KBS GROWTH & INCOME REIT, INC. The following discussion and analysis should be read in conjunction with our accompanying consolidated financial statements and the notes thereto. Also see "Forward-Looking Statements" and "Summary Risk Factors" preceding Part I and Part I, Item 1A, "Risk Factors."
Overview
We were formed onJanuary 12, 2015 as aMaryland corporation that elected to be taxed as a real estate investment trust ("REIT") beginning with the taxable year endedDecember 31, 2015 and we intend to continue to operate in such a manner. Substantially all of our business is conducted through ourOperating Partnership , of which we are the sole general partner. Subject to certain restrictions and limitations, our business is externally managed by our advisor pursuant to an advisory agreement.KBS Capital Advisors manages our operations and our portfolio of core real estate properties.KBS Capital Advisors also provides asset-management, marketing, investor-relations and other administrative services on our behalf. Our advisor acquired 20,000 shares of our Class A common stock for an initial investment of$200,000 . We have no paid employees. We commenced a private placement offering of our shares of common stock that was exempt from registration pursuant to Rule 506(b) of Regulation D of the Securities Act of 1933, as amended (the "Securities Act"), onJune 11, 2015 . We ceased offering shares in the primary portion of our private offering onApril 27, 2016 .KBS Capital Markets Group LLC , an affiliate of our advisor, served as the dealer manager of the offering pursuant to a dealer manager agreement. OnApril 26, 2016 , theSEC declared our registration statement on Form S-11, pursuant to which we registered shares of our common stock for sale to the public, effective, and we retainedKBS Capital Markets Group LLC to serve as the dealer manager of the initial public offering. We terminated the primary initial public offering effectiveJune 30, 2017 . We terminated the distribution reinvestment plan offering effectiveAugust 20, 2020 . OnOctober 3, 2017 , we launched a second private placement offering of our shares of common stock that exempt from registration pursuant to Rule 506(c) of Regulation D of the Securities Act. In connection with the offering, we entered into a dealer manager agreement withKBS Capital Advisors and an unaffiliated third party. InDecember 2019 , in connection with its consideration of strategic alternatives for us, our board of directors determined to suspend the second private offering and terminated the second private offering onAugust 5, 2020 . Through our capital raising activities, we raised$94.0 million from the sale of 10,403,922 shares of our common stock, including$8.5 million from the sale of 924,286 shares of common stock under our dividend reinvestment plan. As ofDecember 31, 2021 , we had 9,855,330 and 310,974 Class A and Class T shares outstanding, respectively. We have used substantially all of the net proceeds from our offerings to invest in a portfolio of core real estate properties. We consider core properties to be existing properties with at least 80% occupancy. As ofDecember 31, 2021 , we owned four office buildings.
Going Concern Considerations
The accompanying consolidated financial statements and notes have been prepared assuming we will continue as a going concern. We have experienced a decline in occupancy from 90.4% as ofDecember 31, 2020 to 75.3% as ofDecember 31, 2021 and such occupancy may continue to decrease in the future as tenant leases expire. The decrease in occupancy has resulted in a decrease in cash flow from operations and has negatively impacted the market values of our properties. Additionally, we have two loans with an aggregate principal balance of$97.9 million maturing within one year from the date the consolidated financial statements are issued. Due to the decrease in occupancies and a decrease in market values of the properties securing these two loans, we may be unable to extend or refinance the upcoming loan maturities at current terms and may be required to paydown a portion of the maturing debt in order to extend or refinance the loans. With our limited amount of cash on hand, our ability to make any loan paydowns, without the sale of real estate assets, is severely limited. Additionally, in order to attract or retain tenants needed to increase occupancy and sustain operations, we will need to spend a substantial amount on capital leasing costs, however we have limited amounts of liquidity to make these capital commitments. These conditions raise substantial doubt about our ability to continue as a going concern. Our ability to continue as a going concern is dependent upon our ability to exercise our extension option or refinance loans maturing over the next 12 months. No assurances can be given that we will be successful in achieving these objectives. 42 -------------------------------------------------------------------------------- Table of Contents Plan of Liquidation Our board of directors and a special committee composed of all of our independent directors (the "Special Committee") has undertaken a review of various strategic alternatives available to us and expects to approve the sale of all of our assets and our dissolution pursuant to the terms of a plan of complete liquidation and dissolution (a "Plan of Liquidation"). Once approved by our board of directors, a Plan of Liquidation will be submitted to our stockholders for approval. We currently intend to send out a proxy statement to our stockholders for a liquidation vote by the end ofMay 2022 , with a stockholder meeting to approve a Plan of Liquidation to be held within 90 days. The principal purpose of a Plan of Liquidation will be to provide liquidity to our stockholders by selling our assets, paying our debts and distributing the net proceeds from liquidation to our stockholders. Although this is the current intention of our board of directors, we can provide no assurances as to the ultimate approval of a Plan of Liquidation or the timing of the liquidation of the company. If our board of directors and our stockholders approve a Plan of Liquidation, we intend to pursue an orderly liquidation of our company by selling all of our remaining assets, paying our debts and our known liabilities, providing for the payment of unknown or contingent liabilities, distributing the net proceeds from liquidation to our stockholders and winding up our operations and dissolving our company. In the interim, we intend to continue to manage our portfolio of assets to maintain and, if possible, improve the quality and income-producing ability of our properties to enhance property stability and better position our assets for a potential sale. A Plan of Liquidation remains subject to approval by our board of directors and our stockholders and we can give no assurance regarding the timing of our liquidation. Additional information regarding a Plan of Liquidation will be provided to our stockholders in a proxy statement to be distributed to stockholders in connection with a liquidation vote.
In connection with its consideration of a Plan of Liquidation, our board of directors determined to cease regular quarterly distributions. We expect any future distributions to our stockholders will be liquidating distributions.
We elected to be taxed as a REIT under the Internal Revenue Code, beginning with the taxable year endedDecember 31, 2015 . If we meet the REIT qualification requirements, we generally will not be subject to federal income tax on the income that we distribute to our stockholders each year. If we fail to qualify for taxation as a REIT in any year after electing REIT status, our income will be taxed at regular corporate rates, and we may be precluded from qualifying for treatment as a REIT for the four-year period following our failure to qualify. Such an event could materially and adversely affect our net income and cash available for distribution to our stockholders. However, we are organized and will operate in a manner that will enable us to qualify for treatment as a REIT for federal income tax purposes beginning with our taxable year endedDecember 31, 2015 , and we will continue to operate so as to remain qualified as a REIT for federal income tax purposes thereafter.
Market Outlook - Real Estate and Real Estate Finance Markets
Volatility in global financial markets, changing political environments and civil unrest can cause fluctuations in the performance of theU.S. commercial real estate 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 from investment properties. Further, revenues from our properties could decrease due to a reduction in occupancy (caused by factors including, but not limited to, tenant defaults, tenant insolvency, early termination of tenant leases and non-renewal of existing tenant leases), rent deferrals or abatements, tenants being unable to pay their rent and/or lower rental rates. Reductions in revenues from our properties would adversely impact the timing of any asset sales and/or the sales price we will receive for our properties if a Plan of Liquidation is approved by our board of directors and/or our stockholders. To the extent there are increases in the cost of financing due to higher interest rates, this may cause difficulty in refinancing debt obligations at terms as favorable as the terms of existing indebtedness. Market conditions can change quickly, potentially negatively impacting the value of real estate investments. Management continuously reviews our investment and debt financing strategies to optimize our portfolio and the cost of our debt exposure. Most recently, the outbreak of COVID-19 has had a negative impact on the real estate market as discussed below. 43 -------------------------------------------------------------------------------- Table of Contents COVID-19 Pandemic and Portfolio Outlook As ofDecember 31, 2021 , the novel coronavirus, or COVID-19, pandemic is ongoing. The spread of COVID-19 in many countries, includingthe United States , has significantly adversely impacted global economic activity, and has contributed to significant volatility in financial markets. The global impact of the pandemic has been rapidly evolving and many countries, includingthe United States , have reacted by restricting many business and travel activities, mandating the partial or complete closures of certain business and schools, and taking other actions to mitigate the spread of the virus, most of which have a disruptive effect on economic activity, including the use of and demand for office space. Many private businesses, including some of our tenants, continue to recommend or mandate some or all of their employees work from home or are rotating employees in and out of the office to encourage social distancing in the workplace. Due to these events, during 2021, the usage of our assets remained lower than pre-pandemic levels. In addition, we experienced a significant reduction in leasing interest and activity when compared to pre-pandemic levels. We cannot predict when, if, and to what extent these restrictions and other actions will end and when, if, and to what extent economic activity, including the use of and demand for office space, will return to pre-pandemic levels. Even after the pandemic has ceased to be active, the prevalence of work-from-home policies during the pandemic may alter tenant preferences in the long-term with respect to the demand for leasing office space. The outbreak of COVID-19 and its impact on the current financial, economic, capital markets and real estate market environment, and future developments in these and other areas present uncertainty and risk with respect to our financial condition, results of operations, liquidity, and ability to pay distributions. Although a recovery is partially underway, it continues to be gradual, uneven and characterized by meaningful dispersion across sectors and regions, and could be hindered by persistent or resurgent infection rates. Issues with respect to the distribution and acceptance of vaccines or the spread of new variants of the virus could adversely impact the recovery. Overall, there remains significant uncertainty regarding the timing and duration of the economic recovery, which precludes any prediction as to the ultimate adverse impact COVID-19 may have on our business. During the years endedDecember 31, 2021 and 2020, we did not experience significant disruptions in our operations from the COVID-19 pandemic. Rent collections for the quarter endedDecember 31, 2021 were approximately 98%. We have granted lease concessions related to the effects of the COVID-19 pandemic but these lease concessions did not have a material impact on our consolidated balance sheet as ofDecember 31, 2021 or consolidated statement of operations for the year endedDecember 31, 2021 . As ofDecember 31, 2021 , we had entered into lease amendments related to the effects of the COVID-19 pandemic, granting approximately$0.2 million of rent deferrals for the period fromApril 2020 throughApril 2021 and granting approximately$0.7 million in rental abatements. As ofDecember 31, 2021 , eleven tenants were granted rental deferrals, rental abatements and/or rent restructures, of which six of these tenants have begun to pay rent in accordance with their lease agreements subsequent to the deferral and/or abatement period, one of these tenants early terminated and two of these tenant leases were modified at lower rental rates. In addition to the direct impact on our rental income, we may also need to recognize impairment charges at our properties to the extent rental projections continue to decline at our properties. In response to a decrease in cash flow projections as a result of changes in leasing projections due in part to the impact of COVID-19 on our leasing efforts and perceived ability to collect rent from tenants, during the year endedDecember 31, 2020 , we recognized impairment charges of$5.8 million at the Institute Property and$0.8 million of equity in loss of unconsolidated joint venture, which included a$0.5 million impairment charge related to the 210 W. Chicago property then-owned by the joint venture. During the year endedDecember 31, 2021 , we recognized impairment charges of$13.2 million at theCommonwealth Building as we are projecting longer lease-up periods for the vacant space as demand for office space inPortland has significantly declined as a result of both the COVID-19 pandemic, with employees continuing to work from home, and the impact of the disruptions caused by protests and demonstrations in the downtown area. The extent to which the COVID-19 pandemic or any other pandemic, epidemic or disease impacts our operations and those of our tenants remains uncertain and cannot be predicted with confidence and will depend on the scope, severity and duration of the pandemic, the actions taken to contain the pandemic or mitigate its impact, and the direct and indirect economic effects of the pandemic and containment measures, among others. Nevertheless, the COVID-19 pandemic (or a future pandemic, epidemic or disease) presents material uncertainty and risk with respect to our business, financial condition, results of operations and cash flows. In response to the uncertainty caused by the ongoing COVID-19 pandemic and its uncertain impact on our operations and those of our tenants, our board of directors adjusted our distribution policy commencing with the fourth quarter of 2020 and during 2021 considered and declared quarterly distributions based on a single quarterly record date. In connection with its consideration of a Plan of Liquidation, our board of directors determined to cease paying regular quarterly distributions with the expectation that any future distributions to our stockholders would be liquidating distributions from the sale of our remaining assets. 44 -------------------------------------------------------------------------------- Table of Contents Our business, like all businesses, is being impacted by the uncertainty regarding the COVID-19 pandemic, the effectiveness of policies introduced to neutralize the disease, and the impact of those policies on economic activity. We believe the current challenging economic circumstances will be a difficult environment in which to continue to create value in our portfolio consistent with our core-plus investment strategy. The properties in our portfolio were acquired to 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 of which we believe will be more difficult as a result of the impacts of COVID-19 on the economy. While the majority of our tenants have continued to pay rent, the weakening macroeconomic conditions have negatively impacted many of our tenants. As ofDecember 31, 2021 , our portfolio was 75.3% occupied with a weighted-average lease term of 3.4 years. During the year endedDecember 31, 2021 , five tenants at the Institute Property, or 12% of the rentable square footage at the property, early terminated their leases and five tenants at theCommonwealth Building , or 29% of the rentable square footage at the property, did not renew their leases at maturity. In addition, occupancy is expected to further decline at theCommonwealth Building as one additional tenant at the property, or 3% of the rentable square footage of the property, has notified the Company that it will not be renewing its lease at maturity. Due to the impact of COVID-19, we believe the leasing environment will be challenged in the short-term and the time to lease up and stabilize a property will be extended. More specifically, our office properties inPortland andChicago will likely take more time to stabilize than previously anticipated. In addition, the timing in which we may be able to implement a liquidation strategy will be affected.
Liquidity and Capital Resources
As described above under "-Overview - Going Concern Considerations," in preparing our financial statements for this annual reporting period, our management determined that substantial doubt exists about our ability to continue as a going concern within one year after the date that the financial statements are issued. In addition, as described above under "-Overview - Plan of Liquidation," our board of directors expects to approve the sale of all of our assets and our dissolution pursuant to the terms of a Plan of Liquidation and submit such plan to our stockholders for approval. The principal purpose of a Plan of Liquidation will be to provide liquidity to our stockholders by selling our assets, paying our debts and distributing the net proceeds from liquidation to our stockholders. Subject to the approval of our board of directors and our stockholders of a Plan of Liquidation we expect our principal demands for funds during the short and long-term are and will be for the payment of operating expenses, capital expenditures and general and administrative expenses, including expenses in connection with a Plan of Liquidation; payments under debt obligations; special redemptions of common stock; capital commitments; and payments of distributions to stockholders pursuant to a Plan of Liquidation. If a Plan of Liquidation is approved by our board of directors and our stockholders, we expect to use our cash on hand and proceeds from the sale of properties as our primary sources of liquidity. To the extent available, we also intend to use cash flow generated by our real estate investments and proceeds from debt financing; however, asset sales will further reduce cash flow from these sources during the implementation of a Plan of Liquidation, if it is approved by our board of directors and our stockholders. Although this is the current intention of our board of directors, we can provide no assurance as to the ultimate approval of a Plan of Liquidation or the timing of the liquidation of the company. Our share redemption program only provides for special redemptions. The dollar amounts available for such redemptions are determined by the board of directors and may be adjusted from time to time. The dollar amount limitation for such redemptions for the calendar year 2021 was$250,000 in the aggregate, of which$90,000 was used for such special redemptions from January throughDecember 2021 . OnDecember 6, 2021 , our board of directors approved the same annual dollar limitation of$250,000 in the aggregate for the calendar year 2022, as may be reviewed and adjusted from time to time by the board of directors. Our share redemption program does not provide for ordinary redemptions and can provide no assurances, when, if ever, we will provide for redemptions other than special redemptions. Our investments in real estate 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 real estate investments is primarily dependent upon the occupancy level of our portfolio (which has decreased from 90.4% as ofDecember 31, 2020 to 75.3% as ofDecember 31, 2021 ), the net effective rental rates on our leases, the collectibility of rent and operating recoveries from our tenants and how well we manage our expenditures, all of which may be adversely affected by the impact of the COVID-19 pandemic as discussed above. 45 -------------------------------------------------------------------------------- Table of Contents Our advisor advanced funds to us, which are non-interest bearing, for distribution record dates through the period endedMay 31, 2016 . We are only obligated to repay our advisor for its advance if and to the extent that: (i)Our modified funds from operations ("MFFO"), as such term is defined by theInstitute for Portfolio Alternatives and interpreted by us, for the immediately preceding quarter exceeds the amount of distributions declared for record dates of such prior quarter (an "MFFO Surplus"), and we will pay our advisor the amount of the MFFO Surplus to reduce the principal amount outstanding under the advance, provided that such payments shall only be made if management in its sole discretion expects an MFFO Surplus to be recurring for at least the next two calendar quarters, determined on a quarterly basis;
(ii)Excess proceeds from third-party financings are available ("Excess Proceeds"), provided that the amount of any such Excess Proceeds that may be used to repay the principal amount outstanding under the advance shall be determined by the conflicts committee in its sole discretion; or
(iii)Net sales proceeds from the sale of our real estate portfolio, after the pay down of any related debt and selling costs and expenses, are available.
In determining whether Excess Proceeds are available to repay the advance, our conflicts committee will consider whether cash on hand could have been used to reduce the amount of third-party financing provided to us. If such cash could have been used instead of third-party financing, the third-party financing proceeds will be available to repay the advance.
Our advisor may defer repayment of the advance notwithstanding that we would otherwise be obligated to repay the advance.
We expect that our debt financing and other liabilities will be between 45% and 65% of the cost of our tangible assets (before deducting depreciation and other non-cash reserves). Though this is our target leverage, our charter does not limit us from incurring debt until our aggregate borrowings would exceed 300% of our net assets (before deducting depreciation and other non-cash reserves), which is effectively 75% of the cost of our tangible assets (before deducting depreciation and other non-cash reserves), though we may exceed this limit under certain circumstances. To the extent financing in excess of this limit is available at attractive terms, the conflicts committee may approve debt in excess of this limit. As ofDecember 31, 2021 , we had mortgage debt obligations in the aggregate principal amount of$101.7 million and our aggregate borrowings were approximately 63% of our net assets before deducting depreciation and other non-cash reserves. As ofDecember 31, 2021 we had$52.3 million of debt maturing during the 12 months endingDecember 31, 2022 , all of which is under our term loan. In addition, we have an additional$45.6 million of debt maturing within 12 months from the date our financial statements are issued. Due to the decrease in occupancies and a decrease in market values of the properties securing these two loans, we may be unable to extend or refinance the upcoming loan maturities at current terms and may be required to paydown a portion of the maturing debt in order to extend or refinance the loans. Further, reductions in property values related to the impact of the COVID-19 pandemic have reduced our availability to draw on the revolving commitment. In addition, asset sales pursuant to a Plan of Liquidation, if approved by our board of directors and our stockholders, will further reduce proceeds available from debt financing. In addition to using our capital resources to meet our debt service obligations, for capital expenditures and for operating costs, we use our capital resources to make certain payments to our advisor and our affiliated property manager. We paid our advisor fees in connection with the acquisition of our assets and pay our advisor fees in connection with the management of our assets and costs incurred by our advisor in providing certain services to us. The asset management fee is a monthly fee payable to our advisor in an amount equal to one-twelfth of 1.0% of the cost of our investments including the portion of the investment that is debt financed. The cost of our real property investments is calculated as the amount paid or allocated to acquire the real property, plus budgeted capital improvement costs for the development, construction or improvements to the property once such funds are disbursed pursuant to a final approved budget and fees and expenses related to the acquisition, but excluding acquisition fees paid or payable to our advisor. In the case of investments made through joint ventures, the asset management fee is determined based on our proportionate share of the underlying investment. Our advisor waived asset management fees for the second and third quarters of 2017 and deferred payment of asset management fees related to the periods fromOctober 2017 throughDecember 31, 2021 . Our advisor's waiver and deferral of its asset management fees resulted in additional cash being available to fund our operations. If our advisor chooses to no longer defer such fees, our ability to fund our operations may be adversely affected. We also continue to reimburse our advisor and our dealer manager for certain stockholder services. We also pay fees toKBS Management Group, LLC (the "Co-Manager"), an affiliate of our advisor, pursuant to property management agreements with the Co-Manager, for certain property management services at our properties. 46
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We elected to be taxed as a REIT and to operate as a REIT beginning with our taxable year endedDecember 31, 2015 . To maintain our qualification as a REIT, we will be required to make aggregate annual distributions to our stockholders of at least 90% of our REIT taxable income (computed without regard to the dividends-paid deduction and excluding net capital gain). Our board of directors may authorize distributions in excess of those required for us to maintain REIT status depending on our financial condition and such other factors as our board of directors deems relevant. We do not expect to pay regular quarterly distributions during the liquidation process. Further, we have not established a minimum distribution level. 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 endedDecember 31, 2021 did not exceed the charter-imposed limitation.
Cash Flows from Operating Activities
As ofDecember 31, 2021 , we owned four office properties. During the years endedDecember 31, 2021 and 2020, net cash provided by operating activities was$1.7 million and$3.8 million , respectively. Net cash provided by operating activities decreased due to a decrease in rental income and the payment of lease commissions during 2021. We expect cash flows provided by operating activities to decrease in future periods to the extent a Plan of Liquidation is approved by our board of directors and our stockholders and we begin selling our assets. In addition, to the extent the impacts of COVID-19 continue to be felt by our tenants, our tenants may defer rent payments or be unable to pay rent or we may be unable to re-lease space vacated by our current tenants which could reduce our cash flow provided by operating activities.
Cash Flows from Investing Activities
Net cash used in investing activities was
Cash Flows from Financing Activities
During the year ended
•$4.6 million of net cash provided by debt financing as a result of$4.7 million proceeds from notes payable, partially offset by payments of deferred financing of$0.1 million ; offset by
•$1.7 million of net cash distributions; and
•$0.1 million of payments to redeem common stock.
Debt Obligations
The following is a summary of our debt obligations as of
Payments Due During the Years Ending December 31,
Debt Obligations Total 2022 2023-2024 2025-2026 Thereafter
Outstanding debt obligations (1) $ 101,666 $ 52,334 $ 49,332 $ - $ -
Interest payments on outstanding debt
obligations (2) 2,823 2,609 214 - -
_____________________
(1) Amounts include principal payments only.
(2) Projected interest payments are based on the outstanding principal amount, maturity date and contractual interest rate in effect as ofDecember 31, 2021 (consisting of the contractual interest rate and the effect of interest rate swaps). We incurred interest expense of$3.7 million , excluding amortization of deferred financing costs totaling$0.2 million and unrealized gains on derivative instruments of$1.6 million during the year endedDecember 31, 2021 . 47
-------------------------------------------------------------------------------- Table of Contents Capital Expenditures Obligations As ofDecember 31, 2021 , we have capital expenditure obligations of$2.4 million , the majority of which is expected to be spent in the next twelve months and of which$2.0 million has already been accrued and included in accounts payable and accrued liabilities on our consolidated balance sheet as ofDecember 31, 2021 . This amount includes unpaid contractual obligations for building improvements and unpaid portions of tenant improvement allowances which were granted pursuant to lease agreements executed as ofDecember 31, 2021 , including amounts that may be classified as lease incentives pursuant to GAAP. In certain cases, tenants may have discretion when to utilize their tenant allowances and may delay the start of projects or tenants control the construction of their projects and may not submit timely requests for reimbursement or there are general construction delays, all of which could extend the timing of payment for a portion of these capital expenditure obligations beyond twelve months.
Results of Operations
In this section, we discuss the results of our operations for the year endedDecember 31, 2021 compared to the year endedDecember 31, 2020 . For a discussion of the year endedDecember 31, 2020 compared to the year endedDecember 31, 2019 , please refer to Item 7 of Part II, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2020 , which was filed with theSEC onMarch 11, 2021 . As ofDecember 31, 2021 and 2020, we owned four office properties. If a Plan of Liquidation is approved by our board of directors and our stockholders, we will undertake an orderly liquidation by selling all of our assets, paying our debts, providing for known and unknown liabilities and distributing the net proceeds from liquidation to our stockholders. There can be no assurances regarding the amounts of any liquidating distributions or the timing thereof. In general, subject to other factors as described below, we expect income and expenses to decrease in future periods due to disposition activity.
The following table provides summary information about our results of operations
for the year ended
Comparison of the year endedDecember 31, 2021 versus the year endedDecember 31, 2020 $ Change Due to Properties Held For the Years Ended December $ Change Due to Throughout 31, Increase Dispositions/JV Both Periods 2021 2020 (Decrease) Percentage Change Consolidation (1) (2) Rental income$ 16,099 $ 17,892 $ (1,793) (10) % $ 598$ (2,391) Other operating income 177 160 17 11 % 7 10 Operating, maintenance and management costs 3,926 3,829 97 3 % 58
39
Property management fees and expenses to affiliate 114 136 (22) (16) % (1)
(21)
Real estate taxes and insurance 2,899 2,672 227 8 % 148
79
Asset management fees to affiliate 1,740 1,729 11 1 % 38
(27)
General and administrative expenses 1,509 2,307 (798) (35) % n/a n/a Depreciation and amortization 7,536 8,104 (568) (7) % 199 (767) Interest expense 2,343 4,965 (2,622) (53) % 62 (2,684) Impairment charges on real estate 13,164 5,750 7,414 129 % - 7,414 Interest and other income - 14 (14) (100) % n/a n/a Gain on sale of real estate, net - 5,245 (5,245) (100) % (5,245)
-
Equity in loss of unconsolidated joint venture - (827) 827 (100) % 827
-
Loss from extinguishment of debt - (29) 29 (100) % 29 - _____________________ (1) Represents the dollar amount increase (decrease) for the year endedDecember 31, 2021 compared to the year endedDecember 31, 2020 related to real estate investments disposed of and real estate acquired through joint venture consolidation on or afterJanuary 1, 2020 .
(2) Represents the dollar amount increase (decrease) for the year ended
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Rental income decreased from $17.9 million for the year ended December 31, 2020
to $16.1 million for the year ended December 31, 2021 , primarily due to a
decrease in occupancy rate as a result of lease expirations at properties held
throughout both periods, partially offset by the consolidation of 210 W.
Chicago. We expect rental income to fluctuate based on the occupancy at our
existing properties and uncertainty and business disruptions as a result of the
outbreak of COVID-19. See "Market Outlook - Real Estate and Real Estate Finance
Markets - COVID-19 Pandemic and Portfolio Outlook" for a discussion on the
impact of the COVID-19 pandemic on our business.
Operating, maintenance, and management costs increased from $3.8 million for the
year ended December 31, 2020 to $3.9 million for the year ended December 31,
2021 , primarily due to the consolidation of 210 W. Chicago and an increase in
repair and maintenance costs at properties held through both periods. We expect
operating, maintenance, and management costs to increase in future periods as a
result of general inflation and as physical occupancy increases as employees
return to the office.
Real estate taxes and insurance increased from $2.7 million for the year ended
December 31, 2020 to $2.9 million for the year ended December 31, 2021 ,
primarily due to the consolidation of 210 W. Chicago and an increase in property
taxes due to increased property values and rates at properties held throughout
both periods. We expect real estate taxes and insurance to increase in future
periods as a result of general inflation.
Asset management fees to affiliate remained consistent at $1.7 million for the
years ended December 31, 2020 and 2021. We expect asset management fees to
increase in future periods as a result of any improvements we make to our
properties. As of December 31, 2021 , we had accrued and deferred payment of $7.6
million of asset management fees related to October 2017 through December 31,
2021 .
General and administrative expenses decreased from $2.3 million for the year
ended December 31, 2020 to $1.5 million for the year ended December 31, 2021 ,
primarily due to pre-development costs which did not meet the criteria for
capitalization for a real estate project, legal fees related to our
consideration of strategic alternatives, including a proposed plan of
liquidation incurred during the year ended December 31, 2020 , and a receivable
as of December 31, 2021 related to estimated amounts charged to us by certain
vendors for services for which we believe we were either overcharged or which
were never performed as discussed under Part II, Item 9B, "Other Information" of
this Annual Report on Form 10-K. General and administrative costs during the
year ended December 31, 2021 , consisted primarily of internal audit compensation
expense, errors and omissions insurance, board of directors fees and audit
costs.
Depreciation and amortization decreased from $8.1 million for the year ended
December 31, 2020 to $7.5 million for the year ended December 31, 2021 ,
primarily due to lease expirations and early lease terminations related to
properties held throughout both periods, partially offset by an increase in
depreciation and amortization as a result of the consolidation of 210 W.
Chicago. We expect depreciation and amortization to increase in future periods
as a result of additional capital improvements, offset by a decrease in
amortization related to fully amortized tenant origination and absorption costs.
Interest expense decreased from $5.0 million for the year ended December 31,
2020 to $2.3 million for the year ended December 31, 2021 . Included in interest
expense is the amortization of deferred financing costs of $0.2 million and
$0.3 million for the years ended December 31, 2021 and 2020, respectively.
Interest expense (including gains and losses) incurred as a result of our
derivative instruments, decreased interest expense by $3,000 during the year
ended December 31, 2021 and increased interest expense by $2.1 million during
the year ended December 31, 2020 . The decrease in interest expense is primarily
due to changes in fair values with respect to our interest rate swaps that are
not accounted for as cash flow hedges and a decrease in one-month LIBOR and its
impact on interest expense related to our variable rate debt. In general, we
expect interest expense to vary based on fluctuations in one-month LIBOR (for
our unhedged variable rate debt) and our level of future borrowings, which will
depend on the availability and cost of debt financing, draws on our debts and
any debt repayments we make.
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-------------------------------------------------------------------------------- Table of Contents During the year endedDecember 31, 2021 , we recorded non-cash impairment charges of$13.2 million to write down the carrying value of theCommonwealth Building , an office property located inPortland, Oregon , to its estimated fair value as a result of a continued decrease in occupancy and changes in cash flow estimates including a change in leasing projections, which triggered the future estimated undiscounted cash flows to be lower than the net carrying value of the property. During the year endedDecember 31, 2020 , we recorded non-cash impairment charges of$5.8 million to write down the carrying value of the Institute Property, an office property located inChicago, Illinois , to its estimated fair value as a result of changes in cash flow estimates including a change in leasing projections, which triggered the future estimated undiscounted cash flows to be lower than the net carrying value of the property. The decrease in cash flow projections during the years endedDecember 31, 2021 and 2020, was primarily due to reduced demand for the office space at both properties resulting in longer lease-up periods and a decrease in projected rental rates due to the COVID-19 pandemic which resulted in additional challenges to re-lease the vacant space. Moreover, the decrease in cash flow projections during the year endedDecember 31, 2021 for the Commonwealth building were also affected by the disruptions caused by protests and demonstrations in the downtown area ofPortland , where the property is located.
We recognized a gain on sale of real estate of
During the year endedDecember 31, 2020 , we recognized$0.8 million of equity in loss of unconsolidated joint venture, which included a$0.5 million of impairment charge related to the 210 W. Chicago property then-owned by the joint venture and a$0.3 million loss recorded related to a put option exercised by the 210 W. Chicago joint venture partner, which required us to acquire the joint venture partner's 50% equity interest for$1.1 million onOctober 5, 2020 pursuant to the joint venture agreement.
Funds from Operations and Modified Funds from Operations
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), gains
and losses from change in control, 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 U.S.
generally accepted accounting principles ("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.
Changes in accounting rules have resulted in a substantial increase in the
number of non-operating and non-cash items included in the calculation of FFO.
As a result, our management also uses MFFO as an indicator of our ongoing
performance as well as our dividend sustainability. MFFO excludes from FFO:
acquisition fees and expenses (to the extent that such fees and expenses have
been recorded as operating expenses); adjustments related to contingent purchase
price obligations; amounts relating to straight-line rents and amortization of
above and below market intangible lease assets and liabilities; accretion of
discounts and amortization of premiums on debt investments; amortization of
closing costs relating to debt investments; impairments of real estate-related
investments; mark-to-market adjustments included in net income; and gains or
losses included in net income for the extinguishment or sale of debt or hedges.
We compute MFFO in accordance with the definition of MFFO included in the
practice guideline issued by the IPA in November 2010 as interpreted by
management. Our computation of MFFO may not be comparable to other REITs that do
not compute MFFO in accordance with the current IPA definition or that interpret
the current IPA definition differently than we do.
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We believe that MFFO is helpful as a measure of ongoing operating performance
because it excludes costs that management considers more reflective of investing
activities and other non-operating items included in FFO. Management believes
that, by excluding acquisition costs (to the extent such costs have been
recorded as operating expenses) as well as non-cash items such as straight line
rental revenue, MFFO provides investors with supplemental performance
information that is consistent with the performance indicators and analysis used
by management, in addition to net income and cash flows from operating
activities as defined by GAAP, to evaluate the sustainability of our operating
performance. MFFO provides comparability in evaluating the operating performance
of our portfolio with other non-traded REITs which typically have limited lives
with short and defined acquisition periods and targeted exit strategies. MFFO,
or an equivalent measure, is routinely reported by non-traded REITs, and we
believe often used by analysts and investors for comparison purposes.
FFO and MFFO are non-GAAP financial measures and do 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 and MFFO include adjustments
that investors may deem subjective, such as adding back expenses such as
depreciation and amortization and the other items described above. Accordingly,
FFO and MFFO should not be considered as alternatives to net income as an
indicator of our current and historical operating performance. In addition, FFO
and MFFO do not represent cash flows from operating activities determined in
accordance with GAAP and should not be considered an indication of our
liquidity. We believe FFO and MFFO, in addition to net income and cash flows
from operating activities as defined by GAAP, are meaningful supplemental
performance measures.
Although MFFO includes other adjustments, the exclusion of adjustments for
straight-line rent, the amortization of above- and below-market leases,
unrealized (gains) losses on derivative instruments and loss from extinguishment
of debt are the most significant adjustments for the periods presented. We have
excluded these items based on the following economic considerations:
•Adjustments for straight-line rent. These are adjustments to rental revenue as
required by GAAP to recognize contractual lease payments on a straight-line
basis over the life of the respective lease. We have excluded these adjustments
in our calculation of MFFO to more appropriately reflect the current economic
impact of our in-place leases, while also providing investors with a useful
supplemental metric that addresses core operating performance by removing rent
we expect to receive in a future period or rent that was received in a prior
period;
•Amortization of above- and below-market leases. Similar to depreciation and
amortization of real estate assets and lease related costs that are excluded
from FFO, GAAP implicitly assumes that the value of intangible lease assets and
liabilities diminishes predictably over time and requires that these charges be
recognized currently in revenue. Since market lease rates in the aggregate have
historically risen or fallen with local market conditions, management believes
that by excluding these charges, MFFO provides useful supplemental information
on the realized economics of the real estate;
•Unrealized (gains) losses on derivative instruments. These adjustments include
unrealized (gains) losses from mark-to-market adjustments on interest rate
swaps. The change in fair value of interest rate swaps not designated as a hedge
are non-cash adjustments recognized directly in earnings and are included in
interest expense. We have excluded these adjustments in our calculation of MFFO
to more appropriately reflect the economic impact of our interest rate swap
agreements; and
•Loss from extinguishment of debt. A loss from extinguishment of debt, which
includes prepayment fees related to the extinguishment of debt, represents the
difference between the carrying value of any consideration transferred to the
lender in return for the extinguishment of a debt and the net carrying value of
the debt at the time of settlement. We have excluded the loss from
extinguishment of debt in our calculation of MFFO because these losses do not
impact the current operating performance of our investments and do not provide
an indication of future operating performance.
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Our calculation of FFO, which we believe is consistent with the calculation of
FFO as defined by NAREIT, is presented in the following table, along with our
calculation of MFFO, for the years ended December 31, 2021 , 2020 and 2019,
respectively (in thousands). No conclusions or comparisons should be made from
the presentation of these periods.
For the
Years Ended
2021 2020 2019
Net loss $ (16,955) $ (7,037) $ (6,102)
Depreciation of real estate assets 4,469 4,466 4,318
Amortization of lease-related costs 3,067 3,638 4,342
Impairment charges on real estate 13,164 5,750 -
Gain on sale of real estate, net - (5,245) -
Adjustment for investment in unconsolidated
joint venture (1) - 611 99
Remeasurement loss on purchase of joint venture
interest (2) - 304 -
FFO 3,745 2,487 2,657
Straight-line rent and amortization of above-
and below-market leases, net (389) (650) (1,824)
Unrealized (gain) loss on derivative
instruments (1,629) 735 1,595
Loss from extinguishment of debt - 29 -
Adjustment for investment in unconsolidated
joint venture (1) - (11) (9)
MFFO $ 1,727 $ 2,590 $ 2,419 _____________________
(1) Reflects adjustments to add back our noncontrolling interest share of the adjustments to convert our net loss attributable to common stockholders to FFO and MFFO for our equity investment in unconsolidated joint venture for the year endedDecember 31, 2020 . InOctober 2020 , we purchased our joint venture partner's membership interest and consolidated the entity that owned 210 W. Chicago.
(2) Reflects the remeasurement loss as a result of a change in control upon our
purchase of our joint venture partner's 50% equity interest in the 210 W.
Chicago Joint Venture on
FFO and MFFO may also be used to fund all or a portion of certain capitalizable items that are excluded from FFO and MFFO, such as tenant improvements, building improvements and deferred leasing costs.
Distributions
We have not paid distributions solely from our cash flows from operations, in
which case distributions have been paid in whole or in part from debt financing,
including advances from our advisor. Distributions declared, distributions paid
and cash flows from operations were as follows during 2021 (in thousands, except
per share amounts):
Cash Flows
(used in)
Distribution Declared Distribution Declared provided by
Distributions Per Class A Share (1) PerClass T Share (1) Operating
Period Declared (1) (2) (2) Distributions Paid Activities
First Quarter 2021 $ 437 $ 0.043 $ 0.043 $ 437 $ (469)
Second Quarter 2021 436 0.043 0.043 436
1,050
Third Quarter 2021 436 0.043 0.043 436
297
Fourth Quarter 2021 436 0.043 0.043 436 842
$ 1,745 $ 0.172 $ 0.172 $ 1,745 $ 1,720
_____________________
(1) Distributions for the periods from January 1, 2021 through December 31, 2021
were calculated at a quarterly rate of $0.04287500 per share based on a single
quarterly record date.
(2) Assumes Class A and Class T shares were issued and outstanding each day that was a record date for distributions during the period presented.
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For the year ended December 31, 2021 , we paid aggregate distributions of $1.7
million , all of which were paid in cash. Our net loss for the year ended
December 31, 2021 was $17.0 million . FFO for the year ended December 31, 2021
was $3.7 million and cash flows provided by operations for the year ended
December 31, 2021 was $1.7 million . See the reconciliation of FFO to net loss
above. We funded our total distributions paid with $1.1 million of cash flow
from current operating activities and $0.6 million of cash flows from operations
in excess of distributions paid from prior periods. In addition, our advisor
waived and deferred certain of its asset management fees which resulted in more
cash being available for distribution. To the extent that we pay distributions
from sources other than our cash flows from operations, the overall return to
our stockholders may be reduced.
Cash distributions will be determined by our board of directors based on our
financial condition and such other factors as our board of directors deems
relevant. Our board of directors has not pre-established a percentage rate of
return for cash distributions to stockholders. We have not established a minimum
distribution level, and our charter does not require that we make distributions
to our stockholders. In connection with its consideration of a Plan of
Liquidation, our board of directors determined to cease paying regular quarterly
distributions with the expectation that any future distributions to our
stockholders would be liquidating distributions from the sale of our remaining
assets. If our board of directors and/or our stockholders do not approve a Plan
of Liquidation, our board of directors will review our payment of regular
quarterly distributions again; however, no assurances can be made with respect
to the payment or amount of any future distributions, whether regular or
liquidating.
Our operating performance cannot be accurately predicted and may deteriorate in
the future due to numerous factors, including those discussed under "Summary
Risk Factors" and Part I, Item 1A, "Risk Factors." Those factors include: the
future operating performance of our current real estate investments in the
existing real estate and financial environment; the success and economic
viability of our tenants; our ability to refinance existing indebtedness at
comparable terms; and changes in interest rates on any variable rate debt
obligations we incur. In the event our FFO and/or cash flow from operations
decrease in the future, the level of our distributions may also decrease. In
addition, future distributions declared and paid may exceed FFO and/or cash flow
from operations.
Critical Accounting Policies and Estimates
Below is a discussion of the accounting policies that management believes are or will be critical to our operations. We consider these policies critical in that they involve significant management judgments and assumptions, require estimates about matters that are inherently uncertain and because they are important for understanding and evaluating our reported financial results. These judgments affect the reported amounts of assets and liabilities and our disclosure of contingent assets and liabilities as of the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. With different estimates or assumptions, materially different amounts could be reported in our financial statements. Additionally, other companies may utilize different estimates that may impact the comparability of our results of operations to those of companies in similar businesses.
Revenue Recognition - Operating Leases
OnJanuary 1, 2019 , we adopted the lease accounting standards under Topic 842 including the package of practical expedients for all leases that commenced before the effective date ofJanuary 1, 2019 . Accordingly, we (i) did not reassess whether any expired or existing contracts are or contain leases, (ii) did not reassess the lease classification for any expired or existing lease, and (iii) did not reassess initial direct costs for any existing leases. We did not elect the practical expedient related to using hindsight to reevaluate the lease term. In addition, we adopted the practical expedient for land easements and did not assess whether existing or expired land easements that were not previously accounted for as leases under the lease accounting standards of Topic 840 are or contain a lease under Topic 842. In addition, Topic 842 provides an optional transition method to allow entities to apply the new lease accounting standards at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings. We adopted this transition method upon its adoption of the lease accounting standards of Topic 842, which did not result in a cumulative effect adjustment to the opening balance of retained earnings onJanuary 1, 2019 . 53 -------------------------------------------------------------------------------- Table of Contents In accordance with Topic 842, tenant reimbursements for property taxes and insurance are included in the single lease component of the lease contract (the right of the lessee to use the leased space) and therefore are accounted for as variable lease payments and are recorded as rental income on our statement of operations. In addition, we adopted the practical expedient available under Topic 842 to not separate nonlease components from the associated lease component and instead to account for those components as a single component if the nonlease components otherwise would be accounted for under the new revenue recognition standard (Topic 606) and if certain conditions are met, specifically related to tenant reimbursements for common area maintenance which would otherwise be accounted for under the revenue recognition standard. We believe the two conditions have been met for tenant reimbursements for common area maintenance as (i) the timing and pattern of transfer of the nonlease components and associated lease components are the same and (ii) the lease component would be classified as an operating lease. Accordingly, tenant reimbursements for common area maintenance are also accounted for as variable lease payments and recorded as rental income on our statement of operations. We recognize minimum rent, including rental abatements, lease incentives and contractual fixed increases attributable to operating leases, on a straight-line basis over the term of the related leases when collectibility is probable and record amounts expected to be received in later years as deferred rent receivable. If the lease provides for tenant improvements, we determine whether the tenant improvements, for accounting purposes, are owned by the tenant or us. When we are the owner of the tenant improvements, the tenant is not considered to have taken physical possession or have control of the physical use of the leased asset until the tenant improvements are substantially completed. When the tenant is the owner of the tenant improvements, any tenant improvement allowance (including amounts that can be taken in the form of cash or a credit against the tenant's rent) that is funded is treated as a lease incentive and amortized as a reduction of rental revenue over the lease term. Tenant improvement ownership is determined based on various factors including, but not limited to:
•whether the lease stipulates how a tenant improvement allowance may be spent;
•whether the lessee or lessor supervises the construction and bears the risk of cost overruns;
•whether the amount of a tenant improvement allowance is in excess of market rates;
•whether the tenant or landlord retains legal title to the improvements at the end of the lease term;
•whether the tenant improvements are unique to the tenant or general purpose in nature; and
•whether the tenant improvements are expected to have any residual value at the end of the lease.
In accordance with Topic 842, we make a determination of whether the collectibility of the lease payments in an operating lease is probable. If we determine the lease payments are not probable of collection, we would fully reserve for any contractual lease payments, deferred rent receivable, and variable lease payments and would recognize rental income only if cash is received. We make estimates of the collectability of the lease payments which requires significant judgment by management. We consider payment history, current credit status, the tenant's financial condition, security deposits, letters of credit, lease guarantees and current market conditions that may impact the tenant's ability to make payments in accordance with its lease agreements, including the impact of the COVID-19 pandemic on the tenant's business, in making the determination. These changes to our collectibility assessment are reflected as an adjustment to rental income. We, as a lessor, record costs to negotiate or arrange a lease that would have been incurred regardless of whether the lease was obtained, such as legal costs incurred to negotiate an operating lease, as an expense and classify such costs as operating, maintenance, and management expense on our consolidated statement of operations, as these costs are no longer capitalizable under the definition of initial direct costs under Topic 842.
Sales of Real Estate
We follow the guidance of ASC 610-20, Other Income - Gains and Losses from the
Derecognition of Nonfinancial Assets ("ASC 610-20"), which applies to sales or
transfers to noncustomers of nonfinancial assets or in substance nonfinancial
assets that do not meet the definition of a business. Generally, our sales of
real estate would be considered a sale of a nonfinancial asset as defined by ASC
610-20.
ASC 610-20 refers to the revenue recognition principles under ASU No. 2014-09,
Revenue from Contracts with Customers (Topic 606). Under ASC 610-20, if we
determine we do not have a controlling financial interest in the entity that
holds the asset and the arrangement meets the criteria to be accounted for as a
contract, we would derecognize the asset and recognize a gain or loss on the
sale of the real estate when control of the underlying asset transfers to the
buyer. The application of these criteria can be complex and incorrect
assumptions on collectability of the transaction price or transfer of control
can result in the improper recognition of the gain or loss from sales of real
estate during the period.
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Real Estate
Depreciation and Amortization
Real estate costs related to the acquisition and improvement of properties are
capitalized and amortized over the expected useful life of the asset on a
straight-line basis. Repair and maintenance costs are charged to expense as
incurred and significant replacements and betterments are capitalized. Repair
and maintenance costs include all costs that do not extend the useful life of
the real estate asset. We consider the period of future benefit of an asset to
determine its appropriate useful life. Expenditures for tenant improvements are
capitalized and amortized over the shorter of the tenant's lease term or
expected useful life. We anticipate the estimated useful lives of our assets by
class to be generally as follows:
Land N/A
Buildings 25 - 40 years
Building improvements 10 - 25 years
Tenant improvements Shorter of lease term or expected useful life
Remaining term of related leases, including
Tenant origination and absorption costs below-market renewal periods
Real Estate Acquisition Valuation
We record the acquisition of income-producing real estate or real estate that will be used for the production of income as a business combination or an asset acquisition. If substantially all of the fair value of the gross assets acquired are concentrated in a single identifiable asset or group of similar identifiable assets, then the set is not a business. For purposes of this test, land and buildings can be combined along with the intangible assets for any in-place leases and accordingly, most acquisitions of investment properties would not meet the definition of a business and would be accounted for as an asset acquisition. To be considered a business, a set must include an input and a substantive process that together significantly contributes to the ability to create an output. All assets acquired and liabilities assumed in a business combination are measured at their acquisition-date fair values. For asset acquisitions, the cost of the acquisition is allocated to individual assets and liabilities on a relative fair value basis. Acquisition costs associated with business combinations are expensed as incurred. Acquisition costs associated with asset acquisitions are capitalized. We assess the acquisition date fair values of all tangible assets, identifiable intangibles and assumed liabilities using methods similar to those used by independent appraisers, generally utilizing a discounted cash flow analysis that applies appropriate discount and/or capitalization rates and available market information. Estimates of future cash flows are based on a number of factors, including historical operating results, known and anticipated trends, and market and economic conditions. The fair value of tangible assets of an acquired property considers the value of the property as if it were vacant. We record above-market and below-market in-place lease values for acquired properties based on the present value (using a discount rate that reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) management's estimate of fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining non-cancelable term of above-market in-place leases and for the initial term plus any extended term for any leases with below-market renewal options. We amortize any recorded above-market or below-market lease values as a reduction or increase, respectively, to rental income over the remaining non-cancelable terms of the respective lease, including any below-market renewal periods. We estimate the value of tenant origination and absorption costs by considering the estimated carrying costs during hypothetical expected lease up periods, considering current market conditions. In estimating carrying costs, we include real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease up periods.
We amortize the value of tenant origination and absorption costs to depreciation and amortization expense over the remaining non-cancelable term of the leases.
Estimates of the fair values of the tangible assets, identifiable intangibles
and assumed liabilities require us to make significant assumptions to estimate
market lease rates, property-operating expenses, carrying costs during lease-up
periods, discount rates, market absorption periods, and the number of years the
property will be held for investment. The use of inappropriate assumptions would
result in an incorrect valuation of our acquired tangible assets, identifiable
intangibles and assumed liabilities, which would impact the amount of our net
income.
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-------------------------------------------------------------------------------- Table of Contents Impairment of Real Estate and Related Intangible Assets and Liabilities We continually monitor events and changes in circumstances that could indicate that the carrying amounts of our real estate and related intangible assets and liabilities may not be recoverable or realized. When indicators of potential impairment suggest that the carrying value of real estate and related intangible assets and liabilities may not be recoverable, we assess the recoverability by estimating whether we will recover the carrying value of the real estate and related intangible assets and liabilities through its undiscounted future cash flows and its eventual disposition. If, based on this analysis, we do not believe that we will be able to recover the carrying value of the real estate and related intangible assets and liabilities, we would record an impairment loss to the extent that the carrying value exceeds the estimated fair value of the real estate and related intangible assets and liabilities. Projecting future cash flows involves estimating expected future operating income and expenses related to the real estate and its related intangible assets and liabilities as well as market and other trends. Using inappropriate assumptions to estimate cash flows or the expected hold period until the eventual disposition could result in incorrect conclusions on recoverability and incorrect fair values of the real estate and its related intangible assets and liabilities and could result in the overstatement of the carrying values of our real estate and related intangible assets and liabilities and an overstatement of our net income. Derivative Instruments We enter into derivative instruments for risk management purposes to hedge our exposure to cash flow variability caused by changing interest rates on our variable rate notes payable. We record these derivative instruments at fair value on the accompanying consolidated balance sheets. The changes in fair value for derivative instruments that are not designated as a hedge or that do not meet the hedge accounting criteria are recorded as gain or loss on derivative instruments and included as interest expense as presented in the accompanying consolidated statements of operations. The calculation of the fair value of derivative instruments is complex and different inputs used in the model can result in significant changes to the fair value of derivative instruments and the related gain or loss on derivative instruments included as interest expense in the accompanying consolidated statements of operations. The valuation of our derivative instruments is based on a proprietary model using the contractual terms of the derivatives, including the period to maturity, as well as observable market-based inputs, including interest rate curves and volatility. The fair values of interest rate swaps are estimated using the market standard methodology of netting the discounted fixed cash payments and the discounted expected variable cash receipts. The variable cash receipts are based on an expectation of interest rates (forward curves) derived from observable market interest rate curves. In addition, credit valuation adjustments, which consider the impact of any credit risks to the contracts, are incorporated in the fair values to account for potential nonperformance risk.
Income Taxes
We have elected to be taxed as a REIT under the Internal Revenue Code. To continue to qualify as a REIT, we must continue to meet certain organizational and operational requirements, including a requirement to distribute at least 90% of our annual REIT taxable income to stockholders (which is computed without regard to the dividends-paid deduction or net capital gain and which does not necessarily equal net income as calculated in accordance with GAAP). As a REIT, we generally will not be subject to federal income tax on income that we distribute as dividends to our stockholders. If we fail to qualify as a REIT in any taxable year, we will be subject to federal income tax on our taxable income at regular corporate income tax rates and generally will not be permitted to qualify for treatment as a REIT for federal income tax purposes for the four taxable years following the year during which qualification is lost, unless the Internal Revenue Service grants us relief under certain statutory provisions. Such an event could materially and adversely affect our net income and net cash available for distribution to stockholders. However, we believe that we are organized and operate in such a manner as to qualify for treatment as a REIT.
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