FORM 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-K

 


 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2005

 

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 1-13087

 

BOSTON PROPERTIES, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   04-2473675

(State or other jurisdiction

of incorporation or organization)

 

(I.R.S. Employer

Identification Number)

111 Huntington Avenue, Suite 300    
Boston, Massachusetts   02199
(Address of principal executive offices)   (Zip Code)

 

Registrant’s telephone number, including area code: (617) 236-3300

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class


   Name of exchange on which registered

Common Stock, par value $.01 per share

   New York Stock Exchange

Preferred Stock Purchase Rights

    

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No  ¨

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  x                    Accelerated filer  ¨                    Non-accelerated filer  ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x

 

As of June 30, 2005, the aggregate market value of the 107,447,151 shares of common stock held by non-affiliates of the Registrant was $7,521,300,570 based upon the last reported sale price of $70.00 per share on the New York Stock Exchange on June 30, 2005. (For this computation, the Registrant has excluded the market value of all shares of Common Stock reported as beneficially owned by executive officers and directors of the Registrant; such exclusion shall not be deemed to constitute an admission that any such person is an affiliate of the Registrant.)

 

As of March 1, 2006, there were 112,628,988 shares of Common Stock outstanding.

 

Certain information contained in the Registrant’s Proxy Statement relating to its Annual Meeting of Stockholders to be held May 3, 2006 is incorporated by reference in Items 10, 11, 12, 13 and 14 of Part III. The Registrant intends to file such Proxy Statement with the Securities and Exchange Commission not later than 120 days after the end of its fiscal year ended December 31, 2005.

 



Table of Contents

TABLE OF CONTENTS

 

ITEM NO.


  

DESCRIPTION


   PAGE NO.

PART I

    

1.

  

BUSINESS

   1

1A.

  

RISK FACTORS

   12

1B.

  

UNRESOLVED STAFF COMMENTS

   26

2.

  

PROPERTIES

   26

3.

  

LEGAL PROCEEDINGS

   31

4.

  

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

   31

PART II

    

5.

  

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

   31

6.

  

SELECTED FINANCIAL DATA

   32

7.

  

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

   34

7A.

  

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

   76

8.

  

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

   77

9.

  

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

   124

9A.

  

CONTROLS AND PROCEDURES

   124

9B.

  

OTHER INFORMATION

   124

PART III

    

10.

  

DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

   125

11.

  

EXECUTIVE COMPENSATION

   125

12.

  

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

   125

13.

  

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   126

14.

  

PRINCIPAL ACCOUNTING FEES AND SERVICES

   126

PART IV

    

15.

  

EXHIBITS, FINANCIAL STATEMENT SCHEDULES

   127


Table of Contents

PART I

 

Item 1. Business

 

General

 

As used herein, the terms “we,” “us,” “our” and the “Company” refer to Boston Properties, Inc., a Delaware corporation organized in 1997, individually or together with its subsidiaries, including Boston Properties Limited Partnership, a Delaware limited partnership, and our predecessors. We are a fully integrated self-administered and self-managed real estate investment trust, or “REIT,” and one of the largest owners and developers of office properties in the United States. Our properties are concentrated in five markets—Boston, Washington, D.C., midtown Manhattan, San Francisco and Princeton, N.J. We conduct substantially all of our business through our subsidiary, Boston Properties Limited Partnership. At December 31, 2005, we owned or had interests in 121 properties, totaling approximately 42.0 million net rentable square feet and structured parking for vehicles containing approximately 9.3 million square feet. Our properties consisted of:

 

    117 office properties comprised of 100 Class A office properties (including three properties under construction) and 17 Office/Technical properties;

 

    two hotels; and

 

    two retail properties.

 

We own or control undeveloped land totaling approximately 527.1 acres, which will support approximately 9.2 million square feet of development. In addition, we have a 25% interest in the Boston Properties Office Value-Added Fund, L.P., which we refer to as the “Value-Added Fund,” which is a strategic partnership with two institutional investors through which we intend to pursue the acquisition of assets within our existing markets that have deficiencies in property characteristics which provide an opportunity to create value through repositioning, refurbishment or renovation. Our investments through the Value-Added Fund are not included in our portfolio information tables or any other portfolio level statistics.

 

We consider Class A office properties to be centrally-located buildings that are professionally managed and maintained, attract high-quality tenants and command upper-tier rental rates, and that are modern structures or have been modernized to compete with newer buildings. The Company considers Office/Technical properties to be properties that support office, research and development and other technical uses. Our definitions of Class A office and Office/Technical properties may be different than those used by other companies.

 

We are a full-service real estate company, with substantial in-house expertise and resources in acquisitions, development, financing, capital markets, construction management, property management, marketing, leasing, accounting, tax and legal services. As of December 31, 2005, we had approximately 673 employees. Our thirty-four senior officers have an average of twenty-three years experience in the real estate industry and an average of fifteen years of experience with us. Our principal executive office is located at 111 Huntington Avenue, Boston, Massachusetts 02199 and our telephone number is (617) 236-3300. In addition, we have regional offices at 901 New York Avenue, NW, Washington, D.C. 20004; 599 Lexington Avenue, New York, New York 10022; Four Embarcadero Center, San Francisco, California 94111; and 302 Carnegie Center, Princeton, New Jersey 08540.

 

Our Web site is located at http://www.bostonproperties.com. On our Web site, you can obtain a copy of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission, or the SEC. The name “Boston Properties” and our logo (consisting of a stylized “b”) are registered service marks of the Company.

 

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Boston Properties Limited Partnership

 

Boston Properties Limited Partnership, or BPLP, is a Delaware limited partnership, and the entity through which we conduct substantially all of our business and own, either directly or through subsidiaries, substantially all of our assets. We are the sole general partner and, as of March 1, 2006, the owner of approximately 80.92% of the economic interests in BPLP. Economic interest was calculated as the number of common partnership units of BPLP owned by the Company as a percentage of the sum of (1) the actual aggregate number of outstanding common partnership units of BPLP, (2) the number of common partnership units issuable upon conversion of outstanding preferred partnership units of BPLP and (3) the number of common units issuable upon conversion of all outstanding long term incentive plan units of BPLP, or LTIP units, assuming all conditions have been met for the conversion of the LTIP units. An LTIP Unit is generally the economic equivalent of a share of our restricted common stock. Our general and limited partnership interests in BPLP entitle us to share in cash distributions from, and in the profits and losses of, BPLP in proportion to our percentage interest and entitle us to vote on all matters requiring a vote of the limited partners. Certain other partners of BPLP are persons who contributed their direct or indirect interests in properties to BPLP in exchange for common units or preferred units of limited partnership interest in BPLP. Under the limited partnership agreement of BPLP, unitholders may present their common units of BPLP for redemption at any time (subject to restrictions agreed upon at the time of issuance of the units that may restrict such right for a period of time, generally one year from issuance). Upon presentation of a unit for redemption, BPLP must redeem the unit for cash equal to the then value of a share of our common stock. In lieu of cash redemption by BPLP, however, we may elect to acquire any common units so tendered by issuing shares of our common stock in exchange for the common units. If we so elect, our common stock will be exchanged for common units on a one-for-one basis. This one-for-one exchange ratio is subject to specified adjustments to prevent dilution. We generally expect that we will elect to issue our common stock in connection with each such presentation for redemption rather than having BPLP pay cash. With each such exchange or redemption, our percentage ownership in BPLP will increase. In addition, whenever we issue shares of our common stock other than to acquire common units of Boston Properties Limited Partnership, we must contribute any net proceeds we receive to BPLP and BPLP must issue to us an equivalent number of common units of BPLP. This structure is commonly referred to as an umbrella partnership REIT, or “UPREIT.”

 

Preferred units of BPLP have the rights, preferences and other privileges, including the right to convert into common units of BPLP, as are set forth in an amendment to the limited partnership agreement of BPLP. As of December 31, 2005 and March 1, 2006, BPLP had one series of its preferred units outstanding. The Series Two preferred units have an aggregate liquidation preference of approximately $185.1 million. The Series Two preferred units are convertible, at the holder’s election, into common units at a conversion price of $38.10 per common unit (equivalent to a ratio of 1.312336 common units per Series Two preferred unit). Distributions on the Series Two preferred units are payable quarterly and, unless the greater rate described in the next sentence applies, accrue at 7.0% until May 12, 2009 and 6.0% thereafter. If distributions on the number of common units into which the Series Two preferred units are convertible are greater than distributions calculated using the rates described in the preceding sentence for the applicable quarterly period, then the greater distributions are payable instead. Since May 2005, distributions have been made at the greater rate determined on the basis of distributions paid on the common units into which the Series Two preferred units are convertible. The terms of the Series Two preferred units provide that they may be redeemed for cash in six annual tranches, beginning on May 12, 2009, at our election or at the election of the holders. We also have the right to convert into common units of BPLP any Series Two preferred units that are not redeemed when they are eligible for redemption.

 

Transactions During 2005

 

Real Estate Acquisitions/Dispositions

 

On December 30, 2005, we acquired Prospect Place, a Class A office property totaling approximately 297,000 net rentable square feet located in Waltham, Massachusetts, at a purchase price of approximately $62.8 million financed with available cash.

 

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On December 20, 2005, our Value-Added Fund acquired 300 Billerica Road, a 111,000 net rentable square foot office property located in Chelmsford, Massachusetts, at a purchase price of approximately $10.0 million. The acquisition was financed with new mortgage indebtedness totaling $7.5 million and approximately $2.5 million in cash, of which our share was approximately $0.6 million.

 

On December 14, 2005, we sold Embarcadero Center West Tower, a Class A office property totaling approximately 475,000 net rentable square feet located in San Francisco, California, at a gross sale price of approximately $205.8 million. Net cash proceeds totaled $195.2 million after customary closing costs, transaction-related expenses and unfunded tenant obligations totaling approximately $10.6 million, resulting in a gain on sale of approximately $48.4 million (net of minority interest share of approximately $9.8 million). The transaction-related expenses consisted of approximately $6.6 million of tax reimbursement and gross-up obligations due to the contributors of the property pursuant to the related tax protection agreement.

 

On November 7, 2005, we sold 40-46 Harvard Street, an industrial property totaling approximately 152,000 net rentable square feet located in Westwood, Massachusetts, at a sale price of approximately $7.8 million, resulting in a gain on sale of approximately $5.9 million (net of minority interest share of approximately $1.1 million).

 

On November 4, 2005, we sold the Residence Inn by Marriott®, a 221-room extended-stay hotel property located in Cambridge, Massachusetts, at a gross sale price of approximately $68.0 million, less customary closing costs and a credit of approximately $3.0 million representing the property controlled furniture, fixtures and equipment escrow set aside for planned property upgrades, resulting in a gain on sale of approximately $33.4 million (net of minority interest share of approximately $6.5 million).

 

On May 16, 2005, we sold Riverfront Plaza, a Class A office property totaling approximately 910,000 net rentable square feet located in Richmond, Virginia, for approximately $247.1 million. Net proceeds totaled approximately $129.9 million after the repayment of mortgage indebtedness of $104.0 million, a prepayment penalty of approximately $4.3 million and unfunded tenant obligations and other closing costs totaling $8.9 million, resulting in a gain on sale of approximately $57.0 million (net of minority interest share of approximately $11.5 million).

 

On May 12, 2005, we sold 100 East Pratt Street, a Class A office property totaling approximately 639,000 net rentable square feet located in Baltimore, Maryland, for approximately $207.5 million. Net cash proceeds totaled approximately $92.8 million after the repayment of mortgage indebtedness of $84.0 million, a prepayment penalty of approximately $6.5 million and unfunded tenant obligations and other closing costs totaling $24.2 million, resulting in a gain on sale of approximately $45.3 million (net of minority interest share of approximately $9.1 million).

 

On April 20, 2005, we sold the Old Federal Reserve, a Class A office property totaling approximately 150,000 net rentable square feet located in San Francisco, California, at a sale price of approximately $46.8 million. Net cash proceeds totaled approximately $45.9 million, resulting in a gain on sale of approximately $8.4 million (net of minority interest share of approximately $1.7 million).

 

On February 28, 2005, we sold Decoverly Four and Five, consisting of two undeveloped land parcels located in Rockville, Maryland for net cash proceeds of approximately $5.3 million, resulting in a gain on sale of approximately $1.2 million (net of minority interest share of approximately $0.2 million).

 

On February 23, 2005, we sold a parcel of land at the Prudential Center located in Boston, Massachusetts for a net sale price of approximately $31.5 million and an additional obligation of the buyer to fund an estimated $18.6 million of future costs at the Prudential Center (of which approximately $18.5 million has been received as of December 31, 2005) for aggregate proceeds of $50.1 million. Due to the structure of the transaction and certain continuing involvement provisions related to the development of the property, this transaction did not

 

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qualify as a sale for financial reporting purposes and was accounted for as a financing transaction in fiscal 2005. In January 2006 the continuing involvement provisions were satisfied and the transaction qualified as a sale for financial reporting purposes.

 

Developments

 

On January 1, 2005, we placed in-service 901 New York Avenue, a 539,000 net rentable square foot Class A office property located in Washington, D.C., in which we have a 25% ownership interest. This property required a total investment during 2005 of approximately $3.9 million which was funded through construction loan draws. Our total investment, including equity and debt, through December 31, 2005 in 901 New York Avenue was approximately $44.0 million.

 

On October 1, 2005, we placed in-service the West Garage phase of our Seven Cambridge Center development project located in Cambridge, Massachusetts. This garage will provide parking for approximately 800 cars. As of December 31, 2005 our total investment in the West Garage was approximately $16.6 million with an estimated total investment of $18.9 million.

 

As of December 31, 2005 we had five active construction projects underway, which aggregate an estimated total investment of $317.6 million. Our Seven Cambridge Center and Parcel E (12290 Sunrise Valley) are fully leased to Massachusetts Institute of Technology and Lockheed Martin Corporation, respectively. On September 26, 2005, we commenced construction on 505 9th Street in Washington, D.C., a joint venture project in which we have a 50% interest. The project consists of a build-to-suit Class A office property totaling approximately 323,000 net rentable square feet, of which 230,000 net rentable square feet have been pre-leased to a law firm for a 15-year term. The estimated total investment for our properties under construction as of December 31, 2005 is detailed below:

 

Properties Under Construction


  

Estimated

Stabilization Date


   Location

  

Estimated Total

Investment


Seven Cambridge Center Office

   First Quarter, 2006    Cambridge, MA    $ 106,156

Parcel E (12290 Sunrise Valley)

   Second Quarter, 2006    Reston, VA      45,754

Capital Gallery Expansion

   Third Quarter, 2007    Washington, D.C.      69,100

Wisconsin Place- Infrastructure (23.89% ownership)

   N/A    Chevy Chase, MD      31,626

505 9th Street (50% ownership)

   Fourth Quarter, 2008    Washington, D.C.      65,000
              

Total Properties Under Construction

             $ 317,636
              

 

On January 17, 2006, we placed-in-service our Seven Cambridge Center development project located in Cambridge, Massachusetts.

 

Equity Transactions

 

During the year ended December 31, 2005, holders of Series Two preferred units of BPLP converted 381,000 Series Two preferred units into 500,000 common units of limited partnership interest. The common units of limited partnership interest were subsequently presented by the holders for redemption and were acquired by us in exchange for an equal number of shares of common stock. In addition, during the year ended December 31, 2005, we acquired an aggregate of 424,976 common units of limited partnership interest, presented by the holders for redemption, in exchange for an equal number of shares of common stock and an aggregate of 25,000 common units of limited partnership interest presented by the holder for cash. During the year ended December 31, 2005, we issued 1,270,436 shares of common stock as a result of stock options being exercised.

 

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Special Dividend

 

On July 21, 2005, our Board of Directors declared a special cash dividend of $2.50 per common share which was paid on October 31, 2005 to shareholders of record as of the close of business on September 30, 2005. The special cash dividend was in addition to the regular quarterly dividend of $0.68 per common share that was paid on October 31, 2005. The holders of common partnership units of BPLP received the same amount, at the same time. Holders of Series Two preferred units of limited partnership interest participated in the special cash dividend on an as-converted basis in connection with their regular February 2006 distribution payment as provided in BPLP’s partnership agreement.

 

Business and Growth Strategies

 

Business Strategy

 

Our primary business objective is to maximize return on investment so as to provide our investors with the greatest possible total return. Our strategy to achieve this objective is:

 

    to concentrate on a few carefully selected geographic markets, including Boston, Washington D.C., midtown Manhattan, San Francisco and Princeton, N.J., and to be one of the leading, if not the leading, owners and developers in each of those markets. We select markets and submarkets where tenants have demonstrated a preference for high-quality office buildings and other facilities;

 

    to emphasize markets and submarkets within those markets where the lack of available sites and the difficulty of receiving the necessary approvals for development and the necessary financing constitute high barriers to the creation of new supply, and where skill, financial strength and diligence are required to successfully develop, finance and manage high-quality office, research and development space as well as selected retail space;

 

    to take on complex, technically challenging projects, leveraging the skills of our management team to successfully develop, acquire or reposition properties which other organizations may not have the capacity or resources to pursue;

 

    to concentrate on high-quality real estate designed to meet the demands of today’s tenants who require sophisticated telecommunications and related infrastructure and support services, and to manage those facilities so as to become the landlord of choice for both existing and prospective clients;

 

    to opportunistically acquire assets which increase our penetration in the markets in which we have chosen to concentrate and which exhibit an opportunity to improve or preserve returns through repositioning (through a combination of capital improvements and shift in marketing strategy), changes in management focus and re-leasing as existing leases terminate;

 

    to explore joint venture opportunities primarily with existing owners of land parcels located in desirable locations, who seek to benefit from the depth of development and management expertise we are able to provide and our access to capital, and/or to explore joint venture opportunities with strategic institutional partners, leveraging our skills as owners, operators and developers of Class A office space;

 

    to pursue on a selective basis the sale of properties, including core properties, to take advantage of our value creation and the demand for our premier properties (see “Part II, Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview” beginning on page 36);

 

    to seek third-party development contracts, which benefits us when our internal development is less active or when new development is less-warranted due to market conditions, which can be a significant source of revenue and enables us to retain and utilize our existing development and construction management staff; and

 

    to enhance our capital structure through our access to a variety of sources of capital.

 

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Growth Strategies

 

External Growth

 

We believe that our development experience and our organizational depth position us to continue to selectively develop a range of property types, including single-story suburban office properties, high-rise urban developments, mixed-use developments and research and laboratory space, within budget and on schedule. Other factors that contribute to our competitive position include:

 

    our control of sites (including sites under contract or option to acquire) in our markets that will support approximately 9.2 million square feet of new office, hotel and residential development;

 

    our reputation gained through 36 years of successful operations and the stability and strength of our existing portfolio of properties;

 

    our relationships with leading national corporations and public institutions seeking new facilities and development services;

 

    our relationships with nationally recognized financial institutions that provide capital to the real estate industry;

 

    our track record and reputation for executing acquisitions efficiently provides comfort to domestic and foreign institutions, private investors and corporations who seek to sell commercial real estate in our market areas;

 

    our ability to act quickly on due diligence and financing; and

 

    our relationships with institutional buyers and sellers of high-quality real estate assets.

 

Opportunities to execute our external growth strategy fall into three categories:

 

    Development in selected submarkets. As market conditions continue to improve, we believe that development of well-positioned office buildings will be justified in many of our submarkets. We believe in acquiring land after taking into consideration timing factors relating to economic cycles and in response to market conditions that allow for its development at the appropriate time. While we purposely concentrate in markets with high barriers-to-entry, we have demonstrated throughout our 36-year history, an ability to make carefully timed land acquisitions in submarkets where we can become one of the market leaders in establishing rent and other business terms. We believe that there are opportunities at key locations in our existing and other markets for a well-capitalized developer to acquire land with development potential.

 

In the past, we have been particularly successful at acquiring sites or options to purchase sites that need governmental approvals for development. Because of our development expertise, knowledge of the governmental approval process and reputation for quality development with local government regulatory bodies, we generally have been able to secure the permits necessary to allow development and to profit from the resulting increase in land value. We seek complex projects where we can add value through the efforts of our experienced and skilled management team leading to attractive returns on investment.

 

Our strong regional relationships and recognized development expertise have enabled us to capitalize on unique build-to-suit opportunities. We intend to seek and expect to continue to be presented with such opportunities in the near term allowing us to earn relatively significant returns on these development opportunities through multiple business cycles.

 

   

Acquisition of assets and portfolios of assets from institutions or individuals. We believe that due to our size, management strength and reputation, we are well positioned to acquire portfolios of assets or individual properties from institutions or individuals if valuations meet our criteria. We may acquire properties for cash, but we are also particularly well-positioned to appeal to sellers wishing to convert on a tax-deferred basis their ownership of property into equity in a diversified real estate operating

 

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company that offers liquidity through access to the public equity markets in addition to a quarterly distribution. Our ability to offer common and preferred units of limited partnership in BPLP to sellers who would otherwise recognize a taxable gain upon a sale of assets for cash or our common stock may facilitate this type of transaction on a tax-efficient basis. In addition, we may consider mergers with and acquisitions of compatible real estate firms.

 

    Acquisition of underperforming assets and portfolios of assets. We believe that because of our in-depth market knowledge and development experience in each of our markets, our national reputation with brokers, financial institutions and others involved in the real estate market and our access to competitively-priced capital, we are well-positioned to identify and acquire existing, underperforming properties for competitive prices and to add significant additional value to such properties through our effective marketing strategies and a responsive property management program. We have developed this strategy and program for our existing portfolio, where we provide high-quality property management services using our own employees in order to encourage tenants to renew, expand and relocate in our properties. We are able to achieve speed and transaction cost efficiency in replacing departing tenants through the use of in-house and third-party vendors’ services for marketing, including calls and presentations to prospective tenants, print advertisements, lease negotiation and construction of tenant improvements. Our tenants benefit from cost efficiencies produced by our experienced work force, which is attentive to preventive maintenance and energy management.

 

Internal Growth

 

We believe that significant opportunities will exist in the long term to increase cash flow from our existing properties because they are of high quality and in desirable locations. In addition, our properties are in markets where, in general, the creation of new supply is limited by the lack of available sites, the difficulty of receiving the necessary approvals for development on vacant land and the difficulty of obtaining financing. Our strategy for maximizing the benefits from these opportunities is two-fold: (1) to provide high-quality property management services using our employees in order to encourage tenants to renew, expand and relocate in our properties, and (2) to achieve speed and transaction cost efficiency in replacing departing tenants through the use of in-house services for marketing, lease negotiation and construction of tenant improvements. We believe that with the continued improvement of the economy, our office properties will add to our internal growth because of their desirable locations. In addition, we believe that with the continued improvement in the business and leisure travel sector, our two hotel properties will continue to add to our internal growth because of their desirable locations in the downtown Boston and East Cambridge submarkets. We expect to continue our internal growth as a result of our ability to:

 

    Cultivate existing submarkets and long-term relationships with credit tenants. In choosing locations for our properties, we have paid particular attention to transportation and commuting patterns, physical environment, adjacency to established business centers, proximity to sources of business growth and other local factors.

 

We had an average lease term of 7.3 years at December 31, 2005 and continue to cultivate long-term leasing relationships with a diverse base of high quality, financially stable tenants. Based on leases in place at December 31, 2005, leases with respect to 4.5% of the total square feet from our Class A office properties will expire in calendar year 2006.

 

    Directly manage properties to maximize the potential for tenant retention. We provide property management services ourselves, rather than contracting for this service, to maintain awareness of and responsiveness to tenant needs. We and our properties also benefit from cost efficiencies produced by an experienced work force attentive to preventive maintenance and energy management and from our continuing programs to assure that our property management personnel at all levels remain aware of their important role in tenant relations.

 

   

Replace tenants quickly at best available market terms and lowest possible transaction costs. We believe that we are well-positioned to attract new tenants and achieve relatively high rental rates as a

 

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result of our well-located, well-designed and well-maintained properties, our reputation for high-quality building services and responsiveness to tenants, and our ability to offer expansion and relocation alternatives within our submarkets.

 

    Extend terms of existing leases to existing tenants prior to expiration. We have also successfully structured early tenant renewals, which have reduced the cost associated with lease downtime while securing the tenancy of our highest quality credit-worthy tenants on a long-term basis and enhancing relationships.

 

Policies with Respect to Certain Activities

 

The discussion below sets forth certain additional information regarding our investment, financing and other policies. These policies have been determined by our Board of Directors and, in general, may be amended or revised from time to time by our Board of Directors.

 

Investment Policies

 

Investments in Real Estate or Interests in Real Estate

 

Our investment objectives are to provide quarterly cash dividends to our securityholders and to achieve long-term capital appreciation through increases in the value of Boston Properties, Inc. We have not established a specific policy regarding the relative priority of these investment objectives.

 

We expect to continue to pursue our investment objectives primarily through the ownership of our current properties, development projects and other acquired properties. We currently intend to continue to invest primarily in developments of properties and acquisitions of existing improved properties or properties in need of redevelopment, and acquisitions of land that we believe have development potential, primarily in our markets—Boston, Washington, D.C., midtown Manhattan, San Francisco and Princeton, N.J. Future investment or development activities will not be limited to a specified percentage of our assets. We intend to engage in such future investment or development activities in a manner that is consistent with the maintenance of our status as a REIT for federal income tax purposes. In addition, we may purchase or lease income-producing commercial and other types of properties for long-term investment, expand and improve the real estate presently owned or other properties purchased, or sell such real estate properties, in whole or in part, when circumstances warrant. We do not have a policy that restricts the amount or percentage of assets that will be invested in any specific property, however, our investments may be restricted by our debt covenants.

 

We may also continue to participate with third parties in property ownership, through joint ventures or other types of co-ownership. These investments may permit us to own interests in larger assets without unduly restricting diversification and, therefore, add flexibility in structuring our portfolio.

 

Equity investments may be subject to existing mortgage financing and other indebtedness or such financing or indebtedness as may be incurred in connection with acquiring or refinancing these investments. Debt service on such financing or indebtedness will have a priority over any distributions with respect to our common stock. Investments are also subject to our policy not to be treated as an investment company under the Investment Company Act of 1940, as amended (the “1940 Act”).

 

Investments in Real Estate Mortgages

 

While our current portfolio consists of, and our business objectives emphasize, equity investments in commercial real estate, we may, at the discretion of the Board of Directors, invest in mortgages and other types of real estate interests consistent with our qualification as a REIT. Investments in real estate mortgages run the risk that one or more borrowers may default under such mortgages and that the collateral securing such mortgages may not be sufficient to enable us to recoup its full investment. We do not presently intend to invest in

 

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mortgages or deeds of trust, but may invest in participating or convertible mortgages if we conclude that we may benefit from the cash flow or any appreciation in value of the property.

 

Securities of or Interests in Persons Primarily Engaged in Real Estate Activities

 

Subject to the percentage of ownership limitations and gross income tests necessary for our REIT qualification, we also may invest in securities of other REITs, other entities engaged in real estate activities or securities of other issuers, including for the purpose of exercising control over such entities.

 

Dispositions

 

Our disposition of properties is based upon the periodic review of our portfolio and the determination by the Board of Directors that such action would be in our best interests. Any decision to dispose of a property will be authorized by the Board of Directors or a committee thereof. Some holders of limited partnership interests in BPLP, including Messrs. Mortimer B. Zuckerman, Edward H. Linde and other executive officers, would incur adverse tax consequences upon the sale of certain of our properties that differ from the tax consequences to us. Consequently, holders of limited partnership interests in BPLP may have different objectives regarding the appropriate pricing and timing of any such sale. Such different tax treatment derives in most cases from the fact that we acquired these properties in exchange for partnership interests in contribution transactions structured to allow the prior owners to defer taxable gain. Generally this deferral continues so long as we do not dispose of the properties in a taxable transaction. Unless a sale by us of these properties is structured as a like-kind exchange or in a manner that otherwise allows deferral to continue, recognition of the deferred tax gain allocable to these prior owners is generally triggered by the sale. Certain assets are subject to tax protection agreements, which may limit our ability to dispose of the assets or require us to pay damages to the prior owners in the event of a taxable sale.

 

Financing Policies

 

The agreement of limited partnership of BPLP and our certificate of incorporation and bylaws do not limit the amount or percentage of indebtedness that we may incur. We do not have a policy limiting the amount of indebtedness that we may incur. However, our mortgages, credit facilities and unsecured debt securities contain customary restrictions, requirements and other limitations on our ability to incur indebtedness. We have not established any limit on the number or amount of mortgages that may be placed on any single property or on our portfolio as a whole.

 

Our Board of Directors will consider a number of factors when evaluating our level of indebtedness and when making decisions regarding the incurrence of indebtedness, including the purchase price of properties to be acquired with debt financing, the estimated market value of our properties upon refinancing, the entering into agreements such as interest rate swaps, caps, floors and other interest rate hedging contracts and the ability of particular properties and BPLP as a whole to generate cash flow to cover expected debt service.

 

Policies with Respect to Other Activities

 

As the sole general partner of BPLP, we have the authority to issue additional common and preferred units of limited partnership interest of BPLP. We have in the past, and may in the future, issue common or preferred units of limited partnership interest of BPLP to persons who contribute their direct or indirect interests in properties to us in exchange for such common or preferred units of limited partnership interest in BPLP. We have not engaged in trading, underwriting or agency distribution or sale of securities of issuers other than BPLP and we do not intend to do so. At all times, we intend to make investments in such a manner as to maintain our qualification as a REIT, unless because of circumstances or changes in the Internal Revenue Code of 1986, as amended (or the Treasury Regulations), our Board of Directors determines that it is no longer in our best interest to qualify as a REIT. We may make loans to third parties, including, without limitation, to joint ventures in which we participate. We intend to make investments in such a way that we will not be treated as an investment

 

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company under the 1940 Act. Our policies with respect to these and other activities may be reviewed and modified or amended from time to time by the Board of Directors.

 

Competition

 

We compete in the leasing of office space with a considerable number of other real estate companies, some of which may have greater marketing and financial resources than are available to us. In addition, our hotel properties compete for guests with other hotels, some of which may have greater marketing and financial resources than are available to us and to the manager of our hotels, Marriott® International, Inc.

 

Principal factors of competition in our primary business of owning, acquiring and developing office properties are the quality of properties, leasing terms (including rent and other charges and allowances for tenant improvements), attractiveness and convenience of location, the quality and breadth of tenant services provided, and reputation as an owner and operator of quality office properties in the relevant market. Additionally, our ability to compete depends upon, among other factors, trends of the national and local economies, investment alternatives, financial condition and operating results of current and prospective tenants, availability and cost of capital, construction and renovation costs, taxes, utilities, governmental regulations, legislation and population trends.

 

The Hotel Properties

 

On November 4, 2005, we sold our Residence Inn by Marriott® at Six Cambridge Center, leaving us with two hotel properties. We operate our two hotel properties through a taxable REIT subsidiary (“TRS”). The TRS, a wholly-owned subsidiary of BPLP, is the lessee pursuant to leases for each of the hotel properties. As lessor, BPLP is entitled to a percentage of gross receipts from the hotel properties. The hotel leases allow all the economic benefits of ownership to flow to us. Marriott® International, Inc. continues to manage the hotel properties under the Marriott® name and under terms of the existing management agreements. Marriott has been engaged under separate long-term incentive management agreements to operate and manage each of the hotels on behalf of the TRS. In connection with these arrangements, Marriott has agreed to operate and maintain the hotels in accordance with its system-wide standard for comparable hotels and to provide the hotels with the benefits of its central reservation system and other chain-wide programs and services. Under a separate management agreement for each hotel, Marriott acts as the TRS’ agent to supervise, direct and control the management and operation of the hotel and receives as compensation base management fees that are calculated as a percentage of the hotel’s gross revenues, and supplemental incentive fees if the hotel exceeds negotiated profitability breakpoints. In addition, the TRS compensates Marriott, on the basis of a formula applied to the hotel’s gross revenues, for certain system-wide services provided by Marriott, including central reservations, marketing and training. During 2005, 2004 and 2003, Marriott received an aggregate of approximately $4.2 million, $4.0 million and $3.4 million, respectively, under the management agreements.

 

Seasonality

 

Our hotel properties traditionally have experienced significant seasonality in their operating income, with the percentage of net operating income by quarter over the year ended December 31, 2005 shown below. Information for the Residence Inn by Marriott® has been excluded due to the sale of this property on November 4, 2005.

 

First Quarter


 

Second Quarter


 

Third Quarter


 

Fourth Quarter


7%   29%   30%   34%

 

Corporate Governance

 

Boston Properties is currently managed by a ten member Board of Directors, which is divided into three classes (Class I, Class II and Class III). Our Board of Directors is currently composed of three Class I directors

 

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(Mortimer B. Zuckerman, Carol B. Einiger and Richard E. Salomon), four Class II directors (Lawrence S. Bacow, Zoë Baird, Alan J. Patricof and Martin Turchin) and three Class III directors (William M. Daley, Edward H. Linde and David A. Twardock). The members of each class of our Board of Directors serve for staggered three-year terms, and the terms of our current Class I, Class II and Class III directors expire upon the election and qualification of directors at the annual meetings of stockholders held in 2007, 2008 and 2006, respectively. At each annual meeting of stockholders, directors will be elected or re-elected for a full term of three years to succeed those directors whose terms are expiring.

 

Our Board of Directors has Audit, Compensation and Nominating and Corporate Governance Committees. The membership of each of these committees is described below.

 

Name of Director


   Audit

    Compensation

   

Nominating

and

Corporate

Governance


 

Lawrence S. Bacow

   X     X        

Zoë Baird

               X  

William M. Daley

               X *

Carol B. Einiger

   X              

Alan J. Patricof

   X *            

Richard E. Salomon

         X *      

David A. Twardock

         X     X  

X=Committee member, *=Chair

 

    Our Board of Directors has adopted charters for each of its Audit, Compensation and Nominating and Corporate Governance Committees. Each committee is comprised of three (3) independent directors. A copy of each of these charters is available on our website at http://www.bostonproperties.com under the heading “Corporate Governance” and subheading “Committees and Charters.” A copy of each of these charters is also available in print to any stockholder upon written request addressed to Investor Relations, Boston Properties, Inc., 111 Huntington Avenue, Boston, MA 02199.

 

    Our Board of Directors has adopted Corporate Governance Guidelines, a copy of which is available on our website at http://www.bostonproperties.com under the heading “Corporate Governance” and subheading “Governance Guidelines.” A copy of these guidelines is also available in print to any stockholder upon written request addressed to Investor Relations, Boston Properties, Inc., 111 Huntington Avenue, Boston, MA 02199.

 

    Our Board of Directors has adopted a Code of Business Conduct and Ethics, which governs business decisions made and actions taken by our directors, officers and employees. A copy of this code is available on our website at http://www.bostonproperties.com under the heading “Corporate Governance” and subheading “Code of Conduct and Ethics.” We intend to disclose on this website any amendment to, or waiver of, any provision of this Code applicable to our directors and executive officers that would otherwise be required to be disclosed under the rules of the SEC or the New York Stock Exchange. A copy of this Code is also available in print to any stockholder upon written request addressed to Investor Relations, Boston Properties, Inc., 111 Huntington Avenue, Boston, MA 02199.

 

    Our Board of Directors has established an ethics reporting system that employees may use to anonymously report possible violations of the Code of Business Conduct and Ethics, including concerns regarding questionable accounting, internal accounting controls or auditing matters, by telephone or over the internet.

 

    On May 26, 2005, Edward H. Linde, President and Chief Executive Officer of the Company, submitted to the New York Stock Exchange (the “NYSE”) the Annual Written Affirmation required by Section 303A of the Corporate Governance Rules of the NYSE certifying that he was not aware of any violation by the Company of NYSE corporate governance listing standards.

 

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Item 1A. Risk Factors.

 

Set forth below are the risks that we believe are material to our investors. We refer to the shares of our common stock and the units of limited partnership interest in BPLP together as our “securities,” and the investors who own shares or units, or both, as our “securityholders.” This section contains forward-looking statements. You should refer to the explanation of the qualifications and limitations on forward-looking statements beginning on page 34.

 

Our performance and value are subject to risks associated with our real estate assets and with the real estate industry.

 

Our economic performance and the value of our real estate assets, and consequently the value of our securities, are subject to the risk that if our office and hotel properties do not generate revenues sufficient to meet our operating expenses, including debt service and capital expenditures, our cash flow and ability to pay distributions to our securityholders will be adversely affected. The following factors, among others, may adversely affect the income generated by our office and hotel properties:

 

    downturns in the national, regional and local economic conditions (particularly increases in unemployment);

 

    competition from other office, hotel and commercial buildings;

 

    local real estate market conditions, such as oversupply or reduction in demand for office, hotel or other commercial space;

 

    changes in interest rates and availability of attractive financing;

 

    vacancies, changes in market rental rates and the need to periodically repair, renovate and re-let space;

 

    increased operating costs, including insurance expense, utilities, real estate taxes, state and local taxes and heightened security costs;

 

    civil disturbances, earthquakes and other natural disasters, or terrorist acts or acts of war which may result in uninsured or underinsured losses;

 

    significant expenditures associated with each investment, such as debt service payments, real estate taxes, insurance and maintenance costs which are generally not reduced when circumstances cause a reduction in revenues from a property;

 

    declines in the financial condition of our tenants and our ability to collect rents from our tenants; and

 

    decreases in the underlying value of our real estate.

 

We are dependent upon the economic climates of our markets—Boston, Washington, D.C., midtown Manhattan, San Francisco and Princeton, N.J.

 

Our revenue is derived from properties located in five markets: Boston, Washington, D.C., midtown Manhattan, San Francisco and Princeton, N.J. A downturn in the economies of these markets, or the impact that a downturn in the overall national economy may have upon these economies, could result in reduced demand for office space. Because our portfolio consists primarily of office buildings (as compared to a more diversified real estate portfolio), a decrease in demand for office space in turn could adversely affect our results of operations. Additionally, there are submarkets within our core markets that are dependent upon a limited number of industries. For example, in our Washington, D.C. market we are primarily dependent on leasing office properties to governmental agencies and contractors, as well as legal firms. In our midtown Manhattan market we have historically leased properties to financial, legal and other professional firms. A significant downturn in one or more of these sectors could adversely affect our results of operations.

 

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Our investment in property development may be more costly than anticipated.

 

We intend to continue to develop and substantially renovate office properties. Our current and future development and construction activities may be exposed to the following risks:

 

    we may be unable to proceed with the development of properties because we cannot obtain financing on favorable terms or at all;

 

    we may incur construction costs for a development project which exceed our original estimates due to increases in interest rates and increased materials, labor, leasing or other costs, which could make completion of the project less profitable because market rents may not increase sufficiently 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 lose deposits or fail to recover expenses already incurred;

 

    we may expend funds on and devote management’s time to projects which we do not complete; and

 

    we may be unable to complete construction and/or leasing of a property on schedule.

 

Investment returns from our developed properties may be lower than anticipated.

 

Our developed properties may be exposed to the following risks:

 

    we may lease developed properties at rental rates that are less than the rates projected at the time we decide to undertake the development; and

 

    occupancy rates and rents at newly developed properties may fluctuate depending on a number of factors, including market and economic conditions, and may result in our investments being less profitable than we expected or not profitable at all.

 

Our use of joint ventures may limit our flexibility with jointly owned investments.

 

In appropriate circumstances, we intend to develop and acquire properties in joint ventures with other persons or entities when circumstances warrant the use of these structures. We currently have seven joint ventures that are not consolidated with our financial statements. Our share of the aggregate revenue of these joint ventures represented approximately 3% of our total revenue (the sum of our total consolidated revenue and our share of such joint venture revenue) for the year ended December 31, 2005. Our participation in joint ventures is subject to the risks that:

 

    we could become engaged in a dispute with any of our joint venture partners that might affect our ability to develop or operate a property;

 

    our joint venture partners may have different objectives than we have regarding the appropriate timing and terms of any sale or refinancing of properties; and

 

    our joint venture partners may have competing interests in our markets that could create conflict of interest issues.

 

In addition, our ability to enter into other joint ventures with third parties to pursue the acquisition of value-added investments similar to those being pursued by the Value-Added Fund is limited by the terms of the Value-Added Fund’s partnership agreement.

 

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We face risks associated with property acquisitions.

 

We have acquired in the past and intend to continue to pursue the acquisition of properties and portfolios of properties, including large portfolios that could increase our size and result in alterations to our capital structure. Our acquisition activities and their success are subject to the following risks:

 

    even if we enter into an acquisition agreement for a property, we may be unable to complete that acquisition after making a non-refundable deposit and incurring certain other acquisition-related costs;

 

    we may be unable to obtain financing for acquisitions on favorable terms or at all;

 

    acquired properties may fail to perform as expected;

 

    the actual costs of repositioning or redeveloping acquired properties may be greater than our estimates;

 

    the acquisition agreement will likely contain conditions to closing, including completion of due diligence investigations to our satisfaction or other conditions that are not within our control, which may not be satisfied;

 

    acquired properties may be located in new markets where we may face risks associated with a lack of market knowledge or understanding of the local economy, lack of business relationships in the area and unfamiliarity with local governmental and permitting procedures; and

 

    we may be unable to quickly and efficiently integrate new acquisitions, particularly acquisitions of portfolios of properties, into our existing operations, and this could have an adverse effect on our results of operations and financial condition.

 

We have acquired in the past and in the future may acquire properties or portfolios of properties through tax deferred contribution transactions in exchange for partnership interests in BPLP. This acquisition structure has the effect, among others, of reducing the amount of tax depreciation we can deduct over the tax life of the acquired properties, and typically requires that we agree to protect the contributors’ ability to defer recognition of taxable gain through restrictions on our ability to dispose of the acquired properties and/or the allocation of partnership debt to the contributors to maintain their tax bases. These restrictions on dispositions could limit our ability to sell an asset at a time, or on terms, that would be favorable absent such restrictions.

 

Acquired properties may expose us to unknown liability.

 

We may acquire properties subject to liabilities and without any recourse, or with only limited recourse against the prior owners or other third parties, with respect to unknown liabilities. As a result, if a liability were asserted against us based upon ownership of those properties, we might have to pay substantial sums to settle or contest it, which could adversely affect our results of operations and cash flow. Unknown liabilities with respect to acquired properties might include:

 

    liabilities for clean-up of undisclosed environmental contamination;

 

    claims by tenants, vendors or other persons against 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 the former owners of the properties.

 

Competition for acquisitions may result in increased prices for properties.

 

We plan to continue to acquire properties as we are presented with attractive opportunities. We may face competition for acquisition opportunities with other investors, particularly private investors who can incur more leverage, and this competition may adversely affect us by subjecting us to the following risks:

 

    we may be unable to acquire a desired property because of competition from other well-capitalized real estate investors, including publicly traded and private REITs, institutional investment funds and other real estate investors; and

 

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    even if we are able to acquire a desired property, competition from other real estate investors may significantly increase the purchase price.

 

We face potential difficulties or delays renewing leases or re-leasing space.

 

We derive most of our income from rent received from our tenants. If a tenant experiences a downturn in its business or other types of financial distress, it may be unable to make timely rental payments. Also, when our tenants decide not to renew their leases or terminate early, we may not be able to re-let the space. Even if tenants decide to renew or lease new space, the terms of renewals or new leases, including the cost of required renovations or concessions to tenants, may be less favorable to us than current lease terms. As a result, our cash flow could decrease and our ability to make distributions to our securityholders could be adversely affected.

 

We face potential adverse effects from major tenants’ bankruptcies or insolvencies.

 

The bankruptcy or insolvency of a major tenant may adversely affect the income produced by our properties. Our tenants could file for bankruptcy protection or become insolvent in the future. We cannot evict a tenant solely because of its bankruptcy. On the other hand, a bankrupt tenant may reject and terminate its lease with us. In such case, our claim against the bankrupt tenant for unpaid and future rent would be subject to a statutory cap that might be substantially less than the remaining rent actually owed under the lease, and, even so, our claim for unpaid rent would likely not be paid in full. This shortfall could adversely affect our cash flow and results of operations.

 

We may have difficulty selling our properties, which may limit our flexibility.

 

Large and high-quality office and hotel properties like the ones that we own could be difficult to sell. This may limit our ability to change our portfolio promptly in response to changes in economic or other conditions. In addition, federal tax laws limit our ability to sell properties and this may affect our ability to sell properties without adversely affecting returns to our securityholders. These restrictions reduce our ability to respond to changes in the performance of our investments and could adversely affect our financial condition and results of operations.

 

Our ability to dispose of some of our properties is constrained by their tax attributes. Properties which we developed and have owned for a significant period of time or which we acquired through tax deferred contribution transactions in exchange for partnership interests in BPLP often have low tax bases. If we dispose of these properties outright in taxable transactions, we may be required to distribute a significant amount of the taxable gain to our securityholders under the requirements of the Internal Revenue Code for REITs, which in turn would impact our cash flow. In some cases, without incurring additional costs we may be restricted from disposing of properties contributed in exchange for our partnership interests under tax protection agreements with contributors. To dispose of low basis or tax-protected properties efficiently we often use like-kind exchanges, which qualify for non-recognition of taxable gain, but can be difficult to consummate and result in the property for which the disposed assets are exchanged inheriting their low tax bases and other tax attributes (including tax protection covenants).

 

Our properties face significant competition.

 

We face significant competition from developers, owners and operators of office properties and other commercial real estate, including sublease space available from our tenants. Substantially all of our properties face competition from similar properties in the same market. This competition may affect our ability to attract and retain tenants and may reduce the rents we are able to charge. These competing properties may have vacancy rates higher than our properties, which may result in their owners being willing to lease available space at lower rates than the space in our properties.

 

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Because we own two hotel properties, we face the risks associated with the hospitality industry.

 

Because the lease payments we receive under the hotel leases are based on a participation in the gross receipts of the hotels, if the hotels do not generate sufficient receipts, our cash flow would be decreased, which could reduce the amount of cash available for distribution to our securityholders. The following factors, among others, are common to the hotel industry, and may reduce the receipts generated by our hotel properties:

 

    our hotel properties compete for guests with other hotels, a number of which have greater marketing and financial resources than our hotel-operating business partners;

 

    if there is an increase in operating costs resulting from inflation and other factors, our hotel-operating business partners may not be able to offset such increase by increasing room rates;

 

    our hotel properties are subject to the fluctuating and seasonal demands of business travelers and tourism; and

 

    our hotel properties are subject to general and local economic and social conditions that may affect demand for travel in general, including war and terrorism.

 

In addition, because our hotel properties are located within two miles of each other in downtown Boston and Cambridge, they are subject to the Boston market’s fluctuations in demand, increases in operating costs and increased competition from additions in supply.

 

Because of the ownership structure of our two hotel properties, we face potential adverse effects from changes to the applicable tax laws.

 

We own two hotel properties. However, under the Internal Revenue Code, REITs like us are not allowed to operate hotels directly or indirectly. Accordingly, we lease our hotel properties to one of our taxable REIT subsidiaries, or TRS. As lessor, we are entitled to a percentage of the gross receipts from the operation of the hotel properties. Marriott International, Inc. manages the hotels under the Marriott® name pursuant to a management contract with the TRS as lessee. While the TRS structure allows the economic benefits of ownership to flow to us, the TRS is subject to tax on its income from the operations of the hotels at the federal and state level. In addition, the TRS is subject to detailed tax regulations that affect how it may be capitalized and operated. If the tax laws applicable to TRSs are modified, we may be forced to modify the structure for owning our hotel properties, and such changes may adversely affect the cash flows from our hotels. In addition, the Internal Revenue Service, the United States Treasury Department and Congress frequently review federal income tax legislation, and we cannot predict whether, when or to what extent new federal tax laws, regulations, interpretations or rulings will be adopted. Any of such actions may prospectively or retroactively modify the tax treatment of the TRS and, therefore, may adversely affect our after-tax returns from our hotel properties.

 

Compliance or failure to comply with the Americans with Disabilities Act or other safety regulations and requirements could result in substantial costs.

 

The Americans with Disabilities Act generally requires that public buildings, including office buildings and hotels, be made accessible to disabled persons. Noncompliance could result in the imposition of fines by the federal government or the award of damages to private litigants. If, under the Americans with Disabilities Act, we are required to make substantial alterations and capital expenditures in one or more of our properties, including the removal of access barriers, it could adversely affect our financial condition and results of operations, as well as the amount of cash available for distribution to our securityholders.

 

Our properties are subject to various federal, state and local regulatory requirements, such as state and local fire and life safety requirements. If we fail to comply with these requirements, we could incur fines or private damage awards. We do not know whether existing requirements will change or whether compliance with future requirements will require significant unanticipated expenditures that will affect our cash flow and results of operations.

 

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Some potential losses are not covered by insurance.

 

We carry insurance coverage on our properties of types and in amounts and with deductibles that we believe are in line with coverage customarily obtained by owners of similar properties. In response to the uncertainty in the insurance market following the terrorist attacks of September 11, 2001, the Federal Terrorism Risk Insurance Act, or TRIA, was enacted in November 2002 to require regulated insurers to make available coverage for certified acts of terrorism (as defined by the statute) through December 31, 2004, which date was extended to December 31, 2005 by the United States Department of Treasury on June 18, 2004 and which date was further extended to December 31, 2007 by the Terrorism Risk Insurance Extension Act of 2005 (the “TRIA Extension Act”). TRIA expires on December 31, 2007, and we cannot currently anticipate whether it will be extended. Effective as of March 1, 2006, our property insurance program per occurrence limits were decreased from $1 billion to $800 million, including coverage for both “certified” and “non-certified” acts of terrorism by TRIA. The amount of such insurance available in the market has decreased because of the natural disasters which occurred during 2005. We also carry nuclear, biological and chemical terrorism insurance coverage (“NBC Coverage”) for “certified” acts of terrorism as defined by TRIA, which is provided by IXP, Inc. as a direct insurer. Effective as of March 1, 2006, we extended the NBC Coverage to March 1, 2007, excluding our Value-Added Fund properties. Effective as of March 1, 2006, the per occurrence limit for NBC Coverage was decreased from $1 billion to $800 million. Under TRIA, after the payment of the required deductible and coinsurance the NBC Coverage is backstopped by the Federal Government if the aggregate industry insured losses resulting from a certified act of terrorism exceed a “program trigger.” Under the TRIA Extension Act (a) the program trigger is $5 million through March 31, 2006, $50 million from April 1, 2006 through December 31, 2006 and $100 million from January 1, 2007 through December 31, 2007 and (b) the coinsurance is 10% through December 31, 2006 and 15% through December 31, 2007. We may elect to terminate the NBC Coverage when the program trigger increases on January 1, 2007, if there is a change in our portfolio or for any other reason. We intend to continue to monitor the scope, nature and cost of available terrorism insurance and maintain insurance in amounts and on terms that are commercially reasonable.

 

We also currently carry earthquake insurance on our properties located in areas known to be subject to earthquakes in an amount and subject to self-insurance that we believe are commercially reasonable. In addition, this insurance is subject to a deductible in the amount of 5% of the value of the affected property. Specifically, we currently carry earthquake insurance which covers our San Francisco portfolio with a $120 million per occurrence limit and a $120 million aggregate limit, $20 million of which is provided by IXP, Inc., as a direct insurer. The amount of our earthquake insurance coverage may not be sufficient to cover losses from earthquakes. As a result of increased costs of coverage and limited availability, the amount of third-party earthquake insurance that we may be able to purchase on commercially reasonable terms may be reduced. In addition, we may discontinue earthquake insurance on some or all of our properties in the future if the premiums exceed our estimation of the value of the coverage.

 

In January 2002, we formed a wholly-owned taxable REIT subsidiary, IXP, Inc., or IXP, to act as a captive insurance company and be one of the elements of our overall insurance program. IXP acts as a direct insurer with respect to a portion of our earthquake insurance coverage for our Greater San Francisco properties and our NBC Coverage for “certified acts of terrorism” under TRIA. Insofar as we own IXP, we are responsible for its liquidity and capital resources, and the accounts of IXP are part of our consolidated financial statements. In particular, if a loss occurs which is covered by our NBC Coverage but is less than the applicable program trigger under TRIA, IXP would be responsible for the full amount of the loss without any backstop by the Federal Government. If we experience a loss and IXP is required to pay under our insurance policy, we would ultimately record the loss to the extent of IXP’s required payment. Therefore, insurance coverage provided by IXP should not be considered as the equivalent of third-party insurance, but rather as a modified form of self-insurance.

 

We continue to monitor the state of the insurance market in general, and the scope and costs of coverage for acts of terrorism in particular, but we cannot anticipate what coverage will be available on commercially reasonable terms in future policy years. There are other types of losses, such as from wars or the presence of mold at our properties, for which we cannot obtain insurance at all or at a reasonable cost. With respect to such

 

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losses and losses from acts of terrorism, earthquakes or other catastrophic events, if we experience a loss that is uninsured or that exceeds policy limits, we could lose the capital invested in the damaged properties, as well as the anticipated future revenues from those properties. Depending on the specific circumstances of each affected property, it is possible that we could be liable for mortgage indebtedness or other obligations related to the property. Any such loss could materially and adversely affect our business and financial condition and results of operations.

 

Actual or threatened terrorist attacks may adversely affect our ability to generate revenues and the value of our properties.

 

We have significant investments in large metropolitan markets that have been or may be in the future the targets of actual or threatened terrorism attacks, including midtown Manhattan, Washington, D.C., Boston and San Francisco. As a result, some tenants in these markets may choose to relocate their businesses to other markets or to lower-profile office buildings within these markets that may be perceived to be less likely targets of future terrorist activity. This could result in an overall decrease in the demand for office space in these markets generally or in our properties in particular, which could increase vacancies in our properties or necessitate that we lease our properties on less favorable terms or both. In addition, future terrorist attacks in these markets could directly or indirectly damage our properties, both physically and financially, or cause losses that materially exceed our insurance coverage. As a result of the foregoing, our ability to generate revenues and the value of our properties could decline materially. See also “—Some potential losses are not covered by insurance.

 

Potential liability for environmental contamination could result in substantial costs.

 

Under federal, state and local environmental laws, ordinances and regulations, we may be required to investigate and clean up the effects of releases of hazardous or toxic substances or petroleum products at our properties simply because of our current or past ownership or operation of the real estate. If unidentified environmental problems arise, we may have to make substantial payments, which could adversely affect our cash flow and our ability to make distributions to our securityholders, because:

 

    as owner or operator we may have to pay for property damage and for investigation and clean-up costs incurred in connection with the contamination;

 

    the law typically imposes clean-up responsibility and liability regardless of whether the owner or operator knew of or caused the contamination;

 

    even if more than one person may be responsible for the contamination, each person who shares legal liability under the environmental laws may be held responsible for all of the clean-up costs; and

 

    governmental entities and third parties may sue the owner or operator of a contaminated site for damages and costs.

 

These costs could be substantial and in extreme cases could exceed the amount of our insurance or the value of the contaminated property. We currently carry environmental insurance in an amount and subject to deductibles that we believe are commercially reasonable. Specifically, we carry a pollution legal liability policy with a $10 million limit per incident and a policy aggregate limit of $25 million. The presence of hazardous or toxic substances or petroleum products or the failure to properly remediate contamination may materially and adversely affect our ability to borrow against, sell or rent an affected property. In addition, applicable environmental laws create liens on contaminated sites in favor of the government for damages and costs it incurs in connection with a contamination. Changes in laws increasing the potential liability for environmental conditions existing at our properties, or increasing the restrictions on the handling, storage or discharge of hazardous or toxic substances or petroleum products or other actions may result in significant unanticipated expenditures.

 

Environmental laws also govern the presence, maintenance and removal of asbestos. Such laws require that owners or operators of buildings containing asbestos:

 

    properly manage and maintain the asbestos;

 

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    notify and train those who may come into contact with asbestos; and

 

    undertake special precautions, including removal or other abatement, if asbestos would be disturbed during renovation or demolition of a building.

 

Such laws may impose fines and penalties on building owners or operators who fail to comply with these requirements and may allow third parties to seek recovery from owners or operators for personal injury associated with exposure to asbestos fibers.

 

Some of our properties are located in urban and previously developed areas where fill or current or historic industrial uses of the areas have caused site contamination. It is our policy to retain independent environmental consultants to conduct Phase I environmental site assessments and asbestos surveys with respect to our acquisition of properties. These assessments generally include a visual inspection of the properties and the surrounding areas, an examination of current and historical uses of the properties and the surrounding areas and a review of relevant state, federal and historical documents, but do not involve invasive techniques such as soil and ground water sampling. Where appropriate, on a property-by-property basis, our practice is to have these consultants conduct additional testing, including sampling for asbestos, for lead in drinking water, for soil contamination where underground storage tanks are or were located or where other past site usage creates a potential environmental problem, and for contamination in groundwater. Even though these environmental assessments are conducted, there is still the risk that:

 

    the environmental assessments and updates did not identify all potential environmental liabilities;

 

    a prior owner created a material environmental condition that is not known to us or the independent consultants preparing the assessments;

 

    new environmental liabilities have developed since the environmental assessments were conducted; and

 

    future uses or conditions such as changes in applicable environmental laws and regulations could result in environmental liability for us.

 

Inquiries about indoor air quality may necessitate special investigation and, depending on the results, remediation beyond our regular indoor air quality testing and maintenance programs. Indoor air quality issues can stem from inadequate ventilation, chemical contaminants from indoor or outdoor sources, and biological contaminants such as molds, pollen, viruses and bacteria. Indoor exposure to chemical or biological contaminants above certain levels can be alleged to be connected to allergic reactions or other health effects and symptoms in susceptible individuals. If these conditions were to occur at one of our properties, we may need to undertake a targeted remediation program, including without limitation, steps to increase indoor ventilation rates and eliminate sources of contaminants. Such remediation programs could be costly, necessitate the temporary relocation of some or all of the property’s tenants or require rehabilitation of the affected property.

 

We face risks associated with the use of debt to fund acquisitions and developments, including refinancing risk.

 

We are subject to the risks normally associated with debt financing, including the risk that our cash flow will be insufficient to meet required payments of principal and interest. We anticipate that only a small portion of the principal of our debt will be repaid prior to maturity. Therefore, we are likely to need to refinance at least a portion of our outstanding debt as it matures. There is a risk that we may not be able to refinance existing debt or that the terms of any refinancing will not be as favorable as the terms of our existing debt. If principal payments due at maturity cannot be refinanced, extended or repaid with proceeds from other sources, such as new equity capital, our cash flow may not be sufficient to repay all maturing debt in years when significant “balloon” payments come due.

 

We have agreements with a number of limited partners of BPLP who contributed properties in exchange for partnership interests that require BPLP to maintain for specified periods of time secured debt on certain of our

 

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assets and/or allocate partnership debt to such limited partners to enable them to continue to defer recognition of their taxable gain with respect to the contributed property. These tax protection and debt allocation agreements may restrict our ability to repay or refinance debt.

 

An increase in interest rates would increase our interest costs on variable rate debt and could adversely impact our ability to refinance existing debt or sell assets.

 

As of December 31, 2005, we had approximately $874.1 million of indebtedness that bears interest at variable rates, and we may incur more of such indebtedness in the future. Accordingly, if interest rates increase, so will our interest costs, which could adversely affect our cash flow and our ability to pay principal and interest on our debt and our ability to make distributions to our securityholders. Further, rising interest rates could limit our ability to refinance existing debt when it matures. We have entered into interest rate swap agreements with respect to a portion of our variable rate debt, and we may in the future enter into similar agreements, including swaps, caps, floors and other interest rate hedging contracts. While these agreements are intended to lessen the impact of rising interest rates on us, they also expose us to the risk that the other parties to the agreements will not perform, the agreements will be unenforceable and the underlying transactions will fail to qualify as highly-effective cash flow hedges under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities, as amended” (See Note 6 to the Consolidated Financial Statements). In addition, an increase in interest rates could decrease the amount third-parties are willing to pay for our assets, thereby limiting our ability to change our portfolio promptly in response to changes in economic or other conditions.

 

Covenants in our debt agreements could adversely affect our financial condition.

 

The mortgages on our properties contain customary covenants such as those that limit our ability, without the prior consent of the lender, to further mortgage the applicable property or to discontinue insurance coverage. Our unsecured credit facility, unsecured debt securities and secured construction loans contain customary restrictions, requirements and other limitations on our ability to incur indebtedness, including total debt to asset ratios, secured debt to total asset ratios, debt service coverage ratios and minimum ratios of unencumbered assets to unsecured debt, which we must maintain. Our continued ability to borrow under our credit facilities is subject to compliance with our financial and other covenants. In addition, our failure to comply with such covenants could cause a default under the applicable debt agreement, and we may then be required to repay such debt with capital from other sources. Under those circumstances, other sources of capital may not be available to us, or be available only on unattractive terms. Additionally, in the future our ability to satisfy current or prospective lenders’ insurance requirements may be adversely affected if lenders generally insist upon greater insurance coverage against acts of terrorism than is available to us in the marketplace or on commercially reasonable terms, particularly if TRIA is not extended beyond December 31, 2007.

 

We rely on debt financing, including borrowings under our unsecured credit facility, issuances of unsecured debt securities and debt secured by individual properties, to finance our acquisition and development activities and for working capital. If we are unable to obtain debt financing from these or other sources, or to refinance existing indebtedness upon maturity, our financial condition and results of operations would likely be adversely affected. If we breach covenants in our debt agreements, the lenders can declare a default and, if the debt is secured, can take possession of the property securing the defaulted loan. In addition, our unsecured debt agreements contain specific cross-default provisions with respect to specified other indebtedness, giving the unsecured lenders the right to declare a default if we are in default under other loans in some circumstances. Defaults under our debt agreements could materially and adversely affect our financial condition and results of operations.

 

Our degree of leverage could limit our ability to obtain additional financing or affect the market price of our common stock or debt securities.

 

On March 1, 2006, we had approximately $4.7 billion in total indebtedness outstanding on a consolidated basis (i.e., excluding unconsolidated joint venture debt). Debt to market capitalization ratio, which measures total

 

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debt as a percentage of the aggregate of total debt plus the market value of outstanding equity securities, is often used by analysts to gauge leverage for equity REITs such as us. Our market value is calculated using the price per share of our common stock. Using the closing stock price of $84.75 per share of our common stock of Boston Properties, Inc. on March 1, 2006, multiplied by the sum of (1) the actual aggregate number of outstanding common partnership units of BPLP (including common partnership units held by us), (2) the number of common partnership units available upon conversion of all outstanding preferred partnership units of BPLP and (3) the number of common units issuable upon conversion of all outstanding LTIP units assuming all conditions have been met for conversion of the LTIP units, our debt to market capitalization ratio was approximately 28.49% as of March 1, 2006.

 

Our degree of leverage could affect our ability to obtain additional financing for working capital, capital expenditures, acquisitions, development or other general corporate purposes. Our senior unsecured debt is currently rated investment grade by the three major rating agencies. However, there can be no assurance we will be able to maintain this rating, and in the event our senior debt is downgraded from its current rating, we would likely incur higher borrowing costs and/or difficulty in obtaining additional financing. Our degree of leverage could also make us more vulnerable to a downturn in business or the economy generally. There is a risk that changes in our debt to market capitalization ratio, which is in part a function of our stock price, or our ratio of indebtedness to other measures of asset value used by financial analysts may have an adverse effect on the market price of our equity or debt securities.

 

Further issuances of equity securities may be dilutive to current securityholders.

 

The interests of our existing securityholders could be diluted if additional equity securities are issued to finance future developments, acquisitions, or repay indebtedness. Our ability to execute our business strategy depends on our access to an appropriate blend of debt financing, including unsecured lines of credit and other forms of secured and unsecured debt, and equity financing, including common and preferred equity.

 

Failure to qualify as a real estate investment trust would cause us to be taxed as a corporation, which would substantially reduce funds available for payment of dividends.

 

If we fail to qualify as a real estate investment trust, or REIT, for federal income tax purposes, we will be taxed as a corporation. We believe that we are organized and qualified as a REIT and intend to operate in a manner that will allow us to continue to qualify as a REIT. However, we cannot assure you that we are qualified as such, or that we will remain qualified as such in the future. This is because qualification as a REIT involves the application of highly technical and complex provisions of the Internal Revenue Code as to which there are only limited judicial and administrative interpretations and involves the determination of facts and circumstances not entirely within our control. Future legislation, new regulations, administrative interpretations or court decisions may significantly change the tax laws or the application of the tax laws with respect to qualification as a REIT for federal income tax purposes or the federal income tax consequences of such qualification.

 

In addition, we currently hold certain of our properties, and the Value-Added Fund holds its properties, through a subsidiary that has elected to be taxed as a REIT and we may in the future determine that it is in our best interests to hold one or more of our other properties through one or more subsidiaries that elect to be taxed as REITs. If any of these subsidiaries fails to qualify as a REIT for federal income tax purposes, then we may also fail to qualify as a REIT for federal income tax purposes.

 

If we fail to qualify as a REIT we will face serious tax consequences that will substantially reduce the funds available for payment of dividends for each of the years involved because:

 

    we would not be allowed a deduction for dividends paid to stockholders in computing our taxable income and would be subject to federal income tax at regular corporate rates;

 

    we also could be subject to the federal alternative minimum tax and possibly increased state and local taxes;

 

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    unless we are entitled to relief under statutory provisions, we could not elect to be subject to tax as a REIT for four taxable years following the year during which we were disqualified; and

 

    all dividends will be subject to tax as ordinary income to the extent of our current and accumulated earnings and profits.

 

In addition, if we fail to qualify as a REIT, we will no longer be required to pay dividends. As a result of all these factors, our failure to qualify as a REIT could impair our ability to expand our business and raise capital, and it would adversely affect the value of our common stock.

 

In order to maintain our REIT status, we may be forced to borrow funds 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 borrowings. To qualify as REIT, we generally must distribute to our stockholders at least 90% of our net taxable income each year, excluding capital gains. In addition, we will be subject to a 4% nondeductible excise tax on the amount, if any, by which dividends paid by us in any calendar year are less than the sum of 85% of our ordinary income, 95% of our capital gain net income and 100% of our undistributed income from prior years. We may need short-term debt or long-term debt or proceeds from asset sales, creation of joint ventures or sales of common stock 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 expenditures, the creation of reserves or required debt or amortization payments. The inability of our cash flows to cover our distribution requirements could have an adverse impact on our ability to raise short and long-term debt or sell equity securities in order to fund distributions required to maintain our REIT status.

 

Limits on changes in control may discourage takeover attempts beneficial to stockholders.

 

Provisions in our certificate of incorporation and bylaws, our shareholder rights agreement and the limited partnership agreement of BPLP, as well as provisions of the Internal Revenue Code and Delaware corporate law, may:

 

    delay or prevent a change of control over us or a tender offer, even if such action might be beneficial to our stockholders; and

 

    limit our stockholders’ opportunity to receive a potential premium for their shares of common stock over then-prevailing market prices.

 

Stock Ownership Limit

 

To facilitate maintenance of our qualification as a REIT and to otherwise address concerns relating to concentration of capital stock ownership, our certificate of incorporation generally prohibits ownership, directly, indirectly or beneficially, by any single stockholder of more than 6.6% of the number of outstanding shares of any class or series of our equity stock. We refer to this limitation as the “ownership limit.” Our board of directors may waive or modify the ownership limit with respect to one or more persons if it is satisfied that ownership in excess of this limit will not jeopardize our status as a REIT for federal income tax purposes. In addition, under our certificate of incorporation each of Mortimer B. Zuckerman and Edward H. Linde, along with their respective families and affiliates, as well as, in general, pension plans and mutual funds, may actually and beneficially own up to 15% of the number of outstanding shares of any class or series of our equity common stock. Shares owned in violation of the ownership limit will be subject to the loss of rights to distributions and voting and other penalties. The ownership limit may have the effect of inhibiting or impeding a change in control.

 

BPLP’s Partnership Agreement

 

We have agreed in the limited partnership agreement of BPLP not to engage in specified extraordinary transactions, including, among others, business combinations, unless limited partners of BPLP other than Boston

 

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Properties, Inc. receive, or have the opportunity to receive, either (1) the same consideration for their partnership interests as holders of our common stock in the transaction or (2) limited partnership units that, among other things, would entitle the holders, upon redemption of these units, to receive shares of common equity of a publicly traded company or the same consideration as holders of our common stock received in the transaction. If these limited partners would not receive such consideration, we cannot engage in the transaction unless limited partners holding at least 75% of the common units of limited partnership interest, other than those held by Boston Properties, Inc. or its affiliates, consent to the transaction. In addition, we have agreed in the limited partnership agreement of BPLP that we will not complete specified extraordinary transactions, including among others, business combinations, in which we receive the approval of our common stockholders unless (1) limited partners holding at least 75% of the common units of limited partnership interest, other than those held by Boston Properties, Inc. or its affiliates, consent to the transaction or (2) the limited partners of BPLP are also allowed to vote and the transaction would have been approved had these limited partners been able to vote as common stockholders on the transaction. Therefore, if our common stockholders approve a specified extraordinary transaction, the partnership agreement requires the following before we can complete the transaction:

 

    holders of partnership interests in BPLP, including Boston Properties, Inc., must vote on the matter;

 

    Boston Properties, Inc. must vote its partnership interests in the same proportion as our stockholders voted on the transaction; and

 

    the result of the vote of holders of partnership interests in BPLP must be such that had such vote been a vote of stockholders, the business combination would have been approved.

 

As a result of these provisions, a potential acquirer may be deterred from making an acquisition proposal, and we may be prohibited by contract from engaging in a proposed extraordinary transaction, including a proposed business combination, even though our stockholders approve of the transaction.

 

Shareholder Rights Plan

 

We have a shareholder rights plan. Under the terms of this plan, we can in effect prevent a person or group from acquiring more than 15% of the outstanding shares of our common stock because, unless we approve of the acquisition, after the person acquires more than 15% of our outstanding common stock, all other stockholders will have the right to purchase securities from us at a price that is less than their then fair market value. This would substantially reduce the value and influence of the stock owned by the acquiring person. Our board of directors can prevent the plan from operating by approving the transaction in advance, which gives us significant power to approve or disapprove of the efforts of a person or group to acquire a large interest in our company.

 

We may change our policies without obtaining the approval of our stockholders.

 

Our operating and financial policies, including our policies with respect to acquisitions of real estate, growth, operations, indebtedness, capitalization and dividends, are exclusively determined by our Board of Directors. Accordingly, our stockholders do not control these policies.

 

Our success depends on key personnel whose continued service is not guaranteed.

 

We depend on the efforts of key personnel, particularly Mortimer B. Zuckerman, Chairman of our Board of Directors, and Edward H. Linde, our President and Chief Executive Officer. Among the reasons that Messrs. Zuckerman and Linde are important to our success is that each has a national reputation, which attracts business and investment opportunities and assists us in negotiations with lenders. If we lost their services, our relationships with lenders, potential tenants and industry personnel could diminish. Mr. Zuckerman has substantial outside business interests that could interfere with his ability to devote his full time to our business and affairs.

 

Our three Executive Vice Presidents and other executive officers that serve as managers of our regional offices also have strong reputations. Their reputations aid us in identifying opportunities, having opportunities

 

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brought to us, and negotiating with tenants and build-to-suit prospects. While we believe that we could find replacements for these key personnel, the loss of their services could materially and adversely affect our operations because of diminished relationships with lenders, prospective tenants and industry personnel.

 

Conflicts of interest exist with holders of interests in BPLP.

 

Sales of properties and repayment of related indebtedness will have different effects on holders of interests in BPLP than on our stockholders.

 

Some holders of interests in BPLP, including Messrs. Zuckerman and Linde, would incur adverse tax consequences upon the sale of certain of our properties and on the repayment of related debt which differ from the tax consequences to us and our stockholders. Consequently, these holders of partnership interests in BPLP may have different objectives regarding the appropriate pricing and timing of any such sale or repayment of debt. While we have exclusive authority under the limited partnership agreement of BPLP to determine when to refinance or repay debt or whether, when, and on what terms to sell a property, subject, in the case of certain properties, to the contractual commitments described below, any such decision would require the approval of our Board of Directors. While the Board of Directors has a policy with respect to these matters, as directors and executive officers, Messrs. Zuckerman and Linde could exercise their influence in a manner inconsistent with the interests of some, or a majority, of our stockholders, including in a manner which could prevent completion of a sale of a property or the repayment of indebtedness.

 

Agreement not to sell some properties.

 

Under the terms of the limited partnership agreement of BPLP, we have agreed not to sell or otherwise transfer some of our properties, prior to specified dates, in any transaction that would trigger taxable income, without first obtaining the consent of Messrs. Zuckerman and Linde. However, we are not required to obtain their consent if, during the applicable period, each of them does not hold at least 30% of his original interests in BPLP, or if those properties are transferred in a nontaxable transaction. In addition, we have entered into similar agreements with respect to other properties that we have acquired in exchange for partnership interests in BPLP. Pursuant to those agreements, we are responsible for the reimbursement of certain tax-related costs to the prior owners if the subject properties are sold in a taxable sale. In general, our obligations to the prior owners are limited in time and only apply to actual damages suffered. As of December 31, 2005, there were a total of 27 wholly-owned properties subject to these restrictions, and those properties are estimated to have accounted for approximately 40% of our total revenue for the year ended December 31, 2005.

 

BPLP has also entered into agreements providing prior owners of properties with the right to guarantee specific amounts of indebtedness and, in the event that the specific indebtedness they guarantee is repaid or reduced, additional and/or substitute indebtedness. These agreements may hinder actions that we may otherwise desire to take to repay or refinance guaranteed indebtedness because we would be required to make payments to the beneficiaries of such agreements if we violate these agreements.

 

Messrs. Zuckerman and Linde will continue to engage in other activities.

 

Messrs. Zuckerman and Linde have a broad and varied range of investment interests. Either one could acquire an interest in a company which is not currently involved in real estate investment activities but which may acquire real property in the future. However, pursuant to each of their employment agreements, Messrs. Zuckerman and Linde will not, in general, have management control over such companies and, therefore, they may not be able to prevent one or more of such companies from engaging in activities that are in competition with our activities.

 

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Changes in market conditions could adversely affect the market price of our common stock.

 

As with other publicly traded equity securities, the value of our common stock depends on various market conditions that may change from time to time. Among the market conditions that may affect the value of our common stock are the following:

 

    the extent of investor interest in our securities;

 

    the general reputation of REITs and the attractiveness of our equity securities in comparison to other equity securities, including securities issued by other real estate-based companies;

 

    our underlying asset value;

 

    investor confidence in the stock and bond markets, generally;

 

    national economic conditions;

 

    changes in tax laws;

 

    our financial performance;

 

    change in our credit rating; and

 

    general stock and bond market conditions.

 

The market value of our common stock is based primarily upon the market’s perception of our growth potential and our current and potential future earnings and cash dividends. Consequently, our common stock may trade at prices that are greater or less than our net asset value per share of common stock. If our future earnings or cash dividends are less than expected, it is likely that the market price of our common stock will diminish.

 

The number of shares available for future sale could adversely affect the market price of our stock.

 

In connection with and subsequent to our initial public offering, we have completed many private placement transactions in which shares of capital stock of Boston Properties, Inc. or partnership interests in BPLP were issued to owners of properties we acquired or to institutional investors. This common stock, or common stock issuable in exchange for such partnership interests in BPLP, may be sold in the public securities markets over time under registration rights we granted to these investors. Additional common stock issuable under our employee benefit and other incentive plans, including as a result of the grant of stock options and restricted equity securities, may also be sold in the market at some time in the future. Future sales of our common stock in the market could adversely affect the price of our common stock. We cannot predict the effect the perception in the market that such sales may occur will have on the market price of our common stock.

 

We did not obtain new owner’s title insurance policies in connection with properties acquired during our initial public offering.

 

We acquired many of our properties from our predecessors at the completion of our initial public offering in June 1997. Before we acquired these properties, each of them was insured by a title insurance policy. We did not obtain new owner’s title insurance policies in connection with the acquisition of these properties. However, to the extent we have financed properties after acquiring them in connection with the IPO, we have obtained new title insurance policies. Nevertheless, because in many instances we acquired these properties indirectly by acquiring ownership of the entity that owned the property and those owners remain in existence as our subsidiaries, some of these title insurance policies may continue to benefit us. Many of these title insurance policies may be for amounts less than the current or future values of the applicable properties. If there was a title defect related to any of these properties, or to any of the properties acquired at the time of our initial public offering, that is no longer covered by a title insurance policy, we could lose both our capital invested in and our anticipated profits from such property. We have obtained title insurance policies for all properties that we have acquired after our initial public offering, however, these policies may be for amounts less than the current or future values of the applicable properties.

 

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We face possible adverse changes in tax laws.

 

From time to time changes in state and local tax laws or regulations are enacted, which may result in an increase in our tax liability. A shortfall in tax revenues for states and municipalities in which we operate may lead to an increase in the frequency and size of such changes. If such changes occur, we may be required to pay additional taxes on our assets or income. These increased tax costs could adversely affect our financial condition and results of operations and the amount of cash available for payment of dividends.

 

We face possible state and local tax audits.

 

Because we are organized and qualify as a REIT, we are generally not subject to federal income taxes, but are subject to certain state and local taxes. In the normal course of business, certain entities through which we own real estate either have undergone, or are currently undergoing, tax audits. Although we believe that we have substantial arguments in favor of our positions in the ongoing audits, in some instances there is no controlling precedent or interpretive guidance on the specific point at issue. Collectively, tax deficiency notices received to date from the jurisdictions conducting the ongoing audits have not been material. However, there can be no assurance that future audits will not occur with increased frequency or that the ultimate result of such audits will not have a material adverse effect on our results of operations.

 

Item 1B. Unresolved Staff Comments.

 

None.

 

Item 2. Properties

 

At December 31, 2005, our portfolio consisted of 121 properties totaling 42.0 million net rentable square feet. Our properties consisted of (1) 117 office properties, comprised of 100 Class A office buildings, including 3 properties under construction and 17 properties that support both office and technical uses, (2) two retail properties and (3) two hotels. In addition, we own or control 527.1 acres of land for future development. The table set forth below shows information relating to the properties we owned, or in which we had an ownership interest, at December 31, 2005. Information relating to properties owned by the Value-Added Fund is not included in our portfolio information tables or any other portfolio level statistics because the Value-Added Fund invests in assets within our existing markets that have deficiencies in property characteristics which provide an opportunity to create value through repositioning, refurbishment or renovation. We therefore believe including such information in our portfolio tables and statistics would render the portfolio information less useful to investors. Information relating to the Value-Added Fund is set forth below separately.

 

Properties


  

Location


  

%

Leased


   

Number

of

Buildings


  

Net

Rentable

Square

Feet


Class A Office                     

399 Park Avenue

   New York, NY    100.0 %   1    1,686,495

Citigroup Center

   New York, NY    96.6 %   1    1,569,022

Times Square Tower

   New York, NY    93.8 %   1    1,238,708

800 Boylston Street at The Prudential Center

   Boston, MA    82.4 %   1    1,183,438

280 Park Avenue

   New York, NY    100.0 %   1    1,179,064

5 Times Square

   New York, NY    100.0 %   1    1,101,779

599 Lexington Avenue

   New York, NY    100.0 %   1    1,016,218

Embarcadero Center Four

   San Francisco, CA    96.1 %   1    938,165

111 Huntington Avenue at The Prudential Center

   Boston, MA    100.0 %   1    854,936

Embarcadero Center One

   San Francisco, CA    89.7 %   1    826,034

Embarcadero Center Two

   San Francisco, CA    86.2 %   1    770,822

 

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Properties


  

Location


  

%

Leased


   

Number

of

Buildings


  

Net

Rentable

Square

Feet


Embarcadero Center Three

   San Francisco, CA    91.3 %   1    767,667

Democracy Center

   Bethesda, MD    78.3 %   3    682,827

Metropolitan Square (51% ownership)

   Washington, D.C.    99.9 %   1    586,482

901 New York Avenue (25% ownership)

   Washington, D.C.    96.3 %   1    539,229

Reservoir Place

   Waltham, MA    85.5 %   1    526,998

601 and 651 Gateway Boulevard

   South San Francisco, CA    84.7 %   2    506,006

101 Huntington Avenue at The Prudential Center

   Boston, MA    86.3 %   1    505,939

One and Two Reston Overlook

   Reston, VA    100.0 %   2    445,892

Two Freedom Square

   Reston, VA    100.0 %   1    421,676

One Tower Center

   East Brunswick, NJ    71.1 %   1    412,222

One Freedom Square

   Reston, VA    99.2 %   1    414,075

Market Square North (50% ownership)

   Washington, D.C.    98.4 %   1    401,279

140 Kendrick Street

   Needham, MA    100.0 %   3    380,987

One and Two Discovery Square

   Reston, VA    100.0 %   2    367,018

265 Franklin Street (35% ownership)

   Boston, MA    72.4 %   1    347,381

Orbital Science Campus

   Dulles, VA    100.0 %   3    337,228

1333 New Hampshire Avenue

   Washington, D.C.    100.0 %   1    315,371

Waltham Weston Corporate Center

   Waltham, MA    96.1 %   1    306,789

Capital Gallery

   Washington, D.C.    100.0 %   1    301,879

Prospect Place

   Waltham, MA    66.5 %   1    297,402

12310 Sunrise Valley

   Reston, VA    100.0 %   1    263,870

Reston Corporate Center

   Reston, VA    100.0 %   2    261,046

Quorum Office Park

   Chelmsford, MA    100.0 %   2    259,918

New Dominion Technology Park, Building Two

   Herndon, VA    100.0 %   1    257,400

611 Gateway Boulevard

   South San Francisco, CA    100.0 %   1    256,302

12300 Sunrise Valley

   Reston, VA    100.0 %   1    255,244

1330 Connecticut Avenue

   Washington, D.C.    100.0 %   1    252,136

200 West Street

   Waltham, MA    98.0 %   1    248,048

500 E Street

   Washington, D.C.    100.0 %   1    246,057

New Dominion Technology. Park, Building One

   Herndon, VA    100.0 %   1    235,201

510 Carnegie Center

   Princeton, NJ    100.0 %   1    234,160

One Cambridge Center

   Cambridge, MA    67.1 %   1    215,385

Sumner Square Office

   Washington, D.C.    100.0 %   1    207,620

University Place

   Cambridge, MA    99.6 %   1    196,007

1301 New York Avenue

   Washington, D.C.    100.0 %   1    188,358

2600 Tower Oaks Boulevard

   Rockville, MD    100.0 %   1    178,887

Eight Cambridge Center

   Cambridge, MA    100.0 %   1    177,226

Newport Office Park

   Quincy, MA    100.0 %   1    170,013

Lexington Office Park

   Lexington, MA    97.0 %   2    164,565

191 Spring Street

   Lexington, MA    100.0 %   1    162,700

210 Carnegie Center

   Princeton, NJ    74.5 %   1    161,776

206 Carnegie Center

   Princeton, NJ    100.0 %   1    161,763

10 & 20 Burlington Mall Road

   Burlington, MA    86.0 %   2    153,048

Ten Cambridge Center

   Cambridge, MA    100.0 %   1    152,664

214 Carnegie Center

   Princeton, NJ    76.8 %   1    150,774

212 Carnegie Center

   Princeton, NJ    100.0 %   1    149,398

 

27


Table of Contents

Properties


  

Location


  

%

Leased


   

Number

of

Buildings


  

Net

Rentable

Square

Feet


506 Carnegie Center

   Princeton, NJ    100.0 %   1    136,213

508 Carnegie Center

   Princeton, NJ    100.0 %   1    131,085

Waltham Office Center

   Waltham, MA    82.3 %   3    129,041

202 Carnegie Center

   Princeton, NJ    68.8 %   1    128,705

101 Carnegie Center

   Princeton, NJ    100.0 %   1    123,659

Montvale Center

   Gaithersburg, MD    84.8 %   1    122,687

504 Carnegie Center

   Princeton, NJ    100.0 %   1    121,990

91 Hartwell Avenue

   Lexington, MA    90.9 %   1    121,425

40 Shattuck Road

   Andover, MA    95.6 %   1    120,000

502 Carnegie Center

   Princeton, NJ    93.8 %   1    116,374

Three Cambridge Center

   Cambridge, MA    87.0 %   1    108,152

104 Carnegie Center

   Princeton, NJ    51.5 %   1    102,830

201 Spring Street

   Lexington, MA    100.0 %   1    102,500

Bedford Office Park

   Bedford, MA    16.3 %   1    90,000

33 Hayden Avenue

   Lexington, MA    100.0 %   1    80,128

Eleven Cambridge Center

   Cambridge, MA    100.0 %   1    79,322

Reservoir Place North

   Waltham, MA    100.0 %   1    73,258

105 Carnegie Center

   Princeton, NJ    84.8 %   1    70,029

32 Hartwell Avenue

   Lexington, MA    100.0 %   1    69,154

302 Carnegie Center

   Princeton, NJ    100.0 %   1    64,726

195 West Street

   Waltham, MA    100.0 %   1    63,500

100 Hayden Avenue

   Lexington, MA    100.0 %   1    55,924

181 Spring Street

   Lexington, MA    58.9 %   1    53,652

211 Carnegie Center

   Princeton, NJ    100.0 %   1    47,025

92 Hayden Avenue

   Lexington, MA    100.0 %   1    31,100

201 Carnegie Center

   Princeton, NJ    100.0 %   —      6,500
         

 
  

Subtotal for Class A Office Properties

        93.7 %   97    28,937,573
         

 
  

Retail

                    

Shops at The Prudential Center

   Boston, MA    89.6 %   1    511,924

Shaws Supermarket at The Prudential Center

   Boston, MA    100.0 %   1    57,235
         

 
  

Subtotal for Retail Properties

        90.7 %   2    569,159
         

 
  

Office/Technical Properties

                    

Bedford Office Park

   Bedford, MA    100.0 %   2    383,704

Broad Run Business Park, Building E

   Dulles,VA    73.7 %   1    128,646

7601 Boston Boulevard

   Springfield, VA    100.0 %   1    103,750

7435 Boston Boulevard

   Springfield, VA    100.0 %   1    103,557

8000 Grainger Court

   Springfield, VA    100.0 %   1    88,775

7500 Boston Boulevard

   Springfield, VA    100.0 %   1    79,971

7501 Boston Boulevard

   Springfield, VA    100.0 %   1    75,756

Fourteen Cambridge Center

   Cambridge, MA    100.0 %   1    67,362

164 Lexington Road

   Billerica, MA    100.0 %   1    64,140

7450 Boston Boulevard

   Springfield, VA    100.0 %   1    62,402

7374 Boston Boulevard

   Springfield, VA    100.0 %   1    57,321

8000 Corporate Court

   Springfield, VA    100.0 %   1    52,539

7451 Boston Boulevard

   Springfield, VA    100.0 %   1    47,001

7300 Boston Boulevard

   Springfield, VA    100.0 %   1    32,000

 

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Table of Contents

Properties


  

Location


  

%

Leased


   

Number

of

Buildings


   

Net

Rentable

Square

Feet


17 Hartwell Avenue

   Lexington, MA    100.0 %   1     30,000

7375 Boston Boulevard

   Springfield, VA    100.0 %   1     26,865
         

 

 

Subtotal for Office/Technical Properties

        97.6 %   17     1,403,789
         

 

 

Hotel Properties

                     

Long Wharf Marriott

   Boston, MA    81.4 %(1)   1     420,000

Cambridge Center Marriott

   Cambridge, MA    73.7 %(1)   1     330,400
         

 

 

Subtotal for Hotel Properties

              2     750,400
         

 

 

Structured Parking

        n/a     —       9,297,705
         

 

 

Subtotal for In-Service Properties

        93.8 %   118     40,958,626
         

 

 

Properties Under Construction

                     

Capital Gallery Expansion

   Washington, D.C.    94.0 %(2)   —   (3)   318,557

Seven Cambridge Center

   Cambridge, MA    100.0 %   1     231,028

12290 Sunrise Valley

   Reston, VA    100.0 %   1     182,000

Wisconsin Place- Infrastructure (23.89% ownership)

   Chevy Chase, MD    n/a     —       —  

505 9th Street (50% ownership)

   Washington, D.C.    73.0 %(2)   1     323,000
         

 

 

Subtotal for Properties Under Construction

        89.9 %   3     1,054,585
         

 

 

Total Portfolio

              121     42,013,211
               

 

(1) Represents the weighted-average occupancy for the year ended December 31, 2005. Note that these amounts are not included in the calculation of the Total Portfolio occupancy rate for In-Service Properties as of December 31, 2005.
(2) Represents percentage leased as of March 1, 2006.
(3) Represents the three-story, low-rise section of the property which was taken out of service in September 2004 as part of the redevelopment project. The total project will result in a total complex size of approximately 610,000 square feet.

 

The following table shows information relating to investments through the Value-Added Fund as of December 31, 2005:

 

Property


   Location

   % Leased

    Number
of
Buildings


   Net
Rentable
Square
Feet


Worldgate Plaza    Herndon, VA    75.0 %   4    322,328
300 Billerica Road    Chelmsford, MA    100.0 %   1    110,882
         

 
  

Total Value-Added Fund

        81.4 %   5    433,210
         

 
  

 

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Table of Contents

Top 20 Tenants by Square Feet

 

    

Tenant


   Square
Feet


   

% of
In-Service

Portfolio


 
1    U.S. Government    1,676,747 (1)   5.42 %
2    Citibank, N.A.    1,116,094     3.61 %
3    Ernst and Young    1,064,939     3.45 %
4    Shearman & Sterling    585,808     1.90 %
5    Lockheed Martin    566,375     1.83 %
6    Genentech    528,218     1.71 %
7    Procter & Gamble    484,051     1.57 %
8    Lehman Brothers    436,723     1.41 %
9    Kirkland & Ellis    416,547 (2)   1.35 %
10    Parametric Technology    380,987     1.23 %
11    Washington Group International    365,245     1.18 %
12    Finnegan Henderson Farabow    349,146 (3)   1.13 %
13    Orbital Sciences    337,228     1.09 %
14    Deutsche Bank Trust    336,137     1.09 %
15    Northrop Grumman    327,677     1.06 %
16    Ann Taylor    318,567     1.03 %
17    Bingham McCutchen    291,415     0.94 %
18    Akin Gump Strauss Hauer & Feld    290,132     0.94 %
19    O’ Melveny & Myers    268,733     0.87 %
20    Accenture    263,878     0.85 %
     Total % of Portfolio Square Feet          33.66 %

(1) Includes 96,600 square feet of space in properties in which we have a 51% and 50% interest.
(2) Includes 162,169 square feet of space in a property in which we have a 51% interest.
(3) Includes 251,941 square feet of space in a property in which we have a 25% interest.

 

Lease Expirations

 

Year of Lease
Expiration


   Rentable
Square Feet
Subject to
Expiring Leases


   Current
Annualized (1)
Contractual
Rent Under
Expiring Leases


    Current
Annualized (1)
Contractual
Rent Under
Expiring Leases
p.s.f.


  

Current
Annualized
Contractual
Rent Under
Expiring Leases
With Future

Step-ups (2)


   Current
Annualized
Contractual Rent
Under Expiring
Leases With
Future
Step-ups p.s.f. (2)


   Percentage of
Total Square
Feet


 

2006

   1,607,215    $ 63,172,146 (3)   $ 39.31    $ 63,417,639    $ 39.46    5.5 %

2007

   2,341,616      83,600,733       35.70      84,359,953      36.03    8.1 %

2008

   1,799,290      74,454,852       41.38      76,463,640      42.50    6.2 %

2009

   2,527,378      94,455,048       37.37      99,493,640      39.37    8.7 %

2010

   2,084,435      85,121,689       40.84      89,548,016      42.96    7.2 %

2011

   2,670,591      115,865,167       43.39      127,365,759      47.69    9.2 %

2012

   2,699,988      125,106,066       46.34      134,204,590      49.71    9.3 %

2013

   645,917      26,541,834       41.09      29,164,625      45.15    2.2 %

2014

   2,069,893      73,870,656       35.69      80,484,606      38.88    7.1 %

2015

   1,297,576      46,278,207       35.67      53,974,747      41.60    4.5 %

Thereafter

   7,587,746      396,143,585       52.21      482,185,490      63.55    26.1 %

(1)

Represents the monthly contractual base rent and recoveries from tenants under existing leases as of December 31, 2005 multiplied by twelve. This amount reflects total rent before any rent abatements and includes expense reimbursements, which may be estimates as of such date.

 

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Table of Contents
(2) Represents the monthly contractual base rent under expiring leases with future contractual increases upon expiration and recoveries from tenants under existing leases as of December 31, 2005 multiplied by twelve. This amount reflects total rent before any rent abatements and includes expense reimbursements, which may be estimates as of such date.
(3) Includes $1.8 million of contractual rent from The Prudential Center retail kiosks and carts.

 

Item 3. Legal Proceedings

 

We are subject to various legal proceedings and claims that arise in the ordinary course of business. These matters are generally covered by insurance. Management believes that the final outcome of such matters will not have a material adverse effect on our financial position, results of operations or liquidity.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

No matters were submitted to a vote of our stockholders during the fourth quarter of the year ended December 31, 2005.

 

PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

(a) Our common stock is listed on the New York Stock Exchange under the symbol “BXP.” The high and low sales prices and distributions for the periods indicated in the table below were:

 

Quarter Ended


   High

   Low

   Distributions

 

December 31, 2005

   $ 76.37    $ 64.87    $ .68 (1)

September 30, 2005

     76.67      68.21      3.18 (2)

June 30, 2005

     70.17      58.84      .68  

March 31, 2005

     65.05      57.13      .65  

December 31, 2004

     64.90      55.15      .65  

September 30, 2004

     56.29      49.86      .65  

June 30, 2004

     55.54      43.63      .65  

March 31, 2004

     54.89      46.69      .63  

(1) Paid on January 30, 2006 to stockholders of record as of the close of business on December 30, 2005.
(2) For the three months ended September 30, 2005, amount includes the $2.50 per common share special dividend which was paid on October 31, 2005 to shareholders of record as of the close of business on September 30, 2005.

 

At March 1, 2006, we had approximately 274 stockholders of record. This does not include beneficial owners for whom Cede & Co. or others act as nominee.

 

In order to maintain our qualification as a REIT, we must make annual distributions to our stockholders of at least 90% of our taxable income (not including net capital gains). We have adopted a policy of paying regular quarterly distributions on our common stock, and we have adopted a policy of paying regular quarterly distributions on the common units of BPLP. Cash distributions have been paid on our common stock and BPLP’s common units since our initial public offering. Distributions are declared at the discretion of the Board of Directors and depend on actual and anticipated cash from operations, our financial condition, capital requirements, the annual distribution requirements under the REIT provisions of the Internal Revenue Code and other factors the Board of Directors may consider relevant.

 

For the three months ended December 31, 2005 there were no unregistered issuances of stock and no repurchases of stock.

 

(b) None.

 

(c) None.

 

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Table of Contents
Item 6. Selected Financial Data

 

The following table sets forth our selected financial and operating data on a historical basis, which has been revised for the reclassification of (1) losses from early extinguishments of debt in accordance with SFAS No. 145, (2) the restatement of earnings per share to include the effects of participating securities in accordance with EITF 03-6 and (3) the disposition of qualifying properties during 2005, 2004, 2003 and 2002 which have been reclassified as discontinued operations, for the periods presented, in accordance with SFAS No. 144. Refer to Notes 6, 14 and 18 of the Consolidated Financial Statements. The following data should be read in conjunction with our financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Form 10-K.

 

Our historical operating results may not be comparable to our future operating results.

 

     For the year ended December 31,

 
     2005

    2004

    2003

    2002

    2001

 
     (in thousands, except per share data)  

Statement of Operations Information:

                                        

Total revenue

   $ 1,437,635     $ 1,386,346     $ 1,283,165     $ 1,157,820     $ 960,735  
    


 


 


 


 


Expenses:

                                        

Rental operating

     438,335       416,327       393,965       361,051       306,791  

Hotel operating

     51,689       49,442       46,732       27,816       —    

General and administrative

     55,471       53,636       45,359       47,292       38,312  

Interest

     308,091       306,170       299,436       263,067       211,391  

Depreciation and amortization

     266,829       249,649       206,686       176,412       140,197  

Net derivative losses

     —         —         1,038       11,874       26,488  

Losses from early extinguishments of debt

     12,896       6,258       1,474       2,386       —    

Losses on investments in securities

     —         —         —         4,297       6,500  
    


 


 


 


 


Income before income from unconsolidated joint ventures and minority interests

     304,324       304,864       288,475       263,625       231,056  

Income from unconsolidated joint ventures

     4,829       3,380       6,016       7,954       4,186  

Minority interests

     (68,086 )     (63,058 )     (70,902 )     (69,179 )     (65,640 )
    


 


 


 


 


Income before gains on sales of real estate

     241,067       245,186       223,589       202,400       169,602  

Gains on sales of real estate and other assets, net of minority interest

     151,884       8,149       57,574       190,443       9,089  
    


 


 


 


 


Income before discontinued operations

     392,951       253,335       281,163       392,843       178,691  

Discontinued operations, net of minority interest

     49,564       30,682       84,159       51,540       36,108  
    


 


 


 


 


Income before cumulative effect of a change in accounting principle

     442,515       284,017       365,322       444,383       214,799  

Cumulative effect of a change in accounting principle, net of minority interest

     (4,223 )     —         —         —         (6,767 )
    


 


 


 


 


Net income before preferred dividend

     438,292       284,017       365,322       444,383       208,032  

Preferred dividend

     —         —         —         (3,412 )     (6,592 )
    


 


 


 


 


Net income available to common shareholders

   $ 438,292     $ 284,017     $ 365,322     $ 440,971     $ 201,440  
    


 


 


 


 


Basic earnings per share:

                                        

Income before discontinued operations and cumulative effect of a change in accounting principle

   $ 3.53     $ 2.38     $ 2.84     $ 4.02     $ 1.92  

Discontinued operations, net of minority interest

     0.45       0.29       0.87       0.55       0.40  

Cumulative effect of a change in accounting principle, net of minority interest

     (0.04 )     —         —         —         (0.08 )
    


 


 


 


 


Net income available to common shareholders

   $ 3.94     $ 2.67     $ 3.71     $ 4.57     $ 2.24  
    


 


 


 


 


Weighted average number of common shares outstanding

     111,274       106,458       96,900       93,145       90,002  
    


 


 


 


 


Diluted earnings per share:

                                        

Income before discontinued operations and cumulative effect of a change in accounting principle

   $ 3.46     $ 2.33     $ 2.80     $ 3.96     $ 1.87  

Discontinued operations, net of minority interest

     0.44       0.28       0.85       0.54       0.39  

Cumulative effect of a change in accounting principle, net of minority interest

     (0.04 )     —         —         —         (0.07 )
    


 


 


 


 


Net income available to common shareholders

   $ 3.86     $ 2.61     $ 3.65     $ 4.50     $ 2.19  
    


 


 


 


 


Weighted average number of common and common equivalent shares outstanding

     113,559       108,762       98,486       94,612       92,200  
    


 


 


 


 


 

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Table of Contents
     December 31,

     2005

   2004

   2003

   2002

   2001

     (in thousands)

Balance Sheet information:

                                  

Real estate, gross

   $ 9,151,175    $ 9,291,227    $ 8,983,260    $ 8,670,711    $ 7,457,906

Real estate, net

     7,886,102      8,147,858      7,981,825      7,847,778      6,738,052

Cash and cash equivalents

     261,496      239,344      22,686      55,275      98,067

Total assets

     8,902,368      9,063,228      8,551,100      8,427,203      7,253,510

Total indebtedness

     4,826,254      5,011,814      5,004,720      5,147,220      4,314,942

Minority interests

     739,268      786,328      830,133      844,581      844,740

Convertible redeemable preferred stock

     —        —        —        —        100,000

Stockholders’ equity

     2,917,346      2,936,073      2,400,163      2,159,590      1,754,073

 

     For the year ended December 31,

 
     2005

    2004

    2003

    2002

    2001

 
     (in thousands, except per share data)  

Other Information:

                                        

Funds from operations available to common shareholders (1)

   $ 479,726     $ 459,497     $ 410,012     $ 380,814     $ 323,227  

Funds from operations available to common shareholders, as adjusted (1)

     488,972       459,497       412,073       399,489       337,823  

Dividends declared per share

     5.19       2.58       2.50       2.41       2.27  

Cash flow provided by operating activities

     472,249       429,506       488,275       437,380       419,403  

Cash flow provided by (used in) investing activities

     356,605       (171,014 )     97,496       (1,017,283 )     (1,303,622 )

Cash flow provided by (used in) financing activities

     (806,702 )     (41,834 )     (618,360 )     537,111       701,329  

Total square feet at end of year

     42,013       44,117       43,894       42,411       40,718  

Percentage leased at end of year

     93.8 %     92.1 %     92.1 %     93.9 %     95.3 %

(1) Pursuant to the revised definition of Funds from Operations adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”), we calculate Funds from Operations, or “FFO,” by adjusting net income (loss) (computed in accordance with GAAP, including non-recurring items) for gains (or losses) from sales of properties, real estate related depreciation and amortization, and after adjustment for unconsolidated partnerships and joint ventures. FFO is a non-GAAP financial measure. The use of FFO, combined with the required primary GAAP presentations, has been fundamentally beneficial in improving the understanding of operating results of REITs among the investing public and making comparisons of REIT operating results more meaningful. Management generally considers FFO to be a useful measure for reviewing our comparative operating and financial performance because, by excluding gains and losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization (which can vary among owners of identical assets in similar condition based on historical cost accounting and useful life estimates), FFO can help one compare the operating performance of a company’s real estate between periods or as compared to different companies. Our computation of FFO may not be comparable to FFO reported by other REITs or real estate companies that do not define the term in accordance with the current NAREIT definition or that interpret the current NAREIT definition differently. Amount represents our share, which was 83.74%, 82.97%, 82.06%, 81.98% and 81.23% for the years ended December 31, 2005, 2004, 2003, 2002 and 2001, respectively, after allocation to the minority interest in the Operating Partnership.

 

In addition to presenting FFO in accordance with the NAREIT definition, for the years ended December 31, 2005, 2003, 2002 and 2001 we also disclose FFO, as adjusted, which excludes the effects of the losses from early extinguishments of debt associated with the sales of real estate, adjustments for non-qualifying derivative contracts and early lease surrender payments.

 

The adjustment to exclude losses from early extinguishments of debt results when the sale of real estate encumbered by debt requires us to pay the extinguishment costs prior to the debt’s stated maturity and to write-off unamortized loan costs at the date of the extinguishment. Such costs are excluded from the gains on sales of real estate reported in accordance with GAAP. However, we view the losses from early extinguishments of debt associated with the sales of real estate as an incremental cost of the sale transactions because we extinguished the debt in connection with the consummation of the sale transactions and we had no intent to extinguish the debt absent such transactions. We believe that this supplemental adjustment more appropriately reflects the results of our operations exclusive of the impact of our sale transactions.

 

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The adjustments for net derivative losses related to non-qualifying derivative contracts for the years ended December 31, 2003, 2002 and 2001 resulted from interest rate contracts we entered into prior to the effective date of SFAS No. 133 to limit our exposure to fluctuations in interest rates with respect to variable rate debt associated with real estate projects under development. Upon transition to SFAS No. 133 on January 1, 2001, the impacts of these contracts were recorded in current earnings, while prior to that time they were capitalized. Although these adjustments were attributable to a single hedging program, the underlying contracts extended over multiple reporting periods and therefore resulted in adjustments from the first quarter of 2001 through the third quarter of 2003. Management presents FFO before the impact of non-qualifying derivative contracts because economically this interest rate hedging program was consistent with our risk management objective of limiting our exposure to interest rate volatility and the change in accounting under GAAP did not correspond to a substantive difference. Management does not currently anticipate structuring future hedging programs in a manner that would give rise to this kind of adjustment.

 

The adjustments for early lease surrender for the years ended December 31, 2002 and 2001 resulted from a unique lease transaction related to the surrender of space by a tenant that was accounted for as a termination for GAAP purposes and recorded in income at the time the space was surrendered. However, we continued to collect payments monthly after the surrender of space through the month of July 2002, the date on which the terminated lease would otherwise have expired under its original terms. Management presents FFO after the early surrender lease adjustment because economically this transaction impacted periods subsequent to the time the space was surrendered by the tenant and, therefore, recording the entire amount of the lease termination payment in a single period made FFO less useful as an indicator of operating performance. Although these adjustments are attributable to a single lease, the transaction impacted multiple reporting periods and resulted in adjustments for the years ended December 31, 2002 and 2001.

 

Although our FFO, as adjusted, clearly differs from NAREIT’s definition of FFO, and may not be comparable to that of other REITs and real estate companies, we believe it provides a meaningful supplemental measure of our operating performance because we believe that, by excluding the effects of the losses from early extinguishments of debt associated with the sales of real estate, adjustments for non-qualifying derivative contracts and early lease surrender payments, management and investors are presented with an indicator of our operating performance that more closely achieves the objectives of the real estate industry in presenting FFO.

 

Neither FFO, nor FFO as adjusted, should be considered as an alternative to net income (determined in accordance with GAAP) as an indication of our performance. Neither FFO nor FFO, as adjusted, represent cash generated from operating activities determined in accordance with GAAP and is not a measure of liquidity or an indicator of our ability to make cash distributions. We believe that to further understand our performance, FFO and FFO, as adjusted should be compared with our reported net income and considered in addition to cash flows in accordance with GAAP, as presented in our Consolidated Financial Statements.

 

A reconciliation of FFO, and FFO, as adjusted, to net income available to common shareholders computed in accordance with GAAP is provided under the heading of “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Funds from Operations.”

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report.

 

Forward-Looking Statements

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the federal securities laws, principally, but not only, under the captions “Business-Business and Growth Strategies,” “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” We caution investors that any forward-looking statements in this report, or which management may make orally or in

 

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writing from time to time, are based on management’s beliefs and on assumptions made by, and information currently available to, management. When used, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “project,” “result” “should,” “will,” and similar expressions which do not relate solely to historical matters are intended to identify forward-looking statements. These statements are subject to risks, uncertainties and assumptions and are not guarantees of future performance, which may be affected by known and unknown risks, trends, uncertainties and factors that are beyond our control. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may differ materially from those anticipated, estimated or projected. We caution you that, while forward-looking statements reflect our good faith beliefs when we make them, they are not guarantees of future performance and are impacted by actual events when they occur after we make such statements. We expressly disclaim any responsibility to update our forward-looking statements, whether as a result of new information, future events or otherwise. Accordingly, investors should use caution in relying on past forward-looking statements, which are based on results and trends at the time they are made, to anticipate future results or trends.

 

Some of the risks and uncertainties that may cause our actual results, performance or achievements to differ materially from those expressed or implied by forward-looking statements include, among others, the following:

 

    general risks affecting the real estate industry (including, without limitation, the inability to enter into or renew leases, dependence on tenants’ financial condition, and competition from other developers, owners and operators of real estate);

 

    risks associated with the availability and terms of financing and the use of debt to fund acquisitions and developments including the risk associated with interest rates impacting the cost and/or availability of financing;

 

    risks associated with forward interest rate contracts and the effectiveness of such arrangements;

 

    failure to manage effectively our growth and expansion into new markets or to integrate acquisitions successfully;

 

    risks and uncertainties affecting property development and construction (including, without limitation, construction delays, cost overruns, inability to obtain necessary permits and public opposition to such activities);

 

    risks associated with downturns in the national and local economies, increases in interest rates, and volatility in the securities markets;

 

    risks associated with actual or threatened terrorist attacks;

 

    risks associated with the impact on our insurance program if TRIA, which expires on December 31, 2007, is not extended or is extended on different terms;

 

    costs of compliance with the Americans with Disabilities Act and other similar laws;

 

    potential liability for uninsured losses and environmental contamination;

 

    risks associated with our potential failure to qualify as a REIT under the Internal Revenue Code of 1986, as amended, and possible adverse changes in tax and environmental laws;

 

    risks associated with possible state and local tax audits; and

 

    risks associated with our dependence on key personnel whose continued service is not guaranteed.

 

The risks included here are not exhaustive. Other sections of this report, including “Part I, Item 1A—Risk Factors,” include additional factors that could adversely affect our business and financial performance. Moreover, we operate in a very competitive and rapidly changing environment. New risk factors emerge from time to time and it is not possible for management to predict all such risk factors, nor can we assess the impact of all such risk factors on our business or the extent to which any factor, or combination of factors, may cause actual

 

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results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. Investors should also refer to our quarterly reports on Form 10-Q for future periods and current reports on Form 8-K as we file them with the SEC, and to other materials we may furnish to the public from time to time through current reports on Form 8-K or otherwise.

 

Overview

 

We are a fully integrated self-administered and self-managed REIT and one of the largest owners and developers of Class A office properties in the United States. Our properties are concentrated in five markets—Boston, midtown Manhattan, Washington, D.C., San Francisco and Princeton, N.J. We generate revenue and cash primarily by leasing our Class A office space to our tenants. Factors we consider when we lease space include the creditworthiness of the tenant, the length of the lease, the rental rate to be paid, the costs of tenant improvements, operating costs and real estate taxes, our current and anticipated vacancy, current and anticipated future demand for office space and general economic factors. We also generate cash through the sale of assets, which may be either non-core assets that have limited growth potential or core assets that command premiums from real estate investors.

 

We continue to believe our corporate strategy of owning and developing high-quality office buildings concentrated in strong, supply-constrained markets and emphasizing long-term leases to creditworthy tenants has allowed us to perform well relative to our peers in difficult markets and even better in favorable markets. In addition, we believe our financial strategy of matching long-term fixed-rate debt with our long-term leases helps to insulate us from rising interest costs and, accordingly, we have fixed the interest rate on approximately 82% of our outstanding debt.

 

The office markets in which we operate showed dramatic improvement in 2005. In particular, our portfolio experienced strong rental rate growth over the past twelve month period in our midtown Manhattan, San Francisco and Washington, D.C. markets and our suburban Boston submarkets. We expect this trend to continue, but its impact on our rental revenues will be felt gradually given the modest magnitude of 2006 lease expirations, some of which reflect the high rents achieved in the late 1990s. In Boston and San Francisco, which make up approximately 74% of our office rollover in 2006, we believe the average expiring rent is between 7% and 10% greater than the current market rents.

 

During 2005, we completed the sale of $838 million of assets while retaining property management on several of the significant properties sold, paid a special dividend of $2.50 per common share in October 2005 and increased our regular quarterly dividend for the eighth consecutive year. Including dividends, we delivered a total return of 23.6% to our shareholders in 2005. Our regional operating teams completed more than 4.1 million square feet of leasing in 2005 while prudently managing transaction costs and non-recurring capital expenses and we increased our occupancy from 92.1% to 93.8%. Other highlights of our 2005 activity include the following:

 

    We placed in-service our 901 New York Avenue project, a 539,000 square-foot Class A office building located in Washington, D.C. in which we have a 25% interest.

 

    We placed in-service the West Garage phase of our Seven Cambridge Center development project located in Cambridge, Massachusetts which will provide parking for approximately 800 cars.

 

    We continued development on four active construction projects and commenced construction on one additional project during the year, which aggregate an estimated total investment of $317.6 million as of December 31, 2005.

 

    In late December 2005, we acquired Prospect Place, a 297,000 square foot Class A office building, for a purchase price of $62.8 million. We intend to invest an additional $8.8 million in this property. Also, in December 2005, our Value-Added Fund acquired 300 Billerica Road, an 111,000 square foot office property, for a purchase price of approximately $10.0 million, of which our share was approximately $2.5 million.

 

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    During 2005, we adopted an interest rate hedging program. As of December 31, 2005, we had entered into twelve forward-starting interest rate swap contracts which fix the ten-year treasury rate for anticipated financings in early 2007 at a weighted-average rate of 4.34% per annum on notional amounts aggregating $500.0 million.

 

Looking ahead we believe the best utilization of our management skills is in the continued success of our development strategies. Given current market conditions, we generally believe that the returns we can generate from developments will be significantly greater than those we can expect to realize from acquisitions. As a result, we continue to pursue new development opportunities, which is one of our core capabilities. We are also considering alternative uses (i.e., non-office) for some of our land holdings and may participate or undertake alternative development projects.

 

We also expect that allocators of capital will continue to place a premium on high-quality, well located office buildings resulting in lower capitalization rates and higher prices per square foot. As an owner of these types of assets, we are pleased with higher valuations, and in 2006 we intend to selectively sell some of our assets (including large core assets) to realize some of this value. While the amount of gross proceeds that we will ultimately realize from these asset sales is uncertain, the Company expects that the magnitude of the sales in 2006 could be significantly greater than the $838 million of assets sold in 2005. However, there can be no assurance that we will sell any of our assets on favorable terms or at all.

 

Unfortunately, the same market conditions that are leading to record valuations for Class A office buildings and that make significant asset sales attractive to us are also continuing to make it more difficult for us to acquire assets at what we believe to be attractive rates of return. To the extent that we successfully sell a significant amount of assets and cannot efficiently use the proceeds for either our development activities or attractive acquisitions, we would, at the appropriate time, decide whether it is better to declare a special dividend, adopt a stock repurchase program, reduce our indebtedness or retain the cash for future investment opportunities. Such a decision will depend on many factors including, among others, the timing, availability and terms of development and acquisition opportunities, our then-current and anticipated leverage, the price of our common stock and REIT distribution requirements. At a minimum, we expect that we would distribute at least that amount of proceeds necessary for the Company to avoid paying corporate level tax on the applicable gains realized from any asset sales.

 

Critical Accounting Policies

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, or GAAP, requires management to use judgment in the application of accounting policies, including making estimates and assumptions. We base our estimates on historical experience and on various other assumptions believed to be reasonable under the circumstances. These judgments affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. If our judgment or interpretation of the facts and circumstances relating to various transactions had been different, it is possible that different accounting policies would have been applied resulting in a different presentation of our financial statements. From time to time, we evaluate our estimates and assumptions. In the event estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current information. Below is a discussion of accounting policies that we consider critical in that they may require complex judgment in their application or require estimates about matters that are inherently uncertain.

 

Real Estate

 

Upon acquisitions of real estate, we assess the fair value of acquired tangible and intangible assets, including land, buildings, tenant improvements, “above-” and “below-market” leases, origination costs, acquired in-place leases, other identified intangible assets and assumed liabilities in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations” and allocate the purchase price to the acquired assets and assumed liabilities, including land at appraised value and buildings at replacement cost.

 

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We assess and consider fair value based on estimated cash flow projections that utilize appropriate discount and/or capitalization rates, as well as available market information. Estimates of future cash flows are based on a number of factors including the historical operating results, known and anticipated trends, and market and economic conditions. The fair value of the tangible assets of an acquired property considers the value of the property as if it were vacant. We also consider an allocation of purchase price of other acquired intangibles, including acquired in-place leases that may have a customer relationship intangible value, including (but not limited to) the nature and extent of the existing relationship with the tenants, the tenants’ credit quality and expectations of lease renewals. Based on our acquisitions to date, our allocation to customer relationship intangible assets has been immaterial.

 

We record acquired “above-” and “below-market” leases at their fair values (using a discount rate which reflects the risks associated with the leases acquired) equal to the difference between (1) the contractual amounts to be paid pursuant to each in-place lease and (2) management’s estimate of fair market lease rates for each corresponding in-place lease, measured over a period equal to the remaining term of the lease for above-market leases and the initial term plus the term of any below-market fixed rate renewal options for below-market leases. Other intangible assets acquired include amounts for in-place lease values that are based on our evaluation of the specific characteristics of each tenant’s lease. Factors to be considered include estimates of carrying costs during hypothetical expected lease-up periods considering current market conditions, and costs to execute similar leases. In estimating carrying costs, we include real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, depending on local market conditions. In estimating costs to execute similar leases, we consider leasing commissions, legal and other related expenses.

 

Real estate is stated at depreciated cost. The cost of buildings and improvements includes the purchase price of property, legal fees and other acquisition costs. Costs directly related to the development of properties are capitalized. Capitalized development costs include interest, internal wages, property taxes, insurance, and other project costs incurred during the period of development.

 

Management reviews its long-lived assets used in operations for impairment when there is an event or change in circumstances that indicates an impairment in value. An impairment loss is recognized if the carrying amount of its assets is not recoverable and exceeds its fair value. If such impairment is present, an impairment loss is recognized based on the excess of the carrying amount of the asset over its fair value. The evaluation of anticipated cash flows is highly subjective and is based in part on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results in future periods. Since cash flows on properties considered to be “long-lived assets to be held and used” as defined by SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” (“SFAS No. 144”) are considered on an undiscounted basis to determine whether an asset has been impaired, our established strategy of holding properties over the long term directly decreases the likelihood of recording an impairment loss. If our strategy changes or market conditions otherwise dictate an earlier sale date, an impairment loss may be recognized and such loss could be material. If we determine that impairment has occurred, the affected assets must be reduced to their fair value. No such impairment losses have been recognized to date.

 

SFAS No. 144, which was adopted on January 1, 2002, requires that qualifying assets and liabilities and the results of operations that have been sold, or otherwise qualify as “held for sale,” be presented as discontinued operations in all periods presented if the property operations are expected to be eliminated and we will not have significant continuing involvement following the sale. The components of the property’s net income that is reflected as discontinued operations include the net gain (or loss) upon the disposition of the property held for sale, operating results, depreciation and interest expense (if the property is subject to a secured loan). We generally consider assets to be “held for sale” when the transaction has been approved by our Board of Directors, or a committee thereof, and there are no known significant contingencies relating to the sale, such that the property sale within one year is considered probable. Following the classification of a property as “held for sale,” no further depreciation is recorded on the assets.

 

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A variety of costs are incurred in the acquisition, development and leasing of properties. After determination is made to capitalize a cost, it is allocated to the specific component of a project that is benefited. Determination of when a development project is substantially complete and capitalization must cease involves a degree of judgement. Our capitalization policy on development properties is guided by SFAS No. 34 “Capitalization of Interest Cost” and SFAS No. 67 “Accounting for Costs and the Initial Rental Operations of Real Estate Properties.” The costs of land and buildings under development include specifically identifiable costs. The capitalized costs include pre-construction costs essential to the development of the property, development costs, construction costs, interest costs, real estate taxes, salaries and related costs and other costs incurred during the period of development. We consider a construction project as substantially completed and held available for occupancy upon the completion of tenant improvements, but no later than one year from cessation of major construction activity. We cease capitalization on the portion (1) substantially completed and (2) occupied or held available for occupancy, and we capitalize only those costs associated with the portion under construction.

 

Investments in Unconsolidated Joint Ventures

 

Except for ownership interests in variable interest entities, we account for our investments in joint ventures under the equity method of accounting because we exercise significant influence over, but do not control, these entities. These investments are recorded initially at cost, as Investments in Unconsolidated Joint Ventures, and subsequently adjusted for equity in earnings and cash contributions and distributions. Any difference between the carrying amount of these investments on our balance sheet and the underlying equity in net assets is amortized as an adjustment to equity in earnings of unconsolidated joint ventures over the life of the related asset. Under the equity method of accounting, our net equity is reflected within the Consolidated Balance Sheets, and our share of net income or loss from the joint ventures is included within the Consolidated Statements of Operations. The joint venture agreements may designate different percentage allocations among investors for profits and losses, however, our recognition of joint venture income or loss generally follows the joint venture’s distribution priorities, which may change upon the achievement of certain investment return thresholds. For ownership interests in variable interest entities, we consolidate those in which we are the primary beneficiary.

 

Revenue Recognition

 

Base rental revenue is reported on a straight-line basis over the terms of our respective leases. In accordance with SFAS No. 141, we recognize rental revenue of acquired in-place “above-” and “below-market” leases at their fair values over the terms of the respective leases. Accrued rental income as reported on the Consolidated Balance Sheets represents rental income recognized in excess of rent payments actually received pursuant to the terms of the individual lease agreements.

 

Our leasing strategy is generally to secure creditworthy tenants that meet our underwriting guidelines. Furthermore, following the initiation of a lease, we continue to actively monitor the tenant’s creditworthiness to ensure that all tenant related assets are recorded at their realizable value. When assessing tenant credit quality, we:

 

    review relevant financial information, including:

 

    financial ratios;

 

    net worth;

 

    debt to market capitalization; and

 

    liquidity;

 

    evaluate the depth and experience of the tenant’s management team; and

 

    assess the strength/growth of the tenant’s industry.

 

As a result of the underwriting process, tenants are then categorized into one of three categories:

 

    low risk tenants;

 

    the tenant’s credit is such that we require collateral in which case we:

 

    require a security deposit; and/or

 

    reduce upfront tenant improvement investments; or

 

    the tenant’s credit is below our acceptable parameters.

 

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We maintain a rigorous process of monitoring the credit quality of our tenant base. We provide an allowance for doubtful accounts arising from estimated losses that could result from the tenant’s inability to make required current rent payments and an allowance against accrued rental income for future potential loses that we deem to be unrecoverable over the term of the lease.

 

Tenant receivables are assigned a credit rating of 1-4 with a rating of 1 representing the highest possible rating with no allowance recorded and a rating of 4 representing the lowest credit rating, recording a full reserve against the receivable balance. Among the factors considered in determining the credit rating include:

 

    payment history;

 

    credit status and change in status (credit ratings for public companies are used as a primary metric);

 

    change in tenant space needs (i.e., expansion/downsize);

 

    tenant financial performance;

 

    economic conditions in a specific geographic region; and

 

    industry specific credit considerations.

 

If our estimates of collectibility differ from the cash received, the timing and amount of our reported revenue could be impacted. The average remaining term of our in-place tenant leases was approximately 7.3 years as of December 31, 2005. The credit risk is mitigated by the high quality of our existing tenant base, reviews of prospective tenants’ risk profiles prior to lease execution and continual monitoring of our portfolio to identify potential problem tenants.

 

Recoveries from tenants, consisting of amounts due from tenants for common area maintenance, real estate taxes and other recoverable costs, are recognized as revenue in the period the expenses are incurred. Tenant reimbursements are recognized and presented in accordance with Emerging Issues Task Force, or EITF, Issue 99-19 “Reporting Revenue Gross as a Principal versus Net as an Agent,” or Issue 99-19. Issue 99-19 requires that these reimbursements be recorded on a gross basis, as we are generally the primary obligor with respect to purchasing goods and services from third-party suppliers, have discretion in selecting the supplier and have credit risk.

 

Our hotel revenues are derived from room rentals and other sources such as charges to guests for long-distance telephone service, fax machine use, movie and vending commissions, meeting and banquet room revenue and laundry services. Hotel revenues are recognized as earned.

 

We receive management and development fees from third parties. Management fees are recorded and earned based on a percentage of collected rents at the properties under management, and not on a straight-line basis, because such fees are contingent upon the collection of rents. We review each development agreement and record development fees on a straight-line basis or percentage of completion depending on the risk associated with each project. Profit on development fees earned from joint venture projects is recognized as revenue to the extent of the third party partners’ ownership interest.

 

Gains on sales of real estate are recognized pursuant to the provisions of SFAS No. 66, “Accounting for Sales of Real Estate.” The specific timing of the sale is measured against various criteria in SFAS No. 66 related to the terms of the transactions and any continuing involvement in the form of management or financial assistance associated with the properties. If the sales criteria are not met, we defer gain recognition and account for the continued operations of the property by applying the finance, installment or cost recovery methods, as appropriate, until the sales criteria are met.

 

Depreciation and Amortization

 

We compute depreciation and amortization on our properties using the straight-line method based on estimated useful asset lives. In accordance with SFAS No. 141, we allocate the acquisition cost of real estate to land, building, tenant improvements, acquired “above-” and “below-market” leases, origination costs and

 

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acquired in-place leases based on an assessment of their fair value and depreciate or amortize these assets over their useful lives. The amortization of acquired “above-” and “below-market” leases and acquired in-place leases is recorded as an adjustment to revenue and depreciation and amortization, respectively, in the Consolidated Statements of Operations.

 

Fair Value of Financial Instruments

 

For purposes of disclosure, we calculate the fair value of our mortgage notes payable and unsecured senior notes. We discount the spread between the future contractual interest payments and future interest payments on our mortgage debt and unsecured notes based on a current market rate. In determining the current market rate, we add our estimate of a market spread to the quoted yields on federal government treasury securities with similar maturity dates to our own debt. Because our valuations of our financial instruments are based on these types of estimates, the fair value of our financial instruments may change if our estimates do not prove to be accurate.

 

Results of Operations

 

The following discussion is based on our Consolidated Financial Statements for the years ended December 31, 2005, 2004 and 2003.

 

At December 31, 2005, 2004 and 2003, we owned or had interests in a portfolio of 121, 125 and 140 properties, respectively (the “Total Property Portfolio”). As a result of changes within our Total Property Portfolio, the financial data presented below shows significant changes in revenue and expenses from period-to-period. Accordingly, we do not believe that our period-to-period financial data are comparable. Therefore, the comparisons of operating results for the years ended 2005, 2004 and 2003 show separately the changes attributable to the properties that were owned by us throughout each period compared (the “Same Property Portfolio”) and the changes attributable to the Total Property Portfolio.

 

In our analysis of operating results, particularly to make comparisons of net operating income between periods meaningful, it is important to provide information for properties that were in-service and owned by us throughout each period presented. We refer to properties acquired or placed in-service prior to the beginning of the earliest period presented and owned by us through the end of the latest period presented as our Same Property Portfolio. The Same Property Portfolio therefore excludes properties placed in-service, acquired or repositioned after the beginning of the earliest period presented or disposed of prior to the end of the latest period presented.

 

Net operating income, or “NOI,” is a non-GAAP financial measure equal to net income available to common shareholders, the most directly comparable GAAP financial measure, plus cumulative effect of a change in accounting principle (net of minority interest), minority interest in Operating Partnership, net derivative losses, losses from early extinguishments of debt, depreciation and amortization, interest expense, general and administrative expense, less gains on sales of real estate from discontinued operations (net of minority interest), income from discontinued operations (net of minority interest), gains on sales of real estate and other assets (net of minority interest), income from unconsolidated joint ventures, minority interest in property partnerships, interest and other income and development and management services revenue. We use NOI internally as a performance measure and believe NOI provides useful information to investors regarding our financial condition and results of operations because it reflects only those income and expense items that are incurred at the property level. Therefore, we believe NOI is a useful measure for evaluating the operating performance of our real estate assets.

 

Our management also uses NOI to evaluate regional property level performance and to make decisions about resource allocations. Further, we believe NOI is useful to investors as a performance measure because, when compared across periods, NOI reflects the impact on operations from trends in occupancy rates, rental rates, operating costs and acquisition and development activity on an unleveraged basis, providing perspective not immediately apparent from net income. NOI excludes certain components from net income in order to provide results that are more closely related to a property’s results of operations. For example, interest expense is

 

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not necessarily linked to the operating performance of a real estate asset and is often incurred at the corporate level as opposed to the property level. In addition, depreciation and amortization, because of historical cost accounting and useful life estimates, may distort operating performance at the property level. NOI presented by us may not be comparable to NOI reported by other REITs that define NOI differently. We believe that in order to facilitate a clear understanding of our operating results, NOI should be examined in conjunction with net income as presented in our consolidated financial statements. NOI should not be considered as an alternative to net income as an indication of our performance or to cash flows as a measure of liquidity or ability to make distributions.

 

Comparison of the year ended December 31, 2005 to the year ended December 31, 2004

 

The table below shows selected operating information for the Same Property Portfolio and the Total Property Portfolio. The Same Property Portfolio consists of 109 properties, including two hotels and three properties in which we have joint venture interests, acquired or placed in-service on or prior to January 1, 2004 and owned by us through December 31, 2005. The Total Property Portfolio includes the effect of the other properties either placed in-service, acquired or repositioned after January 1, 2004 or disposed of on or prior to December 31, 2005. This table includes a reconciliation from Same Property Portfolio to Total Property Portfolio by also providing information for the properties which were sold, acquired, placed in-service or repositioned during the years ended December 31, 2005 and 2004. Our net property operating margins for the Total Property Portfolio, which are defined as rental revenue less operating expenses, exclusive of the two hotel properties, for the years ended December 31, 2005 and 2004, were 68.8% and 69.2%, respectively.

 

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    Same Property Portfolio

    Properties Sold

  Properties
Acquired


    Properties
Placed
In-Service


  Properties
Repositioned


  Total Property Portfolio

 
(dollars in thousands)   2005

  2004

 

Increase/

(Decrease)


   

%

Change


    2005

  2004

  2005

  2004

    2005

  2004

  2005

  2004

  2005

    2004

   

Increase/

(Decrease)


   

%

Change


 

Rental Revenue:

                                                                                                         

Rental Revenue

  $ 1,176,006   $ 1,147,496   $ 28,510     2.48 %   $ 32,247   $ 63,067   $ 26,503   $ 19,344     $ 79,703   $ 40,873   $ 13,094   $ 14,369   $ 1,327,553     $ 1,285,149     $ 42,404     3.30 %

Termination Income

    11,311     3,982     7,329     184.05 %     —       9     —       —         169     —       —       —       11,480       3,991       7,489     187.65 %
   

 

 


 

 

 

 

 


 

 

 

 

 


 


 


 

Total Rental Revenue

    1,187,317     1,151,478     35,839     3.11 %     32,247     63,076     26,503     19,344       79,872     40,873     13,094     14,369     1,339,033       1,289,140       49,893     3.87 %
   

 

 


 

 

 

 

 


 

 

 

 

 


 


 


 

Operating Expenses

    403,964     380,678     23,286     6.12 %     12,399     22,706     5,665     4,198       12,884     4,474     3,423     4,271     438,335       416,327       22,008     5.29 %
   

 

 


 

 

 

 

 


 

 

 

 

 


 


 


 

Net Operating Income, excluding hotels

    783,353     770,800     12,553     1.63 %     19,848     40,370     20,838     15,146       66,988     36,399     9,671     10,098     900,698       872,813       27,885     3.19 %
   

 

 


 

 

 

 

 


 

 

 

 

 


 


 


 

Hotel Net Operating Income (1)

    17,588     16,985     603     3.55 %     —       —       —       —         —       —       —       —       17,588       16,985       603     3.55 %
   

 

 


 

 

 

 

 


 

 

 

 

 


 


 


 

Consolidated Net Operating Income (1)

    800,941     787,785     13,156     1.67 %     19,848     40,370     20,838     15,146       66,988     36,399     9,671     10,098     918,286       889,798       28,488     3.20 %
   

 

 


 

 

 

 

 


 

 

 

 

 


 


 


 

Other Revenue:

                                                                                                         

Development and Management services

    —       —       —       —         —       —       —       —         —       —       —       —       17,310       20,440       (3,130 )   (15.31 )%

Interest and Other

    —       —       —       —         —       —       —       —         —       —       —       —       12,015       10,339       1,676     16.21 %
   

 

 


 

 

 

 

 


 

 

 

 

 


 


 


 

Total Other Revenue

    —       —       —       —         —       —       —       —         —       —       —       —       29,325       30,779       (1,454 )   (4.72 )%

Other Expenses:

                                                                                                         

General and administrative

    —       —       —       —         —       —       —       —         —       —       —       —       55,471       53,636       1,835     3.42 %

Interest

    —       —       —       —         —       —       —       —         —       —       —       —       308,091       306,170       1,921     0.63 %

Depreciation and amortization

    234,937     220,171     14,766     6.71 %     5,983     12,791     5,497     3,850       18,757     7,909     1,655     4,928     266,829       249,649       17,180     6.88 %

Losses from early extinguishments of debt

    —       —       —       —         —       —       —       —         —       —       —       —       12,896       6,258       6,638     106.07 %
   

 

 


 

 

 

 

 


 

 

 

 

 


 


 


 

Total Other Expenses

    234,937     220,171     14,766     6.71 %     5,983     12,791     5,497     3,850       18,757     7,909     1,655     4,928     643,287       615,713       27,574     4.48 %
   

 

 


 

 

 

 

 


 

 

 

 

 


 


 


 

Income before minority interests

  $ 566,004   $ 567,614   $ (1,610 )   (0.28 )%   $ 13,865   $ 27,579   $ 15,341   $ 11,296     $ 48,231   $ 28,490   $ 8,016   $ 5,170   $ 304,324     $ 304,864     $ (540 )   (0.18 )%

Income from unconsolidated joint ventures

  $ 2,602   $ 3,054   $ (452 )   (14.80 )%   $ —     $ 304   $ 103   $ (32 )   $ 2,124   $ 54     —       —       4,829       3,380       1,449     42.87 %

Income from discontinued operations, net of minority interest

  $ —     $ —       —       —       $ 1,908   $ 3,344     —       —         —       —       —       —       1,908       3,344       (1,436 )   (42.95 )%

Minority interests in property partnerships

                                                                                6,017       4,685       1,332     28.43 %

Minority interest in Operating Partnership

                                                                                (74,103 )     (67,743 )     (6,360 )   9.39 %

Gains on sales of real estate, net of minority interest

                                                                                151,884       8,149       143,735     1,763.84 %

Gains on sales of real estate from discontinued operations, net of minority interest

                                                                                47,656       27,338       20,318     74.32 %

Cumulative effect of a change in accounting principle, net of minority interest

                                                                                (4,223 )     —         (4,223 )   (100.0 )%
                                                                               


 


 


 

Net Income available to common shareholders

                                                                              $ 438,292     $ 284,017     $ 154,275     54.32 %
                                                                               


 


 


 


(1) For a detailed discussion of NOI, including the reasons management believes NOI is useful to investors, see page 41.

 

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Table of Contents

Rental Revenue

 

The increase of $42.4 million in the Total Property Portfolio is comprised of increases and decreases within the five categories that represent our Total Property Portfolio. Rental revenue from Properties Placed In-Service increased approximately $38.8 million, Same Property Portfolio increased approximately $28.5 million, Properties Acquired increased approximately $7.2 million, Properties Sold decreased approximately $30.8 million and Properties Repositioned decreased approximately $1.3 million.

 

The increase in rental revenue from Properties Placed In-Service relates to placing in-service Times Square Tower and New Dominion Technology Park, Building Two during the third quarter of 2004, and the West Garage phase of our Seven Cambridge Center development in the fourth quarter of 2005 as detailed below:

 

Property


  

Date Placed-in-

service


  Rental Revenue for the year ended

         2005    

   2004

   Change

         (in thousands)

Times Square Tower

   3rd Quarter 2004   $ 69,608    $ 36,470    $ 33,138

New Dominion Technology Park, Building Two

   3rd Quarter 2004     9,683      4,403      5,280

Cambridge Center West Garage

   4th Quarter 2005     412      —        412
        

  

  

Total

       $ 79,703    $ 40,873    $ 38,830
        

  

  

 

Rental revenue from the Same Property Portfolio increased approximately $28.5 million from 2004. Included in rental revenue is an overall increase in base rental revenue of approximately $8.9 million due to increases in our occupancy from 92.1% on December 31, 2004 to 93.8% on December 31, 2005 which was offset by a roll-down in market rents. Straight-line rent increased approximately $6.5 million for the year ended December 31, 2005 compared to December 31, 2004. Approximately $13.6 million of the increase from the Same Property Portfolio was due to an increase in recoveries from tenants attributed to higher operating expenses. With respect to leases that expire during the next year, we anticipate that occupancy will continue to increase which will be offset by a roll-down of approximately 5% to 6% on the estimated market rents. We currently expect net operating income from the Same Property Portfolio to increase up to 2% in 2006 compared to 2005.

 

The acquisition of Prospect Place on December 30, 2005, 1330 Connecticut Avenue on April 1, 2004 and the purchase of the remaining interest in 140 Kendrick Street on March 24, 2004 increased revenue from Properties Acquired by approximately $7.2 million, as detailed below:

 

Property


   Date Acquired

   Rental Revenue for the year ended

          2005    

       2004    

       Change    

          (in thousands)

1330 Connecticut Avenue

   April 1, 2004    $ 14,860    $ 10,870    $ 3,990

140 Kendrick Street

   March 24, 2004      11,614      8,474      3,140

Prospect Place

   December 30, 2005      29      —        29
         

  

  

Total

        $ 26,503    $ 19,344    $ 7,159
         

  

  

 

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The aggregate increase in rental revenue was offset by the sales of Embarcadero Center West Tower, Riverfront Plaza and 100 East Pratt Street during 2005, and Hilltop Office Center during 2004. These properties have not been classified as discontinued operations due to our continuing involvement as the property manager for each property. Revenue from Properties Sold decreased by approximately $30.8 million, as detailed below:

 

Property


   Date Sold

   Rental Revenue for the year ended

 
      2005

   2004

   Change

 
          (in thousands)  

Embarcadero Center West Tower

   December 14, 2005    $ 15,081    $ 17,837    $ (2,756 )

Riverfront Plaza

   May 16, 2005      8,760      23,488      (14,728 )

100 East Pratt Street

   May 12, 2005      8,406      21,602      (13,196 )

Hilltop Office Center

   February 4, 2004      —        140      (140 )
         

  

  


Total

        $ 32,247    $ 63,067    $ (30,820 )
         

  

  


 

In September 2004, we commenced the redevelopment of our Capital Gallery property in Washington, D.C. Capital Gallery is a Class A office property totaling approximately 397,000 square feet. The project entails removing a three-story low-rise section of the property comprised of 100,000 square feet from in-service status and developing it into a 10-story office building resulting in a total complex size of approximately 610,000 square feet upon completion. This property is included in Properties Repositioned for the year ended December 31, 2005 and 2004. Rental revenue has decreased for the year ended December 31, 2005 due to taking the three-story low-rise section out of service in September 2004.

 

Termination Income

 

Termination income for year ended December 31, 2005 was related to twenty-three tenants across the Total Property Portfolio that terminated their leases, and we recognized termination income totaling approximately $11.5 million. This compared to termination income earned for the year ended December 31, 2004 related to nineteen tenants totaling $4.0 million. During 2005 we completed several leasing transactions which involved taking space back from tenants with resulting termination income and releasing the space at higher rents. We currently anticipate realizing approximately $4.0 million in termination income for the year ended 2006.

 

Operating Expenses

 

The $22.0 million increase in property operating expenses in the Total Property Portfolio (real estate taxes, utilities, insurance, repairs and maintenance, cleaning and other property-related expenses) is comprised of increases and decreases within the five categories that represent our Total Property Portfolio. Operating expenses for the Same Property Portfolio increased approximately $23.3 million, Properties Placed In-Service increased approximately $8.4 million, Properties Acquired increased approximately $1.4 million, Properties Sold decreased approximately $10.3 million and Properties Repositioned decreased approximately $0.8 million.

 

Operating expenses from the Same Property Portfolio increased approximately $23.3 million for the year ended December 31, 2005 compared to 2004. Included in Same Property Portfolio operating expenses is an increase in utility expenses of approximately $10.2 million, an increase of approximately 14% over the prior year utility expense. In addition, real estate taxes increased approximately $7.9 million due to increased real estate tax assessments, with approximately half of this increase specifically attributed to properties located in New York City. The remaining $5.2 million increase in the Same Property Portfolio operating expenses are related to an increase to repairs and maintenance.

 

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Table of Contents

We placed in-service Times Square Tower and New Dominion Technology Park, Building Two during the third quarter of 2004 and the West Garage phase of our Seven Cambridge Center development in the fourth quarter of 2005 increasing operating expenses by approximately $8.4 million as detailed below:

 

Property


  

Date Placed-in-
service


   Operating Expenses for the year ended

          2005    

       2004    

   Change

          (in thousands)

Times Square Tower

   3rd Quarter 2004    $ 11,168    $ 4,053    $ 7,115

New Dominion Technology Park Building Two

   3rd Quarter 2004      1,595      421      1,174

West Garage

   4th Quarter 2005      121      —        121
         

  

  

Total

        $ 12,884    $ 4,474    $ 8,410
         

  

  

 

In addition, approximately $1.4 million of the increase in Total Property Portfolio operating expenses primarily relates to the acquisitions of Prospect Place at the end of 2005 as well as our acquisitions in 2004 of 1330 Connecticut Avenue and the remaining interest in 140 Kendrick Street, as detailed below:

 

Property


  

Date Acquired


   Operating Expenses for the year ended

          2005    

       2004    

   Change

          (in thousands)

1330 Connecticut Avenue

   April 1, 2004    $ 4,220    $ 2,986    $ 1,234

140 Kendrick Street

   March 24, 2004      1,427      1,212      215

Prospect Place

   December 30, 2005      18      —        18
         

  

  

Total

        $ 5,665    $ 4,198    $ 1,467
         

  

  

 

A decrease of approximately $10.3 million in Total Property Portfolio operating expenses relates to the sales of Embarcadero Center West Tower, 100 East Pratt Street and Riverfront Plaza in 2005, and Hilltop Office Center in 2004, as detailed below:

 

Property


   Date Sold

   Operating Expenses for the year ended

 
          2005    

       2004    

       Change    

 
          (in thousands)  

Embarcadero Center West Tower

   December 14, 2005    $ 6,516    $ 6,866    $ (350 )

100 East Pratt Street

   May 12, 2005      3,019      8,039      (5,020 )

Riverfront Plaza

   May 16, 2005      2,864      7,764      (4,900 )

Hilltop Office Center

   February 4, 2004      —        37      (37 )
         

  

  


Total

        $ 12,399    $ 22,706    $ (10,307 )
         

  

  


 

We continue to review and monitor the impact of rising insurance costs and energy costs, as well as other factors, on our operating budgets for fiscal year 2006. Because some operating expenses are not recoverable from tenants, an increase in operating expenses due to one or more of the foregoing factors could have an adverse effect on our results of operations.

 

Hotel Net Operating Income

 

Net operating income for the hotel properties increased by approximately $0.6 million for the year ended December 31, 2005 compared to 2004. For the years ended December 31, 2005 and 2004 the Residence Inn by Marriott® was included as part of discontinued operations due to its sale on November 4, 2005. We expect the two remaining hotels to contribute in the aggregate between approximately $20.0 million and $21.0 million of net operating income in 2006.

 

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Table of Contents

The following reflects our occupancy and rate information for our hotel properties for the year ended December 31, 2005 and 2004. This information excludes the Residence Inn by Marriott® due to its sale on November 4, 2005.

 

     2005

    2004

    Percentage
Change


 

Occupancy

     77.4 %     80.0 %   (3.2 )%

Average daily rate

   $ 197.82     $ 185.42     6.7 %

Revenue per available room, REVPAR

   $ 153.95     $ 149.04     3.3 %

 

Development and Management Services

 

Our third-party fee income decreased approximately $3.1 million for the year ended December 31, 2005 compared to 2004 due to the completion of third-party development projects at the National Institute of Health in Washington, D.C. and near completion of our project at 90 Church Street in New York City, partially offset by maintaining management contracts in connection with certain of our asset sales. For the year ended December 31, 2005, development fees decreased approximately $4.9 million, offset by an increase in management fees and service income of approximately $1.8 million. We expect our third-party management and development fee income in 2006 to be between $13.0 million and $15.0 million.

 

Interest and Other Income

 

Interest and other income increased by approximately $1.7 million for the year ended December 31, 2005 compared to 2004. In the first quarter of 2004 we recognized a net amount of approximately $7.0 million of other income in connection with the termination by a third-party of an agreement to enter into a ground lease with us. Excluding this termination, interest and other income increased approximately $8.6 million for the year ended December 31, 2005 compared to 2004 due to higher cash balances as well as higher interest rates during 2005 compared to 2004.

 

Other Expenses

 

General and Administrative

 

General and administrative expenses increased approximately $1.8 million for the year ended December 31, 2005 compared to 2004. Approximately $2.2 million of the increase was attributable to changes in the form of long-term equity-based compensation, as further described below. In addition, there was an overall increase to bonuses and salaries for the year ended December 31, 2005. These increases were offset by a decrease of approximately $2.8 million attributable to a refund of prior year state taxes based on income and net worth as a result of changes to a state tax law.

 

Commencing in 2003, we issued restricted stock and/or LTIP Units, as opposed to granting stock options and restricted stock, under the 1997 Stock Option and Incentive Plan as our primary vehicle for employee equity compensation. An LTIP Unit is generally the economic equivalent of a share of our restricted stock. Employees generally vest in restricted stock and LTIP Units over a five-year term (for awards granted prior to 2003, vesting is in equal annual installments; for those granted in 2003 and beyond, vesting is over a five-year term with annual vesting of 0%, 0%, 25%, 35% and 40%). Restricted stock and LTIP Units are valued based on observable market prices for similar instruments. Such value is recognized as an expense ratably over the corresponding employee service period. LTIP Units that were issued in January 2005 and any future LTIP Unit awards will be valued using an option pricing model in accordance with the provisions of SFAS No. 123R. To the extent restricted stock or LTIP Units are forfeited prior to vesting, the corresponding previously recognized expense is reversed as an offset to “stock-based compensation.” Stock-based compensation expense associated with $6.1 million of equity-based compensation that was granted in January 2003 will generally be expensed ratably as such restricted stock and LTIP Units vests over a five-year vesting period. Stock-based compensation associated with approximately $9.7 million of restricted stock and LTIP Units granted in January 2004 and approximately $11.4

 

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Table of Contents

million of restricted stock and LTIP Units granted in January 2005 will also be incurred ratably as such restricted stock and LTIP Units vest. To the extent we continue to grant restricted stock and/or LTIP Unit awards, our expense will continue to increase significantly until 2008 even if there are no future increases in the aggregate value of restricted equity granted each year. This is because we expense the value of the restricted stock and LTIP Unit awards ratably over the five-year vesting period and a full run-rate will not be achieved until 2008.

 

Interest Expense

 

Interest expense for the Total Property Portfolio increased approximately $1.9 million for the year ended December 31, 2005 compared to 2004. The majority of the increases/decreases are due to (1) the cessation of interest capitalization at Times Square Tower and New Dominion Technology Park, Building Two, which increased interest expense by $14.9 million, and (2) the assumption of debt in connection with the acquisition of the remaining interest in 140 Kendrick Street and 1330 Connecticut Avenue in the second quarter of 2004, which increased interest expense by $1.3 million. These increases were offset by (1) the repayment of outstanding mortgage debt in connection with the sales of Riverfront Plaza and 100 East Pratt Street in the second quarter of 2005, as well as Embarcadero Center West Tower in October 2005, which decreased interest expense by $9.7 million, and (2) the repayment of mortgage debt at One and Two Reston Overlook and the 12300 and 12310 Sunrise Valley Drive buildings in the beginning of 2004 which decreased interest expense by $1.4 million. In addition, the impact of refinancing our fixed rate debt collateralized by 599 Lexington Avenue using borrowings under our unsecured line at a lower interest rate decreased interest expense approximately $3.0 million.

 

At December 31, 2005, our variable rate debt consisted of our construction loans on our Times Square Tower, Capital Gallery Expansion and Seven Cambridge Center construction projects, as well as our borrowings under our unsecured line of credit. The following summarizes our outstanding debt as of December 31, 2005 compared with December 31, 2004:

 

     December 31,

 
     2005

    2004

 
     (dollars in thousands)  

Debt Summary:

                

Balance

                

Fixed rate

   $ 3,952,151     $ 4,588,024  

Variable rate

     874,103       423,790  
    


 


Total

   $ 4,826,254     $ 5,011,814  
    


 


Percent of total debt:

                

Fixed rate

     81.89 %     91.54 %

Variable rate

     18.11 %     8.46 %
    


 


Total

     100.00 %     100.00 %
    


 


Weighted average interest rate at end of period:

                

Fixed rate

     6.70 %     6.66 %

Variable rate

     4.96 %     3.36 %
    


 


Total

     6.39 %     6.38 %
    


 


 

Depreciation and Amortization

 

Depreciation and amortization expense for the Total Property Portfolio increased approximately $17.2 million for the year ended December 31, 2005 compared to 2004. Depreciation and amortization from Properties Placed In-Service increased approximately $10.8 million, Properties Acquired increased approximately $1.6 million, The Same Property Portfolio increased approximately $14.8 million, Properties Sold decreased approximately $6.8 million and Properties Repositioned decreased approximately $3.3 million. In connection with the redevelopment project at Capital Gallery, which is classified as Properties Repositioned, we recognized an accelerated depreciation charge of approximately $2.6 million in the third quarter of 2004 representing the net book value of the portion of the three-story, low-rise section of the building being redeveloped.

 

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Table of Contents

The additions to the Total Property Portfolio through acquisitions increased depreciation and amortization expense by approximately $1.6 million, as detailed below:

 

Property


   Acquired

  

Depreciation and Amortization for the

year ended


            2005      

         2004      

   Change

          (in thousands)

1330 Connecticut Avenue

   April 1, 2004    $ 3,470    $ 2,292      1,178

140 Kendrick Street

   March 24, 2004      2,027      1,558      469
         

  

  

Total

        $ 5,497    $ 3,850    $ 1,647
         

  

  

 

The additions to the Total Property Portfolio through placing properties in-service increased depreciation and amortization expense by approximately $10.8 million, as detailed below:

 

Property


  

Placed in-service


  

Depreciation and Amortization for the

year ended


              2005        

           2004        

   Change

          (in thousands)

Times Square Tower

   3rd Quarter 2004    $ 16,957    $ 7,066    $ 9,891

New Dominion Technology Park, Building Two

   3rd Quarter 2004      1,706      843      863

West Garage

   4th Quarter 2005      94      —        94
         

  

  

Total

        $ 18,757    $ 7,909    $ 10,848
         

  

  

 

Capitalized Costs

 

Costs directly related to the development of rental properties are not included in our operating results. These costs are capitalized and included in real estate assets on our Consolidated Balance Sheets and amortized over their useful lives. Capitalized development costs include interest, wages, property taxes, insurance and other project costs incurred during the period of development. Capitalized wages for the years ended December 31, 2005 and 2004 was $5.9 million. These costs are not included in the general and administrative expenses discussed above. Interest capitalized for the year ended December 31, 2005 and 2004 was $5.7 million and $10.8 million, respectively. These costs are not included in the interest expense referenced above. During the third quarter of 2004, we placed in-service Times Square Tower and New Dominion Technology Park, Building Two development projects and ceased capitalizing the related interest in accordance with our capitalization policy.

 

Losses from early extinguishments of debt

 

For the year ended December 31, 2005, we recognized a loss from early extinguishment of debt totaling approximately $12.9 million. In connection with the sales of 100 East Pratt Street and Riverfront Plaza, we repaid the mortgage loans collateralized by the properties totaling approximately $188 million. For the year ended December 31, 2005, we recognized a loss from early extinguishment of debt totaling approximately $11.0 million, consisting of prepayment fees of approximately $10.8 million and the write-off of unamortized deferred financing costs of approximately $0.2 million. We also recognized a $1.9 million loss from early extinguishment of debt which relates to the refinancing of our Times Square Tower mortgage loan which is included in Properties placed in-service, as well as the modification of our unsecured line of credit.

 

For the year ended December 31, 2004, we recognized a loss from early extinguishment of debt totaling approximately $6.3 million related to the repayments of our mortgage loans collateralized by One and Two Reston Overlook and the 12300 and 12310 Sunrise Valley Drive buildings.

 

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Table of Contents

Joint Ventures

 

During the first quarter of 2005, we placed in-service 901 New York Avenue, a 539,000 net rentable square foot Class A office property located in Washington, D.C., in which we have a 25% ownership interest. The addition of this property contributed approximately $2.1 million to joint venture income for the year ended December 31, 2005. As of March 1, 2006, this property is 99.3% leased.

 

Income from discontinued operations, net of minority interest

 

The decrease in income from discontinued operations in the Total Property Portfolio for the year ended December 31, 2005 was a result of properties sold or designated as held for sale during 2005 and 2004 which are no longer included in our operations as of December 31, 2005. Below is a list of properties included in discontinued operations for the years ended December 31, 2005 and 2004:

 

Year ended December 31, 2005


  

Year ended December 31, 2004


Old Federal Reserve

  

Old Federal Reserve

40-46 Harvard Street

  

40-46 Harvard Street

Residence Inn by Marriott®

  

Residence Inn by Marriott®

    

Sugarland Business Park-Building One

    

204 Second Avenue

    

560 Forbes Boulevard

    

Decoverly Two, Three, Six and Seven

    

38 Cabot Boulevard

    

The Arboretum

    

430 Rozzi Place

    

Sugarland Business Park-Building Two

 

Gains on sales of real estate and other assets, net of minority interest

 

Gains on sales of real estate for the year ended December 31, 2005 in the Total Property Portfolio relate to the sales of Riverfront Plaza, 100 East Pratt Street and Embarcadero Center West Tower which are not included in discontinued operations due to our continuing involvement in the management, for a fee, of these properties after the sales. Also included in gains on sale of real estate for the year ended December 31, 2005 is the sale of Decoverly Four and Five, consisting of two undeveloped land parcels located in Rockville, Maryland.

 

Gains on sales of real estate for the year ended December 31, 2004 in the Total Property Portfolio relate to the sale of Hilltop Office Center and a land parcel in Burlington, MA. Hilltop Office Center is not included in discontinued operations due to our continuing involvement in the management, for a fee, of this property after the sale.

 

Gains on sales of real estate from discontinued operations, net of minority interest

 

Properties included in our gains on sales of real estate from discontinued operations for the year ended December 31, 2005 and 2004 in the Total Property Portfolio are shown below:

 

Year ended December 31, 2005


  

Date Disposed


  

Year ended December 31, 2004


  

Date Disposed


Old Federal Reserve

  

April 2005

  

430 Rozzi Place

  

January 2004

Residence Inn by Marriott®

  

November 2005

  

Sugarland Business Park-Building Two

  

February 2004

40-46 Harvard Street

  

November 2005

  

Decoverly Two, Three, Six and Seven

  

April 2004

         

The Arboretum

  

April 2004

         

38 Cabot Boulevard

  

May 2004

         

Sugarland Business Park-Building One

  

August 2004

         

204 Second Avenue

  

September 2004

         

560 Forbes Boulevard

  

December 2004

 

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Table of Contents

Minority interest in Operating Partnership

 

Minority interest in Operating Partnership increased $6.4 million for the year ended December 31, 2005 compared to 2004. In connection with the special cash dividend paid to holders of common stock on October 31, 2005, holders of Series Two Preferred Units will participate in the distribution on an as-converted basis with their regular February 2006 distribution payment as provided for in the Operating Partnership’s partnership agreement. As a result, we accrued approximately $12.1 million related to the special cash distribution payable to holders of the Series Two Preferred Units and have allocated earnings to the Series Two Preferred Units of approximately $12.1 million, which amount has been reflected in minority interest in Operating Partnership for the year ended December 31, 2005. This increase was partially offset by a reduction in the minority interest in our Operating Partnership’s income allocation related to changes in the partnership’s ownership interests and an underlying change in allocable income.

 

Cumulative effect of a change in accounting principle, net of minority interest

 

In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143” (“FIN 47”). FIN 47 clarifies that the term “conditional asset retirement obligation” as used in FASB Statement No. 143, “Accounting for Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. At December 31, 2005, we recognized a liability for the fair value of the asset retirement obligation aggregating approximately $7.1 million, which amount is included in “Accounts Payable and Accrued Expenses” on our Consolidated Balance Sheets. In addition, we have recognized the cumulative effect of adopting FIN 47, totaling approximately $4.2 million, which amount is included in “Cumulative Effect of a Change in Accounting Principle, Net of Minority Interest” on our Consolidated Statements of Operations for the year ended December 31, 2005 (See Note 19 to the Consolidated Financial Statements.)

 

Comparison of the year ended December 31, 2004 to the year ended December 31, 2003

 

The table below shows selected operating information for the Same Property Portfolio and the Total Property Portfolio. The Same Property Portfolio consists of 102 properties, including two hotels and three properties in which we have joint venture interests, acquired or placed in-service on or prior to January 1, 2003 and owned by us through December 31, 2004. The Total Property Portfolio includes the effect of the other properties either placed in-service, acquired or repositioned after January 1, 2003 or disposed of on or prior to December 31, 2004. This table includes a reconciliation from Same Property Portfolio to Total Property Portfolio by also providing information for the properties which were sold, acquired, placed in-service or repositioned for the years ended December 31, 2004 and 2003. Our net property operating margins for the Total Property Portfolio, which are defined as rental revenue less operating expenses, exclusive of the two hotel properties, for the year ended December 31, 2004 and 2003, were 69.2% and 68.8%, respectively.

 

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Table of Contents
    Same Property Portfolio

    Properties
Sold


  Properties
Acquired


  Properties Placed
In-Service


  Properties
Repositioned


  Total Property Portfolio

 
(dollars in thousands)   2004

  2003

 

Increase/

(Decrease)


    %
Change


    2004

  2003

  2004

    2003

  2004

  2003

  2004

  2003

  2004

    2003

   

Increase/

(Decrease)


    %
Change


 

Rental Revenue:

                                                                                                         

Rental Revenue

  $ 1,142,012   $ 1,139,919   $ 2,093     0.18 %   $ 140   $ 4,532   $ 77,893     $ 24,796   $ 50,735   $ 9,455   $ 14,369   $ 16,457   $ 1,285,149     $ 1,195,159     $ 89,990     7.53 %

Termination Income

    3,724     6,136     (2,412 )   (39.31 )%     —       —       267       —       —       —       —       —       3,991       6,136       (2,145 )   (34.96 )%
   

 

 


 

 

 

 


 

 

 

 

 

 


 


 


 

Total Rental Revenue

    1,145,736     1,146,055     (319 )   (0.03 )%     140     4,532     78,160       24,796     50,735     9,455     14,369     16,457     1,289,140       1,201,295       87,845     7.31 %
   

 

 


 

 

 

 


 

 

 

 

 

 


 


 


 

Operating Expenses

    387,404     381,231     6,173     1.62 %     37     1,221     17,416       5,078     7,199     2,230     4,271     4,205     416,327       393,965       22,362     5.68 %
   

 

 


 

 

 

 


 

 

 

 

 

 


 


 


 

Net Operating Income, excluding hotels

    758,332     764,824     (6,492 )   (0.85 )%     103     3,311     60,744       19,718     43,536     7,225     10,098     12,252     872,813       807,330       65,483     8.11 %
   

 

 


 

 

 

 


 

 

 

 

 

 


 


 


 

Hotel Net Operating Income

    16,985     14,792     2,193     14.83 %     —       —       —         —       —       —       —       —       16,985       14,792       2,193     14.83 %
   

 

 


 

 

 

 


 

 

 

 

 

 


 


 


 

Consolidated Net Operating Income

    775,317     779,616     (4,299 )   (0.55 )%     103     3,311     60,744       19,718     43,536     7,225     10,098     12,252     889,798       822,122       67,676     8.23 %
   

 

 


 

 

 

 


 

 

 

 

 

 


 


 


 

Other Revenue:

                                                                                                         

Development and Management services

    —       —       —       —         —       —       —         —       —       —       —       —       20,440       17,332       3,108     17.93 %

Interest and Other

    —       —       —       —         —       —       —         —       —       —       —       —       10,339       3,014       7,325     243.03 %
   

 

 


 

 

 

 


 

 

 

 

 

 


 


 


 

Total Other Revenue

    —       —       —       —         —       —       —         —       —       —       —       —       30,779       20,346       10,433     51.28 %

Other Expenses:

                                                                                                         

General and administrative

    —       —       —       —         —       —       —         —       —       —       —       —       53,636       45,359       8,277     18.25 %

Interest

    —       —       —       —         —       —       —         —       —       —       —       —       306,170       299,436       6,734     2.25 %

Depreciation and amortization

    214,765     195,351     19,414     9.94 %     21     518     18,935       6,452     11,000     2,506     4,928     1,859     249,649       206,686       42,963     20.79 %

Net derivative losses

    —       —       —       —         —       —       —         —       —       —       —       —       —         1,038       (1,038 )   (100.0 )%

Losses from early extinguishments of debt

    —       —       —       —         —       —       —         —       —       —       —       —       6,258       1,474       4,784     324.56 %
   

 

 


 

 

 

 


 

 

 

 

 

 


 


 


 

Total Other Expenses

    214,765     195,351     19,414     9.94 %     21     518     18,935       6,452     11,000     2,506     4,928     1,859     615,713       553,993       61,720     11.14 %
   

 

 


 

 

 

 


 

 

 

 

 

 


 


 


 

Income before minority interests

  $ 560,552   $ 584,265   $ (23,713 )   (4.06 )%   $ 82   $ 2,793   $ 41,809     $ 13,266   $ 32,536   $ 4,719   $ 5,170   $ 10,393   $ 304,864     $ 288,475     $ 16,389     5.68 %

Income from unconsolidated joint ventures

  $ 3,054   $ 1,903   $ 1,151     60.49 %   $ 304   $ 4,113   $ (33 )   $ —     $ 55   $ —     $ —     $ —     $ 3,380     $ 6,016     $ (2,636 )   (43.82 )%
                                                                                                           

Income from discontinued operations, net of minority interest

  $ 2,103   $ 4,823   $ (2,720 )   (56.39 )%   $ 1,241   $ 6,102     —         —       —       —       —       —       3,344       10,925       (7,581 )   (69.39 )%

Minority interests in property partnerships