ITEM 1. BUSINESS
The Hallwood Group Incorporated ("Hallwood" or the "Company") (NYSE:HWG), a Delaware corporation, is a diversified holding company and classifies its business operations into two principal divisions: asset management and operating subsidiaries. The asset management division includes the commercial real estate and energy businesses, and the operating subsidiaries division includes the textile products and hotel businesses. For financial reporting purposes, the Company operates in four business segments: real estate, energy, textile products and hotels. Financial information for each industry segment in which the Company operates is set forth in Note 19 to the consolidated financial statements.
Asset Management Division.
Real Estate. Real estate activities are conducted primarily through the Company's wholly owned subsidiaries, HWG, LLC, Hallwood Realty, LLC ("Hallwood Realty") and Hallwood Commercial Real Estate, LLC ("HCRE"). Hallwood Realty is the sole general partner of Hallwood Realty Partners, L.P. ("HRP"), a publicly-traded, master limited partnership (AMEX:HRY). At December 31, 1998, HRP owned twelve real estate properties in six states containing 5,150,000 net rentable square feet. Hallwood Realty owns a 1% general partner interest and HWG, LLC owns a 25% limited partner interest in HRP. Hallwood Realty is responsible for asset management of HRP and its properties, including the decisions regarding financing, acquiring and disposing of properties. It also provides general operating and administrative services to HRP. HCRE is responsible for on-site property management at all HRP properties, and properties it manages for third parties, for which it receives managing, leasing and construction supervision fees.
The Company accounts for its ownership in HRP using the equity method of accounting, recording its proportionate share of net income (loss) and partners' capital transactions reported by HRP. The December 31, 1998 financial statements of HRP are included elsewhere within this document.
Real estate accounted for 7% of the Company's total revenues in the year ended December 31, 1998, compared to 5% in the year ended December 31, 1997, and 3% in the year ended December 31, 1996.
See Note 13 to the Company's consolidated financial statements.
Energy. Energy operations were consolidated beginning in May 1990, when the Company increased its ownership of Hallwood Energy Corporation ("HEC") from 11% to 53%, and thereafter, accounted for HEC as a consolidated subsidiary of the Company. As a result of HEC's subsequent purchases of its own stock for treasury and the Company's acquisition of additional HEC common stock, the Company's effective percentage ownership increased to 82%, and after the Company's November 1996 successful tender offer for the remaining minority shares, HEC was merged into the Company. Certain energy assets acquired by the merger were subsequently transferred to two wholly owned entities, HEPGP Ltd. ("HEPGP") and Hallwood G.P., Inc. ("HGP"), the general partner of HEPGP.
The Company's energy operations are now conducted primarily through HEPGP, and consist of the development, production and sale of oil and gas, and the acquisition, exploration, development and operation of additional oil and gas properties. HEPGP is the sole general partner of Hallwood Energy Partners, L.P. ("HEP"), a publicly-traded oil and gas master limited partnership (AMEX:HEP), and conducts substantially all if its operations through HEP. HEPGP's general partner interest in HEP entitles it to a share of net revenue derived from HEP's properties ranging from 2% to 25%. At December 31, 1998, the Company also held an approximate 6.5% ownership of HEP, consisting of 5.1% of HEP's Class A limited partner units, 100% of HEP's Class B limited partner units and 1.8% of the preferential Class C limited partner units.
HEP owns interests in approximately 1,600 wells, the most significant of which are located in West Texas, South Louisiana, New Mexico and the Rocky Mountain region. The Company and its subsidiaries account for their ownership of HEP using the proportionate consolidation method, whereby it records a proportional share of HEP's revenues and expenses, current assets, current liabilities, noncurrent assets, long-term obligations and fixed assets.
Proposed Consolidation Plan. In December, 1998, HEP and its affiliate, Hallwood Consolidated Resources Corporation ("HCRC"), a publicly-traded oil and gas company (NASDAQ:HCRC), jointly announced a proposal to consolidate HEP with HCRC and the energy interests of the Company into a new publicly-traded entity to be called Hallwood Energy Corporation. After the consolidation, the common stock of Hallwood Energy Corporation will be owned 56% by the current Class A unitholders of HEP, 26% by the current stockholders of HCRC and 18% by the Company. HEP's current Class C unitholders will receive all of the redeemable preferred stock in the new entity.
Because of the larger size of the new corporation, management anticipates that the new company will have the ability to take advantage of opportunities that are unavailable to smaller entities and will have a better ability to raise capital. Hallwood Energy Corporation will focus on reserve growth. A Joint Proxy Statement/Prospectus for the consolidation was filed with the Securities and Exchange Commission on December 30, 1998 and is proceeding through the usual SEC comment process. It is presently anticipated that the Joint Proxy Statement/Prospectus will be mailed to HEP unitholders and HCRC stockholders in April and the consolidation will be concluded in May 1999. There can be no assurance, however, that all conditions to the consolidation will be satisfied by that time.
Energy accounted for 4% of the Company's total revenues in the year ended December 31, 1998, compared to 4% in the year ended December 31, 1997 and 7% in the year ended December 31, 1996.
See Note 14 to the Company's consolidated financial statements.
Operating Subsidiaries Division.
Textile Products. Textile products operations are conducted through the Company's wholly owned Brookwood Companies Incorporated ("Brookwood") subsidiary. Brookwood is a complete textile service firm that develops and produces innovative fabrics and related products through specialized finishing, treating and coating processes.
Textile products accounted for 69% of the Company's total revenues in the year ended December 31, 1998, compared to 62% in the year ended December 31, 1997 and 67% in the year ended December 31, 1996.
See Note 15 to the Company's consolidated financial statements.
Hotels. Hotel operations are conducted through the Company's wholly owned, Hallwood Hotels, Inc. ("Hallwood Hotels"), Brock Suite Hotels, Inc. ("Brock Hotels") and Integra Resort Management, Inc. ("IRM") subsidiaries. Hallwood Hotels holds a long-term leasehold interest in the Holiday Inn hotel, located in Longboat Key, Florida and a fee interest in the Airport Embassy Suites hotel, located in Oklahoma City, Oklahoma. Brock Hotels owns fee interests in Residence Inns located in Tulsa, Oklahoma and Greenville, South Carolina, and a long-term leasehold interest in a Residence Inn located in Huntsville, Alabama. IRM owns 315 owner's rental contracts and certain real estate at The Enclave Suites, a resort condominium hotel located in Orlando, Florida. It manages the property for individual unit owners for which it receives a management fee and other consideration for the services it provides.
Hallwood Hotels and Brock Hotels properties are currently operated under license agreements with Holiday Inns Franchising, Inc., Embassy Suites, Inc. and Marriott International, Inc. The license agreements permit the licensor to prescribe, at such times as it determines, standards for the operation and maintenance of the various properties and their furnishings, equipment and facilities. Substantial capital expenditures may be required from time to time to comply with such standards. In April 1999, all of the Residence Inn franchises will terminate by mutual agreement and are expected to become GuestHouse franchises.
The hotel industry is, in some cases, affected by seasonal fluctuations in demand. The Company's hotel properties as a whole do not experience significant seasonal changes because many of the hotels primarily serve the business traveler. The Holiday Inn hotel in Longboat Key , Florida, does, however, experience some seasonal changes in occupancy, as occupancy levels tend to increase during the winter months and decrease slightly during the rest of the year.
Hotel revenues accounted for 18% of the Company's total revenues in the year ended December 31, 1998, compared to 14% in the year ended December 31, 1997, and 18% in the year ended December 31, 1996.
Associated Company. The Company is no longer engaged in the associated company segment, as its remaining ShowBiz Pizza Time, Inc. ("ShowBiz") investment was sold in March 1997, through a secondary public offering by ShowBiz, for $41,285,000 in cash, resulting in an $18,277,000 gain. The Company had accounted for its investment in ShowBiz on the equity method.
Associated company income accounted for 13% of the Company's total revenues in the year ended December 31, 1997, compared to 4% in the year ended December 31, 1996.
See Note 2 to the Company's consolidated financial statements.
Competition. The Company's real estate operations are subject to substantial competition from other entities which own similar properties in the vicinity in which HRP's properties are located. In addition, there are numerous other potential investors seeking to purchase improved real property and many property holders seeking to dispose of real estate with which the Company and HRP will compete, including companies substantially larger and with greater resources. Furthermore, current economic conditions in each property's respective real estate market are competitive and as such, competition for tenants will continue to affect rental rates and revenue.
The Company and its energy affiliates encounter competition from other oil and gas companies in all areas of their operations, including the acquisition of exploratory prospects and proven properties. Competitors include major integrated oil and gas companies and numerous independent oil and gas companies, individuals and drilling and income programs. The market for oil and gas depends on a number of factors, including the level of domestic production, pace of the general economy, supply of imported oil and gas, actions of foreign oil-producing nations and the extent of governmental regulation and taxation. In addition, oil and gas must compete with coal, atomic energy, hydro-electric power and other forms of energy. In response to volatility, the Company enters into financial contracts for hedging the price of a portion of its oil and gas production.
Textile products operations encounter competition in all regions in which they are conducted. In the volume areas of the textile business, competition is sometimes based on price, particularly during a weak economy.
Hotel operations are subject to competition from similar types of properties in the vicinities in which they are located. The sale of hotels may be impacted by the inability of prospective purchasers to obtain equity capital or suitable financing.
Environmental Compliance. A number of jurisdictions in which the Company operates have adopted laws and regulations relating to environmental matters. Such laws and regulations may require the Company to secure governmental permits and approvals and undertake measures to comply with the laws and regulations. Compliance with the requirements imposed may be time-consuming and costly. While environmental considerations, by themselves, have not significantly affected the Company's business to date, it is possible that such considerations may have a significant and adverse impact in the future. The Company actively monitors its environmental compliance and while certain matters currently exist, management is not aware of any compliance issues which will significantly impact the financial position, operations or cash flows of the Company.
Number of Employees. The Company had 1,058 and 994 employees as of February 28, 1999 and 1998, respectively, comprised as follows:
A substantial amount of the salaries and related costs for the employees of HCRE, Hallwood Realty and Hallwood Petroleum, Inc., an affiliate of HEPGP, are reimbursed by the respective real estate and energy partnership affiliates.
ITEM 2.
ITEM 2. PROPERTIES
Real Properties
The general character, location and nature of the significant real properties owned by the Company and its subsidiaries and the encumbrances against such properties are described below and/or in Schedule III hereto.
Cost of real estate owned by property type and geographic distribution (in thousands of dollars):
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* Less than 1%. (1) Cost represents purchased leasehold interest in hotel property and capital improvements. (2) Property is pledged as collateral under loan or bond indenture agreements.
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* Less than 1%.
As of December 31, 1998, the Company's Embassy Suites hotel in Oklahoma City, Oklahoma was the only real estate property that constituted 10% or more of the Company's consolidated assets.
The textile products' dyeing and finishing plant was custom-built and is a multi-shift facility well-suited for that particular business. The development of new products requires the plant to be constantly upgraded, along with various levels of utilization.
Hotel properties are operated under license and, as such, must meet and maintain standards established by the licensor. At any time during the term of the license, the licensor may require modernization, renovation and other upgrading of the hotel. The Company has recently renovated the Longboat Key Holiday Inn hotel with part of the financing provided by the owner. In April 1999, the Residence Inn by Marriott franchises will terminate by mutual agreement and the properties will become GuestHouse franchises. Renovations to meet the new franchiser's standards are expected to be funded from the Company's capital reserves and equipment leasing facilities.
Oil and Gas Properties
Oil and gas properties consist primarily of the Company's and HEPGP's indirect interest in properties owned through their investment in HEP. Quantities and values presented in the financial statements attached hereto related to HEP's properties, which are shown net to their interest in HEP. The supplemental oil and gas reserve information appended to the consolidated financial statements represents estimated quantities of proved oil and gas reserves. These reserves are located principally in four regions within the United States: the Greater Permian region of Texas and southeast New Mexico, the Gulf Coast region of Louisiana and Texas, and the Rocky Mountain region. The determination of oil and gas reserves is based on estimates which are highly complex and interpretive. The estimates are subject to continuing change as additional information becomes available.
See Note 14 to the Company's consolidated financial statements and Supplemental Oil and Gas Reserve Information.
The following tables summarize certain oil and gas information related to the Company's and HEPGP's direct interests and their share of HEP's oil and gas activities (in thousands):
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On February 27, 1997, a lawsuit was filed in the Chancery Court for New Castle County, Delaware, styled Gotham Partners, L.P. v. Hallwood Realty Partners, L.P. and Hallwood Realty Corporation (C.A. No. 15578). The complaint sought access to certain books and records of HRP, a list of the limited partners and reimbursement of the plaintiff's expenses.
On June 20, 1997, Gotham Partners, L.P. filed a separate complaint in the Chancery Court for New Castle County, Delaware, styled Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., et al. (C.A. No. 15754), against Hallwood, HRP, Realty, and the directors of Realty, alleging claims of breach of fiduciary duties, breach of HRP's partnership agreement, fraud, and as to Hallwood, aiding and abetting these alleged breaches. At the same time as the filing of this complaint, plaintiff filed a motion to amend its complaint in the earlier action to allege the same facts and demand the same relief as plaintiff sought in the separate complaint.
On June 27, 1997, the parties entered into a Stipulation and Order under which HRP provided to plaintiff copies of certain of the documents requested. The other claims in the two actions remain outstanding.
On August 27, 1997, defendants moved to dismiss the complaint in the separate action for plaintiff's failure either to make a demand on the general partner to bring suit or to allege adequately that such a demand was futile. On February 6, 1998, the Court granted defendants' motion to dismiss but gave plaintiff thirty days to file an amended complaint. Plaintiffs filed an amended complaint on March 6, 1998, which defendants again moved to dismiss. This motion was denied and the parties are proceeding with discovery.
HRP's management believes that the claims are without merit and intend to defend the cases vigorously, but because of their early stages, cannot predict the outcome of the claims or any possible effect an adverse outcome might have.
HRP is from time to time involved in various legal proceedings and claims which arise in the ordinary course of business. These matters are generally covered by insurance. Management believes that the resolution of these matters will not have a material adverse effect on HRP's financial position, cash flow or operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the security holders of HRP during the fourth quarter of 1998.
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PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S UNITS AND RELATED SECURITY HOLDER MATTERS
The Partnership's units are traded on the American Stock Exchange under the symbol "HRY". As of March 5, 1999, there were approximately 31,100 unitholders of record of the 1,672,556 units outstanding. HRP has not paid any cash distributions since February, 1992. Each quarter Realty reviews HRP's capacity to make cash distributions to its partners.
The following table shows the range of sales prices for the periods indicated, as reported by the American Stock Exchange:
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ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial data regarding the Partnership's results of operations and financial position as of the dates indicated. This information should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations contained in Item 7
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion should be read in conjunction with Item 6 - Selected Financial Data and Item 8 - Financial Statements and Supplemental Information.
RESULTS OF OPERATIONS: 1998 VERSUS 1997 -
REVENUE FROM PROPERTY OPERATIONS in 1998 increased $2,864,000, or 5.4%, as compared to 1997. The following table illustrates the components of the change:
Rental income increased largely due to rental rate increases at a number of properties and to a lesser degree due to a rise in average occupancy to 93.5% in 1998 from 93.1% in 1997. As of December 31, 1998, HRP had leases executed and in place for 93.3% of the portfolio's net rentable square feet.
INTEREST INCOME increased $311,000 as a result of additional earnings on overnight investments due to higher average cash balances available for investment.
PROPERTY OPERATING EXPENSES for 1998 decreased $987,000, or 4.2%, compared to 1997. The decrease is comprised of the following components:
o Real estate taxes decreased $603,000 primarily due to tax refunds received in 1998 for tax years 1993 to 1997 for Parklane Towers and Raintree Industrial Park.
o Repairs and Maintenance Costs decreased $450,000 primarily due to exterior window glazing costs performed in 1997 at Parklane Towers.
o Management fees rose $121,000 due to the increase in net rental income and occupancy mentioned above.
o Janitorial costs increased $129,000 principally due to the increase in occupancy.
o Combined, all other operating costs decreased $184,000, or 0.8%, between the years.
INTEREST EXPENSE diminished $164,000, or 1.3%, due to lower principal balances as a result of scheduled principal payments and due to lower interest rates from the refinancing of loans secured by Executive Park and Seattle Business Parks during 1998 (see Note 5 to the Consolidated Financial Statements for more information about refinancing of loans).
DEPRECIATION AND AMORTIZATION EXPENSE increased $59,000 primarily due to an increase in lease commission amortization of $131,000 as a result of new leases executed during 1997 which have increased the portfolio's occupancy, partially offset by a decrease in building cost depreciation.
GENERAL AND ADMINISTRATIVE EXPENSES decreased $16,000 for 1998 compared to 1997, due to lower insurance premiums for director and officer coverage and lower investor mailing costs, partially offset by an increase in state franchise taxes for the state of Michigan.
NET GAIN FROM EARLY EXTINGUISHMENTS OF DEBT of $5,347,000 in 1998 is comprised of the following transactions and is further discussed in Note 5 to the Consolidated Financial Statements:
o a gain of $7,223,000 from the early payoff of the loan secured by First Maryland Building comprised of $7,441,000 of unamortized loan forgiveness, net of a $200,000 prepayment penalty and $18,000 of unamortized loan costs, all associated with the retired loan.
o a loss of $1,611,000 from the early payoff of the loan secured by Executive Park comprised of a prepayment penalty of $1,465,000 and the writeoff of $146,000 of unamortized loan costs associated with the retired loan.
o a loss of $265,000 from the early payoff of the loan secured by Seattle Business Park comprised of a prepayment penalty of $190,000 and the writeoff of $75,000 of unamortized loan costs associated with the retired loan.
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RESULTS OF OPERATIONS (CONTINUED) - 1997 VERSUS 1996 -
REVENUE FROM PROPERTY OPERATIONS in 1997 increased $4,099,000, or 8.4%, compared to 1996. The following table illustrates the components of the change:
Rental income increased primarily as the result of a rise in average occupancy to 93.1% in 1997 from 87.8% in 1996. As of December 31, 1997, HRP had leases executed and in place for 94.4% of the portfolio's net rentable square feet.
GAIN FROM PROPERTY SALE of $394,000 in 1997 represents the sale of one building in Fairlane Commerce Park containing 3,500 net rentable square feet and approximately 0.5 acres for $510,000 before expenses of $8,000.
INTEREST INCOME decreased $206,000 primarily as a result of decreased earnings on overnight investments due to lower average cash balances.
PROPERTY OPERATING EXPENSES for 1997 increased $213,000, or 0.9%, compared to 1996. The increase is comprised of the following components:
o Janitorial costs increased $144,000 and security costs increased $64,000 principally due to the increase in occupancy mentioned above.
o Personnel costs increased $145,000, or 4.1%.
o Management fees were $100,000 more due to the increase in net rental income and occupancy mentioned above.
o Property insurance costs decreased $119,000 due to lower premiums.
o Combined, all other operating costs decreased $121,000, or 0.05%, between the years.
INTEREST EXPENSE decreased $577,000, or 4.3%, due to loan modifications/renewals for First Maryland Building and Executive Park in 1996. First Maryland's costs dropped $92,000 and is comprised of a $112,000 reduction in cash interest paid to the lender and a $20,000 decrease in amortization of mortgage principal forgiveness. Executive Park's costs decreased $313,000 due to the reduction in its interest rate by slightly more than 1%. All other interest costs fell $172,000 due to a reduction in debt levels as a result of monthly principal amortization payments.
DEPRECIATION AND AMORTIZATION EXPENSE decreased $6,958,000 primarily due to an extension of depreciable lives of certain building costs effective January 1, 1997 (see Note 2 to the Consolidated Financial Statements in Item 8).
GENERAL AND ADMINISTRATIVE EXPENSES in 1997 decreased $176,000, or 5.1%, as the result of a net decrease in professional fees and services as compared to 1996, including certain due diligence costs for a potential acquisition in 1996, partially offset by an increase in legal costs in 1997 as a result of the legal proceeding described in Note 9 to the Consolidated Financial Statements in Item 8.
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LIQUIDITY AND CAPITAL RESOURCES
HRP is engaged in the acquisition, ownership and operation of commercial real estate assets. While it is the General Partner's primary intention to operate HRP's existing real estate investments and to acquire and operate additional real estate investments, Realty also continually evaluates each of HRP's real estate investments in light of current economic trends and operations to determine if any should be considered for disposal.
HRP's cash position increased $7,832,000 during 1998 from $6,665,000 as of December 31, 1997 to $14,497,000 as of December 31, 1998. The sources of cash for 1998 were $66,500,000 of mortgage principal proceeds and $14,078,000 of cash provided by operating activities. Uses of cash for 1998 were $59,577,000 of mortgage principal repayments from refinancing proceeds, $6,603,000 of property and tenant improvements, $1,855,000 of mortgage prepayment penalties, $2,756,000 of scheduled mortgage principal payments, $1,405,000 of loan fees, and $550,000 of net loan reserve requirements.
As of December 31, 1998, HRP had remaining commitments for current construction projects of about $1,570,000. Additionally, HRP has estimated and budgeted for 1999 tenant and capital improvements (including the aforementioned commitments) of $7,300,000 and lease commissions of about $2,130,000.
For the foreseeable future, HRP anticipates that mortgage principal payments, tenant and capital improvements, and lease commissions will be funded by net cash from operations. The primary sources of capital to fund any future acquisitions will be proceeds from the sale or financing of one or more of its Properties.
Each quarter Realty reviews HRP's capacity to make cash distributions. HRP has not made any cash distributions since February, 1992.
MORTGAGES AND LOAN REFINANCING -
Substantially all of the buildings in eleven of HRP's Properties were encumbered by and pledged as collateral under non-recourse mortgages as of December 31, 1998. HRP has no mortgage loans maturing or requiring balloon principal payments until the year 2003. Based upon loan amortization's in effect, HRP is required to pay $2,470,000 of principal payments in 1999.
On November 16, 1998, HRP refinanced First Maryland Building's loan with a new lender. The interest rate was reduced to LIBOR plus 1.30% from LIBOR plus 3.25% and the maturity date was extended three years to April 30, 2006. The new loan does not require any principal amortization. In connection with the refinancing, HRP entered into an interest rate swap agreement to reduce its exposure to changes in interest rates, which as been designated as a hedge against HRP's variable interest exposure relating to the loan with a notional amount of $25,000,000 terminating on April 30, 2006. This agreement, which is settled monthly, effectively fixes the loan's interest rate at 6.78% compared to the previous rate of 8.47% as of November 1998.
The loan proceeds of $25,000,000 plus $15,000 of cash were used (i) to pay the outstanding principal balance of $24,531,000 with the former lender, (ii) to pay transaction costs of $284,000, and (iii) to pay a prepayment penalty of $200,000.
The remaining unamortized debt forgiveness of $7,441,000 less the prepayment penalty of $200,000 and unamortized loan costs of $18,000, all associated with the retired loan, resulted in a gain from early extinguishment of debt of $7,223,000 included in the Statement of Operations as an extraordinary item.
NEW ACCOUNTING STANDARDS -
HRP has adopted Statements of Financial Accounting Standards ("SFAS") No. 130 "Reporting on Comprehensive Income" effective January 1, 1998. HRP had no items of other comprehensive income in the years presented.
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LIQUIDITY AND CAPITAL RESOURCES (CONTINUED) -
SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information" redefines how operating segments are determined and requires disclosure of certain financial and descriptive information about a company's operating segments. HRP has evaluated the guidance under SFAS No. 131 and determined that it operates in only one segment.
SFAS No. 133 "Accounting of Derivative Instruments and Hedging Activities" was issued in June 1998 and is effective for periods beginning after June 15, 1999. It requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of the derivatives are recorded each period in current earnings of other comprehensive income depending on whether a derivative is designated as part of a hedge transaction, and if it is, the type of hedge transaction. The impact on HRP's results of operation, financial position, or cash flows will be dependent on the level and types of derivative instruments that HRP will have entered into at the time SFAS No. 133 is implemented. HRP is currently not planning on early adoption of SFAS No. 133 and has not had an opportunity to evaluate the impact of the provisions of SFAS No. 133 on its consolidated financial statements relating to future adoption.
Statement of Position ("SOP") 98-5 "Reporting on the Costs of Start-up Activities" was issued in April 1998. SOP 98-5 concluded that costs of start-up activities, including organization costs, should be expensed as incurred. HRP's early adoption of this SOP did not have a significant effect on the financial statements.
YEAR 2000 PLAN -
HRP realizes that many of the world's information systems and/or computer programs currently do not have the ability to recognize four digit date code fields and accordingly, they do not have the ability to distinguish a year that begins with "20" instead of the familiar "19". If not corrected, many computer applications could fail, become unstable, stop working altogether, or create erroneous or incorrect results. Therefore, many companies and organizations are spending considerable resources to update and modify their systems for Year 2000 compliance.
HRP developed a program to review and modify, where necessary, its computers, computer programming and building systems to process transactions and/or operate in the Year 2000 and beyond. HRP identified that its four primary business systems, which are vulnerable to the Year 2000 issue, are: (1) General Ledger/Accounts Payable/Accounts Receivable Systems - These systems were modified by the vendor at no cost to HRP during the third quarter of 1998 and are now Year 2000 compliant. (2) Commercial Lease Administration - The system used by HRP is Year 2000 compliant. (3) K-1 Processing - HRP maintains data used to process its partners Schedule K-1(s) for tax reporting purposes in an environment that is not Year 2000 compliant. HRP has selected a tested and compliant system which will be installed in 1999 at minimal cost. (4) Payroll - The General Partner processed payroll in a non-compliant system through an outside payroll vendor until Year 2000 compliant software was purchased and installed in the fourth quarter of 1998 at minimal cost.
Additionally, HRP is surveying all of its significant service providers and other external parties to determine their compliance with the Year 2000 issue and what impact, if any, their efforts will have on HRP's business and operations. This survey includes the identification of certain on-site, non-information technology systems that may be Year 2000 sensitive. Once these systems have been fully identified , we will determine, with the help of outside vendors, whether these systems are vulnerable to the Year 2000 issue. Potential non-information technology systems include, but are not limited to, access gates, alarms, elevators, heating and air conditioning systems, irrigation systems, security systems, thermostats, and utility meters and switches. HRP anticipates finalizing its survey of service providers and vendors during the second quarter of 1999.
HRP will utilize external and internal resources to reprogram, replace and test its systems for Year 2000 modifications. HRP anticipates completing the Year 2000 project, which includes repairing or replacing any vulnerable systems, by June 30, 1999. Total costs, including information and non-information technology systems, are not expected to exceed $100,000. In the event that a system will not be Year 2000 compliant, HRP will assess the potential risk and, to the extent it is feasible, transfer its business to an alternate vendor.
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LIQUIDITY AND CAPITAL RESOURCES (CONTINUED) -
Although HRP believes that it will not have any detrimental effects on its operations from Year 2000 compliance issues, there can be no assurance that the systems of other companies, on which HRP's systems may rely, will be converted timely, or converted in a manner that is compatible with HRP's systems, or that any such failures by such other companies would not have a material adverse effect or risk to HRP. HRP plans to devote all resources that would be required to resolve any such issues in a timely manner that might arise from matters not previously considered. In the event of a complete failure of our information technology systems, HRP would be able to continue the affected functions either manually or through the use of non-Year 2000 compliant systems. The primary costs associated with such a necessity would probably include (1) increased time delays associated with posting of information, and (2) increased personnel to manually process the information. HRP does not currently have a contingency plan in place and believes, based upon current knowledge, that one is not needed.
The cost of Year 2000 compliance and the estimated date of completion of necessary modifications are based on HRP's best estimates, which were derived from various assumptions of future events, including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated.
FORWARD-LOOKING STATEMENTS -
In the interest of providing investors with certain information regarding HRP's future plans and operations, certain statements set forth in this Form 10-K relate to management's future plans and objectives. Such statements are forward- looking statements. Although any forward-looking statements contained in this Form 10-K or otherwise expressed by or on behalf of HRP are, to the knowledge and in the judgment of the officers and directors of the General Partner, expected to prove true and come to pass, management is not able to predict the future with absolute certainty. Although HRP believes that the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements will prove to be accurate.
Forward-looking statements involve known and unknown risks and uncertainties, which may cause HRP's actual performance and financial results in future periods to differ materially from any projection, estimate or forecasted result. These risks and uncertainties include, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond the control of HRP; other risks and uncertainties may be described, from time to time, in HRP's periodic reports and filings with the Securities and Exchange Commission.
In addition, the dates for completion of HRP's Year 2000 plan are based on its best estimates, which were derived using numerous assumptions of future events. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from the uncertainty of the Year 2000 readiness of third-parties and the interconnection of computer systems, HRP cannot ensure its ability to timely and cost-effectively resolve problems associated with the Year 2000 issue that may affect its operations and business. Accordingly, partners and potential investors are cautioned that certain events or circumstances could cause actual results to differ materially from those projected, estimated or predicted.
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ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As part of HRP's financing activity, derivative securities are sometimes used to achieve the desired mix of fixed versus floating rate debt. HRP does not hold or issue derivative financial instruments for trading. HRP's derivative instrument, which is matched directly against an outstanding borrowing is a "pay fixed/receive variable" interest rate swap with highly rated counterparties in which the interest payments are calculated on a notional amount. The notional amount does not represent amounts exchanged by the parties and thus are not a measure of exposure to HRP through its use of the derivative. HRP is exposed to credit-related gains or losses in the event of non-performance by counterparties to this financial instrument; however, HRP does not expect any counterparties to fail to meet their obligations. The interest rate swap is described as follows (in thousands):
(a) The estimated amount that HRP would have to pay to terminate the interest rate swap agreement (used to hedge against exposure to interest rate fluctuations) as of December 31, 1998 was based on a quote received from the lender.
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ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL INFORMATION
INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTAL INFORMATION
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INDEPENDENT AUDITORS' REPORT
To the Partners of Hallwood Realty Partners, L.P.
We have audited the accompanying consolidated balance sheets of Hallwood Realty Partners, L.P. and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, partners' capital and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedule listed in the Index at Item 8. These financial statements and financial statement schedule are the responsibility of the Partnership's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based upon our audits.
We conducted our audits in accordance with generally accepted auditing standards. 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, such consolidated financial statements present fairly, in all material respects, the financial position of Hallwood Realty Partners, L.P. and subsidiaries as of December 31, 1998 and 1997 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP
Dallas, Texas February 5, 1999
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HALLWOOD REALTY PARTNERS, L.P. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS EXCEPT UNIT AMOUNTS)
See notes to consolidated financial statements.
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HALLWOOD REALTY PARTNERS, L.P. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS EXCEPT PER UNIT AMOUNTS)
See notes to consolidated financial statements.
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HALLWOOD REALTY PARTNERS, L.P. CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL (IN THOUSANDS EXCEPT UNIT AMOUNTS)
See notes to consolidated financial statements.
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HALLWOOD REALTY PARTNERS, L.P. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See notes to consolidated financial statements.
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HALLWOOD REALTY PARTNERS, L. P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 1998
1. ORGANIZATION
Hallwood Realty Partners, L.P. ("HRP" or the "Partnership"), a publicly traded Delaware limited partnership, is engaged in the acquisition, ownership and operation of commercial real estate assets. The limited partners' interests, or units, are traded on the American Stock Exchange under the symbol "HRY". As of December 31, 1998, there were 1,672,556 units outstanding.
As of December 31, 1998, HRP owned twelve real estate assets (the "Properties"), located in six states containing 5,150,000 net rentable square feet. HRP seeks to maximize the value of its real estate by making capital and tenant improvements, by executing marketing programs to attract and retain tenants, and by controlling or reducing, where possible, operating expenses.
Hallwood Realty, LLC, formerly Hallwood Realty Corporation, ("Realty" or the "General Partner"), a Delaware limited liability company and wholly-owned subsidiary of The Hallwood Group Incorporated ("Hallwood") is HRP's general partner and is responsible for asset management of HRP and its Properties, including the decision making responsibility for financing, refinancing, acquiring and disposing of properties. In addition, Realty provides general operating and administrative services to HRP. Hallwood Commercial Real Estate, LLC, formerly Hallwood Commercial Real Estate, Inc., ("HCRE"), another wholly-owned subsidiary of Hallwood, provides property management services to the Properties.
2. ACCOUNTING POLICIES
CONSOLIDATION
HRP fully consolidates into its financial statements majority owned entities and reflects a minority interest for those entities not fully owned. For each of the three years in the period ended December 31, 1998, all entities and Properties were fully owned. All significant intercompany balances and transactions have been eliminated in consolidation.
CASH AND CASH EQUIVALENTS
HRP considers highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents.
PROPERTY
Property is stated at cost. Renovations and improvements are capitalized; maintenance and repairs are expensed. When an asset is sold or otherwise disposed of, the related cost and accumulated depreciation are removed from the accounts and any gain or any previously unanticipated loss is recognized in the year of sale or disposition. HRP's management routinely reviews its investments for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.
Depreciation of buildings is computed using the straight-line method over estimated useful lives ranging from 15 to 43 years. Equipment and other improvements are depreciated on the straight-line method over estimated useful lives ranging from 3 to 23 years. Tenant improvements are capitalized and amortized over the terms of the respective leases.
During 1997, HRP completed a review of its real estate lives. In light of recent improvements and actions taken to increase its preventative maintenance programs, the estimated economic lives for buildings were found to be generally longer than the useful lives being used for depreciation purposes. Accordingly, effective January 1, 1997, HRP extended the depreciable lives of certain building costs. The effect of this change in estimate reduced depreciation and amortization expense and improved the net operating results by $7,200,000 ($4.26 per unit) for the year ended December 31, 1997.
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HALLWOOD REALTY PARTNERS, L. P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 1998
2. ACCOUNTING POLICIES - (CONTINUED)
HRP accrues for losses associated with environmental remediation obligations when such losses are probable and reasonably estimable. Accruals for estimated losses from environmental remediation obligations generally are recognized no later than completion of a remedial feasibility study. Such accruals are adjusted as further information develops or circumstances change. Costs of future expenditures for environmental remediation obligations are not discounted to their present value. Recoveries of environmental remediation costs from other parties are recorded as assets when their receipt is deemed probable. HRP's management is not aware of any environmental remediation obligations which would materially affect the operations, financial position or cash flows of HRP and therefore has made no loss accruals.
OTHER ASSETS
Lease concessions and commissions are amortized over the terms of the respective leases. Leases at the Properties expire from 1999 to 2013. Loan costs are amortized over the terms of the respective loans. The loans mature between 2003 and 2008. Amortization of lease concessions income, included in property operations revenues, was $444,000 and $157,000 in 1998 and 1997, respectively. Amortization of lease concessions expense, included in property operations revenues, was $144,000 in 1996. Amortization of lease commissions, included in depreciation and amortization expense, was $2,232,000, $2,101,000, and $1,897,000 in 1998, 1997 and 1996, respectively. Amortization of loan costs, included in interest expense, was $456,000, $453,000, and $453,000 in 1998, 1997 and 1996, respectively. The caption "Other assets" on the Consolidated Balance Sheet includes prepaid real estate taxes, prepaid insurance and other miscellaneous deposits and prepaid expenses.
REVENUE RECOGNITION
Rental income is recognized as earned on a straight-line basis over the terms of the respective leases.
INTEREST RATE AGREEMENTS
Interest rate swaps are entered into as a hedge against interest exposure of variable rate debt. Differences between amounts to be paid or received on these interest rate agreements designated as hedges are included in interest expense as the payments are made or received. HRP is exposed to credit-related gains or losses in the event of non-performance by counterparties; however, HRP does not expect any counterparties to fail to meet their obligations.
INCOME TAXES
Currently, HRP is a non-taxable entity. Federal and state income taxes, if any, are the responsibility of the individual partners. Accordingly, the Consolidated Financial Statements do not include a provision for income taxes. However, certain business and franchise taxes are the responsibility of HRP and subsidiary entities. These business and franchise taxes, included in general and administrative expenses, were $248,000, $117,000, and $206,000, in 1998, 1997, and 1996, respectively. HRP's tax returns are subject to examination by federal and state taxing authorities. If HRP's amounts are ultimately changed by the taxing authorities, the tax liability of the partners could be changed accordingly. Additionally, no assurance can be given that the federal or state governments will not pass legislation that will characterize HRP as an association taxable as a corporation for federal income tax purposes. Such classification may have an adverse effect on HRP.
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HALLWOOD REALTY PARTNERS, L. P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 1998
2. ACCOUNTING POLICIES - (CONTINUED)
COMPUTATION OF NET INCOME (LOSS) PER UNIT
Basic earnings per unit is computed by dividing net income attributable to the limited partners' interests by the weighted average number of units outstanding. Earnings per unit assuming dilution is computed by dividing net income attributable to the limited partners' interests by the weighted average number of units and potential units outstanding. Options to acquire units were issued during 1995 and are considered to be potential units. The number of potential units is computed using the treasury stock method which assumes that the increase in the number of units is reduced by the number of units which could have been repurchased by HRP with the proceeds from the exercise of these options. The options are considered antidilutive in 1996 and therefore are not taken into consideration in the computation of earnings per unit assuming dilution. The following table illustrates the amounts used to calculate the weighted average number of units outstanding:
FINANCIAL STATEMENTS AND OTHER
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of certain assets, liabilities, revenues, and expenses as of and for the reporting periods. Actual results may differ from these estimates.
HRP has adopted Statements of Financial Accounting Standards ("SFAS") No. 130 "Reporting on Comprehensive Income" effective January 1, 1998. HRP had no items of other comprehensive income in the years presented.
SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information" redefined how operating segments are determined and requires disclosure of certain financial and descriptive information about a company's operating segments. HRP has evaluated the guidance under SFAS No. 131 and determined that it operates in only one segment.
SFAS No. 133 "Accounting of Derivative Instruments and Hedging Activities" was issued in June 1998 and is effective for periods beginning after June 15, 1999. It requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of the derivatives are recorded each period in current earnings of other comprehensive income depending on whether a derivative is designated as part of a hedge transaction, and if it is, the type of hedge transaction. The impact on HRP's results of operation, financial position, or cash flows will be dependent on the level and types of derivative instruments that HRP will have entered into at the time SFAS No. 133 is implemented. HRP is currently not planning on early adoption of SFAS No. 133 and has not had an opportunity to evaluate the impact of the provisions of SFAS No. 133 on its consolidated financial statements relating to future adoption.
Statement of Position ("SOP") 98-5 "Reporting on the Costs of Start-up Activities" was issued in April 1998. SOP 98-5 concluded that costs of start-up activities, including organization costs, should be expensed as incurred. HRP's early adoption of this SOP did not have a significant effect on the financial statements.
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HALLWOOD REALTY PARTNERS, L. P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 1998
3. TRANSACTIONS WITH RELATED PARTIES
Realty receives certain fees in connection with the ongoing management of HRP, including an asset management fee, acquisition fees and incentive disposition fees. Specifically, Realty is entitled to receive (i) an asset management fee equal to 1% of the net aggregate base rents of the Properties, (ii) acquisition fees equal to 1% of the purchase price of newly acquired properties, and (iii) incentive fees for performing disposition services with respect to real estate investments, other than the properties owned at the time of HRP's formation on November 1, 1990, equal to 10% of the amount, by which the sales price of a property disposed of exceeds the purchase price of such property.
HCRE receives compensation in connection with the management of the Properties, which includes a property management fee, lease commissions and construction supervision fees. The management contracts have been extended and expire June 30, 2004 and provide for (i) basic compensation from a property management fee which is an amount equal to 2.85% of cash receipts collected from the Properties' tenants, (ii) lease commissions equal to the current market rate as applied to the net aggregate rent, not to exceed 6% of the net aggregate rent, and (iii) construction supervision fees for administering all construction projects equal to 5% of the total contracted costs of each capital expenditure or tenant improvement project.
Realty and HCRE are compensated for services provided to HRP and its Properties as described above. The following table sets forth such compensation and reimbursement paid by HRP for the periods presented (in thousands):
(a) These costs are mostly recorded as General and Administrative Expenses and represent reimbursement to Realty, at cost, for partnership level salaries, employee and director insurance and certain overhead costs. HRP pays, on a monthly basis, the balance of its account with Realty.
4. PROPERTY ACQUISITION AND PROPERTY SALE
In May 1997, HRP acquired 6.2 acres of land at the Corporate Square office complex of which about half is a parking lot and the other half is wooded land for a purchase price of $725,000, plus about $25,000 of miscellaneous costs. The purchase price consisted of a $75,000 cash down payment and a $650,000 seven year, fully-amortizing non-recourse mortgage note with 0% interest the first year; 4% interest in years two and three; 6% interest in years four and five; and 8% interest in years six and seven. For financial reporting purposes, the carrying values of the mortgage note and land were reduced by $101,000 in order to reflect an imputed market interest rate of 8% for the mortgage note.
In October 1997, HRP sold one building in Fairlane Commerce Park containing 3,500 net rentable square feet on approximately 0.5 acres for $510,000 in cash before closing expenses of $8,000. HRP recorded a $394,000 gain from the property sale.
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HALLWOOD REALTY PARTNERS, L. P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 1998
5. MORTGAGES PAYABLE
Substantially all of the buildings in eleven of HRP's Properties were encumbered and pledged as collateral by eight non-recourse mortgages aggregating $162,078,000 as of December 31, 1998. These mortgages have interest rates varying from 6.78% to 8.7% (with an effective average interest rate of 8.1%) and mature between 2003 and 2008. Cash interest payments were $13,934,000, $14,177,000, and $14,947,000, in 1998, 1997 and 1996, respectively.
Most of the mortgages require monthly principal payments with balloon payments due at maturity. The following table shows for the periods presented the principal and balloon payments that are required (in thousands):
EXECUTIVE PARK -
On February 27, 1998, HRP entered into an agreement to refinance the mortgage loan secured by Executive Park that became effective March 20, 1998. The new loan reduces the interest rate from 8.87% to an effective interest rate of 7.32% and extends the amortization period from fifteen years to twenty-seven years with a maturity date of April 11, 2008. The loan proceeds of $34,000,000 were used (i) to pay the outstanding principal balance of $28,707,000 with the former lender, (ii) to pay transaction costs of $901,000, (iii) to pay a prepayment penalty of $1,465,000, (iv) to pay $550,000 of net loan reserves, and (v) for general working capital. The prepayment penalty along with the writeoff of $146,000 of unamortized loan costs associated with the retired loan were expensed and are included in the Statement of Operations as an extraordinary item.
SEATTLE BUSINESS PARKS -
On June 1, 1998, HRP refinanced the mortgage loan secured by Seattle Business Parks into two new loans which reduced the interest rate from 9.25% to 6.97%. The new loans lengthen the amortization period from twenty-two years to thirty years and the maturity date was extended by seven years to June 7, 2008. The loan proceeds of $7,500,000 were used (i) to pay the outstanding principal balance of $6,339,000 with the former lender, (ii) to pay transaction costs of $220,000, (iii) to pay a prepayment penalty of $190,000, and (iv) for general working capital. The prepayment penalty along with the writeoff of $75,000 of unamortized loan costs associated with the retired loan were expensed and are included in the Statement of Operations as an extraordinary item.
FIRST MARYLAND BUILDING -
Effective May 1, 1996, the lender for First Maryland Building extended the loan to April 30, 2003 with an interest rate of LIBOR plus 3.25% and forgave $3,237,000 of the principal balance in addition to the $9,250,000 of forgiveness granted in September 1995. The extension required 49.9% of the property's net cash flow to be used to amortize the loan's principal balance. During 1997, an additional $144,000 of forgiveness was recorded.
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HALLWOOD REALTY PARTNERS, L. P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 1998
5. MORTGAGES PAYABLE - (CONTINUED)
For financial reporting purposes, the mortgage principal forgiveness was treated as a troubled debt restructuring and accordingly, HRP did not recognize a gain. Instead, the mortgage principal forgiveness remained on the balance sheet and was being amortized over the life of the loan. Interest expense was computed in such a way that a constant effective interest rate (equal to approximately 1.19% as of November 1998) was applied to the carrying amount of the loan.
On November 16, 1998, HRP refinanced First Maryland Building's loan with a new lender. The interest rate was reduced to LIBOR plus 1.30% from LIBOR plus 3.25% and the maturity date was extended three years to April 30, 2006. The new loan does not require any principal amortization. In connection with the refinancing, HRP entered into an interest rate swap agreement to reduce its exposure to changes in interest rates, which as been designated as a hedge against HRP's variable interest exposure relating to the loan with a notional amount of $25,000,000 terminating on April 30, 2006. This agreement, which is settled monthly, effectively fixes the loan's interest rate at 6.78% compared to the previous loan's rate of 8.47% as of November 1998.
The loan proceeds of $25,000,000 plus $15,000 of cash were used (i) to pay the outstanding principal balance of $24,531,000 with the former lender, (ii) to pay transaction costs of $284,000, and (iii) to pay a prepayment penalty of $200,000.
The remaining unamortized debt forgiveness of $7,441,000 less the prepayment penalty of $200,000 and unamortized loan costs of $18,000, all associated with the retired loan, resulted in a gain from early extinguishment of debt of $7,223,000 included in the Statements of Operations as an extraordinary item.
For federal income tax purposes, debt forgiveness of $12,487,000 was reported as a 1996 gain to the partners of HRP.
6. LEASE AGREEMENTS
The lease provisions generally require tenants to pay fixed rental amounts plus their proportionate share of certain building operating costs and real property taxes. In addition, certain leases include provisions for annual rental adjustments. Revenue from expense recoveries, included in property operations, was $2,591,000, $2,561,000, and $2,416,000 in 1998, 1997 and 1996, respectively. At December 31, 1998, the Properties, in the aggregate, were 93% occupied and minimum cash rental payments to be received under non-cancelable leases with tenants were as follows (in thousands):
During 1998, one tenant contributed more than 10% of the total revenues of the Partnership. During 1997, two tenants leasing space each contributed more than 10% of the total revenues of the Partnership. Ford Motor Company and affiliates ("Ford") leases space in Parklane Towers and Fairlane Commerce Park and contributed 13% and 15% of revenues in 1998 and 1997, respectively. The Centers for Disease Control and Prevention ("CDC"), an agency of the U.S. Department of Health and Human Services, leases space in Corporate Square and Executive Park and contributed 9% and 10% of the revenues in 1998 and 1997, respectively.
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HALLWOOD REALTY PARTNERS, L. P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 1998
6. LEASE AGREEMENTS - (CONTINUED)
As of December 31, 1998, Ford occupied 233,000 square feet of office space under 9 separate leases at Parklane Towers and 255,000 square feet of office, technical laboratory and industrial space under 9 separate leases at Fairlane Commerce Park. These leases expire between 1999 and 2003 and most contain renewal options, providing for one to ten year renewals. As of December 31, 1998, CDC occupied 218,000 square feet of office space at Executive Park under 5 leases which expire between 2001 and 2003 and 158,000 square feet of office space at Corporate Square under a lease which expires in 2013.
The remaining tenants are not concentrated in any one industry, nor is HRP otherwise dependent on any group of related tenants for 10% or more of its revenues.
7. PARTNERS' CAPITAL
HRP has adopted the disclosure-only provisions of SFAS No. 123 - "Accounting for Stock Based Compensation". Accordingly, no compensation cost has been recognized for the options. HRP issued options in 1995, which were vested over a three year period ending in 1997, and accordingly had no effect to 1998. Had compensation costs for the Options been determined based on the fair value at the grant date for the awards in 1995 consistent with the provisions of SFAS No. 123, HRP's net loss and net loss per unit for 1997 and 1996 would have been the pro forma amounts indicated below (in thousands except per unit amounts):
The fair value of the option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used: expected volatility of 57.8%, risk-free interest rate of 7.1%, expected life of 5 years and no distribution yield.
UNIT PURCHASES - 1996
HRP purchased, in private transactions, 74,760 units for $1,775,000 in May 1996 and 449 units for $12,000 in July 1996. Accordingly, HRP's outstanding units decreased from 1,747,765 Units to 1,672,556 units. In addition, the General Partner's capital account was adjusted by $18,000 in order to maintain its 1% general partner interest, in accordance with HRP's Partnership Agreement.
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HALLWOOD REALTY PARTNERS, L. P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 1998
8. ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS
Estimated fair value amounts of certain financial instruments have been determined using available market information based upon negotiations held by Realty with potential lenders or other appropriate valuation methodologies that require considerable judgment in interpreting market data and developing estimates. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Partnership could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
The fair value of financial instruments that are short-term or re-price frequently and have a history of negligible credit losses is considered to approximate their carrying value. These include cash and cash equivalents, short term receivables, accounts payable and other liabilities. Real estate and other assets consist of nonfinancial instruments.
Management has reviewed the carrying values of its mortgages payable in connection with interest rates currently available to the Partnership for borrowing with similar characteristics and maturities (approximately 7.25% and 7.75% as of December 31, 1998 and 1997, respectively) and has determined that they would equal approximately $171,921,000 and $166,871,000 (excluding the unamortized mortgage payable forgiveness at December 31, 1997 discussed in Note 4) of estimated fair value as of December 31, 1998 and 1997, respectively.
The fair value of HRP's interest rate swap agreement (used to hedge against exposure to interest rate fluctuations) is $366,000, the estimated amount that HRP would have to pay to terminate the agreement as of December 31, 1998. The amount was determined based on a quote received from its lender.
As of December 31, 1998 and 1997, the fair value information presented herein is based on pertinent information available to management. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date and, therefore current estimates of fair value may differ significantly from the amounts presented herein.
9. COMMITMENTS AND CONTINGENCIES
LITIGATION
On February 27, 1997, a lawsuit was filed in the Chancery Court for New Castle County, Delaware, styled Gotham Partners, L.P. v. Hallwood Realty Partners, L.P. and Hallwood Realty Corporation (C.A. No. 15578). The complaint sought access to certain books and records of HRP, a list of the limited partners and reimbursement of the plaintiff's expenses.
On June 20, 1997, Gotham Partners, L.P. filed a separate complaint in the Chancery Court for New Castle County, Delaware, styled Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., et al. (C.A. No. 15754), against Hallwood, HRP, Realty, and the directors of Realty, alleging claims of breach of fiduciary duties, breach of HRP's partnership agreement, fraud, and as to Hallwood, aiding and abetting these alleged breaches. At the same time as the filing of this complaint, plaintiff filed a motion to amend its complaint in the earlier action to allege the same facts and demand the same relief as plaintiff sought in the separate complaint.
On June 27, 1997, the parties entered into a Stipulation and Order under which HRP provided to plaintiff copies of certain of the documents requested. The other claims in the two actions remain outstanding.
On August 27, 1997, defendants moved to dismiss the complaint in the separate action for plaintiff's failure either to make a demand on the general partner to bring suit or to allege adequately that such a demand was futile. On February 6, 1998, the Court granted defendants' motion to dismiss but gave plaintiff thirty days to file an amended complaint. Plaintiffs filed an amended complaint on March 6, 1998, which defendants again moved to dismiss. This motion was denied and the parties are proceeding with discovery.
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HALLWOOD REALTY PARTNERS, L. P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 1998
9. COMMITMENTS AND CONTINGENCIES - (CONTINUED)
HRP's management believes that the claims are without merit and intend to defend the cases vigorously, but because of their early stages, cannot predict the outcome of the claims or any possible effect an adverse outcome might have.
HRP is from time to time involved in various legal proceedings and claims which arise in the ordinary course of business. These matters are generally covered by insurance. Management believes that the resolution of these matters will not have a material adverse effect on HRP's financial position, cash flow or operations.
ASBESTOS
Parklane Towers, as well as certain other properties to a lesser extent, are known to contain asbestos. Removal of the asbestos at Parklane Towers is estimated to cost approximately $1,700,000; however, it is not required to be removed since it is not friable and the Partnership has an Operations and Maintenance Program in place. Federal and state environmental legislation or regulations may have an impact on the future operations of Parklane Towers or certain other properties if such legislation or regulations require the immediate expenditure of funds to comply with applicable restrictions or requirements.
RIGHTS PLAN
HRP has a Unit Purchase Rights Agreement ("Rights Plan") that provides for a distribution of one right for each unit of the Partnership to holders of record at the close of business as of December 10, 1990. The rights will become exercisable only in the event, with certain exceptions, an acquiring party accumulates 15 percent or more of the Partnership's units, or if a party commences or announces an intent to commence a tender offer or exchange offer to acquire 30 percent or more of such units. The rights will expire on November 30, 2000. Each right will entitle the holder to buy one additional unit at a price of $250. In addition, upon the occurrence of certain events, holders of the rights will be entitled to purchase either Partnership units or shares in an "acquiring entity" at half of market value. HRP will generally be entitled to redeem the rights at $.01 per right at any time on or prior to the tenth day following the acquisition of a 15 percent or greater interest in its units.
OTHER
As of December 31, 1998, HRP had remaining commitments for current construction projects of about $1,570,000. Additionally, HRP has estimated and budgeted for 1999 tenant and capital improvements (including the aforementioned commitments) of $7,300,000 and lease commissions of about $2,130,000.
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HALLWOOD REALTY PARTNERS, L. P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 1998
11. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Set forth below is selected quarterly financial data for the years ended December 31, 1998 and 1997.
(a) Net income (loss) for the first and second quarter of 1998 includes losses on early extinguishments of debt of $1,611,000 and $265,000, respectively. Net income for the fourth quarter of 1998 includes a gain on early extinguishment of debt of $7,223,000. (See Note 5 to the Consolidated Financial Statements for more information about the refinancing of mortgage loans during 1998).
(b) Total revenues in the fourth quarter of 1997 include $394,000 of gain from the sale of a property.
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HALLWOOD REALTY PARTNERS, L.P. SCHEDULE III - REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1998 (IN THOUSANDS)
See notes to Schedule III on following page.
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HALLWOOD REALTY PARTNERS, L.P. NOTES TO SCHEDULE III DECEMBER 31, 1998 (IN THOUSANDS)
(A) PROPERTY LOCATIONS ARE AS FOLLOWS:
(B) RECONCILIATION OF CARRYING COSTS (in thousands):
(C) COMPUTATION OF DEPRECIATION:
Depreciation of buildings is computed using the straight-line method over estimated useful lives ranging from 15 to 43 years. Equipment and other improvements are depreciated on the straight-line method over estimated useful lives ranging from 3 to 23 years. Tenant improvements are capitalized and amortized over the term of the respective leases. Accumulated depreciation also includes loss reserves established for anticipated losses on future dispositions.
During 1997, HRP completed a review of its real estate lives. In light of recent improvements and actions taken to increase its preventative maintenance programs, the estimated economic lives for buildings were found to be generally longer than the useful lives being used for depreciation purposes. Accordingly, effective January 1, 1997, HRP extended the depreciable lives of certain building costs. The effect of this change in estimate reduced depreciation and amortization expense by $7,200,000.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None.
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PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Partnership has no officers or directors. Realty, as general partner of the Partnership, performs all functions ordinarily performed by officers and directors. Realty was originally incorporated in Delaware in January 1990 and became a limited liability company formed in Delaware in December 1998.
BUSINESS EXPERIENCE OF DIRECTORS AND OFFICERS OF REALTY -
ANTHONY J. GUMBINER, 54, CHAIRMAN OF THE BOARD AND DIRECTOR OF REALTY
Mr. Gumbiner has served as Chairman of the Board of Directors of Hallwood since 1981 and as its Chief Executive Officer since April 1984. He has served as Chairman of the Board of Directors since May 1984 and Chief Executive Officer since February 1987 of the general partner of Hallwood Energy Partners, L.P. ("HEP"). He has also served as the managing director of Hallwood Holdings S.A. ("HHSA") since March 1984; as a director of Realty since 1990; and as a director of Hallwood Consolidated Resources Corporation ("HCRC") since 1992. Mr. Gumbiner is also a Solicitor of the Supreme Court of Judicature of England.
BRIAN M. TROUP, 51, DIRECTOR OF REALTY
Mr. Troup has served as a director of Hallwood since 1981 and as President and Chief Operating Officer of Hallwood since April 1986. Mr. Troup has served as a director of the general partner of HEP since May 1984. He also has served as a director of HCRC since 1992; as a director of HHSA since March 1984; and as a director of Realty since 1990. He is an associate of the Institute of Bankers in Scotland and a member of the Society of Investment Analysts in the United Kingdom.
WILLIAM L. GUZZETTI, 55, PRESIDENT AND DIRECTOR OF REALTY
Mr. Guzzetti has been President and a director of Realty since January 1990. He has served as Executive-Vice President of Hallwood since October 1989 and as President and a director of HCRC since 1992. Mr. Guzzetti has been President and a director of the general partner of HEP since February 1985.
JOHN G. TUTHILL, 55, EXECUTIVE VICE PRESIDENT AND SECRETARY
Mr. Tuthill has been an Executive Vice President and Secretary of Realty since January 1990. Mr. Tuthill joined Hallwood in October 1989 to head all property management functions, having previously served as President of Southmark Commercial Management since November 1986, where he was responsible for a diversified real estate portfolio of over 18,000,000 square feet.
UDO H. WALTHER, 50, EXECUTIVE VICE PRESIDENT
Mr. Walther has been an Executive Vice President of Realty since November 1, 1998. Mr. Walther was a member of the Board of Directors of Realty from June 17, 1994 to November 1, 1998. Mr. Walther had been President and Chief Executive Officer of Walther Group, Inc., a full service design and construction consultancy, and President of Precept Builders, Inc. from 1991 to 1998. Previously, Mr. Walther was a Partner at Trammell Crow Company, Project Manager with HCB Contractors and Marketing Vice President for Researched Investments, Ltd.
JEFFREY D. GENT, 51, VICE PRESIDENT - FINANCE
Mr. Gent has been the Vice President-Finance of Realty since March 1990, having previously served as Vice President Finance of Southmark Commercial Management since September 1984, where he was responsible for the financial functions of a diversified real estate portfolio of over 18,000,000 square feet.
ALAN G. CRISP, 57, DIRECTOR OF REALTY
Mr. Crisp was Chairman and Chief Executive Officer of Atlantic Metropolitan Holdings (U.K.) plc from 1979 until 1988, when he joined Interallianz Bank Zurich AG. From 1988 to 1993, he was General Manager of the London Office of the Bank. Since 1994, Mr. Crisp has been a consultant for various international companies. He is a Fellow of the Royal Institution of Chartered Surveyors and holds a B.A. (Hons) Degree.
WILLIAM F. FORSYTH, 49, DIRECTOR OF REALTY
Mr. Forsyth has been Chairman of Kildalton & Co., an investment management consultancy based in Edinburgh, Scotland since 1992. He graduated in law at Edinburgh University in 1971, and is a member of the Society of Investment Analysts in the United Kingdom.
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ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - (CONTINUED)
EDWARD T. STORY, 55, DIRECTOR OF REALTY
Mr. Story has been President and Chief Executive Officer of SOCO International, plc, an oil and gas company, since September, 1991. Prior to September 1991, he was Founder and Chairman of Thaitex Petroleum Company, Co-founder and Chief Financial Officer of Conquest Exploration Company, the Chief Financial Officer for Superior Oil Company and Exploration and Production Controller with Exxon Corporation.
Section 16(a) of the Securities and Exchange Act of 1934 requires a registrant's officers and directors, if any, and persons who own more than ten percent of a registered class of HRP's equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission (the "SEC") and the American Stock Exchange. Officers, directors and greater than ten percent shareholders are required by the SEC regulations to furnish HRP with copies of all Section 16(a) forms they file. Based solely on a review of the copies of such forms furnished to HRP, or written representations that no Forms 5 were required, HRP believes that during the period January 1, 1998 to December 31, 1998, all Section 16(a) filing requirements applicable to its officers and directors were complied with.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
COMPENSATION COMMITTEE INTERLOCKS, INSIDER PARTICIPATION AND COMPENSATION OF DIRECTORS
Realty does not have a compensation committee and compensation decisions are made by the Board of Directors of Realty. During 1998, Messrs. Gumbiner, Troup and Guzzetti served on the Board of Directors of Realty and the compensation committee of Hallwood Energy. Mr. Gumbiner is also Chief Executive Officer of Hallwood, Realty and the general partner of HEP. Mr. Troup is also President and Chief Operating Officer of Hallwood. Mr. Guzzetti is also President and Chief Operating Officer of Realty, Chief Operating Officer and President of the general partner of HEP, and Executive Vice President of Hallwood. Messrs. Forsyth, Crisp, Story and Walther were each paid $20,000 in each of the three years ended December 31, 1998 for director fees.
Realty receives certain fees in connection with the ongoing management of HRP, including an asset management fee, acquisition fees and incentive disposition fees. Specifically, Realty is entitled to receive (i) an asset management fee equal to 1% of the net aggregate base rents of the Properties, (ii) acquisition fees equal to 1% of the purchase price of newly acquired properties, and (iii) incentive fees for performing disposition services with respect to real estate investments, other than the properties owned at the time of HRP's formation on November 1, 1990, equal to 10% of the amount, by which the sales price of a property disposed of exceeds the purchase price of such property.
HCRE receives compensation in connection with the management of the Properties, which includes a property management fee, lease commissions and construction supervision fees. The management contracts expire June 30, 1999 and provide for (i) basic compensation from a property management fee which is an amount equal to 2.85% of cash receipts collected from the Properties' tenants, (ii) lease commissions equal to the current market rate as applied to the net aggregate rent, not to exceed 6% of the net aggregate rent, and (iii) construction supervision fees for administering all construction projects equal to 5% of the total contracted costs of each capital expenditure or tenant improvement project.
Realty and HCRE are compensated for services provided to HRP and its Properties as described above. The following table sets forth such compensation and reimbursement paid by HRP for the periods presented (in thousands):
(a) These costs are mostly recorded as General and Administrative Expenses and represent reimbursement to Realty, at cost, for partnership level salaries, employee and director insurance and certain overhead costs. HRP pays, on a monthly basis, the balance of its account with Realty.
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ITEM 11. EXECUTIVE COMPENSATION - (CONTINUED)
CASH COMPENSATION OF EXECUTIVE OFFICERS
The Partnership has no executive officers, however, employees of Realty (general partner of the Partnership) perform all functions ordinarily performed by executive officers. The following table sets forth annual compensation information for the Chief Executive Officer and the three other executive officers with earnings that exceeded $100,000 for the year ended December 31, 1998.
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(a) Represents executive officers' gross salary before contributions to the qualified 401(k) Tax Favored Savings Plan. .
(b) Represents employer matching contributions to the 401(k) Tax Favored Savings Plan or payments in lieu thereof . made under a special bonus arrangement.
The following table discloses for each of the executive officers of Realty, who have been granted options to purchase securities . of HRP the number of such options held by each of the executive officers and the potential realizable values for their options at December 31, 1998. None of the executive officers exercised any options during the year ended December 31, 1998 and HRP has not granted SARs.
AGGREGATED OPTION/SAR EXERCISES IN 1998 AND OPTION/SAR VALUES AT DECEMBER 31, 1998
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ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth information as of March 5, 1999 concerning the number of Partnership units owned beneficially by (l) the persons who, to the knowledge of the management, beneficially owned more than 5% of the units outstanding on such date, (2) each director and (3) the present directors and executive officers of Realty as a group:
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(a) Unless otherwise indicated, each of the persons named has sole voting and investment power with respect to the units reported.
(b) PMG is an Investment Advisor registered under Section 203 of the Investment Advisers Act of 1940 with sole power to vote or direct the vote of all the units, including their directly-owned 840 units. PMG also has sole power to dispose or direct the disposition of all of the units.
(c) Represents the following address: c/o Hallwood Realty, LLC, 3710 Rawlins, Suite 1500, Dallas, Texas, 75219.
(d) Comprised of currently exercisable options to purchase 25,800 units.
(e) Includes currently exercisable options to purchase 15,000 units.
(f) Comprised of currently exercisable options to purchase 17,200 units.
(g) Includes currently exercisable options to purchase 78,000 units.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
For information covered by this item, see Note 3 to the Registrant's financial statements included in Item 8 hereof.
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PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(1) Financial Statements.
See Index contained in Item 8.
(2) Reports on Form 8-K.
No reports on Form 8-K were filed during the fourth quarter of 1998 or in 1999 prior to the filing of this Form 10-K for the year ended December 31, 1998.
(3) Exhibits and Reports on Form 8-K.
The response to this portion of Item 14 is incorporated by reference as detailed in the Exhibit Index.
(4) Financial Statement Schedules.
See Index contained in Item 8.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
HALLWOOD REALTY PARTNERS, L.P. BY: HALLWOOD REALTY, LLC GENERAL PARTNER
DATE: March 10, 1999 BY: /s/ WILLIAM L. GUZZETTI -------------- -------------------------------------- William L. Guzzetti President and Chief Operating Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K for the year ended December 31, 1998, has been signed below by the following persons on behalf of the Registrant in the capacities and on the date indicated.
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
INDEX TO EXHIBITS