<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number 1-8692
PACIFIC GATEWAY PROPERTIES, INC.
(Exact name of Registrant as specified in its charter)
NEW YORK 04-2816560
------------------------------- ------------------
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
930 MONTGOMERY STREET, SUITE 400, SAN FRANCISCO, CALIFORNIA 94133
- --------------------------------------------------------------------------------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (415) 398-4800
NOT APPLICABLE
- --------------------------------------------------------------------------------
(Former name, former address and former fiscal year, if changed since last
report)
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 the number of shares outstanding of each of the issuer's classes of
common stock, as of September 30, 1997:
$1.00 Par Value Common Stock 3,892,596
- --------------------------------- ----------------------------
(Title of Class) (Number of Shares Outstanding)
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
INDEX
Part I - Financial Information: Page Number
-----------
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of
September 30, 1997 and December 31, 1996 3
Condensed Consolidated Statements of Income for
the Three and Nine Months Ended September 30,
1997 and 1996 4
Condensed Consolidated Statements of Cash Flows
for the Three and Nine Months Ended September 30, 5-6
1997 and 1996
Notes to Condensed Consolidated Financial Statements 7-12
Item 2. Management's Discussion and
Analysis of Financial Condition
and Results of Operations 12-18
Part II - Other Information
Item 1. Legal Proceedings 18
Item 2. Changes in Security None
Item 3. Defaults Upon Senior Securities None
Item 4. Submission of Matters to a Vote None
of Security Holders
Item 5. Other Information None
Item 6. Exhibits and Reports on Form 8-K 18
Signatures 19
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
AS OF AS OF
SEPTEMBER 30, DECEMBER 31,
1997 1996
------------- ------------
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 2,516 $ 2,899
Cash reserved for capital improvements,
acquisitions, debt service, property taxes
and insurance 1,532 9,975
Accounts receivable, prepaid taxes and other
current assets 509 1,179
Investment properties 69,506 46,632
Less-accumulated depreciation and provision
for write-down to net realizable value (15,875) (13,835)
-------- --------
Investment properties, net 53,631 32,797
-------- --------
Deferred tax asset 7,093 4,183
Capitalized loan costs, net 856 717
Capitalized lease commissions and rent
concessions, net 885 643
-------- --------
Total assets $ 67,022 $ 52,393
-------- --------
-------- --------
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable, prepaid rent, tenant security
deposits, accrued interest and other current
liabilities $ 1,792 $ 1,491
Debt related to investment properties 47,615 33,722
Deferred tax liability 16,952 15,012
-------- --------
Total liabilities 66,359 50,225
-------- --------
STOCKHOLDERS' EQUITY
Common stock $1.00 par value--
Authorized--10,000,000 shares
Issued--4,011,150 shares 4,011 4,011
Paid-in-deficit (10,038) (10,222)
Retained earnings 6,837 8,526
Treasury stock, at cost--118,554 common shares at
September 30, 1997 and December 31, 1996 (2,037) (2,037)
Warrants for common stock 1,890 1,890
-------- --------
Total stockholders' equity 663 2,168
-------- --------
Total liabilities and stockholders' equity $ 67,022 $ 52,393
-------- --------
-------- --------
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- -------------------
1997 1996 1997 1996
---- ---- ---- ----
<S> <C> <C> <C> <C>
INVESTMENT PROPERTIES:
Rental revenues $ 3,274 $ 2,699 $ 10,152 $ 8,419
Operating expenses (1,557) (1,456) (4,410) (4,056)
Interest expense (1,089) (661) (2,989) (2,169)
Depreciation and amortization (793) (661) (2,300) (1,899)
-------- -------- -------- --------
Investment properties income (loss) (165) (79) 453 295
-------- -------- -------- --------
General and administrative expenses (250) (408) (950) (1,266)
Other income, net 30 38 131 252
-------- -------- -------- --------
Loss before hotel operations, estimated
settlement obligation, property
transactions and taxes (385) (449) (366) (719)
Income (loss) from hotel operations -- (108) (93) 1,038
-------- -------- -------- --------
Income (loss) before estimated settlement
obligation, property transactions and
taxes (385) (557) (459) 319
Estimated provision for settlement of the
reimbursement obligation -- -- (2,200) --
Gain on sale of real estate assets, net -- -- -- 10,900
-------- -------- -------- --------
Income (loss) before taxes (385) (557) (2,659) 11,219
Income tax benefit (provision) 140 8 970 (4,800)
-------- -------- -------- --------
Net income (loss) $ (245) $ (549) $ (1,689) $ 6,419
-------- -------- -------- --------
-------- -------- -------- --------
Income (loss) per share, primary $(0.05) $(0.13) $(0.37) $ 1.53
------ ------ ------ ------
------ ------ ------ ------
Income (loss) per share, fully diluted $(0.05) $(0.13) $(0.37) $ 1.53
------ ------ ------ ------
------ ------ ------ ------
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- -------------------
1997 1996 1997 1996
---- ---- ---- ----
<S> <C> <C> <C> <C>
Cash flow from operating activities:
Net income (loss) $ (245) $ (549) $ (1,689) $ 6,419
Non-cash revenues and expenses
included in net income (loss):
Depreciation and amortization 793 661 2,300 1,899
Estimated provision for settlement of
the reimbursement obligation -- -- 2,200 --
Gain on sale of real estate assets, net -- -- -- (10,900)
Change in assets and liabilities:
Accounts receivable, prepaid taxes and
other current assets 132 752 670 502
Accounts payable and other current
liabilities 365 182 301 (810)
Current tax liability -- (535) -- 91
Deferred taxes (140) 33 (970) 4,032
-------- -------- -------- --------
NET CASH GENERATED BY OPERATING ACTIVITIES 905 544 2,812 1,233
-------- -------- -------- --------
Cash flow from investing activities:
Additions to investment properties,
capitalized loan costs, and capitalized
lease commissions and rent concessions (878) (359) (2,337) (1,452)
Proceeds from sale of properties, net -- -- -- 19,122
Acquisition of investment properties -- -- (10,975) --
-------- -------- -------- --------
NET CASH GENERATED BY (USED IN) INVESTING
ACTIVITIES (878) (359) (13,312) 17,670
-------- -------- -------- --------
Cash flow from financing activities:
Borrowings on debt related to investment
properties -- 3,850 2,112 3,850
Payments on debt related to investment
properties (219) (4,020) (622) (5,082)
Mortgages satisfied in connection with
property dispositions -- (26) -- (15,250)
Proceeds from shareholder short-swing sale -- -- 184 --
(Increase) decrease in cash reserved for
capital improvements, acquisitions,
debt service, property taxes and
insurance, net 377 (70) 8,443 68
-------- -------- -------- --------
NET CASH GENERATED BY (USED IN) FINANCING
ACTIVITIES 158 (266) 10,117 (16,414)
-------- -------- -------- --------
Increase (decrease) in cash and cash equivalents 185 (81) (383) 2,489
Balance at beginning of period 2,331 2,746 2,899 176
-------- -------- -------- --------
Balance at end of period $ 2,516 $ 2,665 $ 2,516 $ 2,665
-------- -------- -------- --------
-------- -------- -------- --------
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- -------------------
1997 1996 1997 1996
---- ---- ---- ----
<S> <C> <C> <C> <C>
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest $ 968 $ 674 $ 2,868 $ 2,559
------- ------- -------- --------
------- ------- -------- --------
Cash paid for taxes $ -- $ -- $ -- $ 410
------- ------- -------- --------
------- ------- -------- --------
Non-cash transactions:
Portion of acquisition of investment
properties funded by assumption of
mortgage debt $ -- $ -- $ 10,203 $ --
------- ------- -------- --------
------- ------- -------- --------
Increase in mortgage debt in connection
with reimbursement obligation $ -- $ -- $ 2,200 $ --
------- ------- -------- --------
------- ------- -------- --------
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
6
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER AND NINE MONTHS ENDED SEPTEMBER 30, 1997
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited condensed consolidated financial statements
should be read in conjunction with the Registrant's 1996 Form 10-K and Form
10-Q for the quarter and nine months ended September 30, 1996. These
statements have been prepared in accordance with the instructions of the
Securities and Exchange Commission Form 10-Q and do not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements.
In the opinion of the Registrant, all material adjustments of a normal
recurring nature considered necessary for a fair presentation of results of
operations for the interim periods have been included. The results of
consolidated operations for the three and nine months ended September 30,
1997 are not necessarily indicative of the results that may be expected for
the year ending December 31, 1997.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to be consistent with
current year classifications.
ESTIMATES AND ASSUMPTIONS
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities,
disclosure of contingent assets and liabilities at the date of the financial
statements, and the reported amounts of revenues and expenses during the
reporting period. Actual results will differ from those estimates.
2. RINCON CENTER ASSOCIATES PARTNERSHIP (RCA)-- SAN FRANCISCO, CALIFORNIA
The Registrant owns general (non-managing) and limited partnership
interests in RCA totaling approximately 22.8% and, subject to the funding
agreement entered into with RCA's managing general partner, Perini Land &
Development Company (a wholly owned subsidiary of Perini Corporation),
discussed below, is responsible for 20% of cash requirements in excess of
available financing. The Registrant's minority, general (non-managing) and
limited partnership interests in RCA represent significant potential
financial exposure. This exposure includes and may not be limited to the
potential tax liability associated with the Registrant's negative tax basis,
the joint and several guarantees and letter-of-credit provided by the
Registrant to the mortgage lender on Rincon Center Phase Two and the master
lessor on Rincon Center Phase One, and the potential tax liability that would
exist from the cancellation of debt in connection with a possible debt
restructuring. Except for the estimated provision for settlement of the
reimbursement obligation and deferred income tax
7
<PAGE>
liabilities related to the tax that would result from any gain recognized
from the Registrant's negative tax basis in its partnership interest, the
accompanying financial statements do not include any adjustments for these
uncertainties.
RCA sold Rincon Center Phase One to Chrysler MacNalley Corporation
(Chrysler) in June 1988; subsequently, RCA leased the property back under a
master lease which is treated as an operating lease for financial reporting
purposes. In July 1993, Chrysler completed refinancing of Rincon Center
Phase One. The maturity date of this debt is July 1, 1998. Payments under
the master lease agreement may be adjusted to reflect adjustments in the rate
of interest payable by Chrysler on the Rincon Center Phase One debt. The
master lease also permits Chrysler to put the property back to RCA at
stipulated prices beginning January 1998 if long-term financing meeting
certain conditions is not obtained. RCA is attempting to obtain financing or
restructure the existing debt in order to meet the condition of the master
lease prior to January 1998. On June 30, 1997, RCA filed a lawsuit against
Chrysler in Superior Court in the State of California, County of San
Francisco. The lawsuit's primary cause of action alleges that Chrysler has
breached the master lease and a certain letter agreement because the rent
payments due from RCA after the 1993 refinancing of Rincon Center Phase One,
resulted in an increase in Chrysler's after tax rate of return from rent
payments. The lawsuit states that such excessive rent recalculations
directly contravene both the letter and the spirit of the master lease.
In September 1993, RCA completed a refinancing of Rincon Center Phase
Two with its existing lender. A portion of the security for the refinanced
loan was a $3.65 million letter-of-credit issued by a bank (the Issuing Bank)
on behalf of the Registrant in favor of the refinancing lender. The
reimbursement obligation of the Registrant to the Issuing Bank is full
recourse to the Registrant and is secured by the Registrant's 410 First
Avenue property located in Needham, Massachusetts. The letter-of-credit for
$3.65 million was drawn by the refinancing lender prior to its expiration
date of June 23, 1997. The refinancing lender is currently holding the $3.65
million in a separate restricted account on behalf of RCA and has not applied
said funds to any outstanding debt of RCA. The Issuing Bank made a demand on
the Registrant to reimburse them for the $3.65 million drawn on the
letter-of-credit and also notified the Registrant it is in default with
respect to the reimbursement obligation. On August 21, 1997, the Issuing
Bank commenced an action for conditional judgement seeking, among other
remedies, to foreclose on the Massachusetts property. Under Massachusetts
law, such foreclosure could not take place until at least three years and two
months after the issuance of the conditional judgement. However, if the
Registrant does not pay the amount of the conditional judgement within two
months after its issuance, the Issuing Bank could take possession of the
property during the three year period preceding foreclosure. In such action,
the Issuing Bank is seeking to assert a deficiency claim against the
Registrant for any alleged difference between the value of the foreclosed
property and the $3.65 million drawn on the letter-of-credit including
outstanding interest and fees. The Registrant intends to vigorously defend
such deficiency claim. Since any assets of the Registrant which are applied
to the reimbursement obligation would constitute additional investment in
RCA, which the Registrant considers of no value, the net book value of such
assets would be
8
<PAGE>
written off and charged to the earnings of the Registrant when said assets
were applied to the reimbursement obligation. In accordance with generally
accepted accounting principles, effective June 30, 1997, the Registrant
recorded an "estimated provision for settlement of the reimbursement
obligation" in the amount of $2.2 million to provide for the ultimate
settlement of the reimbursement obligation. The accrued amount is equal to
the net book value at June 30, 1997, of the Needham, Massachusetts property
that serves as collateral for the reimbursement obligation, resulting in an
effective discount of the $3.65 million face value of the reimbursement
obligation. The Registrant has recorded rental revenue and operating
expenses related to this property, as well as accrued interest on the $3.65
million settlement obligation at a rate of prime plus three percent. Any
difference between that estimated provision for settlement of the
reimbursement obligation and the amount ultimately settled upon will be
charged or credited to the Registrant's operations as such difference becomes
determinable. Management can provide no assurances as to the ultimate
settlement amount or method (and the timing thereof) relating to the
reimbursement obligation.
In 1993, the Registrant entered into an agreement with RCA's managing
general partner whereby such managing general partner agreed to advance funds
to RCA on behalf of the Registrant on an unsecured non-recourse basis,
subject to interest at prime plus 2% and certain annual fees (principal,
unpaid interest and fees are collectively referred to as the RCA Advances).
This agreement does not reduce the level of the Registrant's general and
limited partner interest in RCA. The RCA Advances are only required to be
repaid from the Registrant's share of future distributions from RCA, if any.
During the first nine months of 1997 and 1996, RCA incurred net losses of
$16,355,000 and $10,650,000 respectively. The RCA Advances amount to
approximately $6,219,000 at September 30, 1997, and as noted above, are not
recorded on the Registrant's financial statements since (i) the RCA advances
are only required to be repaid from the Registrant's share of future
distributions from RCA, if any, (ii) the Registrant has no intention or legal
obligation to repay the RCA Advances other than from its share of
distributions from RCA, if any, and (iii) the Registrant does not anticipate
any material cash distributions by RCA in the foreseeable future.
During 1997, the Registrant has asserted certain claims against RCA for
payment to the Registrant by RCA for leasing services provided to RCA by the
Registrant during 1996. The Registrant has not accrued for such claims
pending resolution of this matter with RCA's managing general partner.
9
<PAGE>
Summary financial statement data for RCA is as follows (in thousands):
AS OF SEPTEMBER 30, DECEMBER 31,
1997 1996
---- ----
Investment properties, net $ 100,034 $ 110,495
Other assets 31,465 21,042
--------- ---------
$ 131,499 $ 131,537
--------- ---------
--------- ---------
Debt $ 54,287 $ 56,012
Amounts due to partners 177,131 158,156
Other liabilities 11,770 12,703
Partners' deficit (111,689) (95,334)
--------- ---------
$ 131,499 $ 131,537
--------- ---------
--------- ---------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- -------------
1997 1996 1997 1996
---- ---- ---- ----
Revenue $ 4,439 $ 5,373 $ 12,166 $ 16,197
Expenses:
Operating and lease expenses 6,177 2,941 15,192 9,621
Interest expense 3,890 4,997 11,129 14,391
Depreciation expense 769 946 2,200 2,835
------- ------- -------- --------
10,836 8,884 28,521 26,847
------- ------- -------- --------
Net loss $(6,397) $(3,511) $(16,355) $(10,650)
------- ------- -------- --------
------- ------- -------- --------
In 1996, the Registrant ceased recording any activity related to its
interest in RCA and has written down its equity investment in and loans to
RCA to zero.
3. PER SHARE DATA - Per share data is based on the weighted average number
of the Registrant's common shares and common share equivalents outstanding.
Outstanding warrants and stock options enter into the common shares
outstanding using the Treasury Stock Method.
The weighted average number of common shares and common share
equivalents outstanding for the three and nine months ended September 30,
1997 and 1996 are as follows:
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
1997 1996 1997 1996
---- ---- ---- ----
Primary 4,567,270 4,290,710 4,509,204 4,208,196
--------- --------- --------- ---------
--------- --------- --------- ---------
Fully diluted 4,567,270 4,290,710 4,545,880 4,208,196
--------- --------- --------- ---------
--------- --------- --------- ---------
10
<PAGE>
In March 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standard No. 128, Earnings Per Share (SFAS No. 128).
SFAS No. 128 requires the disclosure of basic earnings per share and modifies
existing guidance for computing diluted earnings per share. Under the new
standard, basic earnings per share is computed as earnings divided by
weighted average shares, excluding the dilutive effects of stock options and
other potentially dilutive securities. The effective date of SFAS No. 128
is December 15, 1997, and early adoption is not permitted. The Registrant
intends to adopt provisions of SFAS No. 128 during the quarter and year ended
December 31, 1997. Had the provisions of SFAS No. 128 been applied to the
Registrant's results of operations for the three months ended September 30,
1997 and 1996, the Registrant's basic earnings per share would have been
($0.06) and ($0.14) per share, respectively, and its diluted earnings per
share would have been ($0.05) and ($0.13) per share, respectively. Had the
provisions of SFAS No. 128 been applied to the Registrant's results of
operations for the nine months ended September 30, 1997 and 1996, the
Registrant's basic earnings per share would have been ($0.42) and $1.60 per
share, respectively, and its diluted earnings per share would have been
($0.37) and $1.53 per share, respectively.
4. ACQUISITION OF INVESTMENT PROPERTY
On January 17, 1997, the Registrant purchased two properties to complete
a tax deferred exchange in accordance with Section 1031 of the Internal
Revenue Code, in connection with the December 1996 sale of the Radisson
Suites Hotel. The first acquisition was West Valley Executive Park, a
multi-tenant, six building, 165,000 square foot campus style office park in
San Jose, California, that was acquired for $17,500,000. In connection with
the West Valley Executive Park acquisition, the Registrant assumed
approximately $10,203,000 in mortgage debt from Sun Life Assurance Company of
Canada (U.S.). The loan is amortized over twenty years at a fixed annual
interest rate of 9.125% and matures on June 30, 2005. The debt continues to
be assumable and is subject to a prepayment penalty if paid off prior to
maturity. The second acquisition was a multi-tenant, 23,000 square foot, six
story steel frame office building located at 930 Montgomery Street, San
Francisco, California, for $3,250,000. In connection with the 930 Montgomery
Street acquisition, the Registrant obtained $2,112,500 in mortgage debt from
Redwood Bank. The loan is amortized over twenty-five years at a floating
interest rate of 3% over the one year treasury bond rate, adjustable every
six months, and matures on February 1, 2002. The Redwood Bank debt can be
prepaid at any time without a penalty.
11
<PAGE>
The following unaudited pro-forma information reflects adjustments to
the Registrant's historical results from these acquisitions and certain other
transactions as if they had occurred on January 1, 1996 (in thousands, except
share amounts):
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
1997 1996 1997 1996
---- ---- ---- ----
Revenues $ 3,274 $ 3,517 $ 10,297 $ 10,874
------- ------- -------- --------
------- ------- -------- --------
Loss before hotel operations,
estimated settlement
obligation, property
transactions and taxes $ (385) $ (353) $ (317) $ (431)
------- ------- -------- --------
------- ------- -------- --------
Loss before hotel operations,
estimated settlement
obligation, property
transactions and taxes per
common share --
Primary $ (0.08) $ (0.08) $ (0.07) $ (0.10)
------- ------- -------- --------
------- ------- -------- --------
Fully diluted $ (0.08) $ (0.08) $ (0.07) $ (0.10)
------- ------- -------- --------
------- ------- -------- --------
Weighted average common shares
outstanding --
Primary 4,567,270 4,290,710 4,509,204 4,208,196
--------- --------- --------- ---------
--------- --------- --------- ---------
Fully diluted 4,567,270 4,290,710 4,545,880 4,208,196
--------- --------- --------- ---------
--------- --------- --------- ---------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
INTRODUCTION
The Registrant is a New York corporation formed in 1984 for the purpose
of investing and managing income producing real estate. The Registrant's
overall business plan has been to assemble a substantial portfolio of income
producing properties. The Registrant historically focused its property
acquisitions in four markets: Northern California, Arizona, Florida and
Massachusetts. The Registrant's long-term objectives continue to be
maximizing net cash flow from operations and achieving growth through
appreciation of asset values. The current strategic plan of the Registrant
is to focus on real estate investment on the West Coast with specific
emphasis on the San Francisco Bay Area. The current investment emphasis is
on commercial properties which require aggressive management and leasing in
order to maximize their potential. This strategy is influenced by the
following factors: (1) the Registrant's current property portfolio is
concentrated on the West Coast; and (2) the Registrant believes that
geographic concentration will enhance operational efficiencies.
The following discussion should be read in conjunction with the
Registrant's Form 10-K for 1996, quarterly report on Form 10-Q for the quarter
12
<PAGE>
and nine months ended September 30, 1996, and in conjunction with the
Condensed Consolidated Balance Sheet, Statement of Operations and Cash Flows
and the notes thereto. Unless otherwise defined in this report, or unless
the context otherwise requires, the capitalized words or phrases used in this
section either (i) describe accounting terms that are used as line items in
such financial statements, or (ii) have the meaning ascribed to them in such
financial statements and the notes thereto.
FINANCIAL CONDITION
CAPITAL IMPROVEMENTS, TENANT IMPROVEMENTS AND OTHER DEFERRED COSTS --
During the three and nine months ended September 30, 1997, there were
additions to investment properties amounting to approximately $878,000 and
$2,337,000, respectively, for tenant improvements, capital improvements and
other deferred costs which includes leasing commissions. The Registrant
anticipates further additions to investment properties of approximately
$2,000,000 during the remainder of 1997.
FINANCING -- Approximately $219,000 and $622,000 of debt principal was
repaid in the three and nine months ended September 30, 1997, respectively,
as scheduled debt amortization. In connection with the acquisitions of
investment properties during the nine months ended September 30, 1997, the
Registrant assumed and borrowed mortgage notes totaling approximately
$12,315,000. Accordingly, at September 30, 1997, the Registrant has fixed
rate mortgage debt of approximately $43.3 million bearing interest at a
weighted average rate of 8.49%, one floating rate mortgage of approximately
$2.1 million bearing interest at a rate of 8.75%, and a secured estimated
settlement obligation recorded at $2.2 million (accruing interest at a rate
of prime plus 3% on the stated settlement obligation of $3.65 million), as
more fully discussed in Note 2 of the Registrant's unaudited condensed
consolidated financial statements.
MATERIAL CHANGES IN RESULTS OF OPERATIONS
INVESTMENT PROPERTIES - During the first nine months of 1997, the
income from investment properties was $453,000 compared to income of $295,000
during the first nine months of 1996. During the third quarter of 1997 the
loss from investment properties was $165,000 compared to a loss of $79,000
for the third quarter of 1996. Interest expense increased from $2,169,000
during the first nine months of 1996 to $2,989,000 during the first nine
months of 1997 primarily as a result of the debt associated with the
properties acquired in January 1997. Also included in interest expense for
the first nine months of 1997 is $121,000 of interest recorded on the
settlement obligation as described above. Depreciation and amortization
expense increased as a result of commencing depreciation of expenditures
capitalized during 1996 and early 1997 relating to the Registrant's leasing
activities and capital improvement projects, and new investment property
acquisitions completed in the first quarter of 1997.
13
<PAGE>
The following table identifies the impact of certain investment property
dispositions, acquisitions, and properties owned in the three and nine months
ended September 30, 1997 and 1996, respectively (in thousands):
<TABLE>
<CAPTION>
FOR THE THREE FOR THE NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- -------------
1997 1996 1997 1996
---- ---- ---- ----
<S> <C> <C> <C> <C>
INVESTMENT PROPERTIES OWNED IN
1997 AND 1996:
Rental revenue $ 2,539 $ 2,699 $ 7,826 $ 7,713
Operating expense (1,194) (1,479) (3,459) (3,960)
Interest expense (813) (661) (2,207) (1,900)
Depreciation expense (653) (661) (1,945) (1,899)
------- ------- ------- -------
(121) (102) 215 (46)
------- ------- ------- -------
INVESTMENT PROPERTIES ACQUIRED IN
JANUARY 1997:
Rental revenue 735 -- 2,326 --
Operating expense (363) -- (951) --
Interest expense (276) -- (782) --
Depreciation expense (140) -- (355) --
------- ------- ------- -------
(44) 238 --
------- ------- ------- -------
INVESTMENT PROPERTY SOLD IN APRIL 1996:
Rental revenue -- -- -- 706
Operating expense -- 23 -- (96)
Interest expense -- -- -- (269)
Depreciation expense -- -- -- --
------- ------- ------- -------
-- 23 -- 341
------- ------- ------- -------
TOTAL INVESTMENT PROPERTIES:
Rental revenue 3,274 2,699 10,152 8,419
Operating expense (1,557) (1,456) (4,410) (4,056)
Interest expense (1,089) (661) (2,989) (2,169)
Depreciation expense (793) (661) (2,300) (1,899)
------- ------- ------- -------
TOTAL INVESTMENT PROPERTIES
INCOME (LOSS) $ (165) $ (79) $ 453 $ 295
------- ------- ------- -------
------- ------- ------- -------
</TABLE>
GENERAL AND ADMINISTRATIVE EXPENSES - General and administrative
expenses in the first nine months of 1997 amounted to $950,000 compared to
$1,226,000 for the first nine months of 1996. General and administrative
expenses for the third quarter of 1997 and 1996 were $250,000 and $408,000,
respectively. The decrease is primarily attributable to a decrease in
professional services and personnel costs including severance to a former
executive.
14
<PAGE>
OTHER INCOME, NET - Other income, net, consisting primarily of interest
income was $131,000 and $30,000 during the first nine months and third
quarter of 1997, respectively. Other income, net, consisting primarily of
business advisory fees and income from the sale of vacant land in Colorado
was $252,000 and $38,000 during the first nine months and third quarter of
1996, respectively.
HOTEL PROPERTY - The Registrant sold its hotel property in December 1996
and, accordingly, a comparison of operations from the first nine months and
third quarter of 1996 to the first nine months and third quarter of 1997 is
not meaningful.
ESTIMATED PROVISION FOR SETTLEMENT OF THE REIMBURSEMENT OBLIGATION -
Effecive June 30, 1997, the Registrant recorded an estimated provision of
$2.2 million for the ultimate settlement of the letter-of-credit
reimbursement obligation, as more fully discussed in Note 2 to the
Registrant's unaudited condensed consolidated financial statements.
GAIN ON SALE OF REAL ESTATE ASSETS, NET - In April 1996, the Registrant
sold the Village Commons Shopping Center, located in West Palm Beach,
Florida, to an unrelated party and realized a gain of $10,900,000.
INCOME TAX BENEFIT (PROVISION) - A tax benefit of $970,000 and $140,000
has been recorded in connection with the net loss for the first nine months
and third quarter of 1997, respectively. A tax provision of $4,800,000 has
been recorded in connection with the net income for the nine months ended
September 30, 1996. A tax benefit of $8,000 has been recorded in connection
with the net loss for the three months ended September 30, 1996. These
amounts have been recorded in accordance with Statement of Financial
Accounting Standards No. 109.
LIQUIDITY AND CAPITAL RESOURCES
REGULATION AND SUPERVISION
Many jurisdictions have adopted laws and regulations relating to the
ownership of real estate. Compliance with these requirements from time to
time may require capital expenditures by the Registrant (for example,
expenditures necessary in order to comply with the Americans with
Disabilities Act or changes in local building or other codes). In addition,
the Registrant may from time to time have to expend capital for environmental
control facilities. While the ownership of real estate may entail
environmental risks and liabilites to the owner, the Registrant's management
is sensitive to environmental issues and is not currently aware of and does
not expect any material effects on current or future capital expenditures,
earnings or competitive position resulting from compliance with present
federal, state or local environmental control provisions.
DISCUSSION OF KNOWN TRENDS, EVENTS AND UNCERTAINTIES
The economic climate for commercial real estate has begun to show signs
that rental rates and property values have stabilized and in selected markets
have actually improved. Notwithstanding a stabilizing real estate market,
tenants may or may not continue to renew leases as they expire or may renew
on less favorable terms. Conditions differ in each market in which the
Registrant's properties are located. Because of the continuing uncertainty
of future economic
15
<PAGE>
developments in each market, the impact these developments will have on the
Registrant's future cash flow and results of operations is uncertain.
Inflation, inflationary expectations and their effect on interest rates
may affect the Registrant in the future by changing the underlying value of
the Registrant's real estate or by impacting the costs of financing the
Registrant's operations.
LIQUIDITY AND CAPITAL RESOURCES
The bulk of the Registrant's resources are committed to relatively
non-liquid real estate assets. These assets, due to their value and cash
flow, have provided the Registrant with an ability to generate capital as
required, both internally and externally, through asset-based financings. In
addition, since 1992, assets or portions thereof were sold to provide further
liquidity.
The Registrant has taken several actions to generate and conserve cash,
and continues to review and analyze alternative actions. At the same time,
the Registrant is seeking to retain value and identify future opportunities
for investment. At September 30, 1997, the Registrant has approximately $2.5
million of unrestricted cash, investment properties with a net book value of
approximately $53.6 million (including the Needham, Massachusetts property
recorded at its estimated net realizable value of $2.2 million), total
non-recourse mortgage debt and secured estimated settlement obligation of
approximately $47.6 million and stockholders' equity of approximately $.7
million. At September 30, 1997, the Registrant had approximately $1.5
million of restricted cash. Given the Registrant's desire to increase its
liquidity, the Registrant has actively pursued the sale of selected real
estate assets in the past, has restructured and refinanced its mortgage debt,
and has entered into an agreement with the managing general partner of RCA to
limit the Registrant's cash obligations to RCA. The Registrant continues to
evaluate various alternatives to improve its liquidity through debt
refinancing and the sale of properties which do not fit within its long term
strategy. Funds raised in the preceeding fashion would be used for tenant
improvements and other capital requirements, certain mandatory debt
reductions, and possible new investments.
Scheduled principal maturites on the above described debt during the
twelve month period ending September 30, 1998, will amount to approximately
$923,000. This amount does not include the ultimate settlement of the
reimbursement obligation.
The Registrant is also obligated to fund reserves for building, tenant
improvements, leasing commissions and debt service in connection with its
mortgage loans on Walnut Creek Executive Park, North Tucson Business Center
and South Bay Office Tower. Scheduled funding under the various loan
agreements during the twelve month period ending September 30, 1998, will
amount to approximately $695,000.
The Registrant's Massachusetts property is pledged as collateral for a
$3.65 million letter-of-credit that was drawn as of June 30, 1997. As
discussed in Note 2 of the Registrant's unaudited condensed consolidated
financial statements, the Issuing Bank made a demand on the Registrant to
reimburse them for the $3.65 million drawn on the letter-of-credit and also
notified the
16
<PAGE>
Registrant it is in default with respect to the reimbursement obligation. On
August 21, 1997, the Issuing Bank commenced an action for conditional
judgement seeking, among other remedies, to foreclose on the Massachusetts
property. Under Massachusetts law, such foreclosure could not take place
until at least three years and two months after the issuance of the
conditional judgement. However, if the Registrant does not pay the amount of
the conditional judgement within two months after its issuance, the Issuing
Bank could take possession of the property during the three year period
preceding foreclosure. If the Issuing Bank completes a foreclosure on the
Massachusetts property, the Registrant will eliminate $3.65 million in
secured debt (currently recorded at $2.2 million) on a property that is
producing approximately $240,000 in annual cash flow. In such action, the
Issuing Bank is seeking to assert a deficiency claim against the Registrant
for any alleged difference between the value of the foreclosed property and
the $3.65 million drawn on the letter-of-credit including outstanding
interest and fees. The Registrant intends to vigorously defend such
deficiency claim. In accordance with generally accepted accounting
principles, effective June 30, 1997, the Registrant recorded an "estimated
provision for settlement of reimbursement obligation" in the amount of $2.2
million to provide for the ultimate settlement of the reimbursement
obligation. The accrued amount is equal to the net book value at June 30,
1997, of the Needham, Massachusetts property that serves as collateral for
the remibursement obligation, resulting in an effective discount of the $3.65
million face value of the reimbursement obligation. The Registrant has
recorded rental revenue and operating expenses related to this property, as
well as accrued interest on the $3.65 million settlement obligation at a rate
of prime plus three percent. Any difference between that estimated provision
for settlement of the reimbursement obligation and the amount ultimately
settled upon will be charged or credited to the Registrant's operations as
such difference becomes determinable. Management can provide no assurances
as to the ultimate settlement amount or method (and the timing thereof)
relating to the reimbursement obligation.
The Registrant's minority, non-managing partnership interest in RCA
represents significant potential financial exposure. This exposure includes,
and may not be limited to, the potential tax liability associated with the
Registrant's negative tax basis, the joint and several guarantees and
letter-of-credit provided by the Registrant to the mortgage lender on Rincon
Center Phase Two and the master lessor on Rincon Center Phase One, and the
potential tax liability that would exist from the cancellation of debt in
connection with a possible debt restructuring. Additionally, RCA's managing
general partner agreed to advance funds to RCA on behalf of the Registrant on
an unsecured non-recourse basis, subject to interest at prime plus 2% and
certain annual fees (principal, unpaid interest, and fees are collectively
referred to as the RCA Advances). The RCA Advances amount to approximately
$6,219,000 at September 30, 1997, and are not recorded by the Registrant
since (i) the RCA Advances are only required to be repaid from the
Registrant's share of future distributions from RCA, if any, (ii) the
Registrant has no intention or legal obligation to repay the RCA Advances
other than from its share of distributions from RCA, if any, and (iii) the
Registrant does not anticipate any material cash distributions by RCA in the
foreseeable future.
Except as described above, at September 30, 1997, the Registrant has no
contractual commitments for any material capital expenditures over the next
twelve months or beyond that are not expected to be funded from the cash
17
<PAGE>
restricted for capital improvements, acquisitions and debt service or future
cash flow generated by operating activities. Ongoing repair and maintenance
expenditures are expected to be funded from cash flow generated by operating
activiites. Future tenant improvements and leasing commissions will be
funded, in part, from the restricted cash described above, cash flow
generated by operating activities and funds generated from future debt
refinancings or property sales, if any.
The Registrant continued to experience more stabilized operating results
in its wholly owned property during the first three quarters of 1997, and
except for RCA, expects this trend to continue. In addition, the completion
of certain leasing transactions has continued to reduce the level of vacancy
in the Registrant's portfolio; however the Registrant is continuing to
aggressively pursue new leases on currently available space and renew
existing leases as they expire.
ITEM 1. LEGAL PROCEEDINGS
See Note 2 to the Registrant's unaudited condensed consolidated
financial statements in Part I of this Quarterly Report on Form 10-Q
concerning the $3.65 million letter of credit issued by the Bank of America
National Trust and Savings Association (the "Issuing Bank") as a portion of
the security for the refinancing of Rincon Center, Phase Two. On August 21,
1997, the Issuing Bank commenced an action against the Registrant in the Land
Court, Department of the Trial Court, of the Commonwealth of Massachusetts,
to obtain a conditional judgement in the full amount of the Registrant's
indebtedness to the Bank, which the Bank alleges is in excess of $3,700,000,
and in the event Registrant fails to pay such conditional judgement, among
other remedies, to foreclose on the Needham, Massachusetts property. Under
Massachusetts law, such foreclosure cannot take place until three years and
two months after the issuance of a conditional judgement. However, if the
Issuing Bank should obtain a conditional judgement, and the Company does not
pay the amount of the conditional judgement within two months after its
issuance, the Issuing Bank could take possession of the property during the
three-year period preceding foreclosure.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits
No. Description
--- -----------
27 Financial Data Schedule
18
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PACIFIC GATEWAY PROPERTIES, INC.
--------------------------------
Registrant
Date: November 11, 1997 /s/Raymond V. Marino
--------------------
Raymond V. Marino
President and Chief Executive Officer
Date: November 11, 1997 /s/Melanie L. Adkins
--------------------
Melanie L. Adkins
Controller - Management Company
(Principal Accounting Officer)
Date: November 11, 1997 /s/George S. Mercado
--------------------
George S. Mercado
Controller - Corporate
(Principal Accounting Officer)
19
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> SEP-30-1997
<CASH> 4,048
<SECURITIES> 0
<RECEIVABLES> 154
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 4,557
<PP&E> 69,506
<DEPRECIATION> 15,875
<TOTAL-ASSETS> 67,022
<CURRENT-LIABILITIES> 1,792
<BONDS> 47,615
0
0
<COMMON> 4,011
<OTHER-SE> (3,348)
<TOTAL-LIABILITY-AND-EQUITY> 67,022
<SALES> 0
<TOTAL-REVENUES> 10,283
<CGS> 0
<TOTAL-COSTS> 6,710
<OTHER-EXPENSES> 93
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 2,989
<INCOME-PRETAX> 459
<INCOME-TAX> 970
<INCOME-CONTINUING> 1,689
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,689
<EPS-PRIMARY> (0.37)
<EPS-DILUTED> (0.37)
</TABLE>
