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PDM > SEC Filings for PDM > Form 10-K on 18-Feb-2014All Recent SEC Filings

Show all filings for PIEDMONT OFFICE REALTY TRUST, INC.

Form 10-K for PIEDMONT OFFICE REALTY TRUST, INC.


18-Feb-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read in conjunction with the audited consolidated financial statements and notes thereto as of December 31, 2013 and 2012, and for the years ended December 31, 2013, 2012, and 2011 included elsewhere in this Annual Report on Form 10-K. See also "Cautionary Note Regarding Forward-Looking Statements" preceding Part I of this report and "Risk Factors" set forth in Item 1A. of this report.

Overview

We are a fully integrated, self-managed real estate investment trust specializing in the acquisition, ownership, management, development, and disposition of primarily high-quality Class A office buildings located in major U.S. office markets and leased primarily to high-credit-quality tenants. We operate as a real estate investment trust for federal income tax purposes.

Our common stock is listed on the New York Stock Exchange (NYSE:PDM) and based on our December 31, 2013 equity market capitalization of $2.6 billion, Piedmont is among the largest office REITs in the United States based on comparison to the constituents of the Bloomberg U.S. Office REIT Index.

Our portfolio of primarily Class A commercial office buildings was 87.2% and 87.5% leased as of December 31, 2013 and 2012, respectively. Our average lease size is approximately 30,000 square feet with our tenant base being comprised of primarily investment grade or nationally recognized corporations or governmental agencies. As of December 31, 2013, we owned and operated 78 office properties (excluding two buildings owned through an unconsolidated joint venture). Approximately 90% of our ALR is generated from our primary markets: Atlanta, Boston, Chicago, Los Angeles, Minneapolis, the New York MSA, Texas (Dallas, Houston and Austin), and Washington, D.C.

Due to the fact that many of our properties were originally acquired in 2002 and 2003 with typically seven to ten years of lease term remaining at the time, we experienced uncharacteristically high lease expirations during 2011, 2012, and to a lesser extent, 2013; therefore, during the three years ended December 31, 2013, we re-leased a significant portion of our portfolio and consequently, no more than 10% of our lease portfolio is scheduled to expire in any given year over the next five years. In addition, one of our operating objectives has been to sell certain non-strategic assets and recycle the proceeds from these dispositions into our targeted U.S. office markets, which we believe have the greatest potential to contribute to the company's enterprise value over time.

Liquidity and Capital Resources

We intend to use cash flows generated from the operation of our properties, proceeds from our $500 Million Unsecured Line of Credit, and proceeds from selective property dispositions as our primary sources of immediate liquidity. As of the time of this filing, we had approximately $159.6 million of capacity remaining under our $500 Million Unsecured Line of Credit available for future borrowing. Depending on the timing and volume of our property acquisition and disposition activities and debt maturities, we may also issue additional equity or debt securities from time to time. In addition, we may also seek additional borrowings from third-party lenders as additional sources of capital. The availability and attractiveness of terms for these additional sources of capital is highly dependent on market conditions.
We estimate that our most consistent use of capital will be to fund capital expenditures for our existing portfolio of properties. These expenditures include two types of specifically identified building improvement projects: (i) general repair and maintenance projects that we as the owner may choose to perform at our discretion at any of our various properties and (ii) tenant improvement allowances and leasing commissions that we have committed to as part of executed leases with our tenants. We anticipate that the majority of our upcoming capital expenditures will be for these tenant improvement allowances and leasing commissions. During the years ended December 31, 2013 and 2012, we spent approximately $3.55 and $5.39 per square foot per year of lease term, respectively, for such capital expenditures. As of December 31, 2013, unrecorded contractual obligations for non-incremental tenant improvements related to our existing lease portfolio totaled $85.1 million. The timing of the funding of these commitments is largely dependent upon tenant requests for reimbursement; however, we would anticipate that a significant portion of these improvement allowances may be requested over the next 12-24 months based on when the underlying leases commence. In some instances, these obligations may expire with the respective lease, without further recourse to us. Additionally, commitments for


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incremental capital expenditures associated with new leases, primarily at value-add properties, totaled approximately $19.5 million as of December 31, 2013 and we expect to spend approximately $85 million over the next eighteen months related to the construction of an approximately 300,000 square foot office building on one of our land parcels in Houston, Texas. Further, we intend to spend approximately $25 million on a redevelopment project to reposition 220,000 square feet at our 3100 Clarendon asset in Washington, D.C. from governmental use to private sector use.
We also anticipate incurring market-based concession packages, typically consisting of tenant allowances and/or rent abatement periods, and paying broker commissions in conjunction with procuring future leases. Given that our model is to lease large blocks of space to credit-worthy tenants, some of the concession packages that we grant can result in significant capital outlays. Both the timing and magnitude of such concessions have yet to be determined and are highly dependent on competitive market conditions at the time of lease negotiations. In particular, there are four blocks of space in excess of 200,000 square feet in our Washington, D.C and Chicago portfolios that are currently vacant and we may grant significant concession packages to secure new tenants for those spaces, among others.
Additionally, we expect to use capital to repay debt when obligations become due. As of December 31, 2013, we had $575 million in secured debt which was scheduled to mature during the year ending December 31, 2014. During the fourth quarter 2013, we entered into a $300 million unsecured term loan facility, with a delayed draw feature. On January 30, 2014, we drew down the entire $300 million and used the proceeds to repay early $225 million of mortgage notes without penalty that were secured by Aon Center and scheduled to mature on May 1, 2014. The remaining $75 million of proceeds was used to pay down our $500 Million Unsecured Line of Credit. Subject to our assessment of market conditions, we currently anticipate refinancing our remaining 2014 maturities with additional unsecured debt. In anticipation of such an issuance and considering the historically low interest rate environment, we have entered into various forward starting interest rate swaps, both during 2013 and through the date of this filing, to partially protect us against rising interest rates by locking the interest rate portion on any future unsecured debt issuance. Again, subject to our assessment of market conditions, we may enter into additional similar swaps for future debt issuances over the next twelve months. Subject to the identification and availability of attractive investment opportunities and our ability to consummate such acquisitions on satisfactory terms, acquiring new assets compatible with our investment strategy could also be a significant use of capital. Finally, our board of directors has authorized a repurchase plan for our common stock for use when we believe that our stock is trading at a meaningful discount to what we believe the fair value of our net assets to be. From time to time, we may use capital resources to make purchases under this plan. As of December 31, 2013, there was $89.8 million of authorized capacity remaining on the program which can be spent prior to the program's expiration in October 2015.
The amount and form of payment (cash or stock issuance) of future dividends to be paid to our stockholders will continue to be largely dependent upon (i) the amount of cash generated from our operating activities; (ii) our expectations of future cash flows; (iii) our determination of near-term cash needs for debt repayments, development projects, and selective acquisitions of new properties;
(iv) the timing of significant expenditures for tenant improvements, building redevelopment projects, and general property capital improvements; (v) long-term payout ratios for comparable companies; (vi) our ability to continue to access additional sources of capital, including potential sales of our properties; and
(vii) the amount required to be distributed to maintain our status as a REIT. Given the fluctuating nature of cash flows and expenditures, we may periodically borrow funds on a short-term basis to cover timing differences in cash receipts and cash disbursements.

Results of Operations

Comparison of the accompanying consolidated statements of income for the year ended December 31, 2013 vs. the year ended December 31, 2012

Income from Continuing Operations

Income from continuing operations per share on a fully diluted basis increased from $0.35 for the year ended December 31, 2012 to $0.44 for the year ended December 31, 2013 primarily due to additional rental income associated with the acquisition of properties in 2013 as well as the commencement of certain significant leases during the current period, an impact of approximately $0.19 per diluted share. We also received net casualty recoveries of $10.6 million in the current year compared to a net casualty loss of $5.2 million in the prior year and a $1.3 million litigation settlement recovery in the current year compared to a litigation settlement expense of $7.5 million in the prior year, a total increase of $0.15 per diluted share. These increases were offset by $0.16 per diluted share of increases in property operating costs due to newly acquired properties in 2013, as well as higher depreciation expense associated with new tenant and building improvements put into service after January 1, 2012. In addition, we recorded approximately $0.05 per diluted share of increased interest expense as a result of higher outstanding debt balances primarily caused by property acquisitions during the current year. In addition, the current year reflects $5.6 million of impairment charges related to two wholly-owned assets and one equity method joint venture.


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The following table sets forth selected data from our consolidated statements of income for the years ended December 31, 2013 and 2012, respectively, as well as each balance as a percentage of total revenues for the years presented (dollars in millions):

                                                                                                     $ Increase
                                       December 31, 2013      %       December 31, 2012      %       (Decrease)
Revenue:
Rental income                         $           447.7              $           416.0              $      31.7
Tenant reimbursements                             104.6                          106.7                     (2.1 )
Property management fee revenue                     2.2                            2.3                     (0.1 )
Total revenues                                    554.5      100 %               525.0      100 %          29.5
Expense:
Property operating costs                          223.0       40 %               208.3       40 %          14.7
Depreciation                                      122.5       22 %               110.3       21 %          12.2
Amortization                                       45.7        9 %                49.5        9 %          (3.8 )
Impairment losses on real estate
assets                                              1.2        - %                   -        - %           1.2
General and administrative                         21.9        4 %                20.8        4 %           1.1
Real estate operating income                      140.2       25 %               136.1       26 %           4.1
Other income (expense):
Interest expense                                  (73.6 )     13 %               (65.0 )     12 %          (8.6 )
Interest and other income/(expense)                (2.4 )      - %                 0.8        - %          (3.2 )
Litigation settlement
recovery/(expense)                                  1.3        - %                (7.5 )      2 %           8.8
Net casualty recoveries/(loss)                     10.6        2 %                (5.2 )      1 %          15.8
Equity in income/(loss) of
unconsolidated joint ventures                      (3.7 )      1 %                 0.9        - %          (4.6 )
Loss on consolidation                              (0.9 )      - %                   -        - %          (0.9 )
Income from continuing operations     $            71.5       13 %   $            60.1       11 %   $      11.4

Income from discontinued operations   $            27.3              $            33.1              $      (5.8 )

Revenue

Rental income for the year ended December 31, 2013 increased to approximately $447.7 million, as compared to $416.0 million in the prior year primarily due to approximately $22.7 million of additional revenue attributable to properties acquired during the current year and the commencement of several significant leases over the last twelve months. Additionally, rental restructuring income, mostly at our 6021 Connection Drive building, contributed $5.9 million to the increase. These increases were offset by the expiration of a 330,000 square foot lease at our One Independence Square building in Washington, D.C. during March 2013.

Tenant reimbursements decreased from approximately $106.7 million for the year ended December 31, 2012 to approximately $104.6 million for the year ended December 31, 2013. The variance is mainly attributable to an approximate $4.8 million reduction in tenant reimbursements as a result of operating expense and tax abatements granted on a large lease renewal at the 500 W. Monroe building in Chicago, Illinois and an approximate $2.5 million reduction in reimbursements at the One Independence Square building due to the lease expiration discussed above. These decreases were offset by an increase in tenant reimbursements at our 60 Broad Street building in New York City, New York, our US Bancorp Center building, and our Aon Center building in Chicago, Illinois primarily driven by higher recoverable property tax expense and operating expenses in the current period, as well as an increase in reimbursements attributable to the acquisition of the Arlington Gateway building located in Arlington, Virginia.

Expense

Property operating costs increased approximately $14.7 million for the year ended December 31, 2013 compared to the same period in the prior year. Properties acquired during the current year contributed approximately $6.8 million of additional operating costs and higher recoverable property tax expense at our existing properties contributed an additional $5.6 million of operating costs.


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Depreciation expense increased approximately $12.2 million for the year ended December 31, 2013 compared to the same period in the prior year. The variance is largely attributable to depreciation on additional tenant and building improvements placed in service subsequent to January 1, 2012, which contributed approximately $8.4 million to the increase. The remainder of the increase is attributable to properties acquired during the current year.

Amortization expense decreased approximately $3.8 million for the year ended December 31, 2013 compared to the same period in the prior year. The variance is largely attributable to reduced amortization expense of approximately $14.3 million resulting from lease intangible assets becoming fully amortized at certain of our existing properties subsequent to January 1, 2012, as well as lower accelerated amortization expense from lease terminations compared to the prior year. However, these decreases were largely offset by approximately $12.4 million of additional amortization expense related to property acquisitions during the current year.

We recognized an impairment loss of approximately $1.2 million to reduce the carrying value of the 11109 and 11107 Sunset Hills Road buildings in Reston, Virginia to estimated fair value as a result of shortening our intended hold period for these assets during the fourth quarter of 2013.

General and administrative expenses increased approximately $1.1 million for the year ended December 31, 2013 compared to the prior year primarily due to higher personnel and benefits costs in the current year.

Other Income (Expense)

Interest expense increased approximately $8.6 million for the year ended December 31, 2013 as compared to the prior year and is attributable to higher outstanding debt balances during the current period primarily as a result of property acquisitions and repurchases under our stock repurchase plan during the year.

Interest and other income decreased approximately $3.2 million for the year ended December 31, 2013 as compared to the prior year. The decrease reflects approximately $1.6 million of costs associated with acquisition transactions during the year, as well as a decrease in interest income associated with the repayment of a note receivable in October 2012. The remaining variance is attributable to higher costs related to unconsummated capital markets transactions in the current period.

For the year ended December 31, 2013 we recognized $1.3 million in insurance recoveries associated with the $7.5 million of litigation settlement expense we recorded in the prior year related to settlement agreements of two class action lawsuits.

The $10.6 million net casualty gain we recognized during the year ended December 31, 2013 is due to insurance recoveries related to damage incurred at certain of our assets in the New York/New Jersey markets as a result of Hurricane Sandy which occurred during the fourth quarter of 2012. To a lesser extent, we are still pursuing additional insurance recoveries related to these damages in future periods.

Equity in income of unconsolidated joint ventures decreased approximately $4.6 million during the year ended December 31, 2013, as compared to the prior year, primarily as a result of recognizing a $4.4 million, other-than-temporary impairment loss related to an equity interest in an unconsolidated joint venture. We expect operational income included in equity in income of unconsolidated joint ventures to decrease based on the expiration of Two Park Center's sole tenant's lease as of December 31, 2013.

During the year, we purchased all of the remaining interests in three office properties previously held through two unconsolidated joint ventures for $14.7 million in cash. The estimated fair value of the respective properties were derived by reference to a credible, unrelated third-party offer and verified using discounted cash flow analysis. Under the terms of the respective joint venture agreements, we exercised our dissenter's right to buy out each co-venturers' interest based upon the terms of the third-party offer. The $0.9 million difference between the fair value of the properties acquired and the sum of our previously recorded book value in investment in unconsolidated joint ventures plus cash consideration paid for the interests was recorded as a loss on consolidation in our consolidated statement of operations in the current year. The acquisition also resulted in a decrease in equity in income of unconsolidated joint ventures as compared to the prior period, as the result of operations of these properties are now consolidated on the same basis as our other wholly-owned properties.

Income from Discontinued Operations

In accordance with GAAP, the operations of assets that we have sold or classified as held for sale during any of the periods presented in the accompanying statement of operations are classified as discontinued operations for all periods presented (see Note 14 to our accompanying consolidated financial statements for a complete listing of assets sold). Income from discontinued operations decreased approximately $5.8 million for the year ended December 31, 2013 as compared to the same period in the prior year


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primarily due to the recognition of an impairment charge of $6.4 million at the 1111 Durham Avenue building in South Plainfield, New Jersey. We do not expect that income from discontinued operations will be comparable to future periods, as such income is subject to the timing and existence of future property dispositions.

Comparison of the accompanying consolidated statements of income for the year ended December 31, 2012 vs. the year ended December 31, 2011

Income from Continuing Operations

Income from continuing operations per share on a fully diluted basis decreased from $0.49 for the year ended December 31, 2011 to $0.35 for the year ended December 31, 2012 primarily due to the recognition of $7.5 million, or $0.04 per diluted share, in litigation settlement expense and approximately $5.2 million, or $0.03 per diluted share, in net casualty loss in the current year, whereas the prior year's results included approximately $9.0 million, or $0.05 per diluted share, in gains and non-recurring income associated with the foreclosure and consolidation of the 500 W. Monroe building and higher lease termination income.

The following table sets forth selected data from our consolidated statements of income for the years ended December 31, 2012 and 2011, respectively, as well as each balance as a percentage of total revenues for the years presented (dollars in millions):

                                                                                                      $ Increase
                                        December 31, 2012      %       December 31, 2011      %       (Decrease)
Revenue:
Rental income                          $           416.0              $           409.7              $       6.3
Tenant reimbursements                              106.7                          113.8                     (7.1 )
Property management fee revenue                      2.3                            1.6                      0.7
Total revenues                                     525.0      100 %               525.1      100 %          (0.1 )
Expense:
Property operating costs                           208.3       40 %               202.5       39 %           5.8
Depreciation                                       110.3       21 %               100.7       19 %           9.6
Amortization                                        49.5        9 %                54.0       10 %          (4.5 )
General and administrative expense                  20.8        4 %                25.1        5 %          (4.3 )
Real estate operating income                       136.1       26 %               142.8       27 %          (6.7 )
Other income (expense):
Interest expense                                   (65.0 )     12 %               (65.8 )     12 %           0.8
Interest and other income                            0.8        - %                 2.9        1 %          (2.1 )
Litigation settlement
recovery/(expense)                                  (7.5 )      2 %                   -        - %          (7.5 )
Net casualty recoveries/(loss)                      (5.2 )      1 %                   -        - %          (5.2 )
Equity in income of unconsolidated
joint ventures                                       0.9        - %                 1.6        - %          (0.7 )
Gain on consolidation of variable
interest entity                                        -        - %                 1.5        - %          (1.5 )
Gain on extinguishment of debt                         -        - %                 1.1        - %          (1.1 )
Income from continuing operations      $            60.1       11 %   $            84.1       16 %   $     (24.0 )

Income from discontinued operations    $            33.1              $           141.0              $    (107.9 )

Revenue

Rental income for the year ended December 31, 2012 increased to approximately $416.0 million, as compared to $409.7 million in the prior year. Approximately $7.5 million of the variance is attributable to the recognition of a full year's rental revenue for properties acquired during the year ended December 31, 2011, and several significant leases commenced in late 2011 or during the year ended December 31, 2012, contributing approximately $5.4 million of the year over year increase. These increases were offset by a decrease in rental restructuring income, the most significant component of which was related to a lease termination at our 1201 Eye Street building in Washington, D.C., which reduced rental income by approximately $2.6 million. Further, a reduction in leased space due to lease expirations at various other properties offset the increases in rental income mentioned above. However, in many cases, we have since executed new leases for the expiring space.


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Tenant reimbursements decreased from approximately $113.8 million for the year ended December 31, 2011 to approximately $106.7 million for the year ended December 31, 2012. The decrease is attributable to the expiration of several significant leases during the last several years. In many cases, the expiring space has been re-leased; however, the replacement leases were in some form of abatement during the year ended December 31, 2012. Rental abatements, including operating expense reimbursement abatements, are frequently offered as part of a rental concession package in conjunction with negotiating a lease. Operating expense abatements are recognized in the period that they relate to, rather than on a straight-line basis like rental abatements. In addition, tenant reimbursement income related to properties acquired during the year ended December 31, 2011 contributed approximately $1.1 million to offset the decline in tenant reimbursements related to lease expirations and abatements.

Property management fee revenue increased from approximately $1.6 million for the year ended December 31, 2011 to approximately $2.3 million for the year ended December 31, 2012 primarily as a result of retaining the property management of the 35 West Wacker Drive building in Chicago, Illinois subsequent to selling the building to an unrelated third-party in December 2011.

Expense

Property operating costs increased approximately $5.8 million for the year ended December 31, 2012 compared to 2011. Approximately $4.6 million of increase is due to the recognition of a full year's operating expense related to properties acquired during the year ended December 31, 2011. In addition, we also incurred higher property tax expense of approximately $2.4 million due to the non-recurrence of certain favorable tax appeals recognized in the prior year; however, this increase was significantly offset by a decrease in utility costs of approximately $2.0 million due to a milder winter experienced in 2012.

Depreciation expense increased approximately $9.6 million for the year ended December 31, 2012 compared to 2011. Approximately $6.5 million of this increase was attributable to depreciation on additional tenant and building improvements . . .

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