UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

(Mark One)

x                              QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2006

 

OR

 

o                                 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                           to                          

 

Commission File Number: 1-9044

 

DUKE REALTY CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

Indiana

35-1740409

(State or Other Jurisdiction of Incorporation or Organization)

(I.R.S. Employer Identification Number)

 

 

600 East 96th Street, Suite 100
Indianapolis, Indiana

46240

(Address of Principal Executive Offices)

(Zip Code)

 

 

Registrant’s Telephone Number, Including Area Code: (317) 808-6000

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x   No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer x         Accelerated filer o         Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):

Yes o   No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

Class

 

Outstanding at November 1, 2006

Common Stock, $.01 par value per share

 

135,225,177 shares

 

 




DUKE REALTY CORPORATION

INDEX

 

Page

Part I—Financial Information

 

 

 

 

Item 1.

Financial Statements

 

 

Condensed Consolidated Balance Sheets as of September 30, 2006 (Unaudited) and December 31, 2005

2

 

Condensed Consolidated Statements of Operations (Unaudited) for the three and nine months ended September 30, 2006 and 2005

3

 

Condensed Consolidated Statements of Cash Flows (Unaudited) for the nine months ended September 30, 2006 and 2005

4

 

Condensed Consolidated Statement of Shareholders’ Equity (Unaudited) for the nine months ended September 30, 2006

5

 

Notes to Condensed Consolidated Financial Statements (Unaudited)

6-18

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

19-36

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

36

 

 

 

Item 4.

Controls and Procedures

36

 

 

 

Part II—Other Information

 

 

Item 1.

Legal Proceedings

37

 

Item 1A.

Risk Factors

37

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

37-38

 

Item 3.

Defaults Upon Senior Securities

38

 

Item 4.

Submission of Matters to a Vote of Security Holders

38

 

Item 5.

Other Information

38

 

Item 6.

Exhibits

38-40

 




PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

DUKE REALTY CORPORATION AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(in thousands, except per share data)

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

(Unaudited)

 

 

 

ASSETS

 

 

 

 

 

Real estate investments:

 

 

 

 

 

Land and improvements

 

$

751,529

 

$

675,050

 

Buildings and tenant improvements

 

4,378,929

 

4,156,456

 

Construction in progress

 

332,857

 

227,066

 

Investments in unconsolidated companies

 

453,484

 

301,322

 

Land held for development

 

696,551

 

429,270

 

 

 

6,613,350

 

5,789,164

 

Accumulated depreciation

 

(860,504

)

(754,742

)

 

 

 

 

 

 

Net real estate investments

 

5,752,846

 

5,034,422

 

 

 

 

 

 

 

Real estate investments and other assets held-for-sale (see Note 8)

 

838,556

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

25,000

 

26,732

 

Accounts receivable, net of allowance of $1,078 and $1,093

 

21,758

 

31,342

 

Straight-line rent receivable, net of allowance of $1,693 and $1,538

 

105,245

 

95,948

 

Receivables on construction contracts, including retentions

 

62,955

 

50,035

 

Deferred financing costs, net of accumulated amortization of $18,194 and $14,113

 

50,916

 

27,118

 

Deferred leasing and other costs, net of accumulated amortization of $125,843 and $112,245

 

251,538

 

227,648

 

Escrow deposits and other assets

 

164,728

 

154,315

 

 

 

$

7,273,542

 

$

5,647,560

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

Indebtedness:

 

$

371,465

 

$

167,255

 

Secured debt

 

2,800,218

 

2,050,396

 

Unsecured notes

 

904,000

 

383,000

 

Unsecured line of credit

 

4,075,683

 

2,600,651

 

Construction payables and amounts due subcontractors, including retentions

 

125,299

 

93,137

 

Accounts payable

 

82

 

781

 

Accrued expenses:

 

 

 

 

 

Real estate taxes

 

78,255

 

60,883

 

Interest

 

31,976

 

33,022

 

Other

 

47,833

 

54,878

 

Other liabilities

 

111,419

 

133,920

 

Tenant security deposits and prepaid rents

 

32,309

 

34,924

 

Total liabilities

 

4,502,856

 

3,012,196

 

Minority interest

 

172,230

 

182,566

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Preferred shares ($.01 par value); 5,000 shares authorized; 3,241 and 2,365 shares issued and outstanding

 

876,250

 

657,250

 

Common shares ($.01 par value); 250,000 shares authorized; 135,160 and 134,697 shares issued and outstanding

 

1,352

 

1,347

 

Additional paid-in capital

 

2,277,650

 

2,266,204

 

Accumulated other comprehensive income (loss)

 

4,840

 

(7,118

)

Distributions in excess of net income

 

(561,636

)

(464,885

)

Total shareholders’ equity

 

2,598,456

 

2,452,798

 

 

 

$

7,273,542

 

$

5,647,560

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

2




DUKE REALTY CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Operations
For the three and nine months ended September 30,
 (in thousands, except per share data)
(Unaudited)

 

 

Three Months Ended

 

Nine months Ended

 

 

 

2006

 

2005

 

2006

 

2005

 

RENTAL OPERATIONS:

 

 

 

 

 

 

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

Rental income from continuing operations

 

$

208,253

 

$

170,022

 

$

599,175

 

$

486,534

 

Equity in earnings of unconsolidated companies

 

3,492

 

4,143

 

21,447

 

25,033

 

 

 

211,745

 

174,165

 

620,622

 

511,567

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Rental expenses

 

46,073

 

40,502

 

136,498

 

115,885

 

Real estate taxes

 

23,086

 

21,684

 

69,752

 

59,403

 

Interest expense

 

50,173

 

30,523

 

133,288

 

86,123

 

Depreciation and amortization

 

63,892

 

59,494

 

187,099

 

164,239

 

 

 

183,224

 

152,203

 

526,637

 

425,650

 

Earnings from continuing rental operations

 

28,521

 

21,962

 

93,985

 

85,917

 

SERVICE OPERATIONS

 

 

 

 

 

 

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

General contractor gross revenue

 

100,314

 

103,879

 

223,924

 

292,303

 

General contractor costs

 

(93,555

)

(93,750

)

(206,561

)

(267,906

)

Net general contractor revenue

 

6,759

 

10,129

 

17,363

 

24,397

 

Property management, maintenance and leasing fees

 

3,335

 

4,092

 

10,626

 

12,124

 

Construction management and development activity income

 

11,665

 

8,092

 

12,948

 

28,124

 

Other income

 

715

 

271

 

1,261

 

3,382

 

Total revenue

 

22,474

 

22,584

 

42,198

 

68,027

 

Operating expenses

 

11,923

 

10,025

 

23,721

 

30,584

 

Earnings from service operations

 

10,551

 

12,559

 

18,477

 

37,443

 

General and administrative expense

 

(6,804

)

(5,803

)

(27,715

)

(21,308

)

Operating income

 

32,268

 

28,718

 

84,747

 

102,052

 

OTHER INCOME (EXPENSE)

 

 

 

 

 

 

 

 

 

Interest and other income, net

 

4,381

 

1,517

 

8,313

 

3,676

 

Earnings from sale of land, net of impairment adjustments

 

2,982

 

2,371

 

5,427

 

5,779

 

Other minority interest in earnings of subsidiaries

 

(126

)

(1,396

)

(301

)

(1,462

)

Minority interest in earnings of common unitholders

 

(2,306

)

(1,897

)

(5,314

)

(6,934

)

Income from continuing operations

 

37,199

 

29,313

 

92,872

 

103,111

 

Discontinued operations:

 

 

 

 

 

 

 

 

 

Net income (loss) from discontinued operations, net of minority interest

 

(35

)

3,042

 

4,233

 

10,344

 

Gain on sale of discontinued operations, net of impairment adjustment and minority interest

 

39,796

 

192,612

 

41,620

 

200,532

 

Income from discontinued operations

 

39,761

 

195,654

 

45,853

 

210,876

 

Net income

 

76,960

 

224,967

 

138,725

 

313,987

 

Dividends on preferred shares

 

(15,226

)

(11,619

)

(41,193

)

(34,859

)

Adjustments for redemption of preferred shares

 

 

 

(2,633

)

 

Net income available for common shareholders

 

$

61,734

 

$

213,348

 

$

94,899

 

$

279,128

 

Basic net income per common share:

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

.16

 

$

.13

 

$

.36

 

$

.48

 

Discontinued operations

 

.30

 

1.37

 

.34

 

1.47

 

Total

 

$

.46

 

$

1.50

 

$

.70

 

$

1.95

 

Diluted net income per common share:

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

.16

 

$

.12

 

$

.36

 

$

.47

 

Discontinued operations

 

.29

 

1.36

 

.34

 

1.47

 

Total

 

$

.45

 

$

1.48

 

$

.70

 

$

1.94

 

Weighted average number of common shares outstanding

 

135,117

 

142,663

 

134,957

 

143,076

 

Weighted average number of common and dilutive potential common shares

 

150,947

 

158,468

 

149,472

 

157,453

 

 

See accompanying Notes to Condensed Consolidated Financial Statements

3




DUKE REALTY CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
For the nine months ended September 30,
(in thousands)
(Unaudited)

 

 

2006

 

2005

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

138,725

 

$

313,987

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Depreciation of buildings and tenant improvements

 

155,156

 

157,260

 

Amortization of deferred leasing and other costs

 

34,956

 

37,713

 

Amortization of deferred financing costs

 

6,093

 

4,687

 

Minority interest in earnings

 

10,153

 

28,439

 

Straight-line rent adjustment

 

(15,263

)

(16,887

)

Earnings from land and depreciated property sales

 

(46,734

)

(225,371

)

Build-for-sale operations, net

 

(163,106

)

12,783

 

Construction contracts, net

 

(208

)

4,542

 

Other accrued revenues and expenses, net

 

(10,117

)

7,643

 

Operating distributions received in excess of (less than) equity in earnings from unconsolidated companies

 

(4,990

)

(894

)

Net cash provided by operating activities

 

104,665

 

323,902

 

Cash flows from investing activities:

 

 

 

 

 

Development of real estate investments

 

(274,672

)

(130,825

)

Acquisition of in-service real estate investments

 

(735,294

)

(285,342

)

Acquisition of land held for development and infrastructure costs

 

(367,517

)

(93,230

)

Recurring tenant improvements

 

(36,300

)

(44,108

)

Recurring leasing costs

 

(12,338

)

(24,618

)

Recurring building improvements

 

(5,490

)

(10,370

)

Other deferred leasing costs

 

(30,918

)

(11,073

)

Other deferred costs and other assets

 

4,531

 

(18,491

)

Tax deferred exchange escrow, net

 

 

(12,890

)

Proceeds from land and depreciated property sales, net

 

140,273

 

1,095,416

 

Distributions received from unconsolidated companies for land and depreciated property sales

 

21,238

 

 

Repayments from (advances to) unconsolidated companies

 

4,865

 

(9,206

)

Net cash provided by (used for) investing activities

 

(1,291,622

)

455,263

 

Cash flows from financing activities:

 

 

 

 

 

Payments for repurchases of common shares

 

(11,883

)

(95,167

)

Proceeds from exercise of stock options, including tax benefit of $419

 

6,336

 

2,814

 

Proceeds from issuance of preferred shares, net

 

283,994

 

 

Payments for redemption of preferred shares

 

(75,010

)

 

Redemption of limited partner units

 

 

(2,129

)

Proceeds from unsecured debt issuance

 

850,000

 

400,000

 

Payments on unsecured debt

 

(100,000

)

(665,000

)

Proceeds from issuance of secured debt

 

710,450

 

 

Payments on secured indebtedness including principal amortization

 

(722,777

)

(45,281

)

Borrowings on line of credit, net

 

521,000

 

 

Distributions to common shareholders

 

(191,256

)

(200,595

)

Distributions to preferred shareholders

 

(41,193

)

(34,859

)

 

 

 

 

 

 

Distributions to minority interest

 

(17,238

)

(19,141

)

Deferred financing costs

 

(27,198

)

(529

)

Net cash provided by (used for) financing activities

 

1,185,225

 

(659,887

)

Net increase (decrease) in cash and cash equivalents

 

(1,732

)

119,278

 

Cash and cash equivalents at beginning of period

 

26,732

 

5,589

 

Cash and cash equivalents at end of period

 

$

25,000

 

$

124,867

 

Other non-cash items:

 

 

 

 

 

Conversion of Limited Partner Units to common shares

 

$

6,616

 

$

18,049

 

Issuance of Limited Partner Units for acquisition of minority interest

 

$

 

$

15,000

 

Assumption of debt for real estate acquisitions

 

$

217,520

 

$

11,743

 

Transfer of construction in process to investment in unconsolidated joint venture

 

$

96,634

 

$

11,743

 

Contribution of real estate investments to unconsolidated companies

 

$

77,412

 

$

 

 

See accompanying Notes to Condensed Consolidated Financial Statements

4




DUKE REALTY CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statement of Shareholders’ Equity
For the nine months ended September 30, 2006
(in thousands, except per share data)
(Unaudited)

 

 

Preferred
Stock

 

Common
Stock

 

Additional
Paid-in
Capital

 

Accumulated
Other
Comprehensive
Income (Loss)

 

Distributions
in Excess of
Net Income

 

Total

 

Balance at December 31, 2005

 

$

657,250

 

$

1,347

 

$

2,266,204

 

$

(7,118

)

$

(464,885

)

$

2,452,798

 

Comprehensive Income:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

138,725

 

138,725

 

Distributions to preferred shareholders

 

 

 

 

 

(41,193

)

(41,193

)

Adjustment for carrying value of preferred stock redemption

 

 

 

2,633

 

 

(2,633

)

 

Gains on derivative instruments

 

 

 

 

11,958

 

 

11,958

 

Comprehensive income available for common shareholders

 

 

 

 

 

 

 

 

 

 

 

$

109,490

 

Issuance of common shares

 

 

3

 

6,004

 

 

 

6,007

 

Redemption of Preferred Series I shares

 

(75,000

)

 

(10

)

 

 

(75,010

)

Issuance of Preferred Series M shares

 

184,000

 

 

(6,266

)

 

 

177,734

 

Issuance of Preferred Series N shares

 

110,000

 

 

(3,740

)

 

 

106,260

 

Acquisition of minority interest

 

 

2

 

6,614

 

 

 

6,616

 

Tax benefits from employee stock plans

 

 

 

419

 

 

 

419

 

Stock based compensation expense

 

 

 

7,612

 

 

 

7,612

 

Dividends on long-term compensation plans

 

 

 

706

 

 

(706

)

 

Retirement of common shares

 

 

 

(2,526

)

 

 

(2,526

)

Distributions to common shareholders ($1.415 per share)

 

 

 

 

 

(190,944

)

(190,944

)

Balance at September 30, 2006

 

$

876,250

 

$

1,352

 

$

2,277,650

 

$

4,840

 

$

(561,636

)

$

2,598,456

 

 

See accompanying Notes to Condensed Consolidated Financial Statements

5




DUKE REALTY CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.     General Basis of Presentation

The interim condensed consolidated financial statements included herein have been prepared by Duke Realty Corporation (the “Company”) without audit (except for the Balance Sheet as of December 31, 2005). The financial statements have been prepared in accordance with United States generally accepted accounting principles (“GAAP”) for interim financial information and in accordance with Rule 10-01 of Regulation S-X of the Securities Exchange Act of 1934. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. These financial statements should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations included herein and the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005.

Our rental operations are conducted through Duke Realty Limited Partnership (“DRLP”). Approximately 91.1% of the common partnership interests of DRLP (“Units”) were owned by us at September 30, 2006. The remaining Units in DRLP are redeemable for shares of our common stock on a one-to-one basis. We conduct our Service Operations through Duke Realty Services LLC and Duke Realty Services Limited Partnership, both of which we are the sole general partner. We also conduct our Service Operations through Duke Construction Limited Partnership, which is effectively 100% owned by DRLP. The condensed consolidated financial statements include our accounts and our majority-owned or controlled subsidiaries. In this Quarterly Report on Form 10-Q (this “Report”), the terms “we,” “us” and “our” refer to the Company and those entities owned or controlled by the Company.

2.      Reclassifications

Certain 2005 balances have been reclassified to conform to the 2006 presentation.

3.      Acquisitions

In 2006, we completed the acquisition of a Washington D.C. metropolitan area portfolio of suburban office and light industrial properties (the “Mark Winkler Portfolio”). The assets acquired for a purchase price of approximately $865.2 million are comprised of 32 properties with approximately 2.9 million square feet for rental, 166 acres of undeveloped land, as well as certain related assets of the Mark Winkler Company, a real estate management company. The acquisition was financed primarily through assumed mortgage loans and new borrowings (see Note 4). The assets of the Mark Winkler Portfolio related to the 32 in-service properties, consisting of $695.9 million of real estate investments and acquired lease related intangible assets, are classified and accounted for as held-for-sale based on meeting the applicable criteria of Statement of Financial Accounting Standards No. 144, Accounting For the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). As required by SFAS 144, the results of operations of the acquired properties since the date of acquisition have been included in continuing operations, rather than discontinued operations, based on our present intention to sell the majority of our ownership interest in the properties to an entity in which we will retain a minority equity ownership interest. The allocation of purchase price based on the fair value of assets acquired is preliminary.

In the third quarter of 2006, we completed the purchase of a portfolio of industrial real estate properties in

6




Savannah, Georgia with the purpose of expanding our industrial real estate holdings near major port facilities. We completed a majority of the purchase in January 2006. The assets acquired for a purchase price of approximately $196.2 million are comprised of 18 buildings with approximately 5.1 million square feet for rental as well as over 60 acres of undeveloped land. The acquisition was financed in part through assumed mortgage loans (see Note 4). The results of operations for the acquired properties since the date of acquisition have been included in continuing rental operations in our consolidated financial statements.

4.      Indebtedness

We had one unsecured line of credit available as of September 30, 2006, described as follows (dollars in thousands):

 

 

Borrowing

 

Maturity

 

Interest

 

Outstanding Balance

 

Description

 

Capacity

 

Date

 

Rate

 

at September 30, 2006

 

Unsecured Line of Credit

 

$

1,000,000

 

January 2010

 

LIBOR + .525

%

$

904,000

 

 

We use this line of credit to fund development activities, acquire additional rental properties and provide working capital.

The line of credit provides us with an option to obtain borrowings from financial institutions that participate in the line, at rates lower than the stated interest rate, subject to certain restrictions. Interest rates on the amounts outstanding on the unsecured line of credit as of September 30, 2006 ranged from LIBOR + .15% to LIBOR + .525% (equal to 5.48% to 5.86% as of September 30, 2006).

The line of credit also contains financial covenants that require us to meet financial ratios and defined levels of performance, including those related to variable interest indebtedness, consolidated net worth and debt-to-market capitalization. As of September 30, 2006, we were in compliance with all covenants under our line of credit.

We took the following actions during the nine-month period ended September 30, 2006, relevant to our indebtedness:

·                  In January 2006, we renewed our unsecured line of credit. The new facility provides borrowing capacity up to $1.0 billion and, subject to certain conditions, may be increased to $1.3 billion. Under the new facility, which replaced the previous unsecured line of credit agreement, the interest rate was reduced, the borrowing capacity was increased by $500.0 million and the maturity date was extended to January 25, 2010.

·                  To finance the acquisition of the Mark Winkler Portfolio (see Note 3), we obtained a $700.0 million term loan with an interest rate of LIBOR +.525%, secured by certain of the acquired real estate properties. This term loan was paid in full in August 2006 with proceeds from the issuance of senior unsecured debt as described below.

·                  In conjunction with our real estate acquisitions (see Note 3), we assumed $221.6 million of mortgage loans, of which we received $10.5 million of proceeds directly. The assumed mortgage loans bear interest at rates ranging between 5.55% and 8.50% and have maturities ranging between 2011 and 2026. An adjustment of $6.3 million was recorded to increase the assumed loans to fair value.

·                  In March 2006, we issued $150.0 million of 5.50% senior unsecured notes due in 2016. A portion of the proceeds were used to retire our $100.0 million 6.72% unsecured notes. The remaining cash proceeds were used to fund costs associated with the issuance of the debt and to repay amounts outstanding under our line of credit.

7




·                  In August 2006, we issued $450.0 million of 5.95% senior unsecured notes due in 2017 and $250.0 million of 5.625% senior unsecured notes due in 2011. The proceeds from these issuances were used to pay off the $700.0 million secured term loan that was obtained to finance the purchase of the Mark Winkler Portfolio (see Note 3).

5.      Related Party Transactions

We provide property management, leasing, construction and other tenant related services to unconsolidated companies in which we have equity interests. For the nine months ended September 30, 2006 and 2005, we received management fees of $3.3 million and $3.6 million, leasing fees of $2.2 million and $3.4 million and construction and development fees of $16.8 million and $1.6 million, respectively, from these companies. These fees approximate market rates and we eliminated our ownership percentage of these fees in the condensed consolidated financial statements.

6.     Net Income Per Common Share

Basic net income per common share is computed by dividing net income available for common shareholders by the weighted average number of common shares outstanding for the period. Diluted net income per common share is computed by dividing the sum of net income available for common shareholders and the minority interest in earnings allocable to Units not owned by us, by the sum of the weighted average number of common shares and minority Units outstanding, including any dilutive potential common shares for the period.

The following table reconciles the components of basic and diluted net income per common share for the three and nine months ended September 30, 2006 and 2005, respectively (in thousands):

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Basic net income available for common shareholders

 

$

61,734

 

$

213,348

 

$

94,899

 

$

279,128

 

Joint venture partner convertible ownership net income (1)

 

378

 

498

 

 

 

Minority interest in earnings of common unitholders

 

6,083

 

20,255

 

9,396

 

26,571

 

Diluted net income available for common shareholders

 

$

68,195

 

$

234,101

 

$

104,295

 

$

305,699

 

 

 

 

 

 

 

 

 

 

 

Weighted average number of common shares outstanding

 

135,117

 

142,663

 

134,957

 

143,076

 

Weighted average partnership units outstanding

 

13,211

 

13,447

 

13,302

 

13,602

 

Joint venture partner convertible ownership common share
equivalents (1)

 

1,357

 

1,525

 

 

 

Dilutive shares for stock-based compensation plans

 

1,262

 

833

 

1,213

 

775

 

Weighted average number of common shares and dilutive
potential common shares

 

150,947

 

158,468

 

149,472

 

157,453

 


(1)             One of our joint venture partners in one of our unconsolidated companies has the option to convert a portion of its ownership to common shares. The effect of this option on earnings per share is dilutive for the third quarters 2005 and 2006; therefore, conversion to common shares is included in weighted average dilutive potential common shares for both quarters.

7.      Segment Reporting

We are engaged in three reportable operating segments, the first two of which consist of the ownership and rental of office and industrial real estate investments. The third segment consists of our build-to-suit for sale operations and providing various real estate services such as property management, maintenance, leasing, development and construction management to third party property owners and joint ventures (“Service Operations”). Our reportable segments offer different products and services and are managed separately because each segment requires different operating strategies and management expertise.

8




Non-segment revenue consists mainly of equity in earnings of unconsolidated companies. Segment FFO information (FFO is defined below) is calculated by subtracting operating expenses attributable to the applicable segment from segment revenues. Non-segment assets consist of corporate assets including cash, deferred financing costs and investments in unconsolidated companies. Interest expense and other non-property specific revenues and expenses are not allocated to individual segments in determining our performance measure.

We assess and measure segment operating results based upon an industry performance measure referred to as Funds From Operations (“FFO”), which management believes is a useful indicator of our operating performance. FFO is used by industry analysts and investors as a supplemental operating performance measure of an equity real estate investment trust (“REIT”) like Duke. FFO is calculated in accordance with the definition that was adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). NAREIT created FFO as a supplemental measure of REIT operating performance that excludes historical cost depreciation, among other items, from net income determined in accordance with GAAP. FFO is a non-GAAP financial measure developed by NAREIT to compare the operating performance of REITs. The most comparable GAAP measure is net income (loss). FFO should not be considered as a substitute for net income or any other measures derived in accordance with GAAP and may not be comparable to other similarly titled measures of other companies.

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 instead have historically risen or fallen with market conditions, many industry investors and analysts have considered presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. FFO, as defined by NAREIT, represents GAAP net income (loss), excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after similar adjustments for unconsolidated partnerships and joint ventures.

Management believes that the use of FFO, combined with the required primary GAAP presentations, improves the understanding of operating results of REITs among the investing public and makes comparisons of REIT operating results more meaningful. Management considers FFO to be a useful measure for reviewing comparative operating and financial performance (although FFO should be reviewed in conjunction with net income which remains the primary measure of performance) because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization, FFO provides a useful comparison of the operating performance of our real estate between periods or as compared to different companies.

9




The following table shows (i) the revenues and FFO for each of the reportable segments and (ii) a reconciliation of net income available for common shareholders to the calculation of FFO for the three and nine months ended September 30, 2006 and 2005, respectively (in thousands):

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Revenues

 

 

 

 

 

 

 

 

 

Rental Operations:

 

 

 

 

 

 

 

 

 

Office

 

$

158,036

 

$

125,278

 

$

440,244

 

$

356,520

 

Industrial

 

47,664

 

42,240

 

149,976

 

122,879

 

Service Operations

 

22,474

 

22,584

 

42,198

 

68,027

 

Total Segment Revenues

 

228,174

 

190,102

 

632,418

 

547,426

 

Non-Segment Revenue

 

6,045

 

6,647

 

30,402

 

32,168

 

Consolidated Revenue from continuing operations

 

$

234,219

 

$

­196,749

 

$

662,820

 

$

579,594

 

Discontinued Operations

 

1,797

 

31,536

 

13,795

 

99,352

 

Consolidated Revenue

 

$

236,016

 

$

228,285

 

$

676,615

 

$

678,946

 

 

 

 

 

 

 

 

 

 

 

Funds From Operations

 

 

 

 

 

 

 

 

 

Rental Operations:

 

 

 

 

 

 

 

 

 

Office

 

$

100,567

 

$

75,153

 

$

273,731

 

$

217,404

 

Industrial

 

38,127

 

32,001

 

115,436

 

91,625

 

Services Operations

 

10,551

 

12,559

 

18,477

 

37,443

 

Total Segment FFO

 

149,245

 

119,713

 

407,644

 

346,472

 

Non-Segment FFO:

 

 

 

 

 

 

 

 

 

Interest expense

 

(50,173

)

(30,523

)

(133,288

)

(86,123

)

Interest and other income

 

4,381

 

1,517

 

8,313

 

3,676

 

General and administrative expense

 

(6,804

)

(5,803

)

(27,715

)

(21,308

)

Gain on land sales, net of impairment

 

2,982

 

2,371

 

5,427

 

5,779

 

Impairment adjustments on depreciable property

 

(235

)

(79

)

(266

)

(3,643

)

Other income on non-segment FFO

 

401

 

683

 

3,759

 

2,215

 

Minority interest in earnings of subsidiaries

 

(126

)

(1,396

)

(301

)

(1,462

)

Minority interest in earnings of common unitholders

 

(2,306

)

(1,897

)

(5,314

)

(6,934

)

Minority interest share of FFO adjustments

 

(2,621

)

12,038

 

(13,831

)

2,138

 

Joint venture FFO

 

8,341

 

9,146

 

27,060

 

28,671

 

Dividends on preferred shares

 

(15,226

)

(11,619

)

(41,193

)

(34,859

)

Adjustment for redemption of preferred shares

 

 

 

(2,633

)

 

Discontinued operations, net of minority interest

 

928

 

(6,976

)

7,558

 

22,019

 

Consolidated basic FFO

 

$

88,787

 

$

87,175

 

$

235,220

 

$

256,641

 

Depreciation and amortization on continuing operations

 

(63,892

)

(59,494

)

(187,099

)

(164,239

)

Depreciation and amortization on discontinued operations

 

(471

)

(8,129

)

(3,013

)

(30,734

)

Company’s share of joint venture adjustments

 

(4,568

)

(5,003

)

(13,695

)

(14,811

)

Earnings from depreciated property sales on discontinued operations

 

39,537

 

210,837

 

41,573

 

223,235

 

Earnings from depreciated property sales-share of joint venture

 

(280

)

 

8,082

 

11,174

 

Minority interest share of FFO adjustments

 

2,621

 

(12,038

)

13,831

 

(2,138

)

Net income available for common shareholders

 

$

61,734

 

$

213,348

 

$

94,899

 

$

279,128

 

 

10




The assets for each of the reportable segments as of September 30, 2006 and December 31, 2005, respectively, are as follows (in thousands):

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

Assets

 

 

 

 

 

Rental Operations:

 

 

 

 

 

Office

 

$

4,401,853

 

$

3,396,985

 

Industrial

 

1,939,724

 

1,577,631

 

Service Operations

 

216,546

 

177,463

 

Total Segment Assets

 

6,558,123

 

5,152,079

 

Non-Segment Assets

 

715,419

 

495,481

 

Consolidated Assets

 

$

7,273,542

 

$

5,647,560

 

 

In addition to revenues and FFO, we also review our recurring capital expenditures in measuring the performance of our individual Rental Operations segments. These recurring capital expenditures consist of tenant improvements, leasing commissions and building improvements. We review these expenditures to determine the costs associated with re-leasing space and maintaining the condition of our properties. Our recurring capital expenditures by segment are summarized as follows for the nine months ended September 30, 2006 and 2005, respectively (in thousands):

 

 

2006

 

2005

 

Recurring Capital Expenditures

 

 

 

 

 

Office

 

$

42,035

 

$

44,838

 

Industrial

 

9,672

 

37,794

 

Non-segment

 

347

 

28

 

Total

 

$

52,054

 

$

82,660

 

 

8.                 Discontinued Operations

We classified the operations of 257 buildings as discontinued operations in the condensed consolidated statements of operations for the three and nine months ended September 30, 2006 and 2005. These 257 buildings consist of 239 industrial properties, 17 office properties and one retail property. Of these properties, 18 were sold during the first nine months of 2006, 234 were sold during 2005 and five operating properties were classified as held-for-sale at September 30, 2006.

The following table illustrates the operations of the 257 buildings reflected in discontinued operations for the three and nine months ended September 30, 2006 and 2005, respectively (in thousands):

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Statement of Operations:

 

 

 

 

 

 

 

 

 

Revenues

 

$

1,797

 

$

31,536

 

$

13,795

 

$

99,352

 

Expenses:

 

 

 

 

 

 

 

 

 

Operating

 

935

 

10,162

 

3,779

 

31,019

 

Interest

 

428

 

9,851

 

2,327

 

26,142

 

Depreciation and Amortization

 

471

 

8,129

 

3,013

 

30,734

 

General and Administrative

 

2

 

65

 

24

 

130

 

Operating Income (loss)

 

(39

)

3,329

 

4,652

 

11,327

 

Minority interest expense - operating and other income

 

4

 

(287

)

(419

)

(983

)

Income (loss) from discontinued operations, before gain on sales

 

(35

)

3,042

 

4,233

 

10,344

 

Gain on sale of property, net of impairment adjustments

 

43,735

 

210,758

 

45,739

 

219,592

 

Minority interest expense — gain on sales

 

(3,939

)

(18,146

)

(4,119

)

(19,060

)

Gain on sale of discontinued operations, net of impairment adjustments and minority interest

 

39,796

 

192,612

 

41,620

 

200,532

 

Income from discontinued operations

 

$

39,761

 

$

195,654

 

$

45,853

 

$

210,876

 

 

11




At September 30, 2006, we classified as held-for-sale, and included in discontinued operations, four industrial properties and one office property comprising approximately 852,000 square feet. Additionally, we have classified the 32 in-service properties from the Mark Winkler Portfolio (see Note 3), as well as six additional properties, as held-for-sale. However, the results of these 38 properties are included in continuing operations, as required by SFAS 144, either based on our present intention to sell the majority of our ownership interest in the properties to entities in which we will retain a minority equity ownership interest or because the results of operations for the properties are immaterial. The following table illustrates the aggregate balance sheet of the aforementioned five properties included in discontinued operations, as well as the 38 held-for-sale properties whose results are included in continuing operations at September 30, 2006 (in thousands):

 

 

Held-for-Sale and Included in
Discontinued Operations

 

Held-for-Sale and Included in
Continuing Operations

 

Total

 

Real estate investments, net

 

$

29,662

 

$

698,734

 

$

728,396

 

Other assets

 

1,112

 

109,048

 

110,160

 

Assets held-for-sale

 

30,774

 

807,782

 

838,556

 

 

 

 

 

 

 

 

 

Accrued expenses

 

$

779

 

$

3,856

 

$

4,635

 

Other liabilities

 

179

 

5,885

 

6,064

 

Secured debt

 

 

144,423

 

144,423

 

Liabilities held-for-sale

 

$

958

 

$

154,164

 

$

155,122

 

 

We allocate interest expense to discontinued operations as permitted under Emerging Issues Task Force (“EITF”) Issue No. 87-24, Allocation of Interest to Discontinued Operations, and have included such interest expense in computing net income from discontinued operations. Interest expense allocable to discontinued operations includes interest on any debt on secured properties included in discontinued operations and an allocable share of our consolidated unsecured interest expense for unencumbered properties. The allocation of unsecured interest expense to discontinued operations was based upon the gross book value of the discontinued operations unencumbered population as it related to our entire unencumbered population.

For the nine months ended September 30, 2006 and 2005, we recorded impairment adjustments of $576,000 and $3.8 million, respectively. The $576,000 impairment adjustment recorded in the nine months ended September 30, 2006 reflects the write-down of the carrying value of one industrial building, one office building and one land parcel sold in the nine months ended September 30, 2006, in addition to one industrial building that is held for sale as of September 30, 2006. The $3.8 million impairment adjustment recorded in the nine months ended September 30, 2005 reflects the write-down of the carrying value of three office buildings, three industrial buildings and four land parcels sold at various times in 2005 and 2006.

9.                 Shareholders’ Equity

We periodically access the public equity markets to fund the development and acquisition of additional rental properties or to pay down debt. The proceeds of these offerings are contributed to DRLP in exchange for an additional interest in DRLP. In January 2006, we issued $184 million of 6.95% Series M Cumulative Redeemable Preferred Shares, from which a portion of the net proceeds were used to redeem our $75 million of outstanding 8.45% Series I Cumulative Redeemable Preferred Shares. Offering costs of $2.6 million were charged against net income available to common shareholders in conjunction with the redemption of the Series I Cumulative Redeemable Preferred Shares. In June 2006, we issued $110 million of 7.25% Series N Cumulative Redeemable Preferred Shares.

12




The following series of preferred shares were outstanding as of September 30, 2006 (in thousands, except percentage data):

 

 

Shares

 

Dividend

 

Redemption

 

Liquidation

 

Description

 

Outstanding

 

Rate

 

Date

 

Preference

 

Series B Preferred

 

265

 

7.990

%

September 30, 2007

 

$

132,250

 

Series J Preferred

 

400

 

6.625

%

August 29, 2008

 

100,000

 

Series K Preferred

 

600

 

6.500

%

February 13, 2009

 

150,000

 

Series L Preferred

 

800

 

6.600

%

November 30, 2009

 

200,000

 

Series M Preferred

 

736

 

6.950

%

January 31, 2011

 

184,000

 

Series N Preferred

 

440

 

7.250

%

June 30, 2011

 

110,000

 

 

The dividend rate on the Series B preferred shares increases to 9.99% after September 12, 2012.

All series of preferred shares require cumulative distributions and have no stated maturity date (although we may redeem all such preferred shares on or following their optional redemption dates at our option, in whole or in part).

10.          Financial Instruments

We are exposed to capital market risk, such as changes in interest rates. In order to manage the volatility relating to interest rate risk, we may enter into interest rate hedging arrangements from time to time. We do not utilize derivative financial instruments for trading or speculative purposes.

In March 2005, we entered into $300 million of cash flow hedges through forward-starting interest rate swaps to hedge interest rates on $300 million of estimated debt offerings in 2006. The swaps qualified for hedge accounting under SFAS 133 with any changes in fair value recorded in Accumulated Other Comprehensive Income (“OCI”). The market value of these interest rate swaps is dependent upon existing market interest rates, which change over time. In March 2006, we issued $150 million of 5.5% senior unsecured notes due 2016 (see Note 4) and terminated a corresponding amount of the cash flow hedges designated for this transaction. The settlement amount paid of approximately $1 million will be recognized to earnings through interest expense ratably over the life of the senior notes and the ineffective portion of the hedge was insignificant. In August 2006, we issued $450 million of 5.95% senior unsecured notes due 2017 and $250 million of 5.69% senior unsecured notes due 2011 (see Note 4) and terminated the remaining $150 million of cash flow hedges. The settlement amount received of approximately $1.6 million will be recognized to earnings through interest expense ratably over the lives of the senior unsecured notes. The ineffective portion of the hedge was insignificant.

In August 2005, we entered into $300 million of cash flow hedges through forward-starting interest rate swaps to hedge interest rates on $300 million of estimated debt offerings in 2007. The swaps qualify for hedge accounting under SFAS 133 with any changes in fair value recorded in OCI. At September 30, 2006, the fair value of these swaps was approximately $9.6 million in an asset position as the effective rates of the swaps were lower than current interest rates at September 30, 2006.

In June 2006, we entered into a $250 million cash flow hedge through an interest rate swap to fix the rate on $250 million of previously floating rate debt which matures in December 2006. The swap qualifies for hedge accounting under SFAS 133 with any changes in fair value recorded in OCI. At September 30, 2006, the fair value of this swap was approximately $78,000 in a liability position and there was no ineffectiveness.

13




The effectiveness of our hedges will be evaluated throughout their lives using the hypothetical derivative method under which the change in fair value of the actual swap designated as the hedging instrument is compared to the change in fair value of a hypothetical swap.

11.          Stock Based Compensation

Our stock based employee and non-employee compensation plans are described more fully below. We are authorized to issue up to 11,320,552 shares of our common stock under these compensation plans. New shares of common stock are issued to employees upon exercise of share-based awards that are settled in company stock.

For all issuances of stock-based awards prior to 2002, we applied the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related interpretations, in accounting for our stock-based compensation.

Accordingly, for stock options granted prior to 2002, no compensation expense is reflected in net income as all options granted had an exercise price equal to the market value of the underlying common shares on the date of the grant.

Effective January 1, 2002, we prospectively adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), and applied SFAS 123 to all awards granted after January 1, 2002.

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123(R), Share Based Payment, (“SFAS 123(R)”), using the modified prospective application method. Under this method, as of January 1, 2006, we applied the provisions of SFAS 123(R) to new and modified awards, as well as to the nonvested portion of awards granted before the required effective date and outstanding at such time.

Some of our stock-based compensation awards, including both stock options and restricted stock units, have a retirement eligible provision, whereby awards granted to an employee who has reached certain age and service criteria, automatically vest upon such employee’s retirement. We have previously accounted for this type of arrangement by recognizing compensation cost (for both pro forma and expense recognition purposes) over the full stated vesting period of the award and, if the employee retired before the end of the vesting period, recognizing any remaining unrecognized compensation cost at the date of retirement. Upon adoption of SFAS 123(R), new awards granted to retirement eligible employees are subject to accelerated vesting over a period when the employee’s retention of the award is no longer contingent on providing additional service. Had we applied accelerated vesting to all existing unvested awards issued to retirement eligible employees prior to January 1, 2006, we would have recognized an additional $969,000 in stock-based employee compensation expense for the nine months ended September 30, 2006.

An additional requirement of SFAS 123(R) is that estimated forfeitures be considered in determining compensation expense. As previously permitted, we recorded forfeitures when they occurred. The effect of this accounting change on existing nonvested stock compensation was insignificant.

As a result of adopting SFAS 123(R) on January 1, 2006, our net income available for common shareholders for the nine-months ended September 30, 2006, was $437,000 higher than if we had continued to account for share-based compensation under SFAS 123 and APB 25. There was no effect on basic and diluted earnings per share from continuing operations as a result of the adoption of SFAS 123(R).

Cash flows resulting from tax deductions in excess of recognized compensation cost from the exercise of stock options (excess tax benefits) were not significant in either period presented.

14




The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS 123 to all stock-based employee compensation for the three and nine month periods ended September 30, 2005 (in thousands, except per share data):

 

 

Three Months Ended

 

Nine months Ended

 

 

 

September 30, 2005

 

September 30, 2005

 

Net income available for common shareholders, as reported

 

$

213,348

 

$

279,128

 

Add: Stock-based employee compensation expense included in net income determined under fair value method

 

547

 

1,477

 

 

 

 

 

 

 

Deduct: Total stock-based compensation expense determined under fair value method for all awards

 

(603

)

(1,642

)

Pro forma net income available for common shareholders

 

$

213,292

 

$

278,963

 

 

 

 

 

 

 

Basic net income per common share

 

 

 

 

 

As reported

 

$

1.50

 

$

1.95

 

Pro forma

 

$

1.50

 

$

1.95

 

 

 

 

 

 

 

Diluted net income per common share

 

 

 

 

 

As reported

 

$

1.48

 

$

1.94

 

Pro forma

 

$

1.48

 

$

1.94

 

 

Fixed Stock Option Plans

We had options outstanding under six fixed option plans as of September 30, 2006. Additional grants may be made under one of those plans. Stock option awards granted under our stock based employee and non-employee compensation plans generally vest over five years at 20% per year and have contractual lives of ten years. The exercise price for stock option grants is set at the fair value of our common stock on the day of grant.

The following table summarizes transactions under our stock option plans for the nine months ended September 30, 2006:

 

 

Shares

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Contractual
Term (years)

 

Aggregate
Intrinsic
Value (1)
(in millions)

 

Outstanding, beginning of year

 

3,828,157

 

$

25.50

 

 

 

 

 

Granted

 

857,667

 

$

34.16

 

 

 

 

 

Exercised

 

(401,764

)

$

22.03

 

 

 

 

 

Forfeited

 

(80,259

)

$

29.66

 

 

 

 

 

Outstanding at September 30, 2006

 

4,203,801

 

$

27.52

 

6.36

 

$

41.3

 

Options exercisable at September 30, 2006

 

2,297,473

 

$

24.07

 

4.68

 

$

30.5

 


(1)             The aggregate intrinsic value represents the total pre-tax intrinsic value, based on the closing stock price of $37.35 at September 30, 2006, which would have been received by the option holders had all option holders exercised their options as of that date. This amount changes continuously based on the fair value of the stock.

15




Options granted in the nine-month periods ended September 30, 2006 and 2005, respectively, had a weighted average fair value of $3.60 and $3.04. As of September 30, 2006, there was $4.1 million of total unrecognized compensation expense related to stock options granted under the plans, which is expected to be recognized over a weighted average remaining period of 3.23 years. The total intrinsic value of options exercised during the nine-month periods ended September 30, 2006 and 2005, respectively, was $5.8 million and $2.1 million. Compensation expense recognized for fixed stock option plans was $1.4 million and $837,000 in the first nine months of 2006 and 2005, respectively. The fair value of options vested during the nine month periods ending September 30, 2006 and 2005 was $1.3 million and $1.1 million.

The fair values of the options for the nine months ended September 30, 2006 and 2005, were determined using the Black-Scholes option-pricing model with the following assumptions:

 

 

2006

 

2005

 

Dividend yield

 

6.25

%

6.25

%

Volatility

 

20.0

%

20.0

%

Risk-free interest rate

 

4.5

%

3.8

%

Expected life

 

6 years

 

6 years

 

 

The risk free interest rate assumption is based upon observed interest rates appropriate for the term of our employee stock options. The dividend yield assumption is based on the history of and our present expectation of future dividend payouts. Our computation of expected volatility for the valuation of stock options granted in the quarters ended September 30, 2006 and 2005 is based on historic volatility over a period of time equal to the expected term. The expected life of employee stock options represents the weighted average period the stock options are expected to remain outstanding.

Performance Share Plans

Performance shares were granted under the 2000 Performance Share Plan, with each performance share economically equivalent to one share of our common stock.

The performance shares vest over a five-year period with the vesting percentage for a year dependent upon our attainment of certain predefined levels of earnings growth for such year. The performance shares have a contractual life of five years.

In April 2006, the 2000 Performance Share Plan was amended to provide that awards would be settled in shares of common stock rather than cash. The fair value of existing awards was fixed at the date of the amendment and the fair value of subsequent awards will be fixed at the fair value of our common stock at the date of grant. Under our 2005 Long-Term Incentive Plan, additional performance shares may be granted on such terms and conditions as may be selected by our compensation committee, including whether payment will be made in cash, shares of our common stock, DRLP Units or other property.

The following table summarizes transactions for our performance shares for the first nine months of 2006:

2000 Performance Share Plan

 

Vested

 

Unvested

 

Total

 

 

 

 

 

 

 

 

 

Performance Share Plan units at December 31, 2005

 

84,466

 

99,001

 

183,467

 

Granted

 

 

 

 

Vested

 

25,487

 

(25,487

)

 

Forfeited

 

 

(3,746

)

(3,746

)

Dividend reinvestments

 

6,599

 

 

6,599

 

Disbursements

 

(13,744

)

 

(13,744

)

Total Performance Share Plan units outstanding at September 30, 2006

 

102,808

 

69,768

 

172,576

 

16




Compensation expense recognized for Performance Share Plan units was $787,000 and $860,000 for the nine-month periods ended September 30, 2006 and 2005, respectively. As of September 30, 2006, there was $201,000 of total unrecognized compensation expense related to nonvested performance shares granted under the Plan, which will be recognized based on the Company’s actual performance. The total vest date fair value of shares vesting during the nine-month period ended September 30, 2006 was $918,000.

Shareholder Value Plan Awards

Our 2005 Shareholder Value Plan (“2005 SVP Plan”), a sub-plan of our 2005 Long-Term Incentive Plan, was approved by our shareholders in April 2005. Upon vesting, payout of the 2005 Shareholder Value Plan awards will be made in shares of our common stock. Under the 2005 SVP Plan, shareholder value awards fully vest three years after the date of grant. The number of common shares to be issued may range from 0%-300% of the target shares awarded and will be based upon our total shareholder return for such three-year period as compared to the S & P 500 Index and the NAREIT Real Estate 50 Index. Each index is weighted at 50%.

Awards made under the 2005 SVP Plan are measured at fair value, which is determined using a Monte Carlo simulation model that was developed to accommodate the unique features of the 2005 SVP Plan. Compensation cost recognized under the 2005 SVP Plan was $531,000 and $395,000 for the nine-month periods ended September 30, 2006 and 2005, respectively.

The following table summarizes transactions for our awards under the 2005 SVP Plan for the first nine months of 2006:

2005 Shareholder Value Plan Awards

 

Number of
SVP Units

 

Weighted
Average
Grant Date
Fair Value

 

SVP awards at December 31, 2005

 

75,678

 

$

30.64

 

Granted

 

90,356

 

$

34.13

 

Forfeited

 

(3,829

)

$

31.23

 

SVP awards at September 30, 2006

 

162,205

 

$

32.57

 

 

As of September 30, 2006, there was $2.1 million of total unrecognized compensation expense related to nonvested SVP Plan awards granted under the 2005 SVP Plan, which will be recognized over a weighted average period of two years. All 2005 SVP Plan awards have a contractual life of three years.

Restricted Stock Units

Under our 2005 Long-Term Incentive Plan and our 2005 Non-Employee Directors Compensation Plan approved by our shareholders in April 2005, restricted stock units (“RSUs”) may be granted to non-employee directors, executive officers and selected management employees. An RSU is economically equivalent to one share of our common stock. RSUs granted prior to January 1, 2006 vest 20% per year over five years, have contractual lives of five years and are payable in shares of our common stock. RSUs granted to existing non-employee directors subsequent to January 1, 2006 vest 100% over one year, and have contractual lives of one year. We recognize the value of the granted RSUs over this vesting period as expense.

17




The following table summarizes transactions for our RSUs, excluding dividend equivalents, for the first nine months of 2006:

Restricted Stock Units

 

Number of
RSUs

 

Weighted
Average
Grant Date
Fair Value

 

RSUs at December 31, 2005

 

172,095

 

$

32.19

 

Granted

 

108,118

 

$

34.16

 

Vested

 

(16,548

)

$

30.76

 

Forfeited

 

(7,563

)

$

32.62

 

RSUs at September 30, 2006

 

256,102

 

$

33.65

 

 

Compensation cost recognized for RSUs totaled $1.7 million and $245,000 for the nine-month periods ended September 30, 2006 and 2005, respectively.

As of September 30, 2006, there was $6.0 million of total unrecognized compensation expense related to nonvested RSUs granted under the Plan, which is expected to be recognized over a weighted average period of 4 years.

In addition, all RSUs earn dividend equivalents that are deemed to be reinvested in additional RSUs. Dividend equivalents vest immediately and will be paid in shares of our common stock when the corresponding portion of the original RSU award vests or upon termination of the participant. Dividend equivalents of 10,732 RSUs were earned in the first nine months of 2006, and 14,814 dividend equivalents were outstanding as of September 30, 2006. A charge to retained earnings of $706,000 was recorded for the value of these dividend equivalents during the first nine months of 2006.

12.          Recent Accounting Pronouncements

In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Interpretation also provides guidance on description, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 becomes effective on January 1, 2007. We are currently evaluating the effect that the adoption of FIN 48 will have on our financial statements.

In September 2006, the Securities Exchange Commission (“SEC”) issued Staff  Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Qualifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides guidance regarding the process of qualifying financial statement misstatements. We will adopt SAB 108 in the fourth quarter of 2006 and do not believe that the adoption of SAB 108 will have a material effect on our financial statements.

13.          Subsequent Events

Declaration of Dividends

The Company’s Board of Directors declared the following dividends at its October 25, 2006, regularly scheduled Board me

Class

 

Quarterly
Amount/Share

 

Record Date

 

Payment Date

 

Common

 

$

0.4750

 

November 14, 2006

 

November 30, 2006

 

Preferred (per depositary share):

 

 

 

 

 

 

 

Series B

 

$

0.998750

 

December 15, 2006

 

December 29, 2006

 

Series J

 

$

0.414063

 

November 16, 2006

 

November 30, 2006

 

Series K

 

$

0.406250

 

November 16, 2006

 

November 30, 2006

 

Series L

 

$

0.412500

 

November 16, 2006

 

November 30, 2006

 

Series M

 

$

0.434375

 

December 15, 2006

 

December 29, 2006

 

Series N

 

$

0.453125

 

December 15, 2006

 

December 29, 2006

 

 

18




Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement Regarding Forward Looking Statements

Certain statements in this quarterly report, including those related to our future operations, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The words “believe,” “estimate,” “expect,” “anticipate,” “intend,” “plan,” “seek,” “may,” and similar expressions or statements regarding future periods are intended to identify forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause our actual results, performance or achievements, or industry results, to differ materially from any predictions of future results, performance or achievements that we express or imply in this Report. Some of the risks, uncertainties and other important factors that may affect future results include, among others:

·                  Changes in general economic and business conditions, including performance of financial markets;

·                  Our continued qualification as a real estate investment trust, or “REIT”;

·                  Heightened competition for tenants and potential decreases in property occupancy;

·                  Potential increases in real estate construction costs;

·                  Potential changes in the financial markets and interest rates;

·                  Our continuing ability to favorably raise funds through the issuance of debt and equity in the capital markets;

·                  Our ability to successfully identify, acquire, develop and/or manage properties on terms that are favorable to us;

·                  Our ability to successfully dispose of properties on terms that are favorable to us;

·                  Inherent risks in the real estate business including tenant defaults, potential liability relating to environmental matters and liquidity of real estate investments; and

·                  Other risks and uncertainties described herein, including, without limitation, under the caption “Item 1A. Risk Factors”, and in our other reports and other filings with the Securities and Exchange Commission (“SEC”).

This list of risks and uncertainties, however, is not intended to be exhaustive. Additional risk factor information is included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, which we filed with the SEC on March 7, 2006, and is updated by us from time to time in Quarterly Reports on Form 10-Q and other future filings.

Although we presently believe that the plans, expectations and results expressed in or suggested by the forward-looking statements are reasonable, all forward-looking statements are inherently uncertain as they involve substantial risks and uncertainties beyond our control. New factors emerge from time to time, and it is not possible for us to predict the nature or assess the potential impact of each new factor on our business. Given these uncertainties, we caution you not to place undue reliance on these forward-looking statements. We undertake no obligation to update or revise any of our forward-looking statements for events or circumstances that arise after the statement is made.

19




Business Overview

We are a self-administered and self-managed REIT that began operations through a related entity in 1972. As of September 30, 2006, we:

·                  Owned or controlled 733 industrial, office and retail properties (including properties under development), consisting of approximately 112.9 million square feet; and

·                  Owned or controlled more than 6,500 acres of land with an estimated future development potential of more than 94 million square feet of industrial, office and retail properties.

We provide the following services for our properties and for certain properties owned by third parties and joint ventures:

·                  Property leasing;

·                  Property management;

·                  Construction;

·                  Development; and

·                  Other tenant-related services

Acquisitions

In the first quarter of 2006, we completed the majority of the acquisition of a Washington D.C. metropolitan area portfolio of suburban office and light industrial properties (the “Mark Winkler Portfolio”). The assets acquired for a purchase price of approximately $865.2 million are comprised of 32 properties with approximately 2.9 million square feet for rental, 166 acres of undeveloped land, as well as certain related assets of the Mark Winkler Company, a real estate management company. The acquisition was financed primarily through assumed mortgage loans and new borrowings.

In the third quarter of 2006, we completed the purchase of a portfolio of industrial real estate properties in Savannah, Georgia with the purpose of expanding our industrial real estate holdings near major port facilities. We completed a majority of the purchase in January 2006. The assets acquired for a purchase price of approximately $196.2 million are comprised of 18 buildings with approximately 5.1 million square feet for rental as well as over 60 acres of undeveloped land. The acquisition was financed in part through assumed mortgage loans.

Key Performance Indicators

Our operating results depend primarily upon rental income from our office, industrial and retail properties (“Rental Operations”). The following highlights the areas of Rental Operations that we consider critical for future revenue growth. (All square footage totals and occupancy percentages reflect both wholly owned properties and properties in joint ventures).

Occupancy Analysis: Our ability to maintain favorable occupancy rates is a principal driver of our results of operations. The following table sets forth occupancy information regarding our in-service portfolio of rental properties as of September 30, 2006 and 2005, respectively (in thousands, except percentage data):

 

 

Total
Square Feet

 

Percent of
Total Square Feet

 

Percent Occupied

 

Type

 

2006

 

2005

 

2006

 

2005

 

2006

 

2005

 

Industrial

 

 

 

 

 

 

 

 

 

 

 

 

 

Service Centers

 

4,724

 

4,724

 

4.4

%

4.9

%

91.9

%

90.2

%

Bulk

 

69,515

 

61,723

 

64.9

%

63.5

%

93.2

%

92.5

%

Office

 

32,182

 

30,074

 

30.1

%

31.0

%

90.9

%

88.7

%

Retail

 

611

 

611

 

0.6

%

0.6

%

99.7

%

95.6

%

Total

 

107,032

 

97,132

 

100.0

%

100.0

%

92.5

%

91.2

%

 

20




Lease Expiration and Renewal: Our ability to maintain and increase occupancy rates primarily depends upon our continuing ability to re-lease expiring space. The following table reflects our in-service portfolio lease expiration schedule by property type as of September 30, 2006. The following table indicates square footage and annualized net effective rents (based on September 2006 rental revenue) under expiring leases (in thousands, except percentage data):

 

 

Total Portfolio

 

Industrial

 

Office

 

Retail

 

Year of Expiration

 

Square
Feet

 

Ann. Rent
Revenue

 

Percent of
Revenue

 

Square
Feet

 

Ann. Rent
Revenue

 

Square
Feet

 

Ann. Rent
Revenue

 

Square
Feet

 

Ann. Rent
Revenue

 

2006

 

1,967

 

$

10,974

 

2

%

1,582

 

$

6,172

 

385

 

$

4,802

 

 

$

 

2007

 

9,972

 

61,009

 

9

%

7,550

 

29,483

 

2,413

 

31,403

 

9

 

123

 

2008

 

13,686

 

84,441

 

12

%

10,121

 

40,252

 

3,546

 

43,854

 

19

 

335

 

2009

 

12,636

 

82,605

 

12

%

9,031

 

35,574

 

3,601

 

46,953

 

4

 

78

 

2010

 

11,426

 

92,737

 

14

%

7,102

 

31,659

 

4,317

 

60,973

 

7

 

105

 

2011

 

13,015

 

81,942

 

12

%

9,608

 

36,783

 

3,363

 

44,340

 

44

 

819

 

2012

 

8,416

 

57,427

 

8

%

5,696

 

20,772

 

2,713

 

36,322

 

7

 

333

 

2013

 

6,385

 

59,114

 

9

%

3,325

 

14,521

 

3,026

 

44,014

 

34

 

579

 

2014

 

4,990

 

28,212

 

4

%

3,859

 

13,306

 

1,131

 

14,906

 

 

 

2015

 

6,807

 

52,393

 

8

%

4,729

 

18,693

 

2,078

 

33,700

 

 

 

2016 and Thereafter

 

9,711

 

70,978

 

10

%

6,554

 

26,341

 

2,673

 

41,338

 

484

 

3,299

 

Total Leased

 

99,011

 

$

681,832

 

100

%

69,157

 

$

273,556

 

29,246

 

$

402,605

 

608

 

$

5,671

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Portfolio

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Square Feet

 

107,032

 

 

 

 

 

74,239

 

 

 

32,182

 

 

 

611

 

 

 

Percent Occupied

 

92.5

%

 

 

 

 

93.2

%

 

 

90.9

%

 

 

99.7

%

 

 

 

Lease Renewals: We renewed 79.6% and 78.9% of leases up for renewal in the three and nine months ended September 30, 2006, totaling 1.9 million and 5.7 million square feet, respectively. This compared to renewals of 78.8% and 74.2% for the three and nine months ended September 30, 2005 totaling 2.7 million and 7.6 million square feet, respectively.

The average term of renewals for the three and nine months ended September 30, 2006, was 4.7 and 3.9 years, respectively, compared to an average term of 5.3 and 4.4 years for the three and nine months ended September 30, 2005, respectively.

Future Development: Another source of growth in earnings is the development of additional properties. These properties should provide future earnings through Service Operations income upon sale or from Rental Operations growth as they are placed in service. As of September 30, 2006, we had 11.4 million square feet of property under development with total estimated costs upon completion of $1.1 billion, which were 39% pre-leased as of September 30, 2006. This compares to 6.9 million square feet with total estimated costs of $480.8 million, which were 34% pre-leased as of September 30, 2005.

21




A summary of properties under development as of September 30, 2006, follows (in thousands, except percentage data):

Anticipated In-Service Date

 

Square
Feet

 

Percent
Leased

 

Total
Estimated
Project
Costs

 

Anticipated
Stabilized
Return

 

Held for Rental:

 

 

 

 

 

 

 

 

 

4th Quarter 2006

 

3,811

 

32

%

$

189,574

 

9.02

%

1st Quarter 2007

 

891

 

23

%

93,522

 

9.95

%

2nd Quarter 2007

 

372

 

18

%

49,812

 

9.50

%

Thereafter

 

752

 

8

%

115,680

 

9.51

%

 

 

5,826

 

26

%

$

448,588

 

9.39

%

Service Segment: