UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2014

OR

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

For the period from _____ to _____

000-53673

(Commission file No.)

NetREIT, Inc.

(Exact name of registrant as specified in its charter)

1282 Pacific Oaks Place, Escondido, California 92029

(Address of principal executive offices)

(760) 471-8536

(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 þ No o.

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 o No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x.

At November 14, 2014, registrant had issued and outstanding 16,764,578 shares of its common stock, no par value.

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Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

NetREIT, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

See notes to condensed consolidated financial statements

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NetREIT, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations

(Unaudited)

 

See notes to condensed consolidated financial statements.

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NetREIT, Inc. and Subsidiaries

Condensed Consolidated Statements of Stockholders' Equity

Nine Months Ended September 30, 2014

(Unaudited)

See notes to condensed consolidated financial statements

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NetREIT, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

See notes to condensed consolidated financial statements

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NetREIT, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

September 30, 2014

1. ORGANIZATION AND BASIS OF PRESENTATION

NetREIT (the "Company") was incorporated in the State of California on January 28, 1999 for the purpose of investing in real estate properties. Effective August 4, 2010, NetREIT, a California Corporation, merged into NetREIT, Inc., a Maryland Corporation with NetREIT, Inc. becoming the surviving Corporation. As a result of the merger, NetREIT is now incorporated in the State of Maryland. The Company qualifies and operates as a self-administered real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended, (the "Code") and commenced operations with capital provided by its private placement offering of its equity securities in 1999.

The Company invests in a diverse portfolio of real estate assets. The primary types of properties the Company invests in include office, retail, self-storage and residential properties located in the western United States. As of September 30, 2014, including properties held for sale, the Company owned or had an equity interest in twelve office buildings and one industrial building ("Office Properties") which total approximately 963,000 rentable square feet, four retail shopping centers ("Retail Properties") which total approximately 186,000 rentable square feet, seven self-storage facilities ("Self-Storage Properties") which total approximately 666,000 rentable square feet, and 55 Model Homes owned by four limited partnerships  ("Residential Properties").

Basis of Presentation. The accompanying condensed consolidated financial statements have been prepared by the Company's management in accordance with accounting principles generally accepted in the United States of America ("GAAP"). Certain information and footnote disclosures required for annual consolidated financial statements have been condensed or excluded pursuant to rules and regulations of the SEC. In the opinion of management, the accompanying condensed consolidated financial statements reflect all adjustments of a normal and recurring nature that are considered necessary for a fair presentation of our financial position, results of our operations and cash flows as of and for the three and nine months ended September 30, 2014 and 2013, respectively. However, the results of operations for the interim periods are not necessarily indicative of the results that may be expected for the year ending December 31, 2014. These condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2013. The condensed consolidated balance sheet at year ended December 31, 2013 has been derived from the audited consolidated financial statements included in the Form 10-K filed with the Securities and Exchange Commission on March 31, 2014.

2. SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation. The accompanying consolidated financial statements include the accounts of the Company and its direct and indirect wholly-owned subsidiaries and entities the Company controls or of which it is the primary beneficiary. All significant intercompany balances and transactions have been eliminated in consolidation.

The Company believes that it has met all of the REIT distribution and technical requirements for the nine months ended September 30, 2014 and 2013, respectively.

The Company has concluded that there are no significant uncertain tax positions requiring recognition in its financial statements. Neither the Company nor its subsidiaries have been assessed interest or penalties for tax positions by any major tax jurisdictions.

 

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Gains relating to transactions which do not meet the criteria for full accrual method of accounting are deferred and recognized when the full accrual method of accounting criteria are met or by using the installment or deposit methods of profit recognition, as appropriate in the circumstances.

As of September 30, 2014, Management has concluded that there are 12 Model Home properties aggregating approximately $4.6 million which are considered as held for sale and are included in real estate assets. These homes have mortgage notes payable of approximately $2.3 million.

Impairment. The Company reviews the carrying value of each real estate property to determine if circumstances that indicate impairment in the carrying value of the investment exist or that depreciation periods should be modified. If circumstances support the possibility of impairment, the Company prepares a projection of the undiscounted future cash flows, without interest charges, of the specific property and determines if the investment in such property is recoverable. In the quarter ended September 30, 2014, the Company determined that there was an additional impairment charge on its Havana Parker property of $950,000. This impairment charge was determined in the course of ongoing loan modification negotiations with the lender. In the quarter ended September 30, 2013, the Company determined that an impairment existed on its Havana Parker property and recorded an asset impairment of $1.5 million.

Loss Per Common Share. Basic loss per common share ("Basic EPS") is computed by dividing net loss available to common stockholders (the "numerator") by the weighted average number of common shares outstanding (the "denominator") during the period. Diluted loss per common share ("Diluted EPS") is similar to the computation of Basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. In addition, in computing the dilutive effect of convertible securities, the numerator is adjusted to add back the after-tax amount of interest recognized in the period associated with any convertible debt. The computation of Diluted EPS does not assume exercise or conversion of securities that would have an anti-dilutive effect on net earnings per share.

The following is a reconciliation of the denominator of the basic loss per common share computation to the denominator of the diluted loss per common share computations, for the three and nine months ended September 30, 2014 and 2013:

Weighted average shares from share based compensation, shares from conversion of NetREIT 01 LP Partnership, Casa Grande LP Partnership, NetREIT Palm Self-Storage LP Partnership, NetREIT Garden Gateway LP Partnership, NetREIT National City Partners LP Partnership and shares from stock purchase warrants with respect to a total of 1,356,093 shares of common stock for the three and nine months ended September 30, 2014 and 1,382,433 shares of common stock for the three and nine months ended September 30, 2013, were excluded from the computation of diluted earnings per share as their effect was anti-dilutive.

Fair Value Measurements. Certain assets and liabilities are required to be carried at fair value, including long-lived real estate assets that are deemed to be impaired. GAAP requires disclosure of fair values calculated under each level of inputs within the following hierarchy:

Fair value is defined as the price at which an asset or liability is exchanged between market participants in an orderly transaction at the reporting date. The Company's cash equivalents, mortgage notes receivable, accounts receivable and payables and accrued liabilities all approximate fair value due to their short term nature. The Company has one Level 3 long lived impaired real estate asset with a fair value and carrying value of $2.3 million. The Company estimated the fair value for this impaired real estate asset based on the estimated sales price less any selling costs. Management believes that the recorded value of mortgage notes payable are approximate their fair value as of September 30, 2014 and December 31, 2013.

 

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Use of Estimates. The preparation of financial statements in conformity with GAAP requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting periods. Significant estimates include the allocation of purchase price paid for property acquisitions between land, building and intangible assets acquired including their useful lives; valuation of long-lived assets, and the allowance for doubtful accounts, which is based on an evaluation of the tenants' ability to pay and the provision for possible loan losses with respect to mortgages receivable and interest. Actual results may differ from those estimates.

Segments. The Company acquires and operates income producing properties including office properties, residential properties, retail properties and self-storage properties and, as a result, the Company operates in four business segments. See Note 8 "Segment Information".

Subsequent Events. Management has evaluated subsequent events through the date the accompanying financial statements are issued.

Reclassifications. Certain reclassifications have been made to prior condensed consolidated financial statements to conform to the current period presentation. These reclassifications had no effect on previously reported results of consolidated operations or equity.

Recently Issued Accounting Standards Updates. In April 2014, the FASB issued ASU No. 2014-08, Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity ("ASU No. 2014-08"). ASU No. 2014-08 limits discontinued operations reporting to disposals of components of an entity that represents a strategic shift that has (or will have) a major effect on an entity's operations and financial results when any of the following occurs: a) the component of an entity or group of components of an entity meets the criteria to be classified as held for sale; b) the component of an entity or group of components of an entity is disposed of by sale; and c) the component of an entity or group of components of an entity is disposed of other than by sale. ASU No. 2014-08 also requires additional disclosures about discontinued operations. ASU No. 2014-08 is effective for reporting periods beginning after December 15, 2014. Early adoption is permitted, but only for disposals (or classifications as held for sale) that have not been reported in financial statements previously issued or available for issuance. The Company early adopted ASU No. 2014-08 for the reporting period beginning January 1, 2014. As a result of the adoption of ASU No. 2014-08, results of operations for properties that are classified as held for sale in the ordinary course of business on or subsequent to January 1, 2014 will generally be included in continuing operations on the Company's consolidated statements of operations, to the extent such disposals did not meet the criteria for classification as a discontinued operation described above. Additionally, any gain or loss on sale of real estate that do not meet the criteria for classification as a discontinued operation will be presented, on the statements of operations, below income from continuing operations and income from discontinued operations.

 

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3. REAL ESTATE ASSETS AND LEASE INTANGIBLES

 

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The following table sets forth the components of the Company's real estate assets:

Operations from each property are included in the Company's condensed consolidated financial statements from the date of acquisition.

Recent Acquisitions

In August 2014, the Company acquired The Union Terrace Office building for the purchase price of approximately $9.4 million plus closing costs. The Property is a four-story office building with approximately 84,000 rentable square feet located in Lakewood, Colorado. The Company acquired the property with a cash payment of approximately $2.8 million and an interest only fixed rate mortgage note $6.6 million that bears interest 4.5% per annum and is due in August 2024.

In August 2014, the Company, through certain subsidiaries, acquired three Model Home properties in Arizona and leased them back to the home builder. The purchase price for the properties was $1.0 million. The purchase price paid was through a cash payment of $0.4 million and a promissory note $0.6 million.

In April 2014, the Company acquired The Bismarck Office Building for the purchase price of approximately $5.4 million plus closing costs. The property is a six-story office building with of approximately 93,000 rentable square feet located in Bismarck, North Dakota. The Company acquired the property with cash of approximately $2.2 million and a $3.2 million fixed rate mortgage note that bears interest at 6.12% per annum and is due in October 2016.

In February 2014, the Company, through certain subsidiaries, acquired six Model Home properties in Pennsylvania and leased them back to the home builder. The purchase price for the properties was $1.8 million. The purchase price paid was through a cash payment of $0.7 million and a promissory note $1.1 million.

The Company disposed of the following properties in the nine months ended September 30, 2014:

During the nine months ended September 30, 2014, NetREIT Dubose and the other Model Home entities disposed of thirty-two model home properties. The sales price, net of selling costs, aggregated approximately $13.5 million and approximately $5.6 million in mortgage notes payable were retired in connection with these sales. The Company recognized a gain of approximately $2.4 million related to the sale of these Model Homes.

The Company allocated the purchase price of the properties acquired during the nine months ended September 30, 2014 as follows:

 

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Lease Intangibles

The following table summarizes the net value of other intangible assets and the accumulated amortization for each class of intangible asset:

As of September 30, 2014, the estimated aggregate net amortization expense for each of the five succeeding fiscal years and thereafter is as follows:

The weighted average amortization period for the intangible assets, in-place leases, leasing costs, tenant relationships and below-market leases acquired as of September 30, 2014 was approximately 16.0 years.

 

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4. MORTGAGE NOTES PAYABLE

Mortgage notes payable as of September 30, 2014 and December 31, 2013 consisted of the following:

1.

In the quarter ended September 30, 2014, the Company determined that an additional impairment existed on its Havana Parker property and recorded an asset impairment of $950,000. At September 30, 2014, the book value of the property was $2.3 million and the property was encumbered with a CMBS loan with a balance of $3.1 million and a maturity date of July 1, 2016. The Company commenced paying the net cash flow from the property in order to get the loan assigned to the proper Servicing Agent qualified to negotiate a modification of the loan. The net cash flow is substantially less than the monthly payment due. The Company has made reduced mortgage payments for the previous eleven (11) mortgage payments. In May 2013, months before the decision to pay only the net cash flow generated by the Property, the Company engaged a third party consultant with experience in modification of CMBS loans to have the terms of the loan modified by the lender on the property. Negotiations with the lender are currently ongoing. However, on March 4, 2014, the Company received a notice of foreclosure from the lender stating that the covenants of the deed of trust have been violated for failure to pay principal and interest when due together with all other payments provided for in the evidence of debt secured by the deed of trust and other violations. The date of any foreclosure sale has been extended while negotiations are underway. We expect that the debt balance will be reduced, the interest rate will be reduced significantly and an option to extend the maturity date of the loan for an addition year. We also expect we will be required to bring the unpaid accrued interest payments current. We have evaluated the potential loss contingency in accordance with generally accepted accounting principles and concluded that it is not likely at this time that the Company will experience further losses. However, if the negotiations are not successful, the Lender may move forward with the court action and foreclose on the property. The loan on the Havana Parker property is non-recourse. Except as noted above, the Company is in compliance with all conditions and covenants of its mortgage notes payable. The Company has evaluated the potential loss contingency in accordance with generally accepted accounting principles and concluded that it is not likely at this time that the Company will experience further losses. However, if the negotiations are not successful, the Lender may move forward with the court action and foreclose on the property. The loan on the Havana Parker property is non-recourse. Except as noted above, the Company is in compliance with all conditions and covenants of its mortgage notes payable.

2.	The Company is working with the lender to extend the maturity date of this loan. The Company anticipates that the lender will extend the due date of these loans until such time as the model home securing the loan is sold.

 

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From the time that the Company commenced paying only net cash flow, scheduled payments through September 30, 2014 totalled approximately $402,000 and the Company paid approximately $48,000. The Company has accrued all interest and late charges due under the loan through September 30, 2014.

Scheduled principal payments of mortgage notes payable as of September 30, 2014 are as follows:

5. SERIES B PREFERRED STOCK

In August 2014, the Company closed on a private placement transaction of up to $40 million. The investment will be made in a series of capital contributions to be used for investor approved property acquisitions. The initial investment of $15 million dollars was made at the close of the transaction and an additional investment of $25 million dollars will be made on or before the one year anniversary of the initial investment.  The Company issued 15,000 shares of its Series B Preferred Stock at the close of the transaction in exchange for the $15 million investment. The Series B preferred stock has a $0.01 par value and a $1,000 liquidation preference. The Series B preferred stock shall be redeemed through a cash payment of the face value of the shares outstanding at redemption. The preferred return on the funds invested is 14% (10% shall be paid on a monthly basis and the remaining 4% shall accrue and compound monthly payable at the redemption date). The preferred stock must be redeemed by the third anniversary closing date; however, the Company shall have the right to extend a redemption for up to two additional years. The Company has classified the Series B Preferred Stock as long-term debt because of the mandatory redemption feature.

The Company incurred approximately $2.7 million in legal and underwriting costs. These costs have been capitalized and will be amortized to interest and amortization of issuance costs - Series B preferred stock over the three year term of the agreement.

Certain specified management decisions must be approved in advance by the Series B Preferred Investor.  In addition, upon the occurrence of an Event of Default, as defined in the Investor Agreement, the Investor has certain rights including the resignation of any or all of the existing members of the Board of Directors and electing a majority of the Board of Directors.

 

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Through January 31, 2013, the Company had a property management agreement with CHG Properties, Inc. ("CHG") to manage all of its properties at rates up to 5% of gross income. The Company paid CHG total management fees of approximately $113,000 in the quarter ended March 31, 2013.

During the term of the property management agreement, the Company had an option to acquire the business conducted by CHG. The option was exercisable, with the approval of a majority of the Company's directors not otherwise interested in the transaction, without any consent of the property manager, its board or its shareholders. The option price to be paid in shares of the Company was determined by a predefined formula based on the net income of CHG during the 6-month period immediately preceding the month in which the acquisition notice is delivered. In January 2013, the Company completed the purchase CHG.

The Company leases a portion of its corporate headquarters at Pacific Oaks Plaza in Escondido, California to an entity 100% owned by the Company's Chairman and Chief Executive Officer and another related party. Total rents charged and paid by these affiliates was approximately $12,000 and $43,000 for the nine months ended September 30, 2014 and 2013, respectively.

In January 2014, the former limited partner of NetREIT 01, LP, a consolidated subsidiary of the Company (the "Partnership") that owns the Presidio, exercised its option to convert approximately 52.8% of its ownership interests in the Partnership in exchange for approximately 21,000 shares of Company common stock. After conversion, our interest in the Partnership increased to approximately 89%. In January 2014, the Company agreed to purchase all of these shares from the limited partner at a price per share that was determined when the Partnership was formed, which, adjusted for stock dividends, was $7.858 per share. The stock purchase transaction was subjected to the Company's related party transaction policy which requires a review of the transaction by the uninterested parties of the Audit Committee and a subsequent vote by the Company's Board of Directors and was formally approved in December 2013.

Effective April 1, 2014, the former limited partner elected to convert all remaining interests in the Partnership in exchange for 18,807 shares of Company common stock. The Company will buy these shares back in January 2015 for an aggregate purchase price of approximately $147,800.

The limited partner of NetREIT 01, LP is the Allen Trust DTD 7-9-1999. William H. Allen, a Director of the Company and Chairman of the Audit Committee, is a beneficiary and a trustee of the trust. The Partnership was formed approximately one year before Mr. Allen became a Board Member.

Share-Based Incentive Plan. An incentive award plan has been established for the purpose of attracting and retaining officers, key employees and non-employee board members. The Compensation Committee of the Board of Directors adopted a Restricted Stock plan ("Restricted Stock") in December 2006 and granted nonvested shares of restricted common stock effective January 1 since the year of adoption. The nonvested shares have voting rights and are eligible for any dividends paid to common shares. The share awards vest in equal annual installments over a three to five year period from date of issuance. The Company recognized compensation cost for these fixed awards over the service vesting period, which represents the requisite service period, using the straight-line attribution expense method.

The value of the nonvested shares was calculated based on the offering price of the shares in the most recent private placement offering of $10 adjusted for stock dividends since granted and assumed selling costs. The value of granted nonvested restricted stock issued during the nine months ended September 30, 2014 totalled approximately $680,000 which is calculated using the most recent private placement offering of $10 adjusted for estimated selling costs. The value of granted nonvested restricted stock issued during the nine months ended September 30, 2013 totalled approximately $637,000. Compensation expense recorded was approximately $299,000 and $390,000 in the nine months ended September 30, 2014 and 2013, respectively. The 153,056 nonvested restricted shares as of September 30, 2014 will vest in equal installments over the next two to eight years.

 

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A table of non-vested restricted shares granted and vested since December 31, 2013 is as follows:

Cash Dividends - Common Stock. During the nine months ended September 30, 2014 and 2013, the Company paid cash dividends, net of reinvested stock dividends, of $3,830,000, and $3,345,000, respectively, or at an annualized rate $0.543 per share on an annualized basis.  As the Company reported net losses in both of these periods, and on a cumulative basis, these cash dividends represent a return of capital to the stockholders rather than a distribution of earnings. The Company paid cash dividends on the Convertible Series 6.3% Preferred Stock of approximately $77,000 in the nine months ended September 30, 2014 and 2013. The dividends were paid to a subsidiary that is consolidated into the condensed consolidated financial statements of the Company and, as a result, have been eliminated in consolidation.

Convertible series 6.3% preferred stock. The convertible series 6.3% preferred stock was redeemed at its $1.6 million face value in August 2014.

Dividend Reinvestment Plan. The Company has adopted a distribution reinvestment plan that allows stockholders to have dividends and other distributions otherwise distributable to them invested in additional shares of Company common stock. The Company has registered 1,500,000 shares of common stock pursuant to the dividend reinvestment plan. The dividend reinvestment plan became effective on January 23, 2012 just after the close of our private placement offering discussed above. The purchase price per share is 95% of the price the Company was formerly selling its shares for $9.50 per share. No sales commission or dealer manager fee will be paid on shares sold through the dividend reinvestment plan. The Company may amend, suspend or terminate the Plan at any time. Any such amendment, suspension or termination will be effective upon a designated dividend record date and notice of such amendment, suspension or termination will be sent to all Participants at least thirty (30) days prior to such record date. As of the date of the last evaluation, December 31, 2013, the second year under the plan, approximately $7.9 million, or approximately 836,000 shares of common stock were issued under the dividend reinvestment plan.

The Company's reportable segments consist of the four types of commercial real estate properties for which the Company's decision-makers internally evaluate operating performance and financial results: Residential Properties, Industrial and Office Properties, Retail Properties and Self-Storage Properties; The Company also has certain corporate level activities including accounting, finance, legal administration and management information systems which are not considered separate operating segments.

The Company's chief operating decision maker evaluates the performance of its segments based upon net operating income. Net operating income is defined as operating revenues (rental income, tenant reimbursements and other property income) less property and related expenses (property expenses, real estate taxes, ground leases and provisions for bad debts) and excludes other non-property income and expenses, interest expense, depreciation and amortization, and general and administrative expenses. The accounting policies of the reportable segments are the same as those described in the Company's significant accounting policies. There is no intersegment activity.

 

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The following tables reconcile the Company's segment activity to its results of operations and financial position as of September 30, 2014 and December 31, 2013 and for the three and nine months ended September 30, 2014 and 2013, respectively.

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(1)	Total consolidated capital expenditures are equal to the same amounts disclosed for total reportable segments.

9. SUBSEQUENT EVENTS

The Company has entered into purchase and sale agreements for two properties in Colorado Springs, Colorado. The first property is a retail center of approximately 44,000 square feet with a purchase price of $11.3 million. The other property is an office building that is approximately 110,000 square feet with a purchase price of $15.5 million. The Company expects to complete these two acquisitions before December 31, 2014.

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OVERVIEW AND RECENT DEVELOPMENTS

Our growth of the investment portfolio during the year 2013 and the nine months ended September 30, 2014 was slow as our acquisitions were offset by model home sales.  During that eighteen month period we acquired one self-storage facility, two office building and 23 model homes but sold 65 model homes as the leases expired.  The growth was slow during 2013 in the commercial area as we were participating in lengthy negotiations to acquire a package of approximately 12 office buildings that would have required all of our cash balances plus some additional cash through either debt or equity. Through the extended due diligence period, the Company did not entertain any other acquisitions.   In November 2013, we entered into escrow for an office building in Bismarck, North Dakota and completed the purchase in May 2014.   Our growth in model home acquisitions was hampered by our turning away business from one large developer in early 2013 as the acquisition would have resulted in a large concentration with that developer exposing the Company to risks that it did not feel safe to do. In addition, also since early 2013, another one of our large developers started the process of spinning off its homebuilder subsidiaries. Once spun-off these homebuilding companies were going to merge into one large homebuilder. This activity resulted in this developer ceasing to do sale-leaseback financings until the merger is consummated that is expected in late-year 2014.  If this new homebuilder decides to get back into financing arrangements similar to our sale-leaseback product the result should be large increase in our portfolio of Model Homes.

During 2014, we acquired one office building in Bismarck, ND for approximately $5.4 million and one office building in Lakewood, CO for $9.4 million. We currently have two office buildings in escrow for $26.3 million that will close before the year end. We intend to substantially increase our real estate asset portfolio in 2015.

We intend to be active in acquiring additional model homes in the foreseeable future.  We believe that over the next few years we will have excellent opportunities as we have extensive relationships with homebuilders gearing up their development of residential homes if the rebound in the economy continues. The increase in acquisitions of model homes by these entities will increase revenue to our advisor subsidiaries in the future and should generate additional net operating income from our real estate investments.

Operating Portfolio

The Company invests in a diverse portfolio of real estate assets. The primary types of properties the Company invests in include office, retail, self-storage and NNN leased residential properties primarily located in the western United States. As of September 30, 2014, including properties held for sale, the Company owned or had an equity interest in twelve office buildings and one industrial building ("Office Properties") which total approximately 963,000 rentable square feet, four retail shopping centers ("Retail Properties") which total approximately 186,000 rentable square feet, seven self-storage facilities ("Self-Storage Properties") which total approximately 666,000 rentable square feet, and 55 Model Homes owned by four limited partnerships  ("Residential Properties").

NetREIT's office/industrial, retail and self-storage properties are located primarily in Southern California and Colorado, with two office buildings located in North Dakota. Our Model Home properties are located in eight states. We do not develop properties but acquire properties that are stabilized or that we anticipate will be stabilized within two to three years of acquisition. We consider a property to be stabilized once it has achieved an 80% occupancy rate for a full year as of January 1 of such year, or has been operating for three years. Our geographical clustering of assets, especially in the self-storage segment, enables us to reduce our operating costs through economies of scale by servicing a number of properties with less staff, but it also makes us more susceptible to changing market conditions in these discrete geographic areas.

 

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Most of our office/industrial and retail properties are leased to a variety of tenants ranging from small businesses to large public companies, most of which do not have publicly rated debt. We have in the past entered into, and intend to enter into in the future, purchase agreements for real estate having net leases that require the tenant to pay all of the operating expense (Net, Net, Net Leases) or pay increases in operating expenses over s specific base year of the property acquired.

Most of our office leases are for terms of 3 to 5 years with annual rental increases built into such leases. In general, we have experienced decreases in rental rates in many of our submarkets due to recessionary conditions and other related factors when leases expire and are extended. We cannot give any assurance that as the older leases expire or as we add new tenants that rental rates will be equal to or above the current market rates. Also, decreased demand and other negative trends or unforeseeable events that impair our ability to timely renew or re-lease space could have a negative effect on our future financial condition, results of operations and cash flow.

The Model Homes are typically leased for 2 to 3 years to the home developer on a triple net lease.  Under a triple net lease the tenant is required to pay all operating, maintenance and insurance costs and real estate taxes with respect to the leased property.

The self-storage properties are rented pursuant to rental agreements that are for no longer than 6 months. The self-storage properties are located in markets having other self-storage properties. Competition with these other properties will impact the operating results of these properties, which depends materially on our ability to timely lease vacant self-storage units, to actively manage unit rental rates, and our tenants' ability to make required rental payments. To be successful, we must be able to continue to respond quickly and effectively to changes in local and regional economic conditions by adjusting rental rates of these properties within their regional market in Southern California. We depend on websites, advertisements, flyers, etc. to secure new tenants to fill any vacancies.

The United States continues to be on the path of a slow recovery from the recession that began in 2008. The current economic environment has benefited from the recovery in the housing industry that has shown decreases in residential housing foreclosures and shadow inventory and a decreasing supply of homes available for purchase resulting in an increase in single-family home prices, housing starts and building permits. In addition, unemployment rates have decreased over the last several years. On the commercial side, vacancy rates have declined and average rental rates have increased with free rent diminishing in many markets. U.S. corporations have been reporting increased earnings and stock market investments and activity have rebounded. We believe that the pace of the overall recovery will likely continue to be slow and disjointed as some sections of the country have not seen job growth. Full recovery will need increasing job growth, but even then it will not be consistent across industries, geographies or periods of the year causing an uneven tempo of growth.

Management's evaluation of operating results includes an assessment of our ability to generate cash flow necessary to pay operating expenses, general and administrative expenses, debt service and to fund distributions to our stockholders. As a result, Management's assessment of operating results gives less emphasis to the effects of unrealized gains and losses and other non-cash charges, such as depreciation and amortization and impairment charges, which may cause fluctuations in net income for comparable periods but have no impact on cash flows. Management's evaluation of our potential for generating cash flow includes assessments of our recently acquired properties, our non-stabilized properties, long-term sustainability of our real estate portfolio, our future operating cash flow from anticipated acquisitions, and the net proceeds from the sales of our real estate assets.

In addition, Management evaluates our portfolio and individual properties results of operations with a primary focus on increasing and enhancing the value, quality and quantity of properties in our real estate holdings. Properties that have reached goals in occupancy and rental rates are evaluated for potential added value appreciation and, if lacking such potential, are sold with the equity reinvested in properties that have better potential without foregoing cash flow.  Management focuses its efforts on improving underperforming assets through re-leasing efforts, including negotiation of lease renewals and rental rates.

Critical Accounting Policies

There have been no material changes to our critical accounting policies as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2013, as filed with the SEC on March 31, 2014.

RECENT EVENTS HAVING SIGNIFICANT EFFECT ON RESULTS OF OPERATIONS

Equity Raise

In August 2014 the Company closed on a private placement transaction of up to $40 million dollars. The investment will be made in a series of capital contributions to be used for investor approved property acquisitions. The initial investment of $15 million dollars was made at the close of the transaction and an additional investment of $25 million dollars will be made on or before the one year anniversary of the initial investment.  The Company issued 15,000 shares of its Series B Preferred Stock at the close of the transaction.  The preferred return on the funds invested is 14% (10% shall be paid on a monthly basis and the remaining 4% shall accrue and compound monthly). The preferred stock must be redeemed by the third anniversary closing date; however, the Company shall have the right to extend a redemption for up to two additional years.

Certain specified management decisions must be approved in advance by the Series B Preferred Investor.  In addition, upon the occurrence of an Event of Default, as defined in the Investor Agreement, the Investor has certain rights including electing a majority of the Board of Directors.

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Property Acquisitions

Effective January 31, 2013, the Company entered into an Agreement and Plan of Merger to consummate the merger acquisition of CHG Properties, Inc. ("CHG"), a California corporation. CHG was the property manager for all of NetREIT's properties. The Company had the option to purchase CHG pursuant to a February 15, 2005, option agreement.   The Company delivered the option exercise notice provided for in the option agreement to C I Holding Group, Inc. ("CIH"), the parent company of CHG, in November 2012. The President of CIH is Jack K. Heilbron and the Secretary of CIH is Mary Limoges. Mr. Heilbron is President and CEO of the Company and Ms. Limoges is Mr. Heilbron's spouse. The Company determined the fair market value of CHG to be $1.9 million and the transaction was reviewed and unanimously approved by the independent Directors of the Board.

Pursuant to the terms and conditions of the Agreement and Plan of Merger, the Company formed NTR Property Management, Inc. ("NTR"), a California corporation (note 6). NTR functions as the sole in-house property manager for the Company after the merger, reducing the Company's property management expense by the marked-up charges previously paid to CHG.

Below is a chronological listing of the acquisitions and dispositions of properties in for the first nine months of 2014 and the year ended December 31, 2013. Operating results are included in the consolidated financial statements from the date of acquisition.

The Company acquired the following properties in the nine months ended September 30, 2014:

In February 2014, NetREIT Dubose, Dubose Model Home Investors #201 LP and Dubose Model Home Investors #202 LP acquired six Model Home properties in Pennsylvania and leased them back to the home builder. The purchase price for the properties was $1.8 million. The purchase price paid was through a cash payment of $0.7 million and a promissory note of $1.1 million dollars.

In April 2014, the Company acquired an office building located in Bismarck, ND for the purchase price of $5.4 million dollars. The purchase price was paid through a cash payment of $2.2 million and through the assumption of the existing loan on the property of $3.2 million. The property was built in 1976 and is comprised of 93,058 square feet. The property was 85% occupied at acquisition.

In August 2014, the Company acquired an office building located in Lakewood, Colorado for the purchase price of $9.4 million. The purchase price was paid through a cash payment of $2.8 million and a promissory note totaling $6.6 million. The property was built in 1982 (renovated in 2006) and is comprised of approximately 84,000 square feet. The property was 82% occupied at acquisition.

In August 2014, Dubose, Dubose Model Home Investors #201 LP and Dubose Model Home Investors #202 LP acquired three Model Home properties in Arizona and leased them back to the home builder. The purchase price for the properties was $1.0 million. The purchase price paid was through a cash payment of $0.4 million and a promissory note $0.6 million.

The Company disposed of the following properties in the nine months ended September 30, 2014:

During the nine months ended September 30, 2014, NetREIT Dubose and the other Model Home entities disposed of thirty four Model Home properties. The sales price, net of selling costs, aggregated approximately $13.5 million and approximately $5.6 million in mortgage notes payable were retired in connection with these sales. The Company recognized a gain of approximately $2.4 million related to the sale of these Model Homes.

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The Company acquired the following properties in the year ended December 31, 2013:

During the year ended December 31, 2013, NetREIT Dubose and other Model Home entities acquired 14 Model Home properties and leased them back to the home builder. The purchase price for the properties was approximately $3.6 million. The purchase price paid was through a cash payment of approximately $1.5 million and promissory notes totaling approximately $2.1 million.

In May 2013, the Company acquired a self-storage facility in Lancaster, CA for the purchase price of approximately $3.7 million dollars. The purchase price was paid in cash. The facility is comprised of approximately 71,000 square feet of rentable area consisting of approximately 608 self-storage units. The facility was built in 1990 and was approximately 65 percent occupied at acquisition. The results of operations for the year ended December 31, 2013 includes approximately seven months of operations related to this property.

The Company disposed of the following properties in the year ended December 31, 2013:

NetREIT Dubose and the other Model Home entities disposed of 32 Model Home properties. The sales price, net of selling costs, aggregated approximately $9.8 million and approximately $3.5 million in mortgage notes payable were retired in connection with these sales. The Company recognized a gain of $1,297,753 related to the sale of these Model Homes.

In May 2013, the Company sold its Casa Grande Apartments for a sales price of $1.8 million. The sale resulted in mortgage payoff of $1.3 million and a gain of $322,356.

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THE FOLLOWING IS A COMPARISON OF OUR RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013.

Revenues

Total revenue was $5,085,119 for the three months ended September 30, 2014, compared to $4,789,367 for the same period in 2013, an increase of $295,752, or 6.2%. The increase in rental income as reported in 2014 compared to 2013 is primarily attributable rental revenues from Bismarck and Union Terrace totaling $518,000 recorded during the current quarter that were acquired in 2014, offset by a decrease in rental revenue from model homes of $200,000 due to dispositions during 2014 and 2013.

Rental Operating Expenses

Rental operating expenses were $1,984,801 for the three month period ended September 30, 2014 compared to $1,691,280 for the same period in 2013, an increase of $293,521, or 17.4%. The increase in operating expense is primarily attributable to the operating expense of Bismarck and Union Terrace totaling approximately $229,000. Additionally, there was a $67,000 increase in repairs and maintenance and $47,000 increases in on site management fees and administrative fees.

Rental operating costs are expected to continue to increase in future periods, as compared to historical periods, as a result of owning recently acquired assets for entire periods and anticipated future acquisitions of real estate assets.

Interest Expense

Interest expense, including amortization of deferred finance charges, increased by $97,094, to $1,344,698, or 19.9% during the three month period ended September 30, 2014 compared to $1,247,604 for the same period in 2013.  Increases include $57,000 in interest from the Bismarck acquisition and a $57,000 increase in interest from refinancing the Fargo Bank Building and obtaining an additional $5.7 million of debt  on the property. We also accrued $15,000 in late fees related to the Havana Parker loan. These increases are offset by lower interest incurred on loans the Company refinanced at lower rates during 2014 and 2013.

The weighted average interest rate as of September 30, 2014 was 5.10% compared to 5.26% as of September 30, 2013.

The following is a summary of our interest expense on loans by property for the three months ended September 30, 2014 and 2013:

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General and Administrative Expenses

General and administrative expenses increased by $34,162  to $1,200,536  for the three months ended September 30, 2014, compared to $1,166,374  for the same period in 2013. As a percentage of rental and fee income, general and administrative expenses were 23.6% and 24.4% for the three months ended September 30, 2014 and 2013, respectively. In comparing our general and administrative expenses with other REITs, it should be taken into consideration that we are a self-administered REIT, which means such expenses are greater for us than an advisory administered REIT. We expect general and administrative expenses as a percentage of revenues to continue to decline in the future as our revenues continue to increase at a faster rate than our expense.

Gain/Loss on Sale of Real Estate Assets

In the three month period ended September 30, 2014, the Company had a net gain on the sale of 15 model home properties of $1,221,680 compared to a net gain on the sale of 7 model home properties of $169,460  for the same three months of 2013.

Asset impairments

The Company is currently in negation for the modification of the loan secured by the Havana Parker property. Through this process it was determined that the carrying cost of the property exceeded the value of the property and the Company recorded an impairment charge of $950,000. In 2013, when the Company initially began the loan modification process, the Company recorded an estimated $1.5 million impairment charge on this property.

Net Loss

Net loss for the three months ended September 30, 2014, was $1,851,557, or $0.11 loss per share, compared to a net loss for the three months ended September 30, 2013 of $2,310,984, or $0.14 loss per share. The decrease in net loss of $459,427 for the three months ended September 30, 2014 was primarily attributable to an increase in revenue of approximately $295,000, an increase in gains on sales of real estate of approximately $1,050,000, a decrease in impairment charges of approximately $550,000, offset by an increase in total costs of approximately $588,000, preferred stock costs of approximately $201,000, interest expense of approximately $248,000 and an increase in income attributable to noncontrolling interests of approximately $489,00.

THE FOLLOWING IS A COMPARISON OF OUR RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013.

Revenues

Total revenue was $14,556,829 for the nine months ended September 30, 2014, compared to $14,815,232  for the same period in 2013, a decrease of $258,403 , or 1.7%. The change in revenues as reported in 2014 compared to 2013 is primarily attributable to:

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The addition of two office properties acquired in 2014 which generated an additional $612,000 of office rent income in the nine months ended September 30, 2014 compared to the same period in 2013; an increase in other income of $78,000 from parking and protection plan income, an increase in self-storage rental and other income of $130,000 and:

•	A decrease in revenue from a one-time charge to a tenant for an early lease termination in 2013 of $345,000; and

•	A decrease in model home rent of $490,000 due to a net decrease of 22 number of model homes owned.

Overall rental and fee revenues are expected to continue to increase in future periods, as compared to historical periods, as a result of owning the assets acquired during 2014 and 2013 for an entire year and future acquisitions of real estate assets.

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Rental Operating Expenses

Rental operating expenses were $5,394,946  for the nine months ended September 30, 2014 compared to $4,841,809  for the same period in 2013, an increase of $553,137, or 11.4%. The increase in operating expense year over year is primarily attributable to the acquisitions of the Bismarck and Union Terrace properties. The net increase in operating expenses when factoring in the Casa Grande Apartments (sold in May 2013) was $208,000 for the nine months ending September 30, 2014. Excluding costs related to acquisition and disposition, rental operating expenses increased approximately 7% which is consistent with the increases in salaries and benefits expenses included in rental operating costs due to annual increases in compensation levels and an increased head count.  Rental operating costs as a percentage of rental and fee income was 37.1% and 32.7% for the nine months ended September 30, 2014 and 2013, respectively. The increase in operating costs as a percentage of revenue is primarily due to a decrease in model home revenues that have substantially lower operating costs than our other properties. Other items impacting the ratio include the one-time charge for the lease termination which decreased the ratio in 2013 and an increase in operating costs during 2014 as discussed above.

Rental operating costs are expected to continue to increase in future periods, as compared to historical periods, as a result of owning recently acquired assets for entire periods and anticipated future acquisitions of real estate assets.

Interest Expense

Interest expense, including amortization of deferred finance charges, increased by $184,824 to $3,985,783 during the nine months ended September 30, 2014 compared $3,800,959 for the same period in 2013. Increases include $95,000 in interest from the Bismarck acquisition and a $74,000 increase in interest from refinancing the Fargo Bank Building and obtaining an additional $5.7 million in financing on the property. We also accrued $45,000 in late fees related to the Havana Parker loan. These increases are offset by lower interest incurred on loans the Company refinanced during 2014 and 2013.

The weighted average interest rate as of September 30, 2014 was 5.10% compared to 5.64% as of September 30, 2013.

The following is a summary of our interest expense on loans by property for the nine months ended September 30, 2014 and 2013: