XNYS:ESS Essex Property Trust Inc Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2012

OR

o 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 001-13106

ESSEX PROPERTY TRUST, INC.
(Exact name of Registrant as Specified in its Charter)

Maryland
 
77-0369576
(State or Other Jurisdiction of Incorporation or Organization)
 
(I.R.S. Employer Identification Number)

925 East Meadow Drive
Palo Alto, California    94303
(Address of Principal Executive Offices including Zip Code)

(650) 494-3700
(Registrant's Telephone Number, Including Area Code)

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 reports), and (2) has been subject to such filing requirements for the past 90 days. YES  x NO  o

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 x NO

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” ”accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer  x Accelerated filer  o   Non-accelerated filer  o Smaller reporting company  o
    (Do not check if a smaller reporting company)  
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o No  x
 
 APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:  36,414,318 shares of Common Stock as of August 2, 2012.
 


 
 

 


 
 
ESSEX PROPERTY TRUST, INC.
FORM 10-Q
INDEX

   
Page No.
PART I. FINANCIAL INFORMATION
 
     
Item 1.
3
     
 
4
     
 
5
     
 
6
     
 
7
     
 
9
     
Item 2.
23
     
Item 3.
33
     
Item 4.
34
     
PART II. OTHER INFORMATION
 
     
Item 1.
34
     
Item 1A.
35
     
Item 6
35
     
36
 
 

 
Part I -- Financial Information

Item 1: Condensed Financial Statements (Unaudited)

"Essex" or the "Company" means Essex Property Trust, Inc., a real estate investment trust incorporated in the State of Maryland, or where the context otherwise requires, Essex Portfolio, L.P., a limited partnership (the "Operating Partnership") in which Essex Property Trust, Inc. is the sole general partner.

The information furnished in the accompanying unaudited condensed consolidated balance sheets, statements of operations and comprehensive income, equity, and cash flows of the Company reflects all adjustments which are, in the opinion of management, necessary for a fair presentation of the aforementioned condensed consolidated financial statements for the interim periods and are normal and recurring in nature, except as otherwise noted.

The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the notes to such unaudited condensed consolidated financial statements and Management's Discussion and Analysis of Financial Condition and Results of Operations herein.  Additionally, these unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company's annual report on Form 10-K for the year ended December 31, 2011.

 
3

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(Dollars in thousands, except per share amounts)

   
June 30,
   
December 31,
 
Assets
 
2012
   
2011
 
Real estate:
           
Rental properties:
           
Land and land improvements
  $ 901,942     $ 860,661  
Buildings and improvements
    3,702,631       3,452,403  
      4,604,573       4,313,064  
Less accumulated depreciation
    (995,311 )     (920,026 )
      3,609,262       3,393,038  
Real estate under development
    55,343       44,280  
Co-investments
    436,230       383,412  
      4,100,835       3,820,730  
Cash and cash equivalents-unrestricted
    4,132       12,889  
Cash and cash equivalents-restricted
    23,678       22,574  
Marketable securities
    114,166       74,275  
Notes and other receivables
    50,895       66,369  
Prepaid expenses and other assets
    26,859       22,682  
Deferred charges, net
    18,551       17,445  
Total assets
  $ 4,339,116     $ 4,036,964  
Liabilities and  Equity
               
Mortgage notes payable
  $ 1,615,645     $ 1,745,858  
Unsecured debt
    615,000       465,000  
Lines of credit
    257,102       150,000  
Accounts payable and accrued liabilities
    62,636       48,324  
Construction payable
    3,575       6,505  
Dividends payable
    43,708       39,611  
Derivative liabilities
    6,022       3,061  
Other liabilities
    20,724       20,528  
Total liabilities
    2,624,412       2,478,887  
Commitments and contingencies
               
Cumulative convertible Series G preferred stock
    4,349       4,349  
Equity:
               
Cumulative redeemable Series H preferred stock at liquidation value
    73,750       73,750  
Common stock, $.0001 par value, 656,020,000 shares authorized 35,070,620 and 33,888,082 shares issued and outstanding
    3       3  
Additional paid-in capital
    2,017,445       1,844,611  
Distributions in excess of accumulated earnings
    (425,058 )     (408,066 )
Accumulated other comprehensive loss, net
    (72,915 )     (72,771 )
Total stockholders' equity
    1,593,225       1,437,527  
Noncontrolling interest
    117,130       116,201  
Total equity
    1,710,355       1,553,728  
Total liabilities and equity
  $ 4,339,116     $ 4,036,964  
 
See accompanying notes to the unaudited condensed consolidated financial statements.
 
 
4

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARES
Condensed Consolidated Statements of Operations and Comprehensive Income
(Unaudited)
(Dollars in thousands, except per share amounts)

   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Revenues:
                       
Rental and other property
  $ 129,765     $ 114,906     $ 255,238     $ 226,114  
Management and other fees
    2,796       1,420       5,240       2,645  
      132,561       116,326       260,478       228,759  
Expenses:
                               
Property operating, excluding real estate taxes
    30,718       28,946       59,470       56,783  
Real estate taxes
    11,699       10,825       23,112       21,412  
Depreciation
    41,801       37,250       82,535       73,908  
General and administrative
    5,764       5,385       11,164       10,659  
Cost of management and other fees
    1,611       1,073       3,251       1,997  
      91,593       83,479       179,532       164,759  
Earnings from operations
    40,968       32,847       80,946       64,000  
                                 
Interest expense before amortization
    (24,659 )     (22,710 )     (49,316 )     (44,518 )
Amortization expense
    (2,882 )     (2,736 )     (5,754 )     (5,590 )
Interest and other income
    5,455       2,628       7,868       9,616  
Equity income (loss) in co-investments
    3,111       726       5,451       (647 )
Gain on remeasurement of co-investment
    21,947       -       21,947       -  
Loss on early retirement of debt
    (1,450 )     (253 )     (1,450 )     (253 )
Income from continuing operations
    42,490       10,502       59,692       22,608  
Income from discontinued operations
    -       5,551       10,037       5,952  
Net income
    42,490       16,053       69,729       28,560  
Net income attributable to noncontrolling interest
    (4,044 )     (2,304 )     (7,193 )     (5,851 )
Net income attributable to controlling interest
    38,446       13,749       62,536       22,709  
Dividends to preferred stockholders
    (1,368 )     (1,475 )     (2,736 )     (2,017 )
Excess of cash paid to redeem preferred stock and units over the carrying value
    -       (1,949 )     -       (1,949 )
Net income available to common stockholders
  $ 37,078     $ 10,325     $ 59,800     $ 18,743  
                                 
Comprehensive income
  $ 39,983     $ 19,122     $ 69,575     $ 31,020  
Comprehensive income attributable to noncontrolling interest
    (3,887 )     (2,506 )     (7,183 )     (6,011 )
Comprehensive income attributable to controlling interest
  $ 36,096     $ 16,616     $ 62,392     $ 25,009  
                                 
Per common share data:
                               
Basic:
                               
Income from continuing operations
  $ 1.07     $ 0.16     $ 1.47     $ 0.41  
Income from discontinued operations
    -       0.16       0.27       0.18  
Net income available to common stockholders
  $ 1.07     $ 0.32     $ 1.74     $ 0.59  
Weighted average number of common shares outstanding during the period
    34,570,772       32,040,904       34,299,331       31,754,949  
                                 
Diluted:
                               
Income from continuing operations
  $ 1.07     $ 0.16     $ 1.47     $ 0.41  
Income from discontinued operations
    -       0.16       0.27       0.18  
Net income available to common stockholders
  $ 1.07     $ 0.32     $ 1.74     $ 0.59  
Weighted average number of common shares outstanding during the period
    34,708,420       32,135,064       34,430,571       31,844,002  
Dividend per common share
  $ 1.10     $ 1.04     $ 2.20     $ 2.08  
 
See accompanying notes to the unaudited condensed consolidated financial statements.
 
 
5

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
(Dollars and shares in thousands)

   
Series H
               
Additional
   
Distributions
in excess of
   
Accumulated
other
             
   
Preferred stock
   
Common stock
   
paid-in
   
accumulated
   
comprehensive
   
Noncontrolling
       
   
Shares
   
Amount
   
Shares
   
Amount
   
capital
   
earnings
   
loss, net
   
Interest
   
Total
 
Balances at December 31, 2011
    2,950     $ 73,750       33,888     $ 3     $ 1,844,611     $ (408,066 )   $ (72,771 )   $ 116,201     $ 1,553,728  
Comprehensive income:
                                                                       
Net income
    -       -       -       -       -       62,536       -       7,193       69,729  
Change in fair value of cash flow hedges and amortization of swap settlements
    -       -       -       -       -       -       648       42       690  
Change in fair value of marketable securities
    -       -       -       -       -       -       (792 )     (52 )     (844 )
Issuance of common stock under:
                                                                       
Stock option and restricted stock plans
    -       -       42       -       2,240       -       -       -       2,240  
Sale of common stock
    -       -       1,141       -       170,944       -       -       -       170,944  
Equity based compensation costs
    -       -       -       -       (350 )     -       -       1,161       811  
Contributions from noncontrolling interest
    -       -                       -       -       -       2,400       2,400  
Distributions to noncontrolling interest
    -       -       -       -       -       -       -       (9,134 )     (9,134 )
Redemptions of noncontrolling interest
    -       -       -       -       -       -       -       (681 )     (681 )
Common and preferred stock dividends
    -       -       -       -       -       (79,528 )     -       -       (79,528 )
Balances at June 30, 2012
    2,950     $ 73,750       35,071     $ 3     $ 2,017,445     $ (425,058 )   $ (72,915 )   $ 117,130     $ 1,710,355  
 
See accompanying notes to the unaudited condensed consolidated financial statements.
 
 
6

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(Dollars in thousands)
 
   
Six Months Ended
 
   
June 30,
 
   
2012
   
2011
 
Cash flows from operating activities:
           
Net income
  $ 69,729     $ 28,560  
Adjustments to reconcile net income to net cash provided by    operating activities:
               
Gain on sale of marketable securities
    (521 )     (4,543 )
Gain on remeasurement of co-investment
    (21,947 )     -  
Loss on early retirement of debt
    1,450       253  
Co-investments
    3,770       2,120  
Amortization expense
    5,754       5,590  
Amortization of discount on notes receivables
    (917 )     (878 )
Amortization of discount on marketable securities
    (2,518 )     (2,297 )
Gain on the sales of real estate
    (10,870 )     (5,853 )
Depreciation
    82,629       74,541  
Equity-based compensation
    1,925       1,056  
Changes in operating assets and liabilities:
               
Prepaid expenses and other assets
    (4,420 )     (697 )
Accounts payable and accrued liabilities
    5,133       5,299  
Other liabilities
    195       1,200  
Net cash provided by operating activities
    129,392       104,351  
Cash flows from investing activities:
               
Additions to real estate:
               
Acquisitions of real estate
    (80,502 )     (38,958 )
Improvements to recent acquisitions
    (3,569 )     (11,804 )
Redevelopment
    (17,223 )     (16,296 )
Revenue generating capital expenditures
    (1,638 )     (1,220 )
Non-revenue generating capital expenditures
    (7,040 )     (7,711 )
Acquisitons of and additions to real estate under development
    (17,166 )     (65,695 )
Acquisition of membership interest in co-investment
    (85,000 )     -  
Dispositions of real estate
    27,800       15,972  
Changes in restricted cash and refundable deposits
    (1,805 )     (3,210 )
Purchases of marketable securities
    (34,363 )     (6,805 )
Sales and maturities marketable securities
    5,070       27,997  
Collections of notes and other receivables
    6,574       368  
Contributions to co-investments
    (114,746 )     (43,207 )
Distributions from co-investments
    7,430       450  
Net cash used in investing activities
    (316,178 )     (150,119 )
Cash flows from financing activities:
               
Borrowings under debt agreements
    762,580       645,419  
Repayment of debt
    (671,153 )     (661,193 )
Additions to deferred charges
    (2,622 )     (1,441 )
Payment to settle derivative instruments
    -       (2,395 )
Net proceeds from issuance of Preferred stock, Series H
    -       71,427  
Retirement of Series B preferred units
    -       (78,800 )
Redemption of Series F preferred stock
    -       (25,000 )
Equity related issuance cost
    (274 )     (591 )
Net proceeds from stock options exercised
    1,400       5,983  
Net proceeds from issuance of common stock
    170,944       168,592  
Contributions from noncontrolling interest
    2,400       -  
Distributions to noncontrolling interest
    (9,134 )     (9,667 )
Redemption of noncontrolling interest
    (681 )     (4,019 )
Common and preferred stock dividends paid
    (75,431 )     (67,491 )
Net cash provided by financing activities
    178,029       40,824  
Net (decrease) in cash and cash equivalents
    (8,757 )     (4,944 )
Cash and cash equivalents at beginning of year
    12,889       13,753  
Cash and cash equivalents at end of year
  $ 4,132     $ 8,809  
 
 
7

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(Dollars in thousands)

   
2012
   
2011
 
Supplemental disclosure of cash flow information:
           
Cash paid for interest, net of $3.9 million, and $4.5 million capitalized in 2012 and 2011, respectively.
  $ 47,575     $ 43,594  
Supplemental disclosure of noncash investing and financing activities:
               
Transfer from real estate under development to rental properties
  $ 4,294     $ 40,784  
Transfer from real estate under development to co-investments
  $ 148,053     $ 48,886  
Mortgage notes assumed in connection with purchases of real estate including the loan premiums recorded
  $ 30,298     $ 10,500  
Contribution of note receivable to co-investment
  $ 12,325     $ -  
Change in accrual of dividends
  $ 4,097     $ 1,570  
Change in fair value of derivative liabilities
  $ 2,841     $ 1,836  
Purchase of marketable securities pending settlement
  $ 8,340     $ -  
Change in fair value of marketable securities
  $ 845     $ 2,283  
Change in construction payable
  $ 2,930     $ 2,041  
Non-cash contribution from noncontrolling interest
  $ -     $ 800  
 
See accompanying notes to the unaudited condensed consolidated financial statements
 
 
8

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
(1)  Organization and Basis of Presentation

The accompanying unaudited condensed consolidated financial statements present the accounts of Essex Property Trust, Inc. (the “Company”), which include the accounts of the Company and Essex Portfolio, L.P. (the “Operating Partnership,” which holds the operating assets of the Company) and are prepared in accordance with U.S. generally accepted accounting principles for interim financial information and in accordance with the instructions to Form 10-Q.  In the opinion of management, all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows for the periods presented have been included and are normal and recurring in nature.  These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company's annual report on Form 10-K for the year ended December 31, 2011.

All significant intercompany balances and transactions have been eliminated in the condensed consolidated financial statements.

The unaudited condensed consolidated financial statements for the three and six months ended June 30, 2012 and 2011 include the accounts of the Company and the Operating Partnership.  The Company is the sole general partner in the Operating Partnership, with a 94.0% general partnership interest as of June 30, 2012.  Total Operating Partnership units outstanding were 2,238,571 and 2,229,230 as of June 30, 2012 and December 31, 2011, respectively, and the redemption value of the units, based on the closing price of the Company’s common stock totaled $344.6 million and $313.2 million, as of June 30, 2012 and December 31, 2011, respectively.

As of June 30, 2012, the Company owned or had ownership interests in 160 apartment communities, aggregating 33,015 units, excluding the Company’s ownership in preferred interest co-investments,  (collectively, the “Communities”, and individually, a “Community”), five commercial buildings and nine active development projects (collectively, the “Portfolio”).  The Communities are located in Southern California (Los Angeles, Orange, Riverside, San Diego, Santa Barbara, and Ventura counties), Northern California (the San Francisco Bay Area) and the Seattle metropolitan area.

Marketable Securities

The Company reports its available for sale securities at fair value, based on quoted market prices (Level 2 for the unsecured bonds and Level 1 for the common stock and investment funds, as defined by the Financial Accounting Standards Board (“FASB”) standard for fair value measurements as discussed later in Note 1), and any unrealized gain or loss is recorded as other comprehensive income (loss).  Realized gains and losses, interest and dividend income, and amortization of purchase discounts are included in interest and other income on the condensed consolidated statement of operations and comprehensive income.

As of June 30, 2012 and December 31, 2011, marketable securities consisted primarily of investment-grade unsecured bonds, common stock, investments in mortgage backed securities and investment funds that invest in U.S. treasury or agency securities.  As of June 30, 2012 and December 31, 2011, the Company classified its investments in mortgage backed securities, which mature in November 2019 and September 2020, as held to maturity, and accordingly, these securities are stated at their amortized cost.  The estimated fair values of the mortgage backed securities (Level 2 securities) are approximately equal to the carrying values.
 
 
9

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
 
As of June 30, 2012 and December 31, 2011 marketable securities consist of the following ($ in thousands):

   
June 30, 2012
 
   
Cost/
   
Gross
       
   
Amortized
   
Unrealized
       
   
Cost
   
Gain(Loss)
   
Fair Value
 
Available for sale:
                 
Investment-grade unsecured bonds
  $ 5,227     $ (22 )   $ 5,205  
Investment funds - US treasuries
    15,383       593       15,976  
Common stock
    42,970       721       43,691  
Held to maturity:
                       
Mortgage backed securities
    49,294       -       49,294  
Total
  $ 112,874     $ 1,292     $ 114,166  
 
   
December 31, 2011
 
   
Cost/
   
Gross
         
   
Amortized
   
Unrealized
         
   
Cost
   
Gain
   
Fair Value
 
Available for sale:
                       
Investment-grade unsecured bonds
  $ 3,615     $ 399     $ 4,014  
Investment funds - US treasuries
    11,783       121       11,904  
Common stock
    10,067       1,552       11,619  
Held to maturity:
                       
Mortgage backed securities
    46,738       -       46,738  
Total
  $ 72,203     $ 2,072     $ 74,275  

The Company uses the specific identification method to determine the cost basis of a security sold and to reclassify amounts from accumulated other comprehensive income for securities sold.  For the three months ended June 30, 2012, the proceeds from sales of available for sales securities totaled $5.1 million which resulted in a $0.5 million gain. For the six months ended June 30, 2012 and 2011, the proceeds from sales of available for sale securities totaled $5.1 million and $28.0 million, respectively, which resulted in gains of $0.5 million and $4.5 million, respectively.

Variable Interest Entities

The Company evaluates its investments in entities to determine whether such entities may be a variable interest entity, or VIE, and, if a VIE, whether it is the primary beneficiary and therefore should consolidate the VIE. Generally, an entity is determined to be a VIE when either: (1) the equity investment at risk is insufficient to finance that entity's activities without additional subordinated financial support, (2) the equity holders, as a group, lack any of the following three characteristics: (i) the power, through voting rights or similar rights, to direct the activities of the entity that most significantly impact the entity’s economic performance, (ii) the obligation to absorb the expected losses of the entity, (iii) the right to receive the expected residual returns of the entity, or (3) the equity investors have voting rights that are not proportionate to their economic interests and the activities of the entity involve or are conducted on behalf of an investor with a disproportionately small voting interest.

The Company consolidates 19 DownREIT limited partnerships (comprising twelve communities) since the Company is the primary beneficiary of these variable interest entities (“VIEs”).  Total DownREIT units outstanding were 1,061,848 and 1,063,848 as of June 30, 2012 and December 31, 2011, respectively, and the redemption value of the units, based on the closing price of the Company’s common stock totaled $163.4 million and $149.5 million, as of June 30, 2012 and December 31, 2011, respectively.  The consolidated total assets and liabilities related to these VIEs, net of intercompany eliminations, were approximately $201.4 million and $174.0 million, respectively, as of June 30, 2012 and $199.8 million and $171.5 million, respectively, as of December 31, 2011.  Interest holders in VIEs consolidated by the Company are allocated income equal to the cash payments made to those interest holders.  The remaining results of operations are generally allocated to the Company.  As of June 30, 2012 and December 31, 2011, the Company did not have any other VIEs of which it was deemed to be the primary beneficiary.
 
 
10

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
 
Equity Based Compensation

The Company accounts for equity based compensation using the fair value method of accounting.  The estimated fair value of stock options granted by the Company is being amortized over the vesting period of the stock options.  The estimated grant date fair values of the long term incentive plan units (discussed in Note 13, “Equity Based Compensation Plans,” in the Company’s Form 10-K for the year ended December 31, 2011) are being amortized over the expected service periods.
 
Stock-based compensation expense for options and restricted stock totaled $0.4 million for the three months ended June 30, 2012 and 2011, and $0.8 million and $0.7 million for the six months ended June 30, 2012 and 2011, respectively.  The intrinsic value of the stock options exercised during the three months ended June 30, 2012 and 2011 totaled $0.7 million and $2.0 million, respectively and $1.8 million and $3.0 million for the six months ended June 30, 2012 and 2011, respectively.  As of June 30, 2012, the intrinsic value of the stock options outstanding totaled $16.3 million.  As of June 30, 2012, total unrecognized compensation cost related to unvested share-based compensation granted under the stock option and restricted stock plans totaled $4.9 million.  The cost is expected to be recognized over a weighted-average period of 1 to 6 years for the stock option plans and is expected to be recognized straight-line over 7 years for the restricted stock awards.

The Company has adopted an incentive program involving the issuance of Series Z-1 Incentive Units of limited partnership interest in the Operating Partnership.  Stock-based compensation expense for Z-1 Units totaled $0.5 million and $0.3 million for the three months ended June 30, 2012 and 2011, respectively and $1.1 million and $0.5 million for the six months ended June 30, 2012 and 2011, respectively.  Stock-based compensation for Z-1 units capitalized totaled $0.2 million and $0.1 million for the three months ended June 30, 2012, and 2011, respectively and $0.3 million and $0.2 million for the six months ended June 30, 2012 and 2011, respectively.  As of June 30, 2012, the intrinsic value of the Z-1 Units subject to future vesting totaled $22.8 million.  As of June 30, 2012, total unrecognized compensation cost related to Z-1 Units subject to future vesting totaled $9.2 million.  The unamortized cost is expected to be recognized over the next fourteen years subject to the achievement of the stated performance criteria.

Fair Value of Financial Instruments

The Company values its financial instruments based on the fair value hierarchy of valuation techniques described in the FASB's accounting standard for fair value measurements.  Level 1 inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.  Level 2 inputs include quoted prices for similar assets and liabilities in active markets and inputs other than quoted prices observable for the asset or liability.   Level 3 inputs are unobservable inputs for the asset or liability.  The Company uses Level 1 inputs for the fair values of its cash equivalents and its marketable securities except for unsecured bonds and mortgage backed securities.  The Company uses Level 2 inputs for its investments in unsecured bonds, mortgage backed securities, notes receivable, notes payable, and derivative liabilities.  These inputs include interest rates for similar financial instruments.  The Company’s valuation methodology for the swap related to the multifamily revenue refunding bonds for the 101 San Fernando apartment community, is described in more detail in Note 8.  The Company does not use Level 3 inputs to estimate fair values of any of its financial instruments.  The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability. 

Management believes that the carrying amounts of its amounts outstanding under lines of credit, notes receivable and notes and other receivables approximate fair value as of June 30, 2012 and December 31, 2011, because interest rates, yields and other terms for these instruments are consistent with yields and other terms currently available for similar instruments.  Management has estimated that the fair value of the Company’s $1.79 billion of fixed rate debt, including unsecured bonds, at June 30, 2012 is approximately $1.90 billion and the fair value of the Company’s $439.0 million of variable rate debt, excluding borrowings under the lines of credit, at June 30, 2012 is $417.7 million based on the terms of existing mortgage notes payable, unsecured bonds and variable rate demand notes compared to those available in the marketplace.  Management believes that the carrying amounts of cash and cash equivalents, restricted cash, accounts payable and accrued liabilities, construction payables, other liabilities and dividends payable approximate fair value as of June 30, 2012 due to the short-term maturity of these instruments.  The fair values of the Company’s investments in mortgage backed securities are approximately equal to the amortized cost carrying value of these securities.  Marketable securities and both the note payable and the swap related to multifamily revenue refunding bonds for the 101 San Fernando apartment community, are carried at fair value as of June 30, 2012, as discussed above and in Note 8.
 
 
11

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
 
Capitalization Policy

The Company capitalizes all direct and certain indirect costs, including interest and real estate taxes, incurred during development and redevelopment activities. Interest is capitalized on real estate assets that require a period of time to get them ready for their intended use.  The amount of interest capitalized is based upon the average amount of accumulated development expenditures during the reporting period.  Included in capitalized costs are management’s accounting estimates of the direct and incremental personnel costs and indirect project costs associated with the Company's development and redevelopment activities.  Indirect project costs consist primarily of personnel costs associated with construction administration and development, including accounting, legal fees, and various office costs that clearly relate to projects under development.  The Company’s capitalized internal costs related to development and redevelopment projects totaled $1.1 million during each of the three months ended June 30, 2012 and 2011, respectively, and $2.2 million and $2.0 million for the six months ended June 30, 2012 and 2011, respectively, most of which relates to development projects.  These totals include capitalized salaries of $0.6 million for both the three months ended June 30, 2012 and 2011, respectively, and $1.3 million and $1.1 million for six months ended June 30, 2012 and 2011, respectively.

Co-investments

The Company owns investments in joint ventures (“co-investments”) in which it has significant influence, but its ownership interest does not meet the criteria for consolidation in accordance with the accounting standards.  Therefore, the Company accounts for these investments using the equity method of accounting.  Under the equity method of accounting, the investment is carried at the cost of assets contributed, plus the Company’s equity in earnings less distributions received and the Company’s share of losses.  The significant accounting policies of the Company’s co-investments entities are consistent with those of the Company in all material respects.  For preferred equity investments the Company recognizes its preferred interest as equity in earnings.

Upon the acquisition of a controlling interest of a co-investment, the co-investment entity is consolidated and a gain or loss is recognized upon the remeasurement of co-investments in the consolidated statement of operations equal to the amount by which the fair-value of the co-investment interest the Company previously owned exceeds its carrying value.

A majority of the co-investments, excluding the preferred equity investments, compensate the Company for its asset management services and may provide promote distributions if certain financial return benchmarks are achieved.  Asset management fees are recognized when earned, and promote fees are recognized when the earnings events have occurred and the amount is determinable and collectible.

Accounting Estimates and Reclassifications

The preparation of condensed consolidated financial statements, in accordance with U.S. generally accepted accounting principles, requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to acquiring, developing and assessing the carrying values of its real estate portfolio, its investments in and advances to joint ventures and affiliates, its notes receivables and its qualification as a Real Estate Investment Trust (“REIT”). The Company bases its estimates on historical experience, current market conditions, and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may vary from those estimates and those estimates could be different under different assumptions or conditions.

Reclassifications for discontinued operations have been made to prior year statements of operations balances in order to conform to current year presentation.  Such reclassifications have no impact on reported earnings, cash flows, total assets or total liabilities.

 
12

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
 
(2)  Significant Transactions During the Second Quarter of 2012 and Subsequent Events

Acquisitions

In April, the Company purchased the joint venture partner’s membership interest in the co-investment Essex Skyline at MacArthur Place, a 349-unit premier high-rise apartment community containing luxury amenities located in Santa Ana, California, for a total purchase price of $85.0 million.  During the second quarter, the Company recorded promote income of $2.3 million included in interest and other income on the condensed consolidated statements of operations, earned as a result of achieving certain performance hurdles as defined in the joint venture agreement.  Upon the acquisition of partner’s membership interest, the property was consolidated and a gain on remeasurement of the Company’s co-investment interest of $21.9 million was recorded equal to the amount by which the fair value of the Company’s previously owned noncontrolling interest exceeded its carrying value.  The secured $80.0 million loan was repaid early as part of this transaction, and the property is now an unencumbered asset.

In June, the Company purchased Park Catalina, a 90-unit property located in the Koreatown submarket of Los Angeles, California containing a mix of studio, one and two bedrooms apartments, for a total purchase price of $23.7 million.  Also, at the end of June, the Company purchased The Huntington, a 276-unit property located in Huntington Beach, California containing a pool, spa, fitness center and clubhouse, for a purchase price of $48.3 million.  The Company assumed a $30.3 million loan secured by the property at a fixed rate of 5.7% for seven years.  The interest rate on the loan was unfavorable compared to currently available market rates for mortgage loans, and thus in conjunction with the purchase price allocation, the Company recorded a $4.3 million loan premium to reflect the debt at fair value.  This resulted in an effective interest rate for this loan of 3.3%.

In July, the Company purchased Montebello, a 248-unit property located in Kirkland, Washington, containing a mix of one, two and three bedroom units and townhomes, for a purchase price of $52.0 million from a related party entity.  The Company assumed a $26.5 million mortgage loan secured by the property at a fixed rate of 5.6% for eight years.  The interest rate on the loan was unfavorable compared to currently available market rates for mortgage loans, and thus in conjunction with the purchase price allocation, the Company is expected to record a $4.1 million loan premium to reflect the debt at fair value.  This results in an effective interest rate for this loan of 3.1%.

Development

In April, the Company acquired an entity that owns a land parcel in Emeryville, California for the development of a 190-unit apartment and total estimated costs of $58.2 million.  Initial occupancy is expected in the third quarter of 2014.

In June, the Company in a co-investment partnership with the Canada Pension Plan Investment Board (“CPPIB”), acquired two adjacent land parcels in San Francisco, California for the development of two nine story apartment communities containing a total of 463 units and approximately 9,300 square feet of retail space.  The Company expects initial occupancy in the second quarter of 2014 for a total estimated cost of $250 million.  The Company holds a 55% noncontrolling interest in the venture and will earn customary management fees and may earn a promoted interest if certain performance hurdles as defined in the joint venture agreement are achieved.

In July, the Company entered into an agreement to purchase a 121-unit community under construction in Valley Village a district of Los Angeles, California.  The Company made a $1.0 million deposit and will take ownership of the property upon receipt of a temporary certificate of occupancy for total estimated costs of $37.6 million, which is expected in the first quarter of 2014.

Co-investments

In early July, the Company made a $14.0 million preferred equity investment in a related party entity that owns an apartment community located in Cupertino, California.  The investment has a preferred return of 9.5% and matures in May 2016.  The Company will invest an additional $4.0 million in preferred equity to fund renovation costs.

 
13

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
Common Stock

During the second quarter, the Company sold 920,281 shares of common stock for $139.4 million, net of commissions, at an average per share price of $152.94.  Year to date through July, the Company has sold 1,769,989 shares of common stock for $268.2 million, net of commissions, at an average price of $153.01.

Mortgage Notes Payable

During late June, the Company repaid $137.7 million in secured mortgage loans with a weighted average interest rate of 5.6% related to eight communities with the net proceeds from the unsecured note offering announced in March 2012.  Also, the $80.0 million Essex Skyline secured loan was repaid in April.  The Company incurred $1.5 million in losses from early retirement of debt, and these nine communities are now unencumbered assets.

Unsecured Term Loan

In July, the Company increased the capacity of its five-year, $200 million unsecured term loan to $350 million, and the tiered pricing structure was reduced from LIBOR + 142.5 basis points to LIBOR + 130 basis points.  The $150 million of additional funds can be drawn between August and December 31, 2012.

Unsecured Line of Credit

In May, the Company amended its $425 million unsecured revolving credit facility by increasing the borrowing capacity to $500 million. The amended facility, which matures in December 2015, contains two one-year extension options and an accordion feature that allows the Company to borrow up to $600 million.  Based on the Company's current BBB credit rating, the facility carries an interest rate of LIBOR + 120 basis points and a facility fee of 20 basis points.
 
Interest Rate Swaps

During the second quarter, the Company entered into interest rate swap contracts with an aggregate notional amount of $125 million.  The first $50 million notional amount effectively converted the interest rate on the remaining $50 million of the $200 million term loan originated in the fourth quarter of 2011 to a fixed rate of 2.46%.  The remaining $75 million notional amount effectively fixed $75 million of the Company’s unsecured line of credit at 2.2%.

 
14

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
(3) Co-investments
 
The Company has co-investments, which are accounted for under the equity method.  The co-investments own, operate and develop apartment communities.

The following table details the Company's co-investments (dollars in thousands):

   
June 30,
   
December 31,
 
   
2012
   
2011
 
Investments in joint ventures accounted for under the equity  method of accounting:
           
             
Membership interest in Wesco I
  $ 83,919     $ 75,588  
Partnership interest in Fund II
    61,560       64,294  
Membership interest in a limited liability company that owns  Essex Skyline at MacArthur Place
    -       24,063  
Total operating co-investments
    145,479       163,945  
                 
Membership interests in limited liability companies that own and are developing Epic, Lync, Elkhorn, and Folsom and Fifth
    130,870       62,897  
Membership interest in a limited liability company that owns  and is developing Expo
    18,518       17,981  
Membership interests in limited liability companies that own  and are developing Fountain at La Brea and Santa Monica at La Brea
    15,830       15,194  
Total development co-investments
    165,218       96,072  
                 
Membership interest in Wesco II that owns a preferred equity interest in Parkmerced     with a perferred return of 10.1%
    89,986       88,075  
Preferred interests in limited liability companies that own  apartment communities in downtown Los Angeles with preferred returns of 9% and 10%
    22,792       22,792  
Preferred interest in a related party limited liability company that owns Madison Park at Anaheim with a preferred return of 13%
    12,755       12,528  
Total preferred interest investments
    125,533       123,395  
Total co-investments
  $ 436,230     $ 383,412  
 
 
15

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
The combined summarized balance sheet and statements of operations for co-investments, which are accounted for under the equity method, are as follows (dollars in thousands).

   
June 30,
   
December 31,
 
   
2012
   
2011
 
Balance sheets:
           
Rental properties and real estate under development
  $ 1,625,272     $ 1,659,078  
Other assets
    77,879       63,847  
                 
Total assets
  $ 1,703,151     $ 1,722,925  
                 
Debt
  $ 838,003     $ 900,095  
Other liabilities
    59,915       48,518  
Equity
    805,233       774,312  
                 
Total liabilities and equity
  $ 1,703,151     $ 1,722,925  
                 
Company's share of equity
  $ 436,230     $ 383,412  
 
 
 
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Statements of operations:
                       
Property revenues
  $ 28,233     $ 24,084     $ 62,556     $ 42,596  
Property operating expenses
    (10,029 )     (9,719 )     (23,166 )     (17,695 )
Net property operating income
    18,204       14,365       39,390       24,901  
                                 
Interest expense
    (7,792 )     (10,549 )     (16,337 )     (15,410 )
General and administrative
    (920 )     (38 )     (1,716 )     (1,022 )
Depreciation and amortization
    (8,876 )     (9,943 )     (22,772 )     (18,006 )
                                 
Net income (loss)
  $ 616     $ (6,165 )   $ (1,435 )   $ (9,537 )
                                 
Company's share of net income (loss)
  $ 3,111     $ 726     $ 5,451     $ (647 )

(4) Notes and Other Receivables
 
Notes receivable secured by real estate, and other receivables consist of the following as of June 30, 2012 and December 31, 2011 (dollars in thousands):
 
   
June 30,
   
December 31,
 
   
2012
   
2011
 
             
Note receivable, secured, bearing interest at 9.8%, paid in full January 2012
  $ -     $ 7,331  
Note receivable, secured, bearing interest at 5.0%, due November 2012 (1)
    875       12,428  
Note receivable, secured, bearing interest at 8.8%, due December 2012
    10,924       10,928  
Note receivable, secured, bearing interest at LIBOR + 8.0%, due December 2012
    6,372       6,422  
Note receivable, secured, bearing interest at 8.0%, due November 2013
    971       971  
Note receivable, secured, effective interest at 9.6%, due February 2014
    18,075       17,646  
Note receivable, secured, bearing interest at 4.0%, due December 2014 (2)
    3,212       3,221  
Note and other receivables from affiliates
    4,683       2,734  
Other receivables
    5,783       4,688  
    $ 50,895     $ 66,369  
 
(1) $12.4 million note receivable was contributed to the Elkhorn co-investment during the first quarter of 2012.  An additional $0.9     million note was funded in the second quarter of 2012 which was contributed to the co-investment in the third quarter.
(2) During the first quarter 2012, the Company amended the loan secured by Vacationer RV Park to extend the maturity date to December 2014.  Beginning January 1, 2012 the note which has a carrying value of $3.2 million, bears interest at a rate of 4%, and the borrower will fund an impound account for capital replacement.

 
16

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
 
(5) Related Party Transactions

Management and other fees from affiliates include management, development and redevelopment fees from co-investments of $2.8 million and $1.4 million during the three months ended June 30, 2012 and 2011, respectively, and $5.2 million and $2.6 million for the six months ended June 30, 2012 and 2011, respectively.  All of these fees are net of intercompany amounts eliminated by the Company.

The Company’s Chairman and founder, Mr. George Marcus, is the Chairman of The Marcus & Millichap Company, which is a holding company for certain real estate brokerage services and other subsidiary companies including Pacific Urban Residential (“PUR”).  During July 2012, the Company invested $14.0 million as a preferred equity interest investment in an entity affiliated with PUR that owns an apartment community in Cupertino, California.  The investment has a preferred return of 9.5% and matures in May 2016.  The Company will invest an additional $4.0 million in preferred equity to fund renovation costs.  Independent directors on the Company’s Board of Directors approved the investment in this entity.

Also during July 2012, the Company acquired Montebello, a 248 unit apartment community in Kirkland, Washington for $52.0 million from an entity affiliated with PUR.  The Company assumed a $26.5 million mortgage loan secured by the property at a fixed rate of 5.6% for eight years.  Independent directors on the Company’s Board of Directors approved the acquisition of this apartment community.
 
 
17


ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
(6) Segment Information

The Company defines its reportable operating segments as the three geographical regions in which its apartment communities are located: Southern California, Northern California and Seattle Metro.  Excluded from segment revenues are properties classified in discontinued operations, management and other fees from affiliates, and interest and other income.  Non-segment revenues and net operating income included in the following schedule also consist of revenue generated from commercial properties.  Other non-segment assets include co-investments, real estate under development, cash and cash equivalents, marketable securities, notes receivable, other assets and deferred charges.

The revenues, net operating income, and assets for each of the reportable operating segments are summarized as follows for the three and six months ended June 30, 2012 and 2011 (dollars in thousands):
 
   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Revenues:
                       
Southern California
  $ 61,356     $ 55,330     $ 119,916     $ 109,193  
Northern California
    42,570       36,550       84,192       71,867  
Seattle Metro
    22,668       20,210       44,977       39,966  
Other real estate assets
    3,171       2,816       6,153       5,088  
Total property revenues
  $ 129,765     $ 114,906     $ 255,238     $ 226,114  
                                 
Net operating income:
                               
Southern California
  $ 41,107     $ 36,173     $ 80,937     $ 71,559  
Northern California
    29,225       24,099       58,168       47,438  
Seattle Metro
    14,841       12,774       29,673       25,331  
Other real estate assets
    2,175       2,089       3,878       3,591  
Total net operating income
    87,348       75,135       172,656       147,919  
                                 
                                 
                                 
Management and other fees from affiliates
    2,796       1,420       5,240       2,645  
Depreciation
    (41,801 )     (37,250 )     (82,535 )     (73,908 )
General and administrative
    (5,764 )     (5,385 )     (11,164 )     (10,659 )
Cost of management and other fees
    (1,611 )     (1,073 )     (3,251 )     (1,997 )
Interest expense before amortization
    (24,659 )     (22,710 )     (49,316 )     (44,518 )
Amortization expense
    (2,882 )     (2,736 )     (5,754 )     (5,590 )
Interest and other income
    5,455       2,628       7,868       9,616  
Equity income (loss) from co-investments
    3,111       726       5,451       (647 )
Gain on remeasurement of co-investment
    21,947       -       21,947       -  
Loss on early retirement of debt
    (1,450 )     (253 )     (1,450 )     (253 )
Income from continuing operations
  $ 42,490     $ 10,502     $ 59,692     $ 22,608  
 
 
18

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
 
Total assets for each of the reportable operating segments are summarized as follows as of June 30, 2012 and December 31, 2011:
 
   
June 30,
   
December 31,
 
   
2012
   
2011
 
Assets:
           
Southern California
  $ 1,682,453     $ 1,478,018  
Northern California
    1,247,579       1,241,320  
Seattle Metro
    589,653       579,612  
Other real estate assets
    89,577       94,088  
Net reportable operating segment  - real estate assets
    3,609,262       3,393,038  
Real estate under development
    55,343       44,280  
Cash and cash equivalents
    27,810       35,463  
Marketable securities
    114,166       74,275  
Co-investments
    436,230       383,412  
Notes and other receivables
    50,895       66,369  
Other non-segment assets
    45,410       40,127  
Total assets
  $ 4,339,116     $ 4,036,964  
 
(7)  Net Income Per Common Share
(Amounts in thousands, except per share and unit data)

   
Three Months Ended
   
Three Months Ended
 
   
June 30, 2012
   
June 30, 2011
 
   
Income
   
Weighted-
average
Common
Shares
   
Per
Common
Share
Amount
   
Income
   
Weighted-
average
Common
Shares
   
Per
Common
Share
Amount
 
Basic:
                                   
Income from continuing operations available to common stockholders
  $ 37,078       34,571     $ 1.07     $ 5,135       32,041     $ 0.16  
Income from discontinued operations available to common stockholders
    -       34,571       -       5,190       32,041       0.16  
      37,078             $ 1.07       10,325             $ 0.32  
                                                 
Effect of Dilutive Securities (1)
    54       137               -       94          
                                                 
Diluted:
                                               
Income from continuing operations available to common stockholders
    37,132       34,708     $ 1.07       5,135       32,135     $ 0.16  
Income from discontinued operations available to common stockholders
    -       34,708       -       5,190       32,135       0.16  
    $ 37,132             $ 1.07     $ 10,325             $ 0.32  

 
19

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
 
   
Six Months Ended
June 30, 2012
   
Six Months Ended
June 30, 2011
 
    Income    
Weighted
 Average
 Common
 Shares
   
Per 
Common
 Share
 Amount
   
Income 
   
Weighted
 Average
 Common
 Shares  
   
Per 
Common
 Share
 Amount
 
Basic:
                                   
Income before discontinued operations available to common stockholders
  $ 50,379       34,299     $ 1.47     $ 13,183       31,755     $ 0.41  
Income from discontinued operations available to common stockholders
    9,421       34,299       0.27       5,560       31,755       0.18  
      59,800             $ 1.74       18,743             $ 0.59  
                                                 
Effect of Dilutive Securities (1)
    108       132               -       89          
                                                 
Diluted:
                                               
Income from continuing operations available to common stockholders (1)
    50,487       34,431       1.47     $ 13,183       31,844       0.41  
Income from discontinued operations available to common stockholders
    9,421       34,431       0.27       5,560       31,844       0.18  
    $ 59,908             $ 1.74     $ 18,743             $ 0.59  
 
 
(1)
Weighted average convertible limited partnership units of 2,239,057 and 2,230,354, which includes vested Series Z incentive units, for the three months ended June 30, 2012, and 2011, respectively, and 2,242,112 and 2,230,354 for the six months ended June 30, 2012 and 2011, respectively, were not included in the determination of diluted EPS because they were anti-dilutive.  Income allocated to convertible limited partnership units, which includes vested Series Z units, aggregating $2.5 million and $1.0 million for the three months ended June 30, 2012 and 2011, respectively, and $4.1 million and $1.6 million for the six months ended June 30, 2012 and 2011, respectively, have been excluded from income available to common stock holders for the calculation of diluted income per common share since these units are excluded from the diluted weighted average common shares for the period as the effect was anti-dilutive.  The Company has the ability to redeem DownREIT limited partnership units for cash and does not consider them to be potentially dilutive securities.

 
Stock options of 29,500 and 41,250 for the three and six months ended June 30, 2011, respectively, were not included in the diluted earnings per share calculation because the effects on earnings per share were anti-dilutive.

 
All shares of Series G cumulative convertible preferred stock have been excluded in diluted earnings per share for the three and six months ended June 30, 2011, as the effect was anti-dilutive.
 
(8)  Derivative Instruments and Hedging Activities

The Company uses interest rate swaps and interest rate cap contracts to manage certain interest rate risks. The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves. The fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts). The variable cash payments (or receipts) are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves. The Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements.

During the fourth quarter of 2011, the Company entered into four interest rate swap contracts with an aggregate notional amount of $150 million that effectively fixed the interest rate on $150 million of the $200 million unsecured term loan at 2.66% through November 2016.   During the second quarter, the Company entered into interest rate swap contracts with an aggregate notional amount of $125 million.  The first $50 million notional amount effectively converted the interest rate on the remaining $50 million of the $200 million term loan originated in fourth quarter of 2011 to a fixed rate of 2.46%.  The remaining $75 million notional amount effectively fixed $75 million of the Company’s unsecured line of credit at 2.2%.  These derivatives qualify for hedge accounting.
 
 
20


ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
 
As of June 30, 2012 the Company also had twelve interest rate cap contracts totaling a notional amount of $187.8 million that qualify for hedge accounting as they effectively limit the Company’s exposure to interest rate risk by providing a ceiling on the underlying variable interest rate for $202.3 million of the Company’s tax exempt variable rate debt.  As of June 30, 2012 and December 31, 2011 the aggregate carrying value of the interest rate swap contracts was a liability of $5.0 million and $1.4 million, respectively, and the aggregate carrying value of the interest rate cap contracts was an asset of $0.1 million and $0.2 million, respectively.

During July 2010, the Company entered into a swap transaction (the “Swap”) with respect to $38.0 million of tax-exempt bonds for the 101 San Fernando apartment community (the “Bonds”) with Citibank, N.A. (“Citibank”).  This swap is not designated as a hedge; accordingly the change in fair value of the swap is recorded as a gain or loss in the Company’s consolidated statement of operations.  Under the terms of the Swap, the Company pays a variable amount equal to the SIFMA Index plus a fixed spread on a notional amount that starts at $35.2 million and over the three-year term of the Swap increases ratably to $38.0 million.  In return, Citibank pays an amount equal to the coupon on the Bonds multiplied by the outstanding par value of the Bonds, $38.0 million.  The Swap has a termination date of July 12, 2013 and may be terminated by the Company at anytime commencing in July 2011 and by Citibank if certain events occur.  Upon termination of the Swap, whether early or on the stated termination date, a payment based on the change in value of the Bonds will occur.  Should the Bonds decline in value from the $35.2 million value of the Bonds at the inception of the Swap, the Company will be obligated to make a payment equal to 100% of the price depreciation.  Should the Bonds increase in value, Citibank will be obligated to make a payment equal to approximately 85% of the price appreciation. As of June 30, 2012 and December 31, 2011 the fair value of the Swap was a liability of $1.1 million and $1.8 million, respectively.

(9)  Discontinued Operations

The Company classifies real estate as "held for sale" when the sale is considered to be probable.

During the first quarter of 2012, the Company sold Tierra Del Sol/Norte, a 156 unit community located in the San Diego, California for $17.2 million for a gain of $7.0 million.  Also in the first quarter, the Company sold Alpine Country, a 108 unit community located in San Diego metropolitan area, for $11.1 million for a gain of $3.9 million.

The components of discontinued operations are outlined below and include the results of operations for the respective periods that the Company owned such assets, as described above (dollars in thousands).

   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
                         
Rental revenues
  $ -     $ 1,006     $ 608     $ 2,347  
Property operating expenses
    -       (459 )     (260 )     (1,024 )
Depreciation and amortization
    -       (261 )     (94 )     (636 )
Income from real estate sold
    -       286       254       687  
Gain on sale
    -       5,854       10,870       5,854  
Internal dispositon costs
    -       (589 )     (1,087 )     (589 )
Income from discontinued operations
  $ -     $ 5,551     $ 10,037     $ 5,952  
 
(10)  Commitments and Contingencies

As of June 30, 2012, the Company had six non-cancelable ground leases for certain apartment communities and buildings that expire between 2027 and 2080.  Land lease payments are typically the greater of a stated minimum or a percentage of gross rents generated by these apartment communities.  Total minimum lease commitments, under land leases and operating leases, are approximately $1.6 million per year for the next five years.
 
 
21

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
 
To the extent that an environmental matter arises or is identified in the future that has other than a remote risk of having a material impact on the financial statements, the Company will disclose the estimated range of possible outcomes, and, if an outcome is probable, accrue an appropriate liability for remediation and other potential liability. The Company will consider whether such occurrence results in an impairment of value on the affected property and, if so, impairment will be recognized.
 
Except with respect to three communities, the Company has no indemnification agreements from third parties for potential environmental clean-up costs at its communities.  The Company has no way of determining at this time the magnitude of any potential liability to which it may be the subject, arising out of unknown environmental conditions or violations with respect to the communities formerly owned by the Company.  No assurance can be given that existing environmental studies with respect to any of the communities reveal all environmental liabilities, that any prior owner or operator of a Property did not create any material environmental condition not known to the Company, or that a material environmental condition does not otherwise exist as to any one or more of the communities.  The Company has limited insurance coverage for the types of environmental liabilities described above.

The Company may enter into transactions that may require the Company to pay the tax liabilities of the partners in the Operating Partnership or in the DownREIT entities.  These transactions are within the Company’s control. Although the Company plans to hold the contributed assets or defer recognition of gain on their sale pursuant to like-kind exchange rules under Section 1031 of the Internal Revenue Code, the Company can provide no assurance that it will be able to do so and if such tax liabilities are incurred they may have a material impact on the Company’s financial position.

There have been a number of lawsuits in recent years against owners and managers of apartment communities alleging personal injury and property damage caused by the presence of mold in residential real estate. Some of these lawsuits have resulted in substantial monetary judgments or settlements.  The Company has been sued for mold related matters and has settled some, but not all, of such matters.   Insurance carriers have reacted to mold related liability awards by excluding mold related claims from standard policies and pricing mold endorsements at prohibitively high rates.  The Company has, however, purchased pollution liability insurance, which includes some coverage for mold.  The Company has adopted policies for promptly addressing and resolving reports of mold when it is detected, and to minimize any impact mold might have on residents of the property.  The Company believes its mold policies and proactive response to address any known existence, reduces its risk of loss from these cases.  There can be no assurances that the Company has identified and responded to all mold occurrences, but the company promptly addresses all known reports of mold.  Liabilities resulting from such mold related matters are not expected to have a material adverse effect on the Company’s financial condition, results of operations or cash flows.  As of June 30, 2012, potential liabilities for mold and other environmental liabilities are not considered probable or the loss cannot be quantified or estimated.

The Company carries comprehensive liability, fire, extended coverage and rental loss insurance for each of the communities.  Insured risks for comprehensive liabilities covers claims in excess of $100,000 per incident, and property casualty insurance covers losses in excess of a $1.0 million deductible per incident. There are, however, certain types of extraordinary losses, such as, for example, losses from terrorism and earthquake, for which the Company does not have insurance. Substantially all of the communities are located in areas that are subject to earthquakes.

The Company provides loan and construction completion guarantees in order to fulfill the lenders’ standard financing requirements related to the construction of the Company’s co-investment developments.  The Company provided a payment guarantee to the counterparties in relation to the total return swaps entered into by the joint venture responsible for the development of the Fountain at La Brea and Santa Monica at La Brea communities.  Further the Company has guaranteed completion of development and made certain debt service guarantees for Fountain at La Brea and Santa Monica at La Brea.  The outstanding balance for the loans is included in the debt line item in the balance sheet of the co-investments included in Note 3.  The payment guarantee is for the payment of the amounts due to the counterparty related total return swaps which are scheduled to mature in September and December 2016.  The maximum exposure of the guarantee as of June 30, 2012 was $38.7 million based on the aggregate outstanding debt amount.

The outstanding balance for the construction loan is included in the debt line item in the balance sheet of the co-investments included in Note 3.  The construction completion guarantee is for the life of the loan, which is scheduled to mature on July 1, 2014, with two, one-year extension options at the Expo joint venture’s option.  As of June 30, 2012, the Company was in compliance with all terms of the construction loan and the construction of the community is expected to be completed on time and within budget.  The maximum exposure of the guarantee as of June 30, 2012 was $76.0 million based on the construction costs that were budgeted to be incurred to complete the construction.
 
 
22

 
ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2012 and 2011
(Unaudited)
 
The Company is subject to various other lawsuits in the normal course of its business operations.  Such lawsuits are not expected to have a material adverse effect on the Company’s financial condition, results of operations or cash flows.
 
Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the Company’s Condensed Consolidated Financial Statements and accompanying Notes thereto included elsewhere herein and with the Company’s 2011 Annual Report on  Form 10-K for the year ended December 31, 2011.

The Company is a fully integrated Real Estate Investment Trust (“REIT”), and its property revenues are generated primarily from apartment community operations.  The Company’s investment strategy has two components:  constant monitoring of existing markets, and evaluation of new markets in the Company’s current three geographical regions to identify areas with the characteristics that underlie rental growth.  The Company’s strong financial condition supports its investment strategy by enhancing its ability to quickly shift the Company’s acquisition, development, and disposition activities to markets that will optimize the performance of the portfolio.

As of June 30, 2012, the Company had ownership interests in 160 apartment communities, comprising 33,015 apartment units, excluding the Company’s ownership in preferred interest co-investments.  The Company’s apartment communities are located in the following major West Coast regions:

Southern California (Los Angeles, Orange, Riverside, San Diego, Santa Barbara, and Ventura counties)
Northern California (the San Francisco Bay Area)
Seattle Metro (Seattle metropolitan area)

As of June 30, 2012, the Company also had ownership interests in five commercial buildings with approximately 315,900 square feet.

As of June 30, 2012, the Company’s development pipeline was comprised of two consolidated projects under development, seven unconsolidated joint venture projects under development, one unconsolidated joint venture predevelopment project and three consolidated land parcels held for future development or sale aggregating 2,985 units, with total incurred costs of $403.2 million, and estimated remaining project costs of approximately $595.5 million for total estimated project costs of $998.7 million.

The Company’s consolidated apartment communities are as follows:
 
   
As of June 30, 2012
   
As of June 30, 2011
 
   
Apartment Units
   
%
   
Apartment Units
   
%
 
Southern California
    13,656       49 %     13,068       49 %
Northern California
    8,206       29 %     7,817       29 %
Seattle Metro
    6,168       22 %     5,979       22 %
Total
    28,030       100 %     26,864       100 %
 
Co-investments including Fund II and Wesco I communities, and preferred equity co-investment communities are not included in the table presented above for both periods.

Comparison of the Three Months Ended June 30, 2012 to the Three Months Ended June 30, 2011

The Company’s average financial occupancies for the Company’s stabilized apartment communities or “Quarterly Same-Property” (stabilized properties consolidated by the Company for the quarters ended June 30, 2012 and 2011) decreased 60 basis points to 96.2% as of June 30, 2012 from 96.8% as of June 30, 2011.  Financial occupancy is defined as the percentage resulting from dividing actual rental revenue by total possible rental revenue.  Actual rental revenue represents contractual rental revenue pursuant to leases without considering delinquency and concessions.  Total possible rental revenue represents the value of all apartment units, with occupied units valued at contractual rental rates pursuant to leases and vacant units valued at estimated market rents.  We believe that financial occupancy is a meaningful measure of occupancy because it considers the value of each vacant unit at its estimated market rate.
 
 
23

 
Market rates are determined using a variety of factors such as effective rental rates at the property based on recently signed leases and asking rates for comparable properties in the market.  The recently signed effective rates at the property are used as the starting point in the determination of the market rates of vacant units.  The Company then increases or decreases these rates based on the supply and demand in the apartment community’s market.  The Company will check the reasonableness of these rents based on its position within the market and compare the rents against the asking rents by comparable properties in the market.  Financial occupancy may not completely reflect short-term trends in physical occupancy and financial occupancy rates as disclosed by other REITs may not be comparable to the Company’s calculation of financial occupancy.
 
The Company does not take into account delinquency and concessions to calculate actual rent for occupied units and market rents for vacant units.  The calculation of financial occupancy compares contractual rates for occupied units to estimated market rents for unoccupied units, thus the calculation compares the gross value of all apartment units excluding delinquency and concessions. For apartment communities that are development properties in lease-up without stabilized occupancy figures, the Company believes the physical occupancy rate is the appropriate performance metric.  While an apartment community is in the lease-up phase, the Company’s primary motivation is to stabilize the property which may entail the use of rent concessions and other incentives, and thus financial occupancy which is based on contractual revenue is not considered the best metric to quantify occupancy.

The regional breakdown of the Company’s Quarterly Same-Property portfolio for financial occupancy for the quarter ended March 31, 2012 and 2011 is as follows:
 
   
Three months ended
 
   
June 30,
 
   
2012
   
2011
 
Southern California
    95.9 %     96.6 %
Northern California
    96.6 %     97.2 %
Seattle Metro
    96.1 %     96.7 %
 
The following table provides a breakdown of revenue amounts, including revenues attributable to the Quarterly Same-Property portfolio:

         
Three Months Ended
             
   
Number of
   
June 30,
   
Dollar
   
Percentage
 
   
Properties
   
2012
   
2011
   
Change
   
Change
 
Property Revenues (dollars in thousands)
                       
Quarterly Same-Property:
                             
Southern California
    60     $ 56,437     $ 54,542     $ 1,895       3.5 %
Northern California
    33       39,420       35,956       3,464       9.6  
Seattle Metro
    28       21,060       19,510       1,550       7.9  
Total Quarterly Same-Property revenues
    121       116,917       110,008       6,909       6.3  
Quarterly Non-Same Property Revenues (1)