TMCnet News
PHILLIPS EDISON - ARC GROCERY CENTER REIT II, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Note Regarding Forward-Looking Statements Certain statements contained in this Quarterly Report on Form 10-Q of Phillips Edison - ARC Grocery Center REIT II, Inc. ("we", the "Company", "our" or "us") other than historical facts may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). We intend for all such forward-looking statements to be covered by the applicable safe harbor provisions for forward-looking statements contained in those acts. Such statements include, in particular, statements about our plans, strategies, and prospects and are subject to certain risks and uncertainties, including known and unknown risks, which could cause actual results to differ materially from those projected or anticipated. Therefore, such statements are not intended to be a guarantee of our performance in future periods. Such forward-looking statements can generally be identified by our use of forward-looking terminology such as "may," "will," "expect," "intend," "anticipate," "estimate," "believe," "continue," or other similar words. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date this report is filed with the U.S. Securities and Exchange Commission ("SEC"). We make no representations or warranties (express or implied) about the accuracy of any such forward-looking statements contained in this Quarterly Report on Form 10-Q, and we do not intend to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Any such forward-looking statements are subject to risks, uncertainties, and other factors and are based on a number of assumptions involving judgments with respect to, among other things, future economic, competitive, and market conditions, all of which are difficult or impossible to predict accurately. To the extent that our assumptions differ from actual conditions, our ability to accurately anticipate results expressed in such forward-looking statements, including our ability to generate positive cash flow from operations, make distributions to stockholders, and maintain the value of our real estate properties, may be significantly hindered. See Item 1A in Part II of this Form 10-Q and Item 1A in Part I of our Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC on March 6, 2014, for a discussion of some of the risks and uncertainties, although not all of the risks and uncertainties, that could cause actual results to differ materially from those presented in our forward-looking statements. Overview Organization The Company was formed as a Maryland corporation on June 5, 2013, and intends to qualify as a REIT beginning with the taxable year ending December 31, 2014. We are offering to the public, pursuant to a registration statement, $2.475 billion in shares of common stock on a "reasonable best efforts" basis in our initial public offering. Our initial public offering consists of a primary offering of $2.0 billion in shares offered to investors at a price of $25.00 per share, with discounts available for certain categories of purchasers, and $475 million in shares offered to stockholders pursuant to a distribution reinvestment plan (the "DRIP") at a price of $23.75 per share. We have the right to reallocate the shares of common stock offered between the primary offering and the DRIP. On November 25, 2013, the registration statement for our offering was declared effective under the Securities Act of 1933, and on January 9, 2014, we broke the minimum offering escrow requirement of $2.0 million. Prior to January 9, 2014, our operations had not yet commenced. Our advisor is American Realty Capital PECO II Advisors, LLC (the "Advisor"), a newly organized limited liability company that was formed in the State of Delaware on July 9, 2013 that is under common control with AR Capital LLC. We have entered into an advisory agreement with the Advisor which makes the Advisor ultimately responsible for the management of our day-to-day activities and the implementation of our investment strategy. The Advisor has delegated certain duties under the advisory agreement, including the management of our day-to-day operations and our portfolio of real estate assets, to Phillips Edison NTR II LLC (the "Sub-advisor"), which is directly or indirectly owned by Phillips Edison Limited Partnership (the "Phillips Edison sponsor"), and Michael Phillips and Jeffrey Edison, principals of our Phillips Edison sponsor. Notwithstanding such delegation to the Sub-advisor, the Advisor retains ultimate responsibility for the performance of all the matters entrusted to it under the advisory agreement. We plan to continue investing primarily in well-occupied grocery-anchored neighborhood and community shopping centers leased to a mix of national, creditworthy retailers selling necessity-based goods and services in strong demographic markets throughout the United States. In addition, we may invest in other retail properties including power and lifestyle shopping centers, multi-tenant shopping centers, free-standing single-tenant retail properties, and other real estate and real estate-related loans and securities depending on real estate market conditions and investment opportunities that we determine are in the best 19 -------------------------------------------------------------------------------- interests of our stockholders. We expect that retail properties primarily would underlie or secure the real estate-related loans and securities in which we may invest. Equity Raise Activity As of September 30, 2014, we had issued pursuant to our initial public offering a total of 17.1 million shares of common stock, including 0.1 million shares issued through the DRIP, generating gross cash proceeds of $425.7 million. During the three months ended September 30, 2014, we issued 8.2 million shares of common stock, including 0.1 million shares issued through the DRIP, generating gross cash proceeds of $204.0 million. Portfolio Below are statistical highlights of our portfolio's activities from inception to date, as of September 30, 2014: Property Acquisitions Cumulative during the Portfolio through Three Months Ended September 30, 2014 September 30, 2014 Number of properties 8 6 Number of states 5 3 Weighted average capitalization rate(1) 6.7 % 6.7 % Weighted average capitalization rate with straight-line rent(2) 7.0 % 6.8 % Total acquisition purchase price (in thousands) $ 116,317 $ 87,966 Total square feet 720,725 558,786 Leased % of rentable square feet(3) 91.8 % 90.3% Average remaining lease term in years(3) 5.3 4.2 (1) The capitalization rate is calculated by dividing the annualized in-place net operating income of a property as of the date of acquisition by the contract purchase price of the property. Annualized in-place net operating income is calculated by subtracting the estimated annual operating expenses of a property from the annualized rents to be received from tenants occupying space at the property as of the date of acquisition. (2) The capitalization rate with straight-line rent is calculated by dividing the annualized in-place net operating income, inclusive of straight-line rental income, of a property as of the date of acquisition by the contract purchase price of the property. This annualized in-place net operating income is calculated by subtracting the estimated annual operating expenses of a property from the straight-line annualized rents to be received from tenants occupying space at the property as of the date of acquisition. (3) As of September 30, 2014. As of September 30, 2014, we owned eight real estate properties, acquired from third parties unaffiliated with us, the Advisor, or the Sub-advisor. The following table presents information regarding our properties as of September 30, 2014 (dollars in thousands): Average % of Remaining Rentable Lease Square Term in Feet Years as Leased as Contract Rentable of of Date Purchase Square September September Property Name Location Anchor Tenant Acquired Price(1) Feet 30, 2014 30, 2014 Bethany Village Alpharetta, Shopping Center GA Publix 3/14/2014 $ 11,151 81,674 4.9 93.3 % Staunton Plaza Staunton, VA Martin's(2) 4/30/2014 17,200 80,265 10.6 100.0 % United Northpark Village Lubbock, TX Supermarkets(3) 7/25/2014 8,200 70,479 4.2 95.3 % Spring Cypress Village Houston, TX Sprouts 7/30/2014 21,400 97,488 6.8 79.0 % Kipling Littleton, Marketplace CO Safeway 8/7/2014 12,350 90,124 3.0 95.7 % Lake Washington Melbourne, Crossing FL Publix 8/15/2014 13,400 118,698 3.9 86.2 % MetroWest Village Orlando, FL Publix 8/20/2014 18,616 106,977 3.1 92.9 % Sun City Kings Crossing Center, FL Publix 8/26/2014 14,000 75,020 4.0 97.1 % (1) The contract purchase price excludes closing costs and acquisition costs. (2) Martin's is an affiliate of Ahold USA. (3) United Supermarkets is an affiliate of Albertsons LLC. 20-------------------------------------------------------------------------------- The following table lists, on an aggregate basis, all of the scheduled lease expirations after September 30, 2014 over each of the ten years ending December 31, 2014 and thereafter for our eight shopping centers. The table shows the approximate rentable square feet and annualized effective rent represented by the applicable lease expirations (dollars in thousands): Number of % of Total Portfolio Expiring Annualized Annualized Leased Rentable % of Leased Rentable Square Feet Year Leases Effective Rent(1) Effective Rent Expiring Square Feet Expiring 2014 9 $ 419 5.0% 21,429 3.2% 2015 23 1,090 12.9% 86,543 13.1% 2016 26 843 10.0% 47,767 7.2% 2017 16 719 8.5% 69,461 10.5% 2018 19 1,383 16.4% 108,906 16.5% 2019 12 452 5.4% 22,575 3.4% 2020 5 930 11.0% 109,971 16.6% 2021 3 537 6.4% 59,447 9.0% 2022 1 27 0.3% 1,100 0.2% 2023 2 167 2.0% 12,377 1.9% Thereafter 6 1,873 22.1% 121,674 18.4% (1) We calculate annualized effective rent as monthly contractual rent as of September 30, 2014 multiplied by 12 months, less any tenant concessions. Subsequent to September 30, 2014, we executed renewals on two leases that were scheduled to expire in 2014. The square footage associated with these renewals was 4,579 and the annualized rent was $95,000. Portfolio Tenancy Prior to the acquisition of a property, we assess the suitability of the grocery-anchor tenant and other tenants in light of our investment objectives, namely, preserving capital and providing stable cash flows for distributions. Generally, we assess the strength of the tenant by consideration of company factors, such as its financial strength and market share in the geographic area of the shopping center, as well as location-specific factors, such as the store's sales, local competition and demographics. When assessing the tenancy of the non-anchor space at the shopping center, we consider the tenant mix at each shopping center in light of our portfolio, the proportion of national and national franchise tenants, the creditworthiness of specific tenants, and the timing of lease expirations. When evaluating non-national tenancy, we attempt to obtain credit enhancements to leases, which typically come in the form of deposits and/or guarantees from one or more individuals. The following table presents the composition of our portfolio by tenant type as of September 30, 2014 (dollars in thousands): Annualized % of Leased % of Leased Effective Annualized Tenant Type Square Feet Square Feet Rent(1) Effective Rent Grocery anchor 389,655 58.9 % $ 3,742 44.3 % National and regional(2) 146,606 22.2 % 2,449 29.0 % Local 124,989 18.9 % 2,250 26.7 % 661,250 100.0 % $ 8,441 100.0 % (1) We calculate annualized effective rent as monthly contractual rent as of September 30, 2014 multiplied by 12 months, less any tenant concessions. (2) We define national tenants as those that operate in at least three states. Regional tenants are defined as those that have at least three locations. 21 --------------------------------------------------------------------------------The following table presents the composition of our portfolio by tenant industry as of September 30, 2014 (dollars in thousands): Annualized % of Leased % of Leased Effective Annualized Tenant Industry Square Feet Square Feet Rent(1) Effective Rent Grocery 389,655 58.9 % $ 3,742 44.3 % Services(2) 126,730 19.2 % 2,102 24.9 % Restaurant 82,653 12.5 % 1,690 20.0 % Retail Stores(2) 62,212 9.4 % 907 10.8 % 661,250 100.0 % $ 8,441 100.0 % (1) We calculate annualized effective rent as monthly contractual rent as of September 30, 2014 multiplied by 12 months, less any tenant concessions. (2) We define retail stores as those that primarily sell goods, while services tenants primarily sell non-goods services. The following table presents our grocery-anchor tenants by the amount of square footage leased by each tenant as of September 30, 2014 (dollars in thousands): Leased Number of Square % of Leased Annualized % of Annualized Tenant Locations(1) Feet Square Feet Effective Rent(2) Effective Rent Publix 4 191,444 29.0 % $ 1,481 17.6 % Ahold USA(3) 1 68,716 10.4 % 1,146 13.6 % Safeway 1 50,794 7.7 % 381 4.5 % Albertsons(4) 1 50,700 7.6 % 342 4.0 % Sprouts 1 28,001 4.2 % 392 4.6 % 8 389,655 58.9 % $ 3,742 44.3 % (1) Number of locations excludes auxiliary leases with grocery anchors such as fuel stations, pharmacies, and liquor stores, of which there were two as of September 30, 2014. (2) We calculate annualized effective rent as monthly contractual rent as of September 30, 2014 multiplied by 12 months, less any tenant concessions. (3) Martin's is an affiliate of Ahold USA. (4) United Supermarkets is an affiliate of Albertsons LLC. Results of Operations Prior to January 9, 2014, our operations had not yet commenced. As a result, the discussions of the results of operations are only for the three and nine months ended September 30, 2014, with no prior period comparisons provided in the accompanying sections. Three Months Ended September 30, 2014 Total revenues were approximately $2.0 million, with rental income of approximately $1.5 million. Other revenue, largely comprised of tenant reimbursements, was approximately $0.4 million. Property operating costs were $0.3 million for the three months ended September 30, 2014. The significant items comprising this expense were common area maintenance of $0.2 million and property management fees paid to an affiliate of the Sub-advisor of $0.1 million. Real estate taxes were $0.3 million for the three months ended September 30, 2014. General and administrative expenses were approximately $0.4 million. This amount was comprised largely of audit and consulting fees, directors and officers insurance premiums, and board-related expenses. Acquisition expenses, in the amount of approximately $1.5 million, were expensed as incurred. Included in these acquisition expenses were fees and expenses reimbursable to the Advisor and Sub-advisor of $1.0 million as well as $0.4 million in other 22 -------------------------------------------------------------------------------- acquisition expenses owed to third-parties, all related to property acquisitions occurring in the three months ended September 30, 2014. We incurred $0.1 million in expense related to acquisitions that had not closed as of September 30, 2014. Depreciation and amortization expense for the three months ended September 30, 2014 was $0.9 million. Interest expense was $0.5 million for the three months ended September 30, 2014. The net loss attributable to our stockholders was $1.9 million for the three months ended September 30, 2014. Nine Months Ended September 30, 2014 Total revenues were approximately $2.5 million, with rental income of approximately $2.0 million. Other revenue, largely comprised of tenant reimbursements, was approximately $0.5 million. Property operating costs were $0.4 million for the nine months ended September 30, 2014. The significant items comprising this expense were common area maintenance of $0.2 million, insurance expenses of $0.1 million, and property management fees paid to an affiliate of the Sub-advisor of $0.1 million. Real estate taxes were $0.3 million for the nine months ended September 30, 2014. General and administrative expenses were approximately $1.0 million. This amount was comprised largely of audit and consulting fees, directors and officers insurance premiums, and board-related expenses. Acquisition expenses, in the amount of approximately $2.1 million, were expensed as incurred. Included in these acquisition expenses were fees and expenses reimbursable to the Advisor and Sub-advisor of $1.3 million, as well as $0.7 million in other acquisition expenses owed to third-parties, all related to property acquisitions occurring in the nine months ended September 30, 2014. We incurred $0.1 million in expense related to acquisitions that had not closed as of September 30, 2014. Depreciation and amortization expense for the nine months ended September 30, 2014 was $1.2 million. Interest expense was $0.6 million for the nine months ended September 30, 2014. The net loss attributable to our stockholders was $3.0 million for the nine months ended September 30, 2014. We generally expect our revenues and expenses to increase in future years as a result of owning the properties acquired in 2014 for a full year and the acquisition of additional properties. Although we expect our general and administrative expenses to increase, we expect such expenses to decrease as a percentage of our revenues. We currently have substantial uninvested proceeds raised from our initial public offering, which we are seeking to invest promptly on attractive terms. If we are unable to invest the proceeds promptly and on attractive terms, we may have difficulty continuing to pay distributions at a 6.5% annualized rate. Non-GAAP Measures Funds from Operations, Funds from Operations Adjusted for Acquisition Expenses, and Modified Funds from Operations Funds from operations, or FFO, is a non-GAAP performance financial measure that is widely recognized as a measure of REIT operating performance. We use FFO as defined by NAREIT to be net income (loss), computed in accordance with GAAP excluding extraordinary items, as defined by GAAP, and gains (or losses) from sales of property (including deemed sales and settlements of pre-existing relationships), plus depreciation and amortization on real estate assets and impairment charges, and after related adjustments for unconsolidated partnerships, joint ventures and subsidiaries and noncontrolling interests. We believe that FFO is helpful to our investors and our management as a measure of operating performance because it excludes real estate-related depreciation and amortization, gains and losses from property dispositions, impairment charges, and extraordinary items, and as a result, when compared year to year, reflects the impact on operations from trends in occupancy rates, rental rates, operating costs, development activities, general and administrative expenses, and interest costs, which are not immediately apparent from net income. Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate and intangibles diminishes predictably over time, especially if such assets are not adequately maintained or repaired and renovated as required by relevant circumstances and/or are requested or required by lessees for operational purposes in order to maintain the value disclosed. Since real estate values have historically risen or fallen with market conditions, including inflation, changes in interest rates, the business cycle, unemployment and consumer 23 -------------------------------------------------------------------------------- spending, many industry investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting alone to be insufficient. As a result, our management believes that the use of FFO, together with the required GAAP presentations, is helpful for our investors in understanding our performance. In particular, because GAAP impairment charges are not allowed to be reversed if the underlying fair values improve or because the timing of impairment charges may lag the onset of certain operating consequences, we believe FFO provides useful supplemental information related to current consequences, benefits and sustainability related to rental rate, occupancy and other core operating fundamentals. Additionally, we believe it is appropriate to exclude impairment charges from FFO, as these are fair value adjustments that are largely based on market fluctuations and assessments regarding general market conditions which can change over time. Factors that impact FFO include start-up costs, fixed costs, delay in buying assets, lower yields on cash held in accounts, income from portfolio properties and other portfolio assets, interest rates on acquisition financing and operating expenses. In addition, FFO will be affected by the types of investments in our targeted portfolio which will consist of, but is not limited to, necessity-based neighborhood and community shopping centers, first- and second-priority mortgage loans, mezzanine loans, bridge and other loans, mortgage-backed securities, collateralized debt obligations, and debt securities of real estate companies. An asset will only be evaluated for impairment if certain impairment indicators exist and if the carrying or book value exceeds the total estimated undiscounted future cash flows (including net rental and lease revenues, net proceeds on the sale of the property, and any other ancillary cash flows at a property or group level under GAAP) from such asset. Investors should note, however, that determinations of whether impairment charges have been incurred are based partly on anticipated operating performance, because estimated undiscounted cash flows from a property, including estimated future net rental and lease revenues, net proceeds on the sale of the property, and certain other ancillary cash flows, are taken into account in determining whether an impairment charge has been incurred. While impairment charges are excluded from the calculation of FFO as described above, as impairments are based on estimated future undiscounted cash flows, investors are cautioned that we may not recover any impairment charges. FFO is not a useful measure in evaluating net asset value because impairments are taken into account in determining net asset value but not in determining FFO. Since the definition of FFO was promulgated by NAREIT, GAAP has expanded to include several new accounting pronouncements, such that management and many investors and analysts have considered the presentation of FFO alone to be insufficient. Accordingly, in addition to FFO, we use both FFO adjusted for acquisition expenses and modified funds from operations, or MFFO, as defined by the Investment Program Association, or IPA. FFO adjusted for acquisition expenses excludes acquisition fees and expenses from FFO. In addition to excluding acquisition fees and expenses, MFFO also excludes from FFO the following items: (1) straight-line rent amounts, both income and expense; (2) amortization of above- or below-market intangible lease assets and liabilities; (3) amortization of discounts and premiums on debt investments; (4) gains or losses from the early extinguishment of debt; (5) gains or losses on the extinguishment or sales of hedges, foreign exchange, securities and other derivatives holdings except where the trading of such instruments is a fundamental attribute of our operations; (6) gains or losses related to fair-value adjustments forderivatives not qualifying for hedge accounting, including interest rate and foreign exchange derivatives; (7) gains or losses related to consolidation from, ordeconsolidation to, equity accounting; (8) gains or losses related to contingent purchase price adjustments; and (9) adjustments related to the above items for unconsolidated entities in the application of equity accounting. We believe that both FFO adjusted for acquisition expenses and MFFO are helpful in assisting management and investors with the assessment of the sustainability of operating performance in future periods and, in particular, after our offering and acquisition stages are complete, because both FFO adjusted for acquisition expenses and MFFO exclude acquisition expenses that affect property operations only in the period in which the property is acquired. Thus, FFO adjusted for acquisition expenses and MFFO provide helpful information relevant to evaluating our operating performance in periods in which there is no acquisition activity. In evaluating investments in real estate, including both business combinations and investments accounted for under the equity method of accounting, management's investment models and analyses differentiate costs to acquire the investment from the operations derived from the investment. Prior to 2009, acquisition costs for both of these types of investments were capitalized 24 -------------------------------------------------------------------------------- under GAAP; however, beginning in 2009, acquisition costs related to business combinations are expensed. We have funded, and intend to continue to fund, both of these acquisition-related costs from the offering proceeds and borrowings and generally not from operations. However, if offering proceeds and borrowings are not available to fund these acquisition-related costs, operational cash flows may be used to fund future acquisition-related costs. We believe by excluding expensed acquisition costs, FFO adjusted for acquisition expenses and MFFO provide useful supplemental information that is comparable for each type of real estate investment and is consistent with management's analysis of the investing and operating performance of our properties. Acquisition fees and expenses include those paid to the Advisor, the Sub-advisor or third parties. As explained below, management's evaluation of our operating performance excludes the additional items considered in the calculation of MFFO based on the following economic considerations. Many of the adjustments in arriving at MFFO are not applicable to us. Nevertheless, we explain below the reasons for each of the adjustments made in arriving at our MFFO definition. • Adjustments for straight-line rents and amortization of discounts and premiums on debt investments. In the proper application of GAAP, rental receipts and discounts and premiums on debt investments are allocated to periods using various systematic methodologies. This application may result in income recognition that could be significantly different than underlying contract terms. By adjusting for these items, MFFO provides useful supplemental information on the realized economic impact of lease terms and debt investments and aligns results with management's analysis of operating performance. The adjustment to MFFO for straight-line rents, in particular, is made to reflect rent and lease payments from a GAAP accrual basis to a cash basis. • Adjustments for amortization of above- or below-market intangible lease assets. Similar to depreciation and amortization of other real estate related assets that are excluded from FFO, GAAP implicitly assumes that the value of intangibles diminishes ratably over time and that these charges be recognized currently in revenue. Since real estate values and market lease rates in the aggregate have historically risen or fallen with market conditions, management believes that by excluding these charges, MFFO provides useful supplemental information on the performance of the real estate. • Gains or losses related to fair-value adjustments for derivatives not qualifying for hedge accounting and gains or losses related to contingent purchase price adjustments. Each of these items relates to a fair value adjustment, which is based on the impact of current market fluctuations and underlying assessments of general market conditions and specific performance of the holding, which may not be directly attributable to current operating performance. As these gains or losses relate to underlying long-term assets and liabilities, management believes MFFO provides useful supplemental information by focusing on the changes in core operating fundamentals rather than changes that may reflect anticipated gains or losses. • Adjustment for gains or losses related to early extinguishment of hedges, debt, consolidation or deconsolidation and contingent purchase price. Similar to extraordinary items excluded from FFO, these adjustments are not related to continuing operations. By excluding these items, management believes that MFFO provides supplemental information related to sustainable operations that will be more comparable between other reporting periods and to other real estate operators. By providing FFO adjusted for acquisition expenses and MFFO, we believe we are presenting useful information that also assists investors and analysts to better assess the sustainability (that is, the capacity to continue to be maintained) of our operating performance after our offering and acquisition stages are completed. We also believe that MFFO is a recognized measure of sustainable operating performance by the non-listed REIT industry. However, under GAAP, acquisition costs are characterized as operating expenses in determining operating net income (loss). These expenses are paid in cash by us, and therefore such funds will not be available to distribute to investors. FFO adjusted for acquisition expenses and MFFO are useful in comparing the sustainability of our operating performance after our offering and acquisition stages are completed with the sustainability of the operating performance of other real estate companies that are not as involved in acquisition activities. However, investors are cautioned that FFO adjusted for acquisition expenses and MFFO should only be used to assess the sustainability of our operating performance after our offering and acquisition stages are completed, as both measures exclude acquisition costs that have a negative effect on our operating performance during the periods in which properties are acquired. All paid and accrued acquisition costs negatively impact our operating performance during the period in which properties are acquired and will have negative effects on returns to investors, the potential for future distributions, and cash flows generated, unless earnings from operations or net sales proceeds from the disposition of other properties are generated to cover the purchase prices of the properties we acquire. Therefore, MFFO may not be an accurate indicator of our operating performance, especially during periods in which properties are being acquired. MFFO that excludes such costs and expenses would only be comparable to that of non-listed REITs that have completed their acquisition activities and have similar operating characteristics as us. The purchase of properties, and the corresponding expenses associated with that process, is a key 25 -------------------------------------------------------------------------------- operational feature of our business plan to generate operational income and cash flows in order to make distributions to investors. In the event that we are unable to raise any additional proceeds from the sale of shares in our initial offering, we may still be obligated to pay acquisition fees and reimburse acquisition expenses to our Advisor and Sub-Advisor and the Advisor and Sub-Advisor will be under no obligation to reimburse these payments back to us. As a result, such fees and expenses may need to be paid from other sources, including additional debt, operational earnings or cash flows, net proceeds from the sale of properties or from ancillary cash flows. Acquisition costs also adversely affect our book value and equity. The additional items that may be excluded from FFO to determine MFFO are cash flow adjustments made to net income (loss) in calculating the cash flows provided by operating activities. Each of these items is considered an important overall operational factor that affects our long-term operational profitability. These items and any other mark-to-market or fair value adjustments may be based on many factors, including current operational or individual property issues or general market or overall industry conditions. While we are responsible for managing interest rate, hedge and foreign exchange risk, we intend to retain an outside consultant to review any hedging agreements that we may enter into in the future. Inasmuch as interest rate hedges are not a fundamental part of our operations, we believe it is appropriate to exclude such gains and losses in calculating MFFO, as such gains and losses are not reflective of ongoing operations. Each of FFO, FFO adjusted for acquisition expenses, and MFFO should not be considered as an alternative to net income (loss) or income (loss) from continuing operations under GAAP, or as an indication of our liquidity, nor is any of these measures indicative of funds available to fund our cash needs, including our ability to fund distributions. In particular, as we are currently in the acquisition phase of our life cycle, acquisition-related costs and other adjustments that are increases to FFO adjusted for acquisition expenses and MFFO are, and may continue to be, a significant use of cash. MFFO has limitations as a performance measure in an offering such as ours where the price of a share of common stock is a stated value and there is no current net asset value determination. Additionally, FFO adjusted for acquisition expenses, and MFFO may not be a useful measure of the impact of long-term operating performance on value if we do not continue to operate our business plan in the manner currently contemplated. Accordingly, FFO, FFO adjusted for acquisition expenses, and MFFO should be reviewed in connection with other GAAP measurements. FFO, FFO adjusted for acquisition expenses, and MFFO should not be viewed as more prominent measures of performance than our net income or cash flows from operations prepared in accordance with GAAP. Our FFO, FFO adjusted for acquisition expenses, and MFFO as presented may not be comparable to amounts calculated by other REITs. Neither the SEC, NAREIT nor any other regulatory body has passed judgment on the acceptability of the adjustments that we use to calculate FFO adjusted for acquisition expenses or MFFO. In the future, the SEC, NAREIT or another regulatory body may decide to standardize the allowable adjustments across the non-listed REIT industry and we may have to adjust our calculation and characterization of FFO, FFO adjusted for acquisition expenses or MFFO. The following section presents our calculation of FFO, FFO adjusted for acquisition expenses, and MFFO and provides additional information related to our operations. As a result of the timing of the commencement of our initial public offering and our active real estate operations, FFO, FFO adjusted for acquisition expenses, and MFFO are not relevant to a discussion comparing operations for the period presented. We expect revenues and expenses to increase in future periods as we raise additional offering proceeds and use them to acquire additional investments. 26 -------------------------------------------------------------------------------- FFO, FFO ADJUSTED FOR ACQUISITION EXPENSES, AND MFFO FOR THE PERIOD ENDED SEPTEMBER 30, 2014 (Unaudited) (Amounts in thousands, except per share amounts) Three Months Ended Nine Months Ended September 30, 2014 September 30, 2014 Calculation of FFO Net loss $ (1,921 ) $ (3,029 ) Add: Depreciation and amortization of real estate assets 930 1,186 FFO $ (991 ) $ (1,843 ) Calculation of FFO Adjusted for Acquisition Expenses Funds from operations $ (991 ) $ (1,843 ) Add: Acquisition expenses 1,494 2,080 FFO adjusted for acquisition expenses $ 503 $ 237 Calculation of MFFO FFO adjusted for acquisition expenses $ 503 $ 237 Less: Net amortization of above- and below-market leases (42 ) (8 ) Straight-line rental income (46 ) (89 ) Amortization of market debt adjustment (3 ) (6 ) MFFO $ 412 $ 134 Weighted-average common shares outstanding - basic and diluted 13,101 6,826 Net loss per share - basic and diluted $ (0.15 ) $ (0.44 ) FFO per share - basic and diluted $ (0.08 ) $ (0.27 ) FFO adjusted for acquisition expenses per share - basic and diluted $ 0.04 $ 0.03 MFFO per share - basic and diluted $ 0.03 $ 0.02 Liquidity and Capital Resources General Our principal demands for funds are for real estate and real estate-related investments and the payment of acquisition expenses, operating expenses, and distributions to stockholders. Generally, we expect cash needed for items other than acquisitions and acquisition expenses to be generated from operations. The sources of our operating cash flows are primarily driven by the rental income received from leased properties. We expect to continue to raise capital through our initial public offering and to utilize such funds and proceeds from secured or unsecured financing to complete future property acquisitions. As of September 30, 2014, we had raised approximately $425.7 million in gross proceeds from our initial public offering, including $3.2 million through the DRIP. As of September 30, 2014, we had cash and cash equivalents of $243.9 million. During the nine months ended September 30, 2014, we had a net cash increase of $243.8 million. This cash increase was the result of: • $0.1 million provided by operating activities, largely the result of an increase in accrued and other liabilities of $2.0 million. This was substantially offset by a net loss from operations before depreciation and amortization charges. Also included in this total was $2.1 million of real estate acquisition expenses incurred during the period and expensed in accordance with Accounting Standards Codification ("ASC") 805, Business Combinations; • $119.4 million used in investing activities, which was primarily the result of property acquisitions occurring in the nine months ended September 30, 2014; and 27--------------------------------------------------------------------------------• $363.1 million provided by financing activities with $369.7 million from the net proceeds of the issuance of common stock. Partially offsetting this amount were payments on loan financing costs of $3.2 million, distributions paid to our stockholders of $3.0 million (net of DRIP proceeds), and payments on mortgages and notes payable of $0.4 million, Short-term Liquidity and Capital Resources We expect to meet our short-term liquidity requirements through existing cash on hand, net cash provided by property operations, proceeds from our offering, and proceeds from secured and unsecured debt financings. Operating cash flows are expected to increase as additional properties are added to our portfolio. Other than the commissions and dealer manager fees paid to Realty Capital Securities, LLC (the "Dealer Manager"), the organization and offering costs associated with our offering are initially paid by our sponsors. Our sponsors will be reimbursed for such costs up to 2.0% of the gross capital raised in our offering. As of September 30, 2014, we have $12.5 million of contractual debt obligations, representing mortgage loans secured by our real estate assets, excluding below-market debt adjustments of $0.3 million, net of accumulated amortization. As these mature, we intend to refinance our debt obligations, if possible, or pay off the balances at maturity using the remaining net proceeds of our primary offering or other proceeds from operations and/or corporate-level debt. On July 2, 2014, we entered into a revolving loan agreement (the "revolving credit facility") with KeyBank National Association, an unaffiliated entity, as administrative agent, swing line lender and letter of credit issuer ("KeyBank"), along with certain other lenders, to borrow up to $200 million. Subject to certain conditions, the Revolving Credit Facility provides us with the ability from time to time to increase the size of the Revolving Credit Facility from the initial $200 million up to a total of $700 million. We do not currently have any borrowings outstanding under the terms of this facility. For the nine months ended September 30, 2014, gross distributions of approximately $6.2 million were paid to stockholders, including $3.2 million of distributions reinvested through the DRIP, for net cash distributions of $3.0 million. On October 1, 2014, gross distributions of approximately $2.1 million were paid, including $1.1 million of distributions reinvested through the DRIP, for net cash distributions of $1.0 million. Distributions were funded by proceeds from our primary offering. On September 19, 2014, our board of directors authorized distributions to the stockholders of record at the close of business each day in the period commencing October 1, 2014 through and including November 30, 2014. The authorized distributions equal an amount of $0.00445205 per share of common stock, par value $0.01 per share. A portion of each distribution is expected to constitute a return of capital for tax purposes. Long-term Liquidity and Capital Resources On a long-term basis, our principal demands for funds will be for real estate and real estate-related investments and the payment of acquisition expenses, operating expenses, distributions and redemptions to stockholders, interest and principal on indebtedness, and payments on amounts due to our sponsors for organization and offering costs incurred on our behalf. Generally, we expect to meet cash needs for items other than organization and offering costs as well as acquisitions and acquisition expenses from our cash flow from operations, and we expect to meet cash needs for acquisitions and acquisition expenses from the net proceeds of our initial public offering and from debt financings, including our revolving credit facility. As they mature, we intend to refinance our long-term debt obligations if possible, or pay off the balances at maturity using the remaining net proceeds of our primary offering or proceeds from operations and/or other corporate-level debt. We expect that substantially all net cash generated from operations will be used to pay distributions to our stockholders after certain capital expenditures, including tenant improvements and leasing commissions, are funded; however, we have and may continue to use other sources to fund distributions as necessary, including proceeds from our initial public offering, contributions or advances made to us by the Advisor, Sub-advisor and their respective affiliates, and borrowings under current or future debt agreements. Our board of directors has adopted corporate governance guidelines that limit our borrowings to 300% of our net assets (as defined in our corporate governance guidelines); however, we may exceed that limit if a majority of our independent directors approves each borrowing in excess of our charter limitation and if we disclose such borrowing to our stockholders in our next quarterly report with an explanation from the conflicts committee of the justification for the excess borrowing. In all events, we expect that our secured and unsecured borrowings will be reasonable in relation to the net value of our assets and will be reviewed by our board of directors at least quarterly. As of September 30, 2014, our borrowings were 3.5% of our net assets. We believe that careful use of debt will help us to achieve our diversification goals because we will have more funds available for investment. However, high levels of debt could cause us to incur higher interest charges and higher debt service payments, which would decrease the amount of cash available for distribution to our investors. 28 -------------------------------------------------------------------------------- As of September 30, 2014 and December 31, 2013, our leverage ratio (calculated as total debt, less cash and cash equivalents, as a percentage of total real estate investments, including acquired intangible lease assets and liabilities, at cost) could not be calculated, as our cash balances exceeded our debt outstanding. The table below summarizes our consolidated indebtedness at September 30, 2014 (dollars in thousands). Weighted- Principal Amount at Average Weighted- Average Years to Debt(1) September 30, 2014 Interest Rate Maturity Fixed-rate mortgages payable(2) $ 12,516 6.0 % 22.0 (1) The debt maturity table does not include any below-market debt adjustment, of which $0.3 million, net of accumulated amortization, was outstanding as of September 30, 2014. (2) Currently all of our fixed-rate debt represents a loan assumed as part of an acquisition. These loans typically have higher interest rates than interest rates associated with new debt. |