FORM 10-Q

TABLE OF CONTENTS

				PAGE NO.
PART I.	FINANCIAL INFORMATION			3
	Item 1.	Financial Statements		3
		Consolidated Balance Sheets as of September 30, 2008 (unaudited) and December 31, 2007		3
		Consolidated Statements of Operations for the three and nine months ended September 30, 2008 and 2007 (unaudited)		4
		Consolidated Statements of Cash Flows for the nine months ended September 30, 2008 and 2007 (unaudited)		5
		Notes to Consolidated Financial Statements		6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		20
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		26
	Item 4.	Controls and Procedures		26
PART II.	OTHER INFORMATION			27
	Item 1.	Legal Proceedings		27
	Item 1A.	Risk Factors		27
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		27
	Item 3.	Defaults Upon Senior Securities		27
	Item 4.	Submission of Matters to a Vote of Security Holders		27
	Item 5.	Other Information		27
	Item 6.	Exhibits		27
	SIGNATURES			28

 

 

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PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

Consolidated Balance Sheets

(in thousands, except for share data)

		September 30, 2008				December 31, 2007
		(unaudited)
Assets
Investment in real estate:
Land		$	892,239			$	825,560
Buildings and improvements			5,519,479				4,978,124
Tenant improvements and lease intangibles			538,477				460,486
			6,950,195				6,264,170
Less: accumulated depreciation			(426,332	)			(242,114	)
Net investment in real estate			6,523,863				6,022,056
Cash and cash equivalents			2,155				5,843
Tenant receivables, net			688				955
Deferred rent receivables, net			31,691				20,805
Interest rate contracts			92,223				84,600
Acquired lease intangible assets, net			19,735				24,313
Other assets			33,978				31,396
Total assets		$	6,704,333			$	6,189,968
Liabilities
Secured notes payable, including loan premium		$	3,733,872			$	3,105,677
Accounts payable and accrued expenses			65,844				62,704
Security deposits			35,891				31,309
Acquired lease intangible liabilities, net			207,184				218,371
Interest rate contracts			144,496				129,083
Dividends payable			22,814				19,221
Total liabilities			4,210,101				3,566,365
Minority interests			554,048				793,764
Stockholders’ Equity
Common stock, $0.01 par value, 750,000,000 authorized, 121,672,224 and 109,833,903 outstanding at September 30, 2008 and December 31, 2007, respectively.			1,217				1,098
Additional paid-in capital			2,280,396				2,019,716
Accumulated other comprehensive income			(96,045	)			(101,163	)
Accumulated deficit			(245,384	)			(89,812	)
Total stockholders’ equity			1,940,184				1,829,839
Total liabilities and stockholders’ equity		$	6,704,333			$	6,189,968

See notes to consolidated financial statements.

 

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Douglas Emmett, Inc.

Consolidated Statements of Operations

(unaudited and in thousands, except for share data)

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
Revenues
Office rental:
Rental revenues		$	112,787			$	94,592			$	323,016			$	279,088
Tenant recoveries			8,335				7,973				22,523				23,138
Parking and other income			14,681				12,137				41,252				34,335
Total office revenues			135,803				114,702				386,791				336,561
Multifamily rental:
Rental revenues			16,483				16,994				50,130				50,387
Parking and other income			950				765				2,698				2,338
Total multifamily revenues			17,433				17,759				52,828				52,725
Total revenues			153,236				132,461				439,619				389,286
Operating expenses
Office expense			39,915				34,086				109,404				100,121
Multifamily expense			4,238				4,592				12,503				13,943
General and administrative			5,243				5,862				16,257				16,024
Depreciation and amortization			63,611				50,629				184,218				152,244
Total operating expenses			113,007				95,169				322,382				282,332
Operating income			40,229				37,292				117,237				106,954
Other (expense) income			(43	)			205				489				659
Interest expense			(52,586	)			(41,504	)			(145,580	)			(118,119	)
Loss before minority interests			(12,400	)			(4,007	)			(27,854	)			(10,506	)
Minority interests			2,704				1,222				6,230				3,188
Net loss		$	(9,696	)		$	(2,785	)		$	(21,624	)		$	(7,318	)
Net loss per common share – basic and diluted		$	(0.08	)		$	(0.03	)		$	(0.18	)		$	(0.06	)
Dividends declared per common share		$	0.1875			$	0.175			$	0.5625			$	0.525
Weighted average shares of common stock outstanding -basic and diluted			121,509,098				110,956,113				120,372,893				113,593,114

See notes to consolidated financial statements.

 

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Douglas Emmett, Inc.

Consolidated Statements of Cash Flows

(unaudited and in thousands)

		Nine Months Ended September 30,
		2008				2007
Operating Activities
Net loss		$	(21,624	)		$	(7,318	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Minority interests			(6,230	)			(3,188	)
Depreciation and amortization			184,218				152,244
Net accretion of acquired lease intangibles			(32,330	)			(29,933	)
Amortization of deferred loan costs			1,417				782
Amortization of loan premium			(3,530	)			(3,331	)
Non-cash market value adjustments on interest rate contracts			12,908				9,466
Non-cash amortization of stock-based compensation			5,459				1,884
Change in working capital components
Tenant receivables			267				3,366
Deferred rent receivables			(10,886	)			(13,082	)
Accounts payable, accrued expenses and security deposits			4,403				18,337
Other			2,746				(4,955	)
Net cash provided by operating activities			136,818				124,272
Investing Activities
Capital expenditures and property acquisitions			(656,758	)			(72,578	)
Net cash used in investing activities			(656,758	)			(72,578	)
Financing Activities
Proceeds from borrowings			1,510,425				249,800
Deferred loan costs			(6,745	)			(1,672	)
Repayment of borrowings			(858,400	)			(73,000	)
Net change in short-term borrowings			(20,300	)			2,300
Contribution by minority interest partner to consolidated joint venture			319			─
Distributions to minority interests			(21,239	)			(23,304	)
Redemption of minority interests			(23,758	)			(29,211	)
Issuance of common stock			667			─
Repurchase of common stock		─					(125,185	)
Cash dividends paid on common stock			(64,717	)			(53,909	)
Net cash provided by (used in) financing activities			516,252				(54,181	)
Decrease in cash and cash equivalents			(3,688	)			(2,487	)
Cash and cash equivalents at beginning of period			5,843				4,536
Cash and cash equivalents at end of period		$	2,155			$	2,049

See notes to consolidated financial statements.

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements

(in thousands, except shares and per share data)

1. Organization and Description of Business

Douglas Emmett, Inc., a Maryland corporation incorporated on June 28, 2005, is a fully integrated, self-administered and self-managed Real Estate Investment Trust (REIT).  We did not have any meaningful operating activity until the consummation of our initial public offering (IPO) and the related acquisition of our predecessor and certain other entities on October 30, 2006.  Through our interest in Douglas Emmett Properties, LP (our operating partnership) and its subsidiaries, we own, manage, lease, acquire and develop real estate.  As of September 30, 2008, we owned a portfolio of 55 office properties (including ancillary retail space) and nine multifamily properties, as well as the fee interests in two parcels of land that we lease to third parties.  All of these properties are located in Los Angeles County, California and Honolulu, Hawaii.  We qualified as a REIT for federal income tax purposes beginning with our initial taxable year ending December 31, 2006 and expect to maintain such qualification.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements as of September 30, 2008 and December 31, 2007 and for the three and nine months ended September 30, 2008 and 2007 are the consolidated financial statements of Douglas Emmett, Inc. and its subsidiaries including our operating partnership.  All significant intercompany balances and transactions have been eliminated in the consolidated financial statements.  Certain prior period amounts have been reclassified to conform with current period presentation.

 

Unaudited Interim Financial Information

 

The accompanying unaudited interim financial statements have been prepared pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (SEC). Certain information and footnote disclosure normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States (GAAP) may have been condensed or omitted pursuant to such rules and regulations, although we believe that the disclosures are adequate to make the presentation not misleading.  The accompanying unaudited financial statements include, in our opinion, all adjustments, consisting of normal recurring adjustments, necessary to present fairly the financial information set forth therein. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the year ended December 31, 2008.  The interim financial statements should be read in conjunction with the consolidated financial statements in our 2007 Annual Report on Form 10-K and notes thereto.  Any reference to the number of properties and square footage are unaudited and outside the scope of our independent registered public accounting firm’s review of our financial statements in accordance with the standards of the United States Public Company Accounting Oversight Board.

 

Use of Estimates

The preparation of financial statements in conformity with GAAP requires us to make certain estimates and assumptions, for example with respect to the allocation of the purchase price of acquisitions among land, buildings, improvements, equipment and any related intangible assets and liabilities.  These estimates and assumptions are subjective and affect the reported amounts in the consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

Cash and Cash Equivalents

For purposes of the consolidated statements of cash flows, we consider short-term investments with maturities of three months or less when purchased to be cash equivalents.

Interest Rate Contracts

We manage our interest rate risk associated with borrowings by obtaining interest rate swap and interest rate cap contracts.  The interest rate swap agreements we utilize effectively modify our exposure to interest rate risk by converting our floating-rate debt to a fixed-rate basis, thus reducing the impact of interest-rate changes on future interest expense.  These agreements involve the receipt of floating-rate amounts in exchange for fixed-rate interest payments over the life of the agreements without an exchange of the underlying principal amount. We do not use any other derivative instruments.

Statement of Financial Accounting Standards (FAS) No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133), as amended and interpreted, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities.  As required by FAS 133, we record all derivatives on the balance sheet at fair value.  The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and the resulting designation. Derivatives used to hedge the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, are considered fair value hedges. Derivatives used to hedge the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.

Our objective in using derivatives is to add stability to interest expense and to manage our exposure to interest rate movements or other identified risks.  To accomplish this objective, we primarily use interest rate swaps as part of our cash flow hedging strategy.  Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts in exchange for fixed-rate payments over the life of the agreements without exchange of the underlying principal amount.  For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income (outside of earnings) and subsequently reclassified to earnings when the hedged transaction affects earnings.  The ineffective portion of changes in the fair value of the derivative is recognized directly in earnings.  We assess the effectiveness of each hedging relationship by comparing the changes in fair value or cash flows of the derivative hedging instrument with the changes in fair value or cash flows of the designated hedged item or transaction. For derivatives not designated as hedges, changes in fair value are recognized in earnings.  The fair value of these hedges is obtained through independent third-party valuation sources that use conventional valuation algorithms. See Note 8 for the accounting of our interest rate hedges.

 

Income Taxes

 

We elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended (IRC) commencing with our initial taxable year ending December 31, 2006.  To qualify as a REIT, we are required to distribute at least 90% of our REIT taxable income to our stockholders and meet the various other requirements imposed by the IRC relating to such matters as operating results, asset holdings, distribution levels and diversity of stock ownership. Provided we qualify for taxation as a REIT, we are generally not subject to corporate-level income tax on the earnings distributed currently to our stockholders that we derive from our REIT qualifying activities. We are subject to corporate-level tax on the earnings we derive through our taxable REIT subsidiary (TRS). If we fail to qualify as a REIT in any taxable year, and are unable to avail ourselves of certain savings provisions set forth in the IRC, all of our taxable income would be subject to federal income tax at regular corporate rates, including any applicable alternative minimum tax.

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

In addition, we are subject to taxation by various state and local (and potentially foreign) jurisdictions, including those in which we transact business or reside.  Our non-TRS subsidiaries, including the operating partnership, are either partnerships or disregarded entities for federal income tax purposes.  Under applicable federal and state income tax rules, the allocated share of net income or loss from the limited partnerships and S-Corporation is reportable in the income tax returns of the respective partners and stockholders.  Accordingly, no income tax provision is included in the accompanying consolidated financial statements.

 

Earnings Per Share (EPS)

 

Basic EPS is calculated by dividing the net income applicable to common stockholders for the period by the weighted average of common shares outstanding during the period.  Diluted EPS is calculated by dividing the net income applicable to common stockholders for the period by the weighted average number of common and dilutive instruments outstanding during the period using the treasury stock method.  Since we were in a net loss position during the three and nine months ended September 30, 2008 and 2007, all potentially dilutive instruments were anti-dilutive and have been excluded from our computation of weighted average dilutive shares outstanding.

 

Recently Issued Accounting Literature

In February 2007, the Financial Accounting Standards Board (FASB) issued FAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115.  This standard permits entities to choose to measure many financial instruments and certain other items at fair value and is effective for the first fiscal year beginning after November 15, 2007, which for us meant January 1, 2008.  We did not elect the fair value measurement option for any financial assets or liabilities during the first nine months of 2008, nor do we currently expect to elect this option for any financial assets or liabilities in the near future.

In December 2007, the FASB issued FAS No. 160, Non-controlling Interests in Consolidated Financial Statements-an Amendment of Accounting Research Bulletin No. 51 (FAS 160).  FAS 160 establishes new accounting and reporting standards for a non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary.  Specifically, this statement requires the recognition of a non-controlling interest (minority interest) as equity in the consolidated financial statements separate from the parent’s equity.  The amount of net income attributable to the non-controlling interest will be included in consolidated net income on the face of the income statement.  FAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest.  In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated.  Such gain or loss will be measured using the fair value of the non-controlling equity investment on the deconsolidation date.  FAS 160 also includes expanded disclosure requirements regarding the interests of the parent and its non-controlling interest.  FAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008, which for us means January 1, 2009.  We are currently evaluating the impact that FAS 160 will have on our financial statements.

In December 2007, the FASB issued FAS No. 141 (Revised 2007), Business Combinations (FAS 141R).  FAS 141R will significantly change the accounting for business combinations.  Under FAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions.  FAS 141R will require that transaction costs such as legal, accounting and advisory fees be expensed.  FAS 141R also includes a substantial number of new disclosure requirements.  FAS 141R applies prospectively to business combinations occurring in any reporting period beginning on or after December 15, 2008, which for us means January 1, 2009.  We are currently evaluating the impact that FAS 141R will have on our financial statements.

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

 

On January 1, 2008, we adopted FAS No. 157, Fair Value Measurements (FAS 157).  FAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements.  FAS 157 applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements; accordingly, the standard does not require any new fair value measurements of reported balances.  FAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement.  Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability.  As a basis for considering market participant assumptions in fair value measurements, FAS 157 establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).  Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.  Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates, and yield curves that are observable at commonly quoted intervals.

Currently, we use interest rate swaps and caps to manage interest rate risk resulting from variable interest payments on our floating rate debt.  The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities.

To comply with the provisions of FAS 157, we incorporate credit valuation adjustments to appropriately reflect both our own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements.  In adjusting the fair value of our derivative contracts for the effect of nonperformance risk, we considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees.  We have determined that our derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.  We do not have any fair value measurements using significant unobservable inputs (Level 3) as of September 30, 2008.

The table below presents the assets and liabilities measured at fair value on a recurring basis as of September 30, 2008, aggregated by the level in the fair value hierarchy within which those measurements fall.

	Quoted Prices in Active Markets for Identical Assets and Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Balance at September 30, 2008
Assets
Interest Rate Contracts	$                  ─		$	92,223		$                ─		$	92,223
Liabilities
Interest Rate Contracts	$                  ─		$	144,496		$                ─		$	144,496

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

In March 2008, the FASB issued Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities (FAS 161), an amendment of FAS 133, to expand disclosure requirements for an entity's derivative and hedging activities.  Under FAS 161, entities are required to provide enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under FAS 133 and its related interpretations, and how derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows.  In order to meet these requirements, entities shall include quantitative disclosures about derivative fair values and gains/losses on derivative instruments, qualitative disclosures about objectives and strategies for using derivatives, and disclosures about credit-risk-related contingent features in derivative agreements. FAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008, with early adoption encouraged.  We plan to adopt FAS 161 on January 1, 2009 and do not expect FAS 161 to have a significant impact as this statement only addresses disclosures.

 

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

3. Acquisitions

 

On March 26, 2008, we acquired a 1.4 million square foot office portfolio consisting of six Class “A” buildings all located in our core Los Angeles submarkets – Santa Monica, Beverly Hills, Sherman Oaks/Encino and Warner Center/Woodland Hills – for a contract price of approximately $610 million.  Subsequent to acquiring the properties, we entered into a non-recourse $365 million term loan secured by the six-property portfolio.  See Note 7 for a description of the debt.  See Note 13 for a related transaction that occurred subsequent to quarter end.

 

On February 13, 2008, we acquired a two-thirds interest in a 78,298 square-foot office building located in Honolulu, Hawaii.  As part of the same transaction, we also acquired all of the assets of The Honolulu Club, a private membership athletic and social club, which is located in the building.  The aggregate contract price was approximately $18 million and the purchase was made through a consolidated joint venture with our local partner.  The joint venture financed the acquisition with an $18 million loan.  See Note 7 for a description of the debt.  On May 1, 2008, the operations of the athletic club were sold to a third party for a nominal cost.  Simultaneously, the acquirer leased from us the space occupied by the athletic club.  The results of operations and loss on sale of the assets of the athletic club were not material.

In May 2007, we acquired an approximate 50,000 rentable square foot Class “A” office building located in one of our core Los Angeles submarkets, Century City, for a contract price of $32 million.

 

The results of operations for each of the acquired properties are included in our consolidated statements of operations only from the date of each acquisition.  The following table summarizes the allocations of estimated fair values of the assets acquired and liabilities assumed at the date of acquisition.  The amounts shown for 2008 acquisitions represent our preliminary purchase price allocations.  These amounts are likely to change based on a more thorough calculation to be performed during the one-year purchase accounting period provided under the relevant accounting standards.

 

The following table represents acquisitions to our portfolio that impact the current reporting periods:

		2008 Acquisitions				2007 Acquisition
Investment in real estate:
Land		$	66,661			$	3,650
Buildings and improvements			528,179				26,274
Tenant improvements and other in-place lease assets			50,978				3,024
Tenant receivables and other assets		─					24
Accounts payable, accrued expenses and security deposits			(3,476	)			(988	)
Acquired lease intangible liabilities, net			(25,721	)		─
Net acquisition cost		$	616,621			$	31,984

Our acquired lease intangibles related to above/below-market leases is summarized as of:

		September 30, 2008				December 31, 2007
Above-market tenant leases		$	34,227			$	32,770
Accumulated amortization			(17,541	)			(11,564	)
Below-market ground leases			3,198				3,198
Accumulated amortization			(149	)			(91	)
Acquired lease intangible assets, net		$	19,735			$	24,313
Below-market tenant leases		$	288,437			$	261,260
Accumulated accretion			(94,851	)			(57,112	)
Above-market ground leases			16,200				16,200
Accumulated accretion			(2,602	)			(1,977	)
Acquired lease intangible liabilities, net		$	207,184			$	218,371

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

4. Other Assets

Other assets consist of the following at:

		September 30, 2008				December 31, 2007
Deferred loan costs, net of accumulated amortization of $2,721 and $1,304
at September 30, 2008 and December 31, 2007, respectively		$	10,315			$	4,987
Deposits in escrow		─					4,000
Restricted cash			2,929				2,848
Prepaid interest			4,977				7,944
Prepaid expenses			5,824				3,095
Interest receivable			5,044				3,229
Other indefinite-lived intangible			1,988				1,988
Other			2,901				3,305
		$	33,978			$	31,396

We incurred deferred loan cost amortization expense of $577 and $282 for the three months ended September 30, 2008 and 2007, and $1,417 and $782 for the nine months ended September 30, 2008 and 2007, respectively.  The deferred loan cost amortization is included as a component of interest expense in the consolidated statements of operations.

5. Minimum Future Lease Rentals

 We have leased space to tenants primarily under noncancelable operating leases, which generally contain provisions for a base rent plus reimbursement for certain operating expenses. Operating expense reimbursements are reflected in our consolidated statements of operations as tenant recoveries.

We have leased space to certain tenants under noncancelable leases, which provide for percentage rents based upon tenant revenues. Percentage rental income for the three months ended September 30, 2008 and 2007 totaled $232 and $251, respectively, and $661 and $872 for the nine months ended September 30, 2008 and 2007, respectively.

Future minimum base rentals on non-cancelable office and ground operating leases at September 30, 2008 were as follows:

Twelve months ending September 30:

2009	$	389,037
2010		343,811
2011		292,055
2012		239,452
2013		186,577
Thereafter		477,827
Total future minimum base rentals	$	1,928,759

The above future minimum lease payments exclude residential leases, which typically have a term of one year or less, as well as tenant reimbursements, amortization of deferred rent receivables and above/below-market lease intangibles. Some leases are subject to termination options, generally upon payment of a termination fee. The preceding table assumes that these options are not exercised.

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

6. Accounts Payable and Accrued Expenses

Accounts payable and accrued expenses consist of the following as of:

		September 30, 2008				December 31, 2007
Accounts payable		$	37,465			$	43,449
Accrued interest payable			21,933				13,963
Deferred revenue			6,446				5,292
		$	65,844			$	62,704

7. Secured Notes Payable

During the first nine months of 2008, we borrowed additional debt as follows:

·

We obtained a non-recourse $365 million term loan secured by the six-property portfolio that we acquired on March 26, 2008 as described in Note 3.  This loan bears interest at a floating rate equal to one-month LIBOR plus 165 basis points, however we have entered into interest rate swap contracts that effectively fix the interest at 5.515% (based on an actual/360-day basis) until September 4, 2012.  This loan facility matures on August 18, 2013.  This long-term loan replaces the $380 million bridge loan obtained in March 2008 in connection with the property acquisition.  Subsequent to quarter-end, this loan and the related properties that serve as collateral, were contributed to a newly formed institutional fund as described in Note 13.

·

We obtained a non-recourse $340 million term loan secured by four of our previously unencumbered office properties.  This loan bears interest at a floating rate equal to one-month LIBOR plus 150 basis points, however we have entered into interest rate swap contracts that effectively fix the interest rate at 4.77% (based on an actual/360-day basis) until January 2, 2013.  This loan facility matures on April 1, 2015.  Proceeds from this loan were utilized to repay our secured revolving credit facility and for general corporate purposes.

·	The joint venture in which we have a two-thirds interest obtained an $18 million loan that financed the February 2008 acquisition described in Note 3.  This loan has an interest rate of one-month LIBOR plus 125 basis points and a two-year term with a one-year extension.

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

The following summarizes our secured notes payable at:

Type of Debt		Maturity Date		September 30, 2008		December 31, 2007		Variable Rate		Effective Annual Fixed Rate(1)		Swap Maturity Date
Variable Rate Swapped to Fixed Rate:
Fannie Mae Loan I (2)		06/01/12		$293,000		$293,000		DMBS + 0.60%		4.70%		08/01/11
Fannie Mae Loan II(2)		06/01/12		95,080		95,080		DMBS + 0.60%		5.78		08/01/11
Modified Term Loan I(3)(4)		08/31/12		2,300,000		2,300,000		LIBOR + 0.85%		5.13		08/01/10-08/01/12
Term Loan II (5)		08/18/13		365,000		─		LIBOR + 1.65%		5.52		09/04/12
Fannie Mae Loan III(2)		02/01/15		36,920		36,920		DMBS + 0.60%		5.78		08/01/11
Fannie Mae Loan IV(2)		02/01/15		75,000		75,000		DMBS + 0.76%		4.86		08/01/11
Term Loan III(6)		04/01/15		340,000		─		LIBOR + 1.50%		4.77		01/02/13
Fannie Mae Loan V(2)		02/01/16		82,000		82,000		LIBOR + 0.62%		5.62		03/01/12
Fannie Mae Loan VI(2)		06/01/17		18,000		18,000		LIBOR + 0.62%		5.82		06/01/12
Subtotal				3,605,000		2,900,000				5.14%(1)
Variable Rate:
Wells Fargo Loan(8)		03/01/10(9)		18,000		─		LIBOR + 1.25%		--		--
$370 Million Senior Secured Revolving Credit Facility(10)		10/30/09(11)		89,175		180,450		LIBOR / Fed Funds+(12)		--		--
Subtotal				3,712,175		3,080,450
Unamortized Loan Premium(13)				21,697		25,227
Total				$3,733,872		$3,105,677

 

(1)	Includes the effect of interest rate contracts.  Based on actual/360-day basis and excludes amortization of loan fees and unused fees on credit line.  The total effective rate on an actual/365-day basis is 5.21% at September 30, 2008.

(2)	Secured by four separate collateralized pools.  Fannie Mae Discount Mortgage-Backed Security (DMBS) generally tracks 90-day LIBOR.

(3)	Secured by seven separate cross-collateralized pools.  Requires monthly payments of interest only, with outstanding principal due upon maturity.

(4)	Includes $1.11 billion swapped to 4.96% until August 1, 2010; $545.0 million swapped to 5.83% until December 1, 2010; $322.5 million swapped to 5.05% until August 1, 2011; and $322.5 million swapped to 5.09% until August 1, 2012.

(5)	Secured by six properties in a cross-collateralized pool.  Requires monthly payments of interest only, with outstanding principal due upon maturity.

(6)	Secured by four properties in a cross-collateralized pool.  Requires monthly payments of interest only, with outstanding principal due upon maturity.

(7)	As of September 30, 2008, the weighted average remaining life of our total outstanding debt is 4.4 years, and the weighted average remaining life of the interest rate swaps is 2.7 years.

(8)	This is an $18 million loan to a consolidated joint venture in which our Operating Partnership owns a two-thirds interest.  The loan has a one-year extension option.

(9)	The original maturity date of March 1, 2010 may be extended by one year to March 1, 2011, subject to certain conditions.

(10)	This credit facility is secured by nine properties and has two one-year extension options available.

(11)	The original maturity date of October 30, 2009 may be extended by two years to October 30, 2011, subject to certain conditions.

(12)	This revolver bears interest at either LIBOR +0.70% or Fed Funds +0.95% at our election.  If the amount outstanding exceeds $262.5 million, the credit facility bears interest at either LIBOR +0.80% or Fed Funds +1.05% at our election.

(13)	Represents non-cash mark-to-market adjustment on variable rate debt associated with office properties.

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

The minimum future principal payments due on our secured notes payable, excluding the non-cash loan premium amortization, at September 30, 2008 were as follows:

 

Twelve months ending September 30:
2009	$	─
2010		107,175
2011		─
2012		2,688,080
2013		365,000
Thereafter		551,920
Total future principal payments	$	3,712,175

Senior Secured Revolving Credit Facility

We have a $370 million revolving credit facility with a group of banks led by Bank of America, N.A. and Banc of America Securities, LLC.  It bears interest at a rate per annum equal to either LIBOR plus 70 basis points or Federal Funds Rate plus 95 basis points if the amount outstanding is $262.5 million or less and at either LIBOR plus 80 basis points or Federal Funds Rate plus 105 basis points if the amount outstanding is greater than $262.5 million.  Our secured revolving credit facility contains an accordion feature that allows us to increase the availability by an additional $130 million to $500 million under specified circumstances.  The facility bears interest at 15 basis points on the undrawn balance.  The facility expires during the fourth quarter of 2009, with two one-year extensions at our option.

 

8. Interest Rate Contracts

As of September 30, 2008, approximately 97% or $3.6 billion of our outstanding debt had interest payments designated as hedged transactions to receive-floating/pay-fixed interest rate swap agreements.  These derivatives were designated and qualify as highly effective cash flow hedges under FAS 133 and remove the variability from the hedged cash flows.  The change in fair value of these cash flow hedges was recorded as an unrealized gain (loss) during each of the respective reporting periods shown in the following table.  Such unrealized gains (losses) were recorded to accumulated other comprehensive income in our consolidated balance sheets.  An immaterial amount of hedge ineffectiveness has also been recorded in interest expense.  See Note 2 for a discussion about market and credit risk as it relates to our application of FAS 157.

 

The components of comprehensive income consist of the following:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
Net loss		$	(9,696	)		$	(2,785	)		$	(21,624	)		$	(7,318	)
Cash flow hedge adjustment			(7,867	)			(65,103	)			5,118				(34,318	)
Comprehensive income		$	(17,563	)		$	(67,888	)		$	(16,506	)		$	(41,636	)

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

We also have additional interest rate swaps that we acquired from our predecessor at the time of our IPO.  Our predecessor had $2.2 billion notional of pay-fixed interest rate swaps at swap rates ranging between 4.04% and 5.00%.  Concurrent with the completion of our IPO, we executed receive-fixed swaps for the same notional amount at swap rates ranging between 4.96% and 5.00%, which were intended to largely offset the future cash flows and future change in fair value of our predecessor’s pay-fixed swaps.  The acquired pay-fixed swaps and the new receive-fixed swaps were not designated as hedges under FAS 133 and as such, the changes in fair value of these interest rate swaps have been recognized in earnings for all periods.  The aggregate fair value of these swaps decreased $5.5 million and $3.3 million for the three months ended September 30, 2008 and 2007, respectively, and $12.9 million and $9.8 million for the nine months ended September 30, 2008 and 2007, respectively.

9. Stockholders’ Equity and Minority Interests

Minority interests in our operating partnership relate to interests in that partnership which are not owned by us.  Minority interests in our operating partnership amounted to approximately 22% at September 30, 2008.  A unit in our operating partnership and a share of our common stock have essentially the same economic characteristics as they share equally in the total net income or loss distributions of our operating partnership.  Investors who own units in our operating partnership have the right to cause our operating partnership to redeem any or all of their units in our operating partnership for cash equal to the then-current market value of one share of common stock, or, at our election, shares of our common stock on a one-for-one basis.  At the end of each reporting period, we calculate the book value of net assets allocable to minority interests, and adjust the balance to reflect the calculated amount with a reclass to or from the retained earnings (accumulated deficit) balance.

Minority interests also includes the interest of a minority partner in a joint venture formed during the first quarter of 2008 to purchase an office building in Honolulu, Hawaii.  The joint venture is two-thirds owned by our operating partnership and is consolidated in our financial statements as of September 30, 2008.

Dividends

During the first nine months of 2008 and 2007, we declared quarterly dividends of $0.1875 and $0.175 per share, respectively, which equals an annualized rate of $0.75 and $0.70 per share, respectively.

Equity Conversions and Repurchases

During the first nine months of 2008, investors converted 11.8 million operating partnership units to shares of common stock and we repurchased approximately 1.1 million share equivalents in private transactions for a total consideration of approximately $23.8 million.  We may make additional purchases of our share equivalents from time to time in private transactions or in the public markets, but do not have any commitments to do so.  Additionally, during the first nine months of 2008, we issued approximately 31,000 shares of common stock to satisfy the exercise of certain vested employee stock options.

Taxability of Dividends

Earnings and profits, which determine the taxability of distributions to stockholders, will differ from income reported for financial reporting purposes due to the differences for federal income tax purposes in the treatment of loss on extinguishment of debt, revenue recognition, compensation expense and in the basis of depreciable assets and estimated useful lives used to compute depreciation.

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

10. Stock-Based Compensation

The Douglas Emmett, Inc. 2006 Omnibus Stock Incentive Plan, our stock incentive plan, was adopted by our board of directors and approved by our stockholders prior to the consummation of our IPO. Our stock incentive plan is administered by the compensation committee of our board of directors.  All full-time and part-time officers, employees, directors and other key persons (including consultants and prospective employees) are eligible to participate in our stock incentive plan.  For more information on our stock incentive plan, please refer to the notes to the consolidated financial statements in our 2007 Annual Report on Form 10-K.

During the first quarter of 2008, we granted approximately 2.7 million long-term incentive units and stock options with a total fair market value of $9.9 million.  No additional grants have been made during 2008.  Upon the vesting of equity awards, we recognized non-cash compensation expense of $1.1 million and $0.5 million for the three months ended September 30, 2008 and 2007, respectively, and $3.3 million and $1.8 million for the nine months ended September 30, 2008 and 2007, respectively.  An additional $2.2 million of equity awards vested during the first quarter of 2008 to satisfy a portion of the bonuses accrued during 2007.

11. Commitments and Contingencies

We are subject to various legal proceedings and claims that arise in the ordinary course of business. These matters are generally covered by insurance.  We believe that the ultimate outcome of these actions will not have a material adverse effect on our financial position and results of operations or cash flows.

Concentration of Credit Risk

Our properties are located in premier submarkets within Los Angeles County, California and Honolulu, Hawaii. The ability of the tenants to honor the terms of their respective leases is dependent upon the economic, regulatory and social factors affecting the markets in which the tenants operate.  We perform ongoing credit evaluations of our tenants for potential credit losses.  Financial instruments that subject us to credit risk consist primarily of cash, accounts receivable, deferred rents receivable and interest rate contracts. We maintain our cash and cash equivalents with high quality financial institutions. Accounts at each institution are insured by the Federal Deposit Insurance Corporation up to $250,000.00 under the recently increased limit that the U.S. Congress has temporarily granted until December 31, 2009.  We have not experienced any losses to date on our deposited cash.  All of our deposits are maintained at banks with investment grade ratings as evaluated by the predominant rating agencies.

Asset Retirement Obligations

FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143 clarifies that the term “conditional asset retirement obligation” as used in FAS No. 143, Accounting for Asset Retirement Obligations, represents a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement is conditional on a future event that may or may not be within a company’s control.  Under this standard, a liability for a conditional asset retirement obligation must be recorded if the fair value of the obligation can be reasonably estimated.  Environmental site assessments and investigations have identified 18 properties in our portfolio containing asbestos, which would have to be removed in compliance with applicable environmental regulations if these properties undergo major renovations or are demolished.  As of September 30, 2008, the obligations to remove the asbestos from these properties have indeterminable settlement dates, and therefore, we are unable to reasonably estimate the fair value of the associated conditional asset retirement obligation.

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

Future Minimum Lease Payments

We lease portions of the land underlying three of our office properties as more fully described in the notes to consolidated financial statements contained in our 2007 Annual Report on Form 10-K. We expensed ground lease payments in the amount of $809 and $693 for the three months ended September 30, 2008 and 2007, respectively, and $2,400 and $2,397 for the nine months ended September 30, 2008 and 2007, respectively.

The following is a schedule of minimum ground lease payments as of September 30, 2008:

Twelve months ending September 30:
2009	$	668
2010		733
2011		733
2012		733
2013		733
Thereafter		3,970
	$	7,570

Tenant Concentrations

For the nine months ended September 30, 2008 and 2007, no tenant accounted for more than 10% of our total rental revenue and tenant recoveries.

 

12. Segment Reporting

FAS No. 131, Disclosures about Segments of an Enterprise and Related Information, established standards for disclosure about operating segments and related disclosures about products and services, geographic areas and major customers. Segment information is prepared on the same basis that our management reviews information for operational decision-making purposes. We operate in two business segments: (i) the acquisition, redevelopment, ownership and management of office real estate and (ii) the acquisition, redevelopment, ownership and management of multifamily real estate.  The products for our office segment primarily include rental of office space and other tenant services including parking and storage space rental. The products for our multifamily segment include rental of apartments and other tenant services including parking and storage space rental.

Asset information by segment is not reported because we do not use this measure to assess performance and make decisions to allocate resources.  Therefore, depreciation and amortization expense is not allocated among segments.  Interest and other income, management services, general and administrative expenses, interest expense, depreciation and amortization expense and net derivative gains and losses are not included in rental revenues less rental expenses as the internal reporting addresses these items on a corporate level.

Rental revenues less rental expenses is not a measure of operating results or cash flows from operating activities as measured by GAAP, and it is not indicative of cash available to fund cash needs and should not be considered an alternative to cash flows as a measure of liquidity. Not all companies may calculate rental revenues less rental expenses in the same manner. We consider rental revenues less rental expenses to be an appropriate supplemental measure to net income because it assists both investors and management in understanding the core operations of our properties.

 

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Douglas Emmett, Inc.

Notes to Consolidated Financial Statements--(continued)

(in thousands, except shares and per share data)

The following table represents operating activity within our reportable segments:

		Three Months Ended September 30, 2008												Three Months Ended September 30, 2007
		Office				Multifamily				Total				Office				Multifamily				Total
Rental revenues		$	135,803			$	17,433			$	153,236			$	114,702			$	17,759			$	132,461
Percentage of total			89	%			11	%			100	%			87	%			13	%			100	%
Rental expenses		$	39,915			$	4,238			$	44,153			$	34,086			$	4,592			$	38,678
Percentage of total			90	%			10	%			100	%			88	%			12	%			100	%
Rental revenues less rental expenses		$	95,888			$	13,195			$	109,083			$	80,616			$	13,167			$	93,783
Percentage of total			88	%			12	%			100	%			86	%			14	%			100	%

		Nine Months Ended September 30, 2008												Nine Months Ended September 30, 2007
		Office				Multifamily				Total				Office				Multifamily				Total
Rental revenues		$	386,791			$	52,828			$	439,619			$	336,561			$	52,725			$	389,286
Percentage of total			88	%			12	%			100	%			86	%			14	%			100	%
Rental expenses		$	109,404			$	12,503			$	121,907			$	100,121			$	13,943			$	114,064
Percentage of total			90	%			10	%			100	%			88	%			12	%			100	%
Rental revenues less rental expenses		$	277,387			$	40,325			$	317,712			$	236,440			$	38,782			$	275,222
Percentage of total			87	%			13	%			100	%			86	%			14	%			100	%

The following is a reconciliation of rental revenues less rental expenses to net loss:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
Rental revenues less rental expenses		$	109,083			$	93,783			$	317,712			$	275,222
Other (expense) income			(43	)			205				489				659
General and administrative			(5,243	)			(5,862	)			(16,257	)			(16,024	)
Interest expense			(52,586	)			(41,504	)			(145,580	)			(118,119	)
Depreciation and amortization			(63,611	)			(50,629	)			(184,218	)			(152,244	)
Minority interests			2,704				1,222				6,230				3,188
Net loss		$	(9,696	)		$	(2,785	)		$	(21,624	)		$	(7,318	)

13. Subsequent Events

On October 29, 2008 we contributed six Class "A" office properties to our newly formed institutional fund, Douglas Emmett Fund X, LLC (Fund).  These properties were acquired by us on March 26, 2008.  See Note 3 for a description of the acquisition.  The contribution occurred in connection with the initial closing of $300 million of equity commitments for the Fund.  As part of the contribution of the properties, the $365 million loan secured by the properties has been transferred to the Fund.  See Note 7 for a description of the debt.

 

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