Table of Contents

 



UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



FORM 10-Q



Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934



For the quarterly period ended September 30, 2017



or



Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934



For the transition period from ____________ to ____________



Commission File Number 1-10709



PS BUSINESS PARKS, INC.

(Exact name of registrant as specified in its charter)



California

95-4300881

(State or Other Jurisdiction

(I.R.S. Employer

of Incorporation)

Identification Number)



701 Western Avenue, Glendale, California 91201-2397

(Address of principal executive offices) (Zip Code)



Registrant’s telephone number, including area code: (818) 244-8080



Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes  No



Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes  No  



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





 

 

 

 

Large accelerated filer

 

Accelerated filer

 

Non-accelerated filer

 

Smaller reporting company

 

Emerging growth company

 



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



Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes No



As of October 23, 2017, the number of shares of the registrant’s common stock, $0.01 par value per share, outstanding was 27,251,037.




 

Table of Contents

 

PS BUSINESS PARKS, INC.

INDEX







 



 



Page

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

Consolidated balance sheets as of September 30, 2017 (unaudited) and December 31, 2016

3

Consolidated statements of income (unaudited) for the three and nine months ended September 30, 2017 and 2016

4

Consolidated statement of equity (unaudited) for the nine months ended September 30, 2017

5

Consolidated statements of cash flows (unaudited) for the nine months ended September 30, 2017 and 2016

6

Notes to consolidated financial statements (unaudited)

7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

20

Item 3. Quantitative and Qualitative Disclosures About Market Risk

35

Item 4. Controls and Procedures

36

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

36

Item 1A. Risk Factors

36

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

36

Item 6. Exhibits

36











 


 

Table of Contents

 

PART I. FINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



PS BUSINESS PARKS, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)





 

 

 

 

 



 

 

 

 

 



September 30,

 

December 31,



2017

 

2016



(Unaudited)

 

 

 

ASSETS

 

 

 

 

 



 

 

 

 

 

Cash and cash equivalents

$

132,658 

 

$

128,629 



 

 

 

 

 

Real estate facilities, at cost

 

 

 

 

 

Land

 

789,227 

 

 

789,227 

Buildings and improvements

 

2,254,663 

 

 

2,224,522 



 

3,043,890 

 

 

3,013,749 

Accumulated depreciation

 

(1,219,314)

 

 

(1,158,054)



 

1,824,576 

 

 

1,855,695 

Property held for disposition, net

 

 

 

909 

Land and building held for development

 

29,252 

 

 

27,028 



 

1,853,828 

 

 

1,883,632 

Investment in and advances to unconsolidated joint venture

 

96,593 

 

 

67,190 

Rent receivable, net

 

2,203 

 

 

1,945 

Deferred rent receivable, net

 

31,670 

 

 

29,770 

Other assets

 

8,779 

 

 

8,205 



 

 

 

 

 

Total assets

$

2,125,731 

 

$

2,119,371 



 

 

 

 

 

LIABILITIES AND EQUITY

 

 

 

 

 



 

 

 

 

 

Accrued and other liabilities

$

82,618 

 

$

78,657 

Preferred stock called for redemption

 

220,000 

 

 

230,000 

Total liabilities

 

302,618 

 

 

308,657 

Commitments and contingencies

 

 

 

 

 

Equity:

 

 

 

 

 

PS Business Parks, Inc.’s shareholders’ equity

 

 

 

 

 

Preferred stock, $0.01 par value, 50,000,000 shares authorized,

 

 

 

 

 

35,590 and 35,190 shares issued and outstanding at

 

 

 

 

 

September 30, 2017 and December 31, 2016, respectively

 

889,750 

 

 

879,750 

Common stock, $0.01 par value, 100,000,000 shares authorized,

 

 

 

 

 

27,251,037 and 27,138,138 shares issued and outstanding at

 

 

 

 

 

September 30, 2017 and December 31, 2016, respectively

 

272 

 

 

271 

Paid-in capital

 

735,714 

 

 

733,671 

Accumulated earnings (deficit)

 

60 

 

 

(433)

Total PS Business Parks, Inc.’s shareholders’ equity

 

1,625,796 

 

 

1,613,259 

Noncontrolling interests

 

197,317 

 

 

197,455 

Total equity

 

1,823,113 

 

 

1,810,714 

Total liabilities and equity

$

2,125,731 

 

$

2,119,371 



See accompanying notes.

 

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PS BUSINESS PARKS, INC.

CONSOLIDATED STATEMENTS OF INCOME

(Amounts in thousands, except per share data)

(Unaudited)







 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 



For The Three Months

 

For The Nine Months



Ended September 30,

 

Ended September 30,

 

2017

 

2016

 

2017

 

2016



 

 

 

 

 

 

 

 

 

 

 

Rental income

$

100,481 

 

$

97,340 

 

$

300,342 

 

$

289,272 



 

 

 

 

 

 

 

 

 

 

 

Expenses

 

 

 

 

 

 

 

 

 

 

 

Cost of operations

 

31,679 

 

 

30,796 

 

 

92,962 

 

 

92,440 

Depreciation and amortization

 

23,759 

 

 

24,631 

 

 

70,465 

 

 

74,886 

General and administrative

 

1,745 

 

 

2,970 

 

 

7,019 

 

 

11,982 

Total operating expenses

 

57,183 

 

 

58,397 

 

 

170,446 

 

 

179,308 



 

 

 

 

 

 

 

 

 

 

 

Operating income

 

43,298 

 

 

38,943 

 

 

129,896 

 

 

109,964 

Interest and other income

 

212 

 

 

206 

 

 

599 

 

 

940 

Interest and other expense

 

(503)

 

 

(155)

 

 

(972)

 

 

(5,507)

Equity in loss of unconsolidated joint venture

 

(376)

 

 

 

 

(758)

 

 

Gain on sale of real estate facility

 

 

 

 

 

1,209 

 

 

Gain on sale of development rights

 

 

 

 

 

3,865 

 

 

Net income

 

42,631 

 

 

38,994 

 

 

133,839 

 

 

105,397 

Allocation to noncontrolling interests

 

(4,866)

 

 

(5,315)

 

 

(18,610)

 

 

(13,495)

Net income allocable to PS Business Parks, Inc.

 

37,765 

 

 

33,679 

 

 

115,229 

 

 

91,902 

Allocation to preferred shareholders based upon

 

 

 

 

 

 

 

 

 

 

 

Distributions

 

(12,590)

 

 

(13,833)

 

 

(38,472)

 

 

(41,498)

Redemptions (Note 9)

 

(6,900)

 

 

 

 

(6,900)

 

 

Allocation to restricted stock unit holders

 

(137)

 

 

(128)

 

 

(582)

 

 

(387)

Net income allocable to common shareholders

$

18,138 

 

$

19,718 

 

$

69,275 

 

$

50,017 



 

 

 

 

 

 

 

 

 

 

 

Net income per common share

 

 

 

 

 

 

 

 

 

 

 

Basic

$

0.67 

 

$

0.73 

 

$

2.55 

 

$

1.85 

Diluted

$

0.66 

 

$

0.72 

 

$

2.53 

 

$

1.84 



 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

 

 

 

 

 

 

 

 

 

 

Basic

 

27,226 

 

 

27,103 

 

 

27,192 

 

 

27,076 

Diluted

 

27,427 

 

 

27,201 

 

 

27,399 

 

 

27,166 



 

 

 

 

 

 

 

 

 

 

 

Dividends declared per common share

$

0.85 

 

$

0.75 

 

$

2.55 

 

$

2.25 







 

See accompanying notes.

 

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PS BUSINESS PARKS, INC.

CONSOLIDATED STATEMENT OF EQUITY

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2017

(In thousands, except share data)

(Unaudited)







 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total PS

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Business Parks,

 

 

 

 

 

 



Preferred Stock

 

Common Stock

 

Paid-in

 

Accumulated

 

Inc.’s Shareholders’

 

Noncontrolling

 

Total

 

Shares

 

Amount

 

Shares

 

Amount

 

Capital

 

Earnings (Deficit)

 

Equity

 

Interests

 

Equity

Balances at December 31, 2016

35,190 

 

$

879,750 

 

27,138,138 

 

$

271 

 

$

733,671 

 

$

(433)

 

$

1,613,259 

 

$

197,455 

 

$

1,810,714 

Issuance of preferred stock, net of

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

issuance costs

9,200 

 

 

230,000 

 

 

 

 

 

(7,775)

 

 

 

 

222,225 

 

 

 

 

222,225 

Redemption of preferred stock,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

net of issuance costs

(8,800)

 

 

(220,000)

 

 

 

 

 

6,900 

 

 

(6,900)

 

 

(220,000)

 

 

 

 

(220,000)

Issuance of common stock in

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

connection with stock-based

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

compensation

 

 

 

112,899 

 

 

 

 

3,991 

 

 

 

 

3,992 

 

 

 

 

3,992 

Stock compensation, net

 

 

 

 

 

 

 

2,673 

 

 

 

 

2,673 

 

 

 

 

2,673 

Cash paid for taxes in lieu of

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

shares upon vesting of

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

restricted stock units

 

 

 

 

 

 

 

(3,865)

 

 

 

 

(3,865)

 

 

 

 

(3,865)

Net income

 

 

 

 

 

 

 

 

 

115,229 

 

 

115,229 

 

 

18,610 

 

 

133,839 

Distributions

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Preferred stock

 

 

 

 

 

 

 

 

 

(38,472)

 

 

(38,472)

 

 

 

 

(38,472)

Common stock

 

 

 

 

 

 

 

 

 

(69,364)

 

 

(69,364)

 

 

 

 

(69,364)

Noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

 

 

(18,629)

 

 

(18,629)

Adjustment to noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

in the OP

 

 

 

 

 

 

 

119 

 

 

 

 

119 

 

 

(119)

 

 

Balances at September 30, 2017

35,590 

 

$

889,750 

 

27,251,037 

 

$

272 

 

$

735,714 

 

$

60 

 

$

1,625,796 

 

$

197,317 

 

$

1,823,113 





 

See accompanying notes.

 

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PS BUSINESS PARKS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)







 

 

 

 

 



 

 

 

 

 

 

For The Nine Months



Ended September 30,

 

2017

 

2016

Cash flows from operating activities

 

 

 

 

 

Net income

$

133,839 

 

$

105,397 

Adjustments to reconcile net income to net cash provided by operating activities

 

 

 

 

 

Depreciation and amortization

 

70,465 

 

 

74,886 

Tenant improvement reimbursements, net of lease incentives

 

(1,654)

 

 

(1,253)

Equity in loss of unconsolidated joint venture

 

758 

 

 

Gain on sale of real estate facility

 

(1,209)

 

 

Gain on sale of development rights

 

(3,865)

 

 

Stock compensation

 

3,255 

 

 

8,933 

Amortization of financing costs

 

338 

 

 

391 

Other, net

 

4,125 

 

 

1,259 

Total adjustments

 

72,213 

 

 

84,216 

Net cash provided by operating activities

 

206,052 

 

 

189,613 

Cash flows from investing activities

 

 

 

 

 

Capital expenditures to real estate facilities

 

(38,709)

 

 

(24,230)

Capital expenditures to land and building held for development

 

(2,224)

 

 

Investment in and advances to unconsolidated joint venture

 

(30,161)

 

 

(28,800)

Acquisition of real estate facilities

 

 

 

(12,628)

Proceeds from sale of real estate facilities

 

2,144 

 

 

Proceeds from sale of development rights

 

2,400 

 

 

Net cash used in investing activities

 

(66,550)

 

 

(65,658)

Cash flows from financing activities

 

 

 

 

 

Borrowings on credit facility

 

170,000 

 

 

116,000 

Repayment of borrowings on credit facility

 

(170,000)

 

 

(56,000)

Repayment of mortgage note payable

 

 

 

(250,000)

Payment of financing costs

 

(778)

 

 

Proceeds from the exercise of stock options

 

3,992 

 

 

2,956 

Net proceeds from the issuance of preferred stock

 

222,225 

 

 

Redemption of preferred stock

 

(230,000)

 

 

Cash paid for taxes in lieu of shares upon vesting of restricted stock units

 

(3,865)

 

 

(1,940)

Cash paid to restricted stock unit holders

 

(582)

 

 

Distributions paid to preferred shareholders

 

(38,472)

 

 

(41,498)

Distributions paid to common shareholders

 

(69,364)

 

 

(60,932)

Distributions paid to noncontrolling interests

 

(18,629)

 

 

(16,437)

Net cash used in financing activities

 

(135,473)

 

 

(307,851)

Net increase (decrease) in cash and cash equivalents

 

4,029 

 

 

(183,896)

Cash and cash equivalents at the beginning of the period

 

128,629 

 

 

188,912 

Cash and cash equivalents at the end of the period

$

132,658 

 

$

5,016 



 

 

 

 

 

Supplemental schedule of non-cash investing and financing activities

 

 

 

 

 

Adjustment to noncontrolling interests in OP

 

 

 

 

 

Noncontrolling interests

$

(119)

 

$

1,613 

Paid-in capital

$

119 

 

$

(1,613)

Preferred Redemption Allocation

 

 

 

 

 

Paid-in capital

$

6,900 

 

$

 —

Accumulated earnings (deficit)

$

(6,900)

 

$

 —

Preferred stock called for redemption

 

 

 

 

 

Preferred stock called for redemption and reclassified to liabilities

$

220,000 

 

$

 —

Preferred stock called for redemption and reclassified from equity

$

(220,000)

 

$

 —

 

See accompanying notes.

 

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PS BUSINESS PARKS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2017



1. Organization and description of business



PS Business Parks, Inc. (“PSB”) was incorporated in the state of California in 1990. As of September 30, 2017, PSB owned 78.0% of the common partnership units of PS Business Parks, L.P. (the “OP”). The remaining common partnership units are owned by Public Storage (“PS”). PS’s interest in the OP is referred to as the “PS OP Interest.” PSB, as the sole general partner of the OP, has full, exclusive and complete responsibility and discretion in managing and controlling the OP. PSB and its subsidiaries, including the OP, are collectively referred to as the “Company, “we,” “us,” or “our.” PS would own 41.9% (or 14.5 million shares) of the outstanding shares of the Company’s common stock if it redeemed its common partnership units for common shares.  



The Company is a fully-integrated, self-advised and self-managed real estate investment trust (“REIT”) that owns, operates, acquires and develops commercial properties, primarily multi-tenant flex, office and industrial space. As of  September 30, 2017, the Company owned and operated 28.0 million rentable square feet of commercial space in six states and a 95.0% interest in 395 apartments. The Company also manages 684,000 rentable square feet on behalf of PS.



References to the number of properties or square footage are unaudited and outside the scope of the Company’s independent registered public accounting firm’s review of the Company’s consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States).



2. Summary of significant accounting policies



Basis of presentation



The accompanying unaudited consolidated financial statements include the accounts of PSB and its subsidiaries, including the OP. All significant inter-company balances and transactions have been eliminated in the consolidated financial statements. The financial statements are presented on an accrual basis in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for the year ended December 31, 2017. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.  



Consolidation and equity method of accounting



We consider entities to be Variable Interest Entities (“VIEs”) when they have insufficient equity to finance their activities without additional subordinated financial support provided by other parties, or the equity holders as a group do not have a controlling financial interest. A limited partnership is also generally considered a VIE if the limited partners do not participate in operating decisions. We consolidate VIEs when we are the primary beneficiary, generally defined as having (i) the power to direct the activities most significantly impacting economic performance and (ii) either the obligation to absorb losses or the right to receive benefits from the VIE.



We account for investments in entities that are not VIEs that we have significant influence over, but do not control, using the equity method of accounting.  At September 30, 2017, we have an interest in a joint venture engaged in the development and operation of residential real estate, which we account for using the equity method of accounting. See Note 4 for more information on this entity.

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PS, the sole limited partner in the OP, has no power to direct the activities of the OP. We are the primary beneficiary of the OP. Accordingly, we consider the OP a VIE and consolidate it. Substantially all of our assets and liabilities are held by the OP.



Noncontrolling interests



The PS OP Interest represents PS’s noncontrolling interest in the OP through its ownership of 7,305,355 common partnership units. See note 7 for further information. 



Use of estimates



The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from these estimates.



Allowance for doubtful accounts



The Company monitors the collectability of its receivable balances including the deferred rent receivable on an ongoing basis. Tenant receivables are net of an allowance for estimated uncollectible accounts totaling $400,000 at September 30, 2017 and December 31, 2016. Deferred rent receivable is net of an allowance for uncollectible accounts totaling $910,000 and $916,000 at September 30, 2017 and December 31, 2016, respectively.



Financial instruments



The methods and assumptions used to estimate the fair value of financial instruments are described below. The Company has estimated the fair value of financial instruments using available market information and appropriate valuation methodologies. Considerable judgment is required in interpreting market data to develop estimates of market value. Accordingly, estimated fair values are not necessarily indicative of the amounts that could be realized in current market exchanges. The Company determines the estimated fair value of financial assets and liabilities utilizing a hierarchy of valuation techniques based on whether the inputs to a fair value measurement are considered to be observable or unobservable in a marketplace. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect market assumptions. This hierarchy requires the use of observable market data when available. The following is the fair value hierarchy:



·

Level 1—quoted prices for identical instruments in active markets;

·

Level 2—quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which significant inputs and significant value drivers are observable in active markets; and

·

Level 3—fair value measurements derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.



Financial assets that are exposed to credit risk consist primarily of cash and cash equivalents and receivables. The Company considers all highly liquid investments with a remaining maturity of three months or less at the date of purchase to be cash equivalents. Cash and cash equivalents, which consist primarily of money market investments, are only invested in entities with an investment grade rating. Receivables are comprised of balances due from a large number of customers. Balances that the Company expects to become uncollectible are reserved for or written off. Due to the short period to maturity of the Company’s cash and cash equivalents, accounts receivable, other assets and accrued and other liabilities, the carrying values as presented on the consolidated balance sheets are reasonable estimates of fair value.



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Carrying values of the Company’s unsecured Credit Facility (as defined on page 15) approximate fair value. The characteristics of these financial instruments, market data and other comparative metrics utilized in determining these fair values are “Level 2” inputs.



Real estate facilities



Real estate facilities are recorded at cost. Property taxes, insurance, interest and costs essential to the development of property for its intended use are capitalized during the period of development. Costs related to the renovation or improvement of the properties are capitalized. Expenditures for repairs and maintenance are expensed as incurred. Expenditures that are expected to benefit a period greater than two years and exceed $2,000 are capitalized and depreciated over their estimated useful life. Buildings and improvements are depreciated using the straight-line method over their estimated useful lives, which generally range from five to 30 years. Transaction costs, which include tenant improvements and lease commissions, of $1,000 or more for leases with terms greater than one year are capitalized and depreciated over their estimated useful lives. Transaction costs less than $1,000 or for leases of one year or less are expensed as incurred.



Property held for disposition or development



Real estate is classified as held for disposition when the asset is being marketed for sale and we expect that a sale is likely to occur in the next 12 months. Real estate is classified as held for development when it is likely that it will be developed to an alternate use and no longer used in its present form. Property held for development or disposition is not depreciated.



Intangible assets/liabilities



When we acquire facilities, an intangible asset is recorded for leases where the in-place rent is higher than market rents, and an intangible liability is recorded where the market rents are higher than the in-place rents. The amounts recorded are based upon the present value (using a discount rate which reflects the risks associated with the leases acquired) of such differences over the lease term and such amounts are amortized to rental income over the respective remaining lease term.



We have no material intangible assets or liabilities for any periods presented.



Evaluation of asset impairment



We evaluate our real estate and finite-lived intangible assets for impairment each quarter. If there are indicators of impairment and we determine that the asset is not recoverable from future undiscounted cash flows to be received through the asset’s remaining life (or, if earlier, the expected disposal date), we record an impairment charge to the extent the carrying amount exceeds the asset’s estimated fair value or net proceeds from expected disposal.



We evaluate our investment in our unconsolidated joint venture on a quarterly basis. We record an impairment charge to the extent the carrying amount exceeds estimated fair value, when we believe any such shortfall is other than temporary.



No impairments were recorded in any of our evaluations for any period presented herein.



Stock compensation



All share-based payments to employees, including grants of employee stock options, are recognized as stock compensation in the Company’s consolidated statements of income based on their fair values at the beginning of the service period. See Note 11.

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Accrued and other liabilities and other assets



Accrued and other liabilities consist primarily of rents prepaid by our tenants, trade payables, property tax accruals, accrued payroll and contingent loss accruals when probable and estimable. We disclose the nature of significant unaccrued losses that are reasonably possible of occurring and, if estimable, a range of exposure. Other assets are comprised primarily of prepaid expenses. We believe the fair value of our accrued and other liabilities and other assets approximate book value, due to the short period until settlement.



Revenue recognition



Revenue is recognized with respect to contractual arrangements when persuasive evidence of an arrangement exists; the delivery has occurred or services have been rendered; the fee is fixed or determinable; and collectability is reasonably assured. All leases are classified as operating leases. Rental income is recognized on a straight-line basis over the lease term, with the excess of cumulative rental income recognized over the cumulative rent billed for the lease term reflected as “deferred rent receivable” on our consolidated balance sheets. Reimbursements from tenants for real estate taxes and other recoverable operating expenses are recognized as rental income in the period the applicable costs are incurred. Property management fees are recognized in the period earned.



Costs incurred in acquiring tenants (primarily tenant improvements and lease commissions) are capitalized and amortized over the lease period.



Gains from sales of real estate facilities



The Company recognizes gains from sales of real estate facilities at the time of sale using the full accrual method, provided that various criteria related to the terms of the transactions and any subsequent involvement by the Company with the properties sold are met. If the criteria are not met, the Company defers the gains and recognizes them when the criteria are met or uses the installment or cost recovery methods as appropriate under the circumstances.



General and administrative expenses



General and administrative expenses include executive and other compensation, corporate office expenses, professional fees, acquisition transaction costs, state income taxes and other such costs that are not directly related to the operation of our real estate facilities.



Income taxes



We have elected to be treated as a REIT, as defined in the Internal Revenue Code of 1986, as amended (the “Code”). As a REIT, we do not incur federal income tax if we distribute 100% of our REIT taxable income each year, and if we meet certain organizational and operational rules. We believe we have met these REIT requirements for all periods presented herein. Accordingly, we have recorded no federal income tax expense related to our REIT taxable income.



We recognize tax benefits of uncertain income tax positions that are subject to audit only if we believe it is more likely than not that the position would ultimately be sustained assuming the relevant taxing authorities had full knowledge of the relevant facts and circumstances of our positions. As of September 30, 2017, we did not recognize any tax benefits for uncertain positions.



Accounting for preferred equity issuance costs



We record issuance costs as a reduction to paid-in capital on our consolidated balance sheets at the time the preferred securities are issued and reflect the carrying value of the preferred equity at its redemption value. An additional allocation of income is made from the common shareholders to the preferred shareholders in the amount of

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the original issuance costs, and we reclassify the redemption value from equity to liabilities when we call preferred shares for redemption.



Net income per common share



Notwithstanding the presentation of income allocations on our consolidated statements of income, net income is allocated to (a) preferred shareholders, for distributions paid, (b) preferred shareholders, to the extent redemption value exceeds the related carrying value (a “Preferred Redemption Allocation”) and (c) restricted share unit holders, for non-forfeitable dividends paid adjusted for participation rights in undistributed earnings. The remaining net income is allocated to the common partnership units and our common shareholders, respectively, based upon the pro-rata aggregate number of units and shares outstanding.



Basic and diluted net income per common share are each calculated based upon net income allocable to common shareholders, divided by (i) in the case of basic net income per common share, weighted average common shares and (ii) in the case of diluted income per share, weighted average common shares adjusted for the impact, if dilutive, of stock compensation awards outstanding (Note 11).



The following tables set forth the calculation of the components of our basic and diluted income per share that are not reflected on the face of our consolidated statements of income, including the allocation of income to common shareholders and common partnership units, the percentage of weighted average shares and common partnership units, as well as basic and diluted weighted average shares (in thousands):







 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 



For The Three Months

 

For The Nine Months



Ended September 30,

 

Ended September 30,

 

2017

 

2016

 

2017

 

2016

Calculation of net income allocable to common shareholders

 

 

 

 

 

 

 

 

 

Net income

$

42,631 

 

$

38,994 

 

$

133,839 

 

$

105,397 

Less net income allocated to

 

 

 

 

 

 

 

 

 

 

 

Preferred shareholders based upon distributions

 

(12,590)

 

 

(13,833)

 

 

(38,472)

 

 

(41,498)

Preferred shareholders based upon redemptions

 

(6,900)

 

 

 

 

(6,900)

 

 

Restricted stock unit holders

 

(137)

 

 

(128)

 

 

(582)

 

 

(387)

Net income allocable to common shareholders

 

 

 

 

 

 

 

 

 

 

 

and noncontrolling interests

 

23,004 

 

 

25,033 

 

 

87,885 

 

 

63,512 

Net income allocation to noncontrolling interests

 

(4,866)

 

 

(5,315)

 

 

(18,610)

 

 

(13,495)

Net income allocable to common shareholders

$

18,138 

 

$

19,718 

 

$

69,275 

 

$

50,017 



 

 

 

 

 

 

 

 

 

 

 

Calculation of common partnership units as a percentage of common share equivalents

 

Weighted average common shares outstanding

 

27,226 

 

 

27,103 

 

 

27,192 

 

 

27,076 

Weighted average common partnership units outstanding

 

7,305 

 

 

7,305 

 

 

7,305 

 

 

7,305 

Total common share equivalents

 

34,531 

 

 

34,408 

 

 

34,497 

 

 

34,381 

Common partnership units as a percent of common

 

 

 

 

 

 

 

 

 

 

 

share equivalents

 

21.2% 

 

 

21.2% 

 

 

21.2% 

 

 

21.2% 



 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

 

 

 

 

 

 

 

 

 

 

Basic weighted average common shares outstanding

 

27,226 

 

 

27,103 

 

 

27,192 

 

 

27,076 

Net effect of dilutive stock compensation—based on

 

 

 

 

 

 

 

 

 

 

 

treasury stock method using average market price

 

201 

 

 

98 

 

 

207 

 

 

90 

Diluted weighted average common shares outstanding

 

27,427 

 

 

27,201 

 

 

27,399 

 

 

27,166 

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Segment reporting



The Company views its operations as one segment.



Reclassifications



Certain reclassifications have been made to the consolidated financial statements for 2016 and in order to conform to the 2017 presentation, including reclassifying management fee income totaling $130,000 and $389,000 for the three and nine months ended September 30, 2016 into “interest and other income” on our consolidated statements of income.



Recently issued accounting standards



In May 2014 and February 2016, the Financial Accounting Standards Board issued two Accounting Standards Updates (“ASU”s), ASU 2014-09, Revenue from Contracts with Customers (the “Revenue Standard”), and ASU 2016-02, Leases (the “Lease Standard”). These standards apply to substantially all of our revenue generating activities, as well as provide a model to account for the disposition of real estate facilities to non-customers, which is governed under ASU 2017-05.



The Lease Standard will direct how we account for payments from the elements of our leases that are generally fixed and determinable at the inception of the lease (“Fixed Lease Payments”) while the Revenue Standard will direct how we account for the non-lease components of our lease contracts, primarily expense reimbursements (“Non-Lease Payments”) and the accounting for the disposition of real estate facilities.



The Revenue Standard is effective on January 1, 2018, and generally requires that revenue from Non-Lease Payments be based upon the consideration expected from our tenants, and be recognized under various methods depending upon the nature of the underlying expense and the contractual reimbursement arrangement. The standard permits either the retrospective (restatement) method or cumulative effects transition method and allowed for early adoption on January 1, 2017, which we did not elect. We expect to use the cumulative effects transition method, which will result in an adjustment to our retained earnings effective January 1, 2018 for the cumulative impact of the standard as of December 31, 2017. We do not expect this standard to have a material impact on our accounting for our facility management fees for property management services provided to PS or the disposition of real estate facilities as our accounting policy is consistent with the provisions of the standard. Rental income from leasing arrangements is a substantial portion of our revenues and is specifically excluded from the Revenue Standard and will be governed by the Lease Standard. In conjunction with the adoption of the Lease Standard, we are currently evaluating the impact of the standard as it relates to Non-Lease Payments.



The Lease Standard is effective on January 1, 2019. The standard provides definitional guidance of what constitutes a lease, requiring lessees to recognize most leases on the balance sheet and making certain changes to lessor accounting. For leases in which we are the lessor, we are required to account for Fixed Lease Payments on a straight-line basis, with the expected fixed payments recognized ratably over the term of the lease. The standard also requires capitalization of only the incremental costs incurred in executing each particular lease, such as legal fees to draft a lease or commissions based upon a particular lease. Costs that would have been incurred regardless of lease execution, such as allocated costs of internal personnel, are not capitalized. For most leases with a term of greater than 12 months, in which we are the lessee, the present value of future lease payments will be recognized on our balance sheet as a right-of-use asset and related labiality. As of September 30, 2017, the remaining contractual payments under our ground lease agreements aggregated $282,000. The standard requires a modified retrospective transition approach for all leases existing at or entered into after the beginning of the earliest comparative period presented in the financial statements on the date of initial application and allowed early adoption, which we did not elect. We do not expect that the Lease Standard will impact our accounting for Fixed Lease Payments, because our accounting policy is currently consistent with the provisions of the standard. We are currently evaluating the impact of the standard as it relates to the capitalization of costs associated with executed leases.



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In August, 2016, the FASB issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments, which provides guidance on the classification of certain specific cash receipts and cash payments in the statement of cash flows, including, but not limited to, cash distributions received from equity method investees, including unconsolidated joint ventures. The new standard is effective for periods beginning after December 15, 2017, with early adoption permitted and shall be applied retrospectively where practicable. The Company is currently in the process of evaluating the impact of adoption of the new accounting guidance on its consolidated financial statements.



In November, 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230) – Restricted Cash, which requires the statements of cash flows to explain the change during the period in the total cash, cash equivalents, restricted cash and restricted cash equivalents. The new guidance also requires entities to reconcile such total to amounts on the balance sheets and disclose the nature of the restrictions. The guidance is effective for public entities for fiscal years beginning after December 15, 2017 and for interim periods therein, with early adoption permitted. The guidance must be adopted using a modified retrospective approach. The Company does not expect the adoption of this standard to have a material impact on its consolidated financial statements.



In January, 2017, the FASB issued ASU 2017-01, Business Combinations (Topic 805) - Clarifying the Definition of a Business. Under the new guidance, a set of transferred assets and activities is not a business when substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets, which we believe will apply to substantially all of our future acquisitions of real estate facilities. Previously, such acquisitions were considered the acquisition of a business, and transaction costs of such acquisitions were expensed as incurred. Under the new guidance, transaction costs will instead be capitalized as part of the purchase price. This standard is effective for fiscal years beginning after December 15, 2017. We early adopted the standard on January 1, 2017; however, the adoption had no effect because we have not acquired any facilities since January 1, 2017.



3. Real estate facilities



The activity in real estate facilities for the nine months ended September 30, 2017 is as follows (in thousands):





 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 



 

 

 

Buildings and

 

Accumulated

 

 

 

 

Land

 

Improvements

 

Depreciation

 

Total

Balances at December 31, 2016

$

789,227 

 

$

2,224,522 

 

$

(1,158,054)

 

$

1,855,695 

Capital expenditures

 

 

 

39,321 

 

 

 

 

39,321 

Disposals

 

 

 

(9,180)

 

 

9,180 

 

 

Depreciation and amortization

 

 

 

 

 

(70,465)

 

 

(70,465)

Transfer to properties held for disposition

 

 

 

 

 

25 

 

 

25 

Balances at September 30, 2017

$

789,227 

 

$

2,254,663 

 

$

(1,219,314)

 

$

1,824,576 



The purchase price of acquired properties is allocated to land, buildings and improvements (including tenant improvements, unamortized lease commissions, acquired in-place lease values and tenant relationships, if any), intangible assets and intangible liabilities (see Note 2), based upon the relative fair value of each component, which are evaluated independently.



We must make significant assumptions in determining the fair value of assets acquired and liabilities assumed, which can affect the recognition and timing of revenue and depreciation and amortization expense. The fair value of land is estimated based upon, among other considerations, comparable sales of land within the same region. The fair value of buildings and improvements, tenant improvements and unamortized lease commissions are based on current market replacement costs and other market information. The amount recorded to acquired in-place leases is determined based on management’s assessment of current market conditions and the estimated lease-up periods for the respective spaces.



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



On March 31, 2017, the Company sold development rights it held to build medical office buildings on land adjacent to its Westech Business Park in Silver Spring, Maryland for $6.5 million. The Company had acquired the development rights as part of its 2006 acquisition of the park. The Company has received net proceeds of $3.9 million, of which $1.5 million was received in prior years and $2.4 million was received in March, 2017. The Company recorded a gain of $3.9 million related to the net proceeds received through September 30, 2017, which are non-refundable. The Company will report an additional gain of $2.5 million when the final proceeds are received in the fourth quarter of 2017 and the remaining contingencies have lapsed.



As of September 30, 2017, we have commitments, pursuant to executed leases, to spend $12.7 million in transaction costs, which include tenant improvements and lease commissions.



4. Investment in and advances to unconsolidated joint venture



In 2013, the Company entered into a joint venture known as Amherst JV LLC (the “Joint Venture”) with an unrelated real estate development company (the “JV Partner”) for the purpose of developing a 395-unit multi-family building on a five-acre site (the “Project”) within the Company’s 628,000 square foot office park located in Tysons, Virginia (known as “The Mile”).  We hold a 95.0% interest in the Joint Venture with the remaining 5.0% held by the JV Partner. The JV Partner is responsible for the development and construction of the Project, as well as the leasing and operational management of the Project. We do not control the Joint Venture, when considering, among other factors, that the consent of our JV Partner is required for all significant decisions. Accordingly, we account for our investment using the equity method.



On  October 5, 2015 (the “Contribution Date”), the Company contributed the site and improvements to the Joint Venture. We provide the Joint Venture with a construction loan in the amount of $75.0 million bearing interest at the London Interbank Offered Rate (“LIBOR”) plus 2.25%. The loan will mature on April 5, 2019 with two one-year extension options.



The aggregate amount of development costs are estimated to be $105.6 million (excluding unrealized land appreciation). The Company is committed to funding $75.0 million through the construction loan in addition to its equity contribution of $28.5 million, which includes a  land basis of $15.3 million. The Project delivered its first completed units in May, 2017, with final completion date of the overall Project expected during the fourth quarter of 2017.



We have reflected the aggregate cost of the contributed site and improvements,  our equity contributions and loan advances,  as well as capitalized third party interest we incurred as investment in and advances to unconsolidated joint venture. The Company’s investment in and advances to unconsolidated joint venture was $96.6 million and $67.2 million as of September 30, 2017 and December 31, 2016, respectively. For the nine months ended September 30, 2017,  we made loan advances of $29.7 million and capitalized $506,000 of interest. For the nine months ended September 30, 2016, the Company made loan advances to the Joint Venture of $22.3 million, capital contributions of $5.7 million and capitalized $854,000 of interest.



As of September 30, 2017, all 395 units have been completed. During the three and nine months ended September 30, 2017, the Company recorded an equity loss in the unconsolidated joint venture of $376,000 and $758,000, respectively.

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5. Leasing activity



The Company leases space in its real estate facilities to tenants primarily under non-cancelable leases generally ranging from one to 10 years. Future minimum rental revenues, excluding recovery of operating expenses under these leases, are as follows as of September 30, 2017 (in thousands):







 

 



 

 

Remainder of 2017

$

75,498 

2018

 

267,885 

2019

 

196,801 

2020

 

133,240 

2021

 

92,451 

Thereafter

 

168,364 

Total

$

934,239 



In addition to minimum rental payments, certain tenants reimburse the Company for their pro rata share of specified operating expenses. Such reimbursements amounted to $22.6 million and $20.3 million for the three months ended September 30, 2017 and 2016, respectively, and $68.4 million and $61.6 million for the nine months ended September 30, 2017 and 2016, respectively. These amounts are included as rental income in the accompanying consolidated statements of income.



Leases accounting for 3.0% of total leased square footage are subject to termination options, of which 1.2% of total leased square footage have termination options exercisable through December 31, 2017. In general, these leases provide for termination payments should the termination options be exercised. The future minimum rental revenues in the above table assume such options are not exercised.



6. Bank loans



We have a line of credit (the “Credit Facility”) with Wells Fargo Bank, National Association (“Wells Fargo”). The Credit Facility has a borrowing limit of $250.0 million and expires January 10, 2022. The rate of interest charged on borrowings is based on the LIBOR plus 0.80% to LIBOR plus 1.55% depending on the Company’s credit ratings. Currently, the Company’s rate under the Credit Facility is LIBOR plus 0.825%. In addition, the Company is required to pay an annual facility fee ranging from 0.10% to 0.30% of the borrowing limit depending on the Company’s credit ratings (currently 0.125%). We paid $613,000 of loan origination costs in January, 2017. The Company had no balance outstanding on the Credit Facility at September 30, 2017 and December 31, 2016.  Subsequent to September 30, 2017, the Company borrowed net $80.0 million on the Credit Facility. The Company had $979,000 and $539,000 of unamortized loan origination costs as of September 30, 2017 and December 31, 2016, respectively, which is included in other assets in the accompanying consolidated balance sheets. The Credit Facility requires us to meet certain covenants, all of which we were in compliance with as of September 30, 2017. Interest on outstanding borrowings is payable monthly.  



7. Noncontrolling interests



Noncontrolling interests represent 7,305,355 common partnership units of the OP owned by PS. Each common partnership unit receives a cash distribution equal to the dividend paid on our common shares and is redeemable at PS’s option.



If PS exercises its right of redemption, at PSB’s option (a) PS will receive one common share from us for each common partnership unit redeemed, or (b) PS will receive cash from us for each common partnership unit generally equal to the market value of a common share (as defined in the Operating Partnership Agreement). We can prevent redemptions that we believe would violate either our articles of incorporation or securities laws, cause PSB to no longer qualify as a REIT, or could result in the OP no longer being treated as a partnership for federal tax purposes.

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In allocating net income and presenting equity, we treat the common partnership units as if converted to common shares. Accordingly, they receive the same net income allocation per unit as a common share and are adjusted each period to have the same equity per unit as a common share. 



8. Related party transactions



We manage industrial, office and retail facilities in the U.S. for PS under both the “Public Storage” or “PS Business Parks” names (the “PS Management Agreement”). The PS Management Agreement can be cancelled by either party with seven years notice. Under PS’s supervision, we coordinate and assist in rental and marketing activities, property maintenance and other operational activities, including the selection of vendors, suppliers, employees and independent contractors. We receive a management fee based upon a percentage of revenues. Management fee revenues were $126,000 and $130,000 for the three months ended September 30, 2017 and 2016, respectively, and $378,000 and $389,000 for the nine months ended September 30, 2017 and 2016, respectively. We allocate certain operating expenses to PS related to the management of these properties, including payroll and other business expenses, totaling $134,000 and $142,000 for the three months ended September 30, 2017 and 2016, respectively, and $401,000 and $416,000 for the nine months ended September 30, 2017 and 2016, respectively. These amounts are included in “interest and other income” on our consolidated statements of income.



The PS Business Parks name and logo are owned by PS and licensed to us under a non-exclusive, royalty-free license agreement. The license can be terminated by either party for any reason with six months written notice.



PS also provides property management services for the self-storage component of two assets we own, that are located in Florida and operate under the “Public Storage” name. Either the Company or PS can cancel the property management contract upon 60 days’ notice. Under our supervision, PS coordinates and assists in rental and marketing activities, property maintenance and other operational activities, including the selection of vendors, suppliers, employees and independent contractors. Management fee expenses were $24,000 and $22,000 for the three months ended September 30, 2017 and 2016, respectively, and $69,000 and $64,000 for the nine months ended September 30, 2017 and 2016, respectively. Additionally, PS allocated certain operating expenses to us related to the management of these properties, including payroll and other business expenses, totaling $54,000 and $156,000 for the three and nine months ended September 30, 2017, respectively, and $49,000 and $153,000 for the three and nine months ended September 30, 2016, respectively. These amounts are included under “cost of operations” on our consolidated statements of income.



Pursuant to a cost sharing and administrative services agreement, we and PS share certain administrative services and corporate office space, which are allocated between the Company and PS in accordance with a methodology intended to fairly allocate those costs. Costs allocated to the Company totaled $132,000 and $123,000 for the three months ended September 30, 2017 and 2016, respectively, and $397,000 and $370,000 for the nine months ended September 30, 2017 and 2016, respectively. Costs allocated to PS totaled $8,000 and $23,000 for the three and nine months ended September 30, 2017, respectively.



The Company had net amounts due to PS of $30,000 and due from PS of $295,000 at September 30, 2017 and December 31, 2016, respectively, for these contracts, as well as for certain operating expenses paid by the Company on behalf of PS.



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9. Shareholders’ equity



Preferred stock



As of September 30, 2017 and December 31, 2016, the Company had the following series of preferred stock outstanding:





 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

September 30, 2017

 

December 31, 2016



 

 

 

Earliest Potential

 

Dividend

 

Shares

 

Amount

 

Shares

 

Amount

Series 

 

Issuance Date

 

Redemption Date

 

Rate

 

Outstanding

 

(in thousands)

 

Outstanding

 

(in thousands)

Series T

 

May, 2012

 

May, 2017

 

6.00% 

 

5,200 

 

$

130,000 

 

14,000 

 

$

350,000 

Series U

 

September, 2012

 

September, 2017

 

5.75% 

 

9,200 

 

 

230,000 

 

9,200 

 

 

230,000 

Series V

 

March, 2013

 

March, 2018

 

5.70% 

 

4,400 

 

 

110,000 

 

4,400 

 

 

110,000 

Series W

 

October, 2016

 

October, 2021

 

5.20% 

 

7,590 

 

 

189,750 

 

7,590 

 

 

189,750 

Series X

 

September, 2017

 

September, 2022

 

5.25% 

 

9,200 

 

 

230,000 

 

 

 

Total

 

 

 

 

 

 

 

35,590 

 

$

889,750 

 

35,190 

 

$

879,750 



During September, 2017, we called for a partial redemption of 8,800,000 of our outstanding 14,000,000 depositary shares representing interests in our 6.0% Cumulative Preferred Stock, Series T, at par. The aggregate redemption amount of $220.0 million is scheduled to be paid on October 30, 2017 to the holders of the depositary shares. We recorded a Preferred Redemption Allocation of $6.9 million for the three and nine months ended September 30, 2017 and reclassified the shares from equity to “preferred stock called for redemption” on our consolidated balance sheets at September 30, 2017.



On September 21, 2017, we issued $230.0 million or 9,200,000 depositary shares representing interests in our 5.25% Cumulative Preferred Stock, Series X, at $25.00 per depositary share. The 5.25% Series X Cumulative Redeemable Preferred Units are non-callable for five years and have no mandatory redemption. We received $222.2 million in net proceeds.



On December 7, 2016, we called our 6.45% Cumulative Preferred Stock, Series S, for redemption at par and completed the redemption on January 18, 2017. We recorded a Preferred Redemption Allocation of $7.3 million in the three months ended December 31, 2016 and reclassified the shares from equity to “preferred stock called for redemption” on our consolidated balance sheets at December 31, 2016.



We paid $12.6 million and $13.8 million in distributions to our preferred shareholders for the three months ended September 30, 2017 and 2016, respectively, and $38.5 million and $41.5 million in distributions to our preferred shareholders for the nine months ended September 30, 2017 and 2016, respectively.



The holders of our preferred stock have general preference rights with respect to liquidation, quarterly distributions and any accumulated unpaid distributions. Holders of our preferred stock will not be entitled to vote on most matters, except under certain conditions. In the event of a cumulative arrearage equal to six quarterly dividends, the holders of the preferred stock will have the right to elect two additional members to serve on the Company’s Board of Directors (the “Board”) until all events of default have been cured. At September 30, 2017, there were no dividends in arrears.



Except under certain conditions relating to the Company’s qualification as a REIT, the preferred stock is not redeemable prior to the previously noted redemption dates. On or after the respective redemption dates, the respective series of preferred stock will be redeemable, at the option of the Company, in whole or in part, at $25.00 per depositary share, plus any accrued and unpaid dividends.



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Common stock



During the three months ended March 31, 2017, the Board increased our quarterly dividends from $0.75 per common share to $0.85 per common share.



We paid $23.2 million ($0.85 per common share) and $20.3 million ($0.75 per common share) in distributions to our common shareholders for the three months ended September 30, 2017 and 2016, respectively, and $69.4 million ($2.55 per common share) and $60.9 million ($2.25 per common share) in distributions to our common shareholders for the nine months ended September 30, 2017 and 2016, respectively.



Equity stock



In addition to common and preferred stock, the Company is authorized to issue 100.0 million shares of Equity Stock. The Articles of Incorporation provide that Equity Stock may be issued from time to time in one or more series and give the Board broad authority to fix the dividend and distribution rights, conversion and voting rights, redemption provisions and liquidation rights of each series of Equity Stock.



10. Commitments and contingencies



The Company currently is neither subject to any other material litigation nor, to management’s knowledge, is any material litigation currently threatened against the Company other than routine litigation and administrative proceedings arising in the ordinary course of business.



11. Stock compensation



Under various share-based compensation plans, PSB grants non-qualified options to purchase the Company’s common shares at a price not less than fair value on the date of grant, as well as restricted stock units (“RSUs”), to certain directors, officers and key employees.



The service period for stock options and RSUs begins when (i) the Company and the recipient reach a mutual understanding of the key terms of the award, (ii) the award has been authorized, (iii) the recipient is affected by changes in the market price of our stock and (iv) it is probable that any performance conditions will be met, and ends when the stock option or RSU vests.



We amortize the fair value of awards at the beginning of the service period as compensation expense. For awards that are earned solely upon the passage of time and continued service, the entire cost of the award is amortized on a straight-line basis over the service period. For awards with performance conditions, the individual cost of each vesting is amortized separately over each individual service period (the “accelerated attribution” method).



In amortizing share-based compensation expense, we do not estimate future forfeitures in advance. Instead, we reverse previously amortized share-based compensation expense with respect to grants that are forfeited in the period the employee terminates employment.



Stock Options



Stock options vest over a five-year period, expire after the grant date and the exercise price is equal to the closing trading price of our common shares on the grant date. Employees cannot require the Company to settle their award in cash. We use the Black-Scholes option valuation model to estimate the fair value of our stock options.



For the three and nine months ended September 30, 2017, respectively we recorded $53,000 and $156,000 in compensation expense related to stock options, as compared to $51,000 and $229,000 for the same periods in 2016.



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During the nine months ended September 30, 2017, 16,000 stock options were granted and 69,676 options were exercised. A total of 175,979 options were outstanding at September 30, 2017 (229,655 at December 31, 2016). 



Restricted Stock Units



RSUs generally vest ratably over a five-year period from the grant date. The grantee receives dividends for each outstanding RSU equal to the per-share dividends received by our common shareholders. We expense any dividends previously paid upon forfeiture of the related RSU. Upon vesting, the grantee receives common shares equal to the number of vested RSUs, less common shares withheld in exchange for tax deposits made by the Company to satisfy the grantee’s statutory tax liabilities arising from the vesting. The fair value of our RSUs is determined based upon the applicable closing trading price of our common shares on the date of grant.  



For the three and nine months ended September 30, 2017, respectively, we recorded a net reversal of $521,000 and expense of $2.9 million in compensation expense related to RSUs, as compared to expense of $1.7 million and $8.5 million for the same periods in 2016. In conjunction with the departure of our Chief Financial Officer (“CFO”), the Company recorded a reversal of stock compensation of $1.9 million in RSU expense related to RSUs under our LTEIP (see below) during the third quarter of 2017. The 2016 amount includes  $2.0 million in additional RSU expense related to RSUs under our LTEIP expected to be issued to our former Chief Executive Officer (“CEO”).  



During the nine months ended September 30, 2017, 110,750 RSUs were granted, 15,806 RSUs were forfeited and 76,994 RSUs vested. This vesting resulted in the issuance of 43,223 common shares. In addition, tax deposits totaling $3.9 million ($1.9 million for the same period in 2016) were made on behalf of employees in exchange for 33,771 common shares withheld upon vesting. A total of 162,643 RSUs were outstanding at September 30, 2017 (144,693 at December 31, 2016). 



Effective March, 2014, the Company entered into a performance-based restricted stock unit program, the Senior Management Long-Term Equity Incentive Program for 2014-2017 (“LTEIP”), with certain employees of the Company. Under the LTEIP, the Company established three levels of targeted restricted stock unit awards for certain employees, which would be earned only if the Company achieved one of three defined targets during 2014 to 2017. Under the LTEIP there is an annual award following the end of each of the four years in the program, with the award subject to and based on the achievement of total return targets during the previous year, as well as an award based on achieving total return targets during the cumulative four-year period 2014-2017. In the event the minimum defined target is not achieved for an annual award, the restricted stock units allocated to be awarded for such year are added to the restricted stock units that may be received if the four-year target is achieved. All restricted stock unit awards under the LTEIP vest in four equal annual installments beginning from the date of award. Up to 94,150 restricted stock units would be awarded for each of the four years assuming achievement was met and up to 81,800 restricted stock units would be awarded for the cumulative four-year period assuming achievement was met. Compensation expense is recognized based on the restricted stock units expected to be awarded based on the target level that is expected to be achieved. The compensation expense and RSU counts with respect to the LTEIP are included in the aggregate RSU amounts disclosed above.



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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



Forward-Looking Statements: Forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, are made throughout this Quarterly Report on Form 10-Q. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “may,” “believes,” “anticipates,” “plans,” “expects,” “seeks,” “estimates,” “intends” and similar expressions are intended to identify forward-looking statements. There are a number of important factors that could cause the results of the Company to differ materially from those indicated by such forward-looking statements, including but not limited to: (a) changes in general economic and business conditions; (b) decreases in rental rates or increases in vacancy rates/failure to renew or replace expiring leases; (c) tenant defaults; (d) the effect of the recent credit and financial market conditions; (e) our failure to maintain our status as a REIT under the Internal Revenue Code of 1986, as amended; (f) the economic health of our tenants; (g) increases in operating costs; (h) casualties to our properties not covered by insurance; (i) the availability and cost of capital; (j) increases in interest rates and its effect on our stock price; and (k) other factors discussed under the heading “Part I, Item 1A. Risk Factors” in our annual report on Form 10-K for the year ended December 31, 2016. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved. Moreover, we assume no obligation to update these forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting such forward-looking statements, except as required by law.



Critical Accounting Policies: 



Our accounting policies are described in Note 2 to the consolidated financial statements included in this Form 10-Q. We believe the following are our critical accounting policies, because they have a material impact on the portrayal of our financial condition and results, and they require us to make judgments and estimates about matters that are inherently uncertain.



Income Tax Expense: We have elected to be treated as a REIT, as defined in the Internal Revenue Code of 1986, as amended (the “Code”). As a REIT, we do not incur federal income tax on our REIT taxable income that is fully distributed each year (for this purpose, certain distributions paid in a subsequent year may be considered), and if we meet certain organizational and operational rules. We believe we have met these REIT requirements for all periods presented herein. Accordingly, we have recorded no federal income tax expense related to our REIT taxable income.



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



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

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



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



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



Strategic Overview



Our overall operating results are impacted primarily by the performance of our existing real estate facilities, which at September 30, 2017 are comprised of 28.0 million rentable square feet of multi-tenant flex, industrial and office properties concentrated in six states and a 95.0% interest in 395 apartments. Accordingly, a significant degree of management attention is paid to maximizing the cash flow from our existing real estate portfolio. We also acquire properties we believe will create long-term value, and from time to time we dispose of properties which no longer fit within the Company’s strategic objectives.



Existing Real Estate Facilities: The operating results of our existing real estate facilities are substantially influenced by demand for rental space within our properties and our markets, which impacts occupancy, rental rates and capital requirements. We strive to maintain high occupancy levels while increasing rental rates and minimizing capital expenditures when market conditions allow, although the Company may decrease rental rates in markets where conditions require. Management’s initiatives and strategies with respect to our existing real estate facilities which are described in more detail in our December 31, 2016 Form 10-K, include incentivizing our personnel to maximize the return on investment for each lease transaction and providing a superior level of service to our customers.



Acquisitions of Real Estate Facilities: We also seek to grow our operations through acquisitions of facilities generally consistent with the Company’s focus on owning concentrated business parks with easily configurable space. In the third quarter of 2016, we acquired two multi-tenant office buildings aggregating 226,000 square feet in Rockville, Maryland for a purchase price of $13.3 million. The occupancy rate has increased from 18.5% on the date of acquisition to 31.6% as of September 30, 2017. These buildings are located within The Grove 270 (formerly Shady Grove Executive Park) where we already owned three substantially fully-leased buildings aggregating 352,000 square feet. We continue to seek to acquire additional facilities in our existing markets and generally in proximity to our existing facilities; however, there can be no assurance that we will acquire additional facilities that meet our risk-adjusted return and underwriting requirements.



Development or redevelopment of real estate facilities:  We also may seek to redevelop our existing real estate. We own a large contiguous block of real estate (628,000 rentable square feet on 44.5 acres of land) located within The Mile in Tysons, Virginia. We demolished one of our existing office buildings in The Mile and are building a multi-family building (the “Highgate Development”), with completion in stages starting in May, 2017 through the fourth

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quarter of 2017. The total estimated investment upon completion, including the fair value of existing land, will be approximately $117.2 million.



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



We do not consolidate the joint venture that holds the Highgate Development; accordingly, our share of net loss is reflected under “equity in loss of unconsolidated joint venture.”



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



Dispositions of Real Estate Facilities: In 2014, we completed a plan to exit non-strategic markets in Sacramento California, Oregon and Arizona. We do not expect to exit any additional markets. However, we may from time to time dispose of individual real estate assets based on market conditions, fit with our existing portfolio or other reasons. On May 1, 2017, we disposed of Empire Commerce, a two-building single-story office park comprising 44,000 square feet, located in Dallas, Texas, for net proceeds of $2.1 million, which resulted in a net gain of $1.2 million.



Certain Factors that May Impact Future Results



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



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



Industry and Tenant Concentrations: We seek to minimize the risk of industry or tenant concentrations. As of September 30, 2017, leases from our top 10 tenants comprised 10.3% of our annualized rental income, with only two tenants, Kaiser Permanente (1.0%) and the U.S. Government (4.3%), representing more than 1%. In terms of industry concentration, 18.5% of our annualized rental income comes from Business Services; 10.4% from Warehouse, Distribution, Transportation and Logistics; and 10% from Health Services. No other industry group represents more than 10% of our annualized rental income. 



Tenant credit risk: We have historically experienced a low level of write-offs of uncollectible rents, with less than 0.5% of rental income written off each year over the last six years. However, there can be no assurance that write offs may not increase, because there is inherent uncertainty in a tenant’s ability to continue paying rent and meet its full lease obligation. As of October  23, 2017, we had 69,000 square feet of leased space occupied by four tenants that are protected by Chapter 11 of the U.S. Bankruptcy Code. From time to time, tenants contact us, requesting early termination of their lease, reductions in space leased, or rent deferment or abatement.

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Net Operating Income



We evaluate the performance of our business parks primarily based on Net Operating Income (“NOI”), a non-GAAP financial measure, because we believe NOI is an important measure of the value and performance of our real estate. We believe investors utilize NOI in a similar manner and for similar reasons. NOI is defined by the Company as Adjusted Rental Income less Adjusted Cost of Operations (described below) and excludes depreciation and amortization.  Depreciation and amortization is excluded from NOI because management and investors do not consider it important in valuing real estate or evaluating real estate performance, because depreciation assumes the value of real estate declines ratably from its historical cost based upon the passage of time, while we believe the value of real estate changes based upon cash flow and other market factors.



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



Adjusted Cost of Operations represents cost of operations, excluding LTEIP amortization, which can vary significantly period to period based upon-the performance of the whole company, rather than just property operations.



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



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





Results of Operations



Operating Results Overview: Three and Nine Months Ended September 30, 2017 and 2016



For the three months ended September 30, 2017, net income allocable to common shareholders was $18.1 million or $0.66 per diluted share, compared to $19.7 million or $0.72 per diluted share for the same period in 2016. The decrease was mainly due to a $6.9 million Preferred Redemption Allocation, offset by a $2.7 million increase in NOI with respect to our real estate facilities and reduced preferred distributions. The increase in NOI includes a $3.3 million increase for our Same Park facilities (see below) due primarily to higher realized rent per occupied square foot, offset partially by reduced NOI with respect to facilities we sold or are holding for development.



For the nine months ended September 30, 2017, net income allocable to common shareholders was $69.3 million or $2.53 per diluted share, compared to $50.0 million or $1.84 per diluted share for the same period in 2016. The increase was due to a $10.5 million increase in NOI with respect to our real estate facilities, a reduction in interest expense due to the repayment of debt, and gains on the sale of real estate facilities and development rights. The increase in NOI includes a $12.5 million increase for our Same-Park facilities due primarily to higher realized rent per occupied square foot, offset partially by reduced NOI with respect to facilities we sold or are holding for development.



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

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Analysis of Operating Income



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



We segregate our real estate activities into (a) same park operations, representing all operating properties acquired prior to January 1, 2015, comprising 27.8 million rentable square feet of our 28.0 million in rentable space at September 30, 2017 (the “Same Park” facilities), (b) non-same park operations, representing those facilities we own that were acquired after January 1, 2015 (the “Non-Same Park” facilities) and (c) assets sold or held for development, representing facilities whose existing operations are no longer part of our ongoing operations, because they were sold or are expected to be developed or converted to alternate use.



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