XNYS:FPO First Potomac Realty Trust Quarterly Report 10-Q Filing - 3/31/2012

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 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 March 31, 2012.

 

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

For the transition period from             to             .

Commission File Number 1-31824

 

 

FIRST POTOMAC REALTY TRUST

(Exact name of registrant as specified in its charter)

 

 

 

MARYLAND		37-1470730
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

7600 Wisconsin Avenue, 11^th Floor, Bethesda, MD 20814

(Address of principal executive offices) (Zip Code)

(301) 986-9200

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T 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 definitions of “large accelerated filer,” “accelerated filter,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

x		Large Accelerated Filer		¨		Accelerated Filer
¨		Non-Accelerated Filer		¨		Smaller Reporting Company

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

As of May 14, 2012, there were 50,967,635 common shares, par value $0.001 per share, outstanding.

 

 

 

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FIRST POTOMAC REALTY TRUST

FORM 10-Q

INDEX

 

				Page
Part I:		Financial Information
Item 1.		Condensed Consolidated Financial Statements
		Consolidated balance sheets as of March 31, 2012 (unaudited) and December 31, 2011			3
		Consolidated statements of operations (unaudited) for the three months ended March 31, 2012 and 2011			4
		Consolidated statements of comprehensive loss (unaudited) for the three months ended March 31, 2012 and 2011			5
		Consolidated statements of cash flows (unaudited) for the three months ended March 31, 2012 and 2011			6
		Notes to condensed consolidated financial statements (unaudited)			8
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			30
Item 3.		Quantitative and Qualitative Disclosures about Market Risk			58
Item 4.		Controls and Procedures			59
Part II:		Other Information
Item 1.		Legal Proceedings			61
Item 1A.		Risk Factors			61
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			62
Item 3.		Defaults Upon Senior Securities			62
Item 4.		Mine Safety Disclosures			62
Item 5.		Other Information			62
Item 6.		Exhibits			62
		Signatures			64

Explanatory Note

As previously disclosed in the Annual Report on Form 10-K for the year ended December 31, 2011, management of First Potomac Realty Trust (the “Company”) identified a material weakness in the Company’s internal control over financial reporting as of December 31, 2011. In response to this material weakness, on March 20, 2012, the Company’s Board of Trustees appointed a special committee of independent trustees to review the facts and circumstances relating to the material weakness determination and the Company’s processes surrounding the monitoring and oversight of compliance with Company’s financial covenants. The Board of Trustees determined in late April that a more detailed, internal investigation of these matters should be undertaken by the Audit Committee of the Board of Trustees (the “Internal Investigation”), with the assistance of independent outside professionals, which Internal Investigation is ongoing. The filing of this Form 10-Q for the quarter ended March 31, 2012 was delayed due to the time required to address various matters prior to the filing thereof, including those relating to the Internal Investigation and the execution of various waivers and amendments to certain bank debt agreements. For more information regarding these matters, see the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Internal Investigation” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Amendments to Unsecured Revolving Credit Facility, Unsecured Term Loan and Secured Term Loan” under Part I. Item 2 hereof. The Company is unable to predict the ultimate outcome of the Internal Investigation, or the timing of its completion. Notwithstanding the ongoing Internal Investigation, management believes that the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q fairly present in all material respects the Company’s financial condition, results of operations and cash flows for each of the periods presented in this report.

In light of the ongoing Internal Investigation, Michael H. Comer, the Company’s Chief Accounting Officer, has been performing the functions of the Company’s principal financial officer in connection with this Quarterly Report on Form 10-Q and, as such, has provided the certifications included as Exhibits 31.2 and 32.2 to this Form 10-Q. Barry H. Bass continues to serve as the Company’s Chief Financial Officer.

 

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FIRST POTOMAC REALTY TRUST

Consolidated Balance Sheets

(Amounts in thousands, except per share amounts)

 

		March 31, 2012				December 31, 2011
		(unaudited)
Assets:
Rental property, net		$	1,437,847			$	1,439,661
Assets held for sale			2,933				5,297
Cash and cash equivalents			17,157				16,749
Escrows and reserves			18,097				18,455
Accounts and other receivables, net of allowance for doubtful accounts of $2,991 and $3,065, respectively			10,701				11,404
Accrued straight-line rents, net of allowance for doubtful accounts of $299 and $369, respectively			19,814				18,028
Notes receivable, net			54,679				54,661
Investment in affiliates			73,300				72,518
Deferred costs, net			37,241				34,683
Prepaid expenses and other assets			10,821				9,275
Intangible assets, net			56,020				59,021
Total assets		$	1,738,610			$	1,739,752
Liabilities:
Mortgage loans		$	408,241			$	432,023
Senior notes			75,000				75,000
Secured term loans			20,000				30,000
Unsecured term loan			300,000				225,000
Unsecured revolving credit facility			107,000				183,000
Accounts payable and other liabilities			54,984				53,507
Accrued interest			3,765				2,782
Rents received in advance			11,326				11,550
Tenant security deposits			5,740				5,603
Deferred market rent, net			4,537				4,815
Total liabilities			990,593				1,023,280
Noncontrolling interests in the Operating Partnership			40,044				39,981
Equity:
Preferred Shares, $0.001 par value, 50,000 shares authorized; Series A Preferred Shares, $25 liquidation preference, 6,400 and 4,600 shares issued and outstanding, respectively			160,000				115,000
Common shares, $0.001 par value, 150,000 shares authorized; 50,722 and 50,321 shares issued and outstanding, respectively			51				50
Additional paid-in capital			799,605				798,171
Noncontrolling interests in consolidated partnerships			4,270				4,245
Accumulated other comprehensive loss			(5,161	)			(5,849	)
Dividends in excess of accumulated earnings			(250,792	)			(235,126	)
Total equity			707,973				676,491
Total liabilities, noncontrolling interests and equity		$	1,738,610			$	1,739,752

See accompanying notes to condensed consolidated financial statements.

 

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FIRST POTOMAC REALTY TRUST

Consolidated Statements of Operations

(unaudited)

(Amounts in thousands, except per share amounts)

 

		Three Months Ended March 31,
		2012				2011
Revenues:
Rental		$	37,573			$	31,639
Tenant reimbursements and other			9,199				7,902
Total revenues			46,772				39,541
Operating expenses:
Property operating			11,509				10,546
Real estate taxes and insurance			4,846				3,898
General and administrative			4,897				4,008
Acquisition costs			17				2,185
Depreciation and amortization			16,091				12,504
Impairment of real estate assets			2,751				—
Total operating expenses			40,111				33,141
Operating income			6,661				6,400
Other expenses, net:
Interest expense			11,239				8,626
Interest and other income			(1,508	)			(824	)
Equity in losses of affiliates			46				32
Total other expenses, net			9,777				7,834
Loss from continuing operations before income taxes			(3,116	)			(1,434	)
(Provision) benefit for income taxes			(61	)			313
Loss from continuing operations			(3,177	)			(1,121	)
Loss from discontinued operations			(297	)			(2,771	)
Net loss			(3,474	)			(3,892	)
Less: Net loss attributable to noncontrolling interests			318				138
Net loss attributable to First Potomac Realty Trust			(3,156	)			(3,754	)
Less: Dividends on preferred shares			(2,664	)			(1,783	)
Net loss attributable to common shareholders		$	(5,820	)		$	(5,537	)
Basic and diluted earnings per common share:
Loss from continuing operations		$	(0.11	)		$	(0.07	)
Loss from discontinued operations			(0.01	)			(0.05	)
Net loss		$	(0.12	)		$	(0.12	)
Weighted average common shares outstanding:
Basic and diluted			49,781				49,234

See accompanying notes to condensed consolidated financial statements.

 

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FIRST POTOMAC REALTY TRUST

Consolidated Statements of Comprehensive Loss

(unaudited)

(Amounts in thousands)

 

		Three Months Ended March 31,
		2012				2011
Net loss		$	(3,474	)		$	(3,892	)
Unrealized gain on derivative instruments			742				257
Unrealized loss on derivative instruments			(15	)			—
Total comprehensive loss			(2,747	)			(3,635	)
Net loss attributable to noncontrolling interests			318				138
Net unrealized gain from derivative instruments attributable to noncontrolling interests			(39	)			(5	)
Comprehensive loss attributable to First Potomac Realty Trust		$	(2,468	)		$	(3,502	)

See accompanying notes to condensed consolidated financial statements.

 

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FIRST POTOMAC REALTY TRUST

Consolidated Statements of Cash Flows

(Unaudited, amounts in thousands)

 

		Three Months Ended March 31,
		2012				2011
Cash flows from operating activities:
Net loss		$	(3,474	)		$	(3,892	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Discontinued operations:
Depreciation and amortization			30				395
Impairment of real estate assets			270				2,711
Depreciation and amortization			16,337				12,710
Stock based compensation			696				691
Bad debt expense			69				330
Deferred income taxes			(100	)			(313	)
Amortization of deferred market rent			(20	)			172
Amortization of financing costs and discounts			1,277				566
Equity in losses of affiliates			46				32
Distributions from investments in affiliates			122				9
Impairment of real estate assets			2,751				—
Changes in assets and liabilities:
Escrows and reserves			451				(5,434	)
Accounts and other receivables			877				(1,630	)
Accrued straight-line rents			(2,596	)			(1,416	)
Prepaid expenses and other assets			(213	)			126
Tenant security deposits			162				230
Accounts payable and accrued expenses			2,635				140
Accrued interest			983				1,564
Rents received in advance			(253	)			184
Deferred costs			(3,987	)			(2,911	)
Total adjustments			19,537				8,156
Net cash provided by operating activities			16,063				4,264
Cash flows from investing activities:
Purchase deposit on future acquisitions			—				(3,465	)
Proceeds from sale of real estate assets			5,206				10,824
Change in escrow and reserve accounts			15				—
Acquisition of rental property and associated intangible assets			—				(9,974	)
Additions to rental property			(17,207	)			(6,303	)
Acquisition of land parcel			—				(7,500	)
Additions to construction in progress			(1,782	)			(2,807	)
Investment in affiliates			(949	)			(260	)
Net cash used in investing activities			(14,717	)			(19,485	)
Cash flows from financing activities:
Financing costs			(621	)			(920	)
Issuance of preferred shares, net			43,562				111,016
Issuance of common shares, net			3,599				—
Issuance of debt			119,000				30,000
Repayments of debt			(153,567	)			(128,652	)
Dividends to common shareholders			(10,108	)			(10,649	)
Dividends to preferred shareholders			(2,228	)			—
Distributions to noncontrolling interests			(584	)			(191	)
Stock option exercises			9				18
Net cash (used in) provided by financing activities			(938	)			622
Net increase (decrease) in cash and cash equivalents			408				(14,599	)
Cash and cash equivalents, beginning of period			16,749				33,280
Cash and cash equivalents, end of period		$	17,157			$	18,681

See accompanying notes to condensed consolidated financial statements.

 

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FIRST POTOMAC REALTY TRUST

Consolidated Statements of Cash Flows – Continued

(unaudited)

Supplemental disclosure of cash flow information for the three months ended March 31 is as follows (amounts in thousands):

 

		2012				2011
Cash paid for interest, net		$	9,480			$	6,452
Non-cash investing and financing activities:
Debt assumed in connection with acquisitions of real estate			—				86,464
Contingent consideration recorded at acquisition			—				9,356
Conversion of Operating Partnership units into common shares			—				19
Issuance of Operating Partnership units associated with the acquisition of real estate			—				21,721

Cash paid for interest on indebtedness is net of capitalized interest of $0.8 million and $0.4 million for the three months ended March 31, 2012 and 2011, respectively. For the three months ended March 31, 2012 and 2011, the Company did not pay any cash for franchise taxes levied by the city of Washington, D.C.

During the three months ended March 31, 2011, 1,300 Operating Partnership units were redeemed for an equivalent number of the Company’s common shares. No Operating Partnership units were redeemed for an equivalent number of the Company’s common shares during the three months ended March 31, 2012.

During the three months ended March 31, 2011, the Company acquired three consolidated properties at an aggregate purchase price of $131.5 million, including the assumption of $86.5 million of mortgage debt and the issuance of 1,418,715 Operating Partnership units valued at $21.7 million on the date of acquisition. The 2011 acquisitions included 840 First Street, NE, which was acquired for an aggregate purchase price of $90.0 million, with up to $10.0 million of additional consideration payable upon the terms of a lease renewal by the building’s sole tenant or the re-tenanting of the property. As a result, the Company recorded a contingent consideration obligation of $9.4 million at acquisition. In July 2011, the building’s sole tenant renewed its lease through August 2023 on the entire building with the exception of two floors. As a result, the Company issued 544,673 Operating Partnership units to satisfy $7.1 million of its contingent consideration obligation.

 

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FIRST POTOMAC REALTY TRUST

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

(1)	Description of Business

First Potomac Realty Trust (the “Company”) is a leader in the ownership, management, development and redevelopment of office and industrial properties in the greater Washington, D.C. region. The Company separates its properties into four distinct segments, which it refers to as the Washington, D.C., Maryland, Northern Virginia and Southern Virginia reporting segments. The Company strategically focuses on acquiring and redeveloping properties that it believes can benefit from its intensive property management and seeks to reposition these properties to increase their profitability and value. The Company’s portfolio contains a mix of single-tenant and multi-tenant office and industrial properties as well as business parks. Office properties are single-story and multi-story buildings that are used primarily for office use; business parks contain buildings with office features combined with some industrial property space; and industrial properties generally are used as warehouse, distribution or manufacturing facilities.

References in these unaudited condensed consolidated financial statements to “we,” “our” or “First Potomac,” refer to the Company and its subsidiaries, on a consolidated basis, unless the context indicates otherwise.

The Company conducts its business through First Potomac Realty Investment Limited Partnership, the Company’s operating partnership (the “Operating Partnership”). The Company is the sole general partner of, and, as of March 31, 2012, owned a 94.6% interest in the Operating Partnership. The remaining interests in the Operating Partnership, which are presented as noncontrolling interests in the Operating Partnership in the accompanying unaudited condensed consolidated financial statements, are limited partnership interests, some of which are owned by several of the Company’s executive officers and trustees who contributed properties and other assets to the Company upon its formation, and the remainder of which are owned by other unrelated parties.

At March 31, 2012, the Company wholly-owned or had a controlling interest in properties totaling 13.9 million square feet and had a noncontrolling ownership interest in properties totaling an additional 1.0 million square feet through six unconsolidated joint ventures. The Company also owned land that can support development of approximately 2.4 million square feet of additional development. The Company’s consolidated properties were 83.0% occupied by 610 tenants at March 31, 2012. The Company did not include square footage that was in development or redevelopment, which totaled 0.5 million square feet at March 31, 2012, in its occupancy calculation. The Company derives substantially all of its revenue from leases of space within its properties. As of March 31, 2012, the Company’s largest tenant was the U.S. Government, which along with government contractors, accounted for over 25% of the Company’s total annualized base rent. The U.S. Government accounted for approximately 11% of the Company’s outstanding accounts receivables at March 31, 2012. The Company operates so as to qualify as a real estate investment trust (“REIT”) for federal income tax purposes.

 

(2)	Summary of Significant Accounting Policies

(a) Principles of Consolidation

The unaudited condensed consolidated financial statements of the Company include the accounts of the Company, the Operating Partnership and the subsidiaries in which the Company or Operating Partnership has a controlling interest, which includes First Potomac Management LLC, a wholly-owned subsidiary that manages the majority of the Company’s properties. All intercompany balances and transactions have been eliminated in consolidation.

The Company has condensed or omitted certain information and footnote disclosures normally included in financial statements presented in accordance with U.S. generally accepted accounting principles (“GAAP”) in the accompanying unaudited condensed consolidated financial statements. The Company believes the disclosures made are adequate to prevent the information presented from being misleading. However, the unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2011 and as updated from time to time in other filings with the Securities and Exchange Commission.

In the Company’s opinion, the accompanying unaudited condensed consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments and accruals necessary to present fairly the Company’s financial position as of March 31, 2012 and the results of its operations, its comprehensive loss and its cash flows for the three months ended March 31, 2012 and 2011. Interim results are not necessarily indicative of full-year performance due, in part, to the timing of transactions and the impact of acquisitions and dispositions throughout the year as well as the seasonality of certain operating expenses such as utility expense and snow and ice removal costs.

 

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(b) Use of Estimates

The preparation of condensed consolidated financial statements in conformity with GAAP requires management of the Company to make a number of estimates and assumptions relating to the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the period. Estimates include the amount of accounts receivable that may be uncollectible; recoverability of notes receivable, future cash flows, discount and capitalization rate assumptions used to fair value acquired properties and to test impairment of certain long-lived assets and goodwill; derivative valuations; market lease rates, lease-up periods, leasing and tenant improvement costs used to fair value intangible assets acquired and probability weighted cash flow analysis used to fair value contingent liabilities. Actual results could differ from those estimates.

(c) Rental Property

Rental property is initially recorded at fair value, if acquired in a business combination, or initial cost when constructed or acquired in an asset purchase, less accumulated depreciation and, when appropriate, impairment losses. Improvements and replacements are capitalized at fair value when they extend the useful life, increase capacity or improve the efficiency of the asset. Repairs and maintenance are charged to expense when incurred. Depreciation and amortization are recorded on a straight-line basis over the estimated useful lives of the assets. The estimated useful lives of the Company’s assets, by class, are as follows:

 

Buildings		39 years
Building improvements		5 to 20 years
Furniture, fixtures and equipment		5 to 15 years
Lease related intangible assets		The term of the related lease
Tenant improvements		Shorter of the useful life of the asset or the term of the related lease

The Company regularly reviews market conditions for possible impairment of a property’s carrying value. When circumstances such as adverse market conditions, changes in management’s intended holding period or potential sale to a third party indicate a possible impairment of the fair value of a property, an impairment analysis is performed. The Company assesses potential impairments based on an estimate of the future undiscounted cash flows (excluding interest charges) expected to result from the property’s use and eventual disposition. This estimate is based on projections of future revenues, expenses, capital improvement costs, expected holding periods and capitalization rates. These cash flows consider factors such as expected market trends and leasing prospects, as well as the effects of leasing demand, competition and other factors. If impairment exists due to the inability to recover the carrying value of a real estate investment based on forecasted undiscounted cash flows, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property less anticipated selling costs. The Company is required to make estimates as to whether there are impairments in the carrying values of its investments in real estate. Further, the Company will record an impairment loss if it expects to dispose of a property, in the near term, at a price below carrying value. In such an event, the Company will record an impairment loss based on the difference between a property’s carrying value and its projected sales price less any estimated costs to sell.

The Company will classify a building as held-for-sale in the period in which it has made the decision to dispose of the building, the Company’s Board of Trustees or a designated delegate has approved the sale, there is a high likelihood a binding agreement to purchase the property will be signed under which the buyer will be required to commit a significant amount of nonrefundable cash and no significant financing contingencies will exist that could cause the transaction not to be completed in a timely manner. If these criteria are met, the Company will cease depreciation of the asset. The Company will classify any impairment loss, together with the building’s operating results, as discontinued operations in its consolidated statements of operations for all periods presented and classify the assets and related liabilities as held-for-sale in its consolidated balance sheets in the period the held-for-sale criteria are met. Interest expense is reclassified to discontinued operations only to the extent the held-for-sale property is secured by specific mortgage debt and the mortgage debt will not be assigned to another property owned by the Company after the disposition.

The Company recognizes the fair value, if sufficient information exists to reasonably estimate the fair value, of any liability for conditional asset retirement obligations when incurred, which is generally upon acquisition, construction, development or redevelopment and/or through the normal operation of the asset.

 

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The Company capitalizes interest costs incurred on qualifying expenditures for real estate assets under development or redevelopment, which include its investment in assets owned through unconsolidated joint ventures that are under development or redevelopment, while being readied for their intended use in accordance with accounting requirements regarding capitalization of interest. The Company will capitalize interest when qualifying expenditures for the asset have been made, activities necessary to get the asset ready for its intended use are in progress and interest costs are being incurred. Capitalized interest also includes interest associated with expenditures incurred to acquire developable land while development activities are in progress and interest on the direct compensation costs of the Company’s construction personnel who manage the development and redevelopment projects, but only to the extent the employee’s time can be allocated to a project. Any portion of construction management costs not directly attributable to a specific project are recognized as general and administrative expense in the period incurred. The Company does not capitalize any other general administrative costs such as office supplies, office rent expense or an overhead allocation to its development or redevelopment projects. Capitalized compensation costs were immaterial for the three months ended March 31, 2012 and 2011. Capitalization of interest will end when the asset is substantially complete and ready for its intended use, but no later than one year from completion of major construction activity, if the property is not occupied. The Company will also place redevelopment and development assets in service at this time and commence depreciation upon the substantial completion of tenant improvements and the recognition of revenue. Capitalized interest is depreciated over the useful life of the underlying assets, commencing when those assets are placed into service.

(d) Notes Receivable

The Company provides loans to the owners of real estate properties, which can be collateralized by interest in the real estate property. The Company records these investments as “Notes receivable, net” in its consolidated balance sheets. The investments are recorded net of any discount or issuance costs, which are amortized over the life of the respective note receivable using the effective interest method. The Company records interest earned from notes receivable and amortization of any discount or issuance costs within “Interest and other income” in its consolidated statements of operations.

The Company will establish a provision for anticipated credit losses associated with its notes receivable and debt investments when it anticipates that it may be unable to collect any contractually due amounts. This determination is based upon such factors as delinquencies, loss experience, collateral quality and current economic or borrower conditions. The Company’s collectability of its notes receivable may be adversely impacted by the financial stability of the Washington, D.C. region and the ability of its underlying assets to keep current tenants or attract new tenants. Estimated losses are recorded as a charge to earnings to establish an allowance for credit losses that the Company estimates to be adequate based on these factors. Based on the review of the above criteria, the Company did not record an allowance for credit losses for its notes receivable during the three months ended March 31, 2012 and 2011.

(e) Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation, primarily as a result of reclassifying the operating results of several properties that were disposed of after March 31, 2011 as discontinued operations. For more information, see footnote 7, Discontinued Operations.

(f) Application of New Accounting Standards

In June 2011, new accounting guidance was issued that allows only two options for presenting the components of net income (loss) and comprehensive income (loss): (1) in a single continuous financial statement, a statement of comprehensive income (loss), or (2) in two separate but consecutive financial statements, consisting of an income statement followed by a separate statement of comprehensive income (loss). Also, items that are reclassified from other comprehensive income to net income must be presented on the face of the consolidated financial statements. In the fourth quarter of 2011, the requirements to present reclassifications from other comprehensive income to net income were indefinitely deferred. The requirements to present comprehensive income in one of the options mentioned above were effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company adopted the new requirements on January 1, 2012. The Company’s adoption of this update changed the order in which its condensed consolidated financial statements are presented as the Company elected to present a separate statement of comprehensive loss.

In May 2011, additional disclosure requirements were issued that impact the Company’s disclosure of fair value measurements. The new requirements include: (1) quantitative disclosure about the Company’s Level 3 unobservable inputs and information about the Company’s valuation process and other qualitative information; (2) disclosure of all transfers between Level 1 and Level 2 of the fair value hierarchy; and (3) for items not measured at fair value, but for which the fair value is required to be disclosed, a description of the level in which the fair value measurements were determined. The Company adopted these requirements, which did not have a material impact on its condensed consolidated financial statements, on January 1, 2012.

 

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(3)	Earnings Per Share

Basic earnings or loss per share (“EPS”) is calculated by dividing net income or loss attributable to common shareholders by the weighted average common shares outstanding for the periods presented. Diluted EPS is computed after adjusting the basic EPS computation for the effect of dilutive common equivalent shares outstanding during the periods presented, which include stock options, non-vested shares, preferred shares and exchangeable senior notes. The Company applies the two-class method for determining EPS as its outstanding unvested shares with non-forfeitable dividend rights are considered participating securities. The Company’s excess of distributions over earnings related to participating securities are shown as a reduction in total earnings attributable to common shareholders in the Company’s computation of EPS.

The following table sets forth the computation of the Company’s basic and diluted earnings per share (amounts in thousands, except per share amounts):

 

		Three Months Ended March 31,
		2012				2011
Numerator for basic and diluted earnings per share:
Loss from continuing operations		$	(3,177	)		$	(1,121	)
Loss from discontinued operations			(297	)			(2,771	)
Net loss			(3,474	)			(3,892	)
Less: Net loss from continuing operations attributable to noncontrolling interests			302				70
Less: Net loss from discontinued operations attributable to noncontrolling interests			16				68
Net loss attributable to First Potomac Realty Trust			(3,156	)			(3,754	)
Less: Dividends on preferred shares			(2,664	)			(1,783	)
Net loss available to common shareholders			(5,820	)			(5,537	)
Less: Allocation to participating securities			(141	)			(137	)
Net loss attributable to common shareholders		$	(5,961	)		$	(5,674	)
Denominator for basic and diluted earnings per share:
Weighted average shares outstanding – basic and diluted			49,781				49,234
Basic and diluted earnings per share:
Loss from continuing operations		$	(0.11	)		$	(0.07	)
Loss from discontinued operations			(0.01	)			(0.05	)
Net loss		$	(0.12	)		$	(0.12	)

In accordance with accounting requirements regarding earnings per share, the Company did not include the following potential common shares in its calculation of diluted earnings per share as they are anti-dilutive (amounts in thousands):

 

		Three Months Ended March 31,
		2012				2011
Stock option awards			1,462				902
Non-vested share awards			521				421
Conversion of Exchangeable Senior Notes(1)			—				854
Series A Preferred Shares(2)			9,218				7,302
			11,201				9,479

 

(1)	On December 15, 2011, the Company repaid the outstanding balance of $30.4 million on its Exchangeable Senior Notes. At March 31, 2011, each $1,000 principal amount of the Exchangeable Senior Notes was convertible into 28.039 common shares.

(2)

The Company’s Series A Preferred Shares, which have a $25 per share liquidation value, are only convertible into the Company’s common shares upon certain changes in control of the Company. The dilutive shares are calculated as the daily average of the face value of the Series A Preferred Shares divided by the outstanding common share price. In March 2012, the Company issued an additional 1.8 million Series A Preferred Shares.

 

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(4)	Rental Property

Rental property represents property, net of accumulated depreciation, and developable land that are wholly-owned or owned by an entity in which the Company has a controlling interest. All of the Company’s rental properties are located within the greater Washington, D.C. region. Rental property consists of the following (amounts in thousands):

 

		March 31, 2012				December 31, 2011
Land and land improvements		$	387,227			$	384,409
Buildings and improvements			1,061,005				1,052,341
Construction in process			57,081				70,362
Tenant improvements			125,705				116,148
Furniture, fixtures and equipment			5,415				5,400
			1,636,433				1,628,660
Less: accumulated depreciation			(198,586	)			(188,999	)
		$	1,437,847			$	1,439,661

Development and Redevelopment Activity

The Company constructs office buildings, business parks and/or industrial buildings on a build-to-suit basis or with the intent to lease upon completion of construction. Also, the Company owns developable land that can accommodate 2.4 million square feet of additional building space. Below is a summary of the approximate building square footage that can be developed on the Company’s developable land and the Company’s current development and redevelopment activity as of March 31, 2012 (amounts in thousands):

 

Reporting Segment		Developable Square Feet				Square Feet Under Development				Cost to Date of Development Activities				Square Feet Under Redevelopment				Cost to Date of Redevelopment Activities(1)
Washington, D.C.			713				—			$	—				135			$	2,755
Maryland			250				—				—				—				—
Northern Virginia			568				—				—				209				12,044
Southern Virginia			841				166				582				—				—
			2,372				166			$	582				344			$	14,799

 

(1)	Costs to date of redevelopment activities excludes tenant improvements and leasing commissions.

At March 31, 2012, the Company had substantially completed development and redevelopment activities that have yet to be placed in service on 209,000 square feet, at a cost of $12.0 million, in its Northern Virginia reporting segment. The majority of the costs on the construction projects to be placed in service relate to redevelopment activities at Three Flint Hill, located in the Company’s Northern Virginia reporting segment. The Company will place completed construction activities in service upon the shorter of a tenant taking occupancy or twelve months from substantial completion.

During the first quarter of 2012, the Company completed and placed in-service development and redevelopment efforts totaling 93,000 square feet at Sterling Park Business Center and Three Flint Hill, at a cost of $7.2 million, in its Northern Virginia reporting segment.

 

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(5)	Notes Receivable

Below is a summary of the Company’s notes receivable at March 31, 2012 (dollars in thousands):

 

		Balance at March 31, 2012
Issued		Face Amount				Unamortized Origination Costs				Balance				Interest Rate				Property
December 2010		$	25,000			$	(200	)		$	24,800				12.5	%		950 F Street, NW
April 2011			30,000				(121	)			29,879				9.0	%		America’s Square
		$	55,000			$	(321	)		$	54,679

 

		Balance at December 31, 2011
Issued		Face Amount				Unamortized Origination Costs				Balance				Interest Rate				Property
December 2010		$	25,000			$	(211	)		$	24,789				12.5	%		950 F Street, NW
April 2011			30,000				(128	)			29,872				9.0	%		America’s Square
		$	55,000			$	(339	)		$	54,661

During the three months ended March 31, 2012 and 2011, the Company recorded interest income of $1.5 million and $0.8 million, respectively, related to its notes receivable.

The notes require monthly payments of interest to the Company. During the three months ended March 31, 2012 and 2011, the Company recorded income from the amortization of origination costs of $17 thousand and $10 thousand, respectively, within “Interest and other income” in its consolidated statements of operations.

 

(6)	Investment in Affiliates

The Company owns an interest in several properties in which it does not control the activities that are most significant to the operations of the properties. As a result, the assets, liabilities and operating results of these noncontrolled properties are not consolidated within the Company’s condensed consolidated financial statements. The Company’s investment in these properties is recorded as “Investment in affiliates” in its consolidated balance sheets. The Company’s investment in affiliates consisted of the following at March 31, 2012 (dollars in thousands):

 

		Reporting Segment		Ownership Interest		Company Investment
1200 17th Street, NW		Washington, D.C.		95%		$	21,279
Metro Place III & IV		Northern Virginia		51%			27,926
1750 H Street, NW		Washington, D.C.		50%			16,573
Aviation Business Park		Maryland		50%			4,658
RiversPark I and II		Maryland		25%			2,864
						$	73,300

 

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The net assets of the Company’s unconsolidated joint ventures consisted of the following (amounts in thousands):

 

		March 31, 2012				December 31, 2011
Assets:
Rental property, net		$	242,311			$	242,767
Cash and cash equivalents			6,465				4,009
Other assets			21,194				22,734
Total assets			269,970				269,510
Liabilities:
Mortgage loans(1)			131,639				132,370
Other liabilities			7,786				7,207
Total liabilities			139,425				139,577
Net assets		$	130,545			$	129,933

 

(1)	Of the total mortgage debt that encumbers the Company’s unconsolidated properties, $7.0 million is recourse to the Company. The fair value of the potential liability to the Company is inconsequential as the likelihood of the debt being called is remote.

The Company’s share of earnings or losses related to its unconsolidated joint ventures is recorded in its consolidated statements of operations as “Equity in losses of affiliates.” The following table summarizes the results of operations of the Company’s unconsolidated joint ventures, which due to its varying ownership interests in the joint ventures and the varying operations of the joint ventures may or may not be reflective of the amounts recorded in its consolidated statements of operations (amounts in thousands):

 

		Three Months Ended March 31,
		2012				2011
Total revenues		$	6,080			$	3,078
Total operating expenses			(1,768	)			(1,136	)
Net operating income			4,312				1,942
Depreciation and amortization			(3,168	)			(1,302	)
Other expenses, net			(1,082	)			(723	)
Net income (loss)		$	62			$	(83	)

The Company earns various fees from several of its joint ventures, which include management fees, leasing commissions and construction management fees. The Company recognizes fees only to the extent of the third party ownership interest in its unconsolidated joint ventures. The Company recognized $79 thousand and $48 thousand in fees from joint ventures during the three months ended March 31, 2012 and 2011, respectively.

 

(7)	Discontinued Operations

In March 2012, the Company sold its Airpark Place Business Center property, a three-building, 82,400 square foot business park in Gaithersburg, Maryland for net sale proceeds of $5.2 million. During 2011, the Company recorded impairment charges totaling $3.6 million and, during the first quarter of 2012, recorded an immaterial impairment charge based on the difference between the contractual sales price less anticipated selling costs and the carrying value of the property.

During the first quarter of 2012, the Company entered into a contract, which became binding in April 2012, to sell Woodlands Business Center, a 38,000 square foot office building in Largo, Maryland, which the Company acquired as part of a portfolio acquisition in 2004. The property was sold in May 2012 for net proceeds of $2.9 million. The Company recorded impairment charges of $1.6 million in 2011 and $0.2 million in the first quarter of 2012 based on the difference between the contractual sales price less anticipated selling costs and the carrying value of the property. As of March 31, 2012, the Woodlands Business Center property met the GAAP held for sale criteria and, therefore, the property’s assets were classified within “Assets held for sale” and the property’s liabilities, which were immaterial, were classified within “Accounts payable and other liabilities” in the Company’s consolidated balance sheets.

In the second quarter of 2011, the Company sold its Gateway West property in Westminster, Maryland, which was acquired as part of a portfolio acquisition in 2004. Based on the contractual sales price less anticipated selling costs, the Company recorded a $2.7 million impairment charge related to the sale during the first quarter of 2011.

 

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The following table is a summary of property dispositions whose operating results are reflected as discontinued operations in the Company’s consolidated statements of operations for the periods presented:

 

Reporting Segment

Disposition Date

Property Type

Square Feet

Woodlands Business Center

Maryland

5/8/2012

(1)

Office

37,887

Airpark Place Business Center

Maryland

3/22/2012

Business Park

82,429

Aquia Commerce Center I & II

Northern Virginia

6/22/2011

Office

64,488

Gateway West

Maryland

5/27/2011

Office

111,481

Old Courthouse Square

Maryland

2/18/2011

Retail

201,208

 

(1)	The property was classified as held-for-sale at March 31, 2012.

The Company has had, and will have, no continuing involvement with any of its disposed properties subsequent to their disposal. The operations of the disposed properties were not subject to any income based taxes. The Company did not dispose of or enter into any binding agreements to sell any other properties during the three months ended March 31, 2012 and 2011.

The following table summarizes the components of net loss from discontinued operations (amounts in thousands):

 

		Three Months Ended March 31,
		2012				2011
Revenues		$	208			$	974
Net loss, before taxes			(297	)			(2,771	)

 

(8)

Debt

The Company’s borrowings consisted of the following (amounts in thousands):

 

		March 31, 2012				December 31, 2011
Mortgage loans, effective interest rates ranging from 4.40% to 7.29%, maturing at various dates through June 2021		$	408,241			$	432,023
Series A senior notes, effective interest rate of 6.41%, maturing June 2013(1)			37,500				37,500
Series B senior notes, effective interest rate of 6.55%, maturing June 2016(1)			37,500				37,500
Secured term loan, effective interest rate of LIBOR plus 4.50%, with maturity dates in January 2013 and 2014(2)(3)			20,000				30,000
Unsecured term loan, effective interest rates ranging from LIBOR plus 2.15% to LIBOR plus 2.30%, with staggered maturity dates ranging from July 2016 to July 2018(3)(4)			300,000				225,000
Unsecured revolving credit facility, effective interest rate of LIBOR plus 2.50%, maturing January 2015(3)(5)			107,000				183,000
		$	910,241			$	945,023

 

(1)	Subsequent to March 31, 2012, a prepayment notice was sent with respect to the senior notes. See Note 16, Subsequent Events.

(2)	In January 2012, the Company repaid $10.0 million of the loan’s outstanding balance.

(3)	At March 31, 2012, LIBOR was 0.24%.

(4)	In February 2012, the Company increased its unsecured term loan by $75.0 million to $300.0 million.

(5)	The unsecured revolving credit facility matures in January 2014 with a one-year extension at the Company’s option, which it intends to exercise.

 

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(a) Mortgage Loans

The following table provides a summary of the Company’s mortgage debt at March 31, 2012 and December 31, 2011 (dollars in thousands):

 

Encumbered Property		Contractual Interest Rate				Effective Interest Rate				Maturity Date		March 31, 2012				December 31, 2011
Campus at Metro Park North(1)			7.11	%			5.25	%		February 2012		$	—			$	21,692
One Fair Oaks(2)			6.31	%			6.72	%		June 2012			52,502				52,604
1434 Crossways Blvd Building II			7.05	%			5.38	%		August 2012			8,999				9,099
Crossways Commerce Center			6.70	%			6.70	%		October 2012			23,600				23,720
Newington Business Park Center			6.70	%			6.70	%		October 2012			14,886				14,963
Prosperity Business Center			6.25	%			5.75	%		January 2013			3,346				3,381
Cedar Hill			6.00	%			6.58	%		February 2013			15,731				15,838
Merrill Lynch Building			6.00	%			7.29	%		February 2013			13,502				13,571
1434 Crossways Blvd Building I			6.25	%			5.38	%		March 2013			7,871				7,943
Linden Business Center			6.01	%			5.58	%		October 2013			6,875				6,918
840 First Street, NE			5.18	%			6.05	%		October 2013			55,486				55,745
Owings Mills Business Center			5.85	%			5.75	%		March 2014			5,310				5,338
Annapolis Business Center			5.74	%			6.25	%		June 2014			8,326				8,360
Cloverleaf Center			6.75	%			6.75	%		October 2014			16,829				16,908
Plaza 500, Van Buren Office Park, Rumsey Center, Snowden Center, Greenbrier Technology Center II, Norfolk Business Center, Northridge and 15395 John Marshall Highway			5.19	%			5.19	%		August 2015			97,301				97,681
Hanover Business Center:
Building D			8.88	%			6.63	%		August 2015			489				520
Building C			7.88	%			6.63	%		December 2017			889				920
Chesterfield Business Center:
Buildings C,D,G and H			8.50	%			6.63	%		August 2015			1,288				1,369
Buildings A,B,E and F			7.45	%			6.63	%		June 2021			2,192				2,235
Mercedes Center– Note 1			4.67	%			6.04	%		January 2016			4,704				4,713
Mercedes Center – Note 2			6.57	%			6.30	%		January 2016			9,666				9,722
Gateway Centre Manassas Building I			7.35	%			5.88	%		November 2016			971				1,016
Hillside Center			5.75	%			4.62	%		December 2016			14,026				14,122
500 First Street, NW			5.72	%			5.79	%		July 2020			38,143				38,277
Battlefield Corporate Center			4.26	%			4.40	%		November 2020			4,113				4,149
Airpark Business Center			7.45	%			6.63	%		June 2021			1,196				1,219
							5.97	%(3)					408,241				432,023
Unamortized fair value adjustments													(932	)			(1,147	)
Mortgage loans principal												$	407,309			$	430,876

 

(1)	The loan was repaid in February 2012 with borrowings on the Company’s unsecured revolving credit facility.

(2)	The Company intends to refinance the mortgage loan or, if it does not find refinancing terms acceptable, repay the loan with proceeds of additional borrowings under the unsecured revolving credit facility.

(3)	Weighted average interest rate on total mortgage debt.

(b) Term Loans

Unsecured Term Loan

In February 2012, the Company expanded its unsecured term loan from $225.0 million to $300.0 million and used the proceeds to pay down $73.0 million of the outstanding balance under its unsecured revolving credit facility and for other general corporate purposes.

 

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The table below shows the outstanding balances of the three tranches of the $300.0 million unsecured term loan at March 31, 2012 (dollars in thousands):

 

		Maturity Date		Amount				Interest Rate
Tranche A		July 2016		$	60,000			LIBOR, plus 215 basis points
Tranche B		July 2017			147,500			LIBOR, plus 225 basis points
Tranche C		July 2018			92,500			LIBOR, plus 230 basis points
				$	300,000

The term loan agreement contains various restrictive covenants substantially similar to those contained in the Company’s revolving credit facility, including with respect to liens, indebtedness, investments, distributions, mergers and asset sales. In addition, the agreement requires that the Company satisfy certain financial covenants that are also substantially similar to those contained in the Company’s revolving credit facility. The agreement also includes customary events of default, the occurrence of which, following any applicable cure period, would permit the lenders to, among other things, declare the principal, accrued interest and other obligations of the Company under the agreement to be immediately due and payable.

Secured Term Loan

On January 13, 2012, the Company repaid $10.0 million of the outstanding balance on its secured term loan with borrowings under its unsecured revolving credit facility. Of the $20.0 million balance at March 31, 2012, $10.0 million matures in January 2013 and $10.0 million matures in January 2014. At March 31, 2012, the loan’s applicable interest rate was LIBOR plus 450 basis points, which will increase to 550 basis points in January 2013. Interest on the loan is payable on a monthly basis. The Company’s secured term loan contains several restrictive covenants, which in the event of non-compliance may cause the outstanding balance of the loan and accrued interest to become immediately due and payable.

(c) Unsecured Revolving Credit Facility

During the first quarter of 2012, the Company repaid $120.0 million of the outstanding balance of its unsecured revolving credit facility with proceeds from the expansion of its unsecured term loan, the issuance of its Series A Cumulative Redeemable Perpetual Preferred Shares (the “Series A Preferred Shares”) and available cash. During the first quarter of 2012, the Company borrowed $44.0 million on its unsecured revolving credit facility, which was used to repay the outstanding balance on a mortgage loan, to make a $10.0 million principal payment on a secured term loan and for general corporate purposes. The weighted average borrowings outstanding on the unsecured revolving credit facility were $161.0 million with a weighted average interest rate of 2.8% for the three months ended March 31, 2012, compared with $114.6 million and 3.3%, respectively, for the three months ended March 31, 2011. The Company’s maximum outstanding borrowings were $198.0 million and $191.0 million during the three months ended March 2012 and 2011, respectively. At March 31, 2012, outstanding borrowings under the unsecured revolving credit facility were $107.0 million with a weighted average interest rate of 2.7%. The Company is required to pay an annual commitment fee of 0.25% based on the amount of unused capacity under the unsecured revolving credit facility. As of March 31, 2012, the available capacity under the unsecured revolving credit facility was $148.0 million. The Company’s ability to borrow under the credit facility is subject to its satisfaction of certain financial and restrictive covenants.

(d) Interest Rate Swap Agreements

During the first quarter of 2012, the Company entered into four interest rate swap agreements that fixed LIBOR on $75.0 million of its variable rate debt. At March 31, 2012, the Company had fixed LIBOR, at a weighted average interest rate of 1.6328%, on $275.0 million of its variable rate debt through ten interest rate swap agreements. See footnote 10, Derivative Instruments, for more information about the Company’s interest rate swap agreements.

(e) Financial Covenants

The Company’s outstanding corporate debt agreements contain specific financial covenants that may impact future financing decisions made by the Company or may be impacted by a decline in operations. These covenants differ by debt instrument and relate to the Company’s allowable leverage, minimum tangible net worth, fixed charge coverage and other financial metrics. As of March 31, 2012, after giving effect to the amendments described in Note 16, Subsequent Events, the Company was in compliance with all of the financial covenants of its unsecured term loan, secured term loan and unsecured revolving credit facility (together “Bank Debt”). In connection with the Internal Investigation and the review of the Company’s financial and other non-financial covenants contained in its Bank Debt and its 6.41% Series A Senior Notes and 6.55% Series B Senior Notes (collectively, the “Senior Notes”) agreements and further clarification provided as a result of such review, the Company determined it would not have been in compliance with certain of the financial covenants under the documents governing the Senior Notes, as of March 31, 2012, and for one or more prior periods, including the fourth quarter of 2010. However, in connection with the amendments to the Bank Debt agreements, the lenders under the Bank Debt agreements waived, among other things, any cross-defaults with respect to financial covenant non-compliance under the Senior Notes that may have existed with respect to periods prior to the date of such amendments. As a result, any financial covenant non-compliance under the Senior Notes would not create an event of default under the Company’s Bank Debt agreements. Furthermore, the sole remedy available to the holders of the Senior Notes upon the occurrence of an event of default is to accelerate the maturity thereof and to receive a make-whole amount in connection therewith. The Company already sent notices of prepayment to the holders of the Senior Notes on May 11, 2012, pursuant to which the Senior Notes will be repaid on or prior to June 11, 2012, including the payment of a make-whole amount (see footnote 16, Subsequent Events, for further discussion).

 

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The Company’s continued ability to borrow under the revolving credit facility is subject to compliance with financial and operating covenants, and a failure to comply with any of these covenants could result in a default under the credit facility. These debt agreements also contain cross-default provisions that would be triggered if the Company is in default under other loans, including mortgage loans, in excess of certain amounts. In the event of a default, the lenders could accelerate the timing of payments under the debt obligations and the Company may be required to repay such debt with capital from other sources, which may not be available on attractive terms, or at all, which would have a material adverse effect on the Company’s liquidity, financial condition, results of operations and ability to make distributions to our shareholders.

 

(9)	Income Taxes

The Company owns properties located in Washington, D.C. that are subject to local income based franchise taxes at an effective rate of 9.975%. During the three months ended March 31, 2012, the Company recognized a provision for income taxes of $0.1 million and recognized a benefit from income taxes of $0.3 million during the three months ended March 31, 2011. The Company also has interests in two unconsolidated joint ventures that own real estate in Washington, D.C. that are subject to the franchise tax. The impact for income taxes related to these unconsolidated joint ventures is reflected within “Equity in losses of affiliates” in the Company’s consolidated statements of operations.

The Company recognizes deferred tax assets only to the extent that it is more likely than not that deferred tax assets will be realized based on consideration of available evidence, including future reversals of existing taxable temporary differences, future projected taxable income and tax planning strategies. The Company expects to amortize its current deferred tax assets over the life of their respective underlying assets or 39 years. The Company’s deferred tax assets and liabilities are primarily associated with differences in the GAAP and tax basis of recently acquired real estate assets, particularly acquisition costs, but also including intangible assets and deferred market rent assets and liabilities, that are associated with properties located in Washington, D.C. and recorded in its consolidated balance sheets.

The Company has not recorded a valuation allowance as it determined that it is more likely than not that future operations will generate sufficient taxable income to realize the deferred tax assets. The Company has not recognized any deferred tax assets or liabilities as a result of uncertain tax positions and has no material net operating loss, capital loss or alternative minimum tax carryovers. There was no benefit or provision for income taxes associated with the Company’s discontinued operations for any period presented. At March 31, 2012 and December 31, 2011, the Company had deferred tax assets totaling $2.1 million and $1.4 million, respectively, and deferred tax liabilities totaling $5.5 million and $5.0 million, respectively. At March 31, 2012 and December 31, 2011, the Company recorded its deferred tax assets within “Prepaid expenses and other assets” and recorded its deferred tax liabilities within “Accounts payable and other liabilities” in the Company’s consolidated balance sheets.

As the Company believes it both qualifies as a REIT and will not be subject to federal income tax, a reconciliation between the income tax provision calculated at the statutory federal income tax rate and the actual income tax provision has not been provided.

 

(10)	Derivative Instruments

The Company is exposed to certain risks arising from business operations and economic factors. The Company uses derivative financial instruments to manage exposures that arise from business activities in which its future exposure to interest rate fluctuations is unknown. The objective in the use of an interest rate derivative is to add stability to interest expenses and manage exposure to interest rate changes. The Company does not use derivatives for trading or speculative purposes and intends to enter into derivative agreements only with counterparties that it believes have a strong credit rating to mitigate the risk of counterparty default or insolvency. No hedging activity can completely insulate the Company from the risks associated with changes in interest rates. Moreover, interest rate hedging could fail to protect the Company or adversely affect it because, among other things:

 

•

available interest rate hedging may not correspond directly with the interest rate risk for which the Company seeks protection;

 

•

the duration of the hedge may not match the duration of the related liability;

 

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•

the party owing money in the hedging transaction may default on its obligation to pay; and

 

•

the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs the Company’s ability to sell or assign its side of the hedging transaction.

The Company enters into interest rate swap agreements to hedge its exposure on its variable rate debt against fluctuations in prevailing interest rates. The interest rate swap agreements fix LIBOR to a specified interest rate; however, the swap agreements do not affect the contractual spreads associated with each variable debt instrument’s applicable interest rate. During the first quarter of 2012, the Company entered into four interest rate swap agreements that fixed LIBOR on $75.0 million of its variable rate debt. At March 31, 2012, the Company had fixed LIBOR at a weighted average rate of 1.6328% on $275.0 million of its variable rate debt through ten interest rate swap agreements that are summarized below (dollars in thousands):

 

Effective Date		Maturity Date		Amount				Interest Rate Contractual Component				Fixed LIBOR Interest Rate
January 2011		January 2014		$	50,000				LIBOR				1.474	%
July 2011		July 2016			35,000				LIBOR				1.754	%
July 2011		July 2016			25,000				LIBOR				1.7625	%
July 2011		July 2017			30,000				LIBOR				2.093	%
July 2011		July 2017			30,000				LIBOR				2.093	%
September 2011		July 2018			30,000				LIBOR				1.660	%
January 2012		July 2018			25,000				LIBOR				1.394	%
March 2012		July 2017			25,000				LIBOR				1.129	%
March 2012		July 2017			12,500				LIBOR				1.129	%
March 2012		July 2018			12,500				LIBOR				1.383	%
					$275,000

The Company’s interest rate swap agreements are designated as cash flow hedges and the Company records any unrealized gains associated with the change in fair value of the swap agreements within “Accumulated other comprehensive loss” and “Prepaid expenses and other assets” and any unrealized losses within “Accumulated other comprehensive loss” and “Accounts payable and other liabilities” on its consolidated balance sheets. The Company records its proportionate share of any unrealized gains or losses on its cash flow hedges associated with its unconsolidated joint ventures within “Accumulated other comprehensive loss” and “Investment in affiliates” on its consolidated balance sheets. The Company records any cash received or paid as a result of each interest rate swap agreement’s fixed rate deviating from its respective loan’s contractual rate within “Interest expense” in its consolidated statements of operations. The Company did not have any ineffectiveness associated with its cash flow hedges during the three months ended March 31, 2012 and 2011, which would have been recorded in earnings, and does not expect any future ineffectiveness. Therefore, no amounts have been or are expected to be reclassified from “Accumulated other comprehensive loss” into earnings.

 

(11)	Fair Value Measurements

The Company adopted accounting provisions that outline a valuation framework and create a fair value hierarchy, which distinguishes between assumptions based on market data (observable inputs) and a reporting entity’s own assumptions about market data (unobservable inputs). The new disclosures increase the consistency and comparability of fair value measurements and the related disclosures. Fair value is identified, under the standard, as the price that would be received to sell an asset or paid to transfer a liability between willing third parties at the measurement date (an exit price). In accordance with GAAP, certain assets and liabilities must be measured at fair value, and the Company provides the necessary disclosures that are required for items measured at fair value as outlined in the accounting requirements regarding fair value.

Financial assets and liabilities, as well as those non-financial assets and liabilities requiring fair value measurement, are measured using inputs from three levels of the fair value hierarchy.

The three levels are as follows:

Level 1 - Inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date. An active market is defined as a market in which transactions for the assets or liabilities occur with sufficient frequency and volume to provide pricing information on an ongoing basis.

 

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Level 2 - Inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active (markets with few transactions), inputs other than quoted prices that are observable for the asset or liability (i.e., interest rates, yield curves, etc.), and inputs derived principally from or corroborated by observable market data correlation or other means (market corroborated inputs).

Level 3 - Unobservable inputs, only used to the extent that observable inputs are not available, reflect the Company’s assumptions about the pricing of an asset or liability.

In accordance with accounting provisions and the fair value hierarchy described above, the following table shows the fair value of the Company’s consolidated assets and liabilities that are measured on a non-recurring and recurring basis as of March 31, 2012 and December 31, 2011 (amounts in thousands):

 

		Balance at March 31,  2012				Level 1				Level 2				Level 3
Non-recurring Measurements:
Impaired real estate assets		$	18,516			$	—			$	2,929			$	15,587
Recurring Measurements:
Derivative instrument-swap assets			344				—				344				—
Derivative instrument-swap liabilities			5,746				—				5,746				—
Contingent consideration related to acquisition of:
Corporate Campus at Ashburn Center			1,448				—				—				1,448
840 First Street, NE			745				—				—				745
		Balance at December 31, 2011				Level 1				Level 2				Level 3
Non-recurring Measurements:
Impaired real estate assets		$	10,583			$	—			$	5,250			$	5,333
Recurring Measurements:
Derivative instrument-swap liabilities			6,129				—				6,129				—
Contingent consideration related to acquisition of:
Corporate Campus at Ashburn Center			1,448				—				—				1,448
840 First Street, NE			745				—				—				745

Impairment of Real Estate Assets

The Company regularly reviews market conditions for possible impairment of a property’s carrying value. When circumstances such as adverse market conditions, changes in management’s intended holding period or potential sale to a third party indicate a possible impairment of a property, an impairment analysis is performed.

During the first quarter of 2012, the Company reduced its intended holding period for its Owings Mills Business Park property, which is located in the Company’s Maryland reporting segment. Based on an analysis of the property’s cash flows over the Company’s reduced holding period for the property, the Company recorded an impairment charge of $2.8 million in the first quarter of 2012. The Company determined the fair value of the property through an assessment of market data and through an income approach based on discounted cash flows of the future operations and disposition of the property over a reduced holding period.

In April 2012, the Company entered into a binding contract to sell its Woodlands Business Center property and recorded an additional impairment charge of $0.2 million to reduce the Woodlands Business Center property’s carrying value to reflect its fair value, less anticipated selling costs at March 31, 2012. The property was sold in May 2012 for net proceeds of $2.9 million. As of March 31, 2012, the Woodlands Business Center property met the GAAP guidelines to classify its assets and liabilities as held-for-sale in the Company’s consolidated balance sheets and reflected its operating results as discontinued operations in the Company’s consolidated statements of operations for each of the periods presented.

 

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During the fourth quarter of 2011, the Company reduced its intended holding period for its Woodlands Business Center and Goldenrod Lane properties, which are both located in the Company’s Maryland reporting segment. Based on an analysis of each property’s cash flows over the Company’s reduced holding period for each respective property, the Company recorded impairment charges of $1.6 million and $0.9 million, respectively, in the fourth quarter of 2011. The Company determined the fair value of the properties through an assessment of market data and through an income approach based on discounted cash flows anticipated over a reduced holding period. The Company signed an agreement to sell its Goldenrod property in April 2012. The sale is expected to close during the second quarter of 2012.

During the third quarter of 2011, the Company reduced its intended holding period for its Airpark Place Business Center property, which is located in its Maryland reporting segment. Based on an analysis of the property’s anticipated cash flows over the Company’s reduced holding period for the property, the Company recorded an impairment charge of $3.1 million in the third quarter of 2011. In January 2012, the Company entered into a binding contract to sell the property and recorded an impairment charge of $0.4 million to reduce the property’s carrying value to reflect its fair value, less anticipated selling costs at December 31, 2011. The property was sold in March 2012 for net proceeds of $5.2 million. The Company determined the fair value of the property based on the execution of a contract to sell.

For the three months ended March 31, 2012 and 2011, the Company incurred impairment charges of $3.0 million and $2.7 million, respectively. The Company recorded the $2.8 million Owings Mills Business Park impairment charge described above within continuing operations on its consolidated statements of operations. The remaining impairment charges incurred during the three months ended March 31, 2012 and 2011 relate to properties that were or will be subsequently disposed of, including Woodlands Business Center, which was sold in May 2012, and are recorded within discontinued operations in the Company’s consolidated statements of operations.

Interest Rate Derivatives

During the first quarter of 2012, the Company entered into four interest rate swap agreements that fixed LIBOR on $75.0 million of its variable rate debt. At March 31, 2012, the Company had fixed LIBOR, at a weighted average rate of 1.6328%, on $275.0 million of its variable rate debt through ten interest rate swap agreements. See footnote 10, Derivative Instruments, for more information about the Company’s interest rate swap agreements.

The interest rate derivatives are fair valued based on prevailing market yield curves on the measurement date. The Company uses a third party to value its interest rate swap agreements. The third party takes a daily “snapshot” of the market to obtain close of business rates. The snapshot includes over 7,500 rates including LIBOR fixings, Eurodollar futures, swap rates, exchange rates, treasuries, etc. This market data is obtained via direct feeds from Bloomberg and Reuters and from Inter-Dealer Brokers. The selected rates are compared to their historical values. Any rate that has changed by more than normal mean and related standard deviation would be considered an outlier and flagged for further investigation. The rates are then compiled through a valuation process that generates daily valuations, which are used to value the Company’s interest rate swap agreements.

 

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Contingent Consideration

On March 25, 2011, the Company acquired 840 First Street, NE, in Washington, D.C. for an aggregate purchase price of $90.0 million, with up to $10.0 million of additional consideration payable in Operating Partnership units upon the terms of a lease renewal by the building’s sole tenant or the re-tenanting of the property through November 2013. Based on assessment of the probability of renewal and anticipated lease rates, the Company recorded a contingent consideration obligation of $9.4 million at acquisition. In July 2011, the building’s sole tenant renewed its lease through August 2023 on the entire building with the exception of two floors. As a result, the Company issued 544,673 Operating Partnership units to satisfy $7.1 million of its contingent consideration obligation. The Company recognized a $1.5 million gain associated with the issuance of the additional units, which represented the difference between the contractual value of the units and the fair value of the units at the date of issuance. The fair value of the contingent consideration obligation was determined based on several probability weighted discounted cash flow scenarios that projected stabilization being achieved at certain timeframes. The fair value was based, in part, on significant inputs, which are not observable in the market, thus representing a Level 3 measurement in accordance with the fair value hierarchy. At March 31, 2012, the contingent consideration obligation was $0.7 million, which may result in the issuance of additional units dependent upon the leasing of any of the vacant space.

The Company has a contingent consideration obligation associated with the 2009 acquisition of Corporate Campus at Ashburn Center. As part of the acquisition price of Corporate Campus at Ashburn Center, the Company entered into a fee agreement with the seller under which the Company will be obligated to pay additional consideration upon the property achieving stabilization per specified terms of the agreement. The Company determines the fair value of the obligation through an income approach based on discounted cash flows that project stabilization being achieved within a certain timeframe. The more significant inputs associated with the fair value determination of the contingent consideration include estimates of capitalization rates, discount rates and various assumptions regarding the property’s operating performance and profitability. The fair value was based, in part, on significant inputs, which are not observable in the market, thus representing a Level 3 measurement in accordance with the fair value hierarchy. At March 31, 2012, the contingent consideration obligation was $1.4 million.

The Company did not recognize any additional gains or losses associated with its contingent consideration, as there was no change in the fair value of the contingent consideration, for the three months ended March 31, 2012 and 2011.

With the exception of its contingent consideration obligations, the Company did not re-measure or complete any transactions involving non-financial assets or non-financial liabilities that are measured on a recurring basis during the three months ended March 31, 2012 and 2011. Also, no transfers into and out of fair value measurements levels for assets or liabilities that are measured on a recurring basis occurred during the three months ended March 31, 2012 and 2011.

Financial Instruments

The carrying amounts of cash equivalents, accounts and other receivables, accounts payable and other liabilities, with the exception of any items listed above, approximate their fair values due to their short-term maturities. The Company determines the fair value of its notes receivable and debt instruments by discounting future contractual principal and interest payments using prevailing market rates for securities with similar terms and characteristics at the balance sheet date. The Company deems the fair value measurement of its debt instruments as a Level 2 measurement as the Company uses quoted interests rates for similar debt instruments to value its debt instruments. The Company also uses quoted market interest rates to value its notes receivable, which the Company considers a Level 2 measurement as it does not believe notes receivable trade in an active market.

 

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The carrying amount and estimated fair value of the Company’s notes receivable and debt instruments at March 31, 2012 and December 31, 2011 are as follows (amounts in thousands):

 

		March 31, 2012								December 31, 2011
		Carrying Value				Fair Value				Carrying Value				Fair Value
Financial Assets:
Notes receivable(1)		$	54,679			$	55,000			$	54,661			$	55,000
Financial Liabilities:
Mortgage debt		$	408,241			$	416,942			$	432,023			$	437,593
Series A senior notes			37,500				39,098				37,500				39,128
Series B senior notes			37,500				41,904				37,500				41,383
Secured term loan(2)			20,000				20,265				30,000				29,990
Unsecured term loan(3)			300,000				300,376				225,000				224,388
Unsecured revolving credit facility			107,000				107,518				183,000				182,740
Total		$	910,241			$	926,103			$	945,023			$	955,222

 

(1)	The face value of the Company’s notes receivable was $55.0 million at March 31, 2012 and December 31, 2011.

(2)	During the first quarter of 2012, the Company made a $10.0 million principal payment on its secured term loan.

(3)	During the first quarter of 2012, the Company expanded its unsecured term loan by $75.0 million.

 

(12)

Equity

In March 2012, the Company issued 1.8 million additional Series A Preferred Shares with a liquidation preference of $25.00 per share, which generated net proceeds of approximately $44 million. The issuance costs were recorded as a reduction to the Company’s “Additional paid in capital” in its consolidated balance sheets. Dividends on the additional Series A Preferred Shares are cumulative and payable on a quarterly basis beginning on May 15, 2012, at a rate of 7.750%. The Series A Preferred Shares are convertible into the Company’s common shares upon certain changes in control of the Company and have no maturity date or voting rights. The Company can redeem the Series A Preferred Shares, at their par value plus accrued and unpaid dividends, any time after January 18, 2016. The Company used the net proceeds from the issuance of the additional Series A Preferred Shares to repay a portion of the outstanding balance on its unsecured revolving credit facility. The offering was a reopening of the Company’s original issuance of the Series A Preferred Shares, which occurred in January 2011.

During the first quarter of 2012, the Company sold 245,000 common shares through its controlled equity offering program at a weighted average offering price of $14.83 per common share, generating net proceeds of $3.6 million. The Company used the proceeds for general corporate purposes. At March 31, 2012, the Company had 4.3 million common shares available for issuance under its controlled equity offering program.

On February 10, 2012, the Company paid a dividend of $0.20 per common share to common shareholders of record as of February 3, 2012 and, on February 15, 2012, paid a dividend of $0.484375 per share to preferred shareholders of record as of February 3, 2012. On April 24, 2012, the Company declared a dividend of $0.20 per common share, equating to an annualized dividend of $0.80 per common share. The dividend was paid on May 11, 2012 to common shareholders of record as of May 4, 2012. The Company also declared a dividend of $0.484375 per share on its Series A Preferred Shares. The dividend was paid on May 15, 2012 to preferred shareholders of record as of May 4, 2012. Dividends on all non-vested share awards are recorded as a reduction of shareholders’ equity. For each dividend paid by the Company on its common shares, the Operating Partnership distributes an equivalent distribution on its Operating Partnership common units.

The Company’s unsecured revolving credit facility, unsecured term loan, secured term loan and senior notes contain certain restrictions that include, among other things, requirements to maintain specified coverage ratios and other financial covenants, which may limit the Company’s ability to make distributions to its common and preferred shareholders. Further, distributions with respect to the Company’s common shares are subject to its ability to first satisfy its obligations to pay distributions to the holders of its Series A Preferred Shares.

 

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As a result of the redemption feature of the Operating Partnership units requiring delivery of registered shares of the Company, the noncontrolling interests associated with the Operating Partnerhsip are recorded outside of permanent equity. The Company’s equity and redeemable noncontrolling interests are as follows (amounts in thousands):

 

		First Potomac Realty Trust				Non-redeemable noncontrolling interests				Total Equity				Redeemable noncontrolling interests
Balance at December 31, 2011		$	672,246			$	4,245			$	676,491			$	39,981
Net (loss) income			(3,156	)			17				(3,139	)			(335	)
Changes in ownership, net			46,262				8				46,270				942
Distributions to owners			(12,337	)			—				(12,337	)			(583	)
Other comprehensive income			688				—				688				39
Balance at March 31, 2012		$	703,703			$	4,270			$	707,973			$	40,044

 

		First Potomac Realty Trust				Non- redeemable noncontrolling interests				Total Equity				Redeemable noncontrolling interests
Balance at December 31, 2010		$	614,983			$	3,077			$	618,060			$	16,122
Net loss			(3,754	)			(2	)			(3,756	)			(136	)
Changes in ownership, net			110,430				2				110,424				21,620
Distributions to owners			(10,649	)			—				(10,641	)			(191	)
Other comprehensive income			252				—				252				5
Balance at March 31, 2011		$	711,262			$	3,077			$	714,339			$	37,420

A summary of the Company’s accumulated other comprehensive loss is as follows (amounts in thousands):

 

		2012				2011
Beginning balance at January 1,		$	(5,849	)		$	(545	)
Net unrealized gain on derivative instruments			727				257
Net unrealized gain attributable to noncontrolling interests			(39	)			(5	)
Ending balance at March 31,		$	(5,161	)		$	(293	)

 

(13)	Noncontrolling Interests

(a) Noncontrolling Interests in the Operating Partnership

Noncontrolling interests relate to the common interests in the Operating Partnership not owned by the Company. Interests in the Operating Partnership are owned by limited partners who contributed buildings and other assets to the Operating Partnership in exchange for common Operating Partnership units. Limited partners have the right to tender their units for redemption in exchange for, at the Company’s option, common shares of the Company on a one-for-one basis or cash based on the fair value of the Company’s common shares at the date of redemption. Unitholders receive a distribution per unit equivalent to the dividend per common share. Differences between amounts paid to redeem noncontrolling interests and their carrying values are charged or credited to equity. As a result of the redemption feature of the Operating Partnership units, the noncontrolling interests are recorded outside of permanent equity.

Noncontrolling interests are presented at the greater of their fair value or their cost basis, which is comprised of their fair value at issuance, subsequently adjusted for the noncontrolling interests’ share of net income or losses available to common shareholders, other comprehensive income or losses, distributions received or additional contributions. The Company accounts for issuances of Operating Partnership units individually, which could result in some portion of its noncontrolling interests being carried at fair value with the remainder being carried at historical cost. Based on the closing share price of the Company’s common stock at March 31, 2012, the cost to acquire, through cash purchase or issuance of the Company’s common shares, all of the outstanding common Operating Partnership units not owned by the Company would be approximately $35.3 million. At March 31, 2012, the Company recorded an adjustment of $3.1 million to present certain noncontrolling interests at the greater of their carrying value or redemption value.

At March 31, 2012 and December 31, 2011, 2,920,561 of the total common Operating Partnership units were not owned by the Company. There were no common Operating Partnership units redeemed for common shares or with available cash during the three months ended March 31, 2012.

 

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(b) Noncontrolling Interests in the Consolidated Partnerships

When the Company is deemed to have a controlling interest in a partially-owned entity, it will consolidate all of the entity’s assets, liabilities and operating results within its condensed consolidated financial statements. The net assets contributed to the consolidated entity by the third party, if any, will be reflected within permanent equity in the Company’s consolidated balance sheets to the extent they are not mandatorily redeemable. The amount will be recorded based on the third party’s initial investment in the consolidated entity and will be adjusted to reflect the third party’s share of earnings or losses in the consolidated entity and any distributions received or additional contributions made by the third party. The earnings or losses from the entity attributable to the third party are recorded as a component of “Net loss attributable to noncontrolling interests” in the Company’s consolidated statements of operations.

At March 31, 2012, the Company’s consolidated joint ventures owned the following properties:

 

Property		Acquisition Date		Reporting Segment		First Potomac Controlling Interest		Square Footage
1005 First Street, NE		August 2011		Washington, D.C.		97%			30,414	(1)
Redland Corporate Center		November 2010		Maryland		97%			348,469

 

(1)	The site is currently occupied by Greyhound Bus Lines, Inc., which has announced its intention to relocate. Upon the tenant leaving, the Company intends on re-developing the site, which can accommodate up to 712,000 square feet of office space.

 

(14)	Share-Based Compensation

The Company records costs related to its share-based compensation based on the grant-date fair value calculated in accordance with GAAP. The Company recognizes share-based compensation costs on a straight-line basis over the requisite service period for each award and these costs are recorded within “General and administrative expense” or “Property operating expense” in the Company’s consolidated statements of operations based on the employee’s job function.

Stock Options Summary

During the first quarter of 2012, the Company awarded 627,500 stock options, which consisted of 500,000 stock options awarded to an officer and 127,500 stock options awarded to its non-officer employees. The stock options issued to the officer vest ratably over an eight-year service period. The options vest 12.5% on the first anniversary of the date of the grant and 3.125% in each subsequent calendar quarter. The stock options issued to its non-officer employees vest ratably over a four-year service period. The options vest 25% on the first anniversary of the date of grant and 6.25% in each subsequent calendar quarter. Both stock option awards described above have a 10-year contractual life. The Company recognized compensation expense related to stock options of $130 thousand and $65 thousand during the three months ended March 31, 2012 and 2011, respectively.

A summary of the Company’s stock option activity during the three months ended March 31, 2012 is presented below:

 

		Options				Weighted Average Exercise  Price				Weighted Average Remaining Contractual Term				Aggregate Intrinsic Value
Outstanding at December 31, 2011			887,168			$	16.76				4.4 years			$	293,930
Granted			627,500				14.70
Exercised			(907	)			10.43
Forfeited			(7,969	)			17.89
Outstanding at March 31, 2012			1,505,792			$	15.90				6.5 years			$	188,026
Exercisable at March 31, 2012			734,146			$	17.17				3.3 years			$	135,865
Options expected to vest, subsequent to March 31, 2012			736,991			$	14.71				9.5 years			$	49,031

 

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As of March 31, 2012, the Company had $2.4 million of unrecognized compensation cost, net of estimated forfeitures, related to stock option awards. The Company anticipates this cost will be recognized over a weighted-average period of approximately 6.1 years. The Company calculates the grant date fair value of option awards using a Black-Scholes option-pricing model. Expected volatility is based on an assessment of the Company’s realized volatility over the preceding period that is equivalent to the award’s expected life, which in management’s opinion, gives an accurate indication of future volatility. The expected term represents the period of time the options are anticipated to remain outstanding as well as the Company’s historical experience for groupings of employees that have similar behavior and are considered separately for valuation purposes. The risk-free rate is based on the U.S. Treasury rate at the time of grant for instruments of similar term.

The assumptions used in the fair value determination of stock options granted to employees in 2012 are summarized as follows:

Non-Officer Stock Option Award

 

Risk-free interest rate			0.83	%
Expected volatility			50.7	%
Expected dividend yield			5.71	%
Weighted average expected life of options			5 years

Officer Stock Option Award

 

Risk-free interest rate			1.39	%
Expected volatility			44.3	%
Expected dividend yield			5.71	%
Weighted average expected life of options			7 years

The weighted average grant date fair value of the stock options issued during the three months ended March 31, 2012 was $3.27 per share.

Option Exercises

The Company received approximately $9 thousand and $18 thousand from the exercise of stock options during the three months ended March 31, 2012 and 2011, respectively. New common shares are issued as a result of stock option exercises. The total intrinsic value of options exercised during the quarter ended March 31, 2012 and 2011 were $3 thousand and $10 thousand, respectively.

Non-vested share awards

The Company issues non-vested share awards that either vest over a specific time period that is identified at the time of issuance or vest upon the achievement of specific performance goals that are identified at the time of issuance. The Company issues new shares, subject to restrictions, upon each grant of non-vested share awards. In February 2012, the Company granted 249,654 restricted common shares to its officers. The non-vested shares will vest ratably over a five year term and fair value was determined based on the share price of the underlying common shares on the date of issuance.

The Company recognized $0.6 million of compensation expense associated with its non-vested share awards during both the three months ended March 31, 2012 and 2011. Dividends on all non-vested share awards are recorded as a reduction of equity. The Company applies the two-class method for determining EPS as its outstanding unvested shares with non-forfeitable dividend rights are considered participating securities. The Company’s excess of dividends over earnings related to participating securities are shown as a reduction in income available to common shareholders in the Company’s computation of EPS.

 

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A summary of the Company’s non-vested share awards as of March 31, 2012 is as follows:

 

		Non-vested Shares				Weighted Average Grant Date Fair Value
Non-vested at December 31, 2011			748,968			$	12.67
Granted			249,654				14.32
Vested			(109,282	)			16.00
Expired			(61,932	)			11.36
Non-vested at March 31, 2012			827,408			$	12.83

As of March 31, 2012, the Company had $6.7 million of unrecognized compensation cost related to non-vested shares. The Company anticipates this cost will be recognized over a weighted-average period of 4.0 years.

 

(15)	Segment Information

The Company’s reportable segments consist of four distinct reporting and operational segments within the greater Washington D.C, region in which it operates: Maryland, Washington, D.C., Northern Virginia and Southern Virginia. The Company evaluates the performance of its segments based on the operating results of the properties located within each segment, which excludes large non-recurring gains and losses, gains from sale of real estate assets, interest expense, general and administrative costs, acquisition costs or any other indirect corporate expense to the segments. In addition, the segments do not have significant non-cash items other than straight-line and deferred market rent amortization reported in their operating results. There are no inter-segment sales or transfers recorded between segments.

 

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The results of operations for the Company’s four reportable segments are as follows (dollars in thousands):

 

		Three Months Ended March 31, 2012
		Maryland				Washington, D.C.				Northern Virginia				Southern Virginia				Consolidated
Number of buildings			66				4				55				57				182
Square feet			3,878,306				666,714				3,665,510				5,649,491				13,860,021
Total revenues		$	14,406			$	6,826			$	13,315			$	12,225			$	46,772
Property operating expense			(3,828	)			(1,188	)			(3,113	)			(3,380	)			(11,509	)
Real estate taxes and insurance			(1,209	)			(1,042	)			(1,551	)			(1,044	)			(4,846	)
Total property operating income		$	9,369			$	4,596			$	8,651			$	7,801				30,417
Depreciation and amortization expense																			(16,091	)
General and administrative																			(4,897	)
Acquisition costs																			(17	)
Impairment of real estate assets																			(2,751	)
Other expenses, net																			(9,777	)
Provision for income taxes																			(61	)
Loss from discontinued operations																			(297	)
Net loss																		$	(3,474	)
Total assets(1)(2)		$	497,880			$	331,971			$	458,094			$	366,192			$	1,738,610
Capital expenditures(3)		$	8,052			$	863			$	6,458			$	3,012			$	18,989
		Three Months Ended March 31, 2011
		Maryland				Washington, D.C.				Northern Virginia				Southern Virginia				Consolidated
Number of buildings			71				4				57				55				187
Square feet			3,986,034				633,452				3,512,734				5,361,332				13,493,552
Total revenues		$	12,874			$	3,572			$	10,527			$	12,568			$	39,541
Property operating expense			(3,745	)			(721	)			(2,978	)			(3,102	)			(10,546	)
Real estate taxes and insurance			(1,120	)			(573	)			(1,188	)			(1,017	)			(3,898	)
Total property operating income		$	8,009			$	2,278			$	6,361			$	8,449				25,097
Depreciation and amortization expense																			(12,504	)
General and administrative																			(4,008	)
Acquisition costs																			(2,185	)
Other expenses, net																			(7,834	)
Benefit from income taxes																			313
Loss from discontinued operations																			(2,771	)
Net loss																		$	(3,892	)
Total assets(1)(2)		$	482,565			$	265,313			$	367,836			$	340,953			$	1,521,016
Capital expenditures(3)		$	2,799			$	260			$	3,608			$	1,755			$	9,110

 

(1)

Total assets include the Company’s investment in properties that are owned through joint ventures that are not consolidated within the Company’s financial statements. For more information on the Company’s unconsolidated investments, including location within the Company’s reportable segments, see footnote 6, Investment in Affiliates.

(2)	Corporate assets not allocated to any of our reportable segments totaled $84,473 and $64,349 at March 31, 2012 and 2011, respectively.

(3)	Capital expenditures for corporate assets not allocated to any of our reportable segments totaled $604 and $688 at March 31, 2012 and 2011, respectively.

 

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(16)	Subsequent Events

On May 10, 2012, the Company and its Bank Debt lenders amended the Company’s unsecured revolving credit facility, unsecured term loan and secured loan to, among other things, revise certain financial and other covenants to provide additional operating flexibility for the Company to execute its business strategy and clarify the treatment of certain covenant compliance-related definitions. In addition, the unsecured revolving credit facility and the unsecured term loan were amended to give the lenders the right, at their option, to record mortgages on substantially all of the Company’s unencumbered properties. The unsecured term loan also was amended to convert the fixed interest rate spread over LIBOR to an interest rate spread that is floating based on the Company’s leverage levels, which will have the effect of initially increasing the pricing of the unsecured term loan by 25 basis points. Pricing can increase by an additional 25 basis points to the extent the Company’s leverage levels increase further or can revert to the original pricing if the Company’s leverage ratio improves. In connection with these amendments, the lenders under those loan agreements waived (i) all financial covenant non-compliance, if any, and any cross-defaults related thereto, that may have existed with respect to periods prior to the date of such amendments and (ii) any claim to increased or additional interest that may have accrued and been owing by the Company as a result of any such default or event of default described in clause (i). Such waivers are effective with respect to such default or event of default, if any, as of the date such default or event of default occurred. The Company paid $1.2 million in financing costs to amend its unsecured revolving credit facility, unsecured term loan and secured term loan, half of which the Company anticipates expensing in the second quarter of 2012.

On May 11, 2012, the Company delivered notices regarding its intention to prepay in full the $37.5 million principal amount outstanding under each of its Series A and Series B Senior Notes, for an aggregate principal amount of $75.0 million, plus accrued interest to the prepayment date and an estimated $10.5 million make-whole amount, in accordance with the optional prepayment provisions governing the Senior Notes. The Company intends to draw on its unsecured revolving credit facility to finance the prepayment, which is expected to occur on or prior to June 11, 2012. As of the date of this filing, the Company has $141.0 million available under its unsecured revolving credit facility. The make-whole payment of $10.5 million and the extinguishment of unamortized deferred financing costs of $0.1 million will be recorded as a loss on early debt extinguishment in the second quarter of 2012, which is expected to be partially offset by a decrease in interest expense as a result of the lower interest rate on the Company’s unsecured credit facility, compared with the interest rate of the Senior Notes.

As previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, management identified a material weakness in the Company’s internal control over financial reporting as of December 31, 2011. In response to this material weakness, on March 20, 2012, the Company’s Board of Trustees appointed a special committee of independent trustees to review the facts and circumstances relating to the material weakness determination and the Company’s processes surrounding the monitoring and oversight of compliance with the Company’s financial covenants. The Board of Trustees determined in late April that a more detailed, internal investigation of these matters should be undertaken by the Audit Committee of the Board of Trustees (the “Internal Investigation”), with the assistance of independent outside professionals, which Internal Investigation is ongoing. The Company is unable to predict the ultimate outcome of the investigation, or the timing of its completion. See “Risk Factors—The Audit Committee of the Board of Trustees currently is conducting an internal investigation to review the facts and circumstances relating to management’s identification of a material weakness in our internal control over financial reporting as of December 31, 2011, and the processes surrounding the monitoring and oversight of compliance with our financial covenants. We are unable to predict the ultimate outcome and potential impact of the investigation, or the timing of its completion. In addition, we may be required to incur substantial costs and divert management resources in connection with the internal investigation and any related remedial measures, which could have a material adverse effect on our business, financial condition and results of operations.”

 

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ITEM 2:

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

The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q. The discussion and analysis is derived from the consolidated operating results and activities of First Potomac Realty Trust.

First Potomac Realty Trust (the “Company”) is a leader in the ownership, management, development and redevelopment of office and industrial properties in the greater Washington, D.C. region. The Company separates its properties into four distinct segments, which it refers to as the Washington, D.C., Maryland, Northern Virginia and Southern Virginia reporting segments. The Company strategically focuses on acquiring and redeveloping properties that it believes can benefit from its intensive property management and seeks to reposition these properties to increase their profitability and value. The Company’s portfolio contains a mix of single-tenant and multi-tenant office and industrial properties as well as business parks. Office properties are single-story and multi-story buildings that are used primarily for office use; business parks contain buildings with office features combined with some industrial property space; and industrial properties generally are used as warehouse, distribution or manufacturing facilities.

The Company conducts its business through First Potomac Realty Investment Limited Partnership, the Company’s operating partnership (the “Operating Partnership”). The Company is the sole general partner of, and, as of March 31, 2012, owned a 94.6% interest in the Operating Partnership. The remaining interests in the Operating Partnership, which are presented as noncontrolling interests in the Operating Partnership in the accompanying unaudited condensed consolidated financial statements, are limited partnership interests, some of which are owned by several of the Company’s executive officers and trustees who contributed properties and other assets to the Company upon its formation, and other unrelated parties.

At March 31, 2012, the Company wholly-owned or had a controlling interest in properties totaling 13.9 million square feet and had a noncontrolling ownership interest in properties totaling an additional 1.0 million square feet through six unconsolidated joint ventures. The Company also owned land that can accommodate approximately 2.4 million square feet of additional development. The Company’s consolidated properties were 83.0% occupied by 610 tenants. The Company does not include square footage that is in development or redevelopment in its occupancy calculation, which totaled 0.5 million square feet at March 31, 2012. The Company derives substantially all of its revenue from leases of space within its properties. As of March 31, 2012, the Company’s largest tenant was the U.S. Government, which along with government contractors, accounted for over 25% of the Company’s total annualized base rent.

The primary source of the Company’s revenue and earnings is rent received from customers under long-term (generally three to ten years) operating leases at its properties, including reimbursements from customers for certain operating costs. Additionally, the Company may generate earnings from the sale of assets either outright or contributed into joint ventures.

The Company’s long-term growth will principally be driven by its ability to:

 

•

maintain and increase occupancy rates and/or increase rental rates at its properties;

 

•

sell assets to third parties at favorable prices or contribute properties to joint ventures; and

 

•

continue to grow its portfolio through acquisition of new properties, potentially through joint ventures.

Executive Summary

For the three months ended March 31, 2012, the Company incurred a net loss of $3.5 million compared with a net loss of $3.9 million during the three months ended March 31, 2011. The Company’s net loss decreased for the three months ended March 31, 2012 compared with the same period in 2011 primarily due to a decrease in acquisition costs. The Company did not acquire any properties during the three months ended March 31, 2012 compared to the acquisition of three properties during the three months ended March 31, 2011, incurring $2.2 million in acquisition costs.

 

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The Company’s funds from operations (“FFO”) available to common shareholders were $14.4 million, or $0.27 per diluted share, for the three months ended March 31, 2012 compared with FFO of $10.4 million, or $0.21 per diluted share, for the three months ended March 31, 2011. The increase in FFO for the three months ended March 31, 2012 compared with the same period in 2011 is due to an increase in the Company’s net operating income, primarily related to its 2011 acquisitions, which resulted in a larger portfolio in 2012. FFO is a non-GAAP financial measure. For a description of FFO, including why management believes its presentation is useful and a reconciliation of FFO to net loss attributable to First Potomac Realty Trust, see “Funds From Operations.”

Significant Transactions

 

•

Executed 576,000 square feet of leases, generating over 127,000 square feet of positive net absorption;

 

•

Expanded unsecured term loan from $225.0 million to $300.0 million; and

 

•

Raised net proceeds of approximately $44 million through the issuance of 1.8 million additional 7.750% Series A Preferred Shares.

Internal Investigation

As previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, management identified a material weakness in the Company’s internal control over financial reporting as of December 31, 2011. In response to this material weakness, on March 20, 2012, the Company’s Board of Trustees appointed a special committee of independent trustees to review the facts and circumstances relating to the material weakness determination and the Company’s processes surrounding the monitoring and oversight of compliance with the Company’s financial covenants. The Board of Trustees determined in late April that a more detailed, internal investigation of these matters should be undertaken by the Audit Committee of the Board of Trustees (the “Internal Investigation”), with the assistance of independent outside professionals, which Internal Investigation is ongoing. The Company is unable to predict the ultimate outcome of the investigation, or the timing of its completion. See “Risk Factors—The Audit Committee of the Board of Trustees currently is conducting an internal investigation to review the facts and circumstances relating to management’s identification of a material weakness in our internal control over financial reporting as of December 31, 2011, and the processes surrounding the monitoring and oversight of compliance with our financial covenants. We are unable to predict the ultimate outcome and potential impact of the investigation, or the timing of its completion. In addition, we may be required to incur substantial costs and divert management resources in connection with the internal investigation and any related remedial measures, which could have a material adverse effect on our business, financial condition and results of operations.”

In light of the ongoing Internal Investigation, it was necessary for the Company to address various matters prior to the filing of this Form 10-Q, including those relating to the Internal Investigation, the execution of various waivers and amendments to certain bank debt agreements discussed below, and the prepayment of the Senior Notes.

 

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Properties:

The following sets forth certain information for the Company’s consolidated properties by segment as of March 31, 2012 (including properties in development and redevelopment, dollars in thousands):

WASHINGTON, D.C. REGION

 

Property		Buildings		Sub-Market(1)		Square Feet				Annualized Cash Basis Rent(2)				Leased at March 31, 2012(3)				Occupied at March  31, 2012(3)
Downtown DC-Office
500 First Street, NW		1		Capitol Hill			129,035			$	4,783				100.0	%			100.0	%
840 First Street, NE		1		NoMA			247,146				6,841				100.0	%			100.0	%
1005 First Street, NE(4)		1		NoMA			30,414				2,496				100.0	%			100.0	%
1211 Connecticut Avenue, NW		1		CBD			125,119				3,457				98.2	%			98.2	%
Total		4					531,714				17,577				99.6	%			99.6	%
Redevelopment
440 First Street, NW		1		Capitol Hill			135,000				—				—				—
Joint Venture Properties (unconsolidated)
1750 H Street, NW		1		CBD			111,373				4,038				100.0	%			100.0	%
1200 17th Street, NW (Development)		1		CBD			170,000				N/A				N/A				N/A
		2					281,373				4,038				100.0	%			100.0	%
Grand Total		7					948,087			$	21,615				99.7	%			99.7	%

 

(1)	CBD = Central Business District; NoMA = North of Massachusetts Avenue.

(2)

Annualized cash basis rent, which is calculated as the contractual rent due under the terms of the lease, without taking into account rent abatements, is reflected on a triple-net equivalent basis, by deducting operating expense reimbursements that are included, along with base rent, in the contractual payments of the Company’s full service leases. The operating expense reimbursements primarily relate to real estate taxes and insurance expenses.

(3)	Does not include space in development or redevelopment.

(4)	The property was acquired through a consolidated joint venture in which the Company has a 97% controlling economic interest.

 

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MARYLAND REGION

 

Property		Buildings		Location		Square Feet				Annualized Cash Basis Rent(1)				Leased at March 31, 2012(2)				Occupied at March  31, 2012(2)
SUBURBAN MD
Business Park
Ammendale Business Park(3)		7		Beltsville			312,736			$	4,259				97.4	%			95.1	%
Gateway 270 West		6		Clarksburg			255,574				3,207				87.7	%			81.9	%
Girard Business Center(4)		7		Gaithersburg			298,009				3,104				89.7	%			86.7	%
Rumsey Center		4		Columbia			134,514				1,090				70.1	%			67.3	%
Snowden Center		5		Columbia			144,726				2,037				94.6	%			89.5	%
Total Business Park		29					1,145,559				13,697				89.7	%			86.0	%
Office
Worman’s Mill Court		1		Frederick			40,051				367				87.7	%			87.7	%
Goldenrod Lane		1		Germantown			23,518				56				25.9	%			25.9	%
Annapolis Business Center		2		Annapolis			101,898				1,545				98.8	%			98.8	%
Campus at Metro Park North		4		Rockville			190,720				3,488				93.3	%			78.4	%
Cloverleaf Center		4		Germantown			173,655				2,732				86.1	%			86.1	%
Gateway Center		2		Gaithersburg			44,249				635				92.4	%			88.7	%
Hillside Center		2		Columbia			86,189				1,376				100.0	%			100.0	%
Merrill Lynch Building		1		Columbia			136,485				1,546				75.4	%			73.5	%
Patrick Center		1		Frederick			66,469				953				77.8	%			77.8	%
Redland Corporate Center		2		Rockville			348,469				6,664				88.0	%			78.7	%
West Park		1		Frederick			28,566				356				92.9	%			76.6	%
Woodlands Business Center(5)		1		Largo			37,887				205				50.2	%			50.2	%
Total Office		22					1,278,156				19,923				86.3	%			80.9	%
Industrial
Frederick Industrial Park(6)		3		Frederick			550,490				4,050				91.5	%			85.7	%
Glenn Dale Business Center		1		Glenn Dale			315,962				1,490				86.9	%			86.9	%
Total Industrial		4					866,452				5,540				89.8	%			86.2	%
Total Suburban Maryland		55					3,290,167				39,160				88.4	%			84.1	%
BALTIMORE
Business Park
Owings Mills Business Park(7)		6		Owings Mills			219,284				1,644				58.8	%			58.8	%
Triangle Business Center		4		Baltimore			74,182				488				63.2	%			63.2	%
Total Business Park		10					293,466				2,132				59.9	%			59.9	%
Industrial
Mercedes Center		1		Hanover			294,673				1,061				73.1	%			73.1	%
Total Baltimore		11					588,139				3,193				66.5	%			66.5	%
Total Consolidated		66					3,878,306				42,353				85.1	%			81.4	%
Joint Venture Properties (Unconsolidated)
RiversPark I and II		6		Columbia			307,567				3,615				87.5	%			87.5	%
Aviation Business Park		3		Glen Burnie			120,662				568				32.4	%			26.3	%
Total Joint Ventures		9					428,229				4,183				72.0	%			70.3	%
Grand Total		75					4,306,535			$	46,536				83.8	%			80.3	%

 

(1)

Annualized cash basis rent, which is calculated as the contractual rent due under the terms of the lease, without taking into account rent abatements, is reflected on a triple-net equivalent basis, by deducting operating expense reimbursements that are included, along with base rent, in the contractual payments of the Company’s full service leases. The operating expense reimbursements primarily relate to real estate taxes and insurance expenses.

(2)	Does not include space in development or redevelopment.

(3)	Ammendale Business Park consists of the following properties: Ammendale Commerce Center and Indian Creek Court.

(4)	Girard Business Center consists of the following properties: Girard Business Center and Girard Place.

(5)	The property was sold in May 2012 for net proceeds of $2.9 million.

(6)	Frederick Industrial Park consists of the following properties: 4451 Georgia Pacific Boulevard, 4612 Navistar Drive, and 6900 English Muffin Way.

(7)	Owings Mills Business Park consists of the following properties: Owings Mills Business Center and Owings Mills Commerce Center.

 

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NORTHERN VIRGINIA REGION

 

Property		Buildings		Location		Square Feet				Annualized Cash Basis Rent(1)				Leased at March 31, 2012(2)				Occupied at March 31, 2012(2)
Business Park
Corporate Campus at Ashburn Center		3		Ashburn			194,184			$	2,795				100.0	%			100.0	%
Gateway Centre Manassas		3		Manassas			102,388				533				51.1	%			51.1	%
Linden Business Center		3		Manassas			109,724				763				62.4	%			62.4	%
Prosperity Business Center		1		Merrifield			71,343				881				100.0	%			77.4	%
Sterling Park Business Center(3)		7		Sterling			446,401				3,755				81.0	%			81.0	%
Total Business Park		17					924,040				8,727				80.9	%			79.2	%
Office
Atlantic Corporate Park		2		Sterling			221,372				1,058				29.1	%			29.1	%
Cedar Hill		2		Tysons Corner			102,632				2,301				100.0	%			100.0	%
Herndon Corporate Center		4		Herndon			127,918				1,721				89.3	%			89.3	%
Lafayette Business Center(4)		6		Chantilly			254,296				3,518				85.0	%			85.0	%
One Fair Oaks		1		Fairfax			214,214				5,020				100.0	%			100.0	%
Reston Business Campus		4		Reston			83,210				731				60.8	%			60.8	%
Three Flint Hill		1		Oakton			48,787				903				100.0	%			100.0	%
Van Buren Office Park		4		Herndon			70,494				739				73.6	%			73.6	%
Windsor at Battlefield		2		Manassas			155,511				1,984				90.3	%			90.3	%
Total Office		26					1,278,434				17,975				78.5	%			78.5	%
Industrial
13129 Airpark Road		1		Culpeper			149,888				630				75.9	%			75.9	%
15395 John Marshall Highway		1		Haymarket			236,082				3,369				100.0	%			100.0	%
Interstate Plaza		1		Alexandria			109,029				1,122				98.9	%			98.9	%
Newington Business Park Center		7		Lorton			254,272				2,476				87.2	%			85.8	%
Plaza 500		2		Alexandria			505,074				5,071				77.8	%			77.8	%
Total Industrial		12					1,254,345				12,668				85.5	%			85.2	%
Total Consolidated		55					3,456,819				39,370				81,7	%			81.1	%
Total Development / Redevelopment(5)		1		Various(5)			208,691				—				—				—
Joint Venture Property (Unconsolidated)
Metro Place III & IV		2		Merrifield			325,328				5,797				100.0	%			100.0	%
Grand Total		58					3,990,838			$	45,167				83.3	%			82.7	%

 

(1)

Annualized cash basis rent, which is calculated as the contractual rent due under the terms of the lease, without taking into account rent abatements, is reflected on a triple-net equivalent basis, by deducting operating expense reimbursements that are included, along with base rent, in the contractual payments of the Company’s full service leases. The operating expense reimbursements primarily relate to real estate taxes and insurance expenses.

(2)	Does not include space in development or redevelopment.

(3)	Sterling Park Business Center consists of the following properties: 403/405 Glenn Drive, Davis Drive, and Sterling Park Business Center.

(4)	Lafayette Business Center consists of the following properties: Enterprise Center and Tech Court.

(5)	Includes development at Sterling Park Business Center and redevelopment at Three Flint Hill, Sterling Park and Van Buren Office Park.

 

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SOUTHERN VIRGINIA REGION

 

Property		Buildings		Location		Square Feet				Annualized Cash Basis Rent(1)				Leased at March 31, 2012(2)				Occupied at March  31, 2012(2)
RICHMOND
Business Park
Chesterfield Business Center(3)		11		Richmond			320,261			$	1,775				86.3	%			82.8	%
Hanover Business Center		4		Ashland			183,643				786				67.1	%			67.1	%
Park Central		3		Richmond			204,762				1,709				77.9	%			77.9	%
Virginia Center Technology Park		1		Glen Allen			118,579				1,237				85.2	%			74.9	%
Total Business Park		19					827,245				5,507				79.8	%			77.0	%
Industrial
Northridge		2		Ashland			139,346				905				100.0	%			83.5	%
River’s Bend Center(4)		6		Chester			795,080				4,354				95.6	%			95.6	%
Total Industrial		8					934,426				5,259				96.3	%			93.8	%
Total Richmond		27					1,761,671				10,766				88.5	%			85.9	%
NORFOLK
Business Park
Crossways Commerce Center(5)		9		Chesapeake			1,087,250				10,269				93.1	%			91.6	%
Battlefield Corporate Center		1		Chesapeake			96,720				780				100.0	%			100.0	%
Greenbrier Business Park(6)		4		Chesapeake			411,815				3,669				79.2	%			78.0	%
Hampton Roads Center(7)		3		Hampton			585,205				2,609				60.5	%			60.5	%
Norfolk Commerce Park(8)		3		Norfolk			261,886				1,962				74.1	%			68.9	%
Total Business Park		20					2,442,876				19,289				81.2	%			79.8	%
Office
Greenbrier Towers		2		Chesapeake			172,353				2,002				92.9	%			87.6	%
Total Office		2					172,353				2,002				92.9	%			87.6	%
Industrial
Cavalier Industrial Park		4		Chesapeake			394,308				1,520				88.6	%			88.6	%
Diamond Hill Distribution Center		4		Chesapeake			712,683				2,572				88.5	%			88.5	%
Total Industrial		8					1,106,991				4,092				88.5	%			88.5	%
Total Norfolk		30					3,722,220				25,383				83.9	%			82.8	%
Grand Total		57					5,483,891			$	36,149				85.4	%			83.8	%

 

(1)

Annualized cash basis rent, which is calculated as the contractual rent due under the terms of the lease, without taking into account rent abatements, is reflected on a triple-net equivalent basis, by deducting operating expense reimbursements that are included, along with base rent, in the contractual payments of the Company’s full service leases. The operating expense reimbursements primarily relate to real estate taxes and insurance expenses.

(2)	Does not include space in development or redevelopment.

(3)	Chesterfield Business Center consists of the following properties: Airpark Business Center, Chesterfield Business Center, and Pine Glen.

(4)	River’s Bend Center consists of the following properties: River’s Bend Center and River’s Bend Center II.

(5)	Crossways Commerce Center consists of the following properties: Coast Guard Building, Crossways Commerce Center I, Crossways Commerce Center II, 1434 Crossways Boulevard, and 1408 Stephanie Way

(6)	Greenbrier Business Park consists of the following properties: Greenbrier Technology Center I, Greenbrier Technology Center II, and Greenbrier Circle Corporate Center.

(7)	Hampton Roads Center consists of the following properties: 1000 Lucas Way and Enterprise Parkway.

(8)	Norfolk Commerce Park consists of the following properties: Norfolk Business Center, Norfolk Commerce Park II, and Gateway II.

 

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Development and Redevelopment Activity

The Company constructs office buildings, business parks and/or industrial buildings on a build-to-suit basis or with the intent to lease upon completion of construction. Also, the Company owns developable land that can accommodate 2.4 million square feet of additional building space. Below is a summary of the approximate building square footage that can be developed on the Company’s developable land and the Company’s current development and redevelopment activity as of March 31, 2012 (amounts in thousands):

 

Reporting Segment		Developable Square Feet				Square Feet Under Development				Cost to Date of Development Activities				Square Feet Under Redevelopment				Cost to Date of Redevelopment Activities(1)
Washington, D.C.			713				—			$	—				135			$	2,755
Maryland			250				—				—				—				—
Northern Virginia			568				—				—				209				12,044
Southern Virginia			841				166				582				—				—
			2,372				166			$	582				344			$	14,799

 

(1)	Costs to date of redevelopment activities excludes tenant improvements and leasing commissions.

At March 31, 2012, the Company had completed development and redevelopment activities that have yet to be placed in service on 209,000 square feet, at a cost of $12.0 million, in its Northern Virginia reporting segment. The majority of the costs on the construction projects to be placed in service relate to redevelopment activities at Three Flint Hill, located in the Company’s Northern Virginia reporting segment, which were substantially completed in the third quarter of 2011 at a cost of approximately $10.4 million. The Company will place completed construction activities in service upon the shorter of a tenant taking occupancy or twelve months from substantial completion.

During the first quarter of 2012, the Company completed and placed in-service development and redevelopment efforts totaling 93,000 square feet at Sterling Park Business Center and Three Flint Hill, at a cost of $7.2 million, in its Northern Virginia reporting segment.

Lease Expirations

Approximately 6.4% of the Company’s annualized base rent, excluding month-to-month leases, is scheduled to expire during the remainder of 2012, with 9.4% expiring through the twelve months ending March 31, 2013. Current tenants may not renew their leases upon the expiration of their terms. If non-renewals or terminations occur, the Company may not be able to locate qualified replacement tenants and, as a result, could lose a significant source of revenue while remaining responsible for the payment of its financial obligations. Moreover, the terms of a renewal or new lease, including the amount of rent, may be less favorable to the Company than the current lease terms, or the Company may be forced to provide tenant improvements at its expense or provide other concessions or additional services to maintain or attract tenants. We continually strive to increase our portfolio occupancy, and the amount of vacant space in our portfolio at any given time may impact our willingness to reduce rental rates or provide greater concessions to retain existing tenants and attract new tenants. The Company’s management continually monitors its portfolio on a regional and per property basis to assess market trends, including vacancy, comparable deals and transactions, and other business and economic factors that may influence our leasing decisions. During the three months ended March 31, 2012, the Company had a 52% retention rate, based on square footage, due to several leases that expired at December 31, 2011 as a result of tenants not renewing, which were included in the Company’s calculation of its first quarter retention rate. The Company anticipates that its retention rate will increase during the remainder of 2012 to levels more commensurate with its historical experience of approximately 75%. After reflecting all the renewal leases on a triple-net basis to allow for comparability, the weighted average rental rate on the Company’s renewed leases decreased 3.0% compared with the expiring leases. During the first quarter of 2012, the Company executed new leases for 0.3 million square feet, of which substantially all of the leases (based on square footage) contained rent escalations.

 

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The following table sets forth a summary schedule of the lease expirations at the Company’s consolidated properties for leases in place as of March 31, 2012 (dollars in thousands):

 

Year of Lease   Expiration		Number of Leases Expiring				Square Feet				% of Leased Square Feet				Annualized Cash Basis Rent(1)				% of Annualized Cash Basis Rent				Average Base Rent per Square Foot(1)(2)
MTM			9				82,078				0.7	%		$	726				0.5	%		$	8.85
2012			108				750,197				6.6	%			8,630				6.4	%			11.50
2013			137				1,546,278				13.6	%			18,692				13.8	%			10.68
2014			135				1,553,254				13.7	%			15,518				11.5	%			9.99
2015			99				1,017,618				9.1	%			10,262				7.6	%			10.08
2016			93				1,852,946				16.4	%			23,895				17.6	%			12.90
2017			67				1,126,456				9.9	%			13,126				9.7	%			11.65
2018			32				889,506				7.8	%			8,363				6.2	%			9.40
2019			52				559,301				4.9	%			8,105				6.0	%			14.49
2020			22				567,304				5.0	%			8,175				6.0	%			14.41
2021			20				494,959				4.4	%			5,007				3.7	%			10.11
Thereafter			23				897,748				7.9	%			14,950				11.0	%			16.65
Total / Weighted Average			797				11,337,645				100.0	%		$	135,449				100.0	%		$	11.76

 

(1)

Annualized Cash Basis Rent, which is calculated as the contractual rent due under the terms of the lease, without taking into account rent abatements, is reflected on a triple-net equivalent basis, by deducting operating expense reimbursements that are included, along with base rent, in the contractual payments of the Company’s full service leases. The operating expense reimbursements primarily relate to real estate taxes and insurance expenses.

(2)	Represents Annualized Cash Basis Rent divided by the square footage of the space.

Critical Accounting Policies and Estimates

The Company’s condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) that require the Company to make certain estimates and assumptions. Critical accounting policies and estimates are those that require subjective or complex judgments and are the policies and estimates that the Company deems most important to the portrayal of its financial condition, results of operations and cash flows. It is possible that the use of different reasonable estimates or assumptions in making these judgments could result in materially different amounts being reported in its condensed consolidated financial statements. The Company’s critical accounting policies and estimates relate to revenue recognition, including evaluation of the collectability of accounts and notes receivable, impairment of long-lived assets, purchase accounting for acquisitions of real estate, derivative instruments and share-based compensation.

The following is a summary of certain aspects of these critical accounting policies and estimates.

Revenue Recognition

The Company generates substantially all of its revenue from leases on its office and industrial properties as well as business parks. The Company recognizes rental revenue on a straight-line basis over the term of its leases, which includes fixed-rate renewal periods leased at below market rates at acquisition or inception. Accrued straight-line rents represent the difference between rental revenue recognized on a straight-line basis over the term of the respective lease agreements and the rental payments contractually due for leases that contain abatement or fixed periodic increases. The Company considers current information, credit quality, historical trends, economic conditions and other events regarding the tenants’ ability to pay their obligations in determining if amounts due from tenants, including accrued straight-line rents, are ultimately collectible. The uncollectible portion of the amounts due from tenants, including accrued straight-line rents, is charged to property operating expense in the period in which the determination is made.

 

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Tenant leases generally contain provisions under which the tenants reimburse the Company for a portion of property operating expenses and real estate taxes incurred by the Company. Such reimbursements are recognized in the period in which the expenses are incurred. The Company records a provision for losses on estimated uncollectible accounts receivable based on its analysis of risk of loss on specific accounts. Lease termination fees are recognized on the date of termination when the related lease or portion thereof is cancelled, the collectability of the fee is reasonably assured and the Company has possession of the terminated space.

Accounts and Notes Receivable

The Company must make estimates of the collectability of its accounts and notes receivable related to minimum rent, deferred rent, tenant reimbursements, lease termination fees and interest and other income. The Company specifically analyzes accounts receivable and historical bad debt experience, tenant concentrations, tenant creditworthiness and current economic trends when evaluating the adequacy of its allowance for doubtful accounts receivable. These estimates have a direct impact on the Company’s net income as a higher required allowance for doubtful accounts receivable will result in lower net income. The uncollectible portion of the amounts due from tenants, including straight-line rents, is charged to property operating expense in the period in which the determination is made. The Company considers similar criteria in assessing impairment associated with outstanding loans or notes receivable and whether any allowance for anticipated credit loss is appropriate.

Investments in Real Estate and Real Estate Entities

Investments in real estate and real estate entities are initially recorded at fair value if acquired in a business combination or carried at initial cost when constructed or acquired in an asset purchase, less accumulated depreciation and, when appropriate, impairment losses. Improvements and replacements are capitalized at cost when they extend the useful life, increase capacity or improve the efficiency of the asset. Repairs and maintenance are charged to expense when incurred. Depreciation and amortization are recorded on a straight-line basis over the estimated useful lives of the assets. The estimated useful lives of the Company’s assets, by class, are as follows:

 

Buildings		39 years
Building improvements		5 to 20 years
Furniture, fixtures and equipment		5 to 15 years
Lease related intangible assets		The term of the related lease
Tenant improvements		Shorter of the useful life of the asset or the term of the related lease

The Company regularly reviews market conditions for possible impairment of a property’s carrying value. When circumstances such as adverse market conditions, changes in management’s intended holding period or potential sale to a third party indicate a possible impairment of the fair value of a property, an impairment analysis is performed. The Company assesses potential impairments based on an estimate of the future undiscounted cash flows (excluding interest charges) expected to result from the property’s use and eventual disposition. This estimate is based on projections of future revenues, expenses, capital improvement costs, expected holding periods and capitalization rates. These cash flows consider factors such as expected market trends and leasing prospects, as well as the effects of leasing demand, competition and other factors. If impairment exists due to the inability to recover the carrying value of a real estate investment based on forecasted undiscounted cash flows, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property less anticipated selling costs. The Company is required to make estimates as to whether there are impairments in the carrying values of its investments in real estate. Further, the Company will record an impairment loss if it expects to dispose of a property, in the near term, at a price below carrying value. In such an event, the Company will record an impairment loss based on the difference between a property’s carrying value and its projected sales price, less any estimated costs to sell.

The Company will classify a building as held-for-sale in the period in which it has made the decision to dispose of the building, the Company’s Board of Trustees or a designated delegate has approved the sale, there is a high likelihood a binding agreement to purchase the property will be signed under which the buyer will be required to commit a significant amount of nonrefundable cash and no significant financing contingencies will exist that could cause the transaction not to be completed in a timely manner. If these criteria are met, the Company will cease depreciation of the asset. The Company will classify any impairment loss, together with the building’s operating results, as discontinued operations in its consolidated statements of operations for all periods presented and classify the assets and related liabilities as held-for-sale in its consolidated balance sheets in the period the held-for-sale criteria are met. Interest expense is reclassified to discontinued operations only to the extent the held-for-sale property is secured by specific mortgage debt and the mortgage debt will not be assigned to another property owned by the Company after the disposition.

 

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The Company recognizes the fair value, if sufficient information exists to reasonably estimate the fair value, of any liability for conditional asset retirement obligations when incurred, which is generally upon acquisition, construction, development or redevelopment and/or through the normal operation of the asset.

The Company capitalizes interest costs incurred on qualifying expenditures for real estate assets under development or redevelopment, which include its investment in assets owned through unconsolidated joint ventures that are under development or redevelopment, while being readied for their intended use in accordance with accounting requirements regarding capitalization of interest. The Company will capitalize interest when qualifying expenditures for the asset have been made, activities necessary to get the asset ready for its intended use are in progress and interest costs are being incurred. Capitalized interest also includes interest associated with expenditures incurred to acquire developable land while development activities are in progress and interest on the direct compensation costs of the Company’s construction personnel who manage the development and redevelopment projects, but only to the extent the employee’s time can be allocated to a project. Any portion of construction management costs not directly attributable to a specific project are recognized as general and administrative expense in the period incurred. The Company does not capitalize any other general administrative costs such as office supplies, office rent expense or an overhead allocation to its development or redevelopment projects. Capitalized compensation costs were immaterial for the three months ended March 31, 2012 and 2011. Capitalization of interest will end when the asset is substantially complete and ready for its intended use, but no later than one year from completion of major construction activity, if the property is not occupied. The Company will also place redevelopment and development assets in service at this time and commence depreciation upon the substantial completion of tenant improvements and the recognition of revenue. Capitalized interest is depreciated over the useful life of the underlying assets, commencing when those assets are placed into service.

Purchase Accounting

Acquisitions of rental property, including any associated intangible assets, are measured at fair value at the date of acquisition. Any liabilities assumed or incurred are recorded at their fair value at the time of acquisition. The fair value of the acquired property is allocated between land and building (on an as-if vacant basis) based on management’s estimate of the fair value of those components for each type of property and to tenant improvements based on the depreciated replacement cost of the tenant improvements, which approximates their fair value. The fair value of the in-place leases is recorded as follows:

 

•

the fair value of leases in-place on the date of acquisition is based on absorption costs for the estimated lease-up period in which vacancy and foregone revenue are avoided due to the presence of the acquired leases;

 

•

the fair value of above and below-market in-place leases based on the present value (using a discount rate that reflects the risks associated with the acquired leases) of the difference between the contractual rent amounts to be paid under the assumed lease and the estimated market lease rates for the corresponding spaces over the remaining non-cancelable terms of the related leases, which range from one to fifteen years; and

 

•

the fair value of intangible tenant or customer relationships.

The Company’s determination of these fair values requires it to estimate market rents for each of the leases and make certain other assumptions. These estimates and assumptions affect the rental revenue, and depreciation and amortization expense recognized for these leases and associated intangible assets and liabilities.

Derivative Instruments

In the normal course of business, the Company is exposed to the effect of interest rate changes. The Company may enter into derivative agreements to mitigate exposure to unexpected changes in interest rates and may use interest rate protection or cap agreements to reduce the impact of interest rate changes. The Company does not use derivatives for trading or speculative purposes and intends to enter into derivative agreements only with counterparties that it believes have a strong credit rating to mitigate the risk of counterparty default or insolvency.

The Company may designate a derivative as either a hedge of the cash flows from a debt instrument or anticipated transaction (cash flow hedge) or a hedge of the fair value of a debt instrument (fair value hedge). All derivatives are recognized as assets or liabilities at fair value. For effective hedging relationships, the change in the fair value of the assets or liabilities is recorded within equity (cash flow hedge) or through earnings (fair value hedge). Ineffective portions of derivative transactions will result in changes in fair value recognized in earnings. For a cash flow hedge, the Company records its proportionate share of unrealized gains or losses on its derivative instruments associated with its unconsolidated joint ventures within equity and “Investment in affiliates.” 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. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting any applicable credit enhancements, such as collateral postings, thresholds, mutual inputs and guarantees.

 

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Share-Based Compensation

The Company measures the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. For options awards, the Company uses a Black-Scholes option-pricing model. Expected volatility is based on an assessment of the Company’s realized volatility over the preceding period that is equivalent to the award’s expected life, which in management’s opinion, gives an accurate indication of future volatility. The expected term represents the period of time the options are anticipated to remain outstanding as well as the Company’s historical experience for groupings of employees that have similar behavior and considered separately for valuation purposes. For non-vested share awards that vest over a predetermined time period, the Company uses the outstanding share price at the date of issuance to fair value the awards. For non-vested shares awards that vest based on performance conditions, the Company uses a Monte Carlo simulation (risk-neutral approach) to determine the value and derived service period of each tranche. The expense associated with the share-based awards will be recognized over the period during which an employee is required to provide services in exchange for the award – the requisite service period (usually the vesting period). The fair value for all share-based payment transactions are recognized as a component of income or loss from continuing operations.

Results of Operations

Comparison of the Three Months Ended March 31, 2012 with the Three Months Ended March 31, 2011

During 2011, the Company acquired the following consolidated properties: Cedar Hill; Merrill Lynch Building; 840 First Street, NE; One Fair Oaks; Greenbrier Towers; 1005 First Street, NE; and Hillside Center for an aggregate purchase cost of $268.6 million. Collectively, the properties are referred to as the “Acquired Properties.”

As of March 31, 2012, the Company had not acquired any properties in 2012.

The term “Existing Portfolio” refers to all consolidated properties owned by the Company for the entirety of the periods presented.

For discussion of the operating results of the Company’s reporting segments, the terms “Washington, D.C.”, “Maryland”, “Northern Virginia” and “Southern Virginia” will be used to describe the respective reporting segments.

Total Revenues

Total revenues are summarized as follows:

 

Three Months Ended March 31,