The following discussion and analysis should be read in conjunction with the
accompanying financial statements of
Forward-Looking Statements
Certain statements included in this Quarterly Report on Form 10-Q are forward-looking statements. Those statements include statements regarding the intent, belief or current expectations ofKBS Growth & Income REIT, Inc. and members of our management team, as well as the assumptions on which such statements are based, and generally are identified by the use of words such as "may," "will," "seeks," "anticipates," "believes," "estimates," "expects," "plans," "intends," "should" or similar expressions. These include statements about our plans, strategies, prospects and a proposed Plan of Liquidation (defined herein) and these statements are subject to known and unknown risks and uncertainties. Readers are cautioned not to place undue reliance on these forward-looking statements. Actual results may differ materially from those contemplated by such forward-looking statements. Further, forward-looking statements speak only as of the date they are made, and we undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time, unless required by law. Moreover, you should interpret many of the risks identified in this report, as well as the risks set forth below, as being heightened as a result of the continued disruptions in the financial markets.
The following are some of the risks and uncertainties, although not all of the risks and uncertainties, that could cause our actual results to differ materially from those presented in our forward-looking statements:
•The COVID-19 pandemic continues to be one of the most significant risks and uncertainties facing us and the real estate industry generally, and in particular office REITs like our company. We cannot predict to what extent economic activity, including the use of and demand for office space, will return to pre-pandemic levels. Potential changes in customer behavior, such as the continued social acceptance, desirability and perceived economic benefits of work-from-home arrangements, resulting from the COVID-19 pandemic, could materially and negatively impact the demand for office space, resulting in slower overall leasing and an adverse impact to our operations. •Although our board of directors expects to approve the sale of all of our assets and our dissolution pursuant to a Plan of Liquidation and submit such plan to our stockholders for approval, we can give no assurance that our board of directors and/or our stockholders will approve a Plan of Liquidation, or if approved, that we will be able to successfully implement a Plan of Liquidation and sell our assets, pay our debts and distribute the net proceeds from liquidation to our stockholders as we intend. Given the uncertainty and current business disruptions as a result of the outbreak of COVID-19, as well as the current economic slowdown, the rising interest rate environment and inflation (or the public perception that any of these events may continue), and continued social unrest and increased crime in thePortland area where one of our properties is located, our implementation of a Plan of Liquidation, if approved by our board of directors and/or stockholders, may be materially and adversely impacted. •We owe substantial fees to and expenses of our advisor and its affiliates. To the extent these fees are paid, the payments will decrease the amount of cash available for liquidating distribution to our stockholders. •All of our executive officers, one of our directors and other key real estate and debt finance professionals are also officers, directors, managers, key professionals and/or holders of a direct or indirect controlling interest in our advisor, and/or other KBS-affiliated entities. As a result, they face conflicts of interest, including significant conflicts created by our advisor's and its affiliates' compensation arrangements with us and other KBS-sponsored programs and KBS-advised investors and conflicts in allocating time among us and these other programs and investors. Although we have adopted corporate governance measures to ameliorate some of the risks posed by these conflicts, these conflicts could result in action or inaction that is not in the best interests of our stockholders. •As ofSeptember 30, 2022 , we had a limited portfolio of four real estate investments, which may cause the value of an investment in us to vary more widely with the performance of specific assets in our portfolio and cause our general and administrative expenses to constitute a greater percentage of our revenue. •Our advisor waived its asset management fee for the second and third quarters of 2017 and deferred its asset management fee related to the periods fromOctober 2017 throughSeptember 2022 . If our advisor determines to no longer waive or defer certain fees owed to them, our ability to fund our operations may be adversely affected. 26
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) •Our policies do not limit us from incurring debt until our aggregate borrowings would exceed 75% of the cost (before deducting depreciation or other non-cash reserves) of our tangible assets, and we may exceed this limit with the approval of the conflicts committee of our board of directors. High debt levels could limit the amount of cash we have available to distribute and could result in a decline in the value of our stockholders' investment. •We have debt obligations with variable interest rates. The interest and related payments will vary with the movement of SOFR or other indexes. Increases in the indexes will increase the amount of our debt payments and limit our ability to pay distributions to our stockholders. •We depend on tenants for the revenue generated by our real estate investments and, accordingly, the revenue generated by our real estate investments is dependent upon the success and economic viability of our tenants. 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 becoming unable to pay their rent and/or lower rental rates, making it more difficult for us to meet our debt service obligations and reducing our stockholders' returns. Further, the resale value of a property depends principally upon the value of the cash flow generated by the leases associated with that property. Non-renewals, terminations or lease defaults could reduce any net sales proceeds received upon the sale of the property and would adversely affect the amount of liquidating distributions our stockholders would receive if a Plan of Liquidation is approved by our board of directors and/or our stockholders. •Our investments in real estate may be affected by unfavorable real estate market, the rising interest rate environment, and general economic conditions, which could decrease the value of those assets. Revenues from our properties could decrease. Such events would make it more difficult for us to meet our debt service obligations and successfully implement a Plan of Liquidation, which could in turn reduce our stockholders' returns and the amount of any liquidating distributions they receive. •Continued disruptions in the financial markets, including the current economic slowdown, the rising interest rate environment and inflation (or the public perception that any of these events may continue) as well as changes in the demand for office properties and uncertain economic conditions could adversely affect our ability to successfully implement our business strategy and any Plan of Liquidation approved by our board of directors and/or our stockholders, which could reduce our stockholders' returns and the amount of any liquidating distributions they receive. •Our share redemption program only provides for redemptions sought upon a stockholder's death, "qualifying disability" or "determination of incompetence" (each as defined in the share redemption program, and collectively "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 2022 was$250,000 in the aggregate, of which$26,000 was used for such special redemptions from January throughOctober 2022 . Our share redemption program does not provide for ordinary redemptions and we can provide no assurances, when, if ever, we will provide for redemptions other than special redemptions. All forward-looking statements should be read in light of the risks identified herein and in Part I, Item 1A of our Annual Report on Form 10-K for the year endedDecember 31, 2021 , each as filed with theSecurities and Exchange Commission (the "SEC").
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. 27
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) 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 distribution reinvestment plan. As ofSeptember 30, 2022 , we had 9,851,052 and 307,606 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 ofSeptember 30, 2022 , 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 73.1% as ofSeptember 30, 2022 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 in our portfolio. Additionally, the CommonwealthBuilding Mortgage Loan with an outstanding principal balance of$45.7 million is maturing inFebruary 2023 and the Modified Term Loan with an outstanding balance of$52.3 million is maturing inNovember 2023 . Due to the decrease in occupancies and a decrease in market values of the properties securing these two loans, we do not expect to be able to refinance these loans at current terms and may be required to pay down a portion of the maturing debt in order to 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. If we are unable to meet our payment obligations at maturity of the respective loans because we cannot refinance the loans, the lenders could foreclose on the assets that are pledged as collateral to such lender. 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 refinance our mortgage debt. No assurances can be given that we will be successful in achieving these objectives.
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. Our advisor has been working diligently to develop a Plan of Liquidation to present to our board of directors for approval; however, the impact of the COVID-19 pandemic on a Plan of Liquidation for our portfolio, as well as the decreased demand for office space as employees continue to work from home, the rising interest rate environment that is impacting the ability of buyers to obtain favorable financing and continued social unrest and increased crime in thePortland area where one of our properties is located, have created significant headwinds to finalizing a Plan of Liquidation. 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. 28
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) 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.
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 as well as the current economic slowdown, the rising interest rate environment and inflation (or the public perception that any of these events may continue) have had a negative impact on the office real estate market as discussed below.
COVID-19 Pandemic and Portfolio Outlook
One of the most significant risks and uncertainties facing us and the real estate industry generally, and in particular office REITs like our company, continues to be the effect of the public health crisis of the novel coronavirus disease ("COVID-19") pandemic. We recognized impairment charges related to a projected reduction in cash flows as a result of changes in leasing projections that were impacted in part by the COVID-19 pandemic at the Institute Property and 210 W. Chicago during the year endedDecember 31, 2020 , theCommonwealth Building during the year endedDecember 31, 2021 and theCommonwealth Building and the Institute Property during the nine months endedSeptember 30, 2022 . We cannot predict to what extent economic activity, including the use of and demand for office space, will return to pre-pandemic levels. During 2021 and the first, second and third quarters of 2022, 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. Potential changes in customer behavior, such as the continued social acceptance, desirability and perceived economic benefits of work-from-home arrangements, resulting from the COVID-19 pandemic, could materially and negatively impact the demand for office space, resulting in slower overall leasing and an adverse impact to our operations. The current challenging economic circumstances have created 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 have become more difficult as a result of the impacts of COVID-19 on the demand for office space, in particular in thePortland area where one of our properties is located which has been further impacted by the social unrest that continues in the area. In addition, due to the impact of COVID-19, the leasing environment in the short-term will be challenging 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 and our ability to create value for our stockholders through the stabilization and disposition of these assets will be adversely affected. In addition, the timing in which we may be able to implement a liquidation strategy will be affected. 29
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Liquidity and Capital Resources As described above under "-Overview - Going Concern Considerations," 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 2022 is$250,000 in the aggregate, of which$26,000 was used for such special redemptions from January throughOctober 2022 . Our share redemption program does not provide for ordinary redemptions and we 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, 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 and more recently inflation.
Our advisor advanced funds to us, which are non-interest bearing, for
distribution record dates through the period ended
(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.
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) 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 ofSeptember 30, 2022 , we had mortgage debt obligations in the aggregate principal amount of$101.6 million and our aggregate borrowings were approximately 63% of our net assets before deducting depreciation and other non-cash reserves. As ofSeptember 30, 2022 , the CommonwealthBuilding Mortgage Loan with an outstanding principal balance of$45.7 million is maturing during the 12 months endingSeptember 30, 2023 and the Modified Term Loan with an outstanding balance of$52.3 million is maturing inNovember 2023 . Due to the decrease in occupancies and a decrease in market values of the properties securing these two loans, we do not expect to be able to refinance these loans at current terms and may be required to pay down a portion of the maturing debt in order to 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. In particular, with respect to theCommonwealth Building Mortgage Loan, the indebtedness may exceed the market value of theCommonwealth Building securing the loan. Given the current disruptions in the market, rising interest rates and inflation, the cash flow from the property may be insufficient to cover debt service and other required payments due on the loan which may result in a payment default. In the event we default on the loan, the lender would be entitled to foreclose on the property. 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 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. 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 throughSeptember 30, 2022 . 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. 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 endedSeptember 30, 2022 did not exceed the charter-imposed limitation. 31
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Cash Flows from Operating Activities As ofSeptember 30, 2022 , we owned four office properties. During the nine months endedSeptember 30, 2022 , net cash used in operating activities was$0.2 million . During nine months endedSeptember 30, 2021 , net cash provided by operating activities was$0.9 million . Net cash used in operating activities increased due to a decrease in rental income and the payment of lease incentives during 2022. We expect cash flows provided by operating activities to decrease in future periods to the extent a Plan of Liquidation is approved by our board of directors and our stockholders and we begin selling our assets. In addition, to the extent the impacts of COVID-19 continue to be felt by our tenants, our tenants may defer rent payments or be unable to pay rent or we may be unable to re-lease space vacated by our current tenants which could reduce our cash flow provided by operating activities. Further, downtownPortland , where one of our properties is located is experiencing record high vacancies due to the impact of the disruptions caused by protests and demonstrations and increased crime in the downtown area, and it is uncertain when the market will fully recover which we expect to adversely impact our cash flows from operating activities.
Cash Flows from Investing Activities
During the nine months ended
Cash Flows from Financing Activities
During the nine months ended
Debt Obligations
The following is a summary of our contractual obligations as of
Payments Due During the Years Ending December 31, Debt Obligations Total Remainder of 2022 2023-2024 2025-2026 Outstanding debt obligations (1)$ 101,611 $ 19$ 101,592 $ - Interest payments on outstanding debt obligations (2) 4,100 1,288 2,812 - _____________________
(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 ofSeptember 30, 2022 (consisting of the contractual interest rate and the effect of interest rate swaps). We incurred interest expense of$2.8 million , excluding amortization of deferred financing costs totaling$0.2 million and unrealized gains on derivative instruments of$0.6 million during the nine months endedSeptember 30, 2022 . 32
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Results of Operations Overview As ofSeptember 30, 2022 and 2021, we owned four office properties. If a Plan of Liquidation is approved by our board of directors and our stockholders, we will undertake an orderly liquidation by selling all of our assets, paying our debts, providing for known and unknown liabilities and distributing the net proceeds from liquidation to our stockholders. There can be no assurances regarding the amounts of any liquidating distributions or the timing thereof. In general, subject to other factors as described below, we expect income and expenses to decrease in future periods due to disposition activity. The following table provides summary information about our results of operations for the three and nine months endedSeptember 30, 2022 and 2021 (dollar amounts in thousands): Comparison of the three months endedSeptember 30, 2022 versus the three months endedSeptember 30, 2021 For the Three Months Ended September 30, Increase 2022 2021 (Decrease) Percentage Change Rental income$ 3,589 $ 4,004 $ (415) (10) % Other operating income 35 63 (28) (44) % Operating, maintenance and management costs 943 1,063 (120) (11) % Property management fees and expenses to affiliate 24 29 (5) (17) % Real estate taxes and insurance 849 780 69 9 % Asset management fees to affiliate 442 439 3 1 % General and administrative expenses 372 418 (46) (11) % Depreciation and amortization 1,468 1,987 (519) (26) % Interest expense 1,243 620 623 100 % Impairment charges on real estate 2,490 8,779 (6,289) (72) % Interest and other income 14 - 14 100 % Rental income decreased from$4.0 million for the three months endedSeptember 30, 2021 to$3.6 million for the three months endedSeptember 30, 2022 , primarily due to a decrease in occupancy rate from 80.8% as ofSeptember 30, 2021 to 73.1% as ofSeptember 30, 2022 as a result of lease expirations. Overall, we expect rental income to decrease in future periods due to anticipated future dispositions of real estate properties and uncertainty and business disruptions as a result of the outbreak of COVID-19 and social unrest in thePortland area where one of our properties is located. 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 decreased from$1.1 million for the three months endedSeptember 30, 2021 to$0.9 million for the three months endedSeptember 30, 2022 , primarily due to a decrease in operating costs, including janitorial and repairs and maintenance costs, as a result of a decrease in physical occupancy at our real estate properties. We expect operating, maintenance, and management costs to decrease in future periods due to anticipated future dispositions of real estate properties, offset by general increase due to inflation and as physical occupancy increases as employees return to the office. Real estate taxes and insurance remained consistent at$0.8 million for the three months endedSeptember 30, 2022 and 2021. We expect real estate taxes and insurance to decrease in future periods due to anticipated future dispositions of real estate properties, partially offset by general increase due to inflation. Asset management fees to affiliate remained consistent at$0.4 million for the three months endedSeptember 30, 2022 and 2021. We expect asset management fees to decrease in future periods due to anticipated future dispositions of real estate properties, partially offset by increases in capital improvements. As ofSeptember 30, 2022 , we had accrued and deferred payment of$8.9 million of asset management fees related to the periods fromOctober 2017 throughSeptember 30, 2022 . 33
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) General and administrative expenses remained consistent at$0.4 million for the three months endedSeptember 30, 2022 and 2021. General and administrative costs consisted primarily of legal fees, internal audit compensation expense, errors and omissions insurance, board of directors fees and audit cost. Depreciation and amortization decreased from$2.0 million for the three months endedSeptember 30, 2021 to$1.5 million for the three months endedSeptember 30, 2022 , primarily due to lease expirations, early lease terminations and reduced depreciable asset basis for theCommonwealth Building as a result of non-cash impairment charges recorded subsequent toSeptember 30, 2021 . We expect depreciation and amortization to decrease in future periods due to anticipated future dispositions of real estate properties and fully amortized tenant origination and absorption costs related to lease expirations, partially offset by increases in capital improvements. Interest expense increased from$0.6 million for the three months endedSeptember 30, 2021 to$1.2 million for the three months endedSeptember 30, 2022 . Included in interest expense is the amortization of deferred financing costs of$0.1 million for the three months endedSeptember 30, 2022 and 2021. Interest expense (including gains and losses) incurred as a result of our derivative instruments, decreased interest expense by$7,000 for the three months endedSeptember 30, 2022 and increased interest expense by$23,000 for the three months endedSeptember 30, 2021 . The increase in interest expense is primarily due to an increase in one-month LIBOR and one-month Term SOFR and its impact on interest expense related to our variable rate debt. In general, we expect interest expense to decrease in future periods due to debt repayments related to anticipated future asset sales, which may be offset by certain fees and costs that may be incurred due to the prepayment of certain loans. Our interest expense in future periods will also vary based on fluctuations in one-month LIBOR and one-month Term SOFR 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. During the three months endedSeptember 30, 2022 , we recorded non-cash impairment charges of$2.5 million to write down the carrying value of the Institute Property to its estimated fair value as a result of changes in cash flow estimates including a change in leasing projections and an increase in the capitalization rate, which triggered the future estimated undiscounted cash flows to be lower than the net carrying value of the property. During the three months endedSeptember 30, 2021 , we recorded$8.8 million to write down the carrying value of theCommonwealth Building to its estimated fair value as a result of a continued decrease in occupancy and changes in cash flow estimates including a change in leasing projections, which triggered the future estimated undiscounted cash flows to be lower than the net carrying value of the property. The decrease in cash flow projections during the three months endedSeptember 30, 2022 and 2021 was primarily due to reduced demand for the office space at both properties resulting in longer lease-up periods and a decrease in projected rental rates due to the COVID-19 pandemic which resulted in additional challenges to re-lease the vacant space. Moreover, the decrease in cash flow projections during the three months endedSeptember 30, 2021 for the Commonwealth building was also affected by the disruptions caused by protests and demonstrations and increased crime in the downtown area ofPortland, Oregon , where the property is located. Further, tenants at the Institute Property have been adversely impacted by the measures put in place to control the spread of COVID-19 and certain tenants at the Institute Property were granted rent concessions as their businesses have been severely impacted. 34
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Comparison of the nine months endedSeptember 30, 2022 versus the nine months endedSeptember 30, 2021 For the Nine Months Ended September 30, Increase 2022 2021 (Decrease) Percentage Change Rental income$ 10,906 $ 12,379 $ (1,473) (12) % Other operating income 111 132 (21) (16) % Operating, maintenance and management costs 2,768 2,828 (60) (2) % Property management fees and expenses to affiliate 70 88 (18) (20) % Real estate taxes and insurance 2,405 2,274 131 6 % Asset management fees to affiliate 1,308 1,301 7 1 % General and administrative expenses 1,405 1,340 65 5 % Depreciation and amortization 4,520 5,865 (1,345) (23) % Interest expense 2,384 1,801 583 32 % Impairment charges on real estate 14,223 8,779 5,444 62 % Interest and other income 19 - 19 100 % Rental income decreased from$12.4 million for the nine months endedSeptember 30, 2021 to$10.9 million for the nine months endedSeptember 30, 2022 , primarily due to a decrease in occupancy rate from 80.8% as ofSeptember 30, 2021 to 73.1% as ofSeptember 30, 2022 as a result of lease expirations. Overall, we expect rental income to decrease in future periods due to anticipated future dispositions of real estate properties and uncertainty and business disruptions as a result of the outbreak of COVID-19 and social unrest in thePortland area where one of our properties is located. 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 remained consistent at$2.8 million for the nine months endedSeptember 30, 2022 and 2021. We expect operating, maintenance, and management costs to decrease in future periods due to anticipated future dispositions of real estate properties, offset by general increase due to inflation and as physical occupancy increases as employees return to the office. Real estate taxes and insurance increased from$2.3 million for the nine months endedSeptember 30, 2021 to$2.4 million for the nine months endedSeptember 30, 2022 , primarily due to a net increase in property taxes due to increased property values and rates. We expect real estate taxes and insurance to decrease in future periods due to anticipated future dispositions of real estate properties, partially offset by general increase due to inflation. Asset management fees to affiliate remained consistent at$1.3 million for the nine months endedSeptember 30, 2022 and 2021. We expect asset management fees to decrease in future periods due to anticipated future dispositions of real estate properties, partially offset by increases in capital improvements. As ofSeptember 30, 2022 , we had accrued and deferred payment of$8.9 million of asset management fees related to the periods fromOctober 2017 throughSeptember 30, 2022 . General and administrative expenses increased from$1.3 million for the nine months endedSeptember 30, 2021 to$1.4 million for the nine months endedSeptember 30, 2022 , primarily due to legal fees related to our plan of liquidation incurred during the nine months endedSeptember 30, 2022 , offset by a decrease in internal audit compensation expense. General and administrative costs consisted primarily of legal fees, internal audit compensation expense, errors and omissions insurance, board of directors fees and audit cost. Depreciation and amortization decreased from$5.9 million for the nine months endedSeptember 30, 2021 to$4.5 million for the nine months endedSeptember 30, 2022 , primarily due to lease expirations, early lease terminations and reduced depreciable asset basis for theCommonwealth Building as a result of non-cash impairment charges recorded subsequent toSeptember 30, 2021 . We expect depreciation and amortization to decrease in future periods due to anticipated future dispositions of real estate properties and fully amortized tenant origination and absorption costs related to lease expirations, partially offset by increases in capital improvements. 35
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Interest expense increased from$1.8 million for the nine months endedSeptember 30, 2021 to$2.4 million for the nine months endedSeptember 30, 2022 . Included in interest expense is the amortization of deferred financing costs of$0.2 million for the nine months endedSeptember 30, 2022 and 2021. Interest expense (including gains and losses) incurred as a result of our derivative instruments, decreased interest expense by$0.2 million for the nine months endedSeptember 30, 2022 and increased interest expense by$54,000 for the nine months endedSeptember 30, 2021 . The increase in interest expense is primarily due to an increase in one-month LIBOR and one-month Term SOFR and its impact on interest expense related to our variable rate debt, offset by a decrease in interest expense due to the expiration of an interest rate swap inNovember 2021 that was not accounted for as a cash flow hedge. In general, we expect interest expense to decrease in future periods due to debt repayments related to anticipated future asset sales, which may be offset by certain fees and costs that may be incurred due to the prepayment of certain loans. Our interest expense in future periods will also vary based on fluctuations in one-month LIBOR and one-month Term SOFR 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. During the nine months endedSeptember 30, 2022 , we recorded non-cash impairment charges of$14.2 million to write down the carrying value of theCommonwealth Building and the Institute Property to their estimated fair values 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 properties. In addition, theCommonwealth Building has experienced a continued decrease in occupancy. As ofSeptember 30, 2022 , theCommonwealth Building was 51.8% occupied. During the nine months endedSeptember 30, 2021 , we recorded non-cash impairment charges of$8.8 million to write down the carrying value of theCommonwealth Building 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. The decrease in cash flow projections during the nine months endedSeptember 30, 2022 and 2021 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 nine months endedSeptember 30, 2022 and 2021 for the Commonwealth building was also affected by the disruptions caused by protests and demonstrations and increased crime in the downtown area ofPortland, Oregon , where the property is located. Further, tenants at the Institute Property have been adversely impacted by the measures put in place to control the spread of COVID-19 and certain tenants at the Institute Property were granted rent concessions as their businesses have been severely impacted. 36
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) 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 currentNational 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 withU.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 inNovember 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. 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. 37
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Although MFFO includes other adjustments, the exclusion of adjustments for straight-line rent, the amortization of above- and below-market leases and unrealized (gains) losses on derivative instruments 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; and •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. 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 three and nine months endedSeptember 30, 2022 and 2021, respectively (in thousands). No conclusions or comparisons should be made from the presentation of these periods. For the Three Months Ended For the Nine Months Ended September 30, September 30, 2022 2021 2022 2021 Net loss$ (4,193) $
(10,048)
908 1,142 2,767 3,451 Amortization of lease-related costs 560 845 1,753 2,414 Impairment charges on real estate 2,490 8,779 14,223 8,779 FFO (235) 718 696 2,879 Straight-line rent and amortization of above- and below-market leases, net (228) (89) (885) (305) Unrealized gain on derivative instruments (53) (430) (617) (1,280) MFFO$ (516) $ 199 $ (806)$ 1,294 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
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. 38
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PART I. FINANCIAL INFORMATION (CONTINUED)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Critical Accounting Policies Our consolidated interim financial statements and condensed notes thereto have been prepared in accordance with GAAP and in conjunction with the rules and regulations of theSEC . The preparation of our financial statements requires significant management judgments, assumptions and estimates about matters that are inherently uncertain. 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. A discussion of the accounting policies that management considers critical in that they involve significant management judgments, assumptions and estimates is included in our Annual Report on Form 10-K for the year endedDecember 31, 2021 filed with theSEC . There have been no significant changes to our accounting policies during 2022.
Subsequent Events
We evaluate subsequent events up until the date the consolidated financial statements are issued.
Commonwealth
OnNovember 9, 2022 , we, through an indirect wholly owned subsidiary, entered into a letter modification agreement with the lender under the CommonwealthBuilding Mortgage Loan . See Part II, Item 5 "Other Information - CommonwealthBuilding Mortgage Loan Modification ." 39
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PART I. FINANCIAL INFORMATION (CONTINUED)
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