LIFE STORAGE, INC. - Quarter Report: 2016 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2016

Commission file number:

1-13820 (Life Storage, Inc.)

0-24071 (Life Storage LP)

LIFE STORAGE, INC.

LIFE STORAGE LP

(Exact name of Registrant as specified in its charter)

6467 Main Street

Williamsville, NY 14221

(Address of principal executive offices) (Zip code)

(716) 633-1850

(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 such reports), and (2) has been subject to such filing requirements for the past 90 days.

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).

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):

Life Storage, Inc.:

Life Storage LP:

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

As of October 24, 2016, 46,396,450 shares of Common Stock, $.01 par value per share, were outstanding.

EXPLANATORY NOTE

This report combines the quarterly reports on Form 10-Q for the periods ended September 30, 2016 of Life Storage, Inc., formerly known as Sovran Self Storage, Inc. (the “Parent Company”) and Life Storage LP, formerly known as Sovran Acquisition Limited Partnership (the “Operating Partnership”). The Parent Company is a real estate investment trust, or REIT, that owns its assets and conducts its operations through the Operating Partnership, a Delaware limited partnership, and subsidiaries of the Operating Partnership. Effective August 15, 2016, the Parent Company changed its name from “Sovran Self Storage, Inc.” to “Life Storage, Inc.” and the Operating Partnership changed its name from “Sovran Acquisition Limited Partnership” to “Life Storage LP”. The Parent Company, the Operating Partnership and their consolidated subsidiaries are collectively referred to in this report as the “Company.” In addition, terms such as “we,” “us,” or “our” used in this report may refer to the Company, the Parent Company and/or the Operating Partnership.

Life Storage Holdings, Inc., a wholly-owned subsidiary of the Parent Company (“Holdings”), is the sole general partner of the Operating Partnership; the Parent Company is a limited partner of the Operating Partnership, and through its ownership of Holdings and its limited partnership interest, controls the operations of the Operating Partnership, holding a 99.6% ownership interest therein as of September 30, 2016. The remaining ownership interests in the Operating Partnership are held by certain former owners of assets acquired by the Operating Partnership. As the owner of the sole general partner of the Operating Partnership, the Parent Company has full and complete authority over the Operating Partnership’s day-to-day operations and management.

Management operates the Parent Company and the Operating Partnership as one enterprise. The management teams of the Parent Company and the Operating Partnership are identical.

There are few differences between the Parent Company and the Operating Partnership, which are reflected in the note disclosures in this report. The Company believes it is important to understand the differences between the Parent Company and the Operating Partnership in the context of how these entities operate as a consolidated enterprise. The Parent Company is a REIT, whose only material asset is its ownership of the partnership interests of the Operating Partnership. As a result, the Parent Company does not conduct business itself, other than acting as the owner of the sole general partner of the Operating Partnership, issuing public equity from time to time and guaranteeing the debt obligations of the Operating Partnership. The Operating Partnership holds substantially all the assets of the Company and, directly or indirectly, holds the ownership interests in the Company’s real estate ventures. The Operating Partnership conducts the operations of the Company’s business and is structured as a partnership with no publicly traded equity. Except for net proceeds from equity issuances by the Parent Company, which are contributed to the Operating Partnership in exchange for partnership units, the Operating Partnership generates the capital required by the Company’s business through the Operating Partnership’s operations, by the Operating Partnership’s direct or indirect incurrence of indebtedness or through the issuance of partnership units of the Operating Partnership.

The substantive difference between the Parent Company’s and the Operating Partnership’s filings is the fact that the Parent Company is a REIT with public equity, while the Operating Partnership is a partnership with no publicly traded equity. In the financial statements, this difference is primarily reflected in the equity (or capital for the Operating Partnership) section of the consolidated balance sheets and in the consolidated statements of equity (or capital). Apart from the different equity treatment, the consolidated financial statements of the Parent Company and the Operating Partnership are nearly identical.

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The Company believes that combining the quarterly reports on Form 10-Q of the Parent Company and the Operating Partnership into a single report will:

In order to highlight the differences between the Parent Company and the Operating Partnership, the separate sections in this report for the Parent Company and the Operating Partnership specifically refer to the Parent Company and the Operating Partnership. In the sections that combine disclosures of the Parent Company and the Operating Partnership, this report refers to such disclosures as those of the Company. Although the Operating Partnership is generally the entity that directly or indirectly enters into contracts and real estate ventures and holds assets and debt, reference to the Company is appropriate because the business is one enterprise and the Parent Company operates the business through the Operating Partnership.

As the owner of the general partner with control of the Operating Partnership, the Parent Company consolidates the Operating Partnership for financial reporting purposes, and the Parent Company does not have significant assets other than its investment in the Operating Partnership. Therefore, the assets and liabilities of the Parent Company and the Operating Partnership are the same on their respective financial statements. The separate discussions of the Parent Company and the Operating Partnership in this report should be read in conjunction with each other to understand the results of the Company’s operations on a consolidated basis and how management operates the Company.

This report also includes separate Item 4—Controls and Procedures sections, signature pages and Exhibit 31 and 32 certifications for each of the Parent Company and the Operating Partnership in order to establish that the Chief Executive Officer and the Chief Financial Officer of the Parent Company and the Chief Executive Officer and the Chief Financial Officer of the Operating Partnership have made the requisite certifications and that the Parent Company and the Operating Partnership are compliant with Rule 13a-15 or Rule 15d-15 of the Securities Exchange Act of 1934, as amended and 18 U.S.C. §1350.

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LIFE STORAGE, INC.

CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements.

4

LIFE STORAGE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

See notes to consolidated financial statements.

5

LIFE STORAGE, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME

(unaudited)

See notes to consolidated financial statements.

6

LIFE STORAGE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

See notes to consolidated financial statements.

7

LIFE STORAGE LP

CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements.

8

LIFE STORAGE LP

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

See notes to consolidated financial statements.

9

LIFE STORAGE LP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME

(unaudited)

See notes to consolidated financial statements.

10

LIFE STORAGE LP

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

See notes to consolidated financial statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The accompanying unaudited financial statements of Life Storage, Inc., formerly known as Sovran Self Storage, Inc., (the “Parent Company”) and Life Storage LP, formerly known as Sovran Acquisition Limited Partnership, (the “Operating Partnership”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine month period ended September 30, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016.

Reclassification: Certain amounts from the 2015 financial statements have been reclassified to conform with the current year presentation as described in Note 5.

Effective August 15, 2016, the Parent Company changed its name from “Sovran Self Storage, Inc.” to “Life Storage, Inc.” and the Operating Partnership changed its name from “Sovran Acquisition Limited Partnership” to “Life Storage LP”. Also, consistent with these name changes, and in connection with the rebranding of our storage facilities from “Uncle Bob’s Self Storage ^®“ to “Life Storage ^®“, the name of the general partner of the Operating Partnership has been changed from “Sovran Holdings, Inc.” to “Life Storage Holdings, Inc.” and the name of the Parent Company’s taxable REIT subsidiary changed from “Uncle Bob’s Management, LLC” to “Life Storage Solutions, LLC”.

The Parent Company operates as a self-administered and self-managed real estate investment trust (a “REIT”) that owns and operates self-storage facilities throughout the United States. All of the Parent Company’s assets are owned by, and all its operations are conducted through, the Operating Partnership. Life Storage Holdings, Inc., a wholly-owned subsidiary of the Parent Company (“Holdings”), is the sole general partner of the Operating Partnership; the Parent Company is a limited partner of the Operating Partnership, and through its ownership of Holdings and its limited partnership interest controls the operations of the Operating Partnership, holding a 99.6% ownership interest therein as of September 30, 2016. The remaining ownership interests in the Operating Partnership (the “Units”) are held by certain former owners of assets acquired by the Operating Partnership. The Parent Company, the Operating Partnership and their consolidated subsidiaries are collectively referred to in this report as the “Company.” In addition, terms such as “we,” “us,” or “our” used in this report may refer to the Company, the Parent Company and/or the Operating Partnership.

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At September 30, 2016, we had an ownership interest in, and/or managed 657 self-storage properties in 29 states under the names Uncle Bob’s Self Storage ^® and Life Storage ^®. Among our 657 self-storage properties are 39 properties that we manage for an unconsolidated joint venture (Sovran HHF Storage Holdings LLC) of which we are a 20% owner, 30 properties that we manage for an unconsolidated joint venture (Sovran HHF Storage Holdings II LLC) of which we are a 15% owner, and 26 properties that we manage and have no ownership interest. Approximately 39.0% of the Company’s revenue is derived from stores in the states of Texas and Florida. In addition, approximately 9.9% of the Company’s revenue is derived from the Houston, Texas market.

We consolidate all wholly-owned subsidiaries. Partially owned subsidiaries and joint ventures are consolidated when we control the entity. Our consolidated financial statements include the accounts of the Parent Company, the Operating Partnership, Life Storage Solutions, LLC (the Parent Company’s taxable REIT subsidiary), Warehouse Anywhere LLC (an entity owned 60% by Life Storage Solutions, LLC), and all other wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated. Investments in joint ventures that we do not control but for which we have significant influence over are accounted for using the equity method.

Included in the Parent Company’s consolidated balance sheets are noncontrolling redeemable operating partnership units and included in the Operating Partnership’s consolidated balance sheets are limited partners’ redeemable capital interest at redemption value. These interests are presented in the “mezzanine” section of the consolidated balance sheet because they do not meet the functional definition of a liability or equity under current accounting literature. These represent the outside ownership interests of the limited partners in the Operating Partnership. At September 30, 2016, there were 196,008 noncontrolling redeemable operating partnership Units outstanding (168,866 at December 31, 2015). These unitholders are entitled to receive distributions per unit equivalent to the dividends declared per share on the Parent Company’s common stock. The Operating Partnership is obligated to redeem each of these limited partnership Units in the Operating Partnership at the request of the holder thereof for cash equal to the fair market value of a share of the Parent Company’s common stock, at the time of such redemption, provided that the Company at its option may elect to acquire any such Unit presented for redemption for one common share or cash. The Company accounts for these noncontrolling redeemable Operating Partnership Units under the provisions of EITF D-98, “Classification and Measurement of Redeemable Securities” which was codified in FASB ASC Topic 480-10-S99. The application of the FASB ASC Topic 480-10-S99 accounting model requires the noncontrolling interest to follow normal noncontrolling interest accounting and then be marked to redemption value at the end of each reporting period if higher (but never adjusted below that normal noncontrolling interest accounting amount). The offset to the adjustment to the carrying amount of the noncontrolling interests is reflected in the Company’s dividends in excess of net income and in the Operating Partnership’s general partner and limited partners capital balances. Accordingly, in the accompanying consolidated balance sheets, noncontrolling interests are reflected at redemption value at September 30, 2016 and December 31, 2015, equal to the number of noncontrolling interest units outstanding multiplied by the fair market value of the Parent Company’s common stock at that date. Redemption value exceeded the value determined under the Company’s historical basis of accounting at those dates.

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The following is a reconciliation of the Parent Company’s noncontrolling redeemable Operating Partnership Units for the period:

The following is a reconciliation of the Operating Partnership’s limited partners’ redeemable capital interest for the period:

In 2016 the Operating Partnership issued 69,005 Units with a fair market value of $7.8 million to acquire self-storage properties. The fair value of the Units on the date of issuance was determined based upon the fair market value of the Parent Company’s common stock on that date.

The Company accounts for stock-based compensation under the provisions of ASC Topic 718, “Compensation—Stock Compensation”. The Company recognizes compensation cost in its financial statements for all share based payments granted, modified, or settled during the period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the related vesting period.

For the three months ended September 30, 2016 and 2015, the Company recorded compensation expense (included in general and administrative expense) of $4,000 and $46,000, respectively, related to stock options and $1,758,000 and $1,552,000, respectively, related to amortization of non-vested stock grants and performance-based awards. For the nine months ended September 30, 2016 and 2015, the Company recorded compensation expense of $85,000 and $163,000, respectively, related to stock options and $5,515,000 and $4,743,000, respectively, related to amortization of non-vested stock grants and performance-based awards.

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During the three months ended September 30, 2016 and 2015, employees and directors exercised 0 and 1,900 stock options respectively, and 29,205 and 31,078 shares of non-vested stock, respectively, vested. During the nine months ended September 30, 2016 and 2015, employees and directors exercised 0 and 16,900 stock options respectively, and 40,086 and 42,307 shares of non-vested stock, respectively, vested.

The following summarizes our activity in storage facilities during the nine months ended September 30, 2016.

On July 15, 2016, the Company acquired all of the outstanding partnership interests in LifeStorage, LP, a Delaware limited partnership (“LS”). Pursuant to the acquisition, the Company acquired 83 self-storage properties throughout the country, including the following markets: Chicago, Illinois; Las Vegas, Nevada; Sacramento, California; Austin, Texas; and Los Angeles, California. Pursuant to the terms of the Agreement and Plan of Merger dated as of May 18, 2016 by and among LS, the Operating Partnership, Solar Lunar Sub, LLC, a Delaware limited liability company and wholly-owned subsidiary of the Operating Partnership, and Fortis Advisors LLC, a Delaware limited liability company, as Sellers’ Representative, the Company paid aggregate consideration of approximately $1.3 billion, of which $482 million was paid to discharge existing indebtedness of LS (including prepayment penalties and defeasance costs totaling $15.5 million). The merger was funded with the existing cash that was generated primarily from the proceeds from the Company’s May 2016 common stock offering and the 2026 Senior Notes offering, and draws on the Company’s line of credit totaling $482 million.

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Including the LS acquisition, the Company acquired 120 facilities during the nine months ended September 30, 2016. The acquisition of two stores that were acquired at certificate of occupancy were accounted for as asset acquisitions. The cost of these stores, including closing costs, was assigned to land, building, equipment and improvements components based upon their relative fair values. The assets and liabilities of the other 118 storage facilities acquired in 2016, which primarily consist of tangible and intangible assets, are measured at fair value on the date of acquisition in accordance with the principles of FASB ASC Topic 820, “Fair Value Measurements and Disclosures” and were accounted for as business combinations in accordance with the principles of FASB ASC Topic 805 “Business Combinations.” The purchase price of the 120 facilities acquired in 2016 has been preliminarily assigned as follows:

All of the properties acquired were purchased from unrelated third parties. The operating results of the facilities acquired have been included in the Company’s operations since the respective acquisition dates. The $1,783.0 million of cash paid for the properties acquired during 2016 includes payment for cash acquired of $40.8 million and $4.0 million of deposits that were paid in 2015 when certain of these properties originally went under contract. Both of these amounts are excluded from total cash payments for the acquisition of storage facilities in the consolidated statement of cash flows.

Non-cash investing activities during 2016 include the issuance of $7.8 million in Operating Partnership Units, the assumption of two mortgages with outstanding balances of $8.3 million, and the assumption of net other liabilities of $7.3 million.

The Company measures the fair value of in-place customer lease intangible assets based on the Company’s experience with customer turnover and the cost to replace the in-place leases. The Company amortizes in-place customer leases on a straight-line basis over 12 months (the estimated future benefit period). The Company measures the value of trade names, which have an indefinite life and are not amortized, by calculating discounted cash flows utilizing the relief from royalty method.

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In-place customer leases are included in other assets on the Company’s consolidated balance sheets as follows:

Amortization expense related to in-place customer leases was $13.5 million and $0.7 million for the three months ended September 30, 2016 and 2015, respectively and was $16.5 million and $2.7 million for the nine months ended September 30, 2016 and 2015, respectively. The Company expects to record $29.9 million and $24.7 million of amortization expense for the years ended December 31, 2016 and 2017, respectively.

During the nine months ended September 30, 2016, the Company acquired 120 properties. The following pro forma information is based on the combined historical financial statements of the Company and the 120 properties acquired during the nine months ended September 30, 2016 as if the acquisitions had all occurred as of January 1, 2015.

The above pro forma information includes the results of eight stores acquired by LS in 2016 and 17 stores acquired by LS in in 2015. These stores therefore were not owned by LS for the entire pro forma periods and results prior to LS ownership are not included in the above pro forma information. The above pro forma information also includes increases in amortization of in-place customer leases totaling $13.3 million and $39.9 million for the three and nine month periods ending September 30, 2015, respectively. As noted above, in-place customer leases are amortized over their estimated future benefit period of 12 months. Material, nonrecurring pro forma adjustments directly attributable to the business combinations and included in the above pro forma financial information include reductions to interest expense related to acquisition bridge financing totaling $7.3 million for the nine months ended September 30, 2016 and reductions to acquisition costs totaling $25.2 million and $29.3 million for the three and nine months ended September 30, 2016, respectively.

The following table summarizes the revenues and earnings since the acquisition dates that are included in the Company’s consolidated statements of operations for the nine months ended September 30, 2016 related to the 120 properties acquired during the three and nine months ended September 30, 2016.

17

The above net losses attributable to common shareholders were primarily due to amortization of in-place customer leases acquired and the acquisition costs incurred in connection with the 2016 acquisitions.

Property Dispositions

During 2016 the Company sold eight non-strategic properties with a carrying value of $18.8 million and received cash proceeds of $34.1 million, resulting in a $15.3 million gain on sale. During 2015 the Company sold three non-strategic properties purchased in 2014 and 2015 with a carrying value of $5.1 million and received cash proceeds of $4.6 million, resulting in a $0.5 million loss on sale. The following table summarizes the revenues and expenses up to the dates of sale of the 11 properties sold in 2016 and 2015 that are included in the Company’s consolidated statements of operations for 2016 and 2015.

Change in Signage Useful Life Estimates

The change in name of the Company’s storage facilities from Uncle Bob’s Self Storage ^® to Life Storage ^® as discussed in Note 2 will require replacement of signage at all existing storage facilities which are currently included in investment in storage facilities, net on the consolidated balance sheets. The replacement of this signage is being completed at various times based on market and is expected to be completed in the first half of 2017. The Company has reassessed the estimated useful lives of the existing signage which resulted in an increase in depreciation expense of approximately $4 million in the third quarter of 2016 as depreciation was accelerated over the new useful lives. The Company estimates that this change will result in additional increases in depreciation expense of approximately $4 million in the fourth quarter of 2016 and approximately $1 million in 2017 as a result of the replacement of this existing Uncle Bob’s Self Storage ^® signage.

The accelerated depreciation reduced basic earnings per share/unit by approximately $0.10 and $0.11 for the three and nine months ended September 30, 2016, respectively, and reduced diluted earnings per share/unit by approximately $0.10 for the three and nine months ended September 30, 2016.

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Borrowings outstanding on our unsecured line of credit and term notes are as follows:

In January 2016, the Company exercised the expansion feature on its existing amended unsecured credit agreement and increased the revolving credit limit from $300 million to $500 million. The interest rate on the revolving credit facility bears interest at a variable annual rate equal to LIBOR plus a margin based on the Company’s credit rating (at September 30, 2016 the margin is 1.10%), and requires an annual 0.15% facility fee. The amended agreement also reduced the interest rate on the $325 million unsecured term note issued under this credit agreement maturing June 4, 2020, with the term note bearing interest at LIBOR plus a margin based on the Company’s credit rating (at September 30, 2016 the margin is 1.15%). The interest rate at September 30, 2016 on the Company’s line of credit was approximately 1.62% (1.72% at December 31, 2015). At September 30, 2016, there was $260 million available on the unsecured line of credit. The revolving line of credit has a maturity date of December 10, 2019.

On July 21, 2016, the Company entered into a $200 million term note maturing July 21, 2028 bearing interest at a fixed rate of 3.67%. The proceeds from this term note were used to repay a portion of the then outstanding balance on the Company’s line of credit.

On April 8, 2014, the Company entered into a $175 million term note maturing April 8, 2024 bearing interest at a fixed rate of 4.533%. The interest rate on the term note increases to 6.283% if the Company is not rated by at least one rating agency or if the Company’s credit rating is downgraded. The proceeds from this term note were used to repay the $115 million outstanding on the Company’s line of credit at April 8, 2014, with the excess proceeds used for acquisitions.

In 2011, the Company entered into a $100 million term note maturing August 5, 2021 bearing interest at a fixed rate of 5.54%. The interest rate on the term note increases to 7.29% if the notes are not rated by at least one rating agency, the credit rating on the notes is downgraded or if the Company’s credit rating is downgraded. The proceeds from this term note were used to fund acquisitions and investments in unconsolidated joint ventures.

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The Company has maintained a $150 million unsecured term note maturing April 26, 2016 bearing interest at 6.38%. The Company used a draw on the line of credit to pay off the balance of this note on April 26, 2016.

The line of credit and term notes require the Company to meet certain financial covenants, measured on a quarterly basis, including prescribed leverage, fixed charge coverage, minimum net worth, limitations on additional indebtedness and limitations on dividend payouts. At September 30, 2016, the Company was in compliance with its debt covenants.

We believe that if operating results remain consistent with historical levels and levels of other debt and liabilities remain consistent with amounts outstanding at September 30, 2016 the entire availability on the line of credit could be drawn without violating our debt covenants.

On May 17, 2016, the Company entered into two senior unsecured acquisition bridge facilities (the “Bridge Facilities”) totaling $1,675 million with the Company’s third-party advisors to the LS acquisition (see Note 4). In consideration for the bridge financing commitments, the Company paid fees totaling $7.3 million which are included as interest expense – acquisition bridge financing commitment fee in the consolidated statements of operations for the nine month period ending September 30, 2016. The Bridge Facilities commitments were terminated on June 29, 2016.

On June 20, 2016, the Operating Partnership issued $600 million in aggregate principal amount of 3.50% unsecured senior notes due July 1, 2026 (the “2026 Senior Notes”). The 2026 Senior Notes were issued at a 0.553% discount to par value. Interest on the 2026 Senior Notes is payable semi-annually in arrears on January 1 and July 1, beginning on January 1, 2017. The 2026 Senior Notes are fully and unconditionally guaranteed by the Parent Company. Proceeds received upon issuance, net of discount to par of $3.3 million and underwriting discount and other offering expenses of $5.5 million, totaled $591.2 million. The indenture under which the 2026 Senior Notes were issued restricts the ability of the Company and its subsidiaries to incur debt unless the Company and its consolidated subsidiaries comply with a leverage ratio not to exceed 60% and an interest coverage ratio of more than 1.5:1 on all outstanding debt, after giving effect to the incurrence of the debt. The indenture also restricts the ability of the Company and its subsidiaries to incur secured debt unless the Company and its consolidated subsidiaries comply with a secured debt leverage ratio not to exceed 40% after giving effect to the incurrence of the debt. The indenture also contains other financial and customary covenants, including a covenant not to own unencumbered assets with a value less than 150% of the unsecured indebtedness of the Company and its consolidated subsidiaries. As of September 30, 2016, the Company was in compliance with all of the financial covenants under the 2026 Senior Notes.

During April 2015, the FASB issued ASU No. 2015-03, Interest—Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs, which amends the requirements for the presentation of debt issuance costs and requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. ASU No. 2015-03 is effective for fiscal years, beginning after December 15, 2015 and interim periods within those fiscal years, with retrospective application required. Consistent with the guidance in ASU No. 2015-03 there are $3.4 million of debt issuance costs that have been presented as a reduction of term notes in our accompanying consolidated balance sheets at December 31, 2015 that were previously classified in other assets prior to the adoption of ASU No. 2015-03. The implementation of this accounting standards update had no effect on our results of operations or cash flows.

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In August 2015, the FASB issued Accounting Standards Update 2015-15, “Imputation of Interest (Subtopic 835-30): Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements” (“ASU 2015-15”). ASU 2015-15 codifies an SEC staff announcement that entities are permitted to defer and present debt issuance costs related to line-of-credit arrangements as assets. ASU No. 2015-15 is effective for fiscal years, beginning after December 15, 2015 and interim periods within those fiscal years. The implementation of this update did not result in any changes to our consolidated financial statements.

The Company’s fixed rate term notes contain a provision that allows for the noteholders to call the debt upon a change of control of the Company at an amount that includes a make whole premium based on rates in effect on the date of the change of control. At this time no change in control is planned or anticipated.

Mortgages payable at September 30, 2016 and December 31, 2015 consist of the following:

The table below summarizes the Company’s debt obligations and interest rate derivatives at September 30, 2016. The estimated fair value of financial instruments is subjective in nature and is dependent on a number of important assumptions, including discount rates and relevant comparable market information associated with each financial instrument. The fair value of the fixed rate term notes and mortgage notes were estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. These assumptions are considered Level 2 inputs within the fair value hierarchy as described in Note 8. The carrying values of our variable rate debt instruments approximate their fair values as these debt instruments bear interest at current market rates that approximate market participant rates. This is considered a Level 2 input within the fair value hierarchy. The use of different market assumptions and estimation methodologies may have a material effect on the reported estimated fair value amounts. Accordingly, the estimates presented below are not necessarily indicative of the amounts the Company would realize in a current market exchange.

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Interest rate swaps are used to adjust the proportion of total debt that is subject to variable interest rates. The interest rate swaps require the Company to pay an amount equal to a specific fixed rate of interest times a notional principal amount and to receive in return an amount equal to a variable rate of interest times the same notional amount. The notional amounts are not exchanged. Forward starting interest rate swaps are also used by the Company to hedge the risk of changes in the interest-related cash outflows associated with the potential issuance of long-term debt. No other cash payments are made unless the contract is terminated prior to its maturity, in which case the contract would likely be settled for an amount equal to its fair value. The Company enters into interest rate swaps with a number of major financial institutions to minimize counterparty credit risk.

The interest rate swaps qualify and are designated as hedges of the amount of future cash flows related to interest payments on variable rate debt. Therefore, the interest rate swaps are recorded in the consolidated balance sheet at fair value and the related gains or losses are deferred in shareholders’ equity or partners’ capital as Accumulated Other Comprehensive Loss (“AOCL”). These deferred gains and losses are recognized in interest expense during the period or periods in which the related interest payments affect earnings. However, to the extent that the interest rate swaps are not perfectly effective in offsetting the change in value of the interest payments being hedged, the ineffective portion of these contracts is recognized in earnings immediately. Ineffectiveness was de minimis for the three and nine months ended September 30, 2016, and 2015.

The Company has interest rate swap agreements in effect at September 30, 2016 as detailed below to effectively convert a total of $325 million of variable-rate debt to fixed-rate debt.

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In the fourth quarter of 2015, the Company entered into forward starting interest rate swap agreements with a total notional value of $50 million. In the first quarter of 2016, the Company entered into additional forward starting interest rate swap agreements with a total notional value of $100 million. These forward starting interest rate swap agreements were entered into to hedge the risk of changes in the interest-related cash flows associated with the potential issuance of fixed rate long-term debt. In conjunction with the issuance of the $600 million 2026 Senior Notes (see Note 5), the Company settled the forward starting swap agreements for a loss of approximately $9.2 million. The loss was recorded as accumulated other comprehensive loss and is being amortized as additional interest expense over the ten-year term of the $600 million 2026 Senior Notes. Consistent with the Company’s accounting policy, the cash outflow related to the settlement of the forward starting swap agreements is reflected as a financing activity in the consolidated statements of cash flows.

The interest rate swap agreements are the only derivative instruments, as defined by FASB ASC Topic 815 “Derivatives and Hedging”, held by the Company. During the three months ended September 30, 2016 and 2015, the net reclassification from AOCL to interest expense was $1.2 million and $1.2 million, respectively, based on payments made under the swap agreements. During the nine months ended September 30, 2016 and 2015, the net reclassification from AOCL to interest expense was $3.5 million and $3.9 million, respectively, based on payments made under the swap agreements. Reclassification of amounts included in AOCL at September 30, 2016 to interest expense will be approximately $4.3 million for the 12 months ended September 30, 2017. Payments made under the interest rate swap agreements will be reclassified to interest expense as settlements occur or as payments under the 2026 Senior Notes are made. The fair value of the swap agreements, including accrued interest, was a liability of $19.2 million at September 30, 2016, and an asset of $550,000 and a liability of $15.3 million at December 31, 2015.

The Company’s agreements with its interest rate swap counterparties contain provisions pursuant to which the Company could be declared in default of its derivative obligations if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender. The interest rate swap agreements also incorporate other loan covenants of the Company. Failure to comply with the loan covenant provisions would result in the Company being in default on the interest rate swap agreements. As of September 30, 2016, the Company had not posted any collateral related to the interest rate swap agreements. If the Company had breached any of these provisions as of September 30, 2016, it could have been required to settle its obligations under the agreements at their net termination cost of $19.2 million.

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The changes in AOCL for the three and nine months ended September 30, 2016 and September 30, 2015 are summarized as follows: