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GTY > SEC Filings for GTY > Form 10-Q on 8-Nov-2011All Recent SEC Filings

Show all filings for GETTY REALTY CORP /MD/

Form 10-Q for GETTY REALTY CORP /MD/


8-Nov-2011

Quarterly Report


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

The following discussion and analysis of financial condition and results of operations should be read in conjunction with the sections entitled "Part I, Item 1A. Risk Factors" and "Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations," which appear in our Annual Report on Form 10-K for the year ended December 31, 2010, and "Part II, Item 1A. Risk Factors" which appears in our Quarterly Reports on Form 10-Q for each of the quarters ended March 31 and June 30, 2011 filed with the SEC and this Quarterly Report on Form 10-Q.

GENERAL

Recent Developments

Our relationship with Getty Petroleum Marketing Inc. ("Marketing") has deteriorated over the past several months. We are actively pursuing claims related to the non-payment of rent as well as other defaults by Marketing under the unitary master lease (the "Master Lease"), including taking legal action to enforce our rights under the Master Lease. We cannot provide any assurance regarding the ultimate resolution of these or any subsequent actions, including whether Marketing will comply with its rental, environmental and other obligations under the Master Lease.

In August and September 2011, Marketing failed to pay its monthly fixed rent to us when due under the Master Lease. We sent default notices to Marketing as required by the Master Lease and in each instance, Marketing ultimately paid the rent with applicable interest. In late August 2011, Marketing sent us a notice (the "Notice") alleging that we were in default of certain of our obligations under the Master Lease by failing to perform certain environmental remediation. The Notice stated that if we failed to cure the alleged default, Marketing intended to offset the full amount of its monthly rental payments due to us under the Master Lease for October and November 2011. We believe that the alleged default is wholly without merit, that Marketing has no right to offset rent under the Master Lease based on the allegations they have made and that we are in compliance with our environmental obligations under the Master Lease. In compliance with an order issued by the New York State Supreme Court, Marketing paid an amount equal to the full October 2011 fixed rent under the Master Lease of which approximately $4.0 million was paid to us and the balance of approximately $0.9 million was paid to the court to be held in escrow. A judicial determination on the merits of Marketing's claim to have a right of offset against fixed rent otherwise due under the Master Lease, and thus a disposition of monies held by the court, remains pending. We anticipate that, in connection with Marketing's claim regarding rent offset rights or other claims or allegations that have been or may in the future be made, we may continue to experience disruption in rent receipts due from Marketing under the Master Lease. It is also possible that Marketing may assert additional claims against us. We intend to pursue our current actions against Marketing and, if necessary, bring other actions against Marketing to enforce our rights under the Master Lease.

Despite the litigation and other developments between us and Marketing, it is our intent to continue to pursue the sale and simultaneous removal of individual properties from the Master Lease. Any such dispositions require Marketing's cooperation and consent, therefore we cannot provide any assurance that any such dispositions will occur.

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In accordance with accounting principles generally accepted in the United States of America ("GAAP"), the aggregate minimum rent due over the current term of the Master Lease is recognized on a straight-line (or average) basis rather than when payment contractually is due. We record the cumulative difference between lease revenue recognized under this straight-line accounting method and the lease revenue recognized when payment is due under the contractual payment terms as deferred rent receivable on our consolidated balance sheets. We provide reserves for a portion of the recorded deferred rent receivable if circumstances indicate that a property may be disposed of before the end of the current lease term or if it is not reasonable to assume that a tenant will make all of its contractual lease payments during the current lease term. Our assessments and assumptions regarding the recoverability of the deferred rent receivable related to the portfolio of properties subject of the Master Lease is reviewed on an ongoing basis and such assessments and assumptions are subject to change.

As a result of the developments with Marketing described above and in our other filings with the SEC, Marketing's posture related to resolving issues concerning the Master Lease and our assessment of the best way to position the Marketing portfolio to maximize its long-term value to us, we have concluded that it is probable that we will not receive a greater portion of the contractual lease payments when due from Marketing for the entire initial term of the Master Lease than we had previously reserved. Therefore, during the quarter ended September 30, 2011 we increased our reserve by recording an additional non-cash allowance for deferred rental revenue of $11.0 million. This non-cash allowance reduces our net earnings and our funds from operations for the three and nine months ended September 30, 2011, but does not impact our current cash flows from operating activities or adjusted funds from operations since the impact of the straight-line method of accounting is not included in our determination of adjusted funds from operations. As of September 30, 2011 and December 31, 2010, the net carrying value of the deferred rent receivable attributable to the Master Lease was $8.8 million and $21.2 million, respectively, which was comprised of a gross deferred rent receivable of $26.7 million and $29.4 million, respectively, partially offset by a valuation reserve of $17.9 million and $8.2 million, respectively. It is possible that in connection with a restructuring of the portfolio of properties subject of the Master Lease, we may consider a deferral or reduction in the rental payments owed to us under the Master Lease. It is also possible that as a result of a continued deterioration of Marketing's financial condition, Marketing may file bankruptcy and seek to reorganize or liquidate its business.

(See "General - Marketing and the Master Lease" below for additional information.) (For information regarding factors that could adversely affect us relating to our lessees, including Marketing, see "Item 1A. Risk Factors" which appears in our Annual Report on Form 10-K for the year ended December 31, 2010, and "Part II, Item 1A. Risk Factors" which appears in our Quarterly Reports on Form 10-Q for each of the quarters ended March 31 and June 30, 2011 filed with the SEC and this Quarterly Report on Form 10-Q.)

Real Estate Investment Trust

We are a real estate investment trust ("REIT") specializing in the ownership, leasing and financing of retail motor fuel and convenience store properties and petroleum distribution terminals. We elected to be treated as a REIT under the federal income tax laws beginning January 1, 2001. As a REIT, we are not subject to federal corporate income tax on the taxable income we distribute to our shareholders. In order to continue to qualify for taxation as a REIT, we are required, among other things, to distribute at least ninety percent of our ordinary taxable income to our shareholders each year.

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Retail Petroleum Marketing Business

We lease or sublet our properties primarily to distributors and retailers engaged in the sale of gasoline and other motor fuel products, convenience store products and automotive repair services. These tenants are responsible for managing the operations conducted at these properties and for the payment of taxes, maintenance, repair, insurance and other operating expenses relating to our properties. Our tenants' financial results are largely dependent on the performance of the petroleum marketing industry, which is highly competitive and subject to volatility. In those instances where we determine that the best use for a property is no longer as a retail motor fuel outlet, we will seek an alternative tenant or buyer for the property. We lease or sublet approximately twenty of our properties for uses such as fast food restaurants, automobile sales and other retail purposes. (For additional information regarding our real estate business and our properties, see "Item 1. Business - Real Estate Business" and "Item 2. Properties" which appear in our Annual Report on Form 10-K for the year ended December 31, 2010.) (For information regarding factors that could adversely affect us relating to our lessees, including Marketing, see "Item 1A. Risk Factors" which appears in our Annual Report on Form 10-K for the year ended December 31, 2010, "Part II, Item 1A. Risk Factors" which appears in our Quarterly Reports on Form 10-Q for each of the quarters ended March 31 and June 30, 2011 filed with the SEC and this Quarterly Report on Form 10-Q.)

Marketing and the Master Lease

As of September 30, 2011, Marketing leased from us 800 properties comprising a unitary premises pursuant to the Master Lease. The Master Lease has an initial term expiring in December 2015, and provides Marketing with three renewal options of ten years each and a final renewal option of three years and ten months extending to 2049. Marketing is required to notify us of its election to exercise a renewal option one year in advance of the commencement of such renewal term. The Master Lease is a unitary lease and, therefore, Marketing's exercise of any renewal option can only be for all, and not less than all, of the properties then comprising the unitary premises subject of the Master Lease. The Master Lease is a "triple-net" lease, pursuant to which Marketing is responsible for the payment of taxes, maintenance, repair, insurance and other operating expenses.

Our financial results are materially dependent upon the ability of Marketing to meet its rental, environmental and other obligations under the Master Lease. Marketing's financial results depend on retail petroleum marketing margins from the sale of refined petroleum products and rental income from its subtenants. Marketing's subtenants either operate their gas stations, convenience stores, automotive repair services or other businesses at our properties or are petroleum distributors who may operate our properties directly and/or sublet our properties to the operators. Since a substantial portion of our revenues (52% for the three months ended September 30, 2011) are derived from the Master Lease, any factor that adversely affects Marketing's ability to meet its rental, environmental and other obligations under the Master Lease may have a material adverse effect on our business, financial condition, revenues, operating expenses, results of operations, liquidity, ability to pay dividends or stock price. (For additional information regarding the portion of our financial results that are attributable to Marketing, see note 9 in "Item 1. Financial Statements - Notes to Consolidated Financial Statements.") (For information regarding factors that could adversely affect us relating to our lessees, including our primary tenant, Marketing, see "Item 1A. Risk Factors" which appears in our Annual Report on Form 10-K for the year ended December 31, 2010, "Part II, Item 1A. Risk Factors" which appears in our Quarterly Reports on Form 10-Q for each of the quarters ended March 31 and June 30, 2011 filed with the SEC and this Quarterly Report on Form 10-Q.)

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Marketing provided us with financial statements for the year ended December 31, 2010; however, these financial statements were not certified as prepared in accordance with GAAP by either an independent certified public accountant or one of Marketing's executive officers as required by the terms of the Master Lease. For the year ended December 31, 2010, Marketing reported a significant loss, continuing a trend of reporting large losses in recent years. Marketing continued to report significant losses in its preliminary interim financial statements provided to us for the three months ended March 31, 2011 and for the six months ended June 30, 2011. Marketing's financial statements for three months ended March 31, 2011 and for the six months ended June 30, 2011 are preliminary and subject to material adjustment. We believe that Marketing likely does not have the ability to generate cash flows from its business operations sufficient to meet its rental, environmental and other obligations under the terms of the Master Lease unless Marketing shows significant improvement in its financial results, reduces the number of properties under the Master Lease, receives additional capital or credit support or generates funds elsewhere. There can be no assurance that Marketing will be successful in any of these efforts.

In July 2011, an arbitration panel that had been convened to hear a contractual dispute which commenced in 2010 between Marketing and Bionol Clearfield LLC ("Bionol") issued an award in favor of Bionol for approximately $230.0 million. Marketing has filed a motion to vacate this award. The contractual dispute relates to a five-year contract under which Marketing agreed to purchase, at formula-based prices, substantially all of the ethanol production from Bionol's ethanol plant in Pennsylvania. We are not in a position to evaluate the strength of the positions taken by Marketing with respect to its motion to vacate, and we cannot predict the actions that may be taken by Marketing or Bionol with respect to the award, or the timing of any such actions, including as to settlement or enforcement. Also in July 2011 Bionol announced that it, along with its affiliates, Bioenergy Holdings LLC and Bionol Holdings LLC, filed a voluntary petition for Chapter 7 relief in the United States Bankruptcy Court in Delaware. We cannot predict what impact Bionol's Chapter 7 liquidation filing may have on its dispute with Marketing or what actions the Trustee may take to collect on or settle the award or whether the Trustee may pursue other possible remedies. The ultimate resolution of this matter may materially adversely affect Marketing's financial condition and its ability to meet its obligations to the Company as they become due under the terms of the Master Lease.

On February 28, 2011, OAO LUKoil ("Lukoil"), one of the largest integrated Russian oil companies, transferred its ownership interest in Marketing to Cambridge Petroleum Holding Inc. ("Cambridge"). We are not privy to the terms and conditions of this transaction between Lukoil and Cambridge and we do not know what type or amount of consideration, if any, was paid or is payable by Lukoil or its subsidiaries to Cambridge, or by Cambridge to Lukoil or its subsidiaries in connection with the transfer. We did not believe that while Lukoil owned Marketing it would allow Marketing to fail to meet its obligations under the Master Lease. However, there can be no assurance that Cambridge will have the capacity to or will provide capital or financial support to Marketing or that it can or will arrange for the provision of capital investment or financial support to Marketing that Marketing may require to perform its obligations under the Master Lease.

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It is possible that the deterioration of Marketing's financial condition may continue. Without financial support, it is possible that Marketing may file for bankruptcy protection and seek to reorganize or liquidate its business.

From time to time when it was owned by Lukoil, we held discussions with representatives of Marketing regarding potential modifications to the Master Lease. These discussions did not result in a common understanding with Marketing that would form a basis for modification of the Master Lease. After Lukoil's transfer of its ownership of Marketing to Cambridge, we commenced discussions with Marketing's new owners and management. Marketing's new management has indicated a desire to reduce the number of properties comprising the unitary premises it leases from us under the Master Lease in an effort to improve Marketing's financial results. As a result of these recent discussions, with Marketing's consent and agreement on a case-by-case basis, we started to pursue the sale and simultaneous removal of individual properties from the Master Lease. We have focused our initial efforts in this initiative on the sale of terminal properties, and approximately 160 of our retail properties which do not have underground storage tanks and no longer operate as retail motor fuel outlets. Simultaneously with a transaction closing, we would, with Marketing's previously received consent and agreement, remove such property from the unitary premises covered by Master Lease and reduce the rent payable by Marketing by an amount calculated based upon a percentage of net proceeds realized upon the sale of such property.

While we have an ongoing process with Marketing allowing for increased activity intended to sell and simultaneously remove properties from the unitary premises covered by the Master Lease, there is no master agreement in place for this process. In view of the litigation activity described above, we are reevaluating our options related to the removal of properties from the unitary premises covered by the Master Lease. Any modification of the Master Lease that results in the removal of a significant number of properties from the Master Lease premises would likely significantly reduce the amount of rent we receive from Marketing and increase our operating expenses. We cannot predict if or when properties will be removed from the Master Lease premises; what composition of properties, if any, may be removed from the Master Lease; or what the terms of any agreement for modification of the Master Lease or agreements for the removal of individual properties from the Master Lease may be. We also cannot predict what actions Marketing may take, and what our recourse may be, whether the Master Lease is modified or not. We cannot predict if or how Marketing's business strategy, including as it relates to the removal of properties from the Master Lease premises, may change in the future.

Generally, we intend either to re-let or sell properties removed from the Master Lease, whether such removal arises consensually by negotiation or as a result of default by Marketing, and reinvest sales proceeds realized in new properties. With respect to properties that are vacant or have had underground gasoline storage tanks and related equipment removed, it may be more difficult or costly to re-let or sell such properties as gas stations because of capital costs or possible zoning or permitting rights that are required and that may have lapsed during the period since gasoline was last sold at the property. Conversely, it may be easier to re-let or sell properties where underground gasoline storage tanks and related equipment have been removed if the property will not be used as a retail motor fuel outlet or if environmental contamination has been or is being remediated. Although we are the fee or leasehold owner of the portfolio of properties subject of the Master Lease and the owner of the Getty® brand, and have prior experience with tenants who operate their gas stations, convenience stores, automotive repair services or other businesses at our properties, in the event that properties are removed from the Master Lease premises, we cannot predict if, when or on what terms such properties could be re-let or sold.

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Under the Master Lease, our environmental remediation obligations are limited to incidents at 166 retail sites that have not achieved Closure and are scheduled in the Master Lease. We also provide limited environmental indemnification to Marketing, capped at $4.25 million, for certain pre-existing conditions at six of the terminals we own and lease to Marketing. Under the indemnification agreement, Marketing is required to pay (and has paid) the first $1.5 million of costs and expenses incurred in connection with remediating any such pre-existing conditions, Marketing shares equally with us the next $8.5 million of those costs and expenses and Marketing is obligated to pay all additional costs and expenses over $10.0 million. We have accrued $0.3 million as of September 30, 2011 and December 31, 2010 in connection with this indemnification agreement.

Under the Master Lease, Marketing is directly responsible to pay for all other environmental liabilities including: (i) remediation of environmental contamination it causes and compliance with various environmental laws and regulations as the operator of our properties, and (ii) known and unknown environmental liabilities allocated to Marketing under the terms of the Master Lease and various other agreements with us relating to Marketing's business and the properties it leases from us (collectively the "Marketing Environmental Liabilities"). We estimate that as of September 30, 2011, the aggregate amount of the Marketing Environmental Liabilities, net of expected recoveries from underground storage tank funds, for which we may ultimately be responsible to pay but have not accrued range between $13 million and $20 million, of which between $10 million to $15 million relates to that portion of the portfolio subject of the Master Lease that we believe are most likely to be removed from the Master Lease premises. Since we generally do not have access to certain site specific information available to Marketing, which under the Master Lease is the party responsible for paying and managing its environmental remediation expenses at our properties, our estimates were developed in large part by review of the limited publicly available information gathered through electronic databases and freedom of information requests and assumptions we made based on that data and on our own experiences with environmental remediation matters. The actual amounts of the ranges estimated above may be significantly higher than our estimates and we can provide no assurance as to the accuracy of these estimates.

We do not maintain pollution legal liability insurance to protect us from potential future claims for the Marketing Environmental Liabilities. We will be required to accrue for the Marketing Environmental Liabilities if we determine that it is probable that Marketing will not meet its environmental obligations and we can reasonably estimate the amount of the Marketing Environmental Liabilities for which we will be responsible to pay, or if our assumptions regarding the ultimate allocation methods or share of responsibility that we used to allocate environmental liabilities changes. However, as of September 30, 2011, we continued to believe that it was not probable that Marketing would not pay for substantially all of the Marketing Environmental Liabilities. Accordingly, we did not accrue for the Marketing Environmental Liabilities as of September 30, 2011 or December 31, 2010. Nonetheless, we have determined that the aggregate amount of the Marketing Environmental Liabilities (as estimated by us) would be material to us if we were required to accrue for all of the Marketing Environmental Liabilities since as a result of such accrual, we would not be in compliance with the existing financial covenants in our Credit Agreement (defined below) and our Term Loan Agreement (defined below). Such non-compliance would result in an event of default under the Credit Agreement and the Term Loan Agreement which, if not waived, would prohibit us from drawing funds against the Credit Agreement and could result in the acceleration of our indebtedness under the Credit Agreement and the Term Loan Agreement.

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Our estimates, judgments, assumptions and beliefs regarding Marketing and the Master Lease made effective September 30, 2011 that affect the amounts reported in our financial statements are reviewed on an ongoing basis and are subject to possible change. Accordingly, it is possible that during the fourth quarter of 2011 or thereafter, we may be required to increase the deferred rent receivable reserve, record impairment charges related to the portfolio of properties subject of the Master Lease or accrue for the Marketing Environmental Liabilities as a result of the potential or actual modification of the Master Lease or as a result of the potential or actual bankruptcy filing by Marketing or other factors including those discussed above, which may result in material adjustments to the amounts recorded for these assets and liabilities, and as a result of which, we may not be in compliance with the financial covenants in our Credit Agreement and Term Loan Agreement.

We cannot provide any assurance that Marketing will meet its rental, environmental or other obligations under the Master Lease. Marketing's failure to meet its rental, environmental or other obligations to us can lead to a protracted and expensive process for retaking control of our properties. We anticipate that, in connection with Marketing's claim regarding rent offset rights or other claims or allegations that have been or may in the future be made, we may continue to experience disruption in rent receipts due from Marketing under the Master Lease. In addition to the risk of disruption in rent receipts, we are subject to the risk of incurring real estate taxes, maintenance, environmental and other expenses at properties subject of the Master Lease. If Marketing does not perform its rental, environmental or other obligations under the Master Lease; if the Master Lease is modified significantly or terminated; if we determine that it is probable that Marketing will not meet its rental, environmental or other obligations and we accrue for certain of such liabilities; if we are unable to promptly re-let or sell the properties upon recapture from the Master Lease; or, if we change our assumptions that affect the accounting for rental revenue or the Marketing Environmental Liabilities related to the Master Lease and various other agreements; our business, financial condition, revenues, operating expenses, results of operations, liquidity, ability to pay dividends or stock price may be materially adversely affected.

Supplemental Non-GAAP Measures

We manage our business to enhance the value of our real estate portfolio and, as a REIT, place particular emphasis on minimizing risk and generating cash sufficient to make required distributions to shareholders of at least ninety percent of our ordinary taxable income each year. In addition to measurements defined by accounting principles generally accepted in the United States of America ("GAAP"), our management also focuses on funds from operations available to common shareholders ("FFO") and adjusted funds from operations available to common shareholders ("AFFO") to measure our performance. FFO is generally considered to be an appropriate supplemental non-GAAP measure of the performance of REITs. FFO is defined by the National Association of Real Estate Investment Trusts as net earnings before depreciation and amortization of real estate assets, gains or losses on dispositions of real estate (including such non-FFO items reported in discontinued operations), extraordinary items and cumulative . . .

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