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PILLARSTONE CAPITAL REIT - Annual Report: 2018 (Form 10-K)

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

FORM 10-K

(Mark One)
x     ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2018
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: 001-15409
______________________________

PILLARSTONE CAPITAL REIT

(Exact Name of Registrant as Specified in Its Charter)
Maryland
 
39-6594066
(State or Other Jurisdiction of Incorporation or
 
(I.R.S. Employer
Organization)
 
Identification No.)
 
 
 
2600 South Gessner, Suite 555, Houston, Texas
 
77063
(Address of Principal Executive Offices)
 
(Zip Code)
Registrant's telephone number, including area code: (832) 810-0100
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Shares of Beneficial Interest, par value $0.01 per share
(Title of Class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
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. Yes x No o
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes o No x
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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):
Large accelerated filer o Accelerated filer o     Non-accelerated filer x     Smaller reporting company x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
The aggregate market value of the voting common shares held by non-affiliates of the registrant as of June 30, 2018 (the last business day of the registrant's most recently completed second fiscal quarter) was approximately $502,709 based on the closing price of $2.80 per common share on the Over-The-Counter Bulletin Board on that date.
As of March 26, 2019, the Registrant had issued 443,299 common shares of beneficial interest and had 405,169 shares outstanding after deducting 38,130 shares held in treasury.


DOCUMENTS INCORPORATED BY REFERENCE: We incorporate by reference in Part III of this Annual Report on Form 10-K portions of our definitive proxy statement for our 2019 Annual Meeting of Shareholders, which proxy statement will be filed no later than 120 days after the end of our fiscal year ended December 31, 2018.



PILLARSTONE CAPITAL REIT
FORM 10-K
Year Ended December 31, 2018


 
Page
 
 
 
 
 
 
 
Item 1.
 
Item 1B.
 
Item 2.   
 
Item 3.    
 
Item 4.       
 
 
 
 
Item 5.  
 
Item 7. 
 
Item 8.    
 
Item 9.
 
Item 9A.  
 
Item 9B. 
 
 
 
 
Item 10.  
 
Item 11.
 
Item 12. 
 
Item 13.   
 
Item 14.    
 
 
 
 
Item 15.  
 
 
 
 
 
 




Unless the context otherwise requires, all references in this report to the “Company,” “we,” “us” or “our” are to Pillarstone Capital REIT and its consolidated subsidiaries.

Forward-Looking Statements

The following discussion should be read in conjunction with our audited consolidated financial statements and the notes thereto in this Annual Report on Form 10-K. 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the federal securities laws, including discussion and analysis of our financial condition, anticipated capital expenditures required to complete projects, amounts of anticipated cash distributions to our shareholders in the future and other matters. These forward-looking statements are not historical facts but are the intent, belief or current expectations of our management based on its knowledge and understanding of our business and industry. Forward-looking statements are typically identified by the use of terms such as “may,” “will,” “should,” “potential,” “predicts,” “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates” or the negative of such terms and variations of these words and similar expressions, although not all forward-looking statements include these words. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond our control, are difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements.
 
Forward-looking statements that were true at the time made may ultimately prove to be incorrect or false. You are cautioned not to place undue reliance on forward-looking statements, which reflect our management’s view only as of the date of this Annual Report on Form 10-K. We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results. Factors that could cause actual results to differ materially from any forward-looking statements made in this Annual Report on Form 10-K include:
 
•
uncertainties related to the national economy, the real estate industry in general and in our specific markets;
•
legislative or regulatory changes;
•
adverse economic conditions in Texas;
•
adverse changes in governmental rules and fiscal policies;
•
increases in interest rates and operating costs;
•
availability and terms of capital and financing, both to fund our operations and to refinance our indebtedness as it matures;
•
decreases in rental rates or increases in vacancy rates; 
•
litigation risks; 
•
lease-up risks, including leasing risks arising from exclusivity and consent provisions in leases with significant tenants; 
•
our inability to renew tenants or obtain new tenants upon the expiration of existing leases; and 
•
our inability to generate sufficient cash flows due to market conditions, competition, uninsured losses, changes in tax or other applicable laws.

In addition, an investment in the Company involves numerous risks that potential investors should consider carefully, including, without limitation:
•
our cash resources are limited;
•
we have a history of losses;
•
we have not raised funds through a public equity offering;
•
our trustees control a significant percentage of our voting shares;
•
shareholders could experience possible future dilution through the issuance of additional shares;
•
we are dependent on a small number of key senior professionals who are part-time employees; and
•
we currently do not plan to distribute dividends to the holders of our shares.
     

1

PART I

Item 1. Business.

Company Overview
Pillarstone Capital REIT (the “Company,” “Pillarstone,” “we,” “our,” or “us”) is a Maryland real estate investment trust engaged in investing in, owning and operating commercial properties. Future real estate investments may include (i) acquisition and development of retail, office, office warehouse, industrial, multifamily, hotel, and other commercial properties, (ii) acquisition of or merger with a real estate investment trust (“REIT”) or a real estate operating company and (iii) joint venture investments. Excess funds can be invested in cash equivalents depending on market conditions.
The Company was formed on March 15, 1994 as a Maryland REIT. The Company operated as a traditional real estate investment trust by buying, selling, owning and operating commercial and residential properties through December 31, 1999. In 2000, the Company purchased a software technology company, resulting in the Company no longer meeting qualifications to be a REIT under the Internal Revenue Code of 1986, as amended (the “Code”). In 2002, the Company discontinued the operations of the technology segment.
From 2003 through 2006, we pursued a value-added business plan primarily focused on acquiring well located, under-performing multi-family residential properties, including affordable housing communities, and repositioning them through renovation, leasing, improved management and branding. In 2006, the Company did not complete a public offering for a portfolio acquisition due to market conditions, and consequently, was not able to meet the listing requirements of the former American Stock Exchange (“Amex”). Accordingly, Pillarstone’s common shares were delisted from the Amex and commenced being quoted on the Over-The-Counter Bulletin Board (“OTC Bulletin Board”) and on the pink sheets under the symbol “PRLE”.
From 2006 until December 2016, the Company continued its existence as a corporate shell filing its quarterly and annual reports with the Securities and Exchange Commission ("SEC") so that it could be used for future real estate transactions. During this time, the Company was funded by the trustees who contributed $500,000 in exchange for 125,000 Class C Convertible Preferred Shares and $197,780 in exchange for convertible notes payable. In 2016, the shareholders of Pillarstone approved changing the Company's name from Paragon Real Estate Equity and Investment Trust to Pillarstone Capital REIT.
Substantially all of our business is conducted through Pillarstone Capital REIT Operating Partnership LP, a Delaware limited partnership organized in 2016 (“Pillarstone OP”). We are the sole general partner of Pillarstone OP. As of December 31, 2018, we owned 18.6% of the outstanding equity in Pillarstone OP and fully consolidate it on our financial statements.
On December 8, 2016, Pillarstone and Pillarstone OP entered into a Contribution Agreement (the “Contribution Agreement”) with Whitestone REIT Operating Partnership, L.P. (“Whitestone OP”), a subsidiary and the operating partnership of Whitestone REIT (“Whitestone”), both of which are related parties to Pillarstone and Pillarstone OP. Pursuant to the terms of the Contribution Agreement, Whitestone OP contributed to Pillarstone OP all of the equity interests in four of its wholly-owned subsidiaries: Whitestone CP Woodland Ph. 2, LLC, a Delaware limited liability company (“CP Woodland”); Whitestone Industrial-Office, LLC, a Texas limited liability company (“Industrial-Office”); Whitestone Offices, LLC, a Texas limited liability company (“Whitestone Offices”); and Whitestone Uptown Tower, LLC, a Delaware limited liability company (“Uptown Tower”, and together with CP Woodland, Industrial-Office and Whitestone Offices, the “Entities”) that owned 14 real estate assets (the “Real Estate Assets” and, together with the Entities, the “Property”) for aggregate consideration of approximately $84 million, consisting of (1) approximately $18.1 million of Class A units representing limited partnership interests in Pillarstone OP (“OP Units”), issued at a price of $1.331 per OP Unit; and (2) the assumption of approximately $65.9 million of liabilities by Pillarstone OP, consisting of (a) approximately $15.5 million of Whitestone OP’s liability under that certain Amended and Restated Credit Agreement, dated as of November 7, 2014, as amended, among the Bank of Montreal, as Administrative Agent (the “Agent”), the lenders party thereto, BMO Capital Markets, Wells Fargo Securities, LLC, Merrill Lynch, Pierce, Fenner & Smith Incorporated, and U.S. Bank, National Association, Whitestone OP, as borrower, and Whitestone and certain subsidiaries of Whitestone OP, as guarantors (as amended, the “Whitestone Credit Facility”); (b) an approximately $16.3 million promissory note (the “Whitestone Uptown Tower Promissory Note”) of Uptown Tower issued under that certain Loan Agreement, dated as of September 26, 2013, (as amended, the “Whitestone Uptown Tower Loan Agreement” and, together with the Whitestone Uptown Tower Promissory Note, the “Whitestone Uptown Tower Loan Documents”) between Uptown Tower, as borrower, and U.S. Bank National Association, as successor to Morgan Stanley Mortgage Capital Holdings LLC, as lender, and (c) an approximately $34.1 million promissory note (the “Whitestone Industrial-Office Promissory Note”) of Industrial-Office issued under that certain Loan Agreement, dated as of November 26,

2

2013 (the “Whitestone Industrial-Office Loan Agreement” and, together with the Whitestone Industrial-Office Promissory Note, the “Whitestone Industrial-Office Loan Documents”), between Industrial-Office, as borrower, and Jackson National Life Insurance Company, as lender (collectively, the “Acquisition”). During 2018, Pillarstone OP sold three of the Real Estate Assets.
Pursuant to the Contribution Agreement, Pillarstone agreed to file with the SEC on or prior to June 8, 2018, a shelf registration statement to register for sale under the Securities Act of 1933, as amended (the “Securities Act”), the issuance of the common shares of beneficial interest in Pillarstone (the “Common Shares”) that may be issued upon redemption of the OP Units issued pursuant to each of the Contribution Agreement and that certain OP Unit Purchase Agreement dated December 8, 2016 between Pillarstone, Pillarstone OP and Whitestone OP (the "OP Unit Purchase Agreement") and the offer and resale of such Common Shares by the holders thereof. In addition, pursuant to the Contribution Agreement, in the event of a Change of Control (as defined therein) of Whitestone, Pillarstone OP shall have the right, but not the obligation, to repurchase the OP Units issued thereunder from Whitestone OP at their initial issue price of $1.331 per OP Unit. Pillarstone and Whitestone agreed to extend the filing of the shelf registration statement to a date not later than June 8, 2019, or the date that the Company closes a public equity offering. On December 8, 2018, the OP Unit Purchase Agreement and the offer and resale of common shares terminated pursuant to its terms. There was no issuance of our Common Shares during 2018.
In connection with the Acquisition, (1) with respect to each Real Estate Asset (other than the Real Property Asset owned by Uptown Tower), Whitestone TRS, Inc. (“Whitestone TRS”), a subsidiary of Whitestone, entered into a Management Agreement with the Entity that owns such Real Estate Asset and (2) with respect to Uptown Tower, Whitestone TRS entered into a Management Agreement with Pillarstone OP (collectively, the “Management Agreements”). Pursuant to the Management Agreements with respect to each Real Estate Asset (other than Uptown Tower), Whitestone TRS agreed to provide certain property management, leasing and day-to-day advisory and administrative services to such Real Estate Asset in exchange for (x) a monthly property management fee equal to 5.0% of the monthly revenues of such Real Estate Asset and (y) a monthly asset management fee equal to 0.125% of GAV (as defined in each Management Agreement as, generally, the purchase price of the respective Real Estate Asset based upon the purchase price allocations determined pursuant to the Contribution Agreement, excluding all indebtedness, liabilities or claims of any nature) of such Real Estate Asset. Pursuant to the Management Agreement with respect to Uptown Tower, Whitestone TRS agreed to provide certain property management, leasing and day-to-day advisory and administrative services to Pillarstone OP in exchange for (x) a monthly property management fee equal to 3.0% of the monthly revenues of Uptown Tower and (y) a monthly asset management fee equal to 0.125% of GAV of Uptown Tower.
    
As a result of the Acquisition, Whitestone OP owns approximately 81.4% and Pillarstone owns approximately 18.6% of the outstanding equity in Pillarstone OP, which is fully consolidated on Pillarstone's financial statements.

Competition

We compete for the acquisition of properties with many entities, including, among others, publicly traded REITs, life insurance companies, pension funds, partnerships and individual investors. Many competitors have substantially greater financial resources than us. In addition, certain competitors may be willing to accept lower returns on their investments. If competitors prevent us from buying properties that may be targeted for acquisition, our capital appreciation and valuation may be impacted.

Employees
    
As of April 1, 2019, the Company has one full time employee, two part time employees and one full time independent contractor.

Reports to Security Holders
We file or furnish with the SEC pursuant to Section 13(a), 15(d) or 16(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports, proxy statements with respect to meetings of our shareholders, as well as Reports on Forms 3, 4 and 5 regarding our officers, trustees or 10% beneficial owners. The SEC also maintains an internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC as we do. The website address is http://www.sec.gov. Copies of our Audit Committee Charter, Management, Organization and Compensation Committee Charter, Nominating Committee Charter, and Code of Conduct and Ethics are available free of

3

charge through our website (www.pillarstone-capital.com). In the event of any changes to these documents, revised copies will also be made available on our website. Materials on our website are not part of our Annual Report on Form 10-K. The contents of these websites are not incorporated into this filing.

Item 1B.  Unresolved Staff Comments.
 
None.

Item 2.  Properties.

General Physical and Economic Attributes
 
Pursuant to the Contribution Agreement, Pillarstone, through Pillarstone OP, acquired an investment portfolio consisting of 14 Real Estate Assets. During 2018, Pillarstone OP sold three of the Real Estate Assets. The following table sets forth certain information relating to each of our properties owned as of December 31, 2018.
 
 
Community Name
 
 
 
Location
 
 
Year Built/
Renovated
 
GLA
 
Percent
Occupied at
12/31/2018
 
Annualized Base
Rental Revenue 
(in thousands) (1)
 
Average
Base Rental
Revenue Per
Sq. Ft. (2)
 
Average Net Effective Annual Base Rent Per Leased Sq. Ft.(3)
9101 LBJ Freeway
 
Dallas
 
1985
 
125,874

 
62
%
 
$
1,209

 
$
15.49

 
$
15.15

Corporate Park Northwest
 
Houston
 
1981
 
174,359

 
78
%
 
1,659

 
12.20

 
12.54

Corporate Park West
 
Houston
 
1999
 
175,665

 
83
%
 
1,625

 
11.15

 
11.45

Corporate Park Woodland
 
Houston
 
2000
 
99,937

 
93
%
 
880

 
9.47

 
11.13

Corporate Park Woodland II
 
Houston
 
2000
 
14,344

 
100
%
 
232

 
16.17

 
16.38

Holly Hall Industrial Park
 
Houston
 
1980
 
90,000

 
67
%
 
544

 
9.02

 
8.39

Holly Knight
 
Houston
 
1984
 
20,015

 
95
%
 
340

 
17.88

 
17.83

Interstate 10 Warehouse
 
Houston
 
1980
 
151,000

 
85
%
 
713

 
5.56

 
5.44

Plaza Park
 
Houston
 
1982
 
105,530

 
75
%
 
569

 
7.19

 
7.81

Uptown Tower
 
Dallas
 
1982
 
253,981

 
80
%
 
3,825

 
18.83

 
19.58

Westgate Service Center
 
Houston
 
1984
 
97,225

 
87
%
 
610

 
7.21

 
7.01

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total / Weighted Average
 
 
 
 
 
1,307,930

 
80
%
 
$
12,206

 
$
11.67

 
$
12.00


(1) 
Calculated as the tenant's actual December 31, 2018 base rent (defined as cash base rents including abatements) multiplied by 12. Excludes vacant space as of December 31, 2018. Because annualized base rental revenue is not derived from historical results that were accounted for in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”), historical results differ from the annualized amounts. Total abatements for leases in effect as of December 31, 2018 equaled approximately $46,000 for the month ended December 31, 2018.
 
(2)   
Calculated as annualized base rent divided by gross leasable area ("GLA") leased as of December 31, 2018.  Excludes vacant space as of December 31, 2018.

(3) 
Represents (i) the contractual base rent for leases in place as of December 31, 2018, adjusted to a straight-line basis to reflect changes in rental rates throughout the lease term and amortized free rent periods and abatements, but without regard to tenant improvement allowances and leasing commissions, divided by (ii) square footage under commenced leases of December 31, 2018.

Item 3.  Legal Proceedings.
 
We may from time to time become a party to legal proceedings and claims that arise in the ordinary course of our business.  These matters are generally covered by insurance.  While the frequency and resolutions of any such matters cannot be predicted with certainty, we believe that occurrence and outcomes of these matters will not have a material effect on our financial position, results of operations or cash flows.

Item 4.  Mine Safety Disclosures.

Not applicable.

4

PART II

Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities.
 
Market Information
 
Common Shares

Our Common Shares are quoted on the OTC Bulletin Board and on the pink sheets with the symbol "PRLE". The number of holders of record of our Common Shares was 102 as of March 26, 2019, and we estimate we have approximately 304 beneficial holders of Common Shares as of that date. As of March 26, 2019, we had 405,169 Common Shares of beneficial interest outstanding.

The following table sets forth the quarterly high and low sale prices per share of our Common Shares for the years ended December 31, 2108 and 2017 as reported on the OTC Bulletin Board. The quotations shown represent inter-dealer prices without adjustment for retail markups, markdowns or commissions, and may not reflect actual transactions.

For the Year Ended December 31, 2018
 
High
 
Low
 
 
 
 
 
First Quarter
 
$
2.80

 
$
2.78

Second Quarter
 
$
2.80

 
$
2.80

Third Quarter
 
$
3.00

 
$
2.80

Fourth Quarter
 
$
3.00

 
$
2.40

 
 
 
 
 
For the Year Ended December 31, 2017
 
High
 
Low
 
 
 
 
 
First Quarter
 
$
5.25

 
$
3.00

Second Quarter
 
$
3.60

 
$
3.50

Third Quarter
 
$
3.50

 
$
3.24

Fourth Quarter
 
$
4.05

 
$
2.78



On March 26, 2019, the closing price of our Common Shares reported on the OTC Bulletin Board was $1.65 per share.

Our Class A Cumulative Convertible Preferred Shares ("Class A Preferred Shares") are quoted on the OTC Bulletin Board with the symbol "PRLEP". The number of holders of record of our Class A Preferred Shares is two. Class A Preferred shareholders have the right to convert their shares into Common Shares as follows: 95,226 Class A Preferred Shares are each convertible into 0.046 Common Shares and 161,410 Class A Preferred Shares are each convertible into 0.305 Common Shares.

Our Class C Convertible Preferred Shares were issued effective September 29, 2006 to the trustees of the Company who contributed cash and/or services for these shares. The Class C Convertible Preferred Shares are not quoted on an exchange or the OTC Bulletin Board.

Dividend Policy

We have not declared or paid dividends on our Common Shares since 1999, and we do not anticipate paying dividends on our Common Shares in the foreseeable future. Declaration or payment of dividends, if any, in the future, will be at the discretion of the board of trustees and will depend on our then current financial condition, results of operations, capital requirements and other factors deemed relevant by the board of trustees.
 
Issuer Purchases of Equity Securities

The Company did not purchase any of its equity securities in 2018.

5

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

Overview

The Company is a Maryland real estate investment trust engaged in investing in, owning and operating commercial properties. Future real estate investments may include (i) acquisition and development of retail, office, office warehouse, industrial, multifamily, hotel and other commercial properties, (ii) acquisition of or merger with a REIT or real estate operating company, and (iii) joint venture investments. Substantially all of our business is conducted through our operating partnership Pillarstone OP. We are the sole general partner of Pillarstone Capital REIT Operating Partnership LP ("Pillarstone OP"). As of December 31, 2018, we owned approximately 18.6% of the outstanding equity in Pillarstone OP and we fully consolidate it on our financial statements.

As of December 31, 2018, the Company is a smaller reporting company current in its quarterly and annual financial statement filings with the SEC, that may make future real estate investments. There can be no assurance that we will be able to close additional transactions.  Even if our management is successful in closing additional transactions, investors may not value the transactions or the Company in the same manner as we do, and investors may not value the transactions as they would value other transactions or alternatives. Failure to obtain additional sources of capital will materially and adversely affect the Company’s ability to continue operations, as well as its liquidity and financial results.

Brief History

Pillarstone was formed on March 15, 1994 as a Maryland REIT. The Company operated as a traditional real estate investment trust by buying, selling, owning and operating commercial and residential properties through December 31, 1999. In 2000, the Company purchased a software technology company, resulting in the Company not meeting the qualifications to be a REIT under the Code. In 2002, the Company discontinued the operations of the technology segment, and from 2003 through 2006, pursued a value-added business plan primarily focused on acquiring well located, under-performing multifamily residential properties, including affordable housing communities, and repositioning them through renovation, leasing, improved management and branding.

Executive Overview

During most of 2016, the Company existed as a corporate shell current in its SEC filings.

On December 8, 2016, Pillarstone and Pillarstone OP entered into the Contribution Agreement with Whitestone OP, a subsidiary and the operating partnership of Whitestone, both of which are related parties to Pillarstone and Pillarstone OP, pursuant to which Whitestone OP contributed to Pillarstone OP all of the equity interests in four of its wholly-owned subsidiaries: CP Woodland; Industrial-Office; Whitestone Offices; and Uptown Tower that own the Real Estate Assets for aggregate consideration of approximately $84 million, consisting of (1) approximately $18.1 million of Class A units representing limited partnership interests in Pillarstone OP issued at a price of $1.331 per OP Unit; and (2) the assumption of approximately $65.9 million of liabilities by Pillarstone OP (collectively, the “Acquisition”).
During 2018, the Company sold three of the Real Estate Assets, resulting in 11 Real Estate Assets in the Company's real estate portfolio at December 31, 2018.
Results of Operations

The following is a discussion of our results of operations and net income for the years ended December 31, 2018 and 2017 and financial condition, including:

•
Explanation of changes in the results of operations in the Consolidated Statements of Operations for the year ended December 31, 2018 compared to the year ended December 31, 2017.
•
Our critical accounting policies and estimates that require our subjective judgment and are important to the presentation of our financial condition and results of operations.
•
Our primary sources and uses of cash for the year ended December 31, 2018, and how we intend to generate cash for long-term capital needs.
•
Our current income tax status.

6

Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 

Leasing Activity

For the year ended December 31, 2018, we executed 143 leases for a total lease value of $17.5 million compared to 116 leases for a total lease value of $12.3 million for the year ended December 31, 2017.

Results of Operations 

The following table provides a general comparison of our results of operations for the years ended December 31, 2018 and 2017 (dollars in thousands, except for property and sq. ft. information):

 
 
Year Ended December 31,
 
 
2018
 
2017
Number of properties
 
11

 
14

Aggregate GLA (sq. ft.)
 
1,307,930

 
1,531,737

Ending occupancy rate
 
80
%
 
81
%
 
 
 
 
 
Total property revenues
 
$
17,180

 
$
16,768

Total property expenses
 
7,694

 
7,701

Total other expenses
 
7,174

 
6,501

Provision for income taxes
 
229

 
88

Gain on sale of properties
 
(7,778
)
 
—

Loss on disposal of assets
 
55

 
31

Net income
 
9,806

 
2,447

Less:  Net income attributable to noncontrolling interests
 
8,490

 
2,232

Net income attributable common shareholders
 
$
1,316

 
$
215


Revenues from Operations
    
We had total revenues for the years ended December 31, 2018 and 2017 of $17,180,000 and $16,768,000, respectively, for an increase of $412,000, or 2%. The increase was comprised of increases of $287,000 in expense recovery revenues, $74,000 in rent revenues and $51,000 in other revenues.
 
Expenses from Operations

Our property expenses were approximately $7,694,000 for the year ended December 31, 2018 as compared to $7,701,000 for the year ended December 31, 2017, a decrease of $7,000. The primary components of property expenses are detailed in the table below (dollars in thousands):

 
 
Year Ended December 31,
 
 
 
 

 
2018
 
2017
 
Change
 
% Change
Real estate taxes
 
$
2,720

 
$
2,672

 
$
48

 
2
 %
Utilities
 
1,307

 
1,122

 
185

 
16
 %
Contract services
 
1,079

 
1,128

 
(49
)
 
(4
)%
Repairs and maintenance
 
912

 
980

 
(68
)
 
(7
)%
Bad debt
 
292

 
412

 
(120
)
 
(29
)%
Management fees
 
1,008

 
996

 
12

 
1
 %
Labor and other
 
376

 
391

 
(15
)
 
(4
)%
Total property expenses
 
$
7,694

 
$
7,701

 
$
(7
)
 
—
 %


7

Other Expenses

Our other expenses were approximately $7,174,000 for the year ended December 31, 2018 as compared to $6,501,000 for the year ended December 31, 2017, an increase of $673,000, or 10%. The primary components of property expenses are detailed in the table below (dollars in thousands):

 
 
Year Ended December 31,
 
 
 
 
 
 
2018
 
2017
 
Change
 
% Change
General and administrative
 
$
776

 
$
508

 
$
268

 
53
%
Depreciation and amortization
 
3,566

 
3,268

 
298

 
9
%
Interest expense
 
2,832

 
2,725

 
107

 
4
%
Total other expenses
 
$
7,174

 
$
6,501

 
$
673

 
10
%

General and administrative expenses increased approximately $268,000 for the year ended December 31, 2018 due to an increase in legal and other professional fees related to the ongoing SEC discussions regarding the accounting of the Acquisition. Interest expense increased approximately $107,000 as a result of early extinguishment of debt costs following the sale of three of the Real Estate Assets as of December 31, 2018. Depreciation and amortization was approximately $3,566,000 for the year ended December 31, 2018 compared to $3,268,000 for the year ended December 31, 2017. The increase of $298,000 was mostly due to several large capital projects on certain properties being placed in service during 2018.

Gain on Sale of Properties

On December 27, 2018, we completed the sale of Dairy Ashford Business Park, Westbelt Plaza and Main Park (the "Real Estate Assets Sold"), each located in Houston, Texas. Dairy Ashford Business Park sold for $2.1 million, and we recorded a gain on sale of $0.8 million. Westbelt Plaza sold for $5.4 million, and we recorded a gain on sale of $2.7 million. Main Park sold for $8.4 million, and we recorded a gain on sale of $4.3 million. We have not included the Real Estate Assets Sold in discontinued operations as they did not meet the definition of discontinued operations.

Provision for Federal and State Income Taxes

Our provision for income taxes was $229,000 for the year ended December 31, 2018 as compared to $88,000 for the year ended December 31, 2017, an increase of $141,000, or 160%. The increase was primarily comprised of increased federal income taxes resulting from the gains on sale of properties during the year ended December 31, 2018.

Non-Controlling Interest

Our non-controlling interest represents 81.4% of the total outstanding units of Pillarstone OP which is owned by Whitestone OP. Net income from our non-controlling interest was $8.5 million for the year ended December 31, 2018 compared to $2.2 million for the year ended December 31, 2017. The majority of the increase in net income for the non-controlling interest was due to the sale of the three Real Estate Assets sold for a total net income to non-controlling interest contribution of $6.3 million.

Liquidity and Capital Resources

Cash Flows

As of December 31, 2018, our unrestricted cash resources were $2,010,000. We are dependent on cash generated by Pillarstone OP through Pillarstone OP's ownership of the Real Estate Assets acquired in the Acquisition to meet our liquidity needs.
During the year ended December 31, 2018, the Company's cash balance decreased by $981,000 from $2,991,000 at December 31, 2017 to $2,010,000 at December 31, 2018. This decrease in cash was due to cash used in financing activities of $18,782,000 offset by cash provided by operating activities of approximately $5,278,000 and investing activities of approximately $12,523,000.


8


Future Obligations

As part of the Acquisition on December 8, 2016, Pillarstone OP assumed approximately $65.9 million of liabilities related to the Real Estate Assets contributed by Whitestone OP. As the general partner of Pillarstone OP, we are ultimately liable for the repayment of the loans. Included in the $65.9 million of liabilities was $15.5 million due to Whitestone OP by December 8, 2018. As of December 31, 2018, Pillarstone repaid $17.3 million in outstanding loans, which included $9.8 million to Whitestone OP and $7.5 million to other noteholders using cash from operations and proceeds from the sale of certain Real Estate Assets. During the year ended December 31, 2018, the Company sold three of the Real Estate Assets, leaving 11 properties remaining. As of December 31, 2018, the Company's debt obligation is $47,329,000. We expect our remaining debt balance to be repaid from raising capital, selling assets, and debt refinancing. In addition, as of December 31, 2018, Whitestone OP has agreed to extend the maturity date of its loan with Pillarstone OP to December 8, 2021.

Long Term Liquidity and Operating Strategies

Historically, we have financed our long term capital needs, including acquisitions, as follows:

•
borrowings from new loans;
•
additional equity issuances of our common and preferred shares; and
•
proceeds from the sales of our real estate, a technology segment, and marketable securities.

From 2006 until December 2016, the Company continued its existence as a corporate shell filing its periodic reports with the SEC so that the Company could be used for future real estate transactions or sold to another company. During this time, the Company was funded by the trustees who contributed $500,000 in exchange for 125,000 Class C Convertible Preferred Shares and $197,780 in exchange for convertible notes payable.
    
Subsequent to the Acquisition, Pillarstone intends to develop strategies for the properties in order to create value for the enterprise and our shareholders. To implement the strategy to create value with the Real Estate Assets additional capital will need to be raised.

Current Tax Status

As of December 31, 2018 and 2017, we had net deferred tax assets of $199,000 and $490,000, respectively. The major temporary differences that gave rise to the deferred tax assets are depreciation and amortization and acquisition and organizational costs. Realization of deferred tax assets is dependent upon generation of sufficient future taxable income and the effects of other loss utilization provisions. Management has determined that sufficient uncertainty exists regarding the realizability of the net deferred tax assets and has provided a full valuation allowance of $199,000 and $490,000 against the net deferred tax assets of the Company as of December 31, 2018 and 2017, respectively. A valuation allowance is considered to be a significant estimate that may change in the near term.
    
As of December 31, 2018, the Company had no net operating loss carry-forwards available to be carried to future periods.

The Company’s effective income tax rate is lower than what would be expected if the federal statutory rate were applied to income before income taxes primarily because of Whitestone OP’s 81.4% noncontrolling interest in the earnings of Pillarstone OP.

Interest Rates and Inflation

The Company was not significantly affected by inflation during the periods presented in this report due primarily to the relative low nationwide inflation rates and the Company having approximately 76% of its debt with fixed rates.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements that have, or are likely to have, a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.


9

Application of Critical Accounting Estimates

Our consolidated financial statements are prepared in accordance with U.S. GAAP, which requires us to make certain estimates and assumptions. The following section is a summary of certain estimates that both require our most subjective judgment and are most important to the presentation of our financial condition and results of operations. It is possible that the use of different estimates or assumptions in making these judgments could result in materially different amounts being reported in our consolidated financial statements.

Revenue recognition. All leases on our properties are classified as operating leases, and the related rental income is recognized on a straight-line basis over the terms of the related leases.  Differences between rental income earned and amounts due per the respective lease agreements are capitalized or charged, as applicable, to accrued rents and accounts receivable.  Percentage rents are recognized as rental income when the thresholds upon which they are based have been met.  Recoveries from tenants for taxes, insurance, and other operating expenses are recognized as revenues in the period the corresponding costs are incurred.  We have established an allowance for doubtful accounts against the portion of tenant accounts receivable which is estimated to be uncollectible.

Acquired Properties and Acquired Lease Intangibles.  We allocate the purchase price of the acquired properties to land, building and improvements, identifiable intangible assets and to the acquired liabilities based on their respective fair values at the time of purchase. Identifiable intangibles include amounts allocated to acquired out-of-market leases, the value of in-place leases and customer relationship value, if any. We determine fair value based on estimated cash flow projections that utilize appropriate discount and capitalization rates and available market information. Estimates of future cash flows are based on a number of factors including the historical operating results, known trends and specific market and economic conditions that may affect the property. Factors considered by management in our analysis of determining the as-if-vacant property value include an estimate of carrying costs during the expected lease-up periods considering market conditions, and costs to execute similar leases. In estimating carrying costs, management includes real estate taxes, insurance and estimates of lost rentals at market rates during the expected lease-up periods, tenant demand and other economic conditions. Management also estimates costs to execute similar leases including leasing commissions, tenant improvements, legal and other related expenses. Intangibles related to out-of-market leases and in-place lease value are recorded as acquired lease intangibles and are amortized as an adjustment to rental revenue or amortization expense, as appropriate, over the remaining terms of the underlying leases. Premiums or discounts on acquired out-of-market debt are amortized to interest expense over the remaining term of such debt.

Depreciation.  Depreciation is computed using the straight-line method over the estimated useful lives of 5 to 39 years for improvements and buildings. Tenant improvements are depreciated using the straight-line method over the life of the improvement or remaining term of the lease, whichever is shorter.
 
Impairment.  We review our properties for impairment at least annually or whenever events or changes in circumstances indicate that the carrying amount of the assets, including accrued rental income, may not be recoverable through operations.  We determine whether an impairment in value has occurred by comparing the estimated future cash flows (undiscounted and without interest charges), including the estimated residual value of the property, with the carrying cost of the property.  If impairment is indicated, a loss will be recorded for the amount by which the carrying value of the property exceeds its fair value.  Management has determined that there has been no impairment in the carrying value of our real estate assets as of December 31, 2018.

Valuation Allowance of Deferred Tax Asset.     We account for income taxes using the liability method under which deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities using enacted tax rates in effect for the period in which the differences are expected to affect taxable income. Management has determined that sufficient uncertainty exists regarding the realizability of the net deferred tax assets and has provided a full valuation allowance of $199,000 and $490,000 against the net deferred tax assets of the Company as of December 31, 2018 and 2017, respectively.

Item 8.  Financial Statements and Supplementary Data.

The required audited consolidated financial statements of the Company are included herein commencing on page F-1.


10


Item 9. Changes in and Disagreements with Accountants

None.

Item 9A.  Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our principal executive officer and principal financial officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2018. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to its management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2018, our principal executive officer and principal financial officer concluded that, as of such date, our disclosure controls and procedures were effective.

Inherent Limitations of Internal Controls
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Previously Identified Material Weakness
The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. As previously disclosed in the Form 10-K/A for the year ended December 31, 2016, the Chief Executive Officer and the Chief Financial Officer identified a material weakness in the Company's internal control over financial reporting. This material weakness continued to be in place as of September 30, 2018.
A material weakness is defined as a deficiency, or a combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected on a timely basis.
The specific material weakness related to the misapplication of ASC 810 upon the formation of the Company. The Company adjusted its accounting of Pillarstone OP, changing the account from the equity method (ASC 323, "Investments - Equity Method and Joint Venture") to consolidation under ASC 810. This change in accounting is a one-time adjustment that affected several reporting periods through the first quarter 2018 Form 10-Q, after the December 8, 2016 Contribution Agreement (the "Contribution Agreement") with Whitestone REIT Operating Partnership, L.P.
This material weakness was remediated as of December 31, 2018.

Remediation of Material Weakness

We completed the remediation of the material weakness during the fourth quarter of 2018, with revisions to our internal controls over financial reporting, including reviewing the processes that identify unique accounting transactions, implementing new control procedures that clearly document how unique transactions will be assessed under U.S. GAAP and the use of external advisors and adjustments to our communications with the Audit Committee that describe the results of such documentation.

As a result of the implementation of the remediation plan and based on the evaluation of our disclosure controls and procedures as of December 31, 2018, our principal executive officer and principal financial officer concluded that, as of such date, our disclosure controls and procedures were effective.

11

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining an adequate system of internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f), as a process designed by, or under the supervision of, the principal executive and principal financial officers, or persons performing similar functions, and effected by the board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. GAAP defined in the Exchange Act and includes those policies and procedures that:

•
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and disposition of our assets;
•
provide reasonable assurance that the transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. GAAP, and that our receipts and expenditures are being made only in accordance with authorizations of management and/or members of the board of trustees; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements.

Our management's assessment of the effectiveness of our internal control over financial reporting as of December 31, 2018 was based on the criteria for effective internal control over financial reporting described in the 2013 Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

Based on our evaluation under this framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2018.

Changes in Internal Control over Financial Reporting

Other than those described above, there have been no significant changes in our internal control over financial reporting during the quarter ended December 31, 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Item 9B.  Other Information.
 
None.

PART III

Item 10.  Trustees, Executive Officers and Corporate Governance.
 
The information required by Item 10 of Form 10-K is incorporated herein by reference to such information as set forth in the Company’s definitive proxy statement for our 2019 Annual Meeting of Shareholders.

Item 11.  Executive Compensation.

The information required by Item 11 of Form 10-K is incorporated herein by reference to such information as set forth in the Company’s definitive proxy statement for our 2019 Annual Meeting of Shareholders.

Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters.

The information required by Item 12 of Form 10-K is incorporated herein by reference to such information as set forth in the Company’s definitive proxy statement for our 2019 Annual Meeting of Shareholders.

Item 13.  Certain Relationships and Related Transactions, and Director Independence.
 
The information required by Item 13 of Form 10-K is incorporated herein by reference to such information as set forth in the Company’s definitive proxy statement for our 2019 Annual Meeting of Shareholders.

12

Item 14.  Principal Accountant Fees and Services.

The information required by Item 14 of Form 10-K is incorporated herein by reference to such information as set forth in the Company’s definitive proxy statement for our 2019 Annual Meeting of Shareholders.


13

PART IV

Item 15. Exhibits and Financial Statement Schedules.
Exhibit Number
 
Exhibit Description
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

14

Exhibit Number
 
Exhibit Description
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

15

Exhibit Number
 
Exhibit Description
 
 
 
 
 
101.INS*
 
XBRL Instance Document
101.SCH*
 
XBRL Taxonomy Extension Schema Document
101.CAL*
 
XBRL Taxonomy Extension Calculation Linkbase Document
101.LAB*
 
XBRL Taxonomy Extension Label Linkbase Document
101.PRE*
 
XBRL Taxonomy Extension Presentation Linkbase Document
101.DEF*
 
XBRL Taxonomy Extension Definition Linkbase Document

* The following financial information of the Registrant for the years ended December 31, 2018 and 2017, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Cash Flows, and (iv) Notes to Consolidated Financial Statements.

(1)
Indicates a management contract or compensatory plan or arrangement
(2)
Filed or furnished herewith


16

SIGNATURES
 
In accordance with the requirements of the Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
 
 
 
PILLARSTONE CAPITAL REIT
 
 
 
Date:
April 1, 2019
 By:
 
/s/ James C. Mastandrea 
 
 
 
 
James C. Mastandrea, Chairman and CEO
 
 
 
 
 
 
 
 
 
PILLARSTONE CAPITAL REIT
 
 
 
Date:
April 1, 2019
 By:
 
/s/ John J. Dee 
 
 
 
 
John J. Dee, CFO
 
POWER OF ATTORNEY

KNOW ALL PERSON BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints John J. Dee, jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorney-in-fact, or his substitute or substitutes, may do or cause to by done by virtue hereof.

In accordance with Section 13 or 15(d) of the Securities Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

PILLARSTONE CAPITAL REIT

Signature
Title
Date
 
 
 
/s/ James C. Mastandrea
James C. Mastandrea
Trustee, Chief Executive Officer and
   President
April 1, 2019
 
(Principal Executive Officer)
 
 
 
 
/s/ John J. Dee
John J. Dee
Trustee, Senior Vice President and
   Chief Financial Officer
April 1, 2019
 
(Principal Finance and Principal Accounting Officer)
 
 
 
 
/s/ Dennis H. Chookaszian
Dennis H. Chookaszian
Trustee
April 1, 2019
 
 
 
/s/ Daniel G. DeVos
Daniel G. DeVos
Trustee
April 1, 2019
 
 
 
/s/ Kathy M. Jassem
Kathy M. Jassem
Trustee
April 1, 2019
 
 
 
/s/ Paul T. Lambert
Paul T. Lambert
Trustee
April 1, 2019
 
 
 


17

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
 
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 



F-1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


To the Board of Trustees and Shareholders of
Pillarstone Capital REIT:
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Pillarstone Capital REIT and subsidiary (the “Company”) as of December 31, 2018 and 2017, and the related consolidated statements of operations, changes in equity (deficit), and cash flows for each of the years in the two-year period ended December 31, 2018, and the related notes and schedules (collectively referred to as the “Consolidated Financial Statements”). In our opinion, the Consolidated Financial Statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles.
Basis for Opinion
These Consolidated Financial Statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s Consolidated Financial Statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the Consolidated Financial Statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the Consolidated Financial Statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the Consolidated Financial Statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the Consolidated Financial Statements. We believe that our audits provide a reasonable basis for our opinion.

/s/ Pannell Kerr Forster of Texas, P.C.

We have served as the Company’s auditor since 2016.
Houston, Texas
April 1, 2019.



F-2


Pillarstone Capital REIT and Subsidiaries
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)
 
 
 
 
 
December 31,
 
 
2018
 
2017
 
 
 
 
 
ASSETS (1)
Real estate assets, at cost
 
 
 
 
Property
 
$
77,944

 
$
83,144

Accumulated depreciation
 
(5,281
)
 
(2,934
)
Total real estate assets
 
72,663

 
80,210

Cash and cash equivalents
 
2,010

 
2,991

Escrows and acquisition deposits
 
1,835

 
2,188

Accrued rents and accounts receivable, net of allowance for doubtful accounts
 
1,360

 
798

Receivable due from related party
 
58

 
1,304

Unamortized lease commissions. loan costs and deferred legal costs, net
 
1,164

 
1,265

Prepaid expenses and other assets
 
60

 
160

Total assets
 
$
79,150

 
$
88,916

LIABILITIES AND EQUITY (DEFICIT) (2)
Liabilities:
 
 
 
 
Notes payable
 
$
47,064

 
$
64,313

Accounts payable and accrued expenses
 
2,817

 
3,414

Payable due to related party
 
372

 
959

Convertible notes payable - related parties
 
198

 
198

Accrued interest payable
 
258

 
260

Stock redemption payable - related party
 
143

 
—

Tenants' security deposits
 
1,236

 
1,191

Total liabilities
 
52,088

 
70,335

Commitments and contingencies
 
—

 
—

Shareholders' Equity:
 
 
 
 
Preferred A Shares - $0.01 par value, 1,518,000 authorized: 256,636 Class A cumulative convertible shares issued and outstanding at December 31, 2018 and 2017, $10.00 per share liquidation preference
 
3

 
3

Preferred C Shares - $0.01 par value, 300,000 authorized: 231,944 and 244,444 Class C cumulative convertible shares issued and outstanding at December 2018 and 2017, respectively, $10.00 per share liquidation preference
 
2

 
2

Common Shares - $0.01 par value, 400,000,000 authorized: 443,299 shares issued and 405,169 outstanding at December 31, 2018 and 2017
 
4

 
4

Additional paid-in capital
 
28,147

 
28,147

Accumulated deficit
 
(26,319
)
 
(27,635
)
Treasury stock, at cost, 38,130 shares
 
(801
)
 
(801
)
Total Pillarstone Capital REIT shareholders' equity (deficit)
 
1,036

 
(280
)
Noncontrolling interest in subsidiary
 
26,026

 
18,861

Total equity
 
27,062

 
18,581

Total liabilities and equity
 
$
79,150

 
$
88,916


The accompanying notes are an integral part of the consolidated financial statements.

F-3
Table of Contents

Pillarstone Capital REIT and Subsidiaries
CONSOLIDATED BALANCE SHEETS - Continued
(in thousands)
 
 
December 31,
 
 
2018
 
2017
 
 
 
 
 
(1) Assets of consolidated Variable Interest Entity included in the total assets above:
Real estate assets, at cost
 
 
 
 
Property
 
$
77,941

 
$
83,141

Accumulated depreciation
 
(5,281
)
 
(2,934
)
Total real estate assets
 
72,660

 
80,207

Cash and cash equivalents
 
1,872

 
2,812

Escrows and acquisition deposits
 
1,835

 
2,188

Accrued rents and accounts receivable, net of allowance for doubtful accounts
 
1,360

 
798

Receivable due from related party
 
58

 
1,304

Unamortized lease commissions and deferred legal costs, net
 
1,164

 
1,265

Prepaid expenses and other assets
 
51

 
150

Total assets
 
$
79,000

 
$
88,724

 
 
 
 
 
(2) Liabilities of consolidated Variable Interest Entity included in the total liabilities above:
Notes payable
 
$
47,064

 
$
64,313

Accounts payable and accrued expenses
 
2,617

 
3,322

Payable due to related party
 
373

 
959

  Accrued interest payable
 
197

 
218

Tenants' security deposits
 
1,236

 
1,191

Total liabilities
 
$
51,487

 
$
70,003




The accompanying notes are an integral part of the consolidated financial statements.


F-4

Pillarstone Capital REIT and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)
 
 
 
 
 
 
 
Year Ended December 31,
 
 
2018
 
2017
 
 
 
 
 
Property revenues
 
 
 
 
Rental revenues
 
$
14,326

 
$
14,218

Other revenues
 
2,854

 
2,550

Total property revenues
 
17,180

 
16,768

 
 
 
 
 
Property expenses
 
 
 
 
Property operation and maintenance
 
3,966

 
4,033

Real estate taxes
 
2,720

 
2,672

Management fees
 
1,008

 
996

Total property expenses
 
7,694

 
7,701

 
 
 
 
 
Other expenses
 
 
 
 
General and administrative
 
776

 
508

Depreciation and amortization
 
3,566

 
3,268

Interest expense
 
2,832

 
2,725

Total other expense
 
7,174

 
6,501

 
 
 
 
 
Income before gain (loss) on disposal of assets and sale of properties and income taxes
 
2,312

 
2,566

 
 
 
 
 
Loss on disposal of assets
 
(55
)
 
(31
)
Gain on sale of properties
 
7,778

 
—

Provision for income taxes
 
(229
)
 
(88
)
 
 
 
 
 
Net income
 
9,806

 
2,447

 
 
 
 
 
Less: noncontrolling interest in subsidiary
 
8,490

 
2,232

 
 
 
 
 
Net income attributable to Common Shareholders
 
$
1,316

 
215

 
 
 
 
 
Earnings Per Share:
 
 
 
 
Basic income per Common Share:
 
 
 
 
Net income available to Common Shareholders
 
$
3.25

 
$
0.53

Diluted income per Common Share:
 
 
 
 
Net income available to Common Shareholders
 
$
0.44

 
$
0.07

 
 
 
 
 
Weighted average number of Common Shares outstanding:
 
 
 
 
Basic:
 
405,169

 
405,169

Diluted:
 
3,066,027

 
2,903,219


The accompanying notes are an integral part of the consolidated financial statements.

F-5

Pillarstone Capital REIT and Subsidiaries
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (DEFICIT)
(in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
 
 
 
 
 
Class A
 
Class C
 
 
 
Additional
 
 
 
Cost of
 
Shareholders'
 
 
 
 
 
 
Preferred
 
Preferred
 
Common
 
Paid-in
 
Accumulated
 
Shares held
 
Equity
 
Noncontrolling
 
Total
 
 
Shares
 
Shares
 
Shares
 
Capital
 
Deficit
 
in Treasury
 
(Deficit)
 
Interest
 
Equity
Balance, December 31, 2016
 
$
3

 
$
2

 
$
4

 
$
28,147

 
$
(27,850
)
 
$
(801
)
 
$
(495
)
 
$
18,292

 
$
17,797

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Distributions to operating partnership limited partner
 
—

 
—

 
—

 
—

 
—

 
—

 
—

 
(1,663
)
 
(1,663
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 
—

 
—

 
—

 
—

 
215

 
—

 
215

 
2,232

 
2,447

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2017
 
3

 
2

 
4

 
28,147

 
(27,635
)
 
(801
)
 
(280
)
 
18,861

 
18,581

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Distributions to operating partnership limited partner
 
—

 
—

 
—

 
—

 
—

 
—

 
—

 
(1,325
)
 
(1,325
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 
—

 
—

 
—

 
—

 
1,316

 
—

 
1,316

 
8,490

 
9,806

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2018
 
$
3

 
$
2

 
$
4

 
$
28,147

 
$
(26,319
)
 
$
(801
)
 
$
1,036

 
$
26,026

 
$
27,062





The accompanying notes are an integral part of the consolidated financial statements.


F-6

Pillarstone Capital REIT and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
 
 
 
 
 
 
Year Ended December 31,
 
 
2018
 
2017
 
 
 
 
 
Cash flows from operating activities:
 
 
 
 
Net income
 
$
9,806

 
$
2,447

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
3,566

 
3,268

Deferred loan costs
 
100

 
97

Loss (gain) on disposal of assets and sale of properties
 
(7,723
)
 
31

Bad debt expense
 
292

 
412

Changes in operating assets and liabilities:
 
 
 
 
Escrows and acquisition deposits
 
353

 
86

Accrued rent and accounts receivable
 
(854
)
 
(997
)
Receivable from related party
 
1,201

 
120

Unamortized lease commissions and deferred legal costs
 
(346
)
 
(567
)
Prepaid expenses and other assets
 
(119
)
 
(11
)
Accounts payable and accrued expenses
 
(599
)
 
143

Accounts payable due to related party
 
(587
)
 
694

Stock redemption payable - related party
 
143

 
—

Tenants' security deposits
 
45

 
195

Net cash provided by operating activities
 
5,278

 
5,918

 
 
 
 
 
Cash flows from investing activities:
 
 
 
 
Proceeds from sale of real estate
 
14,881

 
—

Additions to real estate
 
(2,358
)
 
(1,249
)
Net cash provided by (used in) investing activities
 
12,523

 
(1,249
)
 
 
 
 
 
Cash flows from financing activities:
 
 
 
 
Distributions paid to noncontrolling interest in subsidiary
 
(1,325
)
 
(1,663
)
Extinguishment of debt costs
 
(108
)
 
—

Repayments of notes payable
 
(17,349
)
 
(1,258
)
Net cash used in financing activities
 
(18,782
)
 
(2,921
)
 
 
 
 
 
Net increase (decrease) in cash and cash equivalents
 
(981
)
 
1,748

Cash and cash equivalents at beginning of period
 
2,991

 
1,243

Cash and cash equivalents at end of period
 
$
2,010

 
$
2,991

 
 
 
 
 
Supplemental disclosure of cash flow information:
 
 
 
 
Cash paid for interest
 
$
2,599

 
$
2,611

Cash paid for taxes
 
88

 
—

Non cash investing and financing activities:
 
 
 
 
Disposal of fully depreciated real estate
 
$
56

 
$
20

Additions to real estate contributed by related party
 
$
45

 
$
1,394



The accompanying notes are an integral part of the consolidated financial statements.


F-7



Notes to Consolidated Financial Statements
December 31, 2018



1.
ORGANIZATION

Pillarstone Capital REIT (the “Company,” “Pillarstone,” “we,” “our,” or “us”) is a Maryland real estate investment trust ("REIT") engaged in investing in, owning and operating commercial properties. Future real estate investments may include (i) acquisition and development of retail, office, office warehouse, industrial, multifamily, hotel, and other commercial properties, (ii) acquisition of or merger with a real estate investment trust (“REIT”) or real estate operating company and (iii) joint venture investments. We serve as the general partner of Pillarstone Capital REIT Operating Partnership LP (the “Operating Partnership” or “Pillarstone OP”), which was formed on September 23, 2016 as a Delaware limited partnership. We currently conduct substantially all operations and activities through Pillarstone OP. As the general partner of Pillatstone OP, we have the exclusive power to manage and conduct the business of Pillarstone OP, subject to certain customary exceptions.    

2. BASIS OF PRESENTATION

Basis of consolidation. We have prepared the consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC") and generally accepted accounting principles in the United States ("U.S. GAAP"). In our opinion, all adjustments (consisting solely of normal recurring items) necessary for a fair presentation of our financial position as of December 31, 2018 and 2017, the results of our operations for the years ended December 31, 2018 and 2017, and of our cash flows for the years ended December 31, 2018 and 2017 have been included. We also consolidate a variable interest entity ("VIE") when we are determined to be the primary beneficiary. Determination of the primary beneficiary is based on whether an entity has (1) the power to direct activities that most significantly impact the economic performance of the VIE and (2) the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. Our determination of the primary beneficiary considers all relationships between us and the VIE, including management and other contractual agreements. Consequently, the accompanying consolidated financial statements include the accounts of Pillarstone OP and a wholly-owned subsidiary that discontinued operations in 2002. See Note 4 for additional disclosure on our VIE.

Noncontrolling interest in the accompanying consolidated financial statements represents the share of equity and earnings of Pillarstone OP allocable to holders of partnership interests other than us. Net income or loss is allocated to noncontrolling interest based on the weighted-average percentage ownership of Pillarstone OP during the year. Issuance of additional units of limited partnership interest in Pillarstone OP changes the percentage of ownership interests of both the noncontrolling interest and Pillarstone.

Going concern. The financial statements have been prepared assuming the Company will continue as a going concern, which contemplates continued operations as a public company and paying liabilities in the normal course of business. The Company, through Pillarstone OP, acquired 14 real estate assets in December 2016 and its distributions of cash from Pillarstone OP are expected to be sufficient for the Company to continue as a going concern.

Reclassification of Prior Year Presentation. Prior year amounts for the year ended December 31, 2017 have been reclassified for consistency with the current year presentation. The reclassifications had no effect on the reported results of operations. Adjustments have been made to the Consolidated Balance Sheet and the Statement of Cash Flows to reclassify related party and non-related party interest. The adjustments reclassify related party interest from related party payable to accrued interest payable and non-related party interest from accounts payable to accrued interest payable.

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Accounting.  Our financial records are maintained on the accrual basis of accounting whereby revenues are recognized when earned and expenses are recorded when incurred.

Use of estimates. In order to conform with U.S. GAAP, management, in preparation of our consolidated financial statements, is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of December 31, 2018 and 2017, and the reported amounts of revenues and expenses for the years ended December 31, 2018 and 2017. Actual results could differ from those estimates. Significant estimates include deferred taxes and the related valuation allowance for deferred taxes, and these significant estimates, as well as other estimates and assumptions, may change in the near term.

F-8



Notes to Consolidated Financial Statements
December 31, 2018



Cash and cash equivalents. We consider all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.  Cash and cash equivalents as of December 31, 2018 and 2017 consisted of demand deposits at commercial banks and brokerage accounts. We maintain our cash in bank accounts that are federally insured.

Acquired Properties and Acquired Lease Intangibles.  We allocate the purchase price of the acquired properties to land, building and improvements, identifiable intangible assets and to the acquired liabilities based on their respective fair values at the time of purchase. Identifiable intangibles include amounts allocated to acquired out-of-market leases, the value of in-place leases and customer relationship value, if any. We determine fair value based on estimated cash flow projections that utilize appropriate discount and capitalization rates and available market information. Estimates of future cash flows are based on a number of factors including the historical operating results, known trends and specific market and economic conditions that may affect the property. Factors considered by management in our analysis of determining the as-if-vacant property value include an estimate of carrying costs during the expected lease-up periods considering market conditions, and costs to execute similar leases. In estimating carrying costs, management includes real estate taxes, insurance and estimates of lost rentals at market rates during the expected lease-up periods, tenant demand and other economic conditions. Management also estimates costs to execute similar leases including leasing commissions, tenant improvements, legal and other related expenses. Intangibles related to out-of-market leases and in-place lease value are recorded as acquired lease intangibles and are amortized as an adjustment to rental revenue or amortization expense, as appropriate, over the remaining terms of the underlying leases. Premiums or discounts on acquired out-of-market debt are amortized to interest expense over the remaining term of such debt.

Depreciation.  Depreciation is computed using the straight-line method over the estimated useful lives of 5 to 39 years for improvements and buildings.  Tenant improvements are depreciated using the straight-line method over the life of the improvement or remaining term of the lease, whichever is shorter.
 
Impairment.  We review our properties for impairment at least annually or whenever events or changes in circumstances indicate that the carrying amount of the assets, including accrued rental income, may not be recoverable through operations.  We determine whether an impairment in value has occurred by comparing the estimated future cash flows (undiscounted and without interest charges), including the estimated residual value of the property, with the carrying cost of the property.  If impairment is indicated, a loss will be recorded for the amount by which the carrying value of the property exceeds its fair value.  Management has determined that there has been no impairment in the carrying value of our real estate assets as of December 31, 2018.

Accrued Rents and Accounts Receivable.  Included in accrued rent and accounts receivable are base rents, tenant reimbursements and receivables attributable to recording rents on a straight-line basis. An allowance for the uncollectible portion of accrued rents and accounts receivable is determined based upon customer credit-worthiness (including expected recovery of our claim with respect to any tenants in bankruptcy), historical bad debt levels, and current economic trends.  As of December 31, 2018 and 2017, we had an allowance for uncollectible accounts of $53,000 and $539,000, respectively, and bad debt expense of $292,000 and $412,000, respectively.

Unamortized Lease Commissions, Loan Costs and Deferred Legal Costs.  Leasing commissions and deferred legal costs are amortized using the straight-line method over the terms of the related lease agreements.  Loan costs are amortized on the straight-line method over the terms of the loans, which approximates the interest method. Costs allocated to in-place leases whose terms differ from market terms related to acquired properties are amortized over the remaining life of the respective leases.

Prepaids and Other assets. Prepaids and other assets include escrows established pursuant to certain mortgage financing arrangements for real estate taxes and insurance.

Noncontrolling Interests.  Noncontrolling interests are the portion of equity in a subsidiary not attributable to a parent.  The ownership interests not held by the parent are considered noncontrolling interests.  Accordingly, we have reported noncontrolling interest in equity on the consolidated balance sheets but separate from Pillarstone’s equity.  On the consolidated statements of operations, subsidiaries are reported at the consolidated amount, including both the amount attributable to Pillarstone and noncontrolling interest.  Consolidated statements of changes in equity are included for both quarterly and annual financial statements, including beginning balances, activity for the period and ending balances for shareholders’ equity, noncontrolling interest and total equity.

F-9



Notes to Consolidated Financial Statements
December 31, 2018



Revenue recognition. All leases on our properties are classified as operating leases, and the related rental income is recognized on a straight-line basis over the terms of the related leases.  Differences between rental income earned and amounts due per the respective lease agreements are capitalized or charged, as applicable, to accrued rents and accounts receivable.  Percentage rents are recognized as rental income when the thresholds upon which they are based have been met.  Recoveries from tenants for taxes, insurance, and other operating expenses are recognized as revenues in the period the corresponding costs are incurred.  We have established an allowance for doubtful accounts against the portion of tenant accounts receivable which is estimated to be uncollectible.

Stock-based compensation. The Company accounts for stock-based compensation in accordance with ASC 718, "Compensation - Stock Compensation," which addresses the accounting for stock-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. ASC 718 generally requires that these transactions be accounted for using a fair-value-based method. The Company uses the Black-Scholes option-pricing model to determine the fair-value of stock-based awards.

Income taxes. Because we have not elected to be taxed as a REIT for federal income tax purposes, we account for income taxes using the liability method under which deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities using enacted tax rates in effect for the period in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.

The Company evaluates potential uncertain tax positions on an annual basis in conjunction with the board of trustees and its tax accountants. Authoritative literature provides a two-step approach to recognize and measure tax benefits when realization of the benefits is uncertain. The first step is to determine whether the benefit meets the more-likely-than-not condition for recognition and the second step is to determine the amount to be recognized based on the cumulative probability that exceeds 50%. The Company has no uncertain tax positions that required adjustments to our consolidated financial statements in 2018 or 2017.

As of December 31, 2018, we have no net operating loss carry-forwards. We have a net deferred tax asset, and a valuation allowance was applied against the asset. Management has determined that sufficient uncertainty exists regarding the realizability of the net deferred tax assets and has provided a full valuation allowance of $199,000 and $490,000 against the net deferred tax assets of the Company as of December 31, 2018 and 2017, respectively.

Fair Value of Financial Instruments.  Our financial instruments consist primarily of cash, cash equivalents, accounts receivable, accounts and notes payable and investments in marketable securities.  The carrying value of cash, cash equivalents, accounts receivable and accounts payable are representative of their respective fair values due to their short-term nature.  The fair value of our long-term debt, consisting of fixed rate secured notes aggregate to approximately $47.2 million and $65.1 million as compared to the book value of approximately $47.3 million and $64.7 million as of December 31, 2018 and 2017, respectively. The fair value of our long-term debt is estimated on a Level 2 basis (as provided by ASC 820, “Fair Value Measurements and Disclosures”), using a discounted cash flow analysis based on the borrowing rates currently available to us for loans with similar terms and maturities, discounting the future contractual interest and principal payments.

Disclosure about fair value of financial instruments is based on pertinent information available to management as of December 31, 2018 and December 31, 2017 . Although management is not aware of any factors that would significantly affect the fair value amounts, such amounts have not been comprehensively revalued for purposes of these consolidated financial statements since December 31, 2018 and current estimates of fair value may differ significantly from the amounts presented herein.

Concentration of Risk.  Substantially all of our revenues are obtained from office and warehouse locations in the Dallas-Fort Worth and Houston metropolitan areas. We maintain cash accounts in major U.S. financial institutions. The terms of these deposits are on demand to minimize risk. The balances of these accounts sometimes exceed the federally insured limits, although no losses have been incurred in connection with these deposits.


F-10



Notes to Consolidated Financial Statements
December 31, 2018


Recent accounting pronouncements. In May 2014, the FASB issued guidance, as amended in subsequent updates, establishing a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most of the existing revenue recognition guidance. The standard also requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services and also requires certain additional disclosures. This guidance became effective for the reporting periods beginning on or after December 15, 2017, and interim periods within those fiscal years. We adopted this guidance as of January 1, 2018 and applied it on a modified retrospective approach upon adoption.

In February 2016, the FASB issued guidance requiring lessees to recognize a lease liability and a right-of-use asset for all leases. Lessor accounting will remain largely unchanged with the exception of changes related to costs which qualify as initial direct costs. The guidance will also require new qualitative and quantitative disclosures to help financial statement users better understand the timing, amount and uncertainty of cash flows arising from leases. This guidance became effective for reporting periods beginning on or after December 15, 2018, with early adoption permitted. We adopted this guidance on a modified retrospective basis beginning January 1, 2019, and such adoption will result in certain costs (primarily legal costs related to lease negotiations) being expensed rather than capitalized. We capitalized $34,000 in legal related costs for the year ended December 31, 2018. We had $47,000 of capitalized legal related costs for the year ended December 31, 2017.

In November 2016, the FASB issued guidance requiring that the statement of cash flows explain the change during the period in the total cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. This guidance will become effective for the reporting periods beginning on or after December 15, 2017, and interim periods within those fiscal years. We adopted this guidance effective January 1, 2018, and we have reconciled cash and cash equivalents and restricted cash and restricted cash equivalents on a retrospective basis, whereas under the previous guidance, we reported restricted cash and restricted cash equivalents under cash flows from financing activities.

In January 2017, the FASB issued guidance clarifying the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. This guidance became effective for the reporting periods beginning on or after December 15, 2017, and interim periods within those fiscal years. We adopted this guidance on a prospective basis beginning January 1, 2018 and continue to believe the majority of our future acquisitions will qualify as asset acquisitions and the associated transaction costs will be capitalized instead of being expensed under previous guidance.

In February 2017, the FASB issued guidance clarifying the scope of asset derecognition guidance, added guidance for partial sales of nonfinancial assets and clarified recognizing gains and losses from the transfer of nonfinancial assets in contracts with noncustomers. This guidance became effective for the reporting periods beginning on or after December 15, 2017, and interim periods within those fiscal years. We adopted this guidance on a modified retrospective basis beginning January 1, 2018, and the adoption of this guidance did not have a material impact on our consolidated financial statements.

4. VARIABLE INTEREST ENTITIES

On December 8, 2016, Pillarstone and Pillarstone OP, entered into a Contribution Agreement (the “Contribution Agreement”) with Whitestone REIT Operating Partnership, L.P. (“Whitestone OP”), a subsidiary and the operating partnership of Whitestone REIT, both of which are related parties to Pillarstone and Pillarstone OP, pursuant to which Whitestone OP contributed to Pillarstone OP all of the equity interests in four of its wholly-owned subsidiaries (the “Subsidiaries”): Whitestone CP Woodland Ph. 2, LLC, a Delaware limited liability company; Whitestone Industrial-Office, LLC, a Texas limited liability company; Whitestone Offices, LLC, a Texas limited liability company; and Whitestone Uptown Tower, LLC, a Delaware limited liability company (“Uptown Tower”). The Subsidiaries owned 14 real estate assets (the “Real Estate Assets” and, together with the Subsidiaries, the “Property”) for aggregate consideration of approximately $84 million, consisting of (1) approximately $18.1 million of Class A units representing limited partnership interests in Pillarstone OP (“OP Units”), issued at a price of $1.331 per OP Unit; and (2) the assumption of approximately $65.9 million of liabilities by Pillarstone OP. Pursuant to the Contribution Agreement, Pillarstone became the general partner of Pillarstone OP with an equity ownership interest in Pillarstone OP totaling approximately a 18.6% valued at $4.1 million as of the date of the agreement.
    

F-11



Notes to Consolidated Financial Statements
December 31, 2018


In connection with the Contribution Agreement, on December 8, 2016, the Company, as the general partner of Pillarstone OP, entered into an Amended and Restated Agreement of Limited Partnership of Pillarstone OP (as amended and restated, the “Amended and Restated Agreement of Limited Partnership”). Pursuant to the Amended and Restated Agreement of Limited Partnership, subject to certain protective rights of the limited partners described below, the general partner has full, exclusive and complete responsibility and discretion in the management and control of Pillarstone OP, including the ability to cause Pillarstone OP to enter into certain major transactions including a merger of Pillarstone OP or a sale of substantially all of the assets of Pillarstone OP. The limited partners have no power to remove the general partner without the general partner's consent. In addition, pursuant to the Amended and Restated Agreement of Limited Partnership, the general partner may not conduct any business without the consent of a majority of the limited partners other than in connection with certain actions described therein. The Company is deemed to exercise significant influence over Pillarstone OP as it has the power to direct the activities that most significantly impact Pillarstone OP's economic performance and the Company's right to receive benefits based on its ownership percentage in Pillarstone OP. Accordingly, the Company accounts for Pillarstone OP as a VIE.

The Amended and Restated Agreement of Limited Partnership designates two classes of units of limited partnership interest in Pillarstone OP: the OP Units and LTIP units. In general, LTIP units are similar to the OP Units and will receive the same quarterly per-unit profit distributions as the OP Units. The rights, privileges, and obligations related to each series of LTIP units will be established at the time the LTIP units are issued. As profits interests, LTIP units initially will not have full parity, on a per-unit basis, with OP Units with respect to liquidating distributions. Upon the occurrence of specified events, LTIP units can over time achieve full parity with the OP Units and therefore accrete to an economic value for the holder equivalent to OP Units. If such parity is achieved, vested LTIP units may be converted on a one-for-one basis into OP Units, which in turn are redeemable by the holder for cash or, at the Company’s election, exchangeable for Common Shares on a one-for-one basis.

The carrying amounts and classification of certain assets and liabilities for Pillarstone OP in our consolidated balance sheet as of December 31, 2018 and 2017 consists of the following (in thousands):
 
 
December 31,
 
 
2018
 
2017
Real estate assets, at cost
 
 
 
 
  Property
 
$
77,941

 
$
83,141

  Accumulated depreciation
 
(5,281
)
 
(2,934
)
    Total real estate assets
 
72,660

 
80,207

Cash and cash equivalents
 
1,872

 
2,812

Escrows and acquisition deposits
 
1,835

 
2,188

Accrued rents and accounts receivable, net of allowance for doubtful accounts (1)
 
1,360

 
798

Receivable due from related party
 
58

 
1,304

Unamortized lease commissions and deferred legal costs, net
 
1,164

 
1,265

Prepaid expenses and other assets
 
51

 
150

     Total assets
 
$
79,000

 
$
88,724

 
 
 
 
 
Liabilities
 
 
 
 
  Notes payable
 
47,064

 
64,313

  Accounts payable and accrued expenses
 
2,617

 
3,322

  Payable due to related party
 
373

 
959

  Accrued interest payable
 
197

 
218

  Tenants' security deposits
 
1,236

 
1,191

     Total liabilities
 
$
51,487

 
$
70,003


(1)    Excludes approximately $0.3 million in accounts receivable due from Pillarstone that was eliminated in consolidation as
of December 31, 2018 and 2017.


F-12



Notes to Consolidated Financial Statements
December 31, 2018




5. REAL ESTATE

As of December 31, 2018, Pillarstone OP owned 11 commercial properties in the Dallas and Houston areas comprised of approximately 1.3 million square feet of gross leasable area.
On December 27, 2018, we completed the sale of Dairy Ashford Business Park, Westbelt Plaza and Main Park (the "Real Estate Assets Sold"), each located in Houston, Texas. Dairy Ashford Business Park sold for $2.1 million, and we recorded a gain on sale of $0.8 million. Westbelt Plaza sold for $5.4 million, and we recorded a gain on sale of $2.7 million. Main Park sold for $8.4 million, and we recorded a gain on sale of $4.3 million. We have not included the Real Estate Assets Sold in discontinued operations as they did not meet the definition of discontinued operations.

6. ACCRUED RENTS AND ACCOUNTS RECEIVABLE, NET

Accrued rents and accounts receivable, net consists of amounts accrued, billed and due from tenants, allowance for doubtful accounts and other receivables as follows (in thousands):
 
 
December 31,
 
 
2018
 
2017
Tenant receivables
 
$
252

 
$
680

Accrued rents and other recoveries
 
1,161

 
657

Allowance for doubtful accounts
 
(53
)
 
(539
)
Total
 
$
1,360

 
$
798


7. UNAMORTIZED LEASE COMMISSIONS AND DEFERRED LEGAL COSTS, NET

Costs which have been deferred consist of the following (in thousands):
 
 
December 31,
 
 
2018
 
2017
Leasing commissions
 
$
1,780

 
$
1,577

Deferred legal costs
 
34

 
47

  Total cost
 
1,814

 
1,624

Less: leasing commissions accumulated amortization
 
(636
)
 
(350
)
Less: deferred legal costs accumulated amortization
 
(14
)
 
(9
)
Total cost, net of accumulated amortization
 
$
1,164

 
$
1,265


A summary of expected future amortization of deferred costs is as follows (in thousands):
Years Ended December 31,
 
Leasing Commissions
 
Deferred Legal Costs (1)
 
Total
2019
 
$
345

 
$
20

 
$
365

2020
 
277

 
—

 
277

2021
 
205

 
—

 
205

2022
 
139

 
—

 
139

2023
 
97

 
—

 
97

Thereafter
 
81

 
—

 
81

Total
 
$
1,144

 
$
20

 
$
1,164


F-13



Notes to Consolidated Financial Statements
December 31, 2018



(1) The Company will recognize a cumulative-effect adjustment to the opening balance of retained earnings of $20,000 in deferred legal costs in 2019 from the modified retrospective adoption of ASC 842.


8. FUTURE MINIMUM LEASE INCOME

We lease the majority of our properties under noncancelable operating leases, which provide for minimum base rents plus, in some instances, contingent rents based upon a percentage of the tenants' gross receipts. A summary of minimum future rents to be received (exclusive of renewals, tenant reimbursements and contingent rents) under noncancelable operating leases in existence as of December 31, 2018 is as follows (in thousands):
Years Ended December 31,
 
Minimum Future Rents
2019
 
$
11,140

2020
 
8,924

2021
 
6,350

2022
 
4,111

2023
 
2,802

Thereafter
 
12,190

Total
 
$
45,517


9. DEBT

Mortgages and other notes payable consist of the following (in thousands):
 
 
December 31,
Description
 
2018
 
2017
Fixed rate notes
 
 
 
 
$37.0 million 3.76% Note, due December 1, 2020
 
$
25,863

 
$
33,148

$16.5 million 4.97% Note, due September 26, 2023
 
15,805

 
16,058

Floating rate notes
 
 
 
 
Related party Note, LIBOR plus 1.40% to 1.95%, due December 31, 2019
 
5,661

 
15,473

Total notes payable principal
 
47,329

 
64,679

Less deferred financing costs, net of accumulated amortization
 
(265
)
 
(366
)
Total notes payable
 
$
47,064

 
$
64,313


Our mortgage debt was collateralized by seven operating properties as of December 31, 2018 and 10 properties as of December 31, 2017 with a combined net book value of $55.8 million and $63.0 million, respectively. Our loans contain restrictions that would require the payment of prepayment penalties for the acceleration of outstanding debt and are secured by deeds of trust on certain of our properties and the assignment of certain rents and leases associated with those properties. Certain other of our loans are subject to customary covenants. As of December 31, 2018, we were in compliance with all loan covenants.


F-14



Notes to Consolidated Financial Statements
December 31, 2018


Annual maturities of notes payable as of December 31, 2018 are due during the following years:
Year
 
Amount Due (in thousands)
2019
 
$
6,856

2020
 
25,272

2021
 
308

2022
 
323

2023
 
14,570

Total
 
$
47,329



F-15



Notes to Consolidated Financial Statements
December 31, 2018


10. CONVERTIBLE NOTES PAYABLE - RELATED PARTIES

On November 20, 2015, five trustees on our board of trustees loaned $197,780 to the Company in exchange for convertible notes payable. The convertible notes payable accrue interest at 10% per annum and originally matured on November 20, 2018. In 2019, the Pillarstone board of trustees approved an extension of the maturity date to November 20, 2021. The convertible notes payable can be converted by the noteholders into Common Shares at the rate of $1.331 per Common Share at any time. After six months, the Company can convert the notes payable into Common Shares. At maturity or when the Company chooses to convert the convertible notes payable into Common Shares, the noteholders have the option to receive cash plus accrued interest or convert the convertible notes payable into Common Shares.

11. SHAREHOLDERS' EQUITY

Operating partnership units. Substantially all of our business is conducted through Pillarstone OP and we are the sole general partner. As of December 31, 2018, we owned an 18.6% interest in Pillarstone OP. At any time on or after six months following the date of the initial issuance thereof, limited partners in Pillarstone OP holding OP Units have the right to convert their OP Units for cash, or at our option, Common Shares of Pillarstone. As of December 31, 2018, there were 16,688,167 OP Units outstanding.

The holders of our common shares, Class A Cumulative Preferred Shares ("Class A Preferred Shares") and Preferred Class C Convertible Preferred shares ("Preferred Class C Shares") approved changes to our declaration of trust, as amended and restated, in March 2016. We presently have authority to issue up to 450,000,000 shares of beneficial interest, $0.01 par value per share, of which 400,000,000 are classified as Common Shares of beneficial interest, $0.01 par value per share and 50,000,000 are classified as preferred shares of beneficial interest, $0.01 par value per share. Of the 50,000,000 preferred shares of beneficial interest, 1,518,000 shares are designated as Preferred Class A Shares and 300,000 shares are designated as Preferred Class C Shares. Previously, we had authority to issue up to 110,000,000 shares of beneficial interest, $0.01 par value per share, of which 100,000,000 were classified as Common Shares of beneficial interest, $0.01 par value per share, and 10,000,000 were classified as preferred shares of beneficial interest, $0.01 par value per share, with 1,518,000 shares designated as Preferred Class A Shares and 300,000 shares designated as Preferred Class C Shares.

Preferred shares. The Company has outstanding 95,226 Class A Cumulative Convertible Preferred Shares (“Class A Preferred Shares”) that were issued to the public. The Class A Preferred Shares bear a liquidation value of $10.00 per share. The Class A Preferred Shares are each convertible into 0.046 Common Shares subject to certain formulas. We have the right to redeem the Class A Preferred Shares.

Effective June 30, 2003, we issued 696,078 Class A Preferred Shares valued at approximately $2.4 million to James C. Mastandrea, our Chairman, Chief Executive Officer and President, and John J. Dee, our Chief Financial Officer and Senior Vice President, pursuant to separate restricted share agreements. Under each restricted share agreement, the restricted shares vest upon the later of the following dates:
•
the date our gross assets exceed $50 million, or

•
50% of the restricted shares on March 4, 2004; 25% of the shares on March 4, 2005 and the remaining 25% of the shares on March 4, 2006.

The Company has not vested any of the above shares. While the Company's gross assets exceed $50 million, when considering its 18.6% ownership of Pillarstone OP, its effective ownership of gross assets is less than $50 million.
In conjunction with a one-time incentive exchange offer for Class A Preferred shareholders, Messrs. Mastandrea and Dee exchanged 534,668 of these restricted Class A Preferred Shares into 163,116 restricted Common Shares. The restrictions described above are also applicable to their Common Shares. The remaining 161,410 restricted Class A Preferred Shares held by Messrs. Mastandrea and Dee can each be converted into 0.305 restricted Common Shares. The market value of 161,410 restricted Class A Preferred Shares and 163,116 restricted Common Shares is approximately $595,000 at December 31, 2018 and there is limited trading volume of the Common Shares on OTC Bulletin Board.
The number of Common Shares and the conversion factor have been revised to reflect the 1-for-75 reverse split of the

F-16



Notes to Consolidated Financial Statements
December 31, 2018


Common Shares that occurred in July 2006.

During 2018 and 2017, no Class A Preferred Shares were converted into Common Shares.

Effective September 29, 2006, Pillarstone filed articles supplementary to its Declaration of Trust, as amended, restated and supplemented with the State Department of Assessment and Taxation of Maryland designating 300,000 Class C Convertible Preferred Shares (“Class C Preferred Shares”). The Class C Preferred Shares have voting rights equal to the number of Common Shares into which they are convertible. Each Class C Preferred Share is convertible into Common Shares by dividing by the sum of $10.00 and any accrued but unpaid dividends on the Class C Preferred Shares by the conversion price of $1.00. The Class C Preferred Shares have a liquidation preference of $10.00 per share, plus any accrued but unpaid dividends, and can be redeemed by the board of trustees at any time, with notice, at the same price per share.
    
Effective September 29, 2006, three independent trustees of Pillarstone signed subscription agreements to purchase 125,000 Class C Preferred Shares for an aggregate contribution of $500,000 to maintain Pillarstone as a corporate shell current in its SEC filings.

In addition, on September 29, 2006, Mr. Mastandrea signed a subscription agreement to purchase 44,444 restricted shares of Class C Preferred Shares. The consideration for the purchase was Mr. Mastandrea’s services as an officer of Pillarstone for the period beginning September 29, 2006 and ending September 29, 2008. The Class C Preferred Shares are subject to forfeiture and are restricted from being sold by Mr. Mastandrea until the latest to occur of a public offering by Pillarstone sufficient to liquidate the Class C Preferred Shares, an exchange of Pillarstone’s existing shares for new shares, or September 29, 2008. These shares were fully amortized by the original date in 2008.
Each of the trustees of Pillarstone signed a restricted share agreement with Pillarstone, dated September 29, 2006, to receive a total of 12,500 restricted Class C Preferred Shares in lieu of receiving fees in cash for service as a trustee for the two years ending September 29, 2008. The restrictions on the Class C Preferred Shares were to be removed upon the latest to occur of a public offering by Pillarstone sufficient to liquidate the Class C Preferred Shares, an exchange of Pillarstone's existing shares for new shares, or September 29, 2008. These shares were fully amortized by the original date in 2008. On October 22, 2018 Daryl Carter, one of the trustees, forfeited his Class C Preferred Shares as a result of his resignation from our board of trustees.
Shares held in treasury. On October 1, 2003, we completed the sale of our 92.9% general partnership interest in our four commercial properties. A portion of the proceeds from the sale was paid in 38,130 of our Common Shares at an average closing price for the 30 calendar days prior to June 27, 2003 of $21.00 or approximately $801,000. These shares are recorded at cost in the accompanying consolidated balance sheets under treasury shares.
    
Restricted Common Shares. The following table summarizes the activity of our unvested restricted Common Shares for the years ended December 31, 2018 and 2017:
 
Unvested Restricted Common Shares
 
 
 
Weighted-Average
 
Number of
 
Grant-Date
 
Shares
 
Fair Value
 
 
 
 
Unvested at December 31, 2016
168,449
 
$11.44
Vested
—
 
—
Unvested at December 31, 2017
168,449
 
$11.44
Vested
—
 
—
Unvested at December 31, 2018
168,449
 
$11.44

In the above table, 163,116 restricted shares vest upon meeting performance goals as discussed under “Preferred Shares.” Since the grant date, we have determined that meeting these performance goals is not probable, and no compensation expense has been recognized related to this grant. The grant date fair value of $1,847,000 would be recognized at the point we

F-17



Notes to Consolidated Financial Statements
December 31, 2018


deem it probable that we would meet the performance goals. The balance of 5,333 restricted shares had grant date fair values totaling $79,000, which was recognized in prior periods though the restrictions remain on the shares.

On June 30, 2003, our shareholders approved the issuance of an agreement to issue additional Common Shares to Paragon Real Estate Development, LLC of which Mr. Mastandrea is the managing member, and Mr. Dee is a member. In September 2006, Pillarstone amended this agreement to include each of the trustees to the agreement so that if a trustee brings a new transaction to Pillarstone, he would receive additional Common Shares of Pillarstone in accordance with a formula in the agreement. In January 2016, the non-employee trustees and Mr. Mastandrea agreed to make this agreement for only non-employee trustees. The agreement is intended to serve as an incentive for our trustees to increase the asset base, net operating income, funds from operations, and share value of Pillarstone. The exact number of Common Shares that would be issued will be calculated in accordance with a formula in the agreement based on future acquisition, development or redevelopment transactions. Any of these transactions would be subject to approval by the members of our board of trustees who are not receiving the additional Common Shares. We would issue our Common Shares only upon the closing of a transaction. The maximum number of Common Shares a trustee may receive under the additional contribution agreement is limited to a total value of $26 million based on the average closing price of our Common Shares for 30 calendar days preceding the closing of any acquisition transaction. The Common Shares will be restricted until we achieve the five years-year pro forma income target for the acquisition, as approved by the board of trustees, and an increase of 5% in Pillarstone's net operating income and funds from operations. The restricted shares would vest immediately upon any “shift in ownership,” as defined in the agreement.
Options. On November 16, 1998, we adopted the 1998 Share Option Plan. In 2004 the board of trustees unanimously recommended and the shareholders approved amendments to our 1998 Share Option Plan to increase the number of shares available for grant from 42,222 to 46,666 and to conform with current tax regulations (“2004 Plan”). The 2004 Plan expired in 2014; the one outstanding grant of 667 options remains effective until 90 days after the term ends of the individual trustee.

The following table summarizes the activity for outstanding stock options:
 
Options Outstanding
 
 
 
 
 
Weighted-Average
 
 
 
 
 
Weighted-Average
 
Remaining
 
 
 
Number of
 
Exercise
 
Contractual Term
 
Aggregate
 
Shares
 
Price
 
(in years)
 
Intrinsic Value (1)
 
 
 
 
 
 
 
 
Balance at December 31, 2016
667

 
$
33.75

 
1.25

 
$
—

Granted
—

 
—

 
 
 
 
Exercised
—

 
—

 
 
 
 
Canceled / forfeited / expired
—

 
$
—

 
 
 
 
Balance at December 31, 2017
667

 
$
33.75

 
1.25

 
$
—

Granted
—

 
—

 
 
 
 
Exercised
—

 
—

 
 
 
 
Canceled / forfeited / expired
—

 
—

 
 
 
 
Balance at December 31, 2018
667

 
$
33.75

 
1.25

 
$
—

Vested and exercisable as of December 31, 2017
—

 
$
—

 
—

 
$
—


(1) 
The aggregate intrinsic value is calculated as approximately the difference between the weighted average exercise price of the underlying awards and the Company’s estimated current fair market value at December 31, 2018. Because the weighted average exercise price exceeds fair market value at December 31, 2018, there is no aggregate intrinsic value for the options.

The Company did not recognize any stock-based compensation expense during the years ending December 31, 2018 and 2017. As of December 31, 2018 and 2017, there was no remaining unrecognized cost related to stock options.


F-18



Notes to Consolidated Financial Statements
December 31, 2018


12. INCENTIVE EQUITY PLAN

At the 2016 Annual Meeting of Shareholders, our shareholders approved the 2016 Equity Plan (“2016 Plan”).
 
The 2016 Plan provides that awards may be made in Common Shares of the Company or units in the Company’s operating partnership, which may be converted into Common Shares. Subject to adjustment as provided by the terms of the 2016 Plan, the maximum aggregate number of Common Shares with respect to which awards may be granted under the 2016 Plan will be increased based on future issuances of Common Shares and units of the operating partnership, including issuances pursuant to the 2016 Plan, so that at any time the maximum number of shares that may be issued under the 2016 Plan shall equal 12.5% of the aggregate number of Common Shares and units of the operating partnership issued and outstanding (other than treasury shares and/or units issued to or held by the Company).
 
The Management, Organization and Compensation Committee (the “Committee”) administers the 2016 Plan, except with respect to awards to non-employee trustees, for which the 2016 Plan is administered by the board of trustees. Subject to the terms of the 2016 Plan, the Committee is authorized to select participants, determine the type and number of awards to be granted, determine and later amend (subject to certain limitations) the terms and conditions of any award, interpret and specify the rules and regulations relating to the 2016 Plan, and make all other determinations which may be necessary or desirable for the administration of the 2016 Plan. The 2016 Plan includes the types of awards for grants and the types of financial performance measures.
 
As of December 31, 2018, the maximum number of Common Shares or OP Units available to be granted is 2,338,569 and no grants have been issued under the 2016 Plan.

13. EARNINGS (LOSS) PER SHARE

The Company applies the guidance of ASC 260, "Earnings Per Share," for all periods presented herein. Net earnings (loss) per weighted average Common Share outstanding, basic and diluted, is computed based on the weighted average number of Common Shares outstanding for the period. The following table shows the weighted average number of Common Shares outstanding and reconciles the numerator and denominator of both earnings (loss) per Common Share calculations for the years ended December 31, 2018 and 2017.

For the year ended December 31, 2018, Class A Preferred Shares and Class C Preferred Shares were included in net income (loss) per weighted average Common Share outstanding-diluted. During the years ended December 31, 2018 and 2017, the Company had $197,780 of convertible notes payable as discussed in Note 10. The convertible notes payable were included in the computation of diluted earnings per share in 2018 but were not included in 2017 because the effect of the conversion would be anti-dilutive in 2017.

F-19



Notes to Consolidated Financial Statements
December 31, 2018


 
For the year ended December 31,
(in thousands, except share and per share data)
2018
 
2017
 
 
 
 
Numerator:
 
 
 
Net income available to Common Shareholders
$
1,316

 
$
215

Dilutive effect of interest from convertible notes payable
20

 
—

Net income available to Common Shareholders with assumed conversion
$
1,336

 
$
215

 
 
 
 
Denominator:
 
 
 
Weighted average number of Common Shares - basic
405,169

 
405,169

Effect of dilutive securities:
 
 
 
Assumed conversion of Preferred A Shares
53,610

 
53,610

Assumed conversion of Preferred C Shares
2,419,782

 
2,444,440

Assumed conversion of convertible notes payable
187,466

 
—

Weighted average number of Common Shares - dilutive
3,066,027

 
2,903,219

 
 
 
 
Earnings Per Share:
 
 
 
Basic income per Common Share:
 
 
 
Net income available to Common Shareholders
$
3.25

 
$
0.53

Diluted income per Common Share:
 
 
 
Net income available to Common Shareholders
$
0.44

 
$
0.07


14. DIVIDENDS AND DISTRIBUTIONS

No cash distributions were declared during 2018 and 2017 with respect to common or preferred shares.


15. INCOME TAXES

For financial reporting purposes, income before federal income taxes attributable to Common Shareholders includes the following components (in thousands):

 
For the year ended December 31,
 
2018
 
2017
Net income
$
9,806

 
$
2,447

Less: noncontrolling interest in subsidiary
8,490

 
2,232

Net income attributable to Common Shareholders
$
1,316

 
$
215


The Company follows the provisions of ASC Topic 740 which provides for recognition of deferred tax assets and liabilities for deductible temporary timing differences, net of a valuation allowance for any asset for which it is more-likely-than-not will not be realized in the Company’s tax return.

Income tax provisions were $229,000 and $88,000 for the years ended December 31, 2018 and 2017, respectively.


F-20



Notes to Consolidated Financial Statements
December 31, 2018


The income tax expense (benefit) included in the consolidated statements of operations for the years ended December 31, 2018 and 2017 was comprised of the following components (in thousands):

 
For the year ended December 31,
 
2018
 
2017
Federal:
 
 
 
Current
$
141

 
$
—

Deferred
291

 
46

Change in deferred rate from 34% to 21% for 2017
—

 
331

Change in valuation allowance
(291
)
 
(377
)
 
$
141

 
$
—

 
 
 
 
State:
 
 
 
Current
$
88

 
$
88

 
$
88

 
$
88

 
 
 
 
Total tax expense
$
229

 
$
88


The items accounting for the difference between income taxes computed at the Federal statutory rate and our effective rate were as follows:
 
For the year ended December 31,
 
2018
 
2017
Federal statutory rate
21
 %
 
34
 %
Effect of:
 
 
 
Noncontrolling interest
(18
)%
 
(31
)%
State income tax benefit, net of Federal tax effect
1
 %
 
4
 %
Change in deferred valuations
1
 %
 
—
 %
Change in deferred rate from 34% to 21% for 2017
—
 %
 
12
 %
Change in valuation allowance
(3
)%
 
(15
)%
Effective rate
2
 %
 
4
 %
    
Deferred tax assets and liabilities consist of the following (in thousands):
 
December 31,
 
2018
 
2017
Deferred tax assets and liabilities:
 
 
 
Net operating loss carry-forwards
$
—

 
$
164

Depreciation and amortization
180

 
209

Acquisition and organizational costs
67

 
72

Accruals and others
(48
)
 
45

Total deferred tax assets and liabilities
199

 
490

Valuation allowance
(199
)
 
(490
)
Deferred tax assets and liabilities net of valuation allowance
$
—

 
$
—

    

F-21



Notes to Consolidated Financial Statements
December 31, 2018


Realization of deferred tax assets is dependent upon generation of sufficient future taxable income and the effects of other loss utilization provisions. Management has determined that sufficient uncertainty exists regarding the realizability of the net deferred tax assets and has provided a full valuation allowance of $199,000 and $490,000, against the net deferred tax assets of the Company as of December 31, 2018 and 2017, respectively. A valuation allowance is considered to be a significant estimate that may change in the near term.
    
As of December 31, 2018, the Company had no net operating loss carry-forwards available to be carried to future periods.

16. RELATED PARTY TRANSACTIONS

On December 8, 2016, the Company entered into the Contribution Agreement with Pillarstone OP and Whitestone OP, both of which are related parties, resulting in the contribution of an equity ownership interest in Pillarstone OP to the Company valued at $4,121,312 and representing approximately 18.6% of the outstanding equity in Pillarstone OP. The terms of the Contribution Agreement were determined through arm's-length negotiations and were recommended to the board of trustees by a special committee of the board of trustees consisting solely of disinterested trustees of the Company and approved by the full board.

Pursuant to the Contribution Agreement, the Company has agreed to file with the SEC on or prior to June 8, 2018, a shelf registration statement to register for sale under the Securities Act, the issuance of the Common Shares of beneficial interest in the Company (the “Common Shares”) that may be issued upon redemption of the OP Units issued pursuant to each of the Contribution Agreement and the OP Unit Purchase Agreement (as defined below) and the offer and resale of such Common Shares by the holders thereof. In addition, pursuant to the Contribution Agreement, in the event of a Change of Control (as defined therein) of Whitestone, Pillarstone OP shall have the right, but not the obligation, to repurchase the OP Units issued thereunder from Whitestone OP at their initial issue price of $1.331 per OP Unit. Pillarstone and Whitestone agreed to extend the filing of the shelf registration statement to a date not later than June 8, 2019, or the date that the Company closes a public equity offering. No additional OP units have been issued as of December 31, 2018 and the requirement has expired.

In connection with the Contribution Agreement, on December 8, 2016, the Company and Pillarstone OP entered into an OP Unit Purchase Agreement (the “OP Unit Purchase Agreement”) with Whitestone OP pursuant to which Pillarstone OP may require Whitestone OP to purchase up to an aggregate of $3.0 million of OP Units at a price of $1.331 per OP Unit over the two-year term of the OP Unit Purchase Agreement on the terms set forth therein. In addition, pursuant to the OP Unit Purchase Agreement, in the event of a Change of Control (as defined therein) of Whitestone, Pillarstone OP shall have the right, but not the obligation, to repurchase the OP Units issued thereunder from Whitestone OP at their initial issue price of $1.331 per OP Unit. On December 8, 2018, the OP Unit Agreement and the offer and resale of common shares terminated pursuant to its terms. There was no issuance of our Common Shares during 2018.

In connection with the Contribution Agreement, on December 8, 2016, the Company and Pillarstone OP entered into a Tax Protection Agreement (the “Tax Protection Agreement”) with Whitestone OP pursuant to which Pillarstone OP agreed to indemnify Whitestone OP for certain tax liabilities resulting from its recognition of income or gain prior to December 8, 2021 if such liabilities result from a transaction involving a direct or indirect taxable disposition of all or a portion of the Property or if Pillarstone OP fails to maintain and allocate to Whitestone OP for taxation purposes minimum levels of liabilities as specified in the Tax Protection Agreement, the result of which causes such recognition of income or gain and Whitestone incurs taxes that must be paid to maintain its REIT status for federal tax purposes. In December 2018, Pillarstone OP sold three properties, which did not create additional tax liabilities for Whitestone OP.

During the ordinary course of business, we have transactions with Whitestone that include, but are not limited to, rental income, interest expense, general and administrative costs, commissions, management and asset management fees, and property expenses.     


F-22



Notes to Consolidated Financial Statements
December 31, 2018


In connection with the Contribution Agreement, on December 8, 2016, the Company and Pillarstone OP entered into a Management Agreement (collectively, the “Management Agreements”) with Whitestone TRS, Inc., a subsidiary of Whitestone (“Whitestone TRS”). Pursuant to the Management Agreements with respect to each property, other than Uptown Tower, Whitestone TRS agreed to provide certain property management, leasing and day-to-day advisory and administrative services to such properties in exchange for (1) a monthly property management fee equal to 5.0% of the monthly revenues of each property and (2) a monthly asset management fee equal to 0.125% of GAV (as defined in each Management Agreement as, generally, the purchase price of the respective property based upon the purchase price allocations determined pursuant to the Contribution Agreement, excluding all indebtedness, liabilities or claims of any nature) of such property. Pursuant to the Management Agreement with respect to Uptown Tower, Whitestone TRS agreed to provide certain property management, leasing and day-to-day advisory and administrative services in exchange for (1) a monthly property management fee equal to 3.0% of the monthly revenues of Uptown Tower and (y) a monthly asset management fee equal to 0.125% of GAV of Uptown Tower.

The following table presents the revenue and expenses with Whitestone OP included in our consolidated statements of operations for the years ended December 31, 2018 and 2017 (in thousands):
 
 
 
 
Year Ended December 31,
 
 
Location of Revenue (Expense)
 
2018
 
2017
Rent
 
Rental revenues
 
$
779

 
$
782

Property management fees and admin salaries
 
Management fees
 
$
(743
)
 
$
(732
)
Asset management fees
 
Management fees
 
$
(265
)
 
$
(264
)
Interest expense
 
Interest expense
 
$
(582
)
 
$
(528
)

Receivables due from related parties consisted of the following as of December 31, 2018 and 2017 (in thousands):
 
 
December 31,
 
 
2018
 
2017
Construction in process (1)
 
$
—

 
$
45

Tenant receivables and other receivables
 
58

 
1,259

  Total
 
$
58

 
$
1,304


(1) 
Amount relates to future tenant and building improvement expenditures implicit within the Contribution Agreement to be paid by Whitestone OP and capitalized by the Company in subsequent periods when placed in service.

Payables due to related parties consisted of the following as of December 31, 2018 and 2017 (in thousands):
 
 
December 31,
 
 
2018
 
2017
Accrued interest due to related party (2)
 
$
112

 
$
88

Other payables due to related party  (3)
 
372

 
959

  Total
 
$
484

 
$
1,047


(2) 
Included in accrued interest payable on the balance sheet.
(3) 
Included in payable due to related party on the balance sheet.

17. COMMITMENTS AND CONTINGENCIES

Employment Agreements

On April 3, 2006, the board of trustees authorized modifications to Mr. Mastandrea’s employment agreement. The modification agreement allows Mr. Mastandrea to devote time to other business and personal investments while performing his

F-23



Notes to Consolidated Financial Statements
December 31, 2018


duties for Pillarstone. The original employment agreement with Mr. Mastandrea provides for an annual salary of $60,000 effective as of March 4, 2003. The initial term of Mr. Mastandrea’s employment is for two years and may be extended for terms of one year. Mr. Mastandrea’s base annual salary may be adjusted from time to time, except that the adjustment may not be lower than the preceding year’s base salary. The employment agreement provides that Mr. Mastandrea will be entitled to base salary and bonus at the rate in effect before any termination for a period of three years in the event that his employment is terminated without cause by us or for good reason by Mr. Mastandrea. Effective September 29, 2006, in lieu of an annual salary of $100,000 and to conserve cash, Mr. Mastandrea agreed to receive 44,444 Class C Preferred Shares for his services as an officer of Pillarstone through September 29, 2008. The shares were fully amortized by the original date in 2008.

Mr. Dee’s employment agreement was also modified on April 3, 2006 in a similar way to Mr. Mastandrea’s employment agreement as explained above, except Mr. Dee does not receive any Class C Preferred Shares for his services as an officer of Pillarstone. Mr. Dee’s base annual salary may be adjusted from time to time, except that the adjustment may not be lower than the preceding year’s base salary. The employment agreement provides that Mr. Dee will be entitled to base salary and bonus at the rate in effect before any termination for a period of three years in the event that his employment is terminated without cause by us or for good reason by Mr. Dee. On September 29, 2006, the board of trustees approved compensation to Mr. Dee of $125 per hour, up to a maximum of $5,000 per month. However, Mr. Dee has forgone receiving any cash compensation under this arrangement in order to preserve the Company’s cash.

Lease Agreement

On February 1, 2017 Pillarstone Capital REIT signed a lease with Whitestone Woodlake Plaza, LLC for the premises located at 2600 S. Gessner Road, Suite 555 Houston, Texas 77063. The lease term is three years and five months. The rentable area of the premises is approximately 678 square feet. Total rent expense for the year ended December 31, 2018 was approximately $14,200 compared to $12,600 for the year ended December 31, 2017.

Years Ended December 31,
 
Minimum Future Rents
2019
 
$
14,604

2020
 
7,410

Total
 
$
22,014


18. SEGMENT INFORMATION

Our management historically has not differentiated by property types and therefore does not present segment information.

F-24

PILLARSTONE CAPITAL REIT
Schedule II - Valuation and Qualifying Accounts
December 31, 2018



 
 
(in thousands)
 
 
Balance at
 
Charged to
 
Deductions
 
Balance at
 
 
Beginning
 
Costs and
 
from
 
End of
Description
 
of Year
 
Expense
 
Reserves
 
Year
Deferred tax asset allowance:
 
 
 
 
 
 
 
 
Year ended December 31, 2018
 
$
490

 
$
(291
)
 
$
—

 
$
199

Year ended December 31, 2017
 
867

 
(377
)
 
—

 
490

Year ended December 31, 2016
 
1,031

 
(164
)
 
—

 
867

 
 
 
 
 
 
 
 
 
Allowance for doubtful accounts:
 
 
 
 
 
 
 
 
Year ended December 31, 2018
 
$
539

 
292

 
(778
)
 
$
53

Year ended December 31, 2017
 
125

 
412

 
2

 
539

Year ended December 31, 2016
 
—

 
127

 
(2
)
 
125



F-25
PILLARSTONE CAPITAL REIT
Schedule III - Real Estate and Accumulated Depreciation
December 31, 2018



 
 
 
 
 
 
Costs Capitalized Subsequent
 
Gross Amount at which Carried at
 
 
Initial Cost (in thousands)
 
to Acquisition (in thousands)
 
End of Period (in thousands)(1) (2)
 
 
 
 
Building and
 
Improvements
 
Carrying
 
 
 
Building and
 
 
Property Name
 
Land
 
Improvements
 
(net)
 
Costs
 
Land
 
Improvements
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Pillarstone OP Properties:
 
 

 
 
 
 

 
 

 
 

 
 

 
 

9101 LBJ Freeway
 
$
3,590

 
$
2,811

 
$
151

 
$
—

 
$
3,590

 
$
2,962

 
$
6,552

Corporate Park Northwest
 
1,326

 
5,009

 
359

 
—

 
1,326

 
5,368

 
6,694

Corporate Park West
 
2,772

 
10,144

 
1,129

 
—

 
2,772

 
11,273

 
14,045

Corporate Park Woodland
 
1,144

 
4,764

 
215

 
—

 
1,144

 
4,979

 
6,123

Corporate Park Woodland II
 
2,730

 
24

 
38

 
—

 
2,730

 
62

 
2,792

Holly Hall Industrial Park
 
2,730

 
1,768

 
16

 
—

 
2,730

 
1,784

 
4,514

Holly Knight
 
807

 
1,231

 
110

 
—

 
807

 
1,341

 
2,148

Interstate 10 Warehouse
 
2,915

 
765

 
122

 
—

 
2,915

 
887

 
3,802

Plaza Park
 
1,527

 
1,660

 
161

 
—

 
1,527

 
1,821

 
3,348

Uptown Tower
 
7,304

 
15,493

 
1,371

 
—

 
7,304

 
16,864

 
24,168

Westgate Service Center
 
937

 
2,502

 
316

 
—

 
937

 
2,818

 
3,755

Total - Pillarstone OP Properties
 
$
27,782

 
$
46,171

 
$
3,988

 
$
—

 
$
27,782

 
$
50,159

 
$
77,941




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PILLARSTONE CAPITAL REIT
Schedule III - Real Estate and Accumulated Depreciation
December 31, 2018




 
 
 
 
Accumulated Depreciation
 
Date
 
Depreciation
Property Name
 
Encumbrances
 
(in thousands)
 
Acquired
 
Life
Pillarstone OP Properties:
 
 
 
 
 
 
 
 
9101 LBJ Freeway
 
 
 
$
374

 
12/8/2016
 
5-39 years
Corporate Park Northwest
 
 
 
818

 
12/8/2016
 
5-39 years
Corporate Park West
 
(3)
 
881

 
12/8/2016
 
5-39 years
Corporate Park Woodland
 
(3)
 
390

 
12/8/2016
 
5-39 years
Corporate Park Woodland II
 
 
 
9

 
12/8/2016
 
5-39 years
Holly Hall Industrial Park
 
(3)
 
180

 
12/8/2016
 
5-39 years
Holly Knight
 
 
 
111

 
12/8/2016
 
5-39 years
Interstate 10 Warehouse
 
(3)
 
110

 
12/8/2016
 
5-39 years
Plaza Park
 
(3)
 
281

 
12/8/2016
 
5-39 years
Uptown Tower
 
(4)
 
1,821

 
12/8/2016
 
5-39 years
Westgate Service Center
 
(3)
 
306

 
12/8/2016
 
5-39 years
Total - Pillarstone OP Properties
 
 
 
$
5,281

 
 
 
 

(1)
Reconciliations of total real estate carrying value for the years ended December 31, 2018 and 2017 follows:
 
 
(in thousands)
 
 
2018
 
2017
Balance at beginning of period
 
$
83,144

 
$
80,564

Additions - improvements
 
2,399

 
2,641

Deductions - cost of real estate sold or retired
 
(7,602
)
 
(61
)
Balance at close of period
 
$
77,941

 
$
83,144


(2) 
The aggregate cost of real estate (in thousands) for federal income tax purposes is $77,358.
(3) 
These properties secure a $25.9 million mortgage note.
(4) 
This property secures a $15.8 million mortgage note.



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