ASSOCIATED ESTATES REALTY CORPORATION

Index

PART 1.  FINANCIAL INFORMATION
ITEM 1.  CONSOLIDATED FINANCIAL STATEMENTS

ASSOCIATED ESTATES REALTY CORPORATION
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

ASSOCIATED ESTATES REALTY CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

ASSOCIATED ESTATES REALTY CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

ASSOCIATED ESTATES REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
UNAUDITED

1.         BASIS OF PRESENTATION AND ACCOUNTING POLICIES

Except as the context otherwise requires, all references to "we," "our," "us," "AERC" and the "Company" in this report collectively refer to Associated Estates Realty Corporation and its consolidated subsidiaries.

Business

We are a fully-integrated, self-administered and self-managed equity real estate investment trust ("REIT") specializing in multifamily ownership, operation, acquisition, development, construction, disposition, and property management activities.  Our primary source of income is rental revenue.  Additional income is derived primarily from construction services.

As of September 30, 2010, our operating property portfolio consisted of: (i) 50 apartment communities containing 12,976 units in seven states that are wholly owned, either directly or indirectly through subsidiaries; (ii) one apartment community that we manage for a third party owner consisting of 258 units; and (iii) and a commercial property containing approximately 145,000 square feet that we asset manage for a government sponsored pension fund.  Effective November 1, 2010, we no longer manage the 258-unit apartment community or the commercial property.

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared by management in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and applicable rules and regulations of the Securities and Exchange Commission.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In the opinion of management, all adjustments, consisting only of normal and recurring adjustments considered necessary for a fair statement, have been included.  The reported results of operations are not necessarily indicative of the results that may be expected for the full year.  These financial statements should be read in conjunction with the audited financial statements and accompanying notes in our Annual Report on Form 10-K for the year ended December 31, 2009.  We have evaluated all subsequent events through November 2, 2010, which is the date the financial statements were issued.

Segment Reporting

All of our owned properties are multifamily communities that have similar economic characteristics.  Management evaluates the performance of our properties on an individual basis.  Our multifamily properties provided approximately 91.5% of our consolidated revenue for the nine months ended September 30, 2010; we have only one reportable segment, which is multifamily properties.

Share-Based Compensation

During the three and nine months ended September 30, 2010, we recognized total share-based compensation cost of $654,000 and $2.2 million, respectively, in "General and administrative expense" in the Consolidated Statements of Operations.  During the three and nine months ended September 30, 2009, we recognized total share based compensation cost of $432,000 and $1.5 million, respectively, in "General and administrative expense."

Stock Options.  During the nine months ended September 30, 2010, there were no stock options awarded and 613,724 options exercised.  During the nine months ended September 30, 2009, there were 58,000 stock options awarded and no stock options were exercised.  We use the Black-Scholes option pricing model to estimate the fair value of share-based awards.  The weighted average Black-Scholes assumptions and fair value for options awarded during the nine months ended September 30, 2010, were as follows:

The expected volatility was based upon the historical volatility of our weekly share closing prices over a period equal to the expected life of the options granted.  The risk-free interest rate used was the yield from U.S. Treasury bonds on the date of grant with a maturity approximating the expected life of the options.  The expected life of the options was derived using our historical experience for similar awards.  The dividend yield was derived using our annual dividend rate as a percentage of the price of our shares on the date of grant.

Restricted Shares.  The following table represents restricted share activity for the nine months ended September 30, 2010:

At September 30, 2010, there was $2.8 million of unrecognized compensation cost related to non-vested restricted share awards that we expect to recognize over a weighted average period of 2.1 years.

Effective January 1, 2010, our Directors' Deferred Compensation Plan will be paid with common shares instead of cash (see Note 11 for additional information regarding the Directors' Deferred Compensation Plan).

A portion of the restricted shares granted during 2010 were awards in which the number of shares that will ultimately vest are subject to satisfaction of certain market conditions, which include total shareholder return on an absolute basis and on a relative basis against a peer group consisting of other multifamily apartment companies.  The total estimated grant-date fair value of these awards was $1.1 million.  We used the Monte Carlo method to estimate the fair value of these awards.  The Monte Carlo method, which is similar to the binomial analysis, evaluates the award for changing stock prices over the term of vesting and uses random situations that are averaged based on past stock characteristics.  There were one million simulation paths used to estimate the fair value of these awards.  The risk-free interest rate used was based on a yield curve derived from U.S. Treasury zero-coupon bonds on the date of grant with a maturity equal to the market condition performance periods.  The expected life used was the market condition performance period.  The expected volatility used for AERC was based upon the historical volatility of our daily share closing prices over a period equal to the market condition performance periods.  The expected volatility used for the peer group was a 50%/50% blend of historical volatility and implied volatility.  Implied volatility was calculated using each company's stock call option contracts.

The following represents the assumption ranges used in the Monte Carlo method during 2010:

Derivative Instruments and Hedging Activities

We record all derivatives on the balance sheet at fair value.  The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and the resulting designation.  Derivatives used to hedge the exposure to changes in the fair value of an asset, liability or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges.  Derivatives used to hedge the exposure to variability in expected future cash flows or other types of forecasted transactions are considered cash flow hedges.

For derivatives designated as fair value hedges, changes in the fair value of the derivative and the hedged item relating to the hedged risk are recognized in earnings.  For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income (outside of earnings) and subsequently reclassified to earnings when the hedged transaction affects earnings, and the ineffective portion of changes in the fair value of the derivative is recognized directly in earnings.  Hedge ineffectiveness is measured by comparing the changes in fair value or cash flows of the derivative hedging instrument with the changes in fair value or cash flows of the designated hedged item or transaction.  For derivatives not designated as hedges, changes in fair value are recognized in earnings.

We do not use derivatives for trading or speculative purposes.  Further, we have a policy of only entering into contracts with major financial institutions based upon their credit ratings and other factors.  When viewed in conjunction with the underlying and offsetting exposure that the derivatives are designed to hedge, we have not sustained a material loss from these hedges.

We have utilized interest rate swaps and caps to add stability to interest expense and to manage our exposure to interest rate movements.  Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts in exchange for fixed-rate payments over the life of the agreements without exchange of the underlying principal amount.  Interest rate caps designated as cash flow hedges involve the receipt of variable-rate amounts if interest rates rise above a certain level in exchange for an upfront premium. 

Interest Rate Hedge Activity:  During 2007, we executed two interest rate swaps to hedge the cash flows of two existing variable rate loans.  In January 2010, we prepaid one of these loans but we did not terminate the corresponding interest rate swap and as a result reclassified the fair value of the related interest rate swap of $777,000 from other comprehensive income to earnings during the three months ended March 31, 2010.  This derivative matured in June 2010, and the change in fair value was recorded in earnings.  No hedge ineffectiveness on the remaining cash flow hedge was recognized during the nine months ended September 30, 2010.  Amounts reported in "Accumulated other comprehensive loss" related to the cash flow hedge will be reclassified to "Interest expense" as interest payments are made on the related variable-rate loan.  During the next twelve months, we estimate that approximately $130,000 will be reclassified from "Accumulated other comprehensive loss" as an increase to "Interest expense."  The following table presents the notional amounts of the swaps as of September 30, 2010:

The following table presents the fair value of our derivative financial instruments as well as their classification on the Consolidated Balance Sheets (see Note 9 for additional information regarding the fair value of these derivative instruments):

The following tables present the effect of our derivative financial instruments on the Consolidated Statements of Operations (see Note 6 for additional information regarding the effect of these derivative instruments on total comprehensive income):

We have an agreement with our derivative counterparty that contains a provision where if we either default or are capable of being declared in default on any of our indebtedness, then such counterparty can declare us to be in default on our derivative obligations.

We have an agreement with a derivative counterparty that incorporates the loan covenant provisions of our indebtedness with a lender affiliate of the derivative counterparty. Failure to comply with the loan covenant provisions would result in our being in default on any derivative instrument obligations covered by the agreement.

As of September 30, 2010, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk, related to these agreements was $193,000. As of September 30, 2010, we have not posted any collateral related to these agreements. If we had breached any of these provisions at September 30, 2010, we would have been required to settle our obligations under the agreements at their termination value of $193,000.

Classification of Fixed Asset Additions

We define recurring fixed asset additions to a property to be capital expenditures made to replace worn out assets to maintain the property's value.  Revenue enhancing/non-recurring fixed asset additions are defined as capital expenditures that increase the value of the property and/or enable us to increase rents.  Acquisition/development fixed asset additions are defined as capital expenditures for the purchase or construction of new properties to be added to our portfolio, or fixed asset additions identified at the time of purchase that are not made until subsequent periods.

2.         ACQUISITION, DEVELOPMENT AND DISPOSITION ACTIVITY

Acquisition Activity

            On September 15, 2010, we acquired The Ashborough, a 504-unit apartment community located in Ashburn, Virginia for a purchase price of approximately $90 million.  We used cash on hand and borrowings on the Company's unsecured line of credit to fund the acquisition.  We determined that the fair value of the property was the same as the purchase price.

On May 18, 2010, we acquired Riverside Station, a 304-unit apartment community located in Woodbridge, Virginia for a purchase price of approximately $54 million.  We paid cash for this acquisition, a portion of which was funded with proceeds from our May 12, 2010 equity offering.  We determined that the fair value of the property was the same as the purchase price.  See Note 12 for additional information related to acquisitions.

For the acquisitions mentioned above during the three months and nine months ended September 30, 2010, we recorded property revenue of $1.7 million and $2.3 million respectively and reported net (loss) income of $(51,000) and $13,000, respectively. In connection with these acquisitions for the three and nine months ended September 30, 2010, we incurred $368,000 and $429,000 of costs, which are included in "Costs associated with acquisitions” in the Consolidated Statements of Operations.

The following pro forma financial information is presented as if the 2010 acquisition had occurred at the beginning of each period presented.  This information is presented for informational purposes only and is not necessarily indicative of what the Company’s actual results of operations would have been had the acquisition occurred at such times:

The purchase price allocations for the operating properties acquired during 2010 were as follows:

Development Activity

During the quarter ended June 30, 2010, we completed a 60-unit expansion of the existing 240-unit River Forest apartment community located in the Richmond, Virginia metropolitan market area.  Total cost of development was approximately $6.8 million, which included $311,000 of capitalized interest.  Also see discussion under “Investment in Partnership” in Note 5 for additional development activity.

Construction Activity

Our subsidiary, Merit Enterprises, Inc., (“Merit”) is engaged as a general contractor and construction manager that acts as our in-house construction division and also provides general contracting and construction management services to third parties.  Merit concentrates its efforts on rehabilitation and ground-up construction projects.  We account for construction contracts using the percentage-of-completion method.  We compute the percentage of completion for each project as the ratio of costs incurred (excluding costs that do not represent progress as of the end of the reporting period, such as certain material purchases) to total estimated costs based on the most recent information.  This percentage is applied to the revenue expected to be received by each project.  Any changes in estimates are recognized in the period in which they are known on a prospective basis.  We recognized $5.7 million and $8.4 million in revenue and $5.0 million and $7.5 million in expense under this method during the three and nine months ended September 30, 2010, respectively.  The remaining costs included in construction and other services expenses include overhead costs, such as payroll and other fixed costs related to Merit. The total costs incurred in excess of amounts recognized as expense are included in "Other assets, net," and totaled $327,000 and $72,000 at September 30, 2010 and December 31, 2009, respectively.  Accounts receivable related to construction activity are included in “Other accounts and notes receivable, net” and were $5.6 million at September 30, 2010 and immaterial at December 31, 2009.  Funds received on uncompleted contracts in excess of revenue recognized, if any, are included in "Accounts payable, accrued expenses and other liabilities," and were immaterial at September 30, 2010 and December 31, 2009.

Disposition Activity

We report the results of operations and gain/loss related to the sale of real estate assets as discontinued operations.  Real estate assets that are classified as held for sale are also reported as discontinued operations.  We classify properties as held for sale when all significant contingencies surrounding the closing have been resolved.  In most transactions, these contingencies are not satisfied until the actual closing of the transaction.  Interest expense included in discontinued operations is limited to interest on mortgage debt specifically associated with properties sold or classified as held for sale. 

"Income from discontinued operations" in the accompanying Consolidated Statements of Operations for the three and nine months ended September 30, 2010 and 2009, includes the operating results for the properties sold in 2009, as well as the gains recognized on properties sold during each reporting period.  The following table summarizes "Income from discontinued operations:"

3.         DEBT

The following table identifies our total debt outstanding and weighted average interest rates:

Mortgage Notes Payable

The following table provides information on mortgage loans repaid and obtained during 2010:

During 2008, 2007 and 2006, we defeased 21 CMBS loans.  These loans were defeased pursuant to the terms of the underlying loan documents.  In accordance with GAAP, we removed those financial assets and the mortgage loans from our financial records.  All risk of loss associated with these defeasances have been transferred from us to the successor borrower and any ongoing relationship between the successor borrower and us was deemed inconsequential at the time of completion of the respective transfers.  However, we subsequently learned that for certain defeasance transactions completed prior to June 2007, the successor borrower may be able to prepay the loans thus enabling us to receive a refund of a portion of the costs incurred in connection with the transaction.  We received defeasance refunds of $553,000 and $563,000 for the nine months ended September 30, 2010 and 2009, respectively, which were included as a reduction to interest expense.  It is possible that we may receive additional refunds in the future, however such amounts cannot be estimated due to the uncertainty of future payments, and we believe that any amounts we may receive would not be material to our consolidated financial position, cash flow or results of operations.

Cash paid for interest, excluding $192,000 and $66,000 of capitalized interest, was $22.6 million and $24.9 million for the nine months ended September 30, 2010 and 2009, respectively.  Included in cash paid for interest are the defeasance refunds received of $553,000 and $563,000 for the nine months ended September 30, 2010 and 2009, respectively, as discussed above.  Additionally excluded in the cash paid for interest is a one-time non cash charge to interest expense of $727,000 related to the redemption of the 7.92% Trust Preferred Securities for the nine months ended September 30, 2010, as discussed below.

Unsecured Debt

On June 30, 2010, we redeemed all of our 7.92% Trust Preferred Securities at a cost of $26.3 million, which included accrued and unpaid interest up to but excluding the redemption date.  In connection with the issuance of those 7.92% Trust Preferred Securities in March 2005, we incurred issuance costs that were recorded as other assets and subsequently charged to interest expense each period over the life of the securities.  In accordance with GAAP, we recognized the remaining balance of $727,000 of issuance costs as a one-time non cash charge to interest expense for the  nine months ended September 30, 2010.

4.         GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill

In June 1998, we recorded goodwill in connection with the MIG Realty Advisors, Inc. merger.  We have a policy of completing our annual review of goodwill during the first quarter of each year and more frequently if events or changes in circumstances indicate that the carrying value may not be recoverable.  The review that was completed during the three months ended March 31, 2010, determined that goodwill was not impaired and no other events have occurred which would require that goodwill be reevaluated, as such there were no changes to the carrying value of goodwill as of September 30, 2010.  In performing this analysis, we use a multiple of revenues to the range of potential alternatives and assign a probability of the various alternatives under consideration by management.  Should the estimates used to determine alternatives or the probabilities of the occurrence thereof change, impairment may result which could materially impact our results of operations for the period in which it is recorded.

Intangible Assets

We allocate a portion of the total purchase price of a property acquisition to any intangible assets identified, such as existing leases and tenant relationships.  The intangible assets are amortized over the remaining lease terms or estimated life of the tenant relationship, which is approximately 12 to 16 months.  Due to the short term nature of residential leases, we believe that existing lease rates approximate market rates; therefore, no allocation is made for above/below market leases.

In connection with our property acquisition completed on May 18, 2010, as discussed in Note 2, we recorded total intangible assets in the amount of $1.4 million related to existing leases, which are being amortized over 12 months, and $300,000 related to tenant relationships, which are being amortized over 16 months.

In connection with our property acquisition completed on September 15, 2010, as discussed in Note 2, we recorded total intangible assets in the amount of $3.2 million related to existing leases and tenant relationships, which are being amortized over 12 months.

5.         INVESTMENT IN PARTNERSHIP

On September 24, 2010, we entered into a partnership agreement with Bristol Development Group, an unrelated third-party for the development of Vista Germantown, a 242-unit apartment community located in downtown Nashville, Tennessee.  We contributed $9.4 million to the partnership and hold a 90% equity interest.  In accordance with GAAP, we have determined that this entity is not a variable interest entity and that we hold a controlling financial interest in the entity.  As such, this entity is included in our consolidated financial statements.  We have also determined that the noncontrolling interest in this entity meets the criterion to be classified as a component of permanent equity.

6.         SHAREHOLDERS' EQUITY

The following table provides a reconciliation of activity in Shareholders' equity accounts:

On September 24, 2010, we entered into a partnership in which we have a controlling financial interest.  We have determined that the noncontrolling interest in this entity meets the criterion to be classified as a component of permanent equity.  See Note 5 for additional information related to this partnership.

The following table identifies total comprehensive (loss) income:

7.         COMMON AND PREFERRED SHARES

Common Shares

On January 15, 2010, we sold 5,175,000 of our common shares in a public offering at a price of $11.10 per share, which resulted in total net proceeds of approximately $54.9 million.

On May 12, 2010, we sold 9,200,000 common shares in a public offering at a price of $13.00 per share, which resulted in total net proceeds of approximately $114.3 million.

See Note 12 for additional information related to common shares.

Preferred Shares

On June 7, 2010, we redeemed all of our 8.70% Class B Series II Cumulative Redeemable Preferred Shares at a cost of approximately $48.3 million, plus accrued and unpaid dividends through the redemption date.  In connection with the issuance of those 8.70% Class B preferred shares in December 2004, we incurred approximately $1.0 million in issuance costs and recorded such costs as a reduction to shareholders’ equity.  In accordance with GAAP, we recognized the $1.0 million of issuance costs as a reduction in net earnings to arrive at net (loss) income applicable to common shares for the  nine months ended September 30, 2010.

8.         EARNINGS PER SHARE

There were approximately 750,000 and 1.4 million options to purchase common shares outstanding at September 30, 2010 and 2009, respectively.  The dilutive effect of these options were not included in the calculation of diluted earnings per share for the periods presented as their inclusion would be anti-dilutive to the net loss applicable to common shares from continuing operations.

The exchange of operating partnership non-controlling interests into common shares was also not included in the computation of diluted EPS because we intend to settle these OP units in cash.

The following table presents a reconciliation of basic and diluted earnings per common share:

9.         FAIR VALUE

Fair value determined in accordance with GAAP should be based on the assumptions that market participants would use when pricing certain assets or liabilities.  Inputs used in determining fair value should be from the highest level available in the following hierarchy:

In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the fair value measurement will fall within the lowest level input that is significant to the fair value measurement in its entirety.

The following table presents the financial liabilities that we measured at fair value on a recurring basis as of September 30, 2010:

We incorporate credit valuation adjustments to appropriately reflect both our own nonperformance risk and that of the respective counterparty in the fair value measurements.  The credit valuation adjustments utilize Level 3 inputs, such as estimates of current credit spreads, to evaluate the likelihood of default by either the respective counterparty or us.  However, we determined that as of September 30, 2010, the impact of the credit valuation adjustments were not significant to the overall valuation of the swaps.  See "Derivative Instruments and Hedging Activities" in Note 1 for additional information regarding the swaps.

Rents, accounts and notes receivable, other assets, accounts payable, accrued expenses and other liabilities are carried at amounts that reasonably approximate corresponding fair values.

Mortgage notes payable, revolving debt and other unsecured debt with an aggregate carrying value of $560.2 million and $525.8 million at September 30, 2010, and December 31, 2009, respectively, have an estimated aggregate fair value of $595.9 million and $520.1 million, respectively.  Estimated fair value is based on interest rates available to us as of the dates reported for issuance of debt with similar terms and remaining maturities.  Considerable judgment is necessary to interpret market data and develop estimated fair values.  Accordingly, the estimates presented herein are not necessarily indicative of the amounts we could realize on disposition of the financial instruments.  The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.

10.        CONTINGENCIES

Legal Proceedings

We are subject to legal proceedings, lawsuits and other claims, including proceedings by government authorities (collectively "Litigation").  Litigation is subject to uncertainties and outcomes are difficult to predict.  We believe any current Litigation will not have a material adverse impact on us after final disposition.  However, because of the uncertainties of Litigation, one or more lawsuits could ultimately result in a material obligation.

11.        DIRECTOR COMPENSATION

Directors' Deferred Compensation Plan

Effective January 1, 2010, the Directors' Deferred Compensation Plan was modified such that all future distributions from the plan will be in the form of our common shares instead of cash, except for the scheduled distributions which were to commence on or before December 31, 2010, which will be made in cash.  As a result, deferred compensation totaling $2.2 million that will be paid in shares was reclassified from "Accounts payable, accrued expenses and other liabilities" to "Paid-in Capital" in the Consolidated Balance Sheets during the nine months ended September 30, 2010.  Prior to the modification the fair value of the directors' deferred compensation accounts was adjusted at the end of each reporting period based on the closing price of our common shares.  However, as a result of the modification, no further adjustment to fair value will be required.

12.        SUBSEQUENT EVENTS

Common Shares

On October 1, 2010, we sold 9,200,000 common shares in a public offering at a price of $13.60 per share, which resulted in total net proceeds of approximately $119.6 million.

Acquisition Activity

On October 12, 2010, we acquired San Raphael Apartments, a 222-unit apartment community located in Dallas, Texas for a purchase price of approximately $21 million.  We paid cash for this acquisition, which was funded with proceeds from our October 1, 2010 equity offering.

Unsecured Revolving Credit Facility

On October 18, 2010, the Company closed on a $250.0 million senior unsecured revolving credit facility.  This credit facility replaces the Company's current $150.0 million line of credit.  This new facility has a three-year term with a one-year extension at the Company's option.

Dividends  

On November 1, 2010, we paid a dividend of $0.17 per common share to shareholders of record on October 15, 2010, which was declared on September 13, 2010.

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Part I, Item 1 of this report on Form 10-Q.  This discussion may contain forward-looking statements based on current judgments and current knowledge of management, which are subject to certain risks, trends and uncertainties that could cause actual results to vary from those projected, including but not limited to, expectations regarding our 2010 performance which are based on certain assumptions.  Accordingly, readers are cautioned not to place undue reliance on forward-looking statements that speak only as of the date of the document.  These forward-looking statements are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.  The words "expects," "projects," "believes," "plans," "anticipates" and similar expressions are intended to identify forward-looking statements.  Investors are cautioned that these forward-looking statements involve risks and uncertainty that could cause actual results to differ from estimates or projections contained in these forward-looking statements, including without limitation the following:

Overview.

We are engaged primarily in the ownership and operation of multifamily residential units. Our primary source of cash and revenue from operations is rents from the leasing of owned apartment units, which represented 91.5% of our consolidated revenue for the nine months ended September 30, 2010.

The operating performance of our properties is affected by general economic trends including, but not limited to, factors such as household formation, job growth, unemployment rates, population growth, immigration, the supply of new multifamily rental communities and in certain markets the supply of other housing alternatives, such as condominiums, single and multifamily rental homes and owner occupied single and multifamily homes.  Additionally, our performance may be affected by access to and cost of debt and equity.

Rental revenue collections are a combination of rental rates, occupancy levels and rent concessions.  We attempt to adjust these factors to adapt to changing market conditions, thus allowing us to maximize rental revenue.  Indicators that we use in measuring these factors include physical occupancy and net collected rent per unit.  These indicators are more fully described in the Results of Operations comparison.  Additionally, we consider property Net Operating Income ("NOI") and Funds from Operations ("FFO") to be important indicators of our overall performance.  Property NOI (property operating revenue less property operating and maintenance expenses) is a measure of the profitability of our properties and has the largest impact on our financial condition and operating results.  FFO is used in the real estate industry as a supplemental measure of the operating performance of real estate companies because it excludes charges such as real estate depreciation that are generally considered not to be reflective of the actual value of real estate assets over time.  Additionally, gains and losses from the sale of most real estate assets and certain other items are also excluded from FFO.

NOI is determined by deducting property operating and maintenance expenses from property revenue (excluding amounts classified as discontinued operations) for our properties, deducting direct property management and service company expenses from management and service company revenue for the management and service operations and deducting construction and other services expenses from construction and other services revenue.  We consider NOI to be an appropriate supplemental measure of our performance because it reflects the operating performance of our real estate portfolio, management and service companies and construction services at the property, management and service company and construction services level and is used to assess regional property level performance.  NOI should not be considered (i) as an alternative to net income (determined in accordance with GAAP), (ii) as an indicator of financial performance, (iii) as an alternative to cash flow from operating activities (determined in accordance with GAAP) or (iv) as a measure of liquidity; nor is it necessarily indicative of sufficient cash flow to fund all of our needs.  Other real estate companies may define NOI in a different manner. 

A reconciliation of NOI to total consolidated net (loss) income attributable to AERC is as follows:

We calculate Funds from Operations ("FFO") in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts ("NAREIT").  This definition includes all operating results, both recurring and non-recurring, except those results defined as "extraordinary items" under GAAP, adjusted for depreciation on real estate assets and amortization of intangible assets, gains on insurance recoveries, and gains and losses from the disposition of properties and land.  We calculate FFO per share using the weighted average shares outstanding amounts used in the calculation of basic and diluted earnings per share in accordance with GAAP.  FFO does not represent cash generated from operating activities in accordance with GAAP and is not necessarily indicative of cash available to fund cash needs and should not be considered an alternative to net income, as an indicator of our operating performance or as an alternative to cash flow as a measure of liquidity.  FFO is used in the real estate industry as a supplemental measure of the operating performance of real estate companies because it excludes charges such as real estate depreciation that are generally considered not to be reflective of the actual value of real estate assets over time.  Other real estate companies may define FFO in a different manner. 

We calculate FFO as adjusted as FFO, as defined above, plus the add back of refunds on previously defeased loans of $(553,000) and $(563,000) for the nine months ended September 30, 2010 and September 30, 2009, respectively.  In accordance with GAAP, these refunds on previously defeased loans are included as interest expense in the Consolidated Statement of Operations.  Additionally, the nine months ended September 30, 2010, includes add backs of non-cash charges of approximately $1.0 million and $727,000, respectively, associated with the redemption of our Series B Preferred Shares and Trust Preferred Securities.   We provide this calculation as an alternative FFO calculation as we consider it a more appropriate measure of comparing the operating performance of a company's real estate between periods or as compared to different REITs.

A reconciliation of net (loss) income attributable to AERC to FFO and FFO as adjusted is as follows:

Updated 2010 Expectations.

Forecast Qualification.  The uncertainties caused by the current economic conditions and the unprecedented financial crisis complicate our ability to forecast future performance.  We believe that the apartment industry is better situated to weather the recession than other real estate sectors because people will normally choose shelter over discretionary spending such as going to the mall or hotel stays and because government sponsored agencies such as Fannie Mae and Freddie Mac continue to provide attractive apartment financing, which may be unavailable to other commercial real estate sectors.  Our 2010 expectations may be adversely impacted if recessionary forces accelerate or Congress curtails Fannie Mae or Freddie Mac financing support to the apartment industry.

LIQUIDITY AND CAPITAL RESOURCES

Cash Flows and Liquidity.  Significant sources and uses of cash during the nine months ended September 30, 2010 and 2009 are summarized as follows:

Our primary sources of liquidity are cash flow provided by operations, short-term borrowings on the unsecured revolver, our secured credit facility, project specific loans and the sale of debt or equity securities.  We believe that we are well positioned to weather the recent turmoil in the financial markets.  Six mortgage loans totaling approximately $78.3 million were scheduled to mature in 2010.  We have repaid five of those debt obligations totaling $57.3 million and expect to repay the remaining $21.0 million obligation with proceeds from a project specific secured loan.

In December 2009, we entered into a credit facility agreement with Wells Fargo Multifamily Corporation on behalf of Freddie Mac.  Pursuant to the terms of the facility, we have the potential to borrow up to $100.0 million over a two-year period ending in December 2011 with obligations being secured by nonrecourse, non cross-collateralized fixed or variable rate mortgages having terms of five, seven or ten years.  In August 2010, we used this facility to borrow $36.0 million at a fixed rate of 5.1% for a term of 10 years leaving $64.0 million of availability under this facility.  Our unsecured revolver provides us additional financial flexibility.  On October 1, 2010, we used proceeds from our common share issuance to repay the $96.2 million outstanding balance on our unsecured revolver.  On October 18, 2010, we entered into an Amended and Restated Credit Agreement that among other things increases the maximum amount of loans available under the revolver to $250.0 million, extends the maturity date to October 18, 2013 and provides for a one year extension option.

Our ability to access the capital markets affords us additional liquidity as demonstrated by our year-to-date sales of 23,575,000 of our common shares in three separate underwritten offerings to the public markets.  The net proceeds from these offerings, which totaled $288.8 million, were used to repay maturing debt, redeem all our outstanding 8.70% Class B Series II Preferred Shares, redeem all of our Trust Preferred Securities, partially pay for three operating properties, acquire a parcel of land that we are developing in a partnership, to repay borrowings on our unsecured revolver, and for general corporate purposes.

We anticipate that cash flow provided by operations for the remainder of the year will continue to meet normal business operations and liquidity requirements for the upcoming year.  We believe that if net cash provided by operations is below projections, other sources such as the unsecured revolver, secured and unsecured borrowings are or can be made available and should be sufficient to meet our normal business operations and liquidity requirements.  We anticipate that we will continue paying our regular quarterly dividends in cash.  Funds to be used for the repayment of debt, property acquisitions, development or other capital expenditures are expected to be provided primarily by proceeds from the refinancing of debt borrowings, our unsecured revolver and possibly the sale of common shares.

Cash flow provided by operations decreased during the nine months ended September 30, 2010, compared to the nine months ended September 30, 2009, primarily due to an increase in accounts receivable during the nine months ended September 30, 2010.  Additionally, general and administrative expenses increased approximately $821,000.  See the discussion under “General and administrative expense” under Results of Operations regarding increases in general and administrative costs.

During the remainder of 2010, we anticipate incurring an additional $4.0 million in capital expenditures.  This includes replacement of worn carpet and appliances, parking lots and similar items in accordance with our current property expenditure plan, as well as commitments for revenue enhancing and non-recurring expenditures.  These capital expenditures are expected to be funded with cash provided by operating activities and borrowings on our unsecured revolver.

RESULTS OF OPERATIONS

Comparison of the three and nine months ended September 30, 2010 to the three and nine months ended September 30, 2009:

Our Same Community portfolio represents operating properties that we have owned for all of the comparison periods.  For the nine months ended September 30, 2010 and 2009, the Same Community portfolio consisted of 48 owned properties containing 12,108 units.  Acquired properties represent the operating properties that we acquired in May and September 2010, while the development property represents 60 newly-constructed units on the land adjacent to River Forest Apartments which are in the lease-up process.  

The net loss from continuing operations decreased $1.0 million for the three month comparison period and increased $325,000 during the nine month comparison period.  The decrease in the three month comparison period was primarily due to the net of the following:  an increase in property revenue, an increase in property operating and maintenance expense, an increase in depreciation and amortization expense and a decrease in interest expense and general and administrative expense.  The increase in the nine month comparison period was primarily due to an increase in property revenue, an increase in property operating and maintenance expense, an increase in depreciation and amortization expense, a decrease in interest expense and an increase in general and administrative expense.  See the following discussion for a detailed description of the changes in these line items.

The following table reflects the amount and percentage change in line items that are relevant to the changes in overall operating performance:

Property NOI increased for both the three month and nine month comparison periods primarily due to the contributions by the acquired properties.  Property NOI for the Same Community properties during the three month comparison period increased slightly primarily due to increased revenues at the Southeast properties.  During the nine month comparison period, Same Community Property NOI decreased primarily due to a decrease in revenue and an increase in expenses at the Mid-Atlantic properties.

The following table presents property NOI results by region:

Property revenue.  Property revenue is impacted by a combination of rental rates, rent concessions and occupancy levels, i.e., net collected rent per unit.  Physical occupancy at the end of each period and net collected rent per unit are presented in the following tables: