| COMMERCIAL NET LEASE REALTY INC Item 1A Risk Factors |
| You should carefully consider the following risks and all of the other information set forth in this Annual Report on Form 10-K, including the consolidated financial statements and the notes thereto |
| If any of the events or developments described below were actually to occur, the Company’s business, financial condition or results of operations could be adversely affected |
| Loss of revenues from tenants would reduce the Company’s cash flow |
| The United States of America (“USA”) accounted for approximately 13 percent of the annualized base rental income from the Company’s investment properties, or base rent, as of December 31, 2005 |
| The Company’s next five largest tenants—Susser (Circle K), CVS, Best Buy, OfficeMax and Barnes & Noble, accounted for an aggregate of approximately 24 percent of the Company’s base rent as of December 31, 2005 |
| The default, financial distress or bankruptcy of one or more of our tenants could cause substantial vacancies among the Company’s investment properties |
| Vacancies reduce the Company’s revenues until the Company is able to re-lease the affected properties and could decrease the ultimate sale value of each such vacant property |
| Upon the expiration of the leases that are currently in place, the Company may not be able to re-lease a vacant property at a comparable lease rate or without incurring additional expenditures in connection with such re-leasing |
| On February 9, 2006, the Company and its wholly owned subsidiary, CNLR DC Acquisitions I, LLC, entered into an agreement with Brookfield Financial Properties, LP, an affiliate of Brookfield Properties Corporation, to sell the property leased to the USA The Company expects to complete the transaction by April 2006, subject to certain conditions |
| Following the transaction, the USA will not be a Company tenant |
| Risks associated with the Company’s August 2003 acquisition of two single-tenant office buildings and a related parking garage in the Washington DC metropolitan area (“DC Office Properties”): Until the completion of the DC Office Properties sale transaction, the Company is subject to the following risks: Risks related to the acquisition of property from a bankrupt estate |
| In August 2003, the Company acquired the DC Office Properties originally owned and occupied by MCI, Inc |
| (formerly MCI WorldCom, Inc |
| Because MCI WorldCom was in bankruptcy, the properties were sold by order of the US Bankruptcy Court in the Southern District of New York for the benefit of the creditors of MCI WorldCom |
| The purchase contract for these properties from bankruptcy did not contain many of the representations and warranties regarding the properties that are customarily obtained from private sellers, and the Company acquired the properties on an “as-is, where-is” basis from a bankrupt seller |
| As a result, the Company may have no recourse if there are pre-existing problems or conditions with the DC Office Properties |
| Risks related to a US Government lease |
| The DC Office Properties are substantially leased to the USA, initially to be used by the Transportation Security Administration, a federal agency |
| US Government leases differ in many respects from leases with other commercial tenants and differ from the leases the Company has with other tenants, particularly tenants in retail properties |
| For example, among other things, the lease with the USA provides that: • the Company cannot provide for acceleration of the government’s payment obligations under the lease even if the government does not make a payment when due or otherwise defaults under the lease; • the Company is required to maintain and repair the buildings in accordance with specific standards and criteria set forth in the lease; • in performing maintenance and other obligations under the lease, the Company must comply with various federal statutes pertaining to government contracts; 8 ______________________________________________________________________ [33]Table of Contents • the Company must comply with certain statutes relating to, among other things, gratuities to government officials and contingent fees and kickbacks, equal opportunity, use of small businesses, a drug-free workplace, small disadvantaged business concerns and women-owned small businesses, and affirmative action for special disabled and Vietnam-era veterans and handicapped workers |
| If the Company fails to comply with such standards, the government may be entitled to terminate the lease or to seek offset against the lease payments; • in the event the Company fails to perform obligations under the lease, the government may be entitled to offset from the lease payments the costs incurred by the government in performing such obligations or deduct from lease payments the value of the services not being performed; • the government may substitute as a tenant any federal government agency or agencies at any time; • the Company must pay a base amount of real estate taxes on the property each year; • the presence of a US Government tenant may increase insurance premiums in the future or may result in increased security costs; • the government is only required to pay increases in operating expenses in excess of a base year amount up to the amount of the annual increases in the consumer price index (“CPI”) cap, and the Company is responsible for increases in operating expenses above the amount of the CPI increase; and • that it expires in 2014, which will increase the risk of re-leasing and could result in substantial costs to re-configure the buildings for a new tenant or tenants |
| There are a number of risks inherent in owning real estate and indirect interests in real estate |
| Factors beyond the Company’s control affect the Company’s performance and value |
| Changes in national, regional and local economic and market conditions may affect the Company’s economic performance and the value of the Company’s real estate assets |
| Local real estate market conditions may include excess supply and intense competition for tenants, including competition based on: (i) rental rates, (ii) attractiveness and location of the property, and (iii) quality of maintenance, insurance and management services |
| In addition, other factors may adversely affect the performance and value of the Company’s properties, including changes in laws and governmental regulations, including those governing: (i) usage, (ii) zoning and taxes, (iii) changes in interest rates, and (iv) the availability of financing |
| Illiquidity of real estate investments |
| Because real estate investments are relatively illiquid, the Company’s ability to adjust the portfolio promptly in response to economic or other conditions is limited |
| Certain significant expenditures generally do not change in response to economic or other conditions, including: (i) debt service (if any), (ii) real estate taxes, and (iii) operating and maintenance costs |
| This combination of variable revenue and relatively fixed expenditures may result, under certain market conditions, in reduced income from investment |
| Such reduction in investment income could have an adverse effect on the Company’s financial condition |
| Property Environmental Considerations |
| The Company may acquire a property whose environmental site assessment indicates that a contamination or potential contamination exists, subject to a determination of the level of risk and potential cost of remediation |
| Investments in real property create a potential for substantial environmental liability on the part of the owner of such property from the presence or discharge of hazardous substances on the property, regardless of fault |
| It is the Company’s policy, as a part of its acquisition due diligence process, generally to obtain a Phase I environmental site assessment for each property and, where warranted, a Phase II environmental site assessment, however, not all properties have been subjected to these site assessments |
| In such cases that the Company intends to acquire real estate where contamination or potential 9 ______________________________________________________________________ [34]Table of Contents contamination exists, the Company generally requires the seller and/or tenant to (i) remediate the problem prior to the Company’s acquiring the property, (ii) indemnify the Company for environmental liabilities or (iii) agree to other arrangements deemed appropriate by the Company to address environmental conditions at the property |
| Phase I assessments involve site reconnaissance and review of regulatory files identifying potential areas of concern, whereas Phase II assessments involve some degree of soil and/or groundwater testing |
| The Company has 16 investment properties currently under some level of environmental remediation |
| In general, the seller or the tenant or an adjacent land owner is contractually responsible for the cost of the environmental remediation for 15 of these investment properties |
| In the event of a bankruptcy or other inability on the part of these sellers and/or tenant to cover these costs, the Company may have to cover the costs of remediation, fines or other environmental liabilities at these and other properties |
| The Company may also own properties where required remediation has not begun or detected adverse environmental conditions that may require remediation or otherwise subject the Company to liability |
| The Company cannot provide assurance that it will not be required to undertake or pay for removal or remediation of any contamination of properties currently or previously owned by the Company, that the Company will not be subject to fines by governmental authorities or litigation or that the costs of such removal, remediation fines or litigation would not be material |
| The Company may not be able to successfully execute its acquisition or development strategies |
| The Company cannot assure that it will be able to implement its investment strategies successfully |
| Additionally, the Company cannot assure that its property portfolio will expand at all, or if it will expand at any specified rate or to any specified size |
| In addition, investment in additional real estate assets is subject to a number of risks |
| Because the Company expects to invest in markets other than the ones in which its current properties are located, the Company will also be subject to the risks associated with investment in new markets that may be relatively unfamiliar to the Company’s management team |
| The Company’s development activities are subject to the risks normally associated with these activities |
| These risks include, without limitation, risks relating to the availability and timely receipt of zoning and other regulatory approvals, the cost and timely completion of construction (including risks from factors beyond the Company’s control, such as weather or labor conditions or material shortages) and the ability to obtain both construction and permanent financing on favorable terms |
| These risks could result in substantial unanticipated delays or expenses and, under certain circumstances, could prevent completion of development activities once undertaken or provide a tenant the opportunity to terminate a lease |
| Any of these situations delay or eliminate proceeds or cash flows the Company expects from these projects, which could have an adverse effect on the Company’s financial condition |
| The Company may not be able to dispose of properties consistent with its operating strategy |
| The Company may not be able to sell Inventory Properties at a profit due to interest rate increases, or other demands for Inventory Properties may wane, thereby, rendering NNN TRS unable to sell these properties |
| A change in the assumptions used to determine the value of mortgage residual interests could adversely affect the Company’s financial position |
| As of December 31, 2005, the mortgage residual interests had a carrying value of dlra55cmam184cmam000 |
| The value of these mortgage residual interests is based on delinquency, loss, prepayment and interest rate assumptions made by the Company to determine their value |
| If actual experience differs materially from these assumptions, the actual future cash flow could be less than expected and the value of the mortgage residual interests, as well as the Company’s earnings, could decline |
| The Company may suffer a loss in the event of a default or bankruptcy of a structured finance loan borrower |
| If a borrower defaults on a structured finance loan and does not have sufficient assets to satisfy the loan, the Company may suffer a loss of principal and interest |
| In the event of the bankruptcy of a borrower, the Company may not be able to recover against all of the assets of the borrower, or the assets of the borrower may not be sufficient to satisfy the balance due on the loan |
| In addition, certain of our loans may be subordinate to other debt of a borrower |
| The structured finance agreements are typically loans secured by a borrower’s pledge of 10 ______________________________________________________________________ [35]Table of Contents ownership interests in the entity that owns the real estate |
| These agreements are typically subordinated to senior loans secured by first mortgages encumbering the underlying real estate |
| Subordinated positions are generally subject to a higher risk of nonpayment of principal and interest than the more senior loans |
| As of December 31, 2005, the structured finance agreements had an outstanding principal balance of dlra27cmam805cmam000 |
| If a borrower defaults on the loan or on debt senior to the Company’s loan, or in the event of the bankruptcy of a borrower, the Company’s loan will be satisfied only after the borrower’s senior creditors’ claims are satisfied |
| Where debt senior to the Company’s loans exists, the presence of intercreditor arrangements may limit the Company’s ability to amend loan documents, assign the loans, accept prepayments, exercise remedies and control decisions made in bankruptcy proceedings relating to borrowers |
| Bankruptcy proceedings and litigation can significantly increase the time needed for the Company to acquire underlying collateral in the event of a default, during which time the collateral may decline in value |
| In addition, there are significant costs and delays associated with the foreclosure process |
| Certain provisions of the structured leases or finance loan agreements may be unenforceable |
| The Company’s rights and obligations with respect to its leases or structured finance loans are governed by written agreements |
| A court could determine that one or more provisions of an agreement are unenforceable, such as a particular remedy, a loan prepayment provision or a provision governing the Company’s security interest in the underlying collateral of a borrower |
| The Company could be adversely impacted if this were to happen with respect to a material asset or group of assets |
| Property ownership through joint ventures and partnerships could limit the Company’s control of those investments |
| Joint ventures or partnerships involve risks not otherwise present for investments the Company makes on its own |
| It is possible that the Company’s co-venturers or partners may have different interests or goals than the Company at any time and that they may take actions contrary to the Company’s requests, policies or objectives, including the Company’s policy with respect to maintaining its qualification as a REIT Other risks of joint venture investment include impasses on decisions, because no single co-venturer or partner has full control over the joint venture or partnership |
| Uninsured losses may adversely affect our ability to pay outstanding indebtedness |
| The Company’s properties are generally covered by comprehensive liability, fire, flood, extended coverage and rental loss insurance with policy specifications and insured limits customarily carried for similar properties |
| The Company believes that the insurance carried on its properties is adequate in accordance with industry standards |
| There are, however, types of losses (such as from hurricanes, wars or earthquakes) which may be uninsurable, or the cost of insuring against these losses may not be economically justifiable |
| If an uninsured loss occurs, the Company could lose both the invested capital in and anticipated revenues from the property |
| In that event, the Company’s cash flow could be reduced |
| Terrorist attacks, such as the attacks that occurred in New York and Washington, DC on September 11, 2001, and other acts of violence or war may affect the markets in which the Company operates, its financial condition and results of operations |
| Terrorist attacks may negatively affect the Company’s operations |
| There can be no assurance that there will not be further terrorist attacks against the United States or US businesses |
| These attacks may directly impact the Company’s physical facilities or the businesses of the Company’s tenants |
| Also, the United States has entered into armed conflict, which could have a further impact on the Company’s tenants |
| The consequences of armed conflict are unpredictable, and the Company may not be able to foresee events that could have an adverse effect on its business |
| More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the United States and worldwide financial markets and economies |
| They also could result in, or cause a deepening of, economic recession in the United States or abroad |
| Any of these occurrences could have a significant adverse impact on the Company’s financial condition or results of operations |
| 11 ______________________________________________________________________ [36]Table of Contents Vacant properties or bankrupt tenants could adversely affect the Company |
| As of December 31, 2005, the Company owns 9 vacant, unleased Investment Properties and 3 unleased land parcels, which account for approximately two percent of the total gross leasable area of the Company’s portfolio of Investment Properties |
| The Company is actively marketing these properties for sale or re-lease but may not be able to sell or re-lease these properties on favorable terms or at all |
| The lost revenues and increased property expenses resulting from the rejection by any bankrupt tenant of any of their respective leases with the Company could have a material adverse effect on the liquidity and results of operations of the Company if the Company is unable to re-lease the Investment Properties at comparable rental rates and in a timely manner |
| Additionally, 0dtta5 percent of the total gross leasable area of the Company’s Investment Portfolio is leased to two tenants that have filed a voluntary petition for bankruptcy under Chapter 11 of the US Bankruptcy Code |
| As a result, the tenants have the right to reject or affirm its leases with the Company |
| The amount of debt the Company has and the restrictions imposed by that debt could adversely affect the Company’s business and financial condition |
| As of December 31, 2005, the Company had total mortgage debt and secured notes payable outstanding of approximately dlra179dtta3 million, total unsecured notes payable of dlra493dtta3 million, and total draws outstanding on our line of credit of dlra162dtta3 million |
| The Company’s organizational documents does not limit the level or amount of debt that it may incur |
| It is the Company’s current policy to maintain a ratio of total indebtedness to total assets (before accumulated depreciation) of not more than 60 percent |
| However, this policy is subject to reevaluation and modification without the approval of the Company’s security holders |
| If the Company incurs additional indebtedness and permits a higher degree of leverage, debt service requirements would increase accordingly |
| Such an increase could adversely affect the Company’s financial condition and results of operations, as well as the Company’s ability to pay principal and interest on the outstanding indebtedness |
| In addition, increased leverage could increase the risk that the Company may default on its debt obligations |
| The amount of Company debt outstanding at any time could have important consequences to the Company’s stockholders |
| For example, it could: • require the Company to dedicate a substantial portion of its cash flow from operations to payments on Company debt, thereby reducing funds available for operations, real estate investments and other appropriate business opportunities that may arise in the future; • limit the Company’s ability to obtain any additional financing it may need in the future for working capital, debt refinancing, capital expenditures, real estate investments, development or other general corporate purposes; • make it difficult to satisfy the Company’s debt service requirements; • limit the Company’s ability to make distributions on its outstanding common and preferred stock; • require the Company to dedicate increased amounts of cash flow from operations to payments on its variable rate, unhedged debt if interest rates rise; • limit the Company’s flexibility in planning for, or reacting to, changes in its business and the factors that affect the profitability of its business; and • limit the Company’s flexibility in conducting its business, which may place the Company at a disadvantage compared to competitors with less debt or debt with less restrictive terms |
| The Company’s ability to make scheduled payments of principal or interest on, or to refinance its debt will depend primarily on its future performance, which to a certain extent is subject to the creditworthiness of its tenants, and economic, financial, competitive and other factors beyond its control |
| There can be no assurance that the Company’s business will continue to generate sufficient cash flow from operations in the future to service its debt or meet its other cash needs |
| If the Company is unable to generate this cash flow from its business, it may be required to refinance all or a portion of its existing debt, sell assets or obtain additional financing to meet its debt 12 ______________________________________________________________________ [37]Table of Contents obligations and other cash needs |
| The Company cannot assure you that any such refinancing, sale of assets or additional financing would be possible on terms and conditions, including but not limited to the interest rate, which the Company would find acceptable |
| The Company is obligated to comply with financial and other covenants in its debt that could restrict its operating activities, and the failure to comply could result in defaults that accelerate the payment under its debt |
| The covenants in our unsecured debt include, among others, provisions restricting our ability to: • incur or guarantee additional debt; • make certain distributions, investments and other restricted payments, including distribution payments on its outstanding common and preferred stock; • limit the ability of restricted subsidiaries to make payments to the Company; • enter into transactions with certain affiliates; • create certain liens; and • consolidate, merge or sell the Company’s assets |
| The Company’s secured debt generally contains customary covenants, including, among others, provisions: • relating to the maintenance of the property securing the debt; • restricting its ability to sell, assign or further encumber the properties securing the debt; • restricting its ability to incur additional debt; • restricting its ability to amend or modify existing leases; and • relating to certain prepayment restrictions |
| The Company’s ability to meet some of the covenants in its debt, including covenants related to the condition of the property or payment of real estate taxes, may be dependent on the performance by the Company’s tenants under their leases |
| In addition, certain covenants in the Company’s debt, including its unsecured line of credit, require the Company and its subsidiaries, among other things, to: • maintain certain maximum leverage ratios, and • maintain certain minimum interest and debt service coverage ratios |
| The Company’s failure to qualify as a real estate investment trust for federal income tax purposes could result in significant tax liability |
| The Company intends to operate in a manner that will allow the Company to continue to qualify as a real estate investment trust |
| The Company believes it has been organized as, and its past and present operations qualify the Company as, a real estate investment trust |
| However, the IRS could successfully assert that the Company is not qualified as such |
| In addition, the Company may not remain qualified as a real estate investment trust in the future |
| This is because qualification as a real estate investment trust involves the application of highly technical and complex Internal Revenue Code provisions for which there are only limited judicial or administrative interpretations and involves the determination of various factual matters and circumstances not entirely within the Company’s control |
| If the Company fails to qualify as a real estate investment trust, it would not be allowed a deduction for dividends paid to shareholders in computing taxable income and would become subject to federal income tax at regular corporate rates |
| In this event, the Company could be subject to potentially significant tax liabilities |
| Unless entitled to relief under certain statutory provisions, the Company would also be disqualified from treatment as a real estate investment trust for the four taxable years following the year during which the qualification was lost |