<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 March 31, 1998
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 March 31, 1998:
$1.00 Par Value Common Stock 3,899,596
- ---------------------------- -----------------------------
(Title of Class) (Number of Shares Outstanding)
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
INDEX
<TABLE>
<CAPTION>
Part I - Financial Information: Page Number
<S> <C>
Item 1. Financial Statements
Condensed Consolidated Balance Sheet as of
March 31, 1998 and December 31, 1997 3
Condensed Consolidated Statement of Income for
the Three Months Ended March 31, 1998 and 1997 4
Condensed Consolidated Statement of Cash Flows
for the Three Months Ended March 31,
1998 and 1997 5
Notes to Condensed Consolidated Financial Statements 6-10
Item 2. Management's Discussion and
Analysis of Financial Condition
and Results of Operations 11-16
Part II - Other Information
Item 1. Legal Proceedings 16-17
Item 2. Changes in Security None
Item 3. Defaults Upon Senior Securities None
Item 4. Submission of Matters to a Vote
of Security Holders None
Item 5. Other Information 17
Item 6. Exhibits and Reports on Form 8-K 17
Signatures 18
</TABLE>
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEET (UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
AS OF AS OF
MARCH 31, DECEMBER 31,
1998 1997
--------- ------------
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 820 $ 2,065
Restricted cash 1,775 1,746
Accounts receivable, prepaid taxes and other
current assets 392 252
Investment properties: 72,294 70,656
Less-accumulated depreciation and reserve
for write-down to net realizable value (17,215) (16,431)
-------- --------
Investment properties, net 55,079 54,225
-------- --------
Deferred tax asset 8,844 8,203
Capitalized loan costs, net 794 818
Capitalized lease commissions, rent concessions
and other deferred costs, net 1,724 1,402
-------- --------
Total assets $ 69,428 $ 68,711
-------- --------
-------- --------
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Accounts payable, prepaid rent, tenant security
deposits, accrued interest and other current
liabilities $ 4,231 $ 2,678
Debt related to investment properties 47,159 47,402
Deferred tax liability 18,534 17,983
-------- --------
Total liabilities 69,924 68,063
-------- --------
STOCKHOLDERS' EQUITY (DEFICIT)
Common stock $1.00 par value--
Authorized--10,000,000 shares
Issued--4,018,150 shares 4,018 4,018
Paid-in-deficit (9,140) (10,023)
Retained earnings 6,663 6,800
Treasury stock, at cost--118,554 common shares at
March 31, 1998 and December 31, 1997 (2,037) (2,037)
Warrants for common stock -- 1,890
-------- --------
Total stockholders' equity (deficit) (496) 648
-------- --------
Total liabilities and stockholders' equity (deficit) $ 69,428 $ 68,711
-------- --------
-------- --------
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF INCOME (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
FOR THE THREE MONTHS
ENDED MARCH 31,
--------------------
1998 1997
------- -------
<S> <C> <C>
INVESTMENT PROPERTIES:
Rental revenues $ 3,469 $ 3,309
Operating expenses (1,395) (1,273)
Interest expense (1,059) (851)
Depreciation and amortization (819) (714)
------- -------
Investment properties income 196 471
------- -------
General and administrative expenses (440) (419)
Other income, net 24 48
------- -------
Income (loss) before hotel operations and taxes (220) 100
Loss from hotel operations -- (94)
------- -------
Income (loss) before taxes (220) 6
Income tax benefit 83 --
------- -------
Net income (loss) $ (137) $ 6
------- -------
------- -------
Income (loss) per share, basic $ (0.04) $ 0.00
------- -------
------- -------
Income (loss) per share, diluted $ (0.04) $ 0.00
------- -------
------- -------
</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
ENDED MARCH 31,
--------------------
1998 1997
------- --------
<S> <C> <C>
Cash flow from operating activities:
Net income (loss) $ (137) $ 6
Non-cash revenues and expenses
included in net income (loss):
Depreciation and amortization 819 714
Deferred taxes, net (90) --
Change in assets and liabilities:
Accounts receivable, prepaid taxes and
other current assets (140) 575
Accounts payable and other current liabilities 1,553 379
------- --------
NET CASH GENERATED BY OPERATING ACTIVITIES 2,005 1,674
------- --------
Cash flow from investing activities:
Additions to building and other improvements,
capitalized lease commissions, rent concessions,
and other deferred costs (1,971) (586)
Acquisition of investment properties -- (10,975)
------- --------
NET CASH USED IN INVESTING ACTIVITIES (1,971) (11,561)
------- --------
Cash flow from financing activities:
Borrowings under debt related to investment properties -- 2,112
Repurchase of warrants (1,007) --
Payments on debt (243) (191)
Payments of loan costs and fees -- (64)
(Increase) decrease in restricted cash (29) 8,193
------- --------
NET CASH GENERATED BY (USED IN) FINANCING
ACTIVITIES (1,279) 10,050
------- --------
Increase (decrease) in cash and cash equivalents (1,245) 163
Balance at beginning of period 2,065 2,899
------- --------
Balance at end of period $ 820 $ 3,062
------- --------
------- --------
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest $ 1,032 $ 943
------- --------
------- --------
Cash paid for taxes $ 1 $ 1
------- --------
------- --------
Non-cash transactions:
Portion of acquisition of investment properties
funded by assumption of mortgage debt $ -- $ 10,203
------- --------
------- --------
Increase in additional paid-in capital
from repurchase of warrants $ 883 $ --
------- --------
------- --------
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER ENDED MARCH 31, 1998
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited condensed consolidated financial statements
should be read in conjunction with the Registrant's 1997 Form 10-K and Form
10-Q for the quarter ended March 31, 1997. 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 months ended March 31, 1998 are not
necessarily indicative of the results that may be expected for the year
ending December 31, 1998.
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 provision for settlement of the reimbursement
obligation and deferred income tax liabilities related to the tax that would
result from any gain recognized from the
6
<PAGE>
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. As of January 1, 1998, no new commitment
had been secured although negotiations with the current lender were in
progress. In order to allow those discussions to continue, Chrysler agreed
to temporarily delay the enforcement of the purchase requirements. RCA can
make no assurances about the outcome of this negotiation. As a result of the
current loan negotiations, RCA has written-down the carrying value of the
assets related to this segment of the property by $17,150,000 in 1997 to the
estimated net realizable value. 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 Citibank. The residential portion of Rincon Center Phase Two is
being financed with redevelopment bonds from the Redevelopment Agency of the
City and County of San Francisco, California, which are due December 1, 2006.
The bonds are secured by an irrevocable letter-of-credit issued by Citibank
in the name of RCA. In the event that drawings are made on the
letter-of-credit, RCA has agreed to reimburse Citibank for such drawings
pursuant to the terms of the Reimbursement Agreement which is secured by a
deed of trust on Rincon Center Phase Two and other guarantees. During 1997,
the irrevocable letter-of-credit was due to expire. RCA is currently in
negotiations with Citibank to extend the letter-of-credit and no assurances
can be made about the outcome of this negotiation. Currently, the
letter-of-credit has been extended to June 15, 1998.
The commercial portion of Rincon Center Phase Two was financed pursuant
to a Construction Loan Agreement between RCA and Citibank. The Construction
Loan Agreement is secured by a deed of trust on the commercial portion of
Rincon Center Phase Two. In 1993, RCA extended the loan to October 1, 1998.
RCA is currently in negotiations with Citibank to extend the loan and no
assurances can be made about the outcome of this negotiation. A portion of
the security for the Construction Loan Agreement was a $3.65 million
letter-of-credit issued by Bank of America National Trust and Savings
Association (the Issuing Bank) on behalf of the Company in favor of Citibank.
The reimbursement obligation of the Registrant to the Issuing Bank is full
7
<PAGE>
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 Citibank prior to its expiration date of June 23,
1997. Citibank 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 410
First Avenue 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 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 a "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 410 First Avenue
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 the provision for settlement of the
reimbursement obligation and the amount ultimately settled upon may 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 1996, the Registrant ceased recording any activity related to its
interest in RCA because (i) it had previously written-down its equity
investment in and loans to RCA to zero in 1995, and (ii) the Registrant
currently has no obligation, prospects or plans to invest further in or on
behalf of RCA.
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 partnership interests in RCA. The RCA Advances are only required to
be repaid from the Registrant's
8
<PAGE>
share of future distributions from RCA, if any. During the first three
months of 1998 and 1997, RCA incurred net losses of $4,403,000 and $4,590,000,
respectively. The RCA Advances amount to approximately $7,289,000 at March
31, 1998, 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 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 recorded these claims pending
resolution of this matter with RCA's managing general partner.
Summary unaudited financial statement data for RCA is as follows (in
thousands):
<TABLE>
<CAPTION>
AS OF FEBRUARY 28, DECEMBER 31,
1998 1997
------------ ------------
<S> <C> <C>
Investment properties, net $ 99,375 $ 107,045
Other assets 9,516 6,857
--------- ---------
$ 108,891 $ 113,902
--------- ---------
--------- ---------
Debt $ 46,487 $ 49,228
Amounts due to partners 188,981 185,208
Other liabilities 9,614 12,723
Partners' deficit (136,191) (133,257)
--------- ---------
$ 108,891 $ 113,902
--------- ---------
--------- ---------
THREE MONTHS ENDED
MARCH 31,
----------------------------
1998 1997
--------- ---------
Revenue $ 4,571 $ 4,008
Expenses:
Operating and lease expenses 4,793 4,407
Interest expense 3,411 3,480
Depreciation expense 770 711
--------- ---------
8,974 8,598
--------- ---------
Net loss $ (4,403) $ (4,590)
--------- ---------
--------- ---------
</TABLE>
As of the date of this report, the managing general partner of RCA had not
completed the financial accounting for RCA. As a result, the Registrant has
recorded an estimate of revenue and expenses for the first three months of
1998 based upon actual operating revenue and expenses for January and
February 1998, and has included the actual unaudited balance sheet as of
February 28, 1998. The Registrant has conferred with the managing general
partner of RCA and considers these estimates to be reasonable; however,
actual results will differ from these estimates.
9
<PAGE>
3. PER SHARE DATA
In March 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 128 (SFAS No. 128), "Earnings Per
Share". SFAS No. 128 requires the disclosure of basic earnings per share and
modifies the existing guidance for computing diluted earnings per share.
Under the new standard, basic earning per share is computed as earnings
divided by weighted average shares, excluding the dilutive effects of stock
options and other potentially dilutive securities. Outstanding warrants and
stock options enter into the weighted average shares outstanding when
computing diluted earnings per share using the Treasury Stock Method.
The number of weighted average common shares and potential common shares
used in the earning per share calculations are as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
-----------------------
1998 1997
---- ----
<S> <C> <C>
Basic 3,899,596 3,892,596
Stock options and warrants -- 349,556
--------- ---------
Diluted 3,899,596 4,242,152
--------- ---------
--------- ---------
</TABLE>
In the first quarter of 1998, due to the Registrant's loss position, the
inclusion of stock options would have been anti-dilutive, and accordingly the
number of outstanding shares used in calculating basic and diluted earnings
per share for this quarter are the same.
4. REPURCHASE OF WARRANTS
On March 31, 1998, the Registrant completed the repurchase of 1,000,000
outstanding warrants to purchase 1,000,000 shares of the Registrant's common
stock at an exercise price of $2.875 per share from Citicorp Real Estate,
Inc. (Citicorp), for $1,000,000. The warrants were issued in 1993 in
connection with a debt restructuring with Citicorp and recorded in the
stockholders' equity section of the Registrant's Unaudited Condensed
Consolidated Balance Sheet at a carrying value of $1,890,000. As a result of
this transaction, the Registrant has recorded the difference between the
carrying value of the warrants and the net purchase price, which amounts to
$883,000, as additional paid-in-capital in the Registrant's Unaudited
Condensed Consolidated Balance Sheet as of March 31, 1998.
10
<PAGE>
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 1997, quarterly report on Form 10-Q for the
quarter ended March 31, 1997, and in conjunction with the Unaudited Condensed
Consolidated Balance Sheet, Statements of Income 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 months ended March 31, 1998, there were additions to investment
properties amounting to approximately $1,971,000 for tenant improvements,
capital improvements and other deferred costs which includes leasing
commissions. The Registrant anticipates further additions to investment
properties of approximately $2,704,000 during the remainder of 1998.
FINANCING -- Approximately $223,000 of debt principal was repaid in the
three months ended March 31, 1998 as scheduled debt amortization.
MATERIAL CHANGES IN RESULTS OF OPERATIONS
INVESTMENT PROPERTIES - During the first three months of 1998, the
income from investment properties was $196,000 compared to income of $471,000
during the first three months of 1997. Interest expense increased from
$851,000 during the first three months of 1997 to $1,059,000 during the first
three months of 1998 primarily as a result of 1997 including only two months
of interest on the properties acquired in January 1997. Also included in
interest expense for the first three months of 1998 is $104,000 of interest
recorded on the settlement
11
<PAGE>
obligation as described above. Depreciation and amortization expense
increased as a result of commencing depreciation of expenditures capitalized
during 1997 and early 1998 relating to the Registrant's leasing activities
and capital improvement projects.
GENERAL AND ADMINISTRATIVE EXPENSES - General and administrative
expenses in the first three months of 1998 amounted to $440,000 compared to
$419,000 for the first three months of 1997. The increase is primarily
attributable to a increase in professional services offset by a decrease in
personnel costs.
OTHER INCOME, NET - Other income, net, consisting primarily of interest
income, was $24,000 and $48,000 during the first three months of 1998 and
1997, respectively. The decrease is primarily due to the reduction of cash
invested resulting from the repurchase of the warrants as more fully
discussed on the following page.
HOTEL PROPERTY - The Registrant sold its hotel property in December 1996
and, accordingly, a comparison of hotel operations for the first quarter of 1998
to the first quarter of 1997 is not meaningful.
INCOME TAX BENEFIT - A tax benefit of $83,000 has been recorded in
connection with the net loss for the first three months of 1998. No tax
provision was recorded in connection with the net income for the three months
ended March 31, 1997. 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 shown signs that
rental rates and property values have stabilized and in selected markets has
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 developments in each market, the impact these developments will have
on the Registrant's future cash flow and
12
<PAGE>
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 March 31, 1998, the Registrant has approximately $.8
million of unrestricted cash, approximately $1.8 million of restricted cash,
investment properties with a net book value of approximately $55.1 million
(including the 410 First Avenue property recorded at its estimated net
realizable value of $2.2 million), total non-recourse mortgage debt and
secured settlement obligation of approximately $47.2 million and
stockholders' deficit of approximately $(0.5) million. 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.
As discussed in the Registrant's Unaudited Condensed Consolidated
Financial Statements, 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 March 31,
1999, will amount to approximately $695,000.
Scheduled principal maturites on the above described debt during the
twelve month period ending March 31, 1999, will amount to approximately
$3,150,000. This amount includes the $2,200,000 liability related to the
reimbursement obligation as described below.
The Registrant's 410 First Avenue 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
13
<PAGE>
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. The
reimbursement obligation of the Registrant to the Issuing Bank is full
recourse to the Registrant and is secured by the 410 First Avenue property.
On August 21, 1997, the Issuing Bank commenced an action for conditional
judgement seeking, among other remedies, to foreclose on the 410 First Avenue
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 410
First Avenue 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 a "provision for settlement of reimbursement
obligation" in the amount of $2.2 million. The accrued amount is equal to
the net book value at June 30, 1997, of the 410 First Avenue 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 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, 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 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). As indicated previously, RCA's managing
general partner is seeking to void the letter agreement under which these
loans were made and is also seeking restitution of the loans advanced. The
RCA Advances amount to approximately $7,289,000 at March 31, 1998, 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
14
<PAGE>
distributions from RCA, if any, and (iii) the Registrant does not anticipate
any material cash distributions by RCA in the foreseeable future. The
managing general partner of RCA is currently in negotiations to refinance the
debt on Rincon Center Phases One and Two as more fully described in Note 2 to
the Registrant's Unaudited Condensed Consolidated Financial Statements. The
proposed refinancing is subject to a number of conditions and approvals among
the parties involved in the refinancing. The managing general partner of RCA
and the Registrant can make no assurances that the refinancing will be
completed.
Except as described above, at March 31, 1998, the Registrant's material
capital expenditures over the next twelve months and beyond are expected to
be funded from restricted cash or future cash flow generated by operating
activities. Ongoing repair and maintenance expenditures are expected to be
funded from cash flow generated by operating activities. Future tenant
improvements and leasing commissions will be funded from restricted cash,
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 properties during the first quarter of 1998, 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 and the Registrant is continuing to aggressively
pursue new leases on currently available space and renew existing leases as
they expire.
REPURCHASE OF WARRANTS
On March 31, 1998, the Registrant completed the repurchase of 1,000,000
outstanding warrants to purchase 1,000,000 shares of the Registrant's common
stock at an exercise price of $2.875 per share from Citicorp Real Estate,
Inc. (Citicorp), for $1,000,000. The warrants were issued in 1993 in
connection with a debt restructuring with Citicorp and recorded in the
stockholders' equity section of the Registrant's Unaudited Condensed
Consolidated Balance Sheet at a carrying value of $1,890,000. As a result of
this transaction, the Registrant has recorded the difference between the
carrying value of the warrants and the net purchase price, which amounts to
$883,000, as additional paid-in-capital in the Registrant's Unaudited
Condensed Consolidated Balance Sheet as of March 31, 1998.
YEAR 2000 COMPLIANCE
To the extent that the Registrant's software applications contain source
code that is unable to appropriately interpret the upcoming calendar year
"2000" and beyond, some level of modification or replacement of such
applications will be necessary. The Registrant has received notification
from its primary software vendor indicating that the software application
used by the Registrant will be Year 2000 compliant by the end of 1998, at a
minimal cost to the Registrant.
FORWARD-LOOKING STATEMENTS; FACTORS THAT MAY AFFECT OPERATING RESULTS
Certain information included in this form 10-Q and other materials filed
15
<PAGE>
or to be filed by the Registrant with the Securities and Exchange Commission
may constitute forward-looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995. Such forward-looking information
involves known and unforseen risks, uncertainties and other factors that may
cause actual results or performance to be materially different from those
expressed or implied by such forward-looking statements. These risks and
uncertainties include, but are not limited to, uncertainties affecting the
real estate business generally, such as lease renewals and the financial
stability of tenants, general economic conditions and conditions in the
Registrant's markets, risks relating to acquisitions and dispositions of
properties, risks relating to interest rate levels and fluctuations, the
availability of financing, and regulatory risks. Given these and other risks
described elsewhere in this Form 10-Q, investors are cautioned not to place
undue reliance on any forward-looking statements.
ITEM 1. LEGAL PROCEEDINGS
On March 20, 1997, the Registrant filed a Complaint in the San Francisco
Superior Court, Case No. 985464, against Rincon Center Associates and Perini
Land and Development Company seeking to recover approximately $812,000 in
commissions due for leasing and construction services performed for Rincon
Center. The Complaint has been answered and a Cross-Complaint has been
filed. The Cross-Complaint seeks indemnity concerning the claim for leasing
commissions on the ground that the Registrant is also a general partner of
RCA, and further seeks to rescind or otherwise avoid the effect of a letter
agreement of June 22, 1993, regarding non-recourse loans from Perini Land and
Development Company to the Registrant, together with restitution of amounts
loaned to the Registrant pursuant to such letter agreement. A trial date has
been set for August 3, 1998, however the case is only in the beginning stages
of discovery, and the Registrant is not in a position at this time to opine
as to the likelihood or remoteness of liability, or the amount of damages
should liability be established.
See Note 2 to the Registrant's Unaudited Condensed Consolidated
Financial Statements 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 18, 1997, the Issuing Bank commenced an action against the
Registrant in the Land Court Department of the Trial Court of Massachusetts,
to obtain a conditional judgement in the full amount of the Registrant's
indebtedness to the Issuing Bank, which the Issuing Bank alleges is in excess
of $3.7 million. In the event that the Registrant fails to pay such
conditional judgement, the complaint seeks, among other remedies, to
foreclose on the 410 First Avenue property and obtain a deficiency judgement.
Under Massachusetts law, such foreclosure cannot take place until at least
three years and two months after the issuance of a conditional judgement.
However, if the Issuing Bank should obtain a conditional judgement, the
Issuing Bank could take possession of the property and receive rents paid
thereon during the three year period preceding foreclosure. The Registrant
is vigorously defending the action. The Registrant filed a complaint against
the Issuing Bank on November 21, 1997 in the Superior Court Department of the
Trial Court of the Commonwealth of Massachusetts seeking damages, equitable
relief and a jury trial for causes of action flowing from the Issuing
16
<PAGE>
Bank's conduct regarding the letter-of-credit. The result of the action
brought by the Issuing Bank against the Registrant is uncertain, and it is
not possible at this time to project a likely outcome of the proceeding.
The Registrant is involved in various other claims and lawsuits
incidental to its business. In the opinion of the Registrant, these other
claims and lawsuits in the aggregate will not have a material adverse impact
on the Registrant's financial condition.
ITEM 5. OTHER INFORMATION
On April 30, 1998, the Registrant filed Form 10-K/A for the year ended
December 31, 1997 to include Items 10 through 13.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits
NO. DESCRIPTION
27 Financial Data Schedule
b) Report on Form 8-K - On April 9, 1998, the Registrant filed Form
8-K to report the Warrant Repurchase Agreement entered into as of
March 31, 1998.
17
<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: May , 1998 /s/ Raymond V. Marino
------------------ -------------------------------------
Raymond V. Marino
President and Chief Executive Officer
(Principal Executive and Financial Officer)
Date: May , 1998 /s/ Melanie L. Adkins
------------------ -------------------------------------
Melanie L. Adkins
Controller - Corporate
(Principal Accounting Officer)
Date: May , 1998 /s/ Neil C. Marck
------------------ -------------------------------------
Neil C. Marck
Controller - Management Company
(Principal Accounting Officer)
18
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