UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


FORM 10-Q
 
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2014

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ________to _________

Commission file number 001-13106

ESSEX PROPERTY TRUST, INC.
ESSEX PORTFOLIO, L.P.
(Exact name of Registrant as Specified in its Charter)
 
Maryland (Essex Property Trust, Inc.)
California (Essex Portfolio, L.P.)
77-0369576 (Essex Property Trust, Inc.)
77-0369575 (Essex Portfolio, L.P.)
 
(State or Other Jurisdiction of Incorporation or Organization)
(I.R.S. Employer Identification Number)
 
925 East Meadow Drive
Palo Alto, California    94303
(Address of Principal Executive Offices including Zip Code)

(650) 494-3700
(Registrant's Telephone Number, Including Area Code)

 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file reports), and (2) has been subject to such filing requirements for the past 90 days.

Essex Property Trust, Inc.    Yes x   No o
Essex Portfolio, L.P.     Yes x   No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Essex Property Trust, Inc.    Yes x   No o
Essex Portfolio, L.P.     Yes x   No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” ”accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 

Essex Property Trust, Inc.:
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o   (Do not check if a smaller reporting company)
Smaller reporting company o

Essex Portfolio, L.P.:
Large accelerated filer o
Accelerated filer o
Non-accelerated filer x   (Do not check if a smaller reporting company)
Smaller reporting company o
   
(Do not check if a smaller reporting company)
 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Essex Property Trust, Inc.    Yes o   No x
Essex Portfolio, L.P.     Yes o   No x
 
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:  63,942,115 shares of Common Stock ($0.0001 par value) of Essex Property Trust, Inc. were outstanding as of November 5, 2014.
 

 
ii

EXPLANATORY NOTE

This report combines the reports on Form 10-Q for the three and nine months period ended September 30, 2014 of Essex Property Trust, Inc. and Essex Portfolio, L.P. Unless stated otherwise or the context otherwise requires, references to “Essex” mean Essex Property Trust, Inc., a Maryland corporation that operates as a self-administered and self-managed real estate investment trust (“REIT ”), and references to “EPLP” mean Essex Portfolio, L.P. (the “Operating Partnership” ). References to the “Company,” “we,” “us” or “our” mean collectively Essex, EPLP and those entities/subsidiaries owned or controlled by Essex and/or EPLP.  References to the “Operating Partnership” mean collectively EPLP and those entities/subsidiaries owned or controlled by EPLP.

Essex is the general partner of  EPLP and as the sole general partner of EPLP, Essex has exclusive control of EPLP's day-to-day management.

The Company is structured as an umbrella partnership REIT (“UPREIT”) and Essex contributes all net proceeds from its various equity offerings to the Operating Partnership. In return for those contributions, Essex receives a number of OP Units (see definition below) in the Operating Partnership equal to the number of shares of common stock it has issued in the equity offering.  Contributions of properties to the Company can be structured as tax-deferred transactions through the issuance of OP Units in the Operating Partnership, which is one of the reasons why the Company is structured in the manner outlined above. Based on the terms of EPLP's partnership agreement, OP Units can be exchanged with Essex common stock on a one-for-one basis. The Company maintains a one-for-one relationship between the OP Units of the Operating Partnership issued to Essex and shares of common stock.

The Company believes that combining the reports on Form 10-Q of Essex and EPLP into this single report provides the following benefits:

· enhances investors' understanding of the Company and the Operating Partnership by enabling investors to view the business as a whole in the same manner as management views and operates the business;
· eliminates duplicative disclosure and provides a more streamlined and readable presentation since a substantial portion of the disclosure applies to both the Company and the Operating Partnership; and
· creates time and cost efficiencies through the preparation of one combined report instead of two separate reports

Management operates the Company and the Operating Partnership as one business. The management of Essex consists of the same members as the management of EPLP.

All of the Company's property ownership, development and related business operations are conducted through the Operating Partnership and Essex has no material assets, other than its investment in EPLP. Essex's primary function is acting as the general partner of EPLP.  As general partner with control of the Operating Partnership, the Company consolidates the Operating Partnership for financial reporting purposes. Therefore, the assets and liabilities of the Company and the Operating Partnership are the same on their respective financial statements.  Essex also issues equity from time to time and guarantees certain debt of EPLP, as disclosed in this report. The Operating Partnership holds substantially all of the assets of the Company, including the Company's ownership interests in its joint ventures. The Operating Partnership conducts the operations of the business and is structured as a partnership with no publicly traded equity.  Except for the net proceeds from equity offerings by the Company, which are contributed to the capital of the Operating Partnership in exchange for additional limited partnership interests in the Operating Partnership (“OP Units”) (on a one-for-one share of common stock per OP Unit basis), the Operating Partnership generates all remaining capital required by the Company's business. These sources include the Operating Partnership's working capital, net cash provided by operating activities, borrowings under its revolving credit facilities, the issuance of secured and unsecured debt and equity securities and proceeds received from disposition of certain properties and joint ventures.

The Company believes it is important to understand the few differences between Essex and EPLP in the context of how Essex and EPLP operate as a consolidated company.  Stockholders' equity, partners' capital and noncontrolling interest are the main areas of difference between the consolidated financial statements of the Company and those of the Operating Partnership. The limited partners of the Operating Partnership are accounted for as partners' capital in the Operating Partnership's consolidated financial statements and as noncontrolling interest in Essex’s consolidated financial statements. The noncontrolling interest in the Operating Partnership's consolidated financial statements include the interest of unaffiliated partners in various consolidated partnerships and joint venture partners. The noncontrolling interest in the Company's  consolidated financial statements include (i) the same noncontrolling interest as presented in the Operating Partnership’s consolidated financial statements and (ii) limited partner OP Unitholders of the Operating Partnership. The differences between stockholders' equity and partners' capital result from differences in the equity issued at the Company and Operating Partnership levels.
 
iii

 
To help investors understand the significant differences between the Company and the Operating Partnership, this report provides separate consolidated financial statements for the Company and the Operating Partnership; a single set of consolidated notes to such financial statements that includes separate discussions of stockholders' equity or partners' capital, and earnings per share/unit, as applicable; and a combined Management's Discussion and Analysis of Financial Condition and Results of Operations.

This report also includes separate Part I, Item 4. Controls and Procedures sections and separate Exhibits 31 and 32 certifications for each of the Company and the Operating Partnership in order to establish that the requisite certifications have been made and that the Company and the Operating Partnership are compliant with Rule 13a-15 or Rule 15d-15 of the Securities Exchange Act of 1934 and 18 U.S.C. §1350.

In order to highlight the differences between the Company and the Operating Partnership, the separate sections in this report for the Company and the Operating Partnership specifically refer to the Company and the Operating Partnership. In the sections that combine disclosure of the Company and the Operating Partnership, this report refers to actions or holdings as being actions or holdings of the Company. Although the Operating Partnership is generally the entity that directly or indirectly enters into contracts and joint ventures and holds assets and debt, reference to the Company is appropriate because the Company is one business and the Company operates that business through the Operating Partnership. The separate discussions of the Company and the Operating Partnership in this report should be read in conjunction with each other to understand the results of the Company on a consolidated basis and how management operates the Company.

The information furnished in the accompanying unaudited condensed consolidated balance sheets, statements of operations and comprehensive income, equity, capital, and cash flows of the Company and the Operating Partnership reflect all adjustments which are, in the opinion of management, necessary for a fair presentation of the aforementioned condensed consolidated financial statements for the interim periods and are normal and recurring in nature, except as otherwise noted.

The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the notes to such unaudited condensed consolidated financial statements and Management's Discussion and Analysis of Financial Condition and Results of Operations herein.  Additionally, these unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company's annual report on Form 10-K for the year ended December 31, 2013.
 
iv

ESSEX PROPERTY TRUST, INC.
ESSEX PORTFOLIO, L.P.
FORM 10-Q
INDEX

   
Page No.
PART I. FINANCIAL INFORMATION
 
 
Item 1.
 
 
Condensed Financial Statements of Essex Property Trust, Inc. (Unaudited)
     
 
2
     
 
3
     
 
4
     
 
5
     
 
Condensed Financial Statements of Essex Portfolio L.P. (Unaudited)
 
     
 
7
     
 
8
     
 
9
     
 
10
     
 
12
     
Item 2.
27
     
Item 3.
38
     
Item 4.
39
     
PART II. OTHER INFORMATION
 
     
Item 1.
40
     
Item 1A.
40
     
Item 2.
52
     
Item 5.
52
     
Item 6.
53
     
54
 

1

Part I – Financial Information

Item 1. Condensed Financial Statements

ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(Unaudited)
(In thousands, except share amounts)

ASSETS
 
September 30,
2014
   
December 31,
2013
 
Real estate:
       
Rental properties:
       
Land and land improvements
 
$
2,453,093
   
$
1,083,552
 
Buildings and improvements
   
8,820,657
     
4,360,205
 
     
11,273,750
     
5,443,757
 
Less accumulated depreciation
   
(1,469,991
)
   
(1,254,886
)
     
9,803,759
     
4,188,871
 
Real estate under development
   
363,193
     
50,430
 
Co-investments
   
1,043,277
     
677,133
 
Real estate held for sale, net
   
107,772
     
-
 
     
11,318,001
     
4,916,434
 
Cash and cash equivalents-unrestricted
   
17,877
     
18,491
 
Cash and cash equivalents-restricted
   
70,123
     
35,275
 
Marketable securities
   
108,147
     
90,084
 
Notes and other receivables
   
22,973
     
68,255
 
Acquired in place lease value and other assets
   
98,381
     
33,781
 
Deferred charges, net
   
31,060
     
24,519
 
Total assets
 
$
11,666,562
   
$
5,186,839
 
                 
LIABILITIES AND EQUITY
               
Mortgage notes payable
 
$
2,258,010
   
$
1,404,080
 
Unsecured debt
   
2,745,487
     
1,410,023
 
Lines of credit
   
222,628
     
219,421
 
Accounts payable and accrued liabilities
   
167,160
     
67,183
 
Construction payable
   
38,453
     
8,047
 
Dividends payable
   
87,609
     
50,627
 
Other liabilities
   
32,330
     
24,871
 
Total liabilities
   
5,551,677
     
3,184,252
 
Commitments and contingencies
               
Redeemable noncontrolling interest
   
21,442
     
-
 
Cumulative convertible Series G preferred stock
   
-
     
4,349
 
                 
Equity:
               
Cumulative redeemable Series H preferred stock at liquidation value
   
73,750
     
73,750
 
Common stock, $0.0001 par value, 656,020,000 shares authorized 63,229,790 and 37,421,219 shares issued and outstanding
   
6
     
4
 
Additional paid-in capital
   
6,569,442
     
2,345,763
 
Distributions in excess of accumulated earnings
   
(608,498
)
   
(474,426
)
Accumulated other comprehensive loss, net
   
(51,408
)
   
(60,472
)
Total stockholders' equity
   
5,983,292
     
1,884,619
 
Noncontrolling interest
   
110,151
     
113,619
 
Total equity
   
6,093,443
     
1,998,238
 
Total liabilities and equity
 
$
11,666,562
   
$
5,186,839
 

See accompanying notes to the unaudited condensed consolidated financial statements.
 
2

ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Operations and Comprehensive Income
(Unaudited)
(In thousands, except share and per share amounts)

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Revenues:
 
   
   
   
 
Rental and other property
 
$
268,118
   
$
152,177
   
$
683,749
   
$
446,017
 
Management and other fees
   
2,361
     
1,771
     
6,856
     
5,812
 
     
270,479
     
153,948
     
690,605
     
451,829
 
Expenses:
                               
Property operating, excluding real estate taxes
   
55,900
     
35,787
     
145,410
     
102,170
 
Real estate taxes
   
31,768
     
14,535
     
77,452
     
42,773
 
Depreciation
   
102,184
     
48,227
     
254,211
     
142,687
 
General and administrative
   
11,479
     
6,263
     
28,621
     
19,852
 
Merger and integration expenses
   
3,857
     
-
     
46,413
     
-
 
Acquisition and dispositions costs
   
51
     
237
     
1,555
     
792
 
     
205,239
     
105,049
     
553,662
     
308,274
 
                                 
Earnings from operations
   
65,240
     
48,899
     
136,943
     
143,555
 
                                 
Interest expense
   
(45,830
)
   
(29,192
)
   
(117,021
)
   
(86,661
)
Interest and other income
   
2,992
     
2,387
     
8,685
     
9,326
 
Equity income in co-investments
   
4,910
     
40,802
     
21,065
     
52,295
 
Gains on sale of real estate and land
   
31,372
     
-
     
39,640
     
1,503
 
Gain (loss) on early retirement of debt
   
-
     
(178
)
   
-
     
846
 
Income from continuing operations
   
58,684
     
62,718
     
89,312
     
120,864
 
Income from discontinued operations
   
-
     
13,157
     
-
     
14,289
 
Net income
   
58,684
     
75,875
     
89,312
     
135,153
 
Net income attributable to noncontrolling interest
   
(3,720
)
   
(5,719
)
   
(8,971
)
   
(12,112
)
Net income attributable to controlling interest
   
54,964
     
70,156
     
80,341
     
123,041
 
Dividends to preferred stockholders
   
(1,296
)
   
(1,368
)
   
(3,977
)
   
(4,104
)
Net income available to common stockholders
 
$
53,668
   
$
68,788
   
$
76,364
   
$
118,937
 
                                 
Comprehensive income
 
$
61,139
   
$
76,112
   
$
98,749
   
$
142,206
 
Comprehensive income attributable to noncontrolling interest
   
(3,789
)
   
(5,732
)
   
(9,345
)
   
(12,493
)
Comprehensive income attributable to controlling interest
 
$
57,350
   
$
70,380
   
$
89,404
   
$
129,713
 
                                 
Per common share data:
                               
Basic:
                               
Income from continuing operations
 
$
0.85
   
$
1.51
   
$
1.41
   
$
2.84
 
Income from discontinued operations
   
-
     
0.33
     
-
     
0.36
 
Net income available to common stockholders
 
$
0.85
   
$
1.84
   
$
1.41
   
$
3.20
 
Weighted average number of common shares outstanding during the period
   
62,892,601
     
37,320,562
     
54,250,104
     
37,206,895
 
                                 
Diluted:
                               
Income from continuing operations
 
$
0.85
   
$
1.51
   
$
1.40
   
$
2.83
 
Income from discontinued operations
   
-
     
0.33
     
-
     
0.36
 
Net income available to common stockholders
 
$
0.85
   
$
1.84
   
$
1.40
   
$
3.19
 
Weighted average number of common shares outstanding during the period
   
63,069,772
     
37,436,983
     
54,443,227
     
37,295,691
 
                                 
Dividend per common share
 
$
1.30
   
$
1.21
   
$
3.81
   
$
3.63
 

See accompanying notes to the unaudited condensed consolidated financial statements.
 
3

ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Condensed Consolidated Statement of Equity for the nine months ended September 30, 2014
(Unaudited)
(Dollars and shares in thousands)

   
Series H
Preferred stock
   
Common stock
   
Additional
paid-in
   
Distributions
in excess of
accumulated
   
Accumulated
other
comprehensive
   
Noncontrolling
     
   
Shares
   
Amount
   
Shares
   
Amount
   
capital
   
earnings
   
loss, net
   
Interest
   
Total
 
Balances at December 31, 2013
   
2,950
   
$
73,750
     
37,421
   
$
4
   
$
2,345,763
   
$
(474,426
)
 
$
(60,472
)
 
$
113,619
   
$
1,998,238
 
                                                                         
Net income
   
-
     
-
     
-
     
-
     
-
     
80,341
     
-
     
8,971
     
89,312
 
Reversal of unrealized gains upon the sale of marketable securities
   
-
     
-
     
-
     
-
     
-
     
-
     
(841
)
   
(45
)
   
(886
)
Change in fair value of derivatives and amortization of swap settlements
   
-
     
-
     
-
     
-
     
-
     
-
     
7,426
     
306
     
7,732
 
Change in fair value of marketable securities
   
-
     
-
     
-
     
-
     
-
     
-
     
2,479
     
112
     
2,591
 
Issuance of common stock under:
                                                                       
Stock consideration in the Merger, net
   
-
     
-
     
23,093
     
2
     
3,777,644
     
-
     
-
     
-
     
3,777,646
 
Stock option and restricted stock plans
   
-
     
-
     
154
     
-
     
6,511
     
-
     
-
     
-
     
6,511
 
Equity distribution agreements, net
   
-
     
-
     
2,527
     
-
     
449,499
     
-
     
-
     
-
     
449,499
 
Equity based compensation costs
   
-
     
-
     
-
     
-
     
5,756
     
-
     
-
     
1,672
     
7,428
 
Reclassification of noncontrolling interest to redeemable noncontrolling interest
   
-
     
-
     
-
     
-
     
(19,823
)
   
-
     
-
     
(1,067
)
   
(20,890
)
Changes in value of redemption value of redeemable noncontrolling interest
                                   
2,126
                             
2,126
 
Conversion of Series G preferred stock
   
-
     
-
     
34
     
-
     
4,349
     
-
     
-
     
-
     
4,349
 
Contributions from noncontrolling interest
   
-
     
-
     
-
     
-
             
-
     
-
     
1,419,816
     
1,419,816
 
Retirement of noncontrolling interest
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
(1,419,816
)
   
(1,419,816
)
Distributions to noncontrolling interest
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
(12,821
)
   
(12,821
)
Redemptions of noncontrolling interest
   
-
     
-
     
-
     
-
     
(2,383
)
   
-
     
-
     
(596
)
   
(2,979
)
Common and preferred stock dividends
   
-
     
-
     
-
     
-
             
(214,413
)
   
-
     
-
     
(214,413
)
Balances at September 30, 2014
   
2,950
   
$
73,750
     
63,229
   
$
6
   
$
6,569,442
   
$
(608,498
)
 
$
(51,408
)
 
$
110,151
   
$
6,093,443
 

See accompanying notes to the unaudited condensed consolidated financial statements.
 
4

ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(In thousands)
 
   
Nine Months Ended
September 30,
 
   
2014
   
2013
 
Cash flows from operating activities:
       
Net income
 
$
89,312
   
$
135,153
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
   
254,211
     
143,662
 
Amortization of discount on marketable securities
   
(6,555
)
   
(4,664
)
Amortization of premium and debt financing costs, net
   
(4,987
)
   
8,111
 
Gain on sale of marketable securities
   
(886
)
   
(1,767
)
Company's share of gain on the sales of co-investment
   
(3,213
)
   
(41,252
)
Gain on the sales of real estate and land
   
(39,640
)
   
(14,161
)
Non-cash merger expense
   
7,562
     
-
 
Equity in income in co-investments, net
   
(14,903
)
   
(1,892
)
Equity-based compensation
   
4,996
     
3,137
 
Gain on early retirement of debt
   
-
     
(846
)
Changes in operating assets and liabilities:
               
Acquired in place lease value and other assets
   
8,923
     
(19,689
)
Accounts payable and accrued liabilities
   
44,775
     
19,091
 
Other liabilities
   
1,393
     
199
 
Net cash provided by operating activities
   
340,988
     
225,082
 
Cash flows from investing activities:
               
Additions to real estate:
               
Acquisitions of real estate
   
(409,018
)
   
(205,539
)
Improvements to recent acquisitions
   
(13,512
)
   
(14,374
)
Redevelopment
   
(35,361
)
   
(32,488
)
Revenue generating capital expenditures
   
(20,560
)
   
(2,165
)
Lessor required capital expenditures
   
(7,562
)
   
(4,320
)
Non-revenue generating capital expenditures
   
(29,070
)
   
(21,885
)
Acquisitions of and additions to real estate under development
   
(108,659
)
   
(13,963
)
Proceeds from insurance claim for property damage
   
29,160
     
-
 
BRE merger consideration paid
   
(555,826
)
   
-
 
Dispositions of real estate
   
61,331
     
33,666
 
Dispositions of co-investments
   
13,900
     
-
 
Contributions to co-investments
   
(128,268
)
   
(150,852
)
Distributions from co-investments
   
40,421
     
117,103
 
Changes in restricted cash and deposits
   
(39,482
)
   
(17,246
)
Purchases of marketable securities
   
(15,516
)
   
(16,442
)
Sales and maturities of marketable securities
   
6,275
     
22,830
 
Purchases of and advances under notes and other receivables
   
-
     
(56,750
)
Collections of notes and other receivables
   
76,585
     
53,438
 
Net cash used in investing activities
   
(1,135,162
)
   
(308,987
)
Cash flows from financing activities:
               
Borrowings under debt agreements
   
1,737,322
     
641,892
 
Principal repayment of debt
   
(1,327,840
)
   
(536,926
)
Additions to deferred and financing costs
   
(16,941
)
   
(3,836
)
Proceeds from issuance of common stock
   
450,812
     
122,905
 
Equity related issuance cost of common stock
   
(1,348
)
   
(616
)
Proceeds from stock options exercises
   
6,526
     
4,756
 
Distributions to noncontrolling interest
   
(13,217
)
   
(14,108
)
Redemption of noncontrolling interest
   
(4,707
)
   
(5,113
)
Common and preferred stock dividends paid
   
(177,400
)
   
(134,146
)
Net cash provided by financing activities
   
653,207
     
74,808
 
Net decrease in cash and cash equivalents-unrestricted
   
(140,967
)
   
(9,097
)
Cash acquired in the BRE merger
   
140,353
     
-
 
Cash and cash equivalents-unrestricted at beginning of period
   
18,491
     
18,606
 
Cash and cash equivalents-unrestricted at end of period
 
$
17,877
   
$
9,509
 
 
(Continued)
 
5

ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(In thousands)

 
 
Nine Months Ended
September 30,
 
 
 
2014
   
2013
 
Supplemental disclosure of cash flow information:
       
Cash paid for interest, net of $17.8 million, and $12.7 million capitalized in 2014 and 2013, respectively
 
$
93,342
   
$
76,596
 
Supplemental disclosure of noncash investing and financing activities:
               
Issuance of Operating Partnership units for contributed properties
 
$
1,419,816
   
$
-
 
Retirement of Operating Partnership units
 
$
(1,419,816
)
 
$
-
 
Transfer from real estate under development to land and building
 
$
71,496
   
$
68
 
Transfer from real estate under development to co-investments
 
$
81,332
   
$
27,906
 
Mortgage notes (excluding BRE merger) assumed in connection with purchases of real estate including the loan premiums recorded
 
$
70,480
   
$
-
 
Change in accrual of dividends
 
$
45,605
   
$
5,434
 
Change in fair value of derivative liabilities
 
$
(1,175
)
 
$
3,649
 
Change in fair value of marketable securities
 
$
2,186
   
$
2,958
 
Change in construction payable
 
$
30,405
   
$
1,544
 
Reclassification to redeemable noncontrolling interest from additional paid in capital and noncontrolling interest
 
$
18,764
   
$
-
 
                 
Assets acquired and liabilities assumed in BRE merger:
               
Cash assumed in merger
 
$
140,353
   
$
-
 
Rental properties and real estate under development
 
$
5,618,067
   
$
-
 
Real estate held for sale, net
 
$
107,772
   
$
-
 
Co-investments
 
$
218,402
   
$
-
 
Acquired in-place lease value
 
$
80,358
   
$
-
 
Other assets
 
$
15,676
   
$
-
 
Mortgage notes payable and unsecured debt
 
$
1,747,382
   
$
-
 
Other liabilities
 
$
94,976
   
$
-
 
Redeemable noncontrolling interest
 
$
4,798
   
$
-
 
Consideration issued
 
$
3,777,646
   
$
-
 

See accompanying notes to the unaudited condensed consolidated financial statements
 
6

ESSEX PORTFOLIO, L.P.  AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(Unaudited)
(In thousands, except unit amounts)

   
September 30,
2014
   
December 31,
2013
 
ASSETS
 
   
 
Real estate:
       
Rental properties:
       
Land and land improvements
 
$
2,453,093
   
$
1,083,552
 
Buildings and improvements
   
8,820,657
     
4,360,205
 
     
11,273,750
     
5,443,757
 
Less accumulated depreciation
   
(1,469,991
)
   
(1,254,886
)
     
9,803,759
     
4,188,871
 
Real estate under development
   
363,193
     
50,430
 
Co-investments
   
1,043,277
     
677,133
 
Real estate held for sale, net
   
107,772
     
-
 
     
11,318,001
     
4,916,434
 
Cash and cash equivalents-unrestricted
   
17,877
     
18,491
 
Cash and cash equivalents-restricted
   
70,123
     
35,275
 
Marketable securities
   
108,147
     
90,084
 
Notes and other receivables
   
22,973
     
68,255
 
Acquired in place lease value and other assets
   
98,381
     
33,781
 
Deferred charges, net
   
31,060
     
24,519
 
Total assets
 
$
11,666,562
   
$
5,186,839
 
                 
LIABILITIES AND CAPITAL
               
Mortgage notes payable.
 
$
2,258,010
   
$
1,404,080
 
Unsecured debt
   
2,745,487
     
1,410,023
 
Lines of credit
   
222,628
     
219,421
 
Accounts payable and accrued liabilities
   
167,160
     
67,183
 
Construction payable
   
38,453
     
8,047
 
Distributions payable
   
87,609
     
50,627
 
Other liabilities
   
32,330
     
24,871
 
Total liabilities
   
5,551,677
     
3,184,252
 
Commitments and contingencies
               
Redeemable noncontrolling interest
   
21,442
     
-
 
Cumulative convertible Series G preferred interest (liquidation value of $4,456)
   
-
     
4,349
 
Capital:
               
General Partner:
               
Common equity (63,229,790 and 37,421,219  units issued and outstanding at September 30, 2014 and December 31, 2013, respectively)
   
5,963,493
     
1,873,882
 
Series H Preferred interest (liquidation value of $73,750)
   
71,209
     
71,209
 
     
6,034,702
     
1,945,091
 
Limited Partners:
               
Common equity (2,155,783 and 2,149,802 units issued and outstanding at September 30, 2014 and December 31, 2013, respectively)
   
45,439
     
45,957
 
Accumulated other comprehensive loss
   
(49,503
)
   
(58,940
)
Total partners' capital
   
6,030,638
     
1,932,108
 
Noncontrolling interest
   
62,805
     
66,130
 
Total capital
   
6,093,443
     
1,998,238
 
                 
Total liabilities and capital
 
$
11,666,562
   
$
5,186,839
 
 
See accompanying notes to the unaudited condensed consolidated financial statements
 
7

ESSEX PORTFOLIO, L.P. AND SUBSIDIARIES
Condensed Consolidated Statements of Operations and Comprehensive Income
(Unaudited)
(In thousands, except unit and per unit amounts)

 
 
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Revenues:
 
   
   
   
 
Rental and other property
 
$
268,118
   
$
152,177
   
$
683,749
   
$
446,017
 
Management and other fees
   
2,361
     
1,771
     
6,856
     
5,812
 
     
270,479
     
153,948
     
690,605
     
451,829
 
Expenses:
                               
Property operating, excluding real estate taxes
   
55,900
     
35,787
     
145,410
     
102,170
 
Real estate taxes
   
31,768
     
14,535
     
77,452
     
42,773
 
Depreciation
   
102,184
     
48,227
     
254,211
     
142,687
 
General and administrative
   
11,479
     
6,263
     
28,621
     
19,852
 
Merger and integration expenses
   
3,857
     
-
     
46,413
     
-
 
Acquisition and dispositions costs
   
51
     
237
     
1,555
     
792
 
     
205,239
     
105,049
     
553,662
     
308,274
 
                                 
Earnings from operations
   
65,240
     
48,899
     
136,943
     
143,555
 
                                 
Interest expense
   
(45,830
)
   
(29,192
)
   
(117,021
)
   
(86,661
)
Interest and other income
   
2,992
     
2,387
     
8,685
     
9,326
 
Equity income in co-investments
   
4,910
     
40,802
     
21,065
     
52,295
 
Gain (loss) on early retirement of debt
   
-
     
(178
)
   
-
     
846
 
Gains on sale of real estate and land
   
31,372
     
-
     
39,640
     
1,503
 
Income from continuing operations
   
58,684
     
62,718
     
89,312
     
120,864
 
Income from discontinued operations
   
-
     
13,157
     
-
     
14,289
 
Net income
   
58,684
     
75,875
     
89,312
     
135,153
 
Net income attributable to noncontrolling interest
   
(1,904
)
   
(1,730
)
   
(5,529
)
   
(5,075
)
Net income attributable to controlling interest
   
56,780
     
74,145
     
83,783
     
130,078
 
Preferred interest distributions
   
(1,296
)
   
(1,368
)
   
(3,977
)
   
(4,104
)
Net income available to common unitholders
 
$
55,484
   
$
72,777
   
$
79,806
   
$
125,974
 
                                 
Comprehensive income
 
$
61,139
   
$
76,112
   
$
98,749
   
$
142,206
 
Comprehensive income attributable to noncontrolling interest
   
(1,904
)
   
(1,730
)
   
(5,529
)
   
(5,075
)
Comprehensive income attributable to controlling interest
 
$
59,235
   
$
74,382
   
$
93,220
   
$
137,131
 
                                 
Per common unit data:
                               
Basic:
                               
Income from continuing operations
 
$
0.85
   
$
1.51
   
$
1.41
   
$
2.84
 
Income from discontinued operations
   
-
     
0.33
     
-
     
0.36
 
Net income available to common unitholders
 
$
0.85
   
$
1.84
   
$
1.41
   
$
3.20
 
Weighted average number of common units outstanding during the period
   
65,057,157
     
39,467,492
     
56,484,589
     
39,333,100
 
                                 
Diluted:
                               
Income from continuing operations
 
$
0.85
   
$
1.51
   
$
1.41
   
$
2.84
 
Income from discontinued operations
   
-
     
0.33
     
-
     
0.36
 
Net income available to common unitholders
 
$
0.85
   
$
1.84
   
$
1.41
   
$
3.20
 
Weighted average number of common units outstanding during the period
   
65,234,328
     
39,583,913
     
56,677,712
     
39,421,896
 
                                 
Distribution per common unit
 
$
1.30
   
$
1.21
   
$
3.81
   
$
3.63
 

See accompanying notes to the unaudited condensed consolidated financial statements
 
8

ESSEX PORTFOLIO, L.P. AND SUBSIDIARIES
Condensed Consolidated Statement of Capital for the nine months ended September 30, 2014
(Dollars and units in thousands)
(Unaudited)

   
General Partner
   
Limited Partners
   
Accumulated
         
           
Preferred
           
Other
         
   
Common Equity
   
Equity
   
Common Equity
   
Comprehensive
   
Noncontrolling
     
   
Units
   
Amount
   
Amount
   
Units
   
Amount
   
(Loss) Income
   
Interest
   
Total
 
Balances at December 31, 2013
   
37,421
   
$
1,873,882
    $
71,209
     
2,150
   
$
45,957
   
$
(58,940
)
 
$
66,130
   
$
1,998,238
 
Comprehensive income:
                                                               
Net income
   
-
     
76,364
     
3,977
     
-
     
3,442
     
-
     
5,529
     
89,312
 
Reversal of unrealized gains upon the sale of marketable securities
   
-
     
-
     
-
     
-
     
-
     
(886
)
   
-
     
(886
)
Change in fair value of derivatives and amortization of swap settlements
   
-
     
-
     
-
     
-
     
-
     
7,732
     
-
     
7,732
 
Change in fair value of marketable securities
   
-
     
-
     
-
     
-
     
-
     
2,591
     
-
     
2,591
 
Issuance of common units under:
                                                               
Common stock issued as consideration by general partner in merger
   
23,093
     
3,777,646
     
-
     
-
     
-
     
-
     
-
     
3,777,646
 
General partner's stock based compensation
   
154
     
6,511
     
-
     
-
     
-
     
-
     
-
     
6,511
 
Sale of common stock by general partner
   
2,527
     
449,499
     
-
     
-
     
-
     
-
     
-
     
449,499
 
Equity based compensation costs
   
-
     
5,756
     
-
     
29
     
1,672
     
-
     
-
     
7,428
 
Reclassification of noncontrolling interest to redeemable noncontrolling interest
   
-
     
(19,823
)
   
-
     
(23
)
   
4,017
     
-
     
(5,084
)
   
(20,890
)
Changes in value of redemption value of redeemable Non-Controlling Interest
           
2,126
                                             
2,126
 
Conversion of Series G preferred stock
   
34
     
4,349
     
-
     
-
     
-
     
-
     
-
     
4,349
 
Contributions from noncontrolling interest
   
-
     
-
     
-
     
8,561
     
1,419,816
     
-
     
-
     
1,419,816
 
Retirement of noncontrolling interest
   
-
     
-
     
-
     
(8,561
)
   
(1,419,816
)
   
-
     
-
     
(1,419,816
)
Distributions to noncontrolling interest
   
-
     
-
     
-
     
-
     
-
     
-
     
(3,462
)
   
(3,462
)
Redemptions
   
-
     
(2,382
)
   
-
     
-
     
(291
)
   
-
     
(308
)
   
(2,981
)
Distributions declared
   
-
     
(210,435
)
   
(3,977
)
   
-
     
(9,358
)
   
-
     
-
     
(223,770
)
Balances at September 30, 2014
   
63,229
   
$
5,963,493
   
$
71,209
     
2,156
   
$
45,439
   
$
(49,503
)
 
$
62,805
   
$
6,093,443
 

See accompanying notes to the unaudited condensed consolidated financial statements
 

9

ESSEX PORTFOLIO, L.P. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(In thousands)
 
 
 
Nine Months Ended
September 30,
 
 
 
2014
   
2013
 
Cash flows from operating activities:
     
 
Net income
 
$
89,312
   
$
135,153
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
   
254,211
     
143,662
 
Amortization of discount on marketable securities
   
(6,555
)
   
(4,664
)
Amortization of premium and debt financing costs, net
   
(4,987
)
   
8,111
 
Gain on sale of marketable securities
   
(886
)
   
(1,767
)
Operating Partnership's share of gain on the sales of co-investment
   
(3,213
)
   
(41,252
)
Gain on the sales of real estate and land
   
(39,640
)
   
(14,161
)
Non-cash merger expense
   
7,562
     
-
 
Equity in income in co-investments, net
   
(14,903
)
   
(1,892
)
Equity-based compensation
   
4,996
     
3,137
 
Gain on early retirement of debt
   
-
     
(846
)
Changes in operating assets and liabilities:
               
Acquired in place lease value and other assets
   
8,923
     
(19,689
)
Accounts payable and accrued liabilities
   
44,775
     
19,091
 
Other liabilities
   
1,393
     
199
 
Net cash provided by operating activities
   
340,988
     
225,082
 
Cash flows from investing activities:
               
Additions to real estate:
               
Acquisitions of real estate
   
(409,018
)
   
(205,539
)
Improvements to recent acquisitions
   
(13,512
)
   
(14,374
)
Redevelopment
   
(35,361
)
   
(32,488
)
Revenue generating capital expenditures
   
(20,560
)
   
(2,165
)
Lessor required capital expenditures
   
(7,562
)
   
(4,320
)
Non-revenue generating capital expenditures
   
(29,070
)
   
(21,885
)
Acquisitions of and additions to real estate under development
   
(108,659
)
   
(13,963
)
Proceeds from insurance claim for property damage
   
29,160
     
-
 
BRE merger consideration paid
   
(555,826
)
   
-
 
Dispositions of real estate
   
61,331
     
33,666
 
Changes in restricted cash and deposits
   
(39,482
)
   
(17,246
)
Purchases of marketable securities
   
(15,516
)
   
(16,442
)
Sales and maturities of marketable securities
   
6,275
     
22,830
 
Purchases of and advances under notes and other receivables
   
-
     
(56,750
)
Collections of notes and other receivables
   
76,585
     
53,438
 
Dispositions of co-investments
   
13,900
     
-
 
Contributions to co-investments
   
(128,268
)
   
(150,852
)
Distributions from co-investments
   
40,421
     
117,103
 
Net cash used in investing activities
   
(1,135,162
)
   
(308,987
)
Cash flows from financing activities:
               
Borrowings under debt agreements
   
1,737,322
     
641,892
 
Principal repayment of debt
   
(1,327,840
)
   
(536,926
)
Additions to deferred charges
   
(16,941
)
   
(3,836
)
Equity related issuance cost of common stock
   
(1,348
)
   
(616
)
Proceeds from stock options exercises
   
6,526
     
4,756
 
Net proceeds from issuance of common units
   
450,812
     
122,905
 
Distributions to noncontrolling interest
   
(3,462
)
   
(6,234
)
Redemption of noncontrolling interest
   
(308
)
   
(1,819
)
Common units and preferred units and preferred interests distributions paid
   
(191,554
)
   
(145,314
)
Net cash provided by financing activities
   
653,207
     
74,808
 
Net decrease in cash and cash equivalents-unrestricted
   
(140,967
)
   
(9,097
)
Cash acquired in the BRE merger
   
140,353
     
-
 
Cash and cash equivalents-unrestricted at beginning of period
   
18,491
     
18,606
 
Cash and cash equivalents-unrestricted at end of period
 
$
17,877
   
$
9,509
 
 
(Continued)
 

10

ESSEX PORTFOLIO, L.P. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(In thousands)
 
 
 
Nine Months Ended
September 30,
 
 
 
2014
   
2013
 
Supplemental disclosure of cash flow information:
       
Cash paid for interest, net of $17.8 million, and $12.7 million capitalized in 2014 and 2013, respectively
 
$
93,342
   
$
76,596
 
Supplemental disclosure of noncash investing and financing activities:
               
Issuance of limited partner common units for contributed properties
 
$
1,419,816
   
$
-
 
Retirement of limited partner common units
 
$
(1,419,816
)
   
-
 
Transfer from real estate under development to land and building
 
$
71,496
   
$
68
 
Transfer from real estate under development to co-investments
 
$
81,332
   
$
27,906
 
Mortgage notes (excluding BRE merger) assumed in connection with purchases of real estate including the loan premiums recorded
 
$
70,480
   
$
-
 
Change in accrual of distributions
 
$
45,605
   
$
5,434
 
Change in fair value of derivative liabilities
 
$
(1,175
)
 
$
3,649
 
Change in fair value of marketable securities
 
$
2,186
   
$
2,958
 
Change in construction payable
 
$
30,405
   
$
1,544
 
Reclassification to redeemable noncontrolling interest from general partner and limited partners common units
 
$
(18,764
)
 
$
-
 
                 
Assets acquired and liabilities assumed in BRE merger:
               
Cash assumed in merger
 
$
140,353
   
$
-
 
Rental properties and real estate under development
 
$
5,618,067
   
$
-
 
Real estate held for sale, net
 
$
107,772
   
$
-
 
Co-investments
 
$
218,402
   
$
-
 
Acquired in-place lease value
 
$
80,358
   
$
-
 
Other assets
 
$
15,676
   
$
-
 
Mortgage notes payable and unsecured debt
 
$
1,747,382
   
$
-
 
Other liabilities
 
$
94,976
   
$
-
 
Redeemable noncontrolling interest
 
$
4,798
   
$
-
 
Consideration issued
 
$
3,777,646
   
$
-
 
 
See accompanying notes to the unaudited condensed consolidated financial statements
 
11

ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
ESSEX PORTFOLIO, L.P. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2014 and 2013
(Unaudited)

1) Organization and Basis of Presentation

The accompanying unaudited condensed consolidated financial statements present the accounts of Essex Property Trust, Inc. (“Essex” or the “Company”), which include the accounts of the Company and Essex Portfolio, L.P. and subsidiaries (the “Operating Partnership,” which holds the operating assets of the Company), prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q.  In the opinion of management, all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows for the periods presented have been included and are normal and recurring in nature.  These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company's  annual report on Form 10-K for the year ended December 31, 2013.

All significant intercompany balances and transactions have been eliminated in the condensed consolidated financial statements.  Certain reclassifications have been made to conform to the current year’s presentation. Such reclassification had no effect on previously reported financial results.

On April 1, 2014, Essex completed the merger with BRE Properties, Inc. (“BRE”).  In connection with the closing of the merger, (1) BRE merged into a wholly owned subsidiary of Essex, and (2) each outstanding share of BRE common stock was converted into (i) 0.2971 shares (the “Stock Consideration”) of Essex common stock, and (ii) $7.18 in cash, (the “Cash Consideration”), plus cash in lieu of fractional shares for total consideration of approximately $4.3 billion.  The Cash Consideration was adjusted as a result of the authorization and declaration of a special distribution to the stockholders of BRE of $5.15 per share of BRE common stock payable to BRE stockholders of record as of the close of business on March 31, 2014 (the “Special Dividend”).  The Special Dividend was payable as a result of the closing of the sale of certain interests in assets of BRE to certain parties, which closed on March 31, 2014.  Pursuant to the terms of the merger agreement, the amounts payable as a Special Dividend reduced the Cash Consideration of $12.33 payable by Essex in the merger to $7.18 per share of BRE common stock.

Essex issued approximately 23.1 million shares of Essex common stock as Stock Consideration in the merger.  For purchase accounting, the value of the common stock issued by Essex upon the consummation of the merger was determined based on the closing price of BRE’s common stock on the closing date of the merger. As a result of Essex being admitted to the S&P 500 on the same date as the closing of the merger, Essex’s common stock price experienced significantly higher than usual trading volume and the closing price of $174 per share was significantly higher than its volume-weighted average trading price for the days before and after April 1, 2014.  BRE’s common stock did not experience the same proportionate increase in common stock price leading up to April 1, 2014.  As a result, given that a substantial component of the purchase price is an exchange of equity instruments, Essex used the closing price of BRE’s common stock on April 1, 2014 of $61 per share, less the Cash Consideration, as the fair value of the equity consideration.  After deducting the Special Dividend and the Cash Consideration per share, this resulted in a value of $48.67 per share of BRE common stock which is the equivalent of approximately $164 per share of Essex common stock issued.

The unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2014 and 2013 include the accounts of the Company and the Operating Partnership.  Essex is the sole general partner in the Operating Partnership, with a 96.7% general partnership interest as of September 30, 2014.  Total OP units outstanding were 2,155,783 and 2,149,802 as of September 30, 2014 and December 31, 2013, respectively, and the redemption value of the OP units, based on the closing price of the Company’s common stock totaled $385.3 million and $308.5 million, as of September 30, 2014 and December 31, 2013, respectively.

As of September 30, 2014, the Company owned or had ownership interests in 239 apartment communities, aggregating 56,622 units, excluding the Company’s ownership in preferred interest co-investments,  (collectively, the “Communities”, and individually, a “Community”), five commercial buildings and fourteen active developments (collectively, the “Portfolio”).  The Communities are located in Southern California (Los Angeles, Orange, Riverside, San Diego, Santa Barbara, and Ventura counties), Northern California (the San Francisco Bay Area) and the Seattle and Phoenix metropolitan areas.

Cyber-intrusion Expenses
 
In the third quarter of 2014, the Company reported that certain of its computer networks containing personal and proprietary information have been compromised by a cyber-intrusion. Essex has confirmed that evidence exists of exfiltration of data on Company systems. The precise nature of the data has not yet been identified and the Company does not presently have any evidence that data belonging to the Company has been misused.
 
12

ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
ESSEX PORTFOLIO, L.P. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2014 and 2013
(Unaudited)

After detecting unusual activity, the Company took immediate steps to assess and contain the intrusion and secure its systems. The Company has retained independent forensic computer experts to analyze the impacted data systems and is consulting with law enforcement. The investigation into this cyber-intrusion is ongoing, and Essex is working as quickly as possible to identify whether any employee or tenant data may be at risk. When the analysis is complete, the Company will promptly notify any affected parties, as appropriate.
 
The Company has recorded $1.2 million in cyber-intrusion expenses in the third quarter of 2014 and are included in general and administrative expense line item on the condensed  consolidated statement of operations and comprehensive income.

Marketable Securities

The Company reports its available for sale securities at fair value, based on quoted market prices (Level 2 for the unsecured bonds and Level 1 for the common stock and investment funds, as defined by the Financial Accounting Standards Board (“FASB”) standard for fair value measurements), and any unrealized gain or loss is recorded as other comprehensive income (loss).  Realized gains and losses, interest and dividend income, and amortization of purchase discounts are included in interest and other income on the condensed consolidated statement of operations and comprehensive income.

As of September 30, 2014 and December 31, 2013, marketable securities consisted primarily of investment-grade unsecured bonds, common stock, investments in mortgage backed securities and investment funds that invest in equities and U.S. treasury or agency securities.  As of September 30, 2014 and December 31, 2013, the Company classified its investments in mortgage backed securities, which mature through November 2019 and September 2020, as held to maturity, and accordingly, these securities are stated at their amortized cost.  As of September 30, 2014 and December 31, 2013, marketable securities consist of the following ($ in thousands):

   
September 30, 2014
 
   
Cost/
Amortized
Cost
   
Gross
Unrealized
Gain
   
Carrying Value
 
Available for sale:
           
Investment-grade unsecured bonds
 
$
14,396
   
$
(51
)
 
$
14,345
 
Investment funds - US treasuries
   
5,018
     
7
     
5,025
 
Common stock
   
22,523
     
957
     
23,480
 
Held to maturity:
                       
Mortgage backed securities
   
65,297
     
-
     
65,297
 
Total
 
$
107,234
   
$
913
   
$
108,147
 
                         
   
December 31, 2013
 
   
Cost/
Amortized
Cost
   
Gross
Unrealized
Gain (Loss)
   
Carrying Value
 
Available for sale:
                       
Investment-grade unsecured bonds
 
$
15,446
   
$
509
   
$
15,955
 
Investment funds - US treasuries
   
3,675
     
3
     
3,678
 
Common stock
   
13,104
     
(1,304
)
   
11,800
 
Held to maturity:
                       
Mortgage backed securities
   
58,651
     
-
     
58,651
 
Total
 
$
90,876
   
$
(792
)
 
$
90,084
 

The Company uses the specific identification method to determine the cost basis of a security sold and to reclassify amounts from accumulated other comprehensive income for securities sold.  For the nine months ended September 30, 2014 and 2013,  the proceeds from sales of available for sale securities totaled $6.3 million and $22.8 million, respectively, which resulted in realized gains of $0.9 million and $1.8 million, respectively.
 
13

ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
ESSEX PORTFOLIO, L.P. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2014 and 2013
(Unaudited)

Variable Interest Entities

The Company consolidates 19 DownREIT limited partnerships (comprising twelve communities) since the Company is the primary beneficiary of these variable interest entities (“VIEs”).  Total DownREIT units outstanding were 991,983 and 1,007,879 as of September 30, 2014 and December 31, 2013 respectively, and the redemption value of the units, based on the closing price of the Company’s common stock totaled $177.3 million and $144.6 million, as of September 30, 2014 and December 31, 2013, respectively.  The consolidated total assets and liabilities related to these VIEs, net of intercompany eliminations, were approximately $234.7 million and $224.4 million, respectively, as of September 30, 2014 and $194.9 million and $178.3 million, respectively, as of December 31, 2013.  Interest holders in VIEs consolidated by the Company are allocated income equal to the cash distributions made to those interest holders.  The remaining results of operations are allocated to the Company.  As of September 30, 2014 and December 31, 2013, the Company did not have any other VIEs of which it was deemed to be the primary beneficiary.

Equity Based Compensation

The Company accounts for equity based compensation using the fair value method of accounting.  The estimated fair value of stock options granted by the Company is being amortized over the vesting period of the stock options.  The estimated grant date fair values of the long term incentive plan units (discussed in Note 13, “Equity Based Compensation Plans,” in the Company’s Form 10-K for the year ended December 31, 2013) are being amortized over the expected service periods.

Stock-based compensation expense for options and restricted stock totaled $0.7 million and $0.5 million for the three months ended September 30, 2014 and 2013, respectively, and $2.9 million and $1.6 million for the nine months ended September 30, 2014 and 2013, respectively.  The intrinsic value of the stock options exercised during the three months ended September 30, 2014 and 2013 totaled $1.0 million and $0.1 million, respectively, and $4.2 million and $2.9 million for the nine months ended September 30, 2014 and 2013, respectively. As of September 30, 2014, the intrinsic value of the stock options outstanding and fully vested totaled $15.7 million.  As of September 30, 2014, total unrecognized compensation cost related to unvested share-based compensation granted under the stock option and restricted stock plans totaled $5.7 million.  The cost is expected to be recognized over a weighted-average period of 1 to 5 years for the stock option plans and is expected to be recognized straight-line over a period of 1 to 7 years for the restricted stock awards.

The Company has adopted an incentive program involving the issuance of Series Z-1 Incentive Units of limited partnership interest in the Operating Partnership.  The Operating Partnership also issued 50,500 units under the 2014 Long-Term Incentive Plan Award agreements in December 2013.  Pursuant to the 2014 Long-Term Incentive Plan Awards, each recipient was initially granted a number of 2014 Long-Term Incentive Plan Units (the “2014 LTIP Units”), 90% of which are subject to performance-based vesting, and 10% of which are subject to service-based vesting based on continued employment.  One-third of the performance-based vesting of the 2014 LTIP Units initially granted will be eligible to be earned by recipients based on Essex’s absolute total stockholder return and two-thirds will be eligible to be earned based on Essex’s relative total stockholder return, in each case, during a one-year performance period beginning on the initial grant date of the awards.  All 2014 LTIP Units that are earned vest over a four year period commencing on the grant date.

Stock-based compensation expense for Z-1 Units and 2014 LTIP Units totaled $0.4 million and $0.5 million for the three months ended September 30, 2014 and 2013, respectively, and $1.5 million for the nine months ended September 30, 2014 and 2013. As of September 30, 2014, the intrinsic value of the Z-1 Units and 2014 LTIP Units subject to future vesting totaled $23.5 million.  As of September 30, 2014, total unrecognized compensation cost related to Z-1 Units and 2014 LTIP Units subject to future vesting totaled $6.7 million.  The unamortized cost is expected to be recognized over 6 years subject to the achievement of the stated performance criteria.

Fair Value of Financial Instruments

Management believes that the carrying amounts of outstanding lines of credit, and notes and other receivables approximate fair value as of September 30, 2014 and December 31, 2013, because interest rates, yields and other terms for these instruments are consistent with yields and other terms currently available for similar instruments.  Management has estimated that the fair value of the Company’s $4.3 billion of fixed rate debt, including unsecured bonds, at September 30, 2014 is approximately $4.5 billion and the fair value of the Company’s $539.2 million of variable rate debt, excluding borrowings under the lines of credit, at September 30, 2014 is $520.4 million based on the terms of existing mortgage notes payable, unsecured bonds and variable rate demand notes compared to those available in the marketplace.  Management believes that the carrying amounts of cash and cash equivalents, restricted cash, accounts payable and accrued liabilities, construction payables, other liabilities and dividends payable approximate fair value as of September 30, 2014 due to the short-term maturity of these instruments.  Marketable securities, except mortgage backed securities that are held to maturity, and derivatives are carried at fair value as of September 30, 2014.
 
14

ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
ESSEX PORTFOLIO, L.P. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2014 and 2013
(Unaudited)

At September 30, 2014, the Company’s investments in mortgage backed securities had a carrying value of $65.3 million and the Company estimated the fair value to be approximately $93.7 million.  At December 31, 2013, the Company’s investments in mortgage backed securities had a carrying value of $58.7 million and the Company estimated the fair value to be approximately $86.2 million.  The Company determines the fair value of the mortgage backed securities based on unobservable inputs (level 3 of the fair value hierarchy) considering the assumptions that market participants would make in valuing these securities.  Assumptions such as estimated default rates and discount rates are used to determine expected discounted cash flows to estimate the fair value.

Capitalization of Costs

The Company’s capitalized internal costs related to development and redevelopment projects totaled $2.9 million and $1.8 million during the three months ended September 30, 2014 and 2013, respectively, and  $7.6 million and $5.1 million during the nine months ended September 30, 2014 and 2013, respectively, most of which relates to development projects. These totals include capitalized salaries of $2.4 million and $0.8 million for the three months ended September, 2014 and 2013, respectively, and $6.7 million and $2.0 million for the nine months ended September 30, 2014 and 2013, respectively. The Company capitalizes leasing commissions associated with the lease-up of a development community and amortizes the costs over the life of the leases.  The amounts capitalized for leasing commissions are immaterial for all periods presented.

Co-investments

The Company owns investments in joint ventures (“co-investments”) in which it has significant influence, but its ownership interest does not meet the criteria for consolidation in accordance with U.S. GAAP.  Therefore, the Company accounts for co-investments using the equity method of accounting.  The equity method employs the accrual basis for recognizing the investor’s share of investee income or losses. In addition, distributions received from the investee are treated as a reduction in the investment account, not as income.  The significant accounting policies of the Company’s co-investment entities are consistent with those of the Company in all material respects.

Upon the acquisition of a controlling interest of a co-investment, the co-investment entity is consolidated and a gain or loss is recognized upon the remeasurement of co-investments in the condensed consolidated statement of operations equal to the amount by which the fair value of the co-investment interest the Company previously owned exceeds its carrying value.  A majority of the co-investments, excluding the preferred equity investments, compensate the Company for its asset management services and may provide promote income if certain financial return benchmarks are achieved.  Asset management fees are recognized when earned, and promote fees are recognized when the earnings events have occurred and the amount is determinable and collectible. Any promote fees are reflected in equity income in co-investments.

Changes in Accumulated Other Comprehensive Loss, Net by Component

Essex Property Trust, Inc.
(in thousands):

   
Change in fair
value and amortization
of derivatives
   
Unrealized
gains/(losses) on
available for sale
securities
   
Total
 
Balance at December 31, 2013
 
$
(59,724
)
 
$
(748
)
 
$
(60,472
)
Other comprehensive income before reclassification
   
1,428
     
2,479
     
3,907
 
Amounts reclassified from accumulated other comprehensive loss
   
5,997
     
(841
)
   
5,156
 
Net other comprehensive income
   
7,425
     
1,638
     
9,063
 
Balance at September 30, 2014
 
$
(52,298
)
 
$
890
   
$
(51,408
)
 
15

ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
ESSEX PORTFOLIO, L.P. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2014 and 2013
(Unaudited)

Essex Portfolio, L.P.
(in thousands):

   
Change in fair
value and amortization
of derivatives
   
Unrealized
gains/(losses) on
available for sale
securities
   
Total
 
Balance at December 31, 2013
 
$
(58,148
)
 
$
(792
)
 
$
(58,940
)
Other comprehensive income before reclassification
   
1,487
     
2,591
     
4,078
 
Amounts reclassified from accumulated other comprehensive loss
   
6,245
     
(886
)
   
5,359
 
Net other comprehensive income
   
7,732
     
1,705
     
9,437
 
Balance at September 30, 2014
 
$
(50,416
)
 
$
913
   
$
(49,503
)

Amounts reclassified from accumulated other comprehensive loss in connection with derivatives are recorded in interest expense on the condensed consolidated statement of operations and comprehensive income.  Realized gains and losses on available for sale securities are included in interest and other income on the condensed consolidated statement of operations and comprehensive income.

Accounting Estimates

The preparation of condensed consolidated financial statements, in accordance with GAAP, requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to acquiring, developing and assessing the carrying values of its real estate portfolio, its investments in and advances to joint ventures and affiliates, its notes receivables and its qualification as a Real Estate Investment Trust (“REIT”). The Company bases its estimates on historical experience, current market conditions, and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may vary from those estimates and those estimates could be different under different assumptions or conditions.

Discontinued Operations

In April 2014, the Financial Accounting Standards Board (“FASB”) issued ASU, No. 2014-018, Presentation of Financial Statements, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. ASU 2014-018 changes the requirements for reporting discontinued operation under Subtopic 205-20, Presentation of Financial Statements—Discontinued Operations.  The amendment updates the definition of discontinued operations and defines discontinued operations to be those disposals of components of an entity that represent a strategic shift that has (or will have) a major effect on an entity’s operations and financial results.  This ASU is effective for disposals of components of an entity that occur within annual periods beginning on or after December 15, 2014 with early adoption permitted, but only for disposals that have not been reported in financial statements previously issued.

The Company adopted ASU 2014-018 in its first quarter of 2014.  In the first quarter of 2014, Essex sold Vista Capri North, a 106 unit community located in San Diego, California for $14.4 million. The total gain on sale was $7.9 million.

The Company did not sell any properties in the second quarter of 2014.

During the third quarter of 2014, the Company sold Coldwater Canyon, a 39 unit community located in Studio City, CA for $9.5 million. The total gain on sale was $2.2 million. Also during the third quarter, the Company sold Mt. Sutro, a 99 unit community located in San Francisco, CA for $39.5 million. The total gain on sale was $29.2 million.

The Company determined that the disposals through the nine months ended September 30, 2014 were not a discontinued operation in accordance with ASU 2014-018. The gains related to these disposals are recorded in gains on sale of real estate and land in the condensed consolidated statements of operations and comprehensive income.
 
16

ESSEX PROPERTY TRUST, INC. AND SUBSIDIARIES
ESSEX PORTFOLIO, L.P. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2014 and 2013
(Unaudited)

BRE Merger

The merger with BRE was a two step process. First, 14 of the BRE properties were acquired on March 31, 2014  in exchange for $1.4 billion of OP units.  The preliminary fair value of these properties was substantially all attributable to rental properties which included land, buildings and improvements, and real estate under development and approximately $19 million was attributable to acquired in-place lease value.  Second,  the BRE merger was closed on April 1, 2014 in exchange for the total consideration of approximately $4.3 billion. A summary of the preliminary fair value of the assets and liabilities acquired on April 1, 2014 was as follows (includes the 14 properties acquired on March 31, 2014 as the OP units issued were retired on April 1, 2014) (in millions):

Cash assumed
 
$
140
 
Rental properties and real estate under development
   
5,618
 
Real estate held for sale, net
   
108
 
Co-investments
   
218
 
Acquired in-place lease value
   
80
 
Other assets
   
16
 
Mortgage notes payable and unsecured debt
   
(1,747
)
Other liabilities
   
(94
)
Redeemable noncontrolling interest
   
(5
)
     
4,334