<PAGE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-Q
(MARK ONE)
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
COMMISSION FILE NUMBER 1-8692
------------------------
PACIFIC GATEWAY PROPERTIES, INC.
(Exact name of registrant as specified in its charter)
NEW YORK 04-2816560
(State of incorporation) (IRS Employer Identification No.)
930 MONTGOMERY STREET, SUITE 400, SAN 94133
FRANCISCO, CALIFORNIA (zip code)
(Address of principal executive offices)
(415) 398-4800
Registrant's telephone number, including area code
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
stock, as of the latest practicable date of November 2, 1998:
3,933,536 shares of Common Stock, $1.00 par value and 300,000 shares of
Series 1 Convertible Preferred Stock, $1.00 par value.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
INDEX
<TABLE>
<CAPTION>
PAGE NUMBER
<S> <C> <C> <C>
Part I--Financial Information:
Item 1. Consolidated Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets as of September 30, 1998 and December 31, 1997 3
Condensed Consolidated Statements of Operations for the Three and Nine Months Ended
September 30, 1998 and 1997 4
Condensed Consolidated Statement of Stockholders' Equity for the Nine Months Ended
September 30, 1998 5
Condensed Consolidated Statements of Cash Flows for the Three and Nine Months Ended
September 30, 1998 and 1997 6
Notes to Condensed Consolidated Financial Statements 7-13
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations 13-18
Part II--Other Information:
Item 1. Legal Proceedings 19
Item 2. Changes in Security 19
Item 3. Defaults Upon Senior Securities None
Item 4. Submission of Matters to a Vote of Security Holders None
Item 5. Other Information None
Item 6. Exhibits and Reports on Form 8-K 20
Signatures 21
</TABLE>
2
<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,
1998 1997
------------- -------------
<S> <C> <C>
ASSETS
Cash and cash equivalents........................................................... $ 6,240 $ 2,065
Restricted cash..................................................................... 1,711 1,746
Accounts receivable, prepaid taxes and other current assets......................... 186 252
Investment properties............................................................... 72,252 70,656
Less--accumulated depreciation and reserve for write-down to net realizable
value........................................................................... (18,101) (16,431)
------------- -------------
Investment properties, net...................................................... 54,151 54,225
------------- -------------
Deferred tax asset.................................................................. 11,679 8,203
Capitalized loan costs, net......................................................... 771 818
Capitalized lease commissions, rent concessions and other deferred costs, net....... 2,109 1,402
------------- -------------
Total assets.................................................................... $ 76,847 $ 68,711
------------- -------------
------------- -------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable, prepaid rent, tenant security deposits, accrued interest and other
current liabilities............................................................... $ 3,176 $ 2,678
Debt related to investment properties............................................... 48,867 47,402
Deferred tax liability.............................................................. 21,653 17,983
------------- -------------
Total liabilities............................................................... 73,696 68,063
------------- -------------
STOCKHOLDERS' EQUITY
Common stock $1.00 par value:
Authorized--10,000,000 shares
Issued--4,052,090 and 4,018,150 shares at September 30, 1998 and December 31,
1997, respectively.............................................................. 4,052 4,018
Series 1 Convertible Preferred Stock $1.00 par value, $3,000,000 preference in
liquidation:
Authorized and issued--300,000 shares............................................. 2,889 --
Paid-in-deficit..................................................................... (8,968) (10,023)
Treasury stock, at cost--118,554 common shares at September 30, 1998 and December
31, 1997.......................................................................... (2,037) (2,037)
Warrants for common stock........................................................... -- 1,890
Retained earnings................................................................... 7,215 6,800
------------- -------------
Total stockholders' equity........................................................ 3,151 648
------------- -------------
Total liabilities and stockholders' equity...................................... $ 76,847 $ 68,711
------------- -------------
------------- -------------
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- --------------------
1998 1997 1998 1997
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
INVESTMENT PROPERTIES:
Rental revenues.................................................. $ 4,133 $ 3,274 $ 12,197 $ 10,152
Operating expenses............................................... (1,658) (1,557) (4,703) (4,410)
Interest expense................................................. (1,088) (1,089) (3,212) (2,989)
Depreciation and amortization.................................... (938) (793) (2,748) (2,300)
--------- --------- --------- ---------
Investment properties income................................... 449 (165) 1,534 453
General and administrative expenses................................ (223) (250) (917) (950)
Other income, net.................................................. 49 30 103 131
--------- --------- --------- ---------
Income (loss) before hotel operations, settlement obligation and
taxes............................................................ 275 (385) 720 (366)
Income (loss) from hotel operations................................ -- -- -- (93)
--------- --------- --------- ---------
Income (loss) before settlement obligation and taxes............... 275 (385) 720 (459)
Provision for settlement of reimbursement obligation............... -- -- -- (2,200)
--------- --------- --------- ---------
Income (loss) before taxes......................................... 275 (385) 720 (2,659)
Income tax benefit (provision)..................................... (113) 140 (305) 970
--------- --------- --------- ---------
Net income (loss).............................................. $ 162 $ (245) $ 415 $ (1,689)
--------- --------- --------- ---------
--------- --------- --------- ---------
Income (loss) per share of common stock, basic..................... $ 0.04 $ (0.06) $ 0.11 $ (0.43)
--------- --------- --------- ---------
--------- --------- --------- ---------
Income (loss) per share of common stock, diluted................... $ 0.04 $ (0.06) $ 0.10 $ (0.43)
--------- --------- --------- ---------
--------- --------- --------- ---------
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (UNAUDITED)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998
(IN THOUSANDS)
<TABLE>
<CAPTION>
SERIES 1
CONVERTIBLE
COMMON PREFERRED PAID-IN- RETAINED TREASURY
STOCK STOCK DEFICIT EARNINGS STOCK
----------- ------------- --------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1997............................... $ 4,018 $ -- $ (10,023) $ 6,800 $ (2,037)
Net income................................................ -- -- -- 415 --
Repurchase of warrants.................................... -- -- 883 -- --
Issuance of preferred stock............................... -- 2,889 --
Tax benefit from exercise of stock options................ -- -- 104 -- --
Issuance of common stock from exercise of stock options... 34 -- 65 -- --
Return of profit from shareholder short-swing sale........ -- -- 3 -- --
----------- ------ --------- ----------- -----------
Balance at September 30, 1998.............................. $ 4,052 $ 2,889 $ (8,968) $ 7,215 $ (2,037)
----------- ------ --------- ----------- -----------
----------- ------ --------- ----------- -----------
<CAPTION>
WARRANTS
FOR COMMON
STOCK TOTAL
----------- ---------
<S> <C> <C>
Balance at December 31, 1997............................... $ 1,890 $ 648
Net income................................................ -- 415
Repurchase of warrants.................................... (1,890) (1,007)
Issuance of preferred stock............................... 2,889
Tax benefit from exercise of stock options................ -- 104
Issuance of common stock from exercise of stock options... -- 99
Return of profit from shareholder short-swing sale........ -- 3
----------- ---------
Balance at September 30, 1998.............................. $ -- $ 3,151
----------- ---------
----------- ---------
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- --------------------
1998 1997 1998 1997
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Cash flow from operating activities:
Net income (loss).................................................................... $ 162 $ (245) $ 415 $ (1,689)
Non-cash revenues and expenses included in net income (loss):
Depreciation and amortization...................................................... 938 793 2,748 2,300
Deferred taxes, net................................................................ 9 (140) 194 (970)
Provision for settlement of reimbursement obligation............................... -- -- -- 2,200
Change in assets and liabilities:
Accounts receivable, prepaid taxes and other current assets........................ 94 132 66 670
Accounts payable and other current liabilities..................................... (134) 365 498 301
--------- --------- --------- ---------
NET CASH GENERATED BY OPERATING ACTIVITIES........................................... 1,069 905 3,921 2,812
Cash flow from investing activities:
Additions to building and other improvements, capitalized lease commissions, rent
concessions, and other deferred costs............................................. (401) (878) (3,272) (2,337)
Acquisition of investment properties................................................. -- -- -- (10,975)
--------- --------- --------- ---------
NET CASH USED IN INVESTING ACTIVITIES................................................ (401) (878) (3,272) (13,312)
--------- --------- --------- ---------
Cash flow from financing activities:
Borrowings under debt related to investment properties............................... 2,697 -- 4,272 2,112
Payments on debt..................................................................... (2,307) (219) (2,807) (622)
Payments of loan costs and fees...................................................... (21) -- (62) --
Repurchase of warrants............................................................... -- -- (1,007) --
Proceeds from sale of preferred stock, net of issuance costs......................... 2,889 -- 2,889 --
Proceeds from stock options exercised................................................ 99 -- 99 --
Tax benefit from exercise of stock options........................................... 104 -- 104 --
Proceeds from shareholder short-swing sale........................................... 3 -- 3 184
Decrease in restricted cash.......................................................... 55 377 35 8,443
--------- --------- --------- ---------
NET CASH GENERATED BY FINANCING ACTIVITIES........................................... 3,519 158 3,526 10,117
--------- --------- --------- ---------
Increase (decrease) in cash and cash equivalents....................................... 4,187 185 4,175 (383)
Balance at beginning of period......................................................... 2,053 2,331 2,065 2,899
--------- --------- --------- ---------
Balance at end of period............................................................... $ 6,240 $ 2,516 $ 6,240 $ 2,516
--------- --------- --------- ---------
--------- --------- --------- ---------
Supplementary disclosures:
Cash paid for interest............................................................... $ 952 $ 968 $ 2,944 $ 2,868
--------- --------- --------- ---------
--------- --------- --------- ---------
Cash paid for taxes.................................................................. $ -- $ -- $ 7 $ --
--------- --------- --------- ---------
--------- --------- --------- ---------
Non-cash transactions:
Portion of acquisition of investment properties funded by assumption of mortgage
debt.............................................................................. $ -- $ -- $ -- $ 10,203
--------- --------- --------- ---------
--------- --------- --------- ---------
Increase in debt related to investment properties in connection with reimbursement
obligation........................................................................ $ -- $ -- $ -- $ 2,200
--------- --------- --------- ---------
--------- --------- --------- ---------
Decrease in paid-in-deficit from repurchase of warrants.............................. $ -- $ -- $ 883 $ --
--------- --------- --------- ---------
--------- --------- --------- ---------
</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, 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 and nine months ended September 30, 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 and nine months ended September 30, 1998
are not necessarily indicative of the results that may be expected for the year
ending December 31, 1998.
RECLASSIFICATIONS
Certain prior period amounts have been reclassified to be consistent with
current period 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 may 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 (PL&D), (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 in the partnership and the
potential tax liability that would exist from the cancellation of debt in
connection with a possible debt restructuring and potential liability as a
general partner of RCA under the master lease described below. The Registrant
has provided certain joint and several guarantees with PL&D to the mortgage
lender on Rincon Center Phase Two. However, the Registrant has been advised by
legal counsel that guarantees provided by the Registrant to the mortgage lender
on Rincon Center Phase Two are not enforceable because (i) the Registrant's
status as a general partner would make it primary obligor, and (ii) the debt is
non-recourse debt. As a result, a guaranty by a primary obligor of non-recourse
debt is not enforceable. Except for the provision for settlement of the
reimbursement obligation (discussed below) and deferred income tax 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 further adjustments for these
uncertainties.
7
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE QUARTER AND NINE MONTHS ENDED SEPTEMBER 30, 1998
2. RINCON CENTER ASSOCIATES PARTNERSHIP (RCA)--SAN FRANCISCO, CALIFORNIA
(CONTINUED)
RCA sold Rincon Center Phase One to Chrysler MacNally 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.
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 future minimum lease payments based on scheduled payments under RCA's
master lease agreement are as follows (in thousands):
<TABLE>
<S> <C>
1998............................................................... $ 5,634
1999............................................................... 5,875
2000............................................................... 5,875
2001............................................................... 5,875
2002............................................................... 5,875
Thereafter......................................................... $ 61,622
---------
Total.............................................................. $ 90,756
---------
---------
</TABLE>
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. 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 July 1993, Chrysler completed a refinancing of Rincon Center Phase One.
This debt matured on July 1, 1998. While the loan to Chrysler on Rincon Center
Phase One has matured, the current lender has deferred enforcement of any
remedies pending completion of the restructuring discussions. In addition,
Chrysler has continued to defer enforcement of the purchase requirement
provisions under the master lease during the loan negotiations. The Registrant
can make no assurances about the outcome of these negotiations. As a result of
the loan negotiations, RCA wrote down the carrying value of the assets related
to this segment of the property by $17,150,000 in 1997 to its estimated net
realizable value.
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 these
negotiations.
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,
8
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE QUARTER AND NINE MONTHS ENDED SEPTEMBER 30, 1998
2. RINCON CENTER ASSOCIATES PARTNERSHIP (RCA)--SAN FRANCISCO, CALIFORNIA
(CONTINUED)
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 Registrant in favor of Citibank.
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 has 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
Registrant's 410 First Avenue property located in Needham, Massachusetts.
On or about August 18, 1997, the Issuing Bank commenced an action against
the Registrant in the Land Court Department of the Trial Court of Massachusetts
(the Land Court) to obtain conditional judgement in the full amount of the
Registrant's indebtedness to the Issuing Bank. 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. On
October 28, 1998, the Land Court issued a conditional judgement in favor of the
Issuing Bank in the principal amount of $3.65 million, together with interest as
set forth in the Amended and Restated Standby Letter of Credit Agreement dated
as of November 8, 1991, expenses in the amount of $36,273 and attorneys fees and
disbursements in the amount of $50,756. Including contractual interest, the
amount of the conditional judgement is in excess of $4.2 million. Pursuant to
the Land Court's order, the Registrant has sixty days from entry of the order to
pay the Issuing Bank the amount of the conditional judgement, plus statutory
interest of 12% from the date of the Land Court's order. Unless the Registrant
makes such payment to the Issuing Bank within sixty days of the order, the
Issuing Bank is entitled to enter and take possession of the Registrant's 410
First Avenue property, and collect all rents derived therefrom, for a period of
three years from the date of entry on the property. If the balance of the
conditional judgement has not been repaid at the end of that three year period,
the property shall be deemed foreclosed and title passes to the Issuing Bank.
The Registrant is appealing the Land Court's entry of the conditional judgement.
The Registrant is also continuing to pursue its claims in a companion action
against the Issuing Bank in the Massachusetts Superior Court. 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 Bank's conduct regarding the letter-of-credit. The Registrant's damages
claim in the Superior Court action could offset or exceed all or some of the
damages that the Issuing Bank is likely to be awarded in the Land Court action.
However, there is no assurance whatsoever that this result will be achieved.
Discovery has commenced and no trial date has been set.
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 (as discussed below), 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
9
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE QUARTER AND NINE MONTHS ENDED SEPTEMBER 30, 1998
2. RINCON CENTER ASSOCIATES PARTNERSHIP (RCA)--SAN FRANCISCO, CALIFORNIA
(CONTINUED)
obligation" in the amount of $2.2 million to provide for the ultimate settlement
of the reimbursement obligation, since the Registrant believes that the fair
market value of the 410 First Avenue property is equal to or greater than $3.65
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 reimbursement
obligation, resulting in an effective discount of the $3.65 million face value
of the reimbursement obligation. The Registrant has continued to record 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
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. During the first nine months of 1998 and 1997, RCA incurred
net losses of approximately $11,673,000 and $16,355,000, respectively. 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. As
indicated previously, RCA's managing general partner continues to advance funds
to RCA under this agreement with the Registrant. The RCA Advances amount to
approximately $8,032,000 at September 30, 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
of leasing services provided to RCA by the Registrant during 1996. The
Registrant has not recorded a receivable for these claims pending resolution of
this matter with RCA's managing general partner.
10
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE QUARTER AND NINE MONTHS ENDED SEPTEMBER 30, 1998
2. RINCON CENTER ASSOCIATES PARTNERSHIP (RCA)--SAN FRANCISCO, CALIFORNIA
(CONTINUED)
Summary unaudited financial statement data for RCA is as follows (in
thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
AS OF 1998 1997
------------- ------------
<S> <C> <C>
Investment properties, net...................................... $ 103,332 $ 107,045
Other assets.................................................... 3,917 6,857
------------- ------------
$ 107,249 $ 113,902
------------- ------------
------------- ------------
Debt............................................................ $ 42,483 $ 49,228
Amounts due to partners......................................... 196,799 185,208
Other liabilities............................................... 12,897 12,723
Partners' deficit............................................... (144,930) (133,257)
------------- ------------
$ 107,249 $ 113,902
------------- ------------
------------- ------------
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS ENDED
NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- ----------------------
<S> <C> <C> <C> <C>
1998 1997 1998 1997
--------- --------- ---------- ----------
Revenue.............................................................. $ 4,743 $ 4,439 $ 13,970 $ 12,166
Expenses:
Operating and lease expenses....................................... 3,645 6,177 10,142 15,192
Interest expense................................................... 4,150 3,890 13,303 11,129
Depreciation expense............................................... 630 769 2,198 2,200
--------- --------- ---------- ----------
8,425 10,836 25,643 28,521
--------- --------- ---------- ----------
Net loss............................................................. $ (3,682) $ (6,397) $ (11,673) $ (16,355)
--------- --------- ---------- ----------
--------- --------- ---------- ----------
</TABLE>
3. PER SHARE DATA
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. Outstanding stock options enter into the weighted average
shares outstanding calculation 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 earnings per share calculations for the three and nine months ended
September 30, 1998 and 1997, are as follows:
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
---------------------- ----------------------
<S> <C> <C> <C> <C>
1998 1997 1998 1997
---------- ---------- ---------- ----------
Basic......................................................... 3,933,167 3,892,596 3,910,868 3,892,596
Stock options................................................. 111,096 -- 100,164 --
---------- ---------- ---------- ----------
Diluted....................................................... 4,044,263 3,892,596 4,011,032 3,892,596
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
</TABLE>
11
<PAGE>
PACIFIC GATEWAY PROPERTIES, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE QUARTER AND NINE MONTHS ENDED SEPTEMBER 30, 1998
3. PER SHARE DATA (CONTINUED)
In the three and nine months ended September 30, 1997, 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 dilutive earnings per share for this quarter and nine month period
exclude the stock options.
4. DEBT RELATED TO INVESTMENT PROPERTIES
In July 1998, the Registrant completed the refinancing of $2,076,000 of
mortgate debt from Redwood Bank related to its 930 Montgomery Street property in
San Francisco, California. The new loan of $2,697,500 carries a variable
interest rate of 2.875% over the one year treasury bond rate, adjustable semi-
annually (8.375% at September 30, 1998). The loan has fixed monthly amortization
payments of principal and interest of approximately $21,500. The loan is
amortized over 25 years but matures on September 1, 2008. This debt is
nonrecourse and can be prepaid at any time without a penalty. This debt contains
a cross default provision with the loan on the Registrant's 4050 Moorpark Avenue
building at West Valley Executive Park in San Jose, California.
5. PREFERRED STOCK
An amendment to the Certificate of Incorporation to provide for the issuance
of 300,000 shares of Series 1 Convertible Preferred Stock, $1.00 par value, (the
Preferred Stock) was approved by unanimous written consent of the Registrant's
Board of Directors on September 10, 1998. A certificate of amendment was filed
with the State of New York on September 13, 1998. The Registrant's Board of
Directors approved the sale of 300,000 shares of the Preferred Stock to GEM
Value/PGP, L.L.C.(GEM), an affiliate of GEM Value Fund, L.P. Proceeds from the
sale of the Preferred Stock were approximately $2,889,000, net of issuance costs
of $111,000. These funds are currently being held in short-term investments
pending potential future acquisitions and/or reduction of debt obligations.
GEM's 300,000 shares of Preferred Stock are convertible at any time, at the
option of GEM, into the Registrant's common stock on a one for one basis and
have identical voting rights. GEM Value Fund, L.P. also owns 101,700 shares of
the Registrant's common stock which it had acquired in open market purchases
prior to entering into discussions to purchase the Preferred Stock. As of
September 21, 1998, GEM's common and preferred stock holdings in the Registrant
represented 9.5% of the Registrant's total preferred and common shares
outstanding and entitled to vote.
The Preferred Stock will receive dividends, if any, from the Registrant's
operating cash flow on a PARI PASSU basis with common shareholders. The
agreement with GEM does not require the Registrant to make any distributions. In
the event of a full or partial liquidation of the Registrant, GEM will be
entitled to a liquidation preference of $10.00 per share. GEM also received
customary registration rights for the common stock issuable upon conversion of
the Preferred Stock.
In addition, GEM has entered into an agreement with the Registrant and three
entities controlled by the Registrant's Chairman, Richard Osborne, whereby GEM
has a "tag along" right to sell its preferred shares, or common shares if
converted, on a pro rata basis with these entities. This right is exercisable
should any of the Osborne controlled entities sell cumulatively in excess of
200,000 shares of the Registrant's common stock.
12
<PAGE>
6. PAID-IN-DEFICIT
During the quarter ended September 30, 1998, the Registrant received
approximately $3,000 in cash from a shareholder as a result of their compliance
with the Securities Exchange Act's requirement that profits from the sale of
certain securities of a company that were held less than six months by certain
officers, directors and principal stockholders must be returned to the
Registrant. In accordance with generally accepted accounting principles, the
Registrant recorded such proceeds as a credit to the Registrant's
paid-in-deficit.
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 investments
on the West Coast with a 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 and nine
months ended September 30, 1997, and in conjunction with the Unaudited Condensed
Consolidated Balance Sheets, Statements 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 meanings 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, 1998, there were additions to
investment properties amounting to approximately $401,000 and $3,272,000,
respectively, for tenant improvements, capital improvements and other deferred
costs which includes leasing commissions. The Registrant anticipates further
additions to investment properties of approximately $1,157,000 during the
remainder of 1998.
FINANCING-- Approximately $231,000 and $731,000 of debt principal was
repaid in the three and nine months ended September 30, 1998, respectively, as
scheduled debt amortization. In connection with the refinancing of $2,076,000 of
mortgage debt on the Registrant's 930 Montgomery Street building in San
Francisco, California, during the three months ended September 30, 1998, the
Registrant borrowed $2,697,500 under a floating rate mortgage note. The proceeds
from this financing are currently being held in short-term investments pending
potential future acquisitions and/or reduction of debt obligations. Accordingly,
at September 30, 1998, the Registrant had fixed rate mortgage debt of
approximately $42.4 million bearing interest at a weighted average rate of
8.49%, two floating rate mortgages for the sum of approximately $4.3 million,
each bearing interest at the rate of 8.38% as of September 30, 1998, and a
secured estimated settlement obligation recorded at $2.2 million (accruing
interest at a rate of prime plus
13
<PAGE>
3% on the stated settlement obligation of $3.65 million). The estimated
settlement obligation is more fully discussed in Note 2 to the Registrant's
Unaudited Condensed Consolidated Financial Statements.
MATERIAL CHANGES IN RESULTS OF OPERATIONS
INVESTMENT PROPERTIES-- During the first nine months of 1998, the income
from investment properties was $1,534,000 compared to income of $453,000 during
the first nine months of 1997. During the third quarter of 1998 the income from
investment properties was $449,000 compared to a loss of $165,000 for the third
quarter of 1997. Rental revenue increased from $10,152,000 during the first nine
months of 1997 to $12,197,000 during the first nine months of 1998, as a result
of an increase in both occupancy and rental rates. Also included in rental
revenues for the first nine months of 1998 is a $340,000 lease buyout from a
tenant at Walnut Creek Executive Park which is being reinvested in re-tenanting
the space during the fourth quarter of 1998. Interest expense increased from
$2,989,000 during the first nine months of 1997 to $3,212,000 during the first
nine months of 1998, primarily as a result of recording $314,000 of interest on
the settlement obligation during the first nine months of 1998, as described
above, compared to $121,000 of interest that was recorded during the first nine
months of 1997. Depreciation and amortization expense increased as a result of
commencing depreciation of expenditures capitalized during 1998 relating to the
Registrant's leasing activities and capital improvement projects.
GENERAL AND ADMINISTRATIVE EXPENSES-- General and administrative expenses
in the first nine months of 1998 amounted to $917,000 compared to $950,000 for
the first nine months of 1997. General and administrative expenses for the third
quarter of 1998 and 1997 were $223,000 and $250,000, respectively. The decrease
is primarily attributable to a decrease in personnel costs offset by an increase
in professional services.
OTHER INCOME, NET-- Other income, net, consisting primarily of interest
income, was $103,000 and $131,000 during the first nine months of 1998 and 1997,
respectively. The decrease is primarily due to the reduction of cash invested as
a result of the repurchase of the warrants in the first quarter of 1998.
HOTEL PROPERTY-- The Registrant sold its hotel property in December 1996
and, accordingly, a comparison of the operations from the first nine months and
third quarter of 1997 to the first nine months and third quarter of 1998 is not
meaningful.
PROVISION FOR SETTLEMENT OF REIMBURSEMENT OBLIGATION-- Effective June 30,
1997, the Registrant recorded a provision of $2,200,000 for the ultimate
settlement of a letter-of-credit reimbursement obligation, as more fully
discussed in Note 2 to the Registrant's Unaudited Condensed Consolidated
Financial Statements.
INCOME TAX BENEFIT (PROVISION)-- A tax provision of $113,000 and $305,000
has been recorded in connection with the net income for the three and nine
months ended September 30, 1998, respectively, at rates that approximate the
effective statutory rate. A tax benefit of $140,000 and $970,000 was recorded in
connection with the net loss for the three and nine months ended September 30,
1997, respectively.
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 liabilities 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,
14
<PAGE>
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 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.
An amendment to the Certificate of Incorporation to provide for the issuance
of 300,000 shares of Series 1 Convertible Preferred Stock, $1.00 par value, (the
Preferred Stock) was approved by unanimous written consent of the Registrant's
Board of Directors on September 10, 1998. A certificate of amendment was filed
with the State of New York on September 13, 1998. The Registrant's Board of
Directors approved the sale of 300,000 shares of the Preferred Stock to GEM
Value/PGP, L.L.C. (GEM), an affiliate of GEM Value Fund, L.P. Proceeds from the
sale of the Preferred Stock were approximately $2,889,000, net of issuance costs
of $111,000. These funds are currently being held in short-term investments
pending potential future acquisitions and/or reduction of debt obligations.
GEM's 300,000 shares of Preferred Stock are convertible at any time, at the
option of GEM, into the Registrant's common stock on a one for one basis, and
have identical voting rights. GEM Value Fund, L.P. also owns 101,700 shares of
the Registrant's common stock which it had acquired in open market purchases
prior to entering into discussions to purchase the Preferred Stock. As of
September 21, 1998, GEM's common and preferred stock holdings in the Registrant
represented 9.5% of the Registrant's total preferred and common shares
outstanding and entitled to vote.
The Preferred Stock will receive dividends, if any, from the Registrant's
operating cash flow on a pari passu basis with common shareholders. The
agreement with GEM does not require the Registrant to make any distributions. In
the event of a full or partial liquidation of the Registrant, GEM will be
entitled to a liquidation preference of $10.00 per share. GEM also received
customary registration rights for the common stock issuable upon conversion of
the Preferred Stock.
In addition, GEM has entered into an agreement with the Registrant and three
entities controlled by the Registrant's Chairman, Richard Osborne, whereby GEM
has a "tag along" right to sell its preferred shares, or common shares if
converted, on a pro rata basis with these entities. This right is exercisable
should any of the Osborne controlled entities sell cumulatively in excess of
200,000 shares of the Registrant's common stock.
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, 1998, the Registrant had approximately $6.2 million
of unrestricted cash, approximately $1.7 million of restricted cash, investment
properties with a net book
15
<PAGE>
value of approximately $54.1 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
$48.9 million and stockholders' equity of approximately $3.1 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 preceding fashion would be
used for tenant improvements and other capital requirements, certain mandatory
debt reductions, and possible new investments.
The Registrant is also obligated to fund reserves for building, tenant
improvements, leasing commissions and debt service in connection with its
mortage 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, 1999, will amount to
approximately $695,000.
Scheduled principal maturities on the above described debt during the twelve
month period ending September 30, 1999, will amount to approximately $3,193,000.
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
for the $3.65 million drawn on the letter-of-credit and has 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 or about August 18, 1997, the Issuing Bank commenced an action against
the Registrant in the Land Court to obtain conditional judgement in the full
amount of the Registrant's indebtedness to the Issuing Bank. 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. On October 28, 1998, the Land Court issued a conditional judgement in
favor of the Issuing Bank in the principal amount of $3.65 million, together
with interest as set forth in the Amended and Restated Standby Letter of Credit
Agreement dated as of November 8, 1991, expenses in the amount of $36,273 and
attorneys fees and disbursements in the amount of $50,756. Including contractual
interest, the amount of the conditional judgement is in excess of $4.2 million.
Pursuant to the Land Court's order, the Registrant has sixty days from entry of
the order to pay the Issuing Bank the amount of the conditional judgement, plus
statutory interest of 12% from the date of the Land Court's order. Unless the
Registrant makes such payment to the Issuing Bank within sixty days of the
order, the Issuing Bank is entitled to enter and take possession of the
Registrant's 410 First Avenue property, and collect all rents derived therefrom,
for a period of three years from the date of entry on the property. If the
balance of the conditional judgement has not been repaid at the end of that
three year period, the property shall be deemed foreclosed and title passes to
the Issuing Bank. The Registrant is appealing the Land Court's entry of the
conditional judgement.
The Registrant is also continuing to pursue its claims in a companion action
against the Issuing Bank in the Massachusetts Superior Court. 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 Bank's conduct regarding the letter-of-credit. The Registrant's damages
claim in the Superior Court action could offset or exceed all or some of the
damages that the Issuing Bank is likely to be awarded in the Land Court action.
However, there is no assurance whatsoever that this result will be achieved.
Discovery has commenced and no trial date has been set.
16
<PAGE>
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 since the Registrant believes that the
fair market value of the 410 First Avenue property is equal to or greater than
$3.65 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
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
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.
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 in the partnership and the
potential tax liability that would exist from the cancellation of debt in
connection with a possible debt restructuring and potential liability as a
general partner of RCA under the master lease as previously discussed. The
Registrant has provided certain joint and several guarantees with PL&D to the
mortgage lender on Rincon Center Phase Two. However, the Registrant has been
advised by legal counsel that guarantees provided by the Registrant to the
mortgage lender on Rincon Center Phase Two are not enforceable because (i) the
Registrant's status as a general partner would make it primary obligor, and (ii)
the debt is non-recourse debt. As a result, a guaranty by a primary obligor of
non-recourse debt is not enforceable. 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). This agreement does not reduce the level of the
Registrant's general and limited partnership interests in RCA. 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. As indicated
previously, RCA's managing general partner continues to advance funds to RCA
under this agreement with the Registrant. The RCA Advances amount to
approximately $8,032,000 at September 30, 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 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 September 30, 1998, the Registrant's material
capital expenditures over the next twelve months or 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 three quarters 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
17
<PAGE>
Registrant's portfolio and the Registrant is continuing to aggressively pursue
new leases on currently available space and renew existing leases as they
expire.
YEAR 2000 COMPLIANCE
THE REGISTRANT'S STATE OF READINESS. The Registrant utilizes a number of
computer software programs and operating systems across its entire organization
including applications used in financial business systems and various
administrative functions. To the extent that the Registrant's software
applications contains 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 currently
believes that its "Year 2000" issues are limited to information technology
("IT") systems (i.e., software programs and computer operating systems). There
are no non-IT systems (i.e., embedded systems such as devices used to control,
monitor or assist the operation of equipment and machinery), the failure of
which would have a material effect on the Registrant's operation that the
Registrant is presently aware of.
The Registrant, employing a team made up of internal personnel, has
completed its identification of IT systems that are not yet Year 2000 compliant
and has commenced modification or replacement of such systems as necessary. The
Registrant is currently communicating with third parties with whom it does
significant business, such as financial institutions and vendors to determine
their readiness for Year 2000 compliance. The Registrant has also completed its
assessment of the Year 2000 compliance issues presented by its hardware
components.
COSTS OF ADDRESSING THE REGISTRANT'S YEAR 2000 ISSUES. Given the
information known at this time about the Registrant's systems that are
non-compliant, coupled with the Registrant's ongoing, normal course-of-business
efforts to upgrade or replace critical systems, as necessary, management does
not expect Year 2000 compliance costs to have any material adverse impact on the
Registrant's liquidity or ongoing results of operations. The costs of such
assessment and remediation will be paid out of the Registrant's general and
administrative expenses.
RISKS OF THE REGISTRANT'S YEAR 2000 ISSUES. In light of the Registrant's
assessment and remediation efforts to date, and the planned, normal
course-of-business upgrades, management believes that any residual Year 2000
risk is limited to non-critical business applications and support hardware. No
assurance can be given, however, that all of the Registrant's systems will be
Year 2000 compliant or that compliance will not have a material adverse effect
on the Registrant's future liquidity or results of operations or ability to
service debt.
THE REGISTRANT'S CONTINGENCY PLANS. The Registrant is currently developing
its contingency plan for all operations to address the most reasonably likely
worst case scenarios regarding Year 2000 compliance. Management expects such
contingency plan to be completed by the end of the year.
FORWARD-LOOKING STATEMENTS; FACTORS THAT MAY AFFECT OPERATING RESULTS
Certain information included in this Form 10-Q and other materials filed 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 unforeseen 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.
18
<PAGE>
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. The trial date has been rescheduled for June
7, 1999, 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 or about
August 18, 1997, the Issuing Bank commenced an action against the Registrant in
the Land Court Department of the Trial Court of Massachusetts (the Land Court)
to obtain a conditional judgement in the full amount of the Registrant's
indebtedness to the Issuing Bank. On October 28, 1998, the Land Court issued a
conditional judgement in favor of the Issuing Bank in the principal amount of
$3.65 million, together with interest as set forth in the Amended and Restated
Standby Letter of Credit Agreement dated as of November 8, 1991, expenses in the
amount of $36,273 and attorneys fees and disbursements in the amount of $50,756.
Including contractual interest, the amount of the conditional judgement is in
excess of $4.2 million. Pursuant to the Land Court's order, the Registrant has
sixty days from entry of the order to pay the Issuing Bank the amount of the
conditional judgement, plus statutory interest of 12% from the date of the Land
Court's order. Unless the Registrant makes such payment to the Issuing Bank
within sixty days of the order, the Issuing Bank is entitled to enter and take
possession of the Registrant's 410 First Avenue property, and collect all rents
derived therefrom, for a period of three years from the date of entry on the
property. If the balance of the conditional judgement has not been repaid at the
end of that three year period, the property shall be deemed foreclosed and title
passes to the Issuing Bank. The Registrant is appealing the Land Court's entry
of the conditional judgement. The Registrant is also continuing to pursue its
claims in the companion action against the Issuing Bank pending in the
Massachusetts Superior Court as discussed below. 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 Bank's conduct regarding the letter-of-credit. The Registrant's damages
claim in the Superior Court action could offset or exceed all or some of the
damages that the Issuing Bank is likely to be awarded in the Land Court action.
However, there is no assurance whatsoever that this result will be achieved.
Discovery has commenced and no trial date has been set.
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 2. CHANGES IN SECURITIES
On September 10, 1998, the Board of Directors of the Registrant approved the
sale of 300,000 shares of Preferred Stock to GEM. See Note 2 to the Registrant's
Unaudited Condensed Consolidated Financial Statements for further discussion.
19
<PAGE>
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits:
<TABLE>
<CAPTION>
NO.
-- DESCRIPTION
----------------------------------------------------------------------------------------------------
<S> <C> <C>
27 Financial Data Schedule
</TABLE>
b) Reports on Form 8-K:
On September 29, 1998, the Company filed a report on Form 8-K reporting
under Item 5.
20
<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
/s/ RAYMOND V. MARINO
-----------------------------------------
Raymond V. Marino
President and Chief Executive Officer
(Principal Executive and Financial
Date: November 9, 1998 Officer)
/s/ MELANIE L. ADKINS
-----------------------------------------
Melanie L. Adkins
Controller--Corporate
Date: November 9, 1998 (Principal Accounting Officer)
/s/ NEIL C. MARCK
-----------------------------------------
Neil C. Marck
Controller--Management Company
Date: November 9, 1998 (Principal Accounting Officer)
21
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 7,951
<SECURITIES> 0
<RECEIVABLES> 103
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 8,136
<PP&E> 72,252
<DEPRECIATION> 18,101
<TOTAL-ASSETS> 76,847
<CURRENT-LIABILITIES> 3,176
<BONDS> 48,867
2,889
0
<COMMON> 4,052
<OTHER-SE> (3,790)
<TOTAL-LIABILITY-AND-EQUITY> 76,847
<SALES> 0
<TOTAL-REVENUES> 12,197
<CGS> 0
<TOTAL-COSTS> 4,703
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 3,212
<INCOME-PRETAX> 720
<INCOME-TAX> 305
<INCOME-CONTINUING> 415
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 415
<EPS-PRIMARY> 0.11
<EPS-DILUTED> 0.10
</TABLE>
