S-11/A 1 ds11a.htm AMENDMENT NO. 1 TO FORM S-11 Amendment No. 1 to Form S-11
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As filed with the Securities and Exchange Commission on January 3, 2011

Registration No. 333-169729

 

 

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Amendment No. 1

to

FORM S-11

FOR REGISTRATION UNDER

THE SECURITIES ACT OF 1933

OF SECURITIES OF CERTAIN REAL ESTATE COMPANIES

 

 

PACIFIC OFFICE PROPERTIES TRUST, INC.

(Exact name of registrant as specified in its governing instruments)

 

 

10188 Telesis Court, Suite 222

San Diego, California 92121

Telephone: (858) 882-9500

(Address, including zip code and telephone number, including

area code, of registrant’s principal executive offices)

 

 

James R. Ingebritsen

President and Chief Executive Officer

10188 Telesis Court, Suite 222

San Diego, California 92121

Telephone: (858) 882-9500

(Name, address, including zip code and telephone number,

including area code, of agent for service)

 

 

Copies to:

 

Howard A. Nagelberg, Esq.

William E. Turner II, Esq.

Barack Ferrazzano Kirschbaum & Nagelberg LLP

200 West Madison Street, Suite 3900

Chicago, Illinois 60606

(312) 984-3100

 

Larry P. Medvinsky, Esq.

Clifford Chance US LLP

31 West 52nd Street

New York, New York 10019

(212) 878-8000

Approximate date of commencement of proposed sale of the securities to the public:

As soon as practicable after this registration statement becomes effective.

 

 

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act, check the following box.  ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check One):

 

Large accelerated filer   ¨      Accelerated filer   ¨
Non-accelerated filer   ¨   (Do not check if a smaller reporting company)    Smaller Reporting Company   þ

 

 

CALCULATION OF REGISTRATION FEE

 

 
Title of Securities to be Registered   Proposed Maximum
Aggregate Offering
Price (1)
  Amount of
Registration Fee (2)

Common Stock, $0.0001 par value per share

  $430,100,000   $31,646
 
 

 

(1) Estimated solely for the purpose of determining the registration fee in accordance with Rule 457(o) under the Securities Act. Includes shares that the underwriters have the option to purchase solely to cover over-allotments, if any.
(2) Of the $31,646 registration fee calculated in connection with the registration of shares of common stock having a proposed maximum aggregate offering price of $430,100,000 pursuant to this registration statement, a registration fee of $29,109 was previously paid to register shares of common stock having a proposed maximum aggregate offering price of $408,250,000 (calculated at $71.30 per $1,000,000 registered) upon the initial filing of this registration statement on October 4, 2010. The remaining $2,537 registration fee is calculated in connection with the registration of an additional $21,850,000 of shares of common stock included in this Amendment No. 1 (calculated at $116.10 per $1,000,000 registered).

 

 

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the registration statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

 


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The information in this preliminary prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

SUBJECT TO COMPLETION, DATED JANUARY 3, 2011

 

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44,000,000 Shares                

 

Pacific Office Properties Trust, Inc.

 

Common Stock                        

 

Pacific Office Properties Trust, Inc. is a publicly traded real estate investment trust that owns, acquires and operates primarily institutional-quality office properties principally in selected long-term growth markets in California and Hawaii. Upon the completion of this offering, we will be internally managed.

We are selling 44,000,000 shares of our common stock. We expect the public offering price to be between $7.50 and $8.50 per share. Shares of our common stock are currently listed on the NYSE Amex under the symbol “PCE.” Our common stock has been approved for listing on the New York Stock Exchange, or NYSE, under the symbol “PCE,” subject to official notice of issuance. We intend to complete a one-for-ten reverse stock split of our common stock immediately prior to the completion of this offering.

All of the shares offered by this prospectus are being sold by us. Concurrent with the completion of this offering, the Chairman of our board of directors, Jay H. Shidler, and certain of our executive officers and affiliates (or entities controlled by them) will purchase $12.0 million in shares of our common stock. These individuals (or entities controlled by them) will also exchange all principal and accrued interest outstanding under unsecured promissory notes (which totaled approximately $24.9 million in the aggregate as of September 30, 2010) issued by Pacific Office Properties, L.P., our operating partnership, for common units of our operating partnership. These concurrent issuances will occur in private placements at a price per share or common unit equal to the public offering price and without payment by us of any underwriting discount or commission. Upon completion of this offering and these and other concurrent issuances, our directors and executive officers will own approximately 12.6% of our common stock on a fully diluted basis. Specifically, our Chairman, Mr. Shidler, will own 7.6%, our President and Chief Executive Officer, James R. Ingebritsen, will own 1.6%, our Chief Investment Officer, Matthew J. Root, will own 1.6% and our Executive Vice President, Lawrence J. Taff, will own 1.4% of our common stock on a fully diluted basis.

In order to assist us in complying with certain federal income tax requirements applicable to real estate investment trusts, among other purposes, upon the completion of this offering, no person or entity may own, directly or indirectly, more than 9.8% in economic value of the aggregate of the outstanding shares of our capital stock or 9.8% in economic value or number of shares, whichever is more restrictive, of the aggregate of the outstanding shares of all classes of our common stock. See “Certain Provisions of Maryland Law and Our Charter and Bylaws—Anti-Takeover Measures—Restrictions on Ownership and Transfer” for a discussion of these restrictions.

The underwriters have an option to purchase a maximum of 6,600,000 additional shares to cover over-allotments of shares.

 

 

Investing in our common stock involves risks. See “Risk Factors” on page 18 and the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2009.

 

 

 

     Price to
Public
     Underwriting
Discounts and
Commissions(1)
     Proceeds to Us  

Per Share

   $                    $                    $                

Total

   $                    $                    $                

 

(1) See “Underwriting.”

Delivery of the shares of common stock will be made on or about                    , 2011.

Neither the Securities and Exchange Commission nor any other state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful and complete. Any representation to the contrary is a criminal offense.

 

 

 

Credit Suisse   Wells Fargo Securities   Citi

 

FBR Capital Markets      
  KeyBanc Capital Markets  
    Raymond James  
     

RBC Capital Markets

 

 

The date of this prospectus is                 , 2011.


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TABLE OF CONTENTS

 

     Page  

PROSPECTUS SUMMARY

     1   

RISK FACTORS

     18   

FORWARD-LOOKING STATEMENTS

     43   

USE OF PROCEEDS

     45   

MARKET PRICE RANGE AND DIVIDENDS ON OUR COMMON STOCK

     48   

DISTRIBUTION POLICY

     49   

CAPITALIZATION

     53   

DILUTION

     54   

SELECTED FINANCIAL DATA

     55   

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     58   

MARKET BACKGROUND AND OPPORTUNITY

     79   

BUSINESS AND PROPERTIES

     89   

MANAGEMENT

     117   

PRINCIPAL STOCKHOLDERS OF THE COMPANY AND PARTNERS OF OUR OPERATING PARTNERSHIP

     128   

STRUCTURE AND FORMATION TRANSACTIONS

     130   

CERTAIN RELATED PARTY RELATIONSHIPS AND TRANSACTIONS

     132   

CONFLICTS OF INTEREST

     138   

CERTAIN PROVISIONS OF MARYLAND LAW AND OUR CHARTER AND BYLAWS

     142   

POLICIES WITH RESPECT TO CERTAIN ACTIVITIES

     151   

THE OPERATING PARTNERSHIP AGREEMENT

     154   

DESCRIPTION OF CAPITAL STOCK

     159   

SHARES ELIGIBLE FOR FUTURE SALE

     163   

FEDERAL INCOME TAX CONSIDERATIONS

     166   

ERISA CONSIDERATIONS

     189   

UNDERWRITING

     193   

LEGAL MATTERS

     198   

EXPERTS

     198   

WHERE YOU CAN FIND MORE INFORMATION

     198   

INDEX TO FINANCIAL STATEMENTS

     F-i   

 

 

Neither we nor the underwriters have authorized anyone to provide any information or to make any representations other than those contained or incorporated by reference in this prospectus or in any free writing prospectuses we have prepared. Neither we nor the underwriters take any responsibility for, and can provide no assurance as to the reliability of, any other information that others may give you. This prospectus is an offer to sell only the shares of common stock offered hereby, but only under circumstances and in jurisdictions where it is lawful to do so. The information contained in this prospectus is current only as of its date.

We use market data and industry forecasts and projections throughout this prospectus, and in particular in the sections entitled “Market Background and Opportunity” and “Business and Properties.” We have obtained substantially all of this information from a market study prepared for us in connection with this offering by Rosen Consulting Group, or RCG, a nationally recognized real estate consulting firm. We have paid RCG a fee for such services. Such information is included in this prospectus in reliance on RCG’s authority as an expert on such matters. See “Experts.” In addition, we have obtained certain market and industry data from publicly available industry publications. These sources generally state that the information they provide has been obtained from sources believed to be reliable, but that the accuracy and completeness of the information are not guaranteed. The forecasts and projections are based on industry surveys and the preparers’ experience in the industry, and there is no assurance that any of the

 

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projected amounts will be achieved. We believe that the surveys and market research others have performed are reliable. Any forecasts prepared by RCG are based on data (including third party data), models and experience of various professionals, and are based on various assumptions, all of which are subject to change without notice.

This prospectus includes certain information regarding total return to stockholders achieved by another public company founded by Jay H. Shidler, the Chairman of our board of directors. The information regarding total return to stockholders is not a guarantee or prediction of the returns that we may achieve in the future, and we can offer no assurance that we will replicate this return.

As used in this prospectus, references to our “common stock” refer only to the class of our common stock that is currently listed on the NYSE Amex under the symbol “PCE” and exclude our Class B Common Stock and Senior Common Stock, each as more fully described under “Description of Capital Stock.” References to “Senior Common Stock” include our Series A Senior Common Stock, Series B Senior Common Stock and Series C Senior Common Stock.

The phrase “on a fully diluted basis” means after giving effect to (i) the redemption of all common units representing limited partnership interests of Pacific Office Properties, L.P., or the Operating Partnership, including common units issuable upon the conversion of preferred units of the Operating Partnership, assuming that all such common units are distributed to the persons holding the economic interests in such units and redeemed for shares of common stock, disregarding any restrictions applicable to those units on conversion, redemption or ownership of our common stock, and (ii) the issuance of shares of common stock upon vesting of all restricted stock units previously awarded to certain of our directors and outstanding upon the completion of this offering.

We use the term “institutional-quality” in this prospectus to refer to properties of a character and quality that we believe an institutional real estate investor such as an insurance company or pension fund would be willing to own outright or in a fund that it manages.

Unless the context otherwise requires or indicates, the information contained in this prospectus assumes no exercise by the underwriters of their option to purchase up to an additional 6,600,000 shares of our common stock solely to cover over-allotments, and assumes the completion of the transactions that we expect to occur concurrent with the completion of this offering, which we refer to as the “concurrent transactions,” consisting of (i) the purchase of shares of our common stock in a private placement by Jay H. Shidler, the Chairman of our board of directors, James R. Ingebritsen, our President and Chief Executive Officer, Matthew J. Root, our Chief Investment Officer, and Lawrence J. Taff, our Executive Vice President and James C. Reynolds, who currently is the beneficial owner of more than 5% of our common stock (or entities controlled by them), (ii) the completion of our pending acquisition of the GRE portfolio as described herein (including the assumption of certain debt and issuance of shares of common stock in a private placement), (iii) the repayment in full of debt outstanding under our existing credit facility with First Hawaiian Bank and the discharge and/or repayment of debt secured by certain of our existing properties, including matured debt secured by our City Square and Pacific Business News Building properties, (iv) the establishment and full collateralization of a new secured revolving credit facility with affiliates of certain of the underwriters, (v) the exchange of unsecured promissory notes issued by our Operating Partnership by Messrs. Shidler, Ingebritsen, Root, Taff and Reynolds (or entities controlled by them) for common units of our Operating Partnership, (vi) the internalization of our management through the acquisition of our external advisor and (vii) the conversion of all of the Operating Partnership’s outstanding preferred units into common units. Unless the context otherwise requires or indicates, all property information is as of September 30, 2010, and the information contained in this prospectus assumes that the public offering price is $8.00 per share, which is the midpoint of the estimated price range set forth on the front cover of this prospectus. As used in this prospectus, the number of common units of our Operating Partnership to be issued upon the exchange of unsecured promissory notes of our Operating Partnership concurrent with the completion of this offering is calculated based on principal and accrued interest outstanding as of September 30, 2010. The actual number of common units to be issued upon such exchange will be greater due to additional accrued interest following September 30, 2010 through the closing date.

 

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We provide certain ratios in this prospectus based on our total market capitalization. As used in this prospectus, “total market capitalization” means the sum of the aggregate principal amount of our consolidated debt on a pro forma basis to reflect this offering and the concurrent transactions as of September 30, 2010, the market value of our outstanding common stock and common stock equivalents and the market value of our outstanding Series A Senior Common Stock (based on its $10.00 per share offering price). The ratios in this prospectus relating to our total market capitalization upon the completion of this offering and the concurrent transactions are based on (i) approximately $383.7 million aggregate principal amount of our consolidated debt on a pro forma basis as of September 30, 2010 and (ii) a total market capitalization of approximately $827.8 million on a pro forma basis, assuming a public offering price of $8.00 per share of our common stock, which is the midpoint of the estimated price range set forth on the front cover of this prospectus, and 663,394 outstanding shares of Series A Senior Common Stock (which was the number of shares outstanding as of September 30, 2010).

 

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PROSPECTUS SUMMARY

The following summary highlights information contained elsewhere in this prospectus and may not contain all of the information that is important to you. You should carefully read the entire prospectus, including the section entitled Risk Factors,” the financial statements and any free writing prospectus before making an investment decision.

Except where the context suggests otherwise, the terms “we,” “our,” “ours,” “us” and “the Company” refer to Pacific Office Properties Trust, Inc. and its consolidated subsidiaries and joint ventures, including our Operating Partnership, and where the context requires, our predecessor corporation, Arizona Land Income Corporation. All share and per share information set forth in this prospectus has been adjusted to reflect the one-for-ten reverse stock split of our common stock and Class B Common Stock that we intend to complete immediately prior to the completion of this offering, and all Operating Partnership unit and per unit information set forth in this prospectus has been adjusted to reflect the one-for-ten reverse unit split of the common units and preferred units that we also intend to complete immediately prior to the completion of this offering.

Overview

We are a publicly traded real estate investment trust, or REIT, that owns, acquires and operates primarily institutional-quality office properties principally in selected long-term growth markets in California and Hawaii. We currently own eight office properties comprising approximately 2.3 million rentable square feet. We also own interests (ranging from 5% to approximately 32%) in 16 joint venture properties, of which we have managing ownership interests in 15, comprising approximately 2.4 million rentable square feet. In addition, we are party to two purchase contracts to acquire the GRE portfolio, which is a portfolio of 12 office properties comprising approximately 1.9 million rentable square feet, for aggregate consideration of approximately $305.9 million. We expect to complete the acquisition of the GRE portfolio concurrently with the completion of this offering. Upon completion of this offering and our pending acquisition of the GRE portfolio, we will own 36 office properties, including the interests in our joint venture properties, comprising approximately 6.6 million rentable square feet in 76 buildings. Our primary business objectives are to achieve long-term growth in net asset value, funds from operations, or FFO, per share and dividends per share. We intend to achieve these objectives through both internal and external growth initiatives.

We were formed in 2008 as a continuation of The Shidler Group’s successful 30-year history of operations in the western United States and Hawaii. Our formation was accomplished through a reverse merger into a publicly traded REIT, Arizona Land Income Corporation, or AZL, whose common stock was listed and traded on the American Stock Exchange. Concurrent with the merger, we changed our name to Pacific Office Properties Trust, Inc. and reincorporated in the State of Maryland. Currently, we are externally managed by Pacific Office Management, Inc., which we refer to as our Advisor or Pacific Office Management, an entity affiliated with and owned by executives of our founder, The Shidler Group. Concurrent with the completion of this offering, we will acquire our Advisor for nominal consideration and thereby become internally managed.

We currently own office buildings in Honolulu, San Diego, Orange County, certain submarkets of Los Angeles and Phoenix. Upon the completion of our pending acquisition of the GRE portfolio, we will expand to the San Francisco Bay Area. We intend to target future acquisitions in the San Francisco Bay Area and all of our current markets with the exception of Phoenix. We refer to these markets as our target markets. We focus primarily on specific long-term growth markets with a high quality of life that, according to Rosen Consulting Group, or RCG, have high barriers to entry for the development of new office supply and a history of long-term job formation. We believe that our target markets provide us with attractive long-term return opportunities and that our integrated operating platform, market knowledge and industry relationships give us an advantage relative to many of our competitors.

 

 

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We believe that the current dislocation in the commercial real estate market and the economic conditions in our target markets afford us the opportunity to acquire institutional-quality office buildings at prices that are substantially below replacement cost. RCG expects employment and the local economy in each of our target markets to improve which, with minimal new office construction expected over the next three years, should lead to improved occupancy and rent growth. Our investment strategy is to acquire those types of office buildings often described as “core” investment properties which, generally, due to their location, building quality and tenant base, produce a predictable and growing income stream, and “value-added” investment properties which generally offer upside potential through improvement upgrades, repositioning, aggressive leasing and intensive management. We access potential acquisitions through a broad network that The Shidler Group has developed over the past 30 years, including lenders, brokers, developers and owners. As a result, we believe we have a “first call” advantage due to our reputation, relationships and ability to provide a broad array of transaction structures to address the varying needs of sellers. We believe this allows us to selectively acquire institutional-quality office properties in off-market transactions with a familiar base of local and institutional owners.

Our capitalization strategy is to create and maintain what we believe to be a stable debt and equity capital structure. We intend to employ prudent amounts of leverage as a means of providing additional funds to acquire properties, to refinance existing debt or for general corporate purposes. At September 30, 2010, on a pro forma basis, the outstanding principal amount of our consolidated debt and aggregate liquidation preference of our outstanding Senior Common Stock and preferred stock was equal to approximately 47.2% of our total market capitalization (40.0% if the underwriters’ over-allotment option is exercised in full and the additional net offering proceeds and cash and cash reserves are offset against both consolidated debt and total market capitalization). We intend to limit this ratio to no more than 55%, although our organizational documents contain no limitations regarding the maximum level of debt that we may incur and we may exceed this amount from time to time. Upon the completion of this offering and the concurrent transactions, we will have minimal near-term consolidated debt maturities, with only approximately $18.4 million maturing on a pro forma basis before 2013. Our debt consists of, and we intend to continue to employ, primarily non-recourse, fixed-rate mortgage financing.

Our principal executive offices are located in our Seaview Corporate Center complex, at 10188 Telesis Court, Suite 222, San Diego, California 92121. Our website address is www.pacificofficeproperties.com. The information on, or otherwise accessible through, our website does not constitute a part of this prospectus.

Competitive Strengths

We believe we distinguish ourselves from our competitors through the following competitive strengths:

 

   

Institutional-Quality Office Assets in Desirable Growth Markets. Our property portfolio consists primarily of institutional-quality office properties located in long-term growth markets with a high quality of life that have, according to RCG, high barriers to entry for the development of new office building supply and a history of long-term job formation. We are the largest owner of office-property space in Honolulu. We believe that our properties could not be replaced on a cost-competitive basis today. We also believe that our target markets of Honolulu, San Diego, certain submarkets of Los Angeles, Orange County and the San Francisco Bay Area are among the most desirable in the United States in terms of favorable demand fundamentals. We believe that the favorable supply and demand fundamentals in our target markets will enable us to achieve consistent cash flow growth over time.

 

   

Established Real Estate Operating Platform. Upon the completion of this offering and the concurrent transactions, we will be an internally managed, fully integrated real estate company with in-house asset management, property management and leasing capabilities. Members of our executive management team were responsible for the acquisition of all of our properties and have been responsible for managing these assets for our company and for The Shidler Group prior to our formation. We employ value creation techniques established by our founder, The Shidler Group, in its

 

 

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long history of highly successful investments in commercial real estate. While conducting our initial due diligence for a potential acquisition, we develop a Value Optimization Plan, or VOP, which is a comprehensive plan of physical improvement, operational efficiencies and leasing potential for the property. Once a property is acquired, we employ our High Occupancy Optimization Program, or HOOP, which is an individualized strategy designed to decrease downtime on vacancies, increase rental rates, improve tenant retention and maintain our high standards of operation. We believe that VOP and HOOP allow us to begin realizing a property’s potential rapidly after acquisition.

 

   

Deep Industry Relationships that Provide Access to Significant Investment Opportunities. Over the past 30 years, The Shidler Group has built an extensive network of long-standing relationships with real estate owners, institutional investors, national and regional lenders, brokers, tenants and other participants in our core markets in California and Hawaii. We believe these relationships will provide us access to a consistent pipeline of attractive acquisition opportunities and access to both equity and debt capital that may not be available to our competitors. Our significant relationships have created a robust current transaction pipeline, evidenced by our pending acquisition of the GRE portfolio, comprised of 12 properties containing approximately 1.9 million rentable square feet, for aggregate consideration of approximately $305.9 million. As part of our pipeline, we are actively reviewing and have made offers on more than $2.0 billion of potential acquisitions in our target markets. These potential acquisitions are not probable and we can provide no assurance that we will acquire any of these properties or as to the timing or terms of any such acquisitions.

 

   

Diverse and Stable Tenant Base. As of September 30, 2010, on a pro forma basis to reflect our pending acquisition of the GRE portfolio, the tenant base in our consolidated properties included approximately 800 tenants across various industries with leases averaging approximately 4,270 square feet, a median lease size of approximately 1,550 square feet and no tenant representing more than 4.3% of our annualized rent. We believe that our diverse tenant base helps us to minimize our exposure to economic fluctuations in any one industry or business sector. In addition, we believe that our base of smaller-sized office tenants is generally less rent sensitive and more likely to renew than larger tenants and minimizes the negotiating power afforded to any single tenant. These factors contribute to strong tenant retention metrics, as evidenced by our tenant retention ratio of 85.5% for our existing consolidated properties for the 12 months ended September 30, 2010.

 

   

Growth Oriented Capital Structure with Minimal Near-Term Maturities. Upon the completion of this offering and the concurrent transactions, we will have minimal near-term consolidated debt maturities, with only approximately $18.4 million maturing on a pro forma basis before 2013. We have received commitments for a three-year $125.0 million secured revolving credit facility, referred to as the new credit facility, from affiliates of certain of the underwriters and expect to close this facility concurrently with the completion of this offering and the concurrent transactions. We believe our capital structure and access to diverse capital sources will enable us to execute our growth strategy.

 

   

Experienced and Committed Executive Management Team with a Proven Track Record. We believe our executive management team’s extensive experience in acquiring, owning, financing, structuring, managing, redeveloping and repositioning office properties in our target markets provides us with a significant competitive advantage. Our executive management team is led by James R. Ingebritsen, James R. Wolford and Matthew J. Root, our President and Chief Executive Officer, Chief Financial Officer and Chief Investment Officer, respectively, who have 23, 25 and 20 years, respectively, of experience in the commercial real estate industry. Messrs. Ingebritsen and Root, acting as principals, have been directly responsible for the sourcing, capital structuring and acquisition of nearly $2 billion of commercial property in our target markets and have worked together with Mr. Shidler, the Chairman of our board of directors, for approximately 15 years. Additionally, Mr. Shidler founded and has served as Chairman of several publicly traded REITs, including Corporate Office Properties Trust (NYSE: OFC), or OFC. Mr. Shidler has been the Chairman of OFC since 1997 and according to SNL Financial, OFC’s total return (capital appreciation and dividends paid) from the date of OFC’s reverse merger with The

 

 

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Shidler Group’s operations on October 14, 1997 to September 30, 2010 was approximately 920%, outperforming the 157% total return for the MSCI U.S. REIT Index over the same period. None of our directors or executive officers are receiving cash proceeds from this offering. Upon completion of this offering and the concurrent transactions, our directors and executive officers will own approximately 12.6% of our common stock on a fully diluted basis.

Our Business and Growth Strategies

Our primary business objectives are to achieve long-term growth in net asset value, FFO per share and dividends per share. We intend to achieve these objectives through both internal and external growth initiatives.

 

   

Maximize Cash Flow through Contractual Rent Increases and Lease-Up. We have embedded future rental revenue growth as our leases typically include contractual annual rental rate increases from 2.5% to 3.0%. We also believe we will be able to achieve significant internal cash flow growth over time, primarily though tenant retention and lease-up and operational leverage. We expect to realize increased rental income by focusing on our strategic leasing initiatives, including focusing on near-term expiring leases and aggressively marketing available space to prospective tenants. As of September 30, 2010, seven of the 12 properties in the GRE portfolio were leased at below submarket occupancy rates, representing a significant opportunity to grow cash flow through lease-up. These properties, totaling approximately 1.2 million rentable square feet, were 75% leased on a weighted average basis compared to, according to RCG, a weighted average submarket occupancy of 86%.

 

   

Generate Internal Growth through Proactive Asset and Property Management. We expect to achieve internal growth through proactive asset and property management including strategic leasing initiatives, tenant retention programs, close relationships with our tenants and our HOOP initiative. In addition to maximizing results within our existing portfolio, we believe that we will be able to apply our asset and property management expertise to newly acquired properties, such as our pending acquisition of the GRE portfolio, in order to increase the performance and cash flow of such properties under our ownership. We also expect that future property acquisitions in our target markets will allow us to generate additional operating efficiencies through greater economies of scale.

 

   

Focus on Acquisitions with Attractive Risk-Adjusted Returns in our Target Markets. Our target markets currently include Honolulu, San Diego, certain submarkets of Los Angeles, Orange County and the San Francisco Bay Area. We will continue to target core investment properties, which we expect to produce a predictable and growing income stream due to their location, building quality and tenant base, and value-added investment properties, which we believe will generally offer upside potential through improvement upgrades, repositioning, aggressive leasing and intensive management. We believe that the current economic conditions in our target markets afford us the opportunity to acquire institutional-quality office buildings at prices that are substantially below replacement cost.

 

   

Pursue Repositioning Initiatives and Value-Added Opportunities. We will continue to pursue cash flow growth through repositioning and value-added initiatives at certain of our existing properties and future acquisitions. At each property that we acquire, we employ our VOP to create a customized plan that we implement to maximize a property’s cash flow potential. For example, in February 2007, we acquired the Bank of Hawaii Waikiki Center, a 152,000 square foot office building located in Waikiki with substantial vacancies. After implementing significant property upgrades and tenant leasing initiatives, we entered into a 30-year lease with the Bank of Hawaii to anchor a significant portion of the property’s ground floor as a flagship branch location. We subsequently completed an aggressive tenant restructuring and street-level repositioning, successfully re-leasing valuable retail frontage on Kalakaua Avenue. The repositioning of this property not only significantly increased income from the time of our acquisition in February 2007 through September 30, 2010, but also considerably improved the overall credit quality of the tenant base.

 

 

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Summary Risk Factors

An investment in our common stock involves a number of risks. You should consider carefully the risks discussed below and under “Risk Factors” beginning on page 18 of this prospectus before purchasing our common stock.

 

   

We may be unable to complete acquisitions that would grow our business, including the properties that we intend to acquire with the proceeds of this offering, which represent approximately 38.8% of the annualized rent of our wholly-owned properties on a pro forma basis including the GRE portfolio. Even if consummated, we may fail to successfully integrate and operate these acquired properties.

 

   

All of our properties are located in California, Honolulu and Phoenix. We are dependent on the California, Honolulu and Phoenix office markets and economies, and are therefore susceptible to risks of events in those markets that could adversely affect our business, such as adverse market conditions, changes in local laws or regulations, and natural disasters.

 

   

We have a limited operating history and may not be able to operate our business successfully or implement our business strategies as described in this prospectus.

 

   

Leases representing approximately 33.3% of the rentable square feet (or approximately 41.4% of our annualized rent) of our consolidated portfolio, on a pro forma basis, are scheduled to expire through 2012. We may be unable to renew leases or lease vacant space at favorable rates or at all, which would negatively impact our ability to generate cash flow.

 

   

We depend on tenants for our revenue, and accordingly, lease terminations and/or tenant defaults, particularly by one of our larger tenants, could adversely affect the income produced by our properties, which may harm our operating performance, thereby limiting our ability to make distributions to our stockholders.

 

   

Our current and future joint venture investments could be adversely affected by a lack of sole decision-making authority and our reliance on joint venture partners’ financial condition and liquidity.

 

   

Our operating performance is subject to risks associated with the real estate industry.

 

   

Volatility in the capital and credit markets could adversely impact our acquisition activities and the pricing of real estate assets.

 

   

We have a substantial amount of debt outstanding, which may affect our ability to pay dividends, may expose us to interest rate fluctuation risk and may expose us to the risk of default under our debt obligations.

 

   

We may be unable to refinance our debt at maturity or the refinancing terms may be less favorable than the terms of our original debt, and our flexibility with respect to certain financing options may be limited in some instances.

 

   

Our estimated annual rate of distribution following the completion of this offering represents approximately 93.9% of our estimated pro forma cash available for distribution to our common stockholders for the 12-month period ending September 30, 2011. We may be unable to make distributions at expected levels. Furthermore, under some circumstances, we may be required to fund distributions from working capital, liquidate assets at prices or times that we regard as unfavorable or borrow to provide funds for distributions, or we may make distributions in the form of a taxable stock dividend.

 

   

Securities eligible for future sale may have adverse effects on the share price of our common stock, and any additional capital raised by us through the sale of equity securities, including our Senior Common Stock, may dilute your ownership in us.

 

 

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Purchasers of our common stock in this offering will experience an immediate dilution of the book value of our common stock upon the completion of this offering and the concurrent transactions.

 

   

Provisions in our charter, our bylaws and Maryland law may delay or prevent our acquisition by a third party, even if such acquisition were in the best interests of our stockholders.

 

   

We are subject to various potential conflicts of interest arising out of our relationships with our directors and executive officers, the dealer manager in our ongoing offering of Series A Senior Common Stock and other parties.

 

   

If we fail to remain qualified as a REIT in any taxable year, our operations and ability to make distributions will be adversely affected because we will be subject to federal income tax on our taxable income at regular corporate rates with no deduction for distributions made to stockholders.

Our Property Portfolio

Upon the completion of this offering and our pending acquisition of the GRE portfolio, we will own 36 office properties, including the interests in our joint venture properties, comprising approximately 6.6 million rentable square feet in 76 buildings.

We are party to two purchase and sale contracts, or PSAs, to acquire the GRE portfolio, which is a portfolio of 12 office properties consisting of 31 buildings located primarily in southern California. This office portfolio contains 1,947,554 rentable square feet and each of the properties is located in one of our target markets. The portfolio consists of a 12-building office complex containing 422,114 rentable square feet in the San Francisco Bay Area, four office complexes containing a total of five buildings with an aggregate of 366,539 rentable square feet in San Diego, two office complexes containing a total of four buildings with an aggregate of 270,685 rentable square feet in Orange County and five office complexes containing a total of ten buildings with an aggregate of 888,216 rentable square feet in certain submarkets of Los Angeles. We agreed to purchase these assets in a negotiated transaction from a privately held, diversified financial services firm with more than $100 billion in assets under supervision. The aggregate purchase price for the portfolio is $305.9 million, including the assumption of approximately $56.3 million in existing non-recourse mortgage debt secured by four properties in the portfolio. Approximately $8.0 million of the purchase price will be paid through the issuance of our common stock, which will be issued in a private placement at a price per share equal to the public offering price of this offering. As of the date of this prospectus, we have cash deposits of $9.0 million in escrow, which will be applied to the cash portion of the purchase price at closing. We have also agreed to reimburse $1.5 million of the sellers’ closing costs upon the completion of this acquisition.

The properties are leased to a diverse group of 289 tenants with leases ranging in size from less than 1,000 to 153,000 rentable square feet. Major tenants of the GRE portfolio include Invensys, Verizon, Toshiba, Kaiser Foundation and Marsh. The portfolio consists of a mix of core and value-added assets, a substantial portion of which provides lease-up opportunities due to current occupancy. We believe that the cost basis of the properties, the diversity in the tenant profile and varying lease sizes and lease durations will result in a stable cash flow stream from the portfolio. As of September 30, 2010, seven of the 12 properties in the GRE portfolio, totaling approximately 1.2 million rentable square feet, were 75% leased on a weighted average basis compared to, according to RCG, a weighted average submarket occupancy of 86%. Below submarket occupancy levels provide the potential for value creation from lease-up opportunities as we implement our property-specific VOP and as the respective markets continue to strengthen. We entered into the letter of intent for these acquisitions on June 17, 2010. From June 30, 2010 through December 1, 2010, leases have been signed improving the percentage leased of the GRE portfolio from 80% to 83%. We also expect to recognize near-term expense savings in the GRE portfolio through reduced insurance premiums and a potential re-assessment of the property taxes associated with the properties in the GRE portfolio. This portfolio opportunity is typical of our past acquisitions of institutionally owned assets that have been under-managed and under-leased.

 

 

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The following table presents an overview of our total portfolio, including the GRE portfolio, based on information as of September 30, 2010.

 

    MARKET   NUMBER
OF
BUILDINGS
    RENTABLE
SQUARE
FEET
    PERCENT
LEASED  (1)
    ANNUALIZED
RENT (2) (3) (4)
    ANNUALIZED
RENT PER
LEASED
SQUARE
FOOT (5)
 
Wholly-Owned Properties  

Existing Properties

 

Waterfront Plaza (6)

  Honolulu     1        534,475        96   $ 18,811,792      $ 36.57   

Davies Pacific Center

  Honolulu     1        353,224        82     10,266,540        35.78   

Pan Am Building

  Honolulu     1        209,889        88     6,980,562        37.92   

First Insurance Center

  Honolulu     1        202,992        100     7,300,416        36.07   

Pacific Business News Building

  Honolulu     1        90,559        71     2,079,588        32.34   

Clifford Center (6)

  Honolulu     1        72,415        83     1,956,900        32.40   

Sorrento Technology Center

  San Diego     2        63,363        100     1,526,268        24.09   

City Square

  Phoenix     3        738,422        71     10,774,877        20.43   
                             

Subtotal/Weighted Average – Existing Properties

      11        2,265,339        84   $ 59,696,943      $ 31.37   
                             

GRE Portfolio

                                 

Kearny Mesa Crossroads

  San Diego     2        126,471        72   $ 2,185,781      $ 23.89   

Rio Vista Plaza

  San Diego     1        108,552        79     2,000,988        23.26   

Alta Sorrento

  San Diego     1        88,315        75     1,510,200        22.70   

Cornerstone Court West

  San Diego     1        43,201        63     647,114        23.60   

Foothill Building

  Orange County     3        152,880        100     2,602,152        17.02   

Toshiba Building

  Orange County     1        117,805        100     1,760,079        14.94   

Empire Towers

  Los Angeles     3        323,109        76     6,621,907        27.02   

Warner Center

  Los Angeles     3        182,058        88     4,473,152        27.88   

Carlton Plaza

  Los Angeles     1        153,911        90     4,106,223        29.68   

Empire Towers IV

  Los Angeles     1        76,109        81     1,293,663        21.06   

Glendale Office

  Los Angeles     2        153,029        87     3,651,105        28.07   

Walnut Creek Executive Center

  San Francisco
Bay Area
    12        422,114        74     6,993,897        22.42   
                             

Subtotal/ Weighted Average – GRE Portfolio

      31        1,947,554        82   $ 37,846,261      $ 23.81   
                             

Total/ Weighted Average – Wholly-Owned Properties

      42        4,212,893        83   $ 97,543,204      $ 27.93   
                             

Joint Venture Properties (7)

           

Torrey Hills Corporate Center (32.17%)

  San Diego     1        24,066        83   $ 898,980      $ 44.74   

Palomar Heights Plaza (32.17%)

  San Diego     3        45,538        75     818,280        23.81   

Palomar Heights Corporate Center (32.17%)

  San Diego     1        64,812        82     1,467,576        27.53   

Scripps Ranch Center (32.17%)

  San Diego     2        47,248        49     567,792        24.66   

Via Frontera Business Park (10%)

  San Diego     2        78,819        49     735,847        19.00   

Poway Flex (10%)

  San Diego     1        112,000        100     1,487,437        13.28   

Carlsbad Corporate Center (10%)

  San Diego     1        121,541        100     2,385,837        19.63   

Savi Tech Center (10%)

  Orange County     4        372,327        97     7,145,399        19.79   

Yorba Linda Business Park (10%)

  Orange County     5        166,042        87     1,514,183        10.53   

South Coast Executive Center (10%)

  Orange County     1        61,025        69     766,715        19.41   

Gateway Corporate Center (10%)

  Los Angeles     1        85,216        90     1,965,645        26.59   

Black Canyon Corporate Center (17.5%)

  Phoenix     1        218,694        77     2,596,332        18.36   

Bank of Hawaii Waikiki Center (6) (17.5%)

  Honolulu     1        152,288        85     5,999,324        54.63   

Seville Plaza (7.5%)

  San Diego     3        138,576        67     2,454,605        26.58   

U.S. Bank Center (7.5%) (6)

  Phoenix     2        372,676        77     6,636,732        23.15   

Seaview Corporate Center (5%)

  San Diego     5        356,504        90     10,693,608        33.17   
                             

Total/ Weighted Average – Joint Venture Properties

      34        2,417,372        84   $ 48,134,292      $ 24.38   
                             

Our Share of Joint Venture Properties’ Annualized Rent

          $ 5,527,985     
                 

TOTAL/WEIGHTED AVERAGE

      76        6,630,265        83     $ 26.65   
                       

 

 

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(1) Based on leases signed as of September 30, 2010. Includes leases signed but not yet commenced for 7,345 rentable square feet as of September 30, 2010.
(2) Annualized Rent represents the monthly contractual rent under commenced leases as of September 30, 2010. This amount reflects total rent before abatements and includes contractual expense reimbursements, which are estimated by annualizing September 2010 actual expense reimbursement billings. Total abatements committed to as of September 30, 2010 for the 12 months ended September 30, 2011 were approximately $1.0 million for our existing wholly-owned properties and $0.6 million for our joint venture properties. Abatements for the GRE Portfolio for the same time period were estimated to be approximately $1.0 million.
(3) Annualized Rent for the joint venture properties is reported with respect to each property in its entirety, rather than the portion of the property represented by our ownership interest. Our share of the joint venture properties’ Annualized Rent is calculated by multiplying the percentage of our ownership interest in such properties by the amount of Annualized Rent. No portion of the joint venture properties’ Annualized Rent is consolidated in our consolidated financial statements because our interests in our joint ventures are accounted for under the equity method of accounting.
(4) Existing net rents are converted to gross rents by adding contractual expense reimbursements, which are estimated by annualizing September 2010 actual expense reimbursement billings, to base rents.
(5) Annualized Rent per Leased Square Foot represents Annualized Rent divided by square feet of commenced leases as of September 30, 2010.
(6) Waterfront Plaza, Clifford Center, BOH Waikiki Center and a portion of the parking garage at U.S. Bank Center are owned pursuant to long-term ground leases.
(7) Our ownership interest in each joint venture property is indicated in parentheses.

The following charts illustrate the relative sizes of our markets by annualized rent and the sources of our annualized rent (as between our wholly-owned and joint venture properties), both for our existing portfolio and on a pro forma basis including the GRE portfolio.

 

EXISTING PORTFOLIO

  

PRO FORMA PORTFOLIO

MARKETS BY ANNUALIZED RENT (1)
LOGO    LOGO

OWNERSHIP BY ANNUALIZED RENT (1)

LOGO    LOGO

 

(1) For joint venture properties, includes the Annualized Rent for the property multiplied by our percentage ownership of the joint venture.

 

 

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Financing Strategies

We believe that we have developed a unique capitalization strategy that will allow us to make office building acquisitions in an increasingly competitive market. The primary objective of our financing strategy is to create a stable yet flexible capital structure.

We believe that, upon the completion of this offering, we will have access to multiple sources of capital to fund our long-term growth capital needs and liquidity requirements. Our ability to access four distinct sources of equity — the public market, the retail investor market, the tax-sensitive owner market and the private institutional market — distinguishes us from most of our office REIT competitors.

LOGO

Our capitalization strategy is to create and maintain what we believe to be a stable debt and equity capital structure. We intend to employ prudent amounts of leverage as a means of providing additional funds to acquire properties, to refinance existing debt or for general corporate purposes. At September 30, 2010, on a pro forma basis, the outstanding principal amount of our consolidated debt and aggregate liquidation preference of our outstanding Senior Common Stock and preferred stock was equal to approximately 47.2% of our total market capitalization (40.0% if the underwriters’ over-allotment option is exercised in full and the additional net offering proceeds and cash and cash reserves are offset against both consolidated debt and total market capitalization). We intend to limit this ratio to no more than 55%, although our organizational documents contain no limitations regarding the maximum level of debt that we may incur and we may exceed this amount from time to time.

Upon the completion of this offering and the concurrent transactions, we will have minimal near-term consolidated debt maturities, with only approximately $18.4 million maturing on a pro forma basis before 2013. Our debt consists of, and we intend to continue to employ, primarily non-recourse, fixed-rate mortgage financing. We have received commitments for a three-year $125.0 million secured revolving credit facility from affiliates of certain of the underwriters and expect to close this facility concurrently with the completion of this offering and the concurrent transactions.

Private Placement, Note Exchange, Unit Conversion and Internalization

Concurrent with the completion of this offering, Messrs. Shidler, Ingebritsen, Root, Taff and Reynolds (or entities controlled by them) will purchase a total of $12.0 million in shares of our common stock (1,500,000 shares) in a private placement at a price per share equal to the public offering price and without payment by us of

 

 

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any underwriting discount or commission. Furthermore, concurrent with the completion of this offering, Messrs. Shidler, Ingebritsen, Root, Taff and Reynolds (or entities controlled by them) will exchange all principal and accrued but unpaid interest outstanding under unsecured promissory notes issued by the Operating Partnership (which totaled approximately $24.9 million in the aggregate as of September 30, 2010) for common units of our Operating Partnership at a price per unit equal to the public offering price per share of common stock in this offering and without payment by us of any underwriting discount or commission.

As a result of our March 2008 formation transactions, POP Venture, LLC, or Venture, an entity controlled by Mr. Shidler, holds all 454,530 outstanding preferred units (after giving effect to the one-for-ten reverse unit split) of our Operating Partnership. Under our Operating Partnership’s agreement of limited partnership, each preferred unit will become convertible into 7.1717 common units upon the completion of this offering. Venture has agreed to convert all of these outstanding preferred units into common units. As a result of this conversion, Venture will relinquish a $113.6 million liquidation preference, and an annual dividend preference of $2.3 million, in exchange for 3,259,752 common units, exchangeable after one year on a one-for-one basis for 3,259,752 shares of our common stock, and having an aggregate value of approximately $26.1 million based upon the assumed public offering price of $8.00, which is the midpoint of the estimated price range set forth on the front cover of this prospectus. These common units have the right to distributions equivalent to dividends on our common stock, without priority. Therefore, these common units would be anticipated to receive approximately $1.2 million in aggregate distributions for the 12-month period following the completion of this offering based upon our estimated distributions described in this prospectus.

Prior to the completion of this offering and the concurrent transactions, we have been externally advised by our Advisor, Pacific Office Management, an entity owned and controlled by Messrs. Shidler, Ingebritsen, Root, Taff and Reynolds. Concurrent with the completion of this offering, we will internalize our management by acquiring all of the outstanding stock of our Advisor for an aggregate purchase price of $25,000 payable in cash. Our Advisor has agreed to forego the $1.0 million termination fee provided for under the Advisory Agreement in connection with the termination of that agreement, and to forego any potential rights to approximately $5.6 million of additional fees that could have accrued in its favor under the Advisory Agreement upon the completion of this offering (assuming no exercise of the underwriters’ over-allotment option), our acquisition of the GRE portfolio and our entry into the new credit facility. We will elect to treat Pacific Office Management as a taxable REIT subsidiary, or TRS, for federal income tax purposes. As a TRS, Pacific Office Management can provide non-customary REIT and other services to our tenants and engage in joint venture and other activities that we may not engage in directly without adversely affecting our qualification as a REIT. We anticipate that, immediately following this offering, Pacific Office Management will continue to provide property management and other administrative services to all of the joint venture properties in our portfolio, as well as six properties and one entity owned by affiliates of The Shidler Group, in consideration for fees payable for these services at what we believe to be market rates. Immediately following the concurrent transactions, we expect our Operating Partnership to have 78 employees, comprised of individuals who are currently employees of our Advisor, including all of our executive officers, and eight other individuals to be hired in connection with our pending acquisition of the GRE portfolio.

Upon the completion of this offering and the concurrent transactions, our directors and executive officers will own approximately 12.6% of our common stock on a fully diluted basis. Specifically, Mr. Shidler will own 7.6%, Mr. Ingebritsen will own 1.6%, Mr. Root will own 1.6% and Mr. Taff will own 1.4% of our common stock on a fully diluted basis. We believe that this is a level of insider ownership that enhances alignment between our executive officers and our stockholders. None of our executive officers, our board of directors or any of our affiliates will receive any additional shares of our common stock, additional units in our Operating Partnership, or interest in the Company as the result of this offering, other than from the transactions described above and the issuance of a total of 2,859 shares of our common stock to three directors who are resigning upon the completion of this offering as a result of accelerated vesting of outstanding restricted stock units.

 

 

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Exchange Listing

Shares of our common stock are currently listed on the NYSE Amex under the symbol “PCE.” Our common stock has been approved for listing on the NYSE under the symbol “PCE,” subject to official notice of issuance. We intend to complete a one-for-ten reverse stock split of our common stock immediately prior to the completion of this offering.

Corporate Structure

The following diagram depicts our ownership structure upon the completion of this offering and the concurrent transactions, assuming no exercise of the underwriters’ over-allotment option and after giving effect to the one-for-ten reverse stock split of our common stock that we intend to complete immediately prior to the completion of this offering. Substantially all of our operations are carried out through our Operating Partnership and its subsidiaries.

LOGO

 

 

(1) Excludes ownership of 663,394 shares of Series A Senior Common Stock with an aggregate liquidation preference of $6,633,940, as of September 30 , 2010.
(2) Includes 1,509,528 shares of our common stock beneficially owned by our directors and executive officers and 1,906 shares of our common stock issuable to our directors upon vesting of outstanding restricted stock unit awards.
(3) Includes ownership of common units (following the conversion of all outstanding preferred units to common units and the issuance of common units upon the exchange of unsecured promissory notes, both occurring upon the completion of this offering), which are exchangeable on a one-for-one basis for 5,356,040 shares of our common stock, subject to certain restrictions.

 

 

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Conflicts of Interest

We are subject to various potential conflicts of interest that may include:

 

   

conflicts resulting from the affiliation between us and the dealer manager in our ongoing offering of Series A Senior Common Stock;

 

   

conflicts with respect to the prepayment or defeasance of debt secured by the properties contributed in our formation transactions;

 

   

conflicts with respect to the grant of registration rights to certain of our affiliates;

 

   

conflicts related to indemnification agreements entered into with certain of our affiliates; and

 

   

conflicts resulting from potential competition with the Chairman of our board of directors.

See “Conflicts of Interest” for more information.

Restrictions on Ownership and Transfer

We and our executive officers, directors, director nominees and Mr. Reynolds have agreed with the underwriters, subject to certain exceptions, not to offer, sell, contract to sell, pledge or otherwise dispose of, directly or indirectly, any shares of our common stock or securities convertible into or exchangeable or exercisable for any shares of our common stock, including common units in our Operating Partnership but excluding Senior Common Stock, for a period of 180 days after the date of this prospectus. In addition, the common units received by Venture upon the conversion of its preferred units cannot be exchanged for shares of our common stock for a period of 365 days following the conversion. We have agreed that we will not offer, sell, contract to sell, pledge or otherwise dispose of, directly or indirectly, any shares of Senior Common Stock or publicly disclose the intention to make any offer, sale, pledge, disposition or filing without the prior written consent of Credit Suisse Securities (USA) LLC, Wells Fargo Securities, LLC and Citigroup Global Markets Inc. for a period of 30 days after the date of this prospectus.

In order to assist us in complying with the limitations on the concentration of ownership of REIT stock imposed by the Internal Revenue Code of 1986, as amended, or the Code, among other purposes, our charter provides that no person or entity, other than Mr. Shidler, certain of our founders or any individual as designated by our charter or our board of directors (referred to as excepted individuals), may own, directly or indirectly, more than 4.9% in economic value of the aggregate of the outstanding shares of our capital stock or 4.9% in economic value or number of shares, whichever is more restrictive, of the aggregate of the outstanding shares of our common stock (including our outstanding shares of Class B Common Stock and Senior Common Stock). However, our charter authorizes our board of directors to increase or decrease the stock ownership limits from time to time provided that the new ownership limits would not allow five or fewer persons to beneficially own more than 49.9% in value of our outstanding capital stock. Pursuant to this authorization, our board of directors has adopted resolutions increasing each of the ownership limits to 9.8% effective upon the completion of this offering.

Our charter also prohibits any person from (1) beneficially or constructively owning shares of our capital stock that would result in our being “closely held” under Section 856(h) of the Code at any time during the taxable year, (2) transferring shares of our capital stock if such transfer would result in our stock being beneficially or constructively owned by fewer than 100 persons, (3) beneficially or constructively owning shares of our capital stock that would result in our owning (directly or constructively) 10% or more of the ownership interest in a tenant of our real property if income derived from such tenant for our taxable year would result in more than a de minimis amount of non-qualifying income for purposes of the REIT tests and (4) beneficially or constructively owning shares of our capital stock if such ownership would cause us otherwise to fail to qualify as a REIT.

 

 

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Our Distribution Policy

Beginning with our first quarterly dividend following the completion of this offering, we intend to make regular quarterly distributions of $0.09 per share to holders of our common stock. On an annualized basis, this would be $0.36 per share, or an annual distribution rate of approximately 4.5% based upon the assumed public offering price of $8.00 per share of our common stock, which is the midpoint of the estimated price range set forth on the front cover of this prospectus. Our estimated annual rate of distribution following the completion of this offering represents approximately 93.9% of our estimated pro forma cash available for distribution to our common stockholders for the 12-month period ending September 30, 2011. Purchasers of shares of our common stock in this offering will not participate in the dividend declared for the fourth quarter of 2010, which was authorized on December 20, 2010 to be paid on January 17, 2011 to stockholders of record on December 31, 2010.

We intend to maintain our distribution rate for the 12-month period following the completion of this offering unless actual results of operations, economic conditions or other factors differ materially from the assumptions used in our estimate. Distributions declared by us will be authorized by our board of directors in its sole discretion out of funds legally available therefor and will be dependent upon a number of factors, including the preferential rights of our Senior Common Stock, restrictions under applicable law, the capital requirements of our company and meeting the distribution requirements necessary to maintain our qualification as a REIT. We cannot assure you, however, that our intended distributions will be made or sustained or that our board of directors will not change our distribution policy in the future. Under some circumstances, we may be required to fund distributions from working capital, liquidate assets at prices or times that we regard as unfavorable or borrow to provide funds for distributions, or we may make distributions in the form of a taxable stock dividend. However, we have no current intention to use the net proceeds from this offering to make distributions nor do we intend to make distributions using shares of our common stock. We do not intend to reduce the expected distribution per share if the underwriters exercise their option to purchase up to 6,600,000 additional shares solely to cover over-allotments.

Tax Status

Our qualification as a REIT depends upon our ability to meet on a continuing basis, through actual investment and operating results, various complex requirements under the Code relating to, among other things, the sources of our gross income, the composition and values of our assets, our distribution levels and the diversity of ownership of our shares.

So long as we continue to qualify as a REIT, we generally will not be subject to federal income tax on our net taxable income that we distribute currently to our stockholders. If we fail to qualify for taxation as a REIT in any taxable year, and the statutory relief provisions of the Code do not apply, we will be subject to federal income tax at regular corporate rates and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year during which we lost our REIT qualification. Distributions to stockholders in any year in which we are not a REIT would not be deductible by us, nor would they be required to be made. Even if we qualify for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income, property or net worth.

For more information, see “Federal Income Tax Considerations.”

 

 

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The Offering

 

Common stock offered by us

44,000,000 shares (plus up to an additional 6,600,000 shares upon exercise of the underwriters’ over-allotment option).

 

Common stock to be outstanding immediately after this offering

46,898,098 shares of common stock (1)

 

Common stock and common units to be outstanding immediately after this offering

54,685,140 shares of common stock and common units (1)(2)

 

Listing

Shares of our common stock are currently listed and traded on the NYSE Amex under the symbol “PCE.” Our common stock has been approved for listing on the NYSE under the symbol “PCE,” subject to official notice of issuance.

 

Use of Proceeds

We estimate that the net proceeds from this offering will be approximately $325.3 million, after deducting underwriting discounts and commissions and estimated offering expenses of approximately $26.7 million (or, if the underwriters exercise their over-allotment option in full, approximately $374.4 million, after deducting underwriting discounts and commissions and estimated offering expenses of approximately $30.4 million). The net proceeds we will receive in the concurrent private placement of our common stock will be $12.0 million.

We expect to contribute the net proceeds of this offering and the concurrent private placement to our Operating Partnership. Our Operating Partnership plans to use substantially all of the net proceeds and existing cash:

 

   

to fund the cash portion of our pending acquisition of the GRE portfolio, net of deposits, and related costs;

 

   

to discharge existing debt on our existing properties, including accrued interest and prepayment and other penalties and exit fees related to such debt;

 

   

to pay fees and expenses associated with the new credit facility; and

 

   

for general working capital purposes.

 

Risk Factors

An investment in our common stock involves risks. Please read “Risk Factors” beginning on page 18 of this prospectus.

 

(1)

The number of shares of our common stock to be outstanding immediately after the completion of this offering and the concurrent transactions is based on the total number of shares of our common stock outstanding at December 1, 2010, as adjusted to give effect to (a) this offering, (b) the concurrent private placement of a total of 1,500,000 shares to Messrs. Shidler, Ingebritsen, Root, Taff and Reynolds (or entities controlled by them), (c) the issuance of 1,004,934 shares of our common stock in connection with our acquisition of the GRE portfolio, (d) the issuance of 2,859 shares of our common stock upon the accelerated vesting of outstanding restricted stock units and (e) the one-for-ten reverse stock split that we intend to complete immediately prior to the completion of this offering, and excludes (i) 6,600,000 shares issuable upon the full exercise of the underwriters’ over-allotment option, (ii) 1,410,102 shares which may be issued upon redemption of the currently outstanding common units of our Operating Partnership, (iii) 3,259,752 shares which may be issued upon redemption of common units into which the outstanding preferred units will be converted upon the completion of this

 

 

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offering (but which shares may not be issued earlier than one year after the date of the conversion of the preferred units into common units), (iv) 3,117,188 shares which may be issued upon the redemption of common units to be issued upon the completion of this offering to Messrs. Shidler, Ingebritsen, Root, Taff and Reynolds (or entities controlled by them) in connection with the exchange by them of all principal and accrued interest outstanding under unsecured promissory notes issued by our Operating Partnership (which totaled approximately $24.9 million in the aggregate as of September 30, 2010), (v) 1,906 shares issuable upon the vesting of outstanding restricted stock units granted to certain directors under the 2008 Directors’ Stock Plan, or the Directors’ Stock Plan and (vi) 1,940 shares issuable in the future under the Directors’ Stock Plan.

(2) The number of common units to be outstanding immediately after this offering takes into account (a) the conversion of all outstanding preferred units to 3,259,752 common units and (b) 3,117,188 common units to be issued upon the completion of this offering to Messrs. Shidler, Ingebritsen, Root, Taff and Reynolds (or entities controlled by them) in connection with the exchange by them of all principal and accrued interest outstanding under unsecured promissory notes issued by our Operating Partnership (which totaled approximately $24.9 million in the aggregate as of September 30, 2010), both of which will occur concurrent with the completion of this offering.

 

 

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Summary Selected Financial Data

The following table sets forth summary selected financial and operating data on a pro forma and historical basis. Our financial information and results of operations were significantly affected by the consummation of our formation transactions on March 19, 2008. We determined that the commercial real estate assets contributed by Venture in connection with our formation transactions were not under common control. Waterfront Partners OP, LLC, or Waterfront, which had the largest interest in Venture, was designated as the acquiring entity in the business combination for financial accounting purposes. Accordingly, historical financial information for Waterfront has also been presented for the period from January 1, 2008 through March 19, 2008. We have not presented historical information for periods prior to January 1, 2008 because we believe that a discussion of the results of Waterfront during those periods would not be meaningful.

You should read the following summary selected financial data in conjunction with our historical consolidated financial statements and combined pro forma financial statements and the related notes thereto and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which are included elsewhere in this prospectus.

The historical balance sheet data as of September 30, 2010 and 2009 and the historical statement of operations data for the nine months ended September 30, 2010 and 2009 have been derived from our historical unaudited condensed consolidated financial statements included elsewhere in this prospectus. The historical balance sheet data as of December 31, 2009 and 2008 and the historical statement of operations data for the years ended December 31, 2009 and 2008 have been derived from the historical audited combined consolidated financial statements included elsewhere in this prospectus.

Our unaudited summary selected pro forma combined financial statements and operating information as of, and for the nine months ended, September 30, 2010 and for the year ended December 31, 2009 assume the completion of this offering and the completion of the concurrent transactions as of January 1, 2009 for the operating data and as of the stated date for the balance sheet data. Our pro forma financial information is not necessarily indicative of what our actual financial position and results of operations would have been as of the date and for the periods indicated, nor does it purport to represent our future financial position or results of operations.

 

 

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    Nine Months Ended September 30,     Year Ended December 31,  
  Pro Forma
Combined
2010
    Historical     Pro Forma
Combined
2009
    Historical  
      2010     2009       2009     2008(1)  
    (unaudited)     (unaudited)     (unaudited)     (unaudited)              
    (in thousands, except share and per share data)  

Statement of Operations Data:

           

Revenue:

           

Rental

  $ 58,575      $ 31,621      $ 31,999      $ 80,498      $ 42,462      $ 37,447   

Tenant reimbursements

    18,804        16,742        16,184        25,016        21,662        19,375   

Parking

    6,349        6,093        6,080        8,437        8,150        6,890   

Property management and other services

    1,793        —          —          2,739        —          —     

Other

    399        267        270        602        365        394   
                                               

Total revenue

    85,920        54,723        54,533        117,292        72,639        64,106   

Expenses:

           

Rental property operating

    40,982        29,885        29,356        54,408        39,480        37,714   

General and administrative

    8,550        2,091        1,997        12,303        2,649        18,577   

Depreciation and amortization

    32,304        17,178        20,470        47,408        27,240        22,295   

Interest

    19,179        22,580        20,348        26,063        27,051        22,932   

Loss on extinguishment of debt

    —          —          171        171        171        —     

Acquisition costs

    —          630        —          —         

Other

    —          —          —          —          —          143   
                                               

Total expenses

    101,015        72,364        72,342        140,353        96,591        101,661   

Loss before equity in net earnings of unconsolidated joint ventures and non-operating income

    (15,095     (17,641     (17,809     (23,061     (23,952     (37,555

Equity in net earnings of unconsolidated joint ventures

    184        184        406        313        313        93   

Non-operating income

    —          —          6        435        434        85   
                                               

Net loss

    (14,911     (17,457     (17,397     (22,313     (23,205     (37,377

Fair value adjustment of Preferred Units

    —          —          —          —          (58,645     —     

Net loss attributable to non-controlling interests

    2,135        13,409        13,984        3,188        66,237        29,557   

Dividends on Series A Senior Common Stock

    (53     (53     —          —          —          —     
                                               

Net loss attributable to common stockholders

  $ (12,829   $ (4,101   $ (3,413   $ (19,125   $ (15,613   $ (7,820
                                               

Balance Sheet Data (at period end):

           

Investments in real estate, net

  $ 651,714      $ 378,274      $ 385,431        $ 382,950      $ 392,657   

Total assets

  $ 824,202      $ 514,324      $ 513,952        $ 510,948      $ 530,933   

Mortgage and other loans, net

  $ 383,728      $ 419,720      $ 403,347        $ 406,439      $ 400,108   

Total liabilities

  $ 423,765      $ 479,845      $ 455,437        $ 459,667      $ 453,825   

Non-controlling interests (mezzanine equity)

  $ —        $ —        $ 130,679        $ —        $ 133,250   

Total stockholders’ equity

  $ 310,964      $ (131,246   $ —          $ (132,326   $ (56,142

Non-controlling interests (permanent equity)

  $ 89,473      $ 165,725      $ —          $ 183,607      $ —     

Total equity

  $ 400,437      $ 34,479      $ (72,164     $ 51,281      $ (56,142

Per Share Data (2):

           

Net loss per common share — basic and diluted

  $ (0.27   $ (10.60   $ (11.15   $ (0.41   $ (47.91     ( 3) 
                                               

Weighted average number of common shares outstanding — basic and diluted

    46,894,792        386,999        305,968        46,833,694        325,901        ( 3) 

Other Data:

           

FFO attributable to common stockholders (4)

  $ 19,289      $ (87   $ 3,274      $ 27,667      $ (54,310  

FFO attributable to common stockholders, excluding non-recurring items and fair value adjustment of preferred units (4)

  $ 19,289      $ 2,976      $ 3,274      $ 27,667      $ 4,335     

 

(1) Amounts in this column represent the sum of the consolidated results of operations of Waterfront for the period from January 1, 2008 through March 19, 2008 and our consolidated results of operations for the period from March 20, 2008 through December 31, 2008.
(2) Historical per share calculations are adjusted for the one-for-ten reverse stock split that we intend to effectuate prior to the completion of this offering and immediately prior to the effectiveness of the registration statement of which this prospectus is a part.
(3) For the period from March 20, 2008 through December 31, 2008, we reported a net loss attributable to common stockholders of $6,741.

 

The per share data is as follows (and adjusted for the one-for-ten reverse stock split):

  

Net loss per common share — basic and diluted

   $ (22.24
        

Weighted average number of common shares outstanding — basic and diluted

     303,113   
        

For the period from January 1, 2008 through March 19, 2008, Waterfront reported a net loss attributable to unitholders of $1,079.

  

The per unit data is as follows (and adjusted for the one-for-ten reverse stock split):

  

Net loss per unit — basic and diluted

   $ (3.09
        

Weighted average number of units outstanding — basic and diluted

     349,462   
        

 

(4) For a definition and reconciliation of FFO and a statement disclosing the reasons why our management believes that presentation of FFO provides useful information to investors and, to the extent material, any additional purposes for which our management uses FFO, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Funds from Operations.”

 

 

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RISK FACTORS

Investing in our common stock involves a high degree of risk. You should carefully consider each of the risks described below, together with all of the other information contained in this prospectus before deciding to invest in shares of our common stock. If any of the following risks develop into actual events, our business, financial condition, results of operations and our ability to make cash distributions to our stockholders could be materially adversely affected, the value of your shares could decline and you may lose all or part of your investment. Some statements in this prospectus, including statements in the following risk factors, constitute forward-looking statements. See “Forward-Looking Statements.”

Risks Related to Our Business and Properties

We may be unable to complete acquisitions that would grow our business, including the properties that we intend to acquire with the proceeds of this offering, which represent approximately 38.8% of the annualized rent of our wholly-owned properties on a pro forma basis including the GRE portfolio.

We have contracted to acquire the GRE portfolio, which is comprised of 12 office properties, containing approximately 1.9 million rentable square feet. We intend to use a substantial portion of the net proceeds from this offering and the concurrent transactions to acquire these properties. However, our acquisition of these properties is subject to customary closing conditions and the contract expires on January 21, 2011. Accordingly, we cannot assure you that the acquisition of any one or all of these properties will be consummated, and our failure to acquire one or more of these properties or to integrate them successfully into our business could materially and adversely affect us.

We plan to acquire additional properties as opportunities arise. Our ability to acquire additional properties on favorable terms is subject to the following significant risks:

 

   

we may not be successful in identifying suitable properties or other assets that meet our investment criteria or in consummating acquisitions on satisfactory terms, if at all;

 

   

because of current market conditions and depressed real estate values, owners of large office properties may be reluctant to sell their properties, resulting in fewer opportunities to acquire properties compatible with our growth strategy;

 

   

we may be unable to acquire desired properties because of competition from other real estate investors with better access to less expensive capital, including other real estate operating companies, publicly traded REITs and investment funds;

 

   

competition for desirable properties may intensify as investments in real estate become increasingly attractive relative to other forms of investment, resulting in increased prices or fewer investment opportunities;

 

   

we may acquire properties that are not accretive to our results upon acquisition, and we may not successfully manage and lease those properties to meet our expectations;

 

   

competition from other potential acquirers may significantly increase purchase prices;

 

   

we may be unable to generate sufficient cash from operations or obtain the necessary debt or equity financing to consummate an acquisition on favorable terms or at all;

 

   

we may spend significant time and money on potential acquisitions that we do not consummate; and

 

   

we may acquire properties without any recourse, or with only limited recourse, for liabilities against the former owners of the properties.

If we cannot complete property acquisitions on favorable terms, our financial condition, results of operations, cash flow, per share trading price of our common stock and ability to satisfy our debt service obligations and to pay dividends to you could be adversely affected.

 

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We may fail to successfully integrate and operate acquired properties, including the properties we intend to acquire with the proceeds of this offering.

Acquired properties may have characteristics or deficiencies unknown to us that could affect such properties’ valuation or revenue potential. In addition, there can be no assurance that the operating performance of acquired properties will not decline under our management. We cannot assure you that we will be able to successfully integrate acquired properties into our business.

Our ability to successfully integrate and operate any acquired property is subject to the following significant risks:

 

   

we may need to spend more than anticipated amounts to make necessary improvements or renovations to acquired properties;

 

   

we may be unable to quickly and efficiently integrate new acquisitions into our existing operations; and

 

   

we may suffer higher than expected vacancy rates and/or lower than expected rental rates.

If we cannot operate acquired properties to meet our goals or expectations, our financial condition, results of operations, cash flow, per share trading price of our common stock and ability to satisfy our debt service obligations and to pay dividends to you could be adversely affected.

We expect to defease and refinance the indebtedness encumbering up to four properties in the GRE portfolio if we cannot obtain the consent of the mortgage lenders for these properties to the assumption of these loans, which will cause us to incur additional costs and will delay the acquisitions of these properties.

The Foothill Building, Carlton Plaza, Warner Center and Toshiba Building properties in the GRE portfolio are encumbered by non-recourse mortgage loans with an aggregate principal amount of approximately $56.3 million as of September 30, 2010. In connection with our acquisition of these properties, we expect to assume these mortgage loans from the sellers. Prior to assuming any of these loans, we must obtain the consent of the applicable mortgage lender. If the consent of the lender for any of these properties is not obtained, we expect to defease the loan in accordance with the applicable loan agreement. Although we expect to obtain all of the required lender consents in a timely manner, if we defease the mortgage loans for each of these four properties, we expect that we will be required to pay an additional $6.3 million in net collateral and other costs and expenses in excess of the aggregate principal amount of these loans. In addition, in the event that we defease the loans secured by these properties, the acquisition of the properties may be delayed by up to 60 days.

We may be unable to successfully expand our operations into new markets in the western United States, which could adversely affect our financial condition.

Each of the risks applicable to our ability to acquire and successfully integrate and operate properties in our target markets of Honolulu, San Diego, Orange County, certain submarkets of Los Angeles and the San Francisco Bay Area are also applicable to our ability to acquire and successfully integrate and operate properties in additional markets in which we might target acquisitions in the future. In addition to these risks, we may not possess the same level of familiarity with the dynamics and market conditions of certain new markets that we may enter, which could adversely affect our ability to expand into those markets. We may be unable to build a significant market share or achieve a desired return on our investments in new markets. If we are unsuccessful in expanding into new markets, it could adversely affect our financial condition, results of operations, cash flow, per share trading price of our common stock and ability to satisfy our debt service obligations and to pay dividends to you.

 

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Our acquisition pipeline may not reflect acquisitions that are actually achieved.

We attempt to maintain a “pipeline” of property acquisitions, a common industry practice, in order to facilitate our understanding of the marketplace and to maximize our acquisition opportunities. Our management monitors the status of pipeline opportunities, including the status of negotiations, due diligence or other acquisition-related process, the potential size, expressed in dollars and square footage, and other factors management considers important. As part of our pipeline, we are actively reviewing and have made offers on more than $2.0 billion of potential acquisitions in our target markets. These status evaluations are sometimes aggregated to describe a sales pipeline. We compare this pipeline at various points in time to evaluate trends in our business and our markets. This analysis provides guidance in business planning and forecasting, but these pipeline estimates are by their nature speculative. Our pipeline evaluations aggregate opportunities and property and transactions information that is dissimilar and do not reflect our beliefs as to the probability of consummation of any transaction. As such, a description of our acquisition pipeline is not necessarily a reliable predictor of future acquisitions, whether in a particular quarter or over a longer period of time. For example, an adverse change in economic conditions or a variety of other factors can cause sales decisions to be delayed or cancelled or funding sources to become scarce or costly while a positive change in market conditions could increase asking prices, which would reduce the attractiveness of transactions in the pipeline. You should not rely upon any expression of our pipeline to predict our future performance.

All of our properties are located in California, Honolulu and Phoenix. We are dependent on the California, Honolulu and Phoenix office markets and economies, and are therefore susceptible to risks of events in those markets that could adversely affect our business, such as adverse market conditions, changes in local laws or regulations, and natural disasters.

Upon the completion of our pending acquisition of the GRE portfolio, 56%, 24% and 20% of the rentable square feet in our property portfolio (including our joint venture properties) will be located in California, Honolulu and Phoenix, respectively. Prior to the completion of our pending acquisition of the GRE portfolio, our consolidated portfolio is particularly concentrated in Honolulu, where six of our eight wholly-owned properties are located, representing 79% of our annualized rent from our wholly-owned properties as of September 30, 2010. Because all of our properties are concentrated in these locations, we are exposed to greater economic risks than if we owned a more geographically dispersed portfolio. We are susceptible to adverse developments in the California, Honolulu and Phoenix economic and regulatory environments (such as business layoffs or downsizing, industry slowdowns, relocations of businesses, increases in real estate and other taxes, costs of complying with governmental regulations or increased regulation and other factors) as well as natural disasters that occur in these areas (such as earthquakes, hurricanes, floods, wildfires and other events). In particular, California is regarded as more litigious and more highly regulated and taxed than many states, which may reduce demand for office space in California. Any adverse developments in the economy or real estate markets in California, Honolulu or Phoenix, or any decrease in demand for office space resulting from the California, Honolulu or Phoenix regulatory or business environments, could adversely impact our financial condition, results of operations and cash flow, the per share trading price of our common stock and our ability to satisfy our debt service obligations and to pay dividends to you.

We have a limited operating history and may not be able to operate our business successfully or implement our business strategies as described in this prospectus.

We were formed in March 2008 via a merger of The Shidler Group’s western U.S. office portfolio and joint venture operations into a then-existing publicly traded REIT. Although we are an existing publicly traded REIT, we have a limited operating history. We cannot assure you that we will be able to operate our business successfully or implement our business strategies as described in this prospectus.

 

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Prior to the completion of this offering, we have been externally managed by an entity controlled by the Chairman of our board of directors and certain of our executive officers; we do not have any operating history as a REIT that is self-administered and self-managed.

Prior to the completion of this offering, we have been externally managed by our Advisor, an entity controlled by the Chairman of our board of directors and certain of our executive officers. Concurrent with the completion of this offering, we will acquire our Advisor and thereby become internally managed. We cannot assure you that our past performance with external management will be indicative of internal management’s ability to function effectively and successfully operate our company. We do not have any operating history with internal management and do not know if we will be able to successfully integrate our existing external management. Once we are internally managed, our direct expenses will include general and administrative costs previously borne by our Advisor. Also, as currently organized, we do not directly employ any employees. However, upon the completion of this offering and the internalization of management, we will directly employ the executive officers and other employees that are now employed and paid by our Advisor. By employing personnel, we will be subject to potential liabilities commonly faced by employers, such as workers’ disability and compensation claims, potential labor disputes and other employee-related liabilities and grievances. Our failure to successfully integrate the operations of our Advisor could have a negative effect on our operations.

We expect our operating expenses to increase following this offering and that they may further increase in the future, even if our revenues do not increase, causing our results of operations to be adversely affected.

Prior to the completion of this offering, we have been externally advised by our Advisor. Our Advisor bore the cost and was not reimbursed by us for any expenses incurred by it in the course of performing operational advisory services for us, including salaries and wages, office rent, equipment costs, travel costs, insurance costs, telecommunications and supplies. Our Advisor has informed us that its expenses for performing operational advisory services for us exceeded the advisory fees that we paid to it. We therefore expect our operating costs, specifically general and administrative costs, to increase following the internalization of our management. Other factors that may adversely affect our ability to control operating costs include the need to pay for insurance and other operating costs, including real estate taxes, which could increase over time, the need periodically to repair, renovate and re-lease space, the cost of compliance with governmental regulation, including zoning and tax laws, the potential for liability under applicable laws, interest rate levels and the availability of financing. If our operating costs increase as a result of any of the foregoing factors, our results of operations may be adversely affected.

Our success depends on key personnel with extensive experience dealing with the real estate industry, and the loss of these key personnel could threaten our ability to operate our business successfully.

Our future success depends, to a significant extent, on the continued services of our management team. In particular, we depend on the efforts of Mr. Shidler, the Chairman of our board of directors, Mr. Ingebritsen, our President and Chief Executive Officer, and our other executive officers. Each of these persons has a national or regional reputation in the real estate industry based on their extensive experience in running public and private companies, including REITs, devoted to real estate investment, management and development. Each member of our management team has developed informal relationships through past business dealings with numerous members of the real estate community, including current and prospective tenants, lenders, real estate brokers, developers and managers. We expect that their reputations afford us a “first call” advantage in attracting business and investment opportunities before the active marketing of properties and assist us in negotiations with lenders, existing and potential tenants, and industry personnel. If we lost their services, our relationships with such lenders, existing and prospective tenants, and industry personnel could suffer.

 

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The prior performance of publicly traded REITs founded by The Shidler Group may not be indicative of our future results.

We can provide no assurance that our management team will replicate the success exhibited in their previous endeavors, and our investment returns could be substantially lower than the returns achieved by these previous endeavors. You should not rely upon the past performance of other publicly traded REITs founded by The Shidler Group, including Corporate Office Properties Trust, to predict our future performance.

The actual rents we receive for the properties in our portfolio may be less than our asking rents, and we may experience lease roll down from time to time, which would negatively impact our ability to generate cash flow growth.

We may be unable to realize our asking rents across the properties in our portfolio because of:

 

   

competitive pricing pressure in our markets;

 

   

adverse conditions in the California, Honolulu or Phoenix real estate markets;

 

   

general economic downturn; and

 

   

the desirability of our properties compared to other properties in our markets.

In addition, the degree of discrepancy between our asking rents and the actual rents we are able to obtain may vary both from property to property and among different leased spaces within a single property. If we are unable to achieve our asking rents across our portfolio, then our ability to generate cash flow growth will be negatively impacted. In addition, depending on asking rental rates at any given time as compared to expiring leases in our portfolio, from time to time rental rates for expiring leases may be higher than starting rental rates for new leases.

The expense of owning and operating a property is not necessarily reduced when circumstances such as market factors and competition cause a reduction in income from the property. As a result, if revenues decline, we may not be able to reduce our expenses accordingly. If a property is mortgaged and we are unable to meet the mortgage payments, the lender could foreclose on the mortgage and take possession of the property, resulting in a further reduction in net income.

Leases representing approximately 33.3% of the rentable square feet (or approximately 41.4% of the annualized rent) of our consolidated portfolio, on a pro forma basis, are scheduled to expire through 2012. We may be unable to renew leases or lease vacant space at favorable rates or at all, which would negatively impact our ability to generate cash flow.

As of September 30, 2010, on a pro forma basis to reflect the acquisition of the GRE portfolio, leases representing approximately 4.3% of the 4,212,893 rentable square feet of our consolidated portfolio were scheduled to expire during the remainder of 2010, and an additional 17% of the rentable square footage of our consolidated portfolio was available for lease. Leases representing approximately 33.3% of the rentable square feet (or approximately 41.4% of our annualized rent) of our consolidated portfolio, on a pro forma basis, are scheduled to expire through 2012. These leases may not be renewed, or may be re-leased at rental rates equal to or below existing rental rates. In addition, some of our leases include early termination provisions that permit the lessee to terminate all or a portion of its lease with us after a specified date or upon the occurrence of certain events with little or no liability to us. Substantial rent abatements, tenant improvements, early termination rights or below-market renewal options may be offered to attract new tenants or retain existing tenants. Portions of our properties may remain vacant for extended periods of time. In addition, some existing leases currently provide tenants with options to renew the terms of their leases at rates that are less than the current market rate or to terminate their leases prior to the expiration date thereof. If we are unable to obtain rental rates that are on average comparable to our asking rents across our portfolio, then our ability to generate cash flow growth will be negatively impacted.

 

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We may be required to make significant capital expenditures to improve our properties in order to retain and attract tenants, causing a decline in operating revenues and reducing cash available for debt service and distributions to stockholders.

We expect that, upon expiration of leases at our properties, we may be required to make rent or other concessions to tenants, accommodate requests for renovations, build-to-suit remodeling and other improvements or provide additional services to our tenants. As a result, we may have to make significant capital or other expenditures in order to retain tenants whose leases expire and to attract new tenants in sufficient numbers. Additionally, we may need to raise capital to make such expenditures. If we are unable to do so or capital is otherwise unavailable, we may be unable to make the required expenditures. This could result in non-renewals by tenants upon expiration of their leases, which would result in declines in revenues from operations and reduce cash available for debt service and distributions to stockholders.

We depend on tenants for our revenue, and accordingly, lease terminations and/or tenant defaults, particularly by one of our larger tenants, could adversely affect the income produced by our properties, which may harm our operating performance, thereby limiting our ability to make distributions to our stockholders.

The success of our investments materially depends on the financial stability of our tenants, any of whom may experience a change in their business at any time. For example, the economic crisis already may have adversely affected or may in the future adversely affect one or more of our tenants. As a result, our tenants may delay lease commencements, decline to extend or renew their leases upon expiration, fail to make rental payments when due or declare bankruptcy. Any of these actions could result in the termination of the tenants’ leases, expiration of existing leases without renewal and the loss of rental income attributable to the terminated or expired leases. In the event of a tenant default or bankruptcy, we may experience delays in enforcing our rights as a landlord and may incur substantial costs in protecting our investment and re-letting our property. It is unlikely that a bankrupt tenant will pay, in full, amounts owed to us under a lease. If significant leases are terminated or defaulted upon, we may be unable to lease the property for the rent previously received or sell the property without incurring a loss. In addition, significant expenditures, such as mortgage payments, real estate taxes and insurance and maintenance costs, are generally fixed and do not decrease when revenues at the related property decrease, so tenant defaults or departures could decrease our cash from operations, liquidity and net income.

The illiquidity of real estate investments could significantly impede our ability to respond to adverse changes in the performance of our properties and harm our financial condition.

Real estate investments, especially office properties like the properties we currently own and intend to acquire, are relatively illiquid and may become even more illiquid during periods of economic downturn. In particular, these risks could arise from weakness in or even the lack of an established market for a property, changes in the financial condition or prospects of prospective purchasers, changes in national or international economic conditions and changes in laws, regulations or fiscal policies of jurisdictions in which the property is located. As a result, we may not be able to sell a property or properties quickly or on favorable terms and realize our investment objectives, or otherwise promptly modify our portfolio, in response to changing economic, financial and investment conditions when it otherwise may be prudent to do so. This inability to respond quickly to changes in the performance of our properties and sell an unprofitable property could adversely affect our cash flows and results of operations, thereby limiting our ability to make distributions to our stockholders. Our financial condition could also be adversely affected if we were, for example, unable to sell one or more of our properties in order to meet our debt obligations upon maturity.

The Code imposes restrictions on a REIT’s ability to dispose of properties that are not applicable to other types of real estate companies. In particular, the tax laws applicable to REITs require that we hold our properties for investment, rather than primarily for sale in the ordinary course of business, which may cause us to forego or defer sales of properties that otherwise would be in our best interest. Therefore, we may not be able to vary our portfolio in response to economic or other conditions promptly or on favorable terms, which may adversely affect our cash flows, financial condition and results of operations, and our ability to pay distributions on, and the market price of, our common stock.

 

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In addition, our ability to dispose of some of our properties could be constrained by their tax attributes. Properties which we own for a significant period of time or which we acquire through tax deferred contribution transactions in exchange for units in our Operating Partnership may have low tax bases. If we dispose of these properties outright in taxable transactions, we may need to distribute a significant amount of the taxable gain to our stockholders under the requirements of the Code for REITs or pay federal income tax at regular corporate rates on the amount of any gain, which in turn would impact our cash flow and increase our leverage. To dispose of low basis or tax-protected properties efficiently, we may from time to time use like-kind exchanges, which qualify for non-recognition of taxable gain, but can be difficult to consummate and result in the property for which the disposed assets are exchanged inheriting their low tax bases and other tax attributes (including tax protection covenants).

Our current and future joint venture investments could be adversely affected by a lack of sole decision-making authority and our reliance on joint venture partners’ financial condition and liquidity.

We own properties through joint venture investments in which we co-invest with another investor. Our business plan contemplates further acquisitions of office properties through joint ventures and sales to institutions of partial ownership of properties that we wholly own. Joint venture investments involve certain risks, including:

 

   

joint venture partners may control or share certain approval rights over major decisions, such as decisions related to the development, financing, leasing, management and other aspects of the project, which may prevent us from taking actions that are opposed by our joint venture partners;

 

   

joint venture partners may fail to fund their share of any required capital commitments;

 

   

joint venture partners might have economic or other business interests or goals that are inconsistent with our business interests or goals that would affect our ability to operate the property;

 

   

joint venture partners may have the power to act contrary to our instructions and policies, including our current policy with respect to maintaining our REIT qualification;

 

   

joint venture agreements often restrict the transfer of a member’s or joint venture partner’s interest, provide for a buyout of a joint venture partner’s interest in certain instances or may otherwise restrict our ability to sell the interest when we desire or on advantageous terms;

 

   

our relationships with our joint venture partners are contractual in nature and may be terminated or dissolved under the terms of the applicable joint venture agreements and, in such event, we may not continue to own or operate the interests or assets underlying such relationship or may need to purchase such interests or assets at a premium to the market price to continue ownership;

 

   

disputes between us and our joint venture partners may result in litigation or arbitration that would increase our expenses and divert attention from other elements of our business and result in subjecting the properties owned by the applicable joint venture to additional risk; and

 

   

we may in certain circumstances be liable for the actions of our joint venture partners.

The occurrence of one or more of the events described above could adversely affect our financial condition, results of operations, cash flow and our ability to pay dividends.

Adverse market and economic conditions could cause us to recognize additional impairment charges.

We review our real estate assets for impairment indicators, such as a decline in a property’s occupancy or the market price for our common stock, in accordance with accounting principles generally accepted in the United States, or GAAP. If we determine that indicators of impairment are present, we review the properties affected by these indicators to determine whether an impairment charge is required. We use considerable judgment in making determinations about impairments, from analyzing whether there are indicators of impairment to the assumptions used in calculating the fair value of the investment. Accordingly, our subjective estimates and evaluations may not be accurate, and such estimates and evaluations are subject to change or revision.

 

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We expect to record a non-cash impairment charge of approximately $0.2 million during the year ending December 31, 2010 to write off our investment in the unconsolidated joint venture that owns our Seville Plaza property. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Subsequent Events” for additional information.

Ongoing adverse market and economic conditions and market volatility will likely continue to make it difficult to value the real estate assets owned by us as well as the value of our joint venture investments. There may be significant uncertainty in the valuation, or in the stability of the cash flows, discount rates and other factors related to such assets due to the adverse market and economic conditions that could result in a substantial decrease in their value. We may be required to recognize additional asset and goodwill impairment charges in the future, which could materially and adversely affect our business, financial condition and results of operations.

If we are deemed an “investment company” under the Investment Company Act of 1940, it could have a material adverse effect on our business.

We do not expect to operate as an “investment company” under the Investment Company Act of 1940, as amended, or the Investment Company Act. However, the analysis relating to whether a company qualifies as an investment company can involve technical and complex rules and regulations. If we own assets that qualify as “investment securities” as such term is defined under the Investment Company Act and the value of such assets exceeds 40% of the value of our total assets, we could be deemed to be an investment company and be required to register under the Investment Company Act. Registered investment companies are subject to a variety of substantial requirements that could significantly impact our operations. The costs and expenses we would incur to register and operate as an investment company, as well as the limitations placed on our operations, could have a material adverse impact on our operations and your investment return. In order to operate in a manner to avoid being required to register as an investment company we may be unable to sell assets we would otherwise want to sell or we may need to sell assets we would otherwise wish to retain. In addition, we may also have to forgo opportunities to acquire interests in companies or entities that we would otherwise want to acquire.

Potential losses may not be covered by insurance and we could incur significant costs and lose our equity in the damaged properties.

We carry comprehensive liability, fire, extended coverage, business interruption and rental loss insurance covering all of our properties under blanket insurance policies. The insurance coverage contains policy specifications and insured limits customarily carried for similar properties and business activities. However, we do not carry insurance for certain losses, including, but not limited to, losses caused by war or by certain environmental conditions, such as mold or asbestos. In addition, if a loss or damages are suffered at one or more of our properties, the insurer may attempt to limit or void coverage by arguing that the loss resulted from facts or circumstances not covered by our policy. Furthermore, our title insurance policies may not insure for the current aggregate market value of our portfolio, and we do not intend to increase our title insurance coverage as the market value of our portfolio increases. As a result, we may not have sufficient coverage against all losses that we may experience, including from adverse title claims. If we experience a loss that is uninsured or that exceeds policy limits, we could incur significant costs and lose the capital invested in the damaged or otherwise adversely affected properties as well as the anticipated future cash flows from those properties.

Our business operations in California, Honolulu and Phoenix are susceptible to, and could be significantly affected by, adverse weather conditions and natural disasters such as earthquakes, tsunamis, hurricanes, volcanoes, wind, floods, landslides, drought and fires. These adverse weather conditions and natural disasters could cause significant damage to the properties in our portfolio, the risk of which is enhanced by the concentration of our properties’ locations. Our insurance may not be adequate to cover business interruption or losses resulting from adverse weather or natural disasters. In addition, our insurance policies include customary deductibles and limitations on recovery. As a result, we may be required to incur significant costs in the event of adverse weather conditions and natural disasters. We may discontinue earthquake or any other insurance coverage on some or all of our properties in the future if the cost of premiums for any of these policies in our judgment exceeds the value of the coverage discounted for the risk of loss.

 

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In addition, our properties may not be able to be rebuilt to their existing height or size at their existing location under current land-use laws and policies. In the event that we experience a substantial or comprehensive loss of one of our properties, we may not be able to rebuild such property to its existing specifications or may be required to upgrade such property in connection with any rebuilding to meet current code requirements.

Because we own real property, we will be subject to extensive environmental regulation which creates uncertainty regarding future environmental expenditures and liabilities.

Environmental laws regulate, and impose liability for, releases of hazardous or toxic substances into the environment. Under some of these laws, an owner or operator of real estate may be liable for costs related to soil or groundwater contamination on or migrating to or from its property. In addition, persons who arrange for the disposal or treatment of hazardous or toxic substances may be liable for the costs of cleaning up contamination at the disposal site. These laws often impose liability regardless of whether the person knew of, or was responsible for, the presence of the hazardous or toxic substances that caused the contamination. The presence of, or contamination resulting from, any of these substances, or the failure to properly remediate them, may adversely affect our ability to sell or rent our property or to borrow funds using the property as collateral. In addition, persons exposed to hazardous or toxic substances may sue for personal injury damages. For example, some laws impose liability for release of or exposure to materials containing asbestos, a substance known to be present in a number of our buildings. In addition, some of our properties may have been affected by contamination from past operations or from off-site sources. As a result, we may be potentially liable for investigation and cleanup costs, penalties and damages under environmental laws.

Although most of our properties have been subjected to preliminary environmental assessments, known as Phase I assessments, by independent environmental consultants that identify conditions that could pose potential environmental liabilities, Phase I assessments are limited in scope, and may not include or identify all potential environmental liabilities or risks associated with the property. Unless required by applicable law or our lenders, we may decide not to further investigate, remedy or ameliorate the liabilities disclosed in the Phase I assessments. Further, these or other environmental studies may not identify all potential environmental liabilities or accurately assess whether we will incur material environmental liabilities in the future. If we do incur material environmental liabilities in the future, we may face significant remediation costs, and we may find it difficult to sell or finance any affected properties.

Compliance with the Americans with Disabilities Act and fire, safety and other regulations may require us to make unanticipated expenditures that could significantly reduce the cash available for distribution to our stockholders.

Our properties must comply with Title III of the Americans with Disabilities Act of 1990, or the ADA, to the extent that such properties are “public accommodations” as defined by the ADA. Under the ADA, all public accommodations must meet federal requirements related to access and use by disabled persons. The ADA may require removal of structural barriers to access by persons with disabilities in certain public areas of our properties where such removal is readily achievable. The obligation to make readily achievable accommodations is an ongoing one, and continual assessment of the properties is required. Although we believe that our properties in the aggregate substantially comply with present requirements of the ADA, we have not conducted a comprehensive audit or investigation of all of our properties to determine compliance, and we are aware that some properties may not be in compliance with the ADA. If one or more of our currently owned properties or future properties is not in compliance with the ADA, then we would be required to incur additional costs to bring the property into compliance. Noncompliance could result in the imposition of fines by the U.S. government or an award of damages and/or attorneys’ fees to private litigants, or both. Additional federal, state and local laws also may require us to modify properties or could restrict our ability to renovate properties. Complying with the ADA or other legislation at noncompliant properties could be very expensive. If we incur substantial costs to comply with such laws, our financial condition, results of operations, cash flow, per share trading price of our common stock, our ability to satisfy our debt service obligations and our ability to pay distributions to our stockholders could be adversely affected. We cannot predict the ultimate amount of the cost of compliance with the ADA or other legislation.

 

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In addition, our properties are subject to various federal, state and local regulatory requirements, such as state and local fire and life safety requirements. Although we believe that our properties in the aggregate substantially comply with these regulatory requirements, we have not conducted a comprehensive review of all of our properties, and we are aware that some properties may not be in compliance with applicable regulatory requirements. If we were to fail to comply with these various requirements, we might incur governmental fines or private damage awards. If we incur substantial costs to comply with these regulatory requirements, our financial condition, results of operations, cash flow, market price of our common stock and our ability to satisfy our debt service obligations and to pay distributions to our stockholders could be adversely affected. Local regulations, including municipal or local ordinances, zoning restrictions and restrictive covenants imposed by community developers may restrict our use of our properties and may require us to obtain approval from local officials or community standards organizations at any time with respect to our properties, including prior to acquiring a property or when undertaking renovations of any of our existing properties.

If we default on the ground leases to which certain of our properties are subject, our business could be adversely affected.

We hold long-term ground leasehold interests in our Clifford Center and Waterfront Plaza properties (as well as Bank of Hawaii Waikiki Center and a portion of the parking garage at U.S. Bank Center, each of which is ground leased to a joint venture in which we hold a minority interest). For these properties, instead of owning fee title to the land, we (or our joint venture) are the lessee under a long-term ground lease. If we default under the terms of these leases, we may be liable for damages and could lose our leasehold interest in the property. If any of these events were to occur, our business and results of operations would be adversely affected.

Our property taxes could increase due to property tax rate changes or reassessment, which would impact our cash flows.

We are required to pay state and local taxes on our properties. The real property taxes on our properties may increase as property tax rates change or as our properties are assessed or reassessed by taxing authorities. Therefore, the amount of property taxes we pay in the future may increase substantially and we may be unable to fully recover these increased costs from our tenants. If the property taxes we pay increase and we are unable to fully recover these increased costs from our tenants, our cash flow would be impacted, and our ability to pay expected dividends to our stockholders could be adversely affected.

We may become subject to litigation, which could have a material adverse effect on our financial condition.

In the future, we may become subject to litigation, including claims relating to our operations, the internalization of our management, offerings and otherwise in the ordinary course of business. Some of these claims may result in significant defense costs and potentially significant judgments against us, some of which are not, or cannot be, insured against. Resolution of these types of matters against us may result in our having to pay significant fines, judgments or settlements, which, if uninsured, or if the fines, judgments and settlements exceed insured levels, could adversely impact our earnings and cash flows, thereby impacting our ability to service debt and make distributions to our stockholders. Certain litigation or the resolution of certain litigation may affect the availability or cost of some of our insurance coverage, which could adversely impact our results of operations and cash flows, expose us to increased risks that would be uninsured, and/or adversely impact our ability to attract officers and directors. Even if we are successful in defending ourselves, certain litigation may require significant attention from our senior management team and distract them from the management of our operations, adversely affecting our financial condition and results of operations.

 

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If we fail to satisfy the regulatory requirements of Section 404 of the Sarbanes-Oxley Act of 2002, or if our disclosure controls or internal control over financial reporting is not effective, investors could lose confidence in our reported financial information, which could adversely affect the perception of our business and the trading price of our common stock.

As a public company, Section 404 of the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, requires that we evaluate the effectiveness of our internal control over financial reporting as of the end of each fiscal year, and to include a management report assessing the effectiveness of our internal control over financial reporting in all annual reports. The design and effectiveness of our disclosure controls and procedures and internal control over financial reporting may not prevent all errors, misstatements, or misrepresentations. Although management will continue to review the effectiveness of our disclosure controls and procedures and internal control over financial reporting, there can be no guarantee that our internal control over financial reporting will be effective in accomplishing all control objectives all of the time. Deficiencies, including any material weakness, in our internal control over financial reporting which may occur in the future could result in misstatements of our results of operations, restatements of our financial statements, a decline in the trading price of our common stock, or otherwise materially adversely affect our business, reputation, results of operations, financial condition, or liquidity.

Risks Related to the Real Estate Industry

Our operating performance is subject to risks associated with the real estate industry.

Real estate investments are subject to various risks and fluctuations and cycles in value and demand, many of which are beyond our control. Certain events may decrease cash available for dividends, as well as the value of our properties. These events include, but are not limited to:

 

   

adverse changes in economic and demographic conditions;

 

   

vacancies or our inability to rent space on favorable terms;

 

   

adverse changes in financial conditions of buyers, sellers and tenants of properties;

 

   

inability to collect rent from tenants;

 

   

competition from other real estate investors with significant capital, including other real estate operating companies, publicly traded REITs and institutional investment funds;

 

   

reductions in the level of demand for office space and changes in the relative popularity of properties;

 

   

increases in the supply of office space;

 

   

fluctuations in interest rates, which could adversely affect our ability, or the ability of buyers and tenants of properties, to obtain financing on favorable terms or at all;

 

   

increases in expenses, including insurance costs, labor costs, energy prices, real estate assessments and other taxes and costs of compliance with laws, regulations and governmental policies, and our inability to pass on some or all of these increases to our tenants; and

 

   

changes in, and changes in enforcement of, laws, regulations and governmental policies, including, without limitation, health, safety, environmental, zoning and tax laws, governmental fiscal policies and the ADA.

In addition, periods of economic slowdown or recession, rising interest rates or declining demand for real estate, or the public perception that any of these events may occur, could result in a general decline in rents or an increased incidence of defaults under existing leases without a corresponding decrease in expenses. Costs associated with real estate investments, such as real estate taxes, ground lease payments, insurance, loan payments and maintenance, generally will not be reduced even if the vacancy rate at a property increases or rental rates decrease. If we cannot operate our properties so as to meet our financial expectations, our financial condition, results of operations, cash flow, per share trading price of our common stock and ability to satisfy our debt service obligations and to pay dividends to you could be adversely affected. There can be no assurance that we can achieve our economic objectives.

 

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Volatility in the capital and credit markets could adversely impact our acquisition activities and the pricing of real estate assets.

Volatility in the capital and credit markets could adversely affect our acquisition activities by causing lenders and credit rating agencies to tighten their underwriting standards. This directly affects a lender’s ability to provide debt financing and increases the cost of available debt financing. As a result, we may not be able to obtain favorable debt financing in the future or at all. This may result in future acquisitions generating lower overall economic returns, which may adversely affect our results of operations and distributions to stockholders. Furthermore, any turmoil in the capital or credit markets could adversely impact the overall amount of capital and debt financing available to invest in real estate, which may result in decreases in price or value of real estate assets.

We face intense competition, which may decrease, or prevent increases of, the occupancy and rental rates of our properties.

We compete with a number of developers, owners and operators of office real estate, many of which own properties similar to ours in the same markets in which our properties are located. If our competitors offer space at rental rates below current market rates, or below the rental rates we currently charge our tenants, we may lose existing or potential tenants and we may be pressured to reduce our rental rates below those we currently charge or to offer more substantial rent abatements, tenant improvements, early termination rights or below-market renewal options in order to retain tenants when our tenants’ leases expire or to entice new tenants to lease space in our properties. In that case, our financial condition, results of operations, cash flow, per share trading price of our common stock and ability to satisfy our debt service obligations and to pay dividends to you may be adversely affected.

We face possible risks associated with climate change.

We cannot predict with certainty whether global warming or cooling is occurring and, if so, at what rate. However, the physical effects of climate change could have a material adverse effect on our properties, operations and business. All of our properties are located in California, Honolulu and Phoenix. To the extent climate change causes changes in weather patterns, our markets could experience increases in storm intensity and rising sea-levels. Over time, these conditions could result in declining demand for office space in our buildings or the inability of us to operate the buildings at all. Climate change may also have indirect effects on our business by increasing the cost of (or making unavailable) property insurance on terms we find acceptable and increasing the cost of energy at our properties. Moreover, compliance with new laws or regulations related to climate change, including compliance with “green” building codes, may require us to make improvements to our existing properties or increase taxes and fees assessed on us or our properties. There can be no assurance that climate change will not have a material adverse effect on our properties, operations or business.

Terrorism and other factors affecting demand for our properties could harm our operating results.

The strength and profitability of our business depends on demand for and the value of our properties. Future terrorist attacks in the United States, such as the attacks that occurred in New York and Washington, D.C. on September 11, 2001, and other acts of terrorism or war may have a negative impact on our operations. Such terrorist attacks could have an adverse impact on our business even if they are not directed at our properties. In addition, the terrorist attacks of September 11, 2001 have substantially affected the availability and price of insurance coverage for certain types of damages or occurrences, and our insurance policies for terrorism include large deductibles and co-payments. Although we maintain terrorism insurance coverage on our portfolio, the lack of sufficient insurance for these types of acts could expose us to significant losses and could have a negative impact on our operations.

 

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Risks Associated with Debt Financing

We have a substantial amount of debt outstanding, which may affect our ability to pay dividends, may expose us to interest rate fluctuation risk and may expose us to the risk of default under our debt obligations.

As of September 30, 2010, on a pro forma basis to reflect the concurrent transactions, our total consolidated debt was approximately $383.7 million. Our joint venture properties are also leveraged, and we may incur significant additional debt for various purposes, including the funding of future acquisitions of properties.

Payments of principal and interest on borrowings may leave our property-owning entities with insufficient cash resources to operate our properties and/or pay distributions to us so that we can make distributions to stockholders currently contemplated or necessary to maintain our REIT qualification. Furthermore, any property-owning entity may default on its obligations and the lenders or mortgagees may foreclose on our properties and execute on any collateral that secures their loans. Certain property-owning entities have defaulted on their obligations in 2010, although no foreclosures have resulted. For tax purposes, a foreclosure of any of our properties would be treated as a sale of the property for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the property, we would recognize taxable income on foreclosure, but we would not receive any cash proceeds.

Our substantial outstanding debt, and the limitations imposed on us by our debt agreements, could have significant other adverse consequences, including the following:

 

   

our cash flow may be insufficient to meet our required principal and interest payments;

 

   

we may be unable to borrow additional funds as needed or on favorable terms, which could adversely affect our liquidity for acquisitions or operations;

 

   

we may be forced to dispose of one or more of our properties, possibly on disadvantageous terms; and

 

   

we will be exposed to interest and future interest rate volatility with respect to debt that is variable rate.

If any one of these events were to occur, our financial condition, results of operations, cash flow, per share trading price of our common stock and ability to satisfy our debt service obligations and to pay dividends to you could be adversely affected. In addition, any foreclosure on our properties could create taxable income without accompanying cash proceeds, which could adversely affect our ability to meet the REIT distribution requirements imposed by the Code.

Existing loan agreements contain, and future financing arrangements will likely contain, restrictive covenants relating to our operations, which could limit our ability to make distributions to our stockholders.

We are subject to certain restrictions pursuant to the restrictive covenants of our outstanding debt, which may affect our distribution and operating policies and our ability to incur additional debt. In addition, we have received commitments for the new credit facility from affiliates of certain of the underwriters and expect to close this facility concurrently with the completion of this offering and the concurrent transactions. Loan documents evidencing our existing debt contain, and loan documents entered into in the future will likely contain, certain operating covenants that limit our ability to further mortgage the property or discontinue insurance coverage. In addition, the loan documents evidencing our existing debt contain, and the new credit facility will contain, financial covenants, including certain limitations on our ability to make distributions to our stockholders, incur secured and unsecured debt, draw on the new credit facility, sell all or substantially all of our assets, and engage in mergers and consolidations and certain acquisitions or investments. In addition, failure to meet any of these covenants could cause an event of default under and/or accelerate some or all of our debt, which would have a material adverse effect on us.

 

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We may be unable to refinance our debt at maturity or the refinancing terms may be less favorable than the terms of our original debt, and our flexibility with respect to certain financing options may be limited in some instances.

We may be unable to refinance our debt at maturity or the refinancing terms may be less favorable than the terms of our original debt. In addition, we have agreed that until March 19, 2018, we will not prepay or defease any mortgage debt secured by the properties contributed by Venture at the time of our formation transactions, other than in connection with a concurrent refinancing with non-recourse mortgage debt of an equal or greater amount and subject to certain other restrictions. These restrictions limit our ability to refinance debt on these contributed properties and may limit our flexibility with respect to certain financing options. As a result, we may be unable to access certain capital resources that would otherwise be available to us. Furthermore, if any defeasance of debt with respect to any of these contributed properties is foreseeable, we are required to notify Venture in order to allow Venture an opportunity to provide input with respect to strategies to defer or mitigate the recognition of gain by Venture under the Code. These contractual obligations may limit our future operating flexibility and compel us to take actions or enter into transactions that we otherwise would not undertake. If we fail to comply with any of these requirements, we will be liable for a make-whole cash payment to Venture, the cost of which could be material and could adversely affect our liquidity.

Market price decreases could cause us to decrease our borrowings.

Our current intention is to limit the outstanding principal amount of our consolidated debt and aggregate liquidation preference of our outstanding Senior Common Stock and preferred stock to no more than 55% of our total market capitalization, although we may exceed this amount from time to time. Because this ratio is based in part upon the market price of our common stock, market price decreases could cause this ratio to exceed 55%, at which point we expect to consider whether it is appropriate to decrease our leverage or our borrowing activity.

Our organizational documents have no limitation on the amount of debt that we may incur. As a result, we may become more highly leveraged in the future, which could adversely affect our financial condition.

Our organizational documents contain no limitations regarding the maximum level of debt that we may incur nor do they restrict the form of our debt (including recourse, non-recourse and cross-collateralized debt). Accordingly, we could, without stockholder approval, become more highly leveraged, which could result in an increase in our debt service, could materially adversely affect our cash flow and our ability to make distributions to our stockholders and/or the distributions required to maintain our REIT qualification, and could harm our financial condition. Higher leverage will also increase the risk of default on our obligations.

Risks Related to this Offering and our Common Stock

Holders of our Senior Common Stock have dividend and liquidation rights that are senior to the rights of the holders of our common stock.

On January 12, 2010, we commenced a registered continuous public offering of shares of our Series A Senior Common Stock. Following the completion of this offering, we intend to limit the maximum number of shares of our Series A Senior Common Stock to be sold in that offering to 10,000,000. As of December 1, 2010, there were 1,739,869 shares of Series A Senior Common Stock issued and outstanding. Upon the completion of this offering, our charter will also permit us to issue up to 8,000,000 shares of Series B Senior Common Stock and up to 8,000,000 shares of Series C Senior Common Stock. The Senior Common Stock ranks senior to our common stock with respect to dividends and distribution of amounts upon liquidation. Holders of our Senior Common Stock are entitled to receive, when and as authorized by our board of directors and declared by us, cumulative cash dividends at specified annual rates before any dividends may be declared or set aside on our common stock. Following the fifth anniversary of the date of the original issuance of each share of Series A Senior Common Stock, each share of Series A Senior Common Stock will become exchangeable, at the holder’s option, for shares of common stock. In addition, if the dividend declared on our common stock exceeds $2.00 per

 

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share per annum, the Series A Senior Common Stock dividend will increase by 2.5% of the amount by which our common stock dividend exceeds $2.00 per share per annum, which would reduce the amount available to be distributed to holders of our common stock. See “Description of Capital Stock — Classes of Common Stock — Senior Common Stock.”

Furthermore, upon our voluntary or involuntary liquidation, dissolution or winding up, before any payment is made to holders of our common stock, holders of our Series A Senior Common Stock are entitled to receive a liquidation preference of $10.00 per share, plus any accrued and unpaid dividends, and holders of our Series B Senior Common Stock and Series C Senior Common Stock, if issued, will be entitled to receive a liquidation preference of $25.00 per share, plus any accrued and unpaid dividends. This will reduce the remaining amount of our assets, if any, available to distribute to holders of our common stock.

We may be unable to make distributions at expected levels.

Beginning with our first quarterly dividend following the completion of this offering, we intend to make regular quarterly distributions of $0.09 per share to holders of our common stock. On an annualized basis, this would be $0.36 per share, or an annual distribution rate of approximately 4.5% based upon the assumed public offering price of $8.00 per share of our common stock, which is the midpoint of the estimated price range set forth on the front cover of this prospectus. Our estimated annual rate of distribution following the completion of this offering represents approximately 93.9% of our estimated pro forma cash available for distribution to our common stockholders for the 12-month period ending September 30, 2011. Purchasers of shares of our common stock in this offering will not participate in the dividend declared for the fourth quarter of 2010, which was authorized on December 20, 2010 to be paid on January 17, 2011 to stockholders of record on December 31, 2010.

Distributions declared by us will be authorized by our board of directors in its sole discretion out of funds legally available therefor and will be dependent upon a number of factors, including the preferential rights of our Senior Common Stock, restrictions under applicable law, the capital requirements of our company and meeting the distribution requirements necessary to maintain our qualification as a REIT. We intend to maintain our distribution rate for the 12-month period following the completion of this offering unless actual results of operations, economic conditions or other factors differ materially from the assumptions used in our estimate. We cannot assure you, however, that our intended distributions will be made or sustained or that our board of directors will not change our distribution policy in the future. Under some circumstances, we may be required to fund distributions from working capital, liquidate assets at prices or times that we regard as unfavorable or borrow to provide funds for distributions, or we may make distributions in the form of a taxable stock dividend. If we need to liquidate assets or borrow funds on a regular basis to meet our distribution requirements or if we reduce the amount of our distribution, the price of our common stock may be adversely affected. In addition, some of our distributions may include a return of capital. To the extent that we decide to make distributions in excess of our current and accumulated earnings and profits, such distributions would generally be considered a return of capital for federal income tax purposes to the extent of the holder’s adjusted tax basis in its shares, and thereafter as gain on a sale or exchange of such shares. See “Federal Income Tax Considerations.”

Our ability to make distributions may also be limited by the new credit facility. Under the anticipated terms of the new credit facility, our distributions with respect to any four quarter period may not exceed the greater of (i) 95.0% of our funds from operations as calculated under the new credit facility for such period or (ii) the amount required for us to qualify and maintain our status as a REIT. If a default or event of default occurs and is continuing, we may be precluded from making certain distributions (other than those required to allow us to qualify and maintain our status as a REIT).

 

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Securities eligible for future sale may have adverse effects on the share price of our common stock, and any additional capital raised by us through the sale of equity securities, including our Senior Common Stock, may dilute your ownership in us.

Upon the completion of this offering, our authorized capital stock will consist of 583,999,900 shares of common stock, 100 shares of Class B Common Stock, 40,000,000 shares of Series A Senior Common Stock, 8,000,000 shares of Series B Senior Common Stock, 8,000,000 shares of Series C Senior Common Stock and 100,000,000 shares of preferred stock.

Our Operating Partnership issued common units representing 1,357,617 common share equivalents and preferred units representing 3,259,752 common share equivalents to Venture in the transactions described in “Structure and Formation Transactions.” The preferred units will become convertible into 3,259,752 common units upon the completion of this offering, and Venture has agreed to elect to convert all of the preferred units to common units at that time. In addition, upon the completion of this offering, we will issue 3,117,188 common units to Messrs. Shidler, Ingebritsen, Root, Taff and Reynolds (or entities controlled by them) in connection with the exchange by them of all principal and accrued interest outstanding under unsecured promissory notes issued by our Operating Partnership (which totaled approximately $24.9 million in the aggregate as of September 30, 2010). Our Operating Partnership also has outstanding common units representing 52,485 common share equivalents held by other unit holders as described in “Structure and Formation Transactions.” The common units in our Operating Partnership may be redeemed on a one-for-one basis for shares of our common stock, subject to certain limitations (including that the common units issued upon conversion of the preferred units may not be redeemed until one year after the date of their conversion from preferred units to common units).

We have an effective registration statement relating to the resale of the 1,410,102 shares of our common stock issuable upon redemption of the currently outstanding common units, and we have entered into a registration rights agreement with Venture and certain holders of our common stock which obligates us to file a registration statement relating to the resale of the 118,000 shares of common stock issued in our formation transactions and the 3,259,752 shares of our common stock which may ultimately be issued upon redemption of the common units into which the outstanding preferred units will be converted upon the completion of this offering. Upon the completion of this offering, we intend to enter into a supplement to the registration rights agreement relating to the resale of the 3,117,188 shares that may be issued upon redemption of the common units to be issued in connection with the exchange of unsecured promissory notes issued by our Operating Partnership by Messrs. Shidler, Ingebritsen, Root, Taff and Reynolds (or entities controlled by them). In addition, upon the completion of this offering, a total of 2,859 shares of our common stock will be issued to three directors who are resigning upon the completion of this offering as a result of the accelerated vesting of outstanding restricted stock units, 1,906 shares of our common stock will be issuable upon the vesting of restricted stock units previously granted under the Directors’ Stock Plan, and 1,940 shares of our common stock will be issuable in the future under that plan (see “Management — Stock Incentive Plan”). The sale of shares of our common stock issued upon the redemption of our Operating Partnership units or through our Directors’ Stock Plan could result in a decrease in the market price of our common stock.

As discussed above, on January 12, 2010, we commenced a registered continuous public offering of up to 40,000,000 shares of our Series A Senior Common Stock. Following the completion of this offering, we intend to limit the maximum number of shares of our Series A Senior Common Stock to be sold in that offering to 10,000,000. As of December 1, 2010, there were 1,739,869 shares of Series A Senior Common Stock issued and outstanding. Furthermore, upon the completion of this offering, we will be authorized to issue up to 8,000,000 shares of Series B Senior Common Stock and up to 8,000,000 shares of Series C Senior Common Stock. The Series A Senior Common Stock has, and, if listed upon a national securities exchange, the Series B Senior Common Stock and Series C Senior Common Stock will have, voting rights that entitle its holders to vote with the holders of our common stock on any matter for which a stockholder vote is required. Accordingly, the issuance of shares of our Senior Common Stock will dilute the voting power attributable to each share of our common stock. In addition, following the fifth anniversary of the date of the original issuance of each share of

 

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Series A Senior Common Stock, each share of Series A Senior Common Stock will become exchangeable, at the holder’s option, for shares of common stock. The exchange ratio will be calculated using a value for our common stock based on the average of the trailing 30-day closing price of our common stock on the date the shares are submitted for exchange (but in no event less than $10.00 per share) and a value for the Series A Senior Common Stock of $10.00 per share. Accordingly, if all 10,000,000 shares of Series A Senior Common Stock are sold, up to 10,000,000 shares of common stock may be issued in exchange for such shares, which would further dilute the voting power attributable to the holders of our common stock and significantly dilute your ownership in us, and may create downward pressure on the market price of the common stock.

In the future, we may attempt to increase our capital resources by making additional offerings of debt or equity securities, including commercial paper, medium term notes, senior or subordinated notes and classes of preferred stock, convertible preferred units or common stock. Upon liquidation, holders of our debt securities, holders of our Senior Common Stock or any preferred stock with preferential distribution rights that we may issue and lenders with respect to other borrowings would receive a distribution of our available assets prior to the holders of our common stock. Future equity offerings may dilute the holdings of our existing stockholders. If we decide to issue preferred stock, it could have a preference on liquidation distributions or a preference on dividend payments that could limit our ability to make a dividend distribution to the holders of our common stock. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. See “Description of Capital Stock.”

Our charter permits our board of directors to issue stock with terms that may subordinate the rights of holders of our common stock or discourage a third party from acquiring us in a manner that could result in a premium price to our stockholders.

Our board of directors may classify or reclassify any unissued common stock or preferred stock and establish the preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends or other distributions, qualifications and terms or conditions of redemption of any such stock. Thus, our board of directors could authorize the issuance of preferred stock with priority as to distributions and amounts payable upon liquidation over the rights of the holders of our common stock. Such preferred stock could also have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all of our assets) that might provide a premium price to holders of our common stock. Our board of directors may also, without stockholder approval, amend our charter from time to time to increase or decrease the aggregate number of shares of our stock or the number of shares of stock of any class or series that we have authority to issue.

Our board of directors can take many actions without stockholder approval.

Our board of directors has overall authority to oversee our operations and determine our major corporate policies. This authority includes significant flexibility. For example, our board of directors can do the following:

 

   

within the limits provided in our charter, prevent the ownership, transfer and/or accumulation of stock in order to protect our status as a REIT;

 

   

issue additional shares of stock without obtaining stockholder approval, which could dilute the ownership of our then-current stockholders;

 

   

amend our charter from time to time to increase or decrease the aggregate number of shares of stock or the number of shares of stock of any class or series that we have authority to issue, without obtaining stockholder approval;

 

   

classify or reclassify any unissued shares of our common or preferred stock and set the preferences, rights and other terms of such classified or reclassified shares, without obtaining stockholder approval;

 

   

employ and compensate affiliates;

 

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direct our resources toward investments that do not ultimately appreciate over time;

 

   

change creditworthiness standards with respect to our tenants;

 

   

change our acquisition or capitalization strategies; and

 

   

determine that it is no longer in our best interest to attempt to qualify, or to continue to qualify, as a REIT.

Any of these actions could increase our operating expenses, impact our ability to make distributions or reduce the value of our assets without giving our stockholders the right to vote.

Our common stock may be thinly traded and may experience price fluctuations as a result.

Although a trading market for our common stock exists, the trading volume prior to this offering has not been significant and there can be no assurance that an active trading market for our common stock will increase or be sustained in the future or that shares of our common stock will be resold at or above the public offering price. The market value of our common stock could be substantially affected by general market conditions, including the extent to which a secondary market develops for our common stock following the completion of this offering, the extent of institutional investor interest in us, the general reputation of REITs and the attractiveness of their equity securities in comparison to other equity securities (including securities issued by other real estate-based companies), our financial performance and general stock and bond market conditions.

You should not rely on the underwriters’ lock-up agreements to limit the number of shares sold into the market by our affiliates.

Our executive officers, directors, director nominees and Mr. Reynolds have agreed with our underwriters to be bound by 180-day lock-up agreements that prohibit these holders from offering, selling, contracting to sell, pledging or otherwise disposing of, directly or indirectly, any shares of our common stock or securities convertible into or exchangeable or exercisable for any shares of our common stock, including, without limitation, common units in our Operating Partnership, except in specified limited circumstances. The lock-up agreements signed by these individuals are only contractual agreements and Credit Suisse Securities (USA) LLC, Wells Fargo Securities, LLC and Citigroup Global Markets Inc. on behalf of the underwriters, can waive the restrictions of the lock-up agreements at an earlier time without prior notice or announcement and allow these individuals to sell their shares. If the restrictions of the lock-up agreement are waived, approximately 1.7 million shares of our common stock (excluding shares that may be issued in the future upon the exchange of common units in our Operating Partnership) will be available for sale into the market, subject only to applicable securities rules and regulations, which would likely reduce the market price for our common stock.

Purchasers of our common stock in this offering will experience an immediate dilution of the book value of our common stock upon completion of this offering and the concurrent transactions.

Purchasers of our common stock in this offering will experience dilution to the extent of the difference between the public offering price per share paid in this offering and the net tangible book value per share of our common stock immediately after the completion of this offering and the concurrent transactions. As of September 30, 2010, our net tangible book value was approximately $(48.5) million, or approximately $(9.58) per share, on a fully diluted basis. After giving effect to the sale by us of common stock in this offering (without any exercise of the underwriters’ over-allotment option) and the completion of the concurrent transactions, after deducting the underwriting discounts and commissions and estimated offering expenses payable by us, our pro forma net tangible book value as of September 30, 2010 on a fully diluted basis would be approximately $285.6 million, or approximately $5.22 per share of common stock, assuming a public offering price of $8.00 per share. This represents an immediate dilution in pro forma net tangible book value of approximately $2.78 per share to new public investors. See “Dilution” for a more detailed discussion of the dilution you will incur in this offering.

 

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Market interest rates may affect the value of our common stock.

One of the factors that will influence the price of our common stock will be the dividend yield on our common stock (as a percentage of the price of our common stock) relative to market interest rates. An increase in market interest rates, which are currently at low levels relative to historical rates, may lead prospective purchasers of our common stock to expect a higher dividend yield, and would likely increase our future borrowing costs and potentially decrease funds available for distribution. Thus, higher market interest rates could cause the market price of our common stock to decline.

Provisions in our charter, our bylaws and Maryland law may delay or prevent our acquisition by a third party, even if such acquisition were in the best interests of our stockholders.

Certain provisions of Maryland law and our charter and bylaws could have the effect of discouraging, delaying or preventing transactions that involve an actual or threatened change in control of us and which could provide the holders of our common stock with the opportunity to realize a premium over the then-prevailing market price of our common stock. These provisions may also have the effect of entrenching our executive officers and members of our board of directors, regardless of their performance. These provisions are described further in “Certain Provisions of Maryland Law and our Charter and Bylaws,” and cover, among other topics, the following:

 

   

removal of directors;

 

   

limitation on stockholder-requested special meetings;

 

   

advance notice provisions for stockholder nominations and proposals;

 

   

exclusive power of our board to amend our bylaws;

 

   

issuance of preferred stock;

 

   

restrictions on transfer and ownership of shares of our stock; and

 

   

duties of directors with respect to unsolicited takeovers.

Maryland law prohibits a business combination between a corporation and any interested stockholder or any affiliate of an interested stockholder for five years following the most recent date upon which the stockholder became an interested stockholder. A business combination includes a merger, consolidation, share exchange or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities. Generally, an interested stockholder is anyone who beneficially owns 10% or more of the voting power of the corporation’s outstanding voting stock. After the five-year period has elapsed, a corporation subject to the statute may not consummate a business combination with an interested stockholder unless (i) the transaction has been recommended by the board of directors and (ii) the transaction has been approved by the affirmative vote of at least (a) 80% of the votes entitled to be cast by holders of outstanding shares of voting stock of the corporation and (b) two-thirds of the votes entitled to be cast by holders of voting stock of the corporation other than shares owned by the interested stockholder with whom or with whose affiliate the business combination is to be effected or held by an affiliate or associate of the interested stockholder. This approval requirement need not be met if the corporation’s common stockholders receive a minimum price for their shares, as defined under Maryland law. Pursuant to the statute, our board of directors has by resolution exempted from the business combination provisions of the Maryland General Corporation Law, or MGCL, and, consequently, the five-year prohibition and the supermajority vote requirements will not apply to, business combinations between us and any person that have been approved by a majority of our directors who are not affiliated with such person. However, at any time our board could revoke this resolution and our exemption from the business combination provisions of the MGCL, and any subsequent proposed business combinations between us and any person would be subject to the five-year moratorium, supermajority vote requirements and the other provisions of the statute.

 

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Maryland law also provides that “control shares” of a Maryland corporation acquired in a “control share acquisition” have no voting rights except to the extent approved by a vote of two-thirds of the votes entitled to be cast on the matter, excluding shares of stock as to which the acquiring person, officers of the corporation and employees of the corporation who are directors of the corporation are entitled to vote. Control shares are voting shares of stock which, if aggregated with all other shares of stock controlled by the acquirer, would entitle the acquirer to exercise voting power in electing directors within one of the following ranges of voting power: (i) one-tenth or more but less than one-third; (ii) one-third or more but less than a majority; or (iii) a majority or more of all voting power. Our bylaws state that the control share acquisition statute of the MGCL will not apply to any acquisition by any person of our stock. However, the exemption from the control share acquisition provision may be repealed, in whole or in part, at any time, whether before or after an acquisition of control shares and, upon a repeal, will apply to any prior or subsequent control share acquisition.

Risks Related to Conflicts of Interest and Certain Relationships

We are subject to various potential conflicts of interest arising out of our relationships with our directors and executive officers, our dealer manager and other parties.

As more fully described in “Conflicts of Interest,” there may be conflicts of interest among us, our management and certain other affiliates. These potential conflicts of interest include the following:

 

   

The parent company of the dealer manager of our ongoing offering of Series A Senior Common Stock is currently 80% owned and controlled by Mr. Shidler. Upon the completion of this offering, subject to regulatory approval, the parent company will redeem Mr. Shidler’s entire 80% ownership interest. The fees paid to the dealer manager for the services provided to us in connection with that offering were determined when the dealer manager was affiliated with us. Accordingly, these fees were agreed upon without the benefit of arm’s-length negotiations of the type normally conducted between unrelated parties and may be in excess of amounts that we would otherwise pay to third parties for such services.

 

   

In the event that the prepayment or defeasance of debt secured by the properties contributed as part of our formation transactions would be beneficial to us but would negatively impact the tax treatment of Venture, it is possible that any of our directors or officers with a financial interest in Venture may experience a conflict of interest.

 

   

In the registration rights agreement we entered into with Venture and other affiliates, we retained certain rights to defer registration in circumstances where such registration would be detrimental to us. It is possible that any of our directors, officers or other parties with such rights or having a financial interest in Venture or its affiliates may experience a conflict of interest in circumstances where a registration would be advantageous to such persons, but detrimental to us.

 

   

The debt encumbering certain of our properties and, in the case of our Honolulu property known as “Clifford Center,” obligations under the ground lease, are secured, in part, by certain guaranty and indemnity obligations of Messrs. Shidler and Reynolds. Our Operating Partnership has entered into certain indemnity agreements with Messrs. Shidler and Reynolds in order to indemnify each of them under these guaranties and indemnities. Our Operating Partnership’s specific indemnity obligation in each of these indemnity agreements is basically to defend, indemnify and hold harmless Mr. Shidler or Mr. Reynolds from and against any and all demands, claims, causes of action, judgments, losses, costs, damages and expenses, including attorneys’ fees and costs of litigation arising from or relating to any or all of the guaranty or indemnity obligations of Mr. Shidler or Mr. Reynolds following formation.

These conflicts may result in terms that are more favorable to our management and/or our other affiliates than would have been obtained on an arm’s-length basis, and may operate to the detriment of our stockholders.

 

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Jay H. Shidler may compete with us and, therefore, may have conflicts of interest with us.

We have entered into a Noncompetition Agreement with Mr. Shidler, who is the Chairman of our board of directors. The Noncompetition Agreement with Mr. Shidler prohibits, without our prior written consent, Mr. Shidler from investing in certain office properties in the counties of San Diego and Los Angeles, California, the city and county of Honolulu, Hawaii, the county of Maricopa, Arizona, and any other county during such time as we own an office property in such county. However, this covenant not to compete does not restrict:

 

   

investments in which Mr. Shidler obtained an interest prior to our formation transactions;

 

   

investments by Mr. Shidler in areas in which we do not own office property at the time of such investment (including investments by Mr. Shidler in our target market of the San Francisco Bay Area until such time that we own a property in that market);

 

   

activities of First Industrial Realty Trust, Inc., Corporate Office Properties Trust and their respective affiliates;

 

   

investment opportunities considered and rejected by us; and

 

   

investments by Mr. Shidler in any entity as long as Mr. Shidler does not own more than 4.9% of the entity and is not actively engaged in the management of such entity.

It is therefore possible, despite the limitations imposed by his Noncompetition Agreement, that a property in which Mr. Shidler or an affiliate of Mr. Shidler has an interest may compete with us in the future if we were to invest in a property similar in type and in close proximity to that property.

Risks Related to Our Tax Status as a REIT

If we fail to remain qualified as a REIT in any taxable year, our operations and ability to make distributions will be adversely affected because we will be subject to federal income tax on our taxable income at regular corporate rates with no deduction for distributions made to stockholders.

We believe that we are organized and operate in conformity with the requirements for qualification and taxation as a REIT under the Code, and that our method of operation enables us to continue to meet the requirements for qualification and taxation as a REIT under the Code. However, qualification as a REIT requires us to satisfy highly technical and complex Code provisions for which only limited judicial and administrative authorities exist, and which are subject to change, potentially with retroactive effect. Even a technical or inadvertent mistake could jeopardize our REIT status. Our continued qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis. In particular, our ability to qualify as a REIT depends on the relative values of our common stock and our other classes of equity, which are susceptible to fluctuations, and on the actions of third parties in which we may own an interest but over which we have no control or limited influence.

If we were to fail to qualify as a REIT in any tax year, then:

 

   

we would not be required to make distributions to our stockholders;

 

   

we would not be allowed to deduct distributions to our stockholders in computing our taxable income;

 

   

we would be subject to federal income tax, including any applicable alternative minimum tax, at regular corporate rates; and

 

   

any resulting tax liability could be substantial and could require us to borrow money or sell assets to pay such liability, and would reduce the amount of cash available for distribution to stockholders. Unless we were entitled to relief under applicable statutory provisions, we would be disqualified from treatment as a REIT for the subsequent four taxable years following the year during which we lost our qualification, and thus, our cash available for distribution to stockholders would be reduced for each of the years during which we did not qualify as a REIT.

 

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The Internal Revenue Service could take the position that our predecessor failed to comply with the REIT asset tests for certain periods and such failures were not due to reasonable cause and resulted in the loss of our REIT status for one or more taxable years.

In connection with our formation transactions, we received a representation from our predecessor, AZL, that it qualified as a REIT under the provisions of the Code. However, during 2009 we became aware that, prior to the consummation of our formation transactions, AZL historically invested excess cash from time to time in money market funds that, in turn, were invested exclusively or primarily in short-term federal government securities. Additionally, during 2009 we became aware that AZL made two investments in local government obligations. Our predecessor, AZL, with no objection from outside advisors, treated these investments as qualifying assets for purposes of the 75% asset test. However, if these investments were not qualifying assets for purposes of the 75% asset test, then AZL would not have satisfied the REIT asset tests for certain quarters, in part, because they would have exceeded 5% of the gross value of AZL’s assets. If these investments resulted in AZL’s noncompliance with the REIT asset tests, however, we and our predecessor, AZL, would retain qualification as a REIT pursuant to certain mitigation provisions of the Code, which provide that so long as any noncompliance was due to reasonable cause and not due to willful neglect, and certain other requirements are met, qualification as a REIT may be retained but a penalty tax would be owed. Any potential noncompliance with the asset tests would be due to reasonable cause and not due to willful neglect so long as we exercised ordinary business care and prudence in attempting to satisfy such tests. Based on our review of the circumstances surrounding the investments, we believe we exercised ordinary business care and prudence in attempting to satisfy the REIT asset tests, including the 5% asset test and, accordingly, that any noncompliance was due to reasonable cause and not due to willful neglect. Additionally, we believe that we have complied with the other requirements of the mitigation provisions of the Code with respect to such potential noncompliance with the asset tests (and have paid the appropriate penalty tax), and, therefore, our qualification, and that of our predecessor, AZL, as a REIT should not be affected. In connection with, and prior to the issuance of any shares of common stock pursuant to this prospectus, we expect to receive an opinion of our tax counsel, Barack Ferrazzano Kirschbaum & Nagelberg LLP, that we qualify as a REIT. Such opinion is based on various assumptions relating to our organization and operation, and is conditioned upon representations and covenants made by our management and affiliated entities as well as the management of our predecessor, AZL, regarding our organization, assets, and present and future conduct of our business operations, including a representation that we and our predecessor, AZL, exercised ordinary business care and prudence in attempting to satisfy the asset test requirements of the REIT provisions of the Code in connection with our investments in money market funds and/or our investments in local government securities. The Internal Revenue Service, or IRS, is not bound by our determination, however, and no assurance can be provided that the IRS will not assert that AZL failed to comply with the REIT asset tests as a result of the money market fund investments and the local government securities investments and that such failures were not due to reasonable cause. If the IRS were to successfully challenge this position, then it could determine that we and AZL failed to qualify as a REIT in one or more of our taxable years.

Our ownership of taxable REIT subsidiaries will be limited, and we will be required to pay a 100% penalty tax on certain income or deductions if our transactions with our taxable REIT subsidiaries are not conducted on arm’s length terms.

We will own an interest in one or more taxable REIT subsidiaries, including Pacific Office Management, and may acquire securities in additional taxable REIT subsidiaries in the future. A taxable REIT subsidiary is a corporation other than a REIT in which a REIT directly or indirectly holds stock, and that has made a joint election with such REIT to be treated as a taxable REIT subsidiary. If a taxable REIT subsidiary owns more than 35% of the total voting power or value of the outstanding securities of another corporation, such other corporation will also be treated as a taxable REIT subsidiary. Other than some activities relating to lodging and health care facilities, a taxable REIT subsidiary may generally engage in any business, including the provision of customary or non-customary services to tenants of its parent REIT. A taxable REIT subsidiary is subject to federal income tax as a regular C corporation. In addition, a 100% excise tax will be imposed on certain transactions between a taxable REIT subsidiary and its parent REIT that are not conducted on an arm’s-length basis.

 

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A REIT’s ownership of securities of a taxable REIT subsidiary is not subject to the 5% or 10% asset tests applicable to REITs. However, not more than 25% of our total assets may be represented by securities of one or more taxable REIT subsidiaries, other than those securities includable in the 75% asset test. We anticipate that the aggregate value of the stock and securities of our taxable REIT subsidiaries will be less than 25% of the value of our total assets, and we will monitor the value of these investments to ensure compliance with applicable ownership limitations. In addition, we intend to structure our transactions with our taxable REIT subsidiaries to ensure that they are entered into on arm’s length terms to avoid incurring the 100% excise tax described above. There can be no assurance, however, that we will be able to comply with the 25% limitation or to avoid application of the 100% excise tax discussed above.

Even if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow.

Even if we remain qualified for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income and assets, including taxes on any undistributed income and any taxable REIT subsidiary will be subject to federal, state and local taxes on its income. Any of these taxes would decrease the amount of cash available for distribution to our stockholders. In addition, in order to meet the REIT qualification requirements, or to avert the imposition of a 100% prohibited transactions tax that generally applies to certain gains derived by a REIT from dealer property or inventory, we may in the future hold some of our assets through taxable REIT subsidiaries, which (unlike REITs) are taxed on their taxable income, whether or not distributed.

Dividends payable by REITs do not qualify for the reduced tax rates available for some dividends.

The maximum tax rate applicable to income from “qualified dividends” payable to U.S. stockholders that are individuals, trusts and estates has been reduced by legislation to 15% (through December 31, 2012). Dividends payable by REITs, however, generally are not eligible for the reduced tax rates. Although this legislation does not adversely affect the taxation of REITs or dividends payable by REITs, the more favorable rates applicable to regular corporate qualified dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the market price of the stock of REITs, including our common stock.

Complying with REIT requirements may force us to borrow or take other adverse actions to make distributions to stockholders.

As a REIT, we must generally distribute at least 90% of our annual REIT taxable income, subject to certain adjustments, to our stockholders. If we satisfy the REIT distribution requirement but distribute less than 100% of our taxable income, we will be subject to federal corporate income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay to our stockholders in a calendar year is less than a minimum amount specified under federal tax laws.

From time to time, we may generate taxable income greater than our cash flow available for distribution to stockholders (for example, due to substantial non-deductible cash outlays, such as capital expenditures or principal payments on debt). In order to avoid income and excise taxes in these situations, we could be required to fund distributions from working capital, liquidate assets at prices or times that we regard as unfavorable or borrow to provide funds for distributions, or we may make distributions in the form of a taxable stock dividend. As a result, having to comply with the distribution requirement could cause us to sell assets in adverse market conditions, borrow on unfavorable terms or distribute amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment of debt. These alternatives could increase our operating costs or diminish our levels of growth.

 

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We may in the future choose to pay dividends in our own stock, in which case you may be required to pay tax in excess of the cash you receive.

We may distribute taxable dividends that are payable in our stock. Under recent IRS guidance, up to 90% of any such taxable dividend with respect to calendar years through 2011, and in some cases declared as late as December 31, 2012, could be payable in our stock. Taxable stockholders receiving such dividends will be required to include the full amount of the dividend as ordinary income to the extent of our current and accumulated earnings and profits for federal income tax purposes. As a result, a U.S. stockholder may be required to pay tax with respect to such dividends in excess of the cash received. If a U.S. stockholder sells the stock it receives as a dividend in order to pay this tax, the sales proceeds may be less than the amount included in income with respect to the dividend, depending on the market price of our stock at the time of the sale. Furthermore, with respect to non-U.S. stockholders, we may be required to withhold U.S. tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in stock. In addition, if a significant number of our stockholders determine to sell shares of our stock in order to pay taxes owed on dividends, such sales may have an adverse effect on the per share trading price of our common stock.

REIT restrictions on ownership of our capital stock may delay or prevent our acquisition by a third party, even if an acquisition is in the best interests of our stockholders.

In order for us to qualify as a REIT, not more than 50% of the value of our capital stock may be owned, directly or indirectly, by five or fewer individuals during the last half of any taxable year.

Pursuant to our charter and a resolution of our board of directors, effective upon the completion of this offering, no person, including entities, may own, or be deemed to own by virtue of the attribution provisions of the Code, more than 9.8% in economic value of the aggregate of the outstanding shares of capital stock, or more than 9.8% in economic value or number of shares, whichever is more restrictive, of our outstanding shares of common stock (including our outstanding shares of Class B Common Stock and Senior Common Stock). While these restrictions may prevent any five individuals from owning more than 49% in value of our outstanding capital stock, they could also discourage a change in control of our company. These restrictions may also deter tender offers that may be attractive to stockholders or limit the opportunity for stockholders to receive a premium for their shares if an investor seeks to acquire a block of shares of our capital stock.

Complying with REIT requirements may affect our profitability and may force us to liquidate or forgo otherwise attractive investments.

To qualify as a REIT, we must continually satisfy tests concerning, among other things, the nature and diversification of our assets, the sources of our income and the amounts we distribute to our stockholders. We may be required to liquidate or forgo otherwise attractive investments in order to satisfy the asset and income tests or to qualify under certain statutory relief provisions. We also may be required to make distributions to stockholders at disadvantageous times or when we do not have funds readily available for distribution. Accordingly, satisfying the REIT requirements could have an adverse effect on our business results, profitability and ability to execute our business plan. Moreover, if we are compelled to liquidate our investments to meet any of these asset, income or distribution tests, or to repay obligations to our lenders, we may be unable to comply with one or more of the requirements applicable to REITs or may be subject to a 100% tax on any resulting gain if such sales constitute prohibited transactions.

Liquidation of collateral may jeopardize our REIT status.

To continue to qualify as a REIT, we must comply with requirements regarding our assets and our sources of income. If we are compelled to liquidate investments to satisfy our obligations to our lenders, we may be unable to comply with these requirements, ultimately jeopardizing our status as a REIT.

 

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Complying with REIT requirements may limit our ability to hedge effectively.

The REIT provisions of the Code may limit our ability to hedge our operations. Under current law, any income that we generate from derivatives or other transactions intended to hedge our interest rate risks, or any income from foreign currency or other hedges, will generally be treated as nonqualifying income for purposes of the REIT 75% and 95% gross income tests unless specified requirements are met. See “Federal Income Tax Considerations — Requirements for REIT Qualification — Hedging Transactions.” As a result of these rules, we may have to limit our use of hedging techniques that might otherwise be advantageous, which could result in greater risks associated with interest rate or other changes than we would otherwise incur.

We may be subject to adverse legislative or regulatory tax changes that could reduce the value of our common stock.

At any time, the federal income tax laws governing REITs, or the administrative interpretations of those laws, may be amended. Any of those new laws or interpretations may take effect retroactively and could adversely affect us or you as a stockholder.

 

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FORWARD-LOOKING STATEMENTS

Some of the statements contained in this prospectus constitute forward-looking statements within the meaning of the federal securities laws. Forward-looking statements relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. In some cases, you can identify forward-looking statements by the use of forward-looking terminology such as “pipeline,” “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “assumes,” “believes,” “estimates,” “predicts” or “potential” or the negative of these words and phrases or similar words or phrases which are predictions of or indicate future events or trends and which do not relate solely to historical matters. You can also identify forward-looking statements by discussions of strategy, plans or intentions.

The forward-looking statements contained in this prospectus reflect our current views about future events and are subject to numerous known and unknown risks, uncertainties, assumptions and changes in circumstances that may cause our actual results to differ significantly from those expressed in any forward-looking statement. Statements regarding the following subjects, among others, may be forward-looking:

 

   

the factors included in this prospectus, including those set forth under headings “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business and Properties;”

 

   

our limited operating history;

 

   

the attributes of the members of our management team;

 

   

the outcome of our internalization of management;

 

   

identification of office properties to acquire and completing acquisitions on terms favorable to us;

 

   

our ability to source off-market deal flow in the future;

 

   

our ability to manage our growth effectively;

 

   

operation of acquired properties;

 

   

adverse economic or real estate conditions or developments in the office real estate sector and/or in the markets in which we acquire properties;

 

   

our projected operating results;

 

   

decreased rental rates or increased vacancy rates;

 

   

defaults on, early terminations of or non-renewal of leases by tenants;

 

   

tenant bankruptcies;

 

   

our ability to sell our interests in properties on a timely basis and on favorable terms;

 

   

our joint ventures;

 

   

declining real estate valuations and impairment charges;

 

   

our status as an entity that is not an “investment company” under the Investment Company Act;

 

   

insurance coverage;

 

   

our ability to comply with the laws, rules and regulations applicable to us;

 

   

impact of changes in governmental regulations, tax law and rates, and similar matters;

 

   

the impact of litigation;

 

   

our ability to satisfy the regulatory requirements of Section 404 of the Sarbanes-Oxley Act of 2002;

 

   

market trends in our industry, interest rates, real estate values, the capital markets and the general economy;

 

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our understanding of our competition;

 

   

the effects of climate change on our business;

 

   

the consequences of any future terrorist attacks;

 

   

our ability to obtain financing arrangements or refinance existing debt;

 

   

availability of borrowings under the new credit facility;

 

   

future debt service obligations;

 

   

our expected leverage;

 

   

the possible defeasance of loans that we intend to assume in connection with our acquisition of the GRE portfolio if we do not obtain the requisite lender consents to the assumptions;

 

   

our ability to execute defeasance documents if we elect to defease the loans intended to be assumed in connection with our acquisition of the GRE portfolio;

 

   

increased interest rates and operating costs;

 

   

availability, terms and deployment of capital;

 

   

estimates relating to our ability to make distributions to our stockholders in the future;

 

   

our stock price;

 

   

future issuances of securities that may be dilutive to the holders of our common stock;

 

   

decisions by our board of directors concerning whether to be covered by certain statutes, or to include provisions in our governing documents, that may prevent our acquisition by a third party;

 

   

conflicts of interests with our directors, officers or other affiliates;

 

   

our ability to maintain our qualification as a REIT for U.S. federal income tax purposes;

 

   

use of proceeds of this offering and the concurrent transactions; and

 

   

changes in our business and investment strategy.

While forward-looking statements reflect our good faith beliefs, assumptions and expectations, they are not guarantees of future performance. Furthermore, we disclaim any obligation to publicly update or revise any forward-looking statement to reflect changes in underlying assumptions or factors, new information, data or methods, future events or other changes. For a further discussion of these and other factors that could cause our future results to differ materially from any forward-looking statements, see the section above entitled “Risk Factors.”

Economic and Market Data

We use market data and industry forecasts and projections throughout this prospectus, and in particular in the sections entitled “Market Background and Opportunity” and “Business and Properties.” We have obtained substantially all of this information from a market study prepared for us in connection with this offering by Rosen Consulting Group, a nationally recognized real estate consulting firm. We have paid RCG a fee for such services. Such information is included in this prospectus in reliance on RCG’s authority as an expert on such matters. See “Experts.” In addition, we have obtained certain market and industry data from publicly available industry publications. These sources generally state that the information they provide has been obtained from sources believed to be reliable, but that the accuracy and completeness of the information are not guaranteed. The forecasts and projections are based on industry surveys and the preparers’ experience in the industry, and there is no assurance that any of the projected amounts will be achieved. We believe that the surveys and market research others have performed are reliable. Any forecasts prepared by RCG are based on data (including third party data), models and experience of various professionals, and are based on various assumptions, all of which are subject to change without notice.

 

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USE OF PROCEEDS

We estimate that the net proceeds we will receive from this offering will be approximately $325.3 million, after deducting underwriting discounts and commissions and estimated offering expenses of approximately $26.7 million (or, if the underwriters exercise their over-allotment option in full, approximately $374.4 million, after deducting underwriting discounts and commissions and estimated offering expenses of approximately $30.4 million) at an assumed public offering price per share of $8.00, which is the midpoint of the estimated price range set forth on the front cover of this prospectus. The net proceeds we will receive in the concurrent private placement of our common stock will be $12.0 million.

We expect to contribute the net proceeds of this offering and the concurrent private placement to our Operating Partnership. The following table sets forth the estimated sources and estimated uses by our Operating Partnership of funds we expect in connection with this offering and the concurrent transactions as reflected in the pro forma financial statements as of and for the period ended September 30, 2010 included elsewhere in this prospectus. Exact payment amounts may differ from estimates due to the amortization of principal, additional borrowings, additional accrued interest, payment of additional deposits in connection with our pending acquisition of the GRE portfolio and the incurrence of additional transaction expenses. This table identifies sources of funds arising from this offering with specific uses for your information; however, sources of funds from this offering may be commingled and have not been earmarked for particular purposes.

 

Sources (in thousands)

       

Uses (in thousands)

     

Gross proceeds from this offering

  $ 352,000     

Funding of cash portion of pending acquisition of the GRE portfolio, net of deposits, and related costs

  $ 242,817 (1) 

Gross proceeds from the concurrent private placement

    12,000      Discharge of existing indebtedness     91,699   

Existing unrestricted cash on hand

    7,355 (2)   

Accrued interest on existing indebtedness being discharged

    856   
   

Prepayment and other penalties and exit fees

    2,151   
   

Fees and expenses associated with new credit facility

    1,365   
    Internalization costs     25 (3) 
   

Transaction expenses (including underwriting discounts and commissions)

    26,655   
   

General working capital purposes (including existing unrestricted cash on hand)

    5,787 (2) 
                 

Total Sources

  $ 371,355      Total Uses   $ 371,355   
                 

 

(1) The amount shown is net of deposits totaling $5.0 million made as of September 30, 2010 which were reflected in other assets on our consolidated balance sheet as of that date. Since September 30, 2010, we have made additional deposits totaling $4.0 million. All of these deposits will be credited against the purchase price for the GRE portfolio.

The cash portion of the purchase price does not include approximately $56.3 million in existing debt intended to be assumed in connection with our acquisition of the GRE portfolio, or the portion of the purchase price, totaling approximately $8.0 million, to be paid through the issuance of shares of our common stock to be issued in a private placement at a price per share equal to the public offering price of this offering and without payment by us of any underwriting discount or commission. The cash portion of the purchase price includes $3.4 million of acquisition costs, $0.7 million in debt assumption fees and $2.1 million to fund reserves for debt intended to be assumed in connection with our acquisition of the GRE portfolio. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Pro Forma Indebtedness” for a description of the debt intended to be assumed by us in connection with our acquisition of the GRE portfolio.

(2) As of December 1, 2010, our existing unrestricted cash on hand was $9.2 million, net of approximately $3.0 million of the $4.0 million of additional deposits made towards the cash portion of the GRE portfolio purchase price between September 30, 2010 and December 1, 2010.
(3) The amount shown represents the $25,000 purchase price to acquire all of the outstanding stock of the Advisor to be paid from existing cash on hand. Our Advisor is currently owned and controlled by Messrs. Shidler, Ingebritsen, Root, Taff and Reynolds. See “Certain Related Party Relationships and Transactions.”

 

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As set forth above, we expect to use a portion of the net proceeds from this offering and the concurrent private placement to repay or discharge approximately $91.7 million of existing indebtedness (based on September 30, 2010 outstanding balances) on our current properties and our existing line of credit with First Hawaiian Bank, which we refer to as the FHB Credit Facility, in accordance with the chart below.

 

Property

   Interest Rate
as of
September 30, 2010
    Principal Balance
as of
September 30, 2010 (1)
    Maturity
Date
 
           (in thousands)        

Secured Debt:

      

Pacific Business News Building

     11.98%(2)      $ 11,601        4/6/2010   

City Square (Senior)

     5.58%(3)        27,500        9/1/2010   

City Square (Mezzanine)

     LIBOR + 7.35%(4)        27,255 (1)      9/1/2010   

Clifford Center

     6.00%        3,296        8/15/2011   

FHB Credit Facility

     1.25%(5)        22,047 (1)      12/31/2013   
            

Total

     $ 91,699     
            

 

(1) Actual amounts repaid may differ from the amounts outstanding as of September 30, 2010. We expect the principal amount outstanding under the FHB Credit Facility to have increased to approximately $25.0 million at the completion of this offering due to additional borrowings. The City Square mezzanine debt was secured, in part, by the posting of letters of credit by Mr. Reynolds and Shidler LP in the aggregate amount of $3.7 million. On October 20, 2010, the lender collected against these letters of credit, reducing the principal amount to be repaid with the proceeds from this offering by approximately $2.0 million. Pursuant to an indemnity agreement entered into on March 19, 2008 in connection with our formation transactions, our Operating Partnership has reimbursed Mr. Reynolds and Shidler LP for their losses under the letters of credit. See “Certain Related Party Relationships and Transactions – Indemnification Agreements” for additional information. Actual amounts repaid may also differ from the amounts outstanding as of September 30, 2010 due to our repayment of amortized principal amounts between September 30, 2010 and the completion of this offering.             
(2) This loan bears interest at a stated rate of 6.98%. On April 6, 2010 an event of default was triggered under this loan for failing to pay all amounts due upon maturity or within a five-day cure period. Upon the occurrence of this event of default, the interest rate increased to 11.98%. We entered into a forbearance agreement with the lender effective December 29, 2010 which expires on the earliest to occur of five business days following the completion of this offering, the occurrence of certain breaches or defaults by us under the forbearance agreement or loan documents and February 28, 2011.
(3) On September 7, 2010, an event of default was triggered under this loan for failing to pay all amounts due upon maturity or within a five-day cure period. On October 15, 2010, we entered into a forbearance agreement (which was amended on December 10, 2010) with the lender pursuant to which late charge penalties totaling 5% of the outstanding principal balance and default interest of 5% in excess of the stated rate will be forgiven if the loan is repaid in full prior to the expiration of the forbearance period, which is the earliest to occur of five business days following the completion of this offering, the occurrence of certain breaches or defaults by us under the forbearance agreement or loan documents, and April 29, 2011.
(4) This loan bears interest at a rate based on the 30-day London Interbank Offered Rate, or LIBOR, which was 0.26% at September 30, 2010, plus a spread. On September 7, 2010, an event of default was triggered under this loan for failing to pay all amounts due upon maturity or within a five-day cure period. Upon the occurrence of this event of default, the interest rate increased to LIBOR plus 7.35%. We entered into a forbearance agreement with the lender effective as of December 21, 2010 pursuant to which default interest of 5% in excess of the stated rate of LIBOR plus 2.35% will be forgiven with respect to the period from the effective date of the forbearance agreement through the date of repayment if the loan is repaid in full prior to February 25, 2011.
(5) The FHB Credit Facility bears interest at a fluctuating annual rate equal to the effective rate of interest paid by First Hawaiian Bank on time certificates of deposit, plus 1.00% (which was 1.25% at September 30, 2010).

If the underwriters exercise their option to purchase an additional 6,600,000 shares of our common stock in full solely to cover over-allotments, we expect to use the additional net proceeds for general working capital purposes, including repaying additional debt and funding capital expenditures, tenant improvements, leasing commissions and future acquisitions. Pending application of any portion of the net proceeds from this offering, we may invest such proceeds in interest-bearing short-term investments, including U.S. treasury securities or a money market account, that are consistent with our qualification as a REIT. If the over-allotment option is not exercised and the public offering price per share of our common stock is below the midpoint of the range of prices on the cover of this prospectus, we intend to borrow funds under the new credit facility and use these funds, in addition to the net proceeds from this offering and the concurrent private placement, to make the payments set forth above, which would increase the ratio of our consolidated debt to our total market capitalization following the completion of this offering and the concurrent transactions. For example, if the over-allotment option is not exercised and the public offering price is $7.50 per share, we would expect to borrow approximately $20.0 million under the new credit facility.

 

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As security for the FHB Credit Facility, Shidler Equities, L.P., a Hawaii limited partnership controlled by Mr. Shidler, referred to as Shidler LP, has pledged to First Hawaiian Bank a certificate of deposit in the principal amount of $25.0 million. As a condition to the pledge, our Operating Partnership agreed to indemnify Shidler LP for any losses arising from the certificate of deposit. Upon the repayment in full and subsequent termination of the FHB Credit Facility, Shidler LP will be released from its pledge and the indemnification agreement will be terminated. For additional information regarding this indemnification agreement, see “Certain Related Party Relationships and Transactions — Indemnification Agreements.”

 

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MARKET PRICE RANGE AND DIVIDENDS ON OUR COMMON STOCK

Our common stock is currently traded on the NYSE Amex under the symbol “PCE.” The following table sets forth the high and low sales prices for our common stock as reported by the NYSE Amex and the dividends declared for each of the periods indicated. The historical stock prices and dividends declared per share set forth below have been adjusted to reflect the one-for-ten reverse stock split of our common stock that we intend to complete immediately prior to the completion of this offering.

 

     High      Low      Dividends
Declared per
Share
 

2010

        

4th Quarter (through December 29, 2010)

   $ 49.40       $ 38.50       $ 0.11   

3rd Quarter

   $ 54.30       $ 39.50       $ 0.50   

2nd Quarter

   $ 48.10       $ 36.00       $ 0.50   

1st Quarter

   $ 44.00       $ 34.00       $ 0.50   

2009

        

4th Quarter

   $ 43.40       $ 29.20       $ 0.50   

3rd Quarter

   $ 48.20       $ 33.60       $ 0.50   

2nd Quarter

   $ 51.00       $ 33.70       $ 0.50   

1st Quarter

   $ 55.00       $ 42.90       $ 0.50   

2008

        

4th Quarter

   $ 66.50       $ 17.10       $ 0.50   

3rd Quarter

   $ 74.80       $ 60.30       $ 0.50   

2nd Quarter

   $ 73.50       $ 59.20       $ —     

1st Quarter (beginning March 20, 2008)

   $ 74.60       $ 65.50       $ —     

The last reported sales price of our common stock on December 29, 2010 was $42.40, after giving effect to the reverse stock split. As of December 1, 2010, our common stock was held by 49 stockholders of record. This figure does not reflect the beneficial ownership of shares held in nominee name.

Our common stock has been approved for listing on the NYSE under the symbol “PCE,” subject to official notice of issuance.

There currently is no established public trading market for our Series A Senior Common Stock, and we do not expect to have our shares of Series A Senior Common Stock listed on any securities exchange or quoted on an automated quotation system in the near future. As of December 1, 2010, our Series A Senior Common Stock was held by 632 stockholders of record. There are currently no outstanding shares of Series B Senior Common Stock or Series C Senior Common Stock.

Our Class B Common Stock has identical voting and dividend rights to our common stock, but has no distribution rights upon liquidation. No established public trading market exists for our Class B Common Stock. As of December 1, 2010, our Class B Common Stock was held by one stockholder of record.

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Pro Forma Indebtedness — Secured Revolving Credit Facility” for a discussion of the restrictions applicable to payment of dividends that we expect will be imposed by the new credit facility.

 

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DISTRIBUTION POLICY

Beginning with our first quarterly dividend following the completion of this offering, we intend to make regular quarterly distributions of $0.09 per share to holders of our common stock. On an annualized basis, this would be $0.36 per share (of which we currently estimate 66% may represent a return of capital for tax purposes), or an annual distribution rate of approximately 4.5% based upon the assumed public offering price of $8.00 per share of our common stock, which is the midpoint of the estimated price range set forth on the front cover of this prospectus. Our estimated annual rate of distribution following the completion of this offering represents approximately 93.9% of our estimated pro forma cash available for distribution to our common stockholders for the 12-month period ending September 30, 2011. Purchasers of shares of our common stock in this offering will not participate in the dividend declared for the fourth quarter of 2010, which was authorized on December 20, 2010 to be paid on January 17, 2011 to stockholders of record on December 31, 2010.

Our intended annual rate of distribution following the completion of this offering has been established based on our estimate of cash available for distribution for the 12 months ending September 30, 2011, which we have calculated based on adjustments to our pro forma net loss before non-controlling interests and Senior Common Stock for the 12 months ending September 30, 2010. In estimating our cash available for distribution for the 12 months ending September 30, 2011, we have made certain assumptions as reflected in the table and footnotes below, including that there will be no new leases or increases in renewals or terminations of existing leases in our portfolio after December 1, 2010.

Our estimate of cash available for distribution does not reflect the amount of cash estimated to be used for tenant improvement costs and leasing commission costs related to leases that may be entered into after December 1, 2010. It also does not reflect the amount of cash estimated to be used for investing activities, such as capital improvements to the GRE portfolio or our other assets and acquisitions. It also does not reflect the amount of cash estimated to be used for financing activities, other than scheduled mortgage loan principal repayments and interest payments on mortgage debt that will be outstanding upon completion of this offering. Our estimate includes substantial adjustments for expenditures that will be funded with offering proceeds and that otherwise would have impacted cash available for distribution. Although we have included all material investing and financing activities that we have commitments to undertake as of December 1, 2010, we may undertake other investing and/or financing activities in the future. Any such investing and/or financing activities may have a material effect on our estimate of cash available for distribution. Because we have made the assumptions set forth above in estimating cash available for distribution, we do not intend this estimate to be a projection or forecast of our actual results of operations or our liquidity, and have estimated cash available for distribution for the sole purpose of determining our intended annual rate of distribution. Our estimate of cash available for distribution should not be considered as an alternative to cash flow from operating activities (computed in accordance with GAAP) or as an indicator of our liquidity or our ability to pay dividends or make distributions. In addition, the methodology upon which we made the adjustments described below is not necessarily intended to be a basis for determining future distributions.

Our common stock ranks junior to our Senior Common Stock with respect to dividends and distribution of amounts upon liquidation. Holders of our Series A Senior Common Stock are entitled to receive, when and as authorized by our board of directors and declared by us, cumulative cash dividends in an amount per share equal to a minimum of $0.725 per share per annum, payable monthly. Holders of our Series A Senior Common Stock are entitled to cumulative dividends before any dividends may be declared or set aside on our common stock. In addition, if the dividend payable on our common stock exceeds $2.00 per share per annum, the Series A Senior Common Stock dividend will increase by 2.5% of the amount by which the common stock dividend exceeds $2.00 per share per annum. Our board of directors has authorized daily dividends on the Series A Senior Common Stock for the months of April 2010 through December 2010. The dividends for each month have been or will be calculated based on holders of record of Series A Senior Common Stock each day during such months, in an aggregate amount equal to $0.06041667 per share per month (pro-rated from the date of issuance). Dividends declared for each month have been or will be paid on or about the 15th day of the following month.

 

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We intend to maintain our distribution rate for the 12-month period following the completion of this offering unless actual results of operations, economic conditions or other factors differ materially from the assumptions used in our estimate. Distributions declared by us will be authorized by our board of directors in its sole discretion out of funds legally available therefor and will be dependent upon a number of factors, including the preferential rights of our Senior Common Stock, restrictions under applicable law, the capital requirements of our company and meeting the distribution requirements necessary to maintain our qualification as a REIT. We believe our estimate of cash available for distribution constitutes a reasonable basis for setting the intended distribution rate; however, no assurance can be given that the estimate will prove accurate, and actual distributions may therefore be significantly different from the expected distributions.

We anticipate that, at least initially, our distributions will exceed our then current and then accumulated earnings and profits as determined for U.S. federal income tax purposes due to non-cash expenses, primarily depreciation and amortization charges that we expect to incur. Therefore, all or a portion of these distributions may represent a return of capital for federal income tax purposes. Distributions in excess of our current and accumulated earnings and profits and not treated by us as a dividend will not be taxable to a taxable U.S. stockholder under current federal income tax law to the extent those distributions do not exceed the stockholder’s adjusted tax basis in his or her common stock, but rather will reduce the adjusted basis of the common stock. Therefore, the gain (or loss) recognized on the sale of that common stock or upon our liquidation will be increased (or decreased) accordingly. To the extent those distributions exceed a taxable U.S. stockholder’s adjusted tax basis in his or her common stock, they generally will be treated as a capital gain realized from the taxable disposition of those shares. The percentage of our stockholder distributions that exceeds our current and accumulated earnings and profits may vary substantially from year to year. For a more complete discussion of the tax treatment of distributions to holders of our common stock, see “Federal Income Tax Considerations.”

We cannot assure you that our intended distributions will be made or sustained or that our board of directors will not change our distribution policy in the future. Any distributions we pay in the future will depend upon our legal and contractual obligations, including the provisions of the Senior Common Stock, as well as actual results of operations, economic conditions, debt service requirements and other factors that could differ materially from our current expectations. Our actual results of operations will be affected by a number of factors, including the revenue we receive from our properties, our operating expenses, interest expense, the ability of our tenants to meet their obligations and unanticipated expenditures. For more information regarding risk factors that could materially adversely affect our actual results of operations, see “Risk Factors.”

Federal income tax law requires that a REIT distribute annually at least 90% of its REIT taxable income excluding net capital gains, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its REIT taxable income including capital gains. For more information, see “Federal Income Tax Considerations.” In order to meet these requirements, we may be required to fund distributions from working capital, liquidate assets at prices or times that we regard as unfavorable or borrow to provide funds for distributions, or we may make distributions in the form of a taxable stock dividend. We have no current intention, however, to use the net proceeds from this offering to make distributions nor do we intend to make distributions using shares of our common stock. We do not intend to reduce the expected distribution per share if the underwriters exercise their option to purchase up to 6,600,000 additional shares to cover over-allotments.

 

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The following table describes our pro forma net loss before non-controlling interests and Series A Senior Common Stock for the 12 months ended September 30, 2010, and the adjustments we have made thereto in order to estimate our pro forma cash available for distribution for the 12 months ending September 30, 2011 (amounts in thousands except share data, per share data, square footage data and percentages):

 

Pro forma net loss before fair value adjustment of preferred units and non-controlling interests for the 12 months ended December 31, 2009

   $ (22,313

Less: Pro forma net loss before non-controlling interests for the nine months ended September 30, 2009

     16,735   

Add: Pro forma net loss before non-controlling interests and Series A Senior Common Stock for the nine months ended September 30, 2010

     (14,911
        

Pro forma net loss before non-controlling interests and Series A Senior Common Stock for the 12 months ended September 30, 2010

   $ (20,489

Add: Pro forma real estate depreciation and amortization

     44,116   

Add: Net increases in contractual rent income (1)

     8,228   

Less: Net decreases in contractual rent income due to lease expirations, assuming no renewals (2)

     (4,158

Less: Net effects of straight-line rent adjustments to tenant leases (3)

     (4,475

Add: Net effects of straight-line ground rent adjustments (4)

     2,092   

Less: Net effects of above- and below-market rent adjustments (5)

     (908

Add: Non-cash compensation expense (6)

     200   

Add: Non-cash interest expense (7)

     2,505   

Add: Net capital distributions from unconsolidated joint ventures (8)

     1,802   
        

Estimated pro forma cash flow from operating activities for the 12 months ending September 30, 2011

   $ 28,913   

Less: Estimated provision for tenant improvement and leasing commission costs (9)

     (5,129

Less: Estimated annual provision for recurring capital expenditures (10)

     (466
        

Total estimated pro forma cash flows used in investing activities

   $ (5,595

Estimated pro forma cash flow used in financing activities

  

Less: Scheduled mortgage loan principal repayments (11)

     (1,098
        

Estimated pro forma cash flow used in financing activities for the 12 months ending September 30, 2011

   $ (1,098

Estimated pro forma cash available for distribution for the 12 months ending September 30, 2011

   $ 22,220   

Less: Dividends on Series A Senior Common Stock (12)

     (1,261
        

Estimated pro forma cash available for distribution for the twelve months ending September 30, 2011 available to our Operating Partnership

   $ 20,959   

Our share of estimated pro forma cash available for distribution available to our Operating Partnership (13)

     17,974   

Non-controlling interests’ share of estimated pro forma cash available for distribution available to our Operating Partnership

     2,985   

Total estimated annual distributions to common stockholders

   $ 16,883   

Estimated annual distributions per share of common stock (14)

   $ 0.36   

Payout ratio based on our share of estimated cash available for distribution (15)

     93.9

 

 

(1) Represents the net increases in contractual rental income, net of expenses and rent abatements, from existing leases and new and renewal leases at the pro forma properties through December 1, 2010 that were not in effect for the entire 12-month period ended September 30, 2010 or signed through December 1, 2010 that will go into effect during the 12 months ending September 30, 2011.
(2) Assumes no lease renewals or new leases (other than month-to-month leases) for leases at the pro forma properties expiring during the 12-month period ending September 30, 2011 unless a new or renewal lease had been entered into by December 1, 2010.
(3) Represents the conversion of estimated rental revenues for the 12 months ended September 30, 2010 from a straight-line accrual basis to a cash basis of revenue recognition.

 

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(4) Represents the conversion of estimated ground lease expense for the 12 months ended September 30, 2010 from a straight-line accrual basis to a cash basis.
(5) Represents the elimination of non-cash adjustments for above- and below-market leases at the pro forma properties for the 12 months ended September 30, 2010.
(6) Pro forma non-cash compensation expense related to restricted stock units issued to our independent directors for the 12 months ended September 30, 2010.
(7) Pro forma non-cash interest expense for the 12 months ended September 30, 2010 includes: (i) amortization of financing costs on existing mortgages and the mortgage loans intended to be assumed in connection with our pending acquisition of the GRE portfolio; (ii) amortization of the assumption fees for debt intended to be assumed in connection with our pending acquisition of the GRE portfolio; and (iii) amortization of fees relating to the new credit facility.
(8) Represents cash distributed from unconsolidated joint ventures pursuant to priority distribution provisions in our joint venture operating agreements of $1,893, net of equity in earnings of unconsolidated joint ventures of $91.
(9) Estimated provision for tenant improvement and leasing commission costs relates solely to tenant improvement and leasing commission costs, net of expected reimbursements, incurred or expected to be incurred in the 12 months ending September 30, 2011 that we are contractually obligated to provide pursuant to leases entered into for the pro forma properties on or before December 1, 2010. During the 12 months ending September 30, 2011, we expect to have additional tenant improvement and leasing commission costs related to new leases that are entered into after December 1, 2010.
(10) Reflects estimated provision for recurring capital expenditures (excluding tenant improvement and leasing commission costs) for the 12 months ending September 30, 2011, based on the weighted average recurring annual capital expenditures (excluding tenant improvement and leasing commission costs) incurred during the years ended December 31, 2008 (annualized) and 2009, multiplied by the number of rentable square feet of the pro forma properties. The following table sets forth information relating to our calculation:

 

     PRO FORMA
WEIGHTED
AVERAGE
     HISTORICAL
YEAR ENDED  DECEMBER 31,
 
            2009                  2008 *        

Recurring capital expenditures

   $ 465,525       $ 186,723       $ 314,050   

Total rentable square feet**

     4,212,893         2,265,339         2,265,339   

Recurring capital expenditures per square foot

   $ 0.11       $ 0.08       $ 0.14   

 

  * Annualized, based on recurring capital expenditures for the period following the completion of our formation transactions on March 19, 2008.
  ** Total rentable square feet for the calculation of pro forma weighted average recurring capital expenditures was obtained by adding the rentable square footage of our existing wholly-owned properties (2,265,339) to the rentable square footage of the GRE portfolio (1,947,554).

 

(11) Represents scheduled payments of mortgage loan principal due on existing mortgages and the mortgage loans intended to be assumed in connection with the acquisition of the GRE portfolio during the 12 months ending September 30, 2011.
(12) Reflects 1,739,869 outstanding shares of Series A Senior Common Stock as of December 1, 2010. Additional shares have been sold and are expected to be sold for the remainder of the 12 months ending September 30, 2011.
(13) Our share is based on an estimated ownership by us of an approximately 85.8% general partnership interest on a pro forma basis.
(14) Based on a total of 46,898,098 shares of our common stock to be outstanding after this offering and the concurrent transactions. Shares of our common stock will include 44,000,000 shares to be sold in this offering, assuming no exercise of the underwriters’ over-allotment option, 1,500,000 shares to be issued in the concurrent private placement and 1,004,934 shares to be issued in connection with the completion of our pending acquisition of the GRE portfolio.
(15) Calculated as estimated annual distribution per share of common stock divided by our common stockholders’ share of estimated pro forma cash available for distribution for the 12 months ending September 30, 2011.

 

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CAPITALIZATION

The following table sets forth our unaudited historical capitalization as of September 30, 2010 and our unaudited pro forma capitalization as of September 30, 2010, adjusted to give effect to this offering and the concurrent transactions and the application of the net proceeds thereof as set forth in “Use of Proceeds.” All information in this table has been adjusted to reflect the one-for-ten reverse stock split of our common stock and Class B Common Stock that we intend to complete immediately prior to the completion of this offering. You should read this table in conjunction with “Use of Proceeds,” “Selected Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Pro Forma Liquidity and Capital Resources” and our unaudited historical financial statements and pro forma combined financial statements and related notes appearing elsewhere in this prospectus.

 

     As of September 30, 2010  
     Actual     Pro forma  
     (unaudited, in thousands,
except share and per share
amounts)
 

Cash, cash equivalents and restricted cash

   $ 14,587      $ 15,076   

Debt:

    

Mortgage and other loans, net

   $ 419,720      $ 383,728 (1) 

Unsecured notes payable to related parties

     21,104        —     
                

Total debt

     440,824        383,728 (1) 

Equity:

    

Stockholders’ equity:

    

Preferred Stock, $0.0001 par value per share; 100,000,000 shares authorized; one share of Proportionate Voting Preferred Stock issued and outstanding on a historical basis; no shares outstanding on a pro forma basis

   $ —        $ —     

Senior Common Stock, $0.0001 par value per share; 40,000,000 shares authorized; 663,394 shares issued and outstanding on a historical basis and 663,394 shares issued and outstanding on a pro forma basis (2)

     5,905        5,905   

Common Stock, $0.0001 par value per share; 599,999,900 shares authorized; 390,305 and 46,898,098 shares issued and outstanding on a historical and pro forma basis, respectively (3) (4)

     185        232   

Class B Common Stock, $0.0001 par value per share; 100 shares authorized; 10 shares issued and outstanding on a historical basis and 10 shares issued and outstanding on a pro forma basis

     —          —     

Additional paid-in capital

     —          344,045   

Cumulative deficit

     (137,336     (39,218
                

Total stockholders’ equity

     (131,246     310,964   

Non-controlling interests:

    

Preferred unitholders in the Operating Partnership

     127,268        —     

Common unitholders in the Operating Partnership

     38,457        89,473   
                

Total equity

     34,479        400,437   

Total capitalization

     475,303        784,165 (1) 

 

(1) This amount includes approximately $56.3 million in existing debt intended to be assumed in connection with our acquisition of the GRE portfolio.
(2) Prior to the completion of this offering, we intend to change the name of the class previously designated as “Senior Common Stock” to “Series A Senior Common Stock.”
(3) Does not include (i) 6,600,000 shares issuable upon the full exercise of the underwriters’ over-allotment option, (ii) 1,410,102 shares which may be issued upon redemption of the currently outstanding common units of the Operating Partnership, (iii) 3,259,752 shares which may be issued upon redemption of common units into which the outstanding preferred units will be converted upon the completion of this offering (but which shares may not be issued earlier than one year after the date of the conversion of the preferred units into common units), (iv) 3,117,188 shares which may be issued upon the redemption of common units to be issued upon the completion of this offering to Messrs. Shidler, Ingebritsen, Root, Taff and Reynolds (or entities controlled by them) in connection with the exchange by them of all principal and accrued interest outstanding under unsecured promissory notes issued by the Operating Partnership (which totaled approximately $24.9 million in the aggregate as of September 30, 2010), (v) 1,906 shares issuable upon the vesting of outstanding restricted stock units granted to certain directors under the Directors’ Stock Plan and (vi) 1,940 shares issuable in the future under the Directors’ Stock Plan.
(4) Prior to or upon the completion of this offering, we expect our board of directors to reclassify 8,000,000 authorized but unissued shares of our common stock as “Series B Senior Common Stock” and 8,000,000 authorized but unissued shares of our common stock as “Series C Senior Common Stock.” See “Description of Capital Stock” for a description of the terms of each of these new series.

 

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DILUTION

If you invest in our common stock in this offering, you will experience an immediate and material dilution of the net tangible book value per share of our common stock from the public offering price. Our net tangible book value as of September 30, 2010 was approximately $(48.5) million, or approximately $(9.58) per share, on a fully diluted basis. We calculate net tangible book value per share by dividing our net tangible book value, which is equal to our total assets less intangible assets (including goodwill, acquired above-market leases, acquired leasing commissions, acquired leases in place, acquired tenant relationship costs and acquired other intangibles) and total liabilities, excluding intangible lease liabilities, by the number of shares outstanding as of September 30, 2010 on a fully diluted basis.

After giving effect to the sale by us of common stock in this offering (without any exercise of the underwriters’ over-allotment option) and the completion of the concurrent transactions, the deduction of the underwriting discounts and commissions and estimated offering expenses payable by us and the use of funds as described under “Use of Proceeds,” our pro forma net tangible book value as of September 30, 2010 on a fully diluted basis would be approximately $285.6 million, or approximately $5.22 per share of common stock, assuming a public offering price of $8.00 per share. This represents an immediate increase in pro forma net tangible book value of approximately $14.80 per share to existing investors and an immediate dilution in net pro forma tangible book value of approximately $2.78 per share to new public investors. The following table illustrates this calculation on a per share basis:

 

Assumed public offering price per share

   $ 8.00   

Net tangible book value per share as of September 30, 2010 before the offering and the concurrent transactions

   $ (9.58

Increase in pro forma net tangible book value per share attributable to this offering and the concurrent transactions (1)

   $ 14.80   

Pro forma net tangible book value per share after the completion of this offering and the concurrent transactions (2)

   $ 5.22   

Dilution in pro forma net tangible book value per share to new investors (3)

   $ 2.78   

 

(1) This amount is calculated after deducting underwriting discounts and commissions and estimated offering expenses.
(2) Based on pro forma net tangible book value of approximately $285.6 million divided by 54,685,140 shares of our common stock to be outstanding upon the completion of this offering and the concurrent transactions, on a fully diluted basis.
(3) Dilution is determined by subtracting pro forma net tangible book value per share of our common stock after giving effect to this offering and the concurrent transactions from the public offering price paid by a new investor for a share of our common stock.

This table assumes no exercise by the underwriters of their option to purchase up to 6,600,000 shares of our common stock solely to cover over-allotments, and excludes 1,906 shares of our common stock issuable upon the vesting of outstanding restricted stock units granted to certain directors under our Directors’ Stock Plan and 1,940 shares issuable in the future under our Directors’ Stock Plan.

 

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SELECTED FINANCIAL DATA

The following table sets forth selected financial and operating data on a pro forma and historical basis. Our financial information and results of operations were significantly affected by the consummation of our formation transactions on March 19, 2008. We determined that the commercial real estate assets contributed by Venture in connection with our formation transactions were not under common control. Waterfront, which had the largest interest in Venture, was designated as the acquiring entity in the business combination for financial accounting purposes. Accordingly, historical financial information for Waterfront has also been presented for the period from January 1, 2008 through March 19, 2008. We have not presented historical information for periods prior to January 1, 2008 because we believe that a discussion of the results of Waterfront during those periods would not be meaningful.

You should read the following selected financial data in conjunction with our historical consolidated financial statements and the related notes and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which are included elsewhere in this prospectus.

The historical balance sheet data as of September 30, 2010 and 2009 and the historical statement of operations data for the nine months ended September 30, 2010 and 2009 have been derived from our historical unaudited condensed consolidated financial statements included elsewhere in this prospectus. The historical balance sheet data as of December 31, 2009 and 2008 and the historical statement of operations data for the years ended December 31, 2009 and 2008 have been derived from the historical audited combined consolidated financial statements included elsewhere in this prospectus.

Our unaudited selected pro forma combined financial statements and operating information as of, and for the nine months ended, September 30, 2010 and for the year ended December 31, 2009 assume the completion of this offering and the completion of the concurrent transactions as of January 1, 2009 for the operating data and as of the stated date for the balance sheet data. Our pro forma financial information is not necessarily indicative of what our actual financial position and results of operations would have been as of the date and for the periods indicated, nor does it purport to represent our future financial position or results of operations.

 

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    Nine Months Ended September 30,     Year Ended December 31,  
    Pro Forma
Combined
2010
    Historical     Pro Forma
Combined
2009
    Historical  
      2010     2009       2009     2008(1)  
    (unaudited)     (unaudited)     (unaudited)     (unaudited)              
    (in thousands, except share and per share data)  

Statement of Operations Data:

           

Revenue:

           

Rental

  $ 58,575      $ 31,621      $ 31,999      $ 80,498      $ 42,462      $ 37,447   

Tenant reimbursements

    18,804        16,742        16,184        25,016        21,662        19,375   

Parking

    6,349        6,093        6,080        8,437        8,150        6,890   

Property management and other services

    1,793        —          —          2,739        —          —     

Other

    399        267        270        602        365        394   
                                               

Total revenue

    85,920        54,723        54,533        117,292        72,639        64,106   

Expenses:

           

Rental property operating

    40,982        29,885        29,356        54,408        39,480        37,714   

General and administrative

    8,550        2,091        1,997        12,303        2,649        18,577   

Depreciation and amortization

    32,304        17,178        20,470        47,408        27,240        22,295   

Interest

    19,179        22,580        20,348        26,063        27,051        22,932   

Loss on extinguishment of debt

    —          —          171        171        171        —     

Acquisition costs

    —          630        —          —         

Other

    —          —          —          —          —          143   
                                               

Total expenses

    101,015        72,364        72,342        140,353        96,591        101,661   

Loss before equity in net earnings of unconsolidated joint ventures and non-operating income

    (15,095     (17,641     (17,809     (23,061     (23,952     (37,555

Equity in net earnings of unconsolidated joint ventures

    184        184        406        313        313        93   

Non-operating income

    —          —          6        435        434        85   
                                               

Net loss

    (14,911     (17,457     (17,397     (22,313     (23,205     (37,377

Fair value adjustment of Preferred Units

    —          —          —          —          (58,645     —     

Net loss attributable to non-controlling interests

    2,135        13,409        13,984        3,188        66,237        29,557   

Dividends on Series A Senior Common Stock

    (53     (53     —          —          —          —     
                                               

Net loss attributable to common stockholders

  $ (12,829   $ (4,101   $ (3,413   $ (19,125   $ (15,613   $ (7,820
                                               

Balance Sheet Data (at period end):

           

Investments in real estate, net

  $ 651,714      $ 378,274      $ 385,431        $ 382,950      $ 392,657   

Total assets

  $ 824,202      $ 514,324      $ 513,952        $ 510,948      $ 530,933   

Mortgage and other loans, net

  $ 383,728      $ 419,720      $ 403,347        $ 406,439      $ 400,108   

Total liabilities

  $ 423,765      $ 479,845      $ 455,437        $ 459,667      $ 453,825   

Non-controlling interests (mezzanine equity)

  $ —        $ —        $ 130,679        $ —        $ 133,250   

Total stockholders’ equity

  $ 310,964      $ (131,246   $ —          $ (132,326   $ (56,142

Non-controlling interests (permanent equity)

  $ 89,473      $ 165,725      $ —          $ 183,607      $ —     

Total equity

  $ 400,437      $ 34,479      $ (72,164     $ 51,281      $ (56,142

Per Share Data (2):

           

Net loss per common share — basic and diluted

  $ (0.27   $ (10.60   $ (11.15   $ (0.41   $ (47.91     ( 3) 
                                               

Weighted average number of common shares outstanding — basic and diluted

    46,894,792        386,999        305,968        46,833,694        325,901        ( 3) 

Other Data:

           

FFO attributable to common stockholders (4)

  $ 19,289      $ (87   $ 3,274      $ 27,667      $ (54,310  

FFO attributable to common stockholders, excluding non-recurring items and fair value adjustment of preferred units (4)

  $ 19,289      $ 2,976      $ 3,274      $ 27,667      $ 4,335     

 

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(1) Amounts in this column represent the sum of the consolidated results of operations of Waterfront for the period from January 1, 2008 through March 19, 2008 and our consolidated results of operations for the period from March 20, 2008 through December 31, 2008.
(2) Historical per share calculations are adjusted for the one-for-ten reverse stock split that we intend to effectuate prior to the completion of this offering and immediately prior to the effectiveness of the registration statement of which this prospectus is a part.
(3) For the period from March 20, 2008 through December 31, 2008, we reported a net loss attributable to common stockholders of $6,741.

 

The per share data is as follows (and adjusted for the one-for-ten reverse stock split):

  

Net loss per common share — basic and diluted

   $ (22.24
        

Weighted average number of common shares outstanding — basic and diluted

     303,113   
        

For the period from January 1, 2008 through March 19, 2008, Waterfront reported a net loss attributable to unitholders of $1,079.

  

The per unit data is as follows (and adjusted for the one-for-ten reverse stock split):

  

Net loss per unit — basic and diluted

   $ (3.09
        

Weighted average number of units outstanding — basic and diluted

     349,462   
        

 

(4) For a definition and reconciliation of FFO and a statement disclosing the reasons why our management believes that presentation of FFO provides useful information to investors and, to the extent material, any additional purposes for which our management uses FFO, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Funds from Operations.”

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion in conjunction with the consolidated financial statements and the related notes thereto that appear elsewhere in this prospectus, as well as the sections of this prospectus entitled “Risk Factors,” “Forward-Looking Statements,” “Business and Properties” and “Structure and Formation Transactions.” Our financial information and results of operations were significantly affected by the consummation of our formation transactions, which are referred to in this section as the Transactions, on March 19, 2008, or the Effective Date. We determined that the commercial real estate assets contributed by Venture in connection with our formation transactions, which we refer to as the Contributed Properties, were not under common control. Waterfront, which had the largest interest in Venture, was designated as the acquiring entity in the business combination for financial accounting purposes. Accordingly, historical financial information for Waterfront has also been presented for the period from January 1, 2008 through March 19, 2008. Additional explanatory notations are contained herein to distinguish the historical information of Waterfront from that of the Company. Historical results set forth in the consolidated financial statements included elsewhere in this prospectus and this section should not be taken as indicative of our future operations. Historical share, per share, unit and per unit amounts have been adjusted to reflect the one-for-ten reverse stock and unit split that we intend to complete immediately prior to the completion of this offering.

Overview

We are a publicly traded REIT that owns, acquires and operates primarily institutional-quality office properties principally in selected long-term growth markets in California and Hawaii. We currently own eight office properties comprising approximately 2.3 million rentable square feet. We also own interests (ranging from 5% to approximately 32%) in 16 joint venture properties, of which we have managing ownership interests in 15, comprising approximately 2.4 million rentable square feet. Our weighted average ownership interest in our joint ventures at September 30, 2010 was 10.6% based upon our allocable share of joint venture net operating income after priority returns for the nine months ended September 30, 2010. In addition, we are party to two purchase contracts to acquire the GRE portfolio, which is a portfolio of 12 office properties comprising approximately 1.9 million rentable square feet, for aggregate consideration of approximately $305.9 million. We expect to complete the acquisition of the GRE portfolio concurrently with the completion of this offering. Upon the completion of this offering and our pending acquisition of the GRE portfolio, we will own 36 office properties, including the interests in our joint venture properties, comprising approximately 6.6 million rentable square feet in 76 buildings. Our primary business objectives are to achieve long-term growth in net asset value, FFO per share and dividends per share. We intend to achieve these objectives through both internal and external growth initiatives.

We were formed in 2008 as a continuation of The Shidler Group’s successful 30-year history of operations in the western United States and Hawaii. Our formation was accomplished through a reverse merger into a publicly traded REIT, AZL, whose common stock was listed and traded on the American Stock Exchange. Concurrent with the merger, we changed our name to Pacific Office Properties Trust, Inc. and reincorporated in the State of Maryland. Currently, we are externally managed by our Advisor. Concurrent with the completion of this offering, we will acquire our Advisor for nominal consideration and thereby become internally managed.

We currently own office buildings in Honolulu, San Diego, Orange County, certain submarkets of Los Angeles and Phoenix. Upon the completion of our pending acquisition of the GRE portfolio, we will expand to the San Francisco Bay Area. We intend to target future acquisitions in the San Francisco Bay Area and all of our current markets with the exception of Phoenix. We refer to these markets as our target markets. We focus primarily on specific long-term growth markets with a high quality of life that, according to RCG, have high barriers to entry for the development of new office supply and a history of long-term job formation. We believe that our target markets provide us with attractive long-term return opportunities and that our integrated operating platform, market knowledge and industry relationships give us an advantage relative to many of our competitors.

We believe that the current dislocation in the commercial real estate market and the economic conditions in our target markets afford us the opportunity to acquire institutional-quality office buildings at prices that are

 

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substantially below replacement cost. RCG expects employment and the local economy in each of our target markets to improve which, with minimal new office construction expected over the next three years, should lead to improved occupancy and rent growth. Our investment strategy is to acquire those types of office buildings often described as “core” investment properties which, generally, due to their location, building quality and tenant base, produce a predictable and growing income stream, and “value-added” investment properties which generally offer upside potential through improvement upgrades, repositioning, aggressive leasing and intensive management. We access potential acquisitions through a broad network that The Shidler Group has developed over the past 30 years, including lenders, brokers, developers and owners. As a result, we believe we have a “first call” advantage due to our reputation, relationships and ability to provide a broad array of transaction structures to address the varying needs of sellers. We believe this allows us to selectively acquire institutional-quality office properties in off-market transactions with a familiar base of local and institutional owners.

Our capitalization strategy is to create and maintain what we believe to be a stable debt and equity capital structure. We intend to employ prudent amounts of leverage as a means of providing additional funds to acquire properties, to refinance existing debt or for general corporate purposes. At September 30, 2010, on a pro forma basis, the outstanding principal amount of our consolidated debt and aggregate liquidation preference of our outstanding Senior Common Stock and preferred stock was equal to approximately 47.2% of our total market capitalization (40.0% if the underwriters’ over-allotment option is exercised in full and the additional net offering proceeds and cash and cash reserves are offset against both consolidated debt and total market capitalization). We intend to limit this ratio to no more than 55%, although our organizational documents contain no limitations regarding the maximum level of debt that we may incur and we may exceed this amount from time to time. Upon the completion of this offering and the concurrent transactions, we will have minimal near-term consolidated debt maturities, with only approximately $18.4 million maturing on a pro forma basis before 2013. Our debt consists of, and we intend to continue to employ, primarily non-recourse, fixed-rate mortgage financing.

Critical Accounting Policies

This discussion and analysis of the historical financial condition and results of operations is based upon the accompanying consolidated financial statements which have been prepared in accordance with GAAP. The preparation of these financial statements in conformity with GAAP requires management to make estimates and assumptions in certain circumstances that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses in the reporting period. Actual amounts may differ from these estimates and assumptions. Summarized below are those accounting policies that require material subjective or complex judgments and that have the most significant impact on financial conditions and results of operations. These estimates have been evaluated on an ongoing basis, based upon information currently available and on various assumptions that management believes are reasonable as of the date hereof. In addition, other companies in similar businesses may use different estimation policies and methodologies, which may impact the comparability of the results of operations and financial conditions to those of other companies.

Investments in Unconsolidated Joint Ventures. Our investments in joint ventures are accounted for under the equity method of accounting because we exercise significant influence over, but do not control, our joint ventures. Our joint venture partners have substantive participating rights, including approval of and participation in setting operating budgets. Accordingly, we have determined that the equity method of accounting is appropriate for our investments in joint ventures.

Investments in unconsolidated joint ventures are initially recorded at cost and are subsequently adjusted for our proportionate equity in the net income or net loss of the joint ventures, contributions made to, or distributions received from, the joint ventures and other adjustments. We record distributions of operating profit from our investments in unconsolidated joint ventures as part of cash flows from operating activities and distributions related to a capital transaction, such as a refinancing transaction or sale, as investing activities in the consolidated statements of cash flows. A description of our impairment policy is set forth below.

 

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The difference between the initial cost of the investment in our joint ventures included in our consolidated balance sheet and the underlying equity in net assets of the respective joint ventures is amortized as an adjustment to equity in net income or net loss of the joint ventures in our consolidated statement of operations over the estimated useful lives of the underlying assets of the respective joint ventures.

We evaluate all investments in accordance with the guidance of Financial Accounting Standards Board, or FASB, Accounting Standards Update 2009-17, Consolidations (Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities, which was effective January 1, 2010 and which requires ongoing assessments of the investments to determine whether or not they are variable interest entities, or VIEs, and if they are VIEs, whether or not we are determined to be the primary beneficiary. We would consolidate a VIE if it is determined that we are the primary beneficiary. We use qualitative analyses to determine whether we are the primary beneficiary of a VIE. Consideration of various factors could include, but is not limited to, the purpose and design of the VIE, risks that the VIE was designed to create and pass through, the form of our ownership interest, our representation of the entity’s governing body, the size and seniority of our investment, our ability to participate in policymaking decisions, and the rights of the other investors to participate in the decision-making process and to replace us as manager and/or liquidate the venture, if applicable. We currently do not hold any investments in VIEs.

Income Taxes. We have elected to be taxed as a REIT under the Code. To qualify as a REIT, we must meet a number of organizational and operational requirements, including a requirement that we currently distribute at least 90% of our REIT taxable income to our stockholders. Also, at least 95% of gross income in any year must be derived from qualifying sources. We intend to adhere to these requirements and maintain our REIT status. As a REIT, we generally will not be subject to corporate level federal income tax on taxable income that we distribute currently to our stockholders. However, we may be subject to certain state and local taxes on our income and property, and to federal income and excise taxes on our undistributed taxable income, if any. Management believes that we have distributed and will continue to distribute a sufficient majority of our taxable income in the form of dividends and distributions to our stockholders and unitholders. Accordingly, we have not recognized any provision for income taxes.

Pursuant to the Code, we may elect to treat certain of our newly created corporate subsidiaries as taxable REIT subsidiaries, or TRSs. In general, a TRS may perform non-customary services for our tenants, hold assets that we cannot hold directly and generally engage in any real estate or non-real estate related business. A TRS is subject to corporate federal income tax. As of September 30, 2010, none of our subsidiaries had elected to be treated as a TRS. However, concurrent with the completion of this offering, we will internalize our management by acquiring all of the outstanding stock of our Advisor for an aggregate purchase price of $25,000 payable in cash. We will elect to treat Pacific Office Management as a TRS for federal income tax purposes.

Investments in Real Estate. We account for acquisitions of real estate utilizing the purchase method and, accordingly, the results of operations of acquired properties are included in our results of operations from the respective dates of acquisition.

Investments in real estate properties are stated at cost, less accumulated depreciation and amortization. A portion of certain assets comprising the Contributed Properties are stated at their historical net cost basis in an amount attributable to the ownership interests in the Contributed Properties owned by Jay H. Shidler. Additions to land, buildings and improvements, furniture, fixtures and equipment and construction in progress are recorded at cost.

Beginning January 1, 2009, transaction costs related to acquisitions are expensed. Costs associated with developing space for its intended use are capitalized and amortized over their estimated useful lives, commencing at the earlier of the lease execution date or the lease commencement date.

 

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Estimates of future cash flows and other valuation techniques are used to allocate the acquisition cost of acquired properties among land, buildings and improvements, and identifiable intangible assets and liabilities such as amounts related to in-place at-market leases, acquired above- and below-market leases, and acquired above- and below-market ground leases.

The fair values of real estate assets acquired are determined on an “as-if-vacant” basis. The “as-if-vacant” fair value is allocated to land, and where applicable, buildings, tenant improvements and equipment based on comparable sales and other relevant information obtained in connection with the acquisition of the property.

Fair value is assigned to above-market and below-market leases based on the difference between (a) the contractual amounts to be paid by the tenant based on the existing lease and (b) management’s estimate of current market lease rates for the corresponding in-place leases, over the remaining terms of the in-place leases. Capitalized above- and below-market lease amounts are reflected in “Acquired above-market leases, net” and “Acquired below-market leases, net,” respectively, in the consolidated balance sheets. Capitalized above-market lease amounts are amortized as a decrease to rental revenue over the remaining initial non-cancellable lease terms plus the terms of any below-market fixed rate renewal options that are considered bargain renewal options. Capitalized below-market lease amounts are amortized as an increase in rental revenue over the remaining initial non-cancellable lease terms plus the terms of any below-market fixed rate renewal options that are considered bargain renewal options. Rental revenues included (above-) below-market lease intangible amortization of $1.5 million and $2.3 million for the nine months ended September 30, 2010 and the year ended December 31, 2009, respectively. If a tenant vacates its space prior to the contractual termination of the lease and no rental payments are being made on the lease, any unamortized balance, net of the security deposit, of the related intangible is written off.

The aggregate value of other acquired intangible assets consists of acquired in-place leases. The fair value allocated to acquired in-place leases consists of a variety of components including, but not necessarily limited to: (a) the value associated with avoiding the cost of originating the acquired in-place lease (i.e. the market cost to execute a lease, including leasing commissions and legal fees, if any); (b) the value associated with lost revenue related to tenant reimbursable operating costs estimated to be incurred during the assumed lease-up period (i.e. real estate taxes, insurance and other operating expenses); (c) the value associated with lost rental revenue from existing leases during the assumed lease-up period; and (d) the value associated with any other inducements to secure a tenant lease. The value assigned to acquired in-place leases is amortized over the remaining lives of the related leases.

We record the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired (including identified intangible assets) and liabilities assumed as goodwill. Goodwill is not amortized but is tested for impairment at a level of reporting referred to as a reporting unit on an annual basis, during the fourth quarter of each calendar year, or more frequently, if events or changes in circumstances indicate that the asset might be impaired. An impairment loss for an asset group is allocated to the long-lived assets of the group on a pro-rata basis using the relative carrying amounts of those assets, except that the loss allocated to an individual long-lived asset shall not reduce the carrying amount of that asset below its fair value. A description of our testing policy is set forth in “Impairment” on the immediately following page.

In connection with the Transactions, we received a representation from our predecessor, AZL, that it qualified as a REIT under the provisions of the Code. However, during 2009 we became aware that, prior to the consummation of the Transactions, AZL historically invested excess cash from time to time in money market funds that, in turn, were invested primarily in short-term federal government securities. Additionally, during 2009 we became aware that AZL made two investments in local government obligations. Our predecessor, AZL, with no objection from outside advisors, treated these investments as qualifying assets for purposes of the 75% gross asset test. However, if these investments were not qualifying assets for purposes of the 75% gross asset test, then AZL may not have satisfied the REIT gross asset tests for certain quarters, in part, because they may have exceeded 5% of the gross value of AZL’s assets. These investments resulted in AZL’s noncompliance with the REIT gross asset tests, however, we and our predecessor, AZL, would retain qualification as a REIT pursuant

 

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to certain mitigation provisions of the Code. The Code provides that so long as any noncompliance was due to reasonable cause and not due to willful neglect, and certain other requirements are met, qualification as a REIT may be retained but a penalty tax would be owed. Any potential noncompliance with the gross asset tests would be due to reasonable cause and not due to willful neglect so long as ordinary business care and prudence were exercised in attempting to satisfy such tests. Based on our review of the circumstances surrounding the investments, we believe that any noncompliance was due to reasonable cause and not due to willful neglect. Additionally, we believe that we have complied with the other requirements of the mitigation provisions of the Code with respect to such potential noncompliance with the gross asset tests (and have paid the appropriate penalty tax), and, therefore, our qualification, and that of our predecessor, AZL, as a REIT should not be affected. The Internal Revenue Service is not bound by our determination, however, and no assurance can be provided that the Internal Revenue Service will not assert that AZL failed to comply with the REIT gross asset tests as a result of the money market fund investments and the local government securities investments and that such failures were not due to reasonable cause. If the Internal Revenue Service were to successfully challenge this position, then it could determine that we and AZL failed to qualify as a REIT in one or more of our taxable years. As a result, we recorded an adjustment to and finalized the purchase price allocation we previously recorded upon consummation of the Transactions. This adjustment resulted in an increase to goodwill by approximately $0.5 million in our consolidated balance sheet at December 31, 2009.

Revenue Recognition. The following four criteria must be met before we recognize revenue and gains:

 

   

persuasive evidence of an arrangement exists;

 

   

the delivery has occurred or services rendered;

 

   

the fee is fixed and determinable; and

 

   

collectibility is reasonably assured.

All of our tenant leases are classified as operating leases. For all leases with scheduled rent increases or other adjustments, minimum rental income is recognized on a straight-line basis over the terms of the related leases. Straight-line rent receivable represents rental revenue recognized on a straight-line basis in excess of billed rents and this amount is included in “Rents and other receivables, net” on the accompanying consolidated balance sheets. The straight line rent adjustment included in rental revenues was $1.0 million and $1.2 million for the nine months ended September 30, 2010 and the year ended December 31, 2009, respectively. Rental property operating expenses for the nine months ended September 30, 2010 and the year ended December 31, 2009 included straight-line ground lease amortization of $1.6 million and $2.2 million, respectively. Reimbursements from tenants for real estate taxes, excise taxes and other recoverable operating expenses are recognized as revenues in the period the applicable costs are incurred.

We have leased space to certain tenants under non-cancelable operating leases, which provide for percentage rents based upon tenant revenues. Percentage rental income is recorded in rental revenues in the consolidated statements of operations.

Rental revenue from parking operations and month-to-month leases or leases with no scheduled rent increases or other adjustments is recognized on a monthly basis when earned.

Lease termination fees, net of the write-off of associated intangible assets and liabilities and straight-line rent balances which are included in other revenues of the accompanying consolidated statements of operations, are recognized when the related leases are canceled and we have no continuing obligation to provide services to such former tenants.

Other revenue on the accompanying consolidated statements of operations generally includes income incidental to our operations and is recognized when earned.

Impairment. We assess the potential for impairment of our long-lived assets, including real estate properties, whenever events occur or a change in circumstances indicate that the recorded value might not be

 

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fully recoverable. We determine whether impairment in value has occurred by comparing the estimated future undiscounted cash flows expected from the use and eventual disposition of the asset to its carrying value. If the undiscounted cash flows do not exceed the carrying value, the real estate or intangible carrying value is reduced to fair value and impairment loss is recognized. Assets to be disposed of are reported at the lower of the carrying amount or fair value, less costs to sell. Based upon such periodic assessments, no indications of impairment were identified for the periods presented in the accompanying consolidated statements of operations.

Goodwill is reviewed for impairment on an annual basis during the fourth quarter of each calendar year, or more frequently if circumstances indicate that a possible impairment has occurred. The assessment of impairment involves a two-step process whereby an initial assessment for potential impairment is performed, followed by a measurement of the amount of impairment, if any. Impairment testing is performed using the fair value approach, which requires the use of estimates and judgment, at the “reporting unit” level. A reporting unit is the operating segment, or a business that is one level below the operating segment if discrete financial information is prepared and regularly reviewed by management at that level. The determination of a reporting unit’s fair value is based on management’s best estimate, which generally considers the market-based earning multiples of the unit’s peer companies or expected future cash flows. If the carrying value of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. An impairment is recognized as a charge against income equal to the excess of the carrying value of goodwill over its implied value on the date of the impairment. As of September 30, 2010, nothing has come to our attention to cause us to believe that our carrying amount of goodwill is impaired. The factors that may cause an impairment in goodwill include, but may not be limited to, a sustained decline in our stock price and the occurrence, or sustained existence, of adverse economic conditions.

Impairment of Investments in Unconsolidated Joint Ventures. Our investment in unconsolidated joint ventures is subject to a periodic impairment review and is considered to be impaired when a decline in fair value is judged to be other-than-temporary. An investment in an unconsolidated joint venture that we identify as having an indicator of impairment is subject to further analysis to determine if the investment is other than temporarily impaired, in which case we write down the investment to its estimated fair value. We did not recognize an impairment loss on our investment in unconsolidated joint ventures during the three and nine months ended September 30, 2010 and 2009, respectively. We expect to record a non-cash impairment charge of approximately $0.2 million during the year ending December 31, 2010 to write off our investment in the unconsolidated joint venture that owns our Seville Plaza property. See “— Subsequent Events” below for additional information.

Tenant Receivables. Tenant receivables are recorded and carried at the amount billable per the applicable lease agreement, less any allowance for doubtful accounts. An allowance for doubtful accounts is made when collection of the full amounts is no longer considered probable. Tenant receivables are included in “Rents and other receivables, net,” in the accompanying consolidated balance sheets. If a tenant fails to make contractual payments beyond any allowance, we may recognize bad debt expense in future periods equal to the amount of unpaid rent and deferred rent. We take into consideration factors to evaluate the level of reserve necessary, including historical termination, default activity and current economic conditions. At September 30, 2010, the balance of the allowance for doubtful accounts was $0.9 million, compared to $1.1 million at December 31, 2009.

Non-controlling Interests. We account for non-controlling interests in accordance with FASB Accounting Standards Codification 810, Consolidation, or FASB ASC 810. In accordance with FASB ASC 810, we report non-controlling interests in subsidiaries within equity in the consolidated financial statements, but separate from the parent stockholders’ equity. Net income attributable to non-controlling interests is presented as a reduction from net income in calculating net income available to common stockholders on the statement of operations. Acquisitions or dispositions of non-controlling interests that do not result in a change of control are accounted for as equity transactions. In addition, FASB ASC 810 requires that a parent company recognize a gain or loss in net income when a subsidiary is deconsolidated upon a change in control. In accordance with FASB ASC 480-10, Distinguishing Liabilities from Equity, non-controlling interests that are determined to be redeemable are carried at their redemption value as of the balance sheet date and reported as temporary equity. We periodically evaluate

 

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individual non-controlling interests for the ability to continue to recognize the non-controlling interest as permanent equity in the consolidated balance sheets. Any non-controlling interest that fails to qualify as permanent equity will be reclassified as temporary equity and adjusted to the greater of (a) the carrying amount, or (b) its redemption value as of the end of the period in which the determination is made, the resulting adjustment is recorded in the consolidated statement of operations.

Historical Nine Months Ended September 30, 2010 Compared to Nine Months Ended September 30, 2009

Results of Operations

Overview

As of September 30, 2010, our total property portfolio (including our consolidated and joint venture properties) was 84.0% leased to a total of 761 tenants. As of September 30, 2010, approximately 4.3% of our total property portfolio leased square footage was scheduled to expire during the remainder of 2010 and another 11.9% of our total property portfolio leased square footage was scheduled to expire during 2011. We receive income primarily from rental revenue (including tenant reimbursements) from our office properties and, to a lesser extent, from our parking revenues. Our office properties are typically leased to tenants with good credit for terms ranging from 2 to 20 years.

As of September 30, 2010, our consolidated Honolulu portfolio was 90.0% leased, with approximately 146,200 square feet available. Our Honolulu portfolio attributable to our unconsolidated joint ventures was 85.5% leased, with approximately 22,100 square feet available.

As of September 30, 2010, our consolidated Phoenix portfolio was 71.4% leased, with approximately 211,100 square feet available. Our Phoenix portfolio attributable to our unconsolidated joint ventures was 77.0% leased, with approximately 136,100 square feet available.

As of September 30, 2010, our consolidated San Diego portfolio, which consists of our Sorrento Technology Center property, was 100% leased. Our San Diego portfolio attributable to our unconsolidated joint ventures was 82.7% leased, with approximately 171,300 square feet available.

Comparison of the nine months ended September 30, 2010 to the nine months ended September 30, 2009

($ in thousands)

 

     September 30,
2010
    September 30,
2009
    $ Change     % Change  

Revenue:

        

Rental

   $ 31,621      $ 31,999      $ (378     (1.2 )% 

Tenant reimbursements

     16,742        16,184        558        3.4  % 

Parking

     6,093        6,080        13        0.2  % 

Other

     267        270        (3     (1.1 )% 
                                

Total revenue

     54,723        54,533        190        0.3  % 

Expenses:

        

Rental property operating

     29,885        29,356        529        1.8  % 

General and administrative

     2,091        1,997        94        4.7  % 

Depreciation and amortization

     17,178        20,470        (3,292     (16.1 )% 

Interest

     22,580        20,348        2,232        11.0  % 

Loss from extinguishment of debt

     —          171        (171     (100.0 )% 

Acquisition costs

     630        —          630        100.0  % 
                                

Total expenses

     72,364        72,342        22        0.0  % 

Loss before equity in net earnings of unconsolidated joint ventures and non-operating income

     (17,641     (17,809     168        0.9  % 

Equity in net earnings of unconsolidated joint ventures

     184        406        (222     (54.7 )% 

Non-operating income

     —          6        (6     (100.0 )% 
                                

Net loss

   $ (17,457   $ (17,397   $ (60     (0.3 )% 
                                

 

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Revenues

Rental Revenue. Rental revenue decreased by $0.4 million, or 1.2%, for the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009. The decrease was primarily due to decreased average occupancy at two of our Hawaii properties: Davies Pacific Center ($0.3 million) and the Pan Am Building ($0.3 million). In addition, we are experiencing lower rental rates at our City Square property ($0.3 million) due to current market conditions in the greater Phoenix area. These decreases were partially offset by increased average occupancy at our Waterfront Plaza property in Hawaii ($0.5 million).

Tenant Reimbursements. Tenant reimbursements increased by $0.6 million, or 3.4%, for the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009. The increase is primarily due to an increase in our common area maintenance expenses recoverable from our tenants as compared to the 2009 period.

All other sources of revenue remained relatively constant.

Expenses

Rental Property Operating Expenses. Rental property operating expenses increased by $0.5 million, or 1.8%, for the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009. The increase was primarily attributable to higher utility costs due to increased rates for electricity at four of our Hawaii properties: Davies Pacific Center ($0.1 million), Waterfront Plaza ($0.5 million), First Insurance Center ($0.2 million) and the Pacific Business News Building ($0.1 million). This increase in utility costs is offset by decreased electrical usage at our City Square property ($0.1 million). In addition, we increased our bad debt expense reserves by $0.2 million at the Pan Am Building, which was offset by a decrease of $0.3 million at the Davies Pacific Center and $0.2 million at the City Square property, for a total net decrease of $0.3 million.

General and Administrative. General and administrative expense increased by $0.1 million, or 4.7%, for the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009. The increase is primarily attributable to an increase in legal fees of $0.4 million offset by a decrease in audit fees of $0.3 million due to a change in auditors during the current year.

Depreciation and Amortization Expense. Depreciation and amortization expense decreased by $3.3 million, or 16.1%, for the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009. The decrease is primarily attributable to the expiration of useful lives of certain intangible assets acquired pursuant to our formation transactions in 2008. We expect the amortization expense related to intangible assets acquired pursuant to our formation transactions in 2008 to continue to decrease as their useful lives expire. An additional decrease was related to an adjustment to expense that took place in 2009 related to our Waterfront property that is expected not to recur in 2010.

Interest Expense. Interest expense increased by $2.2 million, or 11%, for the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009. The increase is primarily attributable to default interest incurred on our Pacific Business News Building loan, with a principal balance of $11.6 million, since April 7, 2010, and on our City Square mezzanine loan, with an aggregate principal balance of $27.3 million, since September 7, 2010. In addition, late charge penalties in connection with the defaults of $0.5 million and $1.5 million, for the respective loans have been accrued. These late charges have not been paid by us as of the date of this prospectus.

Loss from extinguishment of debt. We recognized a $0.2 million loss from extinguishment of debt during the nine months ended September 30, 2009 due to the write-off of unamortized loan costs related to the September 2009 termination of our former credit facility. We did not recognize any comparable losses in the current year period.

 

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Acquisition Costs. We incurred $0.6 million in acquisition costs for the nine months ended September 30, 2010 in connection with our contemplated acquisition of the GRE portfolio ($0.5 million) and the now terminated acquisition of a one-building office property located in San Diego, California ($0.1 million).

Equity in net earnings of unconsolidated joint ventures

Equity in net earnings of unconsolidated joint ventures decreased by $0.2 million, or 54.7%, for the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009. The decrease was attributable to the addition of the Seaview joint venture in December 2009, of which our share of its loss was approximately $0.1 million. In addition, our share of income attributable to our Black Canyon joint venture decreased by $0.1 million due to a recent loan modification, which resulted in higher interest expense for the joint venture.

Historical Year Ended December 31, 2009 Compared to Year Ended December 31, 2008

The following discussion regarding our results of operations was significantly affected by the Transactions; the properties acquired on the Effective Date were in our portfolio for 287 days in 2008 compared to 365 days in 2009. Our discussion below addresses the historical information for the year ended December 31, 2009 for the Company, and the historical information for the period from January 1, 2008 to March 19, 2008 for Waterfront, plus the period from March 20, 2008 to December 31, 2008 for the Company, on a combined basis, or the Combined Entity.

Results of Operations

Overview

As of December 31, 2009, our total property portfolio (including our consolidated and joint venture properties) was 85.2% leased to a total of 1,047 tenants. As of December 31, 2009, approximately 12.5% of our total property portfolio leased square footage was scheduled to expire during 2010 and another 12.5% of our total property portfolio leased square footage was scheduled to expire during 2011. We receive income primarily from rental revenue (including tenant reimbursements) from our office properties, and to a lesser extent, from our parking revenues. Our office properties are typically leased to tenants with good credit for terms ranging from two to 20 years.

As of December 31, 2009, our consolidated Honolulu portfolio was 90.9% leased, with approximately 133,100 square feet available. Our Honolulu portfolio attributable to our unconsolidated joint ventures was 85.6% leased, with approximately 21,900 square feet available.

As of December 31, 2009, our consolidated Phoenix portfolio was 71.9% leased, with approximately 207,600 square feet available. Our Phoenix portfolio attributable to our unconsolidated joint ventures was 74.1% leased, with approximately 153,000 square feet available.

As of December 31, 2009, our consolidated San Diego portfolio, which consists of our Sorrento Technology Center property, was 100% leased. Our San Diego portfolio attributable to our unconsolidated joint ventures was 88.0% leased, with approximately 119,100 square feet available.

 

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Comparison of the year ended December 31, 2009 to the year ended December 31, 2008

($ in thousands)

 

     2009     2008 (1)     $ Change     % Change  

Revenue:

        

Rental

   $ 42,462      $ 37,447      $ 5,015        13.4  % 

Tenant reimbursements

     21,662        19,375        2,287        11.8  % 

Parking

     8,150        6,890        1,260        18.3  % 

Other

     365        394        (29     (7.4 )% 
                                

Total revenue

     72,639        64,106        8,533        13.3  % 

Expenses:

        

Rental property operating

     39,480        37,714        1,766        4.7  % 

General and administrative

     2,649        18,577        (15,928     (85.7 )% 

Depreciation and amortization

     27,240        22,295        4,945        22.2  % 

Interest

     27,051        22,932        4,119        18.0  % 

Loss from extinguishment of debt

     171        —          171        100.0  % 

Other

     —          143        (143     (100.0 )% 
                                

Total expenses

     96,591        101,661        (5,070     (5.0 )% 

Loss before equity in net earnings of unconsolidated joint ventures and non-operating income

     (23,952     (37,555     13,603        36.2  % 

Equity in net earnings of unconsolidated joint ventures

     313        93        220        236.6  % 

Non-operating income

     434        85        349        410.6  % 
                                

Net loss

   $ (23,205   $ (37,377   $ 14,172        37.9  % 
                                

 

(1) Amounts reflected in 2008 represent the sum of the results of the Company for the period from March 20, 2008 to December 31, 2008 and the results of Waterfront for the period from January 1, 2008 to March 19, 2008.

Revenues

Rental Revenue. Rental revenue increased by $5.0 million, or 13.4%, for the year ended December 31, 2009 compared to the year ended December 31, 2008. An increase of $6.0 million was primarily attributable to the number of days the properties acquired at the Effective Date were in our portfolio during 2009 compared to 2008. The increase is partially offset by a $1.0 million decrease due to decreased average occupancy, rental rates and below market rent amortization at our City Square and Davies Pacific Center properties.

Tenant Reimbursements. Tenant reimbursements increased by $2.3 million, or 11.8%, for the year ended December 31, 2009 compared to the year ended December 31, 2008. An increase of $3.5 million was primarily attributable to the number of days the properties acquired at the Effective Date were in our portfolio during 2009 compared to 2008. This increase is partially offset by a decrease in electricity costs (and corresponding decrease in tenant reimbursements) in Hawaii in 2009.

Parking Revenue. Parking revenue increased by $1.3 million, or 18.3%, for the year ended December 31, 2009 compared to the year ended December 31, 2008. The increase was primarily attributable to the number of days the properties acquired at the Effective Date were in our portfolio during 2009 compared to 2008.

Expenses

Rental Property Operating Expenses. Rental property operating expenses increased by $1.8 million, or 4.7%, for the year ended December 31, 2009 compared to the year ended December 31, 2008. An increase of $3.2 million was primarily attributable to the number of days the properties acquired at the Effective Date were in our portfolio during 2009 compared to 2008. This increase was partially offset by a reduction in our bad debt reserves of $0.5 million and a $1.7 million decrease in electricity costs in Hawaii due to lower oil prices in 2009.

 

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General and Administrative. General and administrative expense decreased by $15.9 million, or 85.7%, for the year ended December 31, 2009 compared to the year ended December 31, 2008. The decrease is primarily due to a $16.2 million share-based compensation charge resulting from the Transactions during the year ended December 31, 2008. The decrease is also due to the non-recurrence of certain expenses of $0.4 million related to the Transactions and a $0.1 million decrease in professional fees relating to Sarbanes-Oxley compliance. These decreases are partially offset by additional financial audit fees of $0.3 million and increased fees paid to the Advisor and our board of directors ($0.3 million increase due to the number of days the properties acquired at the Effective Date were in our portfolio during 2009 compared to 2008).

Depreciation and Amortization Expense. Depreciation and amortization expense increased by $4.9 million, or 22.2%, for the year ended December 31, 2009 compared to the year ended December 31, 2008. The increase was primarily attributable to the number of days the properties acquired at the Effective Date were in our portfolio during 2009 compared to 2008.

Interest Expense. Interest expense increased by $4.1 million, or 18.0%, for the year ended December 31, 2009 compared to the year ended December 31, 2008. An increase of $3.4 million was primarily attributable to the number of days the properties acquired at the Effective Date were in our portfolio during the 2009 compared to 2008. An additional increase of $0.7 million was due to interest incurred on the unsecured promissory notes that were in place for a longer period in 2009 partially offset by a decrease in the interest rate on our variable interest rate debt.

Loss from extinguishment of debt. We recognized a $0.2 million loss from extinguishment of debt during the year ended December 31, 2009 due to the write-off of unamortized loan costs related to the termination of our former credit facility with KeyBank in September 2009. We did not recognize any comparable losses in the prior year.

Equity in net earnings of unconsolidated joint ventures

Equity in net earnings of unconsolidated joint ventures increased by $0.2 million, or 236.6%, for the year ended December 31, 2009 compared to the year ended December 31, 2008. The increase was primarily attributable to the addition of the SoCal II joint venture in August 2008.

Non-operating income

Non-operating income increased by $0.3 million, or 410.6%, for the year ended December 31, 2009 compared to the year ended December 31, 2008. The increase was primarily attributable to a write-off of tax penalties accrued in relation to AZL’s potential noncompliance with the REIT asset tests. We paid penalties and fees of $0.07 million instead of the fully accrued amount of $0.5 million.

Historical Cash Flows

Nine Months Ended September 30, 2010 Compared to Nine Months Ended September 30, 2009

Net cash provided by operating activities for the Company for the nine months ended September 30, 2010 was $3.4 million compared to $6.7 million for the nine months ended September 30, 2009. The decrease of $3.3 million was primarily attributable to an increase of $3.4 million in restricted cash balances used to fund operating activities in the prior year period and an increase in other assets during the current period of $1.7 million. The increase in other assets during the current year period was primarily attributable to an increase in prepaid assets related to property taxes that we paid during the quarter ended September 30, 2010. These respective decreases in operating cash flows were offset by an increase in accounts payable of $5.3 million during the current year period. The increase in accounts payable during the current year period was primarily attributable to accrued acquisition costs incurred in the current period related to our contemplated acquisition of the GRE portfolio, and default interest and late fee penalties payable in connection with the Pacific Business News Building and the City Square Mezzanine Note which are currently in default.

 

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Net cash used in investing activities by the Company for the nine months ended September 30, 2010 was $10.3 million compared to $4.9 million for the nine months ended September 30, 2009. The increase in cash used of $5.4 million was primarily attributable to deposits we made in the current year period of $5.0 million related to our contemplated acquisition of the GRE portfolio, and increases of capital improvements to real estate by $1.4 million compared to the same period in the prior year. These respective uses of cash flow from investing activities were offset by our restricted cash used for capital expenditures which decreased by $1.9 million compared to the same period in the prior year.

Net cash provided by financing activities was $11.9 million for the nine months ended September 30, 2010 compared to net cash used in financing activities of $2.8 million during the nine months ended September 30, 2009. The increase in cash provided by financing activities is primarily attributable to a $13.1 million draw on our revolving credit facility during the current year period, compared with a net draw of $2.8 million in the same period in the prior year. In addition, we received net proceeds from the sale of Senior Common Stock of $5.9 million during the nine months ended September 30, 2010. The cash provided by financing activities was partially offset by $0.5 million paid in connection with the redemption of our Operating Partnership common units during the quarter ended September 30, 2010, and an increase in deferred offering costs of $0.8 million compared to the same period in the prior year, incurred in connection with this offering.

Year Ended December 31, 2009 Compared to Year Ended December 31, 2008

Net cash provided by operating activities for the Company for the year ended December 31, 2009 was $5.9 million compared to $2.2 million for the Combined Entity for the year ended December 31, 2008. The increase of $3.7 million for the Company compared to the Combined Entity was primarily attributable to improved vendor payment management in addition to incremental cash flow due to the number of days the properties acquired at the Effective Date were in our portfolio during 2009 compared to 2008, 365 days in 2009 compared to 287 days in 2008.

Net cash used in investing activities for the Company for the year ended December 31, 2009 was $5.5 million compared to $8.9 million for the Combined Entity for the year ended December 31, 2008. During 2009, our restricted cash decreased by $0.8 million due to a return of escrow deposits and property tax payments made from our reserve accounts and we paid $1.4 million to acquire an interest in an unconsolidated joint venture. In addition, we decreased our capital expenditures related to real estate by $2.6 million compared to the same period in the prior year and we received $1.4 million in additional capital distributions from our investments in unconsolidated joint ventures and a catch up in distributions from another joint venture that we did not elect to receive in the prior year. In addition, we received $6.5 million from Contributed Properties upon the Effective Date. This was offset by our payment of $4.1 million of acquisition costs related to the Transactions during the year ended December 31, 2008, which did not recur during the year ended December 31, 2009.

Net cash used in financing activities was $1.6 million for the year ended December 31, 2009 compared to $8.5 million in net cash provided by financing activities for the Combined Entity for the year ended December 31, 2008. Our cash used during the 2009 period was primarily attributable to $5.8 million in distributions paid to non-controlling interests and stockholders, which we expect to continue paying, offset by $5.9 million in net draws from our revolving line of credit. In addition, we paid $1.8 million in offering costs attributable to our Senior Common Stock. During 2008, we received $6.4 million from the issuance of equity securities, as a result of the Transactions. In addition, in 2008, the Combined Entity also received $2.7 million in net equity contributions from the previous partners. We do not, however, expect to continue to receive equity contributions in a manner similar to that received during the 2008 period based on our capital structure after the Transactions.

Subsequent Events

As discussed elsewhere in this prospectus, on January 12, 2010, we commenced a registered continuous public offering of up to 40,000,000 shares of our Series A Senior Common Stock. Following the completion of

 

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this offering, we intend to limit the maximum number of shares of our Series A Senior Common Stock to be sold in that offering to 10,000,000. In connection with the contemplated reduction in size of that offering, we expect to write off approximately $1.7 million of costs associated with that offering that we have previously capitalized. We expect to write off these costs during the year ending December 31, 2010, which would increase our total expenses by that amount, but have no impact on our net cash flow for that period.

In addition, we currently own a 7.5% equity interest in an unconsolidated joint venture that owns our Seville Plaza property. We have identified impairment indicators that are other than temporary, and as such, we do not believe we will be able to recover our investment in this joint venture. Accordingly, we expect to record a non-cash impairment charge of approximately $0.2 million during the year ending December 31, 2010. This non-cash impairment charge represents the difference between the estimated fair value of our investment in this unconsolidated joint venture and its carrying value. Our estimate of the fair value of our investment in this unconsolidated joint venture is determined using widely accepted valuation techniques, including discounted cash flow analysis on expected cash flows as well as other subjective assumptions that are subject to economic and market uncertainties. This non-cash impairment charge will increase our total expenses by an estimated $0.2 million during the year ending December 31, 2010, but have no impact on our net cash flow for that period.

Pro Forma Liquidity and Capital Resources

Liquidity is a measure of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain our assets and operations, acquire properties, make distributions to our stockholders and other general business needs. In order to qualify as a REIT, we must distribute to our stockholders, each calendar year, at least 90% of our REIT taxable income.

While we may be able to anticipate and plan for certain liquidity needs, there may be unexpected increases in uses of cash that are beyond our control and which would affect our financial condition and results of operations. For example, we may be required to comply with new laws or regulations that cause us to incur unanticipated capital expenditures for our properties, thereby increasing our liquidity needs. Even if there are no material changes to our anticipated liquidity requirements, our sources of liquidity may be fewer than, and the funds available from such sources may be less than, anticipated or needed.

Our liquidity requirements primarily consist of operating expenses and other expenditures associated with our properties, distributions to our limited partners and dividend payments to our stockholders required to maintain our REIT status, cumulative dividends on our Senior Common Stock, capital expenditures, debt service requirements and scheduled principal maturities and property acquisitions. We expect to meet our short-term liquidity and capital requirements primarily through net cash provided by operating activities, proceeds from our ongoing offering of Senior Common Stock and unused borrowing capacity under the new credit facility. While our short term need for operating cash will increase due to the operations of the GRE portfolio, we expect that our operating costs for these properties will be less than those of the prior owner. We believe that our insurance premiums for comprehensive property insurance on the GRE portfolio for the first year after our acquisition will be less than the amounts paid by the prior owner of the GRE portfolio. Further, we expect that the properties in the GRE portfolio will be re-assessed under California law following acquisition, which could reduce the aggregate annual property tax liability for these properties in 2011.

We expect to meet our long-term capital requirements through net cash provided by operating activities, borrowings under the new credit facility, refinancing of existing debt, proceeds from our ongoing offering of Senior Common Stock or the issuance of additional securities and through other available investment and financing activities, including the assumption of mortgage debt upon acquisition or the procurement of new mortgage debt on acquisition properties and currently unencumbered properties. Upon completion of this offering and the concurrent transactions, we expect to have approximately $100 million of immediate liquidity through borrowing capacity under the new credit facility and unrestricted cash on hand. Upon the completion of this offering and the concurrent transactions, we expect to have three properties in our portfolio (City Square, Clifford Center and Cornerstone Court West), containing a total of 854,038 rentable square feet, that are unencumbered by mortgage indebtedness. We expect all of our remaining properties that are not encumbered by

 

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mortgages as of the date of this prospectus to collateralize the new credit facility. We have offered the lenders eight properties as collateral but none has been accepted as of the date of this prospectus. Our future financing activities may include selling a portion of the equity in the properties in which we currently hold whole interests. We may also dispose of assets, particularly those that are not in our target markets, if we believe that these sales would provide us with capital to redeploy into new investments or repositioning other assets in our target markets.

We believe that this offering and the concurrent transactions will improve our financial condition through changes in our capital structure, including a reduction of the amount of our consolidated debt as a percentage of our total market capitalization. Our capitalization strategy is to create and maintain what we believe to be a stable debt and equity capital structure. We intend to employ prudent amounts of leverage as a means of providing additional funds to acquire properties, to refinance existing debt or for general corporate purposes. At September 30, 2010, on a pro forma basis, the outstanding principal amount of our consolidated debt and aggregate liquidation preference of our outstanding Senior Common Stock and preferred stock was equal to approximately 47.2% of our total market capitalization (40.0% if the underwriters’ over-allotment option is exercised in full and the additional net offering proceeds and cash and cash reserves are offset against both consolidated debt and total market capitalization). We intend to limit this ratio to no more than 55%, although our organizational documents contain no limitations regarding the maximum level of debt that we may incur and we may exceed this amount from time to time. Upon the completion of this offering and the concurrent transactions, we will have minimal near-term consolidated debt maturities, with only approximately $18.4 million maturing on a pro forma basis before 2013. Our debt consists of, and we intend to continue to employ, primarily non-recourse, fixed-rate mortgage financing.

We have received commitments for a three-year $125.0 million secured revolving credit facility from affiliates of certain of the underwriters and expect to close this facility concurrently with the completion of this offering and the concurrent transactions. We intend to use this facility to fund acquisitions and equity investments, refinance existing debt, fund working capital and capital expenditures and for other general corporate purposes. Availability under the new credit facility requires us to collateralize its borrowing base with mortgages on our properties. Upon completion of this offering and the concurrent transactions, under the financial covenants contained in the new credit facility, we expect to have in excess of $90 million immediately available to us to pursue acquisitions in our target markets and for general working capital purposes. We do not intend to draw on the new credit facility to fund any of the concurrent transactions if the public offering price per share in this offering is equal to or above the midpoint of the estimated price range set forth on the front cover of this prospectus. If we draw on the new credit facility to fund any of the concurrent transactions, the ratio of our consolidated debt to our total market capitalization following the completion of this offering and the concurrent transactions would increase. For example, if the over-allotment option is not exercised and the public offering price is $7.50 per share, we would expect to borrow approximately $20.0 million under the new credit facility, resulting in the ratio of our consolidated debt and aggregate liquidation preference of our outstanding Senior Common Stock and preferred stock to our total market capitalization following the completion of this offering and the concurrent transactions increasing to approximately 48.4%. See “—Pro Forma Indebtedness—Secured Revolving Credit Facility” below.

As of September 30, 2010, on a pro forma basis, our total consolidated debt was approximately $383.7 million, with a weighted average interest rate of 5.96% and a weighted average remaining term of 5.45 years. The principal amount of this debt, minus cash and cash reserves and restricted cash, as of September 30, 2010 was approximately 7.56 times our annualized earnings before interest, taxes, depreciation and amortization, or EBITDA, for the nine months ended September 30, 2010 on a pro forma basis.

We believe that EBITDA and annualized EBITDA are useful supplemental measures of our performance. We believe that EBITDA and annualized EBITDA provide useful information to the investment community about our financial position before the impact of investing and financing transactions. Accordingly, EBITDA and annualized EBITDA should not be considered as alternatives to cash flows from operating activities (as computed in accordance with GAAP) as measures of liquidity. EBITDA and annualized EBITDA should not be

 

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considered as alternatives to net income (loss) as indicators of our operating performance. Other REITs may use different methodologies for calculating EBITDA and accordingly, our EBITDA and annualized EBITDA may not be comparable to other REITs.

The following table presents a reconciliation of our pro forma net loss for the nine months ended September 30, 2010 to EBITDA and annualized EBITDA for the same period (in thousands).

 

     Pro Forma  
     Nine Months Ended
September 30, 2010
 
   (unaudited)  

Net loss attributable to common stockholders

   $ (12,829

Add: Interest expense

     19,179   

Add: Depreciation and amortization of real estate assets

     32,304   

Add: Dividends on Series A Senior Common Stock

     53   

Less: Net loss attributable to non-controlling interests

     (2,135
        

EBITDA

   $ 36,572   
        

Multiply: Annualization rate of 1.3333

  

Annualized EBITDA

   $ 48,763   
        

As of September 30, 2010, on a pro forma basis, we had $5.8 million in cash and cash equivalents. In addition, we had restricted cash balances of $9.3 million on a pro forma basis as of September 30, 2010. Restricted cash primarily consists of interest bearing cash deposits required by certain of our mortgage loans to fund anticipated expenditures for real estate taxes, insurance, debt service and leasing costs.

We intend to make regular quarterly distributions to holders of our common stock. We have paid cash dividends of $0.50 per share of our common stock (after giving effect to our reverse stock split) with respect to every quarter from the third quarter of 2008 through the third quarter of 2010. Our quarterly dividend declared with respect to the fourth quarter of 2010, which was declared on December 20, 2010 to be paid on January 17, 2011 to stockholders of record on December 31, 2010, was $0.11 per share. Beginning with our first quarterly dividend following the completion of this offering, we intend to make regular quarterly distributions of $0.09 per share to holders of our common stock. On an annualized basis, this would be $0.36 per share, or an annual distribution rate of approximately 4.5% based upon the assumed public offering price of $8.00 per share of our common stock, which is the midpoint of the estimated price range set forth on the front cover of this prospectus. Our estimated annual rate of distribution following the completion of this offering represents approximately 93.9% of our estimated pro forma cash available for distribution to our common stockholders for the 12-month period ending September 30, 2011. Purchasers of shares of our common stock in this offering will not participate in the dividend declared for the fourth quarter of 2010.

We intend to maintain our distribution rate for the 12-month period following the completion of this offering unless actual results of operations, economic conditions or other factors differ materially from the assumptions used in our estimate. Under some circumstances, we may be required to fund distributions from working capital, liquidate assets at prices or times that we regard as unfavorable or borrow to provide funds for distributions, or we may make distributions in the form of a taxable stock dividend. We have no current intention, however, to use the net proceeds from this offering to make distributions nor do we intend to make distributions using shares of our common stock.

Pro Forma Indebtedness

The following table sets forth information relating to the material borrowings with respect to our consolidated properties, including borrowings that we intend to assume upon completion of our pending acquisition of the GRE portfolio, on a pro forma basis as of September 30, 2010.

 

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Unless otherwise indicated in the footnotes to the table, each loan requires monthly payments of interest only and a balloon payment at maturity, and all numbers, other than percentages, are reported in thousands:

 

PROPERTY

  PRINCIPAL
BALANCE  (1)
    INTEREST
RATE
    MATURITY
DATE
    BALANCE
DUE AT
MATURITY
DATE
    PREPAYMENT/
DEFEASANCE
 

Existing Properties

         

Waterfront Plaza

  $ 100,000        6.37     9/11/2016      $ 100,000           (2)   

Davies Pacific Center

    95,000        5.86     11/11/2016        95,000           (3)   

Pan Am Building

    60,000        6.17     8/11/2016        60,000           (4)   

First Insurance Center

    38,000        5.74     1/1/2016        38,000           (5)   

First Insurance Center

    14,000        5.40     1/6/2016        14,000           (6)   

Sorrento Technology Center (7)

    11,706        5.75 %(8)      1/11/2016 (8)      10,825           (9)   

Waterfront Plaza

    11,000        6.37     9/11/2016        11,000         (10)   
               

Total — Existing Properties

  $ 329,706           

GRE Portfolio

         

Foothill Building (11)

  $ 21,401        5.69     5/1/2015      $ 19,452        (12)   

Carlton Plaza (13)

    16,506        5.04     8/1/2013        15,398        (14)   

Warner Center

    12,450        5.31     3/1/2012        12,450        (15)   

Toshiba Building (16)

    5,900        6.00     10/11/2012        5,501        (17)   
               

Total — GRE Portfolio

  $ 56,257           
               

Total Portfolio

  $ 385,963           

Less: Unamortized discount, net

    (2,235        
               

Net

  $ 383,728           
               

 

(1) Represents the historical principal balance of each loan at September 30, 2010.
(2) Loan is prepayable subject to payment of a yield maintenance-based prepayment premium; no premium is due after June 11, 2016. Loan may also be defeased.
(3) Loan is prepayable, subject to a prepayment premium equal to the greater of 1% of outstanding principal balance or yield maintenance. No premium is due after August 11, 2016.
(4) Loan is prepayable subject to a prepayment premium equal to the greater of 1% of outstanding principal balance of loan or yield maintenance. No premium is due after May 11, 2016.
(5) Loan is prepayable subject to a prepayment premium equal to the greater of 3% of outstanding principal amount or yield maintenance. No premium is due after October 1, 2015. Loan may also be defeased.
(6) Loan is not prepayable until October 6, 2015; however, loan may be defeased. No premium is due upon prepayment.
(7) Requires monthly principal and interest payments in the amount of $69,000.
(8) Although the maturity date is January 11, 2036, January 11, 2016 is the anticipated repayment date because the interest rate adjusts as of January 11, 2016 to greater of 7.75% or treasury rate plus 70 basis points, plus 2.0%.
(9) Loan is not prepayable until October 11, 2015; however, loan may be defeased. No premium is due upon prepayment.
(10) Loan is prepayable subject to a prepayment premium equal to yield maintenance. No premium is due after June 11, 2016.
(11) Requires monthly principal and interest payments of $133,900 as of September 30, 2010.
(12) Loan is prepayable subject to a prepayment premium equal to the greater of 1% or yield maintenance. No premium is due after February 1, 2015. Loan may also be defeased.
(13) Requires monthly principal and interest payments of $100,600 as of September 30, 2010.
(14) Loan is prepayable subject to a prepayment premium equal to the greater of 1% or yield maintenance. No premium is due after May 1, 2013. Loan may also be defeased.
(15) Loan may be defeased at any time during the term of the loan with 30 days notice. Loan may be prepaid at par after December 1, 2011.
(16) Requires monthly principal and interest payments of $45,600 as of September 30, 2010.
(17) Loan is prepayable subject to a prepayment premium equal to the greater of 1% or yield maintenance. No premium is due after April 11, 2012. Loan may also be defeased.

Secured Revolving Credit Facility

We have received commitments for a three-year $125.0 million secured revolving credit facility from affiliates of certain of the underwriters and expect to close this facility concurrently with the completion of this offering and the concurrent transactions. We expect that the new credit facility will have a feature permitting its expansion at our request to allow borrowings of up to $250.0 million if we satisfy certain conditions. Under this facility, we expect that an affiliate of Credit Suisse Securities (USA) LLC, Wells Fargo Securities, LLC,

 

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Citigroup Global Markets Inc., Raymond James & Associates, Inc., RBC Capital Markets, LLC and an affiliate of KeyBanc Capital Markets Inc. will participate as lenders; Wells Fargo Securities, LLC, Citigroup Global Markets Inc. and Credit Suisse Securities (USA) LLC will act as joint lead arrangers and joint bookrunners; an affiliate of Wells Fargo Securities, LLC will act as administrative agent; and affiliates of Credit Suisse Securities (USA) LLC and Citigroup Global Markets Inc. will act as syndication agents. We expect that the facility will have a term of three years, and we will have the option to extend the facility for one additional year if we meet specified requirements, including the payment of a fee. We intend to use this facility to fund acquisitions and equity investments, refinance existing debt, fund working capital and capital expenditures and for other general corporate purposes.

Borrowings under the new credit facility are expected to bear interest at the rate of LIBOR plus a margin of 350 basis points. The amount available for us to borrow under the facility will be subject to the appraised values of our properties that form the borrowing base of the facility and a minimum implied debt yield. The borrowing base will be comprised of properties that we select and that are acceptable to the lenders and may be changed from time to time at our election, subject to certain conditions. We have selected Pacific Business News Building, Kearny Mesa Crossroads, Rio Vista Plaza, Alta Sorrento, Empire Towers, Empire Towers IV, Glendale Office and Walnut Creek Executive Center properties as the initial borrowing base for the new credit facility, but the lenders have not accepted any of these properties as of the date of this prospectus. Upon completion of this offering and the concurrent transactions, under the financial covenants contained in the new credit facility, we expect to have in excess of $90 million immediately available to us to pursue acquisitions in our target markets and for general working capital purposes.

Our ability to borrow under the new credit facility will also be subject to our ongoing compliance with a number of customary restrictive covenants, which we expect will include:

 

   

a maximum leverage ratio (defined as total indebtedness to total asset value) of 0.70 : 1.00 at any time on or before December 31, 2011, and 0.65 : 1.00 at any time thereafter,

 

   

a minimum fixed charge coverage ratio (defined as consolidated earnings before interest, taxes, depreciation and amortization, excluding capital reserves and certain extraordinary or non recurring items but including our proportionate share of joint venture EBITDA, to total fixed charges) of 1.60 : 1.00,

 

   

a maximum of $25 million in unsecured indebtedness,

 

   

a maximum secured recourse debt ratio (defined as secured recourse indebtedness to total indebtedness) of 0.15 : 1.00, and

 

   

a minimum tangible net worth equal to at least $279 million, plus 75% of the net proceeds of any equity issuances following this offering.

Under the new credit facility, we expect that our distributions with respect to any four quarter period will not be permitted to exceed the greater of (i) 95.0% of our funds from operations as calculated under the new credit facility for such period or (ii) the amount required for us to qualify and maintain our status as a REIT. If a default or event of default occurs and is continuing, we expect that we may be precluded from making certain distributions (other than those required to allow us to qualify and maintain our status as a REIT).

The calculations of earnings before interest, taxes, depreciation and amortization and funds from operations under the new credit facility are different than the calculations of EBITDA and FFO, respectively, used elsewhere in this prospectus.

We and certain of our subsidiaries will guarantee the obligations under the new credit facility and we and certain of our subsidiaries will pledge specified assets (including real property) and other interests as collateral for the new credit facility obligations.

 

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The availability of borrowings under the new credit facility will be subject to customary conditions that we expect will include, among other things, successful completion of this offering, collateralization of the borrowing base, the listing of our common stock on the NYSE, absence of material adverse effect, payment of fees, and the negotiation, execution and delivery of definitive documentation satisfactory to Wells Fargo Bank, National Association and the other lenders. There can be no assurance that all of these conditions will be satisfied. We anticipate closing costs of approximately $1.4 million in connection with our entry into the new credit facility.

Pro Forma Contractual Obligations

The following table provides information with respect to our commitments as of September 30, 2010 on a pro forma basis to reflect the obligations we expect to have upon completion of this offering, including any guaranteed or minimum commitments under contractual obligations. The table does not reflect available debt extensions, and all numbers are reported in thousands.

 

     Payments Due by Period  

Contractual Obligations

   Total      Less than
1 year
     1-3 years      3-5 years      More than
5 years
 

Principal payments on mortgage loans (1) 

   $ 385,963       $ 1,098       $ 35,441       $ 20,550       $ 328,874   

Interest payments on mortgage loans (1)

 &n