our stockholders, which could result in our making investments that are different from, and possibly riskier than, our current targeted investments. A change in our targeted investments or investment guidelines may increase our exposure to interest rate risk, default risk and real estate market fluctuations, all of which could adversely affect the value of our common stock and our ability to make distributions to our stockholders.
Because we are dependent upon PE-NTR and its affiliates to conduct our operations, any adverse changes in the financial health of PE-NTR or its affiliates, or our relationship with them, could hinder our operating performance and the return on our stockholders’ investments.
We are dependent on PE-NTR, which is responsible for our day-to-day operations and is primarily responsible for the selection of our investments. We are also dependent on Phillips Edison & Company Ltd. (“Property Manager”) to manage our portfolio of real estate assets. PE-NTR had no previous operating history prior to serving as our sub-advisor and advisor, and it depends upon the fees and other compensation that it receives from us in connection with the purchase, management and sale of assets to conduct its operations. Any adverse changes in the financial condition of PE-NTR, the Property Manager, or certain of their affiliates, or in our relationship with them, could hinder their ability to successfully manage our operations and our portfolio of investments.
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The loss of or the inability to obtain key real estate professionals at PE-NTR could delay or hinder implementation of our investment strategies, which could limit our ability to make distributions and decrease the value of our stockholders’ investments.
Our success depends to a significant degree upon the contributions of Jeffrey S. Edison, Chief Executive Officer and the Chairman of our Board of Directors; R. Mark Addy, President and Chief Operating Officer; and Devin I. Murphy, Chief Financial Officer, at PE-NTR. We do not have employment agreements with these individuals, and they may not remain associated with us. If any of these persons were to cease their association with us, our operating results could suffer. We do not intend to maintain key person life insurance on any person. We believe that our future success depends, in large part, upon PE-NTR and its affiliates’ ability to hire and retain highly skilled managerial, operational and marketing professionals. The market for such professionals is competitive, and PE-NTR and its affiliates may be unsuccessful in attracting and retaining such skilled individuals. Further, we intend to establish strategic relationships with firms, as needed, which have special expertise in certain services or detailed knowledge regarding real properties in certain geographic regions. Maintaining such relationships will be important for us to effectively compete with other investors for properties and tenants in such regions. We may be unsuccessful in establishing and retaining such relationships. If we lose or are unable to obtain the services of highly skilled professionals or do not establish or maintain appropriate strategic relationships, our ability to implement our investment strategies could be delayed or hindered, and the value of our stockholders’ investments may decline.
Our business and operations would suffer in the event of system failures.
Despite system redundancy, the implementation of security measures and the existence of a disaster recovery plan for our internal information technology systems, our systems are vulnerable to damages from any number of sources, including computer viruses, unauthorized access, energy blackouts, natural disasters, terrorism, war, and telecommunication failures. Any system failure that causes interruptions in our operations could result in a material disruption to our business. We may also incur additional costs to remedy damages caused by such disruptions.
The occurrence of cyber incidents, or a deficiency in our cybersecurity or the cybersecurity of PE-NTR or our affiliates, could negatively impact our business by causing a disruption to our operations, a compromise or corruption of our confidential information, and/or damage to our business relationships, all of which could negatively impact our financial results.
A cyber incident is considered to be any adverse event that threatens the confidentiality, integrity, or availability of our information resources. More specifically, a cyber incident is an intentional attack or an unintentional event that can include gaining unauthorized access to systems to disrupt operations, corrupt data, or steal confidential information. As our reliance on technology has increased, so have the risks posed to our systems, both internal and those we have outsourced. Our three primary risks that could directly result from the occurrence of a cyber incident include operational interruption, damage to our relationship with our tenants, and private data exposure. We have implemented processes, procedures and controls to help mitigate these risks, but these measures, as well as our increased awareness of a risk of a cyber incident, do not guarantee that our financial results will not be negatively impacted by such an incident.
Risks Related to Conflicts of Interest
Our sponsor and its affiliates, including all of our executive officers, one of our directors and other key real estate professionals, face conflicts of interest caused by their compensation arrangements with us, which could result in actions that are not in the long-term best interests of our stockholders.
PE-NTR and its affiliates receive substantial fees from us. These fees could influence PE-NTR’s advice to us as well as their judgment with respect to:
• | the continuation, renewal or enforcement of our agreements with Phillips Edison and its affiliates, including the PE-NTR Agreement and property management agreement; |
• | sales of properties and other investments to third parties, which entitle PE-NTR to disposition fees and possible subordinated incentive fees; |
• | acquisitions of properties and other investments from other Phillips Edison-sponsored programs; |
• | acquisitions of properties and other investments from third parties, which entitle PE-NTR to acquisition and asset-management compensation; |
• | borrowings to acquire properties and other investments, as acquisitions and investments increase the acquisition fees and asset-management compensation payable to PE-NTR; |
• | whether and when we seek to list our common stock on a national securities exchange, which listing could entitle PE-NTR to a subordinated incentive listing fee; and |
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• | whether and when we seek to sell the company or its assets, which sale could entitle PE-NTR to a subordinated participation in net sales proceeds. |
The fees PE-NTR receives in connection with transactions involving the acquisition of assets are based initially on the cost of the investment, including costs related to loan obligations, and are not based on the quality of the investment or the quality of the services rendered to us. This may influence PE-NTR to recommend riskier transactions to us. In addition, because the fees are based on the cost of the investment, it may create an incentive for PE-NTR to recommend that we purchase assets with more debt and at higher prices.
The management of multiple REITs by the officers of PE-NTR may significantly reduce the amount of time the officers of PE-NTR are able to spend on activities related to us and may cause other conflicts of interest, which may cause our operating results to suffer.
The officers of PE-NTR are part of the senior management or are key personnel of Phillips Edison Grocery Center REIT II, Inc. (“PE-GCR II”), and Phillips Edison Grocery Center REIT III, Inc. (“PE-GCR III”), REITs sponsored by Phillips Edison. As a result, PE-GCR II and III may have overlapping acquisition, operational, disposition and liquidation phases as us, which may cause conflicts of interest to arise throughout the life of our company with respect to, among other things, locating and acquiring properties, entering into leases and disposing of properties. The conflicts of interest each of the officers of PE-NTR faces due to the competing time demands may cause our operating results to suffer.
Our sponsor faces conflicts of interest relating to the acquisition of assets and leasing of properties, and such conflicts may not be resolved in our favor, meaning that we could invest in less attractive assets and obtain less creditworthy tenants, which could limit our ability to make distributions and reduce our stockholders’ overall investment returns.
We rely on our sponsor and the executive officers and other key real estate professionals at PE-NTR to identify suitable investment opportunities for us. The key real estate professionals of PE-NTR are also the key real estate professionals at our sponsor and its other public and private programs. Many investment opportunities that are suitable for us may also be suitable for other Phillips Edison-sponsored programs. Thus, the executive officers and real estate professionals of PE-NTR could direct attractive investment opportunities to other entities or investors. Such events could result in us investing in properties that provide less attractive returns, which may reduce our ability to make distributions.
We and other Phillips Edison-sponsored programs also rely on these real estate professionals to supervise the property management and leasing of properties. If the Property Manager directs creditworthy prospective tenants to properties owned by another Phillips Edison-sponsored program when they could direct such tenants to our properties, our tenant base may have more inherent risk than might otherwise be the case. Further, these executive officers and key real estate professionals are not prohibited from engaging, directly or indirectly, in any business or from possessing interests in any other business venture or ventures, including businesses and ventures involved in the acquisition, development, ownership, leasing or sale of real estate investments.
PE-NTR faces conflicts of interest relating to the performance and incentive fee structure under the PE-NTR Agreement, which could result in actions that are not necessarily in the long-term best interests of our stockholders.
Under the PE-NTR Agreement, PE-NTR or its affiliates will be entitled to fees that are structured in a manner intended to provide incentives to PE-NTR to perform in our best interests and in the best interests of our stockholders. However, because neither PE-NTR, nor any of its affiliates maintain a significant equity interest in us and are entitled to receive certain minimum compensation regardless of performance, the interests of PE-NTR are not wholly aligned with those of our stockholders. In that regard, the PE-NTR could be motivated to recommend riskier or more speculative investments in order for us to generate the specified levels of performance or sales proceeds that would entitle PE-NTR to fees. In addition, PE-NTR’s entitlement to fees upon the sale of our assets and to participate in sale proceeds could result in PE-NTR recommending sales of our investments at the earliest possible time at which sales of investments would produce the level of return that would entitle PE-NTR to compensation relating to such sales, even if continued ownership of those investments might be in our best long-term interest. Our operating partnership agreement will require us to pay a performance-based termination fee to an affiliate of PE-NTR if we terminate the PE-NTR Agreement prior to the listing of our shares for trading on an exchange or, absent such termination, in respect of their participation in net sales proceeds. To avoid paying this fee, our independent directors may decide against terminating the PE-NTR Agreement prior to our listing of our shares or disposition of our investments even if, but for the termination fee, termination of the PE-NTR Agreement would be in our best interest. In addition, the requirement to pay the fee to PE-NTR or its affiliates at termination could cause us to make different investment or disposition decisions than we would otherwise make, in order to satisfy our obligation to pay the fee to the terminated PE-NTR. For a more detailed discussion of the fees payable to PE-NTR and its affiliates in connection with the management of our company, see Note 12 to the consolidated financial statements.
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Our sponsor, our officers, PE-NTR and the real estate and other professionals assembled by PE-NTR face competing demands relating to their time, and this may cause our operations and our stockholders’ investment to suffer.
We rely on PE-NTR for the day-to-day operation of our business. In addition, PE-NTR has the primary responsibility for the selection of our investments. PE-NTR relies on our sponsor and its affiliates to conduct our business. Our officers are principals or employees of Phillips Edison and the affiliates that manage the assets of the other Phillips Edison-sponsored programs. As a result of their interests in other Phillips Edison-sponsored programs, their obligations to other investors and the fact that they engage in and they will continue to engage in other business activities, these individuals will continue to face conflicts of interest in allocating their time among us and other Phillips Edison-sponsored programs and other business activities in which they are involved. Should PE-NTR breach its duties to us by inappropriately devoting insufficient time or resources to our business, the returns on our investments and the value of our stockholders’ investments may decline.
All of our executive officers, one of our directors and the key real estate and other professionals assembled by PE-NTR face conflicts of interest related to their positions or interests in affiliates of our sponsors, which could hinder our ability to implement our business strategy and to generate returns to our stockholders.
All of our executive officers, one of our directors and the key real estate and other professionals assembled by PE-NTR are also executive officers, directors, managers, key professionals or holders of a direct or indirect controlling interests in PE-NTR, or other sponsor-affiliated entities. Through our sponsor’s affiliates, some of these persons work on behalf of other Phillips Edison-sponsored public and private programs. As a result, they have loyalties to each of these entities, which loyalties could conflict with the fiduciary duties they owe to us and could result in action or inaction detrimental to our business. Conflicts with our business and interests are most likely to arise from (1) allocation of new investments and management time and services between us and the other entities, (2) our purchase of properties from, or sale of properties to, affiliated entities, (3) development of our properties by affiliates, (4) investments with affiliates of PE-NTR, (5) compensation to PE-NTR, and (6) our relationship with PE-NTR and the Property Manager. If we do not successfully implement our business strategy, we may be unable to generate the cash needed to make distributions to our stockholders and to maintain or increase the value of our assets.
Risks Related to Our Corporate Structure
We use an estimated value of our shares that is based on a number of assumptions that may not be accurate or complete and is also subject to a number of limitations.
To assist members of the Financial Industry Regulatory Authority (“FINRA”) and their associated persons that participated in our initial public offering, pursuant to applicable FINRA and National Association Security Dealers (“NASD”) conduct rules, we disclose in each annual report distributed to stockholders a per share estimated value of our shares, the method by which it was developed, and the date of the data used to develop the estimated value. For this purpose, PE-NTR initially estimated the value of our common shares as $10.00 per share based on the offering price of our shares of common stock in our initial public offering of $10.00 per share (ignoring purchase price discounts for certain categories of purchasers). On April 14, 2016, our board of directors reaffirmed an estimated value per share of our common stock of $10.20 based on the estimated fair value range of our real estate portfolio as indicated in a third party valuation report plus the value of our cash and cash equivalents less the value of our mortgages and loans payable as of March 31, 2016.
Our estimated value per share is based upon a number of estimates and assumptions that may not be accurate or complete. Different parties with different assumptions and estimates could derive a different estimated value per share, and this difference could be significant. The estimated value per share is not audited and does not represent a determination of the fair value of our assets or liabilities based on U.S. generally accepted accounting principles (“GAAP”), nor does it represent a liquidation value of our assets and liabilities or the amount at which our shares of common stock would trade if they were listed on a national securities exchange. Accordingly, with respect to the estimated value per share, there can be no assurance that: (1) a stockholder would be able to resell his or her shares at the estimated value per share; (2) a stockholder would ultimately realize distributions per share equal to our estimated value per share upon liquidation of our assets and settlement of our liabilities or a sale of our company; (3) our shares of common stock would trade at the estimated value per share on a national securities exchange; (4) a third party would offer the estimated value per share in an arm’s-length transaction to purchase all or substantially all of our shares of common stock; (5) an independent third-party appraiser or third-party valuation firm would agree with our estimated value per share; or (6) the methodology used to calculate our estimated value per share would be acceptable to FINRA or for compliance with Employee Retirement Income Security Act of 1974 (“ERISA”) reporting requirements.
Furthermore, we have not made any adjustments to the valuation of our estimated value per share for the impact of other transactions occurring subsequent to March 31, 2016, including, but not limited to, (1) the issuance of common stock under the DRIP, (2) net operating income earned and dividends declared, (3) the repurchase of shares and (4) changes in leases, tenancy or other business or operational changes. The value of our shares will fluctuate over time in response to developments related to individual real estate assets, the management of those assets and changes in the real estate and finance markets. Because of, among other factors, the high concentration of our total assets in real estate and the number of shares of our common stock
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outstanding, changes in the value of individual real estate assets or changes in valuation assumptions could have a very significant impact on the value of our shares. In addition, the estimated value per share reflects a real estate portfolio premium as opposed to the sum of the individual property values; however, it does not reflect a discount for the fact that we are externally managed. The estimated value per share also does not take into account any disposition costs or fees for real estate properties, debt prepayment penalties that could apply upon the prepayment of certain of our debt obligations or the impact of restrictions on the assumption of debt. Accordingly, the estimated value per share of our common stock may or may not be an accurate reflection of the fair market value of our stockholders’ investments and will not likely represent the amount of net proceeds that would result from an immediate sale of our assets.
Our stockholders have limited control over changes in our policies and operations, which increases the uncertainty and risks our stockholders face.
Our board of directors determines our major policies, including our policies regarding financing, growth, debt capitalization, REIT qualification and distributions. Our board of directors may amend or revise these and other policies without a vote of the stockholders. Under the Maryland General Corporation Law and our charter, our stockholders have a right to vote only on limited matters. Our board’s broad discretion in setting policies and our stockholders’ inability to exert control over those policies increases the uncertainty and risks our stockholders face.
Our stockholders’ interests in us will be diluted if we issue additional shares, which could reduce the overall value of our stockholders’ investment.
Our common stockholders do not have preemptive rights to any shares we issue in the future. Our charter authorizes us to issue 1.01 billion shares of capital stock, of which 1 billion shares are designated as common stock and 0.01 billion shares are designated as preferred stock. Our board of directors may amend our charter to increase or decrease the number of authorized shares of capital stock or the number of shares of stock of any class or series that we have authority to issue without stockholder approval. Additionally, our board may elect to (1) sell additional shares in the DRIP and future public offerings, (2) issue equity interests in private offerings, (3) issue share-based awards to our independent directors or to our officers or employees or to the officers or employees of PE-NTR or any of its affiliates, (4) issue shares to PE-NTR, or its successors or assigns, in payment of an outstanding fee obligation or (5) issue shares of our common stock to sellers of properties or assets we acquire in connection with an exchange of limited partnership interests of the Operating Partnership. To the extent we issue additional equity interests, our stockholders’ ownership interest in us will be diluted. In addition, depending upon the terms and pricing of any additional offerings and the value of our real estate investments, our investors may also experience dilution in the book value and fair value of their shares.
Payment of fees to PE-NTR and its affiliates reduce cash available for investment and distribution and increases the risk that our stockholders will not be able to recover the amount of their investments in our shares.
PE-NTR and its affiliates perform valuable services for us in connection with the selection and acquisition of our investments, the management and leasing of our properties and the administration of our other investments. We currently pay or have paid them substantial fees for these services, which results in immediate dilution to the value of our stockholders’ investments and reduces the amount of cash available for investment or distribution to stockholders. We may also pay significant fees during our listing/liquidation stage. Although most of the fees payable during our listing/liquidation stage are contingent on our stockholders first enjoying agreed upon investment returns, the investment-return thresholds may be reduced subject to approval by our conflicts committee.
Therefore, these fees increase the risk that the amount available for distribution to common stockholders upon a liquidation of our portfolio would be less than the price paid by our stockholders to purchase shares in our initial public offering. These substantial fees and other payments also increase the risk that our stockholders will not be able to resell their shares at a profit, even if our shares are listed on a national securities exchange.
If we are unable to obtain funding for future capital needs, cash distributions to our stockholders and the value of our investments could decline.
When tenants do not renew their leases or otherwise vacate their space, we will often need to expend substantial funds for improvements to the vacated space in order to attract replacement tenants. Even when tenants do renew their leases, we may agree to make improvements to their space as part of our negotiation. If we need additional capital in the future to improve or maintain our properties or for any other reason, we may have to obtain financing from sources, beyond our funds from operations, such as borrowings or future equity offerings. These sources of funding may not be available on attractive terms or at all. If we cannot procure additional funding for capital improvements, our investments may generate lower cash flows or decline in value, or both, which would limit our ability to make distributions to our stockholders and could reduce the value of your investment.
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Although we are not currently afforded the protection of the Maryland General Corporation Law relating to deterring or defending hostile takeovers, our board of directors could opt into these provisions of Maryland law in the future, which may discourage others from trying to acquire control of us and may prevent our stockholders from receiving a premium price for their stock in connection with a business combination.
Under Maryland law, “business combinations” between a Maryland corporation and certain interested stockholders or affiliates of interested stockholders are prohibited for five years after the most recent date on which the interested stockholder becomes an interested stockholder. These business combinations include a merger, consolidation, share exchange, or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities. Also under Maryland law, control shares of a Maryland corporation acquired in a control share acquisition have no voting rights except to the extent approved by stockholders by a vote of two-thirds of the votes entitled to be cast on the matter. Should our board opt into these provisions of Maryland law, it may discourage others from trying to acquire control of us and increase the difficulty of consummating any offer. Similarly, provisions of Title 3, Subtitle 8 of the Maryland General Corporation Law could provide similar anti-takeover protection.
Our charter limits the number of shares a person may own, which may discourage a takeover that could otherwise result in a premium price to our stockholders.
Our charter, with certain exceptions, authorizes our directors to take such actions as are necessary and desirable to preserve our qualification as a REIT. To help us comply with the REIT ownership requirements of the Code, among other purposes, our charter prohibits a person from directly or constructively owning more than 9.8% in value of our aggregate outstanding stock or more than 9.8% in value or number of shares, whichever is more restrictive, of our aggregate outstanding common stock, unless exempted by our board of directors. This restriction may have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all of our assets) that might provide a premium price for holders of our common stock.
Our charter permits our board of directors to issue stock with terms that may subordinate the rights of our common stockholders or discourage a third party from acquiring us in a manner that could result in a premium price to our stockholders.
Our board of directors may classify or reclassify any unissued common stock or preferred stock and establish the preferences, conversion or other rights, voting powers, restrictions, limitations as to distributions, qualifications, and terms or conditions of redemption of any such stock. Thus, our board of directors could authorize the issuance of preferred stock with priority as to distributions and amounts payable upon liquidation over the rights of the holders of our common stock. Such preferred stock could also have the effect of delaying, deferring or preventing a change in control, including an extraordinary transaction (such as a merger, tender offer, or sale of all or substantially all of our assets) that might provide a premium price to holders of our common stock.
Because Maryland law permits our board to adopt certain anti-takeover measures without stockholder approval, investors may be less likely to receive a “control premium” for their shares.
In 1999, the State of Maryland enacted legislation that enhances the power of Maryland corporations to protect themselves from unsolicited takeovers. Among other things, the legislation permits our board, without stockholder approval, to amend our charter to:
• | stagger our board of directors into three classes; |
• | require a two-thirds stockholder vote for removal of directors; |
• | provide that only the board can fix the size of the board; and |
• | require that special stockholder meetings may only be called by holders of a majority of the voting shares entitled to be cast at the meeting. |
Under Maryland law, a corporation can opt to be governed by some or all of these provisions if it has a class of equity securities registered under the Exchange Act, and has at least three independent directors. Our charter does not prohibit our board of directors from opting into any of the above provisions permitted under Maryland law. Becoming governed by any of these provisions could discourage an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all of our assets) that might provide a premium price for holders of our securities.
If we were to become self-managed, we could be managed less effectively and our expenses could increase, either of which could have an adverse effect on the value of your investment.
If we were to become self-managed, such transaction could take many forms. For example, we could hire a group of executives and other employees or personnel from our Advisor who have performed services for us under our Advisory Agreement, or we could acquire our Advisor or another management firm. Any such transaction could result in significant payments to the
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owners of the Advisor or management firm. Such costs could make it more difficult for you to realize a profit on your investment. In addition, we may not realize the benefits of becoming self-managed because the costs may be higher than anticipated or the management functions acquired may not be as effective or efficient as those of our Advisor. A transaction to become self-managed could also become the subject of litigation. Even if the claims are without merit, we could be forced to incur significant expenses in defense of such claims. The costs of such litigation, the cost of becoming self-managed or any adverse impact on the effectiveness of the management of our company could cause the value of your investment to decline.
General Risks Related to Investments in Real Estate
Economic and regulatory changes that impact the real estate market generally may decrease the value of our investments and weaken our operating results.
Our properties and their performance are subject to the risks typically associated with real estate, including:
• | downturns in national, regional, and local economic conditions; |
• | increased competition for real estate assets targeted by our investment strategy; |
• | adverse local conditions, such as oversupply or reduction in demand for similar properties in an area and changes in real estate zoning laws that may reduce the desirability of real estate in an area; |
• | vacancies, changes in market rental rates and the need to periodically repair, renovate and re-let space; |
• | changes in interest rates and the availability of permanent mortgage financing, which may render the sale of a property or loan difficult or unattractive; |
• | changes in tax, real estate, environmental, and zoning laws; |
• | periods of high interest rates and tight money supply; and |
• | the illiquidity of real estate investments generally. |
Any of the above factors, or a combination thereof, could result in a decrease in the value of our investments, which would have an adverse effect on our operations, on our ability to pay distributions to our stockholders and on the value of our stockholders’ investments.
We depend on our tenants for revenue, and, accordingly, our revenue and our ability to make distributions to our stockholders is dependent upon the success and economic viability of our tenants.
We depend upon tenants for revenue. Rising vacancies across commercial real estate result in increased pressure on real estate investors and their property managers to find new tenants and keep existing tenants. A property may incur vacancies either by the expiration of a tenant lease, the continued default of a tenant under its lease or the early termination of a lease by a tenant. If vacancies continue for a long period of time, we may suffer reduced revenues resulting in less cash available to distribute to stockholders. In order to maintain tenants, we may have to offer inducements, such as free rent and tenant improvements, to compete for attractive tenants. In addition, if we are unable to attract additional or replacement tenants, the resale value of the property could be diminished, even below our cost to acquire the property, because the market value of a particular property depends principally upon the value of the cash flow generated by the leases associated with that property. Such a reduction on the resale value of a property could also reduce the value of our stockholders’ investments.
Our revenue will be affected by the success and economic viability of our anchor retail tenants. Our reliance on single or significant tenants in certain buildings may decrease our ability to lease vacated space and adversely affect the returns on our stockholders’ investments.
In the retail sector, a tenant occupying all or a large portion of the gross leasable area of a retail center, commonly referred to as an anchor tenant, may become insolvent, may suffer a downturn in business, may decide not to renew its lease, or may decide to cease its operations at the retail center but continue to pay rent. Any of these events could result in a reduction or cessation in rental payments to us and could adversely affect our financial condition. A lease termination or cessation of operations by an anchor tenant could result in lease terminations or reductions in rent by other tenants whose leases may permit cancellation or rent reduction if another tenant terminates its lease or ceases its operations at that shopping center. In such event, we may be unable to re-lease the vacated space. Similarly, the leases of some anchor tenants may permit the anchor tenant to transfer its lease to another retailer. The transfer to a new anchor tenant could cause customer traffic in the retail center to decrease and thereby reduce the income generated by that retail center. A lease transfer to a new anchor tenant could also allow other tenants to make reduced rental payments or to terminate their leases. In the event that we are unable to re-lease the vacated space to a new anchor tenant, we may incur additional expenses in order to re-model the space to be able to re-lease the space to more than one tenant.
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If we enter into long-term leases with retail tenants, those leases may not result in fair value over time.
Long-term leases do not typically allow for significant changes in rental payments and do not expire in the near term. If we do not accurately judge the potential for increases in market rental rates when negotiating these long-term leases, significant increases in future property operating costs could result in receiving less than fair value from these leases. Such circumstances would adversely affect our revenues and funds available for distribution.
The bankruptcy or insolvency of a major tenant may adversely impact our operations and our ability to pay distributions to stockholders.
The bankruptcy or insolvency of a significant tenant or a number of smaller tenants may have an adverse impact on financial condition and our ability to pay distributions to our stockholders. Generally, under bankruptcy law, a debtor tenant has 120 days to exercise the option of assuming or rejecting the obligations under any unexpired lease for nonresidential real property, which period may be extended once by the bankruptcy court. If the tenant assumes its lease, the tenant must cure all defaults under the lease and may be required to provide adequate assurance of its future performance under the lease. If the tenant rejects the lease, we will have a claim against the tenant’s bankruptcy estate. Although rent owing for the period between filing for bankruptcy and rejection of the lease may be afforded administrative expense priority and paid in full, pre-bankruptcy arrears and amounts owing under the remaining term of the lease will be afforded general unsecured claim status (absent collateral securing the claim). Moreover, amounts owing under the remaining term of the lease will be capped. Other than equity and subordinated claims, general unsecured claims are the last claims paid in a bankruptcy, and therefore, funds may not be available to pay such claims in full. See Item 2. Properties, for information related to concentration of our tenants.
Competition with third parties in acquiring properties and other investments may reduce our profitability and the return on our stockholders’ investments.
We face competition from various entities for investment opportunities in retail properties, including other REITs, pension funds, insurance companies, investment funds and companies, partnerships, and developers. Many of these entities have substantially greater financial resources than we do and may be able to accept more risk than we can prudently manage, including risks with respect to the creditworthiness of a tenant or the geographic location of its investments. Competition from these entities may reduce the number of suitable investment opportunities offered to us or increase the bargaining power of property owners seeking to sell.
In our due diligence review of potential investments, we may rely on third-party consultants and advisors and representations made by sellers of potential portfolio properties, and we may not identify all relevant facts that may be necessary or helpful in evaluating potential investments.
Before making investments, our Advisor will typically conduct due diligence that we deem reasonable and appropriate based on the facts and circumstances applicable to each investment. Due diligence may entail evaluation of important and complex business, financial, tax, accounting, environmental and legal issues. Outside consultants, legal advisors, accountants, investment banks and other third parties may be involved in the due diligence process to varying degrees depending on the type of investment, the costs of which will be borne by us. Such involvement of third-party advisors or consultants may present a number of risks primarily relating to the Advisor’s reduced control of the functions that are outsourced. In addition, if the Advisor is unable to timely engage third-party providers, the ability to evaluate and acquire more complex targets could be adversely affected. When conducting due diligence and making an assessment regarding a potential investment, the Advisor will rely on the resources available to it, including information provided by the target of the investment and, in some circumstances, third-party investigations. The due diligence investigation that the Advisor carries out with respect to any investment opportunity may not reveal or highlight all relevant facts that may be necessary or helpful in evaluating such investment opportunity. Moreover, such an investigation will not necessarily result in the investment being successful. There can be no assurance that attempts to provide downside protection with respect to investments, including pursuant to risk management procedures described in this Annual Report on Form 10-K, will achieve their desired effect and potential investors should regard an investment in us as being speculative and having a high degree of risk.
There can be no assurance that the Advisor will be able to detect or prevent irregular accounting, employee misconduct or other fraudulent practices during the due diligence phase or during our efforts to monitor the investment on an ongoing basis or that any risk management procedures implemented by us will be adequate. In the event of fraud by the seller of any portfolio property, we may suffer a partial or total loss of capital invested in that property. An additional concern is the possibility of material misrepresentation or omission on the part of the seller. Such inaccuracy or incompleteness may adversely affect the value of our investments in such portfolio property. We will rely upon the accuracy and completeness of representations made by sellers of portfolio properties in the due diligence process to the extent reasonable when we make our investments, but cannot guarantee such accuracy or completeness.
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We may be unable to successfully integrate and operate acquired properties, which may have a material adverse effect on our business and operating results.
Even if we are able to make acquisitions on favorable terms, we may not be able to successfully integrate and operate them. We may be required to invest significant capital and resources after an acquisition to maintain or grow the properties that we acquire. In addition, we may need to adapt our management, administrative, accounting, and operational systems, or hire and retain sufficient operational staff, to integrate and manage successfully any future acquisitions of additional assets. These and other integration efforts may disrupt our operations, divert PE-NTR’s attention away from day-to-day operations and cause us to incur unanticipated costs. The difficulties of integration may be increased by the necessity of coordinating operations in geographically dispersed locations. Our failure to integrate successfully any acquisitions into our portfolio could have a material adverse effect on our business and operating results. Further, acquired properties may have liabilities or adverse operating issues that we fail to discover through due diligence prior to the acquisition. The failure to discover such issues prior to such acquisition could have a material adverse effect on our business and results of operations.
Changes in supply of or demand for similar real properties in a particular area may increase the price of real properties we seek to purchase and decrease the price of real properties when we seek to sell them.
The real estate industry is subject to market forces. We are unable to predict certain market changes, including changes in supply of, or demand for, similar real properties in a particular area. Any potential purchase of an overpriced asset could decrease our rate of return on these investments and result in lower operating results and overall returns to our stockholders.
We may be unable to adjust our portfolio in response to changes in economic or other conditions or sell a property if or when we decide to do so, limiting our ability to pay cash distributions to our stockholders.
Many factors that are beyond our control affect the real estate market and could affect our ability to sell properties on the terms that we desire. These factors include general economic conditions, the availability of financing, interest rates and other factors, including supply and demand. Because real estate investments are relatively illiquid, we have a limited ability to vary our portfolio in response to changes in economic or other conditions. Further, before we can sell a property on the terms we want, it may be necessary to expend funds to correct defects or to make improvements. However, we can give no assurance that we will have the funds available to correct such defects or to make such improvements. We may be unable to sell our properties at a profit. Our inability to sell properties on the terms we want could reduce our cash flow and limit our ability to make distributions to our stockholders and could reduce the value of our stockholders’ investments. Moreover, in acquiring a property, we may agree to restrictions that prohibit the sale of that property for a period of time or impose other restrictions, such as a limitation on the amount of debt that can be placed or repaid on that property. We cannot predict the length of time needed to find a willing purchaser and to close the sale of a property. Our inability to sell a property when we desire to do so may cause us to reduce our selling price for the property. Any delay in our receipt of proceeds, or diminishment of proceeds, from the sale of a property could adversely affect our ability to pay distributions to our stockholders.
We have acquired, and may continue to acquire or finance, properties with lock-out provisions, which may prohibit us from selling a property, or may require us to maintain specified debt levels for a period of years on some properties.
A lock-out provision is a provision that prohibits the prepayment of a loan during a specified period of time. Lock-out provisions may include terms that provide strong financial disincentives for borrowers to prepay their outstanding loan balance and exist in order to protect the yield expectations of lenders. We currently own properties, and may acquire additional properties in the future, that are subject to lock-out provisions. Lock-out provisions could materially restrict us from selling or otherwise disposing of or refinancing properties when we may desire to do so. Lock-out provisions may prohibit us from reducing the outstanding indebtedness with respect to any properties, refinancing such indebtedness on a non-recourse basis at maturity, or increasing the amount of indebtedness with respect to such properties. Lock-out provisions could impair our ability to take other actions during the lock-out period that could be in the best interests of our stockholders and, therefore, may have an adverse impact on the value of our shares relative to the value that would result if the lock-out provisions did not exist. In particular, lock-out provisions could preclude us from participating in major transactions that could result in a disposition of our assets or a change in control even though that disposition or change in control might be in the best interests of our stockholders.
If we set aside insufficient capital reserves, we may be required to defer necessary capital improvements.
If we do not have enough reserves for capital to supply needed funds for capital improvements throughout the life of the investment in a property and there is insufficient cash available from our operations, we may be required to defer necessary improvements to a property, which may cause that property to suffer from a greater risk of obsolescence or a decline in value, or a greater risk of decreased cash flow as a result of fewer potential tenants being attracted to the property. If this happens, we may not be able to maintain projected rental rates for affected properties, and our results of operations may be negatively impacted.
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Our operating expenses may increase in the future, and, to the extent such increases cannot be passed on to tenants, our cash flow and our operating results would decrease.
Operating expenses, such as expenses for fuel, utilities, labor and insurance, are not fixed and may increase in the future. There is no guarantee that we will be able to pass such increases on to our tenants. To the extent such increases cannot be passed on to tenants, any such increase would cause our cash flow and our operating results to decrease.
Our real properties are subject to property and other taxes that may increase in the future, which could adversely affect our cash flow.
Our real properties are subject to property and other taxes that may increase as tax rates change and as the real properties are assessed or reassessed by taxing authorities. We anticipate that certain of our leases will generally provide that the property taxes, or increases therein, are charged to the lessees as an expense related to the real properties that they occupy, while other leases will generally provide that we are responsible for such taxes. In any case, as the owner of the properties, we are ultimately responsible for payment of the taxes to the applicable government authorities. If real property taxes increase, our tenants may be unable to make the required tax payments, ultimately requiring us to pay the taxes even if otherwise stated under the terms of the lease. If we fail to pay any such taxes, the applicable taxing authority may place a lien on the real property and the real property may be subject to a tax sale. In addition, we are generally responsible for real property taxes related to any vacant space.
Uninsured losses relating to real property or excessively expensive premiums for insurance coverage could reduce our cash flows and the return on our stockholders’ investments.
We will attempt to adequately insure all of our real properties against casualty losses. There are types of losses, generally catastrophic in nature, such as losses due to wars, acts of terrorism, earthquakes, floods, hurricanes, pollution or environmental matters, that are uninsurable or not economically insurable, or may be insured subject to limitations, such as large deductibles or co-payments. Insurance risks associated with potential acts of terrorism could sharply increase the premiums we pay for coverage against property and casualty claims. Additionally, mortgage lenders in some cases have begun to insist that commercial property owners purchase coverage against terrorism as a condition for providing mortgage loans. Such insurance policies may not be available at reasonable costs, if at all, which could inhibit our ability to finance or refinance our properties. In such instances, we may be required to provide other financial support, either through financial assurances or self-insurance, to cover potential losses. We may not have adequate, or any, coverage for such losses. Changes in the cost or availability of insurance could expose us to uninsured casualty losses. If any of our properties incur a casualty loss that is not fully insured, the value of our assets will be reduced by any such uninsured loss, which may reduce the value of our stockholders’ investments. In addition, other than any working capital reserve or other reserves we may establish, we have no source of funding to repair or reconstruct any uninsured property. Also, to the extent we must pay unexpectedly large amounts for insurance, we could suffer reduced earnings that would result in lower distributions to stockholders. The Terrorism Risk Insurance Act of 2002 is designed for a sharing of terrorism losses between insurance companies and the federal government.
Costs of complying with governmental laws and regulations related to environmental protection and human health and safety may reduce our net income and the cash available for distributions to our stockholders.
Real property and the operations conducted on real property are subject to federal, state and local laws and regulations relating to protection of the environment and human health. We could be subject to liability in the form of fines, penalties or damages for noncompliance with these laws and regulations. These laws and regulations generally govern wastewater discharges, air emissions, the operation and removal of underground and above-ground storage tanks, the use, storage, treatment, transportation and disposal of solid and hazardous materials, the remediation of contamination associated with the release or disposal of solid and hazardous materials, the presence of toxic building materials, and other health and safety-related concerns.
Some of these laws and regulations may impose joint and several liability on the tenants, owners or operators of real property for the costs to investigate or remediate contaminated properties, regardless of fault, whether the contamination occurred prior to purchase, or whether the acts causing the contamination were legal. Our tenants’ operations, the condition of properties at the time we buy them, operations in the vicinity of our properties, such as the presence of underground storage tanks, or activities of unrelated third parties may affect our properties.
The presence of hazardous substances, or the failure to properly manage or remediate these substances, may hinder our ability to sell, rent or pledge such property as collateral for future borrowings. Environmental laws also may impose liens on property or restrictions on the manner in which property may be used or businesses may be operated, and these restrictions may require substantial expenditures or prevent us from entering into leases with prospective tenants that may be impacted by such laws. Some of these laws and regulations have been amended so as to require compliance with new or more stringent standards as of future dates. Compliance with new or more stringent laws or regulations or stricter interpretation of existing laws may require us to incur material expenditures. Future laws, ordinances or regulations may impose material environmental liability. Any
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material expenditures, fines, penalties, or damages we must pay will reduce our ability to make distributions and may reduce the value of our stockholders’ investments.
The costs of defending against claims of environmental or personal injury liability, or of paying such claims could reduce the amounts available for distribution to our stockholders.
Environmental laws provide for sanctions for noncompliance and may be enforced by governmental agencies or, in certain circumstances, by private parties. Certain environmental laws and common law principles could be used to impose liability for the release of and exposure to hazardous substances, including asbestos-containing materials and lead-based paint. Third parties may seek recovery from real property owners or operators for personal injury or property damage associated with exposure to released hazardous substances. The costs of defending against claims of environmental or personal injury liability or of paying such claims could reduce the amounts available for distribution to our stockholders. Generally, we expect that the real estate properties that we acquire will have been subject to Phase I environmental assessments at the time they were acquired. A Phase I environmental assessment or site assessment is an initial environmental investigation to identify potential environmental liabilities associated with the current and past uses of a given property.
We could become subject to liability for environmental violations, regardless of whether we caused such violations.
We could become subject to liability in the form of fines or damages for noncompliance with environmental laws and regulations. These laws and regulations generally govern wastewater discharges, air emissions, the operation and removal of underground and above-ground storage tanks, the use, storage, treatment, transportation and disposal of solid hazardous materials, the remediation of contaminated property associated with the disposal of solid and hazardous materials and other health and safety-related concerns. Some of these laws and regulations may impose joint and several liability on tenants, owners or managers for the costs of investigation or remediation of contaminated properties, regardless of fault or the legality of the original disposal. Under various federal, state and local environmental laws, ordinances, and regulations, a current or former owner or manager of real property may be liable for the cost to remove or remediate hazardous or toxic substances, wastes, or petroleum products on, under, from, or in such property. These costs could be substantial and liability under these laws may attach whether or not the owner or manager knew of, or was responsible for, the presence of such contamination. Even if more than one person may have been responsible for the contamination, each liable party may be held entirely responsible for all of the clean-up costs incurred.
In addition, third parties may sue the owner or manager of a property for damages based on personal injury, natural resources, or property damage and/or for other costs, including investigation and clean-up costs, resulting from the environmental contamination. The presence of contamination on one of our properties, or the failure to properly remediate a contaminated property, could give rise to a lien in favor of the government for costs it may incur to address the contamination, or otherwise adversely affect our ability to sell or lease the property or borrow using the property as collateral. In addition, if contamination is discovered on our properties, environmental laws may impose restrictions on the manner in which the property may be used or businesses may be operated, and these restrictions may require substantial expenditures or prevent us from entering into leases with prospective tenants. There can be no assurance that future laws, ordinances or regulations will not impose any material environmental liability, or that the environmental condition of our properties will not be affected by the operations of the tenants, by the existing condition of the land, by operations in the vicinity of the properties. There can be no assurance that these laws, or changes in these laws, will not have a material adverse effect on our business, results of operations or financial condition.
Compliance or failure to comply with the Americans with Disabilities Act could result in substantial costs and may decrease cash available for distributions.
Our properties are, or may become, subject to the Americans with Disabilities Act of 1990, as amended (the “Disabilities Act”). Under the Disabilities Act, all places of public accommodation are required to comply with federal requirements related to access and use by disabled persons. The Disabilities Act has separate compliance requirements for “public accommodations” and “commercial facilities” that generally require that buildings and services be made accessible and available to people with disabilities. The Disabilities Act’s requirements could require removal of access barriers and could result in the imposition of injunctive relief, monetary penalties or, in some cases, an award of damages. We will attempt to acquire properties that comply with the ADA or place the burden on the seller or other third party, such as a tenant, to ensure compliance with the ADA. We cannot assure our stockholders that we will be able to acquire properties or allocate responsibilities in this manner. Any of our funds used for Disabilities Act compliance will reduce our net income and the amount of cash available for distributions to our stockholders.
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Risks Associated with Debt Financing
We have incurred mortgage indebtedness, and we are likely to incur other indebtedness, which increases our business risks, could hinder our ability to pay distributions, and could decrease the value of your investment.
We have obtained, and are likely to continue to obtain, lines of credit and other long-term financing that are secured by our properties and other assets. Our charter does not limit the amount of funds that we may borrow. In some instances, we may acquire real properties by financing a portion of the price of the properties and mortgaging or pledging some or all of the properties purchased as security for that debt. We may also incur mortgage debt on properties that we already own in order to obtain funds to acquire additional properties. In addition, we may borrow as necessary or advisable to ensure that we maintain our qualification as a REIT for U.S. federal income tax purposes, including borrowings to satisfy the REIT requirement that we distribute at least 90% of our annual REIT taxable income to our stockholders (computed without regard to the dividends-paid deduction and excluding net capital gain). We, however, can give our stockholders no assurance that we will be able to obtain such borrowings on satisfactory terms.
High debt levels will cause us to incur higher interest charges, which would result in higher debt service payments and could be accompanied by restrictive covenants. If we do mortgage a property and there is a shortfall between the cash flow from that property and the cash flow needed to service mortgage debt on that property, then the amount of cash available for distributions to stockholders may be reduced. In addition, incurring mortgage debt increases the risk of loss of a property since defaults on indebtedness secured by a property may result in lenders initiating foreclosure actions. In that case, we could lose the property securing the loan that is in default, reducing the value of our stockholders’ investments. For tax purposes, a foreclosure of any of our properties would be treated as a sale of the property for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the property, we would recognize taxable income on foreclosure even though we would not necessarily receive any cash proceeds. We may give full or partial guaranties to lenders of mortgage debt on behalf of the entities that own our properties. When we give a guaranty on behalf of an entity that owns one of our properties, we will be responsible to the lender for satisfaction of the debt if it is not paid by such entity. If any mortgages contain cross-collateralization or cross-default provisions, a default on a single property could affect multiple properties.
We may also obtain recourse debt to finance our acquisitions and meet our REIT distribution requirements. If we have insufficient income to service our recourse debt obligations, our lenders could institute proceedings against us to foreclose upon our assets. If a lender successfully forecloses upon any of our assets, our ability to pay cash distributions to our stockholders will be limited, and our stockholders could lose all or part of their investment.
Increases in interest rates could increase the amount of our loan payments and adversely affect our ability to pay distributions to our stockholders.
Interest we pay on our loan obligations will reduce cash available for distributions. If we obtain variable rate loans, increases in interest rates would increase our interest costs, which would reduce our cash flows and our ability to pay distributions to stockholders. In addition, if we need to repay existing loans during periods of rising interest rates, we could be required to liquidate one or more of our investments in properties at times which may not permit realization of the maximum return on such investments.
If mortgage debt is unavailable at reasonable rates, we may not be able to finance the purchase of properties. If we place mortgage debt on properties, we run the risk of being unable to refinance the properties when the debt becomes due or of being unable to refinance on favorable terms. If interest rates are higher when we refinance the properties, our income could be reduced. We may be unable to refinance properties. If any of these events occurs, our cash flow would be reduced. This, in turn, would reduce cash available for distribution to our stockholders and may hinder our ability to raise capital by issuing more stock or borrowing more money.
We may not be able to access financing or refinancing sources on attractive terms, which could adversely affect our ability to execute our business plan.
We may finance our assets over the long-term through a variety of means, including repurchase agreements, credit facilities, issuance of commercial mortgage-backed securities, collateralized debt obligations and other structured financings. Our ability to execute this strategy will depend on various conditions in the markets for financing in this manner that are beyond our control, including lack of liquidity and greater credit spreads. We cannot be certain that these markets will remain an efficient source of long-term financing for our assets. If our strategy is not viable, we will have to find alternative forms of long-term financing for our assets, as secured revolving credit facilities and repurchase facilities may not accommodate long-term financing. This could subject us to more recourse indebtedness and the risk that debt service on less efficient forms of financing would require a larger portion of our cash flows, thereby reducing cash available for distribution to our stockholders and funds available for operations as well as for future business opportunities.
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Lenders may require us to enter into restrictive covenants relating to our operations, which could limit our ability to make distributions to our stockholders.
When providing financing, a lender may impose restrictions on us that affect our distribution and operating policies and our ability to incur additional debt. Loan agreements into which we enter may contain covenants that limit our ability to further mortgage a property, discontinue insurance coverage or replace PE-NTR. In addition, loan documents may limit our ability to replace a property’s property manager or terminate certain operating or lease agreements related to a property. These or other limitations would decrease our operating flexibility and our ability to achieve our operating objectives, which may adversely affect our ability to make distributions to our stockholders.
Our derivative financial instruments that we use to hedge against interest rate fluctuations may not be successful in mitigating our risks associated with interest rates and could reduce the overall returns on our stockholders’ investment.
We use derivative financial instruments to hedge exposures to changes in interest rates on loans secured by our assets, but no hedging strategy can protect us completely. We cannot assure our stockholders that our hedging strategy and the derivatives that we use will adequately offset the risk of interest rate volatility or that our hedging transactions will not result in losses. In addition, the use of such instruments may reduce the overall return on our investments. These instruments may also generate income that may not be treated as qualifying REIT income for purposes of the 75% or 95% REIT income test.
Interest-only indebtedness may increase our risk of default and ultimately may reduce our funds available for distribution to our stockholders.
We have financed certain of our property acquisitions using interest-only mortgage indebtedness. During the interest-only period, the amount of each scheduled payment is less than that of a traditional amortizing mortgage loan. The principal balance of the mortgage loan will not be reduced (except in the case of prepayments) because there are no scheduled monthly payments of principal during this period. After the interest-only period, we will be required either to make scheduled payments of amortized principal and interest or to make a lump-sum or balloon payment at maturity. These required principal or balloon payments will increase the amount of our scheduled payments and may increase our risk of default under the related mortgage loan. If the mortgage loan has an adjustable interest rate, the amount of our scheduled payments also may increase at a time of rising interest rates. Increased payments and substantial principal or balloon maturity payments will reduce the funds available for distribution to our stockholders because cash otherwise available for distribution will be required to pay principal and interest associated with these mortgage loans.
If we enter into financing arrangements involving balloon payment obligations, it may adversely affect our ability to make distributions to our stockholders.
Some of our financing arrangements may require us to make a lump-sum or “balloon” payment at maturity. Our ability to make a balloon payment at maturity is uncertain and may depend upon our ability to obtain additional financing or our ability to sell the property. At the time the balloon payment is due, we may or may not be able to refinance the balloon payment on terms as favorable as the original loan or sell the property at a price sufficient to make the balloon payment. The effect of a refinancing or sale could affect the rate of return to stockholders and the projected time of disposition of our assets. In addition, payments of principal and interest made to service our debts may leave us with insufficient cash to pay the distributions that we are required to pay to maintain our qualification as a REIT. Any of these results would have a significant, negative impact on our stockholders’ investments.
U.S. Federal Income Tax Risks
Our failure to continue to qualify as a REIT would subject us to federal income tax and reduce cash available for distribution to our stockholders.
We elected to be taxed as a REIT under the Code commencing with our taxable year ended December 31, 2010. We intend to continue to operate in a manner so as to continue to qualify as a REIT for federal income tax purposes. Qualification as a REIT involves the application of highly technical and complex Code provisions for which only a limited number of judicial and administrative interpretations exist. Even an inadvertent or technical mistake could jeopardize our REIT status. Our continued qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis. Moreover, new tax legislation, administrative guidance or court decisions, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to continue to qualify as a REIT. If we fail to continue to qualify as a REIT in any taxable year, we would be subject to federal and applicable state and local income tax on our taxable income at corporate rates, in which case we might be required to borrow or liquidate some investments in order to pay the applicable tax. Losing our REIT status would reduce our net income available for investment or distribution to you because of the additional tax liability. In addition, distributions to our stockholders would no longer qualify for the dividends-paid deduction and we would no longer be required to make distributions. Furthermore, if we fail to qualify as a REIT in any taxable year for which we have elected to be taxed as a REIT, we would generally be unable to elect REIT status for the four taxable years following the year in which our REIT status is lost.
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Complying with REIT requirements may force us to borrow funds to make distributions to you or otherwise depend on external sources of capital to fund such distributions.
To continue to qualify as a REIT, we are required to distribute annually at least 90% of our taxable income, subject to certain adjustments, to our stockholders. To the extent that we satisfy the distribution requirement, but distribute less than 100% of our taxable income, we will be subject to federal corporate income tax on our undistributed taxable income. In addition, we may elect to retain and pay income tax on our net long-term capital gain. In that case, if we so elect, a stockholder would be taxed on its proportionate share of our undistributed long-term gain and would receive a credit or refund for its proportionate share of the tax we paid. A stockholder, including a tax-exempt or foreign stockholder, would have to file a federal income tax return to claim that credit or refund. Furthermore, we will be subject to a 4% nondeductible excise tax if the actual amount that we distribute to our stockholders in a calendar year is less than a minimum amount specified under federal tax laws.
From time-to-time, we may generate taxable income greater than our net income (loss) for GAAP. In addition, our taxable income may be greater than our cash flow available for distribution to you as a result of, among other things, investments in assets that generate taxable income in advance of the corresponding cash flow from the assets (for instance, if a borrower defers the payment of interest in cash pursuant to a contractual right or otherwise).
If we do not have other funds available in the situations described in the preceding paragraphs, we could be required to borrow funds on unfavorable terms, sell investments at disadvantageous prices or find another alternative source of funds to make distributions sufficient to enable us to distribute enough of our taxable income to satisfy the REIT distribution requirement and to avoid corporate income tax and the 4% excise tax in a particular year. These alternatives could increase our costs or reduce our equity.
Because of the distribution requirement, it is unlikely that we will be able to fund all future capital needs, including capital needs in connection with investments, from cash retained from operations. As a result, to fund future capital needs, we likely will have to rely on third-party sources of capital, including both debt and equity financing, which may or may not be available on favorable terms or at all. Our access to third-party sources of capital will depend upon a number of factors, including our current and potential future earnings and cash distributions.
Despite our qualification for taxation as a REIT for federal income tax purposes, we may be subject to other tax liabilities that reduce our cash flow and our ability to make distributions to our stockholders.
Despite our qualification for taxation as a REIT for federal income tax purposes, we may be subject to certain federal, state and local taxes on our income and assets, including taxes on any undistributed income or property. Any of these taxes would decrease cash available for distribution to our stockholders. For instance:
• | In order to continue to qualify as a REIT, we must distribute annually at least 90% of our REIT taxable income (which is determined without regard to the dividends paid deduction or net capital gain for this purpose) to our stockholders. |
• | To the extent that we satisfy the distribution requirement but distribute less than 100% of our REIT taxable income, we will be subject to federal corporate income tax on the undistributed income. |
• | We will be subject to a 4% nondeductible excise tax on the amount, if any, by which distributions we pay in any calendar year are less than the sum of 85% of our ordinary income, 95% of our capital gain net income and 100% of our undistributed income from prior years. |
• | If we have net income from the sale of foreclosure property that we hold primarily for sale to customers in the ordinary course of business or other non-qualifying income from foreclosure property, we must pay a tax on that income at the highest corporate income tax rate. |
• | If we sell an asset, other than foreclosure property, that we hold primarily for sale to customers in the ordinary course of business and do not qualify for a safe harbor in the Code, our gain would be subject to the 100% “prohibited transaction” tax. |
• | Any domestic taxable REIT subsidiary, or TRS, of ours will be subject to federal corporate income tax on its income, and on any non-arm’s-length transactions between us and any TRS, for instance, excessive rents charged to a TRS could be subject to a 100% tax. |
• | We may be subject to tax on income from certain activities conducted as a result of taking title to collateral. |
• | We may be subject to state or local income, property and transfer taxes, such as mortgage recording taxes. |
Complying with REIT requirements may cause us to forego otherwise attractive opportunities or liquidate otherwise attractive investments.
To continue to qualify as a REIT for federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to stockholders and the
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ownership of our stock. As discussed above, we may be required to make distributions to you at disadvantageous times or when we do not have funds readily available for distribution. Additionally, we may be unable to pursue investments that would be otherwise attractive to us in order to satisfy the requirements for qualifying as a REIT.
We must also ensure that at the end of each calendar quarter, at least 75% of the value of our assets consists of cash, cash items, government securities and qualified real estate assets, including certain mortgage loans and mortgage-backed securities. The remainder of our investment in securities (other than government securities and qualified real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of our assets can consist of the securities of any one issuer (other than government securities and qualified real estate assets) and no more than 25% of the value of our gross assets (20% for tax years after 2017) may be represented by securities of one or more TRSs. Finally, for the taxable years after 2015, no more than 25% of our assets may consist of debt investments that are issued by “publicly offered REITs” and would not otherwise be treated as qualifying real estate assets. If we fail to comply with these requirements at the end of any calendar quarter, we must correct such failure within 30 days after the end of the calendar quarter to avoid losing our REIT status and suffering adverse tax consequences, unless certain relief provisions apply. As a result, compliance with the REIT requirements may hinder our ability to operate solely on the basis of profit maximization and may require us to liquidate investments from our portfolio, or refrain from making, otherwise attractive investments. These actions could have the effect of reducing our income and amounts available for distribution to stockholders.
Complying with REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Code may limit our ability to hedge our operations effectively. Our aggregate gross income from non-qualifying hedges, fees and certain other non-qualifying sources cannot exceed 5% of our annual gross income. As a result, we might have to limit our use of advantageous hedging techniques or implement those hedges through a TRS. Any hedging income earned by a TRS would be subject to federal, state and local income tax at regular corporate rates. This could increase the cost of our hedging activities or expose us to greater risks associated with interest rate or other changes than we would otherwise incur.
Liquidation of assets may jeopardize our REIT qualification.
To continue to qualify as a REIT, we must comply with requirements regarding our assets and our sources of income. If we are compelled to liquidate our investments to satisfy our obligations to our lenders, we may be unable to comply with these requirements, ultimately jeopardizing our qualification as a REIT, or we may be subject to a 100% prohibited transaction tax on any resulting gain if we sell assets that are treated as dealer property or inventory.
The prohibited transactions tax may limit our ability to engage in transactions, including disposition of assets and certain methods of securitizing loans, which would be treated as sales for federal income tax purposes.
A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of dealer property, other than foreclosure property, but including loans held primarily for sale to customers in the ordinary course of business. We might be subject to the prohibited transaction tax if we were to dispose of or securitize loans in a manner that is treated as a sale of the loans, for federal income tax purposes. In order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans and may limit the structures we use for any securitization financing transactions, even though such sales or structures might otherwise be beneficial to us. Additionally, we may be subject to the prohibited transaction tax upon a disposition of real property. Although a safe-harbor exception to prohibited transaction treatment is available, we cannot assure you that we can comply with such safe harbor or that we will avoid owning property that may be characterized as held primarily for sale to customers in the ordinary course of our trade or business. Consequently, we may choose not to engage in certain sales of real property or may conduct such sales through a TRS.
It may be possible to reduce the impact of the prohibited transaction tax by conducting certain activities through a TRS. However, to the extent that we engage in such activities through a TRS, the income associated with such activities will be subject to a corporate income tax. In addition, the IRS may attempt to ignore or otherwise recast such activities in order to impose a prohibited transaction tax on us, and there can be no assurance that such recast will not be successful.
We also may not be able to use secured financing structures that would create taxable mortgage pools, other than in a TRS or through a subsidiary REIT.
We may recognize substantial amounts of REIT taxable income, which we would be required to distribute to our stockholders, in a year in which we are not profitable under GAAP principles or other economic measures.
We may recognize substantial amounts of REIT taxable income in years in which we are not profitable under GAAP or other economic measures as a result of the differences between GAAP and tax accounting methods. For instance, certain of our assets will be marked-to-market for GAAP purposes but not for tax purposes, which could result in losses for GAAP purposes that are not recognized in computing our REIT taxable income. Additionally, we may deduct our capital losses only to the extent of our
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capital gains in computing our REIT taxable income for a given taxable year. Consequently, we could recognize substantial amounts of REIT taxable income and would be required to distribute such income to you, in a year in which we are not profitable under GAAP or other economic measures.
REIT distribution requirements could adversely affect our ability to execute our business plan.
We generally must distribute annually at least 90% of our REIT taxable income (which is determined without regard to the dividends paid deduction or net capital gain for this purpose) in order to continue to qualify as a REIT. We intend to make distributions to our stockholders to comply with the REIT requirements of the Code and to avoid corporate income tax and the 4% excise tax. We may be required to make distributions to stockholders at times when it would be more advantageous to reinvest cash in our business or when we do not have funds readily available for distribution. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.
Our qualification as a REIT could be jeopardized as a result of an interest in joint ventures or investment funds.
We may hold certain limited partner or non-managing member interests in partnerships or limited liability companies that are joint ventures or investment funds. If a partnership or limited liability company in which we own an interest takes or expects to take actions that could jeopardize our qualification as a REIT or require us to pay tax, we may be forced to dispose of our interest in such entity. In addition, it is possible that a partnership or limited liability company could take an action which could cause us to fail a REIT gross income or asset test, and that we would not become aware of such action in time to dispose of our interest in the partnership or limited liability company or take other corrective action on a timely basis. In that case, we could fail to continue to qualify as a REIT unless we are able to qualify for a statutory REIT “savings” provision, which may require us to pay a significant penalty tax to maintain our REIT qualification.
Distributions paid by REITs do not qualify for the reduced tax rates that apply to other corporate distributions.
The maximum tax rate for “qualified dividends” paid by corporations to non-corporate stockholders is currently 20%. Distributions paid by REITs, however, generally are taxed at ordinary income rates (subject to a maximum rate of 39.6% for non-corporate stockholders), rather than the preferential rate applicable to qualified dividends.
Legislative or regulatory tax changes could adversely affect us or stockholders.
At any time, the federal income tax laws can change. Laws and rules governing REITs or the administrative interpretations of those laws may be amended. Any of those new laws or interpretations may take effect retroactively and could adversely affect us or stockholders.
Retirement Plan Risks
If the fiduciary of an employee benefit plan subject to ERISA (such as a profit sharing, Section 401(k) or pension plan) or an owner of a retirement arrangement subject to Section 4975 of the Code (such as an IRA) fails to meet the fiduciary and other standards under ERISA or the Code as a result of an investment in our stock, the fiduciary could be subject to penalties and other sanctions.
There are special considerations that apply to employee benefit plans subject to ERISA (such as profit sharing, Section 401(k) or pension plans) and other retirement plans or accounts subject to Section 4975 of the Code (such as an IRA) that are investing in our shares. Fiduciaries and IRA owners investing the assets of such a plan or account in our common stock should satisfy themselves that:
• | the investment is consistent with their fiduciary and other obligations under ERISA and the Code; |
• | the investment is made in accordance with the documents and instruments governing the plan or IRA, including the plan’s or account’s investment policy; |
• | the investment satisfies the prudence and diversification requirements of Sections 404(a)(1)(B) and 404(a)(1)(C) of ERISA and other applicable provisions of ERISA and the Code; |
• | the investment in our shares, for which no public market currently exists, is consistent with the liquidity needs of the plan or IRA; |
• | the investment will not produce an unacceptable amount of “unrelated business taxable income” for the plan or IRA; |
• | our stockholders will be able to comply with the requirements under ERISA and the Code to value the assets of the plan or IRA annually; and |
• | the investment will not constitute a prohibited transaction under Section 406 of ERISA or Section 4975 of the Code. |
Failure to satisfy the fiduciary standards of conduct and other applicable requirements of ERISA and the Code may result in the imposition of civil and criminal penalties and could subject the fiduciary to claims for damages or for equitable remedies,
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including liability for investment losses. In addition, if an investment in our shares constitutes a prohibited transaction under ERISA or the Code, the fiduciary or IRA owner who authorized or directed the investment may be subject to the imposition of excise taxes with respect to the amount invested. In addition, the investment transaction must be undone. In the case of a prohibited transaction involving an IRA owner, the IRA may be disqualified as a tax-exempt account and all of the assets of the IRA may be deemed distributed and subjected to tax. ERISA plan fiduciaries and IRA owners should consult with counsel before making an investment in our common stock.
If our assets are deemed to be plan assets, the Advisor and we may be exposed to liabilities under Title I of ERISA and the Code.
In some circumstances where an ERISA plan holds an interest in an entity, the assets of the entity are deemed to be ERISA plan assets unless an exception applies. This is known as the “look-through rule.” Under those circumstances, the obligations and other responsibilities of plan sponsors, plan fiduciaries and plan administrators, and of parties in interest and disqualified persons, under Title I of ERISA or Section 4975 of the Code, may be applicable, and there may be liability under these and other provisions of ERISA and the Code. We believe that our assets should not be treated as plan assets because the shares should qualify as “publicly-offered securities” that are exempt from the look-through rules under applicable Treasury Regulations. We note, however, that because certain limitations are imposed upon the transferability of shares so that we may qualify as a REIT, and perhaps for other reasons, it is possible that this exemption may not apply. If that is the case, and if the Advisor or we are exposed to liability under ERISA or the Code, our performance and results of operations could be adversely affected.
If stockholders invested in our shares through an IRA or other retirement plan, they may be limited in their ability to withdraw required minimum distributions.
If stockholders established an IRA or other retirement plan through which they invested in our shares, federal law may require them to withdraw required minimum distributions (“RMDs”) from such plan in the future. Our SRP limits the amount of repurchases (other than those repurchases as a result of a stockholder’s death or disability) that can be made in a given year. Additionally, our stockholders will not be eligible to have their shares repurchased until they have held their shares for at least one year. As a result, they may not be able to have their shares repurchased at a time in which they need liquidity to satisfy the RMD requirements under their IRA or other retirement plan. Even if they are able to have their shares repurchased, our share repurchase price is based on the estimated value per share of our common stock as determined by our board of directors, and this value is expected to fluctuate over time. As such, a repurchase may be at a price that is less than the price at which the shares were initially purchased. If stockholders fail to withdraw RMDs from their IRA or other retirement plan, they may be subject to certain tax penalties.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
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ITEM 2. PROPERTIES
Real Estate Investments
As of December 31, 2016, we owned 153 properties throughout the United States acquired from third parties unaffiliated with us or PE-NTR. The following table presents information regarding the geographical location of our properties by leasable square feet as of December 31, 2016 (dollars and square feet in thousands). For additional portfolio information, refer to Schedule III - Real Estate Assets and Accumulated Depreciation, herein.
State | GLA(1) | % GLA | ABR(2) | % ABR | ABR/Leased Square Foot | % Leased | Number of Properties | ||||||||||||||||
Florida | 1,927 | 11.5 | % | $ | 25,865 | 13.0 | % | $ | 13.83 | 97.0 | % | 25 | |||||||||||
Georgia | 1,915 | 11.5 | % | 19,657 | 9.9 | % | 10.80 | 95.1 | % | 20 | |||||||||||||
Ohio | 1,888 | 11.3 | % | 18,064 | 9.1 | % | 9.92 | 96.4 | % | 14 | |||||||||||||
Illinois | 894 | 5.3 | % | 11,010 | 5.6 | % | 13.06 | 94.3 | % | 7 | |||||||||||||
Texas | 818 | 4.9 | % | 14,314 | 7.2 | % | 17.89 | 97.7 | % | 5 | |||||||||||||
Massachusetts | 767 | 4.6 | % | 9,554 | 4.8 | % | 12.92 | 96.4 | % | 6 | |||||||||||||
California | 713 | 4.3 | % | 12,746 | 6.4 | % | 18.93 | 94.5 | % | 7 | |||||||||||||
Virginia | 681 | 4.1 | % | 10,250 | 5.2 | % | 15.78 | 95.4 | % | 6 | |||||||||||||
North Carolina | 609 | 3.6 | % | 8,069 | 4.1 | % | 13.54 | 97.8 | % | 7 | |||||||||||||
Pennsylvania | 600 | 3.6 | % | 5,698 | 2.9 | % | 9.74 | 97.5 | % | 4 | |||||||||||||
Colorado | 592 | 3.5 | % | 6,229 | 3.1 | % | 10.88 | 96.7 | % | 6 | |||||||||||||
Tennessee | 526 | 3.1 | % | 3,777 | 1.9 | % | 7.33 | 98.0 | % | 2 | |||||||||||||
Michigan | 525 | 3.1 | % | 3,510 | 1.8 | % | 7.03 | 95.2 | % | 3 | |||||||||||||
Arizona | 507 | 3.0 | % | 4,796 | 2.4 | % | 11.78 | 80.2 | % | 4 | |||||||||||||
South Carolina | 465 | 2.8 | % | 5,739 | 2.9 | % | 13.64 | 90.6 | % | 6 | |||||||||||||
Kentucky | 424 | 2.5 | % | 4,156 | 2.1 | % | 10.18 | 96.4 | % | 3 | |||||||||||||
Minnesota | 410 | 2.5 | % | 5,211 | 2.6 | % | 13.04 | 97.4 | % | 5 | |||||||||||||
Iowa | 360 | 2.2 | % | 2,957 | 1.5 | % | 8.32 | 98.8 | % | 3 | |||||||||||||
Indiana | 345 | 2.1 | % | 3,571 | 1.8 | % | 10.39 | 99.6 | % | 2 | |||||||||||||
Oregon | 338 | 2.0 | % | 4,611 | 2.3 | % | 13.92 | 98.1 | % | 4 | |||||||||||||
New Mexico | 326 | 2.0 | % | 4,130 | 2.1 | % | 14.88 | 85.1 | % | 3 | |||||||||||||
Wisconsin | 259 | 1.5 | % | 2,402 | 1.2 | % | 9.64 | 96.2 | % | 3 | |||||||||||||
Maryland | 228 | 1.4 | % | 4,149 | 2.1 | % | 18.36 | 99.2 | % | 2 | |||||||||||||
Washington | 170 | 1.0 | % | 2,314 | 1.2 | % | 14.37 | 94.5 | % | 2 | |||||||||||||
Connecticut | 124 | 0.7 | % | 1,716 | 0.9 | % | 14.80 | 93.3 | % | 1 | |||||||||||||
Nevada | 118 | 0.7 | % | 1,968 | 1.0 | % | 17.04 | 97.9 | % | 1 | |||||||||||||
Missouri | 112 | 0.7 | % | 861 | 0.4 | % | 7.67 | 100.0 | % | 1 | |||||||||||||
Kansas | 77 | 0.5 | % | 998 | 0.5 | % | 13.27 | 97.9 | % | 1 | |||||||||||||
16,718 | 100.0 | % | $ | 198,322 | 100.0 | % | $ | 12.41 | 95.6 | % | 153 | ||||||||||||
(1) | Gross leasable area (“GLA”) is defined as the portion of the total square feet of a building that is available for tenant leasing. |
(2) | We calculate annualized base rent (“ABR”) as monthly contractual rent as of December 31, 2016, multiplied by 12 months. |
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Lease Expirations
The following table lists, on an aggregate basis, all of the scheduled lease expirations after December 31, 2016, for each of the next ten years and thereafter for our 153 shopping centers. The table shows the leased square feet and ABR represented by the applicable lease expirations (dollars and square feet in thousands):
Year | Number of Leases Expiring | Leased Square Feet Expiring | % of Leased Square Feet Expiring | ABR | % of Total Portfolio ABR | ||||||||||
2017(1) | 351 | 1,059 | 6.6 | % | $ | 15,752 | 7.9 | % | |||||||
2018 | 358 | 1,711 | 10.7 | % | 21,990 | 11.1 | % | ||||||||
2019 | 402 | 1,987 | 12.4 | % | 26,790 | 13.5 | % | ||||||||
2020 | 297 | 1,719 | 10.8 | % | 21,892 | 11.0 | % | ||||||||
2021 | 332 | 2,085 | 13.0 | % | 24,268 | 12.2 | % | ||||||||
2022 | 135 | 1,399 | 8.8 | % | 12,914 | 6.5 | % | ||||||||
2023 | 101 | 1,525 | 9.5 | % | 19,061 | 9.6 | % | ||||||||
2024 | 128 | 1,191 | 7.5 | % | 11,871 | 6.1 | % | ||||||||
2025 | 104 | 727 | 4.5 | % | 11,076 | 5.6 | % | ||||||||
2026 | 113 | 881 | 5.5 | % | 13,134 | 6.7 | % | ||||||||
Thereafter | 129 | 1,699 | 10.7 | % | 19,574 | 9.8 | % | ||||||||
2,450 | 15,983 | 100.0 | % | $ | 198,322 | 100.0 | % | ||||||||
(1) | Subsequent to December 31, 2016, we renewed 55 of the 351 leases expiring in 2017, which accounts for 282,310 total square feet and total ABR of $5.1 million. |
During the year ended 2016, rent per square foot for renewed leases increased 9.9% when compared to rent per square foot prior to renewal. See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations - Leasing Activity, for further discussion of leasing activity. Based on current market base rental rates, we believe we will achieve an overall positive increase in our average base rental income for leases expiring in 2017. However, changes in base rental income associated with individual signed leases on comparable spaces may be positive or negative, and we can provide no assurance that the base rents on new leases will continue to increase from current levels.
Portfolio Tenancy
Prior to the acquisition of a property, we assess the suitability of the grocery anchor tenant and other tenants in light of our investment objectives, namely, preserving capital and providing stable cash flows for distributions. Generally, we assess the strength of the tenant by consideration of company factors, such as its financial strength and market share in the geographic area of the shopping center, as well as location-specific factors, such as the store’s sales, local competition, and demographics. When assessing the tenancy of the non-anchor space at the shopping center, we consider the tenant mix at each shopping center in light of our portfolio, the proportion of national and national franchise tenants, the creditworthiness of specific tenants, and the timing of lease expirations. When evaluating non-national tenancy, we attempt to obtain credit enhancements to leases, which typically come in the form of deposits and/or guarantees from one or more individuals.
The following table presents the composition of our portfolio by tenant type as of December 31, 2016 (dollars and square feet in thousands):
Tenant Type | Leased Square Feet | % of Leased Square Feet | ABR | % of ABR | |||||||||
Grocery anchor | 8,482 | 53.1 | % | $ | 80,102 | 40.4 | % | ||||||
National & regional(1) | 5,232 | 32.7 | % | 76,436 | 38.5 | % | |||||||
Local | 2,269 | 14.2 | % | 41,784 | 21.1 | % | |||||||
15,983 | 100.0 | % | $ | 198,322 | 100.0 | % | |||||||
(1) | We define national tenants as those tenants that operate in at least three states. Regional tenants are defined as those tenants that have at least three locations. |
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The following table presents the composition of our portfolio by tenant industry as of December 31, 2016 (dollars and square feet in thousands):
Tenant Industry | Leased Square Feet | % of Leased Square Feet | ABR | % of ABR | |||||||||
Grocery | 8,482 | 53.1 | % | $ | 80,102 | 40.4 | % | ||||||
Retail Stores | 3,782 | 23.7 | % | 45,407 | 22.9 | % | |||||||
Services | 2,397 | 15.0 | % | 45,246 | 22.8 | % | |||||||
Restaurant | 1,322 | 8.2 | % | 27,567 | 13.9 | % | |||||||
15,983 | 100.0 | % | $ | 198,322 | 100.0 | % | |||||||
The following table presents our grocery anchor tenants, grouped according to parent company, by leased square feet as of December 31, 2016 (dollars and square feet in thousands):
Tenant | Leased Square Feet | % of Leased Square Feet | ABR | % of ABR | Number of Locations(1) | |||||||||||
Kroger | 2,155 | 13.5 | % | $ | 16,814 | 8.5 | % | 38 | ||||||||
Publix | 1,457 | 9.1 | % | 15,020 | 7.6 | % | 31 | |||||||||
Walmart | 1,121 | 7.0 | % | 4,419 | 2.2 | % | 9 | |||||||||
Albertsons-Safeway | 828 | 5.2 | % | 8,606 | 4.3 | % | 14 | |||||||||
Giant Eagle | 560 | 3.5 | % | 5,396 | 2.7 | % | 7 | |||||||||
Ahold Delhaize | 555 | 3.5 | % | 8,352 | 4.2 | % | 10 | |||||||||
SUPERVALU | 273 | 1.7 | % | 2,382 | 1.2 | % | 4 | |||||||||
Raley's | 193 | 1.2 | % | 3,422 | 1.7 | % | 3 | |||||||||
Sprouts Farmers Market | 168 | 1.0 | % | 1,797 | 0.9 | % | 5 | |||||||||
Winn-Dixie | 147 | 0.9 | % | 1,545 | 0.8 | % | 3 | |||||||||
Hy-Vee | 127 | 0.8 | % | 527 | 0.3 | % | 2 | |||||||||
Schnuck's | 121 | 0.8 | % | 1,459 | 0.7 | % | 2 | |||||||||
BJ's Wholesale Club | 115 | 0.7 | % | 1,223 | 0.6 | % | 1 | |||||||||
Coborn's | 108 | 0.7 | % | 1,388 | 0.7 | % | 2 | |||||||||
H-E-B | 81 | 0.5 | % | 1,210 | 0.6 | % | 1 | |||||||||
Price Chopper | 68 | 0.4 | % | 844 | 0.4 | % | 1 | |||||||||
Big Y | 65 | 0.4 | % | 1,091 | 0.6 | % | 1 | |||||||||
Food 4 Less (PAQ) | 59 | 0.4 | % | 1,046 | 0.5 | % | 1 | |||||||||
Fresh Market | 59 | 0.4 | % | 841 | 0.4 | % | 3 | |||||||||
Trader Joe's | 55 | 0.3 | % | 934 | 0.5 | % | 4 | |||||||||
URM Stores, Inc. | 51 | 0.3 | % | 537 | 0.3 | % | 1 | |||||||||
Save Mart | 50 | 0.3 | % | 399 | 0.2 | % | 1 | |||||||||
Marc's | 36 | 0.2 | % | 400 | 0.2 | % | 1 | |||||||||
Fresh Thyme Farmers Market | 30 | 0.2 | % | 450 | 0.2 | % | 1 | |||||||||
8,482 | 53.1 | % | $ | 80,102 | 40.4 | % | 146 | |||||||||
(1) | Number of locations excludes (a) 30 auxiliary leases with grocery anchors such as fuel stations, pharmacies, and liquor stores, (b) four locations where we do not own the portion of the shopping center that contains the grocery anchor, and (c) four locations that have non-grocery anchors. Number of locations also includes one shopping center that has two grocery anchor tenants. |
ITEM 3. LEGAL PROCEEDINGS
From time to time, we are party to legal proceedings, which arise in the ordinary course of our business. We are not currently involved in any legal proceedings of which the outcome is reasonably likely to have a material impact on our results of operations or financial condition, nor are we aware of any such legal proceedings contemplated by governmental authorities.
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ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
Stockholder Information
As of February 28, 2017, we had approximately 182.1 million shares of common stock outstanding, held by a total of 40,252 stockholders of record.
Market Information
Our common stock is not currently traded on any exchange, and there is no established trading market for our common stock. Therefore, there is a risk that a stockholder may not be able to sell our stock at a time acceptable to the stockholder, or at all. Pursuant to the terms of our charter, certain restrictions are imposed on the ownership and transfer of shares.
Valuation Overview
On April 14, 2016, the Board of Directors of Phillips Edison Grocery Center REIT I, Inc. (the “Company”) reaffirmed its estimated value per share of the Company’s common stock of $10.20 based substantially on the estimated market value of the Company’s portfolio of real estate properties in various geographic locations in the United States (the “Portfolio”) as of March 31, 2016. The Company provided this estimated value per share to assist broker-dealers that participated in the Company’s public offering in meeting their customer account statement reporting obligations under National Association of Securities Dealers Conduct Rule 2340 as required by the Financial Industry Regulatory Authority (“FINRA”). This valuation was performed in accordance with the provisions of Practice Guideline 2013-01, Valuations of Publicly Registered Non-Listed REITs, issued by the Investment Program Association (“IPA”) in April 2013 (“IPA Valuation Guidelines”).
The Company engaged Duff & Phelps, LLC (“Duff & Phelps”) to provide a calculation of the range in estimated value per share of the Company’s common stock as of March 31, 2016. Duff & Phelps prepared a valuation report (“Valuation Report”) that provided this range based substantially on its estimate of the “as is” market values of the Portfolio. Duff & Phelps made adjustments to the aggregate estimated value of the Company’s Portfolio to reflect balance sheet assets and liabilities provided by the Company’s management as of March 31, 2016, before calculating a range of estimated values based on the number of outstanding shares of the Company’s common stock as of March 31, 2016. These calculations produced an estimated value per share in the range of $9.95 to $11.10 as of March 31, 2016. The Board of Directors ultimately approved $10.20 as the estimated value per share of the Company’s common stock.
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The following table summarizes the material components of the estimated value per share of the Company’s common stock as of March 31, 2016 (dollar and shares in thousands):
Low | High | ||||||
Investment in Real Estate Assets | $ | 2,627,700 | $ | 2,841,200 | |||
Other Assets: | |||||||
Cash and cash equivalents | 10,838 | 10,838 | |||||
Restricted cash | 6,762 | 6,762 | |||||
Accounts receivable | 24,930 | 24,930 | |||||
Prepaid expenses and other assets | 5,532 | 5,532 | |||||
Total other assets | $ | 48,062 | $ | 48,062 | |||
Liabilities: | |||||||
Notes payable and credit facility | $ | 813,409 | $ | 813,409 | |||
Mark to market of debt | 12,756 | 12,756 | |||||
Accounts payable and accrued expenses | 69 | 69 | |||||
Security deposits | 5,000 | 5,000 | |||||
Total liabilities | $ | 831,234 | $ | 831,234 | |||
Net Asset Value | $ | 1,844,528 | $ | 2,058,028 | |||
Common stock outstanding | 185,377 | 185,377 | |||||
Net Asset Value Per Share | $ | 9.95 | $ | 11.10 | |||
As with any valuation methodology, the methodologies used are based upon a number of assumptions and estimates that may not be accurate or complete. Different parties with different assumptions and estimates could derive a different estimated value per share, and these differences could be significant. These limitations are discussed further under “Limitations of Estimated Value per Share” below.
Valuation Methodologies
The Company’s goal in calculating an estimated value per share is to arrive at a value that is reasonable and supportable using what the Company deems to be appropriate valuation and appraisal methodologies and assumptions and a process that is in accordance with the IPA Valuation Guidelines. The following is a summary of the valuation methodologies and components used to calculate the estimated value per share.
Real Estate Portfolio
Independent Valuation Firm
Duff & Phelps was recommended by Phillips Edison NTR LLC, the Company’s external advisor (“Advisor”) to the Conflicts Committee of the Company’s Board of Directors (“Conflicts Committee”) to provide independent valuation services. The Conflicts Committee approved the engagement of Duff & Phelps for those services, and they are not affiliated with the Company or our Advisor. Duff & Phelps has previously provided the allocation of acquisition purchase prices for financial reporting purposes pertaining to the Portfolio. They received the usual and customary compensation for such services. Duff & Phelps may be engaged to provide professional services to the Company in the future.
Duff & Phelps’ engagement for its valuation services was not contingent upon developing or reporting predetermined results. In addition, Duff & Phelps’ compensation for completing the valuation services was not contingent upon the development or reporting of a predetermined value or direction in value that favors the cause of the Company, the amount of the value opinion, the attainment of a stipulated result, or the occurrence of a subsequent event directly related to the intended use of its Valuation Report. The Company has agreed to indemnify Duff & Phelps against certain liabilities arising out of this engagement.
Duff & Phelps’ analyses, opinions, and conclusions were developed, and the Valuation Report was prepared, in conformity with the Uniform Standards of Professional Appraisal Practice. The Valuation Report was reviewed, approved, and signed by Duff &
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Phelps’ personnel with the professional designation of Member of the Appraisal Institute (“MAI”). The use of the Valuation Report is subject to the requirements of the Appraisal Institute relating to review by its duly authorized representatives.
In preparing the Valuation Report, Duff & Phelps relied on information provided by the Company and the Advisor regarding the Portfolio. For example, the Company and the Advisor provided information regarding building size, year of construction, land size and other physical, financial and economic characteristics. The Company and the Advisor also provided lease information, such as current rent amounts, rent commencement and expiration dates, and rent increase amounts and dates. Duff & Phelps did not inspect the Portfolio properties as part of the valuation process.
Duff & Phelps did not investigate the legal description or legal matters relating to the Portfolio, including title or encumbrances, and title to the properties was assumed to be good and marketable. The Portfolio was also assumed to be free and clear of liens, easements, encroachments and other encumbrances, and to be in full compliance with zoning, use, occupancy, environmental and similar laws unless otherwise stated by the Company. The Valuation Report contains other assumptions, qualifications and limitations that qualify the analysis, opinions and conclusions set forth therein. Furthermore, the prices at which the Company’s real estate properties may actually be sold could differ from their appraised values.
The foregoing is a summary of the standard assumptions, qualifications and limitations that generally apply to the Valuation Report.
Real Estate Valuation
Duff & Phelps estimated the “as is” market values of the Portfolio as of March 31, 2016, using various methodologies. Generally accepted valuation practice suggests assets may be valued using a range of methodologies. Duff & Phelps utilized the income capitalization approach with support from the sales comparison approach for each property. The income approach was the primary indicator of value, with secondary consideration given to the sales approach. Duff & Phelps performed a study of each market to measure current market conditions, supply and demand factors, growth patterns, and their effect on each of the subject properties.
Duff & Phelps modeled tenant common area maintenance (“CAM”) and real estate tax reimbursements as a dollar-amount-per-square-foot of occupied area and included them as miscellaneous revenue line items, rather than detailed on a contractual tenant-by-tenant basis in the reimbursement module of Argus Enterprise, a long-term financial modeling software program for real estate, for the cash flow projections. The basis of the per square foot unit indicator was provided by the Advisor based on historical and budgeted dollar amounts per-square-foot of occupied area for CAM and real estate tax reimbursements. The Advisor completed an analysis of a sampling of properties where the contractual reimbursements were calculated on a tenant-by-tenant basis within the reimbursement module of Argus Enterprise and compared these to the per square foot of occupied area calculation conclusions. It was deemed that the differences in dollar amounts calculated were insignificant between the two methods; therefore, Duff & Phelps agreed with the Advisor’s conclusion that the methodology used to arrive at reimbursement income on a per square foot of occupied area was reasonable.
The income capitalization approach simulates the reasoning of an investor who views the cash flows that would result from the anticipated revenue and expense on a property throughout its lifetime. Under the income capitalization approach, Duff & Phelps used an estimated net operating income (“NOI”) for each property, and then converted it to a value indication using a discounted cash flow analysis. The discounted cash flow analysis focuses on the operating cash flows expected from a property and the anticipated proceeds of a hypothetical sale at the end of an assumed holding period, with these amounts then being discounted to their present value. The discounted cash flow method is appropriate for the analysis of investment properties with multiple leases, particularly leases with cancellation clauses or renewal options, and especially in volatile markets.
The sales comparison approach estimates value based on what other purchasers and sellers in the market have agreed to as a price for comparable improved properties. This approach is based upon the principle of substitution, which states that the limits of prices, rents and rates tend to be set by the prevailing prices, rents and rates of equally desirable substitutes. Duff & Phelps gathered comparable sales data throughout various markets as secondary support for its valuation estimate.
The following summarizes the range of capitalization and discount rates that were used to arrive at the estimated market values of the Company’s Portfolio:
Range in Values | |
Overall capitalization rate | 6.25% - 6.75% |
Terminal capitalization rate | 6.70% - 7.20% |
Discount rate | 7.25% - 7.75% |
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Sensitivity Analysis
While the Company believes that Duff & Phelps’ assumptions and inputs are reasonable, a change in these assumptions would impact the calculations of the estimated value of the Portfolio and the Company’s estimated value per share. The table below illustrates the impact on Duff & Phelps’ range in estimated value per share if the terminal capitalization rates or discount rates were adjusted by 25 basis points and assumes all other factors remain unchanged. Additionally, the table illustrates the impact of a 5% change in these rates in accordance with the IPA Valuation Guidelines. The table is only hypothetical to illustrate possible results if only one change in assumptions was made, with all other factors held constant. Further, each of these assumptions could change by more than 25 basis points or 5%.
Resulting Range in Estimated Value Per Share | |||||||
Increase of 25 Basis Points | Decrease of 25 Basis Points | Increase of 5% | Decrease of 5% | ||||
Terminal capitalization rate | $9.73 to $10.81 | $10.28 to $11.47 | $9.63 to $10.71 | $10.41 to $11.59 | |||
Discount rate | $9.74 to $10.85 | $10.26 to $11.42 | $9.61 to $10.73 | $10.40 to $11.54 | |||
Other Assets and Other Liabilities
Duff & Phelps made adjustments to the aggregate estimated values of the Company’s investments to reflect other assets and other liabilities of the Company based on balance sheet information provided by the Company and the Advisor as of March 31, 2016.
Role of the Conflicts Committee and the Board of Directors
The Conflicts Committee is composed of all of the Company’s independent directors. It is responsible for the oversight of the valuation process, including the review and approval of the valuation process and methodologies used to determine the Company’s estimated value per share, the consistency of the valuation and appraisal methodologies with real estate industry standards and practices and the reasonableness of the assumptions used in the valuations and appraisals. The Conflicts Committee approved the Company’s engagement of Duff & Phelps to provide an estimation of the value per share as of March 31, 2016. The Conflicts Committee received a copy of the Valuation Report and discussed the report with representatives of Duff & Phelps. The Conflicts Committee also discussed the Valuation Report, the Portfolio, the Company’s assets and liabilities and other matters with senior management of the Advisor. The Advisor recommended to the Conflicts Committee that $10.20 per share be approved as the estimated value per share of the Company’s common stock. The Conflicts Committee discussed the rationale for this value with the Advisor.
Following the Conflicts Committee’s receipt and review of the Valuation Report, the recommendation of the Advisor, and in light of other factors considered by the Conflicts Committee and its own extensive knowledge of the Company’s assets and liabilities, the Conflicts Committee concluded that the range in estimated value per share of $9.95 and $11.10 was appropriate. The Conflicts Committee then recommended to the Company’s Board of Directors that it select $10.20 as the estimated value per share of the Company’s common stock. The Company’s Board of Directors unanimously agreed to accept the recommendation of the Conflicts Committee and approved $10.20 as the estimated value per share of the Company’s common stock as of March 31, 2016, which determination was ultimately and solely the responsibility of the Board of Directors.
Historical Estimated Value per Share
The Company’s Board of Directors previously established an estimated value per share of $10.20 as of July 31, 2015. The Company expects to review its estimated value per share annually.
Limitations of Estimated Value per Share
The Company is providing this estimated value per share to assist broker-dealers that participated in the Company’s public offering in meeting their customer account statement reporting obligations. This valuation was performed in accordance with the provisions of the IPA Valuation Guidelines. As with any valuation methodology, the methodologies used are based upon a number of estimates and assumptions that may not be accurate or complete. Different parties with different assumptions and estimates could derive a different estimated value per share, and this difference could be significant. The estimated value per share is not audited and does not represent a determination of the fair value of the Company’s assets or liabilities based on U.S. generally accepted accounting principles (“GAAP”), nor does it represent a liquidation value of the Company’s assets and liabilities or the amount at which the Company’s shares of common stock would trade on a national securities exchange.
Accordingly, with respect to the estimated value per share, the Company can give no assurance that:
• | a stockholder would be able to resell his or her shares at the estimated value per share; |
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• | a stockholder would ultimately realize distributions per share equal to the Company’s estimated value per share upon liquidation of the Company’s assets and settlement of its liabilities or a sale of the Company; |
• | the Company’s shares of common stock would trade at the estimated value per share on a national securities exchange; |
• | a third party would offer the estimated value per share in an arm’s-length transaction to purchase all or substantially all of the Company’s shares of common stock; |
• | another independent third-party appraiser or third-party valuation firm would agree with the Company’s estimated value per share; or |
• | the methodologies used to calculate the Company’s estimated value per share would be acceptable to FINRA or for compliance with Employee Retirement Income Security Act of 1974 reporting requirements. |
Further, the estimated value per share as of March 31, 2016, is based on the estimated value per share of the Company as of March 31, 2016. The Company did not make any adjustments to the valuation for the impact of other transactions occurring subsequent to March 31, 2016, including, but not limited to, (1) the issuance of common stock under the distribution reinvestment plan, (2) net operating income earned and dividends declared, (3) the repurchase of shares, and (4) changes in leases, tenancy or other business or operational changes. The value of the Company’s shares will fluctuate over time in response to developments related to individual assets in the Portfolio, the management of those assets, and changes in the real estate and finance markets. Because of, among other factors, the high concentration of the Company’s total assets in real estate and the number of shares of the Company’s common stock outstanding, changes in the value of individual assets in the Portfolio or changes in valuation assumptions could have a very significant impact on the value of the Company’s shares. The estimated value per share does not reflect a portfolio premium or the fact that the Company is externally managed. The estimated value per share also does not take into account any disposition costs or fees for real estate properties, debt prepayment penalties that could apply upon the prepayment of certain of the Company’s debt obligations or the impact of restrictions on the assumption of debt.
Dividend Reinvestment Plan
We have adopted the dividend reinvest program (“DRIP”), through which stockholders may elect to reinvest an amount equal to the dividends declared on their shares of common stock into shares of our common stock in lieu of receiving cash dividends. In accordance with the DRIP, because we have established an estimated value per share, participants acquire shares of common stock through the DRIP at a price of $10.20 per share. Participants in the DRIP may purchase fractional shares so that 100% of the dividends may be used to acquire additional shares of our common stock. For the year ended December 31, 2016, 5.8 million shares were issued through the DRIP, resulting in proceeds of approximately $58.9 million. For the year ended December 31, 2015, 6.6 million shares were issued through the DRIP, resulting in proceeds of approximately $63.8 million.
Distribution Information
We pay distributions based on daily record dates, payable monthly in arrears. During the years ended December 31, 2016 and 2015, our board of directors authorized distributions based on daily record dates for each day during the periods from January 1 through December 31, 2016 and 2015. The authorized distributions for 2016 and 2015 were equal to a daily amount of $0.00183060 and $0.00183562 per share of common stock, respectively.
The total distributions paid to common stockholders for the years ended December 31, 2016 and 2015, were as follows (in thousands):
2016 | 2015 | ||||||
Distributions paid to common stockholders | $ | 123,141 | $ | 123,190 | |||
Distributions were paid subsequent to December 31, 2016, to common stockholders from December 2016 through February 2017 as follows (in thousands):
Distribution Period | Date Distribution Paid | Gross Amount of Distribution Paid | ||||
December 1, 2016, through December 31, 2016 | 1/3/2017 | $ | 10,506 | |||
January 1, 2017, through January 31, 2017 | 2/1/2017 | 10,520 | ||||
February 1, 2017, through February 28, 2017 | 3/1/2017 | 9,284 | ||||
All gross distributions paid during the years ended December 31, 2016 and 2015, have been funded by a combination of cash generated through operations or borrowings.
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Unregistered Sales of Equity Securities
During 2016, we did not sell any equity securities that were not registered under the Securities Act.
Share Repurchases
Our Share Repurchase Program (“SRP”) may provide a limited opportunity for stockholders to have shares of common stock repurchased, subject to certain restrictions and limitations, at a price equal to the Company’s most recent estimated value per share.
As of December 31, 2016, we had no liability recorded for an obligation to repurchase shares of common stock.
There are several limitations on our ability to repurchase shares under the program:
• | Unless the shares are being repurchased in connection with a stockholder’s death, “qualifying disability,” or “determination of incompetence,” we may not repurchase shares unless the stockholder has held the shares for one year. |
• | During any calendar year, we may repurchase no more than 5% of the weighted-average number of shares outstanding during the prior calendar year. |
• | We have no obligation to repurchase shares if the repurchase would violate the restrictions on distributions under Maryland law, which prohibits distributions that would cause a corporation to fail to meet statutory tests of solvency. |
• | The cash available for repurchases on any particular date will generally be limited to the proceeds from the DRIP during the preceding four fiscal quarters, less any cash already used for repurchases since the beginning of the same period; however, subject to the limitations described above, we may use other sources of cash at the discretion of the board of directors. The limitations described above do not apply to shares repurchased due to a stockholder’s death, “qualifying disability,” or “determination of incompetence.” |
• | Only those stockholders who purchased their shares from us or received their shares from us (directly or indirectly) through one or more non-cash transactions may be able to participate in the SRP. In other words, once our shares are transferred for value by a stockholder, the transferee and all subsequent holders of the shares are not eligible to participate in the SRP. |
• | The board of directors reserves the right, in its sole discretion, at any time and from time to time, to reject any request for repurchase. |
Initially, shares were repurchased at a price equal to or at a discount from the stockholders’ original purchase price paid for the shares being repurchased. Effective August 24, 2015, the repurchase price per share for all stockholders is equal to the estimated value per share of $10.20. This estimated value per share was reaffirmed on April 14, 2016.
Repurchases of shares of common stock will be made monthly upon written notice received by us at least five days prior to the end of the applicable month, assuming no limitations as noted above exist. Stockholders may withdraw their repurchase request at any time up to five business days prior to the repurchase date. Unfulfilled repurchase requests are treated as requests for repurchase during future months until satisfied or withdrawn, and we will attempt to honor these requests on a pro rata basis.
Our board of directors may amend, suspend, or terminate the program upon 30 days’ notice. We may provide notice by including such information (a) in a current report on Form 8-K or in our annual or quarterly reports, all publicly filed with the Securities and Exchange Commission (“SEC”), or (b) in a separate mailing to the stockholders. Our SRP was temporarily suspended during the self-tender offer we launched on April 25, 2016, as required by SEC rules, and was reinstated on June 22, 2016, ten business days after the expiration of the tender offer. In connection with the tender offer we repurchased 69,271 shares of common stock at a price of $6.00 per share, for an aggregate purchase price of approximately $416,000.
The following table presents all share repurchases for the years ended December 31, 2016 and 2015 (in thousands, except per share amounts):
2016 | 2015 | |||||||
Shares repurchased | 2,019 | 7,386 | ||||||
Cost of repurchases | $ | 20,301 | $ | 74,469 | ||||
Average repurchase price(1) | $ | 10.05 | $ | 10.08 | ||||
(1) | The average repurchase price for 2016 is comprised of shares repurchased in connection with our SRP and tender offer. |
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All of the shares that we repurchased pursuant to our SRP during the quarter ended December 31, 2016, are provided below (in thousands, except per share amounts):
Period | Total Number of Shares Redeemed | Average Price Paid per Share (1) | Total Number of Shares Purchased as Part of a Publicly Announced Plan or Program(2) | Approximate Dollar Value of Shares Available That May Yet Be Redeemed Under the Program | ||||||||
October 2016 | 1,092 | $ | 10.20 | 1,092 | (3) | |||||||
November 2016 | 115 | 10.20 | 115 | (3) | ||||||||
December 2016 | 59 | 10.20 | 59 | (3) | ||||||||
(1) | On August 24, 2015, our board of directors established an estimated value per share of our common stock of $10.20, which was reaffirmed on April 14, 2016. Effective as of that date, the repurchase price per share for all stockholders is equal to the estimated value per share. |
(2) | All purchases of our equity securities by us in the three months ended December 31, 2016, were made pursuant to the SRP. We announced the commencement of the SRP on August 12, 2010, and it was subsequently amended on September 29, 2011. |
(3) | We currently limit the dollar value and number of shares that may yet be repurchased under the SRP as described above. See below regarding funding limitations during the fourth quarter of 2016 and beyond. |
In January 2017, approximately $39.2 million was available and used for repurchases under our SRP. Repurchase requests in connection with a stockholder’s death, “qualifying disability,” or “determination of incompetence” were completed in full. The remaining repurchase requests that were received by January 24, 2017, and that were in good order were fulfilled on a pro rata basis. The 5.6 million shares of unfulfilled repurchase requests were treated as requests for repurchase during future months until satisfied or withdrawn.
The funds available for repurchases during the second and third quarters of 2017, if any, are expected to be limited. We will continue to fulfill repurchases sought upon a stockholder’s death, “qualifying disability,” or “determination of incompetence” in accordance with the terms of the SRP.
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ITEM 6. SELECTED FINANCIAL DATA
As of and for the years ended December 31, 2016, 2015, 2014, 2013, and 2012 | |||||||||||||||||||||
(In thousands, except per share amounts) | |||||||||||||||||||||
2016 | 2015 | 2014 | 2013 | 2012 | |||||||||||||||||
Balance Sheet Data:(1) | |||||||||||||||||||||
Investment in real estate assets at cost | $ | 2,584,005 | $ | 2,350,033 | $ | 2,201,235 | $ | 1,136,074 | $ | 291,175 | |||||||||||
Cash and cash equivalents | 8,224 | 40,680 | 15,649 | 460,250 | 7,654 | ||||||||||||||||
Total assets | 2,380,188 | 2,226,248 | 2,141,196 | 1,716,256 | 324,308 | ||||||||||||||||
Mortgages and loans payable | 1,056,156 | 845,515 | 640,889 | 195,601 | 157,905 | ||||||||||||||||
Operating Data: | |||||||||||||||||||||
Total revenues | $ | 257,730 | $ | 242,099 | $ | 188,215 | $ | 73,165 | $ | 17,550 | |||||||||||
Property operating expenses | (41,890 | ) | (38,399 | ) | (32,919 | ) | (11,896 | ) | (2,957 | ) | |||||||||||
Real estate tax expenses | (36,627 | ) | (35,285 | ) | (25,262 | ) | (9,658 | ) | (2,055 | ) | |||||||||||
General and administrative expenses | (31,804 | ) | (15,829 | ) | (8,632 | ) | (4,346 | ) | (1,717 | ) | |||||||||||
Acquisition expenses | (5,803 | ) | (5,404 | ) | (17,430 | ) | (18,772 | ) | (3,981 | ) | |||||||||||
Vesting of Class B units for asset management services(2) | — | — | (27,853 | ) | — | — | |||||||||||||||
Interest expense, net | (32,458 | ) | (32,390 | ) | (20,360 | ) | (10,511 | ) | (3,020 | ) | |||||||||||
Net income (loss) | 9,043 | 13,561 | (22,635 | ) | (12,350 | ) | (4,273 | ) | |||||||||||||
Net income (loss) attributable to stockholders | 8,932 | 13,360 | (22,635 | ) | (12,404 | ) | (3,346 | ) | |||||||||||||
Other Operational Data:(3)(4) | |||||||||||||||||||||
NOI | $ | 173,910 | $ | 163,017 | $ | 125,816 | $ | 50,152 | $ | 12,493 | |||||||||||
Funds from operations (“FFO”) | 108,782 | 113,357 | 56,513 | 12,769 | 1,209 | ||||||||||||||||
Modified funds from operations (“MFFO”) | 106,256 | 112,671 | 94,552 | 28,982 | 4,295 | ||||||||||||||||
Cash Flow Data: | |||||||||||||||||||||
Cash flows provided by operating activities | $ | 103,076 | $ | 106,073 | $ | 75,671 | $ | 18,540 | $ | 4,033 | |||||||||||
Cash flows used in investing activities | (226,217 | ) | (110,774 | ) | (715,772 | ) | (776,219 | ) | (198,478 | ) | |||||||||||
Cash flows provided by financing activities | 90,685 | 29,732 | 195,500 | 1,210,275 | 195,130 | ||||||||||||||||
Per Share Data: | |||||||||||||||||||||
Net income (loss) per share—basic and diluted | $ | 0.05 | $ | 0.07 | $ | (0.13 | ) | $ | (0.18 | ) | $ | (0.51 | ) | ||||||||
Common distributions declared | $ | 0.67 | $ | 0.67 | $ | 0.67 | $ | 0.67 | $ | 0.65 | |||||||||||
Weighted-average shares outstanding—basic | 183,876 | 183,678 | 179,280 | 70,227 | 6,509 | ||||||||||||||||
Weighted-average shares outstanding—diluted | 186,665 | 186,394 | 179,280 | 70,227 | 6,509 | ||||||||||||||||
(1) | Certain prior period balance sheet amounts have been restated to conform with the adoption of Accounting Standards Update (“ASU”) 2015-03, Simplifying the Presentation of Debt Issuance Costs. |
(2) | Refer to Note 2 to our consolidated financial statements in this Annual Report on Form 10-K for discussion of our significant accounting policies. |
(3) | See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP Measures, for further discussion and for a reconciliation of the non-GAAP financial measures to net income (loss). |
(4) | Certain prior period amounts have been restated to conform with current year presentation. |
The selected financial data should be read in conjunction with the consolidated financial statements and notes appearing in this Annual Report on Form 10-K.
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with our accompanying consolidated financial statements and notes thereto. See also “Cautionary Note Regarding Forward-Looking Statements” preceding Part I.
Overview
Phillips Edison Grocery Center REIT I, Inc. was formed as a Maryland corporation on October 13, 2009, and elected to be taxed as a real estate investment trust (“REIT”) commencing with the taxable year ended December 31, 2010.
Below are statistical highlights of our portfolio:
Total Portfolio as of December 31, 2016 | Property Acquisitions During the Year Ended December 31, 2016 | ||||
Number of properties(1) | 153 | 7 | |||
Number of states | 28 | 6 | |||
Total square feet (in thousands) | 16,718 | 1,348 | |||
Leased % of rentable square feet | 95.6 | % | 93.3 | % | |
Average remaining lease term (in years)(2) | 5.4 | 6.0 | |||
(1) | The number of properties does not include additional real estate purchased adjacent to previously acquired centers. |
(2) | The average remaining lease term in years excludes future options to extend the term of the lease. |
Market Outlook—Real Estate and Real Estate Finance Markets
Management reviews a number of economic forecasts and market commentaries in order to evaluate general economic conditions and to formulate a view of the current environment’s effect on the real estate markets in which we operate.
According to the Bureau of Economic Analysis, as measured by the U.S. real gross domestic product (“GDP”), the U.S. economy’s growth increased 1.6% in 2016 as compared to 2015, according to preliminary estimates. For 2015, real GDP increased 2.6% compared to 2014. The increase in real GDP in 2016 reflected positive contributions from personal consumption expenditures (“PCE”), residential fixed investment, state and local government spending, exports, and federal government spending. These increases were partly offset by negative contributions from private inventory investment and nonresidential fixed investment. Imports, which are a subtraction in the calculation of GDP, increased. The deceleration in real GDP from 2015 to 2016 reflected a downturn in private inventory investment, a deceleration in PCE, a downturn in nonresidential fixed investment, and decelerations in residential fixed investment and in state and local government spending offset by a deceleration in imports and accelerations in federal government spending and in exports.
According to J.P. Morgan’s Global Economic Outlook Summary & 2017 REIT Outlook, real GDP is expected to grow approximately 1.8% in 2017. The U.S. retail real estate market displayed positive fundamentals in 2016, with vacancy rates rising slightly and increasing average leasing spreads as the result of limited new retail supply.
Overall, retail real estate fundamentals remain strong but are expected to decelerate relative to previous years. Short and long term interest rates rose in late 2016 with the expectation for more to come. There is less occupancy to be gained in portfolios, new supply levels are below historical averages but still elevated going into 2017, and job growth is expected to be 1% in 2017, compared to 1.5-2% in 2016. External fiscal stimulus will add to economic growth, although commercial real estate is expected to benefit to a lesser extent than other sectors.
Critical Accounting Policies and Estimates
Below is a discussion of our critical accounting policies and estimates. Our accounting policies have been established to conform with GAAP. We consider these policies critical because they involve significant management judgments and assumptions, require estimates about matters that are inherently uncertain, and are important for understanding and evaluating our reported financial results. These judgments affect the reported amounts of assets and liabilities and our disclosure of contingent assets and liabilities at the dates of the consolidated financial statements, as well as the reported amounts of revenue and expenses during the reporting periods. With different estimates or assumptions, materially different amounts could be reported in our consolidated financial statements. Additionally, other companies may utilize different estimates that may impact the comparability of our results of operations to those of companies in similar businesses.
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Real Estate Assets
Real Estate Acquisition Accounting—In accordance with Accounting Standards Codification (“ASC”) 805, Business Combinations, we record real estate, consisting of land, buildings, and improvements, at fair value. We allocate the cost of an acquisition to the acquired tangible assets, identifiable intangibles, and assumed liabilities based on their estimated acquisition-date fair values. In addition, ASC 805 requires that acquisition costs be expensed as incurred.
We assess the acquisition-date fair values of all tangible assets, identifiable intangibles, and assumed liabilities using methods similar to those used by independent appraisers (e.g., discounted cash flow analysis and replacement cost) and that utilize appropriate discount and/or capitalization rates and available market information. Estimates of future cash flows are based on a number of factors including historical operating results, known and anticipated trends, and market and economic conditions. The fair value of tangible assets of an acquired property considers the value of the property as if it were vacant.
We generally determine the value of construction in progress based upon the replacement cost. However, for certain acquired properties that are part of a ground-up development, we determine fair value by using the same valuation approach as for all other properties and deducting the estimated cost to complete the development. During the remaining construction period, we capitalize interest expense until the development has reached substantial completion. Construction in progress, including capitalized interest, is not depreciated until the development has reached substantial completion.
We record above-market and below-market lease values for acquired properties based on the present value (using an interest rate that reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) management’s estimate of market lease rates for the corresponding in-place leases, measured over a period equal to the remaining non-cancelable term of the lease. We amortize any recorded above-market or below-market lease values as a reduction or increase, respectively, to rental income over the remaining non-cancelable terms of the respective lease. We also include fixed-rate renewal options in our calculation of the fair value of below-market leases and the periods over which such leases are amortized. If a tenant has a unilateral option to renew a below-market lease, we include such an option in the calculation of the fair value of such lease and the period over which the lease is amortized if we determine that the tenant has a financial incentive and wherewithal to exercise such option.
Intangible assets also include the value of in-place leases, which represents the estimated value of the net cash flows of the in-place leases to be realized, as compared to the net cash flows that would have occurred had the property been vacant at the time of acquisition and subject to lease-up. Acquired in-place lease value is amortized to depreciation and amortization expense over the average remaining non-cancelable terms of the respective in-place leases.
We estimate the value of tenant origination and absorption costs by considering the estimated carrying costs during hypothetical expected lease-up periods, considering current market conditions. In estimating carrying costs, management includes real estate taxes, insurance and other operating expenses, and estimates of lost rentals at market rates during the expected lease-up periods.
Estimates of the fair values of the tangible assets, identifiable intangibles, and assumed liabilities require us to estimate market lease rates, property operating expenses, carrying costs during lease-up periods, discount rates, market absorption periods, and the number of years the property will be held for investment. The use of inappropriate estimates would result in an incorrect valuation of our acquired tangible assets, identifiable intangibles and assumed liabilities, which would impact the amount of our net income.
We calculate the fair value of assumed long-term debt by discounting the remaining contractual cash flows on each instrument at the current market rate for those borrowings, which we approximate based on the rate at which we would expect to incur a replacement instrument on the date of acquisition, and recognize any fair value adjustments related to long-term debt as effective yield adjustments over the remaining term of the instrument.
Impairment of Real Estate and Related Intangible Assets—We monitor events and changes in circumstances that could indicate that the carrying amounts of our real estate and related intangible assets may be impaired. When indicators of potential impairment suggest that the carrying value of real estate and related intangible assets may be greater than fair value, we will assess the recoverability, considering recent operating results, expected net operating cash flow, and plans for future operations. If, based on this analysis of undiscounted cash flows, we do not believe that we will be able to recover the carrying value of the real estate and related intangible assets, we would record an impairment loss to the extent that the carrying value exceeds the estimated fair value of the real estate and related intangible assets as defined by ASC 360, Property, Plant, and Equipment. Particular examples of events and changes in circumstances that could indicate potential impairments are significant decreases in occupancy, rental income, operating income, and market values.
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Revenue Recognition
We recognize minimum rent, including rental abatements and contractual fixed increases attributable to operating leases, on a straight-line basis over the terms of the related leases, and we include amounts expected to be received in later years in deferred rents receivable. Our policy for percentage rental income is to defer recognition of contingent rental income until the specified target (i.e., breakpoint) that triggers the contingent rental income is achieved.
We record property operating expense reimbursements due from tenants for common area maintenance, real estate taxes, and other recoverable costs in the period the related expenses are incurred. We make certain assumptions and judgments in estimating the reimbursements at the end of each reporting period. We do not expect the actual results to differ materially from the estimated reimbursement.
We make estimates of the collectability of our tenant receivables related to base rents, expense reimbursements, and other revenue or income. We specifically analyze accounts receivable and historical bad debts, customer creditworthiness, current economic trends, and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. In addition, with respect to tenants in bankruptcy, we will make estimates of the expected recovery of pre-petition and post-petition claims in assessing the estimated collectability of the related receivable. In some cases, the ultimate resolution of these claims can exceed one year. These estimates have a direct impact on our net income because a higher bad debt reserve results in less net income.
We record lease termination income if there is a signed termination letter agreement, all of the conditions of the agreement have been met, collectability is reasonably assured, and the tenant is no longer occupying the property. Upon early lease termination, we provide for losses related to unrecovered intangibles and other assets.
We recognize gains on sales of real estate pursuant to the provisions of ASC 605-976, Accounting for Sales of Real Estate. The specific timing of a sale will be measured against various criteria in ASC 605-976 related to the terms of the transaction and any continuing involvement associated with the property. If the criteria for profit recognition under the full-accrual method are not met, we will defer gain recognition and account for the continued operations of the property by applying the percentage-of-completion, reduced profit, deposit, installment, or cost recovery methods, as appropriate, until the appropriate criteria are met.
Impact of Recently Issued Accounting Pronouncements—The following table provides a brief description of recent accounting pronouncements that could have a material effect on our financial statements:
Standard | Description | Date of Adoption | Effect on the Financial Statements or Other Significant Matters | |||
ASU 2014-09, Revenue from Contracts with Customers (Topic 606) | This update outlines a comprehensive model for entities to use in accounting for revenue arising from contracts with customers. ASU 2014-09 states that “an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” While ASU 2014-09 specifically references contracts with customers, it may apply to certain other transactions such as the sale of real estate or equipment. In 2015, the FASB provided for a one-year deferral of the effective date for ASU 2014-09, making it effective for annual reporting periods beginning after December 15, 2017. | January 1, 2018 | Our revenue-producing contracts are primarily leases that are not within the scope of this standard. As a result, we do not expect the adoption of this standard to have a material impact on our rental income. We continue to evaluate the effect of this standard on our other sources of revenue. These include reimbursement amounts we receive from tenants for operating expenses such as real estate taxes, insurance, and other common area maintenance. However, we currently do not believe the adoption of this standard will significantly affect the timing of the recognition of our reimbursement revenue. | |||
ASU 2016-02, Leases (Topic 842) | This update amends existing guidance by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. This update is effective for annual reporting periods beginning after December 15, 2018, but early adoption is permitted. | January 1, 2019 | We are currently evaluating the impact the adoption of this standard will have on our consolidated financial statements. | |||
Refer to Note 2 to our consolidated financial statements in this Annual Report on Form 10-K for discussion of the impact of additional recently issued accounting pronouncements.
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Results of Operations
Summary of Operating Activities for the Years Ended December 31, 2016 and 2015
Favorable (Unfavorable) Change | ||||||||||||||
(In thousands, except per share amounts) | 2016 | 2015 | $ | % | ||||||||||
Operating Data: | ||||||||||||||
Total revenues | $ | 257,730 | $ | 242,099 | $ | 15,631 | 6.5 | % | ||||||
Property operating expenses | (41,890 | ) | (38,399 | ) | (3,491 | ) | (9.1 | )% | ||||||
Real estate tax expenses | (36,627 | ) | (35,285 | ) | (1,342 | ) | (3.8 | )% | ||||||
General and administrative expenses | (31,804 | ) | (15,829 | ) | (15,975 | ) | (100.9 | )% | ||||||
Acquisition expenses | (5,803 | ) | (5,404 | ) | (399 | ) | (7.4 | )% | ||||||
Depreciation and amortization | (106,095 | ) | (101,479 | ) | (4,616 | ) | (4.5 | )% | ||||||
Interest expense, net | (32,458 | ) | (32,390 | ) | (68 | ) | (0.2 | )% | ||||||
Other income, net | 5,990 | 248 | 5,742 | NM | ||||||||||
Net income | 9,043 | 13,561 | (4,518 | ) | (33.3 | )% | ||||||||
Net income attributable to noncontrolling interests | (111 | ) | (201 | ) | 90 | 44.8 | % | |||||||
Net income attributable to stockholders | $ | 8,932 | $ | 13,360 | $ | (4,428 | ) | (33.1 | )% | |||||
Net income per share—basic and diluted | $ | 0.05 | $ | 0.07 | $ | (0.02 | ) | (28.6 | )% | |||||
Below are explanations of the significant fluctuations in the results of operations for the years ended December 31, 2016 and 2015.
Total revenues— Of the $15.6 million increase in total revenues, $5.6 million was from same-center properties, which are the 132 properties that were owned and operational for the entire portion of both comparable reporting periods, except for those properties we currently classify as redevelopment. The remaining $10.0 million was attributable to non-same-center properties, including the 16 properties that were acquired since the beginning of 2015. The increase in same-center revenue was due to a $3.5 million increase in rental income and a $2.4 million increase in tenant recovery income. The increase in same-center rental income was driven by a $0.20 increase in minimum rent per square foot and a 0.2% increase in occupancy since December 31, 2015. The increase in same-center tenant recovery income stemmed from a 2.3% increase in our overall recovery rate.
Property operating expenses—These expenses include (i) operating and maintenance expense, which consists of property-related costs including repairs and maintenance costs, landscaping, snow removal, utilities, property insurance costs, security, and various other property-related expenses; (ii) bad debt expense; and (iii) property management fees and expenses. Of the $3.5 million increase in property operating expenses, $1.8 million was due to the acquisition of 16 properties in 2015 and 2016. The remaining $1.7 million was primarily a result of an increase in recoverable property maintenance expenses due to an increase in additional maintenance projects during the year, as well as a $0.7 million increase in property management fees due to higher cash receipts from the increase in revenues.
General and administrative expenses—General and administrative expenses include cash asset management fees, legal and professional fees, insurance for directors and officers, transfer agent fees, taxes, and other corporate-level expenses. General and administrative expenses increased $16.0 million, which was primarily related to a $14.6 million increase in cash asset management fees as a result of the change to our advisory fee structure in October 2015. Previously, the asset management fee had been deferred via the issuance of Class B units of our Operating Partnership, which did not result in the recognition of expense in accordance with GAAP. The asset management fee remains at 1% of the cost of our assets; however, 80% is now paid in cash and therefore recognized on a current basis as expense under GAAP, with the remaining 20% paid in Class B units. The remaining $1.4 million increase resulted from both a $1.0 million increase in distributions paid on unvested Class B units as a result of an increase in outstanding Class B units, as well as additional administrative costs associated with managing a larger portfolio.
Acquisition expenses—Acquisition expenses increased $0.4 million due to an increase in the purchase price paid for the seven properties acquired in 2016 compared to the nine properties acquired in 2015.
Other income, net—The $5.7 million increase in other income, net primarily resulted from a gain of $4.7 million on the disposal of a property in December 2016, as well as an increase of $1.3 million stemming from gains recognized on a portion of our derivatives.
We generally expect our revenues and expenses to increase in future years as a result of owning the properties acquired in 2016 for a full year and the potential acquisition of additional properties.
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Summary of Operating Activities for the Years Ended December 31, 2015 and 2014
Favorable (Unfavorable) Change | ||||||||||||||
(In thousands, except per share amounts) | 2015 | 2014 | $ | % | ||||||||||
Operating Data: | ||||||||||||||
Total revenues | $ | 242,099 | $ | 188,215 | $ | 53,884 | 28.6 | % | ||||||
Property operating expenses | (38,399 | ) | (32,919 | ) | (5,480 | ) | (16.6 | )% | ||||||
Real estate tax expenses | (35,285 | ) | (25,262 | ) | (10,023 | ) | (39.7 | )% | ||||||
General and administrative expenses | (15,829 | ) | (8,632 | ) | (7,197 | ) | (83.4 | )% | ||||||
Acquisition expenses | (5,404 | ) | (17,430 | ) | 12,026 | 69.0 | % | |||||||
Vesting of Class B units for asset management services | — | (27,853 | ) | 27,853 | 100.0 | % | ||||||||
Depreciation and amortization | (101,479 | ) | (79,160 | ) | (22,319 | ) | (28.2 | )% | ||||||
Interest expense, net | (32,390 | ) | (20,360 | ) | (12,030 | ) | (59.1 | )% | ||||||
Other income, net | 248 | 766 | (518 | ) | (67.6 | )% | ||||||||
Net income (loss) | 13,561 | (22,635 | ) | 36,196 | 159.9 | % | ||||||||
Net income attributable to noncontrolling interests | (201 | ) | — | (201 | ) | NM | ||||||||
Net income (loss) attributable to stockholders | $ | 13,360 | $ | (22,635 | ) | $ | 35,995 | 159.0 | % | |||||
Net income (loss) per share—basic and diluted | $ | 0.07 | $ | (0.13 | ) | $ | 0.20 | 153.8 | % | |||||
Below are explanations of the significant fluctuations in our results of operations for the years ended December 31, 2015 and 2014.
Total revenues—Of the $53.9 million increase in total revenues, $51.8 million was related to the acquisition of 65 properties since the beginning of 2014. The remaining $2.1 million increase was primarily related to a $1.5 million increase in rental income and a $0.6 million increase in tenant recovery income from same-center properties, which are the 79 properties that were owned and operational for the entire portion of both comparable reporting periods, except for those properties we currently classify as redevelopment. The increase in same-center rental income was driven by an $0.18 increase in minimum rent per square foot and a 1.1% increase in occupancy since December 31, 2014. The increase in same-center tenant recovery income stemmed from an improvement in the occupancy and recovery percentages along with an increase in recoverable real estate tax expenses.
Property operating expenses—Property operating expenses for non-same-center properties increased by $7.2 million due to the acquisition of 65 properties since the beginning of 2014. These costs were partially offset by a decrease in same-center property operating expense of $1.7 million, which was primarily related to a $0.8 million reduction in bad debt expense and a $0.9 million reduction in common area maintenance expense due to upfront maintenance costs incurred in 2014 for the additional same-center properties acquired in 2013.
Real estate tax expenses—The $10.0 million increase in real estate tax expenses was primarily comprised of an $8.9 million increase related to the acquisition of 65 properties in 2014 and 2015, along with approximately $1.2 million of additional expenses due to changes in assessed values of same-center properties.
General and administrative expenses—General and administrative expenses increased $7.2 million, which primarily resulted from a $4.6 million increase due to the change in the payment of asset management fees as a result of amending our advisory fee structure in October 2015 as discussed above. The remaining $2.6 million increase was primarily related to the operation of 65 properties acquired since the beginning of 2014.
Vesting of Class B units for asset management services—In connection with the termination of our prior advisory agreement, we determined that the units issued to PE-NTR and our previous advisor for asset management services provided through December 3, 2014, had vested, resulting in a $27.9 million non-cash expense. During the year ended December 31, 2015, there was no vesting of Class B units. The vesting of Class B units occurs only upon completion of both a market condition and service condition. Because PE-NTR can be terminated as the advisor without cause before a liquidity event occurs, and at such time the market condition and service condition may not be satisfied, the unvested Class B units issued since December 3, 2014, may be forfeited. Refer to Note 2 of the Consolidated Financial Statements and Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates, for more information regarding the vesting of Class B units.
Interest expense, net—Debt incurred in connection with the acquisition of 65 properties since the beginning of 2014 as well as other corporate-level debt activity resulted in a $14.1 million increase in non-same-center interest expense. During 2015 and
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2014 we assumed debt with a fair value of $34.3 million and $189.0 million, respectively, related to our property acquisitions in those years, in addition to borrowings made under our credit facility. Of the corporate-level interest expense increase, $3.2 million was due to additional expense from fixing the interest rate on our unsecured credit facility by entering into interest rate swap agreements and $2.1 million was due to additional expense related to the write-off of deferred financing costs, of which $1.9 million resulted from a reduction of the capacity of our unsecured revolving credit facility. Partially offsetting the increase in non-same-center interest expense was a $2.1 million decrease in interest expense for same-center properties. This reduction was primarily as a result of lower outstanding principal balances from payments on our fixed-rate mortgages, including a reduction of $0.8 million as a result of using our unsecured credit facility to pay off higher fixed-rate mortgages in 2014 and 2015.
Leasing Activity
Below is a summary of leasing activity for the years ended December 31, 2016 and 2015:
Total Deals | Inline Deals(1) | |||||||||||||||
2016 | 2015 | 2016 | 2015 | |||||||||||||
New leases: | ||||||||||||||||
Number of leases | 163 | 186 | 156 | 179 | ||||||||||||
Square footage (in thousands) | 483 | 586 | 351 | 360 | ||||||||||||
First-year base rental revenue (in thousands) | $ | 6,973 | $ | 8,001 | $ | 6,001 | $ | 6,250 | ||||||||
Average rent per square foot (“PSF”) | $ | 14.43 | $ | 13.66 | $ | 17.12 | $ | 17.36 | ||||||||
Average cost PSF of executing new leases(2)(3) | $ | 32.07 | $ | 30.36 | $ | 35.64 | $ | 36.13 | ||||||||
Weighted average lease term (in years) | 9.9 | 8.0 | 7.3 | 7.2 | ||||||||||||
Renewals and options: | ||||||||||||||||
Number of leases | 321 | 259 | 301 | 246 | ||||||||||||
Square footage (in thousands) | 1,639 | 1,247 | 593 | 574 | ||||||||||||
First-year base rental revenue (in thousands) | $ | 19,581 | $ | 16,703 | $ | 12,686 | $ | 11,571 | ||||||||
Average rent PSF | $ | 11.95 | $ | 13.39 | $ | 21.39 | $ | 20.15 | ||||||||
Average rent PSF prior to renewals | $ | 10.87 | $ | 12.10 | $ | 18.94 | $ | 17.60 | ||||||||
Percentage increase in average rent PSF | 9.9 | % | 10.7 | % | 12.9 | % | 14.5 | % | ||||||||
Average cost PSF of executing renewals and options(2)(3) | $ | 2.67 | $ | 3.30 | $ | 4.70 | $ | 5.05 | ||||||||
Weighted average lease term (in years) | 5.3 | 5.7 | 5.2 | 5.0 | ||||||||||||
Portfolio retention rate(4) | 86.7 | % | 86.3 | % | 78.7 | % | 81.3 | % | ||||||||
(1) | We consider an inline deal to be a lease for less than 10,000 square feet of gross leasable area (“GLA”). |
(2) | The cost of executing new leases, renewals, and options includes leasing commissions, tenant improvement costs, and tenant concessions. |
(3) | The costs associated with landlord improvements are excluded for repositioning and redevelopment projects. |
(4) | The portfolio retention rate is calculated by dividing (a) total square feet of retained tenants with current period lease expirations by (b) the square feet of leases expiring during the period. |
The average rent per square foot and cost of executing leases fluctuates based on the tenant mix, size of the space, and lease term. Leases with national and regional tenants generally require a higher cost per square foot than those with local tenants. However, such tenants will also pay for a longer term. As we continue to attract more of these national and regional tenants, our costs to lease may increase.
Non-GAAP Measures
Same-Center Net Operating Income
We present Same-Center NOI as a supplemental measure of our performance. We define NOI as total operating revenues, adjusted to exclude lease buy-out income and non-cash revenue items, less property operating expenses and real estate taxes. Same-Center NOI represents the NOI for the 132 properties that were owned and operational for the entire portion of both comparable reporting periods, except for those properties we currently classify as redevelopment. A property is removed from the Same-Center pool and classified as redevelopment when it is being repositioned in the market and such repositioning is expected to have a significant impact on property operating income. While there is judgment surrounding changes in
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designations, once a redevelopment property has stabilized, it is typically moved to the Same-Center pool the following year. Currently, we have identified five properties that we classify as redevelopment properties.
We believe that NOI and Same-Center NOI provide useful information to our investors about our financial and operating performance because each provides a performance measure of the revenues and expenses directly involved in owning and operating real estate assets and provides a perspective not immediately apparent from net income. Because Same-Center NOI excludes the change in NOI from properties acquired after December 31, 2014, and those considered redevelopment properties, it highlights operating trends such as occupancy levels, rental rates, and operating costs on properties that were operational for both comparable periods. Other REITs may use different methodologies for calculating Same-Center NOI, and accordingly, our Same-Center NOI may not be comparable to other REITs.
Same-Center NOI should not be viewed as an alternative measure of our financial performance since it does not reflect the operations of our entire portfolio, nor does it reflect the impact of general and administrative expenses, acquisition expenses, depreciation and amortization, interest expense, other income, or the level of capital expenditures and leasing costs necessary to maintain the operating performance of our properties that could materially impact our results from operations.
The table below is a comparison of Same-Center NOI for the years ended December 31, 2016 and 2015 (in thousands):
2016 | 2015 | $ Change | % Change | |||||||||||
Revenues: | ||||||||||||||
Rental income(1) | $ | 164,622 | $ | 160,515 | $ | 4,107 | ||||||||
Tenant recovery income | 56,142 | 53,737 | 2,405 | |||||||||||
Other property income | 773 | 1,111 | (338 | ) | ||||||||||
Total revenues | 221,537 | 215,363 | 6,174 | 2.9 | % | |||||||||
Operating Expenses: | ||||||||||||||
Property operating expenses | 36,784 | 35,049 | 1,735 | |||||||||||
Real estate taxes | 31,679 | 31,945 | (266 | ) | ||||||||||
Total operating expenses | 68,463 | 66,994 | 1,469 | 2.2 | % | |||||||||
Total Same-Center NOI | $ | 153,074 | $ | 148,369 | $ | 4,705 | 3.2 | % | ||||||
(1) | Excludes straight-line rental income, net amortization of above- and below-market leases, and lease buyout income. |
Below is a reconciliation of net income to NOI and Same-Center NOI for the years ended December 31, 2016 and 2015 (in thousands):
2016 | 2015(1) | ||||||
Net income | $ | 9,043 | $ | 13,561 | |||
Adjusted to exclude: | |||||||
Lease buyout income | (583 | ) | (6 | ) | |||
General and administrative expenses | 31,804 | 15,829 | |||||
Acquisition expenses | 5,803 | 5,404 | |||||
Depreciation and amortization | 106,095 | 101,479 | |||||
Interest expense, net | 32,458 | ||||||