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Section 1: 10-Q (10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 
FORM 10-Q
 
 ý      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 

For the quarterly period ended June 30, 2018
OR 
o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
For the transition period from  _________ to _________                    
Commission File Number: 001-37512
TIER REIT, Inc.
(Exact name of registrant as specified in its charter)
Maryland
 
68-0509956
(State or other jurisdiction of incorporation or
organization)
 
(I.R.S. Employer
Identification No.)
 
5950 Sherry Lane, Suite 700, Dallas, Texas 75225
(Address of principal executive offices)
(Zip code) 
(972) 483-2400
(Registrant’s telephone number, including area code) 
None
(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 ý  No o
 
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.45 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ý  No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.:
Large accelerated filer x
 
Accelerated filer o
Non-accelerated filer o
 
Smaller reporting company o
(Do not check if a smaller reporting company)
 
Emerging growth company o
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No ý

As of July 31, 2018, TIER REIT, Inc. had 50,775,348 shares of common stock, $.0001 par value, outstanding.




TIER REIT, Inc.
FORM 10-Q
Quarter Ended June 30, 2018
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2



PART I
FINANCIAL INFORMATION
Item 1.                                 Financial Statements


TIER REIT, Inc.
Condensed Consolidated Balance Sheets
(in thousands, except share and per share amounts)
(unaudited)
 
June 30, 2018
 
December 31, 2017
Assets
 

 
 

Real estate
 

 
 

Land
$
156,517

 
$
139,951

Land held for development
45,059

 
45,059

Buildings and improvements, net
1,160,273

 
1,061,418

Real estate under development
72,965

 
29,525

Total real estate
1,434,814

 
1,275,953

Cash and cash equivalents
8,359

 
13,800

Restricted cash
14,086

 
8,510

Accounts receivable, net
80,755

 
81,129

Prepaid expenses and other assets
17,124

 
28,112

Investments in unconsolidated entities
31,714

 
31,852

Deferred financing fees, net
3,211

 
1,387

Lease intangibles, net
106,058

 
87,047

Assets associated with real estate held for sale

 
53,348

Total assets
$
1,696,121

 
$
1,581,138

Liabilities and equity
 

 
 

Liabilities
 

 
 

Notes payable, net
$
886,260

 
$
794,538

Accounts payable and accrued liabilities
82,816

 
81,166

Acquired below-market leases, net
25,910

 
17,942

Other liabilities
6,545

 
7,567

Obligations associated with real estate held for sale

 
2,354

Total liabilities
1,001,531

 
903,567

Commitments and contingencies


 


Equity
 

 
 

Preferred stock, $.0001 par value per share; 17,500,000 shares authorized at June 30, 2018, and December 31, 2017, respectively, none outstanding

 

Convertible stock, $.0001 par value per share; 1,000 shares authorized, none outstanding

 

Common stock, $.0001 par value per share; 382,499,000 shares authorized, 48,574,724 and 47,623,324 shares issued and outstanding at June 30, 2018, and December 31, 2017, respectively
5

 
5

Additional paid-in capital
2,632,635

 
2,609,540

Cumulative distributions and net loss attributable to common stockholders
(1,953,466
)
 
(1,936,960
)
Accumulated other comprehensive income
12,462

 
4,218

Stockholders’ equity
691,636

 
676,803

Noncontrolling interests
2,954

 
768

Total equity
694,590

 
677,571

Total liabilities and equity
$
1,696,121

 
$
1,581,138


See Notes to Condensed Consolidated Financial Statements.

3




TIER REIT, Inc.
Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)
(in thousands, except share and per share amounts)
(unaudited)


 
Three Months Ended
 
Six Months Ended
 
June 30, 2018
 
June 30, 2017
 
June 30, 2018
 
June 30, 2017
Rental revenue
$
53,990

 
$
54,552

 
$
108,133

 
$
110,915

Expenses
 

 
 

 
 
 
 
Property operating expenses
12,395

 
13,930

 
25,550

 
28,620

Interest expense
8,369

 
8,235

 
16,478

 
17,015

Real estate taxes
9,074

 
8,753

 
17,828

 
17,313

Property management fees
97

 
72

 
182

 
132

General and administrative
5,377

 
5,626

 
10,880

 
11,333

Depreciation and amortization
27,134

 
22,652

 
51,750

 
47,181

Total expenses
62,446

 
59,268

 
122,668

 
121,594

Interest and other income
550

 
783

 
595

 
1,101

Loss on early extinguishment of debt

 

 
(8,988
)
 
(545
)
Loss before income taxes, equity in operations of investments, and gains (losses)
(7,906
)
 
(3,933
)
 
(22,928
)
 
(10,123
)
Benefit (provision) for income taxes
(214
)
 
149

 
(409
)
 
(95
)
Equity in operations of investments

 
6,556

 
287

 
6,300

Income (loss) before gains (losses)
(8,120
)
 
2,772

 
(23,050
)
 
(3,918
)
Gain (loss) on sale of assets
(90
)
 
1,262

 
11,924

 
92,012

Gain (loss) on remeasurement of investment in unconsolidated entities
(152
)
 

 
11,090

 
14,168

Net income (loss)
(8,362
)
 
4,034

 
(36
)
 
102,262

Noncontrolling interests
85

 
(3
)
 
149

 
(60
)
Net income (loss) attributable to common stockholders
$
(8,277
)
 
$
4,031

 
$
113

 
$
102,202

Weighted average common shares outstanding - basic
47,684,152

 
47,536,320

 
47,664,709

 
47,523,688

Weighted average common shares outstanding - diluted
47,684,152

 
47,875,418

 
48,476,933

 
47,727,634

 
 
 
 
 
 
 
 
Basic income (loss) per common share
$
(0.17
)
 
$
0.08

 
$
0.00

 
$
2.14

Diluted income (loss) per common share
$
(0.17
)
 
$
0.08

 
$
0.00

 
$
2.13

 
 
 
 
 
 
 
 
Distributions declared per common share
$
0.18

 
$
0.18

 
$
0.36

 
$
0.36

 
 
 
 
 
 
 
 
Comprehensive income (loss):
 

 
 

 
 

 
 

Net income (loss)
$
(8,362
)
 
$
4,034

 
$
(36
)
 
$
102,262

Other comprehensive income (loss): unrealized income (loss) on interest rate derivatives
1,984

 
(1,301
)
 
7,422

 
768

Comprehensive income (loss)
(6,378
)
 
2,733

 
7,386

 
103,030

Comprehensive (income) loss attributable to noncontrolling interests
84

 
(2
)
 
146

 
(60
)
Comprehensive income (loss) attributable to common stockholders
$
(6,294
)
 
$
2,731

 
$
7,532

 
$
102,970


See Notes to Condensed Consolidated Financial Statements.

4



TIER REIT, Inc.
Condensed Consolidated Statements of Changes in Equity
(in thousands, except per share amounts)
(unaudited)
 
 
 
 
 
 
 
Cumulative
Distributions
and
Net Loss Attributable to Common Stockholders
 
Accumulated Other Comprehensive Income (Loss)
 
 
 
 
 
Common Stock
 
Additional Paid-in Capital
 
 
 
 
 
 
 
Number of Shares
 
Par value
 
 
 
 
Noncontrolling Interests
 
Total
 Equity
 
 
 
 
 
 
 
Six months ended June 30, 2018
 

 
 

 
 

 
 

 
 

 
 

 
 

Balance at December 31, 2017
47,623

 
$
5

 
$
2,609,540

 
$
(1,936,960
)
 
$
4,218

 
$
768

 
$
677,571

Cumulative effect of changes in accounting principles

 

 

 
635

 
825

 

 
1,460

Balance at January 1, 2018
47,623

 
$
5

 
$
2,609,540

 
$
(1,936,325
)
 
$
5,043

 
$
768

 
$
679,031

Net income (loss)

 

 

 
113

 

 
(149
)
 
(36
)
Issuance of common stock, net
901

 

 
20,871

 

 

 

 
20,871

Unrealized gain on interest rate derivatives

 

 

 

 
7,419

 
3

 
7,422

Share based compensation, net
51

 

 
2,224

 

 

 
(269
)
 
1,955

Contributions by noncontrolling interests

 

 

 

 

 
2,604

 
2,604

Distributions declared:
 
 
 
 
 
 
 
 
 
 
 
 
 
   Common stock ($0.36 per share)

 

 

 
(17,254
)
 

 

 
(17,254
)
   Noncontrolling interests

 

 

 

 

 
(3
)
 
(3
)
Balance at June 30, 2018
48,575

 
$
5

 
$
2,632,635

 
$
(1,953,466
)
 
$
12,462

 
$
2,954

 
$
694,590

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Six months ended June 30, 2017
 

 
 

 
 

 
 

 
 

 
 

 
 

Balance at December 31, 2016
47,473

 
$
5

 
$
2,606,098

 
$
(1,986,515
)
 
$
(1,042
)
 
$
1,970

 
$
620,516

Cumulative effect of a change in accounting principle

 

 
290

 
(290
)
 

 

 

Balance at January 1, 2017
47,473

 
$
5

 
$
2,606,388

 
$
(1,986,805
)
 
$
(1,042
)
 
$
1,970

 
$
620,516

Net income

 

 

 
102,202

 

 
60

 
102,262

Unrealized gain on interest rate derivatives

 

 

 

 
768

 

 
768

Share based compensation, net
69

 

 
1,872

 

 

 
(268
)
 
1,604

Contributions by noncontrolling interests

 

 

 

 

 
438

 
438

Distributions declared:
 
 
 
 
 
 
 
 
 
 
 
 
 
   Common stock ($0.36 per share)

 

 

 
(17,217
)
 

 

 
(17,217
)
   Noncontrolling interests

 

 

 

 

 
(10
)
 
(10
)
Deconsolidation of investment

 

 

 

 

 
(1,500
)
 
(1,500
)
Balance at June 30, 2017
47,542

 
$
5

 
$
2,608,260

 
$
(1,901,820
)
 
$
(274
)
 
$
690

 
$
706,861














See Notes to Condensed Consolidated Financial Statements.

5



TIER REIT, Inc.
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)
 
Six Months Ended
 
June 30, 2018
 
June 30, 2017
Cash flows from operating activities
 

 
 

Net income (loss)
$
(36
)
 
$
102,262

Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 

 
 

Gain on sale of assets
(11,924
)
 
(92,012
)
Gain on remeasurement of investment in unconsolidated entities
(11,090
)
 
(14,168
)
Loss on early extinguishment of debt
8,988

 
545

Hedge ineffectiveness expense from derivatives

 
1

Amortization of restricted shares and units
2,164

 
1,933

Depreciation and amortization
51,750

 
47,181

Amortization of lease intangibles
(134
)
 
(286
)
Amortization of above- and below-market rent
(2,941
)
 
(1,788
)
Amortization of deferred financing fees
762

 
1,679

Equity in operations of investments
(287
)
 
(6,300
)
Ownership portion of fees from unconsolidated entities
80

 
194

Distributions from investments
10

 
8,963

Change in accounts receivable
(3,695
)
 
(4,207
)
Change in prepaid expenses and other assets
307

 
(222
)
Change in lease commissions
(2,861
)
 
(5,368
)
Change in other lease intangibles
3

 
(387
)
Change in accounts payable and accrued liabilities
(11,725
)
 
(13,515
)
Change in other liabilities
350

 
1,971

Cash provided by operating activities
19,721

 
26,476

 
 
 
 
Cash flows from investing activities
 

 
 

Escrow deposits
(3,350
)
 
(6,000
)
Return of investments
1,711

 
23,433

Purchases of real estate
(99,154
)
 
(93,011
)
Investments in unconsolidated entities
(843
)
 
(10,732
)
Capital expenditures for real estate
(17,559
)
 
(17,720
)
Capital expenditures for real estate under development
(37,788
)
 
(13,992
)
Proceeds from sales of assets
141,149

 
330,045

Cash provided by (used in) investing activities
(15,834
)
 
212,023

 
 
 
 
Cash flows from financing activities
 

 
 

Financing costs
(3,217
)
 
(1,933
)
Proceeds from notes payable
735,000

 
145,000

Payments on notes payable
(737,761
)
 
(338,088
)
Payments for early extinguishment of debt
(3,632
)
 
(436
)
Issuance of common stock
21,302

 

   Costs associated with issuance of common stock
(431
)
 

Transfer of common stock
(210
)
 
(329
)
Distributions paid to common stockholders
(17,254
)
 
(25,811
)
Distributions paid to noncontrolling interests
(3
)
 
(17
)
 Contributions from noncontrolling interests
2,454

 
438

Cash used in financing activities
(3,752
)
 
(221,176
)
 
 
 
 
Net change in cash, cash equivalents, and restricted cash
135

 
17,323

Cash, cash equivalents, and restricted cash at beginning of period
22,310

 
22,393

Cash, cash equivalents, and restricted cash at end of period
$
22,445

 
$
39,716


See Notes to Condensed Consolidated Financial Statements.

6



TIER REIT, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)
 
1.             Business
 
Organization
 
TIER REIT, Inc. is a publicly traded (NYSE: TIER), self-managed, Dallas-based real estate investment trust focused on owning quality, well-managed commercial office properties in dynamic markets throughout the U.S. As used herein, “TIER REIT,” the “Company,” “we,” “us,” or “our” refers to TIER REIT, Inc. and its subsidiaries unless the context otherwise requires.

TIER REIT’s vision is to be the premier owner and operator of best-in-class office properties in TIER1 submarkets, which are primarily higher density and amenity-rich locations within select, high-growth metropolitan areas that offer a walkable experience to various amenities. Our mission is to provide unparalleled, TIER ONE Property Services to our tenants and outsized total return through stock price appreciation and dividend growth to our stockholders. TIER REIT was incorporated in June 2002 as a Maryland corporation and has elected to be treated, and currently qualifies, as a real estate investment trust, or REIT, for federal income tax purposes. As of June 30, 2018, we owned interests in 18 operating office properties, one non-operating property, and three development properties. Our operating properties are located in six markets throughout the United States.
 
Substantially all of our business is conducted through Tier Operating Partnership LP (“Tier OP”), a Texas limited partnership.  Our wholly-owned subsidiary, Tier GP, Inc., a Delaware corporation, is the sole general partner of Tier OP.  Our direct and indirect wholly-owned subsidiaries, Tier Business Trust, a Maryland business trust, and Tier Partners, LLC, a Delaware limited liability company, are limited partners that together with Tier GP, Inc. own all of Tier OP.
    
2.             Basis of Presentation and Significant Accounting Policies
 
Interim Unaudited Financial Information
 
The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2017, which was filed with the Securities and Exchange Commission (“SEC”) on February 12, 2018.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been omitted from this report on Form 10-Q pursuant to the rules and regulations of the SEC.
 
The results for the interim periods shown in this report are not necessarily indicative of future financial results.  The accompanying condensed consolidated balance sheets as of June 30, 2018, and December 31, 2017, and condensed consolidated statements of operations and comprehensive income (loss), changes in equity, and cash flows for the periods ended June 30, 2018 and 2017, have not been audited by our independent registered public accounting firm.  In the opinion of management, the accompanying unaudited condensed consolidated financial statements include all adjustments necessary to present fairly our financial position as of June 30, 2018, and December 31, 2017, and our results of operations and our cash flows for the periods ended June 30, 2018 and 2017.  These adjustments are of a normal recurring nature.

We have evaluated subsequent events for recognition or disclosure in our condensed consolidated financial statements.

Summary of Significant Accounting Policies
 
Described below are certain of our significant accounting policies. The disclosures regarding several of the policies have been condensed or omitted in accordance with interim reporting regulations specified by Form 10-Q pursuant to the rules and regulations of the SEC. Please see our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for a complete listing of our significant accounting policies.


7


Real Estate
 
The following is a summary of our buildings and improvements and related lease intangibles as of June 30, 2018, and December 31, 2017 (in thousands): 
 
 
 
 
Lease Intangibles
 
 
 
 
Assets
 
Liabilities
 
 
 
 
 
 
Acquired Above-Market Leases
 
Acquired Below-Market Leases
 
 
Buildings and Improvements
 
Other Lease Intangibles
 
 
as of June 30, 2018
 
 
 
 
Cost
 
$
1,642,748

 
$
173,283

 
$
4,857

 
$
(61,205
)
Less: accumulated depreciation and amortization
 
(482,475
)
 
(67,405
)
 
(4,677
)
 
35,295

Net
 
$
1,160,273

 
$
105,878

 
$
180

 
$
(25,910
)
 
 
 
 
 
Lease Intangibles
 
 
 
 
Assets
 
Liabilities
 
 
 
 
 
 
Acquired Above-Market Leases
 
Acquired Below-Market Leases
 
 
Buildings and Improvements
 
Other Lease Intangibles
 
 
as of December 31, 2017
 
 
 
 
Cost
 
$
1,514,544

 
$
146,926

 
$
4,857

 
$
(50,399
)
Less: accumulated depreciation and amortization
 
(453,126
)
 
(60,298
)
 
(4,438
)
 
32,457

Net
 
$
1,061,418

 
$
86,628

 
$
419

 
$
(17,942
)
 
We amortize the value of in-place leases, in-place tenant improvements, and in-place leasing commissions to expense over the initial term of the respective leases.  The tenant relationship values are amortized to expense over the tenants’ respective initial lease terms and any anticipated renewal periods, but in no event does the amortization period for intangible assets or liabilities exceed the remaining depreciable life of the building.  Should a tenant terminate its lease, the unamortized portion of the acquired lease intangibles related to that tenant would be charged to expense.  The estimated remaining average useful lives for acquired lease intangibles range from an ending date of July 2018 to an ending date of November 2027. 

Anticipated amortization associated with acquired lease intangibles for each of the following five years is as follows (in thousands):
July 2018 - December 2018
3,594

2019
7,119

2020
6,274

2021
5,025

2022
4,323

 
Hurricane Harvey

In August 2017, One & Two Eldridge Place and Three Eldridge Place (collectively known as the “Eldridge Properties”), located in Houston, Texas, experienced flood-related damage as a result of Hurricane Harvey and its aftermath. By early January 2018, all of the properties were fully operational. We carry comprehensive property, casualty, flood, and business interruption insurance that we anticipate will cover our losses at the properties, subject to a deductible. In the third quarter of 2017, we recognized approximately $15.0 million for the write-off of the net book value of damaged assets, and we have incurred approximately $11.4 million of restoration expenses from August 2017 through June 2018.

The write-off of the net book value of damaged assets and the restoration expenses incurred have been fully offset by an estimated insurance recovery. Since we determined receipt of insurance proceeds is probable, the estimated insurance recovery is recorded as a receivable and is included in “accounts receivable, net” on our condensed consolidated balance sheets. Through June 30, 2018, we have received approximately $7.1 million of this insurance recovery.

To the extent that insurance proceeds ultimately exceed the net book value of damaged assets plus the restoration expenses incurred, the excess (net of the deductible) will be reflected as income in the period insurance proceeds are received or when receipt is deemed probable to occur.


8


During the three and six months ended June 30, 2018, we provided rent abatements of approximately $0.8 million and $4.7 million, respectively, to tenants as a result of Hurricane Harvey. These abatements were a reduction to “rental revenue” on our condensed consolidated statements of operations and comprehensive income (loss) for the three and six months ended June 30, 2018. For the three and six months ended June 30, 2018, these rent abatements were offset by approximately $0.4 million and $3.7 million, respectively, of business interruption insurance proceeds (net of estimated saved expenses). We anticipate we will receive remaining business interruption insurance proceeds in subsequent quarters.

Cash, Cash Equivalents, and Restricted Cash
 
We consider investments in highly-liquid money market funds or investments with original maturities of three months or less to be cash equivalents. Restricted cash includes restricted money market accounts, as required by our lenders or by leases, for anticipated tenant improvements, property taxes and insurance, certain tenant security deposits, and additional loan security reserves.
    
The following is a summary of our total cash, cash equivalents, and restricted cash as presented in our statements of cash flows for the six months ended June 30, 2018 and 2017 (in thousands):
 
June 30,
2018
 
June 30,
2017
Cash and cash equivalents
$
8,359

 
$
28,763

Restricted cash
14,086

 
10,953

Total cash, cash equivalents, and restricted cash
$
22,445

 
$
39,716


Accounts Receivable, net
 
The following is a summary of our accounts receivable as of June 30, 2018, and December 31, 2017 (in thousands):
 
June 30,
2018
 
December 31,
2017
Straight-line rental revenue receivable
$
53,674

 
$
57,372

Insurance receivable
19,717

 
18,826

Tenant receivables
6,217

 
4,221

Non-tenant receivables
1,564

 
893

Allowance for doubtful accounts
(417
)
 
(183
)
Total
$
80,755

 
$
81,129

 
Our allowance for doubtful accounts is an estimate based on management’s evaluation of accounts where it has determined that a tenant may not meet its financial obligations. In these situations, management uses its judgment, based on the facts and circumstances, and records a reserve for that tenant against amounts due to reduce the receivable to an amount it believes is collectible. These reserves are reevaluated and adjusted as additional information becomes available.

Investments in Unconsolidated Entities
 
Investments in unconsolidated entities consist of our noncontrolling interests in properties. We account for these investments using the equity method of accounting in accordance with GAAP. We use the equity method of accounting when we have significant influence, but not control, of the operating and financial decisions of these investments and thereby have some responsibility to create a return on our investment. The equity method of accounting requires these investments to be initially recorded at cost and subsequently increased (decreased) for our share of net income (loss), including eliminations for our share of inter-company transactions, and increased (decreased) for contributions (distributions). To the extent that we contribute assets to an unconsolidated entity, our investment in the unconsolidated entity is recorded at our cost basis in the assets that were contributed to the entity. To the extent that our cost basis is different than the basis reflected at the entity level, the basis difference is generally amortized over the life of the related asset and included in our share of equity in operations of investments.

For unconsolidated investments that have properties under development, we capitalize interest expense to our investment basis using our weighted average interest rate of consolidated debt. Capitalization begins when we are engaged in the activities necessary to get the property ready for its intended use. We cease capitalization when the development is completed and ready for its intended use or if the intended use changes such that capitalization is no longer appropriate. For the six months ended June

9


30, 2018 and 2017, we capitalized interest expense of approximately $0.6 million and $0.7 million, respectively, for unconsolidated entities with properties under development, which is included in our investments in unconsolidated entities on our condensed consolidated balance sheets.

Noncontrolling Interests
 
Noncontrolling interests consists of our third-party partners’ proportionate share of equity in certain consolidated real estate properties and restricted stock units issued to our independent directors.

Revenue Recognition

Our rental revenue primarily consists of revenue generated from leases. We recognize rental income generated from all leases of consolidated real estate assets on a straight-line basis over the terms of the respective leases, including the effect of rent holidays, if any.
For contracts with customers (as defined by GAAP), we recognize revenue when we transfer promised goods or services to a customer in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. Our revenue from contracts with customers primarily consists of parking income, development fee income, and gain on sale of assets.
Parking income - Parking income is primarily generated (1) through contractual arrangements with management companies that operate our parking garages and remit the monthly revenue collected to us or (2) directly through tenant leases. Revenue is recognized at a point in time upon the performance of services. Accounts receivable are recorded for services provided in advance of receiving payment. Management applies judgment in determining whether we are the principal or agent in those arrangements with management companies. We report revenue and expenses from these arrangements on a gross basis since we control the fulfillment of the promise to provide the service.
Development fee income - We serve as a development manager for development projects owned by unconsolidated entities in which we have an ownership interest. Development fees are paid monthly and structured based on costs that approximate the percentage of construction completed. Our performance obligation is therefore satisfied over time, and we recognize development fee income based on progress of the developments.
Gain on sale of assets - Upon the disposition of a property, we recognize a gain or loss at a point in time when we determine control of the underlying asset has been transferred to the buyer. Our performance obligation is generally satisfied at closing of the transaction. Any continuing involvement is analyzed as a separate performance obligation in the contract and a portion of the sales price is allocated to each performance obligation. When the performance obligation related to the continuing involvement is satisfied, the sales price allocated to it is recognized. There is significant judgment applied to estimate the amount of any variable consideration identified within the sales price and assess its probability of occurrence based on current market information, historical transactions, and forecasted information that is reasonably available.
3.            New Accounting Pronouncements

Recently Adopted Accounting Pronouncements
In May 2014, the FASB issued guidance to clarify the principles for recognizing revenue and to develop a common revenue standard for GAAP and International Financial Reporting Standards. The standard outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. Lease contracts are excluded from this revenue recognition criteria; however, the sale of real estate is required to follow the new model. Expanded quantitative and qualitative disclosures regarding the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers are required under the guidance. This guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2017. The guidance permits two implementation approaches, one requiring retrospective application of the new standard with restatement of prior years, or full retrospective, and one requiring prospective application of the new standard with disclosure of results under old standards, or modified retrospective. We adopted this guidance on January 1, 2018, using the modified retrospective approach applied to those contracts which were not completed as of January 1, 2018. The most material potential impact from adoption relates to how revenue is recognized for sales of real estate with continuing involvement. Prior to the adoption, profit for such sales transactions was recognized and then reduced by the maximum exposure to loss related to the nature of the continuing involvement at the time of sale. Under the new guidance, any continuing involvement must be analyzed as a separate performance obligation in the contract and a portion of the sales price allocated to each performance obligation. When the performance obligation related to the continuing involvement is satisfied, the sales price allocated to it is recognized. Upon adoption, we recorded a cumulative-effect adjustment to decrease opening cumulative distributions and net loss attributable to common stockholders by approximately $1.5 million. The adjustment represents a gain on sale that was deferred under the

10


previous guidance. We determined since control of the underlying asset was transferred to the buyer at closing of the transaction, the gain was recognizable at the time of sale. Our internal controls with respect to accounting for real estate sales have been updated accordingly. The adoption of this guidance resulted in no other changes with respect to the timing of revenue recognition or internal controls related to our other revenue from contracts with customers which include primarily parking income and development fee income. The additional disclosures required under the guidance related to our revenue from contracts with customers are provided in Footnote 12.
In August 2016, the FASB issued amended guidance on the classification of certain cash receipts and payments in the statement of cash flows. Of the eight types of cash flows discussed in the new standard, the classification of debt prepayment and debt extinguishment costs as financing outflows impact our financial statements as these items were previously reflected as operating outflows. This guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2017. We adopted this guidance on January 1, 2018, and the condensed consolidated statement of cash flows for the six months ended June 30, 2017, reflects the reclassification of approximately $0.4 million of payments for debt extinguishment costs from cash provided by operating activities to cash used in financing activities.
In February 2017, the FASB issued updated guidance that clarifies the scope of asset derecognition guidance, adds guidance for partial sales of nonfinancial assets, and clarifies recognizing gains and losses from the transfer of nonfinancial assets in contracts with noncustomers. This guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2017. The adoption of this guidance on January 1, 2018, did not have a material impact on our financial statements or disclosures.    
In May 2017, the FASB issued updated guidance on applying modification accounting to changes in the terms or conditions of a share-based payment award. Under the new guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. The guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2017. The adoption of this guidance on January 1, 2018, did not have a material impact on our financial statements or disclosures.

In August 2017, the FASB issued updated guidance to simplify the application of hedge accounting, increase transparency as to the scope and results of hedging programs, and result in a more accurate portrayal of the economics of an entity’s risk management activities in its financial statements. The transition guidance provides the option of early adoption using a modified retrospective transition method in any interim period after issuance of the update, or alternatively requires adoption for fiscal years beginning after December 15, 2018. We early adopted this guidance using the modified retrospective approach on January 1, 2018, and recorded a cumulative-effect adjustment to increase accumulated other comprehensive income with a corresponding increase to cumulative distributions and net loss attributable to common stockholders of approximately $0.8 million to eliminate hedge ineffectiveness income previously recognized.    
New Accounting Pronouncements to be Adopted
In February 2016, the FASB issued updated guidance which sets out revised principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors.  The guidance requires lessees to recognize assets and liabilities for operating leases with lease terms greater than twelve months on the balance sheet.  The guidance modifies lessors’ classification criteria for leases and the accounting for sales-type and direct financing leases.  The guidance also makes changes to lessor accounting and reporting, specifically the classification of lease components and non-lease components, such as services provided to tenants.  New disclosures regarding the amount, timing, and uncertainty of cash flows arising from leases are also required.  In July 2018, the FASB issued updated guidance that provides lessors a practical expedient to not separate non-lease components from associated lease components when certain criteria are met. The combined component is accounted for under the revenue standard if the non-lease component is the predominant component of the combined component; otherwise, the combined component is accounted for as an operating lease in accordance with the new leases standard. The guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2018, with early adoption permitted and was initially required to be adopted using the modified retrospective approach. However, the updated guidance also provides a transition option that allows entities to apply the standard at the adoption date and recognize a cumulative-effect adjustment to opening retained earnings in the period of adoption. We expect to adopt this guidance effective January 1, 2019, and elect to apply the transition option and the practical expedients provided by this standard.  Upon adoption, we will recognize a lease liability and a right-of-use asset for operating leases where we are the lessee, such as ground leases and office equipment leases.

In June 2016, the FASB issued amended guidance which requires measurement and recognition of expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. This is different from the current guidance as this will require immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets. Financial assets that are measured at amortized cost will be required to be presented at the net amount expected to be collected with an allowance for credit losses deducted from the

11


amortized cost basis. Generally, the pronouncement requires a modified retrospective method of adoption. This guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2019, with early adoption permitted. We are currently evaluating the impact this guidance will have on our financial statements when adopted.     

4.           Real Estate Activities

Sales of Real Estate
The following table presents our sales of real estate for the six months ended June 30, 2018 (in thousands):
Property Name
 
Date of Sale
 
Location
 
Rentable Square Footage
 
Contract Sale Price
 
Proceeds from Sale
500 East Pratt
 
02/13/18
 
Baltimore, MD
 
280

 
$
60,000

 
$
56,528

Centreport Office Center
 
02/22/18
 
Fort Worth, TX
 
133

 
12,696

 
12,421

Loop Central
 
03/27/18
 
Houston, TX
 
575

 
72,982

 
71,978

 
 
 
 
 
 
988

 
$
145,678

 
$
140,927

Properties that have been sold contributed income of less than $0.1 million and approximately $0.8 million to our net loss for the three and six months ended June 30, 2018, respectively. Properties that have been sold contributed income of approximately $1.8 million and $3.5 million to our net income for the three and six months ended June 30, 2017, respectively. These amounts exclude any gains on the sales of these properties.

Acquisitions of Real Estate
On January 4, 2018, we acquired a 96.5% initial economic interest in Domain Point for a contract purchase price of approximately $73.8 million (at 100%). We own a 90% interest in the entity that owns Domain Point. Domain Point is located in Austin, Texas, adjacent to our other Domain office properties and includes two buildings with 240,000 rentable square feet (combined). Assets acquired and liabilities assumed were recorded at their relative fair values and include lease intangible assets of approximately $9.3 million and acquired below-market leases of approximately $2.8 million. The estimated remaining average useful lives for these acquired lease intangibles range from an ending date of September 2018 to an ending date of April 2022. 
On March 30, 2018, we acquired the remaining 50% interest in Domain Junction 8 Venture LLC, the entity that owns Domain 8, increasing our ownership interest in this property to 100%, for a contract purchase price of approximately $92.8 million, which includes the assumption of approximately $44.9 million in mortgage debt. As a result of obtaining a controlling interest in the entity, we recognized a gain of approximately $11.1 million from the remeasurement of our previously held equity interest at fair value. Assets acquired and liabilities assumed were recorded at their relative fair values upon consolidation of the property, and include lease intangible assets of approximately $21.3 million and acquired below-market leases of approximately $8.3 million. The estimated remaining average useful lives for these acquired lease intangibles range from having an ending date of May 2025 to an ending date of November 2027. 
Real Estate Held for Sale

We had no properties held for sale as of June 30, 2018. 500 East Pratt (sold in February 2018) was held for sale as of December 31, 2017. The major classes of assets and obligations associated with real estate held for sale as of December 31, 2017, were as follows (in thousands):
 
December 31, 2017
Buildings and improvements, net of approximately $29.0 million in accumulated depreciation
$
45,396

Accounts receivable and other assets
3,335

Lease intangibles, net of approximately $5.6 million in accumulated amortization
2,830

Other intangible assets, net of approximately $1.2 million in accumulated amortization
1,787

Assets associated with real estate held for sale
$
53,348

 
 
Acquired below-market leases, net of approximately $1.3 million in accumulated amortization
$
364

Other liabilities
1,990

   Obligations associated with real estate held for sale
$
2,354




12


5.             Real Estate Under Development
 
When we are engaged in activities to get a potential development ready for its intended use, we capitalize interest, property taxes, insurance, ground lease payments, and direct construction costs. For the six months ended June 30, 2018, we capitalized a total of approximately $43.4 million, including approximately $1.8 million of interest. For the six months ended June 30, 2017, we capitalized a total of approximately $8.9 million, which included approximately $0.6 million of interest. These costs are classified as real estate under development on our condensed consolidated balance sheets until such time that the development is complete.

6.             Investments in Unconsolidated Entities
 
We participate in real estate ventures for the purpose of acquiring and developing office properties in which we may or may not have a controlling financial interest. Our investments in unconsolidated entities consist of our noncontrolling interests in certain properties that are accounted for using the equity method of accounting.

The following is a summary of our investments in unconsolidated entities as of June 30, 2018, and December 31, 2017 (dollar amounts in thousands):
 
 
 
 
Ownership Interest
 
Unconsolidated
Investment Balance
Entity Name
 
Property
 
June 30,
2018
 
December 31, 2017
 
June 30,
2018
 
December 31,
2017
Domain Junction 8 Venture LLC (1)(2)
 
Domain 8
 
100.00
%
 
50.00
%
 
$

 
$
882

208 Nueces Street, LLC (2)
 
Third + Shoal
 
47.50
%
 
47.50
%
 
31,714


30,970

Total (3)
 
 
 
`

 
 

 
$
31,714

 
$
31,852

_________________
(1)
On March 30, 2018, we acquired the unrelated third party’s 50% interest in Domain Junction 8 Venture LLC increasing our ownership interest to 100%, and this property was consolidated.
(2)
We evaluate our investments in unconsolidated entities in order to determine if they are variable interest entities (“VIEs”). Based on our assessment, we identified each of these entities as a VIE, but we are not the primary beneficiary, as we do not have the power to direct the activities that most significantly impact the economic performance of these entities. For VIEs in which we are not deemed to be the primary beneficiary, we continue to account for them using the equity method. The maximum amount of exposure to loss with respect to these VIEs is the carrying amount of our investment and any debt guaranteed by us. As of June 30, 2018, and December 31, 2017, Tier OP guaranteed 25% and 50%, respectively, of the construction loan of 208 Nueces Street, LLC, as discussed below in “Guarantees.” At June 30, 2018, our VIEs have total assets of approximately $108.8 million and total liabilities of approximately $54.3 million. At December 31, 2017, our VIEs had total assets of approximately $172.3 million and total liabilities of approximately $125.1 million.
(3)
Our investments in unconsolidated entities at June 30, 2018, and December 31, 2017, include basis adjustments that total approximately $5.8 million and $9.4 million, respectively. These amounts represent the aggregate difference between our historical cost basis and our equity basis reflected at the joint venture level, which is typically amortized over the life of the related assets and liabilities. Basis differences occur from impairment of investments and upon the transfer of assets that were previously owned by us into a joint venture. In addition, capitalized interest and certain acquisition, transaction, and other costs may not be reflected in the net assets at the joint venture level.

Our equity in operations of investments represents our proportionate share of the combined earnings and losses of our investments for the period of our ownership and in 2017, includes combined gains on the sales of 1325 G Street and the Colorado Building of approximately $6.7 million. For the three months ended June 30, 2018 and 2017, we recorded no income and approximately $6.6 million of income, respectively, for our share of equity in operations from our investments in unconsolidated entities. For the six months ended June 30, 2018 and 2017, we recorded income of approximately $0.3 million and approximately $6.3 million, respectively, for our share of equity in operations from our investments in unconsolidated entities.

Guarantees

The unconsolidated entities in which we have investments generally finance their activities with a combination of partner equity and debt financing. In 2017, 208 Nueces Street, LLC entered into a construction loan for the development of Third + Shoal, in which Tier OP guaranteed up to 50% of the outstanding principal balance. This percentage is reduced when certain conditions in the guarantee agreement are met, and as of June 30, 2018, this percentage was 25%. The guarantee, which extends to October 2021 when the loan matures, includes a project completion guarantee and a payment guarantee covering a percentage of the outstanding loan. 
Additionally, there is a recourse carve-out agreement in which Tier OP guarantees the entire outstanding balance of the loan in addition to any related losses that may arise from certain violations of the joint venture’s contractual agreements, including “bad boy acts.” In these situations, we have an indemnity and contribution agreement with our partners where each partner has indemnified the other for any recourse liability resulting from claims triggered by that partner.

13


As of June 30, 2018, 208 Nueces Street, LLC has a loan commitment of approximately $103.8 million, of which, if the full amount of the debt obligation was borrowed, we estimate approximately $26.0 million is our maximum exposure related to the payment guarantee. As of June 30, 2018, the outstanding balance of the construction loan for 208 Nueces Street, LLC was approximately $44.7 million, of which we estimate approximately $11.2 million is our maximum exposure related to the payment guarantee. These maximum exposure estimates do not take into account any recoveries from the underlying collateral or any reimbursement from our partners. We believe that, as of June 30, 2018, in the event we become legally obligated to perform under the payment guarantee, the collateral in 208 Nueces Street, LLC should be sufficient to repay the obligation. If it is not, we and our partners would need to contribute additional capital to the venture.
7.          Notes Payable, net
 
Our notes payable, net were approximately $886.3 million as of June 30, 2018. Approximately $279.2 million of these notes payable, net were secured by real estate assets with a carrying value of approximately $398.8 million as of June 30, 2018. As of June 30, 2018, all of our outstanding debt was fixed rate debt (or effectively fixed rate debt, through the use of interest rate swaps), with the exception of approximately $172.7 million. As of June 30, 2018, the stated annual interest rates on our outstanding debt, ranged from approximately 3.16% to 6.09%. As of June 30, 2018, the effective weighted average interest rate for our debt is approximately 3.91%. For our loan that is in default and detailed below, we incur a default interest rate that is 500 basis points higher than the stated interest rate, which resulted in an overall effective weighted average interest rate for our debt of approximately 4.19% as of June 30, 2018, and additional interest expense of approximately $1.2 million for the six months ended June 30, 2018. We anticipate, although we can provide no assurance, that when the property to which such loan relates is sold, or if ownership of this property is conveyed to the lender, the default interest will be forgiven.
 
Our loan agreements generally require us to comply with certain reporting and financial covenants.  As of June 30, 2018, we were in default on a non-recourse property loan with an outstanding balance of approximately $48.2 million secured by our Fifth Third Center property located in Columbus, Ohio, which has a carrying value of approximately $31.6 million as of June 30, 2018. A receiver was appointed for this property in March 2016. The loan had an original maturity date of July 2016, and we are currently working with the lender to dispose of this property on its behalf, although there can be no assurance regarding such disposition.

As of June 30, 2018, other than the default discussed above, we believe we were in compliance with the covenants under each of our loan agreements, including our credit facility.
 
Excluding debt already matured as detailed above, our outstanding debt has maturity dates that range from June 2020 to January 2025. The following table provides information regarding the timing of principal payments of our notes payable, net, as of June 30, 2018 (in thousands):
Principal payments due in:
 
July 2018 - December 2018
$
48,917

2019
1,589

2020
91,403

2021
72,402

2022
308,000

Thereafter
366,000

Less: unamortized debt issuance costs (1)
(2,051
)
Notes payable, net
$
886,260

________________
(1)
Excludes approximately $3.2 million of unamortized debt issuance costs associated with the revolving line of credit because these costs are presented as an asset on our condensed consolidated balance sheets.        

Credit Facility

We have a credit agreement through our operating partnership, Tier OP, that provides for total unsecured borrowings of up to $900.0 million, subject to our compliance with certain financial covenants. The facility consists of a $300.0 million term loan, a $275.0 million term loan, and a $325.0 million revolving line of credit. The $300.0 million term loan matures on January 17, 2025. The $275.0 million term loan matures on June 30, 2022. The revolving line of credit matures on January 18, 2022, and can be extended one additional year subject to certain conditions and payment of an extension fee. The annual interest rate on the credit facility is equal to either, at our election, (1) the “base rate” (calculated as the greatest of (i) the agent’s “prime rate”; (ii) 0.5% above the Federal Funds Effective Rate; or (iii) the LIBOR Market Index Rate plus 1.0%) plus the applicable margin or (2) LIBOR for an interest period of one, three, or six months plus the applicable margin.  The applicable margin will be determined

14


based on the ratio of total indebtedness to total asset value and ranges from 10 basis points to 235 basis points.  We have entered into interest rate swap agreements to hedge interest rates on $525.0 million of these borrowings to manage our exposure to future interest rate movements. All amounts owed are guaranteed by us and certain subsidiaries of Tier OP. As of June 30, 2018, we had approximately $575.0 million in borrowings outstanding under the term loans, and $33.0 million in borrowings outstanding under the revolving line of credit with the ability, subject to our most restrictive financial covenants, to borrow an additional approximately $209.4 million under the facility as a whole. As of June 30, 2018, the weighted average effective interest rate for borrowings under the credit facility as a whole, inclusive of our interest rate swaps, was approximately 3.46%.
 
8.          Fair Value Measurements
 
Fair value, as defined by GAAP, is a market-based measurement, not an entity-specific measurement.  Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability.  As a basis for considering market participant assumptions in fair value measurements, a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the fair value hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the fair value hierarchy) has been established.

Assets and Liabilities Measured at Fair Value on a Recurring Basis
 
Derivative financial instruments
 
We use derivative financial instruments, such as interest rate swaps, to manage our interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis of the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. The fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts).  The variable cash payments (or receipts) are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves. 
We incorporate credit valuation adjustments (“CVAs”) to appropriately reflect both our own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of our derivative contracts for the effect of nonperformance risk, we have considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts, and guarantees.
Although we have determined that the majority of the inputs used to value our derivatives fall within Level 2 of the fair value hierarchy, the CVAs associated with our derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by us and our counterparties.  However, we have assessed the significance of the impact of the CVAs on the overall valuation of our derivative positions and have determined that they are not significant.  As a result, we have determined that our derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.  Unrealized gains or losses on derivatives are recorded in accumulated other comprehensive income (loss) (“OCI”) within equity at each measurement date. Our derivative financial instruments are included in “prepaid expenses and other assets” on our condensed consolidated balance sheets.

The following table sets forth our financial assets and liabilities measured at fair value on a recurring basis, which equals book value, by level within the fair value hierarchy as of June 30, 2018, and December 31, 2017 (in thousands):
 
 
 
 
Basis of Fair Value Measurements
 
 
 
 
Quoted Prices In Active Markets for Identical Items (Level 1)
 
Significant Other Observable Inputs (Level 2)
 
Significant Unobservable Inputs (Level 3)
 
 
Total Fair Value
 
 
 
Description
 
 
 
 
June 30, 2018
 
 
 
 
 
 
 
 
Derivative financial instruments:
 
 
 
 
 
 
 
 
Assets
 
$
12,467

 
$

 
$
12,467

 
$

 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
Derivative financial instruments:
 
 
 
 
 
 
 
 
Assets
 
$
5,045

 
$

 
$
5,045

 
$


15


Financial Instruments not Reported at Fair Value
 
Financial instruments held at June 30, 2018, and December 31, 2017, but not measured at fair value on a recurring basis include cash and cash equivalents, restricted cash, accounts receivable, notes payable, accounts payable and accrued liabilities, and other liabilities. With the exception of notes payable, the financial statement carrying amounts of these items approximate their fair values due to their short-term nature. Estimated fair values for notes payable have been determined using recent trading activity and/or bid-ask spreads and are classified as Level 2 in the fair value hierarchy.

Carrying amounts of our notes payable and the related estimated fair value as of June 30, 2018, and December 31, 2017, are as follows (in thousands):
 
June 30, 2018
 
December 31, 2017
 
Carrying Amount
 
Fair
Value
 
Carrying Amount
 
Fair
Value
Notes payable
$
888,311

 
$
891,216

 
$
801,339

 
$
805,786

Less: unamortized debt issuance costs
(2,051
)
 
 
 
(6,801
)
 
 
Notes payable, net
$
886,260

 
 
 
$
794,538

 
 
 
9.              Derivative Instruments and Hedging Activities
 
We may be exposed to the risk associated with variability of interest rates that might impact our cash flows and the results of our operations.  Our objectives in using interest rate derivatives are to add stability to interest expense and to manage our exposure to interest rate movements.  To accomplish this objective, we have used interest rate swaps as part of our interest rate risk management strategy.  Our interest rate swaps involve the receipt of variable-rate amounts from counterparties in exchange for us making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.  Our hedging strategy of entering into interest rate swaps, therefore, is to eliminate or reduce, to the extent possible, the volatility of cash flows.
 
The following table summarizes the notional values of our derivative financial instruments (in thousands) as of June 30, 2018. The notional values provide an indication of the extent of our involvement in these instruments at June 30, 2018, but do not represent exposure to credit, interest rate, or market risks.
Type/Description
 
Notional Value
 
Index
 
Strike Rate
 
Effective Date
 
Maturity Date
Interest rate swap - cash flow hedge
 
$
125,000

 
one-month LIBOR
 
1.6775
%
 
12/31/14
 
10/31/19
Interest rate swap - cash flow hedge
 
$
125,000

 
one-month LIBOR
 
1.6935
%
 
04/30/15
 
10/31/19
Interest rate swap - cash flow hedge
 
$
125,000

 
one-month LIBOR
 
1.7615
%
 
06/30/15
 
05/31/22
Interest rate swap - cash flow hedge
 
$
150,000

 
one-month LIBOR
 
1.7695
%
 
06/30/15
 
05/31/22

The table below presents the fair value of our derivative financial instruments, included in “prepaid expenses and other assets” on our condensed consolidated balance sheets, as of June 30, 2018, and December 31, 2017 (in thousands):
 
Derivatives Designated as Hedging Instruments:
Derivative Assets
 
 
June 30,
2018
 
December 31,
2017
 
 
Interest rate swaps
$
12,467

 
$
5,045

 
The tables below present the effect of the change in fair value of derivative financial instruments in our condensed consolidated statements of operations and comprehensive income (loss) for the three and six months ended June 30, 2018 and 2017 (in thousands):
 
Derivatives in Cash Flow Hedging Relationship
 
Gain (loss) recognized in OCI on derivatives
 
Three Months Ended
 
Six Months Ended
 
June 30, 2018
 
June 30, 2017
 
June 30, 2018
 
June 30, 2017
Interest rate swaps
$
1,984

 
$
(1,301
)
 
$
7,422

 
$
768


16


 
Amount reclassified from OCI into income
 
Three Months Ended
 
Six Months Ended
Location
June 30, 2018
 
June 30, 2017
 
June 30, 2018
 
June 30, 2017
Interest expense (1)
$
(259
)
 
$
953

 
$
(100
)
 
$
2,199

______________
(1)
Increases (decreases) in fair value as a result of accrued interest associated with our swap transactions are recorded in accumulated OCI and subsequently reclassified into income. Such amounts are shown net in the condensed consolidated statements of changes in equity and offset dollar for dollar.    
 
 
Total interest expense presented in the Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) in which the effects of cash flow hedges are recorded
 
 
 
Three Months Ended
 
Six Months Ended
 
Location
June 30, 2018
 
June 30, 2017
 
June 30, 2018
 
June 30, 2017
 
Interest expense
$
8,369

 
$
8,235

 
$
16,478

 
$
17,015

 
Amounts reported in accumulated OCI related to derivatives will be reclassified to interest expense as interest payments and accruals are made on our variable-rate debt. During the next twelve months, we estimate that approximately $3.5 million will be reclassified as a decrease to interest expense.

We have agreements with our derivative counterparties that contain provisions where if we default on any of our indebtedness for at least 30 days, during which time such default has not been remedied, and in all cases provided that the aggregate amount of all such defaults is not less than $10.0 million for recourse debt or $75.0 million for non-recourse debt, then we could also be declared in default on our derivative obligations.    

10.          Commitments and Contingencies
 
As of June 30, 2018, we had commitments of approximately $17.2 million for future building improvements, tenant improvements, and leasing commissions.
 
We have employment agreements with our five named executive officers.  The term of each employment agreement ends on February 10, 2020, provided that the term will automatically continue for an additional one-year period unless either party provides 60 days written notice of non-renewal prior to the expiration of the initial term.  The agreements provide for lump sum payments and an immediate lapse of restrictions on compensation received under the long-term incentive plan upon termination of employment without cause.  As a result, in the event we terminated all of these agreements without cause as of June 30, 2018, we would have recognized approximately $14.3 million in related compensation expense.

11.          Equity

Stock Plans
 
Our 2015 Equity Incentive Plan allows for, and our 2005 Incentive Award Plan allowed for, equity-based incentive awards to be granted to our employees, non-employee directors, and key persons as detailed below:

Restricted stock units held by independent directors. We have outstanding restricted stock units (“RSUs”) held by our independent directors. These units vest 13 months after the grant date. Subsequent to vesting, the restricted stock units will be converted to an equivalent number of shares of common stock upon the earlier to occur of the following events or dates: (i) separation from service for any reason other than cause; (ii) a change in control of the Company; (iii) death; or (iv) July 2019. Expense is measured at the grant date based on the estimated fair value of the award and is recognized over the vesting period. Any forfeitures of awards are recognized as they occur.


17


The following is a summary of the number of outstanding RSUs held by our independent directors as of June 30, 2018 and 2017:
 
June 30, 2018
 
June 30, 2017
 
Units
 
Weighted Average Price per unit
 
Units
 
Weighted Average Price per unit
Outstanding at the beginning of the year
19,672

 
$
17.03

 
39,255

 
$
16.45

Issued
12,910

 
$
23.24

 
19,672

 
$
17.03

Converted
(19,672
)
 
$
17.03

 
(29,307
)
 
$
16.92

Outstanding at the end of the period (1)
12,910

 
$
23.24

 
29,620

 
$
16.38

_____________
(1)
As of June 30, 2018, none of the RSUs held by our independent directors are vested.

Restricted stock units held by employees. We have outstanding RSUs held by employees. These units vest from December 2018 to December 2020 at which time the units will be converted into a number of shares of common stock, which could range from zero shares to 200% of the issued number of units. The actual number of shares of common stock issued will be based on our annualized total stockholder return (“TSR”) percentage as compared to three metrics: our TSR on a predetermined absolute basis, the TSR of the constituent companies of the NAREIT Office Index (unweighted), and the TSR of a select group of peer companies.

The following is a summary of the number of outstanding RSUs held by our employees as of June 30, 2018 and 2017:
 
June 30, 2018
 
June 30, 2017
 
Units
 
Weighted Average Price per unit
 
Units
 
Weighted Average Price per unit
Outstanding at the beginning of the year
208,620

 
$
16.59

 
111,063

 
$
15.26

Issued
129,188

 
$
17.24

 
97,557

 
$
18.10

Outstanding at the end of the period
337,808

 
$
16.84

 
208,620

 
$
16.59


Compensation cost is measured at the grant date, based on the estimated fair value of the award (ranging from $16.80 per unit to $20.95 per unit) as determined by a Monte Carlo simulation-based model using the assumptions outlined in the table below. Any forfeitures of awards are recognized as they occur.
Assumption
 
Value
Expected volatility
 
24% - 26%
Risk-free interest rate
 
1.15% - 2.37%
Expected term
 
35 months
Expected dividend yield
 
3.7% - 4.5%
Restricted stock. We have outstanding restricted stock held by employees. Restrictions on outstanding shares lapse based on various lapse schedules and range from December 2018 to December 2020. Compensation cost is measured at the grant date based on the estimated fair value of the award and is recognized as expense over the service period based on a tiered lapse schedule. Any forfeitures of awards are recognized as they occur.

The following is a summary of the number of shares of restricted stock outstanding as of June 30, 2018 and 2017:
 
June 30, 2018
 
June 30, 2017
 
Shares
 
Weighted Average Price per share
 
Shares
 
Weighted Average Price per share
Outstanding at the beginning of the year
180,791

 
$
20.47

 
246,805

 
$
20.74

Issued
125,558

 
$
17.24

 
121,860

 
$
17.88

Forfeitures
(4,914
)
 
$
17.10

 
(20,089
)
 
$
17.53

Restrictions lapsed
(41,062
)
 
$
26.23

 
(57,553
)
 
$
25.64

Outstanding at the end of the period
260,373

 
$
18.07

 
291,023

 
$
18.79


For the three months ended June 30, 2018 and 2017, we recognized a total of approximately $1.2 million and $1.0 million, respectively, for compensation expense related to the amortization of all of the equity-based incentive awards outlined above. For

18


the six months ended June 30, 2018 and 2017, we recognized a total of approximately $2.2 million and $1.9 million, respectively, for compensation expense related to the amortization of all of the equity-based incentive awards outlined above. As of June 30, 2018, the total remaining compensation cost on unvested awards was approximately $5.9 million, with a weighted average remaining contractual life of approximately 1.4 years.

ATM Program
On May 10, 2017, we established an at-the-market equity offering program (the “ATM Program”) pursuant to which we may issue and sell shares of our common stock having an aggregate offering price of up to $125.0 million in amounts and at times as we determine from time to time. We have no obligation to sell any of such shares. Actual sales will depend on a variety of factors to be determined by the Company from time to time, including, among others, market conditions, the trading price of our common stock, our determinations of the appropriate sources of funding for the Company, and potential uses of funding available to us. We intend to use the net proceeds from the offering of such shares, if any, for general corporate purposes, which may include future acquisitions, development, and repayment of indebtedness, including borrowings under our credit facility. During the three months ended June 30, 2018, we issued 901,300 shares of common stock under the ATM Program, generating proceeds of approximately $20.9 million, net of approximately $0.3 million of commissions and approximately $0.1 million of issuance costs. Subsequent to June 30, 2018, we issued 1,940,251 shares of common stock under the ATM Program, generating proceeds of approximately $44.8 million, net of approximately $0.6 million of commissions and approximately $0.2 million of issuance costs.
12.    Revenue

We recognize rental income generated from all leases of consolidated real estate assets on a straight-line basis over the terms of the respective leases, including the effect of rent holidays, if any.  The total net increase to rental revenue due to straight-line rent adjustments for the three months ended June 30, 2018 and 2017, was approximately $0.8 million and $2.0 million, respectively.  The total net increase to rental revenue due to straight-line rent adjustments for the six months ended June 30, 2018 and 2017, was approximately $1.3 million and $3.8 million, respectively. When a tenant exceeds its tenant improvement allowance, this amount is reimbursed to us and recorded as a deferred rent liability, which is recognized as rental revenue over the life of the lease. The total net increase to rental revenue due to this deferred rent for the three months ended June 30, 2018 and 2017, was approximately $0.4 million and $0.4 million, respectively. The total net increase to rental revenue due to this deferred rent for the six months ended June 30, 2018 and 2017, was approximately $0.8 million and $1.0 million, respectively. Our rental revenue also includes amortization of acquired above- and below-market leases.  The total net increase to rental revenue due to the amortization of acquired above- and below-market leases for the three months ended June 30, 2018 and 2017, was approximately $1.7 million and $0.9 million, respectively. The total net increase to rental revenue due to the amortization of acquired above- and below-market leases for the six months ended June 30, 2018 and 2017, was approximately $2.9 million and $1.8 million, respectively. Revenues relating to lease termination fees are recognized on a straight-line basis amortized from the time that a tenant’s right to occupy the leased space is modified through the end of the revised lease term.  For the three months ended June 30, 2018 and 2017, we recognized lease termination fees of approximately $0.4 million and $0.1 million, respectively. For the six months ended June 30, 2018 and 2017, we recognized lease termination fees of approximately $0.7 million and $0.2 million, respectively.

Included in our rental revenue is parking income of approximately $2.3 million and $2.0 million for the three months ended June 30, 2018 and 2017, respectively, and $4.6 million and $3.9 million for the six months ended June 30, 2018 and 2017, respectively, which represents revenue from contracts with customers. Gain (loss) on sale of assets, which also represents revenue from contracts with customers, was a loss of approximately $0.1 million and a gain of approximately $1.3 million for the three months ended June 30, 2018 and 2017, respectively, and gains of approximately $11.9 million and $92.0 million for the six months ended June 30, 2018 and 2017, respectively. We had no significant development fee income for the three or six months ended June 30, 2018. We had development fee income of approximately $0.2 million for the three and six months ended June 30, 2017.
    
Accounts receivables from contracts with customers were approximately $0.9 million and $0.6 million as of June 30, 2018 and December 31, 2017, respectively.
13.    Net Income (Loss) per Common Share
 
Net income (loss) per common share is calculated using the two-class method, which requires the allocation of undistributed net income between common and participating stockholders. All outstanding restricted stock awards containing rights to non-forfeitable distributions are considered participating securities for this calculation. In periods of net loss, no loss is allocated to participating securities because our participating securities do not have a contractual obligation to share in our losses.     
    

19


The following table reflects the calculation of basic and diluted net income (loss) per common share for the three and six months ended June 30, 2018 and 2017 (in thousands, except per share data):
 
 
Three Months Ended
 
Six Months Ended
 
 
June 30, 2018
 
June 30, 2017
 
June 30, 2018
 
June 30, 2017
Numerator:
 
 
 
 
 
 
 
 
Net income (loss) attributable to common stockholders
 
$
(8,277
)
 
$
4,031

 
$
113

 
$
102,202

Less: net income allocated to participating securities
 

 

 

 
(611
)
Numerator for basic net income (loss) per share
 
$
(8,277
)
 
$
4,031

 
$
113

 
$
101,591

Add: undistributed net income allocated to participating securities
 

 

 

 
506

Less: undistributed net income re-allocated to participating securities
 

 

 

 
(504
)
Numerator for diluted net income (loss) per share (1)
 
$
(8,277
)
 
$
4,031

 
$
113

 
$
101,593

 
 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
 
Weighted average common shares outstanding - basic
 
47,684

 
47,536

 
47,665

 
47,524

Effect of dilutive securities
 

 
339

 
812

 
204

Weighted average common shares outstanding - diluted
 
47,684

 
47,875

 
48,477

 
47,728

 
 
 
 
 
 
 
 
 
Basic net income (loss) per common share
 
$
(0.17
)
 
$
0.08

 
$
0.00

 
$
2.14

Diluted net income (loss) per common share
 
$
(0.17
)
 
$
0.08

 
$
0.00

 
$
2.13

 
 
 
 
 
 
 
 
 
Securities excluded from weighted average common shares outstanding-diluted because their effect would be anti-dilutive
 
992

 
29

 
17

 
29

_______________
(1)
In periods where there is no undistributed net income to allocate to participating securities, the treasury stock method is used to calculate dilutive securities.

14.          Supplemental Cash Flow Information
 
Supplemental cash flow information is summarized below for the six months ended June 30, 2018 and 2017 (in thousands):
 
Six Months Ended
 
June 30, 2018
 
June 30, 2017
Interest paid, net of amounts capitalized
$
14,211

 
$
12,695

Income taxes paid
$
758

 
$
403

 
 
 
 
Non-cash investing activities:
 

 
 

Property and equipment additions in accounts payable and accrued liabilities
$
17,382

 
$
7,816

Liabilities assumed through the purchase of real estate
$
7,028

 
$
3,267

Escrow deposits applied to purchase of real estate
$
21,350

 
$
14,000

Escrow deposit applied to purchase of real estate from noncontrolling interest
$
150

 
$

Sale of real estate and lease intangibles to unconsolidated joint venture
$

 
$
13,804

  Acquisition of controlling interest in unconsolidated entity
$
927

 
$
9,770

 
 
 
 
Non-cash financing activities:
 

 
 

Mortgage notes assumed (1)
$
89,733

 
$
146,000

  Unrealized gain on interest rate derivatives
$
7,422

 
$
768

 _________________
(1)
The approximately $89.7 million mortgage notes assumed during the six months ended June 30, 2018, includes approximately $44.9 million of debt assumed when we acquired the remaining 50.00% interest in our Domain 8 property, and approximately $44.9 million of debt associated with our previously held 50.00% unconsolidated interest in the Domain 8 property. Domain 8 was consolidated during the six months ended June 30, 2018. The approximately $146.0 million mortgage notes assumed during the six months ended June 30, 2017, includes approximately $66.0 million of debt assumed when we acquired Legacy Union One, approximately $40.1 million of debt assumed when we acquired the remaining 50.16% interest in our Domain 2 and Domain 7 properties, and approximately $39.9 million of debt associated with our previously held 49.84% unconsolidated interest in the Domain 2 and Domain 7 properties. Domain 2 and Domain 7 were consolidated during the six months ended June 30, 2017.

20



Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion and analysis should be read in conjunction with the accompanying condensed consolidated financial statements and the notes thereto.
Forward-Looking Statements

Certain statements in this Quarterly Report on Form 10-Q constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  These forward-looking statements include discussion and analysis of the financial condition of TIER REIT, Inc. and our subsidiaries (which may be referred to herein as the “Company,” “we,” “us” or “our”), including our ability to rent space on favorable terms, our ability to address debt maturities and fund our capital requirements, our intentions to acquire, develop, or sell certain properties, the value of our assets, our anticipated capital expenditures, the amount and timing of any anticipated future cash distributions to our stockholders and other matters.  Words such as “may,” “will,” “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “outlook,” “would,” “could,” “should,” “objectives,” “strategies,” “opportunities,” “goals,” “position,” “future,” “vision,” “mission,” “strive,” “project” and variations of these words and similar expressions are intended to identify forward-looking statements.
These forward-looking statements are not historical facts but reflect the intent, belief, or current expectations of our management based on their knowledge and understanding of the business and industry, the economy, and other future conditions. These statements are not guarantees of future performance, and we caution stockholders not to place undue reliance on forward-looking statements.  Actual results may differ materially from those expressed or forecasted in the forward-looking statements due to a variety of risks, uncertainties and other factors, including but not limited to the factors listed and described under “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2017, as filed with the SEC on February 12, 2018, and the factors described below:
market disruptions and economic conditions experienced by the U.S. economy or real estate industry as a whole and the local economic conditions in the markets in which our properties are located;
our ability to renew expiring leases and lease vacant spaces at favorable rates or at all;
the inability of tenants to continue paying their rent obligations due to bankruptcy, insolvency, or a general downturn in their businesses; 
the availability of cash flow from operating activities to fund distributions and capital expenditures;
our ability to raise capital in the future by issuing additional equity or debt securities, selling our assets, or otherwise to fund our future capital needs;
the availability and terms of financing, including the impact of higher interest rates on the cost and/or availability of financing;
our ability to strategically acquire, develop, or dispose of assets on favorable terms, or at all;
our level of debt and the terms and limitations imposed on us by our debt agreements;
our ability to retain our executive officers and other key personnel;
unfavorable changes in laws or regulations impacting our business or our assets; and
factors that could affect our ability to qualify as a real estate investment trust for federal income tax purposes.
Forward-looking statements in this Quarterly Report on Form 10-Q reflect our management’s view only as of the date of this report, and may ultimately prove to be incorrect or false.  We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results.  We intend for these forward-looking statements to be covered by the applicable safe harbor provisions created by Section 27A of the Securities Act and Section 21E of the Exchange Act.



21



Critical Accounting Policies and Estimates    
For a discussion of our critical accounting policies and estimates, please refer to our Annual Report on Form 10-K for the fiscal year ended December 31, 2017. There have been no significant changes to our critical accounting policies since December 31, 2017.
Overview
As of June 30, 2018, we owned interests in 18 operating office properties with approximately 6.7 million rentable square feet, one non-operating property with approximately 331,000 rentable square feet, and three development properties that will consist of approximately 989,000 rentable square feet. Our operating properties are located in six markets throughout the United States, and substantially all of our business is conducted through our operating partnership, Tier Operating Partnership LP (“Tier OP”). 

As an owner of real estate, our operating results depend heavily on successfully leasing and operating the office space in our portfolio. Economic growth and employment levels in our target markets are, and will continue to be, important factors in predicting our future operating results.
    
The key components affecting our rental revenue are occupancy, rental rates, operating cost recovery income, new developments when completed, acquisitions, and dispositions. Occupancy generally increases during times of declining supply or economic growth, as our ability to lease space outpaces vacancies that occur upon the expirations of existing leases. Occupancy generally decreases during times of oversupply or economic decline, when new vacancies tend to outpace our ability to lease space. Acquisitions, dispositions, and new developments when completed directly impact our rental revenue and could impact our occupancy, depending upon the occupancy of the properties that are acquired, sold, or completed. A further indicator of the predictability of future revenue is the expected lease expirations at our operating properties. As a result, in addition to seeking to increase our occupancy by leasing current vacant space, we also concentrate our leasing efforts on renewing existing leases prior to expiration.

2018 Key Objectives
During 2018, we intend to grow in a prudent manner that reinforces our fundamental strategy of owning and operating best-in-class office properties within TIER1 submarkets in our seven target growth markets. Provided accommodative market conditions persist, we expect development to comprise a significant portion of our investment activity over the next several years.
    
Our business strategy for 2018 includes the following four objectives: (1) optimize value in select investments and redeploy capital to create additional value; (2) expand our active development pipeline; (3) extend the portfolio’s weighted average in-place lease term and increase occupancy in the Houston market to drive sustained cash flow growth; and (4) reduce leverage and extend our weighted average debt maturity date. There can be no assurance regarding our achievement of any of our objectives.

Optimize value in select investments and redeploy capital to create additional value

We will seek to sell remaining properties located outside of our target growth markets and divest of select non-core properties in our target markets as we determine that capital can be more efficiently allocated for long-term value creation. In certain instances, we may reallocate capital between target growth markets to balance relative market concentration. In the first half of 2018, we exited the Baltimore, Maryland, market with the sale of 500 East Pratt. Additionally, we sold Centreport Office Center, located in Fort Worth, Texas, and Loop Central located in Houston, Texas. These sales generated approximately $145.7 million in gross proceeds to us. We redeployed these proceeds when we acquired a 96.5% initial economic interest in Domain Point, located in Austin, Texas, for a contract purchase price of $73.8 million (at 100%) and when we acquired the remaining 50% interest in the entity that owns Domain 8, also located in Austin, Texas, for a contract purchase price of $92.8 million, which includes the assumption of approximately $44.9 million in mortgage debt.

Expand our active development pipeline

Development remains an important component of our strategy in 2018; however, we will remain disciplined as we continue our build-to-core development program. In May 2018, we commenced the development of Domain 12. Domain 12 will contain 320,000 rentable square feet and is located in Austin, Texas, adjacent to our Domain 11 development property. Provided certain conditions are met, we intend to proceed with the development of one or more of our remaining land sites in 2018 that are strategically located within our TIER1 submarkets.


22



Extend the portfolio’s weighted average in-place lease term and increase occupancy in the Houston market to drive sustained cash flow growth

As of June 30, 2018, the weighted average in-place lease term for our portfolio was 5.3 years. Through our recent and active development projects, we intend to extend our weighted average in-place lease term, which we believe provides protection from market and industry concentration as well as drives cash flow growth from both superior yields and lower recurring capital expenditures. Additionally, we will seek to increase occupancy in our Houston portfolio, which was 75.8% occupied as of June 30, 2018, as compared to 93.9% for the balance of our portfolio.
The following table sets forth information regarding our leasing activity for the three and six months ended June 30, 2018:
Three months ended June 30, 2018
Renewal
 
Expansion
 
New
 
Total
Square feet leased
48,000

 
23,000

 
23,000

 
94,000

Weighted average lease term (in years)
6.7

 
5.5

 
8.1

 
6.7

Increase in weighted average net rental rates per square foot per year (1)
$
2.39

 
$
5.49

 
$
2.41

 
$
3.19

% increase in weighted average net rental rates per square foot per year
13
%
 
27
%
 
11
%
 
16
%
Leasing cost per square foot per year (2)
$
1.31

 
$
1.50

 
$
4.20

 
$
2.20

 
 
 
 
 
 
 
 
Six months ended June 30, 2018
 
 
 
 
 
 
 
Square feet leased
104,000

 
24,000

 
34,000

 
162,000

Weighted average lease term (in years)
6.4

 
5.4

 
7.5

 
6.5

Increase in weighted average net rental rates per square foot per year (1)
$
3.76

 
$
5.22

 
$
4.12

 
$
4.10

% increase in weighted average net rental rates per square foot per year
19
%
 
25
%
 
21
%
 
20
%
Leasing cost per square foot per year (2)
$
2.74

 
$
1.66

 
$
5.21

 
$
3.13

_________________
(1)
Weighted average net rental rates are calculated as the straight-line fixed base rental amount paid by a tenant under the terms of their related lease agreements, less any portion of that base rent used to offset real estate taxes, utility charges, and other operating expenses incurred in connection with the leased space, weighted for the relative square feet under the lease. Increase reflects change in net rental rates related to the lease previously occupying the specific space.
(2)
Includes tenant improvements and leasing commissions.

Reduce leverage and extend weighted average debt maturity date

We will continue to manage our balance sheet with a goal of reducing our leverage over the intermediate term. We anticipate further reducing our leverage through mark-to-market of in-place leases, delivery of our development properties, and occupancy gains. In early 2018, we amended our credit facility to extend the maturity dates and add key new members to our lending group. Additionally, we reduced our leverage by raising equity under the ATM program, which has generated approximately $65.7 million of net proceeds in 2018.
Results of Operations
The results of operations of our consolidated operating and non-operating properties are included in the discussion below, and include properties sold and acquired (or newly consolidated) in 2018 and 2017 for our period of ownership. The term “same store” in the discussion below includes our consolidated operating office properties that are owned and operated for the entirety of the two periods being compared.
Three months ended June 30, 2018, as compared to the three months ended June 30, 2017
Rental Revenue.  Rental revenue for the three months ended June 30, 2018, was approximately $54.0 million as compared to approximately $54.6 million for the three months ended June 30, 2017, a $0.6 million decrease. Our non-same store properties had a decrease of approximately $1.3 million in rental revenue primarily due to a decrease of approximately $9.8 million from the sale of properties, partially offset by an increase of approximately $8.5 million from acquired and newly consolidated properties. Our same store properties had an increase of approximately $0.7 million, primarily as a result of decreased free rent concessions and lower property operating expense reimbursements to tenants, resulting in increased rental revenue of approximately $1.7 million, an increase of approximately $0.7 million due to increased parking and lease termination fee income and approximately $0.4 million due to increases in occupancy and rental rates. These increases in rental revenue from our same store properties were partially offset by a decrease in straight-line rent adjustments of approximately $2.0 million and approximately $0.4 million of

23



rent abatements (net of business interruption insurance proceeds) provided to tenants at our Eldridge Properties as a result of Hurricane Harvey.
Property Operating Expenses. Property operating expenses for the three months ended June 30, 2018, were approximately $12.4 million as compared to approximately $13.9 million for the three months ended June 30, 2017, a $1.5 million decrease. Our non-same store properties had a decrease of approximately $1.7 million primarily due to a decrease of approximately $2.6 million from the sale of properties, partially offset by an increase of approximately $0.9 million from acquired and newly consolidated properties. Our same store properties had an increase of approximately $0.2 million, primarily due to higher bad debt expense and higher repairs and maintenance expense.
Interest Expense.  Interest expense for the three months ended June 30, 2018, was approximately $8.4 million as compared to approximately $8.2 million for the three months ended June 30, 2017, and was comprised of interest expense and amortization of deferred financing fees. The $0.2 million increase was primarily due to increased overall borrowings, which increased our interest expense by approximately $1.3 million, partially offset by capitalized interest, which reduced our interest expense by approximately $0.6 million, and decreased amortization of deferred financing fees of approximately $0.5 million.

Real Estate Taxes.  Real estate taxes for the three months ended June 30, 2018, were approximately $9.1 million as compared to approximately $8.8 million for the three months ended June 30, 2017, a $0.3 million increase. Our non-same store properties had an increase of approximately $0.8 million primarily due to an increase of approximately $1.7 million from acquired and newly consolidated properties, which was partially offset by a decrease of approximately $0.9 million from the sale of properties. Our same store properties had a decrease of approximately $0.5 million primarily due to lower estimated assessed values in certain markets in 2018, partially offset by lower tax refunds received in 2018.

General and Administrative.  General and administrative expenses for the three months ended June 30, 2018, were approximately $5.4 million as compared to approximately $5.6 million for the three months ended June 30, 2017, and were comprised of corporate general and administrative expenses including payroll costs, directors’ and officers’ insurance premiums, audit and tax fees, legal fees, and other administrative expenses. The $0.2 million decrease is primarily due to lower payroll costs.
Depreciation and Amortization. Depreciation and amortization expense for the three months ended June 30, 2018, was approximately $27.1 million as compared to approximately $22.7 million for the three months ended June 30, 2017, a $4.4 million increase. Our non-same store properties had an increase of approximately $1.7 million due to an increase of approximately $5.0 million from acquired and newly consolidated properties, partially offset by a decrease of approximately $3.3 million from the sale of properties. Our same store properties had an increase of approximately $2.7 million primarily due to accelerated depreciation and amortization expense of approximately $1.8 million as a result of plans to renovate lobby space at our Eldridge properties and approximately $0.3 million from an early lease termination. The remaining approximately $0.6 million of increased expense is primarily due to the addition of real estate assets.
Equity in Operations of Investments. We had no equity in operations of investments for the three months ended June 30, 2018, as compared to approximately $6.6 million for the three months ended June 30, 2017, which was primarily due to gains on the sales of 1325 G Street and the Colorado Building in 2017.

Gain (Loss) on Sale of Assets.  We had approximately $0.1 million in loss on sale of assets for the three months ended June 30, 2018, compared to approximately $1.3 million in gain on sale of assets for the three months ended June 30, 2017. The $1.4 million change is primarily related to our sale of the Louisville Portfolio in 2017.
Six months ended June 30, 2018, as compared to the six months ended June 30, 2017
Rental Revenue.  Rental revenue for the six months ended June 30, 2018, was approximately $108.1 million as compared to approximately $110.9 million for the six months ended June 30, 2017, a $2.8 million decrease. Our non-same store properties had a decrease of approximately $3.7 million in rental revenue primarily due to a decrease of approximately $17.3 million from the sale of properties, partially offset by an increase of approximately $13.6 million from acquired and newly consolidated properties. Our same store properties had an increase of approximately $0.9 million, primarily as a result of decreased free rent concessions and lower property operating expense reimbursements to tenants resulting in increased rental revenue of approximately $2.8 million, an increase in rental rates of approximately $2.1 million, and an increase in parking and lease termination fee income of approximately $1.4 million. These increases in rental revenue from our same store properties were partially offset by a decrease in straight-line rent adjustments of approximately $3.6 million, a decrease in occupancy resulting in a decrease of approximately $1.0 million, and approximately $1.0 million of rent abatements (net of business interruption insurance proceeds) provided to tenants at our Eldridge Properties as a result of Hurricane Harvey.
Property Operating Expenses. Property operating expenses for the six months ended June 30, 2018, were approximately $25.6 million as compared to approximately $28.6 million for the six months ended June 30, 2017, a $3.0 million decrease. Our

24



non-same store properties had a decrease of approximately $3.8 million primarily due to a decrease of approximately $5.2 million from the sale of properties, partially offset by an increase of approximately $1.4 million from acquired and newly consolidated properties. Our same store properties had an increase of approximately $0.8 million, primarily due to higher repairs and maintenance expense and higher bad debt expense.
Interest Expense.  Interest expense for the six months ended June 30, 2018, was approximately $16.5 million as compared to approximately $17.0 million for the six months ended June 30, 2017, and was comprised of interest expense and amortization of deferred financing fees. The $0.5 million decrease was primarily due to increased capitalized interest which reduced our interest expense by approximately $1.1 million, and decreased amortization of deferred financing fees of approximately $0.9 million, partially offset by increased overall borrowings which increased our interest expense by approximately $1.5 million.
Real Estate Taxes.  Real estate taxes for the six months ended June 30, 2018, were approximately $17.8 million as compared to approximately $17.3 million for the six months ended June 30, 2017, a $0.5 million increase. Our non-same store properties had an increase of approximately $0.9 million primarily due to an increase of approximately $2.6 million from acquired and newly consolidated properties, partially offset by a decrease of $1.9 million from the sale of properties. Our same store properties had a decrease of approximately $0.4 million primarily due to lower estimated assessed values in certain markets in 2018, partially offset by lower tax refunds received in 2018.

General and Administrative.  General and administrative expenses for the six months ended June 30, 2018, were approximately $10.9 million as compared to approximately $11.3 million for the six months ended June 30, 2017, and were comprised of corporate general and administrative expenses including payroll costs, directors’ and officers’ insurance premiums, audit and tax fees, legal fees, and other administrative expenses.  The $0.4 million decrease is primarily due to lower transfer agent, legal, and investor relation costs.
Depreciation and Amortization. Depreciation and amortization expense for the six months ended June 30, 2018, was approximately $51.8 million as compared to approximately $47.2 million for the six months ended June 30, 2017, a $4.6 million increase. Our non-same store properties had an increase of approximately $1.4 million primarily due to an increase of approximately $8.0 million from acquired and newly consolidated properties, partially offset by a decrease of approximately $6.6 million from the sale of properties. Our same store properties had an increase of approximately $3.2 million primarily due to accelerated depreciation and amortization expense of approximately $1.8 million as a result of plans to renovate lobby space at our Eldridge properties and approximately $0.6 million from an early lease termination. The remaining approximately $0.8 million of increased expense is primarily due to the addition of real estate assets.
    
Loss on Early Extinguishment of Debt. We had an approximately $9.0 million loss on early extinguishment of debt for the six months ended June 30, 2018, related to the write-off of unamortized deferred financing fees and financing fees paid to lenders in connection with our amended credit facility. We had an approximately $0.5 million loss on early extinguishment of debt for the six months ended June 30, 2017, primarily comprised of prepayment costs and the write-off of unamortized deferred financing fees related to early payoffs of debt.

Equity in Operations of Investments. Equity in operations of investments for the six months ended June 30, 2018, was approximately $0.3 million as compared to approximately $6.3 million for the six months ended June 30, 2017, and was comprised of our share of the earnings and losses of our unconsolidated investments. The $6.0 million decrease was primarily due to gains on the sales of 1325 G Street and the Colorado Building of approximately $6.7 million, partially offset by earnings of Domain 8, which was fully operational in 2018. Domain 8 was consolidated when we purchased the remaining interest in March 2018.  
Gain on Sale of Assets. We had approximately $11.9 million in gain on sale of assets for the six months ended June 30, 2018, primarily related to our sales of 500 East Pratt, Centreport Office Center, and Loop Central. We had approximately $92.0 million in gain on sale of assets for the six months ended June 30, 2017, primarily related to our sales of Buena Vista Plaza, Eisenhower I, Three Parkway, the Louisville Portfolio, and the sale of substantially all of our investment in the Wanamaker Building.
Gain on Remeasurement of Investment in Unconsolidated Entities. We had approximately $11.1 million in gain on remeasurement of investment in unconsolidated entities for the six months ended June 30, 2018, as a result of obtaining a controlling interest in Domain 8 and remeasuring our previously held equity interest at fair value. We had approximately $14.2 million in gain on remeasurement of investment in unconsolidated entities for the six months ended June 30, 2017, as a result of obtaining a controlling interest in Domain 2 and Domain 7 and remeasuring our previously held equity interest at fair value.




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Cash Flow Analysis
Six months ended June 30, 2018, as compared to the six months ended June 30, 2017
Cash provided by operating activities was approximately $19.7 million for the six months ended June 30, 2018. Cash provided by operating activities for the six months ended June 30, 2017, was approximately $26.5 million. We had (1) approximately $10.9 million less cash received primarily due to the results of our real estate property operations, which included approximately $9.0 million of operating distributions from the sales of our investments in unconsolidated entities in 2017, net of interest expense, and general and administrative expenses; partially offset by (2) a decrease in cash paid for lease commissions and other lease intangibles of approximately $2.9 million; and (3) the timing of receipt of revenues and payment of expenses which resulted in approximately $1.2 million less net cash outflows from working capital assets and liabilities in the six months ended June 30, 2018, compared to the six months ended June 30, 2017.
Cash used in investing activities for the six months ended June 30, 2018, was approximately $15.8 million and was primarily comprised of purchases of real estate of approximately $99.2 million, monies used to fund capital expenditures for existing real estate and real estate under development of approximately $55.3 million, and escrow deposits for anticipated real estate purchases of approximately $3.4 million, partially offset by proceeds from the sale of assets of approximately $141.1 million and return of investments of approximately $1.7 million. Cash provided by investing activities for the six months ended June 30, 2017, was approximately $212.0 million and was primarily comprised of proceeds from the sales of assets of approximately $330.0 million and return of investments of approximately $23.4 million primarily due to proceeds received from a loan that was refinanced, partially offset by purchases of real estate of approximately $93.0 million, monies used to fund capital expenditures for existing real estate and real estate under development of approximately $31.7 million, investments in unconsolidated entities of approximately $10.7 million related to development activities at an unconsolidated property, and escrow deposits for anticipated real estate purchases of approximately $6.0 million.
Cash used in financing activities for the six months ended June 30, 2018, was approximately $3.8 million and was primarily comprised of distributions of approximately $17.3 million and payments on notes payable, financing costs, and early extinguishment of debt, net of proceeds from notes payable of approximately $9.6 million, partially offset by approximately$20.9 million of issuance of common stock under the ATM Program, net of associated costs, and $2.5 million of contributions from noncontrolling interests. Cash used in financing activities for the six months ended June 30, 2017, was approximately $221.2 million and was primarily comprised of payments on notes payable and financing costs, net of proceeds from notes payable of approximately $195.5 million and distributions of approximately $25.8 million.
Funds from Operations (“FFO”)

Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate diminishes predictably over time.  Since real estate values have historically risen or fallen with market conditions, many industry investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting alone to be insufficient for evaluating operating performance.  FFO is a non-GAAP financial measure that is widely recognized as a measure of a REIT’s operating performance.  We use FFO as defined by the National Association of Real Estate Investment Trusts (“Nareit”) which is net income (loss), computed in accordance with GAAP, excluding gains (or losses) from sales of property and impairments of depreciable real estate (including impairments of investments in unconsolidated entities which resulted from measurable decreases in the fair value of the depreciable real estate held by the unconsolidated entity), plus depreciation and amortization of real estate assets, and after related adjustments for unconsolidated entities and noncontrolling interests.  The determination of whether impairment charges have been incurred is based partly on anticipated operating performance and hold periods.  Estimated undiscounted cash flows from a property, derived from estimated future net rental and lease revenues, net proceeds on the sale of the property, and certain other ancillary cash flows, are taken into account in determining whether an impairment charge has been incurred.  While impairment charges for depreciable real estate are excluded from net income (loss) in the calculation of FFO as described above, impairments reflect a decline in the value of the applicable property that we may not recover.

We believe that the use of FFO, together with the required GAAP presentations, is helpful in understanding our operating performance because it excludes real estate-related depreciation and amortization, gains and losses from property dispositions, and impairments of depreciable real estate assets, and as a result, when compared period to period, reflects the impact on operations from trends in occupancy rates, rental rates, operating costs, development activities, general and administrative expenses, and interest costs, which are not immediately apparent from net income.  Factors that impact FFO include fixed costs, yields on cash held in accounts, income from portfolio properties and other portfolio assets, interest rates on debt financing, and operating expenses.


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We also evaluate FFO, excluding certain items. The items excluded relate to certain non-operating activities or certain non-recurring activities that create significant FFO volatility. We believe it is useful to evaluate FFO excluding these items because it provides useful information in analyzing comparability between reporting periods and in assessing the sustainability of our operating performance.

FFO and FFO, excluding certain items, should not be considered as alternatives to net income (loss), or as indicators of our liquidity, nor are they indicative of funds available to fund our cash needs, including our ability to make distributions.  Additionally, the exclusion of impairments limits the usefulness of FFO and FFO, excluding certain items, as historical operating performance measures since an impairment charge indicates that operating performance has been permanently affected.  FFO and FFO, excluding certain items, are non-GAAP measurements and should be reviewed in connection with other GAAP measurements.  Our FFO and FFO, excluding certain items, as presented may not be comparable to amounts calculated by other REITs that do not define FFO in accordance with the current Nareit definition, or interpret it differently, or that identify and exclude different items related to non-operating activities or certain non-recurring activities.          
    
The following section presents our calculations of FFO (as defined by Nareit) attributable to common stockholders and FFO attributable to common stockholders, excluding certain items, for the three and six months ended June 30, 2018 and 2017, and provides additional information related to our FFO attributable to common stockholders and FFO attributable to common stockholders, excluding certain items.

The table below is presented in thousands, except per share amounts: 
 
Three Months Ended
 
Six Months Ended
 
June 30, 2018
 
June 30, 2017
 
June 30, 2018
 
June 30, 2017
Net income (loss)
$
(8,362
)
 
$
4,034

 
$
(36
)
 
$
102,262

Noncontrolling interests
85

 
(3
)
 
149

 
(60
)
Net income (loss) attributable to common stockholders
(8,277
)
 
4,031

 
113

 
102,202

Adjustments:
 
 
 
 
 
 
 

Real estate depreciation and amortization from consolidated properties
27,011

 
22,557

 
51,511

 
46,988

Real estate depreciation and amortization from unconsolidated properties

 
131

 
391

 
697

Real estate depreciation and amortization - noncontrolling interests
(782
)
 

 
(1,215
)
 

Loss (gain) on sale of depreciable real estate
90

 
(7,975
)
 
(11,924
)
 
(98,725
)
Loss (gain) on remeasurement of investment in unconsolidated entities
152

 

 
(11,090
)
 
(14,168
)
Noncontrolling interests
610

 
(9
)
 
907

 
39

FFO attributable to common stockholders
18,804

 
18,735

 
28,693

 
37,033

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Adjustments:
 
 
 
 
 
 
 
Severance charges
108

 
451

 
127

 
451

Interest rate hedge ineffectiveness expense (income) (1)

 
(29
)
 

 
1

Loss on early extinguishment of debt

 

 
8,988

 
545

Default interest (2)
609