10-K 1 psb-20171231x10k.htm 10-K psb-20171231 10K



UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



FORM 10-K





 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934



For the fiscal year ended December 31, 2017.



or

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934



For the transition period from                to



 



Commission File Number 1-10709



PS BUSINESS PARKS, INC.

(Exact name of registrant as specified in its charter)



California

95-4300881

(State or other jurisdiction of

(I.R.S. Employer Identification No.)

incorporation or organization)

 



701 Western Avenue, Glendale, California 91201-2349

(Address of principal executive offices) (Zip Code)



818-244-8080

(Registrant’s telephone number, including area code)



Securities registered pursuant to Section 12(b) of the Act:





 

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Common Stock, $0.01 par value per share

 

New York Stock Exchange

Depositary Shares Each Representing 1/1,000 of a Share of

5.750% Cumulative Preferred Stock, Series U, $0.01 par value per share

 

New York Stock Exchange

Depositary Shares Each Representing 1/1,000 of a Share of

5.700% Cumulative Preferred Stock, Series V, $0.01 par value per share

 

New York Stock Exchange

Depositary Shares Each Representing 1/1,000 of a Share of

5.200% Cumulative Preferred Stock, Series W, $0.01 par value per share

 

New York Stock Exchange

Depositary Shares Each Representing 1/1,000 of a Share of

5.250% Cumulative Preferred Stock, Series X, $0.01 par value per share

 

New York Stock Exchange

Depositary Shares Each Representing 1/1,000 of a Share of

5.200% Cumulative Preferred Stock, Series Y, $0.01 par value per share

 

New York Stock Exchange



Securities registered pursuant to Section 12(g) of the Act:

None

(Title of class)



Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes    No  



Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes    No  



Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.  Yes    No



Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes    No



Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§232.405) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 



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





 

 

 

 

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

Emerging growth company



If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 



Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes     No  



As of June 30, 2017, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $2,614,997,862 based on the closing price as reported on that date.



Number of shares of the registrant’s common stock, par value $0.01 per share, outstanding as of February 19, 2018 (the latest practicable date): 27,254,607.



DOCUMENTS INCORPORATED BY REFERENCE



Portions of the definitive proxy statement to be filed in connection with the Annual Meeting of Shareholders to be held in 2018 are incorporated by reference into Part III of this Annual Report on Form 10-K.


 

PART I



ITEM 1. BUSINESS 



Forward-Looking Statements



Forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, are made throughout this Annual Report on Form 10-K. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “may,” “believes,” “anticipates,” “plans,” “expects,” “seeks,” “estimates,” “intends” and similar expressions are intended to identify forward-looking statements. There are a number of important factors that could cause the results of the Company to differ materially from those indicated by such forward-looking statements, including but not limited to (a) changes in general economic and business conditions; (b) decreases in rental rates or increases in vacancy rates/failure to renew or replace expiring leases; (c) tenant defaults; (d) the effect of the recent credit and financial market conditions; (e) our failure to maintain our status as a real estate investment trust (a  “REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”); (f) the economic health of our customers; (g) increases in operating costs; (h) casualties to our properties not covered by insurance; (i) the availability and cost of capital; (j) increases in interest rates and its effect on our stock price; and (k) other factors discussed under the heading Item 1A, “Risk Factors.” In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved. Moreover, we assume no obligation to update these forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting such forward-looking statements, except as required by law.



The Company



PS Business Parks, Inc. (“PSB”) is a fully-integrated, self-advised and self-managed REIT that owns, operates, acquires and develops commercial properties, primarily multi-tenant flex, office and industrial space. Substantially all of PSB’s assets are held, and its business conducted, through PS Business Parks, L.P. (the “OP”),  a California limited partnership. PSB has full, exclusive, and complete control of the OP as the sole general partner and, as of December 31, 2017, owned 78.9% of the common partnership units, with Public Storage (“PS”) owning the remainder. Assuming issuance of PSB common stock upon redemption of the common partnership units held by PS, PS would own 41.9% (or 14.5 million shares) of the outstanding shares of the Company’s common stock.



Unless otherwise indicated or unless the context requires otherwise, all references to “the Company,” “we,” “us,” “our” and similar references mean PS Business Parks, Inc. and its subsidiaries, including the OP.



As of December 31, 2017,  we owned and operated 28.0 million rentable square feet of commercial space, comprising 98 business parks, in California, Texas, Virginia, Florida, Maryland and Washington. The Company focuses on owning concentrated business parks which provide the Company with the greatest flexibility to meet the needs of its customers. Along with the commercial space, we also have a 95.0% interest in a  395-unit apartment complex.  The Company also manages 684,000 rentable square feet on behalf of PS.



History of the Company: The Company was formed in 1990 as a California corporation. Through a series of transactions between January, 1997 to March, 1998, the Company was renamed “PS Business Parks, Inc.” and became a publicly held, fully integrated, self-advised and self-managed REIT having interests in commercial real estate held through our OP.



Principal Business Activities



We are in the commercial property business, with 98 business parks consisting of multi-tenant flex, industrial and office space. We own 14.5 million square feet of flex space, representing buildings that are configured with a combination of warehouse and office space and can be designed to fit a wide variety of uses. The warehouse component of the flex space has a number of uses including light manufacturing and assembly, storage and warehousing, showroom, laboratory, distribution and research and development activities. The office component of flex space is complementary to the warehouse component by enabling businesses to accommodate management and production staff in the same facility. The Company owns 8.8 million square feet of industrial space that has characteristics similar to the warehouse component of the flex space as well as ample dock access. In addition, the Company owns 4.7 million square feet of low-rise office space, generally either in business parks that combine office and flex space or in submarkets where the market demand is more office focused.

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We generally seek to operate in multi-tenant buildings in multi-building business parks which accommodate various businesses and uses. Our business parks average 10 buildings and 750,000 rentable square feet per park, located on parcels of various sizes, ranging from one to 49 buildings and 12,000 to 3.5 million square feet of rentable space. Parking is generally open but in some instances is covered. The ratio of parking spaces to rentable square feet generally ranges from two to six per thousand square feet depending upon the use of the property and its location. Office space generally requires a greater parking ratio than most industrial uses.



The customer base for our facilities is diverse. The portfolio can be bifurcated into those facilities that service small to medium-sized businesses and those that service larger businesses. Approximately 36.1% of in-place rents from the portfolio are derived from facilities that generally serve small to medium-sized businesses. A property in this facility type is typically divided into units under 5,000 square feet and leases generally range from one to three years. The remaining 63.9% of in-place rents from the portfolio are generally derived from facilities that serve larger businesses, with units 5,000 square feet and larger. The Company also has several customers that lease space in multiple buildings and locations. The U.S. Government is the largest customer with multiple leases encompassing approximately 642,000 square feet, or 4.5% of the Company’s annualized rental income. 



We operate in six states and we may expand our operations to other states or reduce the number of states in which we operate. However, we have no current plans to expand into additional markets or exit existing markets. Properties are acquired for both income and potential capital appreciation; there is no limitation on the amount that can be invested in any specific property.



The Company owns land which may be used for the future development of commercial properties including approximately 14.0 acres in Dallas, Texas and 6.4 acres in Northern Virginia.



See “Objectives and Strategies” below for further information. 



Our principal executive offices are located at 701 Western Avenue, Glendale, California 91201-2349, and our telephone number is (818) 244-8080. We maintain a website with the address www.psbusinessparks.com. The information contained on our website is not a part of, or incorporated by reference into, this Annual Report on Form 10-K. We make available free of charge through our website our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to these reports, as soon as reasonably practicable after we electronically file or furnish such material to the Securities and Exchange Commission (the “SEC”).



Recent Company Developments



Acquisition of Real Estate Facilities: In the third quarter of 2016, we acquired two multi-tenant office buildings aggregating 226,000 square feet in Rockville, Maryland for a purchase price of $13.3 million. The occupancy rate has increased from 18.5% on the date of acquisition to 43.1% as of December 31, 2017.



Development of Multi-Family Real Estate: In 2015, we demolished one of our existing office buildings located within our 628,000 square foot office park (known as “The Mile”) in Tysons, Virginia, and completed a 395-unit multi-family building (“Highgate”) in 2017, for an aggregate estimated cost of $115.6 million (including the fair value of the land). We leveraged the expertise of a well-regarded local developer and operator of multi-family real estate, who holds a 5.0% interest in the joint venture that owns this development. We are also seeking entitlements to develop an additional multi-family complex on a site held by a 123,000 square foot vacant building we own located within The Mile. See “Objectives and Strategies” below for further information regarding our development and redevelopment activities.



Dispositions of Real Estate Facilities or Development Rights: On March 31, 2017, we sold development rights to build medical office buildings on land adjacent to our Westech Business Park in Silver Spring, Maryland for $6.5 million. We had acquired the development rights as part of its 2006 acquisition of the park. We received net proceeds of $6.4 million, of which $1.5 million was received in prior years and $4.9 million was received in 2017. We recorded a net gain of $6.4 million for the year ended December 31, 2017.



On May 1, 2017, we disposed of Empire Commerce, a two-building single-story office park comprising 44,000 square feet, located in Dallas, Texas, for net proceeds of $2.1 million, which resulted in a net gain of $1.2 million.



We have certain office properties located in Orange County, California, held for sale. These facilities comprised of 705,000 square feet, and generated $8.4 million in net operating income (defined below) during the year ended December 31, 2017.





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Exit of non-strategic markets: During 2014 and 2015, we sold nine business parks with 2.4 million rentable square feet and 11.5 acres of land for $253.4 million, exiting non-strategic markets including Portland, Oregon, Phoenix, Arizona, and Sacramento, California. We have no plans to exit additional markets.



Tax and Corporate Structure



For all periods presented herein, we have elected REIT status under the Code. As a REIT, we generally do not incur federal income tax if we distribute substantially all of our REIT taxable income (generally, net rents and gains from real property, dividends, and interest) each year, and if we meet certain organizational and operational rules. To the extent that we continue to qualify as a REIT, we will not be taxed, with certain limited exceptions, on the “REIT taxable income that is currently distributed to our shareholders. We believe we have met these requirements in all periods presented herein, and we expect to continue to elect and qualify as a REIT.



PSB is structured as an umbrella partnership REIT (“UPREIT”), with substantially all of our activities conducted through the OP. We acquired interests in certain properties from PS during PSB’s initial formation in exchange for operating partnership units, which allowed PS to defer the recognition of a tax gain. We have the ability to offer similar tax-efficient transactions to potential sellers of real estate in the future.



We are the sole general partner of the OP. As of December 31, 2017, we owned 78.9% of the common partnership units of the OP, with the remainder owned by PS. The common units owned by PS may be redeemed, subject to certain limitations, for shares of our common stock on a one-for-one basis or, at our option, an equivalent value in cash. The Company owns various series of preferred units issued by the OP at terms and amounts substantially identical to the various series of our preferred stock outstanding.



The Company’s interest in the OP entitles it to share in cash distributions from, and the profits and losses of, the OP in proportion to the Company’s economic interest in the OP (apart from tax allocations of profits and losses to take into account pre-contribution property appreciation or depreciation). The Company, since 1998, has paid per share dividends on its common and preferred stock that track, on a one-for-one basis, the amount of per unit cash distributions the Company receives from the OP in respect of the common and preferred partnership units in the OP that are owned by the Company. 



As the general partner of the OP, the Company has the exclusive responsibility under the Operating Partnership Agreement to manage and conduct the business of the OP. The OP is responsible for, and pays when due, its share of all administrative and operating expenses of the properties it owns.



Common Officers and Directors with PS



Ronald L. Havner, Jr., Chairman of the Company, is also the Chairman of the Board of Trustees and Chief Executive Officer of PS. Joseph D. Russell, Jr. is a director of the Company and also President of PS. Gary E. Pruitt, an independent director of the Company, is also a trustee of PS. Other employees of PS render services to the Company pursuant to a cost sharing and administrative services agreement.



Common Services Provided to and by PS



We manage industrial, office, and retail facilities in the United States for PS under either the “Public Storage” or “PS Business Parks” names (the “PS Management Agreement”). Under PS’s supervision, we coordinate and assist in rental and marketing activities, property maintenance and other operational activities, including the selection of vendors, suppliers, employees and independent contractors. Management fee revenue derived from the PS Management Agreement totaled $506,000,  $518,000 and $540,000 for the years ended December 31, 2017,  2016 and 2015, respectively.



PS also provides property management services for the self-storage component of two assets owned by the Company. Management fee expenses under the contract were $92,000, $86,000 and $79,000 for the years ended December 31, 2017,  2016 and 2015, respectively.



Pursuant to a cost sharing and administrative services agreement, we share certain administrative services, corporate office space and certain other third party costs with PS which are allocated based upon time, effort and other methodologies. We reimbursed PS $1.3 million, $1.1 million and $1.2 million, respectively, in the years ended December 31, 2017,  2016 and 2015 for costs paid on our behalf, and PS reimbursed us $31,000 and $38,000 costs we incurred on their behalf for the years ended December 31, 2017 and 2016, respectively.

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Management



Maria R. Hawthorne leads the Company’s senior management team. Ms. Hawthorne is President and Chief Executive Officer of the Company as well as interim Chief Financial Officer. The Company’s senior management includes: John W. Petersen, Executive Vice President and Chief Operating Officer; Christopher M. Auth, Vice President (Washington Metro Division); Trenton A. Groves, Vice President and Corporate Controller; Coby A. Holley, Vice President, Investments; Robin E. Mather, Vice President, Business Development; Stuart H. Hutchison, Vice President (Southern California and Pacific Northwest Divisions); Richard E. Scott, Vice President (Northern California Division); Eugene Uhlman, Vice President, Construction Management; and David A. Vicars, Vice President (Southeast Division, which includes Florida and Texas).



Competition



Our properties compete for tenants with similar properties located in our markets primarily on the basis of location, rent charged, services provided and the design and condition of improvements. Competition in the market areas we operate in is significant and has from time to time negatively impacted occupancy levels and rental rates of, and increased the operating expenses of, certain of our properties. Competition may be accelerated by any increase in availability of funds for investment in real estate, because barriers to entry can be relatively low for those with the necessary capital. The demand for space in our markets is impacted by general economic conditions, which can affect the local competition for tenants. Sublease space and unleased developments have from time to time created competition among operators in certain markets in which the Company operates. We also compete for property acquisitions with entities that have greater financial resources than the Company.



We believe we possess several distinguishing characteristics and strategies, some of which are described below under “Objectives and Strategies,” that enable us to compete effectively. In addition, we believe our personnel are among the most experienced in these real estate markets. The Company’s facilities are part of a comprehensive system encompassing standardized procedures and integrated reporting and information networks.



We believe that the significant operating and financial experience of our executive officers and directors combined with the Company’s capital structure, national investment scope, geographic diversity, financial stability, and economies of scale should enable us to compete effectively.



Objectives and Strategies



Our primary objective is to grow shareholder value in a low-risk, stable manner by maximizing the net cash flow generated by our existing properties, as well as prudently seeking growth through acquisitions and development that generate attractive returns on invested capital.  



We seek to optimize the net cash flow of our existing properties by maximizing occupancy levels and rental rates, while minimizing capital expenditures and leasehold improvements. Below are the primary elements of our strategy:



Concentration in favorable markets: We believe that our properties generally are located in markets that have favorable characteristics such as above average population, job, and income growth, as well as higher education levels. In addition, we believe our business parks are generally in higher barrier to entry markets that are close to critical infrastructure, middle to high income housing or universities and have easy access to major transportation arteries. We believe that these characteristics contribute to favorable cash flow stability and growth.



Standard build outs and finishes: We generally seek to configure our rentable space with standard buildouts and finishes that meet the needs of a wide variety of tenants, minimizing the need for specialized and costly tenant improvements and enabling space to be “move-in ready” quickly upon vacancy. We believe this makes our space more attractive to potential tenants, allows tenants to move in more quickly and seamlessly, and reduces the cost of capital improvements, relative to real estate operators that offer specialized finishes or build outs. Also, such flexibility facilitates our ability to offer diverse sizes and configurations to meet potential customer’s needs, as well as to change space sizes for existing customers when their needs change, at the low relative cost of a standard configuration.  



Large, Diverse Parks: Our business parks are generally concentrated in large complexes of diverse buildings, with a variety of available space sizes and configurations that we can offer to tenants. We believe that this allows us to attract a greater number of potential tenants to our space and minimizes the loss of existing customers when their space requirements change.

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Smaller tenants and diverse tenant base with shorter-term leases: By concentrating on smaller spaces, we seek to reach the large number of smaller tenants in the market. We believe this focus gives us a competitive edge as most institutional owners focus on large users. Small users perceive more incremental value from the level of customer service that we offer. We also believe having smaller tenants improves our diversity of tenants across industries, which improves the stability of our cash flows. In addition, our lease term tends to be shorter, generally an average of three and a half years, which we believe allows us to more quickly capture increases in market rents in our high-growth markets. At December 31, 2017, our average space size is 5,000 rentable square feet per tenant, and no individual tenant, other than the U.S. Government, represents more than 1% of our annualized rental income.



Decentralized operating strategy: Our local market management is empowered, within a prescribed decision and metrics framework, to make many leasing rate, capital, and lease term decisions in a manner which we believe maximizes the return on investment on leasing transactions. We believe this decentralized approach allows us to be more nimble and effective in our decision making, and more effectively price and market our space, relative to a more centralized approach.



Superior Service to Customers: We seek to provide a superior level of service to our customers in order to maintain occupancy and increase rental rates, as well as minimize customer turnover. The Company’s property management offices are located on-site, helping the Company maintain its properties and providing customers with convenient access to management,  while conveying a sense of quality, order and security. We believe that our personnel are among the most experienced and effective in the real estate industry in our markets. The Company has significant experience in acquiring properties managed by others and thereafter improving customer satisfaction, occupancy levels, retention rates and rental income by implementing established customer service programs.



In addition, we seek to expand through acquisitions or development that generate attractive returns on invested capital, as follows:



Acquire facilities in targeted markets at prudent price levels: We have a disciplined capital allocation approach, seeking to purchase properties at prices that are not significantly in excess of the cost to develop similar facilities, which we believe reduces our risk and maximizes long term returns. We seek generally to acquire in our existing markets, which we believe have favorable growth characteristics. We also believe acquiring in our existing markets leverages our operating efficiencies. We would consider expanding to additional markets with similar favorable characteristics of our existing markets, if we could acquire sufficient scale (generally at least 2 million rentable square feet); however, we have no current plans or immediate prospects to do so.



Redevelop existing real estate facilities: Certain of our existing business parks were developed in or near areas that have been undergoing gentrification and an influx of residential development, and, as a result, certain buildings in our business parks may have better and higher uses as residential space. While residential space is generally not a core asset for us, we will seek to identify potential candidates for redevelopment in our portfolio, and plan to leverage the expertise and scale of existing operators and developers. For example, in The Mile in Tysons, Virginia, as noted above, we demolished an existing building and developed, with a joint venture partner, a 395-unit apartment building, and are seeking entitlements for another multi-family complex to be built following demolishment of an existing 123,000 square foot office building. There can be no assurance as to the level of conversion opportunities throughout our portfolio in the future.



Financing Strategy



Overview of financing strategy and sources of capital: As a REIT, we generally distribute substantially all of our “REIT taxable income to our shareholders which, relative to a taxable C corporation, limits the amount of cash flow from operations that we can retain for investments. As a result, in order to expand our asset base, access to capital is important. 



Our financial profile is characterized by strong credit metrics, including low leverage relative to our total capitalization and operating cash flows. Our credit profile and ratings enable us to effectively access both the public and private capital markets to raise capital. We will seek to maintain our credit profile and ratings. 



Sources of capital available to us include retained cash flow, the issuance of preferred and common securities, the issuance of medium and long-term debt, joint venture financing, and the sale of properties. We view our line of credit, as well as short-term bank loans, as “bridge” capital.



Historically, we have financed our cash investment activities primarily with retained operating cash flow and the issuance of preferred securities.

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We select among the sources of capital available to us based upon relative cost, availability and the desire for leverage, as well as intangible factors such as the impact of covenants in the case of debt.



Retained Operating Cash Flow: Although we are required to generally distribute substantially all of our “REIT taxable income to our shareholders, we have nonetheless been able to retain operating cash flow to the extent that our tax depreciation exceeds our maintenance capital expenditures. In recent years, we have retained an average of $40 to $50 million in operating cash flow per year.



Preferred Equity: We view preferred equity as an important source of capital over the long term, because it reduces interest rate and refinancing risks as the dividend rate is fixed and there are no refinancing requirements. In addition, the consequences of defaulting on required preferred distributions are less severe than with debt. The preferred shareholders may elect two additional directors if six quarterly distributions go unpaid, whether or not consecutive. However, rates and market conditions for the issuance of preferred securities can be volatile or inefficient from time to time. As of December 31, 2017, we have $959.8 million in preferred securities outstanding (excluding securities that were redeemed on January  3, 2018) with an average coupon rate of 5.40%. For a discussion regarding the January 3, 2018 redemption, see “Management’s Discussion and Analysis- Liquidity and Capital Resources- Redemption of Preferred Stock.”



Medium or long-term debt:  We have broad powers to borrow in furtherance of our objectives. We may consider the public issuance or private placement of senior unsecured debt in the future in an effort to diversify our sources of capital.



Common equity: We believe that the market for our common equity is liquid and, as a result, common equity is a significant potential source of capital.



Tax advantaged equity: As noted above, we have the ability to offer common or preferred operating partnership units with economic characteristics that are similar to our common and preferred stock, but provide the seller the opportunity to defer the recognition of a tax gain. 



Bridge financing: We have a $250.0 million unsecured line of credit (the “Credit Facility”) which we use as temporary “bridge” financing, along with short-term bank loans, until we are able to raise longer-term capital. As of December 31, 2017, there were no borrowings outstanding on our Credit Facility and no short-term bank loans.



Investments in Real Estate Facilities



As of December 31, 2017, the Company owned and operated 28.0 million rentable square feet comprised of 98 business parks in six states and a 95.0% interest in a  395-unit apartment complex compared to 28.1 million rentable square feet comprised of 99 business parks at December 31, 2016.  



Restrictions on Transactions with Affiliates



The Company’s Bylaws provide that the Company may engage in transactions with affiliates provided that a purchase or sale transaction with an affiliate is (i) approved by a majority of the Company’s independent directors and (ii) fair to the Company based on an independent appraisal or fairness opinion.



Employees



As of December 31, 2017, the Company employed 158 individuals, primarily personnel engaged in property operations.



Insurance



The Company believes that its properties are adequately insured. Facilities operated by the Company have historically been covered by comprehensive insurance, including fire, earthquake, wind damage and liability coverage from nationally recognized carriers, subject to customary levels of deductibles.



Environmental Matters



Compliance with laws and regulations relating to the protection of the environment, including those regarding the discharge of material into the environment, has not had any material effect upon the capital expenditures, earnings or competitive position of the Company.

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Substantially all of the Company’s properties have received Phase I environmental reviews. Such reviews have not revealed, nor is management aware of, any probable or reasonably possible environmental costs that management believes would have a material adverse effect on the Company’s business, assets or results of operations, nor is the Company aware of any potentially material environmental liability. See Item 1A, “Risk Factors” for additional information.



ITEM 1A. RISK FACTORS



In addition to the other information in our Annual Report on Form 10-K, you should consider the risks described below that we believe may be material to investors in evaluating the Company. This section contains forward-looking statements, and in considering these statements, you should refer to the qualifications and limitations on our forward-looking statements that are described in Item 1, “Business — Forward-Looking Statements.”



We have significant exposure to real estate risk.



Since our business consists primarily of acquiring and operating real estate, we are subject to the risks related to the ownership and operation of real estate that can adversely impact our business and financial condition. Certain significant costs, such as mortgage payments, real estate taxes, insurance and maintenance, generally are not reduced even when a property’s rental income is reduced. In addition, environmental and tax laws, interest rate levels, the availability of financing and other factors may affect real estate values and property income. Furthermore, the supply of commercial space fluctuates with market conditions.



Since we derive substantially all our income from real estate operations, we are subject to the following general risks of acquiring and owning real estate related assets that could result in reduced revenues, increased expenses, increased capital expenditures, or increased borrowings, which could negatively impact our operating results, cash flow available for distribution or reinvestment and our stock price:



· changes in the national, state and local economic climate and real estate conditions, such as oversupply of or reduced demand for commercial real estate space and changes in market rental rates;



· how prospective tenants perceive the attractiveness, convenience and safety of our properties;



· difficulties in consummating and financing acquisitions and developments on advantageous terms and the failure of acquisitions and developments to perform as expected;



· our ability to provide adequate management, maintenance and insurance;



· natural disasters, such as earthquakes, hurricanes and floods, which could exceed the aggregate limits of our insurance coverage;



· the expense of periodically renovating, repairing and re-letting spaces;



· the impact of environmental protection laws;



· compliance with federal, state and local laws and regulations;



· increasing operating and maintenance costs, including property taxes, insurance and utilities, if these increased costs cannot be passed through to customers;



· adverse changes in tax, real estate and zoning laws and regulations;



· increasing competition from other commercial properties in our market;



· tenant defaults and bankruptcies;



· tenants’ right to sublease space; and



· concentration of properties leased to non-rated private companies with uncertain financial strength.

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There is significant competition among commercial property operators: Other commercial properties compete with our properties for tenants. Some of the competing properties may be newer and better located than our properties. Competition in the market areas in which many of our properties are located is significant and has affected our occupancy levels, rental rates and operating expenses.  We also expect that new properties will be built in our markets. In addition, we compete with other buyers, some of which are larger than us, for attractive commercial properties. Therefore, we may not be able to grow as rapidly as we would like.



We may encounter significant delays and expense in re-letting vacant space, or we may not be able to re-let space at existing rates, in each case resulting in losses of income: When leases expire, we may incur expenses in retrofitting space and we may not be able to re-lease the space on the same terms. Certain leases provide customers with the right to terminate early if they pay a fee. As of December 31, 2017,  1,875 leases, representing 6.2 million, or 23.3% of the leased square footage of our total portfolio, or 23.8% of annualized rental income, are scheduled to expire in 2018. While we have estimated our cost of renewing leases that expire in 2018, our estimates could be wrong. If we are unable to re-lease space promptly, if the terms are significantly less favorable than anticipated or if the costs are higher, our operating results, cash available for distribution or reinvestment and stock price could be negatively impacted.



Tenant defaults and bankruptcies may reduce our cash flow and distributions: We may have difficulty collecting from customers in default, particularly if they declare bankruptcy. Since many of our customers are non-rated private companies, this risk may be enhanced. There is inherent uncertainty in a customer’s ability to continue paying rent if they are in bankruptcy. This could negatively affect our operating results, cash available for distribution or reinvestment and stock price.



Natural disasters or terrorist attacks could cause damage to our facilities that is not covered by insurance, and could increase costs, reduce revenues, and otherwise impair our operating results: While we maintain insurance coverage for the losses caused by earthquakes or hurricanes, we could suffer uninsured losses or losses in excess of our insurance policy limits for such occurrences. Approximately 40.1% of our properties are located in California and are generally in areas that are subject to risks of earthquake-related damage. In the event of an earthquake, hurricane or other natural disaster, we would remain liable on any mortgage debt or other unsatisfied obligations related to that property. In addition, we may not have sufficient insurance coverage for losses caused by a terrorist attack, or such insurance may not be available or cost-effective. Significant natural disasters, terrorist attacks, threats of future terrorist attacks, or resulting wider armed conflict could have negative impacts on the U.S. economy, reducing demand for our rental space and impairing our operating results, even if our specific losses were covered. This could negatively affect our operating results, cash available for distribution or reinvestment and stock price. 



The illiquidity of our real estate investments may prevent us from adjusting our portfolio to respond to market changes: There may be delays and difficulties in selling real estate. Therefore, we cannot easily change our portfolio when economic conditions change. In addition, when we sell properties at significant gains upon sale, it can increase our distribution requirements, thus making it difficult to retain and reinvest the sales proceeds. Also, REIT tax laws may impose negative consequences if we sell properties held for less than two years.



We may be adversely affected by changes in laws: Increases in income and service taxes may reduce our cash flow and ability to make expected distributions to our shareholders. Additionally, any changes in the tax law applicable to REITs may adversely affect taxation of us and/or our shareholders. Our properties are also subject to various federal, state and local regulatory requirements, such as state and local fire and safety codes. If we fail to comply with these requirements, governmental authorities could fine us or courts could award damages against us. We believe our properties comply with all significant legal requirements. However, these requirements could change in a way that could negatively affect our operating results, cash available for distribution or reinvestment and stock price.



9

 


 

We may incur significant environmental remediation costs: As an owner and operator of real properties, under various federal, state and local environmental laws, we are required to clean up spills or other releases of hazardous or toxic substances on or from our properties. Certain environmental laws impose liability whether or not the owner or buyer knew of, or was responsible for, the presence of the hazardous or toxic substances.  In some cases, liability may not be limited to the value of the property. The presence of these substances, or the failure to properly remediate any resulting contamination, whether from environmental or microbial issues, also may adversely affect our ability to sell, lease, operate, or encumber our facilities.



We have conducted preliminary environmental assessments of most of our properties (and conduct these assessments in connection with property acquisitions) to evaluate the environmental condition of, and potential environmental liabilities associated with, our properties. These assessments generally consist of an investigation of environmental conditions at the property (including soil or groundwater sampling or analysis if appropriate), as well as a review of available information regarding the site and publicly available data regarding conditions at other sites in the vicinity. In connection with these property assessments, our operations and recent property acquisitions, we have become aware that prior operations or activities at some properties or from nearby locations have or may have resulted in contamination to the soil or groundwater at these properties. In circumstances where our environmental assessments disclose potential or actual contamination, we may attempt to obtain indemnifications and, in appropriate circumstances, we obtain limited environmental insurance in connection with the properties acquired, but we cannot assure you that such protections will be sufficient to cover actual future liabilities nor that our assessments have identified all such risks. Although we cannot provide any assurance, based on the preliminary environmental assessments, we are not aware of any environmental contamination of our facilities material to our overall business, financial condition or results of operations.



There has been an increasing number of claims and litigation against owners and managers of rental properties relating to moisture infiltration, which can result in mold or other property damage. When we receive a complaint concerning moisture infiltration, condensation or mold problems and/or become aware that an air quality concern exists, we implement corrective measures in accordance with guidelines and protocols we have developed with the assistance of outside experts. We seek to work proactively with our customers to resolve moisture infiltration and mold-related issues, subject to our contractual limitations on liability for such claims. However, we can give no assurance that material legal claims relating to moisture infiltration and the presence of, or exposure to, mold will not arise in the future.



Any such environmental remediation costs or issues, including any potential ongoing impacts on rent or operating expenses, could negatively impact our operating results, cash flow available for distribution or reinvestment and our stock price.



Operating costs, including property taxes, could increase: We could be subject to increases in insurance premiums, property and other taxes, repair and maintenance costs, payroll, utility costs, workers compensation, and other operating expenses due to various factors such as inflation, labor shortages, commodity and energy price increases, weather, changes to governmental safety and real estate use limitations, as well as other governmental actions. Our property tax expense, which totaled $41.0 million during the year ended December 31, 2017, generally depends upon the assessed value of our real estate facilities as determined by assessors and government agencies, and accordingly could be subject to substantial increases if such agencies changed their valuation approaches or opinions or if new laws are enacted.



We must comply with the Americans with Disabilities Act, fire and safety regulations and zoning requirements, which can require significant expenditures: All of our properties must comply with the Americans with Disabilities Act and with related regulations (the “ADA”). The ADA has separate compliance requirements for “public accommodations” and “commercial facilities,” but generally requires that buildings be made accessible to persons with disabilities.  Various state laws impose similar requirements. A failure to comply with the ADA or similar state laws could lead to government imposed fines on us and/or litigation, which could also involve an award of damages to individuals affected by the non-compliance. In addition, we must operate our properties in compliance with numerous local fire and safety regulations, building codes, zoning requirements and other land use regulations, all of which are subject to change and could become more costly to comply with in the future.  The cost of compliance with these requirements can be substantial, and could reduce cash otherwise available for distribution to shareholders. Failure to comply with these requirements could also affect the marketability and rentability of our real estate facilities.



We incur liability from customer and employment-related claims: From time to time we have to make monetary settlements or defend actions or arbitration to resolve customer or employment-related claims and disputes. Settling any such liabilities could negatively impact our earnings and cash available for distribution to shareholders, and could also adversely affect our ability to sell, lease, operate, or encumber affected facilities

10

 


 

Our development of real estate can subject us to certain risks:  As of December 31, 2017,  we have a 95% interest in a completed 395-unit multifamily development that is in lease-up with an aggregate estimated cost of $115.6 million (including the fair value of the land). We are also seeking entitlements for an additional multifamily development and are considering the potential redevelopment of other facilities in our portfolio. Development or redevelopment of facilities are subject to a number of risks, including construction delays, complications in obtaining necessary zoning, occupancy and other governmental permits, cost overruns, failures of our development partners, financing risks, and the possible inability to meet expected occupancy and rent levels. In addition, we do not have experience in multifamily development and are relying to some degree on the experience of our joint venture partner. As a result of these risks, our development projects may be worth less or may generate less revenue than we believed at the time of development, negatively affecting our operating results. Any of the foregoing risks could negatively impact our operating results, cash flow available for distribution or reinvestment and our stock price. In addition, we may be unable to successfully integrate and effectively manage the properties we develop, which could adversely affect our results of operations.



Global economic conditions can adversely affect our business, financial condition, growth and access to capital. 



Economic conditions in the areas we operate, capital markets, global economic conditions, and other events or factors could adversely affect rental demand for our real estate, our ability to grow our business and acquire new facilities, to access capital, as well as the value of our real estate. Such conditions, which could negatively impact our operating results, cash flow available for distribution or reinvestment and our stock price, include the following:



Commercial credit markets: Our results of operations and share price are sensitive to volatility in the credit markets. From time to time, the commercial real estate debt markets experience volatility as a result of various factors, including changing underwriting standards by lenders and credit rating agencies. This may result in lenders increasing the cost for debt financing, which could affect the economic viability of any acquisition or development activities we may undertake or otherwise increase our costs of borrowing. Conversely, to the extent that debt becomes cheaper or underwriting terms become more favorable, it could increase the overall amount of capital being invested in real estate, allowing more competitors to bid for facilities that we may wish to acquire, reducing the potential yield from acquisitions or preventing us from acquiring assets we might otherwise wish to acquire.



Capital markets: The issuance of perpetual preferred securities historically has been a significant source of capital to grow our business, and we have considered issuing unsecured debt publicly or in private transactions. We also consider issuance of our common equity a potential source of capital. Our ability to access these sources of capital can be adversely affected by challenging market conditions, which can increase the cost of issuance of preferred equity and debt, and reduce the value of our common shares, making such sources of capital less attractive or not feasible. We believe that we have sufficient working capital and capacity under our credit facilities and our retained cash flow from operations to continue to operate our business as usual and meet our current obligations. However, if we were unable to issue public equity or borrow at reasonable rates, that could limit the earnings growth that might otherwise result from the acquisition and development of real estate facilities.



Asset valuations: Market volatility makes the valuation of our properties difficult. There may be significant uncertainty in the valuation, or in the stability of the value, of our properties, which could result in a substantial decrease in the value of our properties. As a result, we may not be able to recover the carrying amount of our properties, which may require us to recognize an impairment charge in earnings. Reductions in the value of our assets could result in a reduction in the value of our common shares.



Potential negative impacts upon demand for our space and customers’ ability to pay: We believe that our current and prospective customers are susceptible to global and local economic conditions as well as the impact of capital markets, asset valuations, and commercial credit markets, which could result in an impairment of our customers’ existing business operations or curtail plans for growth. Such impairment could reduce demand for our rental space, or make it difficult for customers to fulfill their obligations to us under their leases.



The acquisition of existing properties is a significant component of our long-term growth strategy, and acquisitions of existing properties are subject to risks that may adversely affect our growth and financial results.



We acquire existing properties, either in individual transactions or portfolios offered by other commercial real estate owners. In addition to the general risks related to real estate described above, we are also subject to the following risks associated with the acquisition of real estate facilities which could negatively impact our operating results, cash flow available for distribution or reinvestment and our stock price:

11

 


 

Due diligence could be insufficient: Failure to identify all significant circumstances or conditions that affect the value, rentability, or costs of operation of an acquired facility, such as unidentified structural, environmental, zoning, or marketability issues, could jeopardize realization of anticipated earnings from an acquisition and negatively impact our operating results.



We could fail to successfully integrate acquired properties into our platform: Failures to integrate acquired properties into our operating platform, such as a failure to maintain existing relationships with customers due to changes in processes, standards, customer service, could temporarily or permanently impair our operating results.



We compete with other real estate operators for facilities: We face significant competition for suitable acquisition properties from other real estate investors, including other publicly traded real estate investment trusts and private institutional investors. As a result, we may be unable to acquire additional properties we desire or the purchase price for desirable properties may be significantly increased, reducing potential yields from acquisitions.



Acquired properties are subject to property tax reappraisals, which occur following the acquisition and can be difficult to estimate: Facilities that we acquire are subject to property tax reappraisal, which can substantially increase ongoing property taxes. The reappraisal process is subject to a significant degree of uncertainty, because it involves the judgment of governmental agencies regarding real estate values and other factors. In connection with underwriting future or recent acquisitions of properties, if our estimates of property taxes following reappraisal are too low, we may not realize anticipated earnings from an acquisition.



We would incur adverse tax consequences if we fail to qualify as a REIT. 



Our cash flow available for distribution would be reduced if we fail to qualify as a REIT: We believe that we have qualified as a REIT and intend to continue to maintain our REIT status. However, there can be no assurance that we qualify or will continue to qualify as a REIT, because of the highly technical nature of the REIT rules, the ongoing importance of factual determinations, the possibility of unidentified issues in prior periods or changes in our circumstances, as well as share ownership limits in our articles of incorporation that do not necessarily ensure that our shareholder base is sufficiently diverse for us to qualify as a REIT. For any year we fail to qualify as a REIT, unless certain relief provisions apply, we would not be allowed a deduction for dividends paid, we would be subject to corporate tax on our taxable income, and generally we would not be allowed to elect REIT status until the fifth year after such a disqualification. Any taxes, interest, and penalties incurred would reduce our cash available for distributions to shareholders and could negatively affect our stock price. However, for years in which we failed to qualify as a REIT, we would not be subject to REIT rules which require us to distribute substantially all of our taxable income to our shareholders.



We may need to borrow funds to meet our REIT distribution requirements: As a REIT, we must distribute substantially all of our “REIT taxable income to our shareholders. Our income consists primarily of our share of our OP’s income. We intend to make sufficient distributions to qualify as a REIT and otherwise avoid corporate tax. However, differences in timing between income and expenses and the need to make nondeductible expenditures such as capital improvements and principal payments on debt could force us to borrow funds to make necessary shareholder distributions.



The Board of Directors of the Company (the “Board”) will continue to evaluate our dividend rate in light of our actual and projected taxable income, liquidity requirements and other circumstances.  Future dividend levels are not determinable at this time.



Potential changes in tax laws could negatively impact us.



The United States Treasury Department and Congress frequently review federal income tax legislation, regulations and other guidance. We cannot predict whether, when or to what extent new federal tax laws, regulations, interpretations or rulings will be adopted. Any legislative action may prospectively or retroactively modify our tax treatment and, therefore, may adversely affect taxation of us or our shareholders. In particular, the legislation passed last December, commonly referred to as the Tax Cuts and Jobs Act (the TCJA”), which was signed into law on December 22, 2017 and which generally takes effect for taxable years beginning on or after January 1, 2018 (subject to certain exceptions), makes many significant changes to the federal income tax laws that will profoundly impact the taxation of individuals and corporations (both regular C corporations as well as corporations that have elected REIT status). A number of changes that affect non-corporate taxpayers will expire at the end of 2025 unless Congress acts to extend them. These changes will impact us and our shareholders in various ways, some of which are potentially adverse compared to prior law. To date, the Internal Revenue Service has issued only limited guidance with respect to certain of the new provisions, and there are numerous interpretive issues that will require guidance. It is highly

12

 


 

likely that technical corrections legislation will be needed to clarify certain aspects of the new law and give proper effect to Congressional intent. There can be no assurance, however, that technical corrections needed to prevent unintended or unforeseen tax consequences will be enacted by Congress in the near future or that any corrections made will not have further adverse, unintended or unforeseen tax consequences.



PS has significant influence over us.  



As of December 31, 2017, PS owned 7.2 million shares of the Company’s common stock and 7.3 million common units of the OP (100.0% of the common units not owned by the Company). Assuming issuance of the Company’s common stock upon redemption of its partnership units, PS would own 41.9% (or 14.5 million shares) of the outstanding shares of the Company’s common stock at December 31, 2017.  In addition, the PS Business Parks name and logo are owned by PS and licensed to the Company under a non-exclusive, royalty-free license agreement. The license can be terminated by either party for any reason with six months written notice. Ronald L. Havner, Jr., the Company’s chairman, is also Chairman of Trustees and Chief Executive Officer of PS. Joseph D. Russell, Jr. is a director and former Chief Executive Officer of the Company and also President of PS. Gary E. Pruitt, an independent director of the Company, is also a trustee of PS. Consequently, PS has the ability to significantly influence all matters submitted to a vote of our shareholders, including electing directors, changing our articles of incorporation, dissolving and approving other extraordinary transactions such as mergers, and all matters requiring the consent of the limited partners of the OP. PS’s interest in such matters may differ from other shareholders. In addition, PS’s ownership may make it more difficult for another party to take over or acquire our Company without PS’s approval, even if favorable to our public shareholders.

Provisions in our organizational documents may prevent changes in control.  



Our articles generally prohibit any person from owning more than 7% of our shares: Our articles of incorporation restrict the number of shares that may be owned by any “person,” and the partnership agreement of our OP contains an anti-takeover provision. No shareholder (other than PS and certain other specified shareholders) may own more than 7% of the outstanding shares of our common stock, unless our Board waives this limitation. We imposed this limitation to avoid, to the extent possible, a concentration of ownership that might jeopardize our ability to qualify as a REIT. This limitation, however, also makes a change of control much more difficult (if not impossible). These provisions will prevent future takeover attempts not supported by PS even if a majority of our public shareholders consider it to be in their best interests, such as to receive a premium for their shares over market value or for other reasons.



Our Board can set the terms of certain securities without shareholder approval: Our Board is authorized, without shareholder approval, to issue up to 50.0 million shares of preferred stock and up to 100.0 million shares of equity stock, in each case in one or more series. Our Board has the right to set the terms of each of these series of stock. Consequently, the Board could set the terms of a series of stock that could make it difficult (if not impossible) for another party to take over our Company even if it might be favorable to our public shareholders. Our articles of incorporation also contain other provisions that could have the same effect. We can also cause our OP to issue additional interests for cash or in exchange for property.



The partnership agreement of our OP restricts our ability to enter into mergers: The partnership agreement of our OP generally provides that we may not merge or engage in a similar transaction unless either the limited partners of our OP are entitled to receive the same proportionate consideration as our shareholders, or 60% of the OP’s limited partners approve the merger. In addition, we may not consummate a merger unless the matter is approved by a vote of the OP’s partners, with our interests in the OP voted in proportion to the manner in which our shareholders voted to approve the merger. These provisions have the effect of increasing PS’s influence over us due to PS’s ownership of operating partnership units. These provisions may make it more difficult for us to merge with another entity.



The interests of limited partners of our OP may conflict with the interests of our common stockholders.



Limited partners of our OP, including PS, have the right to vote on certain changes to the partnership agreement. They may vote in a way that is against the interests of our shareholders. Also, as general partner of our OP, we are required to protect the interests of the limited partners of the OP. The interests of the limited partners and of our shareholders may differ.



We depend on external sources of capital to grow our Company.



We are generally required under the Code to annually distribute at least 90% of our REIT taxable income. Because of this distribution requirement, we may not be able to fund future capital needs, including any necessary

13

 


 

building and tenant improvements, from operating cash flow. Consequently, we may need to rely on third-party sources of capital to fund our capital needs. We may not be able to obtain the financing on favorable terms or at all. Access to third-party sources of capital depends, in part, on general market conditions, the market’s perception of our growth potential, our current and expected future earnings, our cash flow, and the market price per share of our common stock. If we cannot obtain capital from third-party sources, we may not be able to acquire properties when strategic opportunities exist, satisfy any debt service obligations, or make cash distributions to shareholders.



We are subject to laws and governmental regulations and actions that affect our operating results and financial condition. 



Our business is subject to regulation under a wide variety of U.S. federal, state and local laws, regulations and policies including those imposed by the SEC, the Sarbanes-Oxley Act of 2002, the Dodd-Frank Wall Street Reform and Consumer Protection Act and the New York Stock Exchange (the “NYSE”), as well as applicable local, state and national labor laws. Although we have policies and procedures designed to comply with applicable laws and regulations, failure to comply with the various laws and regulations may result in civil and criminal liability, fines and penalties, increased costs of compliance and restatement of our financial statements and could also affect the marketability of our real estate facilities.



In response to current economic conditions or the current political environment or otherwise, laws and regulations could be implemented or changed in ways that adversely affect our operating results and financial condition, such as legislation that could otherwise increase operating costs. Such changes could also adversely affect the operations of our customers, which could affect the price and demand for our space as well as our customer’s ability to pay their rent.



Holders of depositary shares, each representing 1/1,000 of a share of our outstanding preferred stock, have dividend, liquidation and other rights that are senior to the rights of the holders of shares of our common stock.



Holders of our shares of preferred stock are entitled to cumulative dividends before any dividends may be declared or set aside on our common stock. Upon liquidation, before any payment is made to holders of our common stock, shares of our preferred stock are entitled to receive a liquidation preference of $25,000 per share (or $25.00 per depositary share) plus any accrued and unpaid distributions before any payment is made to the common shareholders. These preferences may limit the amount received by our common shareholders for ongoing distributions or upon liquidation. In addition, our preferred stockholders have the right to elect two additional directors to our Board whenever dividends are in arrears in an aggregate amount equivalent to six or more quarterly dividends, whether or not consecutive.



Future issuances by us of shares of our common stock may be dilutive to existing stockholders, and future sales of shares of our common stock may adversely affect the market price of our common stock.



Sales of substantial amounts of shares of our common stock in the public market (either by us or by PS), or issuances of shares of common stock in connection with redemptions of common units of our OP, could adversely affect the market price of our common stock. The Company may seek to engage in common stock offerings in the future. Offerings of common stock, including by us in connection with portfolio or other property acquisitions or by PS in secondary offerings, and the issuance of common units of the OP in exchange for shares of common stock, could have an adverse effect on the market price of the shares of our common stock.



We rely on technology in our operations and failures, inadequacies or interruptions to our service could harm our business.



The execution of our business strategy is heavily dependent on the use of technologies and systems, including the Internet, to access, store, transmit, deliver and manage information and processes. We also maintain personally identifiable information about our customers and employees. Although we believe we have taken commercially reasonable steps to protect the security of our systems, these systems are subject to damage or interruption from power outages, computer and telecommunications failures, computer worms, viruses and other destructive or disruptive security breaches, natural disasters, terrorist attacks, and other catastrophic events. Disruptions in service, system shutdowns and security breaches could impact our operations, subject us to legal liability or government enforcement actions, and otherwise have a material adverse effect on our business.



ITEM 1B. UNRESOLVED STAFF COMMENTS 



None.

14

 


 

ITEM 2. PROPERTIES



As of December 31, 2017,  we owned 98 business parks consisting of a geographically diverse portfolio of 28.0 million rentable square feet of commercial real estate which consists of 14.5 million square feet of flex space, 8.8 million square feet of industrial space and 4.7 million square feet of office space. The weighted average occupancy rate throughout 2017 was 93.8% and the realized rent per square foot was $15.30.



The following table reflects the geographical diversification of the 98 business parks owned by the Company as of December 31, 2017, the type of the rentable square footage and the weighted average occupancy rates throughout 2017 (except as set forth below, all of the properties are held in fee simple interest) (in thousands, except number of business parks):





 

 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

Weighted



 

Number of

 

 

 

 

 

 

 

 

 

Average



 

Business

 

Rentable Square Footage

 

Occupancy

Region

 

Parks

 

Flex

 

Industrial

 

Office

 

Total

 

Rate

Northern California

 

29 

 

2,999 

 

3,906 

 

340 

 

7,245 

 

95.9% 

Southern California

 

15 

 

2,540 

 

712 

 

31 

 

3,283 

 

96.4% 

Dallas (1)

 

13 

 

2,850 

 

231 

 

 

3,081 

 

90.7% 

Austin

 

 

1,717 

 

246 

 

 

1,963 

 

94.9% 

Northern Virginia

 

17 

 

1,947 

 

 

1,970 

 

3,917 

 

91.4% 

South Florida

 

 

1,074 

 

2,780 

 

12 

 

3,866 

 

97.5% 

Suburban Maryland

 

 

970 

 

 

1,608 

 

2,578 

 

83.2% 

Seattle

 

 

411 

 

951 

 

28 

 

1,390 

 

98.1% 

Total

 

95 

 

14,508 

 

8,826 

 

3,989 

 

27,323 

 

93.8% 

Assets held for sale

 

 

 

 

705 

 

705 

 

92.2% 

Total

 

98 

 

14,508 

 

8,826 

 

4,694 

 

28,028 

 

93.8% 

____________________________



(1)

The Company owns two properties comprised of 232,000 square feet that are subject to ground leases in Las Colinas, Texas. These leases expire in 2019 and 2020, however, we have the option to extend them for another 10 years.



Along with the 28.0 million rentable square feet of commercial space, we also have a 95.0% interest in a  395-unit apartment complex.



We currently anticipate that each of our properties listed will continue to be used for its current purpose. However, we will from time to time evaluate our properties from a highest and best use perspective, and may identify higher and better uses for its real estate. We renovate our properties in connection with the re-leasing of space to customers and expect to fund the costs of such renovations generally from rental income.



Competition exists in each of the market areas in which these properties are located, and we have risks that customers will default on leases and declare bankruptcy. We believe these risks are mitigated through the Company’s geographic diversity and diverse customer base.



Please refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” for portfolio information with respect to lease expirations and operating results in 2017, 2016 and 2015 by region and by type of rentable space.







ITEM 3. LEGAL PROCEEDINGS 



We are not presently subject to material litigation nor, to our knowledge, is any material litigation threatened against us, other than routine actions for negligence and other claims and administrative proceedings arising in the ordinary course of business, some of which are expected to be covered by liability insurance or third party indemnifications and all of which collectively are not expected to have a materially adverse effect on our financial condition, results of operations, or liquidity.



ITEM 4. MINE SAFETY DISCLOSURES 



Not applicable.



15

 


 

PART II



ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES



Market Price of the Registrant’s Common Equity:



The common stock of the Company trades on the NYSE under the symbol PSB. The following table sets forth the high and low sales prices of the common stock on the NYSE for the applicable periods:





 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 



 

Range

 

Dividends

 

Three Months Ended

 

High

Low

 

Declared

 

March 31, 2016

 

$

102.52 

$

81.27 

 

$

0.75 

 

June 30, 2016

 

$

106.17 

$

94.88 

 

$

0.75 

 

September 30, 2016

 

$

117.00 

$

104.44 

 

$

0.75 

 

December 31, 2016

 

$

117.35 

$

102.32 

 

$

0.75 

 



 

 

 

 

 

 

 

 

 

March 31, 2017

 

$

121.81 

$

108.97 

 

$

0.85 

 

June 30, 2017

 

$

134.49 

$

114.18 

 

$

0.85 

 

September 30, 2017

 

$

137.60 

$

126.94 

 

$

0.85 

 

December 31, 2017

 

$

137.45 

$

122.23 

 

$

0.85 

 



Holders:



As of February 19, 2018, there were 298 holders of record of the common stock.



Dividends:



Holders of common stock are entitled to receive distributions when and if declared by our Board out of any funds legally available for that purpose. As a REIT, we do not incur federal income tax if we distribute substantially all of our REIT taxable income each year, and if we meet certain organizational and operation rules. We believe we have met these REIT requirements in all periods presented herein, and we expect to continue to elect and qualify as a REIT.



The Board has established a distribution policy intended to maximize the retention of operating cash flow and distribute the amount required for the Company to maintain its tax status as a REIT.



Issuer Repurchases of Equity Securities:



The Board previously authorized the repurchase, from time to time, of up to 6.5 million shares of the Company’s common stock on the open market or in privately negotiated transactions. During the three months ended December 31, 2017, there were no shares of the Company’s common stock repurchased. As of December 31, 2017, the Company has 1,614,721 shares available for repurchase under the program. The program does not expire. Purchases will be made subject to market conditions and other investment opportunities available to the Company.



Securities Authorized for Issuance Under Equity Compensation Plans:



The equity compensation plan information is provided in Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”  

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ITEM 6. SELECTED FINANCIAL DATA



The following sets forth selected consolidated financial and operating information on a historical basis of the Company. The following information should be read in conjunction with the consolidated financial statements and notes thereto of the Company included in this Form 10-K.





 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

 

 

 



For The Years Ended December 31,

 

2017

 

2016

 

2015

 

2014

 

2013



(In thousands, except per share data)

Rental income

$

402,179 

 

$

386,871 

 

$

373,135 

 

$

376,255 

 

$

359,246 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

Expenses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of operations

 

125,340 

 

 

123,108 

 

 

121,224 

 

 

127,371 

 

 

114,831 

Depreciation and amortization

 

94,270 

 

 

99,486 

 

 

105,394 

 

 

110,357 

 

 

108,917 

General and administrative

 

9,679 

 

 

14,862 

 

 

13,582 

 

 

13,639 

 

 

5,312 

Total operating expenses

 

229,289 

 

 

237,456 

 

 

240,200 

 

 

251,367 

 

 

229,060 



 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

172,890 

 

 

149,415 

 

 

132,935 

 

 

124,888 

 

 

130,186 

Interest and other income

 

942 

 

 

1,233 

 

 

1,130 

 

 

1,032 

 

 

2,124 

Interest and other expenses

 

(1,285)

 

 

(5,664)

 

 

(13,330)

 

 

(13,593)

 

 

(16,166)

Equity in loss of unconsolidated joint venture

 

(805)

 

 

 

 

 

 

 

 

Gain on sale of real estate facilities

 

1,209 

 

 

 

 

28,235 

 

 

92,373 

 

 

Gain on sale of development rights

 

6,365 

 

 

 

 

 

 

 

 

Net income

 

179,316 

 

 

144,984 

 

 

148,970 

 

 

204,700 

 

 

116,144 

Allocation to noncontrolling interests

 

(24,279)

 

 

(16,955)

 

 

(18,495)

 

 

(30,729)

 

 

(12,952)

Net income allocable to PS Business Parks, Inc.

 

155,037 

 

 

128,029 

 

 

130,475 

 

 

173,971 

 

 

103,192 

Allocation to preferred shareholders based upon

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Distributions

 

(52,873)

 

 

(57,276)

 

 

(59,398)

 

 

(60,488)

 

 

(59,216)

Redemptions

 

(10,978)

 

 

(7,312)

 

 

(2,487)

 

 

 

 

Allocation to restricted stock unit holders

 

(761)

 

 

(569)

 

 

(299)

 

 

(329)

 

 

(125)

Net income allocable to common shareholders

$

90,425 

 

$

62,872 

 

$

68,291 

 

$

113,154 

 

$

43,851 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

Per Common Share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash Distributions (1)

$

3.40 

 

$

3.00 

 

$

2.20 

 

$

4.75 

 

$

1.76 

Net income — basic

$

3.32 

 

$

2.32 

 

$

2.53 

 

$

4.21 

 

$

1.77 

Net income — diluted

$

3.30 

 

$

2.31 

 

$

2.52 

 

$

4.19 

 

$

1.77 

Weighted average common shares — basic

 

27,207 

 

 

27,089 

 

 

26,973 

 

 

26,899 

 

 

24,732 

Weighted average common shares — diluted

 

27,412 

 

 

27,179 

 

 

27,051 

 

 

27,000 

 

 

24,833 

17

 


 





 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

 

 

 



For The Years Ended December 31,

 

2017

 

2016

 

2015

 

2014

 

2013



(In thousands, except per square foot data)

Balance Sheet Data

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

$

2,100,159 

 

$

2,119,371 

 

$

2,186,658 

 

$

2,227,114 

 

$

2,238,559 

Total debt

$

 

$

 

$

250,000 

 

$

250,000 

 

$

250,000 

Preferred stock called for redemption

$

130,000 

 

$

230,000 

 

$

 

$

 

$

Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

PS Business Parks, Inc.'s shareholders' equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    Preferred stock

$

959,750 

 

$

879,750 

 

$

920,000 

 

$

995,000 

 

$

995,000 

    Common stock

$

733,561 

 

$

733,509 

 

$

740,496 

 

$

718,281 

 

$

722,941 

Noncontrolling interests

$

196,625 

 

$

197,455 

 

$

200,103 

 

$

194,928 

 

$

196,699 

Other Data

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by operating activities

$

271,614 

 

$

250,507 

 

$

238,839 

 

$

228,180 

 

$

222,680 

Net cash (used in) provided by investing activities

$

(80,325)

 

$

(85,008)

 

$

3,131 

 

$

113,188 

 

$

(172,872)

Net cash used in financing activities

$

(205,036)

 

$

(225,782)

 

$

(205,525)

 

$

(220,382)

 

$

(31,210)

Square footage owned at the end of period

 

28,028 

 

 

28,072 

 

 

27,969 

 

 

28,550 

 

 

29,740 

Weighted average occupancy rate (2)

 

93.8% 

 

 

94.0% 

 

 

92.8% 

 

 

91.3% 

 

 

89.9% 

Realized rent per square foot (2) (3)

$

15.30 

 

$

14.61 

 

$

14.27 

 

$

14.00 

 

$

13.91 

____________________________



(1)

Amount includes a $2.75 per common share special cash dividend for the year ended December 31, 2014.

(2)

Weighted average occupancy and rental rates of our total portfolio for each of the last five years, including assets sold and held for sale.

(3)

Excludes material lease buyout payments of $528,000 and $2.3 million for the years ended December 31, 2016 and 2013, respectively.

18

 


 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



The following discussion and analysis of the results of operations and financial condition should be read in conjunction with the selected financial data and the Company’s consolidated financial statements and notes thereto included in this Form 10-K.



Critical Accounting Policies and Estimates: 



Our accounting policies are described in Note 2 to the consolidated financial statements included in this Form 10-K. We believe our most critical accounting policies relate to income tax expense, accounting for acquired real estate facilities, allowance for doubtful accounts, impairment of long-lived assets, accrual for uncertain and contingent liabilities, each of which are more fully discussed below.



Income Tax Expense: We have elected to be treated as a REIT, as defined under the Code. As a REIT, we do not incur federal income tax on our REIT taxable income that is fully distributed each year (for this purpose, certain distributions paid in a subsequent year may be considered), and if we meet certain organizational and operational rules. We believe we have met these REIT requirements for all periods presented herein. Accordingly, we have recorded no federal income tax expense related to our REIT taxable income. 



Our evaluation that we have met the REIT requirements could be incorrect, because compliance with the tax rules requires factual determinations, and circumstances we have not identified could result in noncompliance with the tax requirements in current or prior years. For any taxable year that we fail to qualify as a REIT and for which applicable statutory relief provisions did not apply, we would be taxed at the regular corporate rates on all of our taxable income for at least that year and the ensuing four years, we could be subject to penalties and interest, and our net income would be materially different from the amounts estimated in our consolidated financial statements.



Accounting for Acquired Real Estate Facilities: We estimate the fair values of the land, buildings, intangible assets and intangible liabilities for purposes of allocating the purchase price. Such estimates are based upon many assumptions and judgments, including (i) market rates of return and capitalization rates on real estate and intangible assets, (ii) building and material cost levels, (iii) comparisons of the acquired underlying land parcels to recent land transactions, (iv) estimated market rent levels and (v) future cash flows from the real estate and the existing customer base. Others could come to materially different conclusions as to the estimated fair values, which would result in different depreciation and amortization expense, rental income, gains and losses on sale of real estate assets, and real estate and intangible assets.



Allowance for Doubtful Accounts: Customer receivables consist primarily of amounts due for contractual lease payments, reimbursements of common area maintenance expenses, property taxes and other expenses recoverable from customers. Deferred rent receivable represents the amount that the cumulative straight-line rental income recorded to date exceeds cash rents billed to date under the lease agreement. Determination of the adequacy of allowances for doubtful accounts requires significant judgments and estimates. Others could come to materially different conclusions regarding the adequacy of our allowance for doubtful accounts. Significant unreserved bad debt losses could materially impact our net income.



Impairment of Long-Lived Assets: The analysis of impairment of our long-lived assets involves identification of indicators of impairment, projections of future operating cash flows and estimates of fair values or selling prices, all of which require significant judgment and subjectivity. Others could come to materially different conclusions. In addition, we may not have identified all current facts and circumstances that may affect impairment. Any unidentified impairment loss, or change in conclusions, could have a material adverse impact on our net income.



Accrual for Uncertain and Contingent Liabilities: We accrue for certain contingent and other liabilities that have significant uncertain elements, such as property taxes, performance bonuses and other operating expenses, as well as other legal claims and disputes involving customers, employees, governmental agencies and other third parties. We estimate such liabilities based upon many factors such as assumptions of past and future trends and our evaluation of likely outcomes. However, the estimates of known liabilities could be incorrect or we may not be aware of all such liabilities, in which case our accrued liabilities and net income could be misstated.



19

 


 

Strategic Overview



Our overall operating results are impacted primarily by the performance of our existing real estate facilities, which at December 31, 2017 are comprised of 28.0 million rentable square feet of multi-tenant flex, industrial and office properties concentrated in six states and a 95.0% interest in a  395-unit apartment complex. Accordingly, a significant degree of management attention is paid to maximizing the cash flow from our existing real estate portfolio. We also acquire properties we believe will create long-term value, and from time to time we dispose of properties which no longer fit within the Company’s strategic objectives.



Existing Real Estate Facilities: The operating results of our existing real estate facilities are substantially influenced by demand for rental space within our properties and our markets, which impacts occupancy, rental rates and capital expenditures requirements. We strive to maintain high occupancy levels while increasing rental rates and minimizing capital expenditures when market conditions allow, although the Company may decrease rental rates in markets where conditions require. Management’s initiatives and strategies with respect to our existing real estate facilities include incentivizing our personnel to maximize the return on investment for each lease transaction and providing a superior level of service to our customers. 



Acquisitions of Real Estate Facilities: We also seek to grow our operations through acquisitions of facilities generally consistent with the Company’s focus on owning concentrated business parks with easily configurable space. In the third quarter of 2016, we acquired two multi-tenant office buildings aggregating 226,000 square feet in Rockville, Maryland for a purchase price of $13.3 million. The occupancy rate has increased from 18.5% on the date of acquisition to 43.1% as of December 31, 2017. These buildings are located within The Grove 270 (formerly Shady Grove Executive Park) where we already owned three substantially fully-leased buildings aggregating 352,000 square feet. We continue to seek to acquire additional facilities in our existing markets and generally in proximity to our existing facilities; however, there can be no assurance that we will acquire additional facilities that meet our risk-adjusted return and underwriting requirements.



Development or redevelopment of real estate facilities: We also may seek to redevelop our existing real estate. We own a large contiguous block of real estate (628,000 rentable square feet on 44.5 acres of land) located within The Mile in Tysons, Virginia. We demolished one of our existing office buildings in The Mile and built Highgate at an estimated cost, including the estimated fair value of existing land, of $115.6 million.



While multi-family real estate is not a core asset for us, we determined that multi-family real estate represented a unique opportunity and the highest and best use of this parcel. We have partnered through a joint venture with a local developer and operator of multi-family space in order to leverage their operational experience. See “Analysis of Items Not Included in Operating Income – Equity in loss of unconsolidated joint venture” below and Note 4 to our consolidated financial statements for more information on Highgate. 



We do not consolidate the joint venture that holds Highgate; accordingly, our share of net loss is reflected under “equity in loss of unconsolidated joint venture.” Effective January 1, 2018, the joint venture agreement was amended to provide the Company control of all significant decisions of the joint venutre. As such, we commenced consolidating the operating results of Highgate beginning January 1, 2018.  



We have an additional 123,000 square foot office building located within The Mile that we are seeking to demolish in order to construct another multi-family complex on the parcel. This parcel is reflected on our consolidated balance sheets as land and building held for development. The scope and timing of development of this site is subject to a variety of contingencies, including approval of entitlement. We do not expect that development will commence any earlier than December 31, 2018.



Dispositions of Real Estate Facilities:  In 2015, we completed a plan to exit non-strategic markets in Sacramento California, Oregon and Arizona. We do not expect to exit any additional markets. However, we may from time to time dispose of individual real estate assets based on market conditions, fit with our existing portfolio or other reasons.



On May 1, 2017, we disposed of a two-building single-story office park comprising 44,000 square feet, located in Dallas, Texas, for net proceeds of $2.1 million, which resulted in a net gain of $1.2 million.  We have 705,000 rentable square feet of office product located in Orange County, California, held for sale and expect to complete the sale of these assets during 2018. The operations of these facilities are presented below under “assets sold or held for sale or development.”

20

 


 

Certain Factors that May Impact Future Results



Impact of Inflation: Although inflation has not been significant in recent years, an increase in inflation could impact our future results, and the Company continues to seek ways to mitigate its potential impact. A substantial portion of the Company’s leases require customers to pay operating expenses, including real estate taxes, utilities and insurance, as well as increases in common area expenses, partially reducing the Company’s exposure to inflation during each lease’s respective lease period.



Regional Concentration: Our portfolio is concentrated in eight regions, in six states. We have chosen to concentrate in these regions because we believe they have characteristics which enable them to be competitive economically, such as above average population growth, job growth, higher education levels and personal income, which we believe will produce better overall economic returns. Changes in economic conditions in these regions in the future could impact our future results.



Industry and Customer Concentrations: We seek to minimize the risk of industry or customer concentrations. As of December 31, 2017, excluding assets held for sale, industry groups that represented more than 10% of our annual rental income comes from business services and warehouse, distribution, transportation and logistics. No other industry group represents more than 10% of our annualized rental income as depicted in the following table.



 

 



 

 



 

Percent of



 

Annualized

Industry

 

Rental Income

Business services

 

18.3% 

Warehouse, distribution, transportation and logistics

 

11.8% 

Health services

 

9.9% 

Computer hardware, software and related services

 

9.9% 

Government

 

7.1% 

Retail, food, and automotive

 

7.1% 

Engineering and construction

 

7.2% 

Insurance and financial services

 

4.0% 

Electronics

 

3.1% 

Aerospace/defense products and services

 

2.8% 

Home furnishings

 

2.6% 

Communications

 

2.0% 

Educational services

 

1.6% 

Other

 

12.6% 

Total

 

100.0% 



As of December 31, 2017, excluding assets held for sale, leases from our top 10 customers comprised 10.6% of our annualized rental income, with only one customer, the U.S. Government (4.5%), representing more than 1% as depicted in the following table (in thousands). 





 

 

 

 

 

 



 

 

 

 

 

 



 

 

 

 

 

Percent of



 

 

Annualized

 

Annualized

Customers

Square Footage

 

Rental Income (1)

 

Rental Income

U.S. Government

642 

 

$

17,759 

 

4.5% 

Keeco, L.L.C.

460 

 

 

3,639 

 

0.9% 

Lockheed Martin Corporation

168 

 

 

3,505 

 

0.9% 

Kaiser Permanente

158 

 

 

3,427 

 

0.9% 

Luminex Corporation

162 

 

 

3,247 

 

0.8% 

KZ Kitchen Cabinet & Stone

192 

 

 

2,255 

 

0.6% 

CEVA Logistics U.S., Inc.

213 

 

 

2,142 

 

0.5% 

Applied Materials, Inc.

162 

 

 

2,086 

 

0.5% 

Inova Health Care Services

66 

 

 

1,913 

 

0.5% 

Investorplace Media, LLC

46 

 

 

1,859 

 

0.5% 

Total

2,269 

 

$

41,832 

 

10.6% 

____________________________



(1)

For leases expiring prior to December 31, 2018, annualized rental income represents income to be received under existing leases from January 1, 2018 through the date of expiration.

21

 


 

Customer credit risk: We have historically experienced a low level of write-offs of uncollectible rents, with less than 0.5% of rental income written off each year over the last six years. However, there can be no assurance that write offs may not increase, because there is inherent uncertainty in a customer’s ability to continue paying rent and meet its full lease obligation. As of February 19, 2018, we had 62,000 square feet of leased space occupied by three customers that are protected by Chapter 11 of the U.S. Bankruptcy Code. From time to time, customers contact us, requesting early termination of their lease, reductions in space leased, or rent deferment or abatement.



Net Operating Income



We evaluate the performance of our business parks primarily based on net operating income (“NOI”), a measure that is not defined in accordance with U.S. generally accepted accounting principles (“GAAP”), because we believe NOI is an important measure of the value and performance of our real estate. We believe investors utilize NOI in a similar manner and for similar reasons. We define NOI as Adjusted Rental Income less Adjusted Cost of Operations (described below). NOI excludes depreciation and amortization because management and investors do not consider it important in valuing real estate or evaluating real estate performance, because depreciation assumes the value of real estate declines ratably from its historical cost based upon the passage of time, while we believe the value of real estate changes based upon cash flow and other market factors.



Adjusted Rental Income represents rental income, excluding material lease buyout payments, which we believe are not reflective of ongoing rental income.



Adjusted Cost of Operations represents cost of operations, excluding Senior Management Long-Term Equity Incentive Plan (“LTEIP”) amortization, which can vary significantly period to period based upon-the performance of the whole company, rather than just property operations.



The Company’s calculation of NOI, Adjusted Rental Income and Adjusted Cost of Operations may not be comparable to those of other companies and should not be used as an alternative to performance measures calculated in accordance with GAAP.



See “Analysis of operating income” below for reconciliations of each of these measures to their closest analogous GAAP measure on our consolidated statements of income. Adjusted Rental Income is reconciled to rental income, Adjusted Cost of Operations is reconciled to cost of operations and Net Operating Income is reconciled to operating income.







Results of Operations



Operating Results for 2017 and 2016



For the year ended December 31, 2017, net income allocable to common shareholders was $90.4 million or $3.30 per diluted share, compared to $62.9 million or $2.31 per diluted share for the year ended December 31, 2016.  The increase was due to a $12.9 million increase in NOI with respect to our real estate facilities, gains on the sale of real estate facilities and development rights, a reduction in preferred distributions and a reduction in interest expense due to the repayment of debt, partially offset by an increase in charges related to the redemption of preferred securities. The increase in NOI includes a $14.5 million increase for our Same-Park facilities (defined below) due primarily to higher realized rent per occupied square foot and increased occupancy, offset partially by reduced NOI with respect to facilities we sold or are holding for sale or development.



Operating Results for 2016 and 2015



For the year ended December 31, 2016, net income allocable to common shareholders for the year ended December 31, 2016 was $62.9 million or $2.31 per diluted share, compared to $68.3 million or $2.52 per diluted share for the year ended December 31, 2015.  The decrease was primarily due to gain on sale of assets reported in 2015 partially offset by an $11.9 million increase in NOI with respect to our real estate facilities and lower interest expense in 2016. The increase in NOI includes a $13.0 million increase for our Same-Park facilities due primarily to an increase in occupancy and higher realized rent per occupied square foot, offset partially by reduced NOI with respect to facilities we sold or are holding for sale or development.



We analyze our net income in this discussion analysis in two main sections: operating income and all other components of net income.

22

 


 





Analysis of Operating Income



Our operating income is comprised primarily of our real estate operations, depreciation and amortization expense and general and administrative expenses.



We segregate our real estate activities into (a) same park operations, representing all operating properties acquired prior to January 1, 2015, comprising 27.1 million rentable square feet of our 28.0 million in rentable space at December 31, 2017 (the “Same Park” facilities), (b) non-same park operations, representing those facilities we own that were acquired after January 1, 2015 (the “Non-Same Park” facilities) and (c) assets sold or held for sale or development, representing facilities whose existing operations are no longer part of our ongoing operations, because they were sold or are expected to be sold or developed or converted to alternate use.  



The table below sets forth the various components of our operating income (in thousands):





 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



For the Years

 

 

 

 

For the Years

 

 

 



Ended December 31,

 

 

 

 

Ended December 31,

 

 

 

 

2017

 

2016

 

 

Variance

 

2016

 

2015

 

 

Variance

RENTAL INCOME

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Adjusted rental income (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Same Park

$

386,133 

 

$

369,000 

 

$

17,133 

 

$

369,000 

 

$

353,804 

 

$

15,196 

Non-Same Park

 

1,495 

 

 

296 

 

 

1,199 

 

 

296 

 

 

 

 

296 

Assets sold or held for sale or development (2)

 

14,551 

 

 

17,047 

 

 

(2,496)

 

 

17,047 

 

 

19,331 

 

 

(2,284)

Lease buyout payment

 

 

 

528 

 

 

(528)

 

 

528 

 

 

 

 

528 

Total rental income

 

402,179 

 

 

386,871 

 

 

15,308 

 

 

386,871 

 

 

373,135 

 

 

13,736 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

COST OF OPERATIONS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Adjusted cost of operations (3)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Same Park

 

115,574 

 

 

112,929 

 

 

2,645 

 

 

112,929 

 

 

110,776 

 

 

2,153 

Non-Same Park

 

1,373 

 

 

289 

 

 

1,084 

 

 

289 

 

 

 

 

289 

Assets sold or held for sale or development (2)

 

6,062 

 

 

6,887 

 

 

(825)

 

 

6,887 

 

 

7,978 

 

 

(1,091)

LTEIP amortization

 

2,331 

 

 

3,003 

 

 

(672)

 

 

3,003 

 

 

2,470 

 

 

533 

Total cost of operations

 

125,340 

 

 

123,108 

 

 

2,232 

 

 

123,108 

 

 

121,224 

 

 

1,884 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

OPERATING INCOME

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net operating income (4)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Same Park

 

270,559 

 

 

256,071 

 

 

14,488 

 

 

256,071 

 

 

243,028 

 

 

13,043 

Non-Same Park

 

122 

 

 

 

 

115 

 

 

 

 

 

 

Assets sold or held for sale or development (2)

 

8,489 

 

 

10,160 

 

 

(1,671)

 

 

10,160 

 

 

11,353 

 

 

(1,193)

Lease buyout payment and LTEIP amortization

 

(2,331)

 

 

(2,475)

 

 

144 

 

 

(2,475)

 

 

(2,470)

 

 

(5)

Depreciation and amortization

 

(94,270)

 

 

(99,486)

 

 

5,216 

 

 

(99,486)

 

 

(105,394)

 

 

5,908 

General and administrative

 

(9,679)

 

 

(14,862)

 

 

5,183 

 

 

(14,862)

 

 

(13,582)

 

 

(1,280)

Operating income

$

172,890 

 

$

149,415 

 

$

23,475 

 

$

149,415 

 

$

132,935 

 

$

16,480 

____________________________



(1)

Adjusted rental income excludes material lease buyout payments.

(2)

The operations for “assets sold or held for sale or development” is primarily comprised of the historical operations of the 705,000 rentable square feet of office product held for sale and are therefore not expected to remain part of our ongoing operations. These assets were removed from the Same Park portfolio in the current year’s presentation. For the years ended December 31, 2016 and 2015, respectively, “assets sold or held for sale or development” also includes $3.3 million and $3.6 million, respectively in adjusted rental income and $905,000 and $702,000 in adjusted cost of operations from a 123,000 square foot office building held for development. For the year ended December 31, 2015, “assets sold or held for sale or development” includes $2.7 million in adjusted rental income and $1.2 million in adjusted cost of operations from 574,000 square feet of assets sold during 2015.

(3)

Adjusted cost of operations excludes the impact of LTEIP amortization.

(4)

Net operating income represents adjusted rental income less adjusted cost of operations.



Rental income increased $15.3 million in 2017 compared to 2016 and by $13.7 million in 2016 as compared to 2015 due primarily to increases in adjusted rental income at the Same Park and Non-Same Park facilities, offset partially by adjusted rental income from assets sold or held for sale or development.  The increases in adjusted rental income at the Same Park facilities in 2017 and 2016 were due primarily to higher annualized realized rental income per occupied square foot and increased occupancy.



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Cost of operations increased $2.2 million in 2017 compared to 2016 and by $1.9 million in 2016 as compared to 2015 due primarily to increases in adjusted cost of operations for the Same Park and Non-Same Park facilities, offset partially by adjusted costs of operations from assets sold or held for sale or development. The 2017 increase in cost of operations was partially offset by lower LTEIP amortization, whereas the increase in 2016 LTEIP amortization increased 2016 cost of operations.



Operating income increased $23.5 million in 2017 compared to 2016 and by $16.5 million in 2016 compare to 2015. The 2017 increase was due primarily to higher rental income, lower depreciation expense and general and administrative expenses. The 2016 increase in operating income was primarily due to higher rental income and lower depreciation expense partially offset by higher general and administrative expenses.



See below for a discussion of depreciation and amortization expense and general and administrative expenses.



Same Park Facilities



The Same Park facilities are those that we have owned and operated since January 1, 2015. We evaluate the operations of these facilities to more effectively evaluate the ongoing performance of our portfolio in 2017, 2016 and 2015. We believe the Same Park information is used by investors and analysts in a similar manner. The following table summarizes the historical operating results of these facilities and certain statistical information related to leasing activity (in thousands, except per square foot data):





 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Summary of Same Park Operations

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



For the Years

 

 

 

For the Years

 

 



Ended December 31,

 

 

 

Ended December 31,

 

 

 

2017

 

2016

 

Variance

 

2016

 

2015

 

Variance

Adjusted rental income

$

386,133 

 

$

369,000 

 

4.6% 

 

$

369,000 

 

$

353,804 

 

4.3% 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Adjusted cost of operations

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Property taxes

 

39,512 

 

 

38,450 

 

2.8% 

 

 

38,450 

 

 

36,587 

 

5.1% 

Utilities

 

21,987 

 

 

22,077 

 

(0.4%)

 

 

22,077 

 

 

21,935 

 

0.6% 

Repairs and maintenance

 

25,949 

 

 

23,520 

 

10.3% 

 

 

23,520 

 

 

23,065 

 

2.0% 

Snow removal

 

544 

 

 

1,810 

 

(69.9%)

 

 

1,810 

 

 

1,938 

 

(6.6%)

Other expenses

 

27,582 

 

 

27,072 

 

1.9% 

 

 

27,072 

 

 

27,251 

 

(0.7%)

Total

 

115,574 

 

 

112,929 

 

2.3% 

 

 

112,929 

 

 

110,776 

 

1.9% 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net operating income

$

270,559 

 

$

256,071 

 

5.7% 

 

$

256,071 

 

$

243,028 

 

5.4% 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selected Statistical Data

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross margin (1)

 

70.1% 

 

 

69.4% 

 

1.0% 

 

 

69.4% 

 

 

68.7% 

 

1.0% 

Weighted average square foot occupancy

 

94.4% 

 

 

94.2% 

 

0.2% 

 

 

94.2% 

 

 

93.0% 

 

1.3% 

Annualized realized rent per occupied square foot (2)

$

15.10 

 

$

14.45 

 

4.5% 

 

$

14.45 

 

$

14.04 

 

2.9% 

____________________________



(1)

Computed by dividing NOI by adjusted rental income. 

(2)

Represents the annualized adjusted rental income earned per occupied square foot.



Analysis of Same Park Adjusted Rental Income



Adjusted rental income generated by the Same Park facilities increased 4.6% in 2017 as compared to 2016 and by 4.3% in 2016 as compared to 2015. These increases were due primarily to higher rental rates charged to our customers, as annualized realized rental income per occupied square foot increased 4.5% and 2.9% in 2017 and 2016, respectively, compared to the year prior. Weighted average occupancy increased 0.2% and 1.3% in 2017 and 2016, respectively, compared to the year prior.



We believe that high occupancies help maximize our rental income. Accordingly, we seek to maintain a weighted average occupancy over 90%.



During 2017 and 2016, most markets continued to reflect favorable conditions allowing for stable occupancy as well as increasing rental rates. With the exception of Northern Virginia and Suburban Maryland markets, new rental rates for the Company improved over expiring rental rates on executed leases as economic conditions and tenant demand remained healthy.

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Our future revenue growth will come primarily from potential increases in market rents allowing us to increase rent levels when leases are either renewed with existing customers or re-leased to new customers. The following table sets forth the expirations of existing leases in our Same Park portfolio in place at December 31, 2017 over the next 10 years (dollars and square feet in thousands):