Overview

Parkway is a self-administered and self-managed REIT specializing in the acquisition, operations, leasing and ownership of office properties. The Company is geographically focused on the Southeastern and Southwestern United States and Chicago. At January 1, 2009 Parkway owned or had an interest in 67 office properties located in 11 states with an aggregate of approximately 13.5 million square feet of leasable space. Included in the portfolio are 21 properties totaling 3.8 million square feet that are owned jointly with other investors, representing 28% of the portfolio. Beginning with the Company's GEAR UP Plan, which started January 1, 2006 and ended December 31, 2008, it is the Company's goal to transform its strategy from being an owner-operator to being an operator-owner. The Company will continue executing on this strategy, which highlights the Company's strength in providing excellent service in the operation of office properties in addition to its direct ownership of real estate assets. Fee-based real estate services are offered through the Company's wholly-owned subsidiary, Parkway Realty Services LLC, which also manages and/or leases approximately 1.8 million square feet for third-party owners at January 1, 2009. The Company generates revenue primarily by leasing office space to its customers and providing management and leasing services to third-party office property owners (including joint venture interests). The primary drivers behind Parkway's revenues are occupancy, rental rates and customer retention.

Occupancy. Parkway's revenues are dependent on the occupancy of its office buildings. At January 1, 2009, occupancy of Parkway's office portfolio was 90.1% compared to 90.4% at October 1, 2008 and 92.0% at January 1, 2008. Not included in the January 1, 2009 occupancy rate are 16 signed leases totaling 93,000 square feet, which commence during the first and second quarters of 2009 and will raise Parkway's percentage leased to 90.8%. To combat rising vacancy, Parkway utilizes innovative approaches to produce new leases. These include the Broker Bill of Rights, a short-form service agreement and customer advocacy programs which are models in the industry and have helped the Company maintain occupancy around 90% during a time when the national occupancy rate is approximately 85%. Parkway currently projects an average annual occupancy range of approximately 88.5% to 89.5% during 2009 for its office properties.

Rental Rates. An increase in vacancy rates has the effect of reducing market rental rates and vice versa. Parkway's leases typically have three to seven year terms. As leases expire, the Company replaces the existing leases with new leases at the current market rental rate. At January 1, 2009, Parkway had $1.11 per square foot in rental rate embedded growth in its office property leases. Embedded growth is defined as the difference between the weighted average in place cash rents and the weighted average market rental rate. Parkway currently expects embedded rent growth per square foot to decrease in 2009.

Customer Retention. Keeping existing customers is important as high customer retention leads to increased occupancy, less downtime between leases, and reduced leasing costs. Parkway estimates that it costs five to six times more to replace an existing customer with a new one than to retain the customer. In making this estimate, Parkway takes into account the sum of revenue lost during downtime on the space plus leasing costs, which rise as market vacancies increase. Therefore, Parkway focuses a great deal of energy on customer retention. Parkway's operating philosophy is based on the premise that it is in the customer retention business. Parkway seeks to retain its customers by continually focusing on operations at its office properties. The Company believes in providing superior customer service; hiring, training, retaining and empowering each employee; and creating an environment of open communication both internally and externally with customers and stockholders. Over the past ten years, Parkway maintained an average 72.5% customer retention rate. Parkway's customer retention for the year ending December 31, 2008 was 70.7% compared to 72.0% for the year ending December 31, 2007.

Strategic Planning

Parkway is a focused office REIT with a hands-on, service-oriented approach, a disciplined capital allocation program and a willingness to recycle assets. However, we see the future transformation taking Parkway from being an owner-operator to being an operator-owner. On January 1, 2006, the Company initiated a three-year operating plan referred to as the "GEAR UP" Plan, which was completed on December 31, 2008. The plan served as the spring board to transform Parkway from being first an owner of real estate and secondarily an operator of real estate for others to being first an operator of real estate for others that also owns an interest in the real estate. Parkway achieved the GEAR UP Plan financial goal of $7.18 cumulative adjusted funds available for distribution per diluted share for the three year period. The goals of the GEAR UP Plan and related accomplishments are discussed below:

º Great People. Great customer service starts with hiring great people, training them well and retaining them. It took great people to accomplish the ambitious goals of the GEAR UP Plan. Parkway retained and recruited great people through expansion of the intern program, boot camp program and parachute program. These programs are used to train our people on the culture of the Company and its uncompromising focus on operations so that they are familiar with all disciplines of the Company.

º Equity Opportunities. Over the last several years management has created a broad array of equity opportunities for Parkway. On the private equity side this includes the use of discretionary funds, such as the Ohio PERS Fund I and Texas Teachers Fund II, and partnerships. The judicious use of private equity provides a greater return on equity to the public shareholders. On the public equity side, this includes the judicious use of common equity and preferred equity to manage the balance sheet and growth. Parkway accomplished the following Equity Opportunities goals during 2006 through 2008:

º Fund II Formation. On May 14, 2008, Parkway entered into Texas Teachers Fund II, a $750.0 million discretionary fund with the TRS for the purpose of acquiring office properties. TRS is a 70% investor and Parkway is a 30% investor.

º Equity Offering. On December 18, 2006, the Company sold 600,000 shares of common stock to Banc of America Securities LLC at a gross offering price of $50.25 per share and a net price of $49.37 per share. The Company used the net proceeds of approximately $29.6 million to repay indebtedness outstanding under a $19.3 million mezzanine loan incurred in connection with the purchase of One Illinois Center and to fund our equity contributions for Ohio PERS Fund I investments.

º Asset Recycling. The Company has demonstrated its willingness in the past to sell assets when management believed the time was right. At the start of the GEAR UP Plan, Parkway identified 25 buildings in 12 markets, totaling approximately 5.0 million rentable square feet to be part of the asset recycling program. Most of these properties were smaller assets or located in smaller markets that do not fit with the Company's strategy of owning larger assets in institutional markets. The dispositions that were planned would help align the Company's portfolio with its current acquisition criteria, which focuses on larger properties in institutional markets. This was a fluid list of assets based on the Company's evaluation of specific market conditions and review of the portfolio. The other side of Asset Recycling is the reinvestment of proceeds from dispositions into other assets, either owned in the fee-simple format or owned jointly with a partner. Parkway accomplished the following Asset Recycling goals during 2006 through 2008:

o Dispositions. Parkway sold 13 office properties for gross sales proceeds of $240.1 million and recorded a total gain on the sales for financial reporting purposes in the amount of $65.7 million. Subsequent to December 31, 2008, Parkway sold one asset for a gross sales price of $7.8 million and has another asset under contract for a gross sales price of $7.7 million with $125,000 in non-refundable earnest money. The Company plans to continue the work started during the GEAR UP Plan and complete many of the non-strategic asset sales outlined previously, subject to market conditions.

o Fund I Acquisitions. Parkway completed the investment for the Ohio PERS Fund I. During 2006 through 2008, 11 office properties were purchased at an aggregate contract purchase price of $465.9 million, which is comprised of investments by the fund totaling $444.3 million plus an additional investment by Parkway of $21.6 million.

o Fee Simple Purchases. In July 2006, Parkway purchased One Illinois Center in Chicago, Illinois at a contract purchase price of $198.0 million.

o Other Purchases. Parkway purchased an additional interest in Moore Building Associates, LP, which owns the Toyota Center in Memphis, Tennessee, for $1.4 million raising Parkway's total ownership interest to 75.025%.

o Office Property Development. The Pinnacle at Jackson Place in Jackson, Mississippi, opened on December 8, 2008, at a total cost of approximately $50.4 million, which includes the cost of the adjacent parking facility. The completion of the Company's only development project consists of an 189,000 net rentable square foot Class-A office building and a 1,734 space parking facility that is leased from the City of Jackson for a period of 90 years.

These two goals, Equity Opportunities and Asset Recycling,are what combine to transform Parkway from being an owner-operator to being an operator-owner. Management believes that these actions will result in Parkway better leveraging its core strength of operating office properties and will be advantageous for the Company's shareholders over the long term. So whether we are in an economy characterized by growth or recession, purchasing assets with a good partner and leveraging our operating expertise through earning recurring fees allows us to increase our core portfolio in larger and more institutional markets and increase our earnings potential from the services provided.

º Retain Customers. Customer retention remains the cornerstone of the Company's business. We believe that our focus on the customer is why partners choose to partner with Parkway. The goal was a customer retention rate of 70% to 75%. The average customer retention rate during the GEAR UP Plan was 71.9%.

º Uncompromising Focus on Operations. Parkway reaffirmed its commitment to do that which it does best, and that is to operate office properties for maximum returns. During the GEAR UP Plan, Parkway increased occupancy from 88.9% at January 1, 2006 to 90.1% at January 1, 2009. Additionally, embedded rent growth increased from a negative $0.74 per square foot at January 1, 2006 to a positive $1.11 per square foot at January 1, 2009. Parkway currently expects embedded rent growth per square foot to decrease in 2009.

º Performance. In the planning process, management first decided what actions to take strategically over the three years of the GEAR UP Plan and secondly, modeled the economic impact of these actions. Given the large component of Asset Recycling in the Plan, management selected a financial metric that would be most appropriate to measure the success of the Plan. This led to the adoption of Cumulative Adjusted FAD as the metric for the GEAR UP Plan, with a target of $7.18 per share cumulative over three years. Parkway achieved an actual Cumulative Adjusted FAD for the plan of $7.20 per diluted share.

Discretionary Funds. On July 6, 2005, Parkway, through affiliated entities, entered into a limited partnership agreement forming Ohio PERS Fund I for the purpose of acquiring high-quality multi-tenant office properties. Ohio PERS is a 75% investor and Parkway is a 25% investor in the Fund, which is capitalized with approximately $200.0 million of equity capital and $300.0 million of non-recourse, fixed-rate first mortgage debt. At February 15, 2008, Ohio PERS Fund I was fully invested.

The Ohio PERS Fund I targeted properties with an anticipated leveraged internal rate of return of greater than 11%. Parkway serves as the general partner of the fund and provides asset management, property management, leasing and construction management services to the fund, for which it is paid market-based fees. After each partner has received a 10% annual cumulative preferred return and a return of invested capital, 20% of the excess cash flow will be paid to the general partner and 80% will be paid to the limited partners. Through its general partner and limited partner ownership interests, Parkway may receive a distribution of the cash flow equivalent to 40%. The term of Ohio PERS Fund I will be seven years until February 2015, with provisions to extend the term for two additional one-year periods.

On May 14, 2008, Parkway, through affiliated entities, entered into a limited partnership agreement forming a $750.0 million discretionary fund, known as Texas Teachers Fund II with the TRS for the purpose of acquiring high-quality multi-tenant office properties. TRS is a 70% investor and Parkway is a 30% investor in the fund, which will be capitalized with approximately $375.0 million of equity capital and $375.0 million of non-recourse, fixed-rate first mortgage debt. Parkway's share of the equity contribution for the fund will be $112.5 million and will be funded with proceeds from asset sales, line of credit advances and/or sales of equity securities. The Texas Teachers Fund II targets acquisitions in the core markets of Houston, Austin, San Antonio, Chicago, Atlanta, Phoenix, Charlotte, Memphis, Nashville, Jacksonville, Orlando, Tampa/St. Petersburg, and other growth markets to be determined by Parkway.

The Texas Teachers Fund II targets properties with an anticipated leveraged internal rate of return of greater than 10%. Parkway serves as the general partner of the fund and provides asset management, property management, leasing and construction management services to the fund, for which it will be paid market-based fees. Cash will be distributed pro rata to each partner until a 9% annual cumulative preferred return is received and invested capital is returned. Thereafter, 56% will be distributed to TRS and 44% to Parkway. Parkway has four years from the inception date of Texas Teachers Fund II to identify and acquire properties (the "Investment Period"), with funds contributed as needed to close acquisitions. Parkway will exclusively represent the fund in making acquisitions within the target markets and acquisitions with certain predefined criteria. Parkway will not be prohibited from making fee-simple or joint venture acquisitions in markets outside of the target markets, acquiring properties within the target markets that do not meet Texas Teachers Fund II's specific criteria or selling or joint venturing currently owned properties. The term of Texas Teachers Fund II will be seven years from the expiration of the Investment Period, with provisions to extend the term for two additional one-year periods at the discretion of Parkway.

Financial Condition

Comments are for the balance sheet dated December 31, 2008 as compared to the balance sheet dated December 31, 2007.

Office and Parking Properties. In 2008, Parkway continued the execution of its strategy of operating and acquiring office properties, joint venturing interests in office assets, as well as liquidating non-core assets and office assets that either no longer meet the Company's investment criteria or the Company has determined value will be maximized by selling. During the year ended December 31, 2008, total assets increased $152.1 million or 9.9% and office and parking properties and real estate development (before depreciation) increased $171.8 million or 11.0%.

Purchases, Improvements and Development

Parkway's investment in consolidated office and parking properties increased $140.6 million net of depreciation, to a carrying amount of $1.5 billion at December 31, 2008 and consisted of 61 office and parking properties. The primary reason for the increase in office and parking properties relates to the net effect of the purchase of three office properties, building improvements, development costs, the sale of three office properties, and depreciation recorded during the year.

For the year ended December 31, 2008, the Company incurred $30.3 million in development costs for the construction of The Pinnacle at Jackson Place, which is a 189,000 net rentable square foot Class-A office building adjacent to the Company's headquarters building in Jackson, Mississippi. The Pinnacle at Jackson Place was completed on December 8, 2008, is currently 82% leased, and was the Company's only development project.

During the year ending December 31, 2008, the Ohio PERS Fund I purchased three office properties as follows (in thousands):

                                                   Parkway  Square   Date    Purchase
        Office Property             Location      Ownership  Feet  Purchased  Price

Ohio PERS Fund I Purchases:
  Gateway Center                Orlando, Florida    25.0%      228 01/18/08  $ 55,000
  Desert Ridge Corporate Center Phoenix, Arizona    26.5%      293 01/31/08    81,600
  Citicorp Plaza                Chicago, Illinois   40.0%      600 02/15/08   100,000
                                                             1,121           $236,600

During the year ending December 31, 2008, the Company capitalized building improvements and additional acquisition costs of $30.5 million and recorded depreciation expense of $67.3 million related to its office and parking properties.

Dispositions



    During the year ending December 31, 2008, Parkway sold three office
properties as follows (in thousands):



                                               Square   Date      Gross
    Office Property           Location          Feet    Sold   Sales Price   Gain

    Town Point Center Norfolk, Virginia           131 07/15/08    $ 12,750 $  1,559
    Wachovia Plaza    St. Petersburg, Florida     186 08/18/08      26,010    9,338
    Capitol Center    Columbia, South Carolina    460 09/05/08      47,500   11,691
                                                  777             $ 86,260 $ 22,588

On February 20, 2009, the Company sold Lynwood Plaza, an 82,000 square foot office property in Hampton Roads, Virginia to an unrelated third party for a gross sales price of $7.8 million. During the fourth quarter of 2008, the Company recognized a non-cash impairment loss of approximately $1.1 million related to this property. Additionally, the Company entered into a contract to sell the Atrium at Stoneridge in Columbia, South Carolina. The gross sales price is estimated at $7.7 million with $125,000 in non-refundable earnest money. In connection with the sale of the Atrium at Stoneridge, the Company expects to seller finance a $5.4 million note receivable that will bear interest at 6.75% per annum on an interest-only basis through maturity in 2014. A non-cash impairment loss of $727,000 was recorded during the fourth quarter of 2008 on this asset. The sale is subject to customary final closing requirements and due diligence documentation, with the sale expected to be completed in the first quarter of 2009, but there can be no assurance that the transaction will be completed. These properties are not classified as held for sale on the Company's balance sheet at December 31, 2008 as the Company did not view the sales as probable until the first quarter of 2009 when earnest money became non-refundable.

Land Available for Sale. A non-cash impairment loss of $717,000 was recorded in the fourth quarter of 2008 in connection with the valuation of approximately 12 acres of land available for sale in New Orleans, Louisiana, based on a change in the estimated fair value of the land. After recording the impairment loss, the carrying value corresponds with the net realizable value of the land based on market research and comparable sales.

Intangible Assets, Net. For the year ending December 31, 2008, intangible assets net of related amortization increased $8.7 million or 12.4% and was primarily due to the net effect of the purchase of three office investments during the year and annual amortization of the existing intangible assets. Parkway accounts for its acquisitions of real estate in accordance with Statement of Financial Accounting Standards No. 141, "Business Combinations", which requires the fair value of the real estate acquired to be allocated to acquired tangible and intangible assets.

Notes Payable to Banks. Notes payable to banks decreased $26.4 million or 12.4% for the year ending December 31, 2008. At December 31, 2008, notes payable to banks totaled $185.9 million and the net decrease is primarily attributable to proceeds received from refinancing the mortgage secured by Capital City Plaza in Atlanta, Georgia and the sale of three office properties, offset by advances under the line of credit to purchase and develop real estate and make improvements to office properties.

On May 7, 2008, the Company entered into an interest rate swap agreement with Regions Bank. The interest rate swap is for a $100.0 million notional amount and fixes the 30-day LIBOR interest rate at 3.635%, which equates to a total interest rate of 4.935% for the period January 1, 2009 through March 31, 2011. The swap serves as a hedge on the variable interest rates on a portion of the borrowings under the Company's line of credit.

During 2008, the Company exercised the option to extend the line of credit, resulting in $311.0 million in total line capacity now maturing in April 2011. The Company paid one-time extension fees totaling approximately $407,000, which will be amortized over the remaining term of the line of credit.

The Company's $311.0 million unsecured credit facility requires compliance with a number of restrictive financial covenants, including tangible net worth, fixed charge coverage ratio, unencumbered interest coverage ratio, total debt to total asset ratio, secured debt to total asset value ratio, secured recourse debt to total asset value ratio and unencumbered pool restrictions. At December 31, 2008 the Company was in compliance with these financial covenants.

Mortgage Notes Payable. Mortgage notes payable increased $155.1 million or 21.7% during the year ending December 31, 2008, as a result of the following (in thousands):

                                                                  Increase
                                                                 (Decrease)
      Placement of mortgage debt by Ohio PERS Fund I              $142,200
      Placement of mortgage debt by wholly-owned properties         60,000
      Advances on mortgage debt to fund the Pinnacle development    29,500
      Principal paid on early extinguishment of debt               (62,980)
      Scheduled principal payments                                 (13,640)
                                                                  $155,080

On February 1, 2008, the Company paid off the mortgage notes payable secured by the 400 North Belt and Woodbranch buildings in Houston, Texas, with a total principal balance of $3.5 million with advances under the Company's line of credit. The mortgages had an interest rate of 8.25% and were scheduled to mature on August 1, 2011. The Company recognized a total of $401,000 in expense associated with the prepayment of these mortgages.

In connection with the Ohio PERS Fund I investments during the first quarter of 2008 discussed under "Financial Condition - Office and Parking Properties - Purchases, Improvements and Development", total non-recourse first mortgage debt was placed in the amount of $142.2 million at a weighted average interest rate of 5.7%. The portion of mortgage debt attributable to the Ohio PERS Fund I was $129.2 million and $13.0 million was attributable to Parkway. The mortgages are secured by the respective properties, have one to three year interest only periods and mature in 2016.

On April 4, 2008, the Company entered into an interest rate swap agreement with US Bank. The interest rate swap is for a $23.5 million notional amount and fixes the 30-day LIBOR interest rate at 4.05%, which equates to a current total interest rate of 5.8%, for the period January 1, 2009 through December 1, 2014. The swap serves as a hedge of the variable interest rates on a portion of the mortgage debt placed on the Pinnacle at Jackson Place. The weighted average interest rate for the total mortgage debt of $29.5 million placed on the Pinnacle at Jackson Place is 5.2%.

On May 2, 2008, the Company completed a $60.0 million recourse mortgage loan related to the refinance of a $41.4 million mortgage that was scheduled to mature in September 2008. The loan is secured by the Company's Capital City Plaza building in Atlanta, Georgia. The interest rate on the loan is a variable rate based on LIBOR plus 165 basis points. The loan term is for two years, with a one-year extension option at the Company's discretion. The excess loan proceeds of approximately $18.4 million were used to pay down the Company's line of credit. The Company recorded a gain on the prepayment of approximately $388,000 associated with the write off of the debt premium in the second quarter of 2008. The mortgage represented the Company's only outstanding maturity in 2008.

In connection with the sale of Capitol Center on September 5, 2008, the Company prepaid the $18.1 million first mortgage plus $2.1 million in related mortgage prepayment expenses with proceeds received from the sale.

On February 27, 2009, the Company paid off the mortgage note payable secured by the 1717 St. James, 5300 Memorial and Town and Country office buildings in Houston, Texas, with a total principal balance of $21.8 million with advances under the Company's line of credit. The mortgage had an interest rate of 4.83% and was scheduled to mature March 1, 2009.

The Company expects to continue seeking fixed-rate, non-recourse mortgage financing with maturities from five to ten years typically amortizing over 25 to 30 years on select office building investments as additional capital is needed. The Company monitors the total debt to total asset value ratio as defined in the loan agreements for the $311.0 million unsecured line of credit. In addition to the total debt to total asset value ratio, the Company monitors interest, fixed charge and modified fixed charge coverage ratios. The interest coverage ratio is computed by comparing the cash interest accrued to earnings before interest, taxes, depreciation and amortization ("EBITDA"). The fixed charge coverage ratio is computed by comparing the cash interest accrued, principal payments made on mortgage loans and preferred dividends paid to EBITDA. The modified fixed charge coverage ratio is computed by comparing cash interest accrued and preferred dividends paid to EBITDA. Management believes the total debt to total . . .