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AMERICAN SPECTRUM REALTY INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in Item 8 of this Annual Report on Form 10-K. Our Business We are a value add real estate investor looking to acquire properties which require operational attention, physical improvement or capital restructuring. Our investment strategy is to acquire, improve and hold real estate while we look for an opportunistic exit that will enable us to achieve our risk/return objectives. Our income producing properties include commercial office, industrial, retail, self-storage, multi-family residential, student housing and land for development. In addition to our real estate portfolio, we offer our market expertise and integrated real estate solutions to select third parties for a fee. Our service offering includes property and asset management, insurance procurement, syndication services, receivership management and brokerage services. We conduct our business in the continental United States. We conduct our business through an Operating Partnership in which we are the sole general partner, and a limited partner with a total equity interest of 94% at December 31, 2013. As the sole general partner of the Operating Partnership, we have the exclusive power to manage and conduct the business of the partnership. We periodically examine our corporate structure in order to evaluate if we are positioned to take advantage of the most favorable tax treatments for our shareholders, our clients and ourselves. It is our objective to consider all applicable tax laws that legally reduce the tax consequences and maximize the tax benefits associated with real estate transactions A Real Estate Investment Trust ("REIT") is a designation for tax purposes that enables a qualifying corporation to take a tax deduction for dividend payments to its shareholders. The ability to qualify as a REIT requires the corporation to meet certain ownership, distribution, income and asset tests established under the Internal Revenue Code of 1986, as amended. As of December 31, 2013, our ownership structure does not allow the Company to qualify as a REIT for federal income tax purposes. Our primary business objective is to acquire and manage multiple tenant real estate in strategically located areas where our cost-effective enhancements, combined with effective leasing and management strategies, can improve the long-term values and economic returns of those properties. We focus on the following fundamentals to achieve this objective: • An opportunistic and disciplined disposition strategy that enhances investment performance and takes advantage of realized gains. We typically dispose of properties when the return from selling is higher than the projected return from holding the property. • Organic (internally developed opportunities) and inorganic (acquisition-generated opportunities) growth of our third party property management contracts and transaction service fees, coupled with; • An opportunistic yet disciplined acquisition strategy that focuses on mid-tier multi-tenant real estate in locations that allow us to capitalize on existing management infrastructure servicing our properties and those of our third party clients. As of December 31, 2013, the properties that we manage were as follows: ASR owned (1) Consolidated VIE's (1) Third Party Total Property type # of Properties Square footage # of Properties Square footage # of Properties Square footage # of Properties Square footage Office 9 804,720 - - 1 29,428 10 834,148 Industrial / Commercial 1 15,795 7 3,972,553 - - 8 3,988,348 Retail 3 100,963 - - 2 40,636 5 141,599 Residential / Multi-family 3 43,773 4 609,961 3 148,146 10 801,880 Self-Storage 3 182,477 9 1,167,234 27 1,937,840 39 3,287,551 Total 19 1,147,728 20 5,749,748 33 2,156,050 72 9,053,526 21-------------------------------------------------------------------------------- Consolidated VIE's ASR owned (1) (1) Third Party Total # of Property type # of Properties Acres Properties Acres # of Properties Acres # of Properties Acres Recreational vehicle 2 56 - - - - 2 56 Land 12 3,968 - - - - 12 3,968 Total 14 4,024 - - - - 14 4,024 ____________________________ (1) See Part I, Item 2. Properties for additional property details. In August 2013, the lender for Morenci Professional Park foreclosed on the asset. Prior to the foreclosure, we elected to discontinue payments on the $1.6 million mortgage as we believed that the balance of the mortgage exceeded the market value of the property. The property securing the debt was held in one of our wholly-owned subsidiaries, and we had not guaranteed the mortgage note payable. Our subsidiary recorded a loss of $0.2 million as a result of the foreclosure. In August 2013, we ceased to be the primary beneficiary of the VIE that owned the property known as University Fountains at Lubbock (a student housing property). Inasmuch as we no longer manage or have a continuing involvement with this property, we have deconsolidated this VIE from our Consolidated Financial Statements. We did not record a gain or loss as a result of the deconsolidation. On July 2013, we sold an office property located at 2620/2630 Fountain View in Houston, Texas, which we held in a partnership with another investor. We sold the property for approximately $8.9 million, and generated proceeds of approximately $3.1 million after selling expenses and repayment of the secured note payable in the amount of approximately $5.2 million. The transaction generated a gain of approximately $1.2 million. In July 2013, the lender for 1501 Mockingbird foreclosed on the asset. Prior to the foreclosure we elected to discontinue payments on the $3.1 million mortgage as we believed that the balance of the mortgage exceeded the market value of the property. The debt was secured by the property, which was held in one of our wholly-owned, consolidated subsidiaries, and we had not guaranteed the mortgage obligation. We recognized a loss of $0.2 million as a result of the foreclosure. In June 2013, the lender for the 11500 Northwest Freeway property foreclosed on the asset. ASR chose to discontinue paying the $3.9 million unpaid debt as it exceeded the market value of the property. The property securing the debt was held by a consolidated, wholly-owned subsidiary that had not guaranteed the debt. The transaction generated a loss of $0.1 million. No proceeds were received as a result of the transaction. During the first quarter of 2013, the Company deconsolidated two VIEs after determining that it was no longer the primary beneficiary. The entities were Fishers Indiana and College Park. ASR no longer manages or has a continuing involvement with properties owned by these entities. There was no gain nor loss associated with these deconsolidations. Revenues: Rental Revenues. We derive rental revenues from tenants who occupy space in our portfolio of consolidated properties. There are three key drivers for rental revenue: • Occupancy rate - Rental revenues are dependent on our ability to lease spaces to quality tenants. • Rental rate - Increased vacancy in the marketplace tends to drive down rental rates. As leases expire, we replace the existing leases with new leases at the current market rental rate. • Tenant retention - High customer retention leads to increased occupancy, less downtime between leases, and reduced leasing costs. We believe in and strive to create open communication with our customers and provide superior customer service. 22-------------------------------------------------------------------------------- Occupancy Rate Weighted Average Occupancy as of December 31, Property Type 2013 2012 Office properties 86 % 82 % Industrial properties 89 % 76 % Retail properties 88 % 79 % Residential / Multi-family properties 92 % 88 % Self storage properties 86 % 86 % In 2013, we were able to increase the weighted average occupancy rate for all property types over 2012, except for self-storage properties, for which the occupancy rate remained the same. We are currently in the process of aggressively marketing all vacated spaces, but cannot make any guarantees as to when we will find quality tenants or if we will experience a reduction in rental rates. Rental Rate Weighted Average Base Rent Per Occupied Square Foot as of December 31, Property Type 2013 2012 Office properties $ 16.25 $ 14.82 Industrial properties $ 4.02 $ 4.04 Retail properties $ 11.76 $ 10.04 Residential / Multi-family properties $ 11.79 $ 10.66 Self storage properties $ 6.46 $ 5.78 In 2013, we were able to increase the weighted average base rent per occupied square foot for all property types over 2012, except for industrial properties, whose base rate decreased slightly year over year. We do not anticipate rent rates to decline in the near term for these properties, and anticipate that our weighted average base rent will remain at its present level in the coming year. We are currently actively marketing our empty square footage but do not know when or at what rental rates we will be able to lease the vacant spaces. Tenant Retention Rate Third party management and leasing revenue. We derive these revenues from the fees charged to our third party clients for management services, tenant acquisition fees, leasing fees and loan advisory fees for arranging financing related to managed properties. If our third party clients elect to sell a property we manage, we will receive transaction fees and commissions relating to the sale of the property. Expenses Property operating expenses. Property operating expenses consist primarily of property taxes, insurance, repairs, maintenance, personnel costs and building service contracts. General and administrative expenses. General and administrative expenses consist primarily of personnel expenses for accounting, human resources, information technology, and corporate administration, as well as professional fees, including audit and legal fees. Depreciation and amortization expenses. Depreciation and amortization expenses consist primarily of depreciation associated with our real estate held for investment, amortization of purchased intangibles, depreciation of additional capital improvements, and the amortization of lease costs associated with consolidated properties. Interest expenses. Interest expenses consist primarily of the interest owed to creditors for debt associated with our consolidated portfolio of properties. 23-------------------------------------------------------------------------------- CRITICAL ACCOUNTING POLICIES The preparation of our consolidated financial statements in accordance with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting periods and the related disclosures in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate these estimates and judgments based on historical experiences and various other factors that are believed to reflect the current circumstances. While we believe our estimates, assumptions and judgments are reasonable, they are based on information presently available. Actual results may differ significantly from these estimates due to changes in judgments, assumptions and conditions as a result of unforeseen events or otherwise, which could have a material effect on our financial position or results of operations. We believe the following critical accounting policies reflect our most significant estimates, judgments and assumptions used in the preparation of our consolidated financial statements: • Variable Interest Entity (VIE) accounting • Business combinations • Investment in real estate assets • Assets held for sale • Discontinued operations • Sales of real estate assets • Fair value measurements • Impairment or assets • Income taxes. Variable Interest Entity Accounting Our determination of the appropriate accounting method with respect to our VIEs is based on Accounting Standards Update (ASU) 2009-17, "Consolidations (Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities." This ASU incorporates Statement of Financial Accounting Standards (SFAS) No. 167, "Amendments to FASB Interpretation No. 46(R)," issued by the Financial Accounting Standards Board, (FASB) in June 2009. The amendments in this ASU replace the quantitative-based risks and rewards calculation for determining which reporting entity, if any, has a controlling financial interest in a variable interest entity. This primarily qualitative approach focused on identifying which reporting entity has both (1) the power to direct the activities of a variable interest entity that most significantly impact such entity's economic performance and (2) the obligation to absorb losses or the right to receive benefits from such entity that could potentially be significant to such entity. The entity which satisfies these criteria is deemed to be the primary beneficiary of the VIE. We analyze our interests in VIEs to determine if we are the primary beneficiary. We consider a variety of factors in identifying the entity that holds the power to direct matters that most significantly impact the VIE's economic performance, including, but not limited to: (a) sign and enter into leases; set, distribute, and implement the capital budgets, the authority to refinance or sell the property within contractually defined limits, (b) the ability to receive fees that are significant to the property and (c) a necessity of funding any deficit cash flows. We consolidate any VIE of which we are the primary beneficiary. We determine whether an entity is a VIE and, if so, whether it should be consolidated, a judgment that is inherently subjective. We deconsolidate a VIE when we determine that we are no longer the primary beneficiary. For VIEs in which we own an insignificant interest, we deconsolidate the VIE by eliminating the accounts from the balance sheet with a corresponding offset to the equity of the non-controlling interest. Operations are recognized through the date of deconsolidation. Business Combinations We apply the provisions of FASB ASC Topic 805 to all transactions or events in which we obtain control of one or more businesses, including those effected without the transfer of consideration, for example, by contract or through a lapse of minority veto rights. These provisions require the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establish the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and require expensing of most transaction and restructuring costs. We determine and allocate the purchase price of an acquired company to the tangible and intangible assets acquired and liabilities assumed as of the business combination date. The purchase price allocation process requires us to use significant estimates and assumptions, including fair value estimates, as of the business combination date. We utilize third-party valuation companies to help us determine certain fair value estimates used for assets and liabilities. 24 -------------------------------------------------------------------------------- Additionally, the purchase price of the applicable property is allocated to the above or below market value of in-place leases and the value of in-place leases and related tenant relationships. The value allocable to the above or below market component of the acquired in-place leases is determined based upon the present value (using a discount rate which reflects the risks associated with the acquired leases) of the difference between (i) the contractual amounts to be paid pursuant to the lease over its remaining term, and (ii) our estimate of the amounts that would be paid using fair market rates over the remaining term of the lease. The amounts allocated to below market lease values are included in accrued and other liabilities in the accompanying consolidated balance sheets and are amortized to rental income over the remaining non-cancelable lease term plus any below market renewal options of the acquired leases with each property. While we use our best estimates and assumptions as a part of the purchase price allocation process to accurately value assets acquired and liabilities assumed at the business combination date, our estimates and assumptions are inherently uncertain and subject to refinement. As a result, during the purchase price allocation period, which is generally one year from the business combination date, we record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill. Investment in Real Estate Assets Rental properties are stated at cost net of accumulated depreciation unless circumstances indicate that cost, net of accumulated depreciation, cannot be recovered. Depreciation is provided using the straight-line method over the estimated useful lives of the respective assets. The useful lives are as follows: Building and Improvements 5 to 40 years Tenant Improvements Term of the related lease Furniture and Equipment 3 to 5 years We evaluate each of our real estate assets on a quarterly basis in order to determine the classification of each asset in our consolidated balance sheet. This evaluation requires judgment by us in considering certain criteria that must be evaluated under Topic 360: Property, Plant and Equipment, such as the estimated timeframe in which we expect to sell our real estate assets. The classification of real estate assets determines which real estate assets are to be depreciated as well as what method is used to evaluate and measure impairment. Had we evaluated our assets differently, the balance sheet classification of such assets, depreciation expense and impairment losses could have been different. Assets Held for Sale We classify assets as held for sale when: a) management approves the plan to sell the asset(s); b) the asset(s) are subject to a legally binding purchase and sale agreement; c) the buyer's due diligence period has expired; d) all other contingencies and conditions precedent to closing have been satisfied; and e) the sale and transfer is probable and expected within one year. If all of the required criteria are met, we discloses the property as properties held for sale and include the revenues and expenses from property operations in our Consolidated Statements of Operations as discontinued operations. Assets held for sale are carried at the lower of (i) net book value, or (ii) fair value less costs to sell. Discontinued Operations Topic 360 extends the reporting of a discontinued operation to a "component of an entity," and further requires that a component be classified as a discontinued operation if the operations and cash flows of the component have been or will be eliminated from the ongoing operations of the entity in the disposal transaction and the entity will not have any significant continuing involvement in the operations of the component after the disposal transaction. As defined in Topic 360, a "component of an entity" comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. Because each of our real estate assets is generally accounted for in a discrete subsidiary, many constitute a component of an entity under Topic 360, increasing the likelihood that the disposition of assets are required to be recognized and reported as operating profits and losses on discontinued operations in the periods in which they occur. The evaluation of whether the component's cash flows have been eliminated and the level of our continuing involvement require judgment by us and a different assessment could result in items not being reported as discontinued operations. Sales of Real Estate Assets Gains on property sales are recognized in full when real estate is sold, provided (i) the gain is determinable, that is, the collectability of the sales price is reasonably assured or the amount that will not be collectible can be estimated, and (ii) the earnings process is virtually complete, that is, we are not obligated to perform significant activities after the sale to earn the gain. Losses on property sales are recognized immediately. 25 -------------------------------------------------------------------------------- Fair Value Measurements Our acquisitions require the application of purchase accounting, which results in tangible and identifiable intangible assets and liabilities of the acquired entity being recorded at fair value. The difference between the purchase price and the fair value of net assets acquired is recorded as goodwill. In determining the fair values of assets and liabilities acquired in a business combination, we use a variety of valuation methods including present value, depreciated replacement cost, market values (where available) and selling prices less costs to dispose. We are responsible for determining the valuation of assets and liabilities and for the allocation of purchase price to assets acquired and liabilities assumed. Assumptions must often be made in determining fair values, particularly where observable market values do not exist. Assumptions may include discount rates, growth rates, cost of capital, royalty rates, tax rates and remaining useful lives. These assumptions can have a significant impact on the value of identifiable assets and accordingly can impact the value of goodwill recorded. Different assumptions could result in different values being attributed to assets and liabilities. Since these values impact the amount of annual depreciation and amortization expense, different assumptions could also impact our statement of operations and could impact the results of future impairment reviews. Impairment of Assets Goodwill is assessed for impairment annually when events or changes in circumstances indicate potential impairment. We may first assess qualitative factors to determine whether it is more-likely-than-not that the carrying value of a reporting unit exceeds its fair value. If this assessment indicates that it is more-likely-than-not that the carrying value of a reporting unit exceeds its fair value, a two-step quantitative assessment will be completed. The first step used to identify potential impairment involves comparing each reporting unit's estimated fair value to its carrying value, including goodwill. We use a discounted cash flow approach to estimate the fair value of our reporting units. Management judgment is required in developing the assumptions for the discounted cash flow model. These assumptions include revenue growth rates, profit margin percentages, discount rates, etc. If the estimated fair value of a reporting unit exceeds its carrying value, goodwill is considered to not be impaired. If the carrying value exceeds estimated fair value, there is an indication of potential impairment and the second step is performed to measure the amount of impairment. The second step of the process involves the calculation of an implied fair value of goodwill for each reporting unit for which step one indicated impairment. The implied fair value of goodwill is determined similar to how goodwill is calculated in a business combination, by measuring the excess of the estimated fair value of the reporting unit as calculated in step one, over the estimated fair values of the individual assets, liabilities and identifiable intangibles as if the reporting unit was being acquired in a business combination. Due to the many variables inherent in the estimation of a business's fair value and the relative size of our goodwill, if different assumptions and estimates were used, it could have an adverse effect on our impairment analysis. Impairment indicators for our rental properties are assessed by property and include, but is not limited to, significant fluctuations in estimated net operating income, occupancy changes, rental rates and other market factors. When these indicators of impairment are present, real estate held for investment is evaluated for impairment and losses are recorded when undiscounted cash flows estimated to be generated by an asset or market comparisons are less than the asset's carrying amount. The amount of the impairment loss is calculated as the excess of the asset's carrying value over its fair value, which is determined using a discounted cash flow analysis, management estimates or market comparisons. Income Taxes We account for income taxes under the liability method whereby deferred tax asset or liability account balances are calculated at the balance sheet date using current tax laws and rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. Deferred tax assets and liabilities are determined based on temporary differences between income and expenses reported for financial reporting and tax reporting. We have assessed, using all available positive and negative evidence, the likelihood that the deferred tax assets will be recovered from future taxable income. An enterprise must use judgment in considering the relative impact of negative and positive evidence. The weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which it can be objectively verified. The more negative evidence that exists (i) the more positive evidence is necessary and (ii) the more difficult it is to support a conclusion that a valuation allowance is not needed for some portion, or all, of the deferred tax asset. Among the more significant types of evidence that we considered are: that future anticipated property sales will produce more than enough taxable income to realize the deferred tax asset; taxable income projections in future years; and whether the carry-forward period is so brief that it would limit realization of tax benefits. Historically, we have incurred taxable losses in years in which we do not sell any real estate assets for gains. We expect to sell real estate assets in the future and have determined that it is more likely than not that future taxable income, primarily from gains on the sales of real estate assets, will be sufficient to enable us to realize all of net deferred tax assets, as adjusted. 26 -------------------------------------------------------------------------------- The Company evaluates tax positions that have been taken or are expected to be taken in its tax returns, and records a liability for uncertain tax positions in accordance with ASC Topic 740, Income Taxes. Benefits from tax positions may only be recognized in the financial statements when it is more likely than not that the tax position will be sustained under examination by the appropriate taxing authority having full knowledge of all relevant information. When a tax position meets the more-likely-than-not recognition threshold it is measured at the largest amount of benefit that exceeds the fifty percent probability threshold for realization upon ultimate settlement. We account for interest and penalties related to uncertain tax positions as part of our provision for federal and state income taxes. Segments Operating segments are defined as components of an enterprise that engage in business activities that earn revenue, incur expenses and prepare financial information that is evaluated regularly by our chief operating decision maker in order to allocate resources and assess performance. In 2012, we operated as one segment that provided comprehensive real estate services to all geographic regions. During the first quarter of 2013, the Company reassessed its application of segment guidance and based on the expected performance of our operating segments, determined that it would be more appropriate to present our reporting units as two reportable segments: (i) real estate portfolio operations and (ii) integrated real estate services provided to third-parties. All inter-segment sales pricing is based on current market conditions. Unallocated corporate amounts include general expenses associated with managing our two reportable operating segments. In conjunction with this reassessment, we have revised our prior period presentation to present information for our segments. 27 -------------------------------------------------------------------------------- RESULTS OF OPERATIONS Revenues by Period The following table sets forth revenues for years ending December 31, 2013 and 2012, respectively and the change between periods: Year ended December 31, (in thousands, except percentages) 2013 2012 Change ($) Change (%) Rental revenue $ 39,226 $ 39,050 $ 176 0.5 Third party management and leasing revenue 3,441 3,060 381 12.5 The changes in revenues during 2013 as compared to 2012 were primarily due to the following: • Rental revenue increased by approximately $0.2 million for the year ended December 31, 2013 compared to the year ended December 31, 2012. Increases in the weighted average occupancy rate and the weighted average base rent per occupied square foot for most property types in 2013 over 2012 contributed to the increase in rental revenue. • Third party management and leasing revenue increased by approximately $0.4 million for the year ended December 31, 2013 compared to the year ended December 31, 2012. The increase was primarily due to an increase in the number of third party contracts to 33 units in 2013 from 21 units in 2012. Operating Expenses by Period The following table sets forth expenses for years ending December 31, 2013 and 2012, respectively and the percentage and dollar change between periods (in thousands, except for percentages): Year ended December 31, Favorable Favorable (Unfavorable) (Unfavorable) 2013 2012 Change ($) Change (%) Property operating expense 13,944 10,505 (3,439 ) (32.7 ) Corporate general and administrative 15,192 10,204 (4,988 ) (48.9 ) Depreciation and amortization 15,909 16,265 356 2.2 Interest expense 14,938 16,508 1,570 9.5 Impairment expense 1,844 982 (862 ) (87.8 ) The changes in operating expenses during the years ending December 31, 2013 and 2012, respectively were primarily due to the following: • For the year ended December 31, 2013, our property operating expenses increased $3.4 million or 33% from $10.5 million in 2012 to $13.9 million during the fiscal year ended December 31, 2013. The increase in operating expense was due to late fees and penalties on our notes payable ($0.8 million), higher repairs and maintenance costs ($0.7 million), late fees and premiums to vendors ($0.7 million), increases in insurance and property taxes ($0.4 million), higher legal and professional fees at the property level ($0.4 million), and increased payroll and other operating expenses( $0.4 million). • Corporate general and administrative expenses increased by $5.0 million for the year ended December 31, 2013 compared to the year ended December 31, 2012. The increase was primarily attributable to attorney fees and settlements related to 2013 litigation cases, (see Item 3 - Legal Proceedings) and higher insurance and payroll costs. • Depreciation and amortization expense decreased by $0.4 million for the year ended December 31, 2013 compared to the year ended December 31, 2012. The decrease in this expense is due to the reduction in property held for investment from 2012 to 2013. • During the year ended December 31, 2013 our interest expense declined approximately $1.6 million or 9.5% from $16.5 million in 2012 to $14.9 million during the same period in 2013. As of December 31, 2013, our notes payable totaled $263.4 million which represented a 15.8% decline from December 31, 2013. The $1.6 million decline in interest expense for our fiscal year ending in 2013 when compared to the same period in 2012 is due primarily to the reduction in notes payable which occurred from 2012 to the end of 2013. 28--------------------------------------------------------------------------------• Impairment expense increased by approximately $0.9 million. This increase was primarily attributable to the write-off of management contracts due to deconsolidation of VIE's. All of our expenses are significantly influenced by the properties we own and the number of VIEs which are consolidated. Other Income Statement Items by Period The following table sets forth our other income statement items for the years ending December 31, 2013 and 2012, respectively and the dollar and percentage change between periods (in thousands, except for percentages): Year ended December 31, Favorable Favorable (Unfavorable) (Unfavorable) 2013 2012 Change ($) Change (%) Interest income 6 125 (119 ) (95.2 ) Income (loss) from discontinued operations (654 ) 6,494 (7,148 ) (110.1 ) Net loss attributable to noncontrolling interests 1,414 3,199 (1,785 ) 55.8 Gain (loss) on extinguishment of debt 10,327 682 9,645 100.0 Loss on litigation settlement (3,928 ) - (3,928 ) N/A The changes in other income statement items during the year ending December 31, 2013 as compared to the year ending December 31, 2012 were primarily due to the following: • Income (loss) from discontinued operations for the the year ending December 31, 2013 includes the net gain from the disposition of four owned properties (Morenci Professional Park , 1501 Mockingbird, 2620/2630 Fountain View and 11500 NW Freeway), their net of tax operating results through the date of disposition as well as the operating results of University Fountains at Lubbock. Income (loss) for the year ended December 31, 2012 includes the net gain from the 11 properties disposed of in 2012 and the net operating loss from properties disposed or deconsolidated in 2012 and 2013. • Non-controlling interests consist of operating partnership unit holders other than us, the non-controlling interests in our partially owned properties, and the non-controlling interests in our VIEs held by others. The decrease in non-controlling interest was in large part attributable to a decrease in loss from our VIE's held by others between periods. • The gain on extinguishment of debt and loss on litigation settlement in 2013 were the result of an agreement to settle all outstanding disputes and litigation related to the 2010 acquisition of assets and business interests from Evergreen Realty Group, LLC and affiliate (see Item 3. - Legal Proceedings). LIQUIDITY AND CAPITAL RESOURCES The Company's business model is to acquire properties that require operational attention, physical improvement, repositioning or capital restructuring. The stated investment strategy is to acquire, improve and hold assets while looking for an opportunistic exit, enabling the Company to achieve its risk/return objectives. This business model relies on the acquisition, repositioning and sale of properties that require operational attention, physical improvement or capital restructuring. The process of repositioning acquired assets sometimes results in near-term operating losses until the individual assets can be stabilized and brought to an optimal operating level. Once this is achieved, the asset may be targeted as needed for disposition to recycle the Company's capital. This process places an operational emphasis on asset dispositions to demonstrate profitability. In preparing our financial statements, we perform an assessment of available resources in relation to our near-term liquid resources, maturing debt instruments and currently due obligations. Given our current financial position, we believe that there is a potential risk that we may not meet our existing and maturing obligations. Accordingly, we have performed an operational review, looking for areas where we could improve operating performance and have done an analysis of our portfolio to look for assets that could be liquidated as a means of generating liquidity to meet our obligations. Although there can be no assurances, we have developed a plan which is designed to address our liquidity issues in the short and long-term. (see Part II, Item 8. Consolidated Financial Statements and Supplementary Data, Note. 3 - Going Concern.) As of December 31, 2013, we had cash and cash equivalents of $2.6 million; our accounts payable and accrued liabilities totaled $8.9 million and $13.3 million, respectively. Approximately $53.69 million of our $263.39 million on notes payable which are outstanding as of December 31, 2013 will come due in 2014. In response to our liquidity challenges, we have developed a set of strategic objectives designed to increase cash flows from operating activities through the following initiatives: • Increased revenues through new syndication or joint venture acquisitions 29--------------------------------------------------------------------------------• Additional receivership assignments • Increased third-party management services • Reduced staffing and related operational expenses Since we began these initiatives in 2014, we anticipate a partial impact on 2014 earnings and the full impact to be reflected thereafter. As a means of generating additional liquidity in 2014 to meet our maturing debt obligations, management has increased the pace of asset sales and expects to continue the process into 2015. The current plan is to dispose of properties that will generate aggregate net sales revenue of approximately $57 million, reduce consolidated secured obligations by approximately $34 million, and provide liquidity to the Company. During 2014, we have completed the following dispositions: In January 2014, we sold Windrose Plaza for $5.75 million and received net sales proceeds of $5.42 million after selling expenses. In conjunction with the sale, we paid off the notes payable secured by Windrose Plaza, and other obligations, totaling approximately $5.1 million. We used the remaining proceeds to fund operations. In June 2014, we sold the property known as 2640/2650 Fountain View for $17.35 million. We received $4.58 million after payments to creditors totaling $12.67 million, and selling expenses of approximately $0.11 million. In October 2014, we sold our property located at 8100 Washington in Houston, Texas for $4.10 million and received net sales proceeds of $4.01 million. At the time of the sale, we also paid off the secured note payable in the amount of $1.49 million. Including closing adjustments for prorations and operating expense, we realized net proceeds of $2.33 million. In addition to planned sales of our properties, we continue to negotiate refinancing of properties allowing for reduced interest and monthly payments, as well as refinancing that will allow us to access funds from appreciated property values. The implementation of our management initiatives, the forecasted sales of real estate and the refinancing of loans are expected to address our liquidity needs in the near-term, and allow us to generate cash flows from operations to reduce our accounts payable and vendor obligations. We believe that our current operating plan is achievable given our demonstrated track record of property refinancing and sales at times when additional liquidity was required. We have taken the following additional steps to meet our liquidity needs: • We continually review the fair value of our assets in relation to market value and cash flows. Where we are unable to generate positive cash flows from property operations, and the achievable value of the property is less than the balance on the mortgage, we will consider a strategic default on the property's mortgage. • We will continue to focus on increasing occupancy rates and managing our cost structure. • We will continue to negotiate with our creditors for extended terms in order to manage our cash resources. During the first half of 2014, we obtained a $3.0 million loan to assist with liquidity needs. We intend to repay the loan upon the sale of our properties held for sale, however, we cannot assure the proceeds ultimately generated from the sale of any assets held for sale will meet our short-term or long-term cash needs. In conjunction with our settlement agreement with Dunham (see Item 3), we restructured the mandatory redemption provisions of the Series B Preferred issued to Dunham in December 2013 (see Note 14 - Capital Structure, Series B Preferred and Note 20 - Subsequent Events, Acquisition Litigation). Pursuant to the restated Articles Supplementary for the Series B Preferred, we are required to redeem the remaining $20.1 million shares of Series B Preferred held by Dunham as follows: (i) approximately $3.011 million, less any "Adjustments" (see definition of Adjustments in Note 14 - Capital Structure, Series B Preferred) received by the Series B Preferred holders, is payable to holders of the Company's Series B Preferred on or before December 1, 2014, (ii) approximately $7.025 million, less any Adjustments received by the Series B Preferred holders, is payable to holders of the Company's Series B Preferred on or before June 1, 2015, and (iii) the remainder of the liquidation preference less any Adjustments will be paid to fully redeem all the remaining outstanding share of the Company's Series B Preferred on or before December 1, 2015. Excluding any reductions for Adjustments and increases for unpaid accruing dividends, the anticipated final liquidation payment due to holders of the Company's Series B Preferred will be approximately $10.035 million on December 1, 2015. 30 --------------------------------------------------------------------------------As of December 31, 2013 we are in default on the notes listed below. The balances disclosed in the table below exclude additional fees that may be the result of non-payment, (in thousands): ASR Ownership Percentage Property Secured by: (%) Balance at December 31, 2013 (in thousands) Atrium 6430 100% $ 2,074 2640/2650 Fountain View 100% 12,632 800/888 Sam Houston Parkway 100% 4,223 2401 Fountain View Office Tower 50% 11,446 Northwest Spectrum Plaza 100% 4,490 Corporate - Unsecured (1) 100% 1,125 Total $ 35,990 ___________________________ (1) Comprised of a $1.0 million Corporate unsecured note - lender had initiated legal proceedings to collect; as of October 29, 2014, negotiation are in progress to settle this debt; and a $0.13 million Corporate unsecured note which matured in May 2012 and paid during October 2014. All of the properties securing the debt in default are held by consolidated, wholly-owned subsidiaries or consolidated VIEs. We do not guarantee these mortgages. All of the notes in default have payment acceleration clauses, and the lenders holding these notes could demand payment in full, including additional fees and interest. In January 2014, the Company filed voluntary petitions for reorganization under Chapter 11, Title 11 of the US Bankruptcy Code for three subsidiaries: ASR-8 Center LP (Northwest Spectrum Plaza), ASR-Parkway One & Two LP (800/888 Sam Houston Parkway), and ASR-Fountain View Place LP (2640/2650 Fountain View). The Company sought protection from the secured creditors in bankruptcy court as a means of preserving the Company's equity in the properties held by these subsidiaries since the creditors were seeking to foreclosure on the assets. Subsequently, in June 2014, the property held and ASR-Fountain View Place LP (2640/2650 Fountain View) was sold for $17.35 million and all creditors were paid in full. In addition, ASR-Parkway One & Two LP and ASR-8 Center LP filed plans of reorganization with the US Bankruptcy Court, which provided for the creditors of these two subsidiaries to be paid the full amount they were owed. ASR-Parkway One & Two LP entered into a new note with the existing secured creditor in the amount of $4.6 million, maturing June 30, 2015 at a fixed rate of interest of 4.25%. Similarly, the property held by ASR-8 Center LP entered into a new note with the lender for $4.9 million, maturing December 31, 2015, at a fixed interest rate of 4.25%. In July 2014, the secured lender foreclosed the property known as 6430 Richmond. The $2.05 million note payable secured by the property had matured in May of 2012 and could not be replaced under terms that were economically viable. The property and the corresponding note payable were held by a consolidated, wholly-owned subsidiary, and the Company did not guarantee the note payable. On September 30, 2014, the Company filed voluntary petitions for reorganization under Chapter 11, Title 11 of the US Bankruptcy Code for ASR 2401 Fountainview, LP, a subsidiary of the Company. The action was taken by the Company in response to foreclosure proceedings instituted by the secured creditor. The Company's management believes that the value of the property known as 2401 Fountainview can be preserved through either a plan of reorganization or orderly marketing and sale of the asset. Although there can be no assurances, the Company believes that the subsidiary will continue to operate as a "debtor in possession" in the ordinary course under the jurisdiction of the Bankruptcy Court. On February 14, 2014, at the request of Nextera Retail of Texas, LP ("Nextera"), the District Court of Harris County, Texas (the "Court") appointed a receiver in connection with a judgment against the Company. The action was the result of a vendor dispute that was settled by the Court in favor of Nextera, in the amount of $2.8 million. On February 20, 2014, the Company satisfied in full all obligations to Nextera, with a payment of $1.5 million and receivership costs of $0.15 million, and the District Court rescinded the order appointing the receiver. Day-to-day operations of the Company were not impacted, and satisfaction of the Nextera obligation did not have a material adverse effect on the operations or financial condition of the Company. DISCUSSION OF THE CONSOLIDATED STATEMENT OF CASH FLOWS 31 -------------------------------------------------------------------------------- Cash Flows from Operations During 2013, net cash used in operating activities totaled $1.5 million. Net cash provided by operating activities was $8.7 million in 2012. Consolidated net loss for 2013 totaled $15.2 million, compared to consolidated net loss of $1.8 million for 2012. Noncash items recognized in 2013 totaled $14.1 million, consisting primarily of depreciation and amortization expense ($17.2 million), loss on litigation settlement ($3.9 million), impairment ($1.9 million) and income tax expense ($1.9 million) partially offset by gain on extinguishment of debt ($10.3 million) and deferred rental income ($0.5 million). Noncash items recognized in 2012 totaled $8.8 million, consisting primarily of depreciation and amortization expense ($22.6 million), impairment ($1.0 million) and income tax expense ($1.0 million) partially offset by gain on disposition of real estate assets ($15.1 million) and deferred rental income ($0.7 million). During 2013 changes in working capital used $0.4 million in cash, primarily consisting of changes in restricted cash ($3.5 million) and higher prepaid and other assets ($1.6 million) and higher receivables ($0.9 million), partially offset by higher accounts payables ($3.4 million) and higher accrued and other liabilities ($2.2 million). During 2012 changes in working capital provided $1.7 million million in cash, primarily consisting of higher accounts payables ($1.8 million) and higher accrued and other liabilities ($2.8 million), partially offset by higher prepaid and other assets ($2.7 million), changes in restricted cash ($0.1 million)and higher receivables ($0.1 million). Cash Flows from Investing Activities During 2013 and 2012, investing activities provided cash of $7.9 million and $41.4 million respectively. Proceeds from the sale of real estate assets were $8.9 million and $42.9 million, respectively. Cash flows from investing activities in 2013 and 2012 were partially offset by capital expenditures of $1.0 million and $1.5 million, respectively. Cash Flows from Financing During 2013, financing activities used net cash of $8.0 million, primarily consisting of payments on borrowings of ($26.1 million) and distributions to noncontrolling interests ($8.2 million), partially offset by proceeds from borrowings ($26.3 million). During 2012, financing activities used net cash of $50.4 million. The primary uses of cash for financing activities were the payments on borrowings of $64.6 million and distributions to noncontrolling interests of $7.7 million. Cash outflows for financing activities were partially offset by proceeds from borrowings of $19.9 million and contributions from noncontrolling interests of $2.0 million INFLATION Inflation has not had a significant impact on our financial results because of the relatively low inflation rate in our geographic areas of operation. Additionally, most of our leases require the customers to pay their pro rata share of operating expenses, including common area maintenance, real estate taxes, utilities and insurance, thereby reducing our exposure to increases in operating expenses resulting from inflation. |