Clipper Realty Inc.: Form 10-Q for the period ended Sep 30, 2023

You should read the following discussion of our financial condition and results of operations in conjunction with the more detailed information set forth under the caption, “Cautionary Note Concerning Forward-Looking Statements,” and in our financial statements and the related notes thereto appearing elsewhere in this Quarterly Report on Form 10-Qas well as information in our Annual Report on Form 10-K for the year ended December 31, 2022.

Overview of Our Company

Clipper Realty Inc. (the “Company” or “we”) is a self-administered and self-managed real estate company that acquires, owns, manages, operates and repositions multifamily residential and commercial properties in the New York metropolitan area, with a current portfolio in Manhattan and Brooklyn. Our primary focus is to own, manage and operate our portfolio and to acquire and reposition additional multifamily residential and commercial properties in the New York metropolitan area. The Company has been organized and operates in conformity with the requirements for qualification and taxation as a real estate investment trust (“REIT”) under the U.S. federal income tax law and elected to be treated as a REIT commencing with the taxable year ended December 31, 2015.

As of September 30, 2023, the Company owns:

• two neighboring residential/retail rental properties at 50 Murray Street and 53 Park Place in the Tribeca neighborhood of Manhattan;
• one residential property complex in the East Flatbush neighborhood of Brooklyn consisting of 59 buildings;
• two primarily commercial properties in Downtown Brooklyn (one of which includes 36 residential apartment units);
• one residential/retail rental property at 1955 1st Avenue in Manhattan;
• one residential rental property at 107 Columbia Heights in the Brooklyn Heights neighborhood of Brooklyn;
• one residential rental property at 10 West 65th Street in the Upper West Side neighborhood of Manhattan;
• one residential rental building at 1010 Pacific Street in the Prospect Heights neighborhood of Brooklyn; and
• the Dean Street property, to be redeveloped as a residential/retail rental building.

These properties are located in the most densely populated major city in the United States, each with immediate access to mass transportation. At September 30, 2023, the Company had two reportable operating segments, residential rental properties and commercial rental properties. The residential reporting segment includes the Flatbush Gardens property, the Clover House property, the 10 West 65th Street property, the 1010 Pacific Street property and portions of the 250 Livingston Street, Tribeca House and Aspen properties. The commercial reporting segment includes the 141 Livingston Street property and portions of the 250 Livingston Street, Tribeca House and Aspen properties.

The Company’s ownership interest in its initial portfolio of properties, which includes the Tribeca House, Flatbush Gardens and the two Livingston Street properties, was acquired in the formation transactions in connection with the private offering. These properties are owned by the LLC subsidiaries, which are managed by the Company through the Operating Partnership. The Operating Partnership’s interests in the LLC subsidiaries generally entitle the Operating Partnership to all cash distributions from, and the profits and losses of, the LLC subsidiaries other than the preferred distributions to the continuing investors who hold Class B LLC units in these LLC subsidiaries. The continuing investors own an aggregate amount of 26,317,396 Class B LLC units, representing 62.1% of the Company’s common stock on a fully diluted basis. Accordingly, the Operating Partnership’s interests in the LLC subsidiaries entitle the Operating Partnership to receive 37.9% of the aggregate distributions from the LLC subsidiaries. The Company, through the Operating Partnership, owns all of the ownership interests in the Aspen property, the Clover House property, the 10 West 65th Street property, the 1010 Pacific Street property and the Dean Street property.

Results of Operations

Our focus throughout 2022 and year-to-date 2023 has been to manage our properties to optimize revenues and control costs, while continuing to renovate and reposition certain properties. The discussion below highlights the specific properties contributing to the changes in the results of operations and focuses on the properties that were in operation for the full period in each comparison.

Income Statement for the Three Months Ended September 30, 2023 and 2022 (in thousands except rent per square foot and occupancy)

Revenue. Residential rental income increased to $24,341 for the three months ended September 30, 2023, from $23,108 for the three months ended September 30, 2022, primarily due to increases in rental rates at all properties of $1,233. For example, base rent per square foot increased at the Tribeca House property to $78.22 at September 30, 2023, from $70.56 at September 30, 2022 and base rent per square foot increased at the Clover House property to $78.33 at September 30, 2023, from $70.13 at September 30, 2022;

Commercial rental income decreased to $9,615 for the three months ended September 30, 2023, from $9,692 for the three months ended September 30, 2022 due to the expiration of a few small leases at the Tribeca House and Aspen properties.

Property operating expenses. Property operating expenses include property-level costs such as compensation costs for property-level personnel, repairs and maintenance, supplies, utilities and landscaping. Property operating expenses increased to $7,644 for the three months ended September 30, 2023, from $7,267 for the three months ended September 30, 2022, primarily due to increased repairs and maintenance costs partially offset by decreased utilities and water and sewer costs.

Real estate taxes and insurance. Real estate taxes and insurance expenses decreased to $7,237 for the three months ended September 30, 2023, from $8,252 for the three months ended September 30, 2022, due to real estate tax exemption at Flatbush Gardens as a result of the Article 11 transaction partially offset by higher insurance costs across the portfolio.

General and administrative. General and administrative expenses increased to $3,218 for the three months ended September 30, 2023, from $3,209 for the three months ended September 30, 2022 primarily due to the decrease in various administrative costs.

Transaction pursuit costs. Transaction pursuit costs during the three months ended September 30, 2023 primarily reflect costs related to the Article 11 Agreement.

Depreciation and amortization. Depreciation and amortization expense increased to $6,854 for the three months ended September 30, 2023, from $6,784 for the three months ended September 30, 2022, due to the additions to real estate across the portfolio during the three months ended September 30, 2023.

Interest expense, net. Interest expense, net, increased to $10,634 for the three months ended September 30, 2023, from $10,086 for the three months ended September 30, 2022 primarily as a result of the interest rate conversion the 10 West 65th Street from fixed to a floating rate in the fourth quarter of 2022.

Net loss. As a result of the foregoing, net loss decreased to $1,631 for the three months ended September 30, 2023, from $2,788 for the three months ended September 30, 2022.

Income Statement for the Nine Months Ended September 30, 2023 and 2022 (in thousands)

Revenue. Residential rental income increased to $72,529 for the nine months ended September 30, 2023, from $67,167 for the nine months ended September 30, 2022, primarily, due to increases in rental rates. For example, base rent per square foot increased at the Tribeca House property to $78.22 at September 30, 2023, from $70.56 at September 30, 2022 and base rent per square foot increased at the Clover House property to $78.33 at September 30, 2023, from $70.13 at September 30, 2022.

Commercial rental income decreased to $28,845 for the nine months ended September 30, 2023, from $29,570 for the nine months ended September 30, 2022 primarily due to a net, $1,103 restoration of revenue as per ASC 842 from a tenant at Tribeca House deemed probable of collection during the nine months ended September 30, 2022, partially offset by the commencement of new leases at the Tribeca House property and increased escalation billings at the 141 Livingston Street property.

Property operating expenses. Property operating expenses include property-level costs such as compensation costs for property-level personnel, repairs and maintenance, supplies, utilities and landscaping. Property operating expenses increased to $22,353 for the nine months ended September 30, 2023, from $21,734 for the nine months ended September 30, 2022, primarily due to increased repairs and maintenance, utilities and payroll costs, primarily at Flatbush Gardens.

Real estate taxes and insurance. Real estate taxes and insurance expenses increased to $24,374 for the nine months ended September 30, 2023, from $24,069 for the nine months ended September 30, 2022, due to increased property taxes and insurance across the portfolio partially offset by the real estate tax exemption at Flatbush Gardens that began July 1, 2023.

General and administrative. General and administrative expenses increased to $9,831 for the nine months ended September 30, 2023, from $9,348 for the nine months ended September 30, 2022 primarily due to higher payroll costs and accounting fees in relation to the separation from our prior auditor.

Transaction pursuit costs. Transaction pursuit costs primarily reflect costs related to the Article 11 Agreement during the nine months ended September 30, 2023 and costs incurred for an abandoned acquisition during the nine months ended September 30, 2022.

Depreciation and amortization. Depreciation and amortization expense increased to $20,525 for the nine months ended September 30, 2023, from $20,221 for the nine months ended September 30, 2022, due to the additions to real estate across the portfolio during the nine months ended September 30, 2023.

Interest expense, net. Interest expense, net, increased to $31,340 for the nine months ended September 30, 2023, from $30,076 for the nine months ended September 30, 2022 primarily due to increased interest at the 10 West 65th Street as a result of the interest rate changing from fixed to a floating rate in the fourth quarter of 2022.

Loss on modification/extinguishment of debt. Loss on the extinguishment of debt consists of costs related to the early termination of our construction loan at 1010 Pacific. Additionally, we accelerated the remaining unamortized loan costs from the prior loan.

Net loss. As a result of the foregoing, net loss increased to $11,274 for the nine months ended September 30, 2023, from $9,217 for the nine months ended September 30, 2022.

Liquidity and Capital Resources

As of September 30, 2023, we had $1,197 million of indebtedness, net of unamortized issuance costs, secured by our properties, $22.5 million of cash and cash equivalents, and $14.9 million of restricted cash. See Note 5, “Notes Payable” of our consolidated financial statements for a discussion of the Company’s property-level debt.

As a REIT, we are required to distribute at least 90% of our REIT taxable income, computed without regard to the dividends paid deduction and excluding net capital gains, to stockholders on an annual basis. We expect that these needs will be met from cash generated from operations and other sources, including proceeds from secured mortgages and unsecured indebtedness, proceeds from additional equity issuances and cash generated from the sale of property.

Short-Term and Long-Term Liquidity Needs

Our short-term liquidity needs will primarily be to fund operating expenses, recurring capital expenditures, property taxes and insurance, interest and scheduled debt principal payments, general and administrative expenses, and distributions to stockholders and unit holders. We generally expect to meet our short-term liquidity requirements through net cash provided by operations and cash on hand, and we believe we will have sufficient resources to meet our short-term liquidity requirements.

Our principal long-term liquidity needs will primarily be to fund additional property acquisitions, major renovation and upgrading projects, and debt payments and debt payments at maturity. We do not expect that net cash provided by operations will be sufficient to meet all these long-term liquidity needs. We anticipate meeting our long-term liquidity requirements by using cash as an interim measure and funds from public and private equity offerings and long-term secured and unsecured debt offerings.

We believe that as a publicly traded REIT, we will have access to multiple sources of capital to fund our long-term liquidity requirements. These sources include the incurrence of additional debt and the issuance of additional equity. However, we cannot provide assurance that this will be the case. Our ability to secure additional debt will depend on a number of factors, including our cash flow from operations, our degree of leverage, the value of our unencumbered assets and borrowing restrictions that may be imposed. Our ability to access the equity capital markets will depend on a number of factors as well, including general market conditions, market conditions for REITs and market perceptions about our company.

We believe that our current cash flows from operations and cash on hand, coupled with additional mortgage debt, will be sufficient to allow us to continue operations, satisfy our contractual obligations and make distributions to our stockholders and the members of our LLC subsidiaries for at least the next twelve months. However, no assurance can be given that we will be able to refinance any of our outstanding indebtedness in the future on favorable terms or at all.

Distributions

In order to qualify as a REIT for Federal income tax purposes, we must currently distribute at least 90% of our taxable income to our shareholders. During the three months ended September 30, 2023 and 2022, we paid dividends and distributions on our common shares, Class B LLC units and LTIP units totaling $4.3 million and $4.3 million, respectively.

Cash Flows for the Nine Months Ended September 30, 2023 and 2022 (in thousands)

Cash flows provided by (used in) operating activities, investing activities and financing activities for the nine months ended September 30, 2023 and 2022, were as follows:

Net cash flow provided by operating activities was $17,130 for the nine months ended September 30, 2023, compared to $15,159 for the nine months ended September 30, 2022. The net increase during the 2023 period primarily reflects improved revenues discussed above, improved collection experience and lower property tax payments due to the entry into the Article 11 Agreement.

Net cash used in investing activities was $27,783 for the nine months ended September 30, 2023, compared to $41,992 for the nine months ended September 30, 2022. The decrease was primarily due to $7,871 lower capital spending at all of our operating properties, primarily Flatbush Gardens and 1010 Pacific Street, partially offset by increased capital spending at the Dean Street property. Additionally, the Company purchased parcels of land at Dean Street for $8,041 in the nine-month period ended September 30, 2022. These were partially offset by a refund of a potential acquisition deposit of $2,015 in the nine-month period ended September 30, 2022.

Net cash provided by financing activities was $17,341 for the nine months ended September 30, 2023, compared to $10,101 for the nine months ended September 30, 2022. For the nine months ended September 30, 2023, $40,617 was provided by refinancing the 1010 Pacific Street and Dean Street property loans, net of scheduled debt amortization payments, partially offset by $9,921 of loan extinguishment and issuance costs, and $13,044 of dividends and distributions. For the nine months ended September 30, 2022, $24,855 was provided by net borrowings under the 1010 Pacific Street and 953 Dean Street development property loans, net of scheduled debt amortization payments, partially offset by $12,767 of dividends and distributions and $335 of loan issuance and extinguishment costs.

Income Taxes

No provision has been made for income taxes since all of the Company’s operations are held in pass-through entities and accordingly the income or loss of the Company is included in the individual income tax returns of the partners or members.

We elected to be treated as a REIT for U.S. federal income tax purposes, beginning with our first taxable three months ended March 31, 2015. As a REIT, we generally will not be subject to federal income tax on income that we distribute to our stockholders. If we fail to qualify as a REIT in any taxable year, we will be subject to federal income tax on our taxable income at regular corporate tax rates. We believe that we are organized and operate in a manner that will enable us to qualify and be taxed as a REIT and we intend to continue to operate to satisfy the requirements for qualification as a REIT for federal income tax purposes.

Inflation

Inflation did not have a significant impact on the results of operations for the Company’s business for the periods reported in the consolidated financial statements. We do not believe that inflation currently poses a material risk to the Company. The leases at our residential rental properties, which comprise approximately 72% of our revenue, are short-term in nature. Our longer-term commercial and retail leases would generally allow us to recover some increased operating costs in the event of significant inflation.

Although the impact of inflation on our results of operations is not material, inflation has recently become a factor in the United States economy and could increase the cost of acquiring, replacing and operating the properties in the future.

Non-GAAP Financial Measures

In this Quarterly Report on Form 10-Q, we disclose and discuss funds from operations (“FFO”), adjusted funds from operations (“AFFO”), adjusted earnings before interest, income taxes, depreciation and amortization (“Adjusted EBITDA”) and net operating income (“NOI”), all of which meet the definition of “non-GAAP financial measures” set forth in Item 10(e) of Regulation S-K promulgated by the SEC.

While management and the investment community in general believe that presentation of these measures provides useful information to investors, neither FFO, AFFO, Adjusted EBITDA, nor NOI should be considered as an alternative to net income (loss) or income from operations as an indication of our performance. We believe that to understand our performance further, FFO, AFFO, Adjusted EBITDA, and NOI should be compared with our reported net income (loss) or income from operations and considered in addition to cash flows computed in accordance with GAAP, as presented in our consolidated financial statements.

Funds From Operations and Adjusted Funds From Operations

FFO is defined by the National Association of Real Estate Investment Trusts (“NAREIT”) as net income (computed in accordance with GAAP), excluding gains (or losses) from sales of property and impairment adjustments, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Our calculation of FFO is consistent with FFO as defined by NAREIT.

AFFO is defined by us as FFO excluding amortization of identifiable intangibles incurred in property acquisitions, straight-line rent adjustments to revenue from long-term leases, amortization costs incurred in originating debt, interest rate cap mark-to-market adjustments, amortization of non-cash equity compensation, acquisition and other costs, transaction pursuit costs, loss on modification/extinguishment of debt, gain on involuntary conversion, gain on termination of lease and certain litigation-related expenses, less recurring capital spending.

Historical cost accounting for real estate assets implicitly assumes that the value of real estate assets diminishes predictably over time. In fact, real estate values have historically risen or fallen with market conditions. FFO is intended to be a standard supplemental measure of operating performance that excludes historical cost depreciation and valuation adjustments from net income. We consider FFO useful in evaluating potential property acquisitions and measuring operating performance. We further consider AFFO useful in determining funds available for payment of distributions. Neither FFO nor AFFO represent net income (loss) or cash flows from operations computed in accordance with GAAP. You should not consider FFO and AFFO to be alternatives to net income (loss) as reliable measures of our operating performance; nor should you consider FFO and AFFO to be alternatives to cash flows from operating, investing or financing activities (computed in accordance with GAAP) as measures of liquidity.

Neither FFO nor AFFO measure whether cash flow is sufficient to fund all of our cash needs, including principal amortization, capital improvements and distributions to stockholders. FFO and AFFO do not represent cash flows from operating, investing or financing activities computed in accordance with GAAP. Further, FFO and AFFO as disclosed by other REITs might not be comparable to our calculations of FFO and AFFO.

The following table sets forth a reconciliation of the Company’s FFO and AFFO for the periods presented to net loss, computed in accordance with GAAP (amounts in thousands):

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Adjusted Earnings Before Interest, Income Taxes, Depreciation and Amortization

We believe that Adjusted EBITDA is a useful measure of our operating performance. We define Adjusted EBITDA as net income (loss) before allocation to non-controlling interests, plus real estate depreciation and amortization, amortization of identifiable intangibles, straight-line rent adjustments to revenue from long-term leases, amortization of non-cash equity compensation, interest expense (net), acquisition and other costs, transaction pursuit costs, loss on modification/extinguishment of debt and certain litigation-related expenses, less gain on involuntary conversion and gain on termination of lease.

We believe that this measure provides an operating perspective not immediately apparent from GAAP income from operations or net income (loss). We consider Adjusted EBITDA to be a meaningful financial measure of our core operating performance.

However, Adjusted EBITDA should only be used as an alternative measure of our financial performance. Further, other REITs may use different methodologies for calculating Adjusted EBITDA, and accordingly, our Adjusted EBITDA may not be comparable to that of other REITs.

The following table sets forth a reconciliation of Adjusted EBITDA for the periods presented to net loss, computed in accordance with GAAP (amounts in thousands):

Net Operating Income

We believe that NOI is a useful measure of our operating performance. We define NOI as income from operations plus real estate depreciation and amortization, general and administrative expenses, acquisition and other costs, transaction pursuit costs, amortization of identifiable intangibles and straight-line rent adjustments to revenue from long-term leases, less gain on termination of lease. We believe that this measure is widely recognized and provides an operating perspective not immediately apparent from GAAP income from operations or net income (loss). We use NOI to evaluate our performance because NOI allows us to evaluate the operating performance of our company by measuring the core operations of property performance and capturing trends in rental housing and property operating expenses. NOI is also a widely used metric in valuation of properties.

However, NOI should only be used as an alternative measure of our financial performance. Further, other REITs may use different methodologies for calculating NOI, and accordingly, our NOI may not be comparable to that of other REITs.

The following table sets forth a reconciliation of NOI for the periods presented to income from operations, computed in accordance with GAAP (amounts in thousands):

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Critical Accounting Policies

Management’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Management bases its estimates on historical experience and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that there have been no material changes to the items that we disclosed as our critical accounting policies under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in our Form 10-K for the year ended December 31, 2022.

Recent Accounting Pronouncements

See Note 2, “Significant Accounting Policies” of our consolidated financial statements for a discussion of recent accounting pronouncements.

Our future income, cash flows and fair value relevant to our financial instruments depend upon prevailing market interest rates. Market risk refers to the risk of loss from adverse changes in market prices and interest rates. Based upon the nature of our operations, the principal market risk to which we are exposed is the risk related to interest rate fluctuations. Many factors, including governmental monetary and tax policies, domestic and international economic and political considerations, and other factors that are beyond our control, contribute to interest rate risk.

A one percent change in interest rates on our $74.4 million of variable rate debt as of September 30, 2023, would impact annual net loss by approximately $0.7 million.

At September 30, 2023, there were no interest rate caps for the Company’s outstanding debt.

The fair value of the Company’s notes payable was approximately $1,117.0 million and $1,092.3 million as of September 30, 2023 and December 31, 2022, respectively.

Evaluation of Disclosure Controls and Procedures

The Company carried out an evaluation under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of September 30, 2023. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, and summarized, within the time periods specified in the SEC's rules and forms.

We continue to review and document our disclosure controls and procedures, including our internal controls and procedures for financial reporting, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that our systems evolve with our business.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting identified in connection with the management’s evaluation pursuant to Rules 13a-15(d) or 15d-15(d) of the Exchange Act that occurred during the period covered by this Quarterly Report on Form 10-Q that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

The risk factors disclosed in the section entitled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2022, as well as subsequent Quarterly Report on Form 10-Q, set forth information relating to various risks and uncertainties that could materially adversely affect our business, financial condition, liquidity, and operating results. Such risk factors continue to be relevant to an understanding of our business, financial condition, liquidity and operating results as of September 30, 2023, and there have been no material changes to those risk factors for the nine months ended September 30, 2023.