ONE LIBERTY PROPERTIES INC (OLP) FY 2021 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Overview

We are a self-administered and self-managed REIT focused on acquiring, owning and managing a geographically diversified portfolio of industrial, retail, restaurant, health and fitness and theater properties, many of which are subject to long-term leases. Most of our leases are “net leases” under which the tenant, directly or indirectly, is responsible for paying the real estate taxes, insurance and ordinary maintenance and repairs of the property. As of December 31, 2021, we own, in 31 states, 121 properties, including three properties owned by consolidated joint ventures and three properties owned through unconsolidated joint ventures.

Challenges and Uncertainties Related to the COVID-19 Pandemic

The COVID-19 pandemic had, and continues to have, a significant impact on the global economy, the U.S. economy, and the economies of the local markets in which our properties are located.  The preventative measures taken to address the pandemic, and the economic consequences resulting therefrom, have affected, and will continue to affect, our tenants to varying degrees depending on, among other things, the location of the subject property, the nature of the tenant and use of the property (i.e., industrial or non-industrial), with theater, health and fitness, restaurant and retail properties having been, and continuing to be, significantly adversely affected.

The pandemic and its impact on the economic, financial, and capital markets environments present material risks and uncertainties.  We are unable to predict the ultimate impact that the pandemic and its direct and indirect consequences will have on us, which will depend largely on future developments relating to many factors outside of our control. Our business, income, cash flow, results of operations, financial condition, liquidity, prospects, ability to service our debt, and ability to pay cash dividends to our stockholders, has been and may continue to be adversely affected by the pandemic.

General Challenges and Uncertainties

In addition to the challenges and uncertainties presented by the pandemic, and as also described under “Cautionary Note Regarding Forward-Looking Statements” and “Item 1A. Risk Factors”, we, among other things, face additional challenges and uncertainties, which are heightened by the pandemic, including the possibility we will not be able to: lease our properties on terms favorable to us or at all; collect amounts owed to us by our tenants; renew or re-let, on acceptable terms, leases that are expiring or otherwise terminating; or acquire or dispose of properties on acceptable terms. Over the past several years, we have sold more properties than we have acquired, the rental income generated by the acquired properties have not fully replaced the income generated by the sold properties and the return on investment on acquired properties has been less than that generated by the sold properties. Furthermore, many of the properties we have sold have been retail properties which generally have generated greater returns than the industrial properties we have been acquiring. As a result of, among other things, the foregoing, the portion of our dividends allocated to ordinary income (as opposed to capital gain and return of capital) has decreased from 88% in 2018 to 43% for 2021. See Note 15 to our consolidated financial statements. If these trends continue over the longer-term, we may be unable to sustain our current level of dividend payments.

We generally seek to manage the risk of our real property portfolio and the related financing arrangements by (i) diversifying among industries, locations, tenants, scheduled lease expirations, mortgage maturities and lenders, and types of properties (for example, industrial, retail, theaters, health and fitness, although over the past several years, we have focused on acquiring industrial properties), and (ii) minimizing our exposure to interest rate fluctuations. As a result, as of December 31, 2021:

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We monitor the risk of tenant non-payments through a variety of approaches tailored to the applicable situation. Generally, based on our assessment of the credit risk posed by our tenants, we monitor a tenant’s financial condition through one or more of the following actions: reviewing tenant financial statements or other financial information, obtaining other tenant related information, changes in tenant payment patterns, regular contact with tenant’s representatives, tenant credit checks and regular management reviews of our tenants. We may sell a property if the tenant’s financial condition is unsatisfactory.

We monitor, on an ongoing basis, our expiring leases and generally approach tenants with expiring leases (including those subject to renewal options) at least a year prior to lease expiration to determine their interest in renewing their leases. During the three years ending December 31, 2024, 58 leases for 55 tenants at 40 properties representing $16.6 million, or 24.2%, of 2022 contractual rental income expire. The following table provides information, as of December 31, 2021, regarding the leases that expire during the three years ending December 31, 2024 (with respect to the multi-tenant shopping center in Lakewood, Colorado, which have both retail and restaurant tenants, we have allocated the property count and associated mortgage debt to the retail (and not restaurant) categories because this is a mixed-use property):

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In acquiring properties, we balance an evaluation of the terms of the leases and the credit of the existing tenants with a fundamental analysis of the real estate to be acquired, which analysis takes into account, among other things, the estimated value of the property, local demographics and the ability to re-rent or dispose of the property on favorable terms upon lease expiration or early termination.

We are sensitive to the risks facing the retail industry as a result of the growth of e-commerce. Over the past several years, we have been addressing our exposure to the retail industry by focusing on acquiring industrial properties (including warehouse and distribution facilities) and properties that we believe capitalize on e-commerce activities – since September 2016, we have not acquired any retail properties and have sold 16 retail properties. As a result of the focus on industrial properties and the sale of retail properties, retail properties generated 30.2%, 32.9%, 35.2% and 41.9%, of rental income, net, in 2021, 2020, 2019 and 2018, respectively, and industrial properties generated 57.0%, 55.4%, 48.7% and 40.1%, of rental income, net, in 2021, 2020, 2019, and 2018, respectively.

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At December 31, 2021, we have variable rate debt in the principal amount of $68.6 million (i.e., $56.9 million of mortgage debt and $11.7 million of credit facility debt) that bear interest at the one-month LIBOR rate plus a negotiated spread. This mortgage debt is hedged through interest rate swaps and the credit facility debt is not hedged. The authority regulating LIBOR announced it intends to stop compelling banks to submit rates for the circulation of LIBOR after June 2023 and it is possible that LIBOR will become unavailable at an earlier date. As approximately $51.2 million of this mortgage debt and the related notional amount of the interest rate swaps mature after June 2023, there is uncertainty as to how the interest rate on this variable rate debt and the related swaps will be determined when LIBOR is unavailable.

Challenges and Uncertainties Facing Certain Properties and Tenants

The Vue – Beachwood, Ohio

A multi-family complex, which we refer to as The Vue, ground leases from us the underlying land located in Beachwood, Ohio. For the past several years, the property has faced, and we anticipate that the property will continue to face, occupancy and financial challenges. As a result, the rental income generated by the property has declined significantly over the past several years (i.e., from $1.4 million in 2018 to $0 in 2021). After giving effect to debt service, the property is operating on a negative cash flow basis, and we anticipate that such trend will continue for an extended period. The tenant has not paid the aggregate $1.7 million of rent for October 2020 through March 2022 that would have been due had it generated specified levels of positive operating cash flow and we anticipate this non-payment of rent trend will continue for an extended period. As a result of the challenges faced by this property, in November 2020, we agreed, subject to our discretion, to fund 78% of any operating expense shortfalls (including the tenant’s debt service payments) and capital expenditures required at the property. We estimate that in 2022, we will provide approximately $700,000 in funding for this property. During 2021 (through March 1, 2022), we provided The Vue with $2.0 million to cover, among other things, operating cash flow shortfalls and capital expenditures. At December 31, 2021, (i) there are no unbilled rent receivables, intangibles or tenant origination costs associated with this property and (ii) the net book value of our land subject to this ground lease is $15.8 million and is subordinate to $66.0 million of mortgage debt incurred by the owner/operator. Our cash flow will be adversely impacted by our funding of additional capital expenditures and operating expense shortfalls (including the tenant’s debt service payments) at the property, the tenant’s continuing non-payment of rent or, if the tenant does not pay its debt service, our payment of the tenant’s debt service obligation. We may incur a substantial impairment charge with respect to this property if we determine that the property is impaired. See Note 6 to our consolidated financial statements.

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Re-development of the Manahawkin Property

We continue to refine our efforts, which commenced in 2018, to re-develop the Manahawkin Property, which is owned by an unconsolidated joint venture in which we have a 50% equity interest. As a result, the income and cash flow from this property is currently significantly less than it was several years ago and at December 31, 2021, the occupancy rate was 53.2%. In 2021, the property’s carrying costs (including debt service payments) exceeded the property’s operating cash flow by approximately $142,000. To date, no construction has begun in connection with the re-development and there is significant uncertainty as to the form the re-development will take, whether and when the re-development will be completed, the costs to complete the re-development and as to the prospects for this property because of, among other things, the (i) decrease in rent and occupancy, (ii) possibility that co-tenancy clauses could be triggered if certain significant tenants vacate or otherwise cease operations, (iii) possibility that tenants that have informally agreed to participate in the re-development may abandon the project in light of, among other things, the extended delay in completing a re-development or challenges facing the retail environment, (iv) difficulty in obtaining financing for the project, (v) significantly greater labor and material costs than those projected at the time the re-development was initiated due, among other things, to inflation and supply chain delivery issues, and (vi) the continuing delay in completing the re-development. As of December 31, 2021, our share of the capitalized costs, (primarily soft costs) related to the re-development is $571,000. Our net income and cash flow have been negatively impacted by the re-development and our net income, cash flow and financial condition will be adversely affected if significant tenants such as Regal Cinemas do not continue paying rent or the re-development is further delayed or not completed. See “—Liquidity and Capital Resources.”

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Round Rock Guaranty Litigation

In 2019, we sued the guarantor of the lease at our former property in Round Rock, Texas, which we refer to as the “Round Rock Property”, at which the tenant obtained bankruptcy protection and terminated its lease. (The lawsuit (the “Lawsuit”) is captioned: OLP Wyoming Springs, LLC, Plaintiff, v. Harden Healthcare, LLC, Defendant, v Benjamin Hanson, Intervenor, District Court of Williamson County, Texas, Cause No. 18-1511-C368). On February 21, 2022, we and the defendant entered into a settlement agreement with respect to the Lawsuit which provides that if we receive approximately $5.4 million (the “Settlement Amount”) by April 15, 2022, the parties to such agreement, among other things, will (i) seek to dismiss with prejudice all of the claims by and between the parties to the agreement, (ii) seek dismissal of the Lawsuit with prejudice and (iii) release each other and certain other persons from claims and liabilities with respect to matters pertaining to the Lawsuit.  If the Settlement Amount is not paid by April 15, 2022, we and the defendant may continue to pursue and assert all of our respective rights, claims and defenses against each other.

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2021 and Recent Developments

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In 2021:

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Subsequent to December 31, 2021, we:

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Comparison of Years Ended December 31, 2021 and 2020

Results of Operations -

Revenues

The following table compares total revenues for the periods indicated:

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Rental income, net.

The following table details the components of rental income, net, for the periods indicated:

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Changes due to acquisitions and dispositions

The year ended December 31, 2021 reflects a decrease of $2.3 million due to the inclusion, in 2020, of rental income from properties sold during 2020 and 2021 (including $1.4 million from four properties sold in 2020). This decrease was offset by a $950,000 increase generated by properties acquired in 2020 and 2021 (including $313,000 from two properties acquired in 2020).

Changes at same store properties

The increase is due to:

Offsetting the increase are decreases of:

Lease termination fees.

In 2021, we recognized $560,000 in connection with the exercise by three tenants of lease termination options.

Operating Expenses

The following table compares operating expenses for the periods indicated:

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Depreciation and amortization. The decrease is due primarily to the inclusion in 2020 of (i) $518,000 from the properties sold since January 1, 2020 and (ii) $247,000 of improvements and tenant origination costs at several properties that prior to December 31, 2021 were fully amortized. The decrease was offset primarily from (i) $490,000 of depreciation and amortization expense on the properties acquired in 2021 and 2020 (including

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$344,000 from properties acquired in 2021) and (ii) $120,000 of depreciation in 2021 from improvements at several properties.

General and administrative. The increase in 2021 is primarily due to increases in non-cash compensation expense of (i) $542,000 due to the re-assessment of the achievability of market and performance metrics related to the RSUs and (ii) $205,000, of which $157,000 was due to the retirement of a non-management director in June 2021 and the related accelerated vesting of such director’s restricted stock awards. The increase was offset due to the inclusion, in 2020, of $152,000 of professional fees primarily related to changes to our charter, offering of securities and compensation determinations.

Real estate expenses.

The increase is due primarily to increases at same store properties of :

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In addition, there was a $107,000 increase from properties acquired in 2020 and 2021, including $82,000 from a property acquired in 2021.

Offsetting the increase are decreases of:

A substantial portion of real estate expenses are rebilled to tenants and are included in Rental income, net, on the consolidated statements of income, other than the expenses related to the Round Rock litigation.

Impairment due to casualty loss.

In August 2020, a building at our Lake Charles, Louisiana property was damaged due to a hurricane and we wrote-off $430,000, representing the carrying value of the damaged portion of the building. See “– Other income” for information about the insurance recoveries received, and to be received, with respect to this impairment.

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Gain on sale of real estate, net

The following table compares gain on sale of real estate, net:

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See “–2021 and Recent Developments” and Note 5 to our consolidated financial statements for information regarding our sales of real estate.

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Other Income and Expenses

The following table compares other income and expenses for the periods indicated:

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Equity in earnings of unconsolidated joint ventures. The increase in 2021 is primarily due to an increase at our Manahawkin Property resulting from (i) higher rent income from several tenants for which there were abatements and unaccrued deferrals in 2020 and (ii) a decrease in real estate taxes, net of amounts rebilled to tenants, due to a lower assessment. These increases were offset by an increase in depreciation and amortization expense primarily for improvements to the property.

Equity in earnings from sale of unconsolidated joint venture properties. The 2021 results represent a gain of $805,000 from the sale of a portion of a joint venture’s property in Savannah, Georgia. The 2020 results represent a gain of $121,000 from the sale of another joint venture’s property in Savannah, Georgia.

Prepayment costs on debt. The 2021 expense includes $799,000 incurred in connection with the sale of the West Hartford, Connecticut property. The 2020 expense includes $833,000 incurred in connection with the sale of the Knoxville, Tennessee property and $290,000 incurred in connection with the sale of the Onalaska, Wisconsin property.

Other income. Other income in 2021 and 2020 include $695,000 and $430,000, respectively, of property insurance recoveries related to our Lake Charles, Louisiana property damaged in an August 2020 hurricane. In February 2022, we received a final payment of $918,000 of additional insurance proceeds related to this property. In addition, 2021 includes a $100,000 fee obtained in connection with an assignment of a lease.

Interest expense. The following table summarizes interest expense for the periods indicated:

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Mortgage interest

The following table reflects the average interest rate on the average principal amount of outstanding mortgage debt during the applicable year:

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The decrease in mortgage interest in 2021 is due to the net decrease in the principal amount of mortgage debt outstanding which resulted from scheduled amortization payments, and, primarily in connection with property sales, the payoff of mortgages.

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Credit facility interest

The following table reflects the average interest rate on the average principal amount of outstanding credit line debt during the applicable year:

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The decrease in credit line interest in 2021 is primarily due to a decrease of $12.3 million in the weighted average balance outstanding under our line of credit and, to a lesser extent, a 67 basis point decrease in the weighted average interest rate due to decreases in the one month LIBOR rate.

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Funds from Operations and Adjusted Funds from Operations

We compute funds from operations, or FFO, in accordance with the “White Paper on Funds From Operations” issued by the National Association of Real Estate Investment Trusts (“NAREIT”) and NAREIT’s related guidance. FFO is defined in the White Paper as net income (calculated in accordance with GAAP), excluding depreciation and amortization related to real estate, gains and losses from the sale of certain real estate assets, gains and losses from change in control, impairment write-downs of certain real estate assets and investments in entities where the impairment is directly attributable to decreases in the value of depreciable real estate held by the entity. Adjustments for unconsolidated partnerships and joint ventures are calculated to reflect FFO on the same basis. In computing FFO, we do not add back to net income the amortization of costs in connection with our financing activities or depreciation of non-real estate assets.

We compute adjusted funds from operations, or AFFO, by adjusting from FFO for our straight-line rent accruals and amortization of lease intangibles, deducting lease termination and certain other non-recurring fees and adding back amortization of restricted stock and restricted stock unit compensation expense, amortization of costs in connection with our financing activities (including our share of our unconsolidated joint ventures), income on insurance recoveries from casualties and debt prepayment costs. Since the NAREIT White Paper does not provide guidelines for computing AFFO, the computation of AFFO may vary from one REIT to another.

We believe that FFO and AFFO are useful and standard supplemental measures of the operating performance for equity REITs and are used frequently by securities analysts, investors and other interested parties in evaluating equity REITs, many of which present FFO and AFFO when reporting their operating results. FFO and AFFO are intended to exclude GAAP historical cost depreciation and amortization of real estate assets, which assumes that the value of real estate assets diminish predictability over time. In fact, real estate values have historically risen and fallen with market conditions. As a result, we believe that FFO and AFFO provide a performance measure that when compared year over year, should reflect the impact to operations from trends in occupancy rates, rental rates, operating costs, interest costs and other matters without the inclusion of depreciation and amortization, providing a perspective that may not be necessarily apparent from net income. We also consider FFO and AFFO to be useful to us in evaluating potential property acquisitions.

FFO and AFFO do not represent net income or cash flows from operations as defined by GAAP. FFO and AFFO and should not be considered to be an alternative to net income as a reliable measure of our operating performance; nor should FFO and AFFO be considered an alternative to cash flows from operating, investing or financing activities (as defined by GAAP) as measures of liquidity. FFO and AFFO do not measure whether cash flow is sufficient to fund all of our cash needs, including principal amortization, capital improvements and distributions to stockholders.

Management recognizes that there are limitations in the use of FFO and AFFO. In evaluating our performance, management is careful to examine GAAP measures such as net income and cash flows from operating, investing and financing activities.

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The following tables provide a reconciliation of net income and net income per common share (on a diluted basis) in accordance with GAAP to FFO and AFFO for the years indicated (dollars in thousands, except per share amounts):

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The $2.2 million, or 6.5%, increase in FFO is due to:

●a $1.4 million decrease in interest expense,

●a $545,000 increase in lease termination fee income,

●a $373,000 increase in other income, and

●a $292,000 net increase in rental income.

Offsetting the increase is a $639,000 increase (net of a $152,000 decrease of professional fees from 2020) in general and administrative expense.

See “—Comparison of Years Ended December 31, 2021 and 2020” for further information regarding these changes.

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The $2.3 million, or 5.9%, increase in AFFO is due to the increase in FFO as described above and:

●the exclusion from AFFO of a $747,000 increase in general and administrative expense related to non-cash compensation expense of RSUs and restricted stock, and

●the addition to AFFO of $389,000 in rental income (i.e., the straight-line rent accruals in the 2020 period were higher than the accruals in the 2021 period due primarily to a lease extension at a property at which the tenant was provided a rent abatement in the 2020 period).

The increase in AFFO was offset by the exclusion from AFFO of:

●the $545,000 increase in lease termination fee income, and

●$366,000 of the increase in other income.

See “—Comparison of Years Ended December 31, 2021 and 2020” for further information regarding these changes.

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Diluted per share FFO and AFFO were impacted negatively in the year ended December 31, 2021 by an average increase from December 31, 2020 of approximately 671,000 in the weighted average number of shares of common stock outstanding as a result of issuances of stock in-lieu of a portion of cash dividends and the equity incentive, at-the-market equity offering and dividend reinvestment programs.

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Comparison of Years Ended December 31, 2020 and 2019

As we qualify as a smaller reporting company, this comparison is omitted in accordance with Instruction 1 to Item 303(a) of Regulation S-K.

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Liquidity and Capital Resources

Our sources of liquidity and capital include cash flow from operations, cash and cash equivalents, borrowings under our credit facility, refinancing existing mortgage loans, obtaining mortgage loans secured by our unencumbered properties, issuance of our equity securities and property sales. In 2021, we obtained approximately $31.0 million of net proceeds from property sales (after giving effect to $20.4 million of mortgage debt repayments, $848,000 of debt prepayment costs and $414,000 which represents a non-controlling interest’s share on the net proceeds of a consolidated joint venture property) and $10.6 million of proceeds from mortgage financings. Our available liquidity at March 4, 2022 was approximately $97.9 million, including approximately $12.6 million of cash and cash equivalents (including the credit facility’s required $3.0 million average deposit maintenance balance) and, subject to borrowing base requirements, up to $85.3 million available under our credit facility.

Liquidity and Financing

We expect to meet our short term (i.e., one year or less) and long term (i) operating cash requirements (including debt service and anticipated dividend payments) principally from cash flow from operations, our available cash and cash equivalents, proceeds from and, to the extent permitted and needed, our credit facility and (ii) investing and financing cash requirements (including an estimated aggregate of $2.2 million of capital and other expenditures for Havertys Furniture and The Vue) from the foregoing, as well as property financings, property sales and sales of our common stock. We and our joint venture partner are also re-developing the Manahawkin Property – however, because the re-development plan is being refined, we are not providing an estimate of the re-development costs or the time frame within which the re-development will be completed.

The following table sets forth, as of December 31, 2021, information with respect to our mortgage debt that is payable from January 2022 through December 31, 2024 (excluding the mortgage debt of our unconsolidated joint venture):

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At December 31, 2021, an unconsolidated joint venture had a first mortgage on its property (i.e., the Manahawkin Property) with an outstanding balance of approximately $22.1 million, bearing interest at 4.0% per annum and maturing in July 2025.

We intend to make debt amortization payments from operating cash flow and, though no assurance can be given that we will be successful in this regard, generally intend to refinance, extend or payoff the mortgage loans which mature in 2022 through 2024. We intend to repay the amounts not refinanced or extended from our existing funds and sources of funds, including our available cash, proceeds from the sale of our common stock and our credit facility (to the extent available).

We continually seek to refinance existing mortgage loans on terms we deem acceptable to generate additional liquidity. Additionally, in the normal course of our business, we sell properties when we determine that it is in our best interests, which also generates additional liquidity. Further, since each of our encumbered properties is subject to a non-recourse mortgage (with standard carve-outs), if our in-house evaluation of the market value of such property is less than the principal balance outstanding on the mortgage loan, we may determine to convey, in certain circumstances, such property to the mortgagee in order to terminate our mortgage obligations, including payment of interest, principal and real estate taxes, with respect to such property.

Typically, we utilize funds from our credit facility to acquire a property and, thereafter secure long-term, fixed rate mortgage debt on such property. We apply the proceeds from the mortgage loan to repay borrowings under the credit facility, thus providing us with the ability to re-borrow under the credit facility for the acquisition of additional properties.

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Credit Facility

Our credit facility provides that subject to borrowing base requirements, we can borrow up to $100.0 million for the acquisition of commercial real estate, repayment of mortgage debt, and renovation and operating expense purposes; provided, that if used for renovation and operating expense purposes, the amount outstanding for such purposes will not exceed the lesser of $30.0 million and 30% of the borrowing base subject to a cap of (i) $10.0 million for renovation purposes and (ii) $20.0 million for operating expense purposes. These limits will apply through June 30, 2022. On July 1, 2022, the maximum amounts we can borrow for renovation expenses and operating expenses will change to $20.0 million and $10.0 million, respectively, and to the extent that either of these maximums is exceeded as of June 30, 2022, such excess must be repaid immediately. See “—Liquidity and Capital Resources”. The facility matures December 31, 2022 and bears interest equal to the one month LIBOR rate plus the applicable margin. The applicable margin ranges from 175 basis points if our ratio of total debt to total value (as calculated pursuant to the facility) is equal to or less than 50%, increasing to a maximum of 300 basis points if such ratio is greater than 65%. The applicable margin was 175 and 200 basis points for 2021 and 2020, respectively. There is an unused facility fee of 0.25% per annum on the difference between the outstanding loan balance and $100.0 million. The credit facility requires the maintenance of $3.0 million in average deposit balances. For 2021, the weighted average interest rate on the facility was approximately 1.86% and as of February 28, 2022, the rate on the facility was 1.88%.

The terms of our credit facility include certain restrictions and covenants which limit, among other things, the incurrence of liens, and which require compliance with financial ratios relating to, among other things, the minimum amount of tangible net worth, the minimum amount of debt service coverage, the minimum amount of fixed charge coverage, the maximum amount of debt to total value, the minimum level of net income, certain investment limitations and the minimum value of unencumbered properties and the number of such properties. Net proceeds received from the sale, financing or refinancing of properties are generally required to be used to repay amounts outstanding under our credit facility.

Material Contractual Obligations

The following sets forth our material contractual obligations as of December 31, 2021:

As of December 31, 2021, we had $399.7 million of mortgage debt outstanding (excluding mortgage debt of our unconsolidated joint venture), all of which is non-recourse (subject to standard carve-outs). We expect that mortgage interest and amortization payments (excluding repayments of principal at maturity) of approximately $81.5 million due through 2024 will be paid primarily from cash generated from our operations. We anticipate

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that principal balances due at maturity through 2024 of $95.3 million will be paid primarily from cash and cash equivalents and mortgage financings and refinancings. If we are unsuccessful in refinancing our existing indebtedness or financing our unencumbered properties, our cash flow, funds available under our credit facility and available cash, if any, may not be sufficient to repay all debt obligations when payments become due, and we may need to issue additional equity, obtain long or short- term debt, or dispose of properties on unfavorable terms.

Inflation

We are exposed to inflation risk as income from long-term leases is the primary source of our cash flows from operations. Approximately 76% of our leases contain provisions intended to mitigate the impact of inflation. These provisions generally increase rental rates during the terms of the leases either at fixed rates or indexed escalations (based on the Consumer Price Index or other measures). In addition, many of our leases require the tenant to pay, or reimburse us for our payment of, all or a majority of the property's operating expenses, including real estate taxes, utilities, insurance and building repairs, which may also mitigate our risks associated with rising costs. However, these rent escalation provisions may not adequately offset the effects of inflation.

Inflation may also affect the overall cost of our unhedged debt (i.e., primarily debt incurred pursuant to our credit facility) and mortgage debt we may incur in the future. (The interest rate risk associated with substantially all of our current mortgage debt is either mitigated through long-term fixed interest rate loans and interest rate hedges). Increasing interest rates on acquisition mortgage debt limits the acquisition opportunities we can pursue and reduces the prices at which we sell our properties.

Cash Distribution Policy

We have elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended. Accordingly, to qualify as a REIT, we must, among other things, meet a number of organizational and operational requirements, including a requirement that we distribute currently at least 90% of our ordinary taxable income to our stockholders. It is our current intention to comply with these requirements and maintain our REIT status. As a REIT, we generally will not be subject to corporate federal, state or local income taxes on taxable income we distribute currently (in accordance with the Internal Revenue Code and applicable regulations) to our stockholders. If we fail to qualify as a REIT in any taxable year, we will be subject to federal, state and local income taxes at regular corporate rates and may not be able to qualify as a REIT for four subsequent tax years. Even if we qualify for federal taxation as a REIT, we may be subject to certain state and local taxes on our income and to federal income taxes on our undistributed taxable income (i.e., taxable income not distributed in the amounts and in the time frames prescribed by the Internal Revenue Code and applicable regulations thereunder) and are subject to Federal excise taxes on our undistributed taxable income.

It is our intention to pay to our stockholders within the time periods prescribed by the Internal Revenue Code no less than 90%, and, if possible, 100% of our annual taxable income, including taxable gains from the sale of real estate. It will continue to be our policy to make sufficient distributions to stockholders in order for us to maintain our REIT status under the Internal Revenue Code.

Our board of directors will continue to evaluate, on a quarterly basis, the amount and nature (i.e., cash, stock or a combination of the foregoing) of dividend payments based on its assessment of, among other things, our short and long-term cash and liquidity requirements, prospects, debt maturities, projections of our REIT taxable income, net income, funds from operations, and adjusted funds from operations.

Critical Accounting Estimates

Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. On an ongoing basis, we reconsider and evaluate our estimates and assumptions.

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We base our estimates on historical experience, current trends and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could materially differ from any of our estimates under different assumptions or conditions. Our significant accounting policies are discussed in Note 2 of our consolidated financial statements in this report. We believe the accounting estimates listed below are the most critical to aid in fully understanding and evaluating our reported financial results, and they require our most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain.

Revenue Recognition

Our main source of revenue is rental income from our tenants. Rental income includes: (i) base rents that our tenants pay in accordance with the terms of their respective leases reported on a straight-line basis over the non-cancellable term of each lease and (ii) reimbursements by tenants of certain real estate operating expenses. Since many of our leases provide for rental increases at specified intervals, straight-line basis accounting requires us to record as an asset and include in revenues, unbilled rent receivables which we will only receive if the tenant makes all rent payments required through the expiration of the term of the lease. Accordingly, our management must determine, in its judgment, that the unbilled rent receivable applicable to each specific tenant is collectable. We review unbilled rent receivables on a quarterly basis and take into consideration the tenant’s payment history and the financial condition of the tenant. In the event that the collectability of an unbilled rent receivable is unlikely, we are required to write-off the receivable, which has an adverse effect on net income for the year in which the direct write-off is taken, and will decrease total assets and stockholders’ equity.

Purchase Accounting for Acquisition of Real Estate

The fair value of real estate acquired is allocated to acquired tangible assets, consisting of land and building, and identified intangible assets and liabilities, consisting of the value of above-market and below-market leases and other value of in-place leases based in each case on their fair values. The fair value of the tangible assets of an acquired property (which includes land, building and building improvements) is determined by valuing the property as if it were vacant, and the “as-if-vacant” value is then allocated to land, building and building improvements based on our determination of relative fair values of these assets. We assess fair value of the lease intangibles based on estimated cash flow projections that utilize appropriate discount rates and available market information. The fair values associated with below-market rental renewal options are determined based on our experience and the relevant facts and circumstances that existed at the time of the acquisitions. The portion of the values of the leases associated with below-market renewal options that we deem likely to be exercised are amortized to rental income over the respective renewal periods. The allocation made by us may have a positive or negative effect on net income and may have an effect on the assets and liabilities on the balance sheet.

Carrying Value of Real Estate Portfolio

We review our real estate portfolio on a quarterly basis to ascertain if there are any indicators of impairment to the value of any of our real estate assets, including deferred costs and intangibles, to determine if there is any need for an impairment charge. In reviewing the portfolio, we examine the type of asset, the current financial statements or other available financial information of the tenant, the economic situation in the area in which the asset is located, the economic situation in the industry in which the tenant is involved and the timeliness of the payments made by the tenant under its lease, as well as any current correspondence that may have been had with the tenant, including property inspection reports. For each real estate asset owned for which indicators of impairment exist, we perform a recoverability test by comparing the sum of the estimated undiscounted future cash flows attributable to the asset to its carrying amount. Management’s assumptions and estimates include projected rental rates during the holding period and property capitalization rates in order to estimate undiscounted future cash flows. If the undiscounted cash flows are less than the asset’s carrying amount, an impairment loss is recorded to the extent that the estimated fair value is less than the asset’s carrying amount. The estimated fair value is determined using a discounted cash flow model of the expected future cash flows through the useful life of the property. Real estate assets that are expected to be disposed of are valued at the lower of carrying amount or fair value less costs to sell on an individual asset basis. We generally do not obtain any independent appraisals in determining value but rely on our own analysis and valuations. Any impairment charge taken with respect to any part of our real estate portfolio will reduce our net income and reduce assets and stockholders’ equity to the extent of the amount of any impairment charge, but it will not affect our cash flow or our distributions until such time as we dispose of the property.

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