UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



FORM 10-Q



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



For the quarterly period ended June 30, 2016



or



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



For the transition period from ____________ to ____________



Commission File Number 1-10709



PS BUSINESS PARKS, INC.

(Exact name of registrant as specified in its charter)





701 Western Avenue, Glendale, California 91201-2397

(Address of principal executive offices) (Zip Code)



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



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

Yes ☒  No ☐



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

Yes ☒  No ☐ 



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





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

Yes ☐ No ☒



As of July 25, 2016, the number of shares of the registrant’s common stock, $0.01 par value per share, outstanding was 27,084,500.



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PS BUSINESS PARKS, INC.

INDEX















 

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PART I. FINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



PS BUSINESS PARKS, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)







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PS BUSINESS PARKS, INC.

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited, in thousands, except per share data)











 

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PS BUSINESS PARKS, INC.

CONSOLIDATED STATEMENT OF EQUITY

FOR THE SIX MONTHS ENDED JUNE 30, 2016

(Unaudited, in thousands, except share data)









 

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PS BUSINESS PARKS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)











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PS BUSINESS PARKS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2016



1. Organization and description of business



PS Business Parks, Inc. (“PSB”) was incorporated in the state of California in 1990. As of June 30, 2016, PSB owned 77.9% of the common partnership units (the “common partnership units”) of PS Business Parks, L.P. (the “Operating Partnership”). The remaining common partnership units are owned by Public Storage (“PS”). PSB, as the sole general partner of the Operating Partnership, has full, exclusive and complete responsibility and discretion in managing and controlling the Operating Partnership. PSB and its subsidiaries, including the Operating Partnership, are collectively referred to as the “Company.” Assuming issuance of the Company’s common stock upon redemption of its common partnership units, PS would own 42.1% (or 14.5 million shares) of the outstanding shares of the Company’s common stock.



The Company is a fully-integrated, self-advised and self-managed real estate investment trust (“REIT”) that owns, operates, acquires and develops commercial properties, primarily multi-tenant flex, office and industrial space. As of June 30, 2016, the Company owned and operated 28.0 million rentable square feet of commercial space in six states. The Company also manages 737,000 rentable square feet on behalf of PS.



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



2. Summary of significant accounting policies



Basis of presentation



The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2016 are not necessarily indicative of the results that may be expected for the year ended December 31, 2016. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.  



Consolidation and Equity Method of Accounting



The Company accounts for its investment in a joint venture that it has significant influence over, but does not control, using the equity method of accounting eliminating intra-entity profits and losses as if the joint venture were a consolidated subsidiary.



The accompanying consolidated financial statements include the accounts of PSB and the Operating Partnership. All significant inter-company balances and transactions have been eliminated in the consolidated financial statements.



The Company consolidates all variable interest entities (each a “VIE”) for which it is the primary beneficiary. Generally, a VIE is a legal entity in which the equity investors do not have the characteristics of a controlling financial interest or the equity investors lack sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. A limited partnership may be considered a VIE if the limited partners do not participate in operating decisions. Under this criteria, the Operating Partnership is considered a VIE. The Company’s significant asset is its investment in the Operating Partnership, and consequently, substantially all of the Company’s assets and

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liabilities represent those assets and liabilities of the Operating Partnership. All of the Company’s debt is an obligation of the Operating Partnership.



Noncontrolling interests



The Company’s noncontrolling interests are reported as a component of equity separate from the parent’s equity. Purchases or sales of equity interests that do not result in a change in control are accounted for as equity transactions. In addition, net income attributable to the noncontrolling interests is included in consolidated net income on the face of the income statement and, upon a gain or loss of control, the interests purchased or sold, as well as any interests retained, are recorded at fair value with any gain or loss recognized in earnings. At the end of each reporting period, the Company determines the amount of equity (book value of net assets) which is allocable to the noncontrolling interests based upon the ownership interest, and an adjustment is made to the noncontrolling interests, with a corresponding adjustment to paid-in capital, to reflect the noncontrolling interests’ equity interest in the Company.



Use of estimates



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



Allowance for doubtful accounts



The Company monitors the collectability of its receivable balances including the deferred rent receivable on an ongoing basis. Based on these reviews, the Company maintains an allowance for doubtful accounts for estimated losses resulting from the possible inability of tenants to make contractual rent payments to the Company. A provision for doubtful accounts is recorded during each period. The allowance for doubtful accounts is netted against tenant and other receivables on the consolidated balance sheets. Tenant receivables are net of an allowance for uncollectible accounts totaling $400,000 at June 30, 2016 and December 31, 2015. Deferred rent receivable is net of an allowance for uncollectible accounts totaling $881,000 and $909,000 at June 30, 2016 and December 31, 2015, respectively.



Financial instruments



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





Financial assets that are exposed to credit risk consist primarily of cash and cash equivalents and receivables. The Company considers all highly liquid investments with a remaining maturity of three months or less at the date of purchase to be cash equivalents. Cash and cash equivalents, which consist primarily of money market investments,

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are only invested in entities with an investment grade rating. Receivables are comprised of balances due from a large number of customers. Balances that the Company expects to become uncollectible are reserved for or written off. Due to the short period to maturity of the Company’s cash and cash equivalents, accounts receivable, other assets and accrued and other liabilities, the carrying values as presented on the consolidated balance sheets are reasonable estimates of fair value.



Carrying values of the Company’s mortgage note payable and unsecured credit facility approximate fair value. The characteristics of these financial instruments, market data and other comparative metrics utilized in determining these fair values are “Level 2” inputs.



Real estate facilities



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



Land held for future development



Property taxes, insurance, interest and costs essential to the development of property for its intended use are capitalized during the period of development. Upon classification of an asset as held for development, depreciation of the asset is ceased.



Properties held for disposition



An asset is classified as an asset held for disposition when it meets certain requirements, which include, among other criteria, the approval of the sale of the asset, the marketing of the asset for sale and the expectation by the Company that the sale will likely occur within the next 12 months. Upon classification of an asset as held for disposition, depreciation of the asset is ceased, and the net book value of the asset is included on the balance sheet as properties held for disposition.



Intangible assets/liabilities



Intangible assets and liabilities include above-market and below-market in-place lease values of acquired properties based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) management’s estimate of fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining non-cancelable term of the lease. The capitalized above-market and below-market lease values (included in other assets and accrued liabilities in the accompanying consolidated balance sheets) are amortized to rental income over the remaining non-cancelable terms of the respective leases.



As of June 30, 2016, the value of in-place leases resulted in net intangible assets of $1.4 million, net of $8.9 million of accumulated amortization with a weighted average amortization period of 9.0 years, and net intangible liabilities of $1.2 million, net of $9.6 million of accumulated amortization with a weighted average amortization period of 5.9 years. As of December 31, 2015, the value of in-place leases resulted in net intangible assets of $1.7 million, net of $8.6 million of accumulated amortization and net intangible liabilities of $1.8 million, net of $9.0 million of accumulated amortization.



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The Company recorded net increases in rental income of $138,000 and $352,000 for the three months ended June 30, 2016 and 2015, respectively, and $331,000 and $663,000 for the six months ended June 30, 2016 and 2015, respectively, due to the amortization of net intangible liabilities resulting from the above-market and below-market lease values.



Evaluation of asset impairment



The Company evaluates its assets used in operations for impairment by identifying indicators of impairment and by comparing the sum of the estimated undiscounted future cash flows for each asset to the asset’s carrying value. When indicators of impairment are present and the sum of the estimated undiscounted future cash flows is less than the carrying value of such asset, an impairment loss is recorded equal to the difference between the asset’s current carrying value and its value based on discounting its estimated future cash flows. In addition, the Company evaluates its assets held for disposition for impairment. Assets held for disposition are reported at the lower of their carrying value or fair value, less cost of disposition. At June 30, 2016, the Company did not consider any assets to be impaired.



Stock compensation



All share-based payments to employees, including grants of employee stock options, are recognized as stock compensation in the Company’s income statement based on their grant date fair values. See Note 12.



Revenue and expense recognition



The Company must meet four basic criteria before revenue can be recognized: persuasive evidence of an arrangement exists; the delivery has occurred or services have been rendered; the fee is fixed or determinable; and collectability is reasonably assured. All leases are classified as operating leases. Rental income is recognized on a straight-line basis over the terms of the leases. Straight-line rent is recognized for all tenants with contractual fixed increases in rent that are not included on the Company’s credit watch list. Deferred rent receivable represents rental revenue recognized on a straight-line basis in excess of billed rents. Reimbursements from tenants for real estate taxes and other recoverable operating expenses are recognized as rental income in the period the applicable costs are incurred. Property management fees are recognized in the period earned.



Costs incurred in connection with leasing (primarily tenant improvements and lease commissions) are capitalized and amortized over the lease period.



Gains from sales of real estate facilities



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



General and administrative expenses



General and administrative expenses include executive and other compensation, office expenses, professional fees, acquisition transaction costs, state income taxes and other such administrative items.



Income taxes



The Company has qualified and intends to continue to qualify as a REIT, as defined in Section 856 of the Internal Revenue Code of 1986, as amended. As a REIT, the Company is not subject to federal income tax to the extent that it distributes its REIT taxable income to its shareholders. A REIT must distribute at least 90% of its taxable income each year. In addition, REITs are subject to a number of organizational and operating requirements. The Company may be

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subject to certain state and local taxes on its income and property and to federal income and excise taxes on its undistributed taxable income. The Company believes it met all organization and operating requirements to maintain its REIT status during 2015 and intends to continue to meet such requirements for 2016. Accordingly, no provision for income taxes has been made in the accompanying consolidated financial statements.



The Company can recognize a tax benefit only if it is “more likely than not” that a particular tax position will be sustained upon examination or audit. To the extent that the “more likely than not” standard has been satisfied, the benefit associated with a position is measured as the largest amount that is greater than 50% likely of being recognized upon settlement. As of June 30, 2016, the Company did not recognize any tax benefit for uncertain tax positions.



Accounting for preferred equity issuance costs



The Company records issuance costs as a reduction to paid-in capital on its balance sheet at the time the preferred securities are issued and reflects the carrying value of the preferred equity at the stated value. Such issuance costs are recorded as non-cash preferred equity distributions at the time the Company notifies the holders of preferred stock of its intent to redeem such shares.



Net income per common share



Per share amounts are computed using the number of weighted average common shares outstanding. “Diluted” weighted average common shares outstanding includes the dilutive effect of stock options and restricted stock units under the treasury stock method. “Basic” weighted average common shares outstanding excludes such effect. The Company's restricted stock units are participating securities and are included in the computation of basic and diluted weighted average common shares outstanding. The Company’s restricted stock unit holders are paid non-forfeitable dividends in excess of the expense recorded which results in a reduction in net income allocable to common shareholders and unit holders.



Earnings per share has been calculated as follows (in thousands, except per share amounts):





Options to purchase 46,000 shares for the three months ended June 30, 2015 were not included in the computation of diluted net income per share because such options were considered anti-dilutive. No  options to purchase shares for the three months ended June 30, 2016 were included in the computation of diluted net income per share. Options to purchase 14,000 and 32,000 shares for the six months ended June 30, 2016 and 2015, respectively, were not included in the computation of diluted net income per share because such options were considered anti-dilutive.



Segment reporting



The Company views its operations as one segment.



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Reclassifications



Certain reclassifications have been made to the consolidated financial statements for 2015 in order to conform to the 2016 presentation.



Recently issued accounting standards



In August, 2014, the Financial Accounting Standards Board (“FASB”) issued new accounting guidance, which is intended to define management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern for a period of one year after the date that the financial statements are issued. This guidance is effective for annual periods ending after December 15, 2016 and interim periods within annual periods beginning after December 15, 2016. Early adoption is permitted. The Company anticipates no impact upon adoption of the new accounting guidance on its consolidated financial statements.



In March, 2016, the FASB issued new accounting guidance, which is intended to simplify several areas of accounting for share-based compensation arrangements, including the income tax impact, classification on the statement of cash flows and forfeitures. This guidance is effective prospectively for fiscal years, and interim periods within those years, beginning after December 15, 2016, and early adoption is permitted. The Company is currently in the process of evaluating the impact of adoption of the new accounting guidance on its consolidated financial statements.



In February, 2015, the FASB issued new accounting guidance, which amended the existing accounting standards for consolidation under both the variable interest model and the voting model. On January 1, 2016, the Company adopted this guidance and as the Operating Partnership is already consolidated in the balance sheets of the Company, the identification of this entity as a VIE has no impact on the consolidated financial statements of the Company. Additionally, the Company’s accounting for its investment in its joint venture was not impacted by the adoption of this guidance.



In May, 2014, the FASB issued new accounting guidance which amended the existing accounting standards for revenue recognition. The new accounting guidance establishes principles for recognizing revenue upon the transfer of promised goods or services to customers, in an amount that reflects the expected consideration received in exchange for those goods or services. This guidance is currently effective for the Company’s fiscal year beginning January 1, 2018. Early adoption is permitted for the Company’s fiscal year beginning January 1, 2017. The amendment allows for full retrospective adoption applied to all periods presented or modified retrospective adoption with the cumulative effect of initially applying the standard recognized at the date of initial application. The Company is currently in the process of evaluating the impact of adoption of the new accounting guidance on its consolidated financial statements.



3. Real estate facilities



The activity in real estate facilities for the six months ended June 30, 2016 is as follows (in thousands):





The purchase price of acquired properties is recorded to land, buildings and improvements (including tenant improvements, unamortized lease commissions, acquired in-place lease values, and tenant relationships, if any) and

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intangible assets and liabilities associated with the value of above-market and below-market leases based on their respective estimated fair values. Acquisition-related costs are expensed as incurred.



In determining the fair value of the tangible assets of the acquired properties, management considers the value of the properties as if vacant as of the acquisition date. Management must make significant assumptions in determining the value of assets acquired and liabilities assumed. Using different assumptions in the recording of the purchase cost of the acquired properties would affect the timing of recognition of the related revenue and expenses. Amounts recorded to land are derived from comparable sales of land within the same region. Amounts recorded to buildings and improvements, tenant improvements and unamortized lease commissions are based on current market replacement costs and other market information. The amount recorded to acquired in-place leases is determined based on management’s assessment of current market conditions and the estimated lease-up periods for the respective spaces.



During the first six months of 2015, the Company sold Milwaukie Business Park located in Milwaukie, Oregon, aggregating 102,000 square feet for net proceeds of $10.6 million, which resulted in a gain of $7.6 million. Additionally, as part of an eminent domain process, the Company sold five buildings, aggregating 82,000 square feet, at the Company’s Overlake Business Park located in Redmond, Washington, for $13.9 million, which resulted in a gain of $4.8 million. 



4.  Investment in and advances to unconsolidated joint venture



In 2013, the Company entered into a joint venture known as Amherst JV LLC (the “Joint Venture”), in which it has a 95.0% economic interest, with an unrelated real estate development company for the purpose of developing a 395-unit multi-family building on a five-acre site within its Westpark Business Park in Tysons, Virginia. The Company contributed the site, along with capitalized improvements, to the Joint Venture on October 5, 2015. Demolition, site preparation and construction commenced in October, 2015. The Company’s partner in the Joint Venture serves as the managing member, with mutual consent from both the Company and the managing member required for all significant decisions. As such, the Company accounts for its investment in the Joint Venture using the equity method.



Along with the equity capital the Company has committed to the Joint Venture, the Company has also agreed to provide the Joint Venture with a construction loan in the amount of $75.0 million. The Joint Venture will pay interest under the construction loan at a rate equal to the London Interbank Offered Rate (“LIBOR”) plus 2.25%. The loan will mature on April 5, 2019. The Company has reflected the aggregate value of the contributed site, equity contributions, capitalized interest and loan advances to date as investment in and advances to unconsolidated joint venture. The Company’s investment in and advances to unconsolidated joint venture was  $40.0 million and $26.7 million as of June 30, 2016 and December 31, 2015, respectively. For the six months ended June 30, 2016, the Company made cash contributions of $5.7 million to the Joint Venture and capitalized $739,000 of interest on its investment in the Joint Venture. In addition to the cash contributions and capitalized interest, the Company made loan advances to the Joint Venture of $6.8 million during the first six months of 2016. For the six months ended June 30, 2015, the Company capitalized costs of $1.8 million related to this development, of which $531,000 related to capitalized interest. The Company made no loan advances to the Joint Venture in 2015.





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5. Leasing activity



The Company leases space in its real estate facilities to tenants primarily under non-cancelable leases generally ranging from one to 10 years. Future minimum rental revenues, excluding recovery of operating expenses under these leases, are as follows as of June 30, 2016 (in thousands):





In addition to minimum rental payments, certain tenants reimburse the Company for their pro rata share of specified operating expenses. Such reimbursements amounted to $20.5 million and $19.9 million for the three months ended June 30, 2016 and 2015, respectively, and $41.3 million and $40.0 million for the six months ended June 30, 2016 and 2015, respectively. These amounts are included as rental income in the accompanying consolidated statements of income.



Leases accounting for 3.1% of total leased square footage are subject to termination options, of which 1.4% of total leased square footage have termination options exercisable through December 31, 2016. In general, these leases provide for termination payments should the termination options be exercised. The future minimum rental revenues in the above table assume such options are not exercised.



6. Bank loans



The Company has a line of credit (the “Credit Facility”) with Wells Fargo Bank, National Association (“Wells Fargo”). The Credit Facility has a borrowing limit of $250.0 million and expires May 1, 2019. The rate of interest charged on borrowings is based on the LIBOR plus 0.875% to LIBOR plus 1.70% depending on the Company’s credit ratings. Currently, the Company’s rate under the Credit Facility is LIBOR plus 0.875%. In addition, the Company is required to pay an annual facility fee ranging from 0.125% to 0.30% of the borrowing limit depending on the Company’s credit ratings (currently 0.125%). As of June 30, 2016, the Company had $54.0 million outstanding on the Credit Facility at an interest rate of 1.33%.  Subsequent to June 30, 2016, the Company repaid $10.0 million on the Credit Facility reducing the outstanding balance to $44.0 million. The Company had no balance outstanding on the Credit Facility at December 31, 2015. The Company had $654,000 and $769,000 of unamortized commitment fees as of June 30, 2016 and December 31, 2015, respectively. The Credit Facility requires the Company to meet certain covenants, all of which the Company was in compliance with as of June 30, 2016. Interest on outstanding borrowings is payable monthly.  



7. Mortgage note payable



On June 1, 2016, the Company repaid in full the $250.0 million mortgage note which had a fixed interest rate of 5.45%. 



8. Noncontrolling interests



As described in Note 2, the Company reports noncontrolling interests within equity in the consolidated financial statements, but separate from the Company’s shareholders’ equity. In addition, net income allocable to noncontrolling interests is shown as a reduction from net income in calculating net income allocable to common shareholders.





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Common partnership units



The Company presents the accounts of PSB and the Operating Partnership on a consolidated basis. Ownership interests in the Operating Partnership that can be redeemed for common stock, other than PSB’s interest, are classified as noncontrolling interests—common units in the consolidated financial statements. Net income allocable to noncontrolling interests—common units consists of the common units’ share of the consolidated operating results after allocation to preferred units and shares. Beginning one year from the date of admission as a limited partner (common units) and subject to certain limitations described below, each limited partner other than PSB has the right to require the redemption of its partnership interest.



A limited partner (common units) that exercises its redemption right will receive cash from the Operating Partnership in an amount equal to the market value (as defined in the Operating Partnership Agreement) of the partnership interests redeemed. In lieu of the Operating Partnership redeeming the common units for cash, PSB, as general partner, has the right to elect to acquire the partnership interest directly from a limited partner exercising its redemption right, in exchange for cash in the amount specified above or by issuance of one share of PSB common stock for each unit of limited partnership interest redeemed.



A limited partner (common units) cannot exercise its redemption right if delivery of shares of PSB common stock would be prohibited under the applicable articles of incorporation, or if the general partner believes that there is a risk that delivery of shares of common stock would cause the general partner to no longer qualify as a REIT, would cause a violation of the applicable securities laws, or would result in the Operating Partnership no longer being treated as a partnership for federal income tax purposes.



At June 30, 2016, there were 7,305,355 common units owned by PS, which are accounted for as noncontrolling interests. Combined with PS’s existing common stock ownership, on a fully converted basis, PS has a combined ownership of 42.1% (or 14.5 million shares) of the Company’s common equity.



9. Related party transactions



The Operating Partnership manages industrial, office and retail facilities for PS. These facilities, all located in the United States, operate under the “Public Storage” or “PS Business Parks” names. The PS Business Parks name and logo are owned by PS and licensed to the Company under a non-exclusive, royalty-free license agreement. The license can be terminated by either party for any reason with six months written notice.



Under the property management contract with PS, the Operating Partnership is compensated based on a percentage of the gross revenues of the facilities managed. Under the supervision of the property owners, the Operating Partnership coordinates rental policies, rent collections, marketing activities, the purchase of equipment and supplies, maintenance activities, and the selection and engagement of vendors, suppliers and independent contractors. In addition, the Operating Partnership assists and advises the property owners in establishing policies for the hire, discharge and supervision of employees for the operation of these facilities, including property managers and leasing, billing and maintenance personnel.



The property management contract with PS is for a seven-year term with the agreement automatically extending for an additional one-year period upon each one-year anniversary of its commencement (unless cancelled by either party). Either party can give notice of its intent to cancel the agreement upon expiration of its current term. Management fee revenues under this contract were $131,000 and $133,000 for the three months ended June 30, 2016 and 2015, respectively, and $259,000 and $280,000 for the six months ended June 30, 2016 and 2015, respectively.



PS also provides property management services for the self-storage component of two assets owned by the Company. These self-storage facilities, located in Palm Beach County, Florida, operate under the “Public Storage” name.



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Under the property management contract, PS is compensated based on a percentage of the gross revenues of the facilities managed. Under the supervision of the Company, PS coordinates rental policies, rent collections, marketing activities, the purchase of equipment and supplies, maintenance activities, and the selection and engagement of vendors, suppliers and independent contractors. In addition, PS is responsible for establishing the policies for the hire, discharge and supervision of employees for the operation of these facilities, including on-site managers, assistant managers and associate managers.



Either the Company or PS can cancel the property management contract upon 60 days’ notice. Management fee expenses under the contract were $21,000 and  $19,000 for the three months ended June 30, 2016 and 2015, respectively, and $42,000 and $38,000 for the six months ended June 30, 2016 and 2015, respectively.  



Pursuant to a cost sharing and administrative services agreement, the Company shares costs with PS for certain administrative services and rental of corporate office space, which are allocated to PS in accordance with a methodology intended to fairly allocate those costs. These costs totaled $123,000 and  $117,000 for the three months ended June 30, 2016 and 2015, respectively,  and $247,000 and $235,000 for the six months ended June 30, 2016 and 2015, respectively.



The Company had net amounts due to PS of $106,000 at June 30, 2016 and due from PS of $57,000 at December 31, 2015, respectively, for these contracts, as well as for certain operating expenses paid by the Company on behalf of PS.



10. Shareholders’ equity



Preferred stock



As of June 30, 2016 and December 31, 2015, the Company had the following series of preferred stock outstanding:





The Company paid $13.8 million and $15.1 million in distributions to its preferred shareholders for the three months ended June 30, 2016 and 2015, respectively, and $27.7 million and $30.2 million in distributions to its preferred shareholders for the six months ended June 30, 2016 and 2015, respectively.



Holders of the Company’s preferred stock will not be entitled to vote on most matters, except under certain conditions. In the event of a cumulative arrearage equal to six quarterly dividends, the holders of the preferred stock will have the right to elect two additional members to serve on the Company’s Board of Directors until all events of default have been cured. At June 30, 2016, there were no dividends in arrears.



Except under certain conditions relating to the Company’s qualification as a REIT, the preferred stock is not redeemable prior to the previously noted redemption dates. On or after the respective redemption dates, the respective series of preferred stock will be redeemable, at the option of the Company, in whole or in part, at $25.00 per depositary share, plus any accrued and unpaid dividends. The Company had $29.3 million of deferred costs in connection with the issuance of preferred stock as of June 30, 2016 and December 31, 2015,  which the Company will report as additional non-cash distributions upon notice of its intent to redeem such shares.



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Common stock



No shares of common stock were repurchased under the board-approved common stock repurchase program during either of the six months ended June 30, 2016 and 2015.



The Company paid $20.3 million ($0.75 per common share) and $13.5 million ($0.50 per common share) in distributions to its common shareholders for the three months ended June 30, 2016 and 2015, respectively, and $40.6 million ($1.50 per common share) and $26.9 million ($1.00 per common share) in distributions to its common shareholders for the six months ended June 30, 2016 and 2015, respectively.



Equity stock



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



11. Commitments and contingencies



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



12. Stock compensation



PSB has a 2003 Stock Option and Incentive Plan (the “2003 Plan”) and a 2012 Equity and Performance-Based Incentive Compensation Plan (the “2012 Plan”) covering 1.5 million and 1.0 million shares of PSB’s common stock, respectively. Under the 2003 Plan and 2012 Plan, PSB has granted non-qualified options to certain directors, officers and key employees to purchase shares of PSB’s common stock at a price not less than the fair market value of the common stock at the date of grant. Additionally, under the 2003 Plan and 2012 Plan, PSB has granted restricted shares of common stock to certain directors and restricted stock units to officers and key employees. 



The weighted average grant date fair value of options granted during the  six months ended June 30, 2016 and 2015 was $8.41 per share and $8.49 per share, respectively. The Company has calculated the fair value of each option grant on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants during the  six months ended June 30, 2016 and 2015, respectively: a dividend yield of 3.1% and 2.5%; expected volatility of 15.2% and 16.1%; expected life of five years; and risk-free interest rates of 1.4% for both years.



The weighted average grant date fair value of restricted stock units granted during the six months ended June 30, 2016 and 2015 was $83.59 and $83.47, respectively. The Company calculated the fair value of each restricted stock unit grant using the market value on the date of grant.



At June 30, 2016, there was a combined total of 1.2 million options and restricted stock units authorized to be granted.

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Information with respect to outstanding options and nonvested restricted stock units granted under the 2003 Plan and 2012 Plan is as follows:









Effective March, 2014, the Company entered into a performance-based restricted stock unit program, the Senior Management Long-Term Equity Incentive Program for 2014-2017 (“2014 LTEIP”), with certain employees of the Company. Under the 2014 LTEIP, the Company established three levels of targeted restricted stock unit awards for certain employees, which would be earned only if the Company achieved one of three defined targets during 2014 to 2017. Under the 2014 LTEIP there is an annual award following the end of each of the four years in the program, with the award subject to and based on the achievement of total return targets during the previous year, as well as an award based on achieving total return targets during the cumulative four-year period 2014-2017. In the event the minimum defined target is not achieved for an annual award, the restricted stock units allocated to be awarded for such year are added to the restricted stock units that may be received if the four-year target is achieved. All restricted stock unit awards under the 2014 LTEIP vest in four equal annual installments beginning from the date of award. Up to 99,150 restricted stock units would be awarded for each of the four years assuming achievement was met and up to 92,900 restricted stock units would be awarded for the cumulative four-year period assuming achievement was met. Compensation expense is recognized based on the restricted stock units expected to be awarded based on the target level that is expected to be achieved. Net compensation expense of $4.1 million and $2.4 million related to the 2014 LTEIP was recognized during the three months ended June 30, 2016 and 2015, respectively, and $6.6 million and $4.5 million for the six months ended June 30, 2016 and 2015, respectively.  Included in the 2016 amounts, the Company recorded a net non-cash stock compensation charge of $2.0 million during the second quarter of 2016 related to a change in senior management and the future issuance of restricted stock units  our former Chief Executive Officer will receive under the Company’s 2014 LTEIP.



In connection with the 2014 LTEIP, targets for 2015 were achieved at the highest threshold total return level. As such, 99,150 restricted stock units were granted during the six months ended June 30, 2016 at a weighted average grant date fair value of $83.59.



Included in the Company’s consolidated statements of income for the three months ended June 30, 2016 and 2015, was $46,000 and $49,000, respectively, in net compensation expense related to stock options. Net compensation expense of $178,000 and $177,000 related to stock options was recognized during the six months ended June 30, 2016 and 2015, respectively. Excluding the 2014 LTEIP amortization of $4.1 million and $2.4 million,  respectively, net compensation expense of $63,000 and $84,000 related to restricted stock units was recognized during the three months ended June 30, 2016 and 2015, respectively. Excluding the 2014 LTEIP amortization of $6.6 million and $4.5 million,

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respectively, net compensation expense of $185,000 and $192,000 related to restricted stock units was recognized during the six months ended June 30, 2016 and 2015, respectively. 



As of June 30, 2016, there was $403,000 of unamortized compensation expense related to stock options expected to be recognized over a weighted average period of 3.3 years. As of June 30, 2016, there was $14.9 million (includes $13.7 million from the 2014 LTEIP) of unamortized compensation expense related to restricted stock units expected to be recognized over a weighted average period of 3.9 years.



Cash received from 16,823 stock options exercised during the six months ended June 30, 2016 was $900,000. Cash received from 39,500 stock options exercised during the six months ended June 30, 2015 was $2.0 million. The aggregate intrinsic value of the stock options exercised was $723,000 and $1.0 million during the six months ended June 30, 2016 and 2015, respectively.



During the six months ended June 30, 2016,  43,689 restricted stock units vested (40,689 related to the 2014 LTEIP); in settlement of these units, 25,604 shares were issued (23,966 related to the 2014 LTEIP), net of shares applied to payroll taxes. The aggregate fair value of the shares vested for the six months ended June 30, 2016 was $4.2 million ($4.0 million related to the 2014 LTEIP). During the six months ended June 30, 2015, 21,184 restricted stock units vested (16,634 related to the 2014 LTEIP); in settlement of these units, 13,224 shares were issued (10,495 related to the 2014 LTEIP), net of shares applied to payroll taxes. The aggregate fair value of the shares vested for the six months ended June 30, 2015 was $1.7 million ($1.3 million related to the 2014 LTEIP).



In April, 2015, the shareholders of the Company approved the issuance of up to 130,000 shares of common stock under the Retirement Plan for Non-Employee Directors (the “Director Plan”). Under the Director Plan, the Company grants 1,000 shares of common stock for each year served as a director up to a maximum of 8,000 shares issued upon retirement. The Company recognizes compensation expense over the requisite service period. As a result, included in the Company’s consolidated statements of income was $85,000 and $79,000 in compensation expense for the three months ended June 30, 2016 and 2015, respectively, and $169,000 and $158,000 for the six months ended June 30, 2016 and 2015, respectively. As of June 30, 2016 and 2015, there was $1.1 million and $1.4 million, respectively, of unamortized compensation expense related to these shares. In April, 2016, the Company issued 8,000 shares to a director upon retirement with an aggregate fair value of $775,000.  No shares were issued during the six months ended June 30, 2015.



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



Forward-Looking Statements: Forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, are made throughout this Quarterly Report on Form 10-Q. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “may,” “believes,” “anticipates,” “plans,” “expects,” “seeks,” “estimates,” “intends,” and similar expressions are intended to identify forward-looking statements. There are a number of important factors that could cause the results of the Company to differ materially from those indicated by such forward-looking statements, including but not limited to: (a) changes in general economic and business conditions; (b) decreases in rental rates or increases in vacancy rates/failure to renew or replace expiring leases; (c) tenant defaults; (d) the effect of the recent credit and financial market conditions; (e) our failure to maintain our status as a real estate investment trust (“REIT”); (f) the economic health of our tenants; (g) increases in operating costs; (h) casualties to our properties not covered by insurance; (i) the availability and cost of capital; (j) increases in interest rates and its effect on our stock price; and (k) other factors discussed under the heading “Part I, Item 1A. Risk Factors” in our annual report on Form 10-K for the year ended December 31, 2015. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved. Moreover, we assume no obligation to update these forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting such forward-looking statements, except as required by law.



Overview



As of June 30, 2016, the Company owned and operated 28.0 million rentable square feet of multi-tenant flex, industrial and office properties concentrated primarily in six states. All operating metrics discussed in this section as of and for the three and six months ended June 30, 2016 and 2015 exclude sold assets. Management believes excluding the results of such assets provides the most relevant perspective on the ongoing operations of the Company. Please refer to “Part I, Item 1. Financial Statements” included in this Quarterly Report on Form 10-Q for financial metrics that include results from sold assets.



The Company focuses on increasing profitability and cash flow aimed at maximizing shareholder value. The Company strives to maintain high occupancy levels while increasing rental rates and minimizing capital expenditures when market conditions allow, although the Company may decrease rental rates in markets where conditions require. The Company also acquires properties it believes will create long-term value, and from time to time disposes of properties which no longer fit within the Company’s strategic objectives. Operating results are driven primarily by income from rental operations and are therefore substantially influenced by demand for rental space within our properties and our markets, which impacts occupancy, rental rates and capital requirements.



During the first six months of 2016, the Company executed leases comprising 3.6 million square feet of space including 2.5 million square feet of renewals of existing leases and 1.1 million square feet of new leases. Overall, the change in rental rates for the Company continued to improve. See further discussion of operating results below.



Critical Accounting Policies and Estimates: Our accounting policies are described in Note 2 to the consolidated financial statements included in this Quarterly Report on Form 10-Q. We believe our most critical accounting policies relate to revenue recognition, property acquisitions, allowance for doubtful accounts, impairment of long-lived assets, depreciation, accruals of operating expenses and accruals for contingencies, each of which are more fully described in “Part I, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K for the year ended December 31, 2015.  



Effect of Economic Conditions on the Company’s Operations: During the first six months of 2016, most markets continued to reflect favorable conditions allowing for stable and improving occupancy as well as increasing rental rates. With the exception of the Virginia and Maryland markets, new rental rates for the Company improved over

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expiring rental rates on executed leases as economic conditions and tenant demand remained healthy. The Virginia and Maryland markets continue to experience soft market conditions as evidenced by continued pressure on occupancy and rental rates. In these markets, rental rates on executed leases declined 7.2% and 6.7%, respectively, over expiring rents for the six months ended June 30, 2016. Given lease expirations of 1.6 million square feet in Virginia and 512,000 square feet in Maryland through December 31, 2017, the Company may continue to experience a decrease in rental income in these markets. 



Tenant Credit Risk: The Company historically has experienced a low level of write-offs of uncollectable rents, but there is inherent uncertainty in a tenant’s ability to continue paying rent and meet its full lease obligation. The table below summarizes the impact to the Company from tenants’ inability to pay rent or continue to meet their lease obligations (in thousands):







As of July 25, 2016, the Company had 14,000 square feet of leased space occupied by tenants that are protected by Chapter 11 of the U.S. Bankruptcy Code. From time to time, tenants contact us, requesting early termination of their lease, reductions in space under lease, or rent deferment or abatement. At this time, the Company cannot anticipate what impact, if any, the ultimate outcome of these discussions will have on our future operating results.



Company Performance and Effect of Economic Conditions on Primary Markets: During the six months ended June 30, 2016, initial rental rates on new and renewed leases within the Company’s total portfolio increased 4.8% over expiring rents, a slight improvement from the year ended December 31, 2015 in which initial rental rates on new and renewed leases increased 4.4%. The Company’s Same Park (defined below) occupancy rate at June 30, 2016 was 93.3%, compared to 93.7% at June 30, 2015. The Company’s operations are substantially concentrated in eight regions. Each of the eight regions in which the Company owns assets is subject to its own unique market influences. See “Supplemental Property Data and Trends” below for more information on regional operating data.



Effect of Acquisitions and Dispositions of Properties on the Company’s Operations: The Company is focused on growing its operations by looking for opportunities to expand its presence in existing and new markets through strategic acquisitions that meet the Company’s focus on multi-tenant flex, industrial and office parks in markets where it has or may obtain a substantial market presence. The Company may also from time to time dispose of assets based on market conditions.



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As of June 30, 2016, the blended occupancy rate of the five assets acquired in 2014, which comprise the 678,000 square feet of Non-Same Park portfolio (defined below), was 95.3% compared to a blended occupancy rate of 46.7% at the time of acquisition. The table below contains the assets acquired in 2014 (dollars and square feet in thousands):









During the first six months of 2015, the Company sold Milwaukie Business Park located in Milwaukie, Oregon, aggregating 102,000 square feet for net proceeds of $10.6 million, which resulted in a gain of $7.6 million. Additionally, as part of an eminent domain process, the Company sold five buildings, aggregating 82,000 square feet, at the Company’s Overlake Business Park located in Redmond, Washington, for $13.9 million, which resulted in a gain of $4.8 million.



In 2013, the Company entered into a joint venture, in which it will maintain 95.0% economic interest, known as Amherst JV LLC, (the “Joint Venture”) with an unrelated real estate development company for the purpose of developing a 395-unit multi-family building on a five-acre site, to be known as Highgate, within its Westpark Business Park in Tysons, Virginia. The Company contributed the site, along with capitalized improvements, to the Joint Venture on October 5, 2015. Subsequent to the contribution date, demolition, site preparation and construction commenced and is expected to be completed in late 2017.



Along with the equity capital the Company has committed to the Joint Venture, the Company has also agreed to provide the Joint Venture with a construction loan in the amount of $75.0 million. The Joint Venture will pay interest under the construction loan at a rate equal to the London Interbank Offered Rate (“LIBOR”) plus 2.25%. The loan will mature on April 5, 2019. The Company’s investment in and advances to unconsolidated joint venture was $40.0 million and $26.7 million at June 30, 2016 and December 31, 2015, respectively. For the six months ended June 30, 2016, the Company made cash contributions of $5.7 million to the Joint Venture and capitalized $739,000 of interest on its investment in the Joint Venture. In addition to the cash contributions and capitalized interest, the Company made loan advances to the Joint Venture of $6.8 million during the first six months of 2016. For the six months ended June 30, 2015, the Company capitalized costs of $1.8 million related to this development, of which $531,000 were capitalized interest. The Company made no loan advances to the Joint Venture in 2015.



Scheduled Lease Expirations: In addition to the 1.8 million square feet, or 6.6%, of vacancy in our total portfolio as of June 30, 2016,  934 leases, representing 2.8 million square feet, or 10.6%, of the leased square footage of our total portfolio are scheduled to expire during the remainder of 2016. Our ability to re-lease available space will depend upon market conditions in the specific submarkets in which our properties are located. As a result, we cannot predict with certainty the rate at which expiring leases will be re-leased.



Impact of Inflation: Although inflation has not been significant in recent years, it remains a potential factor in our economy, and the Company continues to seek ways to mitigate its potential impact. A substantial portion of the Company’s leases require tenants to pay operating expenses, including real estate taxes, utilities, and insurance, as well as increases in common area expenses, partially reducing the Company’s exposure to inflation.

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Net Operating Income: Rental income, cost of operations and rental income less cost of operations, excluding depreciation and amortization, or net operating income (defined as “NOI” for purposes of the following tables), are summarized for the three and six months ended June 30, 2016 and 2015.  NOI is a non-GAAP financial measure that is often used by investors to determine the performance and value of commercial real estate.  Depreciation and amortization have been excluded from NOI as they are generally not used in determining the value of commercial real estate by management or the investment community. Depreciation and amortization are generally not used in determining value as they consider the historical costs of an asset compared to its current value; therefore, to understand the effect of the assets’ historical cost on the Company’s results, investors should look at GAAP financial measures, such as total operating costs including depreciation and amortization. The Company’s calculation of NOI may not be comparable to those of other companies and should not be used as an alternative to measures of performance calculated in accordance with GAAP. As part of the tables below, we have reconciled total NOI to net income, which we consider the most directly comparable financial measure calculated in accordance with GAAP.



In order to provide a meaningful period-to-period comparison, for the purpose of computing NOI, the tables below exclude amortization of the Senior Management Long-Term Equity Incentive Plan (“2014 LTEIP”) in cost of operations (for field leadership) and general and administrative expenses (for executive management).



Concentration of Portfolio by Region: The table below reflects the Company’s square footage based on regional concentration as of June 30, 2016. As part of the table below, we have reconciled total NOI to net income (in thousands):





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Concentration of Credit Risk by Industry: The information below depicts the industry concentration of our tenant base as of June 30, 2016.  The Company analyzes this concentration to minimize significant industry exposure risk.







The information below depicts the Company’s top 10 customers by annualized rental income as of June 30, 2016 (in thousands):





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Comparative Analysis of the Three and Six Months Ended June 30, 2016 to the Three and Six Months Ended June 30, 2015



Results of Operations: In order to evaluate the performance of the Company’s portfolio over comparable periods, management analyzes the operating performance of properties owned and operated throughout both periods (herein referred to as “Same Park”). The Same Park portfolio includes all operating properties acquired prior to January 1, 2014. Operating properties acquired subsequently are referred to as “Non-Same Park.” For the three and six months ended June 30, 2016 and 2015, the Same Park facilities constitute 27.3 million rentable square feet, representing 97.5% of the 28.0 million square feet in the Company’s total portfolio as of June 30, 2016.



The following table presents the operating results of the Company’s properties for the three and six months ended June 30, 2016 and 2015 in addition to other income and expenses items affecting net income (in thousands, except per square foot data):







____________



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Supplemental Property Data and Trends: NOI is summarized for the three and six months ended June 30, 2016 and 2015 by region below. See above for more information on NOI, including why the Company presents NOI and how the Company uses NOI. The Company’s calculation of NOI may not be comparable to those of other companies and should not be used as an alternative to measures of performance calculated in accordance with GAAP.



The following tables summarize the Same Park and Non-Same Park operating results by region for the three and six months ended June 30, 2016 and 2015. In addition, the tables reflect the comparative impact on the overall rental income, cost of operations and NOI from properties that have been acquired since January 1, 2014, and the impact of such is included in Non-Same Park facilities in the tables below. As part of the tables below, we have reconciled total NOI to net income (in thousands):



Three Months Ended June 30, 2016 and 2015:









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Six Months Ended June 30, 2016 and 2015:





The following tables summarize Same Park weighted average occupancy rates and annualized realized rent per square foot by region for the three and six months ended June 30, 2016 and 2015.  



Three Months Ended June 30, 2016 and 2015:





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Six Months Ended June 30, 2016 and 2015:





Rental Income:  Rental income increased $4.1 million from $92.0 million for the three months ended June 30, 2015 to $96.1 million for the three months ended June 30, 2016 as a result of an increase in Same Park rental income of $3.7 million, or 4.1%, combined with a $431,000, or 36.8%, increase from Non-Same Park facilities. Rental income increased $9.0 million from $182.9 million for the six months ended June 30, 2015 to $191.9 million for the six months ended June 30, 2016 as a result of an increase in Same Park rental income of $8.0 million, or 4.4%, combined with a $1.0 million, or 43.6%, increase from Non-Same Park facilities. The three and six month increases in Same Park rental income was due to an increase in occupancy and executed rental rates. Including the sold assets, rental income was $92.9 million and $185.3 million for the three and six months ended June 30, 2015, respectively.



Facility Management Fees: Facility management fees, derived from Public Storage (“PS”), account for a small portion of the Company’s revenues. During the three months ended June 30, 2016,  $131,000 of revenue was recognized from facility management fees compared to $133,000 for the same period in 2015. During the six months ended June 30, 2016,  $259,000 of revenue was recognized from facility management fees compared to $280,000 for the same period in 2015.  The decreases resulted from a reduction in total square footage managed on behalf of PS.



Cost of Operations: Cost of operations increased $108,000,  or 0.4%,  from $28.9 million for the three months ended June 30, 2015 to $29.0 million for the three months ended June 30, 2016 comprised of an increase in the Same Park portfolio of $144,000, or 0.5%, partially offset by a decrease in the Non-Same Park facilities of $36,000, or 6.8%. Cost of operations increased $736,000, or 1.2%, from $59.3 million for the six months ended June 30, 2015 to $60.0 million for the six months ended June 30, 2016 as a result of an increase in the Same Park portfolio of $759,000, or 1.3%, partially offset by a decrease in the Non-Same Park facilities of $23,000, or 2.2%. The three month increase in Same Park cost of operations was a result of higher repairs and maintenance costs. The six month increase was a result of higher repairs and maintenance costs and property taxes partially offset by a decrease in compensation costs.  Including the 2014 LTEIP amortization and sold assets, cost of operations was $29.8 million and $61.6 million for the three and six months ended June 30, 2016, respectively, compared to $30.1 million and $61.8 million for the three and six months ended June 30, 2015, respectively.



Depreciation and Amortization Expense: Depreciation and amortization expense was $25.2 million for the three months ended June 30, 2016 compared to $27.0 million for the same period in 2015. Depreciation and amortization expense was $50.3 million for the six months ended June 30, 2016 compared to $53.3 million for the same period in 2015.  The three and six month decreases in depreciation and amortization expense was due to the disposition of assets.



General and Administrative Expenses: For the three and six months ended June 30, 2016, general and administrative expenses increased $229,000, or 12.3%, and $219,000, or 5.6%, respectively, over the same periods in 2015 due to acquisition and development costs. Including the 2014 LTEIP amortization, for the three and six months ended June 30, 2016, general and administrative expense increased $1.9 million, or 53.8%, and $2.1 million, or 30.7%, respectively, over the same periods in 2015.  The Company recorded a net non-cash stock compensation charge of $2.0

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million during the second quarter of 2016 related to a change in senior management and the future issuances of restricted stock units our former Chief Executive Officer will receive under the Company’s 2014 LTEIP.



Gain on Sale of Real Estate Facilities: The Company recorded a combined net gain of $12.5 million for the six months ended June 30, 2015 related to the sales noted on page 22.



Net Income Allocable to Noncontrolling Interests: Net income allocable to noncontrolling interests reflects the net income allocable to equity interests in PS Business Parks, L.P. (the “Operating Partnership”) that are not owned by the Company. Net income allocable to noncontrolling interests was $4.2 million and $3.0 million of allocated income to common unit holders for the three months ended June 30, 2016 and 2015, respectively. The three month increase was primarily the result of an increase in total NOI of $4.0 million. Net income allocable to noncontrolling interests was $8.2 million and $8.4 million of allocated income to common unit holders for the six months ended June 30, 2016 and 2015, respectively. The six month decrease was primarily the result of the gain on sale of real estate facilities of $12.5 million recognized for the six months ended June 30, 2015 partially offset by an increase in overall NOI.



Liquidity and Capital Resources



Cash and cash equivalents decreased $185.2 million from $188.9 million at December 31, 2015 to $3.7 million at June 30, 2016 for the reasons noted below.



Net cash provided by operating activities for the six months ended June 30, 2016 and 2015 was $116.8 million and $111.4 million, respectively. The increase of $5.4 million in net cash provided by operating activities was primarily due to an increase in NOI. Management believes that the Company’s internally generated net cash provided by operating activities will be sufficient to enable it to meet its operating expenses, capital expenditures, debt service requirements and distributions to shareholders for the foreseeable future.



Net cash used in investing activities was $27.7 million and $1.2 million for the six months ended June 30, 2016 and 2015, respectively. The change was primarily due to net proceeds of $24.5 million received from assets sold in 2015 combined with a $13.2 million increase in cash investment in the Joint Venture. This change was partially offset by a decrease in cash paid related to capital improvements.



Net cash used in financing activities was $274.3 million and $62.5 million for the six months ended June 30, 2016 and 2015, respectively.  The change was primarily due to repayment of mortgage note payable of $250.0 million in 2016 using cash on hand and borrowings from the Credit Facility (defined below) of $54.0 million. This change was also impacted by an increase in quarterly distributions paid to common shareholders of $17.3 million (from $0.50 per share to $0.75 per share commencing the first quarter of 2016).



The Company has a line of credit (the “Credit Facility”) with Wells Fargo Bank, National Association (“Wells Fargo”). The Credit Facility has a borrowing limit of $250.0 million and expires May 1, 2019. The rate of interest charged on borrowings is based on the LIBOR plus 0.875% to LIBOR plus 1.70% depending on the Company’s credit ratings. Currently, the Company’s rate under the Credit Facility is LIBOR plus 0.875%. In addition, the Company is required to pay an annual facility fee ranging from 0.125% to 0.30% of the borrowing limit depending on the Company’s credit ratings (currently 0.125%). As of June 30, 2016, the Company had $54.0 million outstanding on the Credit Facility at an interest rate of 1.33%. Subsequent to June 30, 2016, the Company repaid $10.0 million on the Credit Facility reducing the outstanding balance to $44.0 million. The Company had no balance outstanding on the Credit Facility at December 31, 2015. The Company had $654,000 and $769,000 of unamortized commitment fees as of June 30, 2016 and December 31, 2015, respectively. The Credit Facility requires the Company to meet certain covenants, all of which the Company was in compliance as of June 30, 2016. Interest on outstanding borrowings is payable monthly.



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The Company’s preferred equity outstanding decreased from 22.0% of its market capitalization at December 31, 2015 to 19.9% at June 30, 2016 primarily due to an increase in stock price from $87.43 at December 31, 2015 to $106.08 at June 30, 2016. The Company calculates market capitalization by adding (1) the liquidation preference of the Company’s outstanding preferred equity, (2) principal value of the Company’s outstanding debt and (3) the total number of common shares and common units outstanding at June 30, 2016 multiplied by the closing price of the stock on that date.



The Company focuses on retaining cash for reinvestment, as we believe this provides us the greatest level of financial flexibility. As operating fundamentals improve, additional increases in distributions to the Company’s common shareholders may be required. The Company will continue to monitor its taxable income and the corresponding dividend requirements. During the first quarter of 2016, the Company increased its quarterly dividend from $0.60 per common share to $0.75 per common share, increasing quarterly distributions by $5.2 million per quarter.



Repurchase of Common Stock: No shares of common stock were repurchased under the board-approved common stock repurchase program during the six months ended June 30, 2016 or the year ended December 31, 2015.



Capital Expenditures: The Company defines recurring capital expenditures as those necessary to maintain and operate its commercial real estate at its current economic value. During the six months ended June 30, 2016 and 2015, the Company expended $14.1 million and $21.4 million, respectively, in recurring capital expenditures, or $0.51 and $0.76 per weighted average square foot owned, respectively. Tenant improvement amounts exclude those amounts reimbursed by the tenants. Nonrecurring capital improvements include property renovations and expenditures related to repositioning acquisitions. The following table depicts capital expenditures (in thousands):





Capital expenditures on a per square foot owned basis are as follows:







The decrease in recurring capital expenditures of $7.3 million, or 34.0%, was primarily due to lower tenant improvement costs and continued efforts to reduce capital expenditures.



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Distributions: The Company has elected and intends to qualify as a REIT for federal income tax purposes. In order to maintain its status as a REIT, the Company must meet, among other tests, sources of income, share ownership and certain asset tests. As a REIT, the Company is not taxed on that portion of its taxable income that is distributed to its shareholders provided that at least 90% of its taxable income is distributed to its shareholders prior to the filing of its tax return.



The Company’s funding strategy has been to primarily use permanent capital, including common and preferred stock, along with internally generated retained cash flows to meet its liquidity needs. In addition, the Company may sell properties that no longer meet its investment criteria. From time to time, the Company may use its Credit Facility or other forms of debt to facilitate real estate acquisitions or other capital allocations. The Company targets a minimum ratio of FFO (as defined below) to combined fixed charges and preferred distributions of 3.0 to 1.0. Fixed charges include interest expense and capitalized interest while preferred distributions include amounts paid to preferred shareholders and preferred Operating Partnership unit holders. For the six months ended June 30, 2016, the FFO to fixed charges and preferred distributions coverage ratio was 3.6 to 1.0.



Non-GAAP Supplemental Disclosure Measure: Funds from Operations: Management believes that Funds from Operations (“FFO”) and FFO, as adjusted are useful supplemental measures of the Company’s operating performance. The Company computes FFO in accordance with the White Paper on FFO approved by the Board of Governors of the National Association of Real Estate Investment Trusts. The White Paper defines FFO as net income, computed in accordance with GAAP, before depreciation, amortization, gains or losses on asset dispositions, net income allocable to noncontrolling interests —common units, net income allocable to restricted stock unit holders, impairment charges and nonrecurring items. Management believes that FFO provides a useful measure of the Company’s operating performance and when compared year over year, reflects the impact to operations from trends in occupancy rates, rental rates, operating costs, development activities, general and administrative expenses and interest costs, providing a perspective not immediately apparent from net income.



FFO and FFO, as adjusted should be analyzed in conjunction with net income. However, FFO and FFO, as adjusted should not be viewed as substitutes for net income as measures of operating performance or liquidity as they do not reflect depreciation and amortization costs or the level of capital expenditure and leasing costs necessary to maintain the operating performance of the Company’s properties, which are significant economic costs and could materially affect the Company’s results of operations.



Management believes FFO provides useful information to the investment community about the Company’s operating performance when compared to the performance of other real estate companies as FFO is generally recognized as the industry standard for reporting operations of REITs. Other REITs may use different methods for calculating FFO and/or FFO, as adjusted and, accordingly, our FFO and FFO, as adjusted may not be comparable to other real estate companies’ FFO and/or FFO, as adjusted.

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FFO for the Company is computed as follows (in thousands, except per share data):







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In order to provide meaningful period-to-period comparisons of FFO derived from the Company’s ongoing business operations, the table below reconciles reported FFO to FFO, as adjusted, which excludes a net non-cash stock compensation charge of $2.0 million during the second quarter of 2016 related to a change in senior management and the future issuances of restricted stock units  our former Chief Executive Officer will receive under the 2014 LTEIP.







FFO allocable to common and dilutive shares, as adjusted, increased $6.1 million and $10.8 million for the three and six months ended June 30, 2016 compared to the same periods in 2015. The three and six month increases were due to an increase in NOI and savings from preferred distributions relating to the redemption of preferred equity and lower interest expense.



Related Party Transactions: Assuming issuance of the Company’s common stock upon redemption of its common partnership units, PS would own 42.1% (or 14.5 million shares) of the outstanding shares of the Company’s common stock at June 30, 2016. As of June 30, 2016, PS owned 26.4% of the Operating Partnership (100.0% of the common

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units not owned by the Company). Ronald L. Havner, Jr., the Company’s chairman, is also the Chairman of the Board, Chief Executive Officer of PS. Joseph D. Russell, Jr. is a director of the Company and also President of PS. Gary E. Pruitt, an independent director of the Company is also a trustee of PS.



Pursuant to a cost sharing and administrative services agreement, the Company shares costs with PS for certain administrative services and rental of corporate office space. The administrative services include investor relations, legal, corporate tax and information systems, which were allocated to PS in accordance with a methodology intended to fairly allocate those costs. These costs totaled $123,000 and $117,000 for the three months ended June 30, 2016 and 2015, respectively, and $247,000 and $235,000 for the six months ended June 30, 2016 and 2015, respectively. In addition, the Company provides property management services for properties owned by PS for a management fee of 5% of the gross revenues of such properties in addition to reimbursement of direct costs. These management fee revenues recognized under a management contract with PS totaled $131,000 and $133,000 for the three months ended June 30, 2016 and 2015, respectively, and $259,000 and $280,000 for the six months ended June 30, 2016 and 2015, respectively. PS also provides property management services for the self-storage component of two assets owned by the Company for a fee of 6% of the gross revenues of such properties in addition to reimbursement of certain costs. Management fee expense recognized under the management contract with PS totaled $21,000 and $19,000 for the three months ended June 30, 2016 and 2015, respectively, and $42,000 and $38,000 for the six months ended June 30, 2016 and 2015, respectively.



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



Off-Balance Sheet Arrangements: The Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a material effect on the Company’s financial condition, results of operations, liquidity, capital expenditures or capital resources.



Contractual Obligations: The Company is scheduled to pay cash dividends of $55.3 million per year on its preferred equity outstanding as of June 30, 2016. Dividends are paid when and if declared by the Company’s Board of Directors and accumulate if not paid. Shares of preferred equity are redeemable by the Company in order to preserve its status as a REIT and are also redeemable five years after issuance.



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 



To limit the Company’s exposure to market risk, the Company principally finances its operations and growth with permanent equity capital consisting of either common or preferred stock. As a result, the Company’s debt as a percentage of total equity (based on book values) was 2.9% as of June 30, 2016.



Our exposure to market risk for changes in interest rates relates primarily to the Credit Facility, which is subject to variable interest rates. See Notes 2, 6 and 7 to the consolidated financial statements included in this Quarterly Report on Form 10-Q for additional information regarding the terms, valuations and approximate principal maturities of the Company’s indebtedness, including the mortgage note payable and Credit Facility. Based on borrowing rates currently available to the Company, the difference between the carrying amount of debt and its fair value is insignificant.

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ITEM 4. CONTROLS AND PROCEDURES



The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of June 30, 2016. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of the Company’s disclosure controls and procedures as of June 30, 2016, the Company’s Chief Executive Officer and Chief Financial Officer concluded that, as of such date, the Company’s disclosure controls and procedures were effective at the reasonable assurance level.



No change in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended June 30, 2016 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.



PART II. OTHER INFORMATION 



ITEM 1. LEGAL PROCEEDINGS



The Company currently is not subject to any material litigation other than routine litigation and administrative proceedings arising in the ordinary course of business.



ITEM 1A. RISK FACTORS 



There have been no material changes to the risk factors included in our Annual Report on Form 10-K for the year ended December 31, 2015.



ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS



The Company’s Board of Directors has authorized the repurchase, from time to time, of up to 6.5 million shares of the Company’s common stock on the open market or in privately negotiated transactions. The authorization has no expiration date. Purchases will be made subject to market conditions and other investment opportunities available to the Company.



During the three months ended June 30, 2016, there were no shares of the Company’s common stock repurchased. As of June 30, 2016, 1,614,721 shares remain available for purchase under the program.



See Note 10 to the consolidated financial statements for additional information on repurchases of equity securities.



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ITEM 6. EXHIBITS







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SIGNATURES



Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.





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EXHIBIT INDEX





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