All of our directors are also directors of KBS REIT I and KBS REIT II. TwoOne of our affiliated directors areis also an affiliated directorsdirector of KBS Growth & Income REIT and one of our affiliated directors is also an affiliated director of KBS Strategic Opportunity REIT and KBS Strategic Opportunity REIT II. The loyalties of our directors serving on the boards of directors of KBS REIT I, KBS REIT II, KBS Strategic Opportunity REIT, KBS Strategic Opportunity REIT II and KBS Growth & Income REIT, or possibly on the boards of directors of future KBS-sponsored programs, may influence the judgment of our board of directors when considering issues for us that also may affect other KBS-sponsored programs, such as the following:
The conflicts committee of our board of directors must evaluate the performance of our advisor with respect to whether our advisor is presenting to us our fair share of investment opportunities. If our advisor is not presenting a sufficient number of investment opportunities to us because it is presenting many opportunities to other KBS-sponsored programs or if our advisor is giving preferential treatment to other KBS-sponsored programs in this regard, our conflicts committee may not be well-suited to enforce our rights under the terms of the advisory agreement or to seek a new advisor.
We could enter into transactions with other KBS-sponsored programs, such as property sales, acquisitions or financing arrangements. Such transactions might entitle our advisor or its affiliates to fees and other compensation from both parties to the transaction. For example, acquisitions from other KBS-sponsored programs might entitle our advisor or its affiliates to disposition fees and possible subordinated incentive fees in connection with its services for the seller in addition to acquisition or origination fees and other fees that we might pay to our advisor in connection with such transaction. Similarly, property sales to other KBS-sponsored programs might entitle our advisor or its affiliates to acquisition or origination fees in connection with its services to the purchaser in addition to disposition and other fees that we might pay to our advisor in connection with such transaction. Decisions of our board or the conflicts committee regarding the terms of those transactions may be influenced by our board’s or the conflicts committee’s loyalties to such other KBS-sponsored programs.
A decision of our board or the conflicts committee regarding the timing of a debt or equity offering could be influenced by concerns that the offering would compete with offerings of other KBS-sponsored programs.
A decision of our board or the conflicts committee regarding the timing of property sales could be influenced by concerns that the sales would compete with those of other KBS-sponsored programs.
A decision of our board or the conflicts committee regarding whether and when we seek to list our common stock on a national securities exchange could be influenced by concerns that such listing could adversely affect the sales efforts of other KBS-sponsored programs, depending on the price at which our shares trade.
Because our independent directors are also independent directors of KBS REIT I and KBS REIT II, they receive compensation for service on the boards of KBS REIT I and KBS REIT II. Like us, KBS REIT I and KBS REIT II each pays each independent director an annual retainer of $40,000 as well as compensation for attending meetings as follows: (i) $2,500 for each board meeting attended, (ii) $2,500 for each audit or conflicts committee meeting attended (except that the committee chairman is paid $3,000 for each audit or conflicts committee meeting attended), (iii) $2,000 for each teleconference board meeting attended, and (iv) $2,000 for each teleconference audit or conflicts committee meeting attended (except that the committee chairman is paid $3,000 for each teleconference audit or conflicts committee meeting attended). In addition, KBS REIT I and KBS REIT II also pays each independent director compensation for attending otherspecial committee meetings as follows: (i) $2,000 for each otherspecial committee meeting attended (except that the committee chairman is paid $3,000 for each otherspecial committee meeting attended), and (ii) $2,000 for each otherspecial teleconference committee meeting attended (except that the committee chairman is paid $3,000 for each otherspecial teleconference committee meeting attended). In addition, like us, KBS REIT I and KBS REIT II each reimburses directors for reasonable out-of-pocket expenses incurred in connection with attendance at meetings of their boards of directors.directors or committee meetings.
Risks Related to Our Corporate Structure
Our charter limits the number of shares a person may own and 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 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 Internal Revenue Code, our charter prohibits a person from directly or constructively owning more than 9.8% of our outstanding shares, unless exempted by our board of directors. In addition, 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 dividends and other 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. These charter provisions 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 to holders of our common stock.
Our stockholders’ investment return may be reduced if we are required to register as an investment company under the Investment Company Act; if we or our subsidiaries become an unregistered investment company, we could not continue our business.
Neither we nor any of our subsidiaries intendsintend to register as an investment companiescompany under the Investment Company Act. If we or our subsidiaries were obligated to register as investment companies, we would have to comply with a variety of substantive requirements under the Investment Company Act that impose, among other things:
limitations on capital structure;
restrictions on specified investments;
prohibitions on transactions with affiliates; and
compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly increase our operating expenses.
Under the relevant provisions of Section 3(a)(1) of the Investment Company Act, an investment company is any issuer that:
pursuant to Section 3(a)(1)(A), is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities (the “primarily engaged test”); or
pursuant to Section 3(a)(1)(C), is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire “investment securities” having a value exceeding 40% of the value of such issuer’s total assets (exclusive of U.S. government securities and cash items) on an unconsolidated basis (the “40% test”). “Investment securities” excludes U.S. government securities and securities of majority-owned subsidiaries that are not themselves investment companies and are not relying on the exception from the definition of investment company under Section 3(c)(1) or Section 3(c)(7) (relating to private investment companies).
We believe that neither we nor our Operating Partnership are required to register as an investment company based on the following analyses. With respect to the 40% test, most of the entities through which we and our Operating Partnership own our assets are majority-owned subsidiaries that will not themselves be investment companies and will not be relying on the exceptions from the definition of investment company under Section 3(c)(1) or Section 3(c)(7).
With respect to the primarily engaged test, we and our Operating Partnership will beare holding companies and do not intend to invest or trade in securities ourselves. Rather, through the majority-owned subsidiaries of our Operating Partnership, we and our Operating Partnership will beare primarily engaged in the non-investment company businesses of these subsidiaries, namely the business of purchasing or otherwise acquiring real estate and real estate-related assets.
If any of the subsidiaries of our Operating Partnership fail to meet the 40% test, we believe they will usually, if not always, be able to rely on Section 3(c)(5)(C) of the Investment Company Act for an exception from the definition of an investment company. (Otherwise, they should be able to rely on the exceptions for private investment companies pursuant to Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act.) As reflected in no-action letters, the SEC staff’s position on Section 3(c)(5)(C) generally requires that an issuer maintain at least 55% of its assets in “mortgages and other liens on and interests in real estate,” or qualifying assets; at least 80% of its assets in qualifying assets plus real estate-related assets; and no more than 20% of the value of its assets in other than qualifying assets and real estate-related assets, which we refer to as miscellaneous assets. To constitute a qualifying asset under this 55% requirement, a real estate interest must meet various criteria based on no-action letters. We expect that any of the subsidiaries of our Operating Partnership relying on Section 3(c)(5)(C) will invest at least 55% of its assets in qualifying assets, and approximately an additional 25% of its assets in other types of real estate-related assets. If any subsidiary relies on Section 3(c)(5)(C), we expect to rely on guidance published by the SEC staff or on our analyses of guidance published with respect to types of assets to determine which assets are qualifying real estate assets and real estate-related assets.
Rapid changes in the values of our assets may make it more difficult for us toTo maintain our qualification as a REIT or our exception from the definition of an investment company under the Investment Company Act.
If the market value or income potential of our qualifying real estate assets changes as compared to the market value or income potential of our non-qualifying assets, or if the market value or income potential of our assets that are considered “real estate-related assets” undercompliance with the Investment Company Act, our subsidiaries may be unable to sell assets we would otherwise want them to sell and may need to sell assets we would otherwise wish them to retain. In addition, our subsidiaries may have to acquire additional assets that they might not otherwise have acquired or REIT qualification tests changes as comparedmay have to forego opportunities to make investments that we would otherwise want them to make and would be important to our investment strategy. Moreover, the market valueSEC or income potentialits staff may issue interpretations with respect to various types of our assets that are not considered “real estate-related assets” undercontrary to our views and current SEC staff interpretations are subject to change, which increases the Investment Company Act or REIT qualification tests, whether as a resultrisk of increased interest rates, prepayment rates or other factors, we may need to modify our investment portfolio in order to maintain our REIT qualification or exception fromnon-compliance and the definition of an investment company. If the decline in asset values or income occurs quickly, this may be especially difficult, if not impossible, to accomplish. This difficulty may be exacerbated by the illiquid nature of many of the assetsrisk that we may own. We may havebe forced to make adverse changes to our portfolio. If we were required to register as an investment decisions thatcompany but failed to do so, we otherwise would not make absent REITbe prohibited from engaging in our business and Investment Company Act considerations.criminal and civil actions could be brought against us. In addition, our contracts would be unenforceable unless a court required enforcement and a court could appoint a receiver to take control of us and liquidate our business assets.
Our stockholders will 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 targeted investment allocation, 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 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 may not be able to sell their shares under our share redemption program and, if our stockholders are able to sell their shares under the program, they may not be able to recover the amount of their investment in our shares or an amount equal to the estimated value per share of our common stock.
Our share redemption program includes numerous restrictions that severely limit our stockholders’ ability to sell their shares should they require liquidity and will limit our stockholders’ ability to recover the value they invested in our common stock or an amount equal to the estimated value per share of our common stock. Our stockholders must hold their shares for at least one year in order to participate in our share redemption program, except in connection with a stockholder’s death, “qualifying disability” or “determination of incompetence” (each as defined in the share redemption program, and together with redemptions sought in connection with a stockholder’s death, “special redemptions”“Special Redemptions”). We limit the number of shares redeemed pursuant to our share redemption program as follows: (i) during any calendar year, we may redeem no more than 5% of the weighted‑average number of shares outstanding during the prior calendar year and (ii) during each calendar year, redemptions will be limited to the amount of net proceeds from the sale of shares under our dividend reinvestment plan during the prior calendar year; however, we may increase or decrease the funding available for the redemption of shares upon ten business days’ notice to our stockholders. Further, we have no obligation to redeem shares if the redemption 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. These limits may prevent us from accommodating all redemption requests made in any year.
Pursuant to our share redemption program, unless our shares are being redeemed in connection with a special redemption, at such time as we establish an estimated value per share of our common stock for a purpose other than to set the offering price to acquire a share in our now-terminated primary public offering,Special Redemption, the redemption price for shares eligible for redemption will be calculated based upon the updated estimated value per share. On December 8, 2015,9, 2016, our board of directors approved an estimated value per share of our common stock of $10.04$10.63 based on the estimated value of our assets less the estimated value of our liabilities divided by the number of shares outstanding, all as of September 30, 2015, with the exception of a reduction to our net asset value for acquisition fees and closing costs related to a real estate acquisition that closed subsequent to September 30, 2015 and deferred financing costs related to a mortgage loan that closed subsequent to September 30, 2015.2016. In accordance with our share redemption program, redemptions made in connection with special redemptionsSpecial Redemptions are made at a price per share equal to the most recent estimated value per share of our common stock as of the applicable redemption date. The price at which we will redeem all other shares eligible for redemption is as follows:
For those shares held by the redeeming stockholder for at least one year, 92.5% of our most recent estimated value per share as of the applicable redemption date;
For those shares held by the redeeming stockholder for at least two years, 95.0% of our most recent estimated value per share as of the applicable redemption date;
For those shares held by the redeeming stockholder for at least three years, 97.5% of our most recent estimated value per share as of the applicable redemption date; and
For those shares held by the redeeming stockholder for at least four years, 100% of our most recent estimated value per share as of the applicable redemption date.
We currently expect to announce an updated estimated value per share in December 2016.2017.
In March 2009, in order to preserve capital and value for all stockholders during the 2008-2009 recession, KBS REIT I amended its share redemption program to limit redemptions (other than special redemptions)Special Redemptions) during any calendar year to the amount of the net proceeds from the sale of shares under its dividend reinvestment plan from the prior calendar year less amounts KBS REIT I deemed necessary from such proceeds to fund its current and future funding obligations and needs. Pursuant to this limitation, KBS REIT I suspended ordinary redemptions for the remainder of 2009 and from 2010 through March 2012. KBS REIT I provided notice of this amendment in its Annual Report on Form 10-K filed on March 27, 2009, and the amendment was effective upon 30 days’ notice. The amendment became effective before the April 30, 2009 redemption date. As a result, investors did not have a final opportunity to submit redemptions. In March 2012, KBS REIT I amended and restated its share redemption program to provide only for special redemptions. Special redemptionsRedemptions. Special Redemptions are limited to an annual amount determined by KBS REIT I’s board of directors which may be reviewed and adjusted from time to time during the year.
On January 24, 2014, in consideration of the cash requirements necessary to effectively manage KBS Legacy Partners Apartment REIT’s assets, KBS Legacy Partners Apartment REIT amended and restated its share redemption program to limit redemptions to $2.0 million of shares in the aggregate during any calendar year. Additionally, during any calendar year, once KBS Legacy Partners Apartment REIT has redeemed $1.5 million of shares under its share redemption program, including special redemptions, the remaining $0.5 million of the $2.0 million annual limit shall be reserved exclusively for special redemptions. KBS Legacy Partners Apartment REIT provided notice of this amendment and restatement of its share redemption program in its Current Report on Form 8-K filed on January 28, 2014 and its amended and restated share redemption program became effective for redemptions under the program on or after February 27, 2014. Because of these limitations on the dollar value of shares that may be redeemed under its share redemption program, KBS Legacy Partners Apartment REIT exhausted funds available for all redemptions other than special redemptions for 2014 in August 2014. The $2.0 million annual limitation was reset beginning January 1, 2015 and the outstanding unfulfilled redemption requests as of December 31, 2014 were fulfilled in January 2015. Because of limitation on the dollar value of shares that may be redeemed under its share redemption program as described above, KBS Legacy Partners Apartment REIT exhausted funds available for all redemptions other than special redemptions for the remainder of 2015 in March 2015. The $2.0 million annual limitation was reset beginning January 1, 2016 and $1.0 million of the outstanding unfulfilled redemption requests as of December 31, 2015, representing 103,808 shares, were fulfilled in January 2016. Because of limitation on the dollar value of shares that may be redeemed under its share redemption program as described above,In January 2016, KBS Legacy Partners Apartment REIT exhausted the $1.5 million of funds available for all redemptions other thanfor 2016 and in August 2016, KBS Legacy Partners Apartment REIT exhausted the $0.5 million of funds available for special redemptions for the remainder of 2016. As of December 31, 2016, KBS Legacy Partners Apartment REIT had $1.4 million of outstanding and unfulfilled ordinary redemption requests and $0.3 million of outstanding and unfulfilled special redemption requests. The annual limitation was reset on January 1, 2017, and KBS Legacy Partners Apartment REIT had an aggregate of $2.0 million of funds available for all redemptions, subject to the limitations in the share redemption program, including the requirement that the first $1.5 million of funds is available for all redemptions and the last $0.5 million is available solely for special redemptions. KBS Legacy Partners Apartment REIT exhausted $1.5 million of funds available for all redemptions for 2017 in January 2016.2017 and an aggregate of $0.3 million of funds available for special redemptions for 2017 in January and February 2017. As such, KBS Legacy Partners Apartment REIT will only be able to process $0.2 million of redemption requests related to special redemptions for the remainder of 2017.
On May 15, 2014, KBS REIT II amended and restated its share redemption program to provide only for special redemptions. Special redemptions are limited to an annual amount determined by KBS REIT II’s board of directors which may be reviewed and adjusted from time to time during the year. KBS REIT II provided notice of this amendment and restatement of its share redemption program in its Current Report on Form 8-K filed on May 19, 2014 and its amended and restated share redemption program became effective for redemptions under the program on June 18, 2014.
During the year ended December 31, 2016, KBS Strategic Opportunity REIT’s redemptions were limited to $3.0 million of shares in a given quarter (excluding shares redeemed in connection with a stockholder’s death, “qualifying disability” or “determination of incompetence”). To the extent that KBS Strategic Opportunity REIT redeemed less than $3.0 million of shares (excluding shares redeemed in connection with a stockholder’s death, “qualifying disability” or “determination of incompetence”) in a given fiscal quarter, any remaining excess capacity to redeem shares in such fiscal quarter was added to the capacity to otherwise redeem shares (excluding shares redeemed in connection with a stockholder’s death, “qualifying disability” or “determination of incompetence”) during succeeding fiscal quarters. In December 2016, the amount of redemption requests in connection with a stockholder’s death, “qualifying disability or “determination of incompetence” was less than the amount of the $1.0 million reserved for such redemptions under the share redemption program, therefore the excess funds were used to redeem shares not requested in connection with a stockholder’s death, “qualifying disability or “determination of incompetence” during such month. In 2017, KBS Strategic Opportunity REIT may not redeem more than $3.0 million of shares in a given quarter (excluding shares redeemed in connection with a stockholder’s death, “qualifying disability” or “determination of incompetence”). To the extent that KBS Strategic Opportunity REIT redeems less than $3.0 million of shares (excluding shares redeemed in connection with a stockholder’s death, “qualifying disability” or “determination of incompetence”) in a given fiscal quarter, any remaining excess capacity to redeem shares in such fiscal quarter will be added to our capacity to otherwise redeem shares (excluding shares redeemed in connection with a stockholder’s death, “qualifying disability” or “determination of incompetence”) during succeeding fiscal quarters. The last $1.0 million of net proceeds from the dividend reinvestment plan during 2016 is reserved exclusively for shares redeemed in connection with a stockholder’s death, “qualifying disability,” or “determination of incompetence” with any excess funds being available to redeem shares not requested in connection with a stockholder’s death, “qualifying disability or “determination of incompetence” on the December 2017 redemption date. Based on the amount of net proceeds raised from the sale of shares under the dividend reinvestment plan during 2016, KBS Strategic Opportunity REIT has $12.6 million available for redemptions during 2017, subject to the limitations described above. KBS Strategic Opportunity REIT had $14.3 million of outstanding unfulfilled redemption requests as of December 31, 2016.
Our board may amend, suspend or terminate our share redemption program upon 30 days’ notice to stockholders, provided that we may increase or decrease the funding available for the redemption of shares pursuant to our share redemption program upon ten business days’ notice to our stockholder. See Part II, Item 5, “Share Redemption Program” for more information about the program.
The estimated value per share of our common stock may not reflect the value that stockholders will receive for their investment and does not take into account how developments subsequent to the valuation date related to individual assets, the financial or real estate markets or other events may have increased or decreased the value of our portfolio.
On December 8, 2015,9, 2016, our board of directors approved an estimated value per share of our common stock of $10.04$10.63 based on the estimated value of our assets less the estimated value of our liabilities, or net asset value, divided by the number of shares outstanding, all as of September 30, 2015, with the exception of a reduction to our net asset value for acquisition fees and closing costs related to a real estate acquisition that closed subsequent to September 30, 2015 and deferred financing costs related to a mortgage loan that closed subsequent to September 30, 2015.2016. We did not make any other adjustments to the estimated value per share subsequent to September 30, 2015,2016, including any adjustments relating to the following, among others: (i) the issuance of common stock and the payment of related offering costs related to our dividend reinvestment plan offering; (ii) net operating income earned and distributions declared; and (iii) the redemption of shares. We provided this estimated value per share to assist broker-dealers that participated in our now-terminated initial 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 and also to comply with Practice Guideline 2013—01, Valuations of Publicly Registered, Non-Listed REITs, issued by the Investment Program Association (“IPA”) in April 2013 (the “IPA Valuation Guidelines”).
We engaged Duff & Phelps, LLC (“Duff & Phelps”), an independent third party real estate valuation firm, to provide appraisals for each of our 2729 real estate properties owned as of September 30, 20152016 (the “Appraised Properties”) and to provide a calculation of the range in estimated value per share of our common stock as of December 8, 2015.9, 2016. Duff & Phelps based this range in estimated value per share upon (i) its appraisals of the Appraised Properties, and (ii) valuations performed by KBS Capital Advisors of our real estate loan receivable, cash, other assets, mortgage debt and other liabilities and (iii) a reduction to our net asset value for acquisition fees and closing costs related to a real estate acquisition that closed subsequent to September 30, 2015 and deferred financing costs related to a mortgage loan that closed subsequent to September 30, 2015. investment in the Hardware Village Joint Venture.
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 using different assumptions and estimates could derive a different estimated value per share of our common stock, and this difference could be significant. The estimated value per share is not audited and does not represent the fair value of our assets less the fair value of our liabilities according to U.S. generally accepted accounting principles (“GAAP”), nor does it represent a liquidation value of our assets and liabilities or the price at which our shares of common stock would trade on a national securities exchange. The estimated value per share does not reflect a discount for the fact that we are externally managed, nor does it reflect a real estate portfolio premium/discount versus the sum of the individual property values. The estimated value per share also does not take into account estimated disposition costs and fees for real estate properties, debt prepayment penalties that could apply upon the prepayment of certain of our debt obligations, the impact of restrictions on the assumption of debt or swap breakage fees that may be incurred upon the termination of certain of our swaps prior to expiration. In addition, we are still investing proceeds from our now-terminated initial public offering and theThe estimated value per share does not take into consideration acquisition-relatedacquisition related costs and financing costs related to any future acquisitions.acquisitions we make. Accordingly, with respect to the estimated value per share, we can give no assurance that:
a stockholder would be able to resell his or her shares at our estimated value per share;
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;
our shares of common stock would trade at the estimated value per share on a national securities exchange;
another independent third-party appraiser or third-party valuation firm would agree with our estimated value per share; or
the methodology used to determine our estimated value per share would be acceptable to FINRA or for compliance with ERISA reporting requirements.
The value of our shares will fluctuate over time in response to developments related to future investments, the performance of individual assets in our portfolio and the management of those assets, and the real estate and finance markets.markets and due to other factors. As such, the estimated value per share does not take into account developments in our portfolio since December 8, 2015.9, 2016. For a full description of the methodologies and assumptions used to value our assets and liabilities in connection with the calculation of 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.”
We currently expect to utilize an independent valuation firm to update the estimated value per share in December 2016.2017.
The actual value of shares that we repurchase under our share redemption program may be less than what we pay.
Under our share redemption program, shares currently may be repurchased at varying prices depending on (i) the number of years the shares have been held, and (ii) whether the redemptions are in connection with a special redemptions.Special Redemptions. The current maximum price that may be paid under the program is $10.04$10.63 per share, which is the current estimated value per share. Although this is our current estimated value per share, this reported value is likely to differ from the price at which a stockholder could resell his or her shares for the reasons discussed in the risk factor above. Thus, when we repurchase shares of our common stock at $10.04$10.63 per share, the actual value of the shares that we repurchase is likely to be less, and the repurchase is likely to be dilutive to our remaining stockholders. Even at lower repurchase prices, the actual value of the shares may be less than what we pay and the repurchase may be dilutive to our remaining stockholders.
If funds are not available from our dividend reinvestment plan offering for general corporate purposes, then we may have to use a greater proportion of our cash flow from operations to meet our general cash requirements, which would reduce cash available for distributions and could limit our ability to redeem shares under our share redemption program.
We depend on the proceeds from our dividend reinvestment plan offering for general corporate purposes including, but not limited to: the repurchase of shares under our share redemption program; capital expenditures, tenant improvement costs and leasing costs related to our real estate properties; reserves required by any financings of our real estate investments; funding obligations under any of our real estate loans receivable; the acquisition or origination of real estate investments, which would include payment of acquisition or origination fees to our advisor; and the repayment of debt. We cannot predict with any certainty how much, if any, dividend reinvestment plan proceeds will be available for general corporate purposes. If such funds are not available from our dividend reinvestment plan offering, then we may have to use a greater proportion of our cash flow from operations to meet our general cash requirements, which would reduce cash available for distributions and could limit our ability to redeem shares under our share redemption program.
Our stockholders’ interest in us will be diluted if we issue additional shares, which could reduce the overall value of their investment.
Our common stockholders do not have preemptive rights to any shares we issue in the future. Our charter authorizes us to issue 1,010,000,000 shares of capital stock, of which 1,000,000,000 shares are designated as common stock and 10,000,000 shares are designated as preferred stock. Our board of directors may increase the number of authorized shares of capital stock without stockholder approval. Our board may elect to (i) sell additional shares in our dividend reinvestment plan or in future primary offerings; (ii) issue equity interests in private offerings; (iii) issue shares to our advisor, or its successors or assigns, in payment of an outstanding fee obligation; (iv) 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; or (v) otherwise issue additional shares of our capital stock. To the extent we issue additional equity interests, whether in future primary offerings, pursuant to our dividend reinvestment plan or otherwise, our stockholders’ percentage ownership interest in us would be diluted. In addition, depending upon the terms and pricing of any additional issuance of shares, the use of the proceeds and the value of our real estate investments, our stockholders may also experience dilution in the book value and fair value of their shares and in the earnings and distributions per share.
Payment of fees to our advisor and its affiliates reduces cash available for investment and distribution to our stockholders and increases the risk that our stockholders will not be able to recover the amount of their investment in our shares.
Our advisor and its affiliates perform services for us in connection with the selection and acquisition or origination of our real estate investments, the management and leasing of our real estate properties the administration of our real estate-related investments and the disposition of our investments. We pay them substantial fees for these services, which results in immediate dilution of the value of our stockholders’ investment in us and reduces the amount of cash available for investments or distribution to stockholders. Compensation to be paid to our advisor may be increased with the approval of our conflicts committee and subject to the limitations in our charter, which would further dilute our stockholders’ investment in us and reduce 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 expected to be paid during our listing/liquidation stage are contingent on our stockholders first receiving agreed-upon investment returns, the investment-return thresholds may be reduced with the approval of our conflicts committee and subject to the limitations in our charter.
Therefore, these fees increase the risk that the amount of cash available for distribution to commonour stockholders upon a liquidation of our portfolio would be less than the amount stockholders paid to acquire our shares. 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 an investment in us 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 negotiations. If we need additional capital in the future to improve or maintain our properties or for any other reason, we may have to obtain funding from sources other than our cash flow from operations or proceeds from our dividend reinvestment plan, 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 makepay distributions to our stockholders and could reduce the value of our stockholders’ investment.
Our stockholders may be more likely to sustain a loss on their investment because our sponsors do not have as strong an economic incentive to avoid losses as do sponsors who have made significant equity investments in their companies.
Our sponsors have invested only $200,000 in us through the purchase of 20,000 shares of our common stock at $10.00 per share. With this limited exposure, our stockholders may be at a greater risk of loss because our sponsors do not have as much to lose from a decrease in the value of our shares as do those sponsors who make more significant equity investments in their companies.
Although we will not currently be 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 a vote of two-thirds of the votes entitled to be cast on the matter. Shares owned by the acquirer, an officer of the corporation or an employee of the corporation who is also a director of the corporation are excluded from the vote on whether to accord voting rights to the control shares. Should our board of directors 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 includes an anti-takeover provision that may discourage a stockholder from launching a tender offer for our shares.
Our charter provides that any tender offer made by a stockholder, including any “mini-tender” offer, must comply with most provisions of Regulation 14D of the Securities Exchange Act of 1934, as amended. The offering stockholder must provide our company notice of such tender offer at least 10 business days before initiating the tender offer. If the offering stockholder does not comply with these requirements, our company will have the right to redeem that stockholder’s shares and any shares acquired in such tender offer. In addition, the noncomplying stockholder shall be responsible for all of our company’s expenses in connection with that stockholder’s noncompliance. This provision of our charter may discourage a stockholder from initiating a tender offer for our shares and prevent our stockholders from receiving a premium price for their shares in such a transaction.
General Risks Related to Investments in Real Estate
Economic, market and regulatory changes that impact the real estate market generally may decrease the value of our investments and weaken our operating results.
Our operating results and the performance of our real estate properties are subject to the risks typically associated with real estate, any of which could decrease the value of our investments and could weaken our operating results, including:
downturns in national, regional and local economic conditions;
competition from other office and industrial buildings;
adverse local conditions, such as oversupply or reduction in demand for office and industrial buildings 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 (including real and personal property tax), real estate, environmental and zoning laws;
natural disasters such as hurricanes, earthquakes and floods;
acts of war or terrorism, including the consequences of terrorist attacks, such as those that occurred on September 11, 2001;
the potential for uninsured or underinsured property losses; and
periods of high interest rates and tight money supply.
Any of the above factors, or a combination thereof, could result in a decrease in our cash flow from operations and 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’ investment.
If our acquisitions fail to perform as expected, cash distributions to our stockholders may decline.
As of March 7, 2016,8, 2017, we had acquired 30 real estate properties (one of which was sold on February 19, 2014) and, originated one real estate loan receivable (which was fully repaid on July 1, 2016) and entered into the Hardware Village Joint Venture to develop and subsequently operate Hardware Village, which is currently under construction, based on an underwriting analysis with respect to each asset and how the asset fits into our portfolio. If these assets do not perform as expected we may have less cash flow from operating activities available to fund distributions and stockholder returns may be reduced.
Properties that have significant vacancies could be difficult to sell, which could diminish the return on these properties and adversely affect our cash flow and ability to pay distributions to our stockholders.
A property may incur vacancies either by the expiration and non-renewal of tenant leases or the continued default of tenants under their leases. If vacancies continue for a long period of time, we may suffer reduced revenues resulting in less cash available for distribution to our stockholders. In addition, the resale value of the property could be diminished 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 in the resale value of a property could also reduce the value of our stockholders’ investment.
To the extent that we buy core real estate properties with occupancy of less than 95% or that have significant rollover during the expected hold period, we may incur significant costs for capital expenditures and tenant improvement costs to lease-up the properties, which increases the risk of loss associated with these properties compared to other properties.
We have invested in, and may make additional investments in, core properties that have an occupancy rate of less than 95%, significant rollover during the expected hold period, or other characteristics that could provide an opportunity for us to achieve appreciation by increasing occupancy, negotiating new leases with higher rental rates and/or executing enhancement projects. We likely will need to fund reserves or maintain capacity under our credit facilities to fund capital expenditures, tenant improvements and other improvements in order to attract new tenants to these properties. To the extent we do not maintain adequate reserves to fund these costs, we may use our cash flow from operating activities, which will reduce the amount of cash flow available for distribution to our stockholders. If we are unable to execute our business plan for these investments, the overall return on these investments will decrease.
We may enter into long-term leases with tenants in certain properties, which may not result in fair market rental rates over time.
We may enter into long-term leases with tenants of certain of our properties, or include renewal options that specify a maximum rate increase. These leases would provide for rent to increase over time; however, if we do not accurately judge the potential for increases in market rental rates, we may set the terms of these long-term leases at levels such that, even after contractual rent increases, the rent under our long-term leases is less than then-current market rates. Further, we may have no ability to terminate those leases or to adjust the rent to then-prevailing market rates. As a result, our cash available for distribution could be lower than if we did not enter into long-term leases.
Certain property types, such as industrial properties, or portfolios of such properties, that we may acquire may not have efficient alternative uses and, if we acquire such properties, we may have difficulty leasing them to new tenants and/or have to make significant capital expenditures to them to do so.
Certain property types, particularly industrial properties, can be difficult to lease to new tenants, should the current tenant terminate or choose not to renew its lease. These properties generally will have received significant tenant-specific improvements and only very specific tenants may be able to use such improvements, making the properties very difficult to re-lease in their current condition. Additionally, an interested tenant may demand that, as a condition of executing a lease for the property, we finance and construct significant improvements so that the tenant could use the property. This expense may decrease cash available for distribution, as we likely would have to (i) pay for the improvements up-front or (ii) finance the improvements at potentially unattractive terms.
To the extent we acquire retail properties with anchor tenants, our revenue will be significantly impacted by the success and economic viability of our retail anchor tenants. Our reliance on a single tenant or significant tenants in certain properties may decrease our ability to lease vacated space and adversely affect the returns on our stockholders’ investment in us.
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 and default on or terminate its lease, or may decide not to renew its lease. Any of these events would result in a reduction or cessation in rental payments to us from that tenant and would adversely affect our financial condition. A lease termination 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 an anchor tenant’s lease is terminated. In such event, we may be unable to re-lease the vacated space. Similarly, the leases of some anchor tenants may permit those anchor tenants to transfer their leases to other retailers. 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, under the terms of their respective leases, 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 renovate and subdivide the space to be able to re-lease the space to more than one tenant.
Our retail tenants will face competition from numerous retail channels and may be disproportionately affected by economic conditions. These events could reduce the profitability of our retail properties and affect our ability to pay distributions.
Retailers will face continued competition from discount or value retailers, factory outlet centers, wholesale clubs, mail order catalogues and operators, television shopping networks and shopping via the Internet. Such conditions could adversely affect our retail tenants and, consequently, our funds available for distribution related to such tenants.
We depend on tenants for our revenue generated by our real estate investments and, accordingly, our revenue generated by our real estate investments and our ability to makepay distributions to our stockholders are partially dependent upon the success and economic viability of our tenants and our ability to retain and attract tenants. Non-renewals, terminations or lease defaults could reduce our net income and limit our ability to makepay distributions to our stockholders.
The success of our real estate investments materially depends upon the financial stability of the tenants leasing the properties we own. The inability of a single major tenant or a significant number of smaller tenants to meet their rental obligations would significantly lower our net income. A non-renewal after the expiration of a lease term, termination or default by a tenant on its lease payments to us would cause us to lose the revenue associated with such lease and require us to find an alternative source of revenue to meet mortgage payments and prevent a foreclosure if the property is subject to a mortgage. In the event of a tenant default or bankruptcy, we may experience delays in enforcing our rights as landlord of a property and may incur substantial costs in protecting our investment and re-leasing the property. Tenants may have the right to terminate their leases upon the occurrence of certain customary events of default and, in other circumstances, may not renew their leases or, because of market conditions, may only be able to renew their leases on terms that are less favorable to us than the terms of their initial leases.
Further, some of our assets may be outfitted to suit the particular needs of the tenants. We may have difficulty replacing the tenants of these properties if the outfitted space limits the types of businesses that could lease that space without major renovation. If a tenant does not renew a lease or, terminates or defaults on a lease, we may be unable to lease the property for the rent previously received or sell the property without incurring a loss. Because the market value of a particular property depends principally upon the value of the cash flow generated by the leases associated with such property, we may incur a loss upon the sale of a property with significant vacant space. These events could cause us to reduce distributions to stockholders.
The bankruptcy or insolvency of our tenants or delays by our tenants in making rental payments could seriously harm our operating results and financial condition.
Any bankruptcy filings by or relating to any of our tenants could bar us from collecting pre-bankruptcy debts from that tenant, unless we receive an order permitting us to do so from the bankruptcy court. A tenant bankruptcy could delay our efforts to collect past due balances under the relevant leases, and could ultimately preclude full collection of these sums. If a lease is rejected by a tenant in bankruptcy, we would have only a general unsecured claim for damages. Any unsecured claim we hold against a bankrupt entity may be paid only to the extent that funds are available and only in the same percentage as is paid to all other holders of unsecured claims. We may recover substantially less than the full value of any unsecured claims, which would harm our financial condition.
Our inability to sell a property at the time and on the terms we want could limit our ability to pay distributions to our stockholders and could reduce the value of our stockholders’ investment in us.
Many factors that are beyond our control affect the real estate market and could affect our ability to sell properties for the price, on the terms or within the time frame 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 at the time and on the terms we want could reduce our cash flow, limit our ability to makepay distributions to our stockholders and reduce the value of our stockholders’ investment in us.
If we sell a property by providing financing to the purchaser, we will bear the risk of default by the purchaser, which could delay or reduce cash available for distribution to our stockholders.
If we decide to sell any of our properties, we intend to use our best efforts to sell them for cash; however, in some instances, we may sell our properties by providing financing to purchasers. When we provide financing to a purchaser, we will bear the risk that the purchaser may default, which could reduce our cash distributions to stockholders. Even in the absence of a purchaser default, the distribution of the proceeds of the sale to our stockholders, or the reinvestment of the proceeds in other assets, will be delayed until the promissory note or other property we may accept upon a sale is actually paid, sold, refinanced or otherwise disposed.
Potential development and construction delays and resultant increased costs and risks may hinder our operating results and decrease our net income.
From time to time we may acquire unimproved real property or properties that are under development or construction. Investments in such properties will be subject to the uncertainties associated with the development and construction of real property, such as our investment in Hardware Village, including those related to re-zoning land for development, environmental concerns of governmental entities and/or community groups and our builders’ ability to build in conformity with plans, specifications, budgeted costs and timetables. If a builder fails to perform, we may resort to legal action to rescind the purchase or the construction contract or to compel performance. A builder’s performance may also be affected or delayed by conditions beyond the builder’s control. Delays in completing construction could also give tenants the right to terminate preconstruction leases. We may incur additional risks when we make periodic progress payments or other advances to builders before they complete construction. These and other factors can result in increased costs of a project or loss of our investment. In addition, we will be subject to normal lease-up risks relating to newly constructednewly-constructed projects. We also must rely on rental income and expense projections and estimates of the fair market value of property upon completion of construction when agreeing upon a purchase price at the time we acquire the property. If our projections are inaccurate, we may pay too much for a property, and the return on our investment could suffer.
Actions of our potential future joint venture partners could reduce the returns on joint venture investments and decrease our stockholders’ overall return.
We have entered into the Hardware Village Joint Venture and the Village Center Station II Joint Venture, and may enter into additional joint ventures with third parties to acquire properties and other assets. We may also purchase and develop additional properties in joint ventures or in partnerships, co-tenancies or other co-ownership arrangements. Such investments may involve risks not otherwise present with other methods of investment, including, for example, the following risks:
that our co-venturer, co-tenant or partner in an investment could become insolvent or bankrupt;
that such co-venturer, co-tenant or partner may at any time have economic or business interests or goals that are or that become inconsistent with our business interests or goals;
that such co-venturer, co-tenant or partner may be in a position to take action contrary to our instructions or requests or contrary to our policies or objectives; or
that disputes between us and our co-venturer, co-tenant or partner may result in litigation or arbitration that would increase our expenses and prevent our officers and directors from focusing their time and effort on our operations.
Any of the above might subject a property to liabilities in excess of those contemplated and thus reduce our returns on that investment and the value of our stockholders’ investment in us.
Costs imposed pursuant to laws and governmental regulations may reduce our net income and our cash available for distribution 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. Any material expenditures, fines, penalties or damages we must pay will reduce our ability to pay distributions to our stockholders and may reduce the value of our stockholders’ investment in us.
The costs of defending against claims of environmental liability, of complying with environmental regulatory requirements, of remediating any contaminated property or of paying personal injury or other damage claims could reduce our cash available for distribution to our stockholders.
Under various federal, state and local environmental laws, ordinances and regulations, a current or previous real property owner or operator may be liable for the cost of removing or remediating hazardous or toxic substances on, under or in such property. These costs could be substantial. Such laws often impose liability whether or not the owner or operator knew of, or was responsible for, the presence of such hazardous or toxic substances. 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. 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 and governments may seek recovery for natural resource damage. The costs of defending against claims of environmental liability, of complying with environmental regulatory requirements, of remediating any contaminated property, or of paying personal injury, property damage or natural resource damage claims could reduce our cash available for distribution to our stockholders.
All of our real estate properties are subject to Phase I environmental assessments prior to the time they are acquired; however, such assessments may not provide complete environmental histories due, for example, to limited available information about prior operations at the properties or other gaps in information at the time we acquire the property. A Phase I environmental assessment is an initial environmental investigation to identify potential environmental liabilities associated with the current and past uses of a given property. If any of our properties were found to contain hazardous or toxic substances after our acquisition, the value of our investment could decrease below the amount paid for such investment. In addition, real estate-related investments in which we invest may be secured by properties with recognized environmental conditions. Where we are secured creditors, we will attempt to acquire contractual agreements, including environmental indemnities, that protect us from losses arising out of environmental problems in the event the property is transferred by foreclosure or bankruptcy; however, no assurances can be given that such indemnities would fully protect us from responsibility for costs associated with addressing any environmental problems related to such properties.
Costs associated with complying with the Americans with Disabilities Act may decrease our cash available for distribution.
Our properties may be subject to the Americans with Disabilities Act of 1990, as amended, or 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. Any funds used for Disabilities Act compliance will reduce our net income and the amount of cash available for distribution to our stockholders.
Uninsured losses relating to real property or excessively expensive premiums for insurance coverage could reduce our cash flow from operations and the return on our stockholders’ investment in us.
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 to 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 coverage for such losses. If any of our properties incurs a casualty loss that is not fully insured, the value of our assets will be reduced by any such uninsured loss, which will reduce the value of our stockholders’ investment in us. In addition other than any working capital reserve or other reserves we may establish, we have limited sources 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 our stockholders.
Terrorist attacks and other acts of violence or war may affect the markets in which we plan to operate, which could delay or hinder our ability to meet our investment objectives and reduce our stockholders’ overall return.
Terrorist attacks or armed conflicts may directly impact the value of our properties through damage, destruction, loss or increased security costs. We may not be able to obtain insurance against the risk of terrorism because it may not be available or may not be available on terms that are economically feasible. The terrorism insurance that we obtain may not be sufficient to cover loss for damages to our properties as a result of terrorist attacks. The inability to obtain sufficient terrorism insurance or any terrorism insurance at all could limit our financing and refinancing options as some mortgage lenders have begun to insist that specific coverage against terrorism be purchased by commercial owners as a condition for providing loans.
To the extent we acquire or develop apartment communities, competitionCompetition from other apartment communities for tenants could reduce our profitability and the return on our stockholders’ investment.
The apartment community industry is highly competitive. This competition could reduce occupancy levels and revenues at our apartment communities, which would adversely affect our operations. ToWe are currently developing, through the extentHardware Village Joint Venture, the Hardware Village apartment community, which we acquire or develop apartment communities, wewill subsequently operate through the joint venture. We expect to face competition from many sources. We will face competition from other apartment communities both in the immediate vicinity and in the larger geographic market where our apartment communities are located. Overbuilding of apartment communities may occur. If so, this will increase the number of apartment units available and may decrease occupancy and apartment rental rates. In addition, increases in operating costs due to inflation may not be offset by increased apartment rental rates.
Risks Related to Real Estate-Related Investments
OurAny future real estate-related investments arewe make will be subject to the risks typically associated with real estate.
Our mortgage loan investment and anyAny future investments we make in real estate loans are and generally will be directly or indirectly secured by a lien on real property (or the equity interests in an entity that owns real property) that, upon the occurrence of a default on the loan, could result in our taking ownership of the property. The values of these properties may change after the dates of acquisition or origination of the loans. If the values of the underlying properties drop, our risk will increase because of the lower value of the security associated with such loans. In this manner, real estate values could impact the values of our loan investments. Any investments we make in residential and commercial mortgage-backed securities and other real estate-related investments may be similarly affected by real estate property values. Therefore, ourany real estate-related investments arewe make will be subject to the risks typically associated with real estate, which are described above under the heading “-General“- General Risks Related to Investments in Real Estate.”
Our mortgage loan investment and anyAny future investments we make in real estate loans are and will be subject to interest rate fluctuations that will affect our returns as compared to market interest rates; accordingly, the value of our stockholders’ investment in us iswill be subject to fluctuations in interest rates.
With respect to our fixed rate, long-term loans receivable, if interest rates rise, the loans could yield a return that is lower than then-current market rates. If interest rates decrease, we will be adversely affected to the extent that loans are prepaid because we may not be able to reinvest the proceeds at as high of an interest rate. If we invest in variable-rate loans receivable and interest rates decrease, our revenues will also decrease. For these reasons, our investments in real estate loans, our returns on those loans and the value of our stockholders’ investment in us are and willwould be subject to fluctuations in interest rates.
The mortgage loans we may invest in and the mortgage loans underlying any mortgage securities we may invest in are subject to delinquency, foreclosure and loss, which could result in losses to us.
Commercial real estate loans generally are secured by commercial real estate properties and are subject to risks of delinquency and foreclosure. The ability of a borrower to repay a loan secured by an income-producing property typically is dependent primarily upon the successful operation of such property rather than upon the existence of independent income or assets of the borrower. If the net operating income of the property is reduced, the borrower’s ability to repay the loan may be impaired. Net operating income of an income-producing property can be affected by, among other things: tenant mix, success of tenant businesses, occupancy rates, property management decisions, property location and condition, competition from comparable types of properties, changes in laws that increase operating expenses or limit rents that may be charged, any need to address environmental contamination at the property, the occurrence of any uninsured casualty at the property, changes in national, regional or local economic conditions and/or specific industry segments, declines in regional or local real estate values, declines in regional or local rental or occupancy rates, increases in interest rates, real estate tax rates and other operating expenses, changes in governmental rules, fiscal policies and regulations (including environmental legislation), natural disasters, terrorism, social unrest and civil disturbances.
In the event of any default under a mortgage loan held by us,we may acquire, we will bear a risk of loss of principal and accrued interest to the extent of any deficiency between the value of the collateral and the principal and accrued interest of the mortgage loan, which could have a material adverse effect on our cash flow from operations. Foreclosure on a property securing a mortgage loan can be an expensive and lengthy process that could have a substantial negative effect on our anticipated return on the investment. In the event of the bankruptcy of a mortgage loan borrower, the mortgage loan to such borrower will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the mortgage loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the extent the lien is unenforceable under state law.
Delays in liquidating defaulted mortgage loans could reduce our investment returns.
If there are defaults under our mortgage loan investments, we may not be able to repossess and sell the underlying properties quickly. The resulting time delay could reduce the value of our investment in the defaulted mortgage loans. An action to foreclose on a property securing a mortgage loan is regulated by state statutes and regulations and is subject to many of the delays and expenses of other lawsuits if the borrower raises defenses or counterclaims. In the event of default by a borrower, these restrictions, among other things, may impede our ability to foreclose on or sell the mortgaged property or to obtain proceeds sufficient to repay all amounts due to us on the mortgage loan.
The mezzanine loans that we may originate or in which we may invest would involve greater risks of loss than senior loans secured by the same properties.
We may originate or invest in mezzanine loans that take the form of subordinated loans secured by a pledge of the ownership interests of the entity owning (directly or indirectly) the real property. These types of investments may involve a higher degree of risk than long-term senior mortgage lending secured by income-producing real property because the investment may become unsecured as a result of foreclosure by the senior lender. In the event of a bankruptcy of the entity providing the pledge of its ownership interests as security, we may not have full recourse to the assets of such entity, or the assets of the entity may not be sufficient to satisfy our mezzanine loan. If a borrower defaults on our mezzanine loan or debt senior to our loan, or in the event of a borrower bankruptcy, our mezzanine loan will be satisfied only after the senior debt. As a result, we may not recover some or all of our investment. In addition, mezzanine loans may have higher loan-to-value ratios than conventional mortgage loans, resulting in less equity in the real property and increasing the risk of loss of principal.
The B-Notes in which we may invest may be subject to additional risks relating to the privately negotiated structure and terms of the transaction, which may result in losses to us.
We may invest in B-Notes. A B-Note is a mortgage loan typically (i) secured by a first mortgage on a single large commercial property or group of related properties and (ii) subordinated to an A-Note secured by the same first mortgage on the same collateral. As a result, if a borrower defaults, there may not be sufficient funds remaining for B-Note holders after payment to the A-Note holders. Since each transaction is privately negotiated, B-Notes can vary in their structural characteristics and risks. For example, the rights of holders of B-Notes to control the process following a borrower default may be limited in certain investments. We cannot predict the terms of each B-Note investment. Further, B-Notes typically are secured by a single property, and so reflect the increased risks associated with a single property compared to a pool of properties.
Bridge loans may involve a greater risk of loss than conventional mortgage loans.
We may provide bridge loans secured by first-lien mortgages on properties to borrowers who are typically seeking short-term capital to be used in an acquisition, development or refinancing of real estate. The borrower may have identified an undervalued asset that has been undermanaged or is located in a recovering market. If the market in which the asset is located fails to recover according to the borrower’s projections, or if the borrower fails to improve the quality of the asset’s management or the value of the asset, the borrower may not receive a sufficient return on the asset to repay the bridge loan, and we may not recover some or all of our investment.
In addition, owners usually borrow funds under a conventional mortgage loan to repay a bridge loan. We may, therefore, be dependent on a borrower’s ability to obtain permanent financing to repay our bridge loan, which could depend on market conditions and other factors. Bridge loans are also subject to risks of borrower defaults, bankruptcies, fraud, losses and special hazard losses that are not covered by standard hazard insurance. In the event of any default under bridge loans held by us, we bear the risk of loss of principal and nonpayment of interest and fees to the extent of any deficiency between the value of the mortgage collateral and the principal amount of the bridge loan. To the extent we suffer such losses with respect to our investments in bridge loans, the value of our company and of our common stock may be adversely affected.
Investment in non-conforming and non-investment grade loans may involve increased risk of loss.
Loans we may acquire or originate may not conform to conventional loan criteria applied by traditional lenders and may not be rated or may be rated as non-investment grade. Non-investment grade ratings for these loans typically result from the overall leverage of the loans, the lack of a strong operating history for the properties underlying the loans, the borrowers’ credit history, the properties’ underlying cash flow or other factors. As a result, non-conforming or non-investment grade loans we acquire or originate may have a higher risk of default and loss than conventional loans. Any loss we incur may reduce distributions to stockholders and adversely affect the value of our common stock.
Subordinated loans and subordinated mortgage-backed securities may be subject to losses.
We may acquire or originate subordinated loans and invest in subordinated mortgage-backed securities. In the event a borrower defaults on a subordinated loan and lacks sufficient assets to repay our loan, we may suffer a loss of principal or interest. In the event a borrower declares bankruptcy, we may not have full recourse to the assets of the borrower, or the assets of the borrower may not be sufficient to repay the loan. If a borrower defaults on our loan or on debt senior to our loan, or in the event of a borrower bankruptcy, our loan will be repaid only after the senior debt is paid in full. Where debt senior to our loan exists, the presence of intercreditor arrangements may limit our ability to amend our loan documents, assign our loans, accept prepayments, exercise our remedies (through “standstill periods”) and control decisions made in bankruptcy proceedings relating to borrowers.
In general, losses on a mortgage loan included in a securitization will be borne first by the equity holder of the property, then by a cash reserve fund or letter of credit, if any, and then by the “first loss” subordinated security holder. In the event of default and the exhaustion of any equity support, reserve fund, letter of credit and any classes of securities junior to those in which we invest, we may not be able to recover all of our investment in securities we purchase. In addition, if the underlying mortgage portfolio has been overvalued by the originator, or if the values subsequently decline and, as a result, less collateral is available to satisfy interest and principal payments due on the related mortgage-backed securities, securities in which we invest may effectively become the “first loss” position behind the more senior securities, which may result in significant losses to us.
Risks of cost overruns and non-completion of the construction or renovation of the properties underlying loans we make or acquire may materially adversely affect our investments.
The renovation, refurbishment or expansion by a borrower under a mortgaged or leveraged property involves risks of cost overruns and non-completion. Costs of construction or improvements to bring a property up to standards established for the market position intended for that property may exceed original estimates, possibly making a project uneconomical. Other risks may include environmental risks and the possibility of construction, rehabilitation and subsequent leasing of the property not being completed on schedule. If such construction or renovation is not completed in a timely manner, or if it costs more than expected, the borrower may experience a prolonged impairment of net operating income and may not be able to make payments on our investment, and we may not recover some or all of our investment.
To close loan transactions within a time frame that meets the needs of borrowers of loans we may originate, we may perform underwriting analyses in a very short period of time, which may result in credit decisions based on limited information.
We may gain a competitive advantage by, from time to time, being able to analyze and close loan transactions within a very short period of time. Our underwriting guidelines require a thorough analysis of many factors, including the underlying property’s financial performance and condition, geographic market assessment, experience and financial strength of the borrower and future prospects of the property within the market. If we make the decision to extend credit to a borrower prior to the completion of one or more of these analyses, we may fail to identify certain credit risks that we would otherwise have identified.
The commercial mortgage-backed securities in which we may invest are subject to all of the risks of the underlying mortgage loans and the risks of the securitization process.
Commercial mortgage-backed securities, or CMBS, are securities that evidence interests in, or are secured by, a single commercial mortgage loan or a pool of commercial mortgage loans. Accordingly, these securities are subject to all of the risks of the underlying mortgage loans.
The value of CMBS may be adversely affected when payments on underlying mortgages do not occur as anticipated, resulting in the extension of the security’s effective maturity and the related increase in interest rate sensitivity of a longer-term instrument. The value of CMBS may also change due to shifts in the market’s perception of issuers and regulatory or tax changes adversely affecting the mortgage securities market as a whole. In addition, CMBS are subject to the credit risk associated with the performance of the underlying mortgage properties. In certain instances, third-party guarantees or other forms of credit support can reduce the credit risk.
CMBS are also subject to several risks created through the securitization process. Subordinate CMBS are paid interest only to the extent that there are funds available to make payments after paying the senior class. To the extent that we invest in a subordinate class, we will be paid interest only to the extent that there are funds available after paying the senior class. To the extent the collateral pool includes delinquent loans, there is a risk that interest payments on subordinate CMBS will not be fully paid. Subordinate CMBS are also subject to greater credit risk than senior CMBS that are more highly rated. Further, the ratings assigned to any particular class of CMBS may prove to be inaccurate. Thus, any particular class of CMBS may be riskier and more volatile than the rating may suggest, which may cause the returns on any CMBS investment to be less than anticipated.
We will not have the right to foreclose on commercial mortgage loans underlying CMBS in which we invest since we will not directly own such underlying loans. Accordingly, we must rely on third parties to initiate and execute any foreclosure proceedings upon a default of such mortgage loans.
To the extent that we make investments in real estate-related securities and loans, a portion of those investments may be illiquid and we may not be able to adjust our portfolio in response to changes in economic and other conditions.
Certain of the real estate-related securities that we may purchase in connection with privately negotiated transactions will not be registered under the relevant securities laws, resulting in a prohibition against their transfer, sale, pledge or other disposition except in a transaction that is exempt from the registration requirements of, or is otherwise in accordance with, those laws. The mezzanine and bridge loans we may purchase or originate will be particularly illiquid investments due to their short life, their unsuitability for securitization and the greater difficulty of recoupment in the event of a borrower’s default. This illiquidity may limit our ability to vary our portfolio in response to changes in economic and other conditions, which could increase the likelihood that the value of our stockholders’ investment in us will decrease as a result of such changes in economic and other conditions.
Delays in restructuring or liquidating non-performing real estate securities could reduce the return on our stockholders’ investment in us.
Real estate securities may become non-performing after acquisition for a wide variety of reasons. Such non-performing real estate investments may require a substantial amount of workout negotiations and/or restructuring, which may entail, among other things, a substantial reduction in the interest rate and a substantial write-down of such loan or asset. However, even if a restructuring is successfully accomplished, upon maturity of such real estate security, replacement “takeout” financing may not be available. We may find it necessary or desirable to foreclose on some of the collateral securing one or more of our investments. Intercreditor provisions may substantially interfere with our ability to do so. Even if foreclosure is an option, the foreclosure process can be lengthy and expensive. Borrowers often resist foreclosure actions by asserting numerous claims, counterclaims and defenses including, without limitation, lender liability claims and defenses, in an effort to prolong the foreclosure action. In some states, foreclosure actions can take up to several years or more to litigate. At any time during the foreclosure proceedings, the borrower may file for bankruptcy, which would have the effect of staying the foreclosure action and further delaying the foreclosure process. Foreclosure litigation tends to create a negative public image of the collateral property and may result in disrupting ongoing leasing and management of the property. Foreclosure actions by senior lenders may substantially affect the amount that we may earn or recover from an investment.
We depend on borrowers for the revenue generated by our real estate-related investments and, accordingly, our revenue and our ability to make distributions to our stockholders are partially dependent upon the success and economic viability of such borrowers.
The success of our real estate-related investments materially depends on the financial stability of the borrowers under such investments. The inability of a single major borrower or a number of smaller borrowers to meet their payment obligations could result in reduced revenue or losses for us. In the event of a borrower default or bankruptcy, we may experience delays in enforcing our rights as a creditor, and such rights may be subordinated to the rights of other creditors. These events could negatively affect the cash available for distribution to our stockholders and the value of their investment in us.
Our dependence on the management of other entities in which we invest may adversely affect our business.
We will not control the management, investment decisions or operations of the companies in which we may invest. Management of those enterprises may decide to change the nature of their assets, or management may otherwise change in a manner that is not satisfactory to us. We will have no ability to affect these management decisions and we may have only limited ability to dispose of our investments.
Prepayments can adversely affect the yields on our debt investments.
The yields on our debt investments may be affected by the rate of prepayments differing from our projections. Prepayments on debt instruments, where permitted under the debt documents, are influenced by changes in current interest rates and a variety of economic, geographic and other factors beyond our control, and consequently, such prepayment rates cannot be predicted with certainty. If we are unable to invest the proceeds of any prepayments we receive in assets with at least an equivalent yield, the yield on our portfolio will decline. In addition, we may acquire assets at a discount or premium and if an asset is not repaid when expected, our anticipated yield may be impacted. Under certain interest rate and prepayment scenarios we may fail to recoup fully our cost of acquisition of certain investments.
If credit spreads widen before we obtain long-term financing for our assets, the value of our assets may suffer.
We will price our assets based on our assumptions about future credit spreads for financing of those assets. We may obtain longer-term financing for our assets using structured financing techniques in the future. In such financings, interest rates are typically set at a spread over a certain benchmark, such as the yield on United States Treasury obligations, swaps, or LIBOR. If the spread that borrowers will pay over the benchmark widens and the rates we charge on our assets to be securitized are not increased accordingly, our income may be reduced or we may suffer losses.
Hedging against interest rate exposure may adversely affect our earnings, limit our gains or result in losses, which could adversely affect cash available for distribution to our stockholders.
We have entered into and in the future may enter into interest rate swap agreements or pursue other interest rate hedging strategies. Our hedging activity will vary in scope based on the level of interest rates, the type of investments we hold, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:
interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;
available interest rate hedging products may not correspond directly with the interest rate risk for which protection is sought;
the duration of the hedge may not match the duration of the related liability or asset;
the amount of income that a REIT may earn from hedging transactions to offset losses due to fluctuations in interest rates is limited by federal tax provisions governing REITs;
the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction;
the party owing money in the hedging transaction may default on its obligation to pay; and
we may purchase a hedge that turns out not to be necessary, i.e., a hedge that is out of the money.
Any hedging activity we engage in may adversely affect our earnings, which could adversely affect cash available for distribution to our stockholders. Therefore, while we may enter into such transactions to seek to reduce interest rate risks, unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions. In addition, the degree of correlation between price movements of the instruments used in a hedging strategy and price movements in the investments being hedged or liabilities being hedged may vary materially. Moreover, for a variety of reasons, we may not seek to establish a perfect correlation between such hedging instruments and the interest rate risk sought to be hedged. Any such imperfect correlation may prevent us from achieving the intended accounting treatment and may expose us to risk of loss.
We assume the credit risk of our counterparties with respect to derivative transactions.
We enter into derivative contracts for risk management purposes to hedge our exposure to cash flow variability caused by changing interest rates on our future variable rate real estate loans receivable and variable rate notes payable. These derivative contracts generally are entered into with bank counterparties and are not traded on an organized exchange or guaranteed by a central clearing organization. We would therefore assume the credit risk that our counterparties will fail to make periodic payments when due under these contracts or become insolvent. If a counterparty fails to make a required payment, becomes the subject of a bankruptcy case, or otherwise defaults under the applicable contract, we would have the right to terminate all outstanding derivative transactions with that counterparty and settle them based on their net market value or replacement cost. In such an event, we may be required to make a termination payment to the counterparty, or we may have the right to collect a termination payment from such counterparty. We assume the credit risk that the counterparty will not be able to make any termination payment owing to us. We may not receive any collateral from a counterparty, or we may receive collateral that is insufficient to satisfy the counterparty’s obligation to make a termination payment. If a counterparty is the subject of a bankruptcy case, we will be an unsecured creditor in such case unless the counterparty has pledged sufficient collateral to us to satisfy the counterparty’s obligations to us.
We assume the risk that our derivative counterparty may terminate transactions early.
If we fail to make a required payment or otherwise default under the terms of a derivative contract, the counterparty would have the right to terminate all outstanding derivative transactions between us and that counterparty and settle them based on their net market value or replacement cost. In certain circumstances, the counterparty may have the right to terminate derivative transactions early even if we are not defaulting. If our derivative transactions are terminated early, it may not be possible for us to replace those transactions with another counterparty, on as favorable terms or at all.
We may be required to collateralize our derivative transactions.
We may be required to secure our obligations to our counterparties under our derivative contracts by pledging collateral to our counterparties. That collateral may be in the form of cash, securities or other assets. If we default under a derivative contract with a counterparty, or if a counterparty otherwise terminates one or more derivative contracts early, that counterparty may apply such collateral toward our obligation to make a termination payment to the counterparty. If we have pledged securities or other assets, the counterparty may liquidate those assets in order to satisfy our obligations. If we are required to post cash or securities as collateral, such cash or securities will not be available for use in our business. Cash or securities pledged to counterparties may be repledged by counterparties and may not be held in segregated accounts. Therefore, in the event of a counterparty insolvency, we may not be entitled to recover some or all collateral pledged to that counterparty, which could result in losses and have an adverse effect on our operations.
There can be no assurance that the direct or indirect effects of the Dodd-Frank Act and other applicable non-U.S. regulations will not have an adverse effect on our interest rate hedging activities.
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) imposed additional regulations on derivatives markets and transactions. Such regulations and, to the extent we trade with counterparties organized in non-US jurisdictions, any applicable regulations in those jurisdictions, are still being implemented, and will affect our interest rate hedging activities. While the full impact of regulation on our interest rate hedging activities cannot be fully assessed until all final rules and regulations are implemented, such regulation may affect our ability to enter into hedging or other risk management transactions, may increase our costs in entering into such transactions, and/or may result in us entering into such transactions on less favorable terms than prior to implementation of such regulation. For example, but not by way of limitation, the Dodd-Frank Act and the rulemaking thereunder provides for significantly increased regulation of the derivative transactions used to affect our interest rate hedging activities, including: (i) regulatory reporting, (ii) subject to an exception under the Dodd-Frank Actexemption for “end-users”end-users of swaps upon which we may seek toand our subsidiaries generally rely, we may be required to clearmandated clearing of certain interest rate hedgingderivatives transactions by submitting them to a derivatives clearing organization. In addition,through central counterparties and execution on regulated exchanges or execution facilities, and (iii) to the extent we are required to clear any such transactions, we will be requiredmargin and collateral requirements. The imposition, or the failure to among other things, post margin in connectioncomply with, such transactions. The occurrence of any of the foregoing eventsrequirements may have an adverse effect on our business and our stockholders’ return.
Our investments in real estate-related debt securities and preferred and common equity securities will be subject to the specific risks relating to the particular issuer of the securities and may involve greater risk of loss than secured debt financings.
We may make equity investments in REITs and other real estate companies. We may target a public company that owns commercial real estate or real estate-related assets when we believe its stock is trading at a discount to that company’s net asset value. We may eventually seek to acquire or gain a controlling interest in the companies that we target. We do not expect our non-controlling equity investments in other public companies to exceed 5% of the proceeds of our now terminated initial public offering, or to represent a substantial portion of our assets at any one time. We may also invest in debt securities and preferred equity securities issued by REITs and other real estate companies. Our investments in debt securities and preferred and common equity securities will involve special risks relating to the particular issuer of the securities, including the financial condition and business outlook of the issuer. Issuers that are REITs and other real estate companies are subject to the inherent risks associated with real estate investments. Furthermore, debt securities and preferred and common equity securities may involve greater risk of loss than secured debt financings due to a variety of factors, including that such investments are generally unsecured and may also be subordinated to other obligations of the issuer. As a result, investments in debt securities and preferred and common equity securities are subject to risks of (i) limited liquidity in the secondary trading market, (ii) substantial market price volatility resulting from changes in prevailing interest rates, (iii) subordination to the claims of banks and senior lenders to the issuer, (iv) the operation of mandatory sinking fund or call/redemption provisions during periods of declining interest rates that could cause the issuer to reinvest redemption proceeds in lower yielding assets, (v) the possibility that earnings of the issuer may be insufficient to meet its debt service and distribution obligations, and (vi) the declining creditworthiness and potential for insolvency of the issuer during periods of rising interest rates and economic downturn. These risks may adversely affect the value of outstanding debt securities and preferred and common equity securities and the ability of the issuers thereof to make principal, interest and/or distribution payments to us.
Declines in the market values of our investments may adversely affect periodic reported results of operations and credit availability, which may reduce our earnings and, in turn, cash available for distribution to our stockholders.
A portion of our assets may be classified for accounting purposes as “available-for-sale.” These investments are carried at estimated fair value and temporary changes in the market values of those assets will be directly charged or credited to stockholders’ equity without impacting net income on the income statement. Moreover, if we determine that a decline in the estimated fair value of an available-for-sale security below its amortized value is other-than-temporary, we will recognize a loss on that security on our income statement, which will reduce our earnings in the period recognized.
A decline in the market value of our assets may adversely affect us, particularly in instances where we have borrowed money based on the market value of those assets. As a result, if the market value of those assets declines, the lender may require us to post additional collateral to support the loan. If we were unable to post the additional collateral, we may have to sell assets at a time when we might not otherwise have chosen to do so. A reduction in available credit may reduce our earnings and, in turn, cash available for distribution to stockholders.
Further, credit facility providers may require us to maintain a certain amount of cash reserves or to set aside unleveraged assets sufficient to maintain a specified liquidity position, which would allow us to satisfy our collateral obligations. As a result, if the market value of our investments declines, we may not be able to leverage our assets as fully as we would choose, which could reduce our return on equity. In the event that we are unable to meet these contractual obligations, our financial condition could deteriorate rapidly.
Market values of our real estate-related investments may decline for a number of reasons, such as changes in prevailing market rates, increases in defaults related to the underlying collateral, increases in voluntary prepayments for our investments that are subject to prepayment risk, widening of credit spreads and downgrades of ratings of the securities by ratings agencies.
Some of our real estate-related investments may be carried at estimated fair value as determined by us and, as a result, there may be uncertainty as to the value of these investments.
Some of our investments may be in the form of securities that are recorded at fair value but that have limited liquidity or are not publicly traded. The fair value of securities and other investments that have limited liquidity or are not publicly traded may not be readily determinable. We will estimate the fair value of these investments on a quarterly basis. Because such valuations are inherently uncertain, may fluctuate over short periods of time and may be based on numerous estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. The value of our common stock could be adversely affected if our determinations regarding the fair value of these real estate-related investments are materially higher than the values that we ultimately realize upon their disposal.
Our investments in derivatives are carried at estimated fair value as determined by us and, as a result, there may be uncertainty as to the value of these instruments.
Our investments in derivatives are recorded at fair value but have limited liquidity and are not publicly traded. The fair value of our derivatives may not be readily determinable. We will estimate the fair value of any such investments on a quarterly basis. Because such valuations are inherently uncertain, may fluctuate over short periods of time and may be based on numerous estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these investments existed. The value of our common stock could be adversely affected if our determinations regarding the fair value of these investments are materially higher than the values that we ultimately realize upon their disposal or maturity.
Risks Associated with Debt Financing
We obtain lines of credit, mortgage indebtedness and other borrowings, which increases our risk of loss due to potential foreclosure.
We obtain lines of credit and long-term financing secured by our properties and other assets. We have acquired many of our real estate 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, to fund property improvements and other capital expenditures, to pay distributions and for other purposes. In addition, we may borrow as necessary or advisable to ensure that we maintain our qualification as a REIT for 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). However, we can give our stockholders no assurance that we will be able to obtain such borrowings on satisfactory terms or at all.
If we do mortgage a property and there is a shortfall between the cash flow generated by that property and the cash flow needed to service mortgage debt on that property, then the amount of cash available for distribution to our 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’ investment in us. 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 have given and may give full or partial guarantees to lenders of mortgage or other 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 all or a part of the debt or other amounts related to the debt if it is not paid by such entity. If any mortgages contain cross-collateralization or cross-default provisions, a default on a mortgage secured by a single property could affect mortgages secured by other properties.
We may utilize repurchase agreements as a component of our financing strategy. Repurchase agreements economically resemble short-term, variable-rate financing and usually require the maintenance of specific loan-to-collateral value ratios. If the market value of the assets subject to a repurchase agreement declines, we may be required to provide additional collateral or make cash payments to maintain the required loan-to-collateral value ratios. If we are unable to provide such collateral or cash repayments, we may lose our economic interest in the underlying assets.
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 in us.
High mortgage rates or changes in underwriting standards may make it difficult for us to finance or refinance properties, which could reduce the number of properties we can acquire, our cash flow from operations and the amount of cash available for distribution to our stockholders.
If mortgage debt is unavailable at reasonable rate, we may not be able to finance the purchase of properties. If we place mortgage debt on a property, we run the risk of being unable to refinance part or all of the debt when it becomes due or of being unable to refinance on favorable terms. If interest rates are higher when we refinance properties subject to mortgage debt, our income could be reduced. We may be unable to refinance or may only be able to partly refinance properties if underwriting standards, including loan to value ratios and yield requirements, among other requirements, are more strict than when we originally financed the properties. If any of these events occurs, our cash flow could be reduced and/or we might have to pay down existing mortgages. This, in turn, would reduce cash available for distribution to our stockholders, could cause us to require additional capital and may hinder our ability to raise capital by issuing more stock or by borrowing more money.
We may use leverage in connection with any real estate investments we make, which increases the risk of loss associated with this type of investment.
We may finance the acquisition and origination of certain real estate-related investments with warehouse lines of credit and repurchase agreements. In addition, we may engage in various types of securitizations in order to finance our loan originations. Although the use of leverage may enhance returns and increase the number of investments that we can make, it may also substantially increase the risk of loss. There can be no assurance that leveraged financing will be available to us on favorable terms or that, among other factors, the terms of such financing will parallel the maturities of the underlying assets acquired. If alternative financing is not available, we may have to liquidate assets at unfavorable prices to pay off such financing. The return on our investments and cash available for distribution to our stockholders may be reduced to the extent that changes in market conditions cause the cost of our financing to increase relative to the income that we can derive from the assets we acquire.
Our debt service payments will reduce our cash available for distribution. We may not be able to meet our debt service obligations and, to the extent that we cannot, we risk the loss of some or all of our assets to foreclosure or sale to satisfy our debt obligations. If we utilize repurchase financing and if the market value of the assets subject to a repurchase agreement declines, we may be required to provide additional collateral or make cash payments to maintain the loan to collateral value ratio. If we are unable to provide such collateral or cash repayments, we may lose our economic interest in the underlying assets. Further, credit facility providers and warehouse facility providers may require us to maintain a certain amount of cash reserves or to set aside unleveraged assets sufficient to maintain a specified liquidity position that would allow us to satisfy our collateral obligations. As a result, we may not be able to leverage our assets as fully as we would choose, which could reduce our return on assets. In the event that we are unable to meet these collateral obligations, our financial condition could deteriorate rapidly.
We may not be able to access financing 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, issuances of commercial mortgage-backed securities 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 agreements 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 flow, thereby reducing cash available for distribution to our stockholders and funds available for operations as well as for future business opportunities.
Lenders may require us to enter into restrictive covenants relating to our operations, which could limit our ability to pay 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 or that prohibit us from discontinuing insurance coverage or replacing our advisor. These or other limitations would decrease our operating flexibility and our ability to achieve our operating objectives and limit our ability to pay distributions to our stockholders.
Increases in interest rates would increase the amount of our debt payments and limit our ability to pay distributions to our stockholders.
We have incurred variable rate debt and we expect that we will incur additional debt in the future. Increases in interest rates will increase the cost of that debt, which could reduce our cash flow from operations and the cash we have available for distribution to our stockholders. In addition, if we need to repay existing debt during periods of rising interest rates, we could be required to liquidate one or more of our investments at times that may not permit realization of the maximum return on such investments.
We have broad authority to incur debt and high debt levels could limit the amount of cash we have available to distribute to our stockholders and decrease the value of our stockholders’ investment in us.
We may incur debt until our total liabilities would exceed 75% of the cost of our tangible assets (before deducting depreciation orand other noncash reserves) and we may exceed this limit with the approval of the conflicts committee of our board of directors. As of December 31, 2015,2016, our borrowings and other liabilities were approximately 53%55% of both the cost (before deducting depreciation orand other noncash reserves) and book value (before deducting depreciation) of our tangible assets, respectively. High debt levels would cause us to incur higher interest charges and higher debt service payments and may also be accompanied by restrictive covenants. These factors could limit the amount of cash we have available to distribute to our stockholders and could result in a decline in the value of our stockholders’ investment in us.
Federal Income Tax Risks
Failure to qualify as a REIT would reduce our net earnings available for investment or distribution.
Our qualification as a REIT will depend upon our ability to meet requirements regarding our organization and ownership, distributions of our income, the nature and diversification of our income and assets and other tests imposed by the Internal Revenue Code. If we fail to qualify as a REIT for any taxable year after electing REIT status, we will be subject to federal income tax on our taxable income at corporate rates. In addition, we would generally be disqualified from treatment as a REIT for the four taxable years following the year in which we lost our REIT status. Losing our REIT status would reduce our net earnings available for investment or distribution to stockholders because of the additional tax liability. In addition, distributions to stockholders would no longer qualify for the dividends-paid deduction and we would no longer be required to makepay distributions. If this occurs, we might be required to borrow funds or liquidate some investments in order to pay the applicable tax.
Failure to qualify as a REIT would subject us to federal income tax, which would reduce the cash available for distribution to our stockholders.
We believe that we have operated and will continue to operate in a manner that will allow us to continue to qualify as a REIT for federal income tax purposes.purposes, commencing with the taxable year ended December 31, 2011. However, the federal income tax laws governing REITs are extremely complex, and interpretations of the federal income tax laws governing qualification as a REIT are limited. Qualifying as a REIT requires us to meet various tests regarding the nature of our assets and our income, the ownership of our outstanding stock, and the amount of our distributions on an ongoing basis. Accordingly, we cannot be certain that we will be successful in operating so we can remain qualified as a REIT. While we intend to continue to operate so that we will qualify as a REIT, given the highly complex nature of the rules governing REITs, the ongoing importance of factual determinations, including the tax treatment of certain investments we may make, and the possibility of future changes in our circumstances, no assurance can be given that we will so qualify for any particular year. If we fail to qualify as a REIT in any calendar year and we do not qualify for certain statutory relief provisions, we would be required to pay federal income tax on our taxable income. We might need to borrow money or sell assets to pay that tax. Our payment of income tax would decrease the amount of our income available for distribution to our stockholders. Furthermore, if we fail to maintain our qualification as a REIT and we do not qualify for certain statutory relief provisions, we no longer would be required to distribute substantially all of our REIT taxable income to our stockholders. Unless our failure to qualify as a REIT were excused under federal tax laws, we would be disqualified from taxation as a REIT for the four taxable years following the year during which qualification was lost.
Our stockholders may have current tax liability on distributions they elect to reinvest in our common stock.
If our stockholders participate in our dividend reinvestment plan, they will be deemed to have received, and for income tax purposes will be taxed on, the amount reinvested in shares of our common stock to the extent the amount reinvested was not a tax-free return of capital. In addition, our stockholders will be treated for tax purposes as having received an additional distribution to the extent the shares are purchased at a discount to fair market value, if any. As a result, unless our stockholders are tax-exempt entities, they may have to use funds from other sources to pay their tax liability on the value of the shares of common stock received.
Even if we qualify as a REIT for federal income tax purposes, we may be subject to federal, state, local or other tax liabilities that reduce our cash flow and our ability to makepay distributions to our stockholders.
Even if we qualify as a REIT for federal income tax purposes, we may be subject to some federal, state and local taxes on our income or property. For example:
In order to qualify as a REIT, we must distribute annually at least 90% of our REIT taxable income to our stockholders (which is determined without regard to the dividends-paid deduction or net capital gain). 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 elect to treat property that we acquire in connection with a foreclosure of a mortgage loan or certain leasehold terminations as “foreclosure property,” we may avoid the 100% tax on the gain from a resale of that property, but the income from the sale or operation of that property may be subject to corporate income tax at the highest applicable rate.
If we sell an asset, other than foreclosure property, that we hold primarily for sale to customers in the ordinary course of business, our gain would be subject to the 100% “prohibited transaction” tax unless such sale were made by one of our taxable REIT subsidiaries.
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, subject to certain adjustments and excluding any net capital gain, in order for federal corporate income tax not to apply to earnings that we distribute. To the extent that we satisfy this distribution requirement, but distribute less than 100% of our REIT taxable income, we will be subject to federal corporate income tax on our undistributed REIT taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our stockholders in a calendar year is less than a minimum amount specified under federal tax laws. We also may decide to retain net capital gain we earn from the sale or other disposition of our property and pay U.S. federal income tax directly on such income. In that event, our stockholders would be treated as if they earned that income and paid the tax on it directly. However, stockholders that are tax-exempt, such as charities or qualified pension plans, would have no benefit from their deemed payment of such tax liability unless they file U.S. federal income tax returns and thereon seek a refund of such tax. We also will be subject to corporate tax on any undistributed taxable income. We intend to make distributions to our stockholders to comply with the REIT requirements of the Internal Revenue Code.
From time to time, we may generate taxable income greater than our income for financial reporting purposes, or our taxable income may be greater than our cash flow available for distribution to stockholders (for example, where 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 these situations we could be required to borrow funds, sell investments at disadvantageous prices or find another alternative source of funds to makepay distributions sufficient to enable us to pay out enough of our taxable income to satisfy the REIT distribution requirements 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. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.
To maintain our REIT status, we may be forced to forego otherwise attractive business or investment opportunities, which may delay or hinder our ability to meet our investment objectives and reduce our stockholders’ overall return.
To qualify as a REIT, we must satisfy certain tests on an ongoing basis concerning, among other things, the sources of our income, nature of our assets and the amounts we distribute to our stockholders. We may be required to makepay 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. Compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits and reduce the value of our stockholders’ investment.
If our operating partnership fails to maintain its status as a partnership for federal income tax purposes, its income would be subject to taxation and our REIT status would be terminated.
We intend to maintain the status of our operating partnership as a partnership for federal income tax purposes. However, if the IRSInternal Revenue Service were to successfully challenge the status of our operating partnership as a partnership, it would be taxable as a corporation. In such event, this would reduce the amount of distributions that our operating partnership could make to us. This would also result in our losing REIT status and becoming subject to a corporate level tax on our own income. This would substantially reduce our cash available to pay distributions and the return on your investment. In addition, if any of the entities through which our operating partnership owns its properties, in whole or in part, loses its characterization as a partnership for federal income tax purposes, the underlying entity would become subject to taxation as a corporation, thereby reducing distributions to our operating partnership and jeopardizing our ability to maintain REIT status.
Potential characterization of distributions or gain on sale may be treated as unrelated business taxable income to tax-exempt investors.
If (i) all or a portion of our assets are subject to the rules relating to taxable mortgage pools, (ii) we are a “pension-held REIT,” (iii) a tax-exempt stockholder has incurred debt to purchase or hold our common stock, or (iv) the residual Real Estate Mortgage Investment Conduit interests, or REMICs, we buy (if any) generate “excess inclusion income,” then a portion of the distributions to and, in the case of a stockholder described in clause (iii), gains realized on the sale of common stock by such tax-exempt stockholder may be subject to federal income tax as unrelated business taxable income under the Internal Revenue Code.
The failure of a mezzanine loan to qualify as a real estate asset could adversely affect our ability to qualify as a REIT.
The Internal Revenue Service has issued Revenue Procedure 2003-65, which provides a safe harbor pursuant to which a mezzanine loan that is secured by interests in a pass-through entity will be treated by the Internal Revenue Service as a real estate asset for purposes of the REIT tests, and interest derived from such loan will be treated as qualifying mortgage interest for purposes of the REIT 75% income test. Although the Revenue Procedure provides a safe harbor on which taxpayers may rely, it does not prescribe rules of substantive tax law. We intend to make investments in loans secured by interests in pass-through entities in a manner that complies with the various requirements applicable to our qualification as a REIT. To the extent, however, that any such loans do not satisfy all of the requirements for reliance on the safe harbor set forth in the Revenue Procedure, there can be no assurance that the Internal Revenue Service will not challenge the tax treatment of such loans, which could jeopardize our ability to qualify as a REIT.
The tax on prohibited transactions will limit our ability to engage in transactions, including certain methods of securitizing mortgage loans, that 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 assets, other than foreclosure property, deemed held primarily for sale to customers in the ordinary course of business. We might be subject to this tax if we were to dispose of or securitize loans in a manner that was treated as a sale of the loans for federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans at the REIT level, and may limit the structures we utilize for our securitization transactions, even though the sales or structures might otherwise be beneficial to us.
It may be possible to reduce the impact of the prohibited transaction tax by conducting certain activities through taxable REIT subsidiaries. However, to the extent that we engage in such activities through taxable REIT subsidiaries, the income associated with such activities may be subject to full corporate income tax.
Complying with REIT requirements may force us to liquidate otherwise attractive investments.
To qualify as a REIT, we must 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 REIT real estate assets, including certain mortgage loans and residential and commercial 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 (other than government securities and qualified real estate assets) can consist of the securities of any one issuer, and no more than 25% (20% for taxable years after 2017) of the value of our total assets can be represented by securities of one or more taxable REIT subsidiaries. If we fail to comply with these requirements at the end of any calendar quarter, we must correct the failure within 30 days after the end of the calendar quarter or qualify for certain statutory relief provisions to avoid losing our REIT qualification and suffering adverse tax consequences. As a result, we may be required to liquidate from our portfolio otherwise attractive investments. These actions could have the effect of reducing our income and amounts available for distribution to our stockholders.
Liquidation of assets may jeopardize our REIT qualification.
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 repay 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% tax on any resultant gain if we sell assets that are treated as dealer property or inventory.
Characterization of any repurchase agreements we enter into to finance our investments as sales for tax purposes rather than as secured lending transactions would adversely affect our ability to qualify as a REIT.
We may enter into repurchase agreements with a variety of counterparties to achieve our desired amount of leverage for the assets in which we invest. When we enter into a repurchase agreement, we generally sell assets to our counterparty to the agreement and receive cash from the counterparty. The counterparty is obligated to resell the assets back to us at the end of the term of the transaction. We believe that for federal income tax purposes we will be treated as the owner of the assets that are the subject of repurchase agreements and that the repurchase agreements will be treated as secured lending transactions notwithstanding that such agreement may transfer record ownership of the assets to the counterparty during the term of the agreement. It is possible, however, that the Internal Revenue Service could successfully assert that we did not own these assets during the term of the repurchase agreements, in which case we could fail to qualify as a REIT if tax ownership of these assets was necessary for us to meet the income and/or asset tests.
Complying with REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Internal Revenue Code may limit our ability to hedge our assets and operations. Under these provisions, any income that we generate from transactions intended to hedge our interest rate, inflation and/or currency risks will be excluded from gross income for purposes of the REIT 75% and 95% gross income tests if the purpose of the instrument is to (i) hedge interest rate risk on liabilities incurred to carry or acquire real estate, (ii) hedge risk of currency fluctuations with respect to any item of income or gain that would be qualifying income under the REIT 75% or 95% gross income tests, or (iii) manage risk with respect to the termination of certain prior hedging transactions described in (i) and/or (ii) above and, in each case, such instrument is properly identified under applicable Treasury Regulations. Income from hedging transactions that do not meet these requirements will generally constitute nonqualifying income for purposes of both the REIT 75% and 95% gross income tests. As a result of these rules, we may have to limit our use of hedging techniques that might otherwise be advantageous, which could result in greater risks associated with interest rate or other changes than we would otherwise incur.
Ownership limitations may restrict change of control or business combination opportunities in which our stockholders might receive a premium for their shares.
In order for us to qualify as a REIT for each taxable year, no more than 50% in value of our outstanding capital stock may be owned, directly or indirectly, by five or fewer individuals during the last half of any calendar year. “Individuals” for this purpose include natural persons, and some entities such as private foundations. To preserve our REIT qualification, our charter generally prohibits any person from directly or indirectly owning more than 9.8% in value of our capital stock. This ownership limitation could have the effect of discouraging a takeover or other transaction in which our stockholders might receive a premium for their shares over the then prevailing market price or which our stockholders might believe to be otherwise in their best interests.
Our ownership of and relationship with our taxable REIT subsidiaries will be limited and a failure to comply with the limits would jeopardize our REIT status and may result in the application of a 100% excise tax.
A REIT may own up to 100% of the stock of one or more taxable REIT subsidiaries. A taxable REIT subsidiary may earn income that would not be qualifying income if earned directly by the parent REIT. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a taxable REIT subsidiary. A corporation of which a taxable REIT subsidiary directly or indirectly owns more than 35% of the voting power or value of the stock will automatically be treated as a taxable REIT subsidiary. Overall, no more than 25% (20% for taxable years after 2017) of the value of a REIT’s assets may consist of stock or securities of one or more taxable REIT subsidiaries. A domestic taxable REIT subsidiary will pay federal, state and local income tax at regular corporate rates on any income that it earns. In addition, the taxable REIT subsidiary rules limit the deductibility of interest paid or accrued by a taxable REIT subsidiary to its parent REIT to assure that the taxable REIT subsidiary is subject to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a taxable REIT subsidiary and its parent REIT that are not conducted on an arm’s-length basis. We cannot assure our stockholders that we will be able to comply with the 25% (or 20% as applicable) value limitation on ownership of taxable REIT subsidiary stock and securities on an ongoing basis so as to maintain REIT status or to avoid application of the 100% excise tax imposed on certain non-arm’s length transactions.
The ability of our board of directors to revoke our REIT qualification without stockholder approval may subject us to U.S. federal income tax and reduce distributions to our stockholders.
Our charter provides that our board of directors may revoke or otherwise terminate our REIT election, without the approval of our stockholders, if it determines that it is no longer in our best interest to continue to qualify as a REIT. While we intend to elect and qualify to be taxed as a REIT, we may not elect to be treated as a REIT or may terminate our REIT election if we determine that qualifying as a REIT is no longer in our best interests. If we cease to be a REIT, we would become subject to U.S. federal income tax on our taxable income and would no longer be required to distribute most of our taxable income to our stockholders, which may have adverse consequences on our total return to our stockholders and on the market price of our common stock.
We may be subject to adverse legislative or regulatory tax changes.
At any time, the federal income tax laws or regulations governing REITs or the administrative interpretations of those laws or regulations may be amended. We cannot predict when or if any new federal income tax law, regulation or administrative interpretation, or any amendment to any existing federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation or interpretation may take effect retroactively. We and our stockholders could be adversely affected by any such change in, or any new, federal income tax law, regulation or administrative interpretation. You are urged to consult with your tax advisor with respect to the impact of recent legislation on your investment in our shares and the status of legislative, regulatory or administrative developments and proposals and their potential effect on an investment in our shares.
Although REITs generally receive better tax treatment than entities taxed as regular corporations, it is possible that future legislation would result in a REIT having fewer tax advantages, and it could become more advantageous for a company that invests in real estate to elect to be treated for U.S. federal income tax purposes as a corporation. As a result, our charter provides our board of directors with the power, under certain circumstances, to revoke or otherwise terminate our REIT election and cause us to be taxed as a regular corporation, without the vote of our stockholders. Our board of directors has fiduciary duties to us and our stockholders and could only cause such changes in our tax treatment if it determines in good faith that such changes are in the best interest of our stockholders.
Dividends payable by REITs do not qualify for the reduced tax rates.
In general, the maximum tax rate for dividends payable to domestic stockholders that are individuals, trusts and estates is 20%. Dividends payable by REITs, however, are generally not eligible for this reduced rate. While this tax treatment does not adversely affect the taxation of REITs or dividends paid by REITs, the more favorable rates applicable to regular corporate dividends could cause investors who are individuals, trusts or estates to perceive investments in REITs to be relatively less attractive than investments in stock of non‑REIT corporations that pay dividends, which could adversely affect the value of the stock of REITs, including our common stock.
Qualifying as a REIT involves highly technical and complex provisions of the Internal Revenue Code.
Qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which only limited judicial and administrative authorities exist. Even a technical or inadvertent violation could jeopardize our REIT qualification. 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. In addition, our ability to satisfy the requirements to qualify as a REIT depends in part on the actions of third parties over which we have no control or only limited influence, including in cases where we own an equity interest in an entity that is classified as a partnership for U.S. federal income tax purposes.
The taxation of distributions to our stockholders can be complex; however, distributions that we make to our stockholders generally will be taxable as ordinary income, which may reduce your anticipated return from an investment in us.
Distributions that we make to our taxable stockholders to the extent of our current and accumulated earnings and profits (and not designated as capital gain dividends or qualified dividend income) generally will be taxable as ordinary income. However, a portion of our distributions may (i) be designated by us as capital gain dividends generally taxable as long-term capital gain to the extent that they are attributable to net capital gain recognized by us, (ii) be designated by us as qualified dividend income generally to the extent they are attributable to dividends we receive from non-REIT corporations, such as our taxable REIT subsidiaries, or (iii) constitute a return of capital generally to the extent that they exceed our current and accumulated earnings and profits as determined for U.S. federal income tax purposes. A return of capital distribution is not taxable, but has the effect of reducing the basis of a stockholder’s investment in our common stock.
We may be required to pay some taxes due to actions of a taxable REIT subsidiary which would reduce our cash available for distribution to you.
Any net taxable income earned directly by a taxable REIT subsidiary, or through entities that are disregarded for federal income tax purposes as entities separate from our taxable REIT subsidiaries, will be subject to federal and possibly state corporate income tax. In this regard, several provisions of the laws applicable to REITs and their subsidiaries ensure that a taxable REIT subsidiary will be subject to an appropriate level of federal income taxation. For example, a taxable REIT subsidiary is limited in its ability to deduct certain interest payments made to an affiliated REIT. In addition, the REIT has to pay a 100% penalty tax on some payments that it receives or on some deductions taken by a taxable REIT subsidiary if the economic arrangements between the REIT, the REIT's customers, and the taxable REIT subsidiary are not comparable to similar arrangements between unrelated parties. Finally, some state and local jurisdictions may tax some of our income even though as a REIT we are not subject to federal income tax on that income because not all states and localities follow the federal income tax treatment of REITs. To the extent that we and our affiliates are required to pay federal, state and local taxes, we will have less cash available for distributions to you.
Investments in other REITs and real estate partnerships could subject us to the tax risks associated with the tax status of such entities.
We may invest in the securities of other REITs and real estate partnerships. Such investments are subject to the risk that any such REIT or partnership may fail to satisfy the requirements to qualify as a REIT or a partnership, as the case may be, in any given taxable year. In the case of a REIT, such failure would subject such entity to taxation as a corporation, may require such REIT to incur indebtedness to pay its tax liabilities, may reduce its ability to make distributions to us, and may render it ineligible to elect REIT status prior to the fifth taxable year following the year in which it fails to so qualify. In the case of a partnership, such failure could subject such partnership to an entity level tax and reduce the entity’s ability to make distributions to us. In addition, such failures could, depending on the circumstances, jeopardize our ability to qualify as a REIT.
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 Internal Revenue Code (such as an individual retirement account (“IRA”)) fails to meet the fiduciary and other standards under ERISA or the Internal Revenue 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 Internal Revenue 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 Internal Revenue 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 Internal Revenue 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 Internal Revenue 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 Internal Revenue Code.
With respect to the annual valuation requirements described above, we will provide an estimated value for our sharescommon stock annually. We can make no claim whether such estimated value per share will or will not satisfy the applicable annual valuation requirements under ERISA and the Internal Revenue Code. The Department of Labor or the Internal Revenue Service may determine that a plan fiduciary or an IRA custodian is required to take further steps to determine the value of our common stock. In the absence of an appropriate determination of value, a plan fiduciary or an IRA custodian may be subject to damages, penalties or other sanctions. For information regarding our 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 Annual Report on Form 10-K.
Failure to satisfy the fiduciary standards of conduct and other applicable requirements of ERISA and the Internal Revenue Code may result in the imposition of civil and criminal penalties and could subject the fiduciary to claims for damages or for equitable remedies, including liability for investment losses. In addition, if an investment in our shares constitutes a prohibited transaction under ERISA or the Internal Revenue 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, our advisor and we may be exposed to liabilities under Title I of ERISA and the Internal Revenue 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 Internal Revenue Code, may be applicable, and there may be liability under these and other provisions of ERISA and the Internal Revenue 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 we or our advisor are exposed to liability under ERISA or the Internal Revenue Code, our performance and results of operations could be adversely affected. Stockholders should consult with their legal and other advisors concerning the impact of ERISA and the Internal Revenue Code on their investment and our performance.
The Department of Labor has issued a final regulation revising the definition of “fiduciary” under ERISA and the Internal Revenue Code, which may affect the marketing of investments in our shares.
On April 8, 2016, the Department of Labor issued a final regulation relating to the definition of a fiduciary under ERISA and Section 4975 of the Internal Revenue Code. The final regulation broadens the definition of fiduciary and is accompanied by new and revised prohibited transaction exemptions relating to investments by IRAs and benefit plans. The final regulation and the related exemptions will become applicable for investment transactions on and after April 10, 2017 (subject to delay in the application of the regulation), but generally should not apply to purchases of our shares before that date. The final regulation and the accompanying exemptions are complex, and benefit plan fiduciaries and the beneficial owners of IRAs are urged to consult with their own advisors regarding this development.
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ITEM 1B. | UNRESOLVED STAFF COMMENTS |
We have no unresolved staff comments.
As of December 31, 20152016, we owned 2728 office properties and one mixed-use office/retail property encompassing 10.611.0 million rentable square feet in the aggregate that were collectively 92%94% occupied with a weighted-average remaining lease term of 5.14.7 years. In addition, we had entered into the Hardware Village Joint Venture to develop and subsequently operate Hardware Village, which is currently under construction. The following table provides summary information regarding the properties owned by us as of December 31, 20152016:
| | Property Location of Property | | Date Acquired | | Property Type | | Rentable Square Feet | | Total Real Estate at Cost (in thousands) | | Annualized Base Rent (1) (in thousands) | | Average Annualized Base Rent per Square Foot (2) | | Average Remaining Lease Term in Years | | % of Total Assets | | Occupancy | | Date Acquired | | Property Type | | Rentable Square Feet | | Total Real Estate at Cost (1) (in thousands) | | Annualized Base Rent (2) (in thousands) | | Average Annualized Base Rent per Square Foot (3) | | Average Remaining Lease Term in Years | | % of Total Assets | | Occupancy |
Domain Gateway Austin, TX | | 09/29/2011 | | Office | | 173,962 |
| | $ | 47,373 |
| | $ | 3,716 |
| | $ | 21.36 |
| | 3.7 |
| | 1.2 | % | | 100.0 | % | | 09/29/2011 | | Office | | 173,962 |
| | $ | 47,373 |
| | $ | 3,716 |
| | $ | 21.36 |
| | 2.7 |
| | 1.1 | % | | 100.0 | % |
Town Center Plano, TX | | 03/27/2012 | | Office | | 522,043 |
| | 117,940 |
| | 11,824 |
| | 24.52 |
| | 3.8 |
| | 3.1 | % | | 92.4 | % | | 03/27/2012 | | Office | | 522,043 |
| | 117,254 |
| | 12,685 |
| | 24.37 |
| | 3.4 |
| | 3.0 | % | | 99.7 | % |
McEwen Building Franklin, TN | | 04/30/2012 | | Office | | 175,262 |
| | 40,356 |
| | 4,471 |
| | 25.85 |
| | 2.6 |
| | 1.0 | % | | 98.7 | % | | 04/30/2012 | | Office | | 175,262 |
| | 38,534 |
| | 4,081 |
| | 27.59 |
| | 3.0 |
| | 1.0 | % | | 84.4 | % |
Gateway Tech Center Salt Lake City, UT | | 05/09/2012 | | Office | | 199,361 |
| | 30,405 |
| | 4,689 |
| | 23.58 |
| | 3.7 |
| | 0.8 | % | | 99.8 | % | | 05/09/2012 | | Office | | 199,361 |
| | 24,935 |
| | 4,764 |
| | 23.96 |
| | 3.0 |
| | 0.6 | % | | 99.8 | % |
Tower on Lake Carolyn Irving, TX | | 12/21/2012 | | Office | | 364,336 |
| | 50,533 |
| | 6,949 |
| | 21.60 |
| | 3.3 |
| | 1.3 | % | | 88.3 | % | | 12/21/2012 | | Office | | 364,336 |
| | 52,222 |
| | 7,623 |
| | 23.54 |
| | 4.0 |
| | 1.3 | % | | 88.9 | % |
RBC Plaza Minneapolis, MN | | 01/31/2013 | | Office | | 709,690 |
| | 148,656 |
| | 10,837 |
| | 17.17 |
| | 7.0 |
| | 4.2 | % | | 88.9 | % | | 01/31/2013 | | Office | | 709,690 |
| | 150,579 |
| | 11,376 |
| | 17.32 |
| | 6.3 |
| | 3.9 | % | | 92.5 | % |
One Washingtonian Center Gaithersburg, MD | | 06/19/2013 | | Office | | 313,854 |
| | 90,065 |
| | 9,016 |
| | 30.92 |
| | 7.5 |
| | 2.6 | % | | 92.9 | % | | 06/19/2013 | | Office | | 314,175 |
| | 90,211 |
| | 9,646 |
| | 31.30 |
| | 7.0 |
| | 2.5 | % | | 98.1 | % |
Preston Commons Dallas, TX | | 06/19/2013 | | Office | | 427,799 |
| | 116,978 |
| | 11,274 |
| | 28.15 |
| | 3.4 |
| | 3.3 | % | | 93.6 | % | | 06/19/2013 | | Office | | 427,799 |
| | 115,767 |
| | 11,205 |
| | 27.45 |
| | 3.0 |
| | 3.1 | % | | 95.4 | % |
Sterling Plaza Dallas, TX | | 06/19/2013 | | Office | | 313,609 |
| | 79,253 |
| | 7,133 |
| | 25.72 |
| | 3.3 |
| | 2.2 | % | | 88.4 | % | | 06/19/2013 | | Office | | 313,609 |
| | 79,333 |
| | 7,333 |
| | 27.36 |
| | 3.1 |
| | 2.2 | % | | 85.5 | % |
201 Spear Street San Francisco, CA | | 12/03/2013 | | Office | | 252,591 |
| | 136,067 |
| | 11,687 |
| | 51.44 |
| | 3.2 |
| | 4.1 | % | | 89.9 | % | | 12/03/2013 | | Office | | 252,591 |
| | 135,751 |
| | 13,856 |
| | 56.49 |
| | 3.1 |
| | 3.9 | % | | 97.1 | % |
500 West Madison Chicago, Illinois | | 12/16/2013 | | Office | | 1,457,724 |
| | 440,738 |
| | 36,011 |
| | 25.55 |
| | 4.5 |
| | 12.7 | % | | 96.7 | % | |
500 West Madison Chicago, IL | | | 12/16/2013 | | Office | | 1,457,724 |
| | 440,172 |
| | 35,373 |
| | 25.29 |
| | 4.4 |
| | 12.1 | % | | 95.9 | % |
222 Main Salt Lake City, UT | | 02/27/2014 | | Office | | 426,657 |
| | 164,997 |
| | 14,495 |
| | 35.96 |
| | 7.9 |
| | 4.9 | % | | 94.5 | % | | 02/27/2014 | | Office | | 426,657 |
| | 165,583 |
| | 15,095 |
| | 36.05 |
| | 6.9 |
| | 4.6 | % | | 98.1 | % |
Anchor Centre Phoenix, AZ | | 05/22/2014 | | Office | | 333,014 |
| | 91,698 |
| | 7,642 |
| | 26.88 |
| | 4.4 |
| | 2.7 | % | | 85.4 | % | | 05/22/2014 | | Office | | 333,014 |
| | 92,721 |
| | 7,991 |
| | 26.43 |
| | 4.7 |
| | 2.6 | % | | 90.8 | % |
171 17th Street Atlanta, GA | | 08/25/2014 | | Office | | 510,161 |
| | 129,788 |
| | 11,238 |
| | 24.46 |
| | 5.7 |
| | 3.9 | % | | 90.1 | % | | 08/25/2014 | | Office | | 510,255 |
| | 131,223 |
| | 11,169 |
| | 24.26 |
| | 5.4 |
| | 3.7 | % | | 90.2 | % |
Rocklin Corporate Center Rocklin, CA | | 11/06/2014 | | Office | | 220,020 |
| | 33,049 |
| | 4,523 |
| | 21.41 |
| | 5.2 |
| | 1.0 | % | | 96.0 | % | | 11/06/2014 | | Office | | 220,020 |
| | 33,252 |
| | 4,523 |
| | 21.41 |
| | 4.2 |
| | 0.9 | % | | 96.0 | % |
Reston Square Reston, VA | | 12/03/2014 | | Office | | 139,071 |
| | 46,530 |
| | 5,134 |
| | 39.45 |
| | 6.9 |
| | 1.4 | % | | 93.6 | % | | 12/03/2014 | | Office | | 139,071 |
| | 46,627 |
| | 5,135 |
| | 39.45 |
| | 5.8 |
| | 1.3 | % | | 93.6 | % |
Ten Almaden San Jose, CA | | 12/05/2014 | | Office | | 309,255 |
| | 119,366 |
| | 11,315 |
| | 37.59 |
| | 3.8 |
| | 3.6 | % | | 97.3 | % | | 12/05/2014 | | Office | | 309,255 |
| | 121,716 |
| | 11,204 |
| | 36.23 |
| | 2.8 |
| | 3.5 | % | | 100.0 | % |
Towers at Emeryville Emeryville, CA | | 12/23/2014 | | Office | | 815,018 |
| | 254,357 |
| | 25,542 |
| | 34.81 |
| | 3.4 |
| | 7.7 | % | | 90.0 | % | | 12/23/2014 | | Office | | 815,018 |
| | 261,054 |
| | 26,312 |
| | 35.81 |
| | 2.7 |
| | 7.5 | % | | 90.1 | % |
101 South Hanley St. Louis, MO | | 12/24/2014 | | Office | | 360,505 |
| | 63,816 |
| | 7,393 |
| | 24.79 |
| | 5.3 |
| | 1.9 | % | | 82.7 | % | | 12/24/2014 | | Office | | 360,505 |
| | 67,526 |
| | 8,486 |
| | 24.80 |
| | 5.4 |
| | 1.9 | % | | 94.9 | % |
3003 Washington Boulevard Arlington, VA | | 12/30/2014 | | Office | | 210,804 |
| | 150,763 |
| | 12,436 |
| | 60.06 |
| | 12.0 |
| | 4.7 | % | | 98.2 | % | | 12/30/2014 | | Office | | 210,804 |
| | 151,334 |
| | 12,355 |
| | 59.50 |
| | 11.1 |
| | 4.4 | % | | 98.5 | % |
Village Center Station Greenwood Village, CO | | 05/20/2015 | | Office | | 234,915 |
| | 78,014 |
| | 5,890 |
| | 25.07 |
| | 4.4 |
| | 2.4 | % | | 100.0 | % | | 05/20/2015 | | Office | | 234,915 |
| | 78,039 |
| | 5,891 |
| | 25.08 |
| | 3.6 |
| | 2.3 | % | | 100.0 | % |
Park Place Village Leawood, KS | | 06/18/2015 | | Office/Retail | | 483,054 |
| | 128,685 |
| | 13,782 |
| | 29.72 |
| | 6.6 |
| | 4.0 | % | | 96.0 | % | | 06/18/2015 | | Office/Retail | | 483,054 |
| | 129,509 |
| | 13,904 |
| | 29.80 |
| | 6.7 |
| | 3.8 | % | | 96.6 | % |
201 17th Street Atlanta, GA | | 06/23/2015 | | Office | | 355,870 |
| | 95,465 |
| | 7,018 |
| | 23.68 |
| | 6.8 |
| | 3.0 | % | | 83.3 | % | | 06/23/2015 | | Office | | 355,870 |
| | 103,416 |
| | 9,818 |
| | 28.34 |
| | 6.5 |
| | 3.0 | % | | 97.3 | % |
Promenade I & II at Eilan San Antonio, TX | | 07/14/2015 | | Office | | 205,726 |
| | 62,624 |
| | 5,066 |
| | 25.09 |
| | 5.1 |
| | 2.0 | % | | 98.2 | % | | 07/14/2015 | | Office | | 205,773 |
| | 62,471 |
| | 4,142 |
| | 21.83 |
| | 5.0 |
| | 1.8 | % | | 92.2 | % |
CrossPoint at Valley Forge Wayne, PA | | 08/18/2015 | | Office | | 272,360 |
| | 89,583 |
| | 8,310 |
| | 32.23 |
| | 8.3 |
| | 2.8 | % | | 94.7 | % | | 08/18/2015 | | Office | | 272,360 |
| | 90,041 |
| | 8,684 |
| | 32.30 |
| | 7.3 |
| | 2.7 | % | | 98.7 | % |
515 Congress Austin, TX | | 08/31/2015 | | Office | | 258,176 |
| | 114,318 |
| | 6,268 |
| | 25.21 |
| | 3.0 |
| | 3.6 | % | | 96.3 | % | | 08/31/2015 | | Office | | 263,058 |
| | 116,357 |
| | 6,564 |
| | 26.01 |
| | 2.8 |
| | 3.4 | % | | 95.9 | % |
The Almaden San Jose, CA | | 09/23/2015 | | Office | | 416,126 |
| | 159,122 |
| | 10,804 |
| | 29.28 |
| | 4.0 |
| | 5.0 | % | | 88.7 | % | | 09/23/2015 | | Office | | 416,126 |
| | 162,745 |
| | 12,101 |
| | 31.91 |
| | 4.1 |
| | 4.9 | % | | 91.1 | % |
3001 Washington Boulevard Arlington, VA | | 11/06/2015 | | Office | | 94,837 |
| | 53,616 |
| | — |
| | — |
| | — |
| | 1.7 | % | | 0.0% (3) |
| | 11/06/2015 | | Office | | 94,837 |
| | 54,674 |
| | 1,900 |
| | 56.99 |
| | 9.8 |
| | 1.7 | % | | 35.2 | % |
Carillon Charlotte, NC | | | 01/15/2016 | | Office | | 488,243 |
| | 151,377 |
| | 11,237 |
| | 25.20 |
| | 4.6 |
| | 4.6 | % | | 91.4 | % |
Hardware Village Salt Lake City, UT (4) | | | 08/26/2016 | | Development/Apartment | | N/A | | 21,853 |
| | N/A | | N/A | | N/A | | 0.7 | % | | N/A |
| | 10,555,800 |
| | $ | 3,134,155 |
| | $ | 274,463 |
| | $ | 35.30 |
| | 5.1 |
| | | | 91.8 | % | | 11,049,387 |
| | $ | 3,333,649 |
| | $ | 298,169 |
| | $ | 28.71 |
| | 4.7 |
| | | | 94.0 | % |
_____________________
(1) Total real estate at cost represents the total cost of real estate net of write-offs of fully depreciated/amortized assets.
(2) Annualized base rent represents annualized contractual base rental income as of December 31, 20152016, adjusted to straight-line any contractual tenant concessions (including free rent), rent increases and rent decreases from the lease’s inception through the balance of the lease term.
(2)(3) Average annualized base rent per square foot is calculated as the annualized base rent divided by the leased square feet.
(3)(4) AsOn August 26, 2016, we entered into the Hardware Village Joint Venture to participate in the development and subsequent operation of March 7, 2016,Hardware Village. We own a 99.24% equity interest in the property was 31% leased.joint venture.
Portfolio Lease Expirations
The following table sets forth a schedule of expiring leases for our real estate portfolio by square footage and by annualized base rent as of December 31, 20152016:
| | Year of Expiration | | Number of Leases Expiring | | Annualized Base Rent Expiring (1) (in thousands) | | % of Portfolio Annualized Base Rent Expiring | | Leased Square Feet Expiring | | % of Portfolio Leased Square Feet Expiring | | Number of Leases Expiring | | Annualized Base Rent Expiring (1) (in thousands) | | % of Portfolio Annualized Base Rent Expiring | | Leased Square Feet Expiring | | % of Portfolio Leased Square Feet Expiring |
Month to Month | | 37 |
| | $ | 3,157 |
| | 1.2 | % | | 232,591 |
| | 2.4 | % | | 44 |
| | $ | 4,046 |
| | 1.4 | % | | 296,289 |
| | 2.7 | % |
2016 | | 121 |
| | 21,544 |
| | 7.9 | % | | 781,860 |
| | 8.1 | % | |
2017 | | 145 |
| | 27,002 |
| | 9.8 | % | | 942,941 |
| | 9.7 | % | | 155 |
| | 28,657 |
| | 9.6 | % | | 992,973 |
| | 9.6 | % |
2018 | | 140 |
| | 26,662 |
| | 9.7 | % | | 895,071 |
| | 9.2 | % | | 143 |
| | 25,587 |
| | 8.6 | % | | 883,500 |
| | 8.5 | % |
2019 | | 112 |
| | 36,738 |
| | 13.4 | % | | 1,336,776 |
| | 13.8 | % | | 150 |
| | 44,545 |
| | 14.9 | % | | 1,576,457 |
| | 15.2 | % |
2020 | | 99 |
| | 30,973 |
| | 11.3 | % | | 1,153,345 |
| | 11.9 | % | | 111 |
| | 30,610 |
| | 10.3 | % | | 1,163,228 |
| | 11.2 | % |
2021 | | 49 |
| | 19,617 |
| | 7.1 | % | | 784,035 |
| | 8.1 | % | | 106 |
| | 28,866 |
| | 9.7 | % | | 1,108,617 |
| | 10.7 | % |
2022 | | 58 |
| | 27,196 |
| | 9.9 | % | | 873,863 |
| | 9.0 | % | | 77 |
| | 33,273 |
| | 11.2 | % | | 1,069,369 |
| | 10.3 | % |
2023 | | 32 |
| | 20,289 |
| | 7.4 | % | | 760,649 |
| | 7.9 | % | | 41 |
| | 26,546 |
| | 8.9 | % | | 940,310 |
| | 9.1 | % |
2024 | | 33 |
| | 17,374 |
| | 6.3 | % | | 589,863 |
| | 6.1 | % | | 37 |
| | 18,920 |
| | 6.3 | % | | 649,106 |
| | 6.3 | % |
2025 | | 26 |
| | 22,555 |
| | 8.2 | % | | 666,824 |
| | 6.9 | % | | 26 |
| | 23,170 |
| | 7.8 | % | | 690,809 |
| | 6.7 | % |
2026 | | | 26 |
| | 13,159 |
| | 4.4 | % | | 435,465 |
| | 4.2 | % |
Thereafter | | 21 |
| | 21,356 |
| | 7.8 | % | | 669,616 |
| | 6.9 | % | | 19 |
| | 20,790 |
| | 6.9 | % | | 577,741 |
| | 5.5 | % |
Total | | 873 |
| | $ | 274,463 |
| | 100.0 | % | | 9,687,434 |
| | 100.0 | % | | 935 |
| | $ | 298,169 |
| | 100.0 | % | | 10,383,864 |
| | 100.0 | % |
_____________________
(1) Annualized base rent represents annualized contractual base rental income as of December 31, 20152016, adjusted to straight-line any contractual tenant concessions (including free rent), rent increases and rent decreases from the lease’s inception through the balance of the lease term.
As of December 31, 20152016, our portfolio’s highest tenant industry concentration (greater than 10% of annualized base rent) was as follows:
| | Industry | | Number of Tenants | | Annualized Base Rent (1)(in thousands) | | Percentage of Annualized Base Rent | | Number of Tenants | | Annualized Base Rent(1) (in thousands) | | Percentage of Annualized Base Rent |
Finance | | 151 | | $ | 57,661 |
| | 21.0 | % | | 170 | | $ | 67,084 |
| | 22.5 | % |
_____________________For more information about our real estate portfolio, see Part I, Item 1, “Business.”
From time to time, we are party to legal proceedings that arise in the ordinary course of our business. Management is not aware of any legal proceedings of which the outcome is reasonably likely to have a material adverse effect on our results of operations or financial condition, nor are we aware of any such legal proceedings contemplated by government authorities.
Not applicable.
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 using different assumptions and estimates could derive a different estimated value per share of our common stock, and this difference could be significant. The estimated value per share is not audited and does not represent the fair value of our assets less the fair value of our liabilities according to U.S. generally accepted accounting principles (“GAAP”), nor does it represent a liquidation value of our assets and liabilities or the price at which our shares of common stock would trade on a national securities exchange. The estimated value per share does not reflect a discount for the fact that we are externally managed, nor does it reflect a real estate portfolio premium/discount versus the sum of the individual property values. The estimated value per share also does not take into account estimated disposition costs and fees for real estate properties, debt prepayment penalties that could apply upon the prepayment of certain of our debt obligations, the impact of restrictions on the assumption of debt or swap breakage fees that may be incurred upon the termination of certain of our swaps prior to expiration. In addition, theThe estimated value per share does not take into consideration acquisition-related costs and financing costs related to any future acquisitions. As of December 8, 2015,9, 2016, we had no potentially dilutive securities outstanding that would impact the estimated value per share of our common stock.
Our estimated value per share takes into consideration any potential liability related to a subordinated participation feein cash flows our advisor is entitled to upon meeting certain stockholder return thresholds in accordance with the advisory agreement. For purposes of determining the estimated value per share, our advisor calculated the potential liability related to this incentive fee based on a hypothetical liquidation of the assets and liabilities at their estimated fair values, after considering the impact of any potential closing costs and fees related to the disposition of real estate properties, and determined that there would be no liability related to the subordinated participation fee.in cash flows.
Our goal for the valuation was to arrive at a reasonable and supportable estimated value per share, using a process that was designed to be in compliance with the IPA Valuation Guidelines and using what we and our advisor deemed to be appropriate valuation methodologies and assumptions. The following is a summary of the valuation and appraisal methodologies, assumptions and estimates used to value our assets and liabilities:
Duff & Phelps collected all reasonably available material information that it deemed relevant in appraising the Appraised Properties. Duff & Phelps obtained property-level information from our advisor, including (i) property historical and projected operating revenues and expenses; (ii) property lease agreements; and (iii) information regarding recent or planned capital expenditures. Duff & Phelps reviewed and relied in part on the property-level information provided by our advisor and considered this information in light of its knowledge of each property’s specific market conditions.
For more information with respect to our distributions paid, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Distributions.”
Distributions for these periods are calculated based on stockholders of record each day during these periods at a rate of $0.00178082 per share per day and equal a daily amount that, if paid each day for a 365-day period, would equal a 6.47%6.11% annualized rate based on the current estimated value per share of $10.04.$10.63.
Use of Proceeds from Sales of Registered Securities and Unregistered Sales of Equity Securities
We have a share redemption program that may enable stockholders to sell their shares to us in limited circumstances. The restrictions of our share redemption program will severely limit our stockholders’ ability to sell their shares should they require liquidity and will limit our stockholders’ ability to recover the value they invested in our common stock.stock or recover an amount equal to or greater than our estimated value per share.
There are several limitations on our ability to redeem shares under our share redemption program:
During any calendar year, we may redeem only the number of shares that we could purchase with the amount of net proceeds from the sale of shares under our dividend reinvestment plan during the prior calendar year. Notwithstanding anything contained in our share redemption program to the contrary, we may increase or decrease the funding available for the redemption of shares pursuant to the program upon ten business days’ notice to our stockholders. 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 CommissionSEC or (b) in a separate mailing to our stockholders.
During any calendar year, we may redeem no more than 5% of the weighted-average number of shares outstanding during the prior calendar year.
We have no obligation to redeem shares if the redemption 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.
For a stockholder’s shares to be eligible for redemption in a given month, the administrator must receive a written redemption request from the stockholder or from an authorized representative of the stockholder setting forth the number of shares requested to be redeemed at least five business days before the redemption date. If we cannot redeem all shares presented for redemption in any month because of the limitations on redemptions set forth in our share redemption program, then we will honor redemption requests on a pro rata basis, except that if a pro rata redemption would result in a stockholder owning less than the minimum purchase requirement described in our currently effective, or the most recently effective, registration statement, as such registration statement has been amended or supplemented, then we would redeem all of such stockholder’s shares.
If we do not completely satisfy a redemption request on a redemption date because the program administrator did not receive the request in time, because of the limitations on redemptions set forth in our share redemption program or because of a suspension of our share redemption program, then we will treat the unsatisfied portion of the redemption request as a request for redemption at the next redemption date funds are available for redemption, unless the redemption request is withdrawn. Any stockholder can withdraw a redemption request by sending written notice to the program administrator, provided such notice is received at least five business days before the redemption date.
For those shares held by the redeeming stockholder for at least one year, 92.5% of our most recent estimated value per share as of the applicable redemption date;
For those shares held by the redeeming stockholder for at least two years, 95.0% of our most recent estimated value per share as of the applicable redemption date;
For those shares held by the redeeming stockholder for at least three years, 97.5% of our most recent estimated value per share as of the applicable redemption date; and
For those shares held by the redeeming stockholder for at least four years, 100% of our most recent estimated value per share as of the applicable redemption date.
For purposes of determining the time period a redeeming stockholder has held each share, the time period begins as of the date the stockholder acquired the share; provided, that shares purchased by the redeeming stockholder pursuant to our dividend reinvestment plan will be deemed to have been acquired on the same date as the initial share to which the dividend reinvestment plan shares relate. The date of the share’s original issuance by us is not determinative. In addition, as described above, the shares owned by a stockholder may be redeemed at different prices depending on how long the stockholder has held each share submitted for redemption.
During the year ended December 31, 2015,2016, we fulfilled all redemption requests eligible for redemption under our share redemption program and received in good order andorder. We funded redemptions under our share redemption program with the net proceeds from our dividend reinvestment plan. We redeemed shares pursuant to our share redemption program as follows:
|
| | | | | | | | | |
Month | | Total Number of Shares Redeemed (1) | | Average Price Paid Per Share (2) | | Approximate Dollar Value of Shares Available That May Yet Be Redeemed Under the Program |
January 2015 | | 39,402 |
| | $ | 9.66 |
| | (3) |
February 2015 | | 61,827 |
| | $ | 9.96 |
| | (3) |
March 2015 | | 82,638 |
| | $ | 9.59 |
| | (3) |
April 2015 | | 43,052 |
| | $ | 9.53 |
| | (3) |
May 2015 | | 70,658 |
| | $ | 9.66 |
| | (3) |
June 2015 | | 69,828 |
| | $ | 10.12 |
| | (3) |
July 2015 | | 76,599 |
| | $ | 9.68 |
| | (3) |
August 2015 | | 67,050 |
| | $ | 9.64 |
| | (3) |
September 2015 | | 130,796 |
| | $ | 9.81 |
| | (3) |
October 2015 | | 149,551 |
| | $ | 9.59 |
| | (3) |
November 2015 | | 132,635 |
| | $ | 9.83 |
| | (3) |
December 2015 | | 161,700 |
| | $ | 9.85 |
| | (3) |
Total | | 1,085,736 |
| | | | |
|
| | | | | | | | | |
Month | | Total Number of Shares Redeemed (1) | | Average Price Paid Per Share (2) | | Approximate Dollar Value of Shares Available That May Yet Be Redeemed Under the Program |
January 2016 | | 151,856 |
| | $ | 9.67 |
| | (3) |
February 2016 | | 124,749 |
| | $ | 9.71 |
| | (3) |
March 2016 | | 194,195 |
| | $ | 9.74 |
| | (3) |
April 2016 | | 176,038 |
| | $ | 9.63 |
| | (3) |
May 2016 | | 249,568 |
| | $ | 9.78 |
| | (3) |
June 2016 | | 373,657 |
| | $ | 9.69 |
| | (3) |
July 2016 | | 512,961 |
| | $ | 9.76 |
| | (3) |
August 2016 | | 586,058 |
| | $ | 9.85 |
| | (3) |
September 2016 | | 308,830 |
| | $ | 9.81 |
| | (3) |
October 2016 | | 322,764 |
| | $ | 9.88 |
| | (3) |
November 2016 | | 251,370 |
| | $ | 9.82 |
| | (3) |
December 2016 | | 286,003 |
| | $ | 10.36 |
| | (3) |
Total | | 3,538,049 |
| | | | |
_____________________(1) We announced the adoption and commencement of the program on October 14, 2010. We announced amendments to the program on March 8, 2013 (which amendment became effective on April 7, 2013) and on March 7, 2014 (which amendment became effective on April 6, 2014).
(2) The prices at which we redeem shares under the program are as set forth above.
(3) We limit the dollar value of shares that may be redeemed under the program as described above. One of these limitations is that during each calendar year, our share redemption program limits the number of shares we may redeem to those that we could purchase with the amount of the net proceeds from the issuancesale of shares under our dividend reinvestment plan during the prior calendar year. However, we may increase or decrease the funding available for the redemption of shares upon ten business daysdays’ notice to our stockholders. In 2014,2015, our net proceeds from the dividend reinvestment plan were $29.3$55.4 million. During the year ended December 31, 2015,2016, we redeemed $10.6$34.8 million of shares of common stock. Based on the amount of net proceeds raised from the sale of shares under our dividend reinvestment plan during 2015,2016, we have $55.4$61.9 million available for redemptions of shares eligible for redemption in 2016.2017.
| |
ITEM 6. | SELECTED FINANCIAL DATA |
The following selected financial data as of and for the years ended December 31, 20152016, 2015, 2014, 2013 2012 and 20112012 should be read in conjunction with the accompanying consolidated financial statements and related notes thereto and Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (in thousands, except share and per share amounts):
| | | | December 31, | | December 31, |
| | 2015 | | 2014 | | 2013 | | 2012 | | 2011 | | 2016 | | 2015 | | 2014 | | 2013 | | 2012 |
Balance sheet data | | | | | | | | | | | | | | | | | | | | |
Total real estate and real estate-related investments, net | | $ | 2,933,721 |
| | $ | 2,217,090 |
| | $ | 1,247,319 |
| | $ | 318,661 |
| | $ | 92,639 |
| | $ | 2,988,855 |
| | $ | 2,933,721 |
| | $ | 2,217,090 |
| | $ | 1,247,319 |
| | $ | 318,661 |
|
Total assets | | 3,133,874 |
| | 2,375,288 |
| | 1,305,447 |
| | 348,481 |
| | 130,616 |
| | 3,182,676 |
| | 3,133,874 |
| | 2,375,288 |
| | 1,305,447 |
| | 348,481 |
|
Notes payable, net | | 1,640,654 |
| | 1,311,751 |
| | 724,743 |
| | 118,896 |
| | 42,008 |
| | 1,783,468 |
| | 1,640,654 |
| | 1,311,751 |
| | 724,743 |
| | 118,896 |
|
Total liabilities | | 1,791,675 |
| | 1,412,863 |
| | 790,216 |
| | 136,456 |
| | 45,605 |
| | 1,927,429 |
| | 1,791,675 |
| | 1,412,863 |
| | 790,216 |
| | 136,456 |
|
Redeemable common stock | | 55,367 |
| | 29,329 |
| | 12,414 |
| | 4,804 |
| | 740 |
| | 61,871 |
| | 55,367 |
| | 29,329 |
| | 12,414 |
| | 4,804 |
|
Total stockholders’ equity | | 1,286,832 |
| | 933,096 |
| | 502,817 |
| | 207,221 |
| | 84,271 |
| |
Total equity | | | 1,193,376 |
| | 1,286,832 |
| | 933,096 |
| | 502,817 |
| | 207,221 |
|
| | For the Years Ended December 31, | | For the Years Ended December 31, |
| | 2015 | | 2014 | | 2013 | | 2012 | | 2011 | | 2016 | | 2015 | | 2014 | | 2013 | | 2012 |
Operating data | | | | | | | | | | | | | | | | | | | | |
Total revenues | | $ | 315,709 |
| | $ | 188,896 |
| | $ | 80,423 |
| | $ | 27,283 |
| | $ | 2,512 |
| | $ | 400,407 |
| | $ | 315,709 |
| | $ | 188,896 |
| | $ | 80,423 |
| | $ | 27,283 |
|
Net loss | | (29,015 | ) | | (12,352 | ) | | (21,637 | ) | | (7,682 | ) | | (2,440 | ) | |
Net loss per common share - basic and diluted | | (0.18 | ) | | (0.14 | ) | | (0.50 | ) | | (0.40 | ) | | (0.66 | ) | |
Net income (loss) attributable to common stockholders | | | 763 |
| | (29,015 | ) | | (12,352 | ) | | (21,637 | ) | | (7,682 | ) |
Net income (loss) per common share attributable to common stockholders - basic and diluted | | | — |
| | (0.18 | ) | | (0.14 | ) | | (0.50 | ) | | (0.40 | ) |
Other data | | | | | | | | | | | | | | | | | | | | |
Cash flows provided by operating activities | | 101,129 |
| | 50,346 |
| | 20,164 |
| | 7,657 |
| | 724 |
| | 114,157 |
| | 97,521 |
| | 53,954 |
| | 20,164 |
| | 7,657 |
|
Cash flows used in investing activities | | (831,986 | ) | | (1,035,952 | ) | | (938,610 | ) | | (233,423 | ) | | (93,527 | ) | | (198,884 | ) | | (831,986 | ) | | (1,035,952 | ) | | (938,610 | ) | | (233,423 | ) |
Cash flows provided by financing activities | | 739,964 |
| | 1,051,552 |
| | 928,117 |
| | 212,105 |
| | 129,782 |
| | 48,553 |
| | 739,964 |
| | 1,051,552 |
| | 928,117 |
| | 212,105 |
|
Distributions declared | | 106,189 |
| | 59,481 |
| | 28,309 |
| | 12,525 |
| | 2,195 |
| | 117,025 |
| | 106,189 |
| | 59,481 |
| | 28,309 |
| | 12,525 |
|
Distributions declared per common share (1) | | 0.650 |
| | 0.650 |
| | 0.650 |
| | 0.650 |
| | 0.340 |
| | 0.650 |
| | 0.650 |
| | 0.650 |
| | 0.650 |
| | 0.650 |
|
Weighted-average number of common shares outstanding, basic and diluted | | 163,358,289 |
| | 91,374,493 |
| | 43,547,227 |
| | 19,253,338 |
| | 3,724,745 |
| | 180,043,027 |
| | 163,358,289 |
| | 91,374,493 |
| | 43,547,227 |
| | 19,253,338 |
|
Reconciliation of funds from operations (2) | | | | | | | | | | | | | | | | | | | | |
Net loss | | $ | (29,015 | ) | | $ | (12,352 | ) | | $ | (21,637 | ) | | $ | (7,682 | ) | | $ | (2,440 | ) | |
Net income (loss) | | | $ | 763 |
| | $ | (29,015 | ) | | $ | (12,352 | ) | | $ | (21,637 | ) | | $ | (7,682 | ) |
Depreciation of real estate assets | | 56,957 |
| | 30,088 |
| | 11,445 |
| | 4,150 |
| | 387 |
| | 77,676 |
| | 56,957 |
| | 30,088 |
| | 11,445 |
| | 4,150 |
|
Amortization of lease-related costs | | 79,978 |
| | 49,475 |
| | 23,935 |
| | 9,715 |
| | 713 |
| | 83,688 |
| | 79,978 |
| | 49,475 |
| | 23,935 |
| | 9,715 |
|
Gain on sale of real estate, net | | — |
| | (10,894 | ) | | — |
| | — |
| | — |
| | — |
| | — |
| | (10,894 | ) | | — |
| | — |
|
FFO | | $ | 107,920 |
| | $ | 56,317 |
| | $ | 13,743 |
| | $ | 6,183 |
| | $ | (1,340 | ) | | $ | 162,127 |
| | $ | 107,920 |
| | $ | 56,317 |
| | $ | 13,743 |
| | $ | 6,183 |
|
_____________________
(1) Distributions declared per common share assumes each share was issued and outstanding each day for the periods presented. Distributions for the periods from June 24, 2011January 1, 2012 through February 28, 2012, and March 1, 2012 through February 28, 2016 and March 1, 2016 through December 31, 20152016 were based on daily record dates and calculated at a rate of $0.00178082 per share per day.
(2) We believe that funds from operations (“FFO”) is a beneficial indicator of the performance of an equity REIT. We compute FFO in accordance with the current National Association of Real Estate Investment Trusts (“NAREIT”) definition. FFO represents net income, excluding gains and losses from sales of operating real estate assets (which can vary among owners of identical assets in similar conditions based on historical cost accounting and useful-life estimates), impairment losses on real estate assets, depreciation and amortization of real estate assets, and adjustments for unconsolidated partnerships and joint ventures. We believe FFO facilitates comparisons of operating performance between periods and among other REITs. However, our computation of FFO may not be comparable to other REITs that do not define FFO in accordance with the NAREIT definition or that interpret the current NAREIT definition differently than we do. Our management believes that historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values have historically risen or fallen with market conditions, many industry investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. As a result, we believe that the use of FFO, together with the required GAAP presentations, provides a more complete understanding of our performance relative to our competitors and provides a more informed and appropriate basis on which to make decisions involving operating, financing, and investing activities.
FFO is a non-GAAP financial measure and does not represent net income as defined by GAAP. Net income as defined by GAAP is the most relevant measure in determining our operating performance because FFO includes adjustments that investors may deem subjective, such as adding back expenses such as depreciation and amortization. Investors should exercise caution when using non-GAAP performance measures, such as FFO, to make investment decisions. Accordingly, FFO should not be considered as an alternative to net income as an indicator of our operating performance.
| |
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 the “Selected Financial Data” above and our accompanying consolidated financial statements and the notes thereto. Also see “Forward-Looking Statements” preceding Part I and Part I, Item 1A, “Risk Factors.”
Overview
We were formed on December 22, 2009 as a Maryland corporation that elected to be taxed as a REIT beginning with the taxable year ended December 31, 2011 and we intend to continue to operate in such a manner. We conduct our business primarily through our Operating Partnership, of which we are the sole general partner. Subject to certain restrictions and limitations, our business is managed by our advisor pursuant to an advisory agreement and our advisor conducts our operations and manages our portfolio of real estate investments. Our advisor owns 20,000 shares of our common stock. We have no paid employees.
We have invested in a diverse portfolio of real estate investments. As of December 31, 2016, we owned 28 office properties and one mixed-use office/retail property and had entered into the Hardware Village Joint Venture with a developer to develop and subsequently operate Hardware Village, which is currently under construction.
On February 4, 2010, we filed a registration statement on Form S-11 with the SEC to offer a minimum of 250,000 shares and a maximum of up to 280,000,000 shares, or up to $2,760,000,000 of shares, of common stock for sale to the public, of which up to 200,000,000 shares, or up to $2,000,000,000 of shares, were registered in our primary offering and up to 80,000,000 shares, or up to $760,000,000 of shares, were registered under our dividend reinvestment plan. The SEC declared our registration statement effective on October 26, 2010 and we retained KBS Capital Markets Group to serve as the dealer manager of our initial public offering pursuant to a dealer manager agreement. The dealer manager was responsible for marketing our shares in our now-terminated initial public offering.
We have made investments in core real estate properties, which are generally lower risk, existing properties with at least 80% occupancy and minimal near-term lease rollover. Our primary investment focus is core office properties located throughout the United States, though we may also invest in other types of properties. Our core property focus in the U.S. office sector has reflected a more value-creating core strategy. In many cases, these properties have slightly higher (10% to 15%) vacancy rates and/or higher near-term lease rollover at acquisition than more conservative value-maintaining core properties. These characteristics may provide us with opportunities to lease space at higher rates, especially in markets with increasing absorption, or to re-lease space at higher rates, bringing below-market rates of in-place expiring leases up to market rates. Many of these properties required or will require a moderate level of additional investment for capital expenditures and tenant improvement costs in order to improve or rebrand the properties and increase rental rates. Thus, we believe these properties will provide an opportunity for us to achieve more significant capital appreciation by increasing occupancy, negotiating new leases with higher rental rates and/or executing enhancement projects. All such real estate assets are generally acquired directly by us, though we may invest in other entities that make similar investments. We may also invest in real estate-related investments, such as mortgage loans. As of December 31, 2015, we owned 27 office properties, one mixed-use office/retail property and had originated one first mortgage loan.
We sold 169,006,162 shares of common stock in our now-terminated primary initial public offering for gross offering proceeds of $1.7 billion. As of December 31, 2015, we had also sold 10,487,846 shares of common stock under our dividend reinvestment plan for gross offering proceeds of $103.1 million. We ceased offering shares of common stock in our primary offering on May 29, 2015 and terminated the primary offering on July 28, 2015 upon the completion of review of subscriptions submitted in accordance with our processing procedures. We sold 169,006,162 shares of common stock in our now-terminated primary initial public offering for gross offering proceeds of $1.7 billion. As of December 31, 2016, we had also sold 16,973,229 shares of common stock under our dividend reinvestment plan for gross offering proceeds of $165.0 million. Also as of December 31, 2016, we had redeemed 5,367,281 shares sold in our initial public offering for $52.5 million.
Additionally, on October 3, 2014, we issued 258,462 shares of common stock, for $2.4 million, in private transactions exempt from the registration requirements pursuant to Section 4(2)4(a)(2) of the Securities Act of 1933.
We continue to offer shares under our dividend reinvestment plan. In some states, we will need to renew the registration statement annually or file a new registration statement to continue the dividend reinvestment plan offering. We may terminate our dividend reinvestment plan offering at any time.
Also as of December 31, 2015, we had redeemed 1,829,232 shares sold in our initial public offering for $17.7 million.
As our advisor, KBS Capital Advisors manages our day-to-day operations and our portfolio of real estate investments. KBS Capital Advisors makes recommendations on all investments to our board of directors. All proposed investments must be approved by at least a majority of our board of directors, including a majority of the conflicts committee. Unless otherwise provided by our charter, the conflicts committee may approve a proposed investment without action by the full board of directors if the approving members of the conflicts committee constitute at least a majority of the board of directors. KBS Capital Advisors also provides asset-management, marketing, investor-relations and other administrative services on our behalf. Our advisor owns 20,000 shares of our common stock. We have no paid employees.
Market Outlook – Real Estate and Real Estate Finance Markets
The following discussion is based on management’s beliefs, observations and expectations with respect to the real estate and real estate finance markets.
Current conditionsConditions in the global capital markets remain volatile. The slowdown in global economic growth, and the increase in oil production capacity, has had a ripple effect through the energy and commodity markets. Decreasing levelsvolatile as of demand for commodities have led to a weakening of global economic conditions, particularly in emerging market nations. Many nations in the developing world rely on metals, minerals and oil production as the basis of their economies. When demand for these resources drops, the economic environment deteriorates, and deflation becomes a very real risk. Over the past decade the United States has seen a resurgence of the domestic energy markets. The growth of domestic oil and natural gas production helped the U.S. economy rebound from the 2008-2009 recession. During the first quarter of 2016, supply pressures in2017. Current economic data and financial market developments suggest that the energy markets have driven down the price of oil to levels not seen in many years,global economy is improving, although at a slow and U.S.uneven pace. European economic growth has slowed. recently picked up, whereas the U.K. and China remain areas of concern. Against this backdrop, the central banks of the world’s major industrialized economies are beginning to back away from their strong monetary accommodation. Quantitative easing in Japan and Europe is slowing, but the liquidity generated from these programs continues to impact the global capital markets.
For further discussion of current market conditions, see Part I, Item 1, “Business ─ Market Outlook ─ Real Estate and Real Estate Finance Markets.”
Impact on Our Real Estate Properties
The increased volatility in the global financial markets and the potential increase in U.S. interest rates are introducingcontinues to cause a level of uncertainty intoin our outlook for the performance of the U.S. commercial real estate markets. Currently, bothBoth the investing and leasing environments are highly competitive. While there has been an increase in the amount offoreign capital flowingcontinues to flow into U.S. real estate markets, which has resulted in an increase in real estate values in certain markets, the uncertainty regarding the political, regulatory and economic environmentenvironments has made businesses reluctant to make long-term commitments, as is evidenced byintroduced uncertainty into the lower level of business investment and capital expenditures.markets. Possible future declines in rental rates, slower or potentially negative net absorption of leased space and expectations of future rental concessions, including free rent to renew tenants early, to retain tenants who are up for renewal or to attract new tenants, may result in decreases in cash flows. Historically low interest rates could help offset some of the impact of these potential decreases in operating cash flow for properties financed with variable rate mortgages; however, interest rates likely will not remain at these historically low levels forin the remaining life of many of our investments. In fact, theUnited States have started to increase. The FED increased interest rates in Q4 2015. Currently we expect further increasesthe fourth quarter of 2015 and again in interest rates, but are uncertain as to the timing and levels. Interest rates have become more volatile as the global capital markets react to increasing economic and geopolitical risks.
Impact on Our Real Estate-Related Investment
Our real estate-related investment is directly secured by commercial real estate. As a result, our real estate-related investment, in general, has been and likely will continue to be impacted by the same factors impacting our real estate properties.December 2016. The higher yields and the improving credit position of many U.S. tenants and borrowers have attracted global capital. However, the real estate and capitalfinance markets are fluid, andanticipate further rate increases as long as the positive trends can reverse quickly. Current economic conditions remain relatively volatile and can have a negative impact oneconomy remains strong. If this trend continues, management will review our debt financing strategies to optimize the performancecost of collateral securing our loan investment, and therefore may impact the ability of the borrower under our loan to make contractual interest payments to us.debt exposure.
As of December 31, 2015, we owned one fixed rate real estate loan receivable with a principal balance of $22.0 million and a carrying value of $22.0 million that matures in 2016.
Impact on Our Financing Activities
In light of the risks associated with potentially volatile operating cash flows from some of our real estate properties, and the possible increase in the cost of financing due to higher interest rates, we may have difficulty refinancing some of our debt obligations prior to or at maturity or we may not be able to refinance these obligations at terms as favorable as the terms of our existing indebtedness. Recent financial market conditions have improved from the bottom of the economic cycle, and short-termShort-term interest rates in the U.S.United States have increased. Market conditions can change quickly, potentially negatively impacting the value of our investments.
As of December 31, 2015,2016, we had debt obligations in the aggregate principal amount of $1.7$1.8 billion, with a weighted-average remaining term of 2.92.2 years. We had a totalOur debt obligations consisted of $102.7$194.3 million of fixed rate notes payable and $1.6 billion of variable rate notes payable. TheAs of December 31, 2016, the interest rates on $676.1$919.5 million of our variable rate notes payable are effectively fixed through interest rate swap agreements. In addition, we entered into nineeight interest rate swaps with an aggregate notional amount of $506.7$363.8 million, which will become effective at various times between 2016 and 2017.during 2017 through 2018. We also havehad an interest rate cap for a notional amount of $353.4 million, effective from January 7, 2015 to June 30, 2016. The notional amount on the interest rate cap is reduced to $147.3 million from July 1, 2016 tothat terminated on January 1, 2017.
Liquidity and Capital Resources
We sold 169,006,162 shares of common stock in our now-terminated primary initial public offering for gross offering proceeds of $1.7 billion. As of December 31, 2015,2016, we had also sold 10,487,84616,973,229 shares of common stock under our dividend reinvestment plan for gross offering proceeds of $103.1$165.0 million. Also as of December 31, 20152016, we had redeemed 1,829,2325,367,281 shares sold in our initial public offering for $17.7$52.5 million. We ceased offering shares of common stock in our primary offering on May 29, 2015 and terminated our primary offering on July 28, 2015.
We continue to offer shares under our dividend reinvestment plan. In some states, we will need to renew the registration statement annually or file a new registration statement to continue the dividend reinvestment plan offering. We may terminate our dividend reinvestment plan offering at any time.
To date, weWe have invested substantially all of the proceeds from our now-terminated primary initial public offering, net of selling commissions and dealer manager fees and other organization and offering costs, and proceeds from debt financing, in a diverse portfolio of real estate investments. To date, proceeds from our dividend reinvestment plan have been used primarily to fund redemptions of shares under our share redemption program and for capital expenditures on our real estate investments.
Our principal demands for funds during the short and long-term are and will be for the acquisition of additional real estate investments; operating expenses, capital expenditures and general and administrative expenses; payments under debt obligations; redemptions of common stock; capital commitments and development expenses under our joint venture agreement; and payments of distributions to stockholders. Our primary sources of capital for meeting our cash requirements are as follows:
Remaining proceeds fromCash flow generated by our now-terminated primary initial public offering;
Proceeds from common stock issued under our dividend reinvestment plan;real estate investments;
Debt financings (including amounts currently available under existing loan facilities); and
Cash flow generated byProceeds from common stock issued under our real estate investments.dividend reinvestment plan.
Our real estate properties generate cash flow in the form of rental revenues and tenant reimbursements, which are reduced by operating expenditures, capital expenditures, debt service payments, the payment of asset management fees and corporate general and administrative expenses. Cash flow from operations from our real estate properties is primarily dependent upon the occupancy level of our portfolio, the net effective rental rates on our leases, the collectibilitycollectability of rent and operating recoveries from our tenants and how well we manage our expenditures. As of December 31, 20152016, we owned 2728 office properties and one mixed-use office/retail property that were collectively 92%94% occupied.
Our real estate-related investment generates cash flow in In addition, we had entered into the form of interest income,Hardware VIllage Joint Venture to develop and subsequently operate Hardware Village, which is reduced by the payment of asset management fees and corporate general and administrative expenses. Cash flow from operations from our real estate-related investment is primarily dependent on the operating performance of the underlying collateral and the borrower’s ability to make its debt service payments. As of December 31, 2015, the borrowercurrently under our real estate loan receivable was current on all contractual debt service payments to us.construction.
As of December 31, 20152016, we had mortgage debt obligations in the aggregate principal amount of $1.7$1.8 billion, with a weighted-average remaining term of 2.92.2 years. The maturity dates of certain loans may be extended beyond their current maturity date, subject to certain terms and conditions contained in the loan documents. Assuming our notes payable are fully extended under the terms of the respective loan agreements and other loan documents, we have $1.9 million of debt obligations maturing during the 12 months ending December 31, 2017. As of December 31, 20152016, we had $127.5$126.5 million of revolving debt available for immediate future disbursement under a portfolio loan, subject to certain conditions set forth in the loan agreement.
We madepaid distributions to our stockholders during the year ended December 31, 20152016 using cash flow from operations from current and prior periods and debt financing. We believe that our cash flow from operations, cash on hand, proceeds from our dividend reinvestment plan, proceeds from the sale of real estate and current and anticipated financing activities are sufficient to meet our liquidity needs for the foreseeable future.
Under our charter, we are required to limit our total operating expenses to the greater of 2% of our average invested assets or 25% of our net income for the four most recently completed fiscal quarters, as these terms are defined in our charter, unless the conflicts committee has determined that such excess expenses were justified based on unusual and non-recurring factors. Operating expenses for the four fiscal quarters ended December 31, 20152016 did not exceed the charter-imposed limitation.
Cash Flows from Operating Activities
We commenced operations in connection with our first investment on June 24, 2011. As of December 31, 20152016, we owned 2728 office properties and one mixed-use office/retail property and one real estate loan receivable.had entered into the Hardware Village Joint Venture to develop and subsequently operate Hardware Village, which is currently under construction. During the year ended December 31, 2015,2016, net cash provided by operating activities was $101.1$114.2 million, compared to net cash provided by operating activities of $50.3$97.5 million during the year ended December 31, 2014.2015. Net cash provided by operating activities increased in 20152016 primarily as a result of the growth in our real estate portfolio.
Cash Flows from Investing Activities
Net cash used in investing activities was $832.0198.9 million for the year ended December 31, 20152016 and primarily consisted of the following:
$755.5141.8 million for the acquisitionsacquisition of eightone real estate properties;property;
$69.967.3 million of improvements to real estate;
$4.422.5 million of escrow deposits for future real estate purchase;
$2.0 millioncash received from the repayment of advances on our real estate loan receivable, netpartially offset by advances on loan receivable of repayments of $0.2$0.5 million; and
$0.211.8 million of payments for the purchase of an interest rate cap.construction-in-progress.
Cash Flows from Financing Activities
Our cash flows from financing activities consist primarily of proceeds from our now-terminated initial public offering, debt financings and distributions paid to our stockholders. During the year ended December 31, 20152016, net cash provided by financing activities was $740.048.6 million and primarily consisted of the following:
$472.0 million of net cash provided by offering proceeds related to our now-terminated initial public offering, net of payments of commissions, dealer manager fees and other organization and offering expenses of $52.9 million;
$325.2137.8 million of net cash provided by debt financing as a result of proceeds from notes payable of $576.5$248.5 million, partially offset by principal payments on notes payable of $246.0$108.5 million and payments of deferred financing costs of $5.3$2.2 million;
$47.655.0 million of net cash distributions, after giving effect to distributions reinvested by stockholders of $55.4$61.9 million;
$10.634.8 million of cash used for redemptions of common stock; and
$1.20.3 million of cash reimbursed from affiliate related to other offering costs.provided by noncontrolling interest contributions.
Once we have fully invested the proceeds of our public offering, weWe expect that our debt financing and other liabilities will be between 35% and 65% of the cost of our tangible assets (before deducting depreciation orand other non-cash reserves). We expect our debt financing related to the acquisition of core real estate properties to be between 45% and 65% of the aggregate cost of all such assets. We expect our debt financing related to the acquisition or origination of real estate-related investments to be between 0% and 65% of the aggregate cost of all such assets, depending upon the availability of such financings in the marketplace. Though thisThere is our target leverage,no limitation on the amount we do notmay borrow for the purchase of any single asset. We limit our leverage until our total liabilities would exceedto 75% of the cost of our tangible assets (before deducting depreciation orand other non-cash reserves), meaning that our borrowings and weother liabilities may exceed thisour maximum target leverage of 65% of the cost of our tangible assets without violating these borrowing restrictions. We may exceed the 75% limit with the approvalonly if a majority of the conflicts committee approves each borrowing in excess of this limitation and we disclose such borrowings to our boardstockholders in our next quarterly report with an explanation from the conflicts committee of directors.the justification for the excess borrowing. To the extent financing in excess of this limit is available on attractive terms, our conflicts committee may approve debt in excess of this limit. From time to time, our total liabilities could also be below 35% of the cost of our tangible assets due to the lack of availability of debt financing. As of December 31, 2015,2016, our borrowings and other liabilities were approximately 53%55% of both the cost (before deducting depreciation orand other noncash reserves) and book value (before deducting depreciation) of our tangible assets, respectively.
In addition to making investments in accordance with our investment objectives, we expect to use our capital resources to make certain payments to our advisor and we have made certain payments to our dealer manager. Pursuant to the advisory agreement and the dealer manager agreement, we are obligated to pay fees to and reimburse our advisor, our dealer manager and/or their affiliates, as applicable, for organization and other offering costs related to our public offering. See the discussion under “— Organization and Offering Costs” below. During our acquisition and development stage, we expect to make payments to our advisor in connection with the selection and acquisition or origination of investments, the management of our investments and costs incurred by our advisor in providing services to us. We also pay fees to our advisor in connection with the disposition of investments.
Among the fees payable to our advisor is an asset management fee. With respect to investments in real property, the asset management fee is a monthly fee equal to one-twelfth of 0.75% of the amount paid or allocated to acquire the investment, plus the cost of any subsequent development, construction or improvements to the property. This amount includes any portion of the investment that was debt financed and is inclusive of acquisition expenses related thereto (but excludes acquisition fees paid or payable to our advisor). In the case of investments made through joint ventures, the asset management fee will be determined based on our proportionate share of the underlying investment (but excluding acquisition fees paid to our advisor). With respect to investments in loans and any investments other than real property, the asset management fee is a monthly fee calculated, each month, as one-twelfth of 0.75% of the lesser of (i) the amount actually paid or allocated to acquire or fund the loan or other investment (which amount includes any portion of the investment that was debt financed and is inclusive of acquisition or origination expenses related thereto but is exclusive of acquisition or origination fees paid or payable to our advisor) and (ii) the outstanding principal amount of such loan or other investment, plus the acquisition or origination expenses related to the acquisition or funding of such investment (excluding acquisition or origination fees paid or payable to our advisor), as of the time of calculation.
Pursuant to the advisory agreement, with respect to asset management fees accruing from March 1, 2014, our advisor agreed to defer, without interest, our obligation to pay asset management fees for any month in which our MFFO for such month, as such term is defined in the practice guideline issued by the IPA in November 2010 and interpreted by us, excluding asset management fees, does not exceed the amount of distributions declared by us for record dates of that month. We remain obligated to pay our advisor an asset management fee in any month in which our MFFO, excluding asset management fees, for such month exceeds the amount of distributions declared for the record dates of that month (such excess amount, an “MFFO Surplus”); however, any amount of such asset management fee in excess of the MFFO Surplus will also be deferred under the advisory agreement. If the MFFO Surplus for any month exceeds the amount of the asset management fee payable for such month, any remaining MFFO Surplus will be applied to pay any asset management fee amounts previously deferred in accordance with the advisory agreement.
As of December 31, 20152016, we had reimbursed our advisor for all accrued and deferred payment of $10.1 million of asset management fees under the advisory agreement, as we believe the payment of this amount to our advisor is probable. These fees will be reimbursed in accordance with the terms noted above. The amount of asset management fees deferred, if any, will vary on a month-to-month basis and the total amount of asset management fees deferred as well as the timing of the deferrals and repayments are difficult to predict as they will depend on the amount of and terms of the debt we use to acquire assets, the level of operating cash flow generated by future acquisitions and the performance of all of theour real estate investments in our portfolio and other factors. In addition, deferrals and repayments may occur in the same period, and it is possible that there could be additional deferrals even afterin the initial deferrals are fully repaid.future. As of December 31, 2016, we had $2.1 million of asset management fees payable related to asset management fees incurred for the month of December 2016, which were subsequently paid in January 2017.
However, notwithstanding the foregoing, any and all deferred asset management fees that are unpaid will become immediately due and payable at such time as our stockholders have received, together as a collective group, aggregate distributions (including distributions that may constitute a return of capital for federal income tax purposes) sufficient to provide (i) an 8% per year cumulative, noncompounded return on net invested capital (the “Stockholders’ 8% Return”) and (ii) a return of their net invested capital, or the amount calculated by multiplying the total number of shares purchased by stockholders by the issue price, reduced by any amounts to repurchase shares pursuant to our share redemption program. The Stockholders’ 8% Return is not based on the return provided to any individual stockholder. Accordingly, it is not necessary for each of our stockholders to have received any minimum return in order for our advisor to receive deferred asset management fees.
On September 27, 2015,2016, we and our advisor renewed the advisory agreement. The advisory agreement has a one-year term but may be renewed for an unlimited number of successive one-year periods upon the mutual consent of our advisor and our conflicts committee.
Contractual Commitments and Contingencies
The following is a summary of our contractual obligations as of December 31, 20152016 (in thousands):
| | | | | | Payments Due During the Years Ended December 31, | | | | Payments Due During the Years Ended December 31, |
Contractual Obligations | | Total | | 2016 | | 2017-2018 | | 2019-2020 | | Thereafter | | Total | | 2017 | | 2018-2019 | | 2020-2021 | | Thereafter |
Outstanding debt obligations (1) | | $ | 1,653,392 |
| | $ | 77,457 |
| | $ | 970,190 |
| | $ | 424,150 |
| | $ | 181,595 |
| | $ | 1,793,405 |
| | $ | 298,405 |
| | $ | 947,419 |
| | $ | 366,992 |
| | $ | 180,589 |
|
Interest payments on outstanding debt obligations (2) | | 122,497 |
| | 40,850 |
| | 58,490 |
| | 18,406 |
| | 4,751 |
| | 120,704 |
| | 47,722 |
| | 50,955 |
| | 19,881 |
| | 2,146 |
|
Development obligations | | | 86,000 |
| | (3) | | (3) | | — |
| | — |
|
_____________________
(1) Amounts include principal payments only.
(2) Projected interest payments are based on the outstanding principal amounts, maturity dates and interest rates in effect as of December 31, 20152016 (consisting of the contractual interest rate and the effect of interest rate swaps, if applicable). We incurred interest expense of $35.7$48.3 million, excluding amortization of deferred financing costs totaling $3.6$5.1 million and unrealized lossgain on derivatives of $6.1$1.6 million and including interest capitalized of $0.2 million during the year ended December 31, 2015.2016.
(3) We have entered into the Hardware Village Joint Venture to develop and subsequently operate Hardware Village and expect to incur approximately $86.0 million in development obligations through 2018.
Results of Operations
Overview
As of December 31, 20142015, we owned 2027 office properties, one mixed-use office/retail property and one real estate loan receivable. As of December 31, 20152016, we owned 2728 office properties, one mixed-use office/retail property and one real estate loan receivablehad entered into the Hardware Village Joint Venture to develop and had sold one office property.subsequently operate Hardware Village, which is currently under construction. During the year ended December 31, 2016, the Aberdeen First Mortgage Origination was paid off. In general, we expect that our income and expenses related to our portfolio will increase in future periods as a result of owning the real estate investments acquired in 20152016 for an entire period, the development and anticipatedsubsequent operation of Hardware Village and Village Center Station II and possible future acquisitions of real estate investments. As a result, the results of operations presented for the years ended December 31, 20152016 and 20142015 are not directly comparable.comparable due to our acquisition and development activity.
Comparison of the year ended December 31, 20152016 versus the year ended December 31, 2015
The following table provides summary information about our results of operations for the years ended December 31, 2016 and 2015 (dollar amounts in thousands):
|
| | | | | | | | | | | | | | | | | | | | | | | |
| | For the Years Ended December 31, | | Increase (Decrease) | | Percentage Change | | $ Change Due to Acquisitions and Payoffs (1) | | $ Change Due to Properties Held Throughout Both Periods (2) |
| | 2016 | | 2015 | | | | |
Rental income | | $ | 307,568 |
| | $ | 245,772 |
| | $ | 61,796 |
| | 25 | % | | $ | 50,716 |
| | $ | 11,080 |
|
Tenant reimbursements | | 70,856 |
| | 53,960 |
| | 16,896 |
| | 31 | % | | 11,492 |
| | 5,404 |
|
Interest income from real estate loan receivable | | 831 |
| | 1,603 |
| | (772 | ) | | (48 | )% | | (772 | ) | | — |
|
Other operating income | | 21,152 |
| | 14,374 |
| | 6,778 |
| | 47 | % | | 6,051 |
| | 727 |
|
Operating, maintenance and management costs | | 93,580 |
| | 75,319 |
| | 18,261 |
| | 24 | % | | 17,213 |
| | 1,048 |
|
Real estate taxes and insurance | | 61,090 |
| | 50,320 |
| | 10,770 |
| | 21 | % | | 8,541 |
| | 2,229 |
|
Asset management fees to affiliate | | 24,940 |
| | 20,051 |
| | 4,889 |
| | 24 | % | | 4,443 |
| | 446 |
|
Real estate acquisition fees to affiliate | | 1,473 |
| | 7,697 |
| | (6,224 | ) | | (81 | )% | | (6,224 | ) | | n/a |
|
Real estate acquisition fees and expenses | | 306 |
| | 4,292 |
| | (3,986 | ) | | (93 | )% | | (3,986 | ) | | n/a |
|
General and administrative expenses | | 5,398 |
| | 4,912 |
| | 486 |
| | 10 | % | | n/a |
| | n/a |
|
Depreciation and amortization | | 161,364 |
| | 136,935 |
| | 24,429 |
| | 18 | % | | 27,211 |
| | (2,782 | ) |
Interest expense | | 51,554 |
| | 45,370 |
| | 6,184 |
| | 14 | % | | n/a |
| | n/a |
|
_____________________
(1) Represents the dollar amount increase (decrease) for the year ended December 31, 2016 compared to the year ended December 31, 2015 related to real estate investments acquired or repaid on or after January 1, 2015.
(2) Represents the dollar amount increase (decrease) for the year ended December 31, 2016 compared to the year ended December 31, 2015 related to real estate investments owned by us throughout both periods presented.
Rental income and tenant reimbursements from our real estate properties increased from $299.7 million for the year ended December 31, 2015 to $378.4 million for the year ended December 31, 2016, primarily as a result of the growth in our real estate portfolio. The increase in rental income and tenant reimbursements for properties held throughout both periods was primarily due to an increase in occupancy from 92% as of December 31, 2015 to 94% as of December 31, 2016, an increase in rental rates and an increase in expense recoveries. We expect rental income and tenant reimbursements to vary in future periods as a result of owning the real estate property acquired in 2016 for an entire period, occupancy rates and rental rates of our real estate investments, the development and subsequent operation of Hardware Village and Village Center Station II and acquisition activity.
Interest income from our real estate loan receivable, recognized using the interest method, decreased from $1.6 million for the year ended December 31, 2015 to $0.8 million for the year ended December 31, 2016 as a result of the Aberdeen First Mortgage Origination being paid off on July 1, 2016.
Other operating income increased from $14.4 million during the year ended December 31, 2015 to $21.2 million for the year ended December 31, 2016, primarily as a result of the growth in our real estate portfolio. Other operating income primarily consisted of parking revenues. We expect other operating income to vary in future periods as a result of owning the real estate property acquired in 2016 for an entire period, the development and subsequent operation of Hardware Village and Village Center Station II, occupancy rates and parking rates at our real estate properties and acquisition activity.
Operating, maintenance and management costs increased from $75.3 million for the year ended December 31, 2015 to $93.6 million for the year ended December 31, 2016, primarily as a result of the growth in our real estate portfolio. The increase in operating, maintenance and management costs for properties held throughout both periods was primarily due to an increase in repairs and maintenance, association fees and management fees. We expect operating, maintenance and management costs to vary in future periods as a result of owning the real estate property acquired in 2016 for an entire period, the development and subsequent operation of Hardware Village and Village Center Station II, inflation and acquisition activity.
Real estate taxes and insurance increased from $50.3 million for the year ended December 31, 2015 to $61.1 million for the year ended December 31, 2016, primarily as a result of the growth in our real estate portfolio. The increase of real estate taxes and insurance for properties held throughout both periods was primarily due to higher taxes as the assessed values have increased on several of our properties. We expect real estate taxes and insurance to increase in future periods as a result of owning the real estate property acquired in 2016 for an entire period, the development and subsequent operation of Hardware Village and Village Center Station II, inflation, future reassessments and acquisition activity.
Asset management fees with respect to our real estate investments increased from $20.1 million for the year ended December 31, 2015 to $24.9 million for the year ended December 31, 2016, primarily as a result of the growth in our real estate portfolio. We expect asset management fees to vary in future periods as a result of owning the real estate property acquired in 2016 for an entire period, the development of Hardware Village and Village Center Station II, acquisitions, improvements or dispositions. As of December 31, 2016, $2.1 million of asset management fees were payable, which were subsequently paid in January 2017. For a discussion of accrued and deferred asset management fees, see “Liquidity and Capital Resources - Cash Flows from Financing Activities” herein.
Real estate acquisition fees and expenses to affiliate and non-affiliates decreased from $12.0 million for the year ended December 31, 2015 to $1.8 million for the year ended December 31, 2016 due to a decrease in acquisition activity. We acquired one real estate property for $146.1 million during the year ended December 31, 2016. During the year ended December 31, 2015, we acquired eight real estate properties for $754.8 million. Additionally, during the year ended December 31, 2016, we capitalized $0.1 million in acquisition fees and expenses related to the development of Hardware Village. We expect real estate acquisition fees and expenses to vary in future periods based upon acquisition and development activity.
Depreciation and amortization increased from $136.9 million for the year ended December 31, 2015 to $161.4 million for the year ended December 31, 2016, primarily as a result of the growth in our real estate portfolio. We expect depreciation and amortization to vary in future periods as a result of owning the real estate property acquired in 2016 for an entire period, a decrease in amortization related to fully amortized tenant origination costs, acquisition activity and the development and subsequent operation of Hardware Village and Village Center Station II.
Interest expense increased from $45.4 million for the year ended December 31, 2015 to $51.6 million for the year ended December 31, 2016. Included in interest expense is the amortization of deferred financing costs of $5.1 million and $3.6 million for the years ended December 31, 2016 and 2015, respectively. Additionally, during the year ended December 31, 2016, we capitalized $0.2 million of interest to construction-in-progress. Interest expense incurred as a result of our derivative instruments for the years ended December 31, 2016 and 2015 was $6.4 million and $13.4 million, respectively, which includes $1.6 million of unrealized gains and $6.1 million of unrealized losses on derivative instruments for the years ended December 31, 2016 and 2015, respectively. The increase in interest expense is primarily due to increased borrowings as a result of our use of additional debt in acquiring real estate properties in 2015 and 2016 and changes in value on interest rate swaps. We expect interest expense to vary in future periods as a result of borrowings in 2016 being outstanding for an entire period and acquisition and development activity. In addition, our interest expense in future periods will vary based on fair value changes with respect to our interest rate swaps that are not accounted for as cash flow hedges.
Comparison of the year ended December 31, 2015versus the year ended December 31, 2014
The following table provides summary information about our results of operations for the years ended December 31, 2015 and 2014 (dollar amounts in thousands):
| | | | For the Years Ended December 31, | | Increase (Decrease) | | Percentage Change | | $ Change Due to Acquisitions and Dispositions (1) | | $ Change Due to Properties or Loans Held Throughout Both Periods (2) | | For the Years Ended December 31, | | Increase (Decrease) | | Percentage Change | | $ Change Due to Acquisitions and Dispositions (1) | | $ Change Due to Properties or Loans Held Throughout Both Periods (2) |
| | 2015 | | 2014 | | | 2015 | | 2014 | |
Rental income | | $ | 245,772 |
| | $ | 141,535 |
| | $ | 104,237 |
| | 74 | % | | $ | 101,868 |
| | $ | 2,369 |
| | $ | 245,772 |
| | $ | 141,535 |
| | $ | 104,237 |
| | 74 | % | | $ | 101,868 |
| | $ | 2,369 |
|
Tenant reimbursements | | 53,960 |
| | 40,636 |
| | 13,324 |
| | 33 | % | | 12,559 |
| | 765 |
| | 53,960 |
| | 40,636 |
| | 13,324 |
| | 33 | % | | 12,559 |
| | 765 |
|
Interest income from real estate loan receivable | | 1,603 |
| | 1,352 |
| | 251 |
| | 19 | % | | — |
| | 251 |
| | 1,603 |
| | 1,352 |
| | 251 |
| | 19 | % | | — |
| | 251 |
|
Other operating income | | 14,374 |
| | 5,373 |
| | 9,001 |
| | 168 | % | | 8,425 |
| | 576 |
| | 14,374 |
| | 5,373 |
| | 9,001 |
| | 168 | % | | 8,425 |
| | 576 |
|
Operating, maintenance and management costs | | 75,319 |
| | 46,223 |
| | 29,096 |
| | 63 | % | | 29,869 |
| | (773 | ) | | 75,319 |
| | 46,223 |
| | 29,096 |
| | 63 | % | | 29,869 |
| | (773 | ) |
Real estate taxes and insurance | | 50,320 |
| | 31,623 |
| | 18,697 |
| | 59 | % | | 17,678 |
| | 1,019 |
| | 50,320 |
| | 31,623 |
| | 18,697 |
| | 59 | % | | 17,678 |
| | 1,019 |
|
Asset management fees to affiliate | | 20,051 |
| | 11,476 |
| | 8,575 |
| | 75 | % | | 8,168 |
| | 407 |
| | 20,051 |
| | 11,476 |
| | 8,575 |
| | 75 | % | | 8,168 |
| | 407 |
|
Real estate acquisition fees to affiliate | | 7,697 |
| | 10,441 |
| | (2,744 | ) | | (26 | )% | | (2,744 | ) | | n/a |
| | 7,697 |
| | 10,441 |
| | (2,744 | ) | | (26 | )% | | (2,744 | ) | | n/a |
|
Real estate acquisition fees and expenses | | 4,292 |
| | 2,497 |
| | 1,795 |
| | 72 | % | | 1,795 |
| | n/a |
| | 4,292 |
| | 2,497 |
| | 1,795 |
| | 72 | % | | 1,795 |
| | n/a |
|
General and administrative expenses | | 4,912 |
| | 3,403 |
| | 1,509 |
| | 44 | % | | n/a |
| | n/a |
| | 4,912 |
| | 3,403 |
| | 1,509 |
| | 44 | % | | n/a |
| | n/a |
|
Depreciation and amortization | | 136,935 |
| | 79,563 |
| | 57,372 |
| | 72 | % | | 57,122 |
| | 250 |
| | 136,935 |
| | 79,563 |
| | 57,372 |
| | 72 | % | | 57,122 |
| | 250 |
|
Interest expense | | 45,370 |
| | 27,003 |
| | 18,367 |
| | 68 | % | | n/a |
| | n/a |
| | 45,370 |
| | 27,003 |
| | 18,367 |
| | 68 | % | | n/a |
| | n/a |
|
Gain on sale of real estate, net | | — |
| | 10,894 |
| | (10,894 | ) | | (100 | )% | | (10,894 | ) | | n/a |
| | — |
| | 10,894 |
| | (10,894 | ) | | (100 | )% | | (10,894 | ) | | n/a |
|
Rental income and tenant reimbursements from our real estate properties increased from $182.2 million for the year ended December 31, 2014 to $299.7 million for the year ended December 31, 2015, primarily as a result of the growth in our real estate portfolio, partially offset by the sale of one of our properties on February 19, 2014. We expect that our rental income and tenant reimbursements will increase in future periods as a result of owning the real estate properties acquired in 2015 for an entire period and anticipated future acquisitions of real estate properties.
Interest income from our real estate loan receivable, recognized using the interest method, increased from $1.4 million for the year ended December 31, 2014 to $1.6 million for the year ended December 31, 2015. The increase in interest income is a result of an increase in the overall loan balance as a result of advances made under the real estate loan receivable. We expect interest income to vary in future periods as we make advances under the real estate loan receivable or receive principal repayments and to the extent we make any additional investments in real estate loans receivable.
Other operating income increased from $5.4 million during the year ended December 31, 2014 to $14.4 million for the year ended December 31, 2015, primarily as a result of the growth in our real estate portfolio. Other operating income primarily consisted of parking revenues. We expect other operating income to increase in future periods as a result of owning the real estate properties acquired in 2015 for an entire period and anticipated future acquisitions of real estate properties.
Operating, maintenance and management costs increased from $46.2 million for the year ended December 31, 2014 to $75.3 million for the year ended December 31, 2015, primarily as a result of the growth in our real estate portfolio, partially offset by the sale of one of our properties on February 19, 2014. We expect operating, maintenance and management costs to increase in future periods as a result of owning the real estate properties acquired in 2015 for an entire period and anticipated future acquisitions of real estate properties.
Real estate taxes and insurance increased from $31.6 million for the year ended December 31, 2014 to $50.3 million for the year ended December 31, 2015, primarily as a result of the growth in our real estate portfolio, partially offset by the sale of one of our properties on February 19, 2014. We expect real estate taxes and insurance to increase in future periods as a result of owning the real estate properties acquired in 2015 for an entire period and anticipated future acquisitions of real estate properties.
The Company enters into derivative instruments for risk management purposes to hedge its exposure to cash flow variability caused by changing interest rates. The primary goal of the Company’s risk management practices related to interest rate risk is to prevent changes in interest rates from adversely impacting the Company’s ability to achieve its investment return objectives. The Company does not enter into derivatives for speculative purposes.
The Company enters into interest rate swaps as a fixed rate payer to mitigate its exposure to rising interest rates on its variable rate notes payable. The value of interest rate swaps is primarily impacted by interest rates, market expectations about interest rates, and the remaining life of the instrument. In general, increases in interest rates, or anticipated increases in interest rates, will increase the value of the fixed rate payer position and decrease the value of the variable rate payer position. As the remaining life of the interest rate swap decreases, the value of both positions will generally move towards zero.
The Company enters into interest rate caps to mitigate its exposure to rising interest rates on its variable rate notes payable. The values of interest rate caps are primarily impacted by interest rates, market expectations about interest rates, and the remaining life of the instrument. In general, increases in interest rates, or anticipated increases in interest rates, will increase the value of interest rate caps. As the remaining life of an interest rate cap decreases, the value of the instrument will generally decrease towards zero.
The following table summarizes the notional amount and other information related to the Company’s interest rate swaps and cap as of December 31, 20152016 and 2014.2015. The notional amount is an indication of the extent of the Company’s involvement in each instrument at that time, but does not represent exposure to credit, interest rate or market risks (dollars in thousands):