| EQUITY OFFICE PROPERTIES TRUST Item 1A Risk Factors |
| Forward-Looking Statements This Annual Report on Form 10-K includes certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 |
| When used, words such as “anticipate”, “believe”, “intend”, “may be”, “will be” and similar words or phrases, or the negative thereof, unless the context requires otherwise, are intended to identify forward-looking statements |
| These forward-looking statements are based on management’s present expectations and beliefs about future events |
| As with any projection or forecast, these statements are inherently susceptible to uncertainty and changes in circumstances |
| Important factors that could cause actual results to differ materially from those reflected in such forward-looking statements and that should be considered in evaluating our outlook include, but are not limited to, those listed under the caption “Risk Factors” below |
| Equity Office is under no obligation to, and expressly disclaims any obligation to, update or alter its forward-looking statements whether as a result of such changes, new information, subsequent events or otherwise |
| Risk Factors We are subject to various risks, including the ones identified below |
| If the events discussed in these risk factors occur, Equity Office’s business, financial condition, results of operations or cash flows could be materially adversely affected |
| In such case, the market value of our securities could decline |
| Improvements in our market conditions have not yet offset the impact of prior declines in rent and in overall activity in our markets as well as increases in our expenses and other adverse factors During periods of slower economic growth and decline in white-collar employment, such as occurred beginning in 2001, we experience a decrease in occupancy as well as rental rates accompanied by increases in the cost of re-leasing space (including for tenant improvements) and in uncollectible receivables |
| Although we believe office market conditions have, or have begun to, stabilize and are improving in most of the markets in which we have a presence, the financial impact of the on-going roll-down in rents of expiring leases to lower current market rents will continue to impact our financial results negatively until the earlier of the expiration of all leases entered into at the height of the market or full recovery of such markets |
| A significant contributor to the decline in occupancy for our office properties since 2001 has been early lease terminations |
| Early lease termination payments increased in 2005 as compared to 2004 (largely as a result of a single transaction, which did not impact our occupancy as a result of our ability to re-lease the space) |
| While lease termination fees increase current period income, future rental income is generally lower 10 _________________________________________________________________ [62]Table of Contents because, during periods in which market rents have declined, it is unlikely that we will collect from replacement tenants the full contracted amount which had been payable under the terminated leases |
| Moreover, our ability to release the vacated space is not assured and may be affected by macroeconomic factors we do not control |
| An improvement in our operating results related to the recent improvement in the office market fundamentals has been offset by the rent roll down that we continue to experience, increased operating and general and administrative expenses and the dilutive impact of our disposition activities |
| Our financial results were also adversely impacted by losses and impairment charges as a result of assets sold and assets we intend to sell |
| Our long term leases cause our operating results to lag improving market conditions; our geographic diversity may cause our operating results to be less favorable than operating results in the strongest markets Since our average lease term is approximately five to six years, only 10prca to 15prca of our Total Office Portfolio square feet expires and is “re-priced” to current market rates each year |
| This means that when business fundamentals improve in the office business, improvements in our operating results tend to lag such improvements |
| Further, we operate in a large number of office markets |
| All office markets do not recover at the same pace |
| As a result, our operating results may, in the short or medium term, be less favorable than that demonstrated by portfolios which are concentrated in markets that recover more rapidly than the overall market |
| In order to continue to pay distributions to our common shareholders at anticipated levels, we must borrow funds or sell assets Lower occupancy levels, reduced rental rates, and reduced revenues as a result of asset sales, together with certain increases in operating expenses have had the effect of reducing our net cash provided by operating activities |
| In addition, our tenant improvement and leasing costs have increased significantly due to competitive market conditions for new leases |
| During the years ended December 31, 2005 and 2004, our net cash provided by operating activities was insufficient to pay 100prca of distributions to our shareholders and unitholders, in addition to capital investments in our properties such as tenant improvements, leasing costs and capital improvements |
| We funded these deficits primarily with a combination of borrowings under our line of credit and proceeds from property dispositions |
| Although we anticipate that our 2006 annual common share dividend, which is subject to quarterly board approval, will be reduced from dlra2dtta00 per share to dlra1dtta32 per share, these deficits are likely to continue in 2006 (based on expected levels of capital expenditures), though at a diminished level and it is anticipated that we will fund such deficits in a similar manner |
| We were a net seller of real estate in 2005, which will further reduce our income from continuing operations and funds from operations |
| Future disposition activity may also result in gains or losses on sales of real estate and impairment charges We were a net seller of real estate in 2003, a net buyer in 2004 and a net seller of real estate in 2005 |
| We may engage in additional disposition activity in 2006 (not expected to be at the level of 2005) which will further reduce our income from continuing operations and funds from operations and may also result in gains or losses on sales of real estate and impairment charges |
| The impact from such dispositions on our financial condition and results of operations will also depend, to a great extent, on how we utilize the proceeds of such dispositions and the timing of such utilization |
| Whether we are in fact a net seller of real estate in 2006, will depend on various factors, certain of which are beyond our control, including market conditions |
| 11 _________________________________________________________________ [63]Table of Contents Our performance and share value are subject to risks associated with the real estate industry As a REIT, we are susceptible to the risks associated with the real estate industry, including the following: • Downturns in national, regional and local economic conditions and the level of white-collar employment in markets where our properties are located; • Unfavorable capital market conditions which could affect our ability to complete any property dispositions or acquisitions on a timely basis or on economically attractive terms; • Local conditions such as an oversupply of office properties, including space available by sublease, or a reduction in demand for high-rise and other office properties; • The relative attractiveness of our properties to tenants; • The extent of competition from other available office properties; • Changes in market rental rates, particularly as our buildings age, and our ability to fund repair and maintenance costs; • Our ability to fund the increased cost of tenant improvements and other costs required to lease or re-lease space; • Our ability to collect rent and expense reimbursements from tenants; • Our ability to complete and lease current and future developments on schedule and in accordance with budget; and • The cost and availability of adequate insurance (including coverage for catastrophic events such as earthquakes, hurricanes and terrorist acts) |
| • Increases in utility, security and other operating costs, including real estate taxes, that may increase over time as markets stabilize or otherwise be subject to macroeconomic factors, and that are not necessarily reduced when circumstances such as local market factors and competition cause a reduction in income from the property |
| Our properties face significant leasing competition We face significant competition from other owners, operators and developers of office properties |
| All of our properties face competition from similar properties in the same markets |
| Such competition affects our ability to attract and retain tenants, impacts the rents we are able to charge and may increase tenant improvement and leasing costs |
| These competing properties may have vacancy rates higher than our properties, which may result in their owners being willing to make space available at lower rental rates than the space in our properties |
| We face potential adverse effects from tenant bankruptcies or insolvencies The bankruptcy or insolvency of our tenants may adversely affect the income produced by our properties |
| If a tenant defaults, we may experience delays and incur substantial costs in enforcing our rights as landlord |
| If a tenant files for bankruptcy, we cannot evict the tenant solely because of such bankruptcy |
| A court, however, may authorize the tenant to reject and terminate its lease with us |
| In such a case, our claim against the tenant for unpaid future rent would be subject to a statutory cap that might be substantially less than the remaining rent owed under the lease |
| In other circumstances, where a tenant’s financial condition has become impaired, we have sometimes agreed to partially or wholly terminate the lease in advance of the termination date in consideration for a lease termination fee that is less than the agreed rental amount |
| Without regard to the manner in which a lease termination occurs, we are likely to incur additional costs in the form of tenant improvements and leasing commissions in our efforts to lease the space to a new tenant, as well as likely lower rental rates reflective of declines in market rents |
| 12 _________________________________________________________________ [64]Table of Contents New acquisitions may fail to perform as expected Assuming we are able to obtain capital on commercially reasonable terms, we may acquire new office properties |
| Newly acquired properties may fail to perform as expected |
| Inaccurate assumptions regarding future rental or occupancy rates could result in overly optimistic estimates of future revenues |
| Similarly, we may underestimate future operating expenses or the costs necessary to bring an acquired property up to standards established for its intended market position |
| Contingent or unknown liabilities acquired in acquisitions, mergers or similar transactions could require us to make substantial payments The properties we purchase from time to time may be acquired subject to liabilities and without any recourse with respect to liabilities, whether known or unknown |
| As a result, if liabilities were asserted against us based upon any of those properties, we may incur substantial and unexpected costs |
| Unknown liabilities with respect to properties acquired might include: • liabilities for clean-up or remediation of environmental conditions; • claims of tenants, vendors or other persons dealing with the former owners of the properties; • liabilities incurred in the ordinary course of business; and • claims for indemnification by general partners, directors, officers and others indemnified by us in the context of a merger or the former owners of the properties |
| Competition for acquisitions or disposition of properties could adversely affect us We expect other major real estate investors with significant capital to compete with us for attractive investment opportunities |
| These competitors include publicly traded REITs, private REITs, investment banking firms, domestic or non-domestic institutional investors and private institutional investment funds, some of whom may enjoy a lower cost of capital and therefore, a competitive advantage |
| This competition could increase prices for office properties |
| We face similar competition with other property owners in our efforts to dispose of assets, which may result in lower sales prices |
| Any such increase in prices for acquired office properties or decrease in prices for properties to be sold by us could impair our growth prospects or reduce our available capital |
| Furthermore, our ability to redeploy capital arising from our disposition activities into investments in our core markets depends on our ability to effectively compete for attractive investment opportunities |
| Our investment in property development may be more costly than anticipated We intend to continue to develop and redevelop office properties where we believe market conditions warrant |
| Our development and construction activities may include the following risks: • we may incur construction costs for a development project which exceed our original estimates due to increased material, labor or other costs; this, in turn, could make completion of the project uneconomical because we may not be able to increase rents to compensate for the increase in construction costs; • we may be unable to obtain, or face delays in obtaining, required zoning, land-use, building, occupancy, and other governmental permits and authorizations, which could result in increased costs and could require us to abandon our activities entirely with respect to a project; • we may abandon development opportunities after we begin to explore them and as a result we may fail to recover expenses already incurred; • we may expend funds on and devote management time to projects which we do not complete; • we may be unable to complete construction and leasing of a property on schedule, resulting in increased debt service expense and construction or renovation costs; 13 _________________________________________________________________ [65]Table of Contents • we may lease developed properties at below expected rental rates; and • occupancy rates and rents at newly completed properties may fluctuate depending on a number of factors, including market and economic conditions, and may result in our investment not being profitable |
| Because real estate investments are illiquid, we may not be able to sell properties when appropriate Real estate investments generally cannot be sold quickly |
| In addition, there are limitations under the federal income tax laws applicable to REITs and tax protection agreements that we have entered into in connection with the acquisition of a significant percentage of our properties that may limit our ability to sell our assets or require certain tax free transaction structures |
| As a result, we may not be able to liquidate our portfolio promptly in response to economic or other conditions |
| Various factors limit our ability to dispose of assets Our ability to dispose of assets may be limited by constraints on our ability to utilize disposition proceeds to make acquisitions on financially attractive terms and the requirement that we take additional impairment charges on certain assets |
| More specifically, we are required to distribute or pay tax on all capital gains generated from the sale of assets |
| In addition, we have tax protection agreements which require that we reimburse certain of EOP Partnership’s limited partners for taxes incurred in connection with the sale of certain of our properties |
| To accomplish this we must identify attractive re-investment opportunities |
| Recently, while capital market conditions have been favorable for dispositions, investment yields on acquisitions have been less attractive due to the abundant capital inflows into the real estate sector |
| In addition, if we elect to sell a property we may incur an impairment charge to the extent we determine that the sum of the property’s future cash flow plus eventual disposition proceeds is likely to be less than the property’s recorded carrying value |
| These considerations impact our decision of whether or not to market for sale certain of our assets |
| Certain perils could adversely affect our business Significant portions of our properties are located in California and Washington, which are high risk geographical areas for earthquakes |
| Significant portions of our properties are also located in New York, Washington, DC and other major urban areas which could be the target of future terrorist acts |
| In addition, we have properties that are located in coastal counties or in Florida which can be susceptible to wind or flood damage |
| Depending upon its magnitude, an earthquake, hurricane or terrorist act could severely damage one or more of our properties, which would adversely affect our business |
| As described more fully below, we maintain earthquake, terrorism, wind and flood insurance for our properties and the resulting business interruption |
| However, any earthquake, wind, flood or terrorist peril, whether or not insured, could have an adverse effect on our results of operations and financial condition |
| 14 _________________________________________________________________ [66]Table of Contents Some potential losses, including losses arising from earthquakes and terrorist acts, may not be covered by insurance We carry insurance on our properties with respect to specified catastrophic events, as summarized in the table below: Type of Insurance Coverage Equity Office Loss Exposure/Deductible Third-Party Coverage Limitation Property damage and business interruption(a) dlra50 million per occurrence and dlra75 million annual aggregate exposure (which includes amounts paid for earthquake loss), plus dlra1 million per occurrence deductible dlra1dtta0 billion per occurrence(c) Earthquake(a)(b) dlra75 million per occurrence and annual aggregate exposure (which includes amounts paid for property damage and business interruption loss), plus dlra1 million per occurrence deductible dlra325 million in the aggregate per year(c) Acts of terrorism(d) dlra4dtta9 million per occurrence deductible (plus 10prca of the remainder of each and every loss with a maximum per occurrence exposure of dlra37dtta4 million which includes the dlra4dtta9 million deductible); however, TRIEA provides that if the aggregate industry loss as a result of any such foreign terrorism occurrence is less than dlra50 million (dlra100 million in 2007), we are responsible for 100prca of such loss |
| Our intent is to insure such amounts in excess of dlra50 million in 2007 |
| In the event of a loss in excess of the per occurrence or annual aggregate amount, the third-party insurance carriers would be obligated to cover the losses up to the stated coverage amounts in the table above |
| (b) The amount of the third party insurance relating to earthquakes is based on maximum probable loss studies performed by independent third parties |
| The maximum annual aggregate payment amount for earthquake loss is dlra325 million, inclusive of our loss exposure of dlra75 million plus dlra1 million per occurrence deductible |
| There can be no assurance that the actual losses suffered in the event of an earthquake would not exceed the amount of such insurance coverage |
| (d) This coverage includes nuclear, chemical and biological events under the Terrorism Risk Insurance Act of 2002 (“TRIA”) |
| This coverage does not apply to non-TRIA events (which are terrorism events that are not committed by a foreigner or a foreign country) |
| We maintain separate insurance with a dlra325 million annual aggregate limit subject to a deductible of dlra1 million for non-TRIA events |
| This separate coverage for non-TRIA events excludes nuclear, biological and chemical events |
| TRIA established the Terrorism Risk Insurance Program (“TRIP”) to mandate that insurance carriers offer insurance covering physical damage from terrorist incidents certified by the US government as foreign terrorist acts |
| Under TRIP, the federal government shares in the risk of loss associated with 15 _________________________________________________________________ [67]Table of Contents certain future terrorist acts |
| TRIA was extended for two years under the Terrorism Risk Insurance Extension Act (“TRIEA”), which established new requirements and expires on December 31, 2007 |
| TRIEA created a new program trigger for any certified act of terrorism occurring after March 31, 2006 that prohibits payment of federal compensation unless the aggregate industry insured losses resulting from that act of terrorism exceed dlra50 million for 2006 and dlra100 million for 2007 |
| The trigger for federal reimbursement through March 31, 2006 is dlra5 million, rather than dlra50 million |
| The full interim guidelines established by the US Treasury Department explaining these and other new requirements are available at www |
| There can be no assurance that TRIEA will be further extended |
| Should such legislation not be extended, the premiums and scope of coverages for this program could be adversely affected |
| (e) This amount is in excess of our deductible amounts |
| Should an uninsured loss or a loss in excess of insured limits occur, we could lose all or a portion of the capital we have invested in a property, as well as the anticipated future revenue from the property |
| Nevertheless, we might remain obligated for any mortgage debt or other financial obligations related to the property |
| It is also possible that third-party insurance carriers will not be able to maintain reinsurance sufficient to cover any losses that may be incurred |
| In addition, if any of our properties were to experience a catastrophic loss that was insured, it could still seriously disrupt our operations, delay revenue and result in large expenses to repair or rebuild the property |
| Also, due to inflation, changes in codes and ordinances, environmental considerations and other factors, it may not be feasible to use insurance proceeds to replace a building after it has been damaged or destroyed |
| As a further matter, we also have to renew our policies every year (and in some cases every three years) and negotiate acceptable terms for coverage, exposing us to the volatility of the insurance markets, including the possibility of rate increases or decrease in available coverage |
| Increases in taxes and regulatory compliance costs, including compliance with the Americans with Disabilities Act, may reduce our net income Our properties are subject to increases in real estate taxes |
| Since we generally are not able to pass all real estate tax increases through to our tenants, we may incur significant increases in our operating expenses |
| Our properties are also subject to various federal, state and local regulatory requirements, such as state and local fire and life safety requirements including those mandated by the US Environmental Protection Agency and the US Occupational Safety and Health Administration |
| The EPA and OSHA are increasingly involved in indoor air quality standards, especially with respect to asbestos, mold and medical waste |
| Some trade associations, such as the Building Owners and Managers Association and the National Fire Protection Association, publish standards that are adopted by government authorities |
| These include standards relating to life, safety and fire protection systems published by the NFPA Failure to comply with these requirements could result in the imposition of fines by governmental authorities or awards of damages to private litigants |
| In addition, we cannot provide any assurance that these requirements will not be changed or that new requirements will not be imposed that would require significant unanticipated expenditures by us and could have an adverse effect on our results of operations |
| Under the Americans with Disabilities Act of 1990 and various state and local laws, all public accommodations and commercial facilities must meet certain federal requirements related to access and use by disabled persons |
| Compliance with these requirements could involve removal of structural barriers from certain disabled persons’ entrances |
| Other federal, state and local laws may require modifications to or restrict further renovations of our properties with respect to such means of access |
| Although we believe that our properties are substantially in compliance with present requirements, noncompliance with the ADA or related laws or regulations could result in the imposition of fines by government authorities or in the award to private litigants of damages against us |
| Costs such as these, as well as the general costs of compliance with these laws or regulations, may also adversely affect our results of operations |
| 16 _________________________________________________________________ [68]Table of Contents Environmental problems are possible and can be costly Federal, state and local laws and regulations relating to the protection of the environment may require a current or previous owner or operator of real estate to investigate and clean up hazardous or toxic substances or petroleum product releases at that property or at impacted neighboring properties |
| If unidentified environmental problems arise, we may have to make substantial payments |
| These adverse effects could arise because: • the owner or operator may have to pay a governmental entity or third parties for property damage and for investigation and clean-up costs incurred by these parties in connection with the contamination; • environmental laws typically impose clean-up responsibility and liability without regard to whether the owner or operator knew about or caused the presence of the contaminants; • even if more than one person may have been responsible for the contamination, each person covered by the environmental laws may be held responsible for all of the clean-up costs incurred; and • third parties, such as neighboring property owners, may sue the owner or operator of a site for damages and costs resulting from environmental contamination emanating or migrating from that site |
| Environmental laws also govern the presence, maintenance and removal of asbestos |
| These laws require that owners or operators of buildings containing asbestos: • properly manage and maintain the asbestos; • notify and/or train those who may come into contact with asbestos, such as tenants, visitors and employees; and • undertake special precautions, including removal or other abatement, if asbestos would be disturbed during renovation or demolition of a building |
| These laws may impose fines and penalties on building owners or operators who fail to comply with these requirements |
| Moreover, third parties may seek recovery from owners or operators for personal injuries associated with exposure to asbestos fibers |
| As a result, our properties may be subject to material environmental liabilities |
| In addition, no assurances can be given that (a) future laws, ordinances or regulations will not impose any material environmental liability, (b) the current environmental condition of our properties has not been, or will not be affected by tenants and occupants of our properties, by the condition of other properties in the vicinity of our properties, or by third parties unrelated to us or (c) our limited insurance that we maintain with respect to environmental matters will cover all possible losses |
| We may not control the decisions of joint ventures or partnerships in which we have an interest From time to time we invest in joint ventures or partnerships in which we do not hold a controlling interest |
| These investments involve risks that are not present with assets in which we own a controlling interest, including: • the possibility that our co-venturers or partners might at any time have economic or other business interests or goals that are inconsistent with our business interests or goals; • the possibility that our co-venturers or partners may be in a position to take action contrary to our instructions or requests or contrary to our policies or objectives (including actions that may be inconsistent with our REIT status); • the possibility that our co-venturers or partners may have different objectives from us regarding the appropriate timing and pricing of any sale or refinancing of properties; and • the possibility that our co-venturers or partners might become bankrupt or insolvent |
| Even when we have a controlling interest, certain major decisions may require partner approval |
| 17 _________________________________________________________________ [69]Table of Contents We also have joint venture and partnership agreements that contain buy-sell clauses that could require us to buy or sell our interest at a time we do not deem favorable for financial or other reasons, including the availability of cash at such time and the impact of tax consequences resulting from any sale |
| There is no limitation under our organizational documents as to the amount of available funds that we may invest in joint ventures or partnerships |
| Scheduled debt payments could adversely affect us, including as a result of refinancing risk and foreclosure risk Our business is subject to risks normally associated with debt financing |
| If principal payments due at maturity cannot be refinanced, extended or paid with proceeds of other capital transactions, such as new equity or debt capital, our cash flow may not be sufficient in all years to repay all maturing debt |
| If prevailing interest rates or other factors at the time of refinancing, such as the possible reluctance of lenders to make commercial real estate loans or if our debt is no longer rated investment grade by the rating agencies, result in higher interest rates, it would adversely affect our ability to service our debt and make distributions to our securityholders and our results of operations and financial condition may suffer |
| In addition, if we are unable to refinance our indebtedness on acceptable terms, or at all, events or conditions that may adversely affect our results of operations or financial condition would also include the following: • we may need to dispose of one or more of our properties upon disadvantageous terms; • if we mortgage property to secure payment of indebtedness and are unable to meet mortgage payments, the mortgagee could foreclose upon such property or appoint a receiver to receive an assignment of our rents and leases; and • foreclosures upon mortgaged property could create taxable income without accompanying cash proceeds and, therefore, hinder our ability to meet the REIT distribution requirements of the Internal Revenue Code |
| Neither the limited partnership agreement of EOP Partnership nor our governing documents limit the amount or the percentage of indebtedness that we may incur |
| Accordingly, we may incur substantial additional amounts of secured and unsecured debt, increasing the related risks arising from our indebtedness |
| We are obligated to comply with financial covenants in our debt agreements that could restrict our range of operating activities The mortgages on our properties contain customary negative covenants, including limitations on our ability, without the prior consent of the lender, to further mortgage the property, to enter into new leases outside of stipulated guidelines or to materially modify existing leases |
| In addition, our credit facilities contain customary requirements, including the requirement that we limit indebtedness to no more than a given percentage of the total asset value as defined |
| Other restrictions include limitations on the amount of secured debt to total assets, a minimum fixed charge coverage ratio and a maximum unsecured debt to unencumbered assets ratio |
| The indentures under which our senior unsecured debt have been issued contain financial and operating covenants, including coverage ratios and limitations on the borrower’s ability to incur secured and unsecured debt |
| These covenants reduce our flexibility in conducting our operations and create a risk of default on our debt if we cannot continue to satisfy them |
| Further, if we were to breach certain of our debt covenants, our lenders could require us to repay the debt immediately, and, if the debt is secured, could take possession of the property securing the loan |
| If any other lender declared its loan due and payable as a result of a default, the holders of our senior unsecured debt, along with the lenders under our credit facility, might be able to require that those debts be paid immediately |
| As a result, any default under our debt covenants under any indebtedness could create a risk of default on other material components of our debt |
| 18 _________________________________________________________________ [70]Table of Contents Our leverage could limit our ability to obtain additional financing and have other adverse effects Our debt to market capitalization ratio, which we calculate as total debt as a percentage of total debt plus the liquidation value of our preferred shares and the market value of our outstanding common shares and the outstanding units of EOP Partnership owned by third parties, was 48dtta9prca as of December 31, 2005, compared to 48dtta4prca as of December 31, 2004 |
| Our leverage could have important consequences to our securityholders, including affecting our ability to obtain additional financing in the future for working capital, capital improvements, acquisitions, development or other general corporate purposes (including distributions to security holders) and making us more vulnerable to a downturn in business or the economy generally |
| In addition, as a result of the financial and operating covenants described above, our leverage could reduce our flexibility in conducting our business and planning for, or reacting to, changes in our business and in the real estate industry |
| The indentures pursuant to which EOP Partnership has issued a substantial portion of our unsecured debt contain various covenants which restrict our ability to increase leverage |
| Among other things, this may limit our ability to utilize leverage to increase the compounded annual rate of growth of our per share funds from operations |
| Rising interest rates or a downgrade in credit ratings could adversely affect our cash flow Advances under certain of our credit facilities bear interest at a variable rate |
| We also, from time to time, enter into interest rate swap agreements effectively converting fixed-rate debt into variable rate debt |
| Although we may enter into hedging agreements to limit our exposure to rising interest rates as we determine to be appropriate and cost effective, increases in interest rates, or the loss of the benefits of hedging agreements, would increase our interest expense |
| Moody’s, Standard & Poor’s and Fitch provide credit ratings on our unsecured notes and preferred stock |
| In July 2004, Moody’s downgraded our credit ratings from Baa1 to Baa2 with a stable outlook |
| In December 2005, Standard & Poor’s and Fitch downgraded our credit ratings from BBB+ to BBB As a result of these downgrades, the interest rate on our term loan facility increased 10 basis points to LIBOR plus 55 basis points and the interest rate on our revolving credit facility increased 12dtta5 basis points to LIBOR plus 60 basis points plus a facility fee of 20 basis points |
| In addition, the interest rate associated with any future financings may be impacted or we may not be able to borrow more funds if our credit ratings decline |
| A security rating is not a recommendation to buy, sell or hold securities and is subject to revision or withdrawal at any time by the assigning rating organization |
| Each rating should be evaluated independently of any other rating |
| Further downgrades in our credit rating, or the loss of an investment grade rating, could have a material adverse impact on our cost of new financing and our ability to borrow funds |
| Our hedging arrangements involve risks As noted above, we may use interest rate hedging agreements to manage our exposure to interest rate volatility |
| However, these arrangements may expose us to additional risks |
| Although our interest rate risk management policy establishes minimum credit ratings for counterparties, this does not eliminate the risk that a counterparty may fail to honor its obligations |
| Developing an effective interest rate risk strategy is complex and no strategy can completely insulate us from risks associated with interest rate fluctuations |
| In addition, hedging agreements may involve costs, such as transaction fees or breakage costs, if we terminate them |
| Any failure by us to effectively manage our exposure to interest rate risk through hedging agreements or otherwise, and any costs associated with hedging arrangements, could adversely affect our results of operations or financial condition |
| In order to maintain our REIT status, we may need to borrow funds on a short-term basis during unfavorable market conditions In order to maintain our REIT status, we may need to borrow funds on a short-term basis to meet the REIT distribution requirements, even if the then prevailing market conditions are not favorable for these 19 _________________________________________________________________ [71]Table of Contents borrowings |
| To qualify as a REIT, we generally must distribute to our shareholders at least 90prca of our taxable net income each year, excluding capital gains |
| In addition, we will be subject to a 4prca nondeductible excise tax on the amount, if any, by which dividends paid by us in any calendar year are less than the sum of 85prca of our ordinary income, 95prca of our capital gain net income and 100prca of our undistributed income from prior years |
| We may need short-term debt to fund required distributions as a result of differences in timing between the actual receipt of income and the recognition of income for federal income tax purposes, or the effect of non-deductible capital improvements, the creation of reserves or required debt or amortization payments |
| Provisions of Maryland law and our declaration of trust and bylaws could inhibit changes in control Maryland law and our declaration of trust and bylaws contain a number of provisions that may have the effect of discouraging transactions that involve an actual or threatened change in control |
| As a result, holders of our securities may not receive premiums or other increases in value of our securities that may be associated with any such actual or threatened change in control |
| These provisions include: • Removal of trustees — Under our declaration of trust, subject to the rights of one or more classes or series of preferred shares to elect one or more trustees, a trustee may be removed at any time, but only with cause, at a meeting of the shareholders by the affirmative vote of the holders of not less than a majority of the shares then outstanding and entitled to vote generally in the election of trustees |
| • Unsolicited takeover provisions of Maryland law — Maryland law provides protection for Maryland REITs against unsolicited takeovers by protecting the board of trustees with regard to actions taken in a takeover context |
| Maryland law provides that the duties of trustees will not require them to (a) accept, recommend or respond to any proposal by a person seeking to acquire control, (b) authorize the REIT to redeem any rights under, modify or render inapplicable a shareholder rights plan, (c) make a determination under the Maryland Business Combination Act or the Maryland Control Share Acquisition Act, or (d) act or fail to act solely because of the effect the act or failure to act may have on an acquisition or potential acquisition of control or the amount or type of consideration that may be offered or paid to shareholders in an acquisition |
| Maryland law also establishes a presumption that an act of a trustee satisfies the required standard of care |
| In addition, an act of a trustee relating to or affecting an acquisition or a potential acquisition of control is not subject under Maryland law to a higher duty or greater scrutiny than is applied to any other act of a trustee |
| Maryland law also provides that the duty of a trustee is only enforceable by the REIT or in the right of the REIT A shareholder suit to enforce the duty of a trustee, therefore, can only be brought by or in the right of Equity Office |
| • Call of special meetings of shareholders — Our bylaws provide that special meetings of shareholders may be called only by the chairman of the board, the president, one-third of the trustees or by the holders of shares entitled to cast not less than a majority of all the votes entitled to be cast at the meeting |
| This provision limits the ability of shareholders to call special meetings |
| • Advance notice provisions for shareholder nominations and shareholder new business proposals — Our bylaws require advance written notice for shareholders to nominate a trustee or bring other business before a meeting of shareholders |
| This provision limits the ability of shareholders to make nominations for trustees or introduce other proposals that are not timely received for consideration at a meeting |
| • Board authority to issue preferred shares without shareholder approval — Our board of trustees is authorized to issue preferred shares having a preference as to dividends or liquidation over the common shares without shareholder approval |
| The issuance of preferred shares could adversely affect the voting power of the holders of our common shares and could be used to discourage, delay or prevent a change in control of Equity Office |
| • Two-thirds shareholder vote required to approve many amendments to our declaration of trust — Under Maryland law and our declaration of trust, the trustees, by a two-thirds vote, may at any time amend the declaration of trust solely to enable Equity Office to qualify as a REIT under the Internal Revenue Code or as a real estate investment trust under Maryland law, without action by Equity Office 20 _________________________________________________________________ [72]Table of Contents shareholders |
| Our board of trustees also may amend the declaration of trust to set the terms of one or more series of preferred shares without action by holders of Equity Office common shares |
| Other amendments to the declaration of trust must first be declared advisable by our board of trustees and thereafter must be approved by shareholders by the affirmative vote of not less than two-thirds of all votes entitled to be cast, or, in the case of amendments to the declaration of trust in connection with mergers and other specified business combinations or that involve an increase or decrease in the number of authorized common shares or preferred shares, not less than a majority of all votes entitled to be cast |
| The two-thirds shareholder vote requirement for many amendments to our declaration of trust may make amendments to our declaration of trust that shareholders believe desirable more difficult to effect |
| • Exclusive authority of board to amend bylaws, except for specified amendments — Our bylaws provide that the power to amend, repeal or adopt new bylaws is vested exclusively with the board of trustees, except that any amendments by the board of trustees to the bylaw provisions relating to meetings of shareholders, the size of the board, and the requirement that at least two-thirds of the trustees must be persons who are not executive officers of Equity Office or persons affiliated with Mr |
| Zell or his affiliates are subject to the approval of shareholders by vote of a majority of the votes cast |
| These provisions may make more difficult bylaw amendments that shareholders may believe are desirable |
| • Business combination with interested shareholders — The Maryland Business Combination Act provides that, unless exempted, a Maryland REIT may not engage in business combinations, including mergers, dispositions of 10prca or more of its assets, issuances of shares and other specified transactions, with an “interested shareholder” or its affiliates, for five years after the most recent date on which the interested shareholder became an interested shareholder and thereafter unless specified criteria are met |
| Our board of trustees has elected by resolution to exempt from the provisions of the Maryland Business Combination Act any business combination with any person |
| Our board of trustees may, however, repeal this election in whole or in part at any time and cause us to become subject to these provisions in the future, except with respect to a securityholder who became an interested shareholder in connection with our formation in July 1997 |
| • Other constituencies — Maryland law expressly codifies the authority of a Maryland REIT to include in its charter a provision that allows the board of trustees to consider the effect of a potential acquisition of control on shareholders, employees, suppliers, customers, creditors and communities in which offices or other establishments of the trust are located |
| Our declaration of trust does not include a provision of this type |
| Maryland law also provides, however, that the inclusion or omission of this type of provision in the declaration of trust of a Maryland REIT does not create an inference concerning factors that may be considered by the board of trustees regarding a potential acquisition of control |
| This law may allow the board of trustees to reject an acquisition proposal even though the proposal was in the best interests of our shareholders |
| We have share ownership limits for REIT tax purposes Primarily to facilitate maintenance of our REIT qualification, our declaration of trust generally prohibits ownership by any single shareholder of more than 9dtta9prca, in value or number of shares, whichever is more restrictive, of any class or series of our outstanding shares |
| This is referred to as the “ownership limit |
| ” The federal tax laws include complex stock ownership and attribution rules that apply in determining whether a shareholder exceeds the ownership limit |
| These rules may cause a shareholder to be treated as owning the shares that are actually owned by others, including family members and entities in which a shareholder has an ownership interest |
| Our declaration of trust permits, and in some cases requires, the board of trustees to waive or modify the ownership limit, if the board of trustees is satisfied that the waiver or modification will not jeopardize our REIT qualification |
| In addition, our declaration of trust allows the board of trustees to modify the ownership limits applicable to series of preferred shares issued in business combination transactions |
| Absent a modification or waiver, shares acquired or held in violation of the ownership limit will be transferred to a trust for the exclusive benefit of a designated charitable beneficiary, and the shareholder’s rights to distributions and to vote would terminate |
| Also, the ownership limit could delay or prevent a change in control 21 _________________________________________________________________ [73]Table of Contents that is opposed by the board of trustees and, therefore, could adversely affect our securityholders’ ability to realize a premium over the then-prevailing market price for their securities |
| Our declaration of trust also includes an additional ownership limit designed to help us remain qualified as a “domestically controlled REIT” for federal income tax purposes |
| This ownership limit prevents any person from acquiring our shares if the acquisition by that person would cause 43prca or more of the fair market value of our issued and outstanding shares to be owned, directly or indirectly, by non-US persons |
| The ownership limit does not apply to any acquisition of our preferred shares that were outstanding as of June 19, 2000, or to common shares issued upon conversion of any of these preferred shares |
| We are dependent on key personnel We depend on the efforts of Samuel Zell, our chairman of the board, and our executive officers, particularly Richard D Kincaid, our president and chief executive officer |
| If they were to resign or were unable to serve, our operations could be adversely affected |
| We do not have employment agreements with Mr |
| Zell or any of our executive officers, including Mr |
| Changes in market conditions could adversely affect the market value of our securities As with other publicly traded equity securities, the market value of our securities depends on various market conditions which may change from time to time |
| Among the market conditions that may affect the market value of our securities are the following: • the extent of investor interest in us; • the general reputation of REITs and the attractiveness of our equity securities (including anticipated levels of distribution) in comparison to other equity securities, including securities issued by other real estate-based companies; • our financial performance, credit rating and the perceived attractiveness of our portfolio of assets; and • general stock and bond market conditions |
| We believe the market value of our common shares is based primarily upon the market’s perception of our growth potential and our current and potential future earnings and cash available for distribution |
| Consequently, our common shares may trade at prices that are higher or lower than our net asset value per common share |
| If our future earnings or cash available for distribution is less than expected, it is likely that the market price of our securities will diminish |
| Market interest rates may have an effect on the value of our debt and equity securities One of the factors that investors consider important in deciding whether to buy or sell preferred shares or debt securities of a REIT is the distribution rate on the REIT’s shares or the coupon on its debt securities, considered as a percentage of the price of those shares or debt securities, relative to market interest rates |
| If market interest rates increase, prospective purchasers of REIT shares or debt securities may expect a higher distribution rate or coupon |
| Higher market interest rates would not, however, result in more funds for us to distribute or use to make debt payments |
| To the contrary, higher market interest rates would likely increase our borrowing costs and potentially decrease our funds available for distribution or debt service |
| Thus, higher market interest rates could cause the market value of our preferred equity and debt securities to go down |
| Higher market interest rates could also cause the market value of our common equity to go down |
| The number of shares available for future sale could adversely affect the market value of our securities As part of our initial public offering in 1997 and since then we have completed transactions where units of limited partnership interest in EOP Operating Limited Partnership (“EOP Partnership”) were issued to owners of properties we acquired |
| Common shares issuable in exchange for such interests in EOP Partnership may be sold in the public securities markets over time pursuant to registration rights we granted to these 22 _________________________________________________________________ [74]Table of Contents investors |
| Additional common shares including those reserved under our employee benefit and other incentive plans, including share options, may also be sold in the market at some time in the future |
| Future sales of our common shares in the market, whether in the form of primary or secondary offerings could adversely affect the price of our common shares |
| We cannot predict the effect which the perception in the market that such sales may occur will have on the market value of our common shares |
| We are dependent on external sources of capital for future growth To qualify as a REIT, we must distribute to our shareholders each year at least 90prca of our net taxable income, excluding any net capital gain |
| Because of this distribution requirement, it is not likely that we will be able to fund all future capital needs, including for acquisitions and developments, from income from operations |
| Therefore, we will have to rely on third-party sources of capital, which may or may not be available on favorable terms or at all |
| Our access to third-party sources of capital depends on a number of things, including the market’s perception of our growth potential and our current and potential future earnings |
| To the extent we seek to meet our capital needs through additional equity offerings, that may result in substantial dilution of our shareholders’ interests, and additional debt financing may substantially increase our leverage |
| If we fail to qualify as a REIT, our shareholders would be adversely affected We believe that we have qualified for taxation as a REIT for federal income tax purposes since 1997 |
| We currently plan to continue to meet the requirements for taxation as a REIT but we cannot assure shareholders that we will qualify as a REIT As a REIT, we are subject to various restrictions and requirements, including restrictions and requirements on our income, assets and activities |
| Many of these REIT requirements are highly technical and complex |
| The determination that we are a REIT requires an analysis of various factual matters and circumstances, some of which may not be totally within our control, including, in limited circumstances, factual matters and circumstances relating to some corporations that were operating as REITs at the time we acquired them or actions taken by our joint venture partners |
| For example, to qualify as a REIT, at least 95prca of our gross income must come from sources that are itemized in the REIT tax laws and we are prohibited from owning specified amounts of debt or equity securities of some issuers |
| The fact that we hold our assets through EOP Partnership and its subsidiaries and our ongoing reliance on factual determinations, such as determinations related to the valuation of our assets, further complicate the application of the REIT requirements for us |
| Even a technical or inadvertent mistake could jeopardize our REIT status |
| Furthermore, Congress and the Internal Revenue Service might make changes to the tax laws and regulations, and the courts might issue new rulings that make it more difficult, or impossible, for us to remain qualified as a REIT If we fail to qualify as a REIT for federal income tax purposes, we would be subject to federal and state income tax at regular corporate rates |
| As a regular, non-REIT corporation, we would not be allowed to take a deduction for distributions to shareholders in computing our taxable income |
| Also, unless the Internal Revenue Service were to grant us relief under statutory provisions, we would remain disqualified as a REIT for the four years following the year we first failed to qualify |
| If we failed to qualify as a REIT, we would have to pay significant income taxes, which would reduce our net earnings available for investment or distribution to our shareholders |
| This would likely have a significant adverse effect on the value of our securities |
| In addition, we would no longer be required to make any distributions to shareholders |
| We pay some taxes Even if we qualify as a REIT for federal income tax purposes, we are required to pay some federal, state and local taxes on our income and property |
| For example, we will be subject to income tax to the extent we distribute less than 100prca of our REIT taxable income |
| We also may have to pay some state or local income taxes because not all states and localities treat REITs the same as they are treated for federal income tax purposes |
| Several corporate subsidiaries of Equity Office have elected to be treated as “taxable REIT subsidiaries” of Equity Office for federal income tax purposes since January 1, 2001 |
| A taxable REIT subsidiary is a fully taxable corporation and is limited in its ability to deduct interest payments in excess of a certain amount made to Equity Office |
| In addition, we will be subject to a 100prca penalty tax on some payments 23 _________________________________________________________________ [75]Table of Contents that we receive if the economic arrangements among our tenants, our taxable REIT subsidiaries and us are not comparable to similar arrangements among unrelated parties |
| To the extent that Equity Office or any taxable REIT subsidiary is required to pay federal, state or local taxes, we will have less cash available for distribution to shareholders |
| We may be subject to adverse legislative or regulatory tax changes that could reduce the market price of our common shares At any time, the federal income tax laws or regulations governing REITs or the administrative interpretations of those laws or regulations may be amended |
| Any of those new laws or interpretations may take effect retroactively and could adversely affect us or our shareholders |
| The rules dealing with federal income taxation are constantly under review by persons involved with the legislative process and by the IRS and the Treasury Department, resulting in statutory changes as well as promulgation of new, or revisions to existing, regulations and revised interpretations of established concepts |
| No prediction can be made as to the likelihood of passage of any new tax legislation or other provisions either directly or indirectly affecting us or our shareholders or the value of our common shares |
| Tax Consequences The material US federal income tax consequences relating to the taxation of Equity Office as a REIT and the ownership and disposition of Equity Office common shares are described in our Form 8-K dated March 9, 2006 |