UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 1-K
ANNUAL REPORT
  
ANNUAL REPORT PURSUANT TO REGULATION A OF THE SECURITIES ACT OF 1933
For the fiscal year ended December 31, 2018
  
HC GOVERNMENT REALTY TRUST, INC.
(Exact name of issuer as specified in its charter)
 
I.R.S. Employment Identification Number: 81-1867397
 
Maryland
 
81-1867397
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. No.)
 
 
 
390 S. Liberty Street, Suite 100 Winston-Salem, NC
 
  27101
(Address of principal executive offices)
 
(Zip Code)
 
(336) 477-2535
Issuer’s telephone number, including area code 
 
Common Stock
(Title of each class of securities issued pursuant to Regulation A)
 

 
 
 
Part II
 
In this annual report, references to the “Company,” “we,” “us” or “our” or similar terms refer to HC Government Realty Trust, Inc. a Maryland corporation, together with its consolidated subsidiaries, including HC Government Realty Holdings, L.P., a Delaware limited partnership, which we refer to as our Operating Partnership. We refer to Holmwood Capital, LLC, a Delaware limited liability company, as Holmwood, and Holmwood Capital Advisors, LLC, a Delaware limited liability company, as our Manager. As used in this annual report on Form 1-K, an affiliate of, or person affiliated with, a specified person, is a person, who or which, directly or indirectly through one or more intermediaries, controls, is controlled by, or is under common control with, the person specified.
 
STATEMENTS REGARDING FORWARD-LOOKING INFORMATION
 
We make statements in this annual report on Form 1-K or this annual report that are forward-looking statements within the meaning of the federal securities laws. The words “believe,” “estimate,” “expect,” “anticipate,” “intend,” “plan,” “seek,” “may,” and similar expressions or statements regarding future periods are intended to identify forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause our actual results, performance or achievements, or industry results to differ materially from any predictions of future results, performance or achievements that we express or imply in this annual report or in the information incorporated by reference in this annual report.
 
The forward-looking statements included in this annual report are based upon our current expectations, plans, estimates, assumptions and beliefs that involve numerous risks and uncertainties. Assumptions relating to the foregoing involve, among other things, judgments with respect to future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond our control. Although we believe that the expectations reflected in such forward-looking statements are based on reasonable assumptions, our actual results and performance could differ materially from those set forth in the forward-looking statements. Factors that could have a material adverse effect on our operations and future prospects include, but are not limited to:
 
our ability to effectively deploy the proceeds raised in our securities offering,
 
changes in economic conditions generally and in the real estate and securities markets specifically,
 
the ability of our management team to source, originate and acquire suitable investment opportunities,
 
our ability to effectively operate our Company under a new management team following the Recapitalization Transaction, as described herein,
 
our expectation that there will be opportunities to acquire additional properties leased to the United States of America,
 
our expectations regarding demand by the federal government for leased space,
 
the GSA (acting for the United States as Tenant) renewing or extending one or more of the leases for one or more of our GSA Properties (as defined below), whether pursuant to early termination options or at lease-end, and if not renewed or extended that we will be successful in re-leasing the space,
 
the impact of changes in real estate needs and financial conditions of federal, state and local governments,
 
acts of terrorism and other disasters that are beyond our control,
 
 
 
1
 
 
legislative or regulatory changes impacting our business or our assets, including changes to the laws governing the taxation of real estate investment trust (“REITs”) and SEC guidance related to Regulation A or the JOBS Act,
 
our ability to raise equity or debt capital,
 
our compliance with applicable local, state and federal laws, including the Investment Advisers Act of 1940, as amended (the “Advisers Act”), the Investment Company Act of 1940, as amended (the “40 Act”) and other laws, or
 
changes to generally accepted account principles, or GAAP.
 
Any of the assumptions underlying forward-looking statements could be inaccurate. You are cautioned not to place undue reliance on any forward-looking statements included in this annual report. All forward-looking statements are made as of the date of this annual report and the risk that actual results will differ materially from the expectations expressed in this annual report will increase with the passage of time. Except as otherwise required by the federal securities laws, we undertake no obligation to publicly update or revise any forward-looking statements after the date of this annual report, whether as a result of new information, future events, changed circumstances or any other reason. In light of the significant uncertainties inherent in the forward-looking statements included in this annual report, the inclusion of such forward-looking statements should not be regarded as a representation by us or any other person that the objectives and plans set forth in this annual report will be achieved.
 
Item 1. Business
 
The Company
 
We were formed in 2016 as a Maryland corporation, and incident to filing our federal income tax return for, and commencing with, our fiscal year ended December 31, 2017, we elected to be taxed as a REIT for federal income tax purposes. We were formed primarily to source, acquire, own and manage built-to-suit or improved-to-suit, single-tenant properties leased by the United States of America and administered by the U.S General Services Administration or directly by the occupying agency, both of which are referred to as GSA Properties. We invest primarily in GSA Properties across secondary and smaller markets with sizes ranging from 5,000 to 50,000 rentable square feet, and in their first lease term after construction or improvement to post-9/11 standards. We further emphasize GSA Properties that fulfill mission critical or citizen service functions. Leases associated with the GSA Properties in which our company invests are full faith and credit obligations of the United States of America.
 
Our principal objective is the creation of value for stockholders by utilizing our relationships and knowledge of GSA Properties, specifically, the acquisition, management and disposition of GSA Properties. On December 31, 2018, our portfolio consisted of:
 
(i) 
our Initial Owned Properties, acquired by our company on June 10, 2016, for a purchase price of $11,050,596, financed with $805,807 of proceeds from the issuance of our 7.00% Series A Cumulative Convertible Redeemable Preferred Stock or Series A Preferred Stock, secured mortgage financing in the original principal amount of $7,225,000, unsecured seller financing in the original principal amount of $2,019,789 and $1,000,000 in original principal amount of our unsecured loan from Holmwood;
 
(ii) 
our GSA Property acquired by our company on March 31, 2017, for a purchase price of $14,717,937, financed with proceeds from senior mortgage debt in the original principal amount of $10,875,000, $2,770,000 in original aggregate principal amount of unsecured debt from Baker Hill Holdings, LLC, an entity related to one of our directors (“BH”), $330,000 in original aggregate principal amount of unsecured debt from one of our directors, $300,000 in original aggregate principal amount of unsecured debt from an accredited investor, and $442,937 from other funding sources;
 
 
2
 
 
(iii) 
seven properties contributed to us as of May 26, 2017 by Holmwood, including three properties for which we received all of the rights to the profits, losses, any distributed cash flow and all of the other benefits and burdens of ownership for federal income tax purposes rather than a fee simple interest, each pursuant to an agreement between our Operating Partnership and Holmwood, as amended, or the Contribution Agreement.

 
(iv)
our GSA Property acquired by our company on July 25, 2017, for a purchase price of $4,797,072, financed with secured mortgage financing in the original principal amount of $3,530,000, and proceeds from our offering of Common Stock pursuant to an Offering Statement on Form l-A (File No. 024-10563), as amended, or our Initial Offering, of $1,267,072;
 
(v)
our GSA Property acquired by our company on November 21, 2017, for a purchase price of $8,273,349, financed by secured mortgage debt in original principal amount of $6,991,250 and proceeds from our Initial Offering of $1,282,099;
 
(vi)
our GSA Property acquired by our company on July 27, 2018, for a purchase price of $7,160,000, financed by secured mortgage debt in original principal amount of $5,360,000 and $1,800,000 in original aggregate principal amount of unsecured debt from two accredited investors of which $1,700,000 was from BH;
 
(vii)
our GSA Property acquired by our company on August 30, 2018, for a purchase price of $3,445,000, financed by secured mortgage debt in original principal amount of $2,580,000, $800,000 in original aggregate principal amount of unsecured debt from BH and $65,000 of operating cash; and
 
(viii)
our GSA Property acquired by our company on October 15, 2018, for a purchase price of $11,000,000, financed by secured mortgage debt in original principal amount of $8,250,000, $2,470,000 in original aggregate principal amount of unsecured debt from a BH and $280,000 of operating cash.
 
The GSA-leased, real estate asset class has a number of attributes that we believe will offer our stockholders significant benefits, including a highly creditworthy and very stable tenant base, long-term lease structures and low risk of tenant turnover. GSA leases are backed by the full faith and credit of the United States, and the GSA has never experienced a financial default. Payment of rents under GSA leases are funded through the Federal Buildings Fund and are not subject to direct federal appropriations, which can fluctuate with federal budget and political priorities. In addition to presenting reduced risk of default, GSA leases typically have long initial terms of ten to 20 years with renewal leases having terms of five to ten years, which limit operational risk. Upon renewal of a GSA lease, base rent typically is reset based on a number of factors at the time of renewal, including inflation and the replacement cost of the building, that generally we expect will increase over the life of the lease.
 
GSA-leased properties generally provide attractive investment opportunities but require specialized knowledge and expertise. Each U.S. Government agency has its own customs, procedures, culture, needs and mission, which results in different requirements for its leased space. Furthermore, the GSA-leased sector is highly fragmented with a significant amount of non-institutional owners, who lack our infrastructure and experience with GSA-leased properties. Moreover, while there are a number of national real estate brokers that hold themselves out as having GSA-leased property expertise, there are no national or regional clearing houses for GSA-leased properties. We believe this fragmentation can be ascribed particularly to the U.S. Government’s – including GSA’s – procurement policies, including policies of preference for small, female and minority owned businesses. Long-term relationships and specialized institutional knowledge regarding the agencies, their space needs and the hierarchy and importance of a property to its tenant agency are crucial to understanding which agencies and properties present the greatest likelihood of long-term agency occupancy, and, therefore, to identifying and acquiring attractive GSA-leased properties. Our portfolio is diversified among occupancy agencies, including a number of the largest and most essential agencies, such as the Drug Enforcement Administration, the Federal Bureau of Investigation, the Social Security Administration and the Department of Transportation.
 
 
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We operate as an “UPREIT”, which means we own our GSA-leased properties through single-purpose entities that are wholly owned by our Operating Partnership. While we focus on investments in GSA Properties, in the future we also may invest in state and local government, mission critical single tenant properties or properties previously (but not exclusively) leased to the United States, the GSA or one or more occupying agencies. We are externally managed and advised by Holmwood Capital Advisors, LLC, a Delaware limited liability company, or our Manager. Despite being externally managed, as a result of the Recapitalization Transaction, our internal management team will make all investment decisions for us. The officers of our Company are Mr. Steven A. Hale II as our Chief Executive Officer, Ms. Jacqlyn Piscetelli as our Chief Financial Officer, Treasurer and Secretary and Mr. Robert R. Kaplan Jr. as our President. Our management team will be overseen by our Board of Directors. For more information on our management team and directors please see "Item 3. Directors and Executive Officers” below.
 
We believe in the long-term there will be a consistent flow of GSA Properties in our target markets for purposes of acquisition, leasing and managing, which we expect will enable us to continue our platform into the foreseeable future. We acquire GSA Properties located across secondary and smaller markets throughout the United States. We do not anticipate making acquisitions outside of the United States or its territories.
 
We primarily make direct acquisitions of GSA Properties, but we may also invest in GSA Properties through indirect investments, such as joint ventures, and whereby we may own less than a 100% of the beneficial interest therein; provided, that in such event, we will acquire at least 50 percent of the outstanding voting securities in the investment, or otherwise comply with SEC staff guidance regarding majority-owned subsidiaries so that the investment meets the definition of “majority-owned subsidiary” under the Investment Company Act of 1940, as amended.
 
Our Competitive Strengths and Strategic Opportunities
 
We believe that we will be benefitted by the alignment of the following competitive strengths and strategic opportunities:
 
High Quality Portfolio Leased to Mission-Critical U.S. Government Agencies
 
We own a portfolio of 16 GSA Properties, comprised of 13 GSA Properties we own in fee simple and three additional GSA Properties for which we have all of the rights to the profits, losses, any distributed cash flow and all of the other benefits and burdens of ownership included for federal income tax purposes, each of which is leased to the United States. As of the date of this annual report, based upon net operating income, the weighted average age of the properties in our portfolio was approximately 9.0 years1, and the weighted average remaining lease term is approximately 9.6 years if none of the early termination rights are exercised and 5.8 years, if all of the early termination rights are exercised.
 
All of our GSA Properties are occupied by agencies that serve mission-critical or citizen service functions.
 
Our GSA Properties generally meet our investment criteria, which target GSA Properties across secondary or smaller markets with sizes ranging between 5,000 to 50,000 rentable square feet and in their first term after construction or improvement to post-9/11 standards.
 
Credit Quality of Tenant
 
Leases are full faith and credit obligations of the United States and, as such, are not subject to the risk of annual appropriations.
 
Leases typically include inflation-linked rent increases associated with certain property operating costs, which the Company believes will mitigate expense variability.
 
Investment Strategy
 
We believe there is a significant opportunity to acquire and build a portfolio consisting of high-quality GSA Properties at attractive risk-adjusted returns. We seek primarily to acquire “citizen service” GSA Properties, or GSA Properties that are “mission critical” to an agency’s function. Further, we primarily target GSA Properties located in secondary or smaller markets, with sizes ranging from 5,000 to 50,000 rentable square feet, and in their first term after construction or to post-9/11 standards.
 
We target GSA Properties that are LEED® certified or energy star rated. Of our portfolio of 16 GSA Properties, six are LEED® certified and another GSA Property is in the LEED® certification process.
 
We believe the subset of GSA Properties on which we focus is highly fragmented and often overlooked by larger investors, which can provide opportunities for us to buy at more attractive pricing compared to other properties within the asset class. We also believe selection based on agency function, building use and location in these smaller markets will help to mitigate risk of non-renewal. While we intend to focus on this subset of GSA Properties, we are not limited in the properties in which we may invest. We have the flexibility to expand our investment focus as market conditions may dictate and subject to broad investment policies adopted by our board of directors, as may be amended by the board of directors from time to time.
 
1 The weighted-average age of the properties in our portfolio is based on the later of (i) the date upon which the property was built or (ii) the date upon which the property was fully renovated.
 
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Description of Our Properties
 
The following table presents an overview of our properties as of December 31, 2018.
 
Property
Current Occupant
 
 Rentable Sq. Ft (RSF)
 
 
% of Portfolio 1
 
 
% Leased
 
 
 Effective Annual Rent
 
 
 Effective Annual Rent per RSF
 
 
Effective Annual Rent % of Portfolio
 
Our Portfolio
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Port Saint Lucie, Florida
U.S Drug Enforcement Administration (DEA)
  24,858 
  7.27%
  100%
 $571,824 
 $23.00 
  5.48%
Jonesboro, Arkansas
U.S Social Security Administration (SSA)
  16,439 
  4.81%
  100%
 $621,144 
 $37.78 
  5.95%
Lorain, Ohio
SSA
  11,607 
  3.40%
  100%
 $443,714 
 $38.23 
  4.25%
Cape Canaveral, Florida
U.S. Customs and Border Protection (CBP)
  14,704 
  4.30%
  100%
 $670,729 
 $45.62 
  6.42%
Johnson City, Tennessee
U.S Federal Bureau of Investigation (FBI)
  10,115 
  2.96%
  100%
 $395,613 
 $39.11 
  3.79%
Fort Smith, Arkansas
U.S. Citizenship and Immigration Services (CIS)
  13,816 
  4.04%
  100%
 $425,672 
 $30.81 
  4.08%
Silt, Colorado
U.S. Bureau of Land Management (BLM)
  18,813 
  5.50%
  100%
 $387,677 
 $20.61 
  3.71%
Lakewood, Colorado
U.S. Department of Transportation (DOT)
  19,241 
  5.63%
  100%
 $464,660 
 $24.15 
  4.45%
Moore, Oklahoma
SSA
  15,445 
  4.52%
  100%
 $530,659 
 $34.36 
  5.08%
Lawton, Oklahoma
SSA
  9,298 
  2.72%
  100%
 $284,075 
 $30.55 
  2.72%
Norfolk, Virginia
SSA
  53,917 
  15.78%
  100%
 $1,308,070 
 $24.26 
  12.53%
Montgomery, Alabama
CIS
  21,420 
  6.27%
  76%
 $576,798 
 $26.93 
  5.52%
San Antonio, Texas
U.S. Immigration and Customs Enforcements (ICE)
  38,756 
  11.34%
  100%
 $1,090,140 
 $28.13 
  10.44%
Knoxville, Iowa
U.S. Department of Veterans Affairs (VA)
  12,833 
  3.76%
  100%
 $649,984 
 $50.65 
  6.22%
Champaign, Illinois
FBI
  11,180 
  3.27%
  100%
 $370,240 
 $33.12 
  3.55%
Sarasota, Florida
U.S. Department of Agriculture (USDA)
  28,210 
  8.25%
  100%
 $906,951 
 $32.15 
  8.68%
Total - Our Portfolio
 
  320,652 
  93.82%
  100%
 $9,697,950 
 $30.24 
  92.86%
 
    
    
    
    
    
    
Our Pipeline
 
    
    
    
    
    
    
Monroe, Louisiana
 
  21,124 
  6.18%
  100%
 $745,592 
 $35.30 
  7.14%
Total - Our Pipeline
 
  21,124 
  6.18%
  100%
 $745,592 
 $35.30 
  7.14%
 
    
    
    
    
    
    
Total - Our Portfolio and Pipeline
  341,776 
  100%
  100%
 $10,443,542 
 $30.56 
  100%
 
1By rentable square footage.
2The early termination date, if any, for each lease generally represents the commencement of the time period during which our tenant may exercise its right to terminate the lease, in whole or in part, at any time effective on or after such date by providing us with sufficient prior written notice.  The prior written notice required for early termination under each lease ranges from 60 to 180 days. If our tenant exercises its early termination rights with respect to any lease, we cannot guarantee that we will be able to re-lease the premises on comparable terms, if at all. The lease expiration date is the date the applicable lease will terminate if the early termination is not exercise or if no early termination right exists. As of December 31, 2018, the weighted average remaining lease term of our portfolio and pipeline is 10.4 years if none of the early termination rights are exercised and six years if all of the early termination rights are exercised.
 
A description of our portfolio of GSA Properties and the terms of their acquisition or contribution, including the closing of our anticipated acquisition of the Monroe Property which such closing date has been extended to May 1, 2019 upon our payment of an additional nonrefundable deposit of $1,000,000, is incorporated by reference herein from the post-qualification amendment to our Offering Statement on Form 1-A located at: https://www.sec.gov/Archives/edgar/data/1670010/000165495418012065/hcgov_1apos.htm under the caption “DESCRIPTION OF OUR PROPERTIES—Our Portfolio and the Pipeline;” provided, that, the chart set forth therein has been updated above.
 
Recent Recapitalization Transaction
 
On March 19, 2019, we consummated a recapitalization transaction (the “Recapitalization Transaction”) with Hale Partnership Capital Management, LLC (“Hale”) and certain affiliated investors (each, an “Investor” and collectively, the “Investors”), pursuant to which (i) certain of such Investors provided a $10,500,000 mezzanine loan to us through our Operating Partnership, (ii) certain of such Investors purchased 1,050,000 shares of our 10.00% Series B Cumulative Preferred Stock (the “Series B Preferred Stock”) and (iii) an Investor purchased 300,000 shares of our newly issued common stock (the “Common Stock”).
 
 
 
5
 
 
Amended and Restated Bylaws
 
In connection with the Recapitalization Transaction, on March 13, 2019, the Board of Directors of our Company (the “Board of Directors”) adopted amended and restated bylaws of our Company (the “Bylaws”). The Bylaws were effective immediately and included, among other things, the following changes:
 
● 
removed the requirement that the Board of Directors be comprised of a majority of independent directors;
● 
removed the definition of “independent director;” and,
● 
removed the authority of the chief executive officer and the president to (i) call a special meeting of the Board of Directors, (ii) accept resignation letters from officers of our Company and (iii) appoint independent inspectors of elections to act as the agent of our Company for the purpose of performing a ministerial review of a special meeting request.
 
Articles Supplementary
 
In connection with the Recapitalization Transaction, on March 14, 2019, we filed Articles Supplementary with the Maryland State Department of Assessments and Taxation (the “Series B Articles Supplementary”) to classify 2,050,000 shares of our preferred stock, a portion of which are shares of Series B Preferred Stock to be purchased by Hale pursuant to the Recapitalization Transaction. The Series B Articles Supplementary became effective upon filing on March 14, 2019.
 
Holders of shares of the Series B Preferred Stock are entitled to receive cumulative cash dividends on the Series B Preferred Stock when, as and if authorized by the Board and declared by us, payable quarterly in arrears on each January 5th, April 5th, July 5th and October 5th of each year. From the date of original issue, we will pay dividends at the rate of 10.00% per annum of the $10.00 liquidation preference per share. Dividends on the Series B Preferred Stock will accrue and be cumulative from the end of the most recent dividend period for which dividends have been paid. With respect to priority of payment of dividends, the Series B Preferred Stock will rank on a parity with the Series A Preferred Stock.
 
If our Company liquidates, dissolves or winds-up, holders of shares of the Series B Preferred Stock will have the right to receive $10.00 per share of the Series B Preferred Stock, plus an amount equal to all accrued and unpaid dividends (whether or not authorized or declared) to and including the date of payment. With respect to priority of payment of distributions upon our Company’s voluntary or involuntary liquidation, dissolution or winding up, the Series B Preferred Stock will rank on a parity with the Series A Preferred Stock.
 
The Series B Preferred Stock will automatically convert into common stock upon the occurrence of our initial listing of our common stock on any national securities exchange. As of the date of the listing event, a holder of shares of Series B Preferred Stock will receive a number of shares of common stock in accordance with the conversion formula set forth in the Series B Articles Supplementary. Pursuant to the conversion formula, one share of the Series B Preferred Stock will convert to a number of shares of common stock equal to the original issue price of the Series B Preferred Stock (plus any accrued and unpaid dividends) divided by the lesser of $9.10 or the fair market value of the common stock. If the listing event has not occurred on or prior to March 31, 2020, then holders of the Series B Preferred Stock, at their option, may, at any time and from time to time after such date, convert all, but not less than all, of their outstanding shares of Series B Preferred Stock into common stock. Upon exercise of this optional conversion right, a holder of Series B Preferred Stock will receive a number of shares of common stock in accordance with the same conversion formula referenced above.
 
 
 
6
 
 
 
Subject to the preferential voting rights described below, the Series B Preferred Stock have identical voting rights as our common stock, with each share of Series B Preferred Stock entitling its holder to vote on an as converted basis, on all matters on which our common stockholders are entitled to vote. The Series B Preferred Stock, the Series A Preferred Stock and the common stock vote together as one class. So long as any shares of Series B Preferred Stock remain outstanding, in addition to the voting rights described above, we will not, without the affirmative vote or consent of the holders of at least two-thirds of the outstanding shares of Series B Preferred Stock voting together as a single class, authorize, create or issue, or increase the number of authorized or issued shares of, any class or series of capital stock ranking senior to the Series B Preferred Stock with respect to payment of dividends or the distribution of assets upon our liquidation, dissolution or winding up, or reclassify any of our authorized capital stock into such capital stock, or create, authorize or issue any obligation or security convertible into or evidencing the right to purchase such capital stock.
 
In addition, the holders of the Series B Preferred Stock have registration rights that are substantially similar to those granted to the holders of the Series A Preferred Stock.
 
Change in Control
 
The Series B Articles Supplementary, filed by our Company on March 14, 2019 in connection with the Recapitalization Transaction, provides that a majority of the members of the Board of Directors will be elected by the holders of a majority of the outstanding shares of Series B Preferred Stock. Our Board of Directors currently has up to seven members. In connection with the closing of the Recapitalization Transaction, on March 19, 2019, each of Robert R. Kaplan, Scott A. Musil, William J. Fields and Leo Kiely resigned from his position as a director of our Board of Directors, and, upon issuance of an aggregate of 1,050,000 shares of the Series B Preferred Stock to the Investors at Closing, the Investors elected Steven A. Hale II, Brad G. Garner, Matthew A. Hultquist and Jeffrey S. Stewart to serve on our Company’s Board of Directors, effective as of March 19, 2019, to serve until their successors are duly elected and qualified. Following the closing of the Recapitalization Transaction, on March 20, 2019, each of Dr. Philip Kurlander and Mr. Edwin Stanton resigned from his position as a director of our Board of Directors. As of March 20, 2019, our Board of Directors is comprised of Messrs. Hale, Garner, Hultquist and Stewart. Mr. Hale was named Chairman of our Board of Directors.
 
Departure of Certain Officers
 
On March 13, 2019, in connection with the Recapitalization Transaction and upon approval from the Board of Directors, we terminated Mr. Edwin Stanton from his position as Chief Executive Officer of our Company and Dr. Philip Kurlander from his position as Treasurer of our Company, each effective as of March 13, 2019.
 
On March 19, 2019, the Company accepted the resignation of Mr. Jason D. Post from his position as Vice President of Finance and Corporate Controller of our Company, effective as of March 19, 2019. 
 
Mr. Robert R. Kaplan resigned as Secretary of our Company on March 19, 2019.
 
Appointment of Officers
 
On March 21, 2019, Mr. Steven A. Hale II was appointed to serve as our new Chief Executive Officer and Chairman of the Board of Directors, and Ms. Jacqlyn Piscetelli was appointed to serve as our new Chief Financial Officer, Treasurer and Secretary.
 
Notice of Nonrenewal of Manager and Adoption of New Investment Guidelines
 
In connection with the Recapitalization Transaction, on March 14, 2019, we provided notice to our Manager, that the Board of Directors resolved to amend and restate our Company’s investment guidelines pursuant to the terms of our management agreement with the Manager (the “Management Agreement”). As a result, our management team, under the supervision of our Board of Directors, shall make all strategic decisions on behalf of our Company, including all acquisition, financing and dispositions.
 
In addition, on March 14, 2019, we provided notice to the Manager that we are electing not to renew the Management Agreement under its terms, effective March 31, 2020, pursuant to the resolve of the Board of Directors. Until the termination of the Management Agreement, our Manager will continue to be involved in our day-to-day operations, including back office and accounting functions, as we transition from an externally-managed to an internally-managed REIT.
 
 
 
7
 
 
Securities Issuances
 
In connection with the Recapitalization Transaction, we sold to the Investors (1) 1,050,000 shares of our Series B Preferred Stock for an aggregate purchase price of $10,500,000 and (2) 300,000 shares of our common stock for an aggregate purchase price of $3,000,000.
 
Both securities sales were with respect to a private offering of securities exempt from registration under the Securities Act of 1933, as amended, pursuant to Rule 506 of Regulation D promulgated thereunder.
 
Loan Agreement
 
In connection with the Recapitalization Transaction, on March 19, 2019, we, through our Operating Partnership, the Investors and HCM Agency, LLC (the “Agent”), an affiliate of Hale and the collateral agent, entered into a Loan Agreement (the “Loan Agreement”) pursuant to which certain of the Investors, as lenders (the “Lenders”), provided a $10,500,000 senior secured term loan to our Company (the “Loan”), with an option to fund up to an additional $10,000,000 in term loans, subject to customary terms and conditions, pursuant to which all such debt will accrue interest and mature on the same terms (the “Mezzanine Debt”).
 
The Loan is not evidenced by a promissory note. However, pursuant to the Loan Agreement, promissory notes evidencing the Loan and/or the Mezzanine Debt may be issued in the future at the request of the Lenders.
 
The Mezzanine Debt will accrue interest at a rate of fourteen percent (14%) per annum. Such interest will be paid in monthly, interest-only cash payments payable in arrears at a rate of twelve percent (12%) per annum plus (i) a cash payment at a rate of two percent (2%) per annum, (ii) an increase in the principal of the Mezzanine Debt equal to two percent (2%) per annum or (iii) a combination of both (i) and (ii) above, which such combined amount will be equal to two percent (2%) per annum. We are required to repay all outstanding principal and any accrued but unpaid interest on or before March 19, 2022. All outstanding principal and any accrued but unpaid interest shall become immediately due and payable upon certain events including, but not limited to, an initial public offering of our common stock.
 
The Mezzanine Debt is secured by a security interest in the accounts receivable and other personal property of our Operating Partnership, our Company and its subsidiaries, including our Operating Partnership’s ownership interest in its subsidiaries. We and Holmwood Portfolio Holdings, LLC, a limited partner in the Operating Partnership (the “LP”), also entered into customary guaranty agreements related to the payment by and performance of our Operating Partnership of its obligations under the Loan Agreement.
 
The Loan Agreement also includes customary representations, warranties, covenants and terms and conditions for transactions of this type, including a minimum fixed charge coverage ratio, limitations on incurrence of debt, liens, investments and mergers and asset dispositions, covenants to preserve corporate existence and comply with laws, covenants on the use of proceeds of the Mezzanine Debt and default provisions, including defaults for non-payment, breach of representations and warranties, insolvency, non-performance of covenants, failure to pay other outstanding debt and our failure to maintain our REIT status. The occurrence of an event of default under the Loan Agreement could result in all loans and other obligations becoming immediately due and payable and allow the Agent to exercise all rights and remedies available to it as collateral agent including the foreclosure of all liens granted under the Loan Agreement.
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Overview
 
We are an externally-managed real estate company, formed to grow our business of acquiring, developing, financing, owning and managing properties leased primarily to the United States of America, acting either through the GSA or directly through the federal government agencies or departments occupying such properties, including such properties owned by special purpose entities contributed to our Operating Partnership by Holmwood, our accounting predecessor. We invest primarily in GSA Properties across secondary and smaller markets, in sizes that range from 5,000 to 50,000 rentable square feet, and are in their first term after construction or improvement to post-9/11 standards. We further emphasize GSA Properties that fulfill mission critical or direct citizen service functions.  We intend to grow our portfolio primarily through acquisitions of single-tenanted, federal government-leased properties in such markets; although, at some point in the future we may elect to develop, or joint venture with others in the development of, competitively bid, build-to-suit, single-tenant, federal government-leased properties, or buy facilities that are leased to credit-worthy state or municipal tenants.
 
 
8
 
 
As of December 31, 2018, the Company owned 16 GSA Properties, comprised of 13 GSA Properties that we own in fee simple and three additional GSA Properties for which we have all of the rights to the profits, losses, any distributed cash flow and all of the other benefits and burdens of ownership including for federal income tax purposes, each of which is leased to the United States. Our portfolio of GSA Properties, or our portfolio, contains approximately 320,652 rentable square feet located in 11 states with one additional GSA Property under contract, or our pipeline, for an additional 21,124 rentable square feet. As of December 31, 2018, our portfolio and pipeline properties are 100% leased to the United States of America and occupied, or to be occupied on completion, by federal government agencies. Based on net operating income of each property, our portfolio has a weighted average remaining lease term of 10.0 years if none of the early termination rights are exercised and 6.2 years if the early termination right are exercised.
 
Our Operating Partnership holds substantially all of our assets and conducts substantially all of our business. As of April 30, 2019, on a fully diluted basis, we owned approximately 59.54% of the aggregate common limited partnership interests in our Operating Partnership. We were formed in 2016 as a Maryland corporation and incident to filing our federal income tax return and commencing with our fiscal year ended December 31, 2017, we elected to be taxed as a REIT for federal income tax purposes.
 
Our Predecessor
 
The term, “our predecessor”, refers to Holmwood and its three, remaining, single purpose, wholly owned subsidiaries. Each such remaining subsidiary holds the fee interest in a GSA Property, the rights to the profits from, the leases for, any distributed cash flow from, and all of the benefits and burdens of ownership, including for federal income tax purposes, of which were contributed to our Operating Partnership by Holmwood.
  
Operating Results
 
For the year ended December 31, 2018
 
At December 31, 2018, we owned 13 properties and all of the rights to the profits, losses, any distributed cash flow and all of the other benefits and burdens of ownership including for federal income tax purposes for three other properties. Our portfolio of properties at December 31, 2018 consisted of the following:
 
(i) 
three GSA Properties, or our Initial Owned Properties, acquired by our company on June 10, 2016, for a purchase price of $11,050,596, financed with proceeds from the issuance of our 7.00% Series A Cumulative Convertible Redeemable Preferred Stock or Series A Preferred Stock of $805,807, secured mortgage financing in the original principal amount of $7,225,000, unsecured seller financing in the original principal amount of $2,019,789 and $1,000,000 in original principal amount of our unsecured loan from Holmwood;
 
(ii) 
our GSA Property acquired by our company on March 31, 2017, for a purchase price of $14,717,937, financed with proceeds from senior mortgage debt in the original principal amount of $10,875,000, $2,770,000 in original aggregate principal amount of unsecured debt from BH, $330,000 in original aggregate principal amount of unsecured debt from one of our directors, $300,000 in original aggregate principal amount of unsecured debt from an accredited investor, and $442,937 from other funding sources;
 
(iii) 
seven properties contributed to us as of May 26, 2017 by Holmwood, including three properties for which we received all of the rights to the profits, losses, any distributed cash flow and all of the other benefits and burdens of ownership for federal income tax purposes rather than a fee simple interest, each pursuant to the Contribution Agreement;
 
 
9
 
 

(iv) 
our GSA Property acquired by our company on July 25, 2017, for a purchase price of $4,797,072, financed with secured mortgage financing in the original principal amount of $3,530,000, and proceeds from our Initial Offering of $1,267,072;
 
(v) 
our GSA Property acquired by our company on November 21, 2017, for a purchase price of $8,273,349, financed by secured mortgage debt in original principal amount of $6,991,250 and proceeds from our Initial Offering of $1,282,099;
 
(vi) 
our GSA Property acquired by our company on July 27, 2018, for a purchase price of $7,160,000, financed by secured mortgage debt in original principal amount of $5,360,000 and $1,800,000 in original aggregate principal amount of unsecured debt from two accredited investors of which $1,700,000 was from BH;
 
(vii) 
our GSA Property acquired by our company on August 30, 2018, for a purchase price of $3,445,000, financed by secured mortgage debt in original principal amount of $2,580,000, $800,000 in original aggregate principal amount of unsecured debt from BH and $65,000 of operating cash;
 
(viii) 
and our GSA Property acquired by our company on October 15, 2018, for a purchase price of $11,000,000, financed by secured mortgage debt in original principal amount of $8,250,000, $2,470,000 in original aggregate principal amount of unsecured debt from BH and $280,000 of operating cash.
 
The portfolio contains 320,652 rentable square feet located in 11 states and is 100% leased to the United States and either administered by the GSA or occupying department or agency.
 
We earned revenues of $8,431,607 and incurred operating costs of $3,767,800, excluding depreciation and amortization of $3,102,762 and equity-based compensation of $193,119, for the year ended December 31, 2018. Our net loss was $2,104,526, and after allocating $569,904 of net loss to the noncontrolling interest in our operating partnership and deducting Series A Preferred Stock dividends of $252,875, our net loss attributed to our common shareholders was $1,787,497.
 
For the year ended December 31, 2017
 
At December 31, 2017, we owned ten properties and all of the rights to the profits, losses, any distributed cash flow and all of the other benefits and burdens of ownership including for federal income tax purposes for three other properties. Our portfolio of properties at December 31, 2017 consisted of the following:
 
(i) 
three GSA Properties, or our Initial Owned Properties, acquired by our company on June 10, 2016, for a purchase price of $11,050,596, financed with proceeds from the issuance of our 7.00% Series A Cumulative Convertible Redeemable Preferred Stock or Series A Preferred Stock of $805,807, secured mortgage financing in the original principal amount of $7,225,000, unsecured seller financing in the original principal amount of $2,019,789 and $1,000,000 in original principal amount of our unsecured loan from Holmwood;
 
(ii) 
our GSA Property acquired by our company on March 31, 2017, for a purchase price of $14,717,937, financed with proceeds from senior mortgage debt in the original principal amount of $10,875,000, $2,770,000 in original aggregate principal amount of unsecured debt from BH, $330,000 in original aggregate principal amount of unsecured debt from one of our directors, $300,000 in original aggregate principal amount of unsecured debt from an accredited investor, and $442,937 from other funding sources;
 
(iii) 
seven properties contributed to us as of May 26, 2017 by Holmwood, including three properties for which we received all of the rights to the profits, losses, any distributed cash flow and all of the other benefits and burdens of ownership for federal income tax purposes rather than a fee simple interest, each pursuant to the Contribution Agreement;
 
 
10
 
 
 
(iv) 
our GSA Property acquired by our company on July 25, 2017, for a purchase price of $4,797,072, financed with secured mortgage financing in the original principal amount of $3,530,000, and proceeds from our Initial Offering of $1,267,072; and
 
(v) 
our GSA Property acquired by our company on November 21, 2017, for a purchase price of $8,273,349, financed by secured mortgage debt in original principal amount of $6,991,250 and proceeds from our Initial Offering of $1,282,099.
 
The portfolio contained 263,045 rentable square feet located in nine states and is 100% leased to the United States and either administered by the GSA or occupying department or agency.
 
Our operating activity includes the operating activity of the seven properties contributed to us from the period May 26, 2017 through December 31, 2017. 
 
We earned revenues of $4,764,562 and incurred operating costs of $2,377,368, excluding depreciation and amortization of $1,675,079 and equity-based compensation of $181,031, for the year ended December 31, 2017. Our net loss was $1,459,774 and after allocating $244,844 of net loss to the noncontrolling interest in our operating partnership and deducting Series A Preferred Stock dividends of $316,095 our net loss attributed to our common shareholders was $1,531,025.
 
 Calculating Net Operating Income
 
We believe that our net operating income, or NOI, a non-GAAP measure, is a useful measure of our operating performance. We define NOI as total property revenues less total property operating expenses, excluding depreciation and amortization, interest expense, and asset management fees. Other REITs may use different methodologies for calculating NOI, and accordingly, our NOI may not be comparable to the NOI of other REITs. We believe that NOI as we calculate it, provides an operating perspective not immediately apparent from GAAP operating income or net income. We use NOI to evaluate our performance on a property-by-property basis, because NOI more meaningfully reflects the core operations of our properties as well as their performance by excluding items not related to property operating performance and by capturing trends in property operating expenses. However, NOI should only be used as an alternative measure of our financial performance.
 
 
 
11
 
 
The following table reflects GSA Property contributions to combined NOI together with a reconciliation of NOI to net income (loss) as computed in accordance with GAAP for the periods presented.
 
 
 
For the year ended December 31
 
 
 
2018
 
 
2017
 
 
 
 
 
 
 
 
Revenues
 $8,431,607 
 $4,764,562 
Less:
    
    
Operating expenses
  2,572,811 
  1,353,452 
Management fee
  224,652 
  153,183 
Total expenses
  2,797,463 
  1,506,635 
 
    
    
Net operating income
  5,634,144 
  3,257,927 
Less:
    
    
Asset management fee
  328,053 
  150,299 
Corporate expenses
  835,403 
  901,465 
Depreciation and amortization
  3,102,762 
  1,675,079 
Interest expense
  3,529,982 
  1,990,858 
Gain on asset disposition
  (57,530)
  - 
Net loss
  (2,104,526)
  (1,459,774)
Less: Net (loss) income attributable to noncontrolling interest
  (569,904)
  (244,844)
Net loss attributed to HC Gov Realty Trust, Inc.
  (1,534,622)
  (1,214,930)
Less: Preferred stock dividends
  (252,875)
  (316,095)
Net (loss) income attributed to HC Gov Realty Trust, Inc. available to common shareholders
 $(1,787,497)
 $(1,531,025)
 
Liquidity and Capital Resources
 
Our business model is intended to drive growth through acquisitions. Our Recapitalization Transaction provided us with liquidity through both debt and cash investments. This allowed us to reduce our outstanding debt and provided us with additional capital to continue pursuing our acquisition strategies. In addition, access to the capital markets is an important factor for our continued success. We expect to continue to issue equity in our company with proceeds being used to acquire other single tenanted properties leased to the United States of America or buy facilities that are leased to credit-worthy state or municipal tenants.
 
Liquidity General. 
 
Our need for liquidity will be primarily to fund (i) operating expenses and cash dividends; (ii) property acquisitions; (iii) deposits and fees associated with long-term debt financing for our GSA Properties; (iv) capital expenditures; (v) payment of principal of, and interest on, outstanding indebtedness; and (vi) other investments, consistent with our Investment Guidelines and Investment Policies.
 
We currently have one GSA Property under contract which will require $4,150,000 of funding, as of April 30, 2019, through a combination of cash and secured debt financing.
  
Capital Resources
 
Our capital resources are substantially related to our recent Recapitalization Transaction which is described in detail above under “Item 1. Business—Recent Recapitalization Transaction.” In connection with the Recapitalization Transaction, we received $10,500,000 in mezzanine debt, $10,500,000 through the issuance of our Series B Preferred Stock and $3,000,000 through the issuance of our common stock. This capital was primarily used to pay off existing debt, including accrued interest, in the aggregate amount of $20,139,316 comprised of $9,708,581 to pay off various debt affiliated with our former directors and officers or their affiliates, see “Item 5. Interest of Management and Others in Certain Transactions,” $1,439,557 of unsecured promissory notes payable to accredited investors, and $8,991,178 to pay off a loan cross-collateralized by four of our properties. The remaining $3,860,684 received from the Recapitalization Transaction was used to pay transaction-related expenses and past due accounts payable, with the balance reserved for general working capital purposes including pursuing and making acquisitions.
 
 
 
12
 
 
 
Trend Information
 
Our company, through our Operating Partnership is engaged primarily in the acquisition, leasing and disposition of single-tenanted, mission critical or customer facing properties, leased to the United States of America and that are situated in secondary and tertiary markets throughout the country. As full faith and credit obligations of the United States these leases offer risk-adjusted returns that are attractive, inasmuch as there continues to be no appreciable yield of comparable credit quality in the marketplace.
 
Prior to our Recapitalization Transaction, our Company had been capital constrained, which affected liquidity adversely from an operating perspective and the ability of our Company to manage several viable acquisition opportunities at the same time. While there can be no assurance, we believe the Recapitalization Transaction will enable management to accelerate acquisition plans, provide liquidity to recruit and retain qualified personnel to support growth and enhance purchasing power for goods and services in connection with the operation of our properties.
 
 Item 3. Directors and Officers
 
In connection with the Recapitalization Transaction, we experienced many changes in those who serve as our directors and officers. Information regarding our directors and officers is incorporated herein by reference to the Current Report on Form 1-U filed by our Company at: https://www.sec.gov/Archives/edgar/data/1670010/000165495419002955/hcgrt_1u.htm under the captions “Item 6. Changes in Control of Issuer” and “Item 9. Other Events.”
 
Following the closing of the Recapitalization Transaction, on March 20, 2019, each of Dr. Philip Kurlander and Mr. Edwin Stanton resigned from his position as a director of our Board of Directors. As of March 20, 2019, our Board of Directors is comprised of Messrs. Hale, Garner, Hultquist and Stewart. Mr. Hale was named Chairman of our Board of Directors.  
 
Item 4. Security Ownership of Management and Certain Security Holders
 
The table below sets forth, as of April 30, 2019, certain information regarding the beneficial ownership of our stock for (1) each person who is expected to be the beneficial owner of 10% or more of our outstanding shares of any class of voting stock and (2) each of our directors and named executive officers, if together such group would be expected to be the beneficial owners of 10% or more of our outstanding shares of any class of voting stock. Each person named in the table has sole voting and investment power with respect to all of the shares of common stock shown as beneficially owned by such person.
 
The SEC has defined “beneficial ownership” of a security to mean the possession, directly or indirectly, of voting power and/or investment power over such security. A stockholder is also deemed to be, as of any date, the beneficial owner of all securities that such stockholder has the right to acquire within 60 days after that date through (1) the exercise of any option, warrant or right, (2) the conversion of a security, (3) the power to revoke a trust, discretionary account or similar arrangement or (4) the automatic termination of a trust, discretionary account or similar arrangement. In computing the number of shares beneficially owned by a person and the percentage ownership of that person, our shares of common stock subject to options or other rights (as set forth above) held by that person that are exercisable as of the completion of this offering or will become exercisable within 60 days thereafter, are deemed outstanding, while such shares are not deemed outstanding for purposes of computing percentage ownership of any other person.
 
 
 
13
 
 
 
 
Title of Class
 
Name and Address of Beneficial Owner
 
Amount and Nature of Beneficial Ownership
 
Amount and Nature of Beneficial Ownership Acquirable
 
 
Percent
of Class
 
Common Stock
 
All Executive Officers and Directors1
 
50,000 Shares
 
N/A
 
 
3.6
%
Common Stock
 
HG Holdings, Inc.2
 
300,000 Shares
 
N/A
 
 
21.3
%
Series A Preferred Stock
 
Baker Hill Holding, LLC3
 
26,000 Shares
 
N/A
 
 
18.0
%
Series B Preferred Stock
 
All Executive Officers and Directors1
 
500,000 Shares4
 
N/A
 
 
47.6
%
Series B Preferred Stock
 
Hale Partnership Capital Management5, 6
 
500,000 Shares
 
N/A
 
 
47.6
%
Series B Preferred Stock
 
HG Holdings, Inc.2
 
200,000 Shares
 
N/A
 
 
19.0
%
Series B Preferred Stock
 
The Foursquare Foundation7
 
212,500 Shares
 
N/A
 
 
20.2
%
 
 
 
1 The address of each beneficial owner is 390 S Liberty Street, Suite 100, Winston-Salem, NC 27101.
2 The address of HG Holdings, Inc. is 2115 E. 7th Street, Suite 101, Charlotte, NC 27804.
3 The address of Baker Hill Holding, LLC is 54 Phipps Lane, Plainview, NY 11803.
4 Includes the shares directed by Hale Partnership Capital Management (“HPCM”).
5 The address of HPCM is 3675 Marine Drive, Greenville, NC 27834.
6 HPCM serves as investment manager or adviser to commingled funds, group trusts and separate accounts (such investment companies, funds, trusts and accounts, collectively referred to as the “Funds”). In certain cases, certain subsidiaries of HPCM may act as an adviser or sub-adviser to certain Funds. In its role as investment adviser, sub-adviser and/or manager, HPCM or its subsidiaries may possess voting and/or investment power over the securities of the Company owned by the Funds and may be deemed to be the beneficial owner of these shares. However, all securities reported on the table are owned by the Funds, and HPCM and its subsidiaries disclaim beneficial ownership of all of the shares shown.
7 The address of The Foursquare Foundation is 1910 W. Sunset Boulevard, Suite 200, Los Angeles, CA 90026.
 
 Item 5. Interest of Management and Others in Certain Transactions
 
The information included above under the caption “Item 1. Business—Recent Recapitalization Transaction” is hereby incorporated by reference into this Item 5. The information contained in the post-qualification amendment to our Offering Statement on Form 1-A located at: https://www.sec.gov/Archives/edgar/data/1670010/000165495418012065/hcgov_1apos.htm under the caption “INTEREST OF MANAGEMENT AND OTHERS IN CERTAIN TRANSACTIONS” is incorporated herein by reference.
 
The following information has changed since the date of our post-qualification amendment to our Offering Statement on Form 1-A:
 
Norfolk Interim Loans
 
On March 31, 2017, the Company borrowed $2,770,000 from BH and $300,000 from Mr. Robert R. Kaplan. These loans were repaid in full in the aggregate amount of $3,070,000 with proceeds from our Recapitalization Transaction.
 
 
 
14
 
 
 
Additional Affiliated Loans and Advances
 
In July 2018, Messrs. Kaplan, Kaplan Jr., and Stanton, and BH, each advanced $60,000 to our Company to fund working capital and distributions. As of the date of this annual report, these amounts remain outstanding.
 
In October 2018, BH made two unsecured loans to our company in the amounts of $78,000 and $150,000 to fund distributions to our stockholders. These loans were repaid in full in the aggregate amount of $228,000 with proceeds from our Recapitalization Transaction.
 
Promissory Notes
 
On December 11, 2017, the Company borrowed $1,500,000 in aggregate principal amount pursuant to multiple unsecured promissory notes payable to accredited investors. With respect to these notes, $500,000 in principal amount was loaned by BH, and $250,000 was loaned by a member of the Company’s predecessor. These loans were repaid in full in the aggregate amount of $1,500,000 with proceeds from our Recapitalization Transaction.
 
BH Notes
 
On July 27, 2018, our Operating Partnership borrowed $1,700,000 from BH, pursuant to an unsecured promissory note. Also, on August 30, 2018, our Operating Partnership borrowed $800,000 from BH, pursuant to an unsecured promissory note. In addition, on October 12, 2018, our Operating Partnership borrowed $2,470,000 from BH, pursuant to an unsecured promissory note. These loans were repaid in full, including principal and interest make-whole payment, in the amount of $1,801,150, $856,933 and $2,705,336, respectively, with proceeds from our Recapitalization Transaction.
 
Predecessor Payables
 
Our Company had outstanding payables to our predecessor for various expenses paid on our behalf by our predecessor in the amount of $408,514. As of the date of this annual report, this amount remains outstanding.
 
Item 6. Other Information
 
None
 
 
 
 
15
 
 
 
 Item 7. Financial Statements
 
Report of Independent Registered Public Accounting Firm
 
 
 
To the Board of Directors and Stockholders
HC Government Realty Trust, Inc.
Winston-Salem, North Carolina
 
Opinion on the Consolidated Financial Statements
 
We have audited the accompanying consolidated balance sheets of HC Government Reality Trust, Inc. and subsidiaries (collectively, “the Company”) as of December 31, 2018 and 2017, the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the years in the two-year period ended December 31, 2018 and 2017, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2018 in conformity with accounting principles generally accepted in the United States of America.
 
Basis for Opinion
 
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
 
We conducted our audits in accordance with the standards of the PCAOB and in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
 
 
/s/ Cherry Bekaert LLP
 
We have served as the Company’s auditor since 2016.
 
Richmond, VA
April 30, 2019
 
 
 
 
 
16
 
 
HC Government Realty Trust, Inc.
Consolidated Balance Sheets
December 31, 2018 and 2017
 
 
 
December 31,
2018
 
 
December 31,
2017
 
ASSETS
 
 
 
 
 
 
Investment in real estate, net
 $79,786,230 
 $61,922,635 
Cash and cash equivalents
  1,444,172 
  695,719 
Restricted cash
  1,718,676 
  1,676,152 
Rent and other tenant receivables, net
  1,073,881 
  757,752 
Leasehold intangibles, net
  8,024,729 
  5,635,435 
Deposits on properties under contract
  224,069 
  58,000 
Prepaid expenses and other assets
  235,005 
  307,840 
Total Assets
 $92,506,762 
 $71,053,533 
 
    
    
LIABIILTIES
    
    
Mortgages payable, net of unamortized debt costs
 $65,503,177 
 $49,573,683 
Notes payable - related party
  9,518,000 
  4,150,000 
Notes payable
  1,180,000 
  1,179,610 
Declared dividends and distributions
  378,687 
  344,842 
Accrued interest payable
  417,141 
  248,352 
Accounts payable
  422,162 
  267,232 
Accrued expenses
  483,879 
  357,981 
Deferred revenue
  452,313 
  - 
Tenant improvement obligation
  1,224,923 
  1,315,366 
Acquisition fee payable - related party
  505,239 
  274,345 
Below-market leases, net
  868,786 
  1,001,754 
Related party payable, net
  722,465 
  461,858 
Total Liabilities
  81,676,772 
  59,175,023 
 
    
    
COMMITMENTS AND CONTINGENCIES (Note 14)
  - 
  - 
 
    
    
STOCKHOLDERS' EQUITY
    
    
 
    
    
Preferred stock ($0.001 par value, 750,000,000 shares authorized and 144,500 shares issued and outstanding)
  144 
  144 
Common stock ($0.001 par value, 250,000,000 shares authorized, 1,107,041 and 895,307 common shares issued and outstanding at December 31, 2018 and 2017, respectively)
  1,107 
  895 
Additional paid-in capital
  11,314,818 
  8,948,713 
Offering costs
  (1,459,479)
  (1,459,479)
Accumulated deficit
  (2,875,596)
  (1,340,974)
Accumulated dividends and distributions
  (1,536,708)
  (690,963)
Total Stockholders' Equity
  5,444,286 
  5,458,336 
Noncontrolling interest in operating partnership
  5,385,704 
  6,420,174 
Total Equity
  10,829,990 
  11,878,510 
Total Liabilities and Stockholders' Equity
 $92,506,762 
 $71,053,533 
 
The following table presents the assets and liabilities of the Company's three consolidated variable interest entities as of December 31, 2018 and 2017 which are included on the consolidated balance sheets above. The assets in the table below include those assets that can only be used to settle obligations of the consolidated variable interest entities. The liabilities in the table below include third-party liabilities of the consolidated variable interest entities only, and for which creditors or beneficial interest holders do not have recourse to the Company, and exclude intercompany balances that eliminate in consolidation.
 
 
 
 
 
 
 
 
 
ASSETS OF CONSOLIDATED VARIABLE INTEREST ENTITIES THAT CAN ONLY BE USED TO SETTLE THE OBLIGATIONS OF CONSOLIDATED VARIABLE INTEREST ENTITIES:
 
Buildings and improvements, net
 $11,627,603 
 $12,007,437 
Intangible assets, net
  397,582 
  530,626 
Prepaids and other assets
  122,777 
  457,096 
Total Assets
 $12,147,962 
 $12,995,159 
 
LIABILITIES OF CONSOLIDATED VARIABLE INTEREST ENTITIES FOR WHICH CREDITORS OR BENEFICIAL INTEREST HOLDERS DO NOT HAVE RECOURSE TO THE COMPANY.
 
Mortgages payable
 $9,633,590 
 $9,796,972 
Intangible liabilities, net
  123,985 
  168,733 
Accounts payable and accrued expenses
  255,205 
  242,284 
Total liabilities
 $10,012,780 
 $10,207,989 
 
The accompanying notes are an integral part of the consolidated financial statements
 
17
 
 
HC Government Realty Trust, Inc.
Consolidated Statements of Operations
For the years ended December 31, 2018 and 2017
 
 
 
For the years ended December 31,
 
 
 
2018
 
 
2017
 
Revenues
 
 
 
 
 
 
Rental revenues
 $8,145,067 
 $4,595,560 
Real estate tax reimbursments and other revenues
  286,540 
  169,002 
Total revenues
  8,431,607 
  4,764,562 
 
    
    
Operating expenses
    
    
Depreciation and amortization
  3,102,762 
  1,675,079 
General and administrative
  441,029 
  405,824 
Ground leases
  91,545 
  45,954 
Insurance
  100,359 
  58,373 
Janitorial
  389,552 
  208,618 
Management fees
  552,705 
  303,482 
Professional expenses
  468,263 
  482,070 
Real estate and other taxes
  849,546 
  357,143 
Repairs and maintenance
  435,631 
  248,900 
Equity-based compensation
  193,119 
  181,031 
Utilities
  439,170 
  267,004 
Total operating expenses
  7,063,681 
  4,233,478 
 
    
    
Other (income) expense
    
    
Interest expense
  3,529,982 
  1,990,858 
Gain on disposition of property
  (57,530)
  - 
Net other (income) expense
  3,472,452 
  1,990,858 
 
    
    
Net loss
  (2,104,526)
  (1,459,774)
Less: Net loss attributable to noncontrolling interest in operating partnership
  (569,904)
  (244,844)
Net loss attributed to HC Government Realty Trust, Inc.
  (1,534,622)
  (1,214,930)
Preferred stock dividends
  (252,875)
  (316,095)
Net loss attributed to HC Government Realty Trust, Inc. available to common shareholders
 $(1,787,497)
 $(1,531,025)
 
    
    
Basic and diluted loss per share
 $(1.70)
 $(3.03)
 
    
    
Basic and diluted weighted-average common shares outstanding
  1,048,495 
  504,486 
 
The accompanying notes are an integral part of the consolidated financial statements
 
18
 
HC Government Realty Trust, Inc.
Consolidated Statements of Changes in Stockholders’ Equity
For the years ended December 31, 2018 and 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Additional
 
 
 
 
 
 
 
 
Cumulative Dividends
 
 
Total
 
 
 Non-controlling Interst in
 
 
 
 
 
 
Preferred Series A
 
 
  Common Stock        
 
 
 Paid-in
 
 
Offering
 
 
Accumulated
 
 
 and
 
 
Stockholders'
 
 
 Operating
 
 
Total
 
 
 
Shares
 
 
Par Value
 
 
Shares
 
 
Par Value
 
 
 Capital
 
 
Costs
 
 
Deficit
 
 
 Distributions
 
 
Equity
 
 
 Partnership
 
 
Equity
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2016
  144,500 
  144 
  200,000 
  200 
  3,614,156 
  (1,074,485)
  (126,044)
  (104,636)
  2,309,335 
  - 
  2,309,335 
Proceeds from issuing common shares, net of issuances costs
  - 
  - 
  679,307 
  679 
  6,141,247 
  - 
  - 
  - 
  6,141,926 
  - 
  6,141,926 
Contribution of Holmwood Capital properties for common units
  - 
  - 
  - 
  - 
  (1,316,740)
  - 
  - 
  - 
  (1,316,740)
  7,384,922 
  6,068,182 
Equity-based compensation - restricted stock
  - 
  - 
  16,000 
  16 
  98,651 
  - 
  - 
  - 
  98,667 
  - 
  98,667 
Equity-based compensation long-term incentive plan shares
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  82,364 
  82,364 
Dividends and distributions
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  (586,327)
  (586,327)
  (390,869)
  (977,196)
Offering costs
  - 
  - 
  - 
  - 
  - 
  (384,994)
  - 
  - 
  (384,994)
  - 
  (384,994)
Allocation of NCI in operating partnership
  - 
  - 
  - 
  - 
  411,399 
  - 
  - 
  - 
  411,399 
  (411,399)
  - 
Net loss
  - 
  - 
  - 
  - 
  - 
  - 
  (1,214,930)
  - 
  (1,214,930)
  (244,844)
  (1,459,774)
Balance, December 31, 2017
  144,500 
  144 
  895,307 
  895 
  8,948,713 
  (1,459,479)
  (1,340,974)
  (690,963)
  5,458,336 
  6,420,174 
  11,878,510 
Proceeds from issuing common shares, net of issuances costs
  - 
  - 
  211,734 
  212 
  1,947,443 
  - 
  - 
  - 
  1,947,655 
  - 
  1,947,655 
Issuance of OP Units in connection with property closing
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  400,000 
  400,000 
Equity-based compensation - restricted stock
  - 
  - 
  - 
  - 
  61,333 
  - 
  - 
  - 
  61,333 
  - 
  61,333 
Equity-based compensation long-term incentive plan shares
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  131,786 
  131,786 
Dividends and distributions
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  (845,745)
  (845,745)
  (639,023)
  (1,484,768)
Allocation of NCI in operating partnership
  - 
  - 
  - 
  - 
  357,329 
  - 
  - 
  - 
  357,329 
  (357,329)
  - 
Net loss
  - 
  - 
  - 
  - 
  - 
  - 
  (1,534,622)
  - 
  (1,534,622)
  (569,904)
  (2,104,526)
Balance, December 31, 2018
  144,500 
 $144 
  1,107,041 
 $1,107 
 $11,314,818 
 $(1,459,479)
 $(2,875,596)
 $(1,536,708)
 $5,444,286 
 $5,385,704 
 $10,829,990 
 
The accompanying notes are an integral part of the consolidated financial statements
 
19
 
 
HC Government Realty Trust, Inc.
Consolidated Statements of Cash Flows
For the years ended December 31, 2018 and 2017
 
 
 
For the Years Ended
December 31,
 
 
 
2018
 
 
2017
 
Cash flows from operating activities:
 
 
 
 
 
 
Net loss
 $(2,104,526)
 $(1,459,774)
 
Adjustments to reconcile net loss to net cash provided from (used in) operating activities:
 
Depreciation
  2,385,819 
  1,299,191 
Amortization of acquired lease-up costs
  322,446 
  178,296 
Amortization of in-place leases
  394,497 
  197,592 
Amortization of above/below-market leases
  101,008 
  24,639 
Amortization of debt issuance costs
  243,223 
  97,387 
Equity-based compensation - long-term incentive plan units
  131,786 
  82,364 
Equity-based compensation - restricted shares
  61,333 
  98,667 
Gain on disposition of property
  (57,530)
  - 
Change in assets and liabilities
    
    
Restricted cash
  (42,524)
  (174,271)
Rent and other tenant receivables, net
  (316,129)
  (482,217)
Prepaid expense and other assets
  72,835 
  (130,470)
Deposits on properties under contract
  (166,069)
  - 
Related party receivables, net
  - 
  525,397 
Accrued interest payable
  244,789 
  212,973 
Accounts payable and other accrued expenses
  272,335 
  (90,454)
Deferred revenue
  452,313 
  - 
Tenant improvement obligation
  (90,443)
  - 
Related party payable, net
  20,607 
  461,858 
Net cash provided from operating activities
  1,925,770 
  841,178 
 
    
    
Cash flows from investing activities:
    
    
Restricted cash
  - 
  (1,315,366)
Capital improvements
  (133,101)
  (8,495)
Sale of property
  98,879 
  - 
Property acquisitions
  (22,858,488)
  (26,198,647)
Net cash used in investing activities
  (22,892,710)
  (27,522,508)
 
    
    
Cash flows from financing activities:
    
    
Debt issuance costs
  (345,762)
  (372,317)
Dividends paid
  (1,450,923)
  (632,354)
Mortgage principal payments
  (1,107,967)
  (3,673,038)
Mortgage proceeds
  17,140,000 
  24,146,250 
Notes principal repayments
  (99,610)
  (136,211)
Notes principal repayments - related party
  (330,000)
  - 
Offering costs
  - 
  (384,994)
Proceeds from advances - related party
  765,000 
  - 
Proceeds from notes payable
  100,000 
  1,204,000 
Proceeds from notes payable - related party
  5,622,000 
  4,150,000 
Proceeds from sale of common stock, net of issuance costs
  1,947,655 
  6,141,926 
Repayment of advances - related party
  (525,000)
  - 
Repayment of seller note payable
  - 
  (1,992,140)
Repayment of assumed notes payable
  - 
  (1,321,210)
Net cash provided from financing activities
  21,715,393 
  27,129,912 
 
    
    
Net increase in cash and cash equivalents
  748,453 
  448,582 
Cash and cash equivalents, beginning of period
  695,719 
  247,137 
Cash and cash equivalents, end of period
 $1,444,172 
 $695,719 
 
    
    
Supplemental cash flow information:
    
    
Cash paid for interest
 $3,117,970 
 $1,645,119 
Cash paid for income taxes
 $- 
 $- 
Non cash investing and financing activities:
    
    
Accrued interest added to note payable - related party
 $76,000 
 $- 
Assumed liabilities (See Note 3)
 $- 
 $24,670,469 
Capitalized acquisition fees
 $230,894 
 $274,345 
Common units issued in connection with contribution transaction
 $- 
 $6,068,182 
Common units issued in connection with property acquisition
 $400,000 
 $- 
Contributed assets (See Note 3)
 $- 
 $30,738,651 
Mortgage principal refinanced
 $6,781,386 
 $- 
Refinance costs added to mortgage
 $52,907 
 $- 

The accompanying notes are an integral part of the consolidated financial statements
 
 
20
 
 
HC Government Realty Trust, Inc.
Notes to the Consolidated Financial Statements
For the years ended December 31, 2018 and 2017
 
1.
Organization
 
HC Government Realty Trust, Inc. (the “REIT”), a Maryland corporation, was formed on March 11, 2016 to primarily source, acquire, own and manage built-to-suit and improved-to-suit, single-tenant properties leased by the United States of America through the U.S General Services Administration (“GSA Properties”). The REIT focuses primarily on GSA Properties across secondary and smaller markets, within size ranges of 5,000 to 50,000 rentable square feet, and in their first term after construction or retrofit to post-9/11 standards. Further, the REIT selects GSA Properties that fulfill mission critical or citizen service functions. Leases associated with the GSA Properties are full faith and credit obligations of the United States of America and are administered by the U.S. General Services Administration or directly through the occupying federal agencies, or collectively the GSA.
 
The REIT owns its properties through the REIT’s subsidiary, HC Government Realty Holdings, L.P., a Delaware limited partnership (“Operating Partnership”, and together with the REIT, the “Company”). The Operating Partnership invests through wholly-owned special purpose limited liability companies, or special purpose entities (“SPEs”), primarily in properties across secondary or smaller markets.
 
The consolidated financial statements include the accounts of the Operating Partnership subsidiary and related SPEs and the accounts of the REIT. As of December 31, 2018, the financial statements reflect the operations of 16 properties representing 320,652 rentable square feet located in eleven states. The properties are 100% leased to the government of the United States of America and based on annualized net operating income as of December 31, 2018, have a weighted average remaining lease term of 10.0 years if none of the early termination rights are exercised and 6.2 years if all of the early termination rights are exercised. The Company and its assets are managed externally by Holmwood Capital Advisors, LLC and its subsidiary Holmwood Capital Management, LLC (collectively “HCA” or “Asset Manager”).  The owners of HCA, or their respective affiliates, principally own and control Holmwood Capital, LLC (“predecessor” or “Holmwood”). Holmwood and HCA own an aggregate 43.54% of the common units of Operating Partnership as of December 31, 2018. The CEO of HCA and Holmwood served as the Company’s CEO until March 13, 2019 and as a board member of the Company until March 20, 2019. In addition, two other beneficial owners of HCA and Holmwood served as board members of the Company until March 20, 2019. The Company operates as an UPREIT and has elected to be treated as a real estate investment trust, or REIT, for federal income tax purposes under the Internal Revenue Code of 1986, as amended, or the Code, beginning with the taxable year ended December 31, 2017.
 
2.
Significant Accounting Policies
 
Basis of Accounting and Consolidation Basis - The accompanying consolidated financial statements include the accounts of the Operating Partnership and 16 SPEs as of December 31, 2018. Of the SPEs, 13 are wholly-owned entities that are consolidated based upon the Company having a controlling financial interest, and three SPEs are consolidated variable interest entities based upon management’s determination that the Operating Partnership has a variable interest in the entities and is the primary beneficiary. All other significant intercompany balances and transactions have been eliminated in consolidation.
 
Use of Estimates - The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements, and the amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and assumptions.
 
Cash and Cash Equivalents - Cash and cash equivalents include all cash and liquid investments with an initial maturity of three months or less when purchased. At times, the Company’s cash and cash equivalents balance deposited with financial institutions may exceed federally insurable limits. The Company maintains separate cash balances at the operating partnership and SPE level. At December 31, 2018, two accounts had a combined $1,773,591 in excess of insured limits, all others were below the insurable limits. The Company mitigates this risk by depositing funds with major financial institutions. The Company has not experienced any losses in connection with such deposits.
 
 
 
21
 
 
 
Restricted Cash Restricted cash consists of amounts escrowed for future real estate taxes, insurance, and capital expenditures, as required by certain of the Company’s mortgage debt agreements.
 
Purchase Accounting for Acquisitions of Real Estate Subject to a Lease - In accordance with the Financial Accounting Standards Board (“FASB”) guidance on business combinations, the Company determines the fair value of the real estate assets acquired on an “as if vacant” basis.
 
Management estimates the “as if vacant” value considering a variety of factors, including the physical condition and quality of the buildings, estimated rental and absorption rates, estimated future cash flows, and valuation assumptions consistent with current market conditions. The “as if vacant” fair value is allocated to land and buildings and improvements based on relevant information obtained in connection with the acquisition of the property, including appraisals and property tax assessments. Above-market and below-market lease values are determined on a lease-by-lease basis based on the present value (using an interest rate that reflects the risk associated with the leases acquired) of the difference between (a) the contractual amounts to be paid under the lease and (b) management’s estimate of the fair market lease rate for the corresponding space over the remaining non-cancelable terms of the related leases. Above (below) market lease values are recorded as leasehold intangibles and are recognized as an increase or decrease in rental income over the remaining non-cancelable term of the lease. Amortization relating to above (below) market leases for the years ended December 31, 2018 and 2017 was $101,008 and $24,639, respectively, and was recorded as a reduction to rental revenues.
 
Additionally, in-place leases are valued in consideration of the net rents earned that would have been foregone during an assumed lease-up period; and lease-up costs are valued based upon avoided brokerage fees. The Company has not recognized any value attributable to customer relationships. The difference between the total of the calculated values described above, and the actual purchase price plus acquisition costs, is allocated pro-ratably to each component of calculated value. In-place leases and lease-up costs are amortized over the remaining non-cancelable term of the leases.
 
Management utilizes independent third-parties to assist with the determination of fair value of the various tangible and intangible assets that are acquired.
 
The cost of tenant improvements are capitalized and amortized over the non-cancelable term of each specific lease.
 
Maintenance and repair costs are expensed as incurred while costs incurred that extend the useful life of the real estate investment are capitalized.
 
Depreciation of an asset begins when it is available for use and is calculated using the straight-line method over its estimated useful life. Range of useful lives for depreciable assets are as follows:
 
Category
 
 
 
Term
 
 
Buildings    
 
40 years  
 
Building and site improvements    
 
5- 40 years    
Tenant improvements    
 
Shorter of remaining life of the lease or useful life    

Tenant Improvements - As part of the leasing process, the Company may provide the lessee with an allowance for the construction of leasehold improvements. These leasehold improvements are capitalized and recorded as tenant improvements and depreciated over the shorter of the useful life of the improvements or the remaining lease term. If the allowance represents a payment for a purpose other than funding leasehold improvements, or in the event the Company is not considered the owner of the improvements, the allowance is considered to be a lease incentive and is recognized over the lease term as a reduction of minimum rent revenue. Factors considered during this evaluation include, among other things, who holds legal title to the improvements as well as other controlling rights provided by the lease agreement and provisions for substantiation of such costs (e.g. unilateral control of the tenant space during the build-out process). Determination of the appropriate accounting for the payment of a tenant allowance is made on a lease-by-lease basis, considering the facts and circumstances of the individual tenant lease.
 
 
 
22
 
 
 
Leases - The Company’s real estate is leased to tenants on a modified gross lease basis. The leases provide for a minimum rent which normally is flat during the firm term of the lease. The minimum rent payment may include payments to pay for lessee requests for tenant improvements or to cover the cost for extra security. The tenant is required to pay increases in property taxes over the base year and an increase in operating costs based on the consumer price index of the lease’s base year operating expenses. Operating costs includes repairs and maintenance, cleaning, utilities and other related costs. Generally, the leases provide the tenant with renewal options, subject to generally the same terms and conditions of the base term of the lease. The Company accounts for its leases using the operating method. Such method is described below:
 
Operating method – Properties with leases accounted for using the operating method are recorded at the cost of the real estate. Revenue is recognized as rentals are earned and expenses (including depreciation and amortization) are charged to operations as incurred. Buildings are depreciated on the straight-line method over their estimated useful lives. Leasehold intangibles are amortized on the straight-line method over the terms of their respective leases. When scheduled rentals vary during the lease term, income is recognized on a straight-line basis so as to produce a constant periodic rent revenue over the term of the lease.
 
ImpairmentReal Estate - The Company reviews investments in real estate for impairment whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. To determine if impairment may exist, the Company reviews its properties and identifies those that have experienced either a change or an event or circumstance warranting further assessment of recoverability (such as a decrease in occupancy). If further assessment of recoverability is needed, the Company estimates the future net cash flows expected to result from the use of the property and its eventual disposition, on an individual property basis. If the sum of the expected future net cash flows (undiscounted and without interest charges) is less than the carrying amount of the property on an individual property basis, the Company will recognize an impairment loss based upon the estimated fair value of such property. For the year ended December 31, 2018 and 2017, the Company has not recorded any impairment charges.
 
Organizational, Offering and Related Costs - Organizational and offering costs of the Company are presented as a reduction of shareholders’ equity within the consolidated balance sheets and statements of changes in stockholders’ equity. Organizational and offering costs represent expenses incurred in connection with the formation of the Company and the filing of the Company’s securities offering pursuant to Regulation A. As of December 31, 2018 and 2017, organizational and offering costs totaled $1,459,479.
 
Revenue Recognition - Minimum rents are recognized when due from tenants; however, minimum rent revenues under leases which provide for varying rents over their terms, if any, are straight lined over the term of the leases. In the case of expense reimbursements due from tenants, the revenue is recognized in the period in which the related expense is incurred.
 
Rents and Other Tenant Receivables net - Rents and other tenant receivables represent amounts billed and due from tenants. When a portion of the tenants’ receivable is estimated to be uncollectible, an allowance for doubtful accounts is recorded. Due to the high credit worthiness of the tenants, there were no allowances as of December 31, 2018 and 2017.
 
Income Taxes The Company has elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code and applicable Treasury regulations relating to REIT qualification beginning with its fiscal year ending December 31, 2017. In order to maintain this REIT status, the regulations require the Company to distribute at least 90% of its taxable income to shareholders and meet certain other asset and income tests, as well as other requirements. If the Company fails to qualify as a REIT, it will be subject to tax at regular corporate rates for the years in which it fails to qualify. If the Company loses its REIT status it could not elect to be taxed as a REIT for five years unless the Company’s failure to qualify was due to reasonable cause and certain other conditions were satisfied.
 
 
 
23
 
 
 
Management analyzes its tax filing positions in the U.S. federal, state and local jurisdictions where it is required to file income tax returns for all open tax years. If, based on this analysis, management determines that uncertainties in tax positions exist, a liability is established along with an estimate for interest and penalty. Management has determined that there were no uncertain tax positions; and, accordingly, no associated interest and penalties were required to be accrued at December 31, 2018 and 2017.
 
Noncontrolling Interest - Noncontrolling interest represents the portion of equity in the Company’s Operating Partnership not attributable to the Company. The value of the noncontrolling interest is calculated by multiplying the noncontrolling interest ownership percentage at the balance sheet date by the Operating Partnership’s equity. The noncontrolling interest ownership percentage is calculated by dividing the Operating Partnership common units not owned by the Company by the total Operating Partnership common units outstanding. The noncontrolling interest ownership percentage will change as additional common units are issued or as common units are exchanged for the Company’s common stock. Subsequent changes in the noncontrolling interest value are recorded to additional paid-in capital. Accordingly, the value of the noncontrolling interest is included in the equity section of the consolidated balance sheets but presented separately from the Company’s equity.
 
Debt Issuance Costs – Debt issuance costs incurred in connection with the Company’s mortgages payable have been deferred and are being amortized over the term of the respective loan agreements using the effective interest method. As applicable, the unamortized balance of debt issuance costs is presented as a reduction of the mortgages payable carrying value within the consolidated balance sheets.
  
Earnings (Loss) Per Share - Basic earnings (loss) per share is based on the weighted effect of all common shares issued and outstanding and is calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share is calculated by dividing net income available to common shareholders by the weighted average number of common shares used in the basic earnings per share calculation plus the number of common shares, if any, that would be issued assuming conversion of all potentially dilutive securities outstanding.
  
The following securities were not included in the computation of the Company’s diluted net loss per share as their effect would be anti-dilutive.
 
 
 
As of December 31,
 
 
 
2018
 
 
2017
 
Potentially dilutive securities outstanding
 
 
 
 
 
 
Convertible common units
  1,118,416 
  1,078,416 
Convertible long-term incentive plan units
  72,215 
  66,056 
Convertible preferred stock
  433,500 
  433,500 
Unvested restricted stock
  - 
  16,000 
Total potential dilutive securities
  1,624,131 
  1,593,972 
 
Recent Accounting Pronouncements - In May 2014, the FASB issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers,” which supersedes the revenue recognition requirements of Accounting Standards Codification (“ASC”) Topic 605, “Revenue Recognition” and most industry-specific guidance on revenue recognition throughout the ASC. The new standard is principles based and provides a five-step model to determine when and how revenue is recognized. The core principle of the new standard is that revenue should be recognized when a company transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. The new standard also requires disclosure of qualitative and quantitative information surrounding the amount, nature, timing and uncertainty of revenues and cash flows arising from contracts with customers. The new standard became effective for the Company on January 1, 2019. The Company’s revenue is based on real estate leasing transactions which are not within the scope of the new standard. The Company does not expect for the adoption of ASU 2014-09 to have a material impact on its consolidated financial statements.
 
 
 
24
 
 
 
In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)." ASU 2016-02 is intended to improve financial reporting about leasing transactions.  The ASU will require organizations that lease assets referred to as “Lessees” to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases with lease terms of more than 12 months. An organization is to provide disclosures designed to enable users of financial statements to understand the amount, timing, and uncertainty of cash flows arising from leases. These disclosures include qualitative and quantitative requirements concerning additional information about the amounts recorded in the consolidated financial statements.  The leasing standard will be effective for the year ended December 31, 2020. Early adoption will be permitted upon issuance of the standard and a modified retrospective approach must be applied. The Company is currently evaluating the impact of ASU 2016-02 on its financial statements. See Note 14 Commitments and Contingencies for the Company’s operating leases.
   
In August 2016, the FASB issued ASU 2016-15, "Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.” ASU 2016-15 is intended to improve cash flow statement classification guidance. The standard will be effective for fiscal years beginning after December 15, 2018. The Company is currently evaluating the impact of ASU 2016-15 on its financial statements.
 
In November 2016, the FASB issued ASU 2016-18, "Statement of Cash Flows (Topic 230): Restricted Cash” ASU 2016-18 is intended to address the diversity that exists in practice with respect to the classification and presentation of changes in restricted cash on the statement of cash flows under Topic 230. The standard will be effective for fiscal years beginning after December 15, 2018. The Company is currently evaluating the impact of ASU 2016-18 on its financial statements.
 
In January 2017, the FASB issued ASU 2017-01, "Business Combinations (Topic 805): Clarifying the Definition of a Business.” ASU 2017-01 is intended to help companies evaluate whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The standard will be effective for public business entities beginning with annual periods beginning after December 15, 2017 and for all other entities after December 15, 2018. The Company has early adopted ASU 2017-01 and applied its guidance to the property acquisitions made during the year ended December 31, 2018. The adoption of this guidance did not impact the Company’s historical policy of accounting for property acquisitions as asset purchases rather than business combinations.
 
The Company has adopted reporting standards and disclosure requirements as a “smaller reporting company” as defined in Securities Act rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K as amended September 13, 2017. This rule provides scaled disclosure accommodations, the purpose of which is to provide general regulatory relief to qualifying entities.
 
Other accounting standards that have been issued or proposed by the FASB or other standard-setting bodies are not currently applicable to the Company or are not expected to have a significant impact on the Company’s financial position, results of operations and cash flows.
 
3.
Contribution Transaction
 
On May 26, 2017, Holmwood and the Operating Partnership closed on a transaction that resulted in Holmwood contributing its entire membership interest in four SPEs to the Operating Partnership and assigning to the Operating Partnership all its rights, title and interest in and to any and all profits, losses and distributed cash flow for three other SPEs as well as all of the other benefits and burdens of ownership for federal income tax purposes (the “Contribution Transaction”). In exchange for the aforementioned, the Operating Partnership issued 1,078,416 of its common units (“OP Units”). The agreed upon value of the transaction between the parties was $10,784,161. However, the Company recognized value of $6,068,182 with respect to the issuance of the OP Units based upon the net identifiable assets received. This issuance was recorded as a non-cash transaction in the Consolidated Statement of Changes in Stockholders Equity for the year ended December 31, 2017.
 
The Contribution Transaction was accounted for as a commonly controlled transaction whereby the contributed assets and assumed liabilities are acquired at their historical book values, rather than at the agreed upon value. The historical book value of the net identifiable assets contributed was $6,068,182.
  
 
 
25
 
 
 
A summary of the Company’s contributed assets and assumed liabilities as of May 26, 2017 is as follows:
 
Assets contributed:
 
 
 
Buildings and improvements, net
 $28,748,079 
Intangible assets, net
  1,653,771 
Prepaid and other assets
  336,801 
Total assets contributed, net
 $30,738,651 
Liabilities assumed:
    
Mortgages payable
 $22,307,335 
Notes payable
  1,321,210 
Intangible liabilities, net
  704,941 
Accounts payable and accrued expenses
  336,983 
Total liabilities assumed
 $24,670,469 
 
    
Net identifiable assets contributed
 $6,068,182 
 
As part of the Contribution Transaction, the Company and Holmwood entered into a tax protection agreement indemnifying Holmwood for any taxes resulting from a sale for a period of ten years after the date of the Contribution Transaction.
 
4.
Variable Interest Entities
 
With respect to the three SPEs where Holmwood assigned to the Operating Partnership all its rights, title and interest in and to any and all profits, losses and distributed cash flow, management determined these SPEs to be variable interest entities (“VIE”) in which the Operating Partnership has a variable interest and that Holmwood equity holders lacked the characteristics of a controlling financial interest. The Company determined in accordance with ASC Topic 810 “Consolidation” to consolidate these SPEs.
 
A summary of the VIE’s assets and liabilities that are included within the Company’s Consolidated Balance Sheets at December 31, 2018 and 2017 is as follows:
  
 
 
December 31,
 
 
December 31,
 
Assets:
 
2018
 
 
2017
 
Buildings and improvements, net
 $11,627,603 
 $12,007,437 
Intangible assets, net
  397,582 
  530,626 
Prepaids and other assets
  122,777 
  457,096 
Total assets
 $12,147,962 
 $12,995,159 
 
    
    
Liabilities:
    
    
Mortages payable
 $9,633,590 
 $9,796,972 
Intangible liabilities, net
  123,985 
  168,733 
Accounts payable and accrued expenses
  255,205 
  242,284 
Total liabilities
 $10,012,780 
 $10,207,989 
 
    
    
Net identifiable assets
 $2,135,182 
 $2,787,170 
 
 
 
26
 
 
5.
Investment in Real Estate
 
The following is a summary of the Company’s investment in real estate, net as of December 31, 2018 and 2017:
 
 
 
December 31, 2018
 
 
December 31, 2017
 
Land
 $7,486,554 
 $6,065,137 
Buildings and improvements
  69,150,056 
  52,699,106 
Site improvements
  1,116,653 
  - 
Tenant improvements
  5,962,007 
  4,701,613 
 
  83,715,270 
  63,465,856 
Accumulated depreciation
  (3,929,040)
  (1,543,221)
Investment in real estate, net
 $79,786,230 
 $61,922,635 
 
Depreciation expense for the years ended December 31, 2018 and 2017 was $2,385,819 and $1,299,191, respectively.
 
During the year ended December 31, 2018, the Company acquired three properties located in Knoxville, Iowa (“Knoxville Property”), Champaign, Illinois (“Champaign Property”), and Sarasota, Florida (“Sarasota Property”) with rentable square footage of 12,833, 11,180 and 28,210, respectively. The Knoxville Property and Champaign Property acquisitions were financed with a combination of operating cash, first mortgage loans and unsecured debt; and the Sarasota Property was financed with a combination of operating cash, first mortgage loan, unsecured debt and OP Units. All three properties were acquired with leases in place with the United States of America with remaining firm terms between 9 and 13 years at the time of acquisition.
 
Pursuant to a purchase and sale agreement dated April 27, 2017 (“the Agreement”) and further with respect to our Montgomery Property, the Company was obligated to pay additional purchase price (1) in the event the actual base year property taxes are less than the estimated base year property taxes used in the Agreement and (2) in the event the seller (i) procured an amendment to the existing GSA lease for additional space and (ii) paid for the development and construction of the additional space. Effective October 19, 2018, the Company completed the purchase of the additional space for approximately $1,419,000, including transaction related costs of approximately $14,200. The effect of the lease amendment was to increase rentable square feet by 5,384 and increase rental income approximately $125,000 per year. On December 3, 2018, the Company paid additional purchase price of $89,469 with respect to the base year tax adjustment.
 
A summary of the allocated purchase price, based on estimated fair values, for each acquired property and the additional purchase price paid with respect to the Montgomery Property in 2018 is as follows:
 
 
 
Knoxville
 
 
Champaign
 
 
Sarasota
 
 
Montgomery
 
 
 
 
2018 Acquisitions:
 
7/27/2018
 
 
8/30/2018
 
 
10/15/2018
 
 
10/19/2018
 
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land
 $521,984 
 $149,320 
 $782,969 
 $- 
 $1,454,273 
Buildings and improvements
  4,840,784 
  1,472,576 
  8,907,758 
  1,217,766 
  16,438,884 
Tenant improvements
  213,179 
  704,810 
  286,238 
  56,166 
  1,260,393 
Site improvements
  583,103 
  45,544 
  366,972 
  - 
  995,619 
Acquired In-place leases
  561,078 
  231,651 
  640,536 
  102,586 
  1,535,851 
Acquired lease-up costs
  422,864 
  181,479 
  278,272 
  85,941 
  968,556 
Above market leases
  90,646 
  727,700 
  - 
  46,955 
  865,301 
Below Market leases
  - 
  - 
  (29,493)
  - 
  (29,493)
Acquisition fees payable
  (71,500)
  (34,450)
  (110,000)
  (14,944)
  (230,894)
 
 $7,162,138 
 $3,478,630 
 $11,123,252 
 $1,494,470 
 $23,258,490 
 
 
 
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In addition to the building and site improvements acquired in connection with the 2018 property acquisitions, the Company capitalized building and site improvements with respect to its existing portfolio of $133,101 for the year ended December 31, 2018.
 
During the year ended December 31, 2017 the Company acquired three properties located in Norfolk, Virginia (“Norfolk Property”), Montgomery, Alabama (“Montgomery Property”) and San Antonio, Texas (“San Antonio Property”) with rentable square footage of 53,917, 16,036 and 38,756, respectively. The acquisitions were financed with a combination of cash and first mortgage loans. All three properties were acquired with leases in place with the United States of America with remaining firm terms between 4.3 and 9.5 years at the time of acquisition. A summary of the allocated purchase price, based on estimated fair values, for each acquired property is as follows:
 
 
 
Norfolk
 
 
Montgomery
 
 
San Antonio
 
 
 
 
2017 Acquisitions:
 
March 31,
2017
 
 
July 25,
2017
 
 
November 21,
2017
 
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land
 $1,542,290 
 $549,664 
 $273,588 
 $2,365,542 
Buildings and improvements
  11,115,690 
  2,751,204 
  5,968,136 
  19,835,030 
Tenant improvements
  - 
  504,350 
  1,324,340 
  1,828,690 
Acquired In-place leases
  418,856 
  174,905 
  394,907 
  988,668 
Acquired lease-up costs
  562,611 
  167,501 
  193,487 
  923,599 
Above market leases
  1,078,490 
  649,448 
  118,891 
  1,846,829 
Tenant improvement obligation
  (1,315,366)
  - 
  - 
  (1,315,366)
Acquisition fees payable
  (145,000)
  (47,095)
  (82,250)
  (274,345)
 
 $13,257,571 
 $4,749,977 
 $8,191,099 
 $26,198,647 
 
In connection with the purchase of the Norfolk Property and the assumption of its related lease agreement, the Company assumed an aggregate obligation in the amount of $1,315,366 relating to a build-out allowance and a building specific capital allowance. At closing, the seller provided the Company a credit of an equal amount. The credit was received in cash and is held in escrow until the capital projects begin. As of December 31, 2018, $1,315,366 remained in escrow and is classified as restricted cash on the consolidated balance sheet.
 
During 2017, the Company also capitalized building and improvement costs in the amount of $8,495 related to its property located in Lakewood, Colorado.
 
6.
Leasehold Intangibles, net
 
The following is a summary of the Company’s leasehold intangibles as of December 31, 2018 and 2017.
 
 
 
December 31, 2018
 
 
December 31, 2017
 
Acquired in-place leases
 $3,707,286 
 $2,171,435 
Acquired lease-up costs
  2,990,679 
  2,022,123 
Acquired above-market leases
  2,903,791 
  2,038,492 
 
  9,601,756 
  6,232,050 
Accumulated amortization
  (1,577,027)
  (596,615)
Leasehold intangibles, net
 $8,024,729 
 $5,635,435 
 
Amortization of in-place leases, lease-up costs and acquired above market leases was $980,412 and $520,445 for the years ended December 31, 2018 and 2017, respectively.
 
 
 
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Future amortization of acquired in-place lease value, acquired lease-up costs and acquired above market leases (collectively “Intangible Lease Costs”) as of December 31, 2018 is as follows:
 
 
 
Intangible
 
 
 
Lease
 
Year Ended
 
Costs
 
2019
 $1,225,901 
2020
  1,215,132 
2021
  1,164,461 
2022
  880,364 
2023
  732,962 
Thereafter
  2,805,909 
Total
 $8,024,729 
 
The weighted-average amortization period is approximately 9.6 years.
 
7.
Below-Market Leases, net
 
The Company’s intangible liabilities consist of acquired below-market leases. The following is a summary of the Company’s intangible liabilities, as of December 31, 2018 and 2017.
 
 
 
December 31, 2018
 
 
December 31, 2017
 
Acquired below-market leases
 $1,183,039 
 $1,153,546 
Accumulated amortization
  (314,253)
  (151,792)
Below-market leases, net
 $868,786 
 $1,001,754 
 
Amortization of below-market leases resulted in an increase in rental revenue of $162,461 and $119,918 for the years ended December 31, 2018 and 2017, respectively.
 
The future amortization of acquired below market leases as of December 31, 2018 is as follows:
 
 
 
Below
 
 
 
Market
 
Year Ended
 
Leases
 
2019
 $183,433 
2020
  182,494 
2021
  164,493 
2022
  124,630 
2023
  105,572 
Thereafter
  108,164 
Total
 $868,786 
 
The weighted-average amortization period is approximately 7.2 years.
 
 
29
 
 
8.
Mortgages Payable
 
The following table outlines the mortgages payable as of December 31, 2018 and 2017:
 
 
 
 
 
 
 
 
 
 
Outstanding Principal
 
Issuance Date
 
Initial Balance
 
 
Interest Rate
 
 
Maturity
 
 
December 31, 2018
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
August-2013
 $10,700,000 
  5.27%
August-2023
 $9,784,236 
 $9,976,722 
April-2015
  7,600,000 
  3.72%
March-2018
  - 
  6,874,169 
June-2016
  9,675,000 
  3.93%
July-2019
  9,097,691 
  9,343,234 
July-2017
  10,875,000 
  4.00%
August-2022
  10,527,970 
  10,789,967 
July-2017
  3,530,000 
  4.00%
August-2022