Form 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-K

(Mark One)

 

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

For the fiscal year ended December 31, 2006

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 001-11290

NATIONAL RETAIL PROPERTIES, INC.

(Exact name of registrant as specified in its charter)

Maryland   56-1431377

(State or other jurisdiction of

incorporation or organization)

  (I.R.S. Employer Identification No.)

450 South Orange Avenue, Suite 900

Orlando, Florida 32801

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code: (407) 265-7348

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

 

Title of each class:   Name of exchange on which registered:

Common Stock, $0.01 par value

7.375% Non-Voting Series C Preferred Stock

 

New York Stock Exchange

New York Stock Exchange

Securities registered pursuant to section 12(g) of the Act:

None

(Title of class)

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 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.  ¨

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

The aggregate market value of voting common stock held by non-affiliates of the registrant as of June 30, 2006 was $1,144,188,520.

The number of shares of common stock outstanding as of February 14, 2007 was 60,272,926.


Table of Contents

DOCUMENTS INCORPORATED BY REFERENCE:

Registrant incorporates by reference portions of the National Retail Properties, Inc. Proxy Statement for the 2007 Annual Meeting of Stockholders (Items 10, 11, 12, 13 and 14 of Part III).


Table of Contents

TABLE OF CONTENTS

 

        

PAGE      

REFERENCE

Part I

  
  

Item 1.

  Business    4
  

Item 1A.

  Risk Factors    8
  

Item 1B.

  Unresolved Staff Comments    14
  

Item 2.

  Properties    15
  

Item 3.

  Legal Proceedings    18
  

Item 4.

  Submission of Matters to a Vote of Security Holders    18

Part II

  
  

Item 5.

  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    19
  

Item 6.

  Selected Financial Data    21
  

Item 7.

  Management’s Discussion and Analysis of Financial Condition and Results of Operation    23
  

Item 7A.

  Quantitative and Qualitative Disclosures About Market Risk    46
  

Item 8.

  Financial Statements and Supplementary Data    47
  

Item 9.

  Changes in and Disagreements With Accountants on Accounting and Financial Disclosure    92
  

Item 9A.

  Controls and Procedures    92
  

Item 9B.

  Other Information    94

Part III

  
  

Item 10.

  Directors, Executive Officers and Corporate Governance    95
  

Item 11.

  Executive Compensation    95
  

Item 12.

  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    95
  

Item 13.

  Certain Relationships and Related Transactions, and Director Independence    95
  

Item 14.

  Principal Accountant Fees and Services    95

Part IV

  
  

Item 15.

  Exhibits and Financial Statement Schedules    96

Signatures

   102


Table of Contents

PART I

Statements contained in this annual report on Form 10-K, including the documents that are incorporated by reference, that are not historical facts are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Also, when the Company uses any of the words “anticipate,” “assume,” “believe,” “estimate,” “expect,” “intend,” or similar expressions, the Company is making forward-looking statements. Although management believes that the expectations reflected in such forward-looking statements are based upon present expectations and reasonable assumptions, the Company’s actual results could differ materially from those set forth in the forward-looking statements. Certain factors that could cause actual results or events to differ materially from those the Company anticipates or projects are described in Item 1A. “Risk Factors” of this Annual Report on Form 10-K.

Given these uncertainties, readers are cautioned not to place undue reliance on such statements, which speak only as of the date of this Annual Report on Form 10-K or any document incorporated herein by reference. The Company undertakes no obligation to publicly release any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date of this Annual Report on Form 10-K.

Item 1.  Business

The Company

National Retail Properties, Inc. (formerly known as Commercial Net Lease Realty, Inc.), a Maryland corporation, is a fully integrated real estate investment trust (“REIT”) formed in 1984. The terms “Registrant” or “Company” refer to National Retail Properties, Inc. and its majority owned and controlled subsidiaries. These subsidiaries include the wholly owned qualified REIT subsidiaries of National Retail Properties, Inc., as well as the taxable REIT subsidiaries and their majority owned and controlled subsidiaries (the “NNN TRS”). Effective May 1, 2006, Commercial Net Lease Realty, Inc. changed its name to National Retail Properties, Inc.

The Company’s operations are divided into two primary business segments: (i) investment assets, including real estate assets, structured finance investments (included in mortgages and notes receivable on the consolidated balance sheets) and mortgage residual interests (collectively, “Investment Assets”), and (ii) inventory real estate assets (“Inventory Assets”). The Investment Assets are operated through National Retail Properties, Inc. and its wholly owned qualified REIT subsidiaries. The Inventory Assets are operated through the NNN TRS.

Real Estate Assets

The Company acquires, owns, invests in, manages and develops properties that are leased primarily to retail tenants under long-term net leases (“Investment Properties” or “Investment Portfolio”). As of December 31, 2006, the Company owned 710 Investment Properties, with an aggregate leasable area of 9,341,000 square feet, located in 44 states. Approximately 98 percent of the Company’s Investment Portfolio was leased at December 31, 2006. The NNN TRS, directly and indirectly, through investment interests, owns real estate primarily for the purpose of selling the real estate (“Inventory Properties” or “Inventory Portfolio”). As of December 31, 2006, the NNN TRS owned 97 Inventory Properties.

 

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Structured Finance Investments

Structured finance agreements (included in mortgages, notes and accrued interest receivable on the consolidated balance sheets) are typically loans secured by a borrower’s pledge of ownership interests in the entity that owns the real estate. These agreements are typically subordinated to senior loans secured by first mortgages encumbering the underlying real estate. Subordinated positions are generally subject to a higher risk of nonpayment of principal and interest than the more senior loans. As of December 31, 2006, the structured finance agreements had an outstanding principal balance of $13,917,000.

Mortgage Residual Interests

Orange Avenue Mortgage Investments, Inc. (“OAMI”), a majority owned and consolidated subsidiary of the Company, holds the mortgage residual interests (“Residuals”) from seven commercial real estate loan securitizations. Each of the Residuals is reported at its market value based upon a third party valuation, with unrealized gains and losses reported as other comprehensive income in stockholders’ equity. Losses that are considered other than temporary are reported through earnings. The Residuals had an estimated fair value of $31,512,000 at December 31, 2006.

NNN TRS

Prior to January 1, 2005, the Company held a 98.7 percent, non-controlling and non-voting interest in Commercial Net Lease Realty Services, Inc. and its majority owned and controlled subsidiaries (collectively, “Services”). Kevin B. Habicht, an officer and director of the Company, James M. Seneff, Jr. and Gary M. Ralston, each a former officer and director of the Company, (collectively, the “Services Investors”), owned the remaining 1.3 percent interest, which represented 100 percent of the voting interest in Services. Effective January 1, 2005, the Company acquired the remaining 1.3 percent interest in Services, increasing the Company’s ownership in Services to 100 percent. Effective November 1, 2005, Commercial Net Lease Realty Services, Inc. merged into National Retail Properties, Inc. CNLRS Exchange I, Inc., a taxable REIT subsidiary (“TRS”), became the TRS holding company for the Company’s development and exchange activities. Effective October 2, 2006, CNLRS Exchange I, Inc. changed its name to NNN TRS, Inc.

Competition

The Company generally competes with numerous other REITs, commercial developers, real estate limited partnerships and other investors, including but not limited to, insurance companies, pension funds and financial institutions, that own, manage, finance or develop retail and net leased properties.

Employees

As of December 31, 2006, the Company employed 68 full-time associates including executive and administrative personnel.

The Company’s executive offices are located at 450 S. Orange Avenue, Suite 900, Orlando, Florida 32801, and its telephone number is (407) 265-7348. The Company has an Internet website at www.nnnreit.com where the Company’s filings with the Securities and Exchange Commission can be downloaded free of charge.

 

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Business Strategies and Policies

The following is a discussion of the Company’s operating strategy and certain of its investment, financing and other policies. These strategies and policies have been set by management and/or the Board of Directors and, in general, may be amended or revised from time to time by management and/or the Board of Directors without a vote of the Company’s stockholders.

Operating Strategies

The Company’s strategy is to invest primarily in retail real estate that is typically located along high-traffic commercial corridors near areas of commercial and residential density. Management believes that these types of properties, when leased to national or regional retailers generally pursuant to triple-net leases, provide attractive opportunities for a stable current return and the potential for capital appreciation. Triple-net leases typically require the tenant to pay property operating expenses such as real estate taxes, assessments and other government charges, insurance, utilities, and repairs and maintenance.

In some cases, the Company’s investment in real estate is in the form of structured finance investments, which are typically loans secured by a borrower’s pledge of ownership interests in the entity that owns the real estate. These agreements are typically subordinated to senior loans secured by first mortgages encumbering the underlying real estate. Subordinated positions are generally subject to a higher risk of nonpayment of principal and interest than the more senior loans.

Additionally, the Company may provide mortgage loans which are typically secured by a specific real estate asset owned by the borrower.

The Company holds investment real estate assets until it determines that the sale of such a property is advantageous in view of the Company’s investment objectives. In deciding whether to sell a real estate investment asset, the Company may consider factors such as potential capital appreciation, net cash flow, potential use of sale proceeds and federal income tax considerations.

The Company acquires and develops inventory real estate assets primarily for the purpose of resale.

The Company’s management team considers certain key indicators to evaluate the financial condition and operating performance of the Company. The key indicators for the Company may include items such as: the composition of the Company’s Investment Portfolio (such as tenant, geographic and industry classification diversification), the occupancy rate of the Company’s Investment Portfolio, certain financial performance ratios, profitability measures and industry trends compared to that of the Company.

Investment in Real Estate or Interests in Real Estate

The Company’s management believes that attractive acquisition opportunities for retail properties will continue to be available and that the Company is suited to take advantage of these opportunities because of its access to capital markets, ability to underwrite and acquire properties, either for cash or securities, and because of management’s experience in seeking out, identifying and evaluating potential acquisitions.

In evaluating a particular acquisition, management may consider a variety of factors, including:

 

   

the location and accessibility of the property;

 

   

the geographic area and demographic characteristics of the community, as well as the local real estate market, including potential for growth;

 

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the size of the property;

 

   

the purchase price;

 

   

the non-financial terms of the proposed acquisition;

 

   

the availability of funds or other consideration for the proposed acquisition and the cost thereof;

 

   

the “fit” of the property with the Company’s existing portfolio;

 

   

the potential for, and current extent of, any environmental problems;

 

   

the quality of construction and design and the current physical condition of the property;

 

   

the financial and other characteristics of the existing tenant;

 

   

the tenant’s business plan, operating history and management team;

 

   

the tenant’s industry; and

 

   

the terms of any existing leases.

The Company intends to engage in future investment activities in a manner that is consistent with the maintenance of its status as a REIT for federal income tax purposes and that will not make the Company an investment company under the Investment Company Act of 1940, as amended. Equity investments in acquired properties may be subject to existing mortgage financings and other indebtedness or to new indebtedness which may be incurred in connection with acquiring or refinancing these investments.

Investments in Real Estate Mortgages, Mortgage Residual Interests, and Securities of or Interests in Persons Engaged in Real Estate Activities

While the Company’s current portfolio of, and its business objectives primarily emphasize, equity investments in retail properties, the Company may invest in (i) a wide variety of retail properties or other property and tenant types, (ii) mortgages, participating or convertible mortgages, deeds of trust, mortgage residual interests and other types of real estate interests, or (iii) 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. For example, the Company from time to time has made investments in mortgage loans or held mortgages on properties the Company sold and has made structured finance investments (as discussed above), which are typically loans secured by a pledge of ownership interests in the borrowers (or their subsidiaries) that own the underlying real estate.

Financing Strategy

The Company’s financing objective is to manage its capital structure effectively in order to provide sufficient capital to execute its operating strategies while servicing its debt requirements and providing value to its stockholders. The Company generally utilizes debt and equity security offerings, bank borrowings, the sale of properties, and to a lesser extent, internally generated funds to meet its capital needs.

The Company typically funds its short-term liquidity requirements including investments in additional retail properties with cash from its $300,000,000 unsecured revolving credit facility (“Credit Facility”). As of December 31, 2006, $28,000,000 was outstanding and approximately $272,000,000 was available for future borrowings under the Credit Facility, excluding undrawn letters of credit totaling $5,159,000.

 

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For the year ended December 31, 2006, the Company’s ratio of total indebtedness to total gross assets (before accumulated depreciation) was approximately 41 percent and the secured indebtedness to total gross assets was approximately three percent. The total debt to total market capitalization was approximately 35 percent. Certain financial agreements to which the Company is a party contain covenants that limit the Company’s ability to incur debt under certain circumstances.

The Company anticipates it will be able to obtain additional financing for short-term and long-term liquidity requirements as further described in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation – Liquidity.” However, there can be no assurance that additional financing or capital will be available, or that the terms will be acceptable or advantageous to the Company.

The organizational documents of the Company do not limit the absolute amount or percentage of indebtedness that the Company may incur. Additionally, the Company may change its financing strategy at any time. The Company has not engaged in trading, underwriting or agency distribution or sale of securities of other issues and does not intend to do so.

Strategies and Policy Changes

Any of the Company’s strategies or policies described above may be changed at any time by the Company without notice to or a vote of the Company’s stockholders.

Item 1A.  Risk Factors.

Carefully consider the following risks and all of the other information set forth in this Annual Report on Form 10-K, including the consolidated financial statements and the notes thereto. If any of the events or developments described below were actually to occur, the Company’s business, financial condition or results of operations could be adversely affected.

Loss of revenues from tenants would reduce the Company’s cash flow.

The Company’s five largest tenants accounted for an aggregate of approximately 23 percent of the Company’s annual base rent as of December 31, 2006. The default, financial distress or bankruptcy of one or more of the Company’s tenants could cause substantial vacancies among the Company’s Investment Portfolio. Vacancies reduce the Company’s revenues until the Company is able to re-lease the affected properties and could decrease the ultimate sale value of each such vacant property. Upon the expiration of the leases that are currently in place, the Company may not be able to re-lease a vacant property at a comparable lease rate or without incurring additional expenditures in connection with such re-leasing.

A significant portion of the source of the Company’s annual base rent is heavily concentrated in a specific industry classification and in specific geographic locations.

As of December 31, 2006, an aggregate of approximately 33 percent of the Company’s annual base rent is generated from two retail lines of trade, convenience stores and restaurants, each representing more than 10 percent. In addition, as of December 31, 2006, an aggregate of approximately 36 percent of the Company’s annual base rent is generated from properties in Texas and Florida, each representing more than 10 percent. Any financial hardship and/or changes in these industries or states could have an adverse effect on the Company’s financial results.

 

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There are a number of risks inherent in owning real estate and indirect interests in real estate.

Factors beyond the Company’s control affect the Company’s performance and value. Changes in national, regional and local economic and market conditions may affect the Company’s economic performance and the value of the Company’s real estate assets. Local real estate market conditions may include excess supply and intense competition for tenants, including competition based on rental rates and attractiveness and location of the property.

In addition, other factors may adversely affect the performance and value of the Company’s properties, including (i) changes in laws and governmental regulations, including those governing usage, zoning and taxes; (ii) changes in interest rates; and (iii) the availability of financing.

The Company’s real estate investments are illiquid.

Because real estate investments are relatively illiquid, the Company’s ability to adjust the portfolio promptly in response to economic or other conditions is limited. Certain significant expenditures generally do not change in response to economic or other conditions, including: (i) debt service (if any), (ii) real estate taxes, and (iii) operating and maintenance costs. This combination of variable revenue and relatively fixed expenditures may result, under certain market conditions, in reduced income from investment. Such reduction in investment income could have an adverse effect on the Company’s financial condition.

The Company may be subject to unknown environmental liabilities.

The Company may acquire a property that contains some level of contamination or potential contamination exists, subject to a determination of the level of risk and potential cost of remediation. Investments in real property create a potential for substantial environmental liability on the part of the owner of such property from the presence or discharge of hazardous substances on the property, regardless of fault. It is the Company’s policy, as a part of its acquisition due diligence process, generally to obtain an environmental site assessment for each property. In such cases that the Company intends to acquire real estate where contamination or potential contamination exists, the Company generally requires the seller or tenant to (i) remediate the problem, (ii) indemnify the Company for environmental liabilities, or (iii) agree to other arrangements deemed appropriate by the Company to address environmental conditions at the property.

The Company has 25 Investment Properties currently under some level of environmental remediation. In general, the seller, the tenant or an adjacent land owner is responsible for the cost of the environmental remediation for each of these Investment Properties. In the event of a bankruptcy or other inability on the part of these parties to cover these costs, the Company may have to cover the costs of remediation, fines or other environmental liabilities at these and other properties. The Company may also own properties where required remediation has not begun or adverse environmental conditions have not yet been detected. This may require remediation or otherwise subject the Company to liability. The Company cannot assure that (i) it will not be required to undertake or pay for removal or remediation of any contamination of the properties currently or previously owned by the Company, (ii) the Company will not be subject to fines by governmental authorities or litigation, or (iii) the costs of such removal, remediation fines or litigation would not be material.

The Company may not be able to successfully execute its acquisition or development strategies.

The Company cannot assure that it will be able to implement its investment strategies successfully. Additionally, the Company cannot assure that its property portfolio will expand at all, or if it will

 

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expand at any specified rate or to any specified size. In addition, investment in additional real estate assets is subject to a number of risks. Because the Company expects to invest in markets other than the ones in which its current properties are located or which may be leased to tenants other than those to which the Company has historically leased properties, the Company will also be subject to the risks associated with investment in new markets or with new tenants that may be relatively unfamiliar to the Company’s management team.

The Company’s development activities are subject to without limitation, risks relating to the availability and timely receipt of zoning and other regulatory approvals, the cost and timely completion of construction (including risks from factors beyond the Company’s control, such as weather or labor conditions or material shortages), the risk of finding tenants for the properties and the ability to obtain both construction and permanent financing on favorable terms. These risks could result in substantial unanticipated delays or expenses and, under certain circumstances, could prevent completion of development activities once undertaken or provide a tenant the opportunity to terminate a lease. Any of these situations delay or eliminate proceeds or cash flows the Company expects from these projects, which could have an adverse effect on the Company’s financial condition.

The Company may not be able to dispose of properties consistent with its operating strategy.

The Company may be unable to sell properties targeted for disposition (including its Inventory Properties) at a profit if interest rates increase, or adverse market conditions exist, thereby, rendering the Company unable to sell these properties.

A change in the assumptions used to determine the value of mortgage residual interests could adversely affect the Company’s financial position.

As of December 31, 2006, the Residuals had a carrying value of $31,512,000. The value of these Residuals is based on delinquency, loan loss, prepayment and interest rate assumptions made by the Company to determine their value. If actual experience differs materially from these assumptions, the actual future cash flow could be less than expected and the value of the Residuals, as well as the Company’s earnings, could decline.

The Company may suffer a loss in the event of a default or bankruptcy of a structured finance loan borrower.

If a borrower defaults on a structured finance loan and does not have sufficient assets to satisfy the loan, the Company may suffer a loss of principal and interest. In the event of the bankruptcy of a borrower, the Company may not be able to recover against all of the assets of the borrower, or the assets of the borrower may not be sufficient to satisfy the balance due on the loan. In addition, certain of the Company’s loans may be subordinate to other debt of a borrower. The structured finance agreements are typically loans secured by a borrower’s pledge of its ownership interests in the entity that owns the real estate. These agreements are typically subordinated to senior loans secured by first mortgages encumbering the underlying real estate. Subordinated positions are generally subject to a higher risk of nonpayment of principal and interest than the more senior loans. As of December 31, 2006, the structured finance investments had an outstanding principal balance of $13,917,000. If a borrower defaults on the debt senior to the Company’s loan, or in the event of the bankruptcy of a borrower, the Company’s loan will be satisfied only after the borrower’s senior creditors’ claims are satisfied. Where debt senior to the Company’s loans exists, the presence of intercreditor arrangements may limit the Company’s ability to amend loan documents, assign the loans, accept prepayments, exercise remedies and control decisions made in bankruptcy proceedings relating to borrowers.

 

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Bankruptcy proceedings and litigation can significantly increase the time needed for the Company to acquire underlying collateral in the event of a default, during which time the collateral may decline in value. In addition, there are significant costs and delays associated with the foreclosure process.

Certain provisions of the leases or structured finance loan agreements may be unenforceable.

The Company’s rights and obligations with respect to its leases or structured finance loans are governed by written agreements. A court could determine that one or more provisions of an agreement are unenforceable, such as a particular remedy, a loan prepayment provision or a provision governing the Company’s security interest in the underlying collateral of a borrower. The Company could be adversely impacted if this were to happen with respect to an asset or group of assets.

Property ownership through joint ventures and partnerships could limit the Company’s control of those investments.

Joint ventures or partnerships involve risks not otherwise present for direct investments by the Company. It is possible that the Company’s co-venturers or partners may have different interests or goals than the Company at any time and they may take actions contrary to the Company’s requests, policies or objectives, including the Company’s policy with respect to maintaining its qualification as a REIT. Other risks of joint venture investments include impasses on decisions, because no single co-venturer or partner has full control over the joint venture or partnership.

Competition with numerous other REITs, commercial developers, real estate limited partnerships and other investors may impede the Company’s ability to grow.

The Company may not be in a position or have the opportunity in the future to make suitable property acquisitions on advantageous terms due to competition for such properties with others engaged in real estate investment activities. The Company’s inability to successfully acquire new properties may affect the Company’s ability to achieve anticipated return on investment, which could have an adverse effect on its results of operations.

Uninsured losses may adversely affect the Company’s ability to pay outstanding indebtedness.

The Company’s properties are generally covered by comprehensive liability, fire, flood, extended coverage and business interruption insurance. The Company believes that the insurance carried on its properties is adequate in accordance with industry standards. There are, however, types of losses (such as from hurricanes, wars or earthquakes) which may be uninsurable, or the cost of insuring against these losses may not be economically justifiable. If an uninsured loss occurs, the Company could lose both the invested capital in and anticipated revenues from the property. In that event, the Company’s cash flow could be reduced.

Terrorist attacks, such as the attacks that occurred in New York City and Washington, D.C., on September 11, 2001, and other acts of violence or war may affect the markets in which the Company operates and the Company’s results of operations.

Terrorist attacks may negatively affect the Company’s operations. There can be no assurance that there will not be further terrorist attacks against the United States or United States businesses. These attacks may directly impact the Company’s physical facilities or the businesses of the Company’s tenants.

 

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Also, the United States has been engaged in armed conflict, which could have an impact on the Company’s tenants. The consequences of armed conflict are unpredictable, and the Company may not be able to foresee events that could have an adverse effect on its business.

More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the United States and worldwide financial markets and economies. They also could result in, or cause a deepening of, economic recession in the United States or abroad. Any of these occurrences could have a significant adverse impact on the Company’s financial condition or results of operations.

Vacant properties or bankrupt tenants could adversely affect the Company.

As of December 31, 2006, the Company owned nine vacant, unleased Investment Properties, which accounted for approximately two percent of the total gross leasable area of the Company’s Investment Portfolio and four unleased land parcels. The Company is actively marketing these properties for sale or lease but may not be able to sell or lease these properties on favorable terms or at all. The lost revenues and increased property expenses resulting from the rejection by any bankrupt tenant of any of their respective leases with the Company could have a material adverse effect on the liquidity and results of operations of the Company if the Company is unable to re-lease the Investment Properties at comparable rental rates and in a timely manner. Less than one percent of the total gross leasable area of the Company’s Investment Portfolio is leased to one tenant that has filed a voluntary petition for bankruptcy under Chapter 11 of the U.S. Bankruptcy Code. As a result, the tenant has the right to reject or affirm its lease with the Company.

The amount of debt the Company has and the restrictions imposed by that debt could adversely affect the Company’s business and financial condition.

As of December 31, 2006, the Company had total mortgage debt and secured notes payable outstanding of approximately $60,392,000, total unsecured notes payable of $662,304,000 and $28,000,000 outstanding on the Credit Facility. The Company’s organizational documents do not limit the level or amount of debt that it may incur. If the Company incurs additional indebtedness and permits a higher degree of leverage, debt service requirements would increase and could adversely affect the Company’s financial condition and results of operations, as well as the Company’s ability to pay principal and interest on the outstanding indebtedness or dividends to its stockholders. In addition, increased leverage could increase the risk that the Company may default on its debt obligations. The Credit Facility contains financial covenants that could limit the amount of distributions to the Company’s common and preferred stockholders.

The amount of debt outstanding at any time could have important consequences to the Company’s stockholders. For example, it could:

 

   

require the Company to dedicate a substantial portion of its cash flow from operations to payments on Company debt, thereby reducing funds available for operations, real estate investments and other appropriate business opportunities that may arise in the future;

 

   

limit the Company’s ability to obtain any additional financing it may need in the future for working capital, debt refinancing, capital expenditures, real estate investments, development or other general corporate purposes;

 

   

make it difficult to satisfy the Company’s debt service requirements;

 

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limit the Company’s ability to pay dividends on its outstanding common and preferred stock;

 

   

require the Company to dedicate increased amounts of cash flow from operations to payments on its variable rate, unhedged debt if interest rates rise;

 

   

limit the Company’s flexibility in planning for, or reacting to, changes in its business and the factors that affect the profitability of its business; and

 

   

limit the Company’s flexibility in conducting its business, which may place the Company at a disadvantage compared to competitors with less debt or debt with less restrictive terms.

The Company’s ability to make scheduled payments of principal or interest on its debt, or to refinance such debt will depend primarily on its future performance, which to a certain extent is subject to the creditworthiness of its tenants, competition, as well as economic, financial, and other factors beyond its control. There can be no assurance that the Company’s business will continue to generate sufficient cash flow from operations in the future to service its debt or meet its other cash needs. If the Company is unable to generate this cash flow from its business, it may be required to refinance all or a portion of its existing debt, sell assets or obtain additional financing to meet its debt obligations and other cash needs.

The Company cannot assure you that any such refinancing, sale of assets or additional financing would be possible on terms and conditions, including but not limited to the interest rate, which the Company would find acceptable.

The Company is obligated to comply with financial and other covenants in its debt that could restrict its operating activities, and the failure to comply with such covenants could result in defaults that accelerate the payment under its debt.

The Company’s unsecured debt contains various restrictive covenants which include, among others, provisions restricting the Company’s ability to:

 

   

incur or guarantee additional debt;

 

   

make certain distributions, investments and other restricted payments, including dividend payments on its outstanding common and preferred stock;

 

   

limit the ability of restricted subsidiaries to make payments to the Company;

 

   

enter into transactions with certain affiliates;

 

   

create certain liens; and

 

   

consolidate, merge or sell the Company’s assets.

The Company’s secured debt generally contains customary covenants, including, among others, provisions:

 

   

relating to the maintenance of the property securing the debt;

 

   

restricting its ability to sell, assign or further encumber the properties securing the debt;

 

   

restricting its ability to incur additional debt;

 

   

restricting its ability to amend or modify existing leases; and

 

   

relating to certain prepayment restrictions.

 

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The Company’s ability to meet some of the covenants in its debt, including covenants related to the condition of the property or payment of real estate taxes, may be dependent on the performance by the Company’s tenants under their leases.

In addition, certain covenants in the Company’s debt, including its Credit Facility, require the Company and its subsidiaries, among other things, to:

 

   

maintain certain maximum leverage ratios;

 

   

maintain certain minimum interest and debt service coverage ratios;

 

   

limit dividends declared and paid to the Company’s common and preferred stockholders; and

 

   

limit investments in certain types of assets.

The Company’s failure to qualify as a real estate investment trust for federal income tax purposes could result in significant tax liability.

The Company intends to operate in a manner that will allow the Company to continue to qualify as a real estate investment trust (“REIT”). The Company believes it has been organized as, and its past and present operations qualify the Company as a REIT. However, the IRS could successfully assert that the Company is not qualified as such. In addition, the Company may not remain qualified as a REIT in the future. Qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which there are only limited judicial or administrative interpretations and involves the determination of various factual matters and circumstances not entirely within the Company’s control.

If the Company fails to qualify as a REIT, it would not be allowed a deduction for dividends paid to stockholders in computing taxable income and would become subject to federal income tax at regular corporate rates. In this event, the Company could be subject to potentially significant tax liabilities. Unless entitled to relief under certain statutory provisions, the Company would also be disqualified from treatment as a REIT for the four taxable years following the year during which the qualification was lost. Even if the Company maintains its REIT status, the Company may be subject to certain federal, state and local taxes on its income and property.

Compliance with REIT requirements, including distribution requirements, may limit the Company’s flexibility and negatively affect the Company’s operating decisions.

To maintain its status as a REIT for U.S. federal income tax purposes, the Company must meet certain requirements, on an on-going basis, including requirements regarding its sources of income, the nature and diversification of its assets, the amounts the Company distributes to its stockholders and the ownership of its shares. The Company may also be required to make distributions to its stockholders when it does not have funds readily available for distribution or at times when the Company’s funds are otherwise needed to fund capital expenditures or to fund debt service requirements. The Company generally will not be subject to federal income taxes on amounts distributed to stockholders, providing it distributes 100 percent of its REIT taxable income and meets certain other requirements for qualifying as a REIT. For each of the years in the three-year period ended December 31, 2006, the Company believes it has qualified as a REIT. Notwithstanding the Company’s qualification for taxation as a REIT, the Company is subject to certain state taxes on its income and real estate.

Item 1B.  Unresolved Staff Comments.

None.

 

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Item 2.  Properties

Investment Properties

As of December 31, 2006, the Company owned 710 Investment Properties with an aggregate gross leasable area of 9,341,000 square feet, located in 44 states. Approximately 98 percent of the gross leasable area was leased at December 31, 2006. Reference is made to the Schedule of Real Estate and Accumulated Depreciation and Amortization filed with this report for a listing of the Company’s Investment Properties and their respective carrying costs.

During 2006, the Company disposed of the properties leased to the United States of America which had accounted for more than 10 percent of the Company’s total rental income in 2005. As of December 31, 2006, the Company does not have any one tenant that accounts for ten percent or more of its rental income.

The following table summarizes the Company’s Investment Properties as of December 31, 2006 (dollars in thousands):

 

     Size (1)    Cost (2)
     High        Low          Average      High        Low          Average  

Land

   2,223,000    7,000    112,000    $   10,197    $     25    $     1,001

Building

   135,000    1,000    14,000      13,877      44      1,352

 

 

(1)

Approximate square feet.

 

(2)

Costs vary depending upon size and local demographic factors.

In connection with the development of 11 Investment Properties, the Company has agreed to fund construction commitments (including land costs) of $35,020,000, of which $17,845,000 has been funded as of December 31, 2006.

Leases.  Although there are variations in the specific terms of the leases, the following is a summary of the general structure of the Company’s leases. Generally, the leases of the Investment Properties owned by the Company provide for initial terms of 10 to 20 years. As of December 31, 2006, the weighted average remaining lease term was approximately 12 years. The Investment Properties are generally leased under net leases pursuant to which the tenant typically will bear responsibility for substantially all property costs and expenses associated with ongoing maintenance and operation, including utilities, property taxes and insurance. In addition, the majority of the Company’s leases provide that the tenant is responsible for roof and structural repairs. The leases of the Investment Properties provide for annual base rental payments (payable in monthly installments) ranging from $11,000 to $1,635,000 (average of $210,000). Tenant leases generally provide for limited increases in rent as a result of fixed increases, increases in the consumer price index, and/or increases in the tenant’s sales volume.

Generally, the Investment Property leases provide the tenant with one or more multi-year renewal options subject to generally the same terms and conditions as the initial lease. Some of the leases also provide that in the event the Company wishes to sell the Investment Property subject to that lease, the Company first must offer the lessee the right to purchase the Investment Property on the same terms and conditions as any offer which the Company intends to accept for the sale of the Investment Property.

Certain of the Company’s Investment Properties have leases that provide the tenant with a purchase option to acquire the Investment Property from the Company. The purchase price calculations are generally stated in the lease agreement or are based on current market value.

 

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The following table summarizes the lease expirations of the Company’s Investment Portfolio as of December 31, 2006 (dollars in thousands):

 

     % of
    Total
(1)    
   # of
    Properties    
   Gross
    Leasable    
Area
(2)
        % of
    Total
(1)    
   # of
    Properties    
  

Gross

    Leasable    

Area(2)

2007

   1.2%    13    206,000    2013    5.6%    30    690,000

2008

   1.8%    22    406,000    2014    7.3%    39    591,000

2009

   2.6%    25    490,000    2015    4.6%    22    621,000

2010

   3.9%    36    383,000    2016    4.2%    22    508,000

2011

   3.8%    23    439,000    2017    7.2%    28    808,000

2012

   4.6%    30    531,000    Thereafter    53.2%    407    3,500,000

 

 

(1)

Based on annualized base rent for all leases in place as of December 31, 2006.

 

(2)

Approximate square feet.

The following table summarizes the diversification of trade of the Company’s Investment Portfolio based on the top 10 lines of trade as of December 31, 2006 (dollars in thousands):

 

    

Top 10 Lines of Trade

       2006(1)            2005(1)            2004(1)    

1.

   Convenience Stores    16.3%    12.1%    0.7%

2.

   Restaurants – Full Service    12.1%    6.6%    6.7%

3.

   Drug Stores    8.3%    10.0%    11.5%

4.

   Sporting Goods    7.3%    7.4%    7.8%

5.

   Books    5.7%    5.8%    6.9%

6.

   Grocery    5.7%    6.3%    7.7%

7.

   Consumer Electronics    5.6%    5.9%    7.1%

8.

   Restaurants – Limited Service    4.7%    3.0%    3.1%

9.

   Furniture    4.2%    4.7%    5.0%

10.

   Office Supplies    4.1%    4.4%    5.2%
   Other    26.0%    33.8%    38.3%
                 
      100.0%    100.0%    100.0%
                 

(1)

   Based on annualized base rent for all leases in place as of December 31 of the respective year.

The following table summarizes the diversification by state of the Company’s Investment Portfolio as of December 31, 2006:

 

    

State                

  

#

of
    Properties    

  

% of

Annual

    Base Rent(1)    

1.

 

Texas

   149    22.2%

2.

 

Florida

   77    13.4%

3.

 

Pennsylvania

   77    5.4%

4.

 

Georgia

   37    5.1%

5.

 

Virginia

   19    3.9%

6.

 

California

   18    3.7%

7.

 

Tennessee

   19    3.5%

8.

 

Illinois

   22    3.4%

9.

 

Missouri

   14    3.3%

10.

 

Ohio

   23    3.0%
 

Other

   255    33.1%
           
     710    100.0%
           

(1)

  Based on annualized base rent for all leases in
place as of December 31, 2006.

 

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Structured Finance Investments

Structured finance agreements (included in mortgages, notes and accrued interest receivable on the consolidated balance sheets) are typically loans secured by a borrower’s pledge of its ownership interest in the entity that owns the real estate. These agreements are typically subordinated to senior loans secured by first mortgages encumbering the underlying real estate. Subordinated positions are generally subject to a higher risk of nonpayment of principal and interest than the more senior loans.

In 2006 and 2005, the Company made structured finance investments of $16,477,000 and $5,988,000, respectively. As of December 31, 2006, the structured finance investments bear a weighted average interest rate of 13.3% per annum, of which 10.1% is payable monthly and the remaining 3.2% accrues and is due at maturity. The principal balance of each structured finance investment is due in full at maturity, which range between November 2007 and January 2009. The structured finance investments are secured by the borrowers’ pledge of their respective membership interests in the subsidiaries which own the respective real estate. As of December 31, 2006 and 2005, the outstanding principal balance of the structured finance investments was $13,917,000 and $27,805,000, respectively.

Mortgage Residual Interests

OAMI, a majority owned and consolidated subsidiary of the Company holds the residual interests from seven commercial real estate loan securitizations. Each of the Residuals is recorded at fair value based upon a third party valuation, with adjustments subsequent to the initial acquisition of the Company’s interest in OAMI recorded through earnings. The Residuals had a fair value of $31,512,000 at December 31, 2006.

Inventory Assets

The NNN TRS develops Inventory Properties (“Development Properties” or “Development Portfolio”) as well as acquires existing Inventory Properties (“Exchange Properties” or “Exchange Portfolio”). The Company’s Inventory Portfolio is held with the intent to sell the properties to purchasers who are looking for replacement like-kind exchange property or to other purchasers with different investment objectives. As of December 31, 2006, NNN TRS owned 29 Development Properties (11 completed, five under construction and 13 land parcels) and 68 Exchange Properties. Reference is made to the Schedule of Real Estate and Accumulated Depreciation and Amortization filed with this report for a listing of the Inventory Properties and their respective carrying costs.

The following table summarizes the 11 completed Development Properties and 68 Exchange Properties as of December 31, 2006 (dollars in thousands):

 

     Size (1)    Cost (2)
         High            Low            Average            High            Low            Average    

Completed Development Properties:

                 

Land

   527,000    42,000    205,000    $         6,149    $         387    $         1,598

Building

   71,000    5,000    20,000      10,852      112      3,492

Exchange Properties:

                 

Land

   396,000    8,000    45,000      2,927      59      606

Building

   50,000    2,000    5,000      8,905      74      955

(1) Approximate square feet.

(2) Costs vary depending upon size and local demographic factors.

Under Construction.  In connection with the development of five Inventory Properties by the NNN TRS, the Company has agreed to fund total construction commitments (including land costs) of $36,728,000, of which $27,263,000 has been funded as of December 31, 2006.

 

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Governmental Regulations Affecting Properties

Property Environmental Considerations.  The Company may acquire a property that contains some level of contamination or potential contamination exists, subject to a determination of the level of risk and potential cost of remediation. Investments in real property create a potential for substantial environmental liability on the part of the owner of such property from the presence or discharge of hazardous substances on the property, regardless of fault. It is the Company’s policy, as a part of its acquisition due diligence process, generally to obtain an environmental site assessment for each property. In such cases that the Company intends to acquire real estate where contamination or potential contamination exists, the Company generally requires the seller or tenant to (i) remediate the problem, (ii) indemnify the Company for environmental liabilities, or (iii) agree to other arrangements deemed appropriate by the Company to address environmental conditions at the property.

The Company has 25 Investment Properties currently under some level of environmental remediation. In general, the seller, the tenant or an adjacent land owner is responsible for the cost of the environmental remediation for each of these Investment Properties.

Americans with Disabilities Act of 1990.  The Investment and Inventory Properties, as commercial facilities, are required to comply with Title III of the Americans with Disabilities Act of 1990 (the “ADA”). Investigation of a property may reveal non-compliance with the ADA. The tenants will typically have primary responsibility for complying with the ADA, but the Company may incur costs if the tenant does not comply. As of February 15, 2007, the Company has not been notified by any governmental authority of, nor is the Company’s management aware of, any non-compliance with the ADA that the Company’s management believes would have a material adverse effect on its business, financial condition or results of operations.

Other Regulations.  State and local fire, life-safety and similar requirements regulate the use of the Company’s Investment and Inventory Properties. The leases generally require that each tenant will have primary responsibility for complying with regulations, but failure to comply could result in fines by governmental authorities, awards of damages to private litigants, or restrictions on the ability to conduct business on such properties.

Item 3.  Legal Proceedings

In the ordinary course of its business, the Company is a party to various legal actions that management believes is routine in nature and incidental to the operation of the business of the Company. Management believes that the outcome of these proceedings will not have a material adverse effect upon its operations, financial condition or liquidity.

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

None.

 

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PART II

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

The common stock of the Company currently is traded on the New York Stock Exchange (“NYSE”) under the symbol “NNN.” Set forth below is a line graph comparing the cumulative total stockholder return on the Company’s common stock, based on the market price of the common stock and assuming reinvestment of dividends (“NNN”), with the FTSE National Association of Real Estate Investment Trusts Equity Index (“NAREIT”) and the S&P 500 Index (“S&P 500”) for the five year period commencing December 31, 2001 and ending December 31, 2006. The graph assumes the investment of $100 on December 31, 2001.

LOGO

 

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For each calendar quarter indicated, the following table reflects respective high, low and closing sales prices for the common stock as quoted by the NYSE and the dividends paid per share in each such period.

 

2006

   First
    Quarter    
   Second
    Quarter    
   Third
    Quarter    
   Fourth
    Quarter    
       Year    

High

   $         23.540      23.370    $         22.460    $         24.100    $         24.100

Low

     20.220      18.810      19.820      21.250      18.810

Close

     23.300      19.950      21.600      22.950      22.950

Dividends paid per share

     0.325      0.325      0.335      0.335      1.320

2005

                        

High

   $ 20.880    $         20.990    $ 21.650    $ 20.970    $ 21.650

Low

     18.000      18.300      18.530      18.060      18.000

Close

     18.450      20.470      20.000      20.370      20.370

Dividends paid per share

     0.325      0.325      0.325      0.325      1.300

The following presents the characterizations for tax purposes of such common stock dividends for the years ended December 31:

 

      2006    2005

Ordinary dividends

   $         1.151    87.18%    $         1.068    82.19%

Qualified dividends

     -    -      0.225    17.27%

Capital gain

     0.150    11.38%      -    -

Unrecaptured Section 1250 Gain

     0.019    1.44%      0.002    0.17%

Nontaxable distributions

     -    -      0.005    0.37%
                       
   $ 1.320    100.00%    $ 1.300    100.00%
                       

The Company intends to pay regular quarterly dividends to its stockholders, although all future distributions will be declared and paid at the discretion of the board of directors and will depend upon cash generated by operating activities, the Company’s financial condition, capital requirements, annual distribution requirements under the REIT provisions of the Internal Revenue Code of 1986, as amended, and such other factors as the board of directors deems relevant.

In February 2007 the Company paid dividends to its stockholders of $20,115,000 or $0.335 per share of common stock.

On February 15, 2007, there were 1,526 stockholders of record of common stock.

 

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Item 6.  Selected Financial Data

Historical Financial Highlights

(dollars in thousands, except per share data)

 

         2006             2005             2004             2003             2002      

Gross revenues(1)

  $     180,876     $     151,831     $     133,875     $     112,073     $     102,067  

Earnings from continuing operations

    73,538       44,083       38,216       30,653       28,098  

Net earnings

    182,505       89,400       64,934       53,473       48,058  

Total assets

    1,916,785       1,733,416       1,300,048       1,213,778       958,300  

Total debt

    776,737       861,045       524,241       467,419       386,912  

Total equity

    1,096,505       828,087       756,998       730,754       549,141  

Cash dividends declared to:

         

Common stockholders

    76,035       69,018       66,272       55,473       51,178  

Series A Preferred Stock stockholders

    4,376       4,008       4,008       4,008       4,010  

Series B Convertible Preferred Stock stockholders

    419       1,675       1,675       502       -  

Series C Redeemable Preferred Stock stockholders

    923       -       -       -       -  

Weighted average common shares:

         

Basic

    57,428,063       52,984,821       51,312,434       43,108,213       40,383,405  

Diluted

    58,079,875       54,640,143       51,742,518       43,896,800       40,588,957  

Per share information:

         

Earnings from continuing operations:

         

Basic

    1.18       0.72       0.63       0.61       0.60  

Diluted

    1.17       0.73       0.63       0.61       0.59  

Net earnings:

         

Basic

    3.08       1.58       1.15       1.14       1.09  

Diluted

    3.05       1.56       1.15       1.13       1.09  

Dividends declared to:

         

Common stockholders

    1.32       1.30       1.29       1.28       1.27  

Series A Preferred Stock stockholders

    2.45625       2.25       2.25       2.25       2.25  

Series B Convertible Preferred Stock stockholders

    41.875       167.50       167.50       50.25       -  

Series C Redeemable Preferred Stock depositary stockholders

    0.250955       -       -       -       -  

Other data:

         

Cash flows provided by (used in):

         

Operating activities

    18,561       30,930       85,800       54,215       111,589  

Investing activities

    (106,984 )     (242,487 )     (69,963 )     (256,870 )     (15,142 )

Financing activities

    81,864       217,844       (19,225 )     205,965       (101,654 )

Funds from operations – diluted(2)

    97,121       81,803       73,065       61,749       54,595  

 

  (1) Gross revenues include revenues from the Company’s continuing and discontinued operations. The Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” This statement addresses financial accounting and reporting for the impairment or disposal of long-lived assets and broadens the presentation of discontinued operations in the income statement to include a component of an entity. Accordingly, the results of operations related to these certain properties that have been classified as held for sale or have been disposed of subsequent to December 31, 2001, the effective date of SFAS No. 144, have been reclassified as earnings from discontinued operations.

 

  (2)

The National Association of Real Estate Investment Trusts (“NAREIT”) developed FFO as a relative non-GAAP financial measure of performance of a REIT in order to recognize that income-producing real estate historically has

 

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not depreciated on the basis determined under GAAP. FFO is defined by NAREIT and is used by the Company as follows: net earnings (computed in accordance with GAAP) plus depreciation and amortization of assets unique to the real estate industry, excluding gains (or including losses) on the disposition of real estate held for investment, and the Company’s share of these items from the Company’s unconsolidated partnerships.

FFO is generally considered by industry analysts to be the most appropriate measure of operating performance of real estate companies. FFO does not necessarily represent cash provided by operating activities in accordance with GAAP and should not be considered an alternative to net income as an indication of the Company’s operating performance or to cash flow as a measure of liquidity or ability to make distributions. Management considers FFO an appropriate measure of operating performance of an equity REIT because it primarily excludes the assumption that the value of the real estate assets diminishes predictably over time, and because industry analysts have accepted it as an operating performance measure. The Company’s computation of FFO may differ from the methodology for calculating FFO used by other equity REITs, and therefore, may not be comparable to such other REITs.

The Company has earnings from discontinued operations in each of its segments, investment assets and inventory assets, real estate held for investment and real estate held for sale. All property dispositions from the Company’s investment segment are classified as discontinued operations. In addition, certain properties in the Company’s inventory segment that have generated revenues before disposition are classified as discontinued operations. These inventory properties have not historically been classified as discontinued operations, therefore, prior period comparable consolidated financial statements have been restated to include these properties in its earnings from discontinued operations. These adjustments resulted in a decrease in the Company’s reported total revenues and total and per share earnings from continuing operations and an increase in the Company’s earnings from discontinued operations. However, the Company’s total and per share net earnings available to common stockholders is not affected.

The following table reconciles FFO to their most directly comparable GAAP measure, net earnings for the years ended December 31:

 

        2006             2005             2004             2003             2002      

Reconciliation of funds from operations:

         

Net earnings

  $     182,505     $     89,400     $     64,934     $     53,473     $     48,058  

Real estate depreciation and amortization:

         

Continuing operations

    20,874       14,871       11,296       9,572       8,822  

Discontinued operations

    1,545       5,536       4,419       2,300       1,506  

Partnership real estate depreciation

    463       606       622       699       479  

Partnership gain on sale of asset

    (262 )     -       -       -       -  

Gain on disposition of equity investment

    (11,373 )     -       -       -       -  

Gain on disposition of investment assets

    (91,332 )     (9,816 )     (2,523 )     (287 )     (260 )

Extraordinary gain

    -       (14,786 )     -       -       -  
                                       

FFO

    102,420       85,811       78,748       65,757       58,605  

Series A Preferred Stock dividends

    (4,376 )     (4,008 )     (4,008 )     (4,008 )     (4,010 )

Series B Convertible Preferred Stock dividends

    (419 )     (1,675 )     (1,675 )     (502 )     -  

Series C Redeemable Preferred Stock dividends

    (923 )     -       -       -       -  
                                       

FFO available to common stockholders – basic

    96,702       80,128       73,065       61,247       54,595  

Series B Convertible Preferred Stock dividends, if dilutive

    419       1,675       -       502       -  
                                       

FFO available to common stockholders – diluted

  $ 97,121     $ 81,803     $ 73,065     $ 61,749     $ 54,595  
                                       

For a discussion of material events affecting the comparability of the information reflected in the selected financial data, refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.”

 

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

The following discussion and analysis should be read in conjunction with Item 6. “Selected Financial Data,” and the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K, and the forward-looking disclaimer language in italics before Item 1. “Business.”

National Retail Properties, Inc., a Maryland corporation, is a fully integrated real estate investment trust (“REIT”) formed in 1984. The terms “Registrant” or “Company” refer to National Retail Properties, Inc. and its majority owned and controlled subsidiaries. These subsidiaries include the wholly owned qualified REIT subsidiaries of National Retail Properties, Inc., as well as the taxable REIT subsidiaries and their majority owned and controlled subsidiaries (the “NNN TRS”). Effective May 1, 2006, Commercial Net Lease Realty, Inc. changed its name to National Retail Properties, Inc.

Overview

The Company’s operations are divided into two primary business segments: (i) investment assets, including real estate assets, structured finance investments (included in mortgages, notes and accrued interest receivable on the consolidated balance sheets) and mortgage residual interests (collectively, “Investment Assets”), and (ii) inventory real estate assets (“Inventory Assets”). The Investment Assets are operated through National Retail Properties, Inc. and its wholly owned qualified REIT subsidiaries. The Company acquires, owns, invests in, manages and develops properties that are leased primarily to retail tenants under long-term net leases (“Investment Properties” or “Investment Portfolio”). The Inventory Assets are operated through the NNN TRS. The NNN TRS, directly and indirectly, through investment interests, owns real estate primarily for the purpose of selling the real estate (“Inventory Properties” or “Inventory Portfolio”).

As of December 31, 2006, the Company owned 710 Investment Properties, with an aggregate leasable area of 9,341,000 square feet, located in 44 states. Approximately 98 percent of the Company’s Investment Portfolio was leased at December 31, 2006. In addition to the Investment Properties, as of December 31, 2006, the Company had $13,917,000 and $31,512,000 in structured finance investments and mortgage residual interests, respectively. As of December 31, 2006, the NNN TRS owned 97 Inventory Properties.

As of October 31, 2005, the Inventory Assets were operated through Commercial Net Lease Realty Services, Inc. (“Services”) and its majority owned and controlled subsidiaries. Effective November 1, 2005, Services merged with and into National Retail Properties, Inc., and a former Services subsidiary, CNLRS Exchange I, Inc., became the holding company for the Company’s development and exchange activities. Effective October 2, 2006, CNLRS Exchange I, Inc. changed its name to NNN TRS, Inc.

The NNN TRS, directly and indirectly, through investment interests, owns real estate primarily for the purpose of selling the real estate (“Inventory Properties” or “Inventory Portfolio”). The NNN TRS acquires and develops Inventory Properties (“Development Properties” or “Development Portfolio”) and also acquires existing Inventory Properties (“Exchange Properties” or “Exchange Portfolio”). As of December 31, 2006, the NNN TRS owned 29 Development Properties (11 completed inventory, five under construction and 13 land parcels) and 68 Exchange Properties.

The Company’s management team focuses on certain key indicators to evaluate the financial condition and operating performance of the Company. The key indicators for the Company include items such

 

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as: the composition of the Company’s Investment Portfolio and structured finance investments (such as tenant, geographic and industry classification diversification), the occupancy rate of the Company’s Investment Portfolio, certain financial performance ratios and profitability measures, industry trends and performance compared to that of the Company, and returns the Company receives on its invested capital.

The Company has recently increased its investments in the convenience store and restaurant sectors. Both of these sectors represent a large part of the freestanding retail property marketplace which the Company believes represents areas of attractive investment opportunity. Similarly, the Company has some geographic focus in Texas and Florida which the Company believes are areas of above average population growth which provide relatively strong investment opportunity for retailers and retail real estate investments.

Critical Accounting Policies and Estimates

The preparation of the Company’s consolidated financial statements in conformance with accounting principles generally accepted in the United States of America requires management to make numerous estimates and judgments on assumptions that affect the reported amounts of assets, liabilities, revenues and expenses as well as other disclosures in our financial statements. On an ongoing basis, management evaluates its estimates and judgments. However, actual results may differ from these estimates and assumptions which in turn could have a material impact on the Company’s financial statements. A summary of the Company’s accounting policies and procedures are included in Note 1 of the Company’s consolidated financial statements. Management believes the following critical accounting policies among others affect its more significant judgments and estimates used in the preparation of the Company’s consolidated financial statements.

Real Estate – Investment Portfolio.  The Company records the acquisition of real estate at cost, including acquisition and closing costs. The cost of properties developed by the Company includes direct and indirect costs of construction, property taxes, interest and other miscellaneous costs incurred during the development period until the project is substantially complete and available for occupancy.

Purchase Accounting for Acquisition of Real Estate Subject to a Lease – For acquisitions of real estate subject to a lease subsequent to June 30, 2001, the effective date of Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations,” (“SFAS 141”), the fair value of the real estate acquired is allocated to the acquired tangible assets, consisting of land, building and tenant improvements, and identified intangible assets and liabilities, consisting of the value of above-market and below-market leases, value of in-place leases value of tenant relationships, based in each case on their relative fair values.

Real estate is generally leased to tenants on a net lease basis, whereby the tenant is responsible for all operating expenses relating to the property, including property taxes, insurance, maintenance and repairs. The leases are accounted for using either the operating or the direct financing method. Such methods are described below:

Operating method – Leases accounted for using the operating method are recorded at the cost of the real estate. Revenue is recognized as rentals are earned and expenses (including depreciation) are charged to operations as incurred. Buildings are depreciated on the straight-line method over their estimated useful lives (generally 35 to 40 years). Leasehold interests are amortized on the straight-line method over the terms of their respective leases. When scheduled

 

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rentals vary during the lease term, income is recognized on a straight-line basis so as to produce a constant periodic rent over the term of the lease. Accrued rental income is the aggregate difference between the scheduled rents which vary during the lease term and the income recognized on a straight-line basis.

Direct financing method – Leases accounted for using the direct financing method are recorded at their net investment (which at the inception of the lease generally represents the cost of the property). Unearned income is deferred and amortized into income over the lease terms so as to produce a constant periodic rate of return on the Company’s net investment in the leases.

Management periodically assesses its real estate for possible impairment whenever events or changes in circumstances indicate that the carrying value of the asset, including accrued rental income, may not be recoverable through operations. Management determines whether an impairment in value has occurred by comparing the estimated future cash flows (undiscounted and without interest charges), including the residual value of the real estate, with the carrying cost of the individual asset. If an impairment is indicated, a loss will be recorded for the amount by which the carrying value of the asset exceeds its fair value.

Real Estate – Inventory Portfolio.  The NNN TRS acquires, develops and owns properties that it intends to sell. The properties that are classified as held for sale at any given time may consist of properties that have been acquired in the marketplace with the intent to sell and properties that have been, or are currently being, constructed by the NNN TRS. The NNN TRS records the acquisition of the real estate at cost, including the acquisition and closing costs. The cost of the real estate developed by the NNN TRS includes direct and indirect costs of construction, interest and other miscellaneous costs incurred during the development period until the project is substantially complete and available for occupancy. Real estate held for sale is not depreciated.

Mortgage Residual Interests, at Fair Value.  Mortgage residual interests, classified as available for sale, are reported at their market values with unrealized gains and losses reported as other comprehensive income in stockholders’ equity. The mortgage residual interests were acquired in connection with the acquisition of 78.9 percent equity interest of OAMI. The Company recognizes the excess of all cash flows attributable to the mortgage residual interests estimated at the acquisition/transaction date over the initial investment (the accretable yield) as interest income over the life of the beneficial interest using the effective yield method. Losses are considered other than temporary valuation impairments if and when there has been a change in the timing or amount of estimated cash flows, exclusive of changes in interest rates, that leads to a loss in value. Certain of the mortgage residual interests have been pledged as security for notes payable.

Revenue Recognition.  Rental revenues for non-development real estate assets are recognized when earned in accordance with SFAS 13, “Accounting for Leases,” based on the terms of the lease at the time of acquisition of the leased asset. Rental revenues for properties under construction commence upon completion of construction of the leased asset and delivery of the leased asset to the tenant.

Use of Estimates.  Additional critical accounting policies of the Company include management’s estimates and assumptions relating to the reporting of assets and liabilities, revenues and expenses and the disclosure of contingent assets and liabilities to prepare the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. Additional critical accounting policies include management’s estimates of the useful lives used in calculating depreciation expense relating to the Company’s real estate assets, the recoverability of the carrying

 

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value of long-lived assets, including the mortgage residual interests, the collectibility of receivables from tenants, including accrued rental income, and capitalized overhead relating to development projects. Actual results could differ from those estimates.

Results of Operations

Property Analysis – Investment Portfolio

General.  The following table summarizes the Company’s Investment Portfolio as of December 31:

 

         2006            2005            2004    

Investment Properties Owned:

        

Number

   710    524    362

Total gross leasable area (square feet)

   9,341,000    9,227,000    8,542,000

Investment Properties Leased:

        

Number

   697    512    351

Total gross leasable area (square feet)

   9,173,000    9,066,000    8,322,000

Percent of total gross leasable area

   98%    98%    97%

Weighted average remaining lease term (years)

   12    11    10

The following table summarizes the lease expirations of the Company’s Investment Portfolio as of December 31, 2006.

 

    % of
    Total
(1)    
 

# of

    Properties    

  Gross
    Leasable    
Area
(2)
      % of
    Total
(1)    
  # of
    Properties    
 

Gross

    Leasable    

Area(2)

2007

  1.2%   13   206,000   2013   5.6%   30   690,000

2008

  1.8%   22   406,000   2014   7.3%   39   591,000

2009

  2.6%   25   490,000   2015   4.6%   22   621,000

2010

  3.9%   36   383,000   2016   4.2%   22   508,000

2011

  3.8%   23   439,000   2017   7.2%   28   808,000

2012

  4.6%   30   531,000   Thereafter   53.2%   407   3,500,000

 

 

(1)

Based on the annualized base rent for all leases in place as of December 31, 2006.

 

(2)

Approximate square feet.

The following table summarizes the diversification of the Company’s Investment Portfolio based on the top 10 lines of trade as of December 31, 2006 (dollars in thousands):

 

    

Top 10 Lines of Trade

       2006(1)            2005(1)            2004(1)    

1.

   Convenience Stores    16.3%    12.1%    0.7%

2.

   Restaurants – Full Service    12.1%    6.6%    6.7%

3.

   Drug Stores    8.3%    10.0%    11.5%

4.

   Sporting Goods    7.3%    7.4%    7.8%

5.

   Books    5.7%    5.8%    6.9%

6.

   Grocery    5.7%    6.3%    7.7%

7.

   Consumer Electronics    5.6%    5.9%    7.1%

8.

   Restaurants – Limited Service    4.7%    3.0%    3.1%

9.

   Furniture    4.2%    4.7%    5.0%

10.

   Office Supplies    4.1%    4.4%    5.2%
   Other    26.0%    33.8%    38.3%
                 
      100.0%    100.0%    100.0%
                 

(1)

   Based on the annualized base rent for all leases in place as of December 31 of the respective year.

 

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The following table shows the top 10 states in which the Company’s Investment Properties are located in as of December 31, 2006 (dollars in thousands):

 

   

State

  

Number

of

    Properties    

  

% of

    Annual    

Base

Rent(1)

1.

  Texas    149    22.2%

2.

  Florida    77    13.4%

3.

  Pennsylvania    77    5.4%

4.

  Georgia    37    5.1%

5.

  Virginia    19    3.9%

6.

  California    18    3.7%

7.

  Tennessee    19    3.5%

8.

  Illinois    22    3.4%

9.

  Missouri    14    3.3%

10.

  Ohio    23    3.0%
  Other    255    33.1%
           
     710    100.0%
           

(1)

  Based on annualized base rent for all leases in place as of December 31, 2006.

Property Acquisitions.  The following table summarizes the Investment Property acquisitions for each of the years ended December 31 (dollars in thousands):

 

      2006    2005    2004

Acquisitions:

        

Number of Investment Properties

     213      170      36

Gross leasable area (square feet)

     1,130,000      1,150,000      825,000

Total dollars invested (1)

   $         371,898    $         332,461    $         139,303

 

 

(1)

Includes dollars invested on projects currently under construction.

Property Dispositions.  The following table summarizes the Investment Properties sold by the Company for each of the years ended December 31 (dollars in thousands):

 

      2006    2005    2004

Number of properties

     30      12      20

Gross leasable area (square feet)

     1,015,000      476,000      155,000

Net sales proceeds

     319,361      40,377      32,544

Net gain

   $         91,332    $             9,816    $             2,523

Property Analysis – Inventory Portfolio

General.  The following summarizes the number of properties held for sale in the Company’s Inventory Portfolio as of December 31:

 

          2006            2005            2004    

Development Portfolio:

        

Completed Inventory Properties

   11    1    4

Properties under construction

   5    12    7

Land parcels

   13    4    4
              
   29    17    15
              

Exchange Portfolio:

        

Inventory Properties

   68    46    6
              

Total Inventory Properties

   97    63    21
              

 

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Property Acquisitions.  The following table summarizes the property acquisitions and dollars invested in the Inventory Portfolio for each of the years ended December 31 (dollars in thousands):

 

          2006            2005            2004    

Development Portfolio:

        

Number of properties acquired

     16      58      33

Dollars invested (1)

   $ 82,524    $ 66,527    $ 48,318

Exchange Portfolio:

        

Number of properties acquired

     77      4      8

Dollars invested

   $ 118,553    $ 10,714    $ 26,366

Total dollars invested

   $       201,077    $       134,373    $       76,647

 

 

(1)

Includes dollars invested on projects currently under construction.

Property Dispositions.  The following table summarizes the number of Inventory Properties sold and the corresponding gain recognized from the disposition of real estate held for sale included in earnings from continuing and discontinued operations for each of the years ended December 31 (dollars in thousands):

 

      2006     2005     2004  
      # of
  Properties  
   Gain     # of
  Properties  
   Gain     # of
  Properties  
   Gain  

Development

   9    $ 9,698     12    $ 18,065     16    $ 20,673  

Exchange

   55      3,892     16      2,641     8      1,912  

Intercompany eliminations

   -      190     -      921     -      817  

Minority interest, Development

   -      (4,114 )   -      (5,999 )   -      (6,422 )
                                       
   64    $ 9,666     28    $ 15,628     24    $ 16,980  
                                       

Business Combinations

Orange Avenue Mortgage Investments, Inc.  On May 2, 2005, the Company exercised its option to acquire 78.9 percent of the common shares of OAMI for $9,379,000. In December 2004, OAMI sold its loan origination, securitization and servicing operations and the majority of its assets and liabilities to a third party, leaving OAMI with an interest in seven commercial real estate loan securitization residual interests. The loans in each of the securitizations are secured by first mortgages on commercial real estate and generally borrower personal guarantees. As a result of the option exercise, the Company has consolidated OAMI in its consolidated financial statements.

In accordance with SFAS No. 141, “Business Combinations,” (“SFAS 141”), the Company recorded the assets and liabilities of OAMI at fair value. The Company recognized an extraordinary gain of $14,786,000, equal to the excess fair value over the option price, as all assets acquired were financial assets and current assets.

Between June 2001 and July 2003, a wholly owned subsidiary of the Company, Net Lease Funding, Inc. (“NLF”), entered into five limited liability company agreements with OAMI to create five limited liability companies (collectively, the “LLCs”). Kevin B. Habicht, an officer and director of the Company is an officer, director and indirect stockholder of OAMI. Craig Macnab, an officer and director of the Company and Julian E. Whitehurst, an officer of the Company, are each an officer and director of OAMI. Each of the LLCs holds an interest in mortgage loans and is 100 percent equity financed. Prior to the acquisition of the 78.9 percent equity interest in OAMI, NLF held a non-voting

 

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and non-controlling interest in each of the LLCs ranging between 36.7 and 44.0 percent and accounted for its investment under the equity method of accounting.

As a result of the Company’s acquisition of 78.9 percent equity interest in OAMI, the Company’s interest in the LLCs is no longer accounted for as an equity investment and is now included as part of OAMI in the Company’s consolidated financial statements. In addition, certain officers and directors of the Company own preferred shares of OAMI.

Prior to the acquisition of 78.9 percent equity interest in OAMI, the Company received $2,749,000 and $10,562,000 in distributions from the LLCs during the years ended December 31, 2005 and 2004, respectively. For the years ended December 31, 2005 and 2004, the Company recognized $1,467,000 and $5,042,000 of earnings, respectively, from the LLCs.

In connection with the independent valuations of the Residuals’ fair value, the Company reduced the carrying value of the Residuals to reflect such fair value at December 31, 2005. The reduction in the Residuals’ value that related to the Residuals acquired at the time of the option exercise was recorded as a purchase price allocation adjustment. The reduction in the Residuals’ value acquired at the time of the option exercise that related to the period subsequent to the option exercise, as well as the reduction in the value related to the portion of the Residuals owned by NLF, was recorded as an aggregate other than temporary valuation impairment of $8,779,000 and $2,382,000 for the years ended December 31, 2006 and 2005, respectively. Unrealized gains of $1,992,000 were recorded as other comprehensive income in the Statement of Stockholders Equity during the year ended December 31, 2006.

The Company merged certain of its wholly owned subsidiaries into National Retail Properties, Inc. and elected to convert OAMI to a REIT. As a result, effective January 1, 2005, OAMI was taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended, and related regulations. Upon making the REIT conversion, $3,453,000 of OAMI’s tax liability was eliminated and recorded as an adjustment to the net assets acquired at the time of the option exercise. The remaining tax liability will be reduced over the next ten years in proportion to the reduction of the basis of the respective mortgage residual interests.

National Properties Corporation.  On June 16, 2005, the Company acquired 100 percent of National Properties Corporation (“NAPE”), a publicly traded company, which owned 43 freestanding properties located in 12 states. Results of NAPE operations have been included in the consolidated financial statements since the date of acquisition. NAPE stockholders received 1,636,532 newly issued shares of the Company’s common stock. In accordance with SFAS 141, the acquisition price of $32,199,000 was allocated to the assets acquired and liabilities assumed at their fair values.

Revenue from Continuing Operations Analysis

General.  During the year ended December 31, 2006, the Company’s rental income increased primarily due to the acquisition of Investment Properties (See “Results of Operations – Property Analysis – Investment Portfolio – Property Acquisitions”). The Company anticipates any significant increase in rental income will continue to come primarily from additional property acquisitions.

 

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The following summarizes the Company’s revenues from continuing operations for each of the years ended December 31 (dollars in thousands):

 

                           

2006

Versus

2005

Percent
Increase
  (Decrease)  

 

2005

Versus

2004

Percent
Increase
  (Decrease)  

                Percent of Total    
        2006           2005           2004           2006           2005           2004        

Rental Income (1)

  $   134,196   $   100,836   $   84,546   89.0%   85.1%   88.9%   33.1%   19.3%

Real estate expense reimbursement from tenants

    4,862     4,094     2,828   3.2%   3.5%   3.0%   18.8%   44.8%

Interest and other income from real estate transactions

    4,462     6,143     7,695   3.0%   5.2%   8.1%   (27.4)%   (20.2)%

Interest income on mortgage residual interests

    7,268     7,349     -   4.8%   6.2%   -   (1.1)%   100.0%
                                 

Total revenues

  $ 150,788   $ 118,422   $ 95,069   100.0%   100.0%   100.0%   27.3%   24.6%
                                 

 

(1)

Includes rental income from operating leases, earned income from direct financing leases and contingent rental income from continuing operations (“Rental Income”).

Revenue from Operations by Source of Income.  The Company has identified two primary business segments, and thus, sources of revenue: (i) earnings from the Company’s Investment Assets and (ii) earnings from the Company’s Inventory Assets. The revenues generated by each of the Company’s two primary operating segments have remained relatively consistent as a percentage of the Company’s total revenues from continuing operations. The following table summarizes the revenues from continuing operations for each of the years ended December 31, (dollars in thousands):

 

                           

2006

Versus

2005

Percent

Increase

    (Decrease)    

 

2005

Versus

2004

Percent

Increase

    (Decrease)    

                Percent of Total    
        2006           2005           2004           2006           2005           2004        

Investment Assets

  $   134,334   $   113,865   $   91,018   89.1%   96.2%   95.7%   18.0%   25.1%

Inventory Assets

    16,454     4,557     4,051   10.9%   3.8%   4.3%   261.1%   12.5%
                                 

Total revenue from continuing operations

  $ 150,788   $ 118,422   $ 95,069   100.0%   100.0%   100.0%   27.3%   24.6%
                                 

Comparison of Year Ended December 31, 2006 to Year Ended December 31, 2005.

Rental Income.  The Company’s Rental Income increased primarily due to the addition of an aggregate gross leasable area of 1,130,000 square feet to the Company’s Investment Portfolio resulting from the acquisition of an additional 213 Investment Properties during the year ended December 31, 2006, of which 38 Investment Properties with an aggregate 272,000 square feet of gross leasable area were acquired in the last three months of 2006. The Investment Portfolio occupancy rate remained relatively stable at approximately 98 percent for each of the years ended December 31, 2006 and 2005.

Real Estate Expense Reimbursements from Tenants.  Real estate expense reimbursements from tenants remained fairly constant as a percent of total revenues from continuing operations. The increase for the

 

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year ended December 31, 2006 as compared to the year ended December 31, 2005 was attributable to a full year of reimbursements from certain tenants acquired in 2005 and the reimbursements from the newly acquired Investment Properties in 2006.

Interest and Other Income from Real Estate Transactions.  Interest and other income from real estate transactions decreased for the year ended December 31, 2006, primarily due to a decrease in interest earned on the structured finance investments compared to the year ended December 31, 2005. The weighted average outstanding principal balance of the structured finance investments during the year ended December 31, 2006 and 2005 was $16,834,000 and $27,584,000, respectively. In addition, the Company received $886,000 of disposition and development fee income during the year ended December 31, 2005. There was no fee income recognized in 2006.

Interest Income on Mortgage Residual Interests.  The Company recognizes interest income on mortgage residual interests as a result of its acquisition of 78.9 percent equity interest in OAMI in May 2005. As a result of the timing of the acquisition, the Company recognized such income for the entire year ended December 31, 2006, versus a partial period in 2005 (see “Business Combinations”). However, the increase in interest income from the mortgage residual interests for the year ended December 31, 2006, is partially offset by a decrease in interest income as a result of the amortization and prepayments of the underlying loans.

Gain from Disposition of Real Estate, Inventory Portfolio.  Inventory Properties typically are operating properties and are classified as discontinued operations. However, the gains on the sale of Inventory Properties which are sold prior to rent commencement are reported in continuing operations. The increase in the gain from the disposition of real estate is primarily due to the varying gross margin on sales of these Inventory Properties and the timing of such sales.

The following table summarizes the Inventory Property dispositions included in continuing operations for the years ended December 31 (dollars in thousands):

 

     2006     2005
     # of
    Properties    
       Gain         # of
    Properties    
       Gain    

Gain

   6    $     8,000     6    $     2,010

Minority interest

   -      (3,609 )   -      -
                        

Gain, net of minority interest

   6    $ 4,391     6    $ 2,010
                        

Comparison of Year Ended December 31, 2005 to Year Ended December 31, 2004.

Rental Income.  Rental Income increased for the year ended December 31, 2005, as compared to the year ended December 31, 2004, primarily due to the addition of an aggregate gross leasable area of 1,150,000 square feet to the Company’s Investment Portfolio resulting from the acquisition of 170 Investment Properties during the year ended December 31, 2005.

Real Estate Expense Reimbursements from Tenants.  Real estate expense reimbursements from tenants increased for the year ended December 31, 2005, as compared to the year ended December 31, 2004, primarily due to a full year of expense reimbursements during 2005 from certain tenants acquired during 2004.

Gain from Disposition of Real Estate, Inventory Portfolio.  The gain on disposition of real estate held for sale included in continuing operations decreased for the year ended December 31, 2005, as

 

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compared to the year ended December 31, 2004, primarily due to the number of properties sold and the varying gross margin on sales of Inventory Properties. The following table summarizes the property dispositions included in continuing operations for the year ended December 31 (dollars in thousands):

 

     2005    2004  
     # of
    Properties    
       Gain        # of
    Properties    
       Gain      

Gain

   6    $       2,010    7    $       4,700  

Minority interest

   -      -    -      (1,717 )
                         

Gain, net of minority interest

   6    $ 2,010    7    $ 2,983  
                         

Interest and Other Income from Real Estate Transactions.  Interest and other income from real estate transactions decreased for the year ended December 31, 2005, as compared to the year ended December 31, 2004, primarily due to a decrease in interest earned on the structured finance investments for the year ended December 31, 2005. The weighted average outstanding principal balance of the structured finance investments during the year ended December 31, 2005 and 2004 was $27,584,000 and $44,424,000, respectively. However, the decrease was partially offset by the $886,000 and $175,000 of disposition and development fee income received during the year ended December 31, 2005 and 2004, respectively.

Analysis of Expenses from Continuing Operations

General.  During 2006 operating expenses from continuing operations increased primarily as a result of the acquisition of additional properties but remained generally proportionate to the Company’s total revenues from continuing operations. The following summarizes the Company’s expenses from continuing operations (dollars in thousands):

 

         2006             2005             2004      

General and administrative

   $         24,012     $         22,418     $         21,664  

Real estate

     7,088       5,938       4,986  

Depreciation and amortization

     22,971       16,792       12,975  

Impairment – real estate, Investment Portfolio

     -       1,673       -  

Impairment – mortgage residual interests valuation adjustment

     8,779       2,382       -  

Restructuring costs

     1,580       -       -  

Transition costs

     -       -       3,741  
                        

Total operating expenses

   $ 64,430     $ 49,203     $ 43,366  
                        

Interest and other income

   $ (3,815 )   $ (2,039 )   $ (3,760 )

Interest expense

     45,874       33,309       27,972  
                        

Total other expenses (revenues)

   $ 42,059     $ 31,270     $ 24,212  
                        

 

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                            2006
Versus
2005
Percent
Increase
(Decrease)
  2005
Versus
2004
Percent
Increase
(Decrease)
   

Percentage of Total

Operating Expenses

  Percentage of Revenues from
Continuing Operations
   
        2006           2005           2004           2006           2005           2004        

General and administrative

  37.3%   45.6%   50.0%   15.9%   18.9%   22.8%   7.1%   3.5%

Real estate

  11.0%   12.1%   11.5%   4.7%   5.0%   5.2%   19.4%   19.1%

Depreciation and amortization

  35.7%   34.1%   29.9%   15.2%   14.2%   13.6%   36.8%   29.4%

Impairment – real estate, Investment Portfolio

  -   3.4%   -   -   1.4%   -   (100.0)%   100.0%

Impairment – mortgage residual interests valuation adjustment

  13.6%   4.8%   -   5.8%   2.0%   -   268.6%   100.0%

Restructuring costs

  2.4%   -   -   1.1%   -   -   100.0%   -

Transition costs

  -   -   8.6%   -   -   3.9%   -   (100.0)%
                           

Total operating expenses

  100.0%   100.0%   100.0%   47.2%   41.5%   45.5%   30.9%   13.5%
                           

Interest and other income

  (9.1)%   (6.5)%   (15.5)%   (2.5)%   (1.7)%   (4.0)%   87.1%   (45.8)%

Interest expense

  109.1%   106.5%   115.5%   30.4%   28.1%   29.4%   37.7%   19.1%
                           

Total other expenses (revenues)

  100.0%   100.0%   100.0%   27.9%   26.4%   25.5%   34.5%   29.2%
                           

Comparison of Year End December 31, 2006 to Year Ended December 31, 2005.

General and Administrative.  General and administrative expenses increased for the year ended December 31, 2006, however, such expenses decreased as a percentage of total operating expenses from continuing operations for the year ended December 31, 2006. The increase in general and administrative expenses for 2006 was primarily attributable to (i) an increase in expenses related to personnel compensation, (ii) an increase in professional services provided to the Company, and (iii) an increase in lost pursuit costs. The increase in 2006 was partially offset by the decrease in expenses related to personnel as a result of a workforce reduction in April 2006 and an increase in costs capitalized to projects under development.

Real Estate.  Real estate expenses increased for the year ended December 31, 2006, as compared to the year ended December 31, 2005; however, such expenses remained fairly consistent as a percentage of total operating expenses and total revenues from continuing operations. The increase in real estate expenses for 2006 when compared to the same period for 2005 is primarily attributable to (i) an increase in tenant reimbursable real estate expenses, (ii) an increase in expenses related to vacant properties, and (iii) an increase in certain real estate expenses that were not reimbursable by tenants.

Depreciation and Amortization.  Depreciation and amortization expenses increased for the year ended December 31, 2006, as compared to the year ended December 31, 2005; however, such expenses remained fairly consistent as a percentage of total operating expenses and total revenues from continuing operations. The increase for the year ended December 31, 2006, when compared to the same period in 2005 is attributable to (i) the acquisition of 213 Investment Properties with an aggregate gross leasable area of 1,130,000 square feet in 2006 and (ii) a full year of depreciation and amortization on the 170 Investment Properties with an aggregate gross leasable area of 1,150,000 square feet acquired in 2005. The increase in depreciation and amortization was partially offset by the disposition of 30 Investment Properties with an aggregate gross leasable area of 1,015,000 square feet during the year ended December 31, 2006.

Impairment – Real Estate, Investment Portfolio.  The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset

 

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may not be recoverable. Events or circumstances that may occur include changes in real estate market conditions, the ability of the Company to re-lease properties that are currently vacant or become vacant, and the ability to sell properties at an attractive return. Generally, the Company calculates a possible impairment by comparing the future cash flows to the current net book value. Impairments are measured as the amount by which the current book value of the asset exceeds the fair value of the asset.

Impairment – Mortgage Residual Interests Valuation Adjustment.  In connection with the independent valuations of the Residuals’ fair value, the Company reduced the carrying value of the Residuals to reflect such fair value at December 31, 2006 and 2005.

The reduction in the Residuals’ value that related to the Residuals acquired at the time of the option exercise was recorded as a purchase price allocation adjustment. The reduction in the Residuals’ value acquired at the time of the option exercise that related to the period subsequent to the option exercise, as well as the reduction in value related to the portion of the Residuals previously owned by NLF, were recorded as an aggregate other than temporary valuation impairment in 2005 (see “Business Combinations”).

The Company reduced the carrying value of the Residuals during the year ended December 31, 2006, based upon the fair value as determined by an independent valuation. The decrease in the value of the Residuals was primarily the result of the increase in prepayment speeds of the underlying loans. The valuation adjustments that are considered other than temporary are recorded as a reduction of earnings from operations.

Restructuring Costs.  During the year ended December 31, 2006, the Company recorded restructuring costs of $1,580,000, which included severance costs and accelerated vesting of restricted stock in connection with a workforce reduction in April 2006.

Interest Expense.  The increase in interest expense for the year ended December 31, 2006, over the year ended December 31, 2005, was primarily due to a $241,104,000 increase in the weighted average long-term debt outstanding for the year ended December 31, 2006. The increase in the weighted average long-term debt outstanding is attributable to the increase in Investment and Inventory Properties and the acquisition of the 78.9 percent equity interest in OAMI. This increase was offset slightly by a 25 basis point decrease in the overall weighted average interest rate for 2006 compared to 2005. The following represents the primary changes in debt:

 

  (i) issuance of $150,000,000 of notes payable in November 2005 with an effective interest rate of 6.185% due in December 2015,
  (ii) the increase in the weighted average debt outstanding on the revolving credit facility (increased by $61,819,000),
  (iii) issuance of $172,500,000 of notes payable in September 2006 with an effective interest rate of 3.95% due in September 2026,
  (iv) the $20,800,000 variable rate term note assumed in connection with the acquisition of NAPE in June 2005,
  (v) the $32,000,000 secured notes payable acquired in May 2005 in connection with the 78.9 percent equity interest in OAMI, and
  (vi) repayment of a mortgage in February 2006 with a balance of $18,538,000 at December 31, 2005 with an interest rate of 7.435%.

 

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Comparison of Year Ended December 31, 2005 to Year Ended December 31, 2004.

General and Administrative.  General and administrative expenses increased for the year ended December 31, 2005 compared to the year ended December 31, 2004, primarily as a result of (i) an increase in professional services provided to the Company, and (ii) increases in expenses related to personnel.

Real Estate.  Real estate expenses for the year ended December 31, 2005 compared to the year ended December 31, 2004, increased primarily due to a decrease in tenant reimbursable real estate expenses and a decrease in property expenses related to vacant properties due to an increased Investment Property occupancy rate from 97 percent as of December 31, 2004 to 98 percent as of December 31, 2005.

Depreciation and Amortization.  The increase in depreciation and amortization expense for the year ended December 31, 2005 compared to the year ended December 31, 2004, is primarily attributable to (i) the depreciation on the 170 Investment Properties with an aggregate gross leasable area of 1,150,000 square feet acquired during the year ended December 31, 2005, and (ii) a full year of depreciation on the 36 Investment Properties with an aggregate gross leasable area of 825,000 square feet acquired during the year ended December 31, 2004.

Transition Costs.  During the year ended December 31, 2004, the Company recorded transition costs of $3,741,000, including severance, accelerated vesting of restricted stock and recruitment costs in connection with the appointment of Craig Macnab as Chief Executive Officer in February 2004, and the resignation of Gary M. Ralston as President and Chief Operating Officer in May 2004.

Interest Expense.  The increase in interest expense for the year ended December 31, 2005 over the year ended December 31, 2004 was primarily attributable to a $69,982,000 increase in the average long-term debt outstanding for the year ended December 31, 2005. Weighted average interest rates remained fairly consistent. The increase in the weighted average debt outstanding is primarily attributable to the increase in Investment and Inventory Property acquisitions and the acquisition of the 78.9 percent equity interest in OAMI. The following represents the changes in debt:

 

  (i) the increase in the weighted average debt outstanding on the revolving credit facility (increased by $21,905,000),
  (ii) the $32,000,000 secured notes payable acquired in May 2005 in connection with the 78.9 percent equity interest in OAMI,
  (iii) the $20,800,000 variable rate term note assumed in connection with the acquisition of NAPE in June 2005,
  (iv) issuance of $150,000,000 of notes payable in November 2005 with an effective interest rate of 6.185% due in December 2015,
  (v) issuance of $150,000,000 of notes payable in June 2004 with an effective interest rate of 5.910% due in June 2014,
  (vi) repayment of $100,000,000 of notes payable in June 2004 with an effective interest rate of 7.547%, and
  (vii) repayment of the $20,000,000 variable rate term note in November 2004.

Unconsolidated Affiliates

For details on each of the Company’s unconsolidated affiliates, see “Capital Resources – Investments in Unconsolidated Affiliates.”

 

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During the years ended December 31, 2006, 2005 and 2004, the Company recognized equity in earnings of unconsolidated affiliates of $122,000, $1,209,000, and $4,724,000, respectively. The decrease in equity in earnings of unconsolidated affiliates subsequent to the year ended December 31, 2004, was primarily attributable to the decrease in the income earned on investments in mortgage residual interests as a result of the acquisition of 78.9 percent equity interest in OAMI in May 2005. The Company’s interest in the LLCs is no longer accounted for as an equity investment and is now included as a part of OAMI in the Company’s consolidated financial statements.

In October 2006, the Company sold its equity investment in CNL Plaza, Ltd. and CNL Plaza Venture, Ltd. (collectively, “Plaza”) for $10,239,000 and recognized a gain of $11,373,000. Plaza owns a 346,000 square foot office building and an interest in an adjacent parking garage. In connection with the sale, the Company was released as a guarantor of Plaza’s $14,000,000 unsecured promissory note.

Earnings from Discontinued Operations

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company classified as discontinued operations the revenues and expenses related to its Investment Properties that were sold and its leasehold interests that expired subsequent to December 31, 2001, as well as, the revenues and expenses related to any Investment Property that was held for sale at December 31, 2006. The Company also classified as discontinued operations the revenues and expenses of its Inventory Properties that were sold which generated rental revenues, as well as, the revenues and expenses related to its Inventory Properties held for sale which generated rental revenues as of December 31, 2006. The Company records discontinued operations by the Company’s identified segments: (i) Investment Assets and (ii) Inventory Assets. The following table summarizes the earnings from discontinued operations for the years ended December 31 (dollars in thousands):

 

    2006   2005   2004
    # of Sold
  Properties  
      Gain         Earnings     # of Sold
  Properties  
      Gain           Earnings       # of Sold
  Properties  
      Gain         Earnings  

Investment Assets

  30   $   91,332   $   100,925   12   $ 9,816   $ 21,151   20   $ 2,523   $ 17,171

Inventory
Assets, net of minority interest

  58     5,275     8,042   22     13,618     9,380   17     13,997     9,547
                                               
  88   $ 96,607   $ 108,967   34   $   23,434   $         30,531   37   $   16,520   $   26,718
                                               

The Company occasionally sells Investment Properties and may reinvest the proceeds of the sales to purchase new properties. The Company evaluates its ability to pay dividends to stockholders by considering the combined effect of income from continuing and discontinued operations.

Extraordinary Gain

During the year ended December 31, 2005, the Company recognized an extraordinary gain of $14,786,000, which resulted from the difference between the Company’s portion of the fair value of net assets acquired in the acquisition of 78.9 percent equity interest in OAMI and the purchase price (see “Business Combinations”).

 

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Impact of Inflation

The Company’s leases typically contain provisions to mitigate the adverse impact of inflation on the Company’s results of operations. Tenant leases generally provide for limited increases in rent as a result of fixed increases, increases in the consumer price index, and/or increases in the tenant’s sales volume. During times when inflation is greater than increases in rent, rent increases may not keep up with the rate of inflation.

The Investment Properties are leased to tenants under long-term, net leases which typically require the tenant to pay certain operating expenses of a property, thus, the Company’s exposure to inflation is reduced. Inflation may have an adverse impact on the Company’s tenants.

Liquidity

General.  The Company’s demand for funds has been and will continue to be primarily for (i) payment of operating expenses and dividends; (ii) property acquisitions and development, structured finance investments and capital expenditures; (iii) payment of principal and interest on its outstanding indebtedness, and (iv) other investments.

The Company expects to meet these requirements (other than amounts required for additional property investments and structured finance investments) through cash provided from operations and the Company’s revolving credit facility. The Company utilizes its credit facility to meet its short term working capital requirements. As of December 31, 2006, $28,000,000 was outstanding and approximately $272,000,000 was available for future borrowings under the Credit Facility, excluding undrawn letters of credit totaling $5,159,000. The Company anticipates that any additional investments in properties and structured finance investments during the next 12 months will be funded with cash provided from operations, long-term unsecured debt and the issuance of common or preferred equity, each of which may be initially funded with proceeds from the Company’s revolving credit facility. However, there can be no assurance that additional financing or capital will be available, or that the terms will be acceptable or advantageous to the Company.

Below is a summary of the Company’s cash flows for each of the years ended December 31 (in thousands):

 

          2006             2005             2004      

Cash and cash equivalents:

      

Provided by operating activities

   $     18,561     $     30,930     $     85,800  

Used in investing activities

     (106,984 )     (242,487 )     (69,963 )

Provided by (used in) financing activities

     81,864       217,844       (19,225 )
                        

Increase (decrease)

     (6,559 )     6,287       (3,388 )

January 1

     8,234       1,947       5,335  
                        

December 31

   $ 1,675     $ 8,234     $ 1,947  
                        

Cash provided by operating activities represents cash received primarily from rental income from tenants, gain on the disposition of Inventory Properties and interest income less general and administrative expenses and interest expense. The change in cash provided by operations for the years ended December 31, 2006, 2005 and 2004, is primarily the result of changes in revenues and expenses as discussed in “Results of Operations.” Cash generated from operations is expected to fluctuate in the future.

Changes in cash for investing activities are primarily attributable to the acquisitions and dispositions of Investment Properties.

 

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The Company’s financing activities for the year ended December 31, 2006 included the following significant transactions:

 

   

$172,500,000 in gross proceeds from the issuance of 3.95% convertible senior notes payable

 

   

$76,035,000 in dividends paid to common stockholders

 

   

$5,718,000 in aggregate dividends paid to Series A, B and C Preferred Stock stockholders

 

   

$134,300,000 in net payments on the Company’s Credit Facility

 

   

$92,000,000 in gross proceeds from the issuance of 3,680,000 depositary shares of Series C Preferred Stock

 

   

$65,722,000 in net proceeds from the issuance of 3,046,408 common shares in connection with the Dividend Reinvestment and Stock Purchase Plan (“DRIP”)

Financing Strategy

The Company’s financing objective is to manage its capital structure effectively in order to provide sufficient capital to execute its operating strategy while servicing its debt requirements and providing value to the Company’s stockholders. The Company generally utilizes debt and equity security offerings, bank borrowings, the sale of properties, and to a lesser extent, internally generated funds to meet its capital needs.

The Company typically funds its short-term liquidity requirements including investments in additional retail properties with cash from its $300,000,000 unsecured revolving credit facility (“Credit Facility”). As of December 31, 2006, $28,000,000 was outstanding and approximately $272,000,000 was available for future borrowings under the Credit Facility, excluding undrawn letters of credit totaling $5,159,000.

For the year ended December 31, 2006, the Company’s ratio of total indebtedness to total gross assets (before accumulated depreciation) was approximately 41 percent and the secured indebtedness to total gross assets was approximately three percent. The total debt to total market capitalization was approximately 35 percent. Certain financial agreements to which the Company is a party contain covenants that limit the Company’s ability to incur debt under certain circumstances. The organizational documents of the Company do not limit the absolute amount or percentage of indebtedness that the Company may incur. Additionally, the Company may change its financing strategy.

Contractual Obligations and Commercial Commitments.  The information in the following table summarizes the Company’s contractual obligations and commercial commitments outstanding as of December 31, 2006. The table presents principal cash flows by year-end of the expected maturity for debt obligations and commercial commitments outstanding as of December 31, 2006. As the table incorporates only those exposures that exist as of December 31, 2006, it does not consider those exposures or positions which may arise after that date.

 

   

Expected Maturity Date

(dollars in thousands)

    Total   2007   2008   2009   2010   2011     Thereafter  

Long-term debt (1)

  $   749,733   $   20,913   $   113,190   $   21,800   $   21,022   $   173,598   $   399,210

Revolving Credit Facility

    28,000     -     -     28,000     -     -     -

Operating lease

    7,076     815     839     865     891     917     2,749
                                         

Total contractual cash obligations(2)

  $ 784,809   $ 21,728   $ 114,029   $ 50,665   $ 21,913   $ 174,515   $ 401,959
                                         

 

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(1)

Includes amounts outstanding under the mortgages payable, secured notes payable, convertible notes payable, notes payable and financing lease obligation and excludes unamortized note discounts and unamortized interest rate hedge gain.

(2)

Excludes $5,989 of accrued interest payable.

In addition to the contractual obligations outlined above, the Company has agreed to fund construction commitments in connection with the development of additional properties as outlined below (dollars in thousands):

 

      # of
    Properties    
  

Total

Construction
  Commitment
(1)  

  

Amount

Funded at
  December 31,  
2006

Investment Portfolio

   11    $               35,020    $               17,845

Inventory Portfolio

   5      36,728      27,263
                  
   16    $ 71,748    $ 45,108
                  
(1)       Including land costs.

As of December 31, 2006 the Company had outstanding letters of credit totaling $5,159,000 under its revolving credit facility.

As of December 31, 2006, the Company does not have any other contractual cash obligations, such as purchase obligations, financing lease obligations or other long-term liabilities other than those reflected in the table. In addition to items reflected in the table, the Company has preferred stock with cumulative preferential cash distributions, as described below under “Dividends.”

Management anticipates satisfying these obligations with a combination of the Company’s current capital resources on hand, its revolving credit facility and debt or equity financings.

Many of the Investment Properties are recently constructed and are generally net leased. Therefore, management anticipates that capital demands to meet obligations with respect to these Investment Properties will be modest for the foreseeable future and can be met with funds from operations and working capital. Certain of the Company’s Investment Properties, are subject to leases under which the Company retains responsibility for certain costs and expenses associated with the Investment Property. Management anticipates the costs associated with the Company’s vacant Investment Properties or those Investment Properties that become vacant will also be met with funds from operations and working capital. The Company may be required to borrow under the Company’s revolving Credit Facility or use other sources of capital in the event of unforeseen significant capital expenditures.

The lost revenues and increased property expenses resulting from the rejection by any bankrupt tenant of any of their respective leases with the Company could have a material adverse effect on the liquidity and results of operations of the Company if the Company is unable to release the Investment Properties at comparable rental rates and in a timely manner. As of January 31, 2007, the Company owns nine vacant, unleased Investment Properties which account for approximately two percent of the total gross leasable area of the Company’s Investment Portfolio and four unleased land parcels. Additionally, less than one percent of the total gross leasable area of the Company’s Investment Portfolio is leased to a tenant that has filed a voluntary petition for bankruptcy under Chapter 11 of the U.S. Bankruptcy Code. As a result, the tenant has the right to reject or affirm its lease with the Company.

Dividends.  The Company has made an election to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended, and related regulations. The Company generally

 

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will not be subject to federal income tax on income that it distributes to its stockholders, provided that it distributes 100 percent of its REIT taxable income and meets certain other requirements for qualifying as a REIT. If the Company fails to qualify as a REIT in any taxable year, it will be subject to federal income tax on its taxable income at regular corporate rates and will not be permitted to qualify for treatment as a REIT for federal income tax purposes for four years following the year during which qualification is lost. Such an event could materially affect the Company’s income and its ability to pay dividends. The Company believes it has been organized as, and its past and present operations qualify the Company as, a REIT. Additionally, the Company intends to continue to operate so as to remain qualified as a REIT for federal income tax purposes.

One of the Company’s primary objectives, consistent with its policy of retaining sufficient cash for reserves and working capital purposes and maintaining its status as a REIT, is to distribute a substantial portion of its funds available from operations to its stockholders in the form of dividends. During the years ended December 31, 2006, 2005 and 2004, the Company declared and paid dividends to its common stockholders of $76,035,000, $69,018,000, and $66,272,000 and, respectively, or $1.32, $1.30 and $1.29 per share, respectively, of common stock.

The following presents the characterizations for tax purposes of such common stock dividends for the years ended December 31:

 

     2006    2005    2004

Ordinary dividends

   $         1.151    87.18%    $         1.068    82.19%    $         0.916    70.99%

Qualified dividends

     -    -      0.225    17.27%      -    -

Capital gain

     0.150    11.38%      -    -      0.040    3.13%

Unrecaptured Section 1250 Gain

     0.019    1.44%      0.002    0.17%      0.041    3.21%

Nontaxable distributions

     -    -      0.005    0.37%      0.293    22.67%
                                   
   $ 1.320    100.00%    $ 1.300    100.00%    $ 1.290      100.00%
                                   

In February 2007, the Company paid dividends to its common stockholders of $20,115,000, or $0.335 per share of common stock.

Holders of each of the Company’s preferred stock issuances are entitled to receive, when and as authorized by the board of directors, cumulative preferential cash distributions based on the stated rate and liquidation preference per annum. The following table outlines each issuance of the Company’s preferred stock (dollars in thousands, except per share data):

 

Non-Voting

Preferred

Stock

Issuance

  Shares
Outstanding
At
December 31,
2006
  Liquidation
Preference
(per share)
  Fixed
Annual Cash
Distribution
(per share)
 

Dividends Declared and Paid

For the Year Ended December 31,

        2006   2005   2004
        Total  

Per

Share

  Total   Per Share   Total   Per Share

9% Series A (1)

  1,781,589   $           25.00   $             2.25   $     4,376   $     2.45625   $     4,008   $         2.25   $     4,008   $         2.25

6.7% Series B
Convertible (2)

  -     2,500.00     167.50     419     41.875     1,675     167.50     1,675     167.50

7.375% Series C
Redeemable (3)

  3,680,000     25.00     1.84375     923     0.250955     -     -     -     -

 

(1)

Effective January 2, 2007, the Company redeemed all 1,781,589 shares of Series A Preferred Stock, at their redemption price of $25.00 per share plus all accumulated and unpaid dividends through the redemption date of $0.20625 per share, for an aggregate redemption price of $25.20625. Dividends declared and paid in 2006 include $368 of dividends payable.

(2)

In April 2006, the holder of the Company’s Series B Convertible Preferred Stock elected to convert those 10,000 shares into 1,293,996 shares of common stock.

(3)

In October 2006, the Company issued 3,680,000 depositary shares, each representing 1/100th of a share of 7.375% Series C Redeemable Preferred Stock. See Capital Resources – Debt and Equity Securities.”

 

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In February 2007, the Company declared dividends of $1,696,000 or $0.4609375 per depositary share of Series C Redeemable Preferred Stock payable in March 2007.

Restricted Cash.  Restricted cash consists of amounts held in restricted accounts in connection with the sale of certain assets of OAMI to a third party (the “Buyer”). The use of the cash is restricted pursuant to agreements with the Buyer and will be released in December 2007 subject to any pending indemnity claims. The amount held in these accounts at December 31, 2006 and 2005 was $36,728,000 and $30,530,000, respectively. The carrying value for restricted cash was $36,587,000 and $30,191,000 at December 31, 2006 and 2005, respectively, and is calculated as the present value of the expected release of monies.

Capital Resources

Generally, cash needs for property acquisitions, structured finance investments, capital expenditures, development and other investments have been funded by equity and debt offerings, bank borrowings, the sale of properties and, to a lesser extent, from internally generated funds. Cash needs for other items have been met from operations. Potential future sources of capital include proceeds from the public or private offering of the Company’s debt or equity securities, secured or unsecured borrowings from banks or other lenders, proceeds from the sale of properties, as well as undistributed funds from operations.

Debt

The following is a summary of the Company’s total outstanding debt as of December 31 (dollars in thousands):

 

     2006      Percentage  
of Total
   2005      Percentage  
of Total

Line of credit payable

   $         28,000    3.6%    $         162,300    18.8%

Mortgages payable

     35,892    4.6%      151,133    17.6%

Notes payable – secured

     24,500    3.2%      28,250    3.3%

Notes payable – convertible

     172,500    22.2%      -    -

Notes payable

     489,804    63.1%      493,321    57.3%

Financing lease obligation

     26,041    3.3%      26,041    3.0%
                       

Total outstanding debt

   $ 776,737    100.0%    $ 861,045    100.0%
                       

Line of Credit Payable.  In December 2005, the Company entered into an amended and restated loan agreement for a $300,000,000 revolving credit facility (the “Credit Facility”). The Credit Facility amended the Company’s existing loan agreement by (i) increasing the borrowing capacity to $300,000,000 from $225,000,000, (ii) lowering the interest rates of the tiered rate structure from a maximum of 135 points above LIBOR to a maximum rate of 112.5 basis points above LIBOR (based upon the debt rating of the Company, the current interest rate is 80 basis points above LIBOR), (iii) requiring the Company to pay a commitment fee based on a tiered rate structure to a maximum of 25 basis points per annum (based upon the debt rating of the Company, the current commitment fee is 20 basis points), (iv) providing for a competitive bid option for up to 50 percent of the facility amount, (v) extending the expiration date to May 8, 2009 and (vi) amending certain of the financial covenants of the Company. The principal balance is due in full upon expiration of the Credit Facility in May 2009, which the Company may request to be extended for an additional 12 months. As of December 31, 2006, $28,000,000 was outstanding and approximately $272,000,000 was available for future borrowings under the Credit Facility, excluding undrawn letters of credit totaling $5,159,000.

 

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In accordance with the terms of the Credit Facility, the Company is required to meet certain restrictive financial covenants, which, among other things, require the Company to maintain certain (i) maximum leverage ratios, (ii) debt service coverage, (iii) cash flow coverage and (iv) investment limitations. At December 31, 2006, the Company was in compliance with those covenants. In the event that the Company violates any of these restrictive financial covenants, its access to the debt or equity markets may become impaired.

Mortgages Payable.  In February 2006, upon maturity, the Company repaid the outstanding principal balance of its long-term, fixed rate loan with an original principal balance of $39,450,000, which was secured by a first mortgage on certain of the Company’s Investment Properties. Upon repayment of the loan, the Investment Properties were released from the mortgage. As of December 31, 2005, the outstanding principal balance was $18,538,000.

In May 2006, the Company disposed of three Investment Properties that were subject to a first mortgage with an original and outstanding principal balance of $95,000,000. Upon disposition of these Investment Properties, the buyer assumed the mortgage.

Note Payable.  In connection with the acquisition of NAPE, the Company assumed a $20,800,000 term note payable (“Term Note”), and a line of credit with an outstanding balance of $7,400,000, which was paid in full with proceeds from the Company’s existing line of credit in June 2005. The principal balance on the Term Note is due in full upon its expiration in June 2009. The Term Note bears interest based on a tiered rate structure to a maximum rate of 165 basis points above LIBOR. Based on the current debt rating of the Company, the current interest rate is 120 basis points above LIBOR or 6.55% at December 31, 2006. In accordance with the terms of the Term Note, the Company is required to meet certain restrictive financial covenants, which, among other things, require the Company to maintain certain (i) maximum leverage ratios, (ii) debt service coverage and (iii) cash flow coverage.

Debt and Equity Securities.  The Company has used, and expects to use in the future, issuances of debt and equity securities primarily to pay down its outstanding indebtedness and to finance investment acquisitions. The Company has maintained investment grade debt ratings from Standard and Poor’s, Moody’s Investor Service and Fitch Ratings on its senior, unsecured debt since 1998. In February 2006, the Company filed a shelf registration statement with the Securities and Exchange Commission which permits the issuance by the Company of an indeterminate amount of debt and equity securities.

Each of the Company’s outstanding series of publicly held non-convertible notes are summarized in the table below (dollars in thousands).

 

Notes

      Issue Date           Principal         Discount(3)     Net
    Price    
      Stated    
Rate
 

    Effective  

Rate(4)

 

    Commencement    

of Semi-
Annual Interest
Payments

 

    Maturity    

Date

2008 (1)

  March 1998   $         100,000   $             271   $         99,729   7.125%   7.163%   September 1998   March 2008

2010 (1)

  September 2000     20,000     126     19,874   8.500%   8.595%   March 2001   September 2010

2012 (1)

  June 2002     50,000     287     49,713   7.750%   7.833%   December 2002   June 2012

2014 (1)(2)(5)

  June 2004     150,000     440     149,560   6.250%   5.910%   June 2004   June 2014

2015 (1)

  November 2005     150,000     390     149,610   6.150%   6.185%   June 2006   December 2015

 

(1)

The proceeds from the note issuance were used to pay down outstanding indebtedness of the Company’s Credit Facility.

(2)

The proceeds from the note issuance were used to repay the obligation of the 2004 Notes.

(3)

The note discounts are amortized to interest expense over the respective term of each debt obligation using the effective interest method.

(4)

Includes the effects of the discount, treasury lock gain and swap gain (as applicable).

(5)

The Company entered into a forward starting interest rate swap agreement which fixed a swap rate of 4.61% on a notional amount of $94,000. Upon issuance of the 2014 Notes, the Company terminated the forward starting interest rate swap agreement resulting in a gain of $4,148. The gain has been deferred and is being amortized as an adjustment to interest expense over the term of the 2014 Notes using the effective interest method.

 

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Each series of notes represent senior, unsecured obligations of the Company and are subordinated to all secured indebtedness of the Company. The notes are redeemable at the option of the Company, in whole or in part, at a redemption price equal to the sum of (i) the principal amount of the notes being redeemed plus accrued interest thereon through the redemption date and (ii) the make-whole amount, as defined in the respective supplemental indenture relating to the notes.

In connection with the note offerings, the Company incurred debt issuance costs totaling $4,542,000 consisting primarily of underwriting discounts and commissions, legal and accounting fees, rating agency fees and printing expenses. Debt issuance costs for all note issuances have been deferred and are being amortized over the term of the respective notes using the effective interest method.

In accordance with the terms of the indenture, pursuant to which the Company’s notes have been issued, the Company is required to meet certain restrictive financial covenants, which, among other things, require the Company to maintain (i) certain leverage ratios and (ii) certain interest coverage. At December 31, 2006, the Company was in compliance with those covenants. In the event that the Company violates any of the certain restrictive financial covenants, its access to the debt or equity markets may become impaired.

Convertible Notes – In September 2006, the Company filed a prospectus supplement to the prospectus contained in its February 2006 shelf registration statement and issued $150,000,000 of 3.95% convertible senior notes due September 2026 (with a 2011 put option). Subsequently, the Company issued an additional $22,500,000 in connection with the underwriters’ over-allotment option (collectively, the “Convertible Notes”). The Convertible Notes were sold at par with interest payable semi-annually commencing on March 15, 2007 (effective interest rate of 3.95%).

The notes are convertible, at the option of the holder, at any time on or after September 15, 2025. Prior to September 15, 2025, holders may convert their Convertible Notes under certain circumstances. The initial conversion rate per $1,000 principal amount of Convertible Notes is 40.9015 shares of the Company’s common stock, which is equivalent to an initial conversion price of $24.4490 per share of common stock. The initial conversion rate is subject to adjustment in certain circumstances. Upon conversion of each $1,000 principal amount of Convertible Notes, the Company will settle any amounts up to the principal amount of the notes in cash and the remaining conversion value, if any, will be settled, at the Company’s option, in cash, common stock or a combination thereof.

The Convertible Notes are redeemable at the option of the Company, in whole or in part, on or after September 20, 2011 for cash equal to 100% of the principal amount of the Convertible Notes being redeemed plus unpaid interest accrued to, but not including, the redemption date. In addition, on September 20, 2011, September 15, 2016 and September 15, 2021 note holders may require the Company to repurchase the notes for cash equal to the principal amount of the Convertible Notes to be repurchased plus accrued interest thereon.

In connection with the Convertible Notes offering, the Company incurred debt issuance costs totaling $3,850,000 consisting primarily of underwriting discounts and commissions, legal and accounting fees, rating agency fees and printing expenses. Debt issuance costs have been deferred and are being amortized over the period to the earliest put option of the holders, September 20, 2011 using the effective interest method.

The Company used the proceeds of the Convertible Notes to pay down outstanding indebtedness under the Credit Facility.

 

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7.375% Series C Cumulative Redeemable Preferred Stock – In October 2006, the Company filed a prospectus supplement to the prospectus contained in its February 2006 shelf registration statement and issued 3,200,000 depositary shares, each representing 1/100th of a share of 7.375% Series C Cumulative Redeemable Preferred Stock (“Series C Redeemable Preferred Stock”), and received gross proceeds of $80,000,000. Subsequently, the Company issued an additional 480,000 depositary shares in connection with the underwriters’ over-allotment option and received gross proceeds of $12,000,000. In connection with this offering, the Company incurred stock issuance costs of approximately $3,098,000, consisting primarily of underwriting commissions and fees, legal and accounting fees and printing expenses.

Holders of the depositary shares are entitled to receive, when and as authorized by the board of directors, cumulative preferential cash dividends at the rate of 7.375 percent of the $25.00 liquidation preference per depositary share per annum (equivalent to a fixed annual amount of $1.84375 per depositary share). The Series C Redeemable Preferred Stock underlying the depositary shares ranks senior to the Company’s common stock with respect to dividend rights and rights upon liquidation, dissolution or winding up of the Company. The Company may redeem the Series C Redeemable Preferred Stock underlying the depositary shares on or after October 12, 2011, for cash, at a redemption price of $2,500.00 per share (or $25.00 per depositary share), plus all accumulated, accrued and unpaid dividends.

The Company used $44,540,000 of the net proceeds from the offering to redeem the Series A Preferred Stock in January 2007, and used the remainder of the net proceeds to repay borrowings under the Credit Facility.

Dividend Reinvestment and Stock Purchase Plan – In February 2006, the Company filed a shelf registration statement with the Securities and Exchange Commission for its Dividend Reinvestment and Stock Purchase Plan (“DRIP”), which permits the issuance by the Company of 12,191,394 shares of common stock. The DRIP provides an economical and convenient way for current stockholders and other interested new investors to invest in the Company’s common stock. The following outlines the common stock issuances pursuant to the Company’s DRIP for each of the years ended December 31 (dollars in thousands):

 

     2006    2005

Shares of common stock

     3,046,408      1,048,746

Net proceeds

   $ 65,722    $ 20,747

The proceeds from the issuances were used to pay down outstanding indebtedness under the Company’s Credit Facility.

In June 2005, in connection with the acquisition of National Properties Corporation (see “Results of Operations – Business Combination”), the Company issued 1,636,532 newly issued shares of the Company’s common stock in exchange for 100 percent of the common stock of NAPE.

Financing Lease Obligation.  In July 2004, the Company sold five investment properties for approximately $26,041,000 and subsequently leased back the properties under a 10-year financing lease obligation. The Company may repurchase one or more of the properties subject to put and call options included in the financing lease. In accordance with the provisions of SFAS No. 66, “Accounting for Sales of Real Estate,” the Company has recognized the sale as a financing transaction.

 

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The 10-year financing lease bears an interest rate of 5.00% annually with monthly interest payments of $109,000 and expires in June 2014 unless either the put or call option is exercised. The Company used the proceeds from two properties to reinvest in other Investment Properties and the remaining proceeds to pay down outstanding indebtedness of the Company’s Credit Facility.

Structured Finance Investments.  Structured finance agreements are typically loans secured by a borrower’s pledge of ownership interests in the entity that owns the real estate. These agreements are typically subordinated to senior loans secured by first mortgages encumbering the underlying real estate. Subordinated positions are generally subject to a higher risk of nonpayment of principal and interest than the more senior loans.

As of December 31, 2006, the structured finance investments bear a weighted average interest rate of 13.3% per annum, of which 10.1% is payable monthly and the remaining 3.2% accrues and is due at maturity. The principal balance of each structured finance investment is due in full at maturity, which range between November 2007 and January 2009. The structured finance investments are secured by the borrowers’ pledge of their respective membership interests in the certain subsidiaries which own the respective real estate.

The following table summarizes the activity of the structured finance investments for each of the last two years ended December 31 (dollars in thousands):

 

     2006     2005  

Balance at January 1

   $     27,805     $     29,390  

New investments

     16,477       5,988  

Principal repayments

     (30,365 )     (7,573 )
                

Balance at December 31

   $ 13,917     $ 27,805  
                

Mortgage Residual Interests.  In connection with the independent valuations of the mortgage residual interests’ (the “Residuals”) fair value, the Company reduced the carrying value of the Residuals to reflect such fair value at December 31, 2006. The reduction in the Residuals’ value that related to the Residuals acquired at the time of the option exercise was recorded as a purchase price allocation adjustment. The reduction in the Residuals’ value acquired at the time of the option exercise that related to the period subsequent to the option exercise, as well as the reduction in the value related to the portion of the Residuals owned by NLF, were recorded as an aggregate other than temporary valuation impairment of $8,779,000 and $2,382,000, for the years ended December 31, 2006 and 2005, respectively. Unrealized gains of $1,992,000 were recorded as other comprehensive income in the Statement of Stockholders’ Equity for the year ended December 31, 2006.

 

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Item 7A.  Quantitative and Qualitative Disclosures About Market Risk

The Company is exposed to interest changes primarily as a result of its variable rate Credit Facility and its long-term, fixed rate debt used to finance the Company’s development and acquisition activities, and for general corporate purposes. The Company’s interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower its overall borrowing costs. To achieve its objectives, the Company borrows at both fixed and variable rates on its long-term debt. The Company had no outstanding derivatives as of December 31, 2006 and 2005.

The information in the table below summarizes the Company’s market risks associated with its debt obligations outstanding as of December 31, 2006 and 2005. The table presents principal cash flows and related interest rates by year for debt obligations outstanding as of December 31, 2006. The variable interest rates shown represent the weighted average rates for the Credit Facility and Term Note at the end of the periods. As the table incorporates only those exposures that exist as of December 31, 2006, it does not consider those exposures or positions which could arise after this date. Moreover, because firm commitments are not presented in the table below, the information presented therein has limited predictive value. As a result, the Company’s ultimate realized gain or loss with respect to interest rate fluctuations will depend on the exposures that arise during the period, the Company’s hedging strategies at that time and interest rates. If interest rates on the Company’s variable rate debt increased by 1%, the Company’s interest expense would have increased by approximately three percent for the year ended December 31, 2006.

 

    Debt Obligations (dollars in thousands)
    Variable Rate Debt   Fixed Rate Debt
   

Credit Facility &

Term Note

  Mortgages   Unsecured Debt(2)(3)   Secured Debt
    Debt
  Obligation  
  Weighted
Average
Interest
Rate
(1)
  Debt
  Obligation  
  Weighted
Average
Interest
Rate
  Debt
  Obligation  
  Effective
Interest
Rate
  Debt
  Obligation  
  Weighted
Average
Interest
Rate

2007

    -   -     8,413   7.12%     -   -     10,500   10.00%

2008

    -   -     1,190   7.04%     99,956   7.16%     14,000   10.00%

2009

    48,800   5.98%     1,000   7.02%     -   -     -   -

2010

    -   -     1,022   7.01%     19,941   8.60%     -   -

2011

    -   -     1,098   7.00%     172,500   3.95%     -   -

Thereafter

    -   -     23,169   6.99%     375,148   6.21%     -   -
                               

Total

  $     48,800   5.98%   $     35,892   7.12%   $     667,545   5.84%   $     24,500   10.00%
                               

Fair Value:

               

December 31, 2006

  $ 48,800   5.98%   $ 35,892   7.12%   $ 690,198   5.84%   $ 24,500   10.00%
                                       

December 31, 2005

  $ 183,100   4.81%   $ 151,133   6.18%   $ 520,144   6.50%   $ 28,250   10.00%
                                       

 

(1)

The Credit Facility interest rate varies based upon a tiered rate structure ranging from 55 to 112.5 basis points above LIBOR based upon the debt rating of the Company. The Term Note interest rate varies based upon a tiered rate structure ranging from 85 to 165 basis points above LIBOR based upon the debt rating of the Company.

(2)

Includes Company’s notes payable, net of unamortized note discounts and convertible notes payable.

(3)

In July 2004, the Company sold five investment properties for $26,041 and subsequently leased back the properties under a 10-year financing lease obligation. The Company may repurchase one or more of the properties subject to put and call options included in the financing lease.

The Company is also exposed to market risks related to the Company’s Residuals. Factors that may impact the market value of the Residuals include delinquencies, loan losses, prepayment speeds and interest rates. The Residuals, which are reported at market value, had a carrying value of $31,512,000 and $55,184,000 as of December 31, 2006 and December 31, 2005, respectively. Unrealized gains and losses are reported as other comprehensive income in stockholders’ equity. Losses are considered other than temporary and reported as a valuation impairment in earnings from operations if and when there has been a change in the timing or amount of estimated cash flows that leads to a loss in value.

 

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Item 8.  Financial Statements and Supplementary Data

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

National Retail Properties, Inc. and Subsidiaries:

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that National Retail Properties, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). National Retail Properties, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that National Retail Properties, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, National Retail Properties, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.

 

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We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of National Retail Properties, Inc. and subsidiaries as of December 31, 2006, and the related consolidated statements of earnings, stockholders’ equity, and cash flows for the year then ended, and our report dated February 13, 2007 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Certified Public Accountants

February 13, 2007

Miami, Florida

 

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

National Retail Properties, Inc. and Subsidiaries:

We have audited the accompanying consolidated balance sheet of National Retail Properties, Inc. and subsidiaries as of December 31, 2006, and the related consolidated statements of earnings, stockholders’ equity, and cash flows for the year then ended. Our audit also included the financial statement schedules listed in the index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Retail Properties and subsidiaries at December 31, 2006, and the consolidated results of their operations and their cash flows for the year then ended, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of National Retail Properties’ internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 13, 2007 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Certified Public Accountants

February 13, 2007

Miami, Florida

 

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

National Retail Properties, Inc. and Subsidiaries:

We have audited the accompanying consolidated balance sheet of National Retail Properties, Inc. and subsidiaries as of December 31, 2005, and the related consolidated statements of earnings, stockholders’ equity, and cash flows for each of the years in the two-year period ended December 31, 2005. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules III and IV for the years ended December 31, 2005 and 2004. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules for 2005 and 2004 information based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of National Retail Properties, Inc. and subsidiaries as of December 31, 2005, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the 2005 and 2004 information included in the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

LOGO

Orlando, Florida

February 17, 2006, except as to notes 2, 3, 20, 26 and 27 which are as of February 16, 2007

Certified Public Accountants

 

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NATIONAL RETAIL PROPERTIES, INC.

and SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except per share data)

 

ASSETS    December 31,
2006
   December 31,
2005
 

Real estate, Investment Portfolio:

     

Accounted for using the operating method, net of accumulated depreciation and amortization:

     

Held for investment

   $         1,439,002    $         1,297,254  

Held for sale

     1,994      1,139  

Accounted for using the direct financing method:

     

Held for investment

     70,683      94,134  

Held for sale

     651      1,570  

Real estate, Inventory Portfolio, held for sale

     228,159      131,074  

Mortgages, notes and accrued interest receivable, net of allowance of $634 and $676, respectively

     30,945      51,086  

Mortgage residual interests

     31,512      55,184  

Cash and cash equivalents

     1,675      8,234  

Restricted cash

     36,587      30,191  

Receivables, net of allowance of $722 and $847, respectively

     7,915      8,547  

Accrued rental income, net of allowance

     26,413      27,999  

Debt costs, net of accumulated amortization of $11,339 and $9,567, respectively

     8,180      6,096  

Other assets

     33,069      20,908  
               

Total assets

   $ 1,916,785    $ 1,733,416  
               

LIABILITIES AND STOCKHOLDERS’ EQUITY

     

Line of credit payable

   $ 28,000    $ 162,300  

Mortgages payable

     35,892      151,133  

Notes payable – secured

     24,500      28,250  

Notes payable – convertible

     172,500      -  

Notes payable, net of unamortized discount of $996 and $1,133, respectively,
and an unamortized interest rate hedge gain of $3,653 at December 31, 2005

     489,804      493,321  

Financing lease obligation

     26,041      26,041  

Accrued interest payable

     5,989      5,539  

Other liabilities

     30,116      20,058  

Income tax liability

     6,340      13,748  
               

Total liabilities

     819,182      900,390  
               

Commitments and contingencies (Note 28)

     

Minority interest

     1,098      4,939  

Stockholders’ equity:

     

Preferred stock, $0.01 par value. Authorized 15,000,000 shares

     

Series A, 1,781,589 shares issued and outstanding, stated liquidation value
of $25 per share

     44,540      44,540  

Series B Convertible, 10,000 shares issued and outstanding at December
31, 2005, stated liquidation value of $2,500 per share

     -      25,000  

Series C Redeemable, 3,680,000 depositary shares issued and outstanding
at December 31, 2006, stated liquidation value of $25 per share

     92,000      -  

Common stock, $0.01 par value. Authorized 190,000,000 shares;
59,823,031 and 55,130,876 shares issued and outstanding at December 31, 2006 and 2005, respectively

     598      551  

Excess stock, $0.01 par value. Authorized 205,000,000 shares; none issued or outstanding

     -      -  

Capital in excess of par value

     873,885      778,485  

Retained earnings (accumulated dividends in excess of net earnings)

     80,263      (20,489 )

Accumulated other comprehensive income

     5,219      -  
               

Total stockholders’ equity

     1,096,505      828,087  
               
   $ 1,916,785    $ 1,733,416  
               

See accompanying notes to consolidated financial statements.

 

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NATIONAL RETAIL PROPERTIES, INC.

and SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS

Years Ended December 31, 2006, 2005 and 2004

(dollars in thousands, except per share data)

 

      Year Ended December 31,  
          2006              2005              2004      

Revenues:

        

Rental income from operating leases

   $     126,173      $     92,714      $         76,272  

Earned income from direct financing leases

     7,291        7,678        7,938  

Contingent rental income

     732        444        336  

Real estate expense reimbursement from tenants

     4,862        4,094        2,828  

Interest and other income from real estate transactions

     4,462        6,143        7,695  

Interest income on mortgage residual interests

     7,268        7,349        -  
                          
     150,788        118,422        95,069  
                          

Disposition of real estate, Inventory Portfolio:

        

Gross proceeds

     36,705        13,569        20,888  

Costs

     (28,705 )      (11,559 )      (16,188 )
                          

Gain

     8,000        2,010        4,700  
                          

Operating expenses:

        

General and administrative

     24,012        22,418        21,664  

Real estate

     7,088        5,938        4,986  

Depreciation and amortization

     22,971        16,792        12,975  

Impairment – real estate, Investment Portfolio

     -        1,673        -  

Impairment – mortgage residual interests valuation adjustment

     8,779        2,382        -  

Restructuring costs

     1,580        -        -  

Transition costs

     -        -        3,741  
                          
     64,430        49,203        43,366  
                          

Earnings from operations

     94,358        71,229        56,403  
                          

Other expenses (revenues):

        

Interest and other income

     (3,815 )      (2,039 )      (3,760 )

Interest expense

     45,874        33,309        27,972  
                          
     42,059        31,270        24,212  
                          

Earnings from continuing operations before income tax benefit, minority interest, equity in earnings of unconsolidated affiliates and gain on disposition of equity investment

     52,299        39,959        32,191  

Income tax benefit

     11,143        2,778        2,544  

Minority interest

     (1,399 )      137        (1,243 )

Equity in earnings of unconsolidated affiliates

     122        1,209        4,724  

Gain on disposition of equity investment

     11,373        -        -  
                          

Earnings from continuing operations

     73,538        44,083        38,216  

Earnings from discontinued operations:

        

Real estate, Investment Portfolio

     100,925        21,151        17,171  

Real estate, Inventory Portfolio, net of income tax expense and
minority interest

     8,042        9,380        9,547  
                          
     108,967        30,531        26,718  
                          

Earnings before extraordinary gain

     182,505        74,614        64,934  

Extraordinary gain

     -        14,786        -  
                          

Net earnings

     182,505        89,400        64,934  

Other comprehensive income

     5,219        -        -  
                          

Total comprehensive income

   $ 187,724      $ 89,400      $ 64,934  
                          

See accompanying notes to consolidated financial statements.

 

52


Table of Contents

NATIONAL RETAIL PROPERTIES, INC.

and SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS – CONTINUED

(dollars in thousands, except per share data)

 

      Year Ended December 31,  
      2006     2005     2004  

Net earnings

   $ 182,505     $ 89,400     $ 64,934  

Series A preferred stock dividends

     (4,376 )     (4,008 )     (4,008 )

Series B Convertible preferred stock dividends

     (419 )     (1,675 )     (1,675 )

Series C Redeemable preferred stock dividends

     (923 )     -       -  
                        

Net earnings available to common stockholders – basic

     176,787       83,717       59,251  

Series B convertible preferred stock dividends, if dilutive

     419       1,675       -  
                        

Net earnings available to common stockholders – diluted

   $ 177,206     $ 85,392     $ 59,251  
                        

Net earnings per share of common stock:

      

Basic:

      

Continuing operations

   $ 1.18     $ 0.72     $ 0.63  

Discontinued operations

     1.90       0.58       0.52  

Extraordinary gain

     -       0.28       -  
                        

Net earnings

   $ 3.08     $ 1.58     $ 1.15  
                        

Diluted:

      

Continuing operations

   $ 1.17     $ 0.73     $ 0.63  

Discontinued operations

     1.88       0.56       0.52  

Extraordinary gain

     -       0.27       -  
                        

Net earnings

   $ 3.05     $ 1.56     $ 1.15  
                        

Weighted average number of common shares outstanding:

      

Basic

     57,428,063       52,984,821       51,312,434  
                        

Diluted

     58,079,875       54,640,143       51,742,518  
                        

 

See accompanying notes to consolidated financial statements.

 

53


Table of Contents

NATIONAL RETAIL PROPERTIES, INC.

and SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

Years Ended December 31, 2006, 2005 and 2004

(dollars in thousands, except per share data)

 

    Series A
  Preferred  
Stock
   

Series B
Convertible
Preferred

Stock

 

Series C
Redeemable
Preferred

Stock

  Common
Stock
  Capital in
  Excess of  
Par Value
   

Retained

Earnings
  (Accumulated  
Dividends in
Excess of Net
Earnings)

      Accumulated  
Other
Comprehensive
Income
    Total  

Balances at December 31, 2003

  $         44,541     $       25,000   $                 -   $           500   $     688,880     $           (28,167 )   $                     -     $     730,754  

Net earnings

    -       -     -     -     -       64,934       -       64,934  

Dividends declared and paid:

               

$2.25 per share of Series A Preferred Stock

    -       -     -     -     -       (4,008 )     -       (4,008 )

$167.50 per share of Series B Convertible Preferred Stock

    -       -     -     -     -       (1,675 )     -       (1,675 )

$1.29 per share of common stock

    -       -     -     1     1,056       (66,272 )     -       (65,215 )

Deferred changes in fair value of interest rate swap

    -       -     -     -     -       -       4,148       4,148  

Reversal of 56 shares of preferred stock and 51 shares of common stock originally offered to the dissenting stockholders in connection with the merger in 2001

    (1 )     -     -     -     -       -       -       (1 )

Issuance of common stock:

               

886,962 shares

    -       -     -     9     12,129       -       -       12,138  

953,551 shares in exchange for a partnership interest

    -       -     -     9     17,440       -       -       17,449  

Issuance of 205,579 shares of restricted common stock

    -       -     -     2     (2 )     -       -       -  

Stock issuance costs

    -       -     -     -     (6 )     -       -       (6 )

Amortization of deferred compensation

    -       -     -     -     2,628       -       -       2,628  

Termination and reclass of interest rate swap

    -       -     -     -     -       -       (4,148 )     (4,148 )
                                                         

Balances at December 31, 2004

    44,540       25,000     -     521     722,125       (35,188 )     -       756,998  

Net earnings

    -       -     -     -     -       89,400       -       89,400  

Dividends declared and paid:

               

$2.25 per share of Series A Preferred Stock

    -       -     -     -     -       (4,008 )     -       (4,008 )

$167.50 per share of Series B Convertible Preferred Stock

    -       -     -     -     -       (1,675 )     -       (1,675 )

$1.30 per share of common stock

    -       -     -     1     2,684       (69,018 )     -       (66,333 )

Issuance of common stock:

               

1,636,532 shares in connection with business combination

    -       -     -     16     31,143       -       -       31,159  

180,580 shares

    -       -     -     2     2,649       -       -       2,651  

912,334 shares under discounted stock purchase program

    -       -     -     9     18,063       -       -       18,072  

Issuance of 216,168 shares of restricted common stock

    -       -     -     2     (2 )     -       -       -  

Stock issuance costs

    -       -     -     -     (8 )     -       -       (8 )

Amortization of deferred compensation

    -       -     -     -     1,831       -       -       1,831  
                                                         

Balances at December 31, 2005

  $ 44,540     $ 25,000   $ -   $ 551   $ 778,485     $ (20,489 )   $ -     $ 828,087  

See accompanying notes to consolidated financial statements.

 

54


Table of Contents

NATIONAL RETAIL PROPERTIES, INC.

and SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY – CONTINUED

Years Ended December 31, 2006, 2005 and 2004

(dollars in thousands, except per share data)

 

    Series A
  Preferred  
Stock
 

Series B
Convertible
Preferred

Stock

   

Series C
Redeemable
Preferred

Stock

  Common
Stock
  Capital in
  Excess of  
Par Value
   

Retained

Earnings
  (Accumulated  
Dividends in
Excess of Net
Earnings)

      Accumulated  
Other
Comprehensive
Income
    Total  

Balances at December 31, 2005

  $         44,540   $       25,000     $                 -   $           551   $     778,485     $           (20,489 )   $                     -     $     828,087  

Net earnings

    -     -       -     -     -       182,505       -       182,505  

Dividends declared and paid:

               

$2.25 per share of Series A Preferred Stock

    -     -       -     -     -       (4,376 )     -       (4,376 )

$41.875 per share of Series B Convertible Preferred Stock(1)

    -     -       -     -     -       (419 )     -       (419 )

$0.250955 per depositary share of Series C Redeemable Preferred Stock

    -     -       -     -     -       (923 )     -       (923 )

$1.32 per share of common stock

    -     -       -     3     7,073       (76,035 )     -       (68,959 )

Conversion of 10,000 shares of Series B Convertible Preferred Stock to 1,293,996 shares of common stock

    -     (25,000 )     -     13     24,987       -       -       -  

Issuance of 3,680,000 depositary shares of Series C Redeemable Preferred Stock

    -     -       92,000     -     -       -       -       92,000  

Issuance of common stock:

               

272,184 shares

    -     -       -     3     4,654       -       -       4,657  

2,715,235 shares – discounted stock purchase program

    -     -       -     27     58,632       -       -       58,659  

Issuance of 79,500 shares of restricted common stock

    -     -       -     1     (1 )     -       -       -  

Stock issuance costs

    -     -       -     -     (3,111 )     -       -       (3,111 )

Amortization of deferred compensation

    -     -       -     -     3,166       -       -       3,166  

Treasury lock – gain on interest rate swap(2)

    -     -       -     -     -       -       3,653       3,653  

Amortization of interest rate swap

    -     -       -     -     -       -       (345 )     (345 )

Unrealized gain – Mortgage residual interests

    -     -       -     -     -       -       1,992       1,992  

Stock value adjustment

    -     -       -     -     -       -       (81 )     (81 )
                                                         

Balances at December 31, 2006

  $ 44,540   $ -     $ 92,000   $ 598   $ 873,885     $ 80,263     $ 5,219     $ 1,096,505  
                                                         

(1) Includes $368 dividends paid in January 2007.

               

(2) Fair value of interest rate swaps net of prior year amortization reclassified from the Company’s unsecured notes payable from the unamortized interest rate hedge gain resulting from the termination of the $94,000,000 swap in June 2004.

    

 

See accompanying notes to consolidated financial statements.

 

55


Table of Contents

NATIONAL RETAIL PROPERTIES, INC.

and SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

 

     Year Ended December 31,  
     2006     2005     2004  

Cash flows from operating activities:

      

Net earnings

   $   182,505     $     89,400     $     64,934  

Adjustments to reconcile net earnings to net cash provided by operating activities:

      

Stock compensation expense

     3,170       1,971       978  

Depreciation and amortization

     24,524       22,350       17,398  

Impairment – real estate

     693       3,729       -  

Impairment – mortgage residual interests valuation adjustment

     8,779       2,382       -  

Amortization of notes payable discount

     137       105       123  

Amortization of deferred interest rate hedge gains

     (345 )     (326 )     (457 )

Equity in earnings of unconsolidated affiliates

     (122 )     (1,209 )     (5,064 )

Distributions received from unconsolidated affiliates

     864       3,293       11,008  

Minority interests

     2,622       (5,854 )     1,828  

Gain on disposition of real estate, Investment Portfolio

     (91,165 )     (9,816 )     (2,523 )

Gain on disposition of equity investment

     (11,373 )     -       -  

Gain on disposition of real estate, Inventory Portfolio

     (13,781 )     (21,627 )     (23,402 )

Extraordinary gain

     -       (14,786 )     -  

Deferred income taxes

     (8,366 )     (1,709 )     2,726  

Transition costs

     -       -       1,929  

Change in operating assets and liabilities, net of assets acquired and liabilities assumed in business combinations:

      

Additions to real estate, Inventory Portfolio

     (195,956 )     (137,286 )     (74,024 )

Proceeds from disposition of real estate, Inventory Portfolio

     101,324       79,065       87,321  

Decrease in real estate leased to others using the direct financing method

     2,982       2,915       2,770  

Increase in work in process

     (3,315 )     (4,355 )     (2,093 )

Increase in mortgages, notes and accrued interest receivable

     795       6,465       6,243  

Decrease (increase) in receivables

     642       7,730       (1,642 )

Decrease in mortgage residual interests

     16,885       11,704       -  

Increase in accrued rental income

     (5,777 )     593       (3,438 )

Decrease (increase) in other assets

     (520 )     877       (1,456 )

Increase in accrued interest payable

     450       913       485  

Increase (decrease) in other liabilities

     1,951       (4,365 )     1,646  

Increase (decrease) in current tax liability

     958       (1,229 )     510  
                        

Net cash provided by operating activities

     18,561       30,930       85,800  
                        

Cash flows from investing activities:

      

Proceeds from the disposition of real estate, Investment Portfolio

     222,778       38,982       32,639  

Proceeds from the disposition of equity investment

     10,239       -       -  

Additions to real estate, Investment Portfolio:

      

Accounted for using the operating method

     (351,100 )     (267,488 )     (134,565 )

Accounted for using the direct financing method

     (1,449 )     (309 )     -  

Investment in unconsolidated affiliates

     -       -       (4 )

Increase in mortgages and notes receivable

     (18,371 )     (17,738 )     (6,857 )

Mortgage and notes payments received

     39,075       16,846       23,301  

Increase in mortgages and other receivables from unconsolidated affiliates

     -       -       (115,600 )

Payments received on mortgages and other receivables from unconsolidated affiliates

     -       -       132,200  

Business combination, net of cash acquired

     -       2,183       1,068  

Restricted cash

     (6,396 )     (12,764 )     -  

Acquisition of 1.3 percent interest in Services

     -       (829 )     -  

Payment of lease costs

     (2,790 )     (1,253 )     (1,491 )

Other

     1,030       (117 )     (654 )
                        

Net cash used in investing activities

     (106,984 )     (242,487 )     (69,963 )
                        

See accompanying notes to consolidated financial statements.

 

56


Table of Contents

NATIONAL RETAIL PROPERTIES, INC.

and SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS – CONTINUED

(dollars in thousands)

 

    Year Ended December 31,  
    2006     2005     2004  

Cash flows from financing activities:

     

Proceeds from line of credit payable

    379,000       373,500       350,900  

Repayment of line of credit payable

    (513,300 )     (229,100 )     (360,800 )

Proceeds from mortgages payable

    -       -       406  

Repayment of mortgages payable

    (20,241 )     (6,644 )     (9,163 )

Proceeds from notes payable – convertible

    172,500       -       -  

Proceeds from notes payable

    -       149,610       149,560  

Proceeds from forward starting interest rate swap

    -       -       4,148  

Repayment of notes payable

    (3,750 )     (11,150 )     (120,000 )

Payment of debt costs

    (3,864 )     (3,073 )     (1,450 )

Proceeds from financing lease obligation

    -       -       26,041  

Proceeds from issuance of common stock

    70,392       23,268       13,230  

Proceeds from issuance of preferred stock

    88,902       -       -  

Payment of Series A Preferred Stock dividends

    (4,376 )     (4,008 )     (4,008 )

Payment of Series B Convertible Preferred Stock dividends

    (419 )     (1,675 )     (1,675 )

Payment of Series C Redeemable Preferred Stock dividends

    (923 )     -       -  

Payment of common stock dividends

    (76,039 )     (69,018 )     (66,272 )

Minority interest distributions

    (5,817 )     (3,858 )     (140 )

Minority interest contributions

    2       -       -  

Stock issuance costs

    (203 )     (8 )     (2 )
                       

Net cash provided by (used in) financing activities

    81,864       217,844       (19,225 )
                       

Net increase (decrease) in cash and cash equivalents

    (6,559 )     6,287       (3,388 )

Cash and cash equivalents at beginning of year

    8,234       1,947       5,335  
                       

Cash and cash equivalents at end of year

  $ 1,675     $ 8,234     $ 1,947  
                       

Supplemental disclosure of cash flow information:

     

Interest paid, net of amount capitalized

  $ 50,774     $         38,684     $         33,855  
                       

Taxes paid

  $ 1,137     $ 4,494     $ 60  
                       

Supplemental disclosure of non-cash investing and financing activities:

     

Issued 79,500, 223,468 and 205,579 shares of restricted and unrestricted common stock in 2006, 2005 and 2004, respectively, pursuant to the Company’s 2000 Performance Incentive Plan, including grants in connection with transition costs

  $ 1,763     $ 4,003     $ 3,016  
                       

Converted 10,000 shares of Series B Convertible Preferred Stock to 1,293,996 shares of common stock

  $ 25,000     $ -     $ -  
                       

Issued 14,062 shares of common stock in 2006 to directors pursuant to the Company’s 2000 Performance Incentive Plan

  $ 307     $ -     $ -  
                       

Issued 33,379 shares of common stock in 2006 pursuant to the Company’s Deferred Director Fee Plan

  $ 655     $ -     $ -  
                       

Surrender of 30,135 and 29,926 shares of restricted common stock in 2005 and 2004, respectively

  $ -     $ 461     $ 473  
                       

Dividends or unvested restricted stock shares

    4       -       -  
                       

Change in other comprehensive income

  $ 5,219     $ 1,254     $ -  
                       

Change in lease classification

  $ 885     $ 2,158     $ -  
                       

Transfer of real estate from Inventory Portfolio to Investment Portfolio

  $ 12,933     $ 4,752     $ -  
                       

Note and mortgage notes receivable accepted in connection with real estate transactions

  $ 1,582     $ 2,415     $ -  
                       

Acquisition of real estate held for investment and assumption of related mortgage payable

  $ -     $ -     $ 7,357  
                       

Assignment of mortgage payable in connection with the disposition of real estate

  $         95,000     $ 406     $ 2,251  
                       

Issued 953,551 shares of common stock in exchange for a partnership interest

  $ -     $ -     $ 17,449  
                       

Issued 1,636,532 shares of common stock in connection with the acquisition of National Properties Corporation (“NAPE”)

  $ -     $ 31,160     $ -  
                       

See accompanying notes to consolidated financial statements.

 

57


Table of Contents

NATIONAL RETAIL PROPERTIES, INC.

and SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2006, 2005 and 2004

Note 1 Organization and Summary of Significant Accounting Policies:

Organization and Nature of Business – National Retail Properties, Inc. (formerly known as Commercial Net Lease Realty, Inc.), a Maryland corporation, is a fully integrated real estate investment trust (“REIT”) formed in 1984. The term “Company” refers to National Retail Properties, Inc. and its majority owned and controlled subsidiaries. These subsidiaries include the wholly owned qualified REIT subsidiaries of National Retail Properties, Inc., as well as the taxable REIT subsidiaries and their majority owned and controlled subsidiaries (collectively, the “NNN TRS”). Effective May 1, 2006, Commercial Net Lease Realty, Inc. changed its name to National Retail Properties, Inc.

Prior to January 1, 2005, the Company held a 98.7 percent, non-controlling and non-voting interest in Commercial Net Lease Realty Services, Inc. and its majority owned and controlled subsidiaries (“Services”). Kevin B. Habicht, an officer and director of the Company, James M. Seneff, Jr. and Gary M. Ralston, each a former officer and director of the Company, (collectively the “Services Investors”) owned the remaining 1.3 percent interest, which was 100 percent of the voting interest in Services. Effective January 1, 2005, the Company acquired the remaining 1.3 percent interest in Services, increasing the Company’s ownership in Services to 100 percent. Effective November 1, 2005, Commercial Net Lease Realty Services, Inc. merged into National Retail Properties, Inc. CNLRS Exchange I, Inc., a taxable REIT subsidiary (“TRS”), became the TRS holding company for the Company’s development and exchange activities. Effective October 2, 2006, CNLRS Exchange I, Inc. changed its name to NNN TRS, Inc.

The Company’s operations are divided into two primary business segments: (i) investment assets, including real estate assets, structured finance investments (included in mortgages and notes receivable on the consolidated balance sheets) and mortgage residual interests (collectively, “Investment Assets”), and (ii) inventory real estate assets (“Inventory Assets”). The Investment Assets are operated through National Retail Properties, Inc. and its wholly owned qualified REIT subsidiaries. The Company acquires, owns, invests in, manages and develops properties that are leased primarily to retail tenants under long-term net leases (“Investment Properties” or “Investment Portfolio”). As of December 31, 2006, the Company owned 710 Investment Properties, with an aggregate gross leasable area of 9,341,000 square feet, located in 44 states. In addition to the Investment Properties, as of December 31, 2006, the Company had $13,917,000 and $31,512,000 in structured finance investments and mortgage residual interests, respectively. The Inventory Assets are operated through the NNN TRS. The NNN TRS, directly and indirectly, through investment interests, acquires and develops real estate primarily for the purpose of selling the real estate (“Inventory Properties” or “Inventory Portfolio”). As of December 31, 2006, the NNN TRS owned 97 Inventory Properties.

Principles of Consolidation – In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities” (“FIN 46R”). This Interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” addresses consolidation by business enterprises of variable interest entities.

 

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The Company’s consolidated financial statements include the accounts of each of the respective majority owned and controlled affiliates. All significant intercompany account balances and transactions have been eliminated. The Company applies the equity method of accounting to investments in partnerships and joint ventures that are not subject to control by the Company due to the significance of rights held by other parties.

The NNN TRS develops real estate through various joint venture development affiliate agreements. The NNN TRS consolidates the joint venture development entities listed in the table below based upon either the Company being the primary beneficiary of the respective variable interest entity or the Company having a controlling interest over the respective entity. The Company eliminates significant intercompany balances and transactions and records a minority interest for its other partners’ ownership percentage. The following table summarizes each of the investments, as of December 31, 2006:

 

Date of Agreement

  

Entity Name

  

NNN TRS’

    Ownership %    

 

November 2002

   WG Grand Prairie TX, LLC    60 %

February 2003

   Gator Pearson, LLC    50 %

February 2004

   CNLRS Yosemite Park CO, LLC    50 %

September 2004

   CNLRS Bismarck ND, LLC    50 %

December 2004

   CNLRS WG Long Beach MS, LLC    50