Associated Estates Realty Corporation
1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
Business
Associated Estates Realty Corporation (the "Company") is a self-administered and self-managed real estate investment trust ("REIT") which specializes in the acquisition, development, ownership and management of multifamily properties. At December 31, 1997, the Company owned or was a joint venture partner in 88 multifamily properties containing 17,600 suites. Additionally, the Company managed 40 non-owned properties, 32 of which were multifamily properties consisting of 7,052 suites and eight of which were commercial properties containing an aggregate of approximately 825,000 square feet of gross leasable area. Through special purpose entities, collectively referred to as the "Service Companies," the Company provides to both owned and non-owned properties, management, painting and computer services as well as mortgage origination and servicing.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company, all subsidiaries, and the Service Companies. The Company holds a preferred share interest in the Service Companies which entitles it to receive 95% of the economic benefits from operations and which is convertible into a majority interest in the voting common shares. The outstanding voting common shares of these Service Companies are held by an executive officer of the Company. The Service Companies are consolidated because, from a financial reporting perspective, the Company is entitled to virtually all economic benefits and has operating control.
Investments in joint ventures, which are 50% or less owned by the Company, are presented using the equity method of accounting.
All significant intercompany balances and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting periods. Actual results could differ from these estimates.
Cash Equivalents
The Company considers highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents.
Real Estate and Depreciation
Real estate assets are stated at cost less accumulated depreciation. Included in construction in progress are parcels of undeveloped land held for future development. Depreciation is provided on a straight-line basis over the estimated useful lives of the assets as follows:
| Buildings and improvements | 10 - 30 years |
| Furniture, fixtures and equipment | 3 - 10 years |
Management reviews the carrying value of real estate assets using estimated future cash flows, including estimated proceeds from disposition, whenever an event or change in circumstances indicates that the asset value may not be recoverable.
Expenditures that extend the life or improve an asset beyond its original condition are capitalized. Expenditures for maintenance and repairs, and costs incurred in connection with resident turnover such as suite cleaning, painting, carpet cleaning or replacement, appliance repair or replacement and other associated costs are charged to operations.
Deferred Leasing and Financing Costs
Costs incurred in obtaining long-term financing are deferred and amortized over the life of the associated instrument on a straight-line basis, which approximates the effective interest method. Costs incurred with respect to shelf registrations are capitalized and allocated on a pro rata basis to subsequent offerings thereunder. External costs incurred in the leasing of commercial and retail space are amortized on a straight-line basis over the terms of the related lease agreements.
Revenue Recognition
The Company's residential property leases are for terms of generally one year or less. Rental income is recognized on the straight-line basis. Retroactive revenue increases related to budget based Government-Assisted Properties are recognized based on applications submitted to the U.S. Department of Housing and Urban Development ("HUD"). Provision is made for estimated amounts of revenue increases that may not be granted.
Revenues earned by the Service Companies are recognized on the accrual basis.
Income Taxes
The Company has elected to be taxed as a REIT under the Internal Revenue Code of 1986 (the "Code"), as amended. As a REIT, the Company is entitled to a tax deduction for dividends paid to its shareholders, thereby effectively subjecting the distributed net income of the Company to taxation at the shareholder level only, provided it distributes at least 95% of its taxable income and meets certain other qualifications.
At December 31, 1997 and 1996, the Company's net tax basis of properties exceeds the amount set forth in the Company's Consolidated Balance Sheets by $83 million and $78 million, respectively.
Reclassifications
Certain reclassifications have been made to the 1996 and 1995 financial statements to conform to the 1997 presentation.
Recent Accounting Pronouncements
Effective December 31, 1997, the Company implemented Statement of Financial Accounting Standards ("SFAS") No. 128 - Earnings Per Share (Note 14).
In June 1997, the FASB issued SFAS No. 130 - Reporting Comprehensive Income. SFAS No. 130 establishes standards for the reporting and display of comprehensive income and its components in a full set of general purpose financial statements. Comprehensive income is defined as the change in equity of a business during a period and other events and circumstances from non-owner sources. The new standard becomes effective for the Company for the year ending December 31, 1998, and requires that comparative information from earlier years be restated to conform to the requirements of this standard. In June 1997, the FASB issued SFAS No. 131 - Disclosure about Segments of an Enterprise and Related Information. SFAS No. 131 establishes standards for disclosure about operating segments in annual financial statements and selected information in interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The statement supersedes SFAS No. 14 - Financial Reporting for Segments of a Business Enterprise. The new standard becomes effective for the Company for the year ending December 31, 1998, and requires that comparative information from earlier years be restated to conform to the requirements of this standard.
2. DEVELOPMENT, ACQUISITIONS AND DISPOSITION ACTIVITY
Development Activity
Construction in progress, including the cost of land, for the development of multifamily properties was $16,439,393 and $18,516,982 at December 31, 1997 and 1996, respectively. The Company capitalizes interest costs on funds used in construction, real estate taxes and insurance from the commencement of development activity through the time the property is ready for leasing. Interest, real estate taxes and insurance aggregating approximately $1,880,830, $1,394,800 and $440,000 were capitalized during the years ended December 31, 1997, 1996 and 1995, respectively. During 1997, one project was completed, Bradford at Easton, a 324 suite property located in Columbus, Ohio at a total cost of construction of $18.8 million. During 1997, the construction and leasing of 175 suites at three properties were completed for a total cost of $14.2 million. During 1996, the construction and leasing of 116 suites at two properties were completed at a total cost of $6.5 million. During 1995, the construction and leasing of 132 additional suites adjacent to three of the Company's properties were completed at a total cost of $6 million.
Acquisition Activity
During 1997, the Company acquired, in separate purchase transactions, eight multifamily properties containing an aggregate of 1,762 suites and two parcels of land consisting of 14.7 acres for an aggregate purchase price of $105.1 million, of which $4.5 million represented liabilities assumed. The acquired properties are located in Clinton Township and Farmington Hills, Michigan; Indianapolis, Indiana; and Cincinnati, Columbus and Toledo, Ohio. The purchase price of the acquired properties has been financed primarily with proceeds from borrowings on the Company's Line of Credit (Note 6).
During 1996, the Company acquired, in separate purchase transactions, six multifamily properties containing an aggregate of 1,289 suites and three parcels of undeveloped land consisting of 43 acres for an aggregate purchase price of $59.1 million, which were financed with (i) borrowings under the Company's Line of Credit of $46.1 million, (ii) net proceeds of $9.9 million from the issuance of a Medium-Term Note, and (iii) the assumption of mortgage indebtedness with a stated value of $3.1 million.
During 1995, the Company acquired, in separate purchase transactions, 15 multifamily properties consisting of 2,276 suites and three parcels of land consisting of 89.7 acres for an aggregate cost of $106 million. These acquisitions were financed with (i) $2.5 million of available cash, (ii) $42.2 million of proceeds from the Perpetual Preferred Share offering (Note 13), (iii) borrowings under the Revolving Credit Facility and Line of Credit of $37.4 million, and (iv) the assumption of mortgage indebtedness with a stated value of $23.9 million. The mortgage indebtedness was adjusted to market value at the date of acquisition, using interest rates reflecting the Company's incremental borrowing rate.
Disposition Activity
In December 1997, the Company sold a 90 acre parcel of land zoned for office and industrial use, which was one of the assets acquired by the Company at the time of the Company's initial public offering of common shares. Net cash proceeds from the sale of $4.9 million, resulting in a gain of $1.6 million were placed in a trust restricting the Company to use these funds exclusively for the purchase of other property of like-kind and qualifying use. The like- kind exchange was consummated subsequent to December 31, 1997.
3. RESTRICTED CASH
Restricted cash, some of which is required by HUD for certain government-subsidized properties, includes funds held in trust for a pending like-kind exchange (Note 2), residents' security deposits, reserve funds for replacements and other escrows held for the future payment of real estate taxes and insurance. The reserve funds for replacements are intended to provide cash to defray future costs that may be incurred to maintain the associated property. In addition, certain escrows are maintained in connection with mortgage servicing operations.
Restricted cash is comprised of the following:
Amounts held in the like-kind exchange trust were invested in money market funds at December 31, 1997. Resident security deposits are held in separate bank accounts in the name of the properties for which the funds are being held. Reserve funds for replacements are invested in a combination of money market funds, U.S. treasury bills with maturities less than 18 months, and collateralized mortgage obligations issued by the Federal Home Loan Mortgage Company ("FHLMC") maturing in 2023.
Debt securities owned with a purchased maturity of less than 18 months are classified as "held to maturity" and securities with a purchased maturity greater than 18 months are classified as "available for sale". At December 31, 1997 and 1996, treasury bills with a cost of $1,873,088 and $1,899,433 had fair values of $1,904,255 and $1,929,890, respectively, and are stated at cost in the Consolidated Balance Sheet. Investments in obligations issued by the FHLMC were stated at fair value which compares to cost of $398,000 and $423,000 at December 31, 1997 and 1996, respectively. Included in additional paid-in capital is a $15,000 unrealized holding gain and $18,500 unrealized holding loss at December 31, 1997 and 1996, respectively, related to available for sale securities.
4. DEFERRED CHARGES AND PREPAID EXPENSES
Deferred charges and prepaid expenses consist of the following:
Amortization expense was $700,118, $608,594 and $765,404 for the years ended December 31, 1997, 1996 and 1995, respectively.
5. EXTRAORDINARY ITEMS AND NON-RECURRING CHARGE
In 1997, unamortized debt discount was written off upon the early repayment of mortgage debt. In 1995, deferred financing costs were written off upon the early termination of a Revolving Credit Facility and early repayment of mortgage debt. These transactions have been reflected as an extraordinary credit or charge in 1997 and 1995, respectively.
During 1997, the Company wrote off $1,764,044 of receivables principally comprised of two advances to managed but non-owned properties (third parties). This write off is reflected as a charge for unrecoverable funds advanced to non-owned properties and other in the Consolidated Statements of Income.
6. DEBT
The Company's borrowings are evidenced by both secured and unsecured debt. Secured debt consists of the following:
Conventional Mortgage Debt
Conventional mortgages payable are comprised of four and six loans (nonrecourse, fixed rate, project specific loans) at December 31, 1997 and 1996, respectively, each of which is collateralized by the associated real estate and resident leases. Mortgages payable are generally due in monthly installments of principal and/or interest and mature at various dates through March 1, 2007. At December 31, 1997, three of the four conventional mortgages have a fixed rate and the remaining mortgage ($8,100,000) is a variable rate. The average interest rate on conventional mortgages was 8.45% and 8.02% at December 31, 1997 and 1996, respectively.
Federally Insured Mortgage Debt
Federally insured mortgage debt which encumbered seven and eight of the properties at December 31, 1997 and 1996, respectively (including one property which is funded through Industrial Development Bonds), is insured by HUD pursuant to one of the mortgage insurance programs administered under the National Housing Act of 1934. These government-insured loans are nonrecourse to the Company. Payments of principal, interest and HUD mortgage insurance premiums are made in equal monthly installments and mature at various dates through March 1, 2024. At December 31, 1997, six of the seven federally insured mortgages have a fixed rate and the remaining mortgage ($1,892,401) is a variable rate. Interest rates on the HUD-insured indebtedness range from 7.0% to 10.25% (averaging 8.18% at December 31, 1997).
Under certain of the mortgage agreements, the Company is required to make escrow deposits for taxes, insurance and replacement of project assets. The variable rate mortgage is secured by a letter of credit which is renewed annually.
Real estate assets pledged as collateral for all mortgage debt had a net book value of $50,030,137 and $65,757,695 at December 31, 1997 and 1996, respectively.
Unsecured debt consists of the following:
Senior Notes
The Senior Notes with aggregate net proceeds of $83.6 million after underwriting commissions, offering expenses and discount, were issued during 1995 in the principal amounts of $75 million and $10 million and accrue interest at 8.38% and 7.10%, respectively, and mature in 2000 and 2002, respectively. The balance of the $75 million Senior Note, net of unamortized discounts, was $74.9 million and $74.8 million at December 31, 1997 and 1996, respectively.
Medium-Term Notes ProgramThe Company issued ten Medium-Term Notes (the "MTN's") having an aggregate balance of $92.5 million and $42.5 million at December 31, 1997 and 1996, respectively. The principal amounts of these MTN's range from $2.5 million to $20 million and bear interest from 6.18% to 7.93% over terms ranging from two to 30 years, with a stated weighted average maturity of 10.27 years at December 31, 1997. The holders of two MTN's with stated terms of 30 years each may request repayment five and seven years from the issue date of the respective MTN. Should these holders request prepayment, the weighted average maturity would be 5.48 years. The weighted average interest rate of the ten MTN's is 6.97%. Six of the MTN's in the aggregate amount of $42.5 million were issued in 1996, with the balance issued in 1997.
The Company's current MTN Program provides for the issuance from time-to-time of up to $102.5 million of MTN's due nine months or more from the date of issue and may be subject to redemption at the option of the Company or repayment at the option of the holder prior to the stated maturity date. These MTN's may bear interest at fixed rates or at floating rates and can be issued in minimum denominations of $1,000. At December 31, 1997, $82.5 million of additional MTN borrowings were available under the current program.
Line of CreditDuring September 1997, the Company reached an agreement with its agent bank to increase its $75 million unsecured credit facility (the "Line of Credit") to $100 million. The Company also negotiated a competitive bid option which could further reduce interest cost on its Line of Credit. The Line of Credit includes certain restrictive covenants which, among others, requires the Company to (i) maintain a minimum level of net worth, (ii) limit dividends to 90% of Distributable Cash Flow, as defined in the agreement, (iii) restrict the use of its borrowings, and (iv) maintain certain debt coverage ratios. The Line of Credit provides for a scaled reduction in the LIBOR, prime rate and commitment fee margins based on the Company's credit ratings. For the year ended December 31, 1997, based on the Company's present credit ratings, the LIBOR margin was 125 basis points, fixed in increments of 30, 60, 90, 120 or 180 days or, alternatively, borrowings are at prime rate. An annual commitment fee of 15 to 25 basis points on the average daily unused amount of the facility is payable quarterly in arrears. The Company also exercised its option to extend the line for one additional year through September 1998. The weighted average interest rate on borrowings outstanding under the Line of Credit was 7.04% at December 31, 1997.
As of December 31, 1997, the scheduled maturities of secured and unsecured indebtedness for each of the next five years and thereafter, are as follows:
7. INVESTMENTS IN AND ADVANCES TO JOINT VENTURES
At December 31, 1997, the Company's interests in the joint venture partnerships are as follows:
Summarized financial information for these joint ventures is as follows:
The Company's proportionate share of net distributions was $485,513, $509,977 and $438,312 for the years ended December 31, 1997, 1996 and 1995, respectively. Revenues from property management fees charged to joint ventures aggregated $764,338, $746,514 and $745,924 for the years ended December 31, 1997, 1996 and 1995, respectively. The corresponding expenses are included in the operating and maintenance expenses of the joint ventures, as set forth above.
Lakeshore Village is governed by regulations pursuant to the property's rent subsidy and mortgage insurance programs under HUD, which contain provisions governing certain aspects of the operations of the property (Note 10). Rent subsidies of $785,883, $802,517 and $809,032 for the years ended December 31, 1997, 1996 and 1995, respectively, were received by the property.
8. TRANSACTIONS WITH AFFILIATES AND JOINT VENTURES
The Company provides management and other services to (and is reimbursed for certain expenses incurred on behalf of) certain non-owned properties in which the Company's Chief Executive Officer and/or other related parties have varying ownership interests. The entities which own these properties, as well as other related parties, are referred to as "affiliates". The Company also provides similar services to joint venture properties.
Summarized affiliate and joint venture transaction activity follows:
Property management fees and other miscellaneous receivables due from affiliates and joint venture properties were $4,542,798 and $1,111,215 in the aggregate at December 31, 1997 and 1996, respectively. Other miscellaneous payables due to affiliates and joint venture properties were $329,000 and $219,747 in the aggregate at December 31, 1997 and 1996, respectively.
In the normal course of business, the Company advances funds on behalf of, or holds funds for the benefit of affiliates and joint ventures. Funds advanced to affiliates and joint ventures aggregated $9,048,403 and $847,954 at December 31, 1997, respectively, and $5,010,697 and $616,723 at December 31, 1996, respectively. Except for insignificant amounts, advances to affiliates bear interest; on a weighted average basis, the rate charged was 8.0% during 1997 and 7.0% during 1996. The Company held funds for the benefit of affiliates and joint ventures in the aggregate amount of $4,989,674 and $1,805,543 at December 31, 1997, respectively, and $4,666,068 and $1,375,410 at December 31, 1996, respectively.
At December 31, 1997, two notes of equal amounts were receivable from the Company's Chief Executive Officer aggregating $3,342,000 (included in "Accounts and notes receivables-affiliates and joint ventures"). The notes were entered into on May 23, 1997 and bear interest, payable quarterly at the 30-day LIBOR plus the LIBOR margin on the Company's Line of Credit, with principal due May 1, 2002. The 30-day LIBOR averaged 5.52% during 1997 while the LIBOR margin on the Company's Line of Credit ranged from 150 to 100 basis points. One of the notes is collateralized by 150,000 of the Company's common shares; the other note is unsecured. The Company recognized interest income of $143,289 at December 31, 1997 relating to these notes.
Subsequent to December 31, 1997, certain affiliated entities which owed the Company a substantial amount of the advances described above, made capital calls to their partners for the purpose of effecting repayment of such advances. Thereafter, approximately $3.5 million of advances were repaid pursuant to such capital calls. However, a corporation (the "Corporation") owned by a member of the Company's board of directors and his siblings (including the wife of the Company's Chairman and Chief Executive Officer), which serves as general partner of certain affiliated entities, has informed the Company that the Corporation has caused the commencement of a review of expenditures relating to approximately $2.9 million of capital calls from certain HUD subsidized affiliated entities, to determine the appropriateness of such expenditures and whether certain of such expenditures are properly the responsibility of the Company. Should this review result in any dispute with respect to the foregoing expenditures, such disagreement will be resolved through binding arbitration. The Company believes that all expenditures were appropriate and, accordingly, does not believe that the ultimate outcome of any disagreement will have a material adverse effect on the Company's financial position, results of operations or cash flows.
9. NOTEHOLDER INTEREST
The Company has a noteholder interest in one multifamily property which, since 1984, has been unable to generate sufficient cash flow, as defined, to meet the scheduled interest payments under notes payable to the Company. Accordingly, the Company is entitled to all cash flows from operations. To the extent that the cumulative unpaid debt service on the notes is greater than seven years of aggregate principal and interest amortization (the cumulative amount of debt service), which occurred in 1995, the Company can exercise its rights under a security agreement and foreclose on the property. Because, in substance, the Company will eventually own title to the property, most likely through foreclosure, the property is presented in the financial statements as if owned by the Company. Summarized financial information for this property is as follows:
10. COMMITMENTS AND CONTINGENCIES
The Company owns one property which derives part of its rental revenues from commercial tenants with noncancelable operating leases. Future minimum lease payments to be received, assuming no new or renegotiated leases, or option extensions, for each of the next five years and thereafter, are as follows:
The Company leases certain equipment under capital leases. Such equipment is included in property, plant and equipment with a cost of $1,038,169 and accumulated depreciation of $426,093 at December 31, 1997. The Company also leases certain equipment under operating leases. Future minimum lease payments under all capital and noncancelable operating leases in which the Company is the lessee, principally for ground leases, for each of the next five years and thereafter, are as follows:
Certain of the ground lease agreements contain provisions which, upon expiration of the lease, require reversion of the land and building to the lessor. Such provisions exist for nine properties included in the financial statements and expire at various dates from 2021 to 2086. Rental revenues derived from such properties were $9,476,338, $9,376,871 and $9,257,290 for the years ended December 31, 1997, 1996 and 1995, respectively. Furthermore, at the end of the term of the lease, any remaining replacement reserves revert to the lessor. Management believes that the replacement reserves will be utilized for their intended purpose prior to the end of the lease term. Such cash reserves included in restricted cash were $1,564,010 and $1,481,538 at December 31, 1997 and 1996, respectively. With respect to such leases, the Company incurred ground rent expense of $101,261 for each of the years ended December 31, 1997, 1996 and 1995.
The Company owns one property which is subject to a warranty deed reversion provision. This provision requires that the assignment of fee simple title shall expire in 2037. At December 31, 1997, the net book value of this property was $1,618,097.
Certain of the Company's properties are governed by regulations pursuant to rent subsidies or mortgage insurance programs, which contain provisions governing certain aspects of the operations of the properties. Among other things, such provisions may include the maintenance of a reserve fund for replacements, the renting of properties to qualifying residents, and the requirement to make distributions in accordance with certain regulations. Certain approvals may be required to encumber properties having rental subsidies.
The rent subsidy program provides that HUD will make monthly housing assistance payments to the Company on behalf of persons who reside in approved properties and who meet the eligibility criteria. The amount of the total monthly rental and the subsidy is determined at least annually by HUD. This arrangement is evidenced by a contract between HUD and the Company. Such contracts have scheduled expiration dates between September 2000 and December 2018. HUD may abate subsidy payments if the Company defaults on any obligations under such contracts and fails to cure each default after receiving notice thereof. Rent subsidies of $11,004,881, $11,174,488 and $10,666,547 for the years ended December 31, 1997, 1996 and 1995, respectively, were received or recognized in income by the 15 wholly owned properties eligible for federal rent subsidies. As discussed in Note 6, certain obligations are insured by federal mortgage insurance programs. The Company believes that the contracts will be renewed or that the properties will be operated as conventional, market-rate apartments upon expiration of the contracts.
HUD recently notified the Company that Rainbow Terrace Apartments, Inc. (the Company's subsidiary corporation that owns Rainbow Terrace Apartments) is in default under the terms of the Regulatory Agreement and Housing Assistance Payments Contract ("HAP Contract") pertaining to this property. Among other matters, HUD alleges that the property is poorly managed and Rainbow Terrace Apartments has failed to complete certain physical improvements to the property. Moreover, HUD claims that the property is not in compliance with numerous technical regulations concerning whether certain expenses are properly chargeable to the property. As provided in the Regulatory Agreement and HAP Contract, in the event of a default, HUD has the right to exercise various remedies including terminating future payments under the HAP Contract and foreclosing the government-insured mortgage encumbering the property.
This controversy arose out of a Comprehensive Management Review of the property initiated by HUD in the Spring of 1997, which included a complete physical inspection of the property. Rainbow Terrace Apartments believes that it has corrected the management deficiencies cited by HUD in the Comprehensive Management Review (other than the completion of certain physical improvements to the property) and, in a series of written responses to HUD, justified the expenditures questioned by HUD as being properly chargeable to the property in accordance with HUD's regulations. Moreover, Rainbow Terrace Apartments believes it has repaired any physical deficiencies noted by HUD in its Comprehensive Management Review that might pose a threat to the life and safety of its residents. The Company is unable to predict the outcome of the controversy with HUD, but does not believe it will have a material adverse effect on the Company's financial position, results of operations or cash flows.
11. DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosures of estimated fair value were determined by management using available market information and appropriate valuation methodologies. Considerable judgment is necessary to interpret market data and develop estimated fair values. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize on disposition of the financial instruments. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
Rents, accounts and notes receivable, accounts payable, accrued expenses and other liabilities are carried at amounts which reasonably approximate corresponding fair values.
Mortgages and notes payable with an aggregate carrying value of $57,817,981 and $69,024,253 at December 31, 1997 and 1996, respectively, have an estimated aggregate fair value of approximately $60,958,924 and $69,029,601 respectively. The Line of Credit is carried at an amount which approximates fair market value. Estimated fair value is based on interest rates currently available to the Company for issuance of debt with similar terms and remaining maturities.
Senior and Medium-Term Notes with an aggregate carrying value of $177,352,307 and $127,288,707 at December 31, 1997 and 1996, respectively, have an estimated fair value of $185,572,168 and $130,446,465, respectively.
The Company may, from time to time, enter into interest rate agreements to manage interest costs and risks associated with changing rates. On December 12, 1997, the Company entered into a treasury lock rate agreement for a notional amount of $20,000,000. The carrying value of the agreement was zero and the fair market value was a liability of approximately $76,000 at December 31, 1997.
Disclosure about the fair value of financial instruments is based on pertinent information available to management as of December 31, 1997 and 1996. Although management is not aware of any factors that would significantly affect the fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since these dates and current estimates of fair value may differ significantly from the amounts presented herein.
12. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid for interest for the years ended December 31, 1997, 1996 and 1995 was $19,628,642, $16,294,050 and $10,430,373, respectively, which is net of capitalized interest.
The following summarizes the non-cash investing and financing activities of the Company which are not reflected in the Consolidated Statements of Cash Flows:
13. PREFERRED AND COMMON SHARES
On July 2, 1997, the Company completed an offering of 1,750,000 common shares at $23.50 per share. The net proceeds of approximately $38.8 million were applied to reduce debt.
On December 17, 1996, the Company completed an offering of 1,450,000 common shares at $22.375 per share. The net proceeds of approximately $30.7 million were applied to reduce debt.
On July 27, 1995, the Company completed an offering of 2,250,000 Depositary Shares, each representing 1/10 of a share of the Company's 9.75% Class A Cumulative Redeemable Preferred Shares (the "Perpetual Preferred Shares"). Net proceeds to the Company after expenses relating to the offering and underwriting discounts and commissions were approximately $54.1 million, which were utilized for acquisitions and to reduce existing debt. Dividends on the Perpetual Preferred Shares are cumulative from the date of issue and are payable quarterly. Except in certain circumstances relating to the preservation of the Company's status as a REIT, the Perpetual Preferred Shares are not redeemable prior to July 25, 2000. On and after July 25, 2000, the Perpetual Preferred Shares will be redeemable for cash at the option of the Company.
The Company is authorized to issue 3,000,000 Class B Cumulative Preferred Shares, without par value, and 3,000,000 Noncumulative Preferred Shares, without par value. There are no noncumulative preferred shares issued or outstanding at December 31, 1997, 1996 or 1995.
14. EARNINGS AND DIVIDENDS PER SHARE
Earnings Per Share
Earnings per share ("EPS") has been computed pursuant to the provisions of SFAS No. 128 which became effective after December 15, 1997; all periods prior thereto have been restated to conform with the provisions of this Statement.
The following table provides a reconciliation of both income before extraordinary items and the number of common shares used in the computations of basic EPS, which utilizes the weighted average number of common shares outstanding without regard to dilutive potential common shares, and diluted EPS, which includes all such shares.
Options to purchase 389,274, 369,349 and 349,600 shares of common stock were outstanding at December 31, 1997, 1996 and 1995, respectively (Note 15), a portion of which has been reflected above using the treasury stock method.
Dividends Per Share
Total dividends declared per common share and the related components for the years ended December 31, 1997 and 1996, as reported for income tax purposes, were as follows:
15. EMPLOYEE BENEFIT PLANS
401(k) Plan
The Company sponsors a defined contribution retirement plan pursuant to Section 401(k) of the Internal Revenue Code, whereby eligible employees may elect to contribute between 1% and 12% of their gross wages. The Company matches such contributions at a rate of 25% up to a maximum participant contribution of 4%. The Company made contributions to this plan, net of reimbursements from managed but non-owned properties, of $60,016, $46,555 and $39,827 for the years ended December 31, 1997, 1996 and 1995, respectively. Additionally, the Company offers medical, dental and life insurance benefits to employees.
AERC Share Option PlanThe Company provides an incentive and nonqualified stock option plan (the "AERC Share Option Plan") under which 543,093 of the Company's common shares are reserved for awards of share options to eligible key employees. Options may be granted at per share prices not less than fair market value at the date of grant, and in the case of incentive options, must be exercisable within ten years thereof. Option awards granted are vested in equal annual increments over no fewer than three years, beginning on the first anniversary of the date of grant. Activity under the AERC Share Option Plan is summarized as follows:
The weighted average exercise prices of options outstanding at December 31, 1995, 1996 and 1997 were $22.00, $21.87 and $22.67 per share, respectively. The weighted average exercise prices of options exercisable at December 31, 1995 and 1996 were $22.00 and $21.96 per share at December 31, 1997.
Long-Term Plan
In 1995, the Company's shareholders approved a long-term incentive compensation plan (the "Long-Term Plan"). Participants in the Long-Term Plan will earn incentive compensation over a three year period (the "Plan Period") based on specific levels of Funds From Operations per share, as defined, that are established at the outset of the Plan Period. Initial awards under the Long-Term Plan were based on the Plan Period beginning January 1, 1995 and ending December 31, 1997. There were no charges to earnings under this plan in 1996 or 1997. An accrual for $273,207 was recorded under this plan at December 31, 1995, but subsequently reversed during 1996. Beginning with the calendar year 1998, a new three year Plan Period will begin each year. Payment of the incentive compensation earned under the Long-Term Plan may be made in cash, restricted shares of the Company's common shares or a combination thereof as determined by the board of directors. The first payment eligibility date under the Long-Term Plan will be in 1998, the second in 2001, and then it is anticipated that participants will be eligible for payments each year thereafter until the Long-Term Plan terminates in 2005.
Omnibus Equity Plan
In 1995, the Company's shareholders approved an equity-based incentive compensation plan (the "Omnibus Equity Plan").The Omnibus Equity Plan provides for the grant to participants of options to purchase common shares, awards of common shares subject to restrictions on transfer, awards of common shares issuable in the future upon satisfaction of certain conditions, rights to purchase common shares and other awards based on common shares. The option price with respect to the grant of options to purchase common shares will be determined at the time of the grant but will not be less than 100% of the fair market value of the common shares at the date of the grant or 110% in the case of a participant who, at the date of grant, owns shares with more than 10% of the total combined voting power of all classes of stock of the Company. The rights to purchase common shares will enable a participant to purchase common shares (i) at the fair market value of such shares on the date of such grant or (ii) at 85% of such fair market value on such date if the grant is made in lieu of cash compensation. Under the terms of the Omnibus Equity Plan, these grants and awards may not aggregate more than 1,400,000 common shares and no participating employee may receive awards with respect to more than 250,000 common shares during any calendar year.
Restricted shares and option awards granted are vested in equal annual increments over three and five years, respectively, beginning on the first anniversary of the date of grant. Activity under the Omnibus Equity Plan is summarized as follows:
Deferred compensation of $30,600, $40,800 and $61,200 at December 31, 1997, 1996 and 1995, respectively, has been reflected as a reduction of paid-in capital in the accompanying financial statements relating to the issuance of 1,317 restricted shares in 1997 and 3,000 restricted shares in 1995.
Options Granted to Outside DirectorsThe Company has granted options to outside directors on a periodic basis since the IPO. The shares granted are determined by the Company's Executive Compensation Committee. Option awards granted vest one year from the date of grant. Activity is summarized as follows:
The weighted average exercise prices of options outstanding at December 31, 1995 and 1996 were $22.00 per share and $22.94 per share at December 31, 1997. The weighted average exercise prices of options exercisable at December 31, 1995, 1996 and 1997 were $22.00 per share.
Executive CompensationThe Company has an employment agreement with the President and Chief Executive Officer for an initial three-year term which commenced November 18, 1993 and is automatically extended for an additional year at the end of each year of the agreement. Annual base salary under the agreement was $458,480, $440,000 and $385,000 for 1997, 1996 and 1995, respectively. The initial agreement provided for an annual cash bonus equal to 15% to 100% of the base salary if the Company's Distributable Cash Flow, as defined, per common share, for any year exceeded, by 5% to 20% or more, the amount for the immediate preceding year. Under the bonus plan, $101,000 was earned in 1995. This employment agreement was amended in January 1996 to provide for a performance bonus based upon annual performance benchmarks tied to Funds From Operations per share. The incentive amounts are set at the beginning of each fiscal year commensurate with the responsibilities of a CEO. In 1997 and 1996, respectively, $0 and $227,854 in incentive compensation was earned.
SFAS 123
The Company does not recognize compensation cost for stock options when the option exercise price equals or exceeds the market value on the date of the grant. Had compensation cost for the Company's stock-based compensation plans been determined based on the fair values of the options granted at the grant dates, consistent with the method of SFAS 123, the Company's net income and earnings per share would have been as follows:
The fair value of each option grant was estimated on the date of grant using the Black-Scholes options pricing model using the following assumptions:
The pro forma effect on net income as set forth above is not representative of the pro forma effect on net income in future years because it does not take into consideration pro forma compensation expense related to grants made prior to 1995.
16. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
17. PRO FORMA CONDENSED FINANCIAL INFORMATION (UNAUDITED)
As more fully described in Note 2, during the years ended December 31, 1997 and 1996, the Company completed the acquisition of eight and six multifamily properties (the "Acquired Properties") with total suites of 1,762 and 1,289 during 1997 and 1996, respectively, for an aggregate purchase price of $104.6 million and $57.4 million. The multifamily property acquisitions are summarized as follows:
The operating results of the Acquired Properties are included in the results of operations of the Company from the dates of acquisition.
The following unaudited supplemental pro forma operating data for 1997 is presented to reflect, as of January 1, 1997, the effects of: (i) the eight property acquisitions completed in 1997, and (ii) the offering of 1,750,000 common shares. The following unaudited supplemental pro forma operating data for 1996 is presented to reflect, as of January 1, 1996, the effects of: (i) the six property acquisitions completed in 1996, (ii) the offering of 1,450,000 common shares completed in 1996, (iii) the offering of 1,750,000 common shares completed in 1997, and (iv) the eight property acquisitions completed in 1997.
The 1997 and 1996 pro forma financial information does not include the revenue and expenses for Oak Bend Commons and Waterstone Apartments, properties that were acquired in 1997, for the period January 1, 1997 through the date the properties were acquired by the Company or for the period January 1, 1996 through December 31, 1996, respectively. The revenue and expenses of the aforementioned properties were excluded from the pro forma financial information for such periods as they were under construction during substantially all of the periods prior to their acquisition.
The unaudited pro forma condensed statement of operations is not necessarily indicative of what the actual results of operations of the Company would have been assuming the transactions had been completed as set forth, nor does it purport to represent the results of operations of future periods of the Company.
18. SUBSEQUENT EVENTS
Proposed Merger
Subject to customary conditions to closing and the approval of the Company's shareholders, the Company has entered into a definitive merger agreement with MIG Realty Advisors, Inc. ("MIGRA"). Pursuant to the terms of the merger agreement with MIGRA, the Company will also acquire the property management business of several of MIGRA's affiliates and the right to receive certain asset management fees, including disposition fees that would have otherwise been received by MIGRA upon the sale of certain of the properties owned by institutions advised by MIGRA. Founded in 1982, MIGRA currently manages, through its affiliated management companies, 36 Multifamily Apartment Properties containing 11,059 suites. MIGRA's asset management, property management, investment advisory and mortgage servicing operations are collectively referred to herein as the "MIGRA Operations".
In exchange for their interest in MIGRA and the affiliated property management businesses, the shareholders of MIGRA will receive approximately 408,318 (based on the average closing prices of the Company's common shares for the 20 trading days preceding the date of the merger agreement price, which average price is $23.63) of the Company's common shares at the closing of the merger. Subject to the achievement of certain performance criteria, the shareholders of MIGRA have the opportunity to receive additional contingent consideration to be paid in the form of the Company's common shares. Such contingent consideration may have a value of up to $3.1 million and $6.4 million on the first and second anniversary of the merger, respectively. A portion of the shares to be issued will be based on the average closing price of the Company's common shares for the 20 days immediately preceding the contingent payment date. Assuming all contingent consideration is paid, the total purchase price for MIGRA, the property management business, and the rights to the disposition fees will be approximately $19.1 million.
The Company may reduce the purchase price for the MIGRA Operations to the extent that any of MIGRA's or a MIGRA affiliate's advisory clients have not consented to the assignment of or have terminated any advisory, asset, property management or mortgage servicing agreement to the Company. Conversely, the purchase price may be increased to the extent that MIGRA enters into any new asset or property management or mortgage servicing agreement on or before the 90 days preceding the closing of the merger. In no event, however, will the amount of any price increase exceed the amount of any price decrease.
Acquisition Activity
From January 1 through February 26, 1998, the Company acquired four multifamily properties containing 1,320 suites for an aggregate purchase price of $74.4 million of which $15.5 million represents liabilities assumed including mortgage indebtedness of $15.0 million. The balance of the purchase price was financed using borrowings under an unsecured 90 day term loan of $44.5 million and borrowings under the Company's Line of Credit of approximately $14.4 million. The properties are located in Coconut Creek, Florida; Duluth, Georgia; Columbia, Maryland; and Toledo, Ohio.
Proposed Acquisitions
On January 28, 1998 (the "Contract Date"), the Company entered into a contract to acquire certain assets, consisting principally of the multifamily properties as further described below, from MIG Residential REIT, Inc. (the "Proposed Acquisition Properties"). The Proposed Acquisition Properties are as follows:
The seller of the Proposed Acquisition Properties has agreed to exchange its assets for a combination of cash and an equity interest (the "Equity Consideration") in the Company totaling $108.5 million. The seller may elect to receive a portion of the total consideration in cash, up to a maximum of $11.1 million. The number of common shares issued will be determined based on the amount of Equity Consideration divided by the average closing price of the Company's common shares over the 20 day period preceding the purchase of the Proposed Acquisition Properties. For purposes of determining the number of shares issued as Equity Consideration, however, the 20 day average price cannot exceed the average closing price of the Company's common shares over the 20 day period preceding Contract Date times 106%. The Company intends to finance any cash portion of the purchase price with borrowings made available through the Company's Line of Credit.
The Company has also entered into separate contracts to purchase three parcels of undeveloped land containing an aggregate of 144 acres for an approximate purchase price of $9.8 million. One of the parcels is located in Avon, Ohio (a suburb of Cleveland), one of the parcels is located in Crestview Hills, Kentucky adjacent to a multifamily real estate property currently under contract and one of the parcels is located in Cranberry Township, Pennsylvania (a suburb of Pittsburgh). Approximately 838 multifamily apartments may be constructed on the undeveloped land: 312 in Avon, Ohio; 300 in Crestview Hills, Kentucky; and 226 in Cranberry Township, Pennsylvania. The Company expects to finance the undeveloped land acquisitions using borrowings under the Line of Credit.
There can be no assurances, however, that the Company will be successful in its attempts to acquire the Proposed Acquisition Properties and the three parcels of undeveloped land currently under contract.
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