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DRE > SEC Filings for DRE > Form 10-K on 17-Feb-2017All Recent SEC Filings

Show all filings for DUKE REALTY CORP

Form 10-K for DUKE REALTY CORP


17-Feb-2017

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Business Overview
The General Partner and Partnership collectively specialize in the ownership, management and development of industrial and medical office real estate. The General Partner is a self-administered and self-managed REIT that began operations in 1986 and is the sole general partner of the Partnership. The Partnership is a limited partnership formed in 1993, at which time all of the properties and related assets and liabilities of the General Partner, as well as proceeds from a secondary offering of the General Partner's common shares, were contributed to the Partnership. Simultaneously, the Partnership completed the acquisition of Duke Associates, a full-service commercial real estate firm operating in the Midwest whose operations began in 1972. We operate the General Partner and the Partnership as one enterprise, and therefore, our discussion and analysis refers to the General Partner and its consolidated subsidiaries, including the Partnership, collectively. At December 31, 2016, we:
Owned or jointly controlled 561 industrial, medical office and office properties, of which 534 properties totaling 130.2 million square feet were in service and 27 properties totaling 9.4 million square feet were under development. The 534 in-service properties were comprised of 492 consolidated properties totaling 119.5 million square feet and 42 jointly controlled properties totaling 10.7 million square feet. The 27 properties under development consisted of 25 consolidated properties with 8.4 million square feet and two jointly controlled properties with 1.0 million square feet.

Owned, including through ownership interests in unconsolidated joint ventures (with acreage not adjusted for our percentage ownership interest), 2,190 acres of land and controlled an additional 1,600 acres through purchase options.

Our overall strategy is to continue to increase our investment in quality industrial properties in both existing and select new markets, and to continue to increase our investment in on-campus or hospital affiliated medical office properties. Based on in-place net operating income, the Company's overall portfolio was comprised of 78% industrial, 21% medical office and 1% non-reportable rental operations at December 31, 2016 and 73% industrial, 19% medical office and 8% non-reportable rental operations at December 31, 2015. We have three reportable operating segments at December 31, 2016, the first two of which consist of the ownership and rental of (i) industrial and (ii) medical office real estate investments. Properties not included in our reportable segments, which do not by themselves meet the quantitative thresholds for separate presentation as a reportable segment, are generally referred to as non-reportable Rental Operations. Our non-reportable Rental Operations primarily include our office properties. The operations of our industrial and medical office properties, as well as our non-reportable Rental Operations, are collectively referred to as "Rental Operations." The third reportable segment consists of various real estate services such as property management, asset management, maintenance, leasing, development, general contracting and construction management to third-party property owners and joint ventures, and is collectively referred to as "Service Operations." Our reportable segments offer different products or services and are managed separately because each segment requires different operating strategies and management expertise. Our Service Operations segment also includes our taxable REIT subsidiary, a legal entity through which certain of the segment's aforementioned operations are conducted. Operational Strategy
Our operational focus is to drive profitability by maximizing cash from operations as well as FFO through (i) maintaining and increasing property occupancy and rental rates, while also keeping lease-related capital costs contained, by effectively managing our portfolio of existing properties;
(ii) selectively developing new build-to-suit, substantially pre-leased and, in certain circumstances, speculative development projects; (iii) leveraging our construction expertise to act as a general contractor or construction manager on a fee basis; and (iv) providing a full line of real estate services to our tenants and to third parties.

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Asset Strategy
Our strategic objectives include (i) increasing our investment in quality industrial properties through development; (ii) managing our medical office portfolio nationally to focus on hospital system relationships in order to take advantage of demographic trends; (iii) acquiring industrial properties in markets we believe provide the best potential for future rental growth; and (iv) maintaining an optimal land inventory through selected strategic land acquisitions, new development activity and sales of surplus land. We are continuing to execute our asset strategy through a disciplined approach by identifying development opportunities, identifying select acquisition targets where the asset quality and pricing meet our objectives and continually evaluating our portfolio for disposition by regularly identifying assets that no longer meet our long-term objectives.
Capital Strategy
Our capital strategy is to maintain a strong balance sheet by actively managing the components of our capital structure in coordination with the execution of our overall operational and asset strategies. We are focused on maintaining our current investment grade ratings from our credit rating agencies. As of December 31, 2016, our senior unsecured notes have been assigned a rating of Baa1 by Moody's Investors Services and BBB+ by Standard & Poor's Ratings Group, which reflect increases to both ratings during 2016.
In support of our capital strategy, we employ an asset disposition program to sell non-strategic real estate assets, which generate proceeds that can be recycled into new property investments that better fit our growth objectives or otherwise manage our capital structure.
We continue to focus on improving our balance sheet by maintaining a balanced and flexible capital structure which includes: (i) extending and sequencing the maturity dates of our outstanding debt obligations; (ii) borrowing primarily at fixed rates by targeting a variable rate component of total debt less than 20%; and (iii) issuing common equity as needed to maintain appropriate leverage parameters or support significant strategic developments or acquisitions. With our successes to date and continued focus on maintaining a strong balance sheet, we expect to be in a very strong position to be opportunistic in our investment opportunities on a self-funding basis.
Environmental, Social and Governance Strategy As a leading commercial real estate firm in the United States, we are committed to sustainable practices in environmental, social and corporate governance initiatives. Our sustainability practices have included research, development, and deployment of sustainable building strategies and technologies, staff education and LEED accreditation to construct high-performing sustainable buildings and to operate an energy-efficient portfolio. We have successfully redeveloped a number of environmentally impacted sites by removing obsolete, unused buildings and cleaning up environmental contaminants. We are committed to charitable giving, volunteerism, diversity and inclusion that make a positive impact on the communities in which we conduct business. We are also committed to maintaining an effective corporate governance structure and compliance with applicable laws, rules, regulations and policies. Through these efforts, we demonstrate that operating and developing commercial real estate can be conducted with a conscious regard for the environment and community while mutually benefiting our tenants, investors, employees and the communities in which we operate.

Results of Operations
A summary of our operating results and property statistics for each of the years in the three-year period ended December 31, 2016, is as follows (in thousands, except number of properties and per share or per Common Unit data):

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                                                          2016          2015          2014
Rental and related revenue from continuing operations  $ 813,434     $ 816,065     $ 822,351
General contractor and service fee revenue                88,810       133,367       224,500
Operating income                                         476,981       448,396       411,068
General Partner
Net income attributable to common shareholders         $ 312,143     $ 615,310     $ 204,893
Weighted average common shares outstanding               349,942       345,057       335,777
Weighted average common shares and potential dilutive    357,076       352,197       340,446
securities
Partnership
Net income attributable to common unitholders          $ 315,232     $ 621,714     $ 207,520
Weighted average Common Units outstanding                353,423       348,639       340,085
Weighted average Common Units and potential dilutive     357,076       352,197       340,446
securities
General Partner and Partnership
Basic income per common share or Common Unit:
Continuing operations                                  $    0.88     $    0.53     $    0.51
Discontinued operations                                $    0.01     $    1.24     $    0.09
Diluted income per common share or Common Unit:
Continuing operations                                  $    0.88     $    0.53     $    0.51
Discontinued operations                                $       -     $    1.24     $    0.09
Number of in-service consolidated properties at end of       492           489           621
year
In-service consolidated square footage at end of year    119,493       115,588       127,029
Number of in-service joint venture properties at end          42            70            85
of year
In-service joint venture square footage at end of year    10,736        19,145        19,841

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Year in Review
Overall, the economy has slightly underperformed forecasts as growth in the gross domestic product was 1.5% and there have been periods of volatility caused by oil pricing, Brexit and the United States presidential election. The 10 year Treasury rate fluctuated between 1.5% and 2.0% for most of the year but ended the year at its high point of 2.3%. The continued growth in e-commerce has been a significant positive for the bulk warehouse business. Under these conditions, we were able to execute our asset and capital strategies and believe that we had a successful 2016 by all accounts.
Net income attributable to the common shareholders of the General Partner for the year ended December 31, 2016, was $312.1 million, or $0.88 per share (diluted), compared to net income of $615.3 million, or $1.77 per share (diluted) for the year ended December 31, 2015. Net income attributable to the common unitholders of the Partnership for the year ended December 31, 2016, was $315.2 million, or $0.88 per unit (diluted), compared to net income of $621.7 million, or $1.77 per unit (diluted) for the year ended December 31, 2015. The decrease in net income in 2016 for the General Partner and the Partnership, when compared to 2015, was primarily the result of significant gains on property sales recognized during 2015.
FFO attributable to common shareholders of the General Partner totaled $428.4 million for the year ended December 31, 2016, compared to $300.8 million for 2015. FFO attributable to common unitholders of the Partnership totaled $432.7 million for the year ended December 31, 2016, compared to $304.0 million for 2015. The increase to FFO in 2016 for the General Partner and the Partnership was the result of lower debt extinguishment costs and promote income recognized in 2016.
The following table shows a reconciliation of net income attributable to common shareholders or common unitholders to the calculation of FFO attributable to common shareholders or common unitholders for the years ended December 31, 2016, 2015 and 2014, respectively (in thousands):

                                                          2016          2015          2014
Net income attributable to common shareholders of the  $ 312,143     $ 615,310     $ 204,893
General Partner
Add back: Net income attributable to noncontrolling
interests - common limited partnership interests in
the Partnership                                            3,089         6,404         2,627
Net income attributable to common unitholders of the     315,232       621,714       207,520
Partnership
Adjustments:
Depreciation and amortization                            317,818       320,846       384,617
Impairment charges - depreciable property                  3,719         3,406        15,406
Company share of joint venture depreciation and           14,188        27,247        28,227
amortization
Gain on dissolution of unconsolidated company            (30,697 )           -             -
Earnings from depreciable property sales-wholly owned   (163,109 )    (654,594 )    (185,478 )
Income tax (benefit) expense triggered by depreciable       (589 )        (753 )       2,125
property sales
Earnings from depreciable property sales-share of        (23,896 )     (13,911 )     (84,649 )
joint venture
Funds From Operations attributable to common           $ 432,666     $ 303,955     $ 367,768
unitholders of the Partnership
Additional General Partner Adjustments:
Net income attributable to noncontrolling interests -
common limited partnership interests in the
Partnership                                               (3,089 )      (6,404 )      (2,627 )
    Noncontrolling interest share of adjustments          (1,157 )       3,265        (2,030 )
Funds From Operations attributable to common           $ 428,420     $ 300,816     $ 363,111
shareholders of the General Partner

In addition to net income (loss) computed in accordance with GAAP, we assess and measure the overall operating results of the General Partner and the Partnership based upon FFO, which is a non-GAAP industry performance measure that management believes is a useful indicator of consolidated operating performance. FFO is used by industry analysts and investors as a supplemental operating performance measure of a REIT. NAREIT created FFO as a non-GAAP supplemental measure of REIT operating performance. FFO, as defined by NAREIT, represents GAAP net income
(loss), excluding gains or losses from sales of previously depreciated real estate assets and impairment charges related to depreciable real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after similar adjustments for unconsolidated partnerships and joint ventures. Taxes associated with sales of previously depreciated real estate assets are also excluded from FFO as defined by NAREIT. The most comparable GAAP measure is net income (loss) attributable to common shareholders or common unitholders. FFO attributable to common shareholders or common unitholders should not be

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considered as a substitute for net income (loss) attributable to common shareholders or common unitholders or any other measures derived in accordance with GAAP and may not be comparable to other similarly titled measures of other companies. FFO is calculated in accordance with the definition that was adopted by the Board of Governors of NAREIT.

Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many industry analysts and investors have considered presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. Management believes that the use of FFO attributable to common shareholders or common unitholders, combined with net income (which remains the primary measure of performance), improves the understanding of operating results of REITs among the investing public and makes comparisons of REIT operating results more meaningful. Management believes that the use of FFO as a performance measure enables investors and analysts to readily identify the operating results of the long-term assets that form the core of a REIT's activity and assist them in comparing these operating results between periods or between different companies.

In accordance with our strategic plan, we substantially completed the disposition of our suburban office properties, further reduced leverage and continued to increase our investment in high quality industrial and medical office properties. Additionally, we continued to experience improved operational metrics during 2016, which we believe validate our strategy. Highlights of our 2016 strategic and operational activities are as follows:
We generated $538.6 million of total net cash proceeds from the disposition of 32 consolidated buildings and 448 acres of wholly-owned undeveloped land.

We started new development projects with expected total costs of $697.2 million during 2016, which included $54.0 million of expected total costs for three development projects started within unconsolidated joint ventures. The development projects started in 2016 were mostly comprised of new industrial projects and were, in aggregate, 67.0% pre-leased.

In the fourth quarter of 2016, pursuant to a pre-existing purchase option, we acquired 14 properties in the Washington D.C. area from an unconsolidated joint venture (the "Quantico Joint Venture"). These 14 properties were comprised of 11 industrial buildings and three office properties. These 14 properties were previously encumbered by a $131.3 million CMBS loan and, pursuant to the terms of the purchase option, we repaid the loan as consideration for the acquisition of the underlying properties. One of the acquired office properties was sold immediately following the acquisition for $53.4 million, which was equal to the property's fair value.

During 2016, we placed 21 newly completed wholly-owned development projects in service, across all product types, which totaled 6.0 million square feet with total costs of $507.6 million. These properties were 94.9% leased at December 31, 2016.

The total estimated cost of our consolidated properties under construction at December 31, 2016 totaled $713.1 million, with $338.6 million of such costs already incurred. The total estimated cost for jointly controlled properties under construction was $42.1 million at December 31, 2016, with $28.8 million of costs already incurred. The consolidated properties under construction are 74% pre-leased, while the jointly controlled properties under construction are 29% pre-leased.

Same-property net operating income, on a cash basis, as defined hereafter under "Supplemental Performance Measures" grew by 6.0% for the twelve months ended December 31, 2016, as compared to the same period in 2015.

The percentage of total square feet leased for our in-service portfolio of consolidated properties increased from 96.5% at December 31, 2015 to 97.2% at December 31, 2016.

Total leasing activity for our consolidated properties totaled 26.2 million square feet in 2016 compared to 19.4 million square feet in 2015. The increase in total leasing activity in 2016 was largely the result of leasing new development projects as well as a higher volume of lease renewals.

Total leasing activity for our consolidated properties in 2016 included 12.3 million square feet of renewals, which represented a 75.6% retention rate on a square foot basis, and resulted in a 13.7% increase in net effective rents.

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We utilized the capital generated during the year to reduce debt and to fund our development activities. Highlights of our key financing activities are as follows:
Throughout 2016, we issued 8.4 million shares of common stock pursuant to our at the market ("ATM") equity program at an average price of $25.93 per share, generating gross proceeds of $218.2 million and, after deducting commissions and other costs, net proceeds of $215.6 million.

In June 2016, we issued $375.0 million of senior unsecured notes that bear interest at a stated interest rate of 3.25%, an effective interest rate of 3.36%, and mature on June 30, 2026.

During June and July 2016, we repaid $275.0 million of our 5.95% senior unsecured notes, which had a scheduled maturity of February 2017. Through a tender offer we repurchased $72.0 million of the notes and redeemed the remaining outstanding notes, for cash payments totaling $283.5 million. The repayment of these notes resulted in an $8.8 million loss on debt extinguishment, which included premiums paid to the holders of the notes as well as the write-off of unamortized deferred financing costs.

Throughout 2016, we repaid seven secured loans, totaling $346.7 million, which had a weighted average stated interest rate of 5.90%.

In October 2016, we redeemed $129.5 million of senior unsecured notes, which had a scheduled maturity in August of 2019, for a cash payment of $154.1 million. As the result of this redemption, we recognized a net loss on extinguishment totaling $25.2 million, which was comprised of premiums paid to the holders of the notes as well as the write-off of unamortized deferred financing costs.

Supplemental Performance Measures

In addition to FFO we use (i) Property Level Net Operating Income - Cash Basis ("PNOI") and (ii) Same Property Net Operating Income - Cash Basis ("SPNOI") as supplemental non-GAAP performance measures. Management believes that the use of PNOI and SPNOI combined with net income (which remains the primary measure of performance), improves the understanding of operating results of REITs among the investing public and makes comparisons of REIT operating results more meaningful. The most comparable GAAP measure to PNOI and SPNOI is income from continuing operations before income taxes.

PNOI and SPNOI each exclude expenses that materially impact our overall results of operations and, therefore, should not be considered as a substitute for income from continuing operations before income taxes, or any other measures derived in accordance with GAAP. Furthermore, these metrics may not be comparable to other similarly titled measures of other companies.

Property Level Net Operating Income - Cash Basis PNOI is comprised of rental revenues from continuing operations less rental expenses and real estate taxes from continuing operations, along with certain other adjusting items. As a performance metric that consists of only the cash-based revenues and expenses directly related to ongoing real estate rental operations, PNOI is narrower in scope than FFO.
PNOI, as we calculate it, may not be directly comparable to similarly titled, but differently calculated, measures for other REITs. We believe that PNOI is another useful supplemental performance measure, as it is an input in many REIT valuation models and it provides a means by which to evaluate the performance of the properties within our Rental Operations segments.
The major factors influencing PNOI are occupancy levels, acquisitions and sales, development properties that achieve stabilized operations, rental rate increases or decreases, and the recoverability of operating expenses.
Note 8 to the consolidated financial statements included in Part IV, Item 15 of this Report shows a calculation of our PNOI for the years ended 2016, 2015 and 2014 and provides a reconciliation of PNOI for our Rental Operations segments to income from continuing operations before income taxes.

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Same Property Net Operating Income - Cash Basis We also evaluate the performance of our properties, including our share of properties we jointly control, on a "same property" basis, using a metric referred to as SPNOI. We view SPNOI as a useful supplemental performance measure because it improves comparability between periods by eliminating the effects of changes in the composition of our portfolio.
On an individual property basis, SPNOI is computed in a consistent manner as
PNOI.
We have defined our same property portfolio, for the three and twelve months ended December 31, 2016, as those properties that have been owned and in operation throughout the twenty-four months ended December 31, 2016. In addition to excluding properties that have not been owned and in operation for the twenty-four months ended December 31, 2016, we have also excluded properties from our same property portfolio where revenues from individual lease buyouts in excess of $250,000 have been recognized. A reconciliation of income or loss from continuing operations before income taxes to SPNOI is presented as follows (in thousands):

                                               Three Months Ended December 31,     Percent       Twelve Months Ended December 31,     Percent
                                                  2016                 2015         Change           2016                 2015         Change
Income from continuing operations before
income taxes                               $        46,983       $        17,275              $       312,682       $       185,277
 Share of SPNOI from unconsolidated
joint ventures                                       5,132                 5,301                       20,964                20,694
 PNOI excluded from the same property
population                                         (22,825 )             (11,582 )                    (66,375 )             (43,808 )
 Earnings from Service Operations                     (127 )              (2,332 )                     (8,343 )             (14,197 )
 Rental Operations revenues and expenses
excluded from PNOI                                  (6,633 )             (14,687 )                    (41,386 )             (81,365 )
 Non-Segment Items                                 105,634               128,611                      286,984               409,505
SPNOI                                      $       128,164       $       122,586      4.5 %   $       504,526       $       476,106      6.0 %

The composition of the line items titled "Rental Operations revenues and expenses excluded from PNOI" and "Non-Segment Items" from the table above are shown in greater detail in Note 8 to the consolidated financial statements included in Part IV, Item 15 of this Report.

We believe the factors that impact SPNOI are generally the same as those that impact PNOI. The following table details the number of properties, square feet, average occupancy and cash rental rates for the properties included in SPNOI for the respective periods:

                                                         Three Months            Twelve Months
                                                        Ended December          Ended December
                                                              31,                     31,
                                                        2016      2015          2016      2015
Number of properties                                     464       464           464       464
Square feet (in thousands) (1)                         108,604   108,604       108,604   108,604
Average commencement occupancy percentage (2)           98.1%     97.0%         97.5%     96.3%
. . .
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