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HOME PROPERTIES INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the accompanying consolidated financial statements and notes thereto. Forward-Looking Statements This discussion contains forward-looking statements. Historical results and percentage relationships set forth in the consolidated financial statements, including trends which might appear, should not be taken as indicative of future operations. The Company considers portions of the information to be "forward-looking statements" within the meaning of Section 27A of the Securities Exchange Act of 1933 and Section 21E of the Securities Exchange Act of 1934, both as amended, with respect to the Company's expectations for future periods. Some examples of forward-looking statements include statements related to acquisitions (including any related pro forma financial information), future capital expenditures, potential development and redevelopment opportunities, projected costs and rental rates for development and redevelopment projects, financing sources and availability, and the effects of environmental and other regulations. Although the Company believes that the expectations reflected in those forward-looking statements are based upon reasonable assumptions, it can give no assurance that its expectations will be achieved. Factors that may cause actual results to differ include general economic and local real estate conditions, the weather and other conditions that might affect operating expenses, the timely completion of repositioning activities and development within anticipated budgets, the actual pace of future development, acquisitions and sales, and continued access to capital to fund growth. For this purpose, any statements contained in this Form 10-Q that are not statements of historical fact should be considered to be forward-looking statements. Some of the words used to identify forward-looking statements include "believes", "anticipates", "plans", "expects", "seeks", "estimates", "intends", and any other similar expressions. Readers should exercise caution in interpreting and relying on forward-looking statements since they involve known and unknown risks, uncertainties and other factors which are, in some cases, beyond the Company's control and could materially affect the Company's actual results, performance or achievements. Liquidity and Capital Resources General The Company's principal liquidity demands are expected to be distributions to the common stockholders and holders of UPREIT Units, capital improvements and repairs and maintenance for its properties, acquisition and completion of current development properties and debt repayments. The Company may also acquire equity ownership in other public or private companies that own and manage portfolios of apartment communities. The Company intends to meet its short-term liquidity requirements through cash flows provided by operating activities and its existing bank unsecured line of credit, described below. The Company considers its ability to generate cash to be adequate to meet all operating requirements, including availability to pay dividends to its stockholders and make distributions to its unitholders in accordance with the provisions of the Internal Revenue Code, as amended, applicable to REITs. To the extent that the Company does not satisfy its short-term liquidity requirements through net cash flows provided by operating activities and its existing bank unsecured line of credit, it intends to satisfy such requirements through proceeds from the issuance of unsecured senior notes, from the issuance of its common stock through its equity offering program, described below, and from the sale of properties. On November 11, 2013, Moody's Investors Service assigned a Baa2 issuer rating to the Company with a rating outlook of stable. On October 3, 2014, Standard & Poor's Ratings Services assigned a BBB issuer rating to the Company with a rating outlook of stable. On October 6, 2014, Fitch, Inc. reaffirmed the Company's corporate credit rating of BBB with a rating outlook of positive. 23 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources (continued) Cash Flow Summary The Company's cash flow activities for the nine months ended September 30, 2014 and 2013, respectively, are summarized as follows (in millions): Operating Cash Flow Activities 2014 2013 Net income $ 111 $ 124 Non-cash adjustments to net income 119 96 Cash provided by operating activities $ 230 $ 220 The Company's cash flow from operating activities was $230 million in 2014 compared to $220 million in 2013. The increase is primarily attributable to interest expense savings as a result of paying off maturing debt over the past year. Investing Cash Flow Activities 2014 2013 Proceeds from sale of properties $ 106 $ 121 Purchase of properties and land for development (76 ) (28 ) Capital improvements to properties including redevelopment (100 ) (108 ) Construction in progress and predevelopment costs (37 ) (48 ) Other investing activities - 1 Cash used in investing activities $ (107 ) $ (62 ) Investing activities include the sale and purchase of properties and land for development, capital improvements to properties, redevelopment, construction in progress and predevelopment. The Company considers the sale of properties as a potential source of capital for funding acquisitions. Management's strategy also includes continuous repositioning and performance of selective rehabilitation in markets that are able to support rent increases, with a demand in the market for upgraded apartments. Changes between periods are primarily due to net acquisition and disposition activity, the rate of capital improvements and construction in progress expenditures for active development projects. Cash used in investing activities was $107 million during 2014. In 2014, the Company raised $106 million in net proceeds from the sale of one property with 864 units. The Company purchased two properties with 624 units for $76 million. Cash outflows for capital improvements and redevelopment were $95 million and $5 million, respectively. Cash outflows for additions to construction in progress were $37 million which were primarily for the development of Eleven55 Ripley and The Courts at Spring Mill Station. Cash used in investing activities was $62 million during 2013. In 2013, the Company raised $121 million in net proceeds from the sale of three properties with 669 units. These proceeds were partially used to fund the purchase of a land parcel for development for $28 million. Cash outflows for capital improvements and redevelopment were $102 million and $6 million, respectively. Cash outflows for additions to construction in progress were $48 million which were primarily for the development of Eleven55 Ripley and The Courts at Spring Mill Station. 24 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources (continued) Cash Flow Summary (continued) Financing Cash Flow Activities 2014 2013 Proceeds from equity issuance $ 10 $ 312 Proceeds from unsecured debt 178 (56 ) Secured debt repayments (160 ) (286 ) Dividends and distributions (148 ) (135 ) Other financing activities 1 (2 ) Cash used in financing activities $ (119 ) $ (167 ) Financing activities include proceeds from equity issuances, net debt proceeds or payments and dividend and distribution payments. Equity and debt activities are closely aligned with investing activities discussed above. The Company has elected to be taxed as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended, which requires the Company to distribute annually at least 90% of its REIT taxable income to its shareholders. Cash used in financing activities totaled $119 million for 2014, comprised primarily of reducing secured indebtedness. Proceeds raised through the sale of common stock from stock option exercises of $10 million, combined with net proceeds from the unsecured line of credit of $178 million were more than offset by scheduled payments on mortgages of $23 million, payoff of mortgages of $137 million and distributions paid to stockholders and UPREIT Unitholders of $148 million. Cash used in financing activities totaled $167 million for 2013, comprised primarily of reducing secured indebtedness. Proceeds raised through the sale of common stock under the public offering of $268 million, the ATM offering of $28 million and from stock option exercises of $16 million, combined with proceeds from unsecured notes payable of $25 million during the period were more than offset by scheduled payments of mortgages of $26 million, payoff of mortgages of $260 million, repayment on the line of credit of $56 million, repayment of unsecured notes payable of $25 million and distributions paid to stockholders and UPREIT Unitholders of $135 million. Unsecured Line of Credit As of September 30, 2014, the Company had a $450 million unsecured line of credit agreement with M&T Bank and U.S. Bank National Association, as joint lead banks, and nine other participating commercial banks, with an initial maturity date of August 18, 2017 and a one-year extension, at the Company's option. The Company had $371 million outstanding under the credit facility on September 30, 2014. The line of credit agreement provides the ability to issue up to $20 million in letters of credit. While the issuance of letters of credit does not increase the borrowings outstanding under the line of credit, it does reduce the amount available. At September 30, 2014, the Company had outstanding letters of credit of $3.8 million resulting in the amount available on the credit facility of $75.2 million. Borrowings under the line of credit bear interest at a variable rate based on LIBOR, plus a spread from 1.00% to 2.00% based on the Company's leverage ratio. As of September 30, 2014, based on the Company's leverage ratio, the LIBOR margin was 1.00%, and the one-month LIBOR was 0.19%; resulting in an effective rate of 1.19% for the Company. The unsecured line of credit has not been used, nor is expected to be used in the future, for long-term financing but adds a certain amount of flexibility, especially in meeting the Company's acquisition goals. Many times it is easier to temporarily finance an acquisition, development or stock repurchases by short-term use of the line of credit, with long-term secured and unsecured financing or other sources of capital replenishing the line of credit availability. 25 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources (continued) Unsecured Term Loans On December 9, 2011, the Company entered into a $250 million five-year unsecured term loan with M&T Bank as lead bank, and ten other participating lenders, which was set to mature on December 8, 2016. The term loan generated net proceeds of $248 million, after fees and closing costs, which were used to pay off an unsecured term loan, purchase an unencumbered property and acquire land for future development. On August 19, 2013, the Company amended the term loan agreement to extend the maturity date to August 18, 2018. No other changes were made to the terms of the unsecured term loan. The loan bears monthly interest at a variable rate based on LIBOR, plus a spread from 1.00% to 2.00% based on the Company's leverage ratio. On July 19, 2012, the Company entered into two interest rate swap agreements with major financial institutions that effectively convert the variable LIBOR portion of this loan to a fixed rate of 0.685% through December 7, 2016. On November 4, 2013, the Company entered into three additional interest rate swap agreements that effectively convert the variable LIBOR portion of this loan to a fixed rate of 2.604% for the period of December 8, 2016 through August 18, 2018. As of September 30, 2014, based on the Company's leverage ratio, the spread was 1.00%, and the swapped one-month LIBOR was 0.685%; resulting in an effective rate of 1.685% for the Company. The loan has covenants that align with the unsecured line of credit facility. On June 28, 2013, the Company entered into an unsecured loan agreement with M&T Bank with a September 30, 2013 maturity date. The note had a maximum principal amount of $75 million with monthly interest at a variable rate based on LIBOR, plus a spread from 1.00% to 2.00% based on the Company's leverage ratio. On June 28, 2013, the Company borrowed $25 million which was repaid in its entirety on July 12, 2013. Proceeds from this term loan were utilized to partially fund the repayment of secured debt. On August 19, 2013, the loan commitment was terminated in connection with an amendment to the unsecured line of credit. Unsecured Senior Notes On December 19, 2011, the Company issued $150 million of unsecured senior notes. The notes were offered in a private placement in two series: Series A: $90 million with a seven-year term due December 19, 2018 at a fixed interest rate of 4.46% ("Series A"); and, Series B: $60 million with a ten-year term due December 19, 2021 at a fixed interest rate of 5.00% ("Series B"). The net proceeds of $89 million and $60 million for Series A and Series B, respectively, after fees and closing costs, were used to purchase an unencumbered property and pay off a maturing mortgage note. The notes require semiannual interest payments on June 19 and December 19 of each year until maturity and are subject to various covenants and maintenance of certain financial ratios. Although the covenants of the notes do not duplicate all the covenants of the unsecured line of credit facility, any covenants applicable to both the notes and the line are identical. On June 27, 2012, the Company issued a private placement note in the amount of $50 million with a seven-year term, a fixed rate of 4.16% and a June 27, 2019 due date. The proceeds from this note were used to partially fund the purchase of a 1,350 unit apartment community on June 28, 2012. The note requires semiannual interest payments on June 27 and December 27 of each year until maturity and is subject to various covenants and maintenance of certain financial ratios. Although the covenants of the note do not duplicate all the covenants of the unsecured line of credit facility, any covenants applicable to both the note and the line are identical. Indebtedness As of September 30, 2014, the weighted average interest rate on the Company's total indebtedness of $2.5 billion was 4.18% with staggered maturities ranging from 5 months to 7 years and averaging approximately 4 years. Approximately 84% of total indebtedness is at fixed rates, including the $250 million unsecured term loan subject to interest rate swap agreements. This limits the exposure to changes in interest rates, minimizing the effect of interest rate fluctuations on the Company's results of operations and cash flows. 26 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources (continued) Unencumbered Assets The value of the unencumbered asset pool (unencumbered assets as a percent of total undepreciated assets) was 57% as of September 30, 2014 compared to 52% as of December 31, 2013. Higher levels of unsecured assets add borrowing flexibility because more capacity is available for unsecured debt under the terms of the Company's unsecured line of credit agreement, and/or for the issuance of additional unsecured senior notes. It also permits the Company to place secured financing on unencumbered assets if desired. UPREIT Units The Company believes that the issuance of UPREIT Units for property acquisitions will continue to be a potential source of capital for the Company. During 2013 and continuing through September 30, 2014, there were no UPREIT Units issued for property acquisitions. Universal Shelf Registration On February 28, 2013, the Company filed a Form S-3 universal shelf registration statement with the SEC that registers the issuance, from time to time, of common stock, preferred stock or debt securities. The Company may offer and sell securities issued pursuant to the universal shelf registration statement after a prospectus supplement, describing the type of security and amount being offered, is filed with the SEC. Sales of common stock under the Company's equity offerings on or after February 28, 2013 described below were made under this registration statement. On March 3, 2010, the Company filed a Form S-3 universal shelf registration statement with the SEC having substantially the same provisions and purposes as the February 2013 registration statement. The registration statement expired in March 2013. Sales of common stock under the Company's equity offerings from September 2010 to February 27, 2013 as described below were made under this registration statement. Common Stock On April 29, 2014, the stockholders of the Company approved an amendment to the Company's Articles of Amendment and Restatement of the Articles of Incorporation, as amended, to increase the number of authorized shares of the Company's Common Stock, par value $.01 per share, from 80,000,000 shares to 160,000,000 shares. At-the-Market Equity Offering Program On May 14, 2012, the Company filed a prospectus supplement with respect to an ATM equity offering program through which it is authorized to sell up to 4.4 million shares of common stock, from time to time in ATM offerings or negotiated transactions. Through the second quarter of 2013, the Company issued 2,430,233 shares of common stock at an average price per share of $62.81, for aggregate gross proceeds of $152.6 million and aggregate net proceeds of $149.4 million after deducting commissions and other transaction costs of $3.2 million. No shares were issued under the ATM equity offering program during the third and fourth quarters of 2013 or during 2014. As of September 30, 2014, approximately 2.0 million shares remain available. The Company used the net proceeds from the ATM offerings primarily for general corporate purposes including acquisitions, development and redevelopment of apartment communities. Public Equity Offering Program On July 9, 2013, the Company issued a prospectus supplement offering 4.4 million shares of its common stock at a price of $63.00 per share, including 0.6 million shares issued pursuant to the exercise in full of an underwriters' option to purchase additional shares. Net proceeds were $267.6 million after underwriting discounts, commissions and offering expenses. All of the 4.4 million shares offered were purchased and subsequently delivered on July 12, 2013. The net proceeds were used to pay off outstanding indebtedness. 27 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources (continued) Stock Repurchase Program In 1997, the Board approved a stock repurchase program under which the Company may repurchase shares of its common stock or UPREIT Units ("Company Program"). The shares and units may be repurchased through open market or privately negotiated transactions at the discretion of Company management. The Board's action did not establish a target stock price or a specific timetable for repurchase. There were no repurchases under the Company Program during 2013 and through September 30, 2014. The remaining authorization level as of September 30, 2014 is 2.3 million shares. The Company will continue to monitor stock prices relative to management's estimate of net asset value to determine the current best use of capital among our major uses of capital: stock buybacks, debt paydown to increase the unencumbered pool, acquisitions, rehabilitation and/or redevelopment of owned properties and development of new properties. Dispositions On February 26, 2014, the Company sold a property located in the Washington, D.C. region with a total of 864 units for $110.0 million. At closing, a $58.5 million mortgage was repaid, prepayment penalties of $0.6 million and closing costs of $3.3 million were incurred for a net cash flow of $47.6 million. A gain on sale of $31.3 million was recorded in the first quarter of 2014 related to this sale. Property Development Discontinuance of New Development During the second quarter of 2014, the Company made a strategic decision to discontinue the Company's business of developing new apartment communities. The two projects currently under construction will be completed: Eleven55 Ripley in Silver Spring, MD and The Courts at Spring Mill Station in Conshohocken, PA. No additional new apartment communities will be started. Land parcels previously held for development will not be developed by the Company. Impairment and other charges of $3.8 million were incurred in the second quarter of 2014 in connection with the decision to discontinue new property development. The Company expects to incur severance charges in connection with the elimination of development positions in the amount of $1.8 million. Severance costs include severance, a stay bonus and unamortized equity compensation. Employees are required to fulfill specific service requirements in order to earn the severance compensation. Severance expense earned will be recorded ratably over the requisite service period during the third and fourth quarters of 2014 and the first quarter of 2015. During the three month period ended September 30, 2014, the Company recognized severance costs in the amount of $1.0 million which is included in impairment and other charges. Current Construction Projects Eleven55 Ripley, a 379 unit high rise development consisting of two buildings, a 21 story high-rise and a 5 story mid-rise, is located in Silver Spring, Maryland. Construction commenced in the fourth quarter of 2011, and is expected to continue through the fourth quarter of 2014. Initial occupancy occurred in the fourth quarter of 2013 with 239 of 351 available units leased or preleased as of September 30, 2014. The construction in progress for this development was $63.3 million as of September 30, 2014 and the total estimated cost is $113 million. The Courts at Spring Mill Station, a 385 unit development consisting of two buildings, being built in a combination donut/podium style, is located in Conshohocken, Pennsylvania. Construction commenced in the second quarter of 2012, and is expected to continue through the first quarter of 2015 with initial occupancy in the fourth quarter of 2014. The construction in progress for this development was $66.4 million as of September 30, 2014 and the total estimated cost is $89 million. 28 -------------------------------------------------------------------------------- Table of Contents Property Development (continued) Redevelopment The Company has one project under redevelopment. Arbor Park, located in Alexandria, Virginia, has 851 garden apartments in fifty-two buildings built in 1967. The Company plans to extensively renovate all of the units over several years on a building by building basis. As of September 30, 2014, there were six buildings with 105 units under renovation and forty-one buildings with 674 units completed and 616 of those units occupied, with rents in the renovated units averaging $1,688 compared to $1,360 for the existing non-renovated units. As of September 30, 2014, the Company has incurred costs of $27.3 million for the renovation which is included in buildings, improvements and equipment. The entire project is expected to be completed in 2015 for a total estimated cost of $32 million. Contractual Obligations and Other Commitments The primary obligations of the Company relate to its borrowings under the unsecured line of credit, unsecured notes and mortgage notes. The Company's line of credit matures in August 2017 (not including a one-year extension at the option of the Company), and had $371 million in loans and letters of credit totaling $3.8 million outstanding at September 30, 2014. The $450 million in unsecured notes have maturities ranging from approximately 4 to 7 years. The $1.7 billion in mortgage notes have varying maturities ranging from 5 months to 7 years. The weighted average interest rate of the Company's secured debt was 5.18% at September 30, 2014. The weighted average interest rate on the Company's total indebtedness of $2.5 billion at September 30, 2014 was 4.18%. The Company leases its corporate and regional office space from non-affiliated third parties. The rent for the corporate office space is a gross rent that includes real estate taxes and common area maintenance. The regional office leases are net leases which require an annual base rent plus a pro-rata portion of real estate taxes. The Company has a secondary guarantee through 2015 on certain low income housing tax credits to limited partners in a partnership in which it previously was a general partner totaling approximately $3 million. With respect to the guarantee of the low income housing tax credits, the new unrelated general partner assumed operating deficit guarantee and primary tax credit guarantee positions. The Company believes the property's operations conform to the applicable requirements and does not anticipate any payment on the guarantee; therefore, no liability has been recorded in the financial statements. Capital Improvements (dollars in thousands, except unit and per unit data) The Company's policy is to capitalize costs related to the acquisition, development, rehabilitation, construction and improvement of properties. Capital improvements are costs that increase the value and extend the useful life of an asset. Ordinary repair and maintenance costs that do not extend the useful life of the asset are expensed as incurred. Costs incurred on a lease turnover due to normal wear and tear by the resident are expensed on the turn. Recurring capital improvements typically include appliances, carpeting and flooring, HVAC equipment, kitchen and bath cabinets, new roofs, site improvements and various exterior building improvements. Non-recurring revenue generating upgrades include community centers, new windows, and kitchen and bath apartment upgrades. Revenue generating capital improvements are expected to directly result in increased rental earnings or expense savings. The Company capitalizes interest and certain internal personnel costs related to the communities under rehabilitation and construction. The Company estimates, that on an annual basis, $900 and $848 per apartment unit is spent on recurring capital expenditures in 2014 and 2013, respectively. During the three months ended September 30, 2014 and 2013, approximately $225 and $212 per apartment unit, respectively, was estimated to be spent on recurring capital expenditures. For the nine months ended September 30, 2014 and 2013, approximately $675 and $636 per apartment unit, respectively, was estimated to be spent on recurring capital expenditures. 29 -------------------------------------------------------------------------------- Table of Contents Capital Improvements (continued) The table below summarizes the actual total capital improvements incurred by major categories for the three and nine months ended September 30, 2014 and 2013 and an estimate of the breakdown of total capital improvements by major categories between recurring, and non-recurring revenue generating, capital improvements for the three and nine months ended September 30, 2014 as follows: For the three months ended September 30, 2014 2013 Non- Total Total Recurring Per Recurring Per Capital Per Capital Per Cap Ex Unit(a) Cap Ex Unit(a) Improvements Unit(a) Improvements Unit(a) New buildings $ - $ - $ 355 $ 9 $ 355 $ 9 $ 125 $ 3 Major building improvements 1,289 32 4,436 108 5,725 140 6,979 175 Roof replacements 389 10 1,127 28 1,516 38 1,041 26 Site improvements 706 17 6,520 159 7,226 176 5,016 126 Apartment upgrades 1,124 27 10,484 256 11,608 283 12,758 320 Appliances 1,956 48 - - 1,956 48 2,000 50 Carpeting, flooring 2,619 64 1,992 49 4,611 113 4,454 112 HVAC, mechanicals 911 22 4,174 102 5,085 124 6,338 159 Miscellaneous 215 5 646 16 861 21 830 21 Total $ 9,209 $ 225 $ 29,734 $ 727 $ 38,943 $ 952 $ 39,541 $ 992 (a) Calculated using the weighted average number of units owned, including 39,916 core units, 2013 acquisition units of 457, and 2014 acquisition units of 550 for the three months ended September 30, 2014. For the nine months ended September 30, 2014 2013 Non- Total Total Recurring Per Recurring Per Capital Per Capital Per Cap Ex Unit(a) Cap Ex Unit(a) Improvements Unit(a) Improvements Unit(a) New buildings $ - $ - $ 858 $ 21 $ 858 $ 21 $ 379 $ 9 Major building improvements 3,834 94 10,778 266 14,612 360 17,907 449 Roof replacements 1,156 28 2,003 49 3,159 77 3,103 78 Site improvements 2,100 52 12,515 308 14,615 360 10,168 255 Apartment upgrades 4,187 103 24,695 609 28,882 712 30,739 770 Appliances 4,973 123 - - 4,973 123 5,059 127 Carpeting, flooring 7,791 192 2,632 65 10,423 257 10,193 255 HVAC, mechanicals 2,708 67 10,190 251 12,898 318 13,863 347 Miscellaneous 639 16 1,767 44 2,406 60 2,937 74 Totals $ 27,388 $ 675 $ 65,438 $ 1,613 $ 92,826 $ 2,288 $ 94,348 $ 2,364 (a) Calculated using the weighted average number of units owned, including 39,916 core units, 2013 acquisition units of 457, and 2014 acquisition units of 203 for the nine months ended September 30, 2014. 30 -------------------------------------------------------------------------------- Table of Contents Capital Improvements (continued) The schedule below summarizes the breakdown of total capital improvements between core and non-core as follows: For the three months ended September 30, 2014 2013 Non- Total Total Recurring Per Recurring Per Capital Per Capital Per Cap Ex Unit(a) Cap Ex Unit(a) Improvements Unit(a) Improvements Unit(a) Core Communities $ 8,982 $ 225 $ 28,425 $ 712 $ 37,407 $ 937 $ 39,541 $ 992 2014 Acquisition Communities 124 225 71 129 195 355 - - 2013 Acquisition Communities 103 225 1,238 2,709 1,341 2,934 - - Sub-total 9,209 225 29,734 727 38,943 952 39,541 992 2014 Disposed Community - - - - - - 118 137 2013 Disposed Communities - - - - - - 67 195 Corporate office expenditures(b) - - - - 515 - 664 - Total $ 9,209 $ 225 $ 29,734 $ 727 $ 39,458 $ 952 $ 40,390 $ 966 (a) Calculated using the weighted average number of units owned, including 39,916 core units, 2013 acquisition units of 457, and 2014 acquisition units of 550 for the three months ended September 30, 2014; and 39,916 core units, 2013 disposed units of 344, and 2014 disposed units of 864 for the three months ended September 30, 2013. (b) No distinction is made between recurring and non-recurring expenditures for corporate office. Corporate office expenditures include principally computer hardware, software, office furniture, fixtures and leasehold improvements. Corporate office expenditures are excluded from per unit figures. For the nine months ended September 30, 2014 2013 Non- Total Total Recurring Per Recurring Per Capital Per Capital Per Cap Ex Unit(a) Cap Ex Unit(a) Improvements Unit(a) Improvements Unit(a) Core Communities $ 26,943 $ 675 $ 62,483 $ 1,565 $ 89,426 $ 2,240 $ 94,348 $ 2,364 2014 Acquisition Communities 137 675 62 305 199 980 - - 2013 Acquisition Communities 308 675 2,893 6,329 3,201 7,004 - - Sub-total 27,388 675 65,438 1,613 92,826 2,288 94,348 2,364 2014 Disposed Community 45 248 - - 45 248 513 594 2013 Disposed Communities - - - - - - 377 669 Corporate office expenditures(b) - - - - 1,593 - 1,830 - Totals $ 27,433 $ 673 $ 65,438 $ 1,606 $ 94,464 $ 2,279 $ 97,068 $ 2,304 (a) Calculated using the weighted average number of units owned, including 39,916 core units, 2013 acquisition units of 457, 2014 acquisition units of 203, and 2014 disposed units of 180 for the nine months ended September 30, 2014; and 39,916 core units, 2013 disposed units of 563, and 2014 disposed units of 864 for the nine months ended September 30, 2013. (b) No distinction is made between recurring and non-recurring expenditures for corporate office. Corporate office expenditures include principally computer hardware, software, office furniture, fixtures and leasehold improvements. Corporate office expenditures are excluded from per unit figures. 31 -------------------------------------------------------------------------------- Table of Contents Results of Operations (dollars in thousands, except unit and per unit data) Net operating income ("NOI") falls within the definition of "non-GAAP financial measure" set forth in Item 10(e) of Regulation S-K and, as a result, the Company is required to include in this report a statement disclosing the reasons why management believes that presentation of this measure provides useful information to investors. The Company believes that NOI is helpful to investors as a supplemental measure of the operating performance of a real estate company because it is a direct measure of the actual operating results of the Company's apartment communities. In addition, the apartment communities are valued and sold in the market by using a multiple of NOI. The Company uses this measure to compare its performance to that of its peer group. For a reconciliation of NOI to income from continuing operations, please refer to Note 11 to Consolidated Financial Statements of this Form 10-Q. Summary of Core Properties The Company had 115 apartment communities with 39,916 units which were owned during the three and nine months ended September 30, 2014 and 2013 (the "Core Properties"). The Company has one property with 851 units undergoing significant renovations that began in 2011; therefore, the operating results for 2014 are not comparable to 2013 due to those units being taken out of service during the redevelopment period (the "Redevelopment Property"). The Company acquired two apartment communities with 457 units, placed into service another 90 units at one development community during 2013; and acquired two apartment communities with 624 units and had another 261 units become available to rent at one development community during 2014 (the "Acquisition Communities"). The inclusion of these acquired and developed communities generally accounted for the significant changes in operating results for the three and nine months ended September 30, 2014 as compared to the operating results for the three and nine months ended September 30, 2013. A summary of the net operating income for Core Properties is as follows: Three Months Nine Months $ % $ % 2014 2013 Change Change 2014 2013 Change Change Rental Income $150,900 $146,170 $4,730 3.2% $447,965 $436,609 $11,356 2.6% Utility recovery revenue 5,063 4,772 291 6.1% 18,832 17,205 1,627 9.5% Rent including recoveries 155,963 150,942 5,021 3.3% 466,797 453,814 12,983 2.9% Property other income 7,198 7,144 54 0.8% 21,497 21,209 288 1.4% Total revenue 163,161 158,086 5,075 3.2% 488,294 475,023 13,271 2.8% Operating and maintenance (59,014 ) (55,846 ) (3,168 ) (5.7% ) (180,895 ) (171,365 ) (9,530 ) (5.6% ) Net operating income $104,147 $102,240 $1,907 1.9% $307,399 $303,658 $ 3,741 1.2% A summary of the net operating income for the Company as a whole is as follows: Three Months Nine Months $ % $ % 2014 2013 Change Change 2014 2013 Change Change Rental Income $158,535 $149,588 $8,947 6.0% $465,910 $446,194 $19,716 4.4% Utility recovery revenue 5,217 4,860 357 7.3% 19,248 17,578 1,670 9.5% Rent including recoveries 163,752 154,448 9,304 6.0% 485,158 463,772 21,386 4.6% Property other income 7,537 7,280 257 3.5% 22,236 21,571 665 3.1% Total revenue 171,289 161,728 9,561 5.9% 507,394 485,343 22,051 4.5% Operating and maintenance (62,245 ) (57,060 ) (5,185 ) (9.1% ) (189,006 ) (175,061 ) (13,945 ) (8.0% ) Net operating income $109,044 $104,668 $4,376 4.2% $318,388 $310,282 $ 8,106 2.6% 32 -------------------------------------------------------------------------------- Table of Contents Results of Operations (continued) Comparison of three months ended September 30, 2014 to the same period in 2013 Of the $8,947 increase in rental income, $4,217 is attributable to the Acquisition Communities and Redevelopment Property. The balance, an increase of $4,730, relates to a 3.2% increase from the Core Properties as the result of an increase of 2.6% in weighted average rental rates to $1,340 from $1,306 per apartment unit, and by a 0.5% increase in economic occupancy to 94.0% from 93.5%. Economic occupancy is defined as total possible rental income, net of vacancy and bad debt expense, as a percentage of total possible rental income. Total possible rental income is determined by valuing occupied units at contract rents and vacant units at market rents. Of the $357 increase in utility recovery revenue, $291 is attributable to the Core Properties and $66 is attributable to the Acquisition Communities and Redevelopment Property. The increase in Core Properties is due primarily to the rollout of a trash recovery program in mid-2013 plus the pass through to residents of new storm water fees in certain regions. Property other income, which consists primarily of income from operation of laundry facilities, late charges, administrative fees, garage and carport rentals, revenue from corporate apartments, cable revenue, pet charges, and miscellaneous charges to residents, increased by $257. Of the increase, $54 is attributable to the Core Properties, and $203 is attributable to the Acquisition Communities and Redevelopment Property. The increase in Core Properties is primarily from increases in cable revenue and lower bad debt expense, partially offset by decreases in revenue from corporate apartments, damages and remarketing fees. Of the $5,185 increase in operating and maintenance expenses, $2,017 is attributable to the Acquisition Communities and Redevelopment Property and $3,168 is attributable to the Core Properties. The increase in Core Properties is primarily due to increases in water & sewer costs, repairs & maintenance expense and real estate taxes, partially offset by a decrease in personnel costs and property insurance costs. Water & sewer costs were up $212, or 4.4%, from the 2013 period due primarily to new fees for storm water handling instituted by municipalities in our Mid-Atlantic region. Repairs & maintenance expense was up $1,527, or 18.0%, primarily due to proceeds from an insurance claim exceeding the cost basis of destroyed assets, related to a significant fire in the 2013 period of $1,227. Without the impact of the fire loss, the recurring repairs & maintenance expenses increased $300, or 3.1%. Real estate taxes were up $1,977, or 12.9%, primarily due to annual tax assessment increases and the 2013 period experiencing a $608 non-recurring decrease from successful tax incentive programs and tax assessment challenges. The Company continues to challenge tax assessments on existing properties. Personnel costs decreased $305, or 2.3%, primarily due to an $809 decrease of workers compensation self-insurance reserves in the 2014 period, compared to a reserve decrease of $160 in the 2013 period, which reflects ongoing efforts towards the proactive settlement of prior year claims and the positive impacts of the Company's safety in the workplace initiatives. Without the impact of the reserve adjustments, personnel costs increased $344, or 2.6%, reflecting the annual wage increase. Property insurance decreased $204, or 8.5%, primarily due to the 2013 period including unusually high property losses from a significant fire at one of the Company's communities. General and administrative expenses decreased $864, or 14.0%. General and administrative expenses as a percentage of total revenues were 3.1% for 2014 as compared to 3.7% for 2013. Stock-based compensation costs were $476 lower than the same period of 2013 due primarily to restricted stock grants to non-executives (which are granted in the second quarter of each period) at or near official retirement age resulting in these grants being expensed immediately, or one year less based on age which resulted in $348 lower expense and the discontinuance of stock option grants in 2014 which resulted in $128 lower expense. In addition, the 2014 corporate bonus costs were $466 less than the 2013 period. Interest expense decreased by $2,437, or 8.9%, in 2014 primarily as a result of paying off $109,000 in maturing loans on several Core Properties over the past year. In addition, the Acquisition Communities were acquired without secured mortgage debt. Refer to the information under the heading "Liquidity and Capital Resources" above for specific discussion of debt transactions impacting the average rate and overall interest expense. 33 -------------------------------------------------------------------------------- Table of Contents Results of Operations (continued) Depreciation and amortization expense increased $3,670, or 8.6%, due to the depreciation on the Acquisition Communities and the capital additions to the Core Properties and Redevelopment Property. Other expenses of $335 in 2014 and $16 in 2013 are property acquisition costs of the Acquisition Communities. Impairment and other charges of $1,024 were incurred in the third quarter of 2014 in connection with the decision to discontinue new property development and represent severance accruals and accelerated recognition of stock-based compensation over the remaining service period of development personnel. Comparison of nine months ended September 30, 2014 to the same period in 2013 Of the $19,716 increase in rental income, $8,175 is attributable to the Acquisition Communities and $185 is attributable to the Redevelopment Property. The balance, an increase of $11,356, relates to a 2.6% increase from the Core Properties as the result of an increase of 2.7% in weighted average rental rates to $1,325 from $1,290 per apartment unit, partially offset by a 0.1% decrease in economic occupancy to 94.1% from 94.2%. Economic occupancy is defined as total possible rental income, net of vacancy and bad debt expense, as a percentage of total possible rental income. Total possible rental income is determined by valuing occupied units at contract rents and vacant units at market rents. Of the $1,670 increase in utility recovery revenue, $1,627 is attributable to the Core Properties and $43 is attributable to the Acquisition Communities and Redevelopment Property. The higher Core Properties utility recovery revenue is a direct result of higher energy consumption due to the extreme cold weather experienced during the 2014 period and initiating a trash recovery program which began in the second quarter of 2013. Property other income, which consists primarily of income from operation of laundry facilities, late charges, administrative fees, garage and carport rentals, revenue from corporate apartments, cable revenue, pet charges, and miscellaneous charges to residents, increased by $665. Of the increase, $288 is attributable to the Core Properties, $351 is attributable to the Acquisition Communities and $26 is attributable to the Redevelopment Property. The increase in Core Properties is primarily from increases in cable revenue, pet charges, late charges, damages and lower bad debt expense, partially offset by decreases in revenue from corporate apartments and remarketing fees. Of the $13,945 increase in operating and maintenance expenses, $4,350 is attributable to the Acquisition Communities, $68 is attributable to the Redevelopment Property and $9,530 is attributable to the Core Properties. The increase in Core Properties is primarily due to increases in natural gas heating, repairs & maintenance expense, property insurance, real estate taxes, and snow removal expense, partially offset by lower property management general & administrative costs. Natural gas heating costs were up $812, or 8.3%, from a year ago due to a significant increase in consumption due to the extreme cold winter of 2014 compared to slightly warmer than average temperatures in the 2013 period, partially offset by lower commodity rates. For 2014, our natural gas weighted average cost, including transportation of $3.00 per decatherm, was $7.65 per decatherm, compared to $7.80 per decatherm for the 2013 period, a 1.9% decrease. Repairs & maintenance expense was up $2,085, or 8.8%, partly due to accounting for involuntary conversions related to fires and floods and the associated insurance claims at certain properties. Without the impact of these recoveries, the recurring repairs & maintenance expenses increased $743, or 3.0%, primarily due to increased costs related to the harsh winter in the first quarter of 2014. Property insurance increased $2,046, or 42.2%, primarily due to higher self insured property losses in 2014 compared to 2013. The 2014 losses were comprised of seventy-five properties experiencing $814 in losses due to pipe breaks caused by the extreme cold weather in all of our regions and $336 in water intrusion related losses due to heavy wind and severe rain storms that impacted a significant number of our properties in the Mid-Atlantic regions. The 2013 period contained a $288 one-time insurance reimbursement and experienced no significant storm or weather-related losses. The 2014 general liability losses were $241, or 20.5% higher than 2013, due to the impact of the harsher winter conditions experienced in 2014 compared to the mild winter in 2013. Without the impact of the major items above, recurring property and general liability insurance costs were up $367, or 7.6%. 34 -------------------------------------------------------------------------------- Table of Contents Results of Operations (continued) Real estate taxes were up $2,593, or 5.5%, primarily due to annual tax assessment increases some of which are triggered by our investments in apartment upgrades and repositioning. In addition, the 2014 period contained prior period refunds and tax abatements of $73 compared to $608 in 2013. Without these refunds and tax abatements real estate taxes were up $2,058, or 4.3%. The Company continues to challenge tax assessments on existing properties. Snow removal costs were up $1,111, or 122.1%, due primarily to the Mid-Atlantic region experiencing significantly higher than normal snowfall and more numerous snow storms than in the 2013 period. Property management general & administrative costs decreased $315, or 2.5%. Despite increases in the number of apartment communities and units, the Company has been able to offset costs of growth due to its scalable operating platform, including efficiencies enabled by key application software investments. General and administrative expenses decreased in 2014 by $899, or 4.0%. General and administrative expenses as a percentage of total revenues were 4.2% for 2014 as compared to 4.5% for 2013. Stock-based compensation costs were $101, or 1.3% higher due primarily to $452 increased executive equity compensation from the performance based restricted stock unit program that began in 2012 and $200 higher director restricted grants due to the addition of two new directors in 2014 which was partially offset by $551 lower stock option expense due to the discontinuance of stock option grants in 2014. In addition, the 2014 corporate bonus costs were $1,223 less than the 2013 period. Interest expense decreased by $10,598, or 12.3%, in 2014 primarily as a result of paying off $109,000 in maturing loans on several Core Properties over the past year. In addition, the Acquisition Communities were acquired without secured mortgage debt. Refer to the information under the heading "Liquidity and Capital Resources" above for specific discussion of debt transactions impacting the average rate and overall interest expense. Depreciation and amortization expense increased $9,802, or 7.8%, due to the depreciation on the Acquisition Communities and the capital additions to the Core Properties and Redevelopment Property. Other expenses of $617 in 2014 and $48 in 2013 are property acquisition costs of the Acquisition Communities. Impairment and other charges of $4,866 were incurred in 2014 in connection with the decision to discontinue new property development. Funds From Operations Pursuant to the updated guidance for Funds From Operations ("FFO") provided by the Board of Governors of the National Association of Real Estate Investment Trusts ("NAREIT"), FFO is defined as net income (computed in accordance with accounting principles generally accepted in the United States of America ("GAAP")) excluding gains or losses from sales of property, impairment write-downs of depreciable real estate, noncontrolling interest, extraordinary items and cumulative effect of change in accounting principle plus depreciation from real property including adjustments for unconsolidated partnerships and joint ventures less dividends from non-convertible preferred shares. Because of the limitations of the FFO definition as published by NAREIT as set forth above, the Company has made certain interpretations in applying the definition. The Company believes all adjustments not specifically provided for are consistent with the definition. In addition to presenting FFO in accordance with the NAREIT definition, we also disclose FFO after a specific and defined supplemental adjustment to exclude losses from early extinguishments of debt associated with the sales of real estate ("FFO as adjusted"). The adjustment to exclude losses from early extinguishments of debt results when the sale of real estate encumbered by debt requires us to pay the extinguishment and other one-time costs prior to the debt's stated maturity and to write-off unamortized loan costs at the date of the extinguishment. Such costs are excluded from the gains on sales of real estate reported in accordance with GAAP. However, we view the losses from early extinguishments of debt associated with the sales of real estate as an incremental cost of the sale transactions because we extinguished the debt in connection with the consummation of the sale transactions and we had no intent to extinguish the debt absent such transactions. We believe that this supplemental adjustment more appropriately reflects the results of our operations exclusive of the impact of our sale transactions. 35 -------------------------------------------------------------------------------- Table of Contents Funds From Operations (continued) Although our FFO as adjusted clearly differs from NAREIT's definition of FFO, and may not be comparable to that of other REITs and real estate companies, we believe it provides a meaningful supplemental measure of our operating performance because we believe that, by excluding the effects of the losses from early extinguishments of debt associated with the sales of real estate, management and investors are presented with an indicator of our operating performance that more closely achieves the objectives of the real estate industry in presenting FFO. Neither FFO, nor FFO as adjusted, should be considered as an alternative to net income (determined in accordance with GAAP) as an indication of our performance. Neither FFO, nor FFO as adjusted, represents cash generated from operating activities determined in accordance with GAAP, and neither is a measure of liquidity or an indicator of our ability to make cash distributions. We believe that to further understand our performance, FFO, and FFO as adjusted, should be compared with our reported net income and considered in addition to cash flows in accordance with GAAP, as presented in our consolidated financial statements. FFO, and FFO as adjusted, fall within the definition of "non-GAAP financial measure" set forth in Item 10(e) of Regulation S-K and as a result the Company is required to include in this report a statement disclosing the reasons why management believes that presentation of this measure provides useful information to investors. Management believes that in order to facilitate a clear understanding of the combined historical operating results of the Company, FFO, and FFO as adjusted, should be considered in conjunction with net income as presented in the consolidated financial statements included herein. Management believes that by excluding gains or losses related to dispositions of property and excluding real estate depreciation (which can vary among owners of similar assets in similar condition based on historical cost accounting and useful life estimates), FFO, and FFO as adjusted, can help one compare the operating performance of a company's real estate between periods or as compared to different companies. In addition, FFO as adjusted ties the losses on early extinguishment of debt to the real estate which was sold triggering the extinguishment. The Company also uses these measures to compare its performance to that of its peer group. The calculation of FFO, and FFO as adjusted, and reconciliation to GAAP net income attributable to common stockholders for the three and nine months ended September 30, 2014 and 2013 are presented below (in thousands): Three Months Nine Months 2014 2013 2014 2013 Net income attributable to common stockholders $ 26,244 $ 25,038 $ 94,504 $ 103,954 Real property depreciation and amortization 45,882 43,472 134,557 128,832 Noncontrolling interest 4,650 4,586 16,824 20,395 Gain on disposition of property - - (31,306 ) (45,004 ) FFO - Basic and Diluted, as defined by NAREIT 76,776 73,096 214,579 208,177 Loss from early extinguishment of debt in connection with sale of real estate - - 802 1,416 FFO - Basic and Diluted, as adjusted by the Company $ 76,776 $ 73,096 $ 215,381 $ 209,593 Weighted average common shares/units outstanding (1): Basic 67,611.3 66,717.3 67,458.8 63,834.0 Diluted 68,169.1 67,291.0 67,946.0 64,441.3 (1) Basic includes common stock outstanding plus UPREIT Units which can be converted into shares of common stock. Diluted includes additional common stock equivalents. All REITs may not be using the same definition for FFO. Accordingly, the above presentation may not be comparable to other similarly titled measures of FFO of other REITs. 36 -------------------------------------------------------------------------------- Table of Contents Debt Covenants The unsecured notes payable agreements and Credit Agreement provide for the Company to maintain certain financial ratios and measurements including a limitation on outstanding indebtedness and a minimum interest coverage ratio. The Company was in compliance with these financial covenants for all periods presented. Economic Conditions Substantially all of the leases at the communities are for a term of one year or less, which enables the Company to seek increased rents upon renewal of existing leases or commencement of new leases. These short-term leases minimize the potential adverse effect of inflation on rental income, although residents may leave without penalty at the end of their lease terms and may do so if rents are increased significantly. Dividends and Distributions On October 28, 2014, the Board of Directors declared a dividend of $0.73 per share on the Company's common stock and approved a distribution of $0.73 per UPREIT Unit for the quarter ended September 30, 2014. This is the equivalent of an annual dividend/distribution of $2.92 per share/unit. The dividend and distribution are payable November 21, 2014, to stockholders and unitholders of record on November 10, 2014. Contingencies The Company is not a party to any legal proceedings which are expected to have a material adverse effect on the Company's liquidity, financial position or results of operations. The Company is subject to a variety of legal actions for personal injury or property damage arising in the ordinary course of its business, most of which are covered by general liability and property insurance. Various claims of employment and resident discrimination are also periodically brought, most of which also are covered by insurance. While the resolution of these matters cannot be predicted with certainty, management believes that the final outcome of such legal proceedings and claims will not have a material adverse effect on the Company's liquidity, financial position or results of operations. Recently Adopted and Recently Issued Accounting Standards Disclosure of recently adopted and recently issued accounting standards is incorporated herein by reference to the discussion under Part I, Item 1, Notes to Consolidated Financial Statements, Note 2. 37 -------------------------------------------------------------------------------- Table of Contents |