PARKWAY PROPERTIES, INC.

FORM 10-Q

TABLE OF CONTENTS
FOR THE QUARTER ENDED MARCH 31, 2008

Part I. Financial Information

 

See notes to consolidated financial statements.

 

 

See notes to consolidated financial statements.

 

 

 

See notes to consolidated financial statements.

 

Page 5 of 32

 

 

 

 

See notes to consolidated financial statements.

 

Page 6 of 32

 

Parkway Properties, Inc.
Notes to Consolidated Financial Statements (Unaudited)
March 31, 2008

(1)           Basis of Presentation

 

                The consolidated financial statements include the accounts of Parkway Properties, Inc. ("Parkway" or "the Company"), its wholly-owned subsidiaries and joint ventures in which the Company has a controlling interest.  The other partners' equity interests in the consolidated joint ventures are reflected as minority interests in the consolidated financial statements.  Parkway also consolidates subsidiaries where the entity is a variable interest entity and Parkway is the primary beneficiary, as defined in FASB Interpretation 46R, Consolidation of Variable Interest Entities ("FIN 46R").  All significant intercompany transactions and accounts have been eliminated in the accompanying financial statements.

                The Company determines consolidation for joint ventures based on standards set forth in EITF 96-16, Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights; EITF 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights; Statement of Position 78-9, Accounting for Investments in Real Estate Ventures; and FIN 46R.  Based on the guidance set forth in these pronouncements, the Company consolidates certain joint ventures where it exercises significant control over major operating and management decisions, or where the Company is the sole general partner and the limited partners do not possess kick-out rights or other substantive participating rights or where the entity is a variable interest entity and Parkway is the primary beneficiary.  The equity method of accounting is used for those joint ventures that do not meet the criteria for consolidation and where Parkway exercises significant influence but does not control these joint ventures.

 

                The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by United States generally accepted accounting principles for complete financial statements.

 

                The accompanying financial statements reflect all adjustments which are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented.  All such adjustments are of a normal recurring nature.  Operating results for the three months ended Mach 31, 2008 are not necessarily indicative of the results that may be expected for the year ended December 31, 2008.  The financial statements should be read in conjunction with the annual report and the notes thereto.

 

                The balance sheet at December 31, 2007 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by United States generally accepted accounting principles for complete financial statements.

 

                In December 2007, the FASB issued SFAS No. 141(R), "Business Combinations" (SFAS No. 141R), which revised the previously issued SFAS No. 141 (SFAS No. 141).  SFAS No. 141R retains the fundamental requirements of SFAS No. 141, but expands the scope to include all transactions and other events in which one entity obtains control over one or more other businesses.  SFAS No. 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.  SFAS No. 141R requires that the acquisition related transaction costs be expensed as incurred.  SFAS No. 141R also includes new disclosure requirements. The Company is currently evaluating the impact of SFAS No. 141R on the Company's consolidated financial statements.

 

In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements-an amendment of ARB No. 51" (SFAS No. 160).  SFAS No. 160 amends ARB No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary.  SFAS No. 160 also amends certain of ARB No. 51's consolidation procedures for consistency with the requirements of SFAS No. 141R.  SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008.  The Company is currently evaluating the impact of SFAS No. 160 on the Company's consolidated financial statements.

 

(2)           Net Loss Per Common Share

                Basic earnings per share ("EPS") are computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period.  In arriving at income available to common stockholders, preferred stock dividends are deducted.  Diluted EPS reflects the potential dilution that could occur if share equivalents such as employee stock options, restricted shares and deferred incentive share units were exercised or converted into common stock that then shared in the earnings of Parkway.

The computation of diluted EPS is as follows (in thousands, except per share data):

 

 

                The computation of diluted EPS for the three months ended March 31, 2008 and 2007 did not include the effect of share equivalents because their inclusion would have been anti-dilutive.

 

(3)           Supplemental Cash Flow Information and Schedule of Non-Cash Investing and Financing Activity

 

                The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.

 

 

(4)                 Acquisitions

 

                On January 18, 2008, the discretionary fund with Ohio PERS (the "Fund"), of which Parkway owns 25%, purchased Gateway Center, a 228,000 square foot office property in the central business district of Orlando, Florida for a purchase price of $55.0 million.  The Fund expects to spend an additional $2.8 million for closing costs, building improvements, leasing costs and tenant improvements during the first two years of ownership.  The purchase was funded with a $33.0 million first mortgage placement by the Fund and with equity contributions from the partners. 

 

                On January 31, 2008, the Company purchased Desert Ridge Corporate Center, a 293,000 square foot office project in Phoenix, Arizona for a purchase price of $81.6 million on behalf of the Fund.  An additional $2.3 million is expected to be spent for closing costs, building improvements, leasing costs and tenant improvements during the first two years of ownership.  The purchase was funded with a $49.2 million first mortgage placement and with equity contributions from the partners.  Due to the Fund's $80.0 million limit on a single investment, Parkway's effective ownership interest in this asset is 26.5%.  

                On February 15, 2008, the Company purchased Citicorp Plaza, a 600,000 square foot office project in Chicago, Illinois for a purchase price of $100.0 million on behalf of the Fund.  An additional $9.2 million is expected to be spent for closing costs, building improvements, leasing costs and tenant improvements during the first two years of ownership.  The purchase was funded with a $60.0 million first mortgage placement and with equity contributions from the partners.  Due to the Fund's $80.0 million limit on a single investment, Parkway's effective ownership interest in this asset is 40%.

 

                The amount of purchase price allocated to intangible assets and (liabilities) and weighted average amortization period (in years) for each class of asset or liability for Gateway Center, Desert Ridge Corporate Center and Citicorp Plaza is as follows (in thousands, except weighted average life):

 

 

(5)           Office Property Development

 

                As of March 31, 2008, the Company had incurred $19.2 million in total development costs for the construction of The Pinnacle at Jackson Place, which is a 194,000 square foot Class A+ office building development adjacent to the Company's headquarters building in Jackson, Mississippi.  The estimated cost of the development is $48.5 million with expected completion in the fall of 2008.  The Company has received commitments to lease approximately 70% of the new office space from four major customers.  Parkway is considering a joint venture structure for the development whereby Parkway will retain an ownership interest of approximately 20%.  The development is designed to utilize benefits available under the Gulf Opportunity Zone Act for new developments in areas affected by Hurricane Katrina.

 

(6)           Mortgage Loan

 

                On November 7, 2007, the Company purchased the B participation piece (the "B piece") of a first mortgage secured by an 844,000 square foot office building in Dallas, Texas known as 2100 Ross for $6.9 million.  The B piece was originated by Wachovia Bank, N.A. and has a face value of $10 million and a stated coupon rate of 6.065%.  Upon maturity in May 2012, the Company will receive a principal payment of $10 million, which produces a yield to maturity of 15.6%.  The balance of the mortgage loan was $7.1 million as of March 31, 2008.

 

(7)           Investment in Unconsolidated Joint Ventures

 

In addition to the 63 office and parking properties included in the consolidated financial statements, the Company is also invested in four unconsolidated joint ventures with unrelated investors.  These investments are accounted for using the equity method of accounting, as Parkway does not control any of these joint ventures.  Accordingly, the assets and liabilities of the joint ventures are not included on Parkway's consolidated balance sheets as of March 31, 2008 and December 31, 2007.  Information relating to these unconsolidated joint ventures is detailed below (in thousands).

 

        Cash distributions from unconsolidated joint ventures are made to each partner based on their percentage of ownership in each entity.  Cash distributions made to partners in joint ventures where the percentage of debt assumed is disproportionate to the ownership percentage in the venture is distributed based on each partner's share of cash available for distribution before debt service, based on their ownership percentage, less the partner's share of debt service based on the percentage of debt assumed by each partner.

 

                Parkway provides management, construction and leasing services for all of the unconsolidated joint ventures except for the Wink-Parkway Partnership, and receives market based fees for these services.  The portion of fees earned on unconsolidated joint ventures attributable to Parkway's ownership interest is eliminated in consolidation.

 

                Balance sheet information for the unconsolidated joint ventures is summarized below as of March 31, 2008 and December 31, 2007 (in thousands):

 

 

        (a)   The mortgage debt, all of which is non-recourse, is collateralized by the individual real estate properties within each venture.

 

In most cases the Company's share of debt related to its unconsolidated joint ventures is the same as its ownership percentage in the venture.  However, in the case of the Rubicon Joint Venture and the Maitland Joint Venture, the Company's share of debt is disproportionate to its ownership percentage.  The disproportionate debt structure was created to meet the Company's partner's financing criteria.  In the Rubicon Joint Venture, Parkway owns a 20% interest in the venture but assumed 13.85% of the debt.  In the Maitland Joint Venture, the Company owns a 20% interest in the venture and assumed none of the debt. The terms related to Parkway's share of unconsolidated joint venture mortgage debt are summarized below (in thousands):

 

               

The following table presents Parkway's proportionate share of principal payments due for mortgage debt in unconsolidated joint ventures as of March 31, 2008 (in thousands):

 

                Income statement information for the unconsolidated joint ventures is summarized below for the three months ending March 31, 2008 and 2007 (in thousands):

 

 

 

 

 

 

(8)           Capital and Financing Transactions

 

                As of March 31, 2008, the Company had a total of $257.7 million outstanding under bank lines of credit and was in compliance with all loan covenants under the credit facility.  The Company's bank lines of credit allow Parkway to borrow up to a combined $311.0 million.  Based on the loan covenants, the Company had $25.4 million in additional capacity available on bank lines of credit as of March 31, 2008, and approximately $44.0 million in additional capacity at May 2, 2008, based on the $60.0 million mortgage refinance as discussed in Note 12 - Subsequent Events.

 

                In connection with the Fund investments during the first quarter of 2008 discussed in Note 4 - Acquisitions, total non-recourse first mortgage debt was placed in the amount of $142.2 million at a weighted average interest rate of 5.7%.  The portion of mortgage debt attributable to the Fund was $129.2 million, and $13.0 million was attributable to Parkway.  The mortgages are secured by the respective properties, have one to three year interest only periods and mature in 2016.

 

                On August 3, 2007, the Board of Directors authorized the repurchase of up to 1.7 million shares of Parkway's outstanding common stock through July 30, 2008.  The shares may be purchased in the open market or in privately negotiated transactions, and at times and in amounts that the Company deems appropriate.  In 2007, the Company had purchased approximately 687,000 shares for $29.1 million, which equates to an average price of $42.36 per share.  No shares were purchased under this authorization during the quarter ended March 31, 2008.

 

                On February 1, 2008, the Company paid off two mortgage notes payable secured by the 400 North Belt and Woodbranch buildings in Houston, Texas with a total principal balance of $3.5 million with advances under bank lines of credit.  The mortgages had an interest rate of 8.25% and were scheduled to mature on August 1, 2011.  The Company recognized a total of $401,000 in expense associated with the prepayment of these mortgages. 

 

(9)   Minority Interest - Real Estate Partnerships

 

The Company has an interest in two joint ventures that are included in its consolidated financial statements. Information relating to these consolidated joint ventures is detailed below.

 

Moore Building Associates, LP ("MBALP") was established for the purpose of owning a commercial office building (the Toyota Center in Memphis, Tennessee).  In acting as the general partner, Parkway is committed to providing additional funding to meet partnership operating deficits up to an aggregate amount of $1 million.  Parkway receives income from MBALP in the form of interest from a construction note receivable, incentive management fees and property management fees.  Parkway also receives interest income on a note receivable from Parkway Moore, LLC ("PMLLC").  Any intercompany asset, liability, revenue and expense accounts between Parkway and MBALP and PMLLC have been eliminated.

 

Parkway serves as the general partner of Parkway Properties Office Fund, LP (the "Fund") and provides asset management, property management, leasing and construction management services to the Fund, for which it is paid market-based fees.  Cash distributions from the Fund are made to each joint venture partner based on their percentage of ownership in the Fund.  Since Parkway is the sole general partner and has the authority to make major decisions on behalf of the Fund, Parkway is considered to have a controlling interest.  Accordingly, Parkway is required to include the Fund in its consolidated financial statements.  As of February 15, 2008, the Fund was fully invested.

 

Minority interest in real estate partnerships represents the other partners' proportionate share of equity in the partnerships discussed above at March 31, 2008.  Income is allocated to minority interest based on the weighted average percentage ownership during the year.

 

(10)         Share Based Compensation

 

                Effective January 1, 2003, the stockholders of the Company approved Parkway's 2003 Equity Incentive Plan (the "2003 Plan") that authorized the grant of up to 200,000 equity based awards to employees of the Company.  At present, it is Parkway's intention to grant restricted shares and/or deferred incentive share units instead of stock options.  Restricted shares and deferred incentive share units are valued based on the New York Stock Exchange closing market price of Parkway common shares (NYSE ticker symbol, PKY) as of the date of grant.

 

                Compensation expense, including estimated forfeitures, is recognized over the expected vesting period, which is four to seven years from grant date for restricted shares subject to service conditions and four years from grant date for deferred incentive share units.  Certain restricted shares have been granted to officers of the Company where vesting is contingent upon achieving the cumulative goals of the GEAR UP Plan, which began January 1, 2006 and ends December 31, 2008.  Compensation expense will not be recorded on the shares that vest based on performance conditions until the Company determines that it is probable that the goal will be achieved.  Therefore, no expense has been recorded in 2006, 2007 and 2008 for these shares.

 

Compensation expense related to restricted shares and deferred incentive share units of $454,000 and $353,000 was recognized for the three months ending March 31, 2008 and 2007, respectively.  Total compensation expense related to nonvested awards subject to service conditions not yet recognized was $5.0 million as of March 31, 2008.  The weighted average period over which this expense is expected to be recognized is approximately 2.8 years.  Total potential compensation expense associated with shares that vest based on performance conditions is $1.5 million as of March 31, 2008.

 

                Restricted shares and deferred incentive share units are forfeited if an employee leaves the Company before the vesting date.  Shares and/or units that are forfeited become available for future grant under the 2003 Plan.

 

                During the three months ended March 31, 2008, the Board of Directors approved the grant of 38,017 restricted shares to officers of the Company.  The shares were valued at $1.2 million and 36,975 shares will vest four years from grant date and 1,042 shares will vest subject to achievement of the cumulative goals of the GEAR UP plan, which will end on December 31, 2008. 

                A summary of the Company's restricted shares and deferred incentive share unit activity for the three months ended March 31, 2008 is as follows:

 

 (11)        Segment Information

 

                Parkway's primary business is the ownership and operation of office properties. The Company accounts for each office property or groups of related office properties as an individual operating segment.  Parkway has aggregated its individual operating segments into a single reporting segment due to the fact that the individual operating segments have similar operating and economic characteristics.

 

                The Company believes that the individual operating segments exhibit similar economic characteristics such as being leased by the square foot, sharing the same primary operating expenses and ancillary revenue opportunities and being cyclical in the economic performance based on current supply and demand conditions.  The individual operating segments are also similar in that revenues are derived from the leasing of office space to customers and each office property is managed and operated consistently in accordance with Parkway's standard operating procedures.  The range and type of customer uses of our properties is similar throughout our portfolio regardless of location or class of building and the needs and priorities of our customers do not vary from building to building. Therefore, Parkway's management responsibilities do not vary from location to location based on the size of the building, geographic location or class.

 

The management of the Company evaluates the performance of the reportable office segment based on funds from operations applicable to common shareholders ("FFO").  Management believes that FFO is an appropriate measure of performance for equity REITs and computes this measure in accordance with the National Association of Real Estate Investment Trusts' ("NAREIT") definition of FFO.  Funds from operations is defined by NAREIT as net income (computed in accordance with generally accepted accounting principles "GAAP"), excluding gains or losses from sales of property and extraordinary items under GAAP, plus depreciation and amortization, and after adjustments to derive the Company's pro rata share of FFO of consolidated and unconsolidated joint ventures.  Further, the Company does not adjust FFO to eliminate the effects of non-recurring charges.  The Company believes that FFO is a meaningful supplemental measure of its operating performance because historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time, as reflected through depreciation and amortization expenses.  However, since real estate values have historically risen or fallen with market and other conditions, many industry investors and analysts have considered presentation of operating results for real estate companies that use historical cost accounting to be insufficient.  Thus, NAREIT created FFO as a supplemental measure of operating performance for real estate investment trusts that excludes historical cost depreciation and amortization, among other items, from net income, as defined by GAAP.  The Company believes that the use of FFO, combined with the required GAAP presentations, has been beneficial in improving the understanding of operating results of real estate investment trusts among the investing public and making comparisons of operating results among such companies more meaningful.  FFO as reported by Parkway may not be comparable to FFO reported by other REITs that do not define the term in accordance with the current NAREIT definition.  Funds from operations do not represent cash generated from operating activities in accordance with accounting principles generally accepted in the United States and is not an indication of cash available to fund cash needs.  Funds from operations should not be considered an alternative to net income as an indicator of the Company's operating performance or as an alternative to cash flow as a measure of liquidity.

The following is a reconciliation of FFO and net income available to common stockholders for office properties and total consolidated entities for the three months ending March 31, 2008 and 2007.  Amounts presented as "Unallocated and Other" represent primarily income and expense associated with providing management services, corporate general and administration expense, interest expense on unsecured lines of credit and preferred dividends.

 

 

(12)         Subsequent Events

 

With the Fund with Ohio PERS fully invested, management is now focused on establishing a second discretionary fund.  Subsequent to March 31, 2008, the Teacher Retirement System of Texas ("TRS") approved a $262.5 million equity commitment to Parkway Properties Office Fund II, LP.  The equity commitment is subject to the execution of a partnership agreement and no assurance can be given that an agreement will be reached. 

 

On April 4, 2008, the Company entered into an interest rate swap agreement with US Bank.  The interest rate swap is for a $23.5 million notional amount and fixes the 30-day LIBOR interest rate at 4.05%, which equates to a total interest rate of 5.55%, for the period January 1, 2009 through December 1, 2014.  The swap serves as a hedge of the variable interest rates on a portion of the debt placed on the Pinnacle development.

 

On May 2, 2008, the Company completed a $60.0 million recourse mortgage loan related to the refinance of a $41.7 million mortgage that was scheduled to mature in September 2008.  The loan is secured by the Company's Capital City Plaza building in Atlanta, Georgia.  The interest rate on the loan is a variable rate based on LIBOR plus 165 basis points.  The loan term is for two years, with a one-year extension option at the Company's discretion. The excess loan proceeds of approximately $18.4 million were used to pay down the Company's bank line of credit.  The Company will record a gain on the prepayment of approximately $500,000 associated with the write off of the debt premium in the second quarter of 2008.  The mortgage represented the Company's only outstanding maturity in 2008. 

 

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations.

 
Overview

 

Parkway is a self-administered and self-managed REIT specializing in the operation, leasing, acquisition and ownership of office properties.  The Company performs these services for its own account and for other institutional investors through co-ownership structures such as discretionary funds and/or partnerships.  The Company is geographically focused on the Southeastern and Southwestern United States and Chicago.  As of April 1, 2008, Parkway owned or had an interest in 69 office properties located in 11 states with an aggregate of approximately 14.1 million square feet of leasable space.  Included in the portfolio are one discretionary fund and several partnership arrangements which encompass 21 properties totaling 3.8 million square feet, representing 27% of the portfolio.  With the discretionary fund and/or partnerships, the Company receives fees for asset management, property management, leasing and construction management services and potentially receives incentive fees upon sale if certain investment targets are achieved.  Increasing the number of co-investments, and consequently the related fee income, is part of the Company's strategy to transform itself to an operator-owner versus an owner-operator.   The strategy highlights the Company's strength in providing excellent service in the operation and acquisition of office properties for investment clients in addition to its direct ownership of real estate assets. Fee-based real estate services are offered through the Company's wholly owned subsidiary, Parkway Realty Services LLC, which also manages and/or leases approximately 1.8 million square feet for third party owners as of April 1, 2008. A significant phase of the transformation to an operator-owner is currently under way through the Company's GEAR UP Plan, which started January 1, 2006 and ends December 31, 2008.  The Company generates revenue primarily by leasing office space to its customers and providing management and leasing services to third party office property owners (including joint venture interests).  The primary drivers behind Parkway's revenues are occupancy, rental rates and customer retention. 

Occupancy.  Parkway's revenues are dependent on the occupancy of its office buildings.  As of April 1, 2008, occupancy of Parkway's office portfolio was 90.3% compared to 92.0% as of January 1, 2008 and 90.9% as of April 1, 2007.  Not included in the April 1, 2008 occupancy rate are 19 signed leases totaling 128,000 square feet, which commence during the second through third quarters of 2008 and will raise Parkway's percentage leased to 91.2%.  To combat rising vacancy, Parkway utilizes innovative approaches to produce new leases.  These include the Broker Bill of Rights, a short-form service agreement and customer advocacy programs which are models in the industry and have helped the Company maintain occupancy around 90% during a time when the national occupancy rate is approximately 87%.  Parkway projects average occupancy of approximately 93% during 2008 for its office properties.

Rental Rates.  An increase in vacancy rates has the effect of reducing market rental rates and vice versa.  Parkway's leases typically have three to seven year terms.  As leases expire, the Company replaces the existing leases with new leases at the current market rental rate.  As of April 1, 2008, Parkway had $1.30 per square foot in rental rate embedded growth in its office property leases.  Embedded growth is defined as the difference between the weighted average in place cash rents and the weighted average market rental rate.  

Customer Retention.  Keeping existing customers is important as high customer retention leads to increased occupancy, less downtime between leases, and reduced leasing costs.  Parkway estimates that it costs five to six times more to replace an existing customer with a new one than to retain the customer.  In making this estimate, Parkway takes into account the sum of revenue lost during downtime on the space plus leasing costs, which rise as market vacancies increase.  Therefore, Parkway focuses a great deal of energy on customer retention.  Parkway's operating philosophy is based on the premise that it is in the customer retention business.  Parkway seeks to retain its customers by continually focusing on operations at its office properties.  The Company believes in providing superior customer service; hiring, training, retaining and empowering each employee; and creating an environment of open communication both internally and externally with customers and stockholders.  Over the past ten years, Parkway maintained an average 73% customer retention rate.  Parkway's customer retention for the quarter ending March 31, 2008 was 57.6% compared to 77.2% for quarter ending December 31, 2007 and 52.4% for the quarter ending March 31, 2007.  The largest lease that was not retained during the quarter ending March 31, 2008 was First NLC Financial Services ("FNLC"), a 50,100 square foot customer in Ft. Lauderdale, Florida, that declared bankruptcy in early 2008.  Excluding FNLC, the Company's customer retention rate was 62.7% for the quarter ending March 31, 2008.

Strategic Planning.   Parkway is a focused office REIT with a hands-on, service-oriented approach, a disciplined asset allocation program and a willingness to recycle assets.  However, we see the future transformation taking Parkway from being an owner-operator to being an operator-owner.  On January 1, 2006, the Company initiated a new three-year operating plan referred to as the "GEAR UP" Plan that will serve as the spring board to transform Parkway from being first an owner of real estate and secondarily an operator of real estate for others to being first an operator of real estate for others that also owns an interest in the real estate.  The goals of the GEAR UP Plan are as follows:

 

o      Great People.  Great customer service starts with hiring great people, training them well and retaining them.  It will take great people to accomplish the ambitious goals of the Plan.

 

o      Equity Opportunities.  Over the last several years management has created a broad array of equity opportunities for Parkway.  On the private equity side this includes the use of discretionary funds, such as the Fund with Ohio PERS, and partnerships.  The judicious use of private equity provides a greater return on equity to the public shareholders. Parkway intends to contribute assets from its balance sheet to form new joint ventures and expects these subsequent ventures to be similar to discretionary funds in their duration and economics. On the public equity side, this includes the judicious use of common equity and preferred equity to manage the balance sheet and growth. 

 

o      Asset Recycling. The Company has demonstrated its willingness in the past to sell assets when management believed the time was right.  At the start of the GEAR UP Plan, Parkway identified 25 buildings in twelve markets, totaling approximately 5 million rentable square feet to be part of the asset recycling program.  Most of these properties are smaller assets or located in smaller markets that do not fit with the Company strategy of owning larger assets in institutional markets.  The dispositions that are planned will help align the Company's portfolio with its current acquisition criteria, which focuses on larger properties in institutional markets.  In most cases, Parkway will seek to keep a 10% to 30% joint venture interest in the properties being recycled and retain management and leasing agreements.  This is a fluid list of assets based on the Company's evaluation of specific market conditions and review of the portfolio.  The other side of Asset Recycling is the reinvestment of proceeds from dispositions into other assets, either owned in the fee-simple format or owned jointly with a partner.

 

                These two goals, Equity Opportunities and Asset Recycling, are what combine to transform Parkway from being an owner-operator to being an operator-owner.  Management strongly believes that these actions will result in Parkway better leveraging its core strength of operating office properties and will be advantageous for the Company's shareholders over the long term.  So whether we are in  an economy characterized by growth or recession, we believe purchasing assets with a good partner and leveraging our operating expertise through earning recurring fees allows us to increase our core portfolio in larger and more institutional markets and increase our earnings potential from the services provided.

o     Retain Customers.  Customer retention remains the cornerstone of the Company's business and is why partners choose to partner with Parkway.  The goal is a customer retention rate of 70% to 75%.  The average customer retention rate since the inception of the GEAR UP Plan on January 1, 2006 is 70%, and we anticipate that the annual customer retention rate for 2008 will be in the range of 70% to 75%.

 

o     Uncompromising Focus on Operations.  Parkway is reaffirming its commitment to do that which it does best, and that is to operate office properties for maximum returns.

 

o     Performance.  In the planning process, management first decided what actions to take strategically over the three years of the GEAR UP Plan and secondly, modeled the economic impact of these actions.  Given the large component of Asset Recycling in the Plan, management selected a financial metric that would be most appropriate to measure the success of the Plan.   This led to the adoption of Cumulative Adjusted Funds Available for Distribution ("Cumulative Adjusted FAD") as the metric for the GEAR UP Plan, with a target of $7.18 per share cumulative over three years.  Actual Adjusted FAD for 2006 and 2007 exceeded the amount projected by the Company at the beginning of the Plan.   Management set an internal target for fixed charged coverage before principal payments of 2.5 times as a measure of leverage for the plan.  While not a requirement in the plan, this self-imposed target serves to prevent the performance goals being met by over-leveraging the Company.

 

For the GEAR UP Plan, Parkway is not abandoning Funds from Operations, but rather carrying it a step further to include accountability for capital items and removing the accounting adjustments which are not directly influenced by the operations of its properties.   Management believes an Adjusted FAD goal provides an effective alignment with the shareholders by focusing the team on maximizing income from operations while being mindful of capital expenses and ultimately the funds available to cover the dividend.   Cumulative Adjusted FAD is calculated as the sum of Adjusted FAD for each of the three years of the plan.    The adjustments that will be made to FAD reported each quarter principally include charges for impairment of value and expenses related to the early extinguishment of debt. 

 

                Parkway has made progress on its Asset Recycling and Equity Opportunities goals in 2006, 2007 and 2008 as follows:

 

o     Dispositions.   Parkway sold ten office properties for a gross sales price totaling $153.8 million and recorded a total gain on the sales for financial reporting purposes in the amount of $43.1 million.

 

o     Fund Acquisitions.  The Fund with Ohio PERS and Parkway purchased eleven office properties at an aggregate contract purchase price of $465.9 million, which is comprised of investments by the Fund totaling $444.3 million plus an additional investment by Parkway of $21.6 million.  The Fund was fully invested as of February 15, 2008.

 

o     Fee Simple Purchases.  Parkway purchased One Illinois Center in Chicago, Illinois at a contract purchase price of $198 million.

 

o    Other Purchases.  Parkway purchased an additional interest in Moore Building Associates, LP, which owns the Toyota Center in Memphis, Tennessee, for $1.4 million raising Parkway's total ownership interest to 75.025%.

 

o     Equity Offering.  On December 18, 2006, the Company sold 600,000 shares of common stock to Banc of America Securities LLC at a gross offering price of $50.25 per share and a net price of $49.37 per share. The Company used the net proceeds of approximately $29.6 million to repay indebtedness outstanding under a $19.3 million mezzanine loan incurred in connection with the purchase of One Illinois Center and to purchase additional investments in office properties.

 

o     Stock Buyback.  On August 3, 2007, the Board of Directors authorized the repurchase of up to 1.7 million shares of Parkway's outstanding common stock through July 30, 2008.  During 2007, the Company purchased approximately 687,000 shares of Parkway common stock under this authorization for $29.1 million, which equates to an average price of $42.36 per share.

 

Discretionary Fund.  On July 6, 2005, Parkway, through affiliated entities, entered into a limited partnership agreement forming a $500 million discretionary fund with Ohio PERS (the "Fund") for the purpose of acquiring high-quality multi-tenant office properties.  Ohio PERS is a 75% investor and Parkway is a 25% investor in the Fund, which will be capitalized with approximately $200 million of equity capital and $300 million of non-recourse, fixed-rate first mortgage debt.  The Fund targets acquisitions in the existing core Parkway markets of Memphis, Houston, Phoenix, Atlanta, Chicago, Charlotte, Orlando, Tampa/St. Petersburg, Ft. Lauderdale and Jacksonville.  As of December 31, 2007, there was approximately $228 million remaining capacity for Fund office investments.  During the quarter ending March 31, 2008, the Company purchased three office investments for a total purchase price of $236.6 million on behalf of the Fund.  Estimated closing costs, building improvements, tenant improvements and leasing costs of $14.2 million are anticipated during the first two years of ownership for a total investment of $250.8 million.  Of the total investment, $227.4 million represents investments by the Fund and $23.4 million represents an additional investment by Parkway.  Therefore, as of February 15, 2008, the Fund was fully invested.

 

                The Fund targets properties with an anticipated leveraged internal rate of return of greater than 11%.  Parkway serves as the general partner of the Fund and provides asset management, property management, leasing and construction management services to the Fund, for which it will be paid market-based fees.  After each partner has received a 10% annual cumulative preferred return and a return of invested capital, 20% of the excess cash flow will be paid to the general partner and 80% will be paid to the limited partners.    Through its general partner and limited partner ownership interests, Parkway may receive a distribution of the cash flow equivalent to 40%.  Parkway had three years from the inception date of the Fund to identify and acquire properties (the "Commitment Period"), with funds contributed as needed to close acquisitions.  The Commitment Period for the Fund ended February 15, 2008. The term of the Fund will be seven years from the expiration of the Commitment Period, with provisions to extend the term for two additional one-year periods.

 

                With the Fund with Ohio PERS fully invested, management is now focused on establishing a second discretionary fund.  Subsequent to March 31, 2008, the Teacher Retirement System of Texas ("TRS") approved a $262.5 million equity commitment to Parkway Properties Office Fund II, LP.  The equity commitment is subject to the execution of a partnership agreement and no assurance can be given that an agreement will be reached. 

 

Financial Condition

Comments are for the balance sheet dated March 31, 2008 compared to the balance sheet dated December 31, 2007.

 

                Office and Parking Properties.  In 2008, Parkway continued the application of its strategy of operating and acquiring office properties, joint venturing interests in office assets, as well as liquidating non-core assets and office assets that no longer meet the Company's investment criteria and/or the Company has determined value will be maximized by selling.  During the three months ending March 31, 2008, total assets increased $222.8 million or 14.5% and office and parking properties (before depreciation) increased $208.9 million or 13.5%

                Purchases, Improvements and Development. Parkway's investment in office and parking properties increased $199.4 million net of depreciation to a carrying amount of $1.5 billion at March 31, 2008, and consisted of 63 office and parking properties and one office property development.  The primary reason for the increase in office and parking properties relates to the net effect of the purchase of office properties, building improvements, development costs and depreciation recorded during the year.

 

                During the three months ending March 31, 2008, the Company incurred $5.7 million in development costs for the construction of The Pinnacle at Jackson Place, which is a 194,000 square foot Class A+ office building development adjacent to the Company's headquarters building in Jackson, Mississippi.  The estimated cost of the development is $48.5 million with expected completion in the fall of 2008.  The Company has received commitments to lease approximately 70% of the new office space from four major customers.  Parkway is considering a joint venture structure for the development whereby Parkway will retain an ownership interest of approximately 20%.  The development is designed to utilize benefits available under the Gulf Opportunity Zone Act for new developments in areas affected by Hurricane Katrina.

               

                On January 18, 2008, the discretionary fund with Ohio PERS (the "Fund"), of which Parkway owns 25%, purchased Gateway Center, a 228,000 square foot office property in the central business district of Orlando, Florida for a purchase price of $55.0 million.  The Fund expects to spend an additional $2.8 million for closing costs, building improvements, leasing costs and tenant improvements during the first two years of ownership.  The purchase was funded with a $33.0 million first mortgage placement by the Fund and with equity contributions from the partners. 

 

                On January 31, 2008, the Company purchased Desert Ridge Corporate Center, a 293,000 square foot office project in Phoenix, Arizona for a purchase price of $81.6 million on behalf of the Fund.  An additional $2.3 million is expected to be spent for closing costs, building improvements, leasing costs and tenant improvements during the first two years of ownership.  The purchase was funded with a $49.2 million first mortgage placement and with equity contributions from the partners.  Due to the Fund's $80.0 million limit on a single investment, Parkway's effective ownership interest in this asset is 26.5%.  

 

                On February 15, 2008, the Company purchased Citicorp Plaza, a 600,000 square foot office project in Chicago, Illinois for a purchase price of $100.0 million on behalf of the Fund.  An additional $9.2 million is expected to be spent for closing costs, building improvements, leasing costs and tenant improvements during the first two years of ownership.  The purchase was funded with a $60.0 million first mortgage placement and with equity contributions from the partners.  Due to the Fund's $80.0 million limit on a single investment, Parkway's effective ownership interest in this asset is 40%.

 

                During the three months ending March 31, 2008, the Company capitalized building improvements and additional purchase expenses of $7.0 million and recorded depreciation expense of $16.2 million related to its office and parking properties.

 

Intangible Assets, Net.  For the three months ended March 31, 2008, intangible assets net of related amortization increased $25.8 million and was primarily due to the net effect of the purchase of three office investments during the quarter and amortization of the existing intangible assets for the period.

 

Notes Payable to Banks.  Notes payable to banks increased $45.3 million or 21.3% during the three months ended March 31, 2008.  At March 31, 2008, notes payable to banks totaled $257.7 million and the increase is primarily attributable to the advances under bank lines of credit to purchase and develop real estate and make improvements to office properties.

 

                Mortgage Notes Payable.  During the three months ended March 31, 2008, mortgage notes payable increased $141.2 million or 19.8% and is due to the net effect of scheduled principal payments on mortgages of $3.8 million, the prepayment of existing mortgage debt of $3.5 million and the placement of mortgage debt of $142.2 million and advances on mortgage debt of $6.3 million to fund The Pinnacle development.

 

                On February 1, 2008, the Company paid off the mortgage notes payable secured by the 400 North Belt and Woodbranch buildings in Houston, Texas, with a total principal balance of $3.5 million with advances under bank lines of credit.  The mortgages had an interest rate of 8.25% and were scheduled to mature on August 1, 2011.  The Company recognized a total of $401,000 in expense associated with the prepayment of these mortgages. 

 

                In connection with the Fund investments during the first quarter of 2008 discussed under "Financial Condition - Office and Parking Properties - Purchases, Improvements and Development",  total non-recourse first mortgage debt was placed in the amount of $142.2 million at a weighted average interest rate of 5.7%.  The portion of mortgage debt attributable to the Fund was $129.2 million, and $13.0 million was attributable to Parkway.  The mortgages are secured by the respective properties, have one to three year interest only periods and mature in 2016.

 

On April 4, 2008, the Company entered into an interest rate swap agreement with US Bank.  The interest rate swap is for a $23.5 million notional amount and fixes the 30-day LIBOR interest rate at 4.05%, which equates to a total interest rate of 5.55%, for the period January 1, 2009 through December 1, 2014.  The swap serves as a hedge of the variable interest rates on a portion of the debt placed on the Pinnacle development.

 

                On May 2, 2008, the Company completed a $60.0 million recourse mortgage loan related to the refinance of a $41.7 million mortgage that was scheduled to mature in September 2008.  The loan is secured by the Company's Capital City Plaza building in Atlanta, Georgia.  The interest rate on the loan is a variable rate based on LIBOR plus 165 basis points.  The loan term is for two years, with a one-year extension option at the Company's discretion. The excess loan proceeds of approximately $18.4 million were used to pay down the Company's bank line of credit.  The Company will record a gain on the prepayment of approximately $500,000 associated with the write off of the debt premium in the second quarter of 2008.  The mortgage represented the Company's only outstanding maturity in 2008. 

 

                The Company expects to continue seeking fixed-rate, non-recourse mortgage financing with maturities from five to ten years typically amortizing over 25 to 30 years on select office building investments as additional capital is needed.  The Company targets a debt to total market capitalization rate at a percentage in the range of 45% to 50%. This rate may vary at times pending acquisitions, sales and/or equity offerings.  In addition, volatility in the price of the Company's common stock may affect the debt to total market capitalization ratio.  However, over time the Company plans to maintain a percentage in the range of 45% to 50%.  The Company calculates this ratio by including its proportionate share of any debt on assets held in funds and partnerships.  In addition to this debt ratio, the Company monitors interest, fixed charge and modified fixed charge coverage ratios.  The interest coverage ratio is computed by comparing the cash interest accrued to earnings before interest, taxes, depreciation and amortization ("EBITDA"). The fixed charge coverage ratio is computed by comparing the cash interest accrued, principal payments made on mortgage loans and preferred dividends paid to EBITDA.  The modified fixed charge coverage ratio is computed by comparing cash interest accrued and preferred dividends paid to EBITDA. In connection with the GEAR UP Plan, management set an internal target for the modified fixed charge coverage ratio of 2.5 times as a measure of leverage for the plan.  While not a requirement of the plan, this self-imposed target serves to prevent the performance goals being met by over-leveraging the Company.  Management believes the debt to market capitalization, interest coverage, fixed charge coverage and modified fixed charge coverage ratios provide useful information on total debt levels as well as the Company's ability to cover interest, principal and/or preferred dividend payments with current income. As of March 31, 2008, Parkway's debt to total market capitalization rate was 59.3%, which is higher than the Company's target range of 45% to 50%.  The increase in the rate was due primarily to a stock price decrease.

 

                The computation of the interest, fixed charge and modified fixed charge coverage ratios and the reconciliation of net income to EBITDA is as follows for the three months ended March 31, 2008 and 2007 (in thousands):

 

 

(1)           Parkway defines EBITDA, a non-GAAP financial measure, as net income before interest, income taxes, depreciation, amortization, losses on early extinguishment of debt and other gains and losses.  EBITDA, as calculated by us, is not comparable to EBITDA reported by other REITs that do not define EBITDA exactly as we do.

 

                The Company believes that EBITDA helps investors and Parkway's management analyze the Company's ability to service debt and pay cash distributions.  However, the material limitations associated with using EBITDA as a non-GAAP financial measure compared to cash flows provided by operating, investing and financing activities are that EBITDA does not reflect the Company's historical cash expenditures or future cash requirements for working capital, capital expenditures or the cash required to make interest and principal payments on the Company's outstanding debt.  Although EBITDA has limitations as an analytical tool, the Company compensates for the limitations by using EBITDA only to supplement GAAP financial measures.  Additionally, the Company believes that investors should consider EBITDA in conjunction with net income and the other required GAAP measures of its performance and liquidity to improve their understanding of Parkway's operating results and liquidity. 

 

                Parkway views EBITDA primarily as a liquidity measure and, as such, the GAAP financial measure most directly comparable to it is cash flows provided by operating activities.  Because EBITDA is not a measure of financial performance calculated in accordance with GAAP, it should not be considered in isolation or as a substitute for operating income, net income, cash flows provided by operating, investing and financing activities prepared in accordance with GAAP.  The following table reconciles EBITDA to cash flows provided by operating activities for the three months ended March 31, 2008 and 2007 (in thousands):

 

 

                Minority Interest - Real Estate Partnerships. During the three months ending March 31, 2008, minority interest associated with real estate partnerships increased $57.4 million or 71.3%.  The increase is attributable to the minority interest partner's equity contribution toward the three Fund office investments during the first quarter of 2008 discussed under "Financial Condition - Office and Parking Properties - Purchases, Improvements and Development".

 

                Stockholders' Equity. Stockholders' equity decreased $13.2 million or 3.0% during the three months ended March 31, 2008, as a result of the following (in thousands):

 

 

                On August 3, 2007, the Board of Directors authorized the repurchase of up to 1.7 million shares of Parkway's outstanding common stock through July 30, 2008.  The shares may be purchased in the open market or in privately negotiated transactions, and at times and in amounts that the Company deems appropriate.  During 2007, the Company purchased approximately 687,000 shares of Parkway common stock under this authorization for $29.1 million, which equates to an average price of $42.36 per share.  No shares were purchased under this authorization during the quarter ended March 31, 2008.

 

Results of Operations

Comments are for the three months ended March 31, 2008 compared to the three months ended March 31, 2007.

 

                Net loss available to common stockholders for the three months ended March 31, 2008 was $3.8 million ($0.25 per basic common share) as compared to net loss available to common stockholders of $772,000 ($0.05 per basic common share) for the three months ended March 31, 2007.  The primary reason for the increase in net loss is due to an increase in depreciation and amortization expense related to office and parking properties and interest expense on mortgage notes payable.

 

                Office and Parking Properties.  The analysis below includes changes attributable to same store properties, acquisitions and dispositions of office properties.  Same store properties are those that the Company owned for the current and prior year reporting periods, excluding properties classified as discontinued operations.  At March 31, 2008, same store properties consisted of 58 properties comprising 11.8 million square feet.  Properties acquired in 2007 and 2008 that do not meet the definition of same store properties consisted of five properties with 1.4 million square feet.

 

                The following table represents revenue from office and parking properties for the three months ended March 31, 2008 and 2007 (in thousands):

 

 

                Revenue from office and parking properties for same store properties increased $978,000 for the three months ended March 31, 2008, compared to the same period for 2007.  The primary reason for the increase is due to lease termination fee income as well as an increase in same store occupancy and average rental rates for same store properties for the three months ended March 31, 2008 compared to March 31, 2007.  Average same store occupancy was 91.2% for the three months ended March 31, 2008 compared to 90.5% for the same period of 2007.  Additionally, same store rental rates increased 2.1% for the three months ended March 31, 2008 compared to the same period of 2007.

 

                The following table represents property operating expenses for the three months ended March 31, 2008 and 2007 (in thousands):

 

       

                Property operating expenses for same store properties increased $1.8 million for the three months ended March 31, 2008 compared to the same period of 2007.  The primary reason for the increase is due to increased real estate taxes, personnel costs and bad debt expense.

 

                Depreciation and amortization expense attributable to office and parking properties increased  $3.0 million for the three months ended March 31, 2008, compared to the same period for 2007 and is due to the additional depreciation associated with the acquisition of office properties and improvements to properties.

 

                Share Based Compensation Expense.  Effective January 1, 2006, Parkway adopted FASB Statement No. 123R, Share-Based Payment ("FAS 123R") using the modified-prospective transition method. In the past the Company had granted stock options for a fixed number of shares to employees and directors with an exercise price equal to or above the fair value of the shares at the date of grant.  However, no stock options have been granted to employees since 2002 or to directors since 2003.  Since 2003, Parkway has elected to grant restricted shares and deferred incentive share units instead of stock options.  Therefore, the adoption of FAS 123R has not had a material impact on income from continuing operations, net income, cash flow from operations, cash flow from financing activities or basic and diluted earnings per share. 

 

                During the three months ended March 31, 2008, the Board of Directors approved the grant of 38,017 restricted shares to officers of the Company.  The shares were valued at $1.2 million and 36,975 shares will vest four years from grand date and 1,042 shares will vest subject to achievement of the cumulative goals of the GEAR UP plan, which will end on December 31, 2008.  Compensation expense will not be recorded on the shares that vest based on performance conditions until the Company determines that it is probable that the goal will be achieved.  Therefore, no expense has been recorded to date for the shares that vest based on achievement of the cumulative goals of the GEAR UP Plan.

 

                Share based compensation expense of $454,000 and $353,000 was recognized for the three months ending March 31, 2008 and 2007, respectively.  Total compensation expense related to nonvested awards subject to service conditions not yet recognized was $5.0 million as of March 31, 2008.  The weighted average period over which this expense is expected to be recognized is approximately 2.8 years.  Total potential compensation expense associated with shares that vest based on performance conditions is $1.5 million as of March 31, 2008.

                General and Administrative Expense.  General and administrative expense increased $650,000 for the three months ended March 31, 2008, compared to the same period of 2007 and is primarily attributable to increased personnel costs and share based compensation expense.

 

                Interest Expense.  Interest expense, including amortization, increased $2.4 million for the three months ended March 31, 2008, compared to the same period of 2007 and is comprised of the following (in thousands):

 

                Mortgage interest expense increased $1.3 million for the three months ended March 31, 2008, compared to the same period for 2007 and is due to the net effect of new loans placed in 2007 and 2008 and the early extinguishment of two mortgages in 2008.  The average interest rate on mortgage notes payable as of March 31, 2008 and 2007 was 5.7% and 5.8%, respectively.

 

                Bank line interest expense increased $614,000  for the three months ended March 31, 2008, compared to the same period of 2007 and is primarily due to an increase in average borrowings due to additional purchases of office investments offset by a decrease in average interest rate from 6.3% for the quarter ended March 31, 2007 to 5.4% for the quarter ended March 31, 2008.

 

Liquidity and Capital Resources

 

Statement of Cash Flows.   Cash and cash equivalents were $14.9 million and $8.3 million at March 31, 2008 and December 31, 2007, respectively.  Cash flows provided by operating activities for the three months ended March 31, 2008 were $12.8 million compared to $14.2 million for the same period of 2007.  The decrease in cash flows from operating activities of $1.4 million is primarily attributable to the effect of the timing of receipt of revenues and payment of expenses and an increase in deferred leasing costs.

 

Cash used in investing activities was $243.8 million for the three months ended March 31, 2008 compared to cash used in investing activities of $7.6 million for the same period of 2007.  The increase in cash used in investing activities of $236.2 million is primarily due to office property purchases, office property improvements and development costs in 2008.

 

                Cash provided by financing activities was $234.6 million for the three months ended March 31, 2008 compared to cash used in financing activities of $2.8 million for the same period of 2007.  The increase in cash provided by financing activities of $237.4 million is primarily due to additional mortgage placements in 2008 and contributions from minority interest partners to fund office property purchases.

 

Liquidity.   The Company plans to continue pursuing the acquisition of additional investments that meet the Company's investment criteria and intends to use bank lines of credit, proceeds from the sale of non-core assets and office properties, proceeds from the sale of portions of owned assets through joint ventures, possible sales of securities and cash balances to fund those acquisitions. 

 

                The Company's cash flows are exposed to interest rate changes primarily as a result of its lines of credit used to maintain liquidity and fund capital expenditures and expansion of the Company's real estate investment portfolio and operations.  The Company's interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower its overall borrowing costs.  To achieve its objectives, the Company borrows at fixed rates, but also utilizes a four-year unsecured revolving credit facility, a five-year unsecured term loan and two one-year unsecured lines of credit.

 

                The Company's bank lines of credit allow Parkway to borrow up to a combined $311 million.  At March 31, 2008, the Company had a total of $257.7 million outstanding under its bank lines of credit.  Based on the loan covenants, Parkway had $25.4 million in additional capacity available at March 31, 2008, and approximately $44 million in additional capacity at May 2, 2008, based on a $60 million mortgage refinance on that date.  At March 31, 2008, the following amounts were outstanding under bank lines of credit (in thousands):

 

 

(1)     The interest rate on the $236 million unsecured line of credit interest rate is currently LIBOR plus 130 basis points.  The interest rate noted above represents the weighted average interest rate of short-term LIBOR borrowings, a $30 million interest rate swap that expires August 31, 2008 and a $50 million interest rate swap that expires June 30, 2008.    The Company pays an annual administration fee of $35,000 and fees on the unused portion of the revolver ranging between 12.5 and 20 basis points based upon overall Company leverage, with the rate set at 12.5 basis points at March 31, 2008.  The line includes rights to a one-year extension with the same terms through April 2011. 

 

(2)   The interest rate on the $60 million term loan represents the weighted average interest rate of two interest rate swaps that expire December 31, 2008.

 

                The Company's $236 million unsecured revolving credit facility and $60 million unsecured term loan are both led by Wachovia Bank and syndicated to nine other banks.  The credit facility requires compliance with a number of restrictive financial covenants, including tangible net worth, fixed charge coverage ratio, unencumbered interest coverage ratio, total debt to total asset ratio, secured debt to total asset value ratio, secured recourse debt to total asset value ratio and unencumbered pool restrictions.  As of March 31, 2008, the Company was in compliance with these financial covenants.

 

The $15 million line is expected to fund the daily cash requirements of the Company's treasury management system.  The interest rate on the $15 million line is based on LIBOR plus 80 to 130 basis points, depending upon overall Company leverage, with the current rate set at LIBOR plus 130 basis points as of March 31, 2008.  Under the $15 million line, the Company does not pay annual administration fees or fees on the unused portion of the line.

 

The $9 million line with Trustmark National Bank has a current interest rate equal to the 30-day LIBOR rate plus 132.5 basis points.  The proceeds of the loan were used to finance the construction of the City Centre Garage, which was completed in 2005.

 

To protect against the potential for rapidly rising interest rates, the Company entered into interest rate swap agreements in 2007, 2005 and 2004.  The Company designated the swaps as hedges of the variable interest rates on the Company's borrowings under the Wachovia unsecured revolving credit facility.  These swaps are considered to be fully effective and changes in the fair value of the swaps are recognized in accumulated other comprehensive income.  The Company's interest rate hedge contracts as of March 31, 2008 and 2007 are summarized as follows (in thousands):

 

 

                At March 31, 2008, the Company had $855.7 million in mortgage notes payable with an average interest rate of 5.7% secured by office properties and $257.7 million drawn under bank lines of credit.  Parkway's pro rata share of unconsolidated joint venture debt was $9.8 million with an average interest rate of 5.1% at March 31, 2008.  Based on the Company's total market capitalization of approximately $1.5 billion at March 31, 2008 (using the March 31, 2008 closing price of $36.96 per common share), the Company's debt represented approximately 59.3% of its total market capitalization.  The Company targets a debt to total market capitalization rate at a percentage in the range of 45% to 50%.  This rate may vary at times pending acquisitions, sales and/or equity offerings.  In addition, volatility in the price of the Company's common stock may affect the debt to total market capitalization ratio.  However, over time the Company plans to maintain a percentage in the range of 45% to 50%.  The increase in the debt to total market capitalization rate at March 31, 2008 was due primarily to a stock price decrease.

 

                In addition to the debt to total market capitalization ratio, the Company also monitors interest, fixed charge and modified fixed charge coverage ratios.  The interest coverage ratio is computed by comparing the cash interest accrued to earnings before interest, taxes, depreciation and amortization ("EBITDA").  This ratio for the three months ended March 31, 2008 and 2007 was 2.35 and 2.51 times, respectively.  The fixed charge coverage ratio is computed by comparing the cash interest accrued, principal payments made on mortgage loans and preferred dividends paid to EBITDA.  This ratio for the three months ended March 31, 2008 and 2007 was 1.68 and 1.74 times, respectively.   The modified fixed charge coverage ratio is computed by comparing the cash interest accrued and preferred dividends paid to EBITDA.  This ratio for the three months ended March 31, 2008 and 2007 was 2.14 and 2.28 times, respectively.    In connection with the GEAR UP Plan, management set an internal target for the modified fixed charge coverage ratio of 2.5 times as a measure of leverage for the plan.  While not a requirement of the plan, this self-imposed target serves to prevent the performance goals being met by over-leveraging the Company.  Management believes the debt to market capitalization, interest coverage, fixed charge coverage and modified fixed charge coverage ratios provide useful information on total debt levels as well as the Company's ability to cover interest, principal and/or preferred dividend payments with current income.

 

 

                The table below presents the principal payments due and weighted average interest rates for the mortgage notes payable as of March 31, 2008.

 

*Remaining nine months

 

The Company presently has plans to make additional capital improvements at its office properties in 2008 of approximately $35 million.  These expenses include tenant improvements, capitalized acquisition costs and capitalized building improvements.  Approximately $16 million of these improvements relate to upgrades on properties acquired in recent years that were anticipated at the time of purchase.  All such improvements are expected to be financed by cash flow from the properties, capital expenditure escrow accounts, advances on the bank lines of credit or contributions from partners.

 

In the fall of 2008, the Company expects to complete the development of a 194,000 square foot Class A+ office building in Jackson, Mississippi known as The Pinnacle at Jackson Place, adjacent to the Company's headquarters building.  The total estimated cost of the development is $48.5 million, and for the remainder of 2008, the Company expects to incur approximately $29.3 million in construction costs, which will be funded with advances under mortgage notes payable secured by The Pinnacle.  The Company has commitments to lease approximately 70% of the new office space from four major customers.  Parkway is considering a joint venture structure for the development whereby Parkway will retain an ownership interest of approximately 20%.  The development is designed to utilize benefits available under the Gulf Opportunity Zone Act for new developments in areas affected by Hurricane Katrina.

 

On May 2, 2008, the Company completed a $60.0 million recourse mortgage loan related to the refinance of a $41.7 million mortgage that was scheduled to mature in September 2008.  The loan is secured by the Company's Capital City Plaza building in Atlanta, Georgia.  The interest rate on the loan is a variable rate based on LIBOR plus 165 basis points.  The loan term is for two years, with a one-year extension option at the Company's discretion. The excess loan proceeds of approximately $18.4 million were used to pay down the Company's bank line of credit.  The Company will record a gain on the prepayment of approximately $500,000 associated with the write off of the debt premium in the second quarter of 2008.  The mortgage represented the Company's only outstanding maturity in 2008. 

 

                The Company anticipates that its current cash balance, operating cash flows, contributions from partners and borrowings (including borrowings under the working capital line of credit) will be adequate to pay the Company's (i) operating and administrative expenses, (ii) debt service obligations, (iii) distributions to shareholders, (iv) capital improvements, and (v) normal repair and maintenance expenses at its properties, both in the short and long term.  In addition, the Company may use proceeds from sales of assets, possible sales of securities and borrowings to fund property acquisitions.

Contractual Obligations

 

                See information appearing under the caption "Financial Condition - Notes Payable to Banks and Mortgage Notes Payable" in Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations for a discussion of changes in long-term debt since December 31, 2007. 

 

Funds From Operations

 

Management believes that funds from operations available to common shareholders ("FFO") is an appropriate measure of performance for equity REITs and computes this measure in accordance with the National Association of Real Estate Investment Trusts' ("NAREIT") definition of FFO.  Funds from operations is defined by NAREIT as net income (computed in accordance with generally accepted accounting principles "GAAP"), excluding gains or losses from sales of property and extraordinary items under GAAP, plus depreciation and amortization, and after adjustments to derive the Company's pro rata share of FFO of consolidated and unconsolidated joint ventures.  Further, the Company does not adjust FFO to eliminate the effects of non-recurring charges.  The Company believes that FFO is a meaningful supplemental measure of its operating performance because historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time, as reflected through depreciation and amortization expenses.  However, since real estate values have historically risen or fallen with market and other conditions, many industry investors and analysts have considered presentation of operating results for real estate companies that use historical cost accounting to be insufficient.  Thus, NAREIT created FFO as a supplemental measure of operating performance for real estate investment trusts that excludes historical cost depreciation and amortization, among other items, from net income, as defined by GAAP.  The Company believes that the use of FFO, combined with the required GAAP presentations, has been beneficial in improving the understanding of operating results of real estate investment trusts among the investing public and making comparisons of operating results among such companies more meaningful.  FFO as reported by Parkway may not be comparable to FFO reported by other REITs that do not define the term in accordance with the current NAREIT definition.  Funds from operations do not represent cash generated from operating activities in accordance with accounting principles generally accepted in the United States and is not an indication of cash available to fund cash needs.  Funds from operations should not be considered an alternative to net income as an indicator of the Company's operating performance or as an alternative to cash flow as a measure of liquidity.

 

The following table presents a reconciliation of the Company's net income to FFO for the three months ended March 31, 2008 and 2007 (in thousands):

 

Inflation

 

                Inflation has not had a significant impact on the Company because of the relatively low inflation rate in the Company's geographic areas of operation.  Additionally, most of the leases require the customers to pay their pro rata share of operating expenses, including common area maintenance, real estate taxes, utilities and insurance, thereby reducing the Company's exposure to increases in operating expenses resulting from inflation.  The Company's leases typically have three to seven year terms, which may enable the Company to replace existing leases with new leases at market base rent, which may be higher or lower than the existing lease rate.

 

 

Forward-Looking Statements

 

                In addition to historical information, certain sections of this Form 10-Q may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, such as those that are not in the present or past tense, that discuss the Company's beliefs, expectations or intentions or those pertaining to the Company's capital resources, profitability and portfolio performance and estimates of market rental rates.  Forward-looking statements involve numerous risks and uncertainties.  The following factors, among others discussed herein and in the Company's filings under the Securities Exchange Act of 1934, could cause actual results and future events to differ materially from those set forth or contemplated in the forward-looking statements:  defaults or non-renewal of leases, increased interest rates and operating costs, failure to obtain necessary outside financing, difficulties in identifying properties to acquire and in effecting acquisitions, the failure to acquire or sell properties as and when anticipated, failure to qualify as a real estate investment trust under the Internal Revenue Code of 1986, as amended, environmental uncertainties, risks related to natural disasters, financial market fluctuations, changes in real estate and zoning laws and increases in real property tax rates.  The success of the Company also depends upon the trends of the economy, including interest rates, income tax laws, governmental regulation, legislation, population changes and those risk factors discussed elsewhere in this Form 10-Q and in the Company's filings under the Securities Exchange Act of 1934.  Readers are cautioned not to place undue reliance on forward-looking statements, which reflect management's analysis only as the date hereof.  The Company assumes no obligation to update forward-looking statements.

 

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

 

                See information appearing under the caption "Liquidity" in Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations.

 

Item 4.  Controls and Procedures

 

                The Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13a‑15.  Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of the end of the Company's most recent fiscal quarter, the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic SEC filings.

 

                During the period covered by this report, the Company reviewed its internal controls, and there have been no changes in the Company's internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company's internal controls over financial reporting.

 

 

PART II.  OTHER INFORMATION

Item 1A.  Risk Factors

 

There have been no material changes to the risk factors disclosed in Parkway's Form 10-K for the year ended December 31, 2007.

 

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

 

On August 3, 2007, the Board of Directors authorized the repurchase of up to 1.7 million shares of Parkway's outstanding common stock through July 30, 2008.  The shares may be purchased in the open market or in privately negotiated transactions, and at times and in amounts that the Company deems appropriate.  In 2007, the Company purchased 687,245 shares of Parkway common stock for $29.1 million, which equates to an average price of $42.36 per share, with 1,012,755 shares still authorized for repurchase.  No shares were purchased under this authorization during the quarter ended March 31, 2008. 

 

Item 6.  Exhibits

 

31.1    Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2    Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1    Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2    Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

SIGNATURES

 

        Pursuant to the requirements 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.