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FSP 303 EAST WACKER DRIVE CORP. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

May 13, 2014

The following discussion should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report and in our Annual Report on Form 10-K for the year ended December 31, 2013. Historical results and percentage relationships set forth in the consolidated financial statements, including trends which might appear, should not be taken as necessarily indicative of future operations. The following discussion and other parts of this Quarterly Report on Form 10-Q may also 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 differ materially from those indicated in such forward-looking statements. Accordingly, readers are cautioned not to place undue reliance on forward-looking statements. Investors are cautioned that our forward-looking statements involve risks and uncertainty, including without limitation economic conditions in the United States and in the market where we own the Property, disruptions in the debt markets, risks of a lessening of demand for the type of real estate owned by us, changes in government regulations and regulatory uncertainty, geopolitical events, and expenditures that cannot be anticipated such as utility rate and usage increases, unanticipated repairs, uncertainty about government fiscal policy, additional staffing, insurance increases and real estate tax valuation reassessments. Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We may not update any of the forward-looking statements after the date this Quarterly Report on Form 10-Q is filed to conform them to actual results or to changes in our expectations that occur after such date, other than as required by law.

Overview



Our company, FSP 303 East Wacker Drive Corp., which we refer to as the Company, is a Delaware corporation formed to purchase, own, and operate a twenty-eight story multi-tenant office tower containing approximately 860,000 rentable square feet of office and retail space and a 294-stall underground parking garage located in downtown Chicago, Illinois, which we refer to as the Property.

Franklin Street Properties Corp., which we refer to as Franklin Street, is the sole holder of our one share of common stock, $.01 par value per share, which we refer to as the Common Stock, that is issued and outstanding. Between February 2007 and December 2007, FSP Investments LLC (member, FINRA and SIPC), a wholly-owned subsidiary of Franklin Street, completed the sale on a best efforts basis of 2,210 shares of our preferred stock, $.01 par value per share, which we refer to as the Preferred Stock. FSP Investments LLC sold the Preferred Stock in a private placement offering to "accredited investors" within the meaning of Regulation D under the Securities Act of 1933. Since the completion of the placement of the Preferred Stock in December 2007, Franklin Street has not been entitled to share in any earnings or dividend related to the Common Stock.

We operate in one business segment, which is real estate operations, and own a single property. Our real estate operations involve real estate rental operations, leasing services and property management services. The main factor that affects our real estate operations is the broad economic market conditions in the United States and, more specifically, the economic conditions in Chicago, Illinois, the relevant local market. These market conditions affect the occupancy levels and the rent levels on both a national and local level. We have no influence on national or local market conditions.

Trends and Uncertainties Economic Conditions



The economy in the United States is continuing to experience a period of slow economic growth, including relatively high levels of unemployment, which directly affects the demand for office space, our primary income producing asset. The broad economic market conditions in the United States are affected by numerous factors, including but not limited to, inflation and employment levels, energy prices, slow economic growth and/or recessionary concerns, uncertainty about government fiscal and tax policy, changes in currency exchange rates, geopolitical events, the regulatory environment, the availability of debt and interest rate fluctuations. However, unemployment rates have been trending lower. We also believe that the Federal Reserve Bank's current tapering program has been generally received as a harbinger of real improvement in the economy, which could bode well for our real estate operations. We could benefit from any further improved economic fundamentals and increasing levels of employment. We believe that the economy is in the early stages of a cyclically-slower but prolonged broad-based upswing. However, future economic factors may negatively affect real estate values, occupancy levels and property income.

9 Real Estate Operations



The Property was approximately 54% leased as of March 31, 2014 to a diverse group of tenants with staggered lease expirations. Management believes that any tenant that leases 10% or more of the Property's rentable space is material. As of March 31, 2014, 33 tenants were leasing space at the Property and no tenant leased 10% or more of the Property's rentable space.

During the three months ended March 31, 2014, we executed a new lease with Smithfield Foods for 7,363 square feet. Management continues to observe steady touring activity at the Property by smaller prospective tenants (under 20,000 square feet), but believes that office buildings in the East Loop submarket of Chicago, where the Property is located, continue to struggle with attracting larger prospective users. As a result, management believes that the trend of higher vacancy rates and disappointing net absorption has continued within the East Loop. We believe that the East Loop has had difficulty stabilizing during the past six years, with several of its office properties losing anchor tenants and experiencing declining occupancies. During this period of time, we believe that users in fields such as the technology sector have absorbed significant amounts of quasi-office and warehouse spaces along the Chicago River in a submarket known as River North and in locations considered to be on the fringes of downtown Chicago. Many of the retrofitted buildings that have been attracting these users were built in the early twentieth century with very large floor plates that allow for extremely dense populations on a single floor.

It is difficult for management to predict what will happen to occupancy and rents in the future because the need for space and the price tenants are willing to pay are tied to both the local economy and to the larger trends in the national economy, such as job growth, interest rates, the availability of credit and corporate earnings, which in turn are tied to even larger macroeconomic and political factors, such as recessionary concerns, volatility in energy pricing and the risk of terrorism. In addition to the difficulty of predicting macroeconomic factors, it is difficult to predict how our local market or tenants (existing and potential) will suffer or benefit from changes in the larger economy. In addition, because the Property is in a single geographical market, these macroeconomic trends may have a different effect on the Property and on its tenants (existing and potential), some of which may operate on a national level. Although we cannot predict how long it will take to lease vacant space at the Property or what the terms and conditions of any new leases will be, we expect to sign new leases at then-current market rates which may be below the expiring rates.

During the three months ended March 31, 2014, we believe that vacancy rates increased slightly and that rental rates were stable for buildings in Chicago'sEast Loop office submarket. These trends may continue, worsen or improve in the future. Although occupancy levels have decreased at the Property, management believes that the position of the Property within the East Loop office submarket is strong compared to competing buildings in that submarket and management is optimistic that the existing vacant space will ultimately be leased to new tenants. In order to further improve the Property's position in Chicago's office market, management has implemented a number of lobby upgrades. If we can stabilize the Property at a high occupancy level with long-term quality rental income streams from credit-worthy tenants, we could create value for the holders of our Preferred Stock. If successful in re-leasing the existing vacant space under favorable terms, the opportunity for payment of dividends and/or a sale of the Property at an attractive price could be a real possibility. Of course, any sale of the Property would be subject to a number of conditions, including approval by our board of directors and a majority of the holders of our Preferred Stock. However, we may not be able to lease all of the remaining vacant space.

The potential for any of our tenants to default on its lease or to seek the protection of bankruptcy laws exists. If any of our tenants defaults on its lease, we may experience delays in enforcing our rights as a landlord and may incur substantial costs in protecting our investment. In addition, at any time, a tenant may seek the protection of bankruptcy laws, which could result in the rejection and termination of such tenant's lease and thereby cause a reduction in cash available for distribution to our stockholders. Bankruptcy or a material adverse change in the financial condition of a material tenant would likely have a material adverse effect on our results of operations.

Dividends, Future Tenant Improvement Costs and Leasing Commissions

Management believes that the Company will need to be able to quickly access cash in order to fund the potentially significant tenant improvements costs and leasing commissions that may be required to stabilize the occupancy and rent roll at the Property. We expect no or lower dividend distributions until occupancy levels at the Property recover and we have a better idea of the Property's actual future capital and leasing needs. We cannot guarantee the future payment of dividends or the amount of any such dividends.

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In light of the amount of vacant space that needs to be leased at the Property and the potential for significant tenant improvement allowance costs and leasing commissions, on August 3, 2011, we entered into a mortgage note in favor of John Hancock Life Insurance Company (U.S.A.), which we refer to as the Lender, to evidence a loan, which we refer to as the Loan, in the original principal amount of $35,000,000 that matures on September 1, 2021. The remaining proceeds of the Loan are being held by the Lender for our benefit in a restricted reserve account or accounts to be drawn upon by us from time to time for tenant improvement costs and leasing commissions at the Property upon satisfaction of certain conditions. The Loan bears interest at the fixed rate of 4.83% per annum. We are obligated to make monthly payments of interest only for the initial 60 months of the Loan. Thereafter, we are obligated to make monthly payments of principal and interest for the remaining 60 months, based on a 25-year amortization schedule, until the maturity date, when all outstanding amounts become due. The Loan is secured, in part, by a mortgage, assignment of leases and rents and security agreement, which we refer to as the Mortgage, from us in favor of the Lender. The Mortgage constitutes a lien against the Property and has been recorded in the land records of Cook County, Illinois. Subject to customary exceptions, the Loan is nonrecourse to the Company. As of March 31, 2014, we had made aggregate draw requests under the Loan of $12,811,000. Interest expense paid on the Loan for the three months ended March 31, 2014 and 2013 was $423,000 for both periods. The documents evidencing and securing the Loan include restrictions on property liens and requires compliance with various financial covenants. Financial covenants include the requirement that we provide annual reporting. We were in compliance with the Loan covenants as of March 31, 2014 and December 31, 2013.

Critical Accounting Policies



We have certain critical accounting policies that are subject to judgments and estimates by our management and uncertainties of outcome that affect the application of these policies. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances. On an on-going basis, we evaluate our estimates. In the event estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current information. The accounting policies that we believe are most critical to the understanding of our financial position and results of operations and that require significant management estimates and judgments are discussed below.

Critical accounting policies are those that have the most impact on the reporting of our financial condition and results of operations and those requiring significant judgments and estimates. We believe that our judgments and estimates are consistently applied and produce financial information that fairly presents our results of operations. Our most critical accounting policies involve our investments in real property.

No change to our critical accounting policies has occurred since the filing of our Annual Report on Form 10-K for the year ended December 31, 2013.

Results of Operations



As of March 31, 2014, the Property was approximately 54% leased to a diverse group of tenants with staggered lease expirations.

Comparison of the three months ended March 31, 2014 to the three months ended March 31, 2013

Revenue



Total revenue decreased by approximately $0.3 million to $3.3 million for the three months ended March 31, 2014, as compared to $3.6 million for the three months ended March 31, 2013. This decrease was primarily due to a decrease in rental revenue of $0.4 million due to a decrease in occupancy which was partially offset by an increase in recoverable income of $0.1 million.

Expenses



Total expenses increased by approximately $0.5 million to $4.3 million for the three months ended March 31, 2014, as compared to $3.8 million for the three months ended March 31, 2013. The increase is predominantly a result of an increase in real estate taxes and insurance of $0.2 million, an increase in depreciation and amortization of $0.2 million and an increase in operating expenses of $0.1 million.

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Liquidity and Capital Resources

Cash and cash equivalents were $19.1 million at March 31, 2014 and $18.8 million at December 31, 2013. The $0.3 million increase for the three months ended March 31, 2014 is primarily attributable to approximately $8.6 million used for operating activities, which was offset by approximately $8.9 million provided by investing activities.

Management believes that the existing cash and cash anticipated to be generated internally by operations will be sufficient to meet working capital requirements, any distributions required for us to maintain our status as a real estate investment trust and anticipated capital expenditures for at least the next 12 months.

Operating Activities



The cash used for operating activities of $8.6 million for the three months ended March 31, 2014 was primarily attributable to a net loss of approximately $1.0 million, an increase in restricted cash of $6.5 million, a decrease of $2.6 million by uses arising from other current accounts and payment of deferred leasing costs of $0.1 million. The decrease was partially offset by add back of $1.6 million of depreciation and amortization.

Investing Activities



The cash provided by investing activities of approximately $8.9 million for the three months ended March 31, 2014 was attributable to the redemptions of the restricted investment of $9.0 million, which was offset by the purchases of real estate assets of $0.1 million.

Financing Activities



There was no cash provided by or used for financing activities for the three months ended March 31, 2014.

Sources and Uses of Funds



The Company's principal demands on liquidity are cash for operations, interest on debt payments and distributions to equity holders. As of March 31, 2014, we had approximately $3.2 million in accrued liabilities, and $35 million in long-term debt. In the near term, liquidity is generated by cash from operations.

Secured Debt



On August 3, 2011, we entered into a mortgage note in favor of John Hancock Life Insurance Company (U.S.A.), which we refer to as the Lender, to evidence a loan, which we refer to as the Loan, in the original principal amount of $35,000,000 that matures on September 1, 2021. The remaining proceeds of the Loan are being held by the Lender for our benefit in a restricted reserve account or accounts to be drawn upon by us from time to time for tenant improvement costs and leasing commissions at the Property upon satisfaction of certain conditions. The Loan bears interest at the fixed rate of 4.83% per annum. We are obligated to make monthly payments of interest only for the initial 60 months of the Loan. Thereafter, we are obligated to make monthly payments of principal and interest for the remaining 60 months, based on a 25-year amortization schedule, until the maturity date, when all outstanding amounts become due. The Loan is secured, in part, by a mortgage, assignment of leases and rents and security agreement, which we refer to as the Mortgage, from us in favor of the Lender. The Mortgage constitutes a lien against the Property and has been recorded in the land records of Cook County, Illinois. Subject to customary exceptions, the Loan is nonrecourse to the Company. As of March 31, 2014, we had made aggregate draw requests under the Loan of $12,811,000. Interest expense from the Loan for the three months ended March 31, 2014 and 2013 is $423,000 for both periods.

The Loan agreement includes restrictions on property liens and requires compliance with various financial covenants. Financial covenants include the requirement that we provide annual reporting. We were in compliance with the Loan covenants as of March 31, 2014 and December 31, 2013.

Contingencies



We may be subject to various legal proceedings and claims that arise in the ordinary course of our business. Although occasional adverse decisions (or settlements) may occur, we believe that the final disposition of such matters will not have a material adverse effect on our financial position or results of operations.

12 Related Party Transactions Asset Management Agreement



We have in the past engaged in and currently engage in transactions with a related party, Franklin Street, and its subsidiaries, FSP Investments LLC and FSP Property Management LLC, which we collectively refer to as FSP. We expect to continue to have related party transactions with FSP in the form of management fees paid to FSP to manage the Company on behalf of our stockholders. FSP Property Management LLC currently provides us with asset management and financial reporting services. The asset management agreement between us and FSP Property Management LLC requires us to pay FSP Property Management LLC a monthly fee equal to one-half of one percent (.5%) of the gross revenues of the Property. The asset management agreement between us and FSP Property Management LLC may be terminated by either party without cause at any time, upon at least thirty (30) days' written notice. For the three months ended March 31, 2014 and 2013, management fees paid were approximately $16,000 and $18,000, respectively.

Investor Services Agreement



On August 14, 2012, we entered into an Investor Services Agreement, which we refer to as the FSPI Agreement, with FSP Investments LLC for the provision of investor services to holders of our preferred stock. FSP Investments LLC is a wholly-owned subsidiary of Franklin Street, which is the sole holder of our one share of Common Stock that is issued and outstanding. FSP Investments LLC acted as a real estate investment firm and broker/dealer with respect to (a) our organization, (b) our acquisition of the Property and (c) the sale of our equity interests. The FSPI Agreement requires us to pay a monthly service fee of $500 for services performed under the FSPI Agreement, and to reimburse FSP Investments LLC for its reasonable out-of-pocket expenses incurred in connection with the FSPI Agreement. The FSPI Agreement may be terminated by either party with thirty days written notice or immediately upon certain events of default set forth in the FSPI Agreement. For the three months ended March 31, 2014 and 2013, investor services fees paid were approximately $3,700 and $3,500, respectively.

Ownership of Preferred Stock and Common Stock

On December 27, 2007, Franklin Street purchased 965.75 shares of the Preferred Stock (or approximately 43.7%), of the Company for consideration totaling $82,813,000. Prior to purchasing any shares of the Preferred Stock, Franklin Street agreed to vote any shares held by it on any matter presented to the holders of the Preferred Stock in a manner that approximates as closely as possible the votes cast in favor of and opposed to such matter by the holders of the Preferred Stock other than Franklin Street and its affiliates. For purposes of determining how Franklin Street votes its shares of the Preferred Stock, abstentions and non-votes by stockholders other than Franklin Street are not considered. Franklin Street is entitled to distributions that are declared on the Preferred Stock.

Franklin Street is the sole holder of the Company's one share of Common Stock that is issued and outstanding. Subsequent to the completion of the private placement of the Preferred Stock in December 2007, Franklin Street has not been entitled to share in our earnings or any dividend related to the Common Stock of the Company.

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Source: Edgar Glimpses