PHILLIPS EDISON GROCERY CENTER REIT II, INC. - FORM 10-Q - November 10, 2014

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EX-31.1 - EXHIBIT 31.1 - PHILLIPS EDISON GROCERY CENTER REIT II, INC.pe-arc2q32014exhibit311.htm
EX-32.1 - EXHIBIT 32.1 - PHILLIPS EDISON GROCERY CENTER REIT II, INC.pe-arc2q32014exhibit321.htm
EX-32.2 - EXHIBIT 32.2 - PHILLIPS EDISON GROCERY CENTER REIT II, INC.pe-arc2q32014exhibit322.htm
EX-31.2 - EXHIBIT 31.2 - PHILLIPS EDISON GROCERY CENTER REIT II, INC.pe-arc2q32014exhibit312.htm
EXCEL - IDEA: XBRL DOCUMENT - PHILLIPS EDISON GROCERY CENTER REIT II, INC.Financial_Report.xls
EX-10.1 - EXHIBIT 10.1 - PHILLIPS EDISON GROCERY CENTER REIT II, INC.exhibit101creditagreementd.htm


 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
x    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2014
OR
¨     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 333-190588
 
PHILLIPS EDISON – ARC GROCERY CENTER REIT II, INC.  
 
(Exact Name of Registrant as Specified in Its Charter)
 
Maryland
61-1714451
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
 
11501 Northlake Drive
 Cincinnati, Ohio
45249
(Address of Principal Executive Offices)
(Zip Code)
(513) 554-1110
(Registrant’s Telephone Number, Including Area Code)
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No   ¨   
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨   
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
¨
Accelerated Filer
¨
 
 
 
 
Non-Accelerated Filer
o  (Do not check if a smaller reporting company)
Smaller reporting company
x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x 
As of November 1, 2014, there were 20.5 million outstanding shares of common stock of Phillips Edison – ARC Grocery Center REIT II, Inc.



PHILLIPS EDISON – ARC GROCERY CENTER REIT II, INC.
FORM 10-Q
September 30, 2014
INDEX
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


1


PART I.        FINANCIAL INFORMATION
 
Item 1.          Financial Statements

PHILLIPS EDISON – ARC GROCERY CENTER REIT II, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
AS OF SEPTEMBER 30, 2014 AND DECEMBER 31, 2013
(Unaudited)
(In thousands, except share and per share amounts)
  
September 30, 2014
 
December 31, 2013
ASSETS
  
 
  
Investment in real estate:
  
 
  
Land
$
26,930

 
$
—

Building and improvements
80,231

 
—

Total investment in real estate assets
107,161

 
—

Accumulated depreciation and amortization
(780
)
 
—

Total investment in real estate assets, net
106,381

 
—

Acquired intangible lease assets, net of accumulated amortization of $489 and $0, respectively
11,229

 
—

Cash and cash equivalents
243,948

 
100

Restricted cash
68

 
—

Deferred offering costs
—

 
1,858

Accounts receivable, net
410

 
—

Deferred financing expense, less accumulated amortization of $189 and $0, respectively
2,986

 
—

Prepaid expenses and other
16,745

 
390

Total assets
$
381,767

 
$
2,348

LIABILITIES AND EQUITY
  

 
  

Liabilities:
  

 
  

Mortgages and loans payable
$
12,825

 
$
—

Acquired below market lease intangibles, less accumulated amortization of $91 and $0, respectively
1,844

 
—

Accounts payable
34

 
—

Accounts payable – affiliates
686

 
1,988

Accrued and other liabilities
4,473

 
9

Notes payable
—

 
296

Total liabilities
19,862

 
2,293

Commitments and contingencies (Note 9)
—

 
—

Equity:
  

 
  

Preferred stock, $0.01 par value per share, 10,000,000 shares authorized, zero shares issued and outstanding at September 30, 2014
  
 
  
and December 31, 2013
—

 
—

Common stock, $0.01 par value per share, 1,000,000,000 shares authorized, 17,127,943 and 8,888 shares issued and
  
 
  
outstanding at September 30, 2014 and December 31, 2013, respectively
171

 
—

Additional paid-in capital
373,198

 
200

Accumulated deficit
(11,464
)
 
(145
)
Total equity
361,905

 
55

Total liabilities and equity
$
381,767

 
$
2,348


See notes to condensed consolidated financial statements.

2


PHILLIPS EDISON – ARC GROCERY CENTER REIT II, INC.
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS AND COMPREHENSIVE LOSS
FOR THE PERIOD ENDED SEPTEMBER 30, 2014
(Unaudited)
(In thousands, except share and per share amounts)
  
Three Months Ended
 
Nine Months Ended
  
September 30, 2014
 
September 30, 2014
Revenues:
  
 
  
Rental income
$
1,521

 
$
1,995

Tenant recovery income
423

 
541

Other property income
11

 
12

Total revenues
1,955

 
2,548

Expenses:
  

 
  

Property operating
313

 
411

Real estate taxes
262

 
322

General and administrative
393

 
962

Acquisition expenses
1,494

 
2,080

Depreciation and amortization
930

 
1,186

Total expenses
3,392

 
4,961

Operating loss
(1,437
)
 
(2,413
)
Other income (expense):
  

 
  

Interest expense, net
(499
)
 
(631
)
Other income
15

 
15

Net loss
$
(1,921
)
 
$
(3,029
)
Per share information - basic and diluted:
  

 
  

Net loss per share - basic and diluted
$
(0.15
)
 
$
(0.44
)
Weighted-average common shares outstanding - basic and diluted
13,100,886

 
6,825,981

 
 
 
  

Comprehensive loss:
  

 
 
Net loss
$
(1,921
)
 
$
(3,029
)
Other comprehensive income
—

 
—

Comprehensive loss
$
(1,921
)
 
$
(3,029
)

See notes to condensed consolidated financial statements.

3


PHILLIPS EDISON – ARC GROCERY CENTER REIT II, INC.
CONDENSED CONSOLIDATED STATEMENT OF EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2014
(Unaudited)
(In thousands, except share and per share amounts)
  
  
 
  
 
  
 
  
 
  
  
  
 
  
 
Additional
 
  
 
Total
  
Common Stock
 
Paid-In
 
Accumulated
 
Stockholders'
  
Shares
 
Amount
 
Capital
 
Deficit
 
Equity
Balance at January 1, 2014
8,888

 
$
—

 
$
200

 
$
(145
)
 
$
55

Issuance of common stock
16,985,349

 
170

 
422,197

 
—

 
422,367

Share repurchases
—

 
—

 
(32
)
 
—

 
(32
)
Distribution reinvestment plan (DRIP)
133,706

 
1

 
3,175

 
—

 
3,176

Common distributions declared, $1.08 per share
—

 
—

 
—

 
(8,290
)
 
(8,290
)
Offering costs
—

 
—

 
(52,342
)
 
—

 
(52,342
)
Net loss
—

 
—

 
—

 
(3,029
)
 
(3,029
)
Balance at September 30, 2014
17,127,943

 
$
171

 
$
373,198

 
$
(11,464
)
 
$
361,905


See notes to condensed consolidated financial statements.

4


PHILLIPS EDISON – ARC GROCERY CENTER REIT II, INC.
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2014
(Unaudited)
(In thousands)
  
Nine Months Ended
  
September 30, 2014
CASH FLOWS FROM OPERATING ACTIVITIES:
  
Net loss
$
(3,029
)
Adjustments to reconcile net loss to net cash provided by operating activities:
  

Depreciation and amortization
1,180

Net amortization of above- and below-market leases
(8
)
Amortization of deferred financing costs
189

Straight-line rental income
(89
)
Changes in operating assets and liabilities:
  

Accounts receivable
(321
)
Prepaid expenses and other
144

Accounts payable
11

Accounts payable – affiliates
16

Accrued and other liabilities
2,040

Net cash provided by operating activities
133

CASH FLOWS FROM INVESTING ACTIVITIES:
  

Real estate acquisitions
(119,074
)
Capital expenditures
(249
)
Change in restricted cash
(68
)
Net cash used in investing activities
(119,391
)
CASH FLOWS FROM FINANCING ACTIVITIES:
  

Proceeds from issuance of common stock
422,367

Payment of offering costs
(52,696
)
Payments on mortgages and loans payable
(102
)
Payments on notes payable
(296
)
Distributions paid, net of DRIP
(2,992
)
Payments of loan financing costs
(3,175
)
Net cash provided by financing activities
363,106

NET INCREASE IN CASH AND CASH EQUIVALENTS
243,848

CASH AND CASH EQUIVALENTS:
  

Beginning of period
100

End of period
$
243,948

SUPPLEMENTAL CASHFLOW DISCLOSURE, INCLUDING NON-CASH INVESTING AND FINANCING ACTIVITIES:
  
Cash paid for interest
$
262

Change in offering costs payable to advisor and sub-advisor
(2,212
)
Change in distributions payable
2,122

Change in accrued share repurchase obligation
32

Assumed debt
12,933

Accrued capital expenditures
293

Distributions reinvested
3,176

Reclassification of deferred offering costs to additional paid-in capital
1,858


See notes to condensed consolidated financial statements.

5


 Phillips Edison—ARC Grocery Center REIT II, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
1. ORGANIZATION
 
Phillips Edison—ARC Grocery Center REIT II, Inc. (“we”, the “Company”, “our” or “us”) was formed as a Maryland corporation on June 5, 2013, and intends to qualify as a real estate investment trust (“REIT”) beginning with the taxable year ending December 31, 2014. Substantially all of our business is conducted through Phillips Edison—ARC Grocery Center Operating Partnership II, L.P. (the “Operating Partnership”), a Delaware limited partnership formed on June 4, 2013. We are a limited partner of the Operating Partnership, and our wholly owned subsidiary, PE-ARC Grocery Center OP GP II LLC, is the sole general partner of the Operating Partnership. As we accept subscriptions for shares in our continuous public offering, we will transfer all of the net proceeds of the offering to the Operating Partnership as a capital contribution in exchange for units of limited partnership interest; however, we are deemed to have made capital contributions in the amount of the gross offering proceeds received from investors.
 
We are offering to the public, pursuant to a registration statement filed on Form S-11 with the Securities and Exchange Commission (the “SEC”) and deemed effective on November 25, 2013, $2.475 billion in shares of common stock on a “reasonable best efforts” basis in our initial public offering (“our initial public offering”). Our initial public offering consists of a primary offering of $2.0 billion in shares offered to investors at a price of $25.00 per share, with discounts available for certain categories of purchasers, and $0.475 billion in shares offered to stockholders pursuant to a distribution reinvestment plan (the “DRIP”) at a price of $23.75 per share. We have the right to reallocate the shares of common stock offered between the primary offering and the DRIP.
 
Our advisor is American Realty Capital PECO II Advisors, LLC (the “Advisor”), a newly organized limited liability company that was formed in the State of Delaware on July 9, 2013 and is under common control with AR Capital LLC (the “AR Capital sponsor”). We have entered into an advisory agreement with the Advisor which makes the Advisor ultimately responsible for the management of our day-to-day activities and the implementation of our investment strategy. The Advisor has delegated certain duties under the advisory agreement, including the management of our day-to-day operations and our portfolio of real estate assets, to Phillips Edison NTR II LLC (the “Sub-advisor”), which is directly or indirectly owned by Phillips Edison Limited Partnership (the “Phillips Edison sponsor”), and Michael Phillips and Jeffrey Edison, principals of our Phillips Edison sponsor. Notwithstanding such delegation to the Sub-advisor, the Advisor retains ultimate responsibility for the performance of all the matters entrusted to it under the advisory agreement.
 
We plan to invest primarily in well-occupied grocery-anchored neighborhood and community shopping centers leased to a mix of national, creditworthy retailers selling necessity-based goods and services in strong demographic markets throughout the United States. In addition, we may invest in other retail properties including power and lifestyle shopping centers, multi-tenant shopping centers, free-standing single-tenant retail properties, and other real estate and real estate-related loans and securities depending on real estate market conditions and investment opportunities that we determine are in the best interests of our stockholders. We expect that retail properties primarily would underlie or secure the real estate-related loans and securities in which we may invest.

As of September 30, 2014, we owned a fee simple interest in eight real estate properties, acquired from third parties unaffiliated with us, the Advisor, or the Sub-advisor.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Set forth below is a summary of the significant accounting estimates and policies that management believes are important to the preparation of our condensed consolidated interim financial statements. Certain of our accounting estimates are particularly important for an understanding of our financial position and results of operations and require the application of significant judgment by management. As a result, these estimates are subject to a degree of uncertainty. There have been no changes to our significant accounting policies during the nine months ended September 30, 2014, except that subsequent to the issuance of our Annual Report on Form 10-K, we have continued to adopt additional accounting policies as required by our increasing operational activity, as disclosed below. For a summary of our significant accounting policies previously adopted, refer to our Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC on March 6, 2014.
 
Basis of Presentation and Principles of Consolidation—The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not

6


include all of the information and footnotes required by GAAP for complete financial statements. Readers of this Quarterly Report on Form 10-Q should refer to the audited financial statements of Phillips Edison—ARC Grocery Center REIT II, Inc. for the year ended December 31, 2013, which are included in our 2013 Annual Report on Form 10-K, as certain footnote disclosures contained in such audited financial statements have been omitted from this Quarterly Report on Form 10-Q. In the opinion of management, all normal and recurring adjustments necessary for the fair presentation have been included in this Quarterly Report. Our results of operations for the three and nine months ended September 30, 2014 are not necessarily indicative of the operating results expected for the full year.
 
Although we were formed on June 5, 2013, we were not capitalized until July 1, 2013, and our first expenses were not incurred until the fourth quarter of 2013. We did not commence operations until January 9, 2014, when we broke the minimum offering escrow requirement. As such, we had no results from operations for the period ended September 30, 2013, and therefore have not presented this as a comparative period within our condensed consolidated financial statements.

The accompanying condensed consolidated financial statements include our accounts and those of our wholly-owned subsidiaries. All intercompany balances and transactions are eliminated upon consolidation.
 
Organizational and Offering Costs—The Advisor and the Sub-advisor have paid offering expenses on our behalf. Pursuant to the terms of our advisory agreement with the Advisor, we will reimburse the Advisor and the Sub-advisor on a monthly basis for these costs and future offering costs they or any of their respective affiliates may incur on our behalf but only to the extent that the reimbursement would not exceed 2.0% of gross offering proceeds over the life of the offering or cause the selling commissions, the dealer manager fee and the other organization and offering expenses borne by us to exceed 15.0% of gross offering proceeds as of the date of the reimbursement. Organization and offering expenses include all expenses (other than selling commissions and the dealer manager fee) incurred by or on behalf of us in connection with or in preparing for the registration of and subsequently offering and distributing our shares of common stock to the public, which may include, but are not limited to, expenses for printing, engraving and mailing; compensation of employees while engaged in sales activity; charges of transfer agents, registrars, trustees, escrow holders, depositaries and experts; third-party due diligence fees as set forth in detailed and itemized invoices; and expenses of qualification of the sale of the securities under federal and state laws, including taxes and fees, accountants’ and attorneys’ fees. Pursuant to the terms of the sub-advisory agreement between the Advisor and Sub-advisor, this organization and offering expense limitation of 2.0% is apportioned as follows: 1.5% to our Sub-advisor; and 0.5% to our Advisor. Organizational costs are expensed as incurred by us, the Advisor, Sub-advisor or their respective affiliates on behalf of us.

Investment Property and Lease Intangibles—Real estate assets we have acquired are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method. The estimated useful lives for computing depreciation are generally five to seven years for furniture, fixtures and equipment, 15 years for land improvements and 30 years for buildings and building improvements. Tenant improvements are amortized over the shorter of the respective lease term or the expected useful life of the asset. Major replacements that extend the useful lives of the assets are capitalized, and maintenance and repair costs are expensed as incurred.
 
Real estate assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the individual property may not be recoverable. In such an event, a comparison will be made of the projected operating cash flows of each property on an undiscounted basis to the carrying amount of such property. Such carrying amount would be adjusted, if necessary, to estimated fair values to reflect impairment in the value of the asset. We recorded no impairments for the nine months ended September 30, 2014.
 
The results of operations of acquired properties are included in our results of operations from their respective dates of acquisition. We assess the acquisition-date fair values of all tangible assets, identifiable intangibles and assumed liabilities using methods similar to those used by independent appraisers (e.g., discounted cash flow analysis and replacement cost) and that utilize appropriate discount and/or capitalization rates and available market information. Estimates of future cash flows are based on a number of factors including historical operating results, known and anticipated trends, and market and economic conditions. The fair value of tangible assets of an acquired property considers the value of the property as if it was vacant. Acquisition-related costs are expensed as incurred.
 
The fair values of buildings and improvements are determined on an as-if-vacant basis.  The estimated fair value of acquired in-place leases is the cost we would have incurred to lease the properties to the occupancy level of the properties at the date of acquisition. Such estimates include leasing commissions, legal costs and other direct costs that would be incurred to lease the properties to such occupancy levels. Additionally, we evaluate the time period over which such occupancy levels would be achieved. Such evaluation includes an estimate of the net market-based rental revenues and net operating costs (primarily

7


consisting of real estate taxes, insurance and utilities) that would be incurred during the lease-up period. Acquired in-place leases as of the date of acquisition are amortized over the average remaining lease terms.  
 
Acquired above- and below-market lease values are recorded based on the present value (using interest rates that reflect the risks associated with the leases acquired) of the difference between the contractual amounts to be paid pursuant to the in-place leases and management’s estimate of the market lease rates for the corresponding in-place leases. The capitalized above- and below-market lease values are amortized as adjustments to rental income over the remaining terms of the respective leases.  We also consider fixed rate renewal options in our calculation of the fair value of below-market leases and the periods over which such leases are amortized.  If a tenant has a unilateral option to renew a below-market lease and we determine that the tenant has a financial incentive to exercise such option, we include such an option in the calculation of the fair value of such lease and the period over which the lease is amortized.
 
Management estimates the fair value of assumed mortgage notes payable based upon indications of then-current market pricing for similar types of debt with similar maturities. Assumed mortgage notes payable are initially recorded at their estimated fair value as of the assumption date, and the difference between such estimated fair value and the note’s outstanding principal balance is amortized over the life of the mortgage note payable as an adjustment to interest expense.

Deferred Financing Costs—Deferred financing costs are capitalized and amortized on a straight-line basis over the term of the related financing arrangement, which approximates the effective interest method. Deferred financing costs incurred during the three and nine months ended September 30, 2014 were approximately $2.7 million and $3.2 million, respectively. Amortization of deferred financing costs for the three and nine months ended September 30, 2014 was approximately $0.2 million and was recorded in interest expense in the consolidated statements of operations and comprehensive loss.

Revenue Recognition—We commence revenue recognition on our leases based on a number of factors. In most cases, revenue recognition under a lease begins when the lessee takes possession of or controls the physical use of the leased asset. Generally, this occurs on the lease commencement date. The determination of who is the owner, for accounting purposes, of the tenant improvements determines the nature of the leased asset and when revenue recognition under a lease begins. If we are the owner, for accounting purposes, of the tenant improvements, then the leased asset is the finished space, and revenue recognition begins when the lessee takes possession of the finished space, typically when the improvements are substantially complete.
 
If we conclude that we are not the owner, for accounting purposes, of the tenant improvements (the lessee is the owner), then the leased asset is the unimproved space and any tenant improvement allowances funded under the lease are treated as lease incentives, which reduce revenue recognized over the term of the lease. In these circumstances, we begin revenue recognition when the lessee takes possession of the unimproved space to construct their own improvements. We consider a number of different factors in evaluating whether we or the lessee is the owner of the tenant improvements for accounting purposes. These factors include:
•
whether the lease stipulates how and on what a tenant improvement allowance may be spent;
•
whether the tenant or landlord retains legal title to the improvements;
•
the uniqueness of the improvements;
•
the expected economic life of the tenant improvements relative to the length of the lease; and
•
who constructs or directs the construction of the improvements.
 
We recognize rental income on a straight-line basis over the term of each lease. The difference between rental income earned on a straight-line basis and the cash rent due under the provisions of the lease agreements is recorded as deferred rent receivable and is included as a component of accounts receivable. Due to the impact of the straight-line basis, rental income generally will be greater than the cash collected in the early years and will be less than the cash collected in the later years of a lease. Our policy for percentage rental income is to defer recognition of contingent rental income until the specified target (i.e. breakpoint) that triggers the contingent rental income is achieved. We periodically review the collectability of outstanding receivables. Allowances will be taken for those balances that we deem to be uncollectible, including any amounts relating to straight-line rent receivables.
 
Reimbursements from tenants for recoverable real estate tax and operating expenses are accrued as revenue in the period in which the applicable expenses are incurred. We make certain assumptions and judgments in estimating the reimbursements at the end of each reporting period. We do not expect the actual results to materially differ from the estimated reimbursements.
 

8


Income Taxes—We intend to elect to be taxed as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”) commencing with the taxable year ending December 31, 2014. Our qualification and taxation as a REIT depends on our ability, on a continuing basis, to meet certain organizational and operational qualification requirements imposed upon REITs by the Code. If we fail to qualify as a REIT for any reason in a taxable year, we will be subject to tax on our taxable income at regular corporate rates. We would not be able to deduct distributions paid to stockholders in any year in which we fail to qualify as a REIT. We will also be disqualified for the four taxable years following the year during which qualification was lost unless we are entitled to relief under specific statutory provisions. Even if we qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income, property or net worth, respectively, and to federal income and excise taxes on our undistributed income. Additionally, GAAP prescribes a recognition threshold and measurement attribute for the financial statement recognition of a tax position taken, or expected to be taken, in a tax return. A tax position may only be recognized in the consolidated financial statements if it is more likely than not that the tax position will be sustained upon examination. We believe it is more likely than not that our tax positions will be sustained in any tax examinations.

Restricted Cash—Restricted cash was $0.1 million as of September 30, 2014. This primarily consisted of escrowed tenant improvement funds, real estate taxes, capital improvement funds, insurance premiums, and other amounts required to be escrowed pursuant to loan agreements.

Earnings Per Share—Earnings per share are calculated based on the weighted-average number of common shares outstanding during each period. Diluted income per share considers the effect of any potentially dilutive share equivalents for the three and nine months ended September 30, 2014.
 
There were 4,455 Class B units of the Operating Partnership outstanding and held by the Advisor and the Sub-advisor as of September 30, 2014. The vesting of the Class B units is contingent upon a market condition and service condition. The satisfaction of the market or service condition was not probable as of September 30, 2014, and, therefore, the Class B units are not included in earnings per share.

Impact of Recently Issued Accounting Pronouncements—In April 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The amendments in this update raise the threshold for a property disposal to qualify as a discontinued operation and require new disclosures of both discontinued operations and certain other disposals that do not meet the definition of a discontinued operation. Unless we elect early adoption, the standard will be effective for us on January 1, 2015. In future periods, the adoption of this pronouncement may result in property disposals not qualifying for discontinued operations presentation, and thus the results of those disposals will remain in income from continuing operations.

In May 2014, FASB issued ASU 2014-09, Revenue from Contracts with Customers. ASU 2014-09 will eliminate the transaction- and industry-specific revenue recognition guidance currently in place under GAAP and will replace it with a principle-based approach for determining revenue recognition. ASU 2014-09 does not apply to lease contracts accounted for under Accounting Standards Codification (“ASC”) 840, Leases. ASU 2014-09 will be effective for annual and interim periods beginning after December 15, 2016, and early adoption is prohibited. We are currently assessing the impact the adoption of ASU 2014-09 will have on our financial statements.

3. EQUITY
 
General—We have the authority to issue a total of 1 billion shares of common stock with a par value of $0.01 per share and 10 million shares of preferred stock, $0.01 par value per share. As of September 30, 2014, we had issued 17.1 million shares of common stock generating gross cash proceeds of $425.7 million. We had issued no shares of preferred stock. The holders of shares of common stock are entitled to one vote per share on all matters voted on by stockholders, including election of the board of directors. Our charter does not provide for cumulative voting in the election of directors.
 
Distribution Reinvestment Plan—We have adopted the DRIP that allows stockholders to invest distributions in additional shares of our common stock at a price equal to $23.75 per share. Stockholders who elect to participate in the DRIP,
and who are subject to U.S. federal income taxation laws, will incur a tax liability on an amount equal to the fair value on the relevant distribution date of the shares of our common stock purchased with reinvested distributions, even though such stockholders have elected not to receive the distributions used to purchase those shares of common stock in cash.  Distributions reinvested through the DRIP for the three and nine months ended September 30, 2014 were $2.3 million and $3.2 million, respectively.
 

9


Share Repurchase Program—Our share repurchase program may provide a limited opportunity for stockholders to have shares of common stock repurchased, subject to certain restrictions and limitations, at a price equal to or at a discount from the purchase prices paid for the shares being repurchased.

Repurchase of shares of common stock will be made at least quarterly upon written notice received by us by 4:00 p.m. Eastern time on the last business day prior to a quarterly financial filing. Stockholders may withdraw their repurchase request at any time before 4:00 p.m. Eastern time on the last business day prior to a quarterly financial filing.

The board of directors may, in its sole discretion, amend, suspend, or terminate the share repurchase program at any time. If the board of directors decides to amend, suspend or terminate the share repurchase program, stockholders will be provided with no less than 30 days' written notice.

As of September 30, 2014, we had not repurchased any shares under our share repurchase program or otherwise. We did record a liability of $32,000 that represents our intent to repurchase 1,300 shares of common stock submitted as of September 30, 2014 but not yet repurchased. This repurchase will be made outside of the program.

4. FAIR VALUE MEASUREMENT
 
ASC 820, Fair Value Measurement (“ASC 820”) defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. ASC 820 emphasizes that fair value is intended to be a market-based measurement, as opposed to a transaction-specific measurement. Fair value is defined by ASC 820 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Depending on the nature of the asset or liability, various techniques and assumptions can be used to estimate the fair value. Assets and liabilities are measured using inputs from three levels of the fair value hierarchy, as follows:
Level 1—Inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access at the measurement date. An active market is defined as a market in which transactions for the assets or liabilities occur with sufficient frequency and volume to provide pricing information on an ongoing basis.
Level 2—Inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active (markets with few transactions), inputs other than quoted prices that are observable for the asset or liability (i.e., interest rates, yield curves, etc.), and inputs that are derived principally from or corroborated by observable market data correlation or other means (market corroborated inputs).
Level 3—Unobservable inputs, only used to the extent that observable inputs are not available, reflect our assumptions about the pricing of an asset or liability.
 
The following describes the methods we use to estimate the fair value of our financial and non-financial assets and liabilities:
 
Cash and cash equivalents, restricted cash, accounts receivable, and accounts payable—We consider the carrying values of these financial instruments to approximate fair value because of the short period of time between origination of the instruments and their expected realization.

Real estate investments—The purchase prices of the investment properties, including related lease intangible assets and liabilities, were allocated at estimated fair value based on Level 3 inputs, such as discount rates, capitalization rates, comparable sales, replacement costs, income and expense growth rates and current market rents and allowances as determined
by management.

Mortgages and loans payable —We estimate the fair value of our debt by discounting the future cash flows of each instrument at rates currently offered for similar debt instruments of comparable maturities by our lenders using Level 3 inputs.  The discount rate used approximates current lending rates for loans or groups of loans with similar maturities and credit quality, assuming the debt is outstanding through maturity and considering the debt’s collateral (if applicable).  Such discount rate was 5.00% for secured fixed-rate debt as of September 30, 2014. We did not have any mortgage loans as of December 31, 2013. We have utilized market information, as available, or present value techniques to estimate the amounts required to be disclosed.  The fair value and recorded value of our borrowings as of September 30, 2014, were $13.8 million and $12.8 million, respectively.


10


5. REAL ESTATE ACQUISITIONS
 
During the nine months ended September 30, 2014, we acquired a 100% ownership in eight grocery-anchored retail centers for a purchase price of approximately $116.3 million, including $12.6 million of assumed debt with a fair value of $12.9 million. The following tables present certain additional information regarding our acquisitions. We allocated the purchase price of these acquisitions to the fair value of the assets acquired as follows (in thousands):
  
  
 
Building and
 
In-Place
 
Above-Market
 
Below-Market
 
  
Acquisition
Land
 
Improvements
 
Leases
 
Leases
 
Leases
 
Total
Bethany Village Shopping Center
$
4,125

 
$
6,182

 
$
844

 
$
—

 
$
—

 
$
11,151

Staunton Plaza
3,315

 
11,031

 
1,310

 
1,906

 
(46
)
 
17,516

Northpark Village
1,123

 
6,556

 
632

 
20

 
(131
)
 
8,200

Spring Cypress Village
6,321

 
13,629

 
1,385

 
65

 
—

 
21,400

Kipling Marketplace
2,535

 
9,120

 
1,347

 
136

 
(788
)
 
12,350

Lake Washington Crossing
3,134

 
9,604

 
1,596

 
—

 
(934
)
 
13,400

MetroWest Village
3,412

 
13,781

 
1,417

 
42

 
(36
)
 
18,616

Kings Crossing
2,965

 
10,017

 
986

 
32

 
—

 
14,000

Total
$
26,930


$
79,920


$
9,517


$
2,201


$
(1,935
)

$
116,633


The amounts recognized for revenues, acquisition expenses and net income (loss) from the acquisition date to September 30, 2014 related to the operating activities of our acquisitions are as follows (in thousands):

Acquisition
 
Acquisition Date
 
Revenues
 
Acquisition Expenses
 
Net Income (Loss)
Bethany Village Shopping Center
 
3/14/2014
 
$
631

 
$
185

 
$
14

Staunton Plaza
 
4/30/2014
 
611

 
360

 
(433
)
Northpark Village
 
7/25/2014
 
148

 
154

 
(134
)
Spring Cypress Village
 
7/30/2014
 
344

 
326

 
(281
)
Kipling Marketplace
 
8/7/2014
 
240

 
187

 
(157
)
Lake Washington Crossing
 
8/15/2014
 
249

 
232

 
(176
)
MetroWest Village
 
8/20/2014
 
200

 
309

 
(306
)
Kings Crossing
 
8/26/2014
 
125

 
212

 
(214
)
Total
 
 
 
$
2,548

 
$
1,965

 
$
(1,687
)
 
The following unaudited pro forma information summarizes selected financial information from our combined results of operations, as if the acquisitions had been acquired on July 1, 2013 (date of capitalization).
 
We estimated that revenues, on a pro forma basis, for the three months ended September 30, 2014, would have been approximately $2.9 million, and our net loss, on a pro forma basis, would have been approximately $0.2 million. The pro forma net loss per share would have been approximately $0.02 for the three months ended September 30, 2014.
 
We estimated that revenues, on a pro forma basis, for the nine months ended September 30, 2014, would have been approximately $8.6 million, and our net income, on a pro forma basis, would have been approximately $12,000. The pro forma net income per share would have been approximately $0.00 for the nine months ended September 30, 2014.

This pro forma information is presented for informational purposes only and may not be indicative of what actual results of operations would have been had the transactions occurred at the beginning of the period, nor does it purport to represent the results of future operations.


11


6. ACQUIRED INTANGIBLE ASSETS

Acquired intangible lease assets consisted of the following (in thousands):
  
September 30, 2014
 
December 31, 2013
Acquired in-place leases, net of accumulated amortization of $406 and $0, respectively
$
9,111

 
$
—

Acquired above-market leases, net of accumulated amortization of $83 and $0, respectively
2,118

 
—

Total 
$
11,229

 
$
—

 
Amortization recorded on the intangible assets for the three and nine months ended September 30, 2014 was $0.4 million and $0.5 million, respectively.
 
Estimated future amortization of the respective acquired intangible lease assets as of September 30, 2014 for the remainder of 2014 and for each of the five succeeding calendar years and thereafter is as follows (in thousands):
Year
In-Place Leases
 
Above-Market Leases
October 1 to December 31, 2014
$
439

 
$
53

2015
1,942

 
234

2016
1,942

 
222

2017
1,935

 
209

2018
1,158

 
187

2019 and thereafter
1,695

 
1,213

Total
$
9,111

 
$
2,118


The weighted-average amortization periods for acquired in-place lease intangibles and acquired above-market lease intangibles are six years and eleven years, respectively.

7. MORTGAGES AND LOANS PAYABLE
 
Note Payable

As of December 31, 2013, we had a note payable of $0.3 million related to financing for our annual directors and officers insurance premiums, pursuant to which we made monthly payments of principal and interest. In April 2014, we used the proceeds from our initial public offering to pay the remaining $0.2 million balance of the note payable.

Revolving Credit Facility

Through KeyBank in its capacity as administrative agent and a group of eight lenders (also including KeyBank), we have access to a $200 million revolving credit facility from which we may draw additional funds as needed. Subject to certain conditions, the revolving credit facility provides us with the ability from time to time to increase the size of the facility up to a total of $700 million. The facility matures on July 2, 2018 and contains two six-month extension options that we may exercise upon payment of an extension fee equal to 0.075% of the total commitments under the facility at the time of each extension. The interest rate on the revolving credit facility is variable, based on either the prime rate, one-month LIBOR, or the federal funds rate and is affected by other factors, such as company size and leverage. There were no outstanding borrowings under this facility as of September 30, 2014, nor did we have any borrowing capacity under the facility, as we had not yet designated any of our properties as being included in the calculation of the borrowing base as defined by the terms of the credit facility.

Mortgage Loans Payable

As of September 30, 2014, we had one mortgage note payable in the amount of $12.8 million, inclusive of a below-market assumed debt adjustment of $0.3 million, net of accumulated amortization. We did not have any outstanding mortgage notes payable as of December 31, 2013. The mortgage note payable is secured by Staunton Plaza, the property on which the debt was placed. As of September 30, 2014, the interest rate for the loan was 6.0%. Due to the non-recourse nature of the mortgage, the assets and liabilities of Staunton Plaza are neither available to pay the debt of the consolidated limited liability companies nor do they constitute an obligation of the consolidated limited liability companies.


12


During the nine months ended September 30, 2014, in conjunction with our acquisition of Staunton Plaza, we assumed debt of $12.6 million. The assumed debt market adjustment will be amortized over the remaining life of the loan, and this amortization is classified as interest expense. The amortization recorded on the assumed below-market debt adjustment was $3,000 and $6,000 for the three and nine months ended September 30, 2014, respectively.

Included below are the yearly principal payment obligations (in thousands) and weighted-average interest rates for the Staunton Plaza mortgage loan:

  
2014 (1)
 
2015
 
2016
 
2017
 
2018
 
Thereafter
 
Total
Maturing debt:(2)
  

 
  

 
  

 
  

 
  

 
  

 
  

Fixed-rate mortgages payable
$
64

 
$
264

 
$
279

 
$
299

 
$
317

 
$
11,293

 
$
12,516

Weighted-average interest rate on debt:
  

 
  

 
  

 
  

 
  

 
  

 
  

Fixed-rate mortgages payable
6.0
%
 
6.0
%
 
6.0
%
 
6.0
%
 
6.0
%
 
6.0
%
 
6.0
%

(1) 
Includes only October 1, 2014 through December 31, 2014.
(2) 
The debt maturity table does not include any below-market debt adjustment, of which $0.3 million, net of accumulated amortization, was outstanding as of September 30, 2014.

8. ACQUIRED BELOW-MARKET LEASE INTANGIBLES

Amortization recorded on the intangible liabilities for the three and nine months ended September 30, 2014 was $91,000. 

Estimated future amortization income of the intangible lease liabilities as of September 30, 2014 for the remainder of 2014 and for each of the five succeeding calendar years and thereafter is as follows (in thousands):
Year
Below-Market Leases
October 1 to December 31, 2014
$
132

2015
534

2016
534

2017
328

2018
199

2019 and thereafter
117

Total
$
1,844


The weighted-average amortization period for below-market lease intangibles is four years.

9. COMMITMENTS AND CONTINGENCIES
 
Litigation
 
In the ordinary course of business, we may become subject to litigation or claims. There are no material legal proceedings pending, or known to be contemplated, against us.
 
Environmental Matters
 
In connection with the ownership and operation of real estate, we may be potentially liable for costs and damages related to environmental matters. We have not been notified by any governmental authority of any material non-compliance, liability or other claim, nor are we aware of any other environmental condition that we believe will have a material impact on our condensed consolidated financial statements.

10. RELATED PARTY TRANSACTIONS

Economic Dependency—We are dependent on the Advisor, the Sub-advisor, the Property Manager, the Dealer Manager and their respective affiliates for certain services that are essential to us, including the sale of our shares of common stock, asset

13


acquisition and disposition decisions, asset management, operating and leasing of our properties, and other general and administrative responsibilities. In the event that the Advisor, the Sub-advisor, the Property Manager and/or the Dealer Manager are unable to provide such services, we would be required to find alternative service providers or sources of capital, which could result in higher costs and expenses.

Advisory Agreement—Pursuant to our advisory agreement, the Advisor is entitled to specified fees for certain services, including managing our day-to-day activities and implementing our investment strategy. The Advisor has entered into a sub-advisory agreement with the Sub-advisor, which manages our day-to-day affairs and our portfolio of real estate investments, on behalf of the Advisor, subject to the board’s supervision and certain major decisions requiring the consent of both the Advisor and Sub-advisor. The expenses to be reimbursed to the Advisor and Sub-advisor will be reimbursed in proportion to the amount of expenses incurred on our behalf by the Advisor and Sub-advisor, respectively.

Organization and Offering Costs—Under the terms of the advisory agreement, we are to reimburse on a monthly basis the Advisor, the Sub-advisor or their respective affiliates (the “Advisor Entities”) for cumulative organization and offering costs and future organization and offering costs they may incur on our behalf but only to the extent that the reimbursement would not exceed 2.0% of gross offering proceeds over the life of our initial public offering. As of September 30, 2014, the Advisor, Sub-advisor and their affiliates have charged us approximately $12.1 million of cumulative organization and offering costs, and we have remitted payment in the amount of $12.5 million towards such costs, resulting in net prepaid organization and offering costs of $0.4 million. As of December 31, 2013, the Advisor, Sub-advisor and their affiliates had charged us approximately $1.9 million of cumulative organization and offering costs, and we had not yet reimbursed any such costs, resulting in a payable of $1.9 million.
 
Acquisition Fee—We pay our Advisor Entities or their assignees an acquisition fee related to services provided in connection with the selection and purchase or origination of real estate and real estate-related investments. The acquisition fee is equal to 1.0% of the contract purchase price of each property we acquire, including acquisition or origination expenses and any debt attributable to such investments.
 
Acquisition Expenses—We reimburse the Sub-advisor for expenses actually incurred related to selecting, evaluating and acquiring assets on our behalf.  During the three and nine months ended September 30, 2014, we reimbursed the Sub-advisor for personnel costs related to due diligence services for assets we acquired during the period.

Asset Management Subordinated Participation—Within 60 days after the end of each calendar quarter (subject to the approval of our board of directors), we will pay an asset management subordinated participation by issuing a number of restricted operating partnership units designated as Class B Units to the Advisor and Sub-advisor equal to: (i) 0.25% multiplied by (a) prior to the NAV pricing date, the cost of assets and (b) on and after the NAV pricing date, the lower of the cost of assets and the applicable quarterly NAV divided by (ii) (a) prior to the NAV pricing date, the value of one share of common stock as of the last day of such calendar quarter, which is equal initially to $22.50 (the primary offering price minus selling commissions and dealer manager fees) and (b) on and after the NAV pricing date, the per share NAV.
 
The Advisor and Sub-advisor are entitled to receive distributions on the vested and unvested Class B units they receive in connection with their asset management subordinated participation at the same rate as distributions are paid to common stockholders. Such distributions are in addition to the incentive fees that the Advisor and Sub-advisor and their affiliates may receive from us. During the three and nine months ended September 30, 2014, the Operating Partnership issued 3,209 and 4,455 Class B units, respectively, to the Advisor and the Sub-advisor under the advisory agreement for the asset management services performed by the Advisor and the Sub-advisor during the period from January 1, 2014 to June 30, 2014. These Class B units will not vest until an economic hurdle has been met. The Advisor and Sub-advisor continue to provide advisory services through the date that such economic hurdle is met. The economic hurdle will be met when the value of the Operating Partnership’s assets plus all distributions made equal or exceed the total amount of capital contributed by investors plus a 6.0% cumulative, pre-tax, non-compounded annual return thereon.

Financing Coordination Fee—When our Advisor Entities provide services in connection with the origination or refinancing of any debt that we obtain and use to finance properties or other permitted investments, we pay the Advisor Entities a financing fee equal to 0.75% of all amounts made available under any such loan or line of credit.
 
Disposition Fee—For substantial assistance in connection with the sale of properties or other investments, we will pay our Advisor Entities or their respective affiliates up to the lesser of: (i) 2.0% of the contract sales price of each property or other investment sold; or (ii) one-half of the total brokerage commissions paid if a non-affiliated broker is also involved in the sale, provided that total real estate commissions paid (to our Advisor Entities and others) in connection with the sale may not exceed the lesser of a competitive real estate commission and 6.0% of the contract sales price. The Conflicts Committee will determine

14


whether our Advisor Entities or their affiliates have provided substantial assistance to us in connection with the sale of an asset. Substantial assistance in connection with the sale of a property includes our Advisor Entities’ preparation of an investment package for the property (including an investment analysis, rent rolls, tenant information regarding credit, a property title report, an environmental report, a structural report and exhibits) or such other substantial services performed by our Advisor Entities in connection with a sale.
 
General and Administrative Expenses—As of September 30, 2014 and December 31, 2013, we owed both the Advisor and the Sub-advisor and their affiliates $68,000 and $130,000, respectively, for general and administrative expenses paid on our behalf. As of September 30, 2014, neither the Advisor nor the Sub-advisor has allocated any portion of their employees’ salaries to general and administrative expenses.

Summarized below are the fees earned by and the expenses reimbursable to the Advisor and the Sub-advisor, except for organization and offering costs and general and administrative expenses, which we disclose above, for the three and nine months ended September 30, 2014 and any related amounts unpaid as of September 30, 2014 and December 31, 2013 (in thousands):

  
For the Three Months Ended
 
For the Nine Months Ended
 
Unpaid Amount as of
  
September 30,
 
September 30,
 
September 30,
 
December 31,
  
2014

2014

2014

2013
Acquisition fees
$
880

 
$
1,164

 
$
—

 
$
—

Acquisition expenses
107

 
147

 
—

 
—

Class B unit distribution(1)
2

 
2

 
1

 
—

Financing fees
1,500

 
1,595

 
—

 
—

Disposition fees
—

 
—

 
—

 
—

Total
$
2,489

 
$
2,908

 
$
1

 
$
—

(1) 
Represents the distributions paid to the Advisor and the Sub-advisor as holders of Class B units of the Operating Partnership.

Annual Subordinated Performance Fee—We will pay our Advisor Entities or their respective affiliates an annual subordinated performance fee calculated on the basis of our total return to stockholders, payable annually in arrears, such that for any year in which our total return on stockholders’ capital exceeds 6.0% per annum, our Advisor Entities will be entitled to 15.0% of the amount in excess of such 6.0% per annum, provided that the amount paid to the Advisor Entities does not exceed 10.0% of the aggregate total return for that year. No such amounts were incurred or payable as of September 30, 2014 or December 31, 2013.

Subordinated Participation in Net Sales Proceeds—The Operating Partnership will pay to PE-ARC Special Limited Partner II, LLC (the “Special Limited Partner”) a subordinated participation in the net sales proceeds of the sale of real estate assets equal to 15.0% of remaining net sales proceeds after return of capital contributions to stockholders plus payment to investors of a 6.0% cumulative, pre-tax, non-compounded return on the capital contributed by stockholders. The Advisor has a 22.5% interest and the Sub-advisor has an 77.5% interest in the Special Limited Partner. No sales of real estate assets have occurred to date.
 
Subordinated Incentive Listing Distribution—The Operating Partnership will pay to the Special Limited Partner a subordinated incentive listing distribution upon the listing of our common stock on a national securities exchange. Such incentive listing distribution is equal to 15.0% of the amount by which the market value of all of our issued and outstanding common stock plus distributions exceeds the aggregate capital contributed by stockholders plus an amount equal to a 6.0% cumulative, pre-tax non-compounded annual return to stockholders. 
 
Neither the Special Limited Partner nor any of its affiliates can earn both the subordinated participation in the net sales proceeds and the subordinated incentive listing distribution. No subordinated incentive listing distribution has been earned to date.
 
Subordinated Distribution Upon Termination of the Advisor Agreement—Upon termination or non-renewal of the advisory agreement, the Special Limited Partner shall be entitled to a subordinated termination distribution in the form of a non-interest bearing promissory note equal to 15.0% of the amount by which the sum of our market value plus distributions exceeds the aggregate capital contributed by stockholders plus an amount equal to a 6.0% cumulative, pre-tax non-compounded annual return to stockholders.  In addition, the Special Limited Partner may elect to defer its right to receive a subordinated distribution upon termination until either a listing on a national securities exchange or other liquidity event occurs. No such termination has been occurred to date.

15


 
Property Manager—All of our real properties are managed and leased by Phillips Edison & Company Ltd. (the “Property Manager”), an affiliated property manager. The Property Manager is wholly owned by our Phillips Edison sponsor and was organized on September 15, 1999. The Property Manager also manages real properties acquired by the Phillips Edison affiliates or other third parties.
 
Commencing June 1, 2014, the amount we pay to the Property Manager in monthly property management fees decreased from 4.5% to 4.0% of the monthly gross cash receipts from the properties managed by the Property Manager. In the event that we contract directly with a non-affiliated third-party property manager with respect to a property, we will pay the Property Manager a monthly oversight fee equal to 1.0% of the gross revenues of the property managed. In addition to the property management fee or oversight fee, if the Property Manager provides leasing services with respect to a property, we pay the Property Manager leasing fees in an amount equal to the leasing fees charged by unaffiliated persons rendering comparable services based on national market rates. The Property Manager shall be paid a leasing fee in connection with a tenant’s exercise of an option to extend an existing lease, and the leasing fees payable to the Property Manager may be increased by up to 50% in the event that the Property Manager engages a co-broker to lease a particular vacancy. We reimburse the costs and expenses incurred by the Property Manager on our behalf, including employee compensation, legal, travel and other out-of-pocket expenses that are directly related to the management of specific properties, as well as fees and expenses of third-party accountants.

If we engage the Property Manager to provide construction management services with respect to a particular property, we pay a construction management fee in an amount that is usual and customary for comparable services rendered to similar projects in the geographic market of the property.
 
The Property Manager hires, directs and establishes policies for employees who have direct responsibility for the operations of each real property it manages, which may include, but is not limited to, on-site managers and building and maintenance personnel. Certain employees of the Property Manager may be employed on a part-time basis and may also be employed by the Sub-advisor or certain of its affiliates. The Property Manager also directs the purchase of equipment and supplies and will supervise all maintenance activity.

Summarized below are the fees earned by and the expenses reimbursable to the Property Manager for the three and nine months ended September 30, 2014 and any related amounts unpaid as of September 30, 2014 and December 31, 2013 (in thousands):
  
For the Three Months Ended
 
For the Nine Months Ended
 
Unpaid Amount as of
  
September 30,
 
September 30,
 
September 30,
 
December 31,
  
2014
 
2014
 
2014
 
2013
Property management fees
$
68

 
$
92

 
$
43

 
$
—

Leasing commissions
—

 
7

 
—

 
—

Construction management fees
7

 
12

 
5

 
—

Other fees and reimbursements
60

 
76

 
25

 
—

Total
$
135

 
$
187

 
$
73

 
$
—


Dealer Manager—Our dealer manager is Realty Capital Securities, LLC (the “Dealer Manager”). The Dealer Manager is a member firm of the Financial Industry Regulatory Authority, Inc. (“FINRA”) and was organized on August 29, 2007. The Dealer Manager is under common control with our AR Capital sponsor and will provide certain sales, promotional and marketing services in connection with the distribution of the shares of common stock offered under our offering. Excluding shares sold pursuant to the “friends and family” program, the Dealer Manager will generally be paid a sales commission equal to 7.0% of the gross proceeds from the sale of shares of the common stock sold in the primary offering and a dealer manager fee equal to 3.0% of the gross proceeds from the sale of shares of the common stock sold in the primary offering.

The Dealer Manager typically reallows 100% of the selling commissions and a portion of the dealer manager fee to participating broker-dealers. Alternatively, a participating broker-dealer may elect to receive a commission based upon the proceeds from the sale of shares by such participating broker-dealer, with a portion of such fee being paid at the time of such sale and the remaining amounts paid on each anniversary of the closing of such sale up to and including the fifth anniversary of the closing of such sale, in which event, a portion of the dealer manager fee will be reallowed such that the combined selling commission and dealer manager fee do not exceed 10% of the gross proceeds of our primary offering.
 

16


Starting with the commencement of our public offering, the Company utilizes transfer agent services provided by an affiliate of the Dealer Manager. Fees incurred from the transfer agent represent amounts paid to the affiliate of the Dealer Manager for such services. The following table details total selling commissions, dealer manager fees, and service fees paid to the Dealer Manager and its affiliate related to the sale of common stock for the three and nine months ended September 30, 2014 and any related amounts unpaid as of September 30, 2014 and December 31, 2013 (in thousands):

  
For the Three Months Ended
 
For the Nine Months Ended
 
Payable as of
 
September 30,
 
September 30,
 
September 30,
 
December 31,
  
2014
 
2014
 
2014
 
2013
Total commissions and fees incurred from Dealer Manager
$
19,189

 
$
40,195

 
$
—

 
$
—

Fees incurred from the transfer agent
234

 
447

 
227

 
—


Share Purchases by Sub-advisor and AR Capital sponsor—Our Sub-advisor made an initial investment in us through the purchase of 8,888 shares of our common stock. The Sub-advisor may not sell any of these shares while serving as the Sub-advisor. Our AR Capital sponsor has also purchased 17,778 shares of our common stock. The Sub-advisor and AR Capital sponsor purchased shares at a purchase price of $22.50 per share, reflecting no dealer manager fee or selling commissions paid on such shares.

11. OPERATING LEASES
 
The terms and expirations of our operating leases with our tenants vary. The lease agreements frequently contain options to extend the terms of leases and other terms and conditions as negotiated. We retain substantially all of the risks and benefits of ownership of the real estate assets leased to tenants.
 
Approximate future rentals to be received under non-cancelable operating leases in effect at September 30, 2014, assuming no new or renegotiated leases or option extensions on lease agreements, are as follows (in thousands):
Year
Amount
October 1 to December 31, 2014
$
2,008

2015
7,708

2016
6,665

2017
5,973

2018
4,983

2019 and thereafter
19,711

Total
$
47,048


Publix and Martin's comprised approximately 17.6% and 13.6%, respectively, of the aggregate annualized effective rent of our eight owned shopping centers as of September 30, 2014.  No other tenants comprised 10% or more of our aggregate annualized effective rent as of September 30, 2014.

12. SUBSEQUENT EVENTS
 
Sale of Shares of Common Stock

From October 1, 2014 through October 31, 2014, we raised gross proceeds of approximately $79.9 million through the issuance of 3.2 million shares of common stock under our offering. As of November 1, 2014, approximately 59.8 million shares remained available for sale to the public under our offering, exclusive of shares available under the DRIP.

Distributions
 
On October 1, 2014, we paid a distribution equal to a daily amount of $0.00445210 per share of common stock outstanding for stockholders of record for the period from September 1, 2014 through September 30, 2014. The total gross amount of the distribution was approximately $2.1 million, with $1.1 million being reinvested in the DRIP, for a net cash distribution of $1.0 million.
 

17


On November 3, 2014, we paid a distribution equal to a daily amount of $0.00445210 per share of common stock outstanding for stockholders of record for the period from October 1, 2014 through October 31, 2014. The total gross amount of the distribution was approximately $2.6 million, with $1.4 million being reinvested in the DRIP, for a net cash distribution of $1.2 million.

Acquisitions

Subsequent to September 30, 2014, we acquired a 100% ownership in the following properties (dollars in thousands):
Property Name
 
Location
 
Anchor Tenant
 
Acquisition Date
 
Purchase Price
 
Mortgage Loan Assumed
 
Square Footage
 
Leased % of Rentable Square Feet at Acquisition
Commonwealth Square
 
Folsom, CA
 
Raley's
 
10/2/2014
 
$
19,371

 
$
7,172

 
141,310
 
84.8
%
Colonial Promenade
 
Winter Haven, FL
 
Walmart(1)
 
10/10/2014
 
33,277

 
—

 
280,228
 
97.4
%
Point Loomis
 
Milwaukee, WI
 
Pick 'n Save
 
10/21/2014
 
10,350

 
—

 
160,533
 
100.0
%
Hilander Village
 
Roscoe, IL
 
Schnuck's
 
10/24/2014
 
9,252

 
—

 
125,712
 
86.6
%
Milan Plaza
 
Milan, MI
 
Kroger
 
10/24/2014
 
2,300

 
—

 
61,357
 
84.3
%
(1) The anchor tenant of Colonial Promenade is a Walmart Supercenter.

The supplemental purchase accounting disclosures required by GAAP relating to the recent acquisitions of the aforementioned properties have not been presented as the initial accounting for these acquisitions were incomplete at the time this Quarterly Report on Form 10-Q was filed with the SEC. The initial accounting was incomplete due to the late closing dates of the acquisitions.


18


Item 2.        Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Cautionary Note Regarding Forward-Looking Statements
 
Certain statements contained in this Quarterly Report on Form 10-Q of Phillips Edison – ARC Grocery Center REIT II, Inc. (“we”, the “Company”, “our” or “us”) other than historical facts may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We intend for all such forward-looking statements to be covered by the applicable safe harbor provisions for forward-looking statements contained in those acts. Such statements include, in particular, statements about our plans, strategies, and prospects and are subject to certain risks and uncertainties, including known and unknown risks, which could cause actual results to differ materially from those projected or anticipated. Therefore, such statements are not intended to be a guarantee of our performance in future periods. Such forward-looking statements can generally be identified by our use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “anticipate,” “estimate,” “believe,” “continue,” or other similar words. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date this report is filed with the U.S. Securities and Exchange Commission (“SEC”). We make no representations or warranties (express or implied) about the accuracy of any such forward-looking statements contained in this Quarterly Report on Form 10-Q, and we do not intend to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
 
Any such forward-looking statements are subject to risks, uncertainties, and other factors and are based on a number of assumptions involving judgments with respect to, among other things, future economic, competitive, and market conditions, all of which are difficult or impossible to predict accurately. To the extent that our assumptions differ from actual conditions, our ability to accurately anticipate results expressed in such forward-looking statements, including our ability to generate positive cash flow from operations, make distributions to stockholders, and maintain the value of our real estate properties, may be significantly hindered. See Item 1A in Part II of this Form 10-Q and Item 1A in Part I of our Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC on March 6, 2014, for a discussion of some of the risks and uncertainties, although not all of the risks and uncertainties, that could cause actual results to differ materially from those presented in our forward-looking statements.
 
Overview
 
Organization
 
The Company was formed as a Maryland corporation on June 5, 2013, and intends to qualify as a REIT beginning with the taxable year ending December 31, 2014. We are offering to the public, pursuant to a registration statement, $2.475 billion in shares of common stock on a “reasonable best efforts” basis in our initial public offering. Our initial public offering consists of a primary offering of $2.0 billion in shares offered to investors at a price of $25.00 per share, with discounts available for certain categories of purchasers, and $475 million in shares offered to stockholders pursuant to a distribution reinvestment plan (the “DRIP”) at a price of $23.75 per share. We have the right to reallocate the shares of common stock offered between the primary offering and the DRIP. On November 25, 2013, the registration statement for our offering was declared effective under the Securities Act of 1933, and on January 9, 2014, we broke the minimum offering escrow requirement of $2.0 million. Prior to January 9, 2014, our operations had not yet commenced.

Our advisor is American Realty Capital PECO II Advisors, LLC (the “Advisor”), a newly organized limited liability company that was formed in the State of Delaware on July 9, 2013 that is under common control with AR Capital LLC. We have entered into an advisory agreement with the Advisor which makes the Advisor ultimately responsible for the management of our day-to-day activities and the implementation of our investment strategy. The Advisor has delegated certain duties under the advisory agreement, including the management of our day-to-day operations and our portfolio of real estate assets, to Phillips Edison NTR II LLC (the “Sub-advisor”), which is directly or indirectly owned by Phillips Edison Limited Partnership (the “Phillips Edison sponsor”), and Michael Phillips and Jeffrey Edison, principals of our Phillips Edison sponsor. Notwithstanding such delegation to the Sub-advisor, the Advisor retains ultimate responsibility for the performance of all the matters entrusted to it under the advisory agreement.

We plan to continue investing primarily in well-occupied grocery-anchored neighborhood and community shopping centers leased to a mix of national, creditworthy retailers selling necessity-based goods and services in strong demographic markets throughout the United States. In addition, we may invest in other retail properties including power and lifestyle shopping centers, multi-tenant shopping centers, free-standing single-tenant retail properties, and other real estate and real estate-related loans and securities depending on real estate market conditions and investment opportunities that we determine are in the best

19


interests of our stockholders. We expect that retail properties primarily would underlie or secure the real estate-related loans and securities in which we may invest.
 
Equity Raise Activity
 
As of September 30, 2014, we had issued pursuant to our initial public offering a total of 17.1 million shares of common stock, including 0.1 million shares issued through the DRIP, generating gross cash proceeds of $425.7 million. During the three months ended September 30, 2014, we issued 8.2 million shares of common stock, including 0.1 million shares issued through the DRIP, generating gross cash proceeds of $204.0 million.
 
Portfolio
 
Below are statistical highlights of our portfolio’s activities from inception to date, as of September 30, 2014:
 
 
 
Property Acquisitions
 
Cumulative
 
during the  
 
Portfolio through
 
Three Months Ended
 
September 30, 2014
 
September 30, 2014
Number of properties
8

 
6

Number of states
5

 
3

Weighted average capitalization rate(1)
6.7
%
 
6.7
%
Weighted average capitalization rate with straight-line rent(2)
7.0
%
 
6.8
%
Total acquisition purchase price (in thousands)
$
116,317

 
$
87,966

Total square feet
720,725

 
558,786

Leased % of rentable square feet(3)
91.8
%
 
90.3%

Average remaining lease term in years(3)
5.3

 
4.2

(1) 
The capitalization rate is calculated by dividing the annualized in-place net operating income of a property as of the date of acquisition by the contract purchase price of the property.  Annualized in-place net operating income is calculated by subtracting the estimated annual operating expenses of a property from the annualized rents to be received from tenants occupying space at the property as of the date of acquisition.
(2) 
The capitalization rate with straight-line rent is calculated by dividing the annualized in-place net operating income, inclusive of straight-line rental income, of a property as of the date of acquisition by the contract purchase price of the property. This annualized in-place net operating income is calculated by subtracting the estimated annual operating expenses of a property from the straight-line annualized rents to be received from tenants occupying space at the property as of the date of acquisition.
(3) 
As of September 30, 2014.
 
As of September 30, 2014, we owned eight real estate properties, acquired from third parties unaffiliated with us, the Advisor, or the Sub-advisor. The following table presents information regarding our properties as of September 30, 2014 (dollars in thousands):
Property Name
 
Location
 
Anchor Tenant
 
Date
Acquired
 
Contract
Purchase
Price(1)
 
Rentable
Square
Feet
 
Average
Remaining
Lease Term in Years as of September 30, 2014
 
% of Rentable Square Feet Leased as of September 30, 2014
Bethany Village Shopping Center
 
Alpharetta, GA
 
Publix
 
3/14/2014
 
$
11,151

 
81,674

 
4.9
 
93.3
%
Staunton Plaza
 
Staunton, VA
 
Martin's(2)
 
4/30/2014
 
17,200

 
80,265

 
10.6
 
100.0
%
Northpark Village
 
Lubbock, TX
 
United Supermarkets(3)
 
7/25/2014
 
8,200

 
70,479

 
4.2
 
95.3
%
Spring Cypress Village
 
Houston, TX
 
Sprouts
 
7/30/2014
 
21,400

 
97,488

 
6.8
 
79.0
%
Kipling Marketplace
 
Littleton, CO
 
Safeway
 
8/7/2014
 
12,350

 
90,124

 
3.0
 
95.7
%
Lake Washington Crossing
 
Melbourne, FL
 
Publix
 
8/15/2014
 
13,400

 
118,698

 
3.9
 
86.2
%
MetroWest Village
 
Orlando, FL
 
Publix
 
8/20/2014
 
18,616

 
106,977

 
3.1
 
92.9
%
Kings Crossing
 
Sun City Center, FL
 
Publix
 
8/26/2014
 
14,000

 
75,020

 
4.0
 
97.1
%
(1) 
The contract purchase price excludes closing costs and acquisition costs.
(2) 
Martin's is an affiliate of Ahold USA.
(3) 
United Supermarkets is an affiliate of Albertsons LLC.

20



The following table lists, on an aggregate basis, all of the scheduled lease expirations after September 30, 2014 over each of the ten years ending December 31, 2014 and thereafter for our eight shopping centers. The table shows the approximate rentable square feet and annualized effective rent represented by the applicable lease expirations (dollars in thousands):
  
 
Number of
 
  
 
% of Total Portfolio
 
  
 
  
  
 
Expiring
 
Annualized
 
Annualized
 
Leased Rentable
 
% of Leased Rentable
Year
 
Leases
 
Effective Rent(1)
 
Effective Rent
 
Square Feet Expiring
 
Square Feet Expiring
2014
 
9
 
$
419

 
5.0%
 
21,429

 
3.2%
2015
 
23
 
1,090

 
12.9%
 
86,543

 
13.1%
2016
 
26
 
843

 
10.0%
 
47,767

 
7.2%
2017
 
16
 
719

 
8.5%
 
69,461

 
10.5%
2018
 
19
 
1,383

 
16.4%
 
108,906

 
16.5%
2019
 
12
 
452

 
5.4%
 
22,575

 
3.4%
2020
 
5
 
930

 
11.0%
 
109,971

 
16.6%
2021
 
3
 
537

 
6.4%
 
59,447

 
9.0%
2022
 
1
 
27

 
0.3%
 
1,100

 
0.2%
2023
 
2
 
167

 
2.0%
 
12,377

 
1.9%
Thereafter
 
6
 
1,873

 
22.1%
 
121,674

 
18.4%
(1) 
We calculate annualized effective rent as monthly contractual rent as of September 30, 2014 multiplied by 12 months, less any tenant concessions.

Subsequent to September 30, 2014, we executed renewals on two leases that were scheduled to expire in 2014. The square footage associated with these renewals was 4,579 and the annualized rent was $95,000.

Portfolio Tenancy
 
Prior to the acquisition of a property, we assess the suitability of the grocery-anchor tenant and other tenants in light of our investment objectives, namely, preserving capital and providing stable cash flows for distributions. Generally, we assess the strength of the tenant by consideration of company factors, such as its financial strength and market share in the geographic area of the shopping center, as well as location-specific factors, such as the store’s sales, local competition and demographics. When assessing the tenancy of the non-anchor space at the shopping center, we consider the tenant mix at each shopping center in light of our portfolio, the proportion of national and national franchise tenants, the creditworthiness of specific tenants, and the timing of lease expirations. When evaluating non-national tenancy, we attempt to obtain credit enhancements to leases, which typically come in the form of deposits and/or guarantees from one or more individuals.

The following table presents the composition of our portfolio by tenant type as of September 30, 2014 (dollars in thousands):
  
 
  
 
  
 
Annualized
 
% of
  
 
Leased
 
% of Leased
 
Effective
 
Annualized
Tenant Type
 
Square Feet
 
Square Feet
 
Rent(1)
 
Effective Rent
Grocery anchor
 
389,655

 
58.9
%
 
$
3,742

 
44.3
%
National and regional(2)
 
146,606

 
22.2
%
 
2,449

 
29.0
%
Local
 
124,989

 
18.9
%
 
2,250

 
26.7
%
 
 
661,250

 
100.0
%
 
$
8,441

 
100.0
%
(1) 
We calculate annualized effective rent as monthly contractual rent as of September 30, 2014 multiplied by 12 months, less any tenant concessions.
(2) 
We define national tenants as those that operate in at least three states.  Regional tenants are defined as those that have at least three locations.


21


The following table presents the composition of our portfolio by tenant industry as of September 30, 2014 (dollars in thousands):
  
 
  
 
  
 
Annualized
 
% of
  
 
Leased
 
% of Leased
 
Effective
 
Annualized
Tenant Industry
 
Square Feet
 
Square Feet
 
Rent(1)
 
Effective Rent
Grocery
 
389,655

 
58.9
%
 
$
3,742

 
44.3
%
Services(2)
 
126,730

 
19.2
%
 
2,102

 
24.9
%
Restaurant
 
82,653

 
12.5
%
 
1,690

 
20.0
%
Retail Stores(2)
 
62,212

 
9.4
%
 
907

 
10.8
%
 
 
661,250

 
100.0
%
 
$
8,441

 
100.0
%
(1)
We calculate annualized effective rent as monthly contractual rent as of September 30, 2014 multiplied by 12 months, less any tenant concessions.
(2) 
We define retail stores as those that primarily sell goods, while services tenants primarily sell non-goods services.

The following table presents our grocery-anchor tenants by the amount of square footage leased by each tenant as of September 30, 2014 (dollars in thousands):
Tenant  
 
Number of Locations(1)
 
Leased Square Feet
 
% of Leased Square Feet
 
Annualized Effective Rent(2)
 
% of Annualized Effective Rent
Publix
 
4

 
191,444

 
29.0
%
 
$
1,481

 
17.6
%
Ahold USA(3)
 
1

 
68,716

 
10.4
%
 
1,146

 
13.6
%
Safeway
 
1

 
50,794

 
7.7
%
 
381

 
4.5
%
Albertsons(4)
 
1

 
50,700

 
7.6
%
 
342

 
4.0
%
Sprouts
 
1

 
28,001

 
4.2
%
 
392

 
4.6
%
  
 
8

 
389,655

 
58.9
%
 
$
3,742

 
44.3
%
(1) 
Number of locations excludes auxiliary leases with grocery anchors such as fuel stations, pharmacies, and liquor stores, of which there were two as of September 30, 2014.
(2) 
We calculate annualized effective rent as monthly contractual rent as of September 30, 2014 multiplied by 12 months, less any tenant concessions.
(3) 
Martin's is an affiliate of Ahold USA.
(4) 
United Supermarkets is an affiliate of Albertsons LLC.

Results of Operations
 
Prior to January 9, 2014, our operations had not yet commenced. As a result, the discussions of the results of operations are only for the three and nine months ended September 30, 2014, with no prior period comparisons provided in the accompanying sections.

Three Months Ended September 30, 2014

Total revenues were approximately $2.0 million, with rental income of approximately $1.5 million. Other revenue, largely comprised of tenant reimbursements, was approximately $0.4 million.

Property operating costs were $0.3 million for the three months ended September 30, 2014. The significant items comprising this expense were common area maintenance of $0.2 million and property management fees paid to an affiliate of the Sub-advisor of $0.1 million.

Real estate taxes were $0.3 million for the three months ended September 30, 2014.

General and administrative expenses were approximately $0.4 million. This amount was comprised largely of audit and consulting fees, directors and officers insurance premiums, and board-related expenses.

Acquisition expenses, in the amount of approximately $1.5 million, were expensed as incurred. Included in these acquisition expenses were fees and expenses reimbursable to the Advisor and Sub-advisor of $1.0 million as well as $0.4 million in other

22


acquisition expenses owed to third-parties, all related to property acquisitions occurring in the three months ended September 30, 2014. We incurred $0.1 million in expense related to acquisitions that had not closed as of September 30, 2014.

Depreciation and amortization expense for the three months ended September 30, 2014 was $0.9 million.

Interest expense was $0.5 million for the three months ended September 30, 2014.

The net loss attributable to our stockholders was $1.9 million for the three months ended September 30, 2014.

Nine Months Ended September 30, 2014

Total revenues were approximately $2.5 million, with rental income of approximately $2.0 million. Other revenue, largely comprised of tenant reimbursements, was approximately $0.5 million.

Property operating costs were $0.4 million for the nine months ended September 30, 2014. The significant items comprising this expense were common area maintenance of $0.2 million, insurance expenses of $0.1 million, and property management fees paid to an affiliate of the Sub-advisor of $0.1 million.

Real estate taxes were $0.3 million for the nine months ended September 30, 2014.

General and administrative expenses were approximately $1.0 million. This amount was comprised largely of audit and consulting fees, directors and officers insurance premiums, and board-related expenses.

Acquisition expenses, in the amount of approximately $2.1 million, were expensed as incurred. Included in these acquisition expenses were fees and expenses reimbursable to the Advisor and Sub-advisor of $1.3 million, as well as $0.7 million in other acquisition expenses owed to third-parties, all related to property acquisitions occurring in the nine months ended September 30, 2014. We incurred $0.1 million in expense related to acquisitions that had not closed as of September 30, 2014.

Depreciation and amortization expense for the nine months ended September 30, 2014 was $1.2 million.

Interest expense was $0.6 million for the nine months ended September 30, 2014.

The net loss attributable to our stockholders was $3.0 million for the nine months ended September 30, 2014.

We generally expect our revenues and expenses to increase in future years as a result of owning the properties acquired in 2014 for a full year and the acquisition of additional properties. Although we expect our general and administrative expenses to increase, we expect such expenses to decrease as a percentage of our revenues. We currently have substantial uninvested proceeds raised from our initial public offering, which we are seeking to invest promptly on attractive terms. If we are unable to invest the proceeds promptly and on attractive terms, we may have difficulty continuing to pay distributions at a 6.5% annualized rate.

Non-GAAP Measures

Funds from Operations, Funds from Operations Adjusted for Acquisition Expenses, and Modified Funds from Operations
 
Funds from operations, or FFO, is a non-GAAP performance financial measure that is widely recognized as a measure of REIT operating performance. We use FFO as defined by NAREIT to be net income (loss), computed in accordance with GAAP excluding extraordinary items, as defined by GAAP, and gains (or losses) from sales of property (including deemed sales and settlements of pre-existing relationships), plus depreciation and amortization on real estate assets and impairment charges, and after related adjustments for unconsolidated partnerships, joint ventures and subsidiaries and noncontrolling interests. We believe that FFO is helpful to our investors and our management as a measure of operating performance because it excludes real estate-related depreciation and amortization, gains and losses from property dispositions, impairment charges, and extraordinary items, and as a result, when compared year to year, reflects the impact on operations from trends in occupancy rates, rental rates, operating costs, development activities, general and administrative expenses, and interest costs, which are not immediately apparent from net income. Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate and intangibles diminishes predictably over time, especially if such assets are not adequately maintained or repaired and renovated as required by relevant circumstances and/or are requested or required by lessees for operational purposes in order to maintain the value disclosed. Since real estate values have historically risen or fallen with market conditions, including inflation, changes in interest rates, the business cycle, unemployment and consumer

23


spending, many industry investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting alone to be insufficient. As a result, our management believes that the use of FFO, together with the required GAAP presentations, is helpful for our investors in understanding our performance. In particular, because GAAP impairment charges are not allowed to be reversed if the underlying fair values improve or because the timing of impairment charges may lag the onset of certain operating consequences, we believe FFO provides useful supplemental information related to current consequences, benefits and sustainability related to rental rate, occupancy and other core operating fundamentals. Additionally, we believe it is appropriate to exclude impairment charges from FFO, as these are fair value adjustments that are largely based on market fluctuations and assessments regarding general market conditions which can change over time. Factors that impact FFO include start-up costs, fixed costs, delay in buying assets, lower yields on cash held in accounts, income from portfolio properties and other portfolio assets, interest rates on acquisition financing and operating expenses. In addition, FFO will be affected by the types of investments in our targeted portfolio which will consist of, but is not limited to, necessity-based neighborhood and community shopping centers, first- and second-priority mortgage loans, mezzanine loans, bridge and other loans, mortgage-backed securities, collateralized debt obligations, and debt securities of real estate companies.

An asset will only be evaluated for impairment if certain impairment indicators exist and if the carrying or book value exceeds the total estimated undiscounted future cash flows (including net rental and lease revenues, net proceeds on the sale of the property, and any other ancillary cash flows at a property or group level under GAAP) from such asset. Investors should note, however, that determinations of whether impairment charges have been incurred are based partly on anticipated operating performance, because estimated undiscounted cash flows from a property, including estimated future net rental and lease revenues, net proceeds on the sale of the property, and certain other ancillary cash flows, are taken into account in determining whether an impairment charge has been incurred. While impairment charges are excluded from the calculation of FFO as described above, as impairments are based on estimated future undiscounted cash flows, investors are cautioned that we may not recover any impairment charges. FFO is not a useful measure in evaluating net asset value because impairments are taken into account in determining net asset value but not in determining FFO.

Since the definition of FFO was promulgated by NAREIT, GAAP has expanded to include several new accounting pronouncements, such that management and many investors and analysts have considered the presentation of FFO alone to be insufficient. Accordingly, in addition to FFO, we use both FFO adjusted for acquisition expenses and modified funds from operations, or MFFO, as defined by the Investment Program Association, or IPA. FFO adjusted for acquisition expenses excludes acquisition fees and expenses from FFO. In addition to excluding acquisition fees and expenses, MFFO also excludes from FFO the following items:
(1)
straight-line rent amounts, both income and expense;
(2)
amortization of above- or below-market intangible lease assets and liabilities;
(3)
amortization of discounts and premiums on debt investments;
(4)
gains or losses from the early extinguishment of debt;
(5)
gains or losses on the extinguishment or sales of hedges, foreign exchange, securities and other derivatives holdings except where the trading of such instruments is a fundamental attribute of our operations;
(6)
gains or losses related to fair-value adjustments for derivatives not qualifying for hedge accounting, including interest rate and foreign exchange derivatives;
(7)
gains or losses related to consolidation from, or deconsolidation to, equity accounting;
(8)
gains or losses related to contingent purchase price adjustments; and
(9)
adjustments related to the above items for unconsolidated entities in the application of equity accounting.

We believe that both FFO adjusted for acquisition expenses and MFFO are helpful in assisting management and investors with the assessment of the sustainability of operating performance in future periods and, in particular, after our offering and acquisition stages are complete, because both FFO adjusted for acquisition expenses and MFFO exclude acquisition expenses that affect property operations only in the period in which the property is acquired. Thus, FFO adjusted for acquisition expenses and MFFO provide helpful information relevant to evaluating our operating performance in periods in which there is no acquisition activity.

In evaluating investments in real estate, including both business combinations and investments accounted for under the equity method of accounting, management’s investment models and analyses differentiate costs to acquire the investment from the operations derived from the investment. Prior to 2009, acquisition costs for both of these types of investments were capitalized

24


under GAAP; however, beginning in 2009, acquisition costs related to business combinations are expensed. We have funded, and intend to continue to fund, both of these acquisition-related costs from the offering proceeds and borrowings and generally not from operations. However, if offering proceeds and borrowings are not available to fund these acquisition-related costs, operational cash flows may be used to fund future acquisition-related costs. We believe by excluding expensed acquisition costs, FFO adjusted for acquisition expenses and MFFO provide useful supplemental information that is comparable for each type of real estate investment and is consistent with management’s analysis of the investing and operating performance of our properties. Acquisition fees and expenses include those paid to the Advisor, the Sub-advisor or third parties.

As explained below, management’s evaluation of our operating performance excludes the additional items considered in the calculation of MFFO based on the following economic considerations. Many of the adjustments in arriving at MFFO are not applicable to us. Nevertheless, we explain below the reasons for each of the adjustments made in arriving at our MFFO definition.

•
Adjustments for straight-line rents and amortization of discounts and premiums on debt investments. In the proper application of GAAP, rental receipts and discounts and premiums on debt investments are allocated to periods using various systematic methodologies. This application may result in income recognition that could be significantly different than underlying contract terms. By adjusting for these items, MFFO provides useful supplemental information on the realized economic impact of lease terms and debt investments and aligns results with management’s analysis of operating performance.  The adjustment to MFFO for straight-line rents, in particular, is made to reflect rent and lease payments from a GAAP accrual basis to a cash basis.
•
Adjustments for amortization of above- or below-market intangible lease assets. Similar to depreciation and amortization of other real estate related assets that are excluded from FFO, GAAP implicitly assumes that the value of intangibles diminishes ratably over time and that these charges be recognized currently in revenue. Since real estate values and market lease rates in the aggregate have historically risen or fallen with market conditions, management believes that by excluding these charges, MFFO provides useful supplemental information on the performance of the real estate.
•
Gains or losses related to fair-value adjustments for derivatives not qualifying for hedge accounting and gains or losses related to contingent purchase price adjustments. Each of these items relates to a fair value adjustment, which is based on the impact of current market fluctuations and underlying assessments of general market conditions and specific performance of the holding, which may not be directly attributable to current operating performance. As these gains or losses relate to underlying long-term assets and liabilities, management believes MFFO provides useful supplemental information by focusing on the changes in core operating fundamentals rather than changes that may reflect anticipated gains or losses.
•
Adjustment for gains or losses related to early extinguishment of hedges, debt, consolidation or deconsolidation and contingent purchase price. Similar to extraordinary items excluded from FFO, these adjustments are not related to continuing operations. By excluding these items, management believes that MFFO provides supplemental information related to sustainable operations that will be more comparable between other reporting periods and to other real estate operators.

By providing FFO adjusted for acquisition expenses and MFFO, we believe we are presenting useful information that also assists investors and analysts to better assess the sustainability (that is, the capacity to continue to be maintained) of our operating performance after our offering and acquisition stages are completed. We also believe that MFFO is a recognized measure of sustainable operating performance by the non-listed REIT industry. However, under GAAP, acquisition costs are characterized as operating expenses in determining operating net income (loss). These expenses are paid in cash by us, and therefore such funds will not be available to distribute to investors. FFO adjusted for acquisition expenses and MFFO are useful in comparing the sustainability of our operating performance after our offering and acquisition stages are completed with the sustainability of the operating performance of other real estate companies that are not as involved in acquisition activities. However, investors are cautioned that FFO adjusted for acquisition expenses and MFFO should only be used to assess the sustainability of our operating performance after our offering and acquisition stages are completed, as both measures exclude acquisition costs that have a negative effect on our operating performance during the periods in which properties are acquired. All paid and accrued acquisition costs negatively impact our operating performance during the period in which properties are acquired and will have negative effects on returns to investors, the potential for future distributions, and cash flows generated, unless earnings from operations or net sales proceeds from the disposition of other properties are generated to cover the purchase prices of the properties we acquire. Therefore, MFFO may not be an accurate indicator of our operating performance, especially during periods in which properties are being acquired. MFFO that excludes such costs and expenses would only be comparable to that of non-listed REITs that have completed their acquisition activities and have similar operating characteristics as us. The purchase of properties, and the corresponding expenses associated with that process, is a key

25


operational feature of our business plan to generate operational income and cash flows in order to make distributions to investors. In the event that we are unable to raise any additional proceeds from the sale of shares in our initial offering, we may still be obligated to pay acquisition fees and reimburse acquisition expenses to our Advisor and Sub-Advisor and the Advisor and Sub-Advisor will be under no obligation to reimburse these payments back to us. As a result, such fees and expenses may need to be paid from other sources, including additional debt, operational earnings or cash flows, net proceeds from the sale of properties or from ancillary cash flows. Acquisition costs also adversely affect our book value and equity.

The additional items that may be excluded from FFO to determine MFFO are cash flow adjustments made to net income (loss) in calculating the cash flows provided by operating activities. Each of these items is considered an important overall operational factor that affects our long-term operational profitability. These items and any other mark-to-market or fair value adjustments may be based on many factors, including current operational or individual property issues or general market or overall industry conditions. While we are responsible for managing interest rate, hedge and foreign exchange risk, we intend to retain an outside consultant to review any hedging agreements that we may enter into in the future. Inasmuch as interest rate hedges are not a fundamental part of our operations, we believe it is appropriate to exclude such gains and losses in calculating MFFO, as such gains and losses are not reflective of ongoing operations.

Each of FFO, FFO adjusted for acquisition expenses, and MFFO should not be considered as an alternative to net income (loss) or income (loss) from continuing operations under GAAP, or as an indication of our liquidity, nor is any of these measures indicative of funds available to fund our cash needs, including our ability to fund distributions. In particular, as we are currently in the acquisition phase of our life cycle, acquisition-related costs and other adjustments that are increases to FFO adjusted for acquisition expenses and MFFO are, and may continue to be, a significant use of cash. MFFO has limitations as a performance measure in an offering such as ours where the price of a share of common stock is a stated value and there is no current net asset value determination. Additionally, FFO adjusted for acquisition expenses, and MFFO may not be a useful measure of the impact of long-term operating performance on value if we do not continue to operate our business plan in the manner currently contemplated. Accordingly, FFO, FFO adjusted for acquisition expenses, and MFFO should be reviewed in connection with other GAAP measurements. FFO, FFO adjusted for acquisition expenses, and MFFO should not be viewed as more prominent measures of performance than our net income or cash flows from operations prepared in accordance with GAAP. Our FFO, FFO adjusted for acquisition expenses, and MFFO as presented may not be comparable to amounts calculated by other REITs.
Neither the SEC, NAREIT nor any other regulatory body has passed judgment on the acceptability of the adjustments that we use to calculate FFO adjusted for acquisition expenses or MFFO. In the future, the SEC, NAREIT or another regulatory body may decide to standardize the allowable adjustments across the non-listed REIT industry and we may have to adjust our calculation and characterization of FFO, FFO adjusted for acquisition expenses or MFFO.

The following section presents our calculation of FFO, FFO adjusted for acquisition expenses, and MFFO and provides additional information related to our operations. As a result of the timing of the commencement of our initial public offering and our active real estate operations, FFO, FFO adjusted for acquisition expenses, and MFFO are not relevant to a discussion comparing operations for the period presented. We expect revenues and expenses to increase in future periods as we raise additional offering proceeds and use them to acquire additional investments.


26



FFO, FFO ADJUSTED FOR ACQUISITION EXPENSES, AND MFFO
FOR THE PERIOD ENDED SEPTEMBER 30, 2014
(Unaudited)
(Amounts in thousands, except per share amounts)
  
Three Months Ended
 
Nine Months Ended
  
September 30, 2014
 
September 30, 2014
Calculation of FFO
  
 
  
Net loss
$
(1,921
)
 
$
(3,029
)
Add:
  

 
  

Depreciation and amortization of real estate assets
930

 
1,186

FFO
$
(991
)
 
$
(1,843
)
Calculation of FFO Adjusted for Acquisition Expenses
  

 
  

Funds from operations
$
(991
)
 
$
(1,843
)
Add:
  

 
  

Acquisition expenses
1,494

 
2,080

FFO adjusted for acquisition expenses
$
503

 
$
237

Calculation of MFFO
  

 
  

FFO adjusted for acquisition expenses
$
503

 
$
237

Less:
  

 
  

Net amortization of above- and below-market leases
(42
)
 
(8
)
Straight-line rental income
(46
)
 
(89
)
Amortization of market debt adjustment
(3
)
 
(6
)
MFFO
$
412

 
$
134

Weighted-average common shares outstanding - basic and diluted
13,101

 
6,826

Net loss per share - basic and diluted
$
(0.15
)
 
$
(0.44
)
FFO per share - basic and diluted
$
(0.08
)
 
$
(0.27
)
FFO adjusted for acquisition expenses per share - basic and diluted
$
0.04

 
$
0.03

MFFO per share - basic and diluted
$
0.03

 
$
0.02


Liquidity and Capital Resources
 
General
 
Our principal demands for funds are for real estate and real estate-related investments and the payment of acquisition expenses, operating expenses, and distributions to stockholders. Generally, we expect cash needed for items other than acquisitions and acquisition expenses to be generated from operations. The sources of our operating cash flows are primarily driven by the rental income received from leased properties. We expect to continue to raise capital through our initial public offering and to utilize such funds and proceeds from secured or unsecured financing to complete future property acquisitions. As of September 30, 2014, we had raised approximately $425.7 million in gross proceeds from our initial public offering, including $3.2 million through the DRIP.
 
As of September 30, 2014, we had cash and cash equivalents of $243.9 million. During the nine months ended September 30, 2014, we had a net cash increase of $243.8 million.
 
This cash increase was the result of:

•
$0.1 million provided by operating activities, largely the result of an increase in accrued and other liabilities of $2.0 million. This was substantially offset by a net loss from operations before depreciation and amortization charges. Also included in this total was $2.1 million of real estate acquisition expenses incurred during the period and expensed in accordance with Accounting Standards Codification (“ASC”) 805, Business Combinations;
•
$119.4 million used in investing activities, which was primarily the result of property acquisitions occurring in the nine months ended September 30, 2014; and

27


•
$363.1 million provided by financing activities with $369.7 million from the net proceeds of the issuance of common stock.  Partially offsetting this amount were payments on loan financing costs of $3.2 million, distributions paid to our stockholders of $3.0 million (net of DRIP proceeds), and payments on mortgages and notes payable of $0.4 million,
 
Short-term Liquidity and Capital Resources
 
We expect to meet our short-term liquidity requirements through existing cash on hand, net cash provided by property operations, proceeds from our offering, and proceeds from secured and unsecured debt financings. Operating cash flows are expected to increase as additional properties are added to our portfolio. Other than the commissions and dealer manager fees paid to Realty Capital Securities, LLC (the “Dealer Manager”), the organization and offering costs associated with our offering are initially paid by our sponsors.  Our sponsors will be reimbursed for such costs up to 2.0% of the gross capital raised in our offering.
 
As of September 30, 2014, we have $12.5 million of contractual debt obligations, representing mortgage loans secured by our real estate assets, excluding below-market debt adjustments of $0.3 million, net of accumulated amortization. As these mature, we intend to refinance our debt obligations, if possible, or pay off the balances at maturity using the remaining net proceeds of our primary offering or other proceeds from operations and/or corporate-level debt. 

On July 2, 2014, we entered into a revolving loan agreement (the “revolving credit facility”) with KeyBank National Association, an unaffiliated entity, as administrative agent, swing line lender and letter of credit issuer (“KeyBank”), along with certain other lenders, to borrow up to $200 million. Subject to certain conditions, the Revolving Credit Facility provides us with the ability from time to time to increase the size of the Revolving Credit Facility from the initial $200 million up to a total of $700 million. We do not currently have any borrowings outstanding under the terms of this facility.

For the nine months ended September 30, 2014, gross distributions of approximately $6.2 million were paid to stockholders, including $3.2 million of distributions reinvested through the DRIP, for net cash distributions of $3.0 million. On October 1, 2014, gross distributions of approximately $2.1 million were paid, including $1.1 million of distributions reinvested through the DRIP, for net cash distributions of $1.0 million. Distributions were funded by proceeds from our primary offering.
 
On September 19, 2014, our board of directors authorized distributions to the stockholders of record at the close of business each day in the period commencing October 1, 2014 through and including November 30, 2014. The authorized distributions equal an amount of $0.00445205 per share of common stock, par value $0.01 per share. A portion of each distribution is expected to constitute a return of capital for tax purposes. 

Long-term Liquidity and Capital Resources
 
On a long-term basis, our principal demands for funds will be for real estate and real estate-related investments and the payment of acquisition expenses, operating expenses, distributions and redemptions to stockholders, interest and principal on indebtedness, and payments on amounts due to our sponsors for organization and offering costs incurred on our behalf.  Generally, we expect to meet cash needs for items other than organization and offering costs as well as acquisitions and acquisition expenses from our cash flow from operations, and we expect to meet cash needs for acquisitions and acquisition expenses from the net proceeds of our initial public offering and from debt financings, including our revolving credit facility. As they mature, we intend to refinance our long-term debt obligations if possible, or pay off the balances at maturity using the remaining net proceeds of our primary offering or proceeds from operations and/or other corporate-level debt. We expect that substantially all net cash generated from operations will be used to pay distributions to our stockholders after certain capital expenditures, including tenant improvements and leasing commissions, are funded; however, we have and may continue to use other sources to fund distributions as necessary, including proceeds from our initial public offering, contributions or advances made to us by the Advisor, Sub-advisor and their respective affiliates, and borrowings under current or future debt agreements.
 
Our board of directors has adopted corporate governance guidelines that limit our borrowings to 300% of our net assets (as defined in our corporate governance guidelines); however, we may exceed that limit if a majority of our independent directors approves each borrowing in excess of our charter limitation and if we disclose such borrowing to our stockholders in our next quarterly report with an explanation from the conflicts committee of the justification for the excess borrowing. In all events, we expect that our secured and unsecured borrowings will be reasonable in relation to the net value of our assets and will be reviewed by our board of directors at least quarterly. As of September 30, 2014, our borrowings were 3.5% of our net assets.

We believe that careful use of debt will help us to achieve our diversification goals because we will have more funds available for investment. However, high levels of debt could cause us to incur higher interest charges and higher debt service payments, which would decrease the amount of cash available for distribution to our investors.

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As of September 30, 2014 and December 31, 2013, our leverage ratio (calculated as total debt, less cash and cash equivalents, as a percentage of total real estate investments, including acquired intangible lease assets and liabilities, at cost) could not be calculated, as our cash balances exceeded our debt outstanding.

The table below summarizes our consolidated indebtedness at September 30, 2014 (dollars in thousands).
 
Principal Amount at
 
Weighted- Average Interest Rate
 
Weighted- Average Years to Maturity
Debt(1)
September 30, 2014
 
 
Fixed-rate mortgages payable(2)
$
12,516

 
6.0
%
 
22.0

(1) 
The debt maturity table does not include any below-market debt adjustment, of which $0.3 million, net of accumulated amortization, was outstanding as of September 30, 2014.
(2) 
Currently all of our fixed-rate debt represents a loan assumed as part of an acquisition.  These loans typically have higher interest rates than interest rates associated with new debt.

Contractual Commitments and Contingencies

Our contractual obligations as of September 30, 2014, were as follows (in thousands):
  
Payments due by period
  
Total
 
2014
 
2015
 
2016
 
2017
 
2018
 
Thereafter
Long-term debt obligations - principal payments
$
12,516

 
$
64

 
$
264

 
$
279

 
$
299

 
$
317

 
$
11,293

Long-term debt obligations - interest payments
10,465

 
188

 
738

 
723

 
703

 
685

 
7,428

Total
$
22,981

 
$
252

 
$
1,002

 
$
1,002

 
$
1,002

 
$
1,002

 
$
18,721


Our portfolio debt instrument and the revolving credit facility contain certain covenants and restrictions that require us to meet certain financial ratios, including but not limited to: borrowing base loan-to-value ratio, debt service coverage ratio and fixed charge ratio. As of September 30, 2014, we were in compliance with the restrictive covenants of our outstanding debt obligation. We expect to continue to meet the requirements of our debt covenants over the short and long term.

Distributions
 
Distributions for the nine months ended September 30, 2014 accrued at an average daily rate of $0.00445205 per share of common stock.

Activity related to distributions to our stockholders for the three and nine months ended September 30, 2014 is as follows (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
September 30, 2014
 
September 30, 2014
Gross distributions paid
$
4,293

 
$
6,168

Distributions reinvested through DRIP
2,267

 
3,176

Net cash distributions
2,026

 
2,992

Net loss attributable to stockholders
1,921

 
3,029

Net cash provided by operating activities
551

 
133


There were gross distributions of $2.1 million accrued and payable as of September 30, 2014. To the extent that distributions paid were greater than our cash provided by operating activities for the nine months ended September 30, 2014, we funded such excess distributions with proceeds from our primary offering.










 We expect to pay distributions monthly and continue paying distributions monthly unless our results of operations, our general financial condition, general economic conditions or other factors make it imprudent to do so. The timing and amount of distributions will be determined by our board and will be influenced in part by our intention to comply with REIT requirements of the Internal Revenue Code.
 

29


We may receive income from interest or rents at various times during our fiscal year and, because we may need funds from operations during a particular period to fund capital expenditures and other expenses, we expect that at least during the early stages of our development and from time to time during our operational stage, we will declare distributions in anticipation of funds that we expect to receive during a later period.  We will pay these distributions in advance of our actual receipt of these funds. In these instances, we expect to look to borrowings or proceeds from our initial public offering to fund our distributions. We may also fund such distributions from advances from our sponsors or from any deferral or waiver of fees by the Advisor or Sub-advisor. To the extent that we pay distributions from sources other than our cash provided by operating activities, we will have fewer funds available for investment in properties. The overall return to our stockholders may be reduced, and subsequent investors may experience dilution.
 
Our general distribution policy is not to use the proceeds of our offering to pay distributions.  However, our board has the authority under our organizational documents, to the extent permitted by Maryland law, to pay distributions from any source without limit, including proceeds from our offering or the proceeds from the issuance of securities in the future, and, therefore, proceeds of our offering may fund distributions. As we have raised substantial amounts of offering proceeds and are continuing to seek additional opportunities to invest these proceeds on attractive terms, our cash provided by operating activities has not yet been sufficient to fully fund our ongoing distributions. Because we do not intend to borrow money for the specific purpose of funding distribution payments, we have funded, and may continue to fund, a portion of our distributions with proceeds from our offerings.
 
To maintain our qualification as a REIT, we must make aggregate annual distributions to our stockholders of at least 90.0% of our REIT taxable income (which is computed without regard to the dividends paid deduction or net capital gain and which does not necessarily equal net income as calculated in accordance with GAAP). If we meet the REIT qualification requirements, we generally will not be subject to U.S. federal income tax on the income that we distribute to our stockholders each year. However, we may be subject to certain state and local taxes on our income, property or net worth, respectively, and to federal income and excise taxes on our undistributed income.
 
We have not established a minimum distribution level, and our charter does not require that we make distributions to our stockholders.

Critical Accounting Policies
 
There have been no changes to our critical accounting policies during the nine months ended September 30, 2014, except that subsequent to the issuance of our Annual Report on Form 10-K, we have continued to adopt additional accounting policies as required by our increasing operational activity. For a summary of our critical accounting policies, refer to our Annual Report on Form 10-K for the year ended December 31, 2013. The additional accounting policies that we have adopted since the issuance of our Annual Report on Form 10-K have been included within Note 2 to the condensed consolidated interim financial statements presented herein.

Impact of Recently Issued Accounting Pronouncements—In April 2014, FASB issued ASU 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The amendments in this update raise the threshold for a property disposal to qualify as a discontinued operation and require new disclosures of both discontinued operations and certain other disposals that do not meet the definition of a discontinued operation. Unless we elect early adoption, the standard will be effective for us on January 1, 2015. In future periods, the adoption of this pronouncement may result in property disposals not qualifying for discontinued operations presentation, and thus the results of those disposals will remain in income from continuing operations.

In May 2014, FASB issued ASU 2014-09, Revenue from Contracts with Customers. ASU 2014-09 will eliminate the transaction- and industry-specific revenue recognition guidance currently in place under GAAP and will replace it with a principle-based approach for determining revenue recognition. ASU 2014-09 does not apply to lease contracts accounted for under ASC 840, Leases. ASU 2014-09 will be effective for annual and interim periods beginning after December 15, 2016, and early adoption is prohibited. We are currently assessing the impact the adoption of ASU 2014-09 will have on our financial statements.

Off-Balance Sheet Arrangements

As of September 30, 2014, we did not have any off-balance sheet arrangements.


30


Item 3.       Quantitative and Qualitative Disclosures About Market Risk
 
As of September 30, 2014, we had no variable-rate debt outstanding and therefore are not directly exposed to interest rate changes. We may hedge a portion of any future exposure to interest rate fluctuations through the utilization of interest rate swaps in order to mitigate the risk of this exposure. We do not intend to enter into derivative or interest rate transactions for speculative purposes.  Our hedging decisions will be determined based upon the facts and circumstances existing at the time of the hedge and may differ from our currently anticipated hedging strategy.  Because we may use derivative financial instruments to hedge against interest rate fluctuations, we may be exposed to both credit risk and market risk. Credit risk is the failure of the counterparty to perform under the terms of the derivative contract. If the fair value of a derivative contract is positive, the counterparty will owe us, which creates credit risk for us. If the fair value of a derivative contract is negative, we will owe the counterparty and, therefore, do not have credit risk. We will seek to minimize the credit risk in derivative instruments by entering into transactions with high-quality counterparties.  Market risk is the adverse effect on the value of a financial instrument that results from a change in interest rates. The market risk associated with interest-rate contracts is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken. As of September 30, 2014, we were not party to any interest rate swap agreements.
 
As the information presented above includes only those exposures that exist as of September 30, 2014, it does not consider those exposures or positions that could arise after that date. Hence, the information represented herein has limited predictive value. As a result, the ultimate realized gain or loss with respect to interest rate fluctuations will depend on the exposures that arise during the period, the hedging strategies at the time, and the related interest rates.
 
We do not have any foreign operations, and thus we are not exposed to foreign currency fluctuations. 

Item 4.         Controls and Procedures
 
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Principal Executive Officer and Principal Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of September 30, 2014. Based on that evaluation, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) were effective as of September 30, 2014.
Internal Control Over Financial Reporting
During the third quarter of 2014, there were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

31


 PART II.     OTHER INFORMATION
 
Item 1.         Legal Proceedings
 
From time to time, we are party to legal proceedings, which arise in the ordinary course of our business. We are not currently involved in any legal proceedings of which the outcome is reasonably likely to have a material adverse effect on our results of operations or financial condition, nor are we aware of any such legal proceedings contemplated by governmental authorities.
 
Item 1A.        Risk Factors
 
The following risk factors supplement the risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2013.
 
Risks Related to an Investment in Us

Recent disclosures made by American Realty Capital Properties Inc. (“ARCP”), an entity previously sponsored by AR Capital LLC (our “AR Capital sponsor”), regarding certain accounting errors have led to the temporary suspension of selling agreements by certain broker-dealers.

ARCP recently announced that its audit committee had concluded that its previously issued financial statements and other financial information contained in certain of their public filings should no longer be relied upon as a result of certain accounting errors that were not corrected after being discovered. These accounting errors resulted in the resignations of ARCP’s former chief financial officer and its former chief accounting officer.  ARCP’s former chief financial officer is one of the non-controlling owners of our AR Capital sponsor, but does not have a role in the management of our business.

As a result of this announcement, a number of broker-dealer firms that had been participating in the distribution of offerings of public, non-listed REITs sponsored directly or indirectly by our AR Capital sponsor have temporarily suspended their participation in the distribution of those offerings, including ours.  These temporary suspensions, as well as any future suspensions, could have a material adverse effect on our ability to raise additional capital.  We cannot predict the length of time these temporary suspensions will continue, and whether the broker-dealer firms will reinstate their participation in the distribution of our offering.  If we are unable to raise substantial funds, we will be limited in the number and type of investments we may make and the value of your investment in us will fluctuate with the performance of the specific properties we acquire. 

To date, we have not generated sufficient cash flow from operations to pay distributions, and, therefore, we have paid, and may continue to pay, a portion of our distributions from the net proceeds of our ‘‘best efforts’’ offering, which reduces the amount of cash we ultimately have to invest in assets, negatively impacting the value of our stockholders’ investment and is dilutive to our stockholders.

Our organizational documents permit us to pay distributions from sources other than cash flow from operations. Specifically, some or all of our distributions may be paid from retained cash flow, from borrowings and from cash flow from investing activities, including the net proceeds from the sale of our assets, or from the net proceeds of our ‘‘reasonable best efforts’’ offering. Accordingly, until such time as we are generating cash flow from operations sufficient to cover distributions, during the pendency of our ‘‘reasonable best efforts’’ offering, we have and will likely continue to pay distributions from the net proceeds of the offering. We have not established any limit on the extent to which we may use alternate sources, including borrowings or proceeds of the offering, to pay distributions. We began declaring distributions to stockholders of record during February 2014. A portion of the distributions paid to stockholders to date have been paid from the net proceeds of our ‘‘reasonable best efforts’’ offering, which reduces the proceeds available for other purposes. For the nine months ended September 30, 2014, we paid distributions of $6.2 million, including distributions reinvested through our distribution reinvestment plan, and our GAAP cash flows from operations were $0.1 million. To the extent we pay cash distributions, or a portion thereof, from sources other than cash flow from operations, we will have less capital available to invest in properties and other real estate-related assets, the book value per share may decline, and there will be no assurance that we will be able to sustain distributions at that level. In addition, by using the net proceeds of our ‘‘reasonable best efforts’’ offering to fund distributions, earlier investors may benefit from the investments made with funds raised later in our ‘‘reasonable best efforts’’ offering, while later investors may not benefit from all of the net offering proceeds raised from earlier investors.


32


The failure of any bank in which we deposit our funds could reduce the amount of cash we have available to pay distributions and invest in real estate assets.

The Federal Insurance Deposit Corporation, or “FDIC,” generally only insures limited amounts per depositor per insured bank. Through 2014, the FDIC is insuring up to $250,000 per depositor per insured bank account. At September 30, 2014, we had cash and cash equivalents exceeding these federally insured levels. If the banking institutions in which we have deposited funds ultimately fail, we may lose our deposits over the federally insured levels. The loss of our deposits could reduce the amount of cash we have available to distribute or invest.

Two of our tenants generated a significant portion of our revenue, and a rental payment default by these significant tenants could adversely affect our results of operations.

For the nine months ended September 30, 2014, approximately 17.6% and 13.6%, respectively, of our consolidated base rental revenue was generated from leases with Publix Super Markets and with an affiliate of Ahold USA. As a result of the concentration of revenue generated from these tenants, if Publix Super Markets or Ahold USA were to cease paying rent or fulfilling their other monetary obligations we could have significantly reduced rental revenues or higher expenses until the default was cured or the space was leased to a new tenant or tenants. In addition, there is no assurance that the space could be re-leased on similar or better terms, if at all.

Item 2.        Unregistered Sales of Equity Securities and Use of Proceeds
 
a)
We did not sell any equity securities that were not registered under the Securities Act of 1933, as amended, during the nine months ended September 30, 2014.
b)
On November 25, 2013, our registration statement on Form S-11 (File No. 333-190588), covering a public offering of up to 100,000,000 shares of common stock, was declared effective under the Securities Act of 1933, and we commenced our initial public offering. We are offering 80,000,000 shares of common stock in our primary offering at an aggregate offering price of up to $2.0 billion, or $25.00 per share with discounts available to certain categories of purchasers. The 20,000,000 shares offered under the DRIP are initially being offered at an aggregate offering price of $475 million, or $23.75 per share. We are selling the shares registered in our primary offering over a two-year period, which ends November 25, 2015. Under rules promulgated by the SEC, in some instances we may extend the primary offering beyond that date. We may sell shares under the DRIP beyond the termination of the primary offering until we have sold all the shares under the plan.
c)
As of September 30, 2014, we had issued a total of 17.1 million shares of common stock including 0.1 million shares issued through the DRIP, generating gross cash proceeds of $425.7 million, since our inception.
The following table reflects the offering costs associated with the issuance of common stock for the nine months ended September 30, 2014 (in thousands):
  
Nine Months Ended
September 30, 2014
Selling commissions and dealer manager fees
$
40,195

Other offering costs
12,147

Total
$
52,342

The Dealer Manager reallowed the selling commissions and a portion of the dealer manager fees to participating broker-dealers. The following table details the selling commissions incurred and reallowed related to the sale of shares of common stock (in thousands):
  
Nine Months Ended
September 30, 2014
Total commissions incurred from the Dealer Manager
$
40,195

Less:
 
  Commissions to participating broker-dealers
(27,573
)
  Reallowance to participating broker-dealers
(4,600
)
Net to the Dealer Manager
$
8,022



33


As of September 30, 2014, we have incurred $52.3 million of cumulative offering costs in connection with the issuance and distribution of common stock. Offering proceeds of $425.7 million exceeded cumulative offering costs by $373.4 million at September 30, 2014.

To the extent that we are able to identify suitable investments, we have used, and expect to continue to use, substantially all of the net proceeds from our ongoing initial public offering to invest primarily in grocery-anchored neighborhood and community shopping centers throughout the United States. We may use the net proceeds from the sale of shares under our distribution reinvestment plan for general corporate purposes, including, but not limited to, the repurchase of shares under our share repurchase program, capital expenditures, tenant improvement costs, and other funding obligations. As of September 30, 2014, we have used the net proceeds from our ongoing primary public offering to purchase $116.3 million in real estate and to pay $2.1 million of acquisition fees and expenses.
d)
We did not repurchase any of our securities during the nine months ended September 30, 2014.


34


Item 6.          Exhibits
 
Ex.
Description
 
 
10.1
Credit Agreement dated as of July 2, 2014, among Phillips Edison - ARC Grocery Center Operating Partnership II, L.P.; Phillips Edison - ARC Grocery Center REIT II, Inc.; Certain Subsidiaries of the Parent Entity; KeyBank National Association; JPMorgan Chase Bank, Bank of America, N.A.; Wells Fargo Bank, National Association; MUFG Union Bank, N.A.; and certain other lenders thereto
31.1
Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of Principal Executive Officer pursuant to 18 U.S.C. 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002
32.2
Certification of Principal Financial Officer pursuant to 18 U.S.C. 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002
101.1
The following information from the Company’s quarterly report on Form 10-Q for the quarter ended September 30, 2014, formatted in XBRL (eXtensible Business Reporting Language): (i) Condensed Consolidated Balance Sheets; (ii) Condensed Consolidated Statement of Operations and Comprehensive Loss; (iii) Condensed Consolidated Statement of Equity; and (iv) Condensed Consolidated Statement of Cash Flows

35


SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
PHILLIPS EDISON – ARC GROCERY CENTER REIT II, INC.
 
 
 
Date: November 10, 2014
By:
/s/ Jeffrey S. Edison 
 
 
Jeffrey S. Edison
 
 
Chairman of the Board and Chief Executive Officer
 
 
(Principal Executive Officer)
 
 
 
Date: November 10, 2014
By:
/s/ Devin I. Murphy 
 
 
Devin I. Murphy
 
 
Chief Financial Officer, Secretary and Treasurer
 
 
(Principal Financial Officer)


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PHILLIPS EDISON GROCERY CENTER REIT II, INC. Reports

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