PILLARSTONE CAPITAL REIT - Quarter Report: 2022 June (Form 10-Q)

PART 1. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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

Pillarstone Capital REIT and Subsidiaries

CONDENSED CONSOLIDATED BALANCE SHEETS - Continued

(in thousands)

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

Pillarstone Capital REIT and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except share and per share data)

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

Pillarstone Capital REIT and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS - Continued

(unaudited)

(in thousands)

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

 Pillarstone Capital REIT and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (DEFICIT)

(unaudited)

(in thousands)

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

Pillarstone Capital REIT and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

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

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Accounting.  Pillarstone Capital REIT's (the “Company,” “Pillarstone,” “we,” “our,” or “us”) 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 generally accepted accounting principles in the United States ("U.S. GAAP"), management, in preparation of our condensed 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 June 30, 2022 and December 31, 2021, and the reported amounts of revenues and expenses for the three and six months ended June 30, 2022 and 2021. Actual results could differ from those estimates. Significant estimates that we use include the estimated fair value of properties acquired, allowance for doubtful accounts, impairment, the estimated useful lives for depreciable and amortizable assets and costs, and deferred taxes and the related valuation allowance for deferred taxes.

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 June 30, 2022 and December 31, 2021 consisted of demand deposits at a commercial bank and a brokerage account. 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 June 30, 2022.

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. We review the collectability of charges under our tenant operating leases on a regular basis, taking into consideration changes in factors such as the tenant’s payment history, the financial condition of the tenant, business conditions in the industry in which the tenant operates and economic conditions in the area where the property is located, including the impact of the COVID-19 pandemic on tenants' businesses and financial condition. We recognize an adjustment to rental revenue if we deem it probable that the receivable will not be collected. Our review of collectability under our operating leases includes any accrued rental revenues related to the straight-line method of reporting rental revenue. As of June 30, 2022 and December 31, 2021, we had an allowance for uncollectible accounts of approximately $577,000 and $538,000, respectively. For the three and six months ended June 30, 2022, we recorded an adjustment to rental revenue in the amount of approximately $24,000 and $39,000, respectively.  For the three months ended June 30, 2022, there was no bad debt adjustment related to a potential credit loss from our COVID-19 collectibility analysis.  For the six months ended June 30, 2022 there was approximately $40,000 related to a credit loss for the conversion of two tenants to cash basis revenue as a result of our COVID-19 collecitibility analysis.   For the three and six months ended June 30, 2021, we recorded an adjustment to rental revenue in the amount of approximately $(11,000) and $29,000, respectively.  Included in our adjustments to rental revenue for the three and six months ended June 30, 2021 was a bad debt adjustment of $10,913 and $51,174, respectively, related to a potential credit loss for the conversion of three tenants to cash basis revenue as a result of our COVID-19 collectibility analysis.

Unamortized Lease Commissions and Deferred Legal Cost.  Leasing commissions and deferred legal cost are amortized using the straight-line method over the terms of the related lease agreements.  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.

Prepaid expenses and Other assets. Prepaid expenses 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. Accordingly, we have reported noncontrolling interest in equity on the condensed consolidated balance sheets but separate from Pillarstone’s equity.  On the condensed consolidated statements of operations, subsidiaries are reported at the consolidated amount, including both the amount attributable to Pillarstone and noncontrolling interest.

Revenue recognition. All leases on our properties are classified as noncancelable operating leases, and the related rental income is recognized on a straight-line basis over the terms of the related leases.  For the three months ended June 30, 2022, we did not have a straight-line rent reserve adjustment.  For the six months ended June 30, 2022, we had a straight-line rent reserve adjustment of $1,000 for the conversion of one tenant to cash basis as a result of our COVID-19 collectibility analysis.  For the three and six months ended June 30, 2021 we had a straight-line rent reserve adjustment of $1,000 for the conversion of one tenant to cash basis as a result of our COVID-19 collectibility analysis.  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. Recoveries from tenants for taxes, insurance, and other operating expenses are recognized as revenues in the period the corresponding costs are incurred.  We combine lease and nonlease components in lease contracts, which includes combining base rent and recoveries into a single line item, Rental, within the condensed consolidated statements of operations. We recognize lease termination fees in the year that the lease is terminated and collection of the fee is reasonably assured.

Stock-based compensation. The Company accounts for stock-based compensation in accordance with ASC No. 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 No.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 asset and 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. We are also subject to certain state and local income, excise and franchise taxes. The provision for state and local taxes has been reflected in provision for income taxes in the condensed consolidated statements of operations and has not been separately stated due to its insignificance.

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%.

As of June 30, 2022, we had a net operating loss carry-forward of approximately $139,000, and as of June 30, 2022 and December 31, 2021, we had net deferred tax liabilities of approximately $11,000 and $36,000, respectively. 

Concentration of Risk.  Substantially all of our revenues are obtained from office and warehouse locations in the Dallas 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.

Recent accounting pronouncements. In April 2020, the Financial Accounting Standards Board ("FASB") issued guidance on the application of Topic 842, relating to concessions being made by lessors in response to the COVID-19 pandemic. The guidance notes that it would be acceptable for entities to make an election to account for lease concessions relating to the effects of the COVID-19 pandemic consistent with how those concessions would be accounted for under Topic 842 as though enforceable rights and obligations for those concessions existed, even if such enforceable rights and obligations are not explicitly contained in the lease contract. Thus, for concessions relating to COVID-19, an entity would not have to analyze each contract to determine whether enforceable rights and obligations for concessions exist in the contract, and would have the option to apply, or not to apply, the general lease modification guidance in Topic 842 as it stands. We have elected this option to account for lease concessions relating to the effects of the COVID-19 pandemic consistent with how those concessions would be accounted for under Topic 842 as though enforceable rights and obligations for those concessions existed. Therefore, such concessions are not accounted for as a lease modification under Topic 842.

2. 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):

3. LEASES

As a Lessor. All leases on our properties are classified as noncancelable 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, if applicable, 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 combine lease and nonlease components in lease contracts, which includes combining base rent, recoveries, and percentage rents into a single line item, Rental, within the condensed consolidated statements of operations.

A summary of minimum future rents to be received (exclusive of renewals, tenant reimbursements, contingent rents, and collectability adjustments under Topic 842) under noncancelable operating leases in existence as of June 30, 2022 is as follows (in thousands): 

⁽¹⁾ These amounts do not reflect future rental revenues from the renewal or replacement of existing leases and exclude reimbursements of operating expenses and rental increases that are not fixed.

As a Lessee. On June 8, 2021, Pillarstone's lease became month to month with Whitestone for the premises located at 2600 S. Gessner Road, Suite 555 Houston, Texas 77063. The rentable area of the premises is approximately 678 square feet. Total rent expense for the three and six months ended June 30, 2022 was $5,670 and $11,340, respectively.  Total rent expense for the three and six months ended June 30, 2021 was $10,051 and $17,611, respectively.

4. UNAMORTIZED LEASE COMMISSIONS AND DEFERRED LEGAL COST, NET

Costs which have been deferred consist of the following (in thousands):

5. VARIABLE INTEREST ENTITY

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 (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”) that 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 an 18.6% interest valued at $4.1 million as of the date of the Contribution Agreement.

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 Variable Interest Entity.

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 condensed consolidated balance sheets as of June 30, 2022 and December 31, 2021 consists of the following (in thousands):

6. REAL ESTATE

As of June 30, 2022, Pillarstone OP owned eight Real Estate Assets in the Dallas and Houston areas comprised of approximately 0.9 million square feet of gross leasable area.

7. DEBT

Mortgages and other notes payable consist of the following (in thousands):

Our mortgage debt was collateralized by one operating property as of June 30, 2022 and December 31, 2021 with a net book value of $21.3 million. Our loan contains restrictions that would require the payment of prepayment penalties for the acceleration of outstanding debt and is secured by a deed of trust on our property and the assignment of certain rents and leases associated with the property. Our loan is subject to customary covenants. During the period ending June 30, 2022, we also entered into an additional loan related to our commercial property insurance policy. As of June 30, 2022, we were in compliance with all loan covenants.

Scheduled maturities of notes payable as of June 30, 2022 were as follows (in thousands):

8. 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, our board of trustees approved an extension of the maturity date to November 20, 2021. In 2021, the noteholders agreed to extend the maturity date to November 30, 2022. 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. At maturity or when the Company chooses to call the convertible notes payable, the noteholders have the option to receive cash plus accrued interest or convert the convertible notes payable into Common Shares at $1.331 per Common Share. Accrued interest on these related convertible notes was approximately $131,000 as of June 30, 2022 compared with approximately $121,000 as of December 31, 2021.

9. 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 earnings per Common Share calculations for the three and six month periods ended June 30, 2022 and 2021.

For the three and six month periods ended June 30, 2022 and 2021, Class A Preferred Shares and Class C Preferred Shares were not included in net loss per weighted average number of Common Share outstanding-diluted, because the effect of the conversion would be anti-dilutive.

During the three and six month periods ended June 30, 2022 and 2021, the Company had $197,780 of convertible notes payable as discussed in Note 8. The convertible notes payable were not included in the computation of diluted loss per share for the three and six months ended June 30, 2022 and 2021 because the effect of the conversion would be anti-dilutive.  For the three and six month periods ended June 30, 2022 and 2021, Restricted Common Shares awarded pursuant to the 2016 plan (defined in Note 11 below) were not included in net loss per weighted average number of Common Share outstanding-dilutive, because the effect of the conversion would be anti-dilutive.

10. RELATED PARTY TRANSACTIONS

On December 8, 2016, the Company entered into the Contribution Agreement with Whitestone OP, a related party, resulting in the contribution of an equity ownership interest in Pillarstone OP by 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 agreed to file with the Securities and Exchange Commission (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 issuance of the common shares in the Company that may be issued upon redemption of the OP Units issued pursuant to the Contribution 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 the date that the Company closes a public equity offering.

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.     

In connection with the Contribution Agreement, on December 8, 2016, the Company 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 (2) a monthly asset management fee equal to 0.125% of GAV of Uptown Tower.  On July 19, 2022, Pillarstone received written notice that Whitestone TRS confirmed termination of the Management Agreements for the Pillarstone OP Real Estate Assets even though neither Pillarstone and Pillarstone OP had made any efforts to terminate the Management Agreements. See Note 12-Subesequent Events for additional information.

The following table presents the revenue and expenses with Whitestone included in our condensed consolidated statement of operations for the three and six months ended June 30, 2022 and 2021 (in thousands):

Receivables due from and payables due to related parties consisted of the following as of June 30, 2022 and December 31, 2021 (in thousands):

11. 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 types of financial performance measures.

As of the six months ended June 30, 2022, the following shares are available for grant:

For the three and six months ended  June 30, 2022, the Company did not recognize any stock-based compensation expense for trustee compensation or employee stock-based compensation.. For the three and six months ended June 30, 2021, the Company recognized approximately $2,000 and $17,000 in employee stock-based compensation, respectively.  For the three and six months ended June 30, 2021, the Company did not recognize any stock-based compensation expense for trustee compensation.

12. SUBSEQUENT EVENTS

During the first quarter of 2022, based on a legal review of the Pillarstone OP operating partnership agreement dated December 8, 2016, between Pillarstone, as general partner, and Whitestone OP, as limited partner, Pillarstone determined that its operating and administrative expenses should be reimbursed by Pillarstone OP on a historical and on-going basis. Accordingly, Pillarstone notified Whitestone OP, which manages Pillarstone OP's properties and provides the accounting function for both Pillarstone and Pillarstone OP, to transfer cash of $1,819,729 from Pillarstone OP to Pillarstone as reimbursement for Pillarstone's operating and administrative expenses for the years ended 2017 through 2021. In April 2022, Whitestone and Whitestone OP contested the expense reimbursement. Pillarstone and Pillarstone OP recorded the expense reimbursement of $1,819,729 with a reserve of $1,819,729 on each company’s separate books and records in the first quarter 2022 although these amounts are eliminated in the consolidated financial statements herein. The reserve was recorded due to Whitestone and Whitestone OP's contesting the expense reimbursement. Pillarstone intends to pursue the collection of the expense reimbursement from Pillarstone OP based on the provisions of the Amended and Restated Agreement of Limited Partnership.

After Pillarstone notified Whitestone of the $1,819,729 expense reimbursement required from Pillarstone OP, Whitestone and Whitestone OP made a claim to Pillarstone and Pillarstone OP to be reimbursed for construction and lease commission expenditures of $1,425,972 paid by Whitestone OP on behalf of Pillarstone OP during 2017 and 2018. Pillarstone requested additional information for the $1,425,972 expenditures to determine if any of the items claimed should have been prorated between Pillarstone OP and Whitestone OP when the December 8, 2016 transaction occurred for Pillarstone OP’s acquisition of the Real Estate Assets. Whitestone OP is an 81.4% limited partner of Pillarstone OP and Pillarstone is the general partner owning the remaining 18.6% of Pillarstone OP. The $1,425,972 expenditures were recorded on Pillarstone OP in 2017 and 2018 as an increase in the Whitestone OP limited partner investment account and as assets of Pillarstone OP that have been depreciated and amortized to expense over their useful lives. The amount due Whitestone OP for these expenditures, if any, has not been determined. If Pillarstone OP reimburses any amounts to Whitestone OP, the payment would reduce the Whitestone OP limited partner investment account.

In April 2022, Pillarstone determined the expense reimbursement of $176,593 was due from Pillarstone OP for Pillarstone's operating and administrative expenses for the first quarter of 2022. Pillarstone OP transferred $117,186 to Pillarstone in May 2022. The difference of $59,407 between the expense reimbursement $176,593 and the cash transferred $117,186 are Pillarstone expenses contested by Whitestone and Whitestone OP. Pillarstone and Pillarstone OP recorded the expense reimbursement of $176,593 with an allowance of $59,407 on each company’s separate books and records in the first quarter 2022 although these amounts are eliminated in the consolidated financial statements herein. Pillarstone intends to pursue reimbursement of the contested expenses based on the provisions of the Amended and Restated Agreement of Limited Partnership.

In July 2022, Pillarstone determined the expense reimbursement of $94,550 was due from Pillarstone OP for Pillarstone’s operating and administrative expenses for the second quarter of 2022 of which Whitestone and Whitestone OP contested expenses of $61,724. Pillarstone and Pillarstone OP recorded the expense reimbursement of $94,550 with an allowance of $61,724 on each company’s separate books and records in the second quarter 2022 although these amounts are eliminated in the consolidated financial statements herein. Pillarstone OP will transfer $32,826 of uncontested expenses to Pillarstone in the third quarter of 2022 and Pillarstone intends to pursue reimbursement of the contested expenses based on the provisions of the Amended and Restated Agreement of Limited Partnership.

On July 12, 2022, Pillarstone was named as a defendant in a lawsuit filed in the Court of Chancery of the State of Delaware by Whitestone OP. The suit challenges Pillarstone’s rights agreement, dated as of December 27, 2021 (as the same may be amended from time to time, the “Rights Agreement”), between Pillarstone and American Stock Transfer & Trust Company, LLC, as rights agent, and claims that Pillarstone’s adoption of the Rights Agreement breached the Amended and Restated Agreement of Limited Partnership, and that Pillarstone breached its fiduciary duties as general partner of Pillarstone OP to Whitestone OP and breached the implied covenant of good faith and fair dealing under the Amended and Restated Agreement of Limited Partnership. On July 21, 2022, Whitestone OP filed a Motion to Preserve the Status Quo requesting broad restrictions on Pillarstone’s ability to conduct its business, including buying properties, enforcing the Rights Agreement, incurring expenses, or engaging in transactions. Pillarstone believes that these allegations are without merit, intends to vigorously defend against them, and is considering its rights and potential courses of action with respect to the lawsuit. However, an unfavorable outcome of this lawsuit is unpredictable and could result in substantial costs to Pillarstone.

On July 19, 2022, Pillarstone received written notice that Whitestone TRS confirmed termination of the management agreements for the Pillarstone OP’s Real Estate Assets. Whitestone TRS is a subsidiary of Whitestone REIT, which owns Whitestone OP, the holder of 81.4% of the total outstanding Class A units representing limited partnership interests in Pillarstone OP. Substantially all of Pillarstone’s business is conducted through Pillarstone OP. Pillarstone is the sole general partner of Pillarstone OP and owns 18.6% of the outstanding equity in Pillarstone OP. Pursuant to the management agreements with respect to each Real Estate Asset (other than the Uptown Tower Real Estate Asset), 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 pursuant to which Pillarstone OP acquired the equity interests of the entities that owned the Real Estate Assets) of such Real Estate Asset. Pursuant to the management agreement with respect to the Uptown Tower Real Estate Asset, 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. Pillarstone had previously communicated to Whitestone REIT its plan to internalize the management of the Real Estate Assets, but Pillarstone had not made efforts to terminate the management agreements. However, Whitestone TRS stated in its notice letter that while it had not received written notice of the termination of the management agreements, it “confirms receipt of your intent to terminate, and hereby confirms termination of the Agreements effective 30 days from” July 19, 2022. Following the transition of management from Whitestone TRS, Pillarstone intends to internalize the management of its Real Estate Assets and to continue to pursue its business without the management services provided by Whitestone TRS under the management agreements.

On July 21, 2022, before receiving Whitestone OP’s filed Motion to Preserve the Status Quo requesting broad restrictions on Plllarstone’s ability to conduct its business (see above), Pillarstone’s board of trustees increased the size of the board from five to six trustees and appointed Bradford Johnson as Pillarstone’s President and Chief Executive Officer and to the board to serve as a Class I trustee with a term expiring at Pillarstone’s annual meeting of shareholders to be held in 2025. Mr. Johnson replaces James C. Mastandrea as President and Chief Executive Officer. Mr. Mastandrea, who had been Pillarstone’s Chairman, President and Chief Executive Officer since 2003, ended his term as President and Chief Executive Officer and continues to serve in his role as Chairman and trustee of Pillarstone. In addition, the board appointed Daniel P. Kovacevic as Pillarstone’s Chief Financial Officer. Mr. Kovacevic replaces John J. Dee as Chief Financial Officer. Mr. Dee, who had been Pillarstone’s Senior Vice President, Chief Financial Officer, Secretary and a trustee since 2003, ended his term as Chief Financial Officer and continues to serve in his role as a trustee of Pillarstone. The board also appointed William J. Carter as Pillarstone’s Chief Operating Officer. Pillarstone is proceeding to internalize management and become a self-directed, self-managed real estate company.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 unaudited condensed consolidated financial statements and the notes thereto in this Quarterly Report on Form 10-Q. 

This Quarterly Report on Form 10-Q 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 Quarterly Report on Form 10-Q. 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 Report include:

In addition, an investment in the Company involves numerous risks that potential investors should consider carefully, including, without limitation:

Overview

The Company is a Maryland real estate investment trust ("REIT") engaged in investing in, owning and operating commercial properties. Future real estate opportunities 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, (iii) sales of existing properties, (iv) redevelopment of existing properties, and (v) joint venture investments. Substantially all of our business is conducted through our operating partnership Pillarstone OP. We are the sole general partner of Pillarstone OP. As of June 30, 2022, we owned approximately 18.6% of the outstanding equity in Pillarstone OP and we fully consolidate it on our condensed consolidated financial statements.

As of June 30, 2022, 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 REIT 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. From 2006 until December 2016, the Company continued its existence 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: 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”) that owned 14 real estate assets (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”).  Whitestone OP is the 81.4% limited partner of Pillarstone OP.

            In connection with the Contribution Agreement, on December 8, 2016, Pillarstone entered into 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 (2) a monthly asset management fee equal to 0.125% of GAV of Uptown Tower.

Lawsuit and Termination of Management Agreements

            On July 12, 2022, after the quarterly period ended June 30, 2022, Pillarstone was named as a defendant in a lawsuit filed in the Court of Chancery of the State of Delaware by Whitestone OP. The suit challenges Pillarstone’s rights agreement, dated as of December 27, 2021 (as the same may be amended from time to time, the “Rights Agreement”), between Pillarstone and American Stock Transfer & Trust Company, LLC, as rights agent, and claims that Pillarstone’s adoption of the Rights Agreement breached the Amended and Restated Agreement of Limited Partnership, and that Pillarstone breached its fiduciary duties as general partner of Pillarstone OP to Whitestone OP and breached the implied covenant of good faith and fair dealing under the Amended and Restated Agreement of Limited Partnership. On July 21, 2022, Whitestone OP filed a Motion to Preserve the Status Quo requesting broad restrictions on Pillarstone’s ability to conduct its business, including buying properties, enforcing the Rights Agreement, incurring expenses, or engaging in transactions. Pillarstone believes that these allegations are without merit, intends to vigorously defend against them, and is considering its rights and potential claims for affirmative relief with respect to the lawsuit. However, an unfavorable outcome of this lawsuit is unpredictable and could result in substantial costs to Pillarstone.

             On July 19, 2022, Pillarstone received written notice that Whitestone TRS confirmed termination of the management agreements for the Real Estate Assets.  Pillarstone had previously communicated to Whitestone its plan to internalize the management of the Real Estate Assets, but Pillarstone had not made efforts to terminate the management agreements.  However, Whitestone TRS stated in its notice letter that while it had not received written notice of the termination of the management agreements, it “confirms receipt of your intent to terminate, and hereby confirms termination of the Agreements effective 30 days from” July 19, 2022. Following the transition of management from Whitestone TRS, Pillarstone intends to internalize the management of its Real Estate Assets and to continue to pursue its business without the management services provided by Whitestone TRS under the management agreements.

Prior to receiving the termination notice, Pillarstone had anticipated an orderly transition of the management of the Real Estate Assets over an appropriate timeframe.  The management agreements provided for Whitestone TRS to provide such services, or in certain cases contracting with other providers to perform such services, as:

The services under the management agreements are extensive and material to the operation of Pillarstone’s business and financial reporting. Pillarstone believes the management functions as operated by Whitestone were deeply integrated with Whitestone’s management functions for its own business and may be difficult, expensive, and time-consuming to separate.  If the timeframe to internalize the management functions based on the termination notice is too short, and if Whitestone does not cooperate with an orderly transfer of the management of the Real Estate Assets, Pillarstone’s business, income, cash flow, results of operations, financial condition, liquidity, and prospects could be materially and adversely affected.

Impact of COVID-19

The ongoing COVID-19 pandemic has in the past and may continue to materially and adversely impact and disrupt our business, financial condition, results of operations and cash flows. Any future outbreak of any COVID-19 variants or any other highly infectious or contagious disease could have a similar impact.

The impact of COVID-19, including any resurgences, future pandemics or other health crises may adversely affect our business, financial condition, results of operations, cash flows and market value. These type of health crises may impact our business in the following ways:

Because substantially all of our income is derived from rentals of commercial real property, our business, income, cash flow, results of operations, financial condition, liquidity, prospects and ability to service our debt obligation would be adversely affected if a significant number of tenants are unable to meet their obligations or their revenues decline. The extent to which the COVID-19 pandemic, or a future pandemic, impacts our operations and those of our tenants will depend on future developments, which are highly uncertain and cannot be predicted with confidence.

Results of Operations

The following is a discussion of our results of operations for the three and six months ended June 30, 2022 and 2021 and our financial condition, including:

The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and notes thereto appearing elsewhere in this Quarterly Report.

Comparison of the Six Month Periods Ended June 30, 2022 and 2021

Leasing Activity

For the six month period ended June 30, 2022, we executed 32 leases for a total lease value of $1.7 million compared to 46 leases for a total lease value of $3.2 million for the six month period ended June 30, 2021.

Results of Operations

The following provides a general comparison of our results of operations for the six month periods ended June 30, 2022 and 2021 (dollars in thousands):

Revenues from Operations

We had total revenues for the six month periods ended June 30, 2022 and 2021 of approximately $4,604,000 and $4,462,000, respectively, for an increase of approximately $142,000, or 3%. The difference was comprised of a decrease of approximately $74,000 in rental revenues, an increase of $216,000 in expense reimbursements, an increase of $10,000 in other revenue, and an increase of $10,000 in bad debt, which is classified as a part of revenue. The majority of the overall increase was due to higher reimbursements from common area maintenance and unbilled recoveries from the prior year.

Expenses from Operations

Our operating expenses were approximately $4,009,000 for the six months ended June 30, 2022 compared to approximately $3,922,000 for the six months ended June 30, 2021, an increase of approximately $87,000, or 2%. The overall increase was primarily due to increases in miscellaneous repairs, contract services, and electricity usage at our properties, offset by a decrease in real estate taxes for the six months ended June 30, 2022, compared to the six months ended June 30, 2021. The primary components of operating expenses are detailed in the table below (in thousands):

Comparison of the Three Month Periods Ended June 30, 2022 and 2021

Leasing Activity

For the three month period ended June 30, 2022, we executed 15 leases for a total lease value of $700,000 compared to 23 leases for a total lease value of $1.9 million for the three month period ended June 30, 2021.

Results of Operations

The following provides a general comparison of our results of operations for the three month periods ended June 30, 2022 and 2021 (dollars in thousands):

Revenues from Operations

We had total revenues for the three month periods ended June 30, 2022 and 2021 of approximately $2,278,000 and $2,272,000, respectively, for an increase of approximately $6,000. The difference was comprised of a decrease of approximately $50,000 in rental revenues, an increase of $87,000 in expense reimbursements, an increase of $4,000 in other revenue, and an increase of $35,000 in bad debt, which is classified as a part of revenue. The majority of the overall increase was due to higher reimbursements from common area maintenance and unbilled recoveries from the prior year.

Expenses from Operations

Our operating expenses were approximately $2,099,000 for the three months ended June 30, 2022 compared to approximately $1,952,000 for the three months ended June 30, 2021, an increase of approximately $147,000, or 8%. The overall increase was primarily due to increases in miscellaneous repairs, contract services, and electricity usage at our properties for the three months ended June 30, 2022, compared to the three months ended June 30, 2021. The primary components of operating expenses are detailed in the table below (in thousands):

Liquidity and Capital Resources

Cash Flows

As of June 30, 2022, our unrestricted cash resources were approximately $4,796,000. We are dependent on cash generated by our ownership of the eight Real Estate Assets to meet our liquidity needs.

During the six months ended June 30, 2022, the Company's cash balance decreased by $410,000 from $5,206,000 at December 31, 2021 to $4,796,000 at June 30, 2022. This decrease in cash was due to cash provided by operating activities of approximately $608,000, cash used in investing activities of approximately $700,000 and cash used in financing activities of approximately $318,000.

During the first quarter of 2022, Pillarstone Capital REIT (“Pillarstone REIT”) determined that it should be reimbursed for its operating and administrative expenses from Pillarstone OP on a historical and ongoing basis in accordance with the Pillarstone OP operating partnership agreement in which Pillarstone REIT is the general partner and Whitestone OP is the limited partner. Whitestone and Whitestone OP contested the reimbursement of expenses of approximately $1.8 million for the years ended 2017 through 2021 and Pillarstone REIT intends to pursue the reimbursement from Pillarstone OP. The funds are in bank accounts currently controlled by affiliates of Whitestone and Whitestone OP pursuant to Pillarstone OP management agreements with those Whitestone affiliates, and the parties are in the process of transitioning the accounts to Pillarstone's control. For financial reporting purposes, Pillarstone REIT and Pillarstone OP report on a consolidated basis, therefore, the reimbursement of Pillarstone REIT's expenses would not change net income but only the allocations between controlling and noncontrolling interests. For the three months ended March 31, 2022, Pillarstone OP reimbursed Pillarstone REIT in May 2022 approximately $117,000 for a portion of operating and administrative expenses and Pillarstone REIT will pursue reimbursement from Pillarstone OP for the remaining amount of approximately $59,000 that Whitestone and Whitestone OP have contested.  For the three months ended June 30, 2022, Pillarstone determined approximately $95,000 of its operating and administrative expenses should be reimubursed by Pillarstone OP, of which Whitestone and Whitestone OP contested approximately $62,000.  Pillarstone OP will reimburse Pillarstone approximately $33,000 for the uncontested expenses in the third quarter of 2022 and Pillarstone will pursue the contested expenses based on the provisions in the Amended and Restated Agreement of Limited Partnership.

.

When Pillarstone REIT made its determination for reimbursement of its operating and administrative expenses from Pillarstone OP for the years ended 2017 through 2021, Whitestone and Whitestone OP determined Whitestone OP should be reimbursed for construction and lease commissions of approximately $1.4 million that it paid on behalf of Pillarstone OP for 2017 and 2018. Pillarstone REIT and Pillarstone OP requested additional information from Whitestone and Whitestone OP for these expenditures. If any reimbursement is made to Whitestone OP, then Pillarstone OP would have less cash available for operations and distributions to its partners and Pillarstone OP’s investment account with Whitestone OP would be reduced.

Our ability to access the capital markets will be dependent on a number of factors, including general market conditions and market perceptions about our Company.

Future Obligations

None.

Long Term Liquidity and Operating Strategies

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

From 2006 until December 2016, the Company continued its existence as a corporate shell filing its periodic reports with the SEC so that it could be used for future real estate transactions or sold to another company. During this time, the Company was funded by its trustees who contributed $500,000 in exchange for 125,000 Preferred C Shares and $197,780 in exchange for convertible notes payable.

Subsequent to the Acquisition, Pillarstone has been developing strategies for the Real Estate Assets in order to create value for the enterprise and our shareholders and selling assets to pay off some of its debt. To implement the strategy to create value with the Real Estate Assets, additional capital will need to be raised.

Current Tax Status

As of June 30, 2022 and December 31, 2021, we had net deferred tax liabilities of approximately $11,000 and $36,000, respectively. As of June 30, 2022, we have an operating loss carryforward of approximately $139,000 available to be carried to future periods.

The income tax expense (benefit) included in the condensed consolidated statements of operations for the three and six months ended June 30, 2022 and 2021 was comprised of the following components (in thousands):

Interest Rates

The Company was not significantly affected by interest rates during the periods presented in this report due primarily to the Company having approximately 100% of its debt with fixed rates as of June 30, 2022.

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.

Application of Critical Accounting Estimates

Our condensed consolidated financial statements are prepared in accordance with GAAP, which require 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 condensed consolidated financial statements.

Revenue recognition. All leases on our properties are classified as noncancelable operating leases, and the related rental income is recognized on a straight-line basis over the terms of the related leases. For the three months ended June 30, 2022, we did not have a straight-line rent reserve adjustment.  For the six months ended June 30, 2022, we had a straight-line rent reserve adjustment of $1,000 for the conversion of one tenant to cash basis as a result of our COVID-19 collectibility analysis.  For the three and six months ended June 30, 2021, we had a straight-line rent reserve adjustment of $1,000 for the conversion of one tenant to cash basis as a result of our COVID-19 collectibility analysis. 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. Recoveries from tenants for taxes, insurance, and other operating expenses are recognized as revenues in the period the corresponding costs are incurred.  We combine lease and nonlease components in lease contracts, which includes combining base rent and recoveries into a single line item, Rental, within the condensed consolidated statements of operations. We recognize lease termination fees in the year that the lease is terminated and collection of the fee is reasonably assured.

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 June 30, 2022.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Our management, under the supervision and with the participation of our principal executive and financial officers, has evaluated the effectiveness of our disclosure controls and procedures in ensuring that the information required to be disclosed in our filings under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, including ensuring that such information is accumulated and communicated to its management, as appropriate, to allow timely decisions regarding required disclosure.

Based on such evaluation, our principal executive and financial officers have concluded that such disclosure controls and procedures were effective as of June 30, 2022 (the end of the period covered by this Quarterly Report).

Changes in Internal Control Over Financial Reporting

There have been no significant changes in our internal control over financial reporting during the three months ended June 30, 2022 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On July 12, 2022, after the quarterly period ended June 30, 2022, Pillarstone was named as a defendant in a lawsuit filed in the Court of Chancery of the State of Deleware by Whitestone OP.  The lawsuit is described in Part I, Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations", under the heading "Lawsuit and Termination of Management Agreements".  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 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. MINE SAFETY DISCLOSURES.

Not applicable.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

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.