##### 



UNITED STATES SECURITIES AND EXCHANGE COMMISSION  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 June 30, 2004 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to . Commission File Number 1-31824 FIRST POTOMAC REALTY TRUST (Exact name of registrant as specified in its charter) MARYLAND
(State or other jurisdiction of
incorporation or organization)
    
    37-1470730
(I.R.S. Employer
Identification No.)
 7200 Wisconsin Avenue, Suite 310, Bethesda, MD 20814
(Address of principal executive offices) (Zip Code) (301) 986-9200
(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 o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). YES x NO o As of August 9, 2004, there were 14,154,000 common shares of beneficial
interest, par value $.001 per share, outstanding. 1




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##### 



FIRST POTOMAC REALTY TRUST
FORM 10-Q INDEX PagePart I: Financial InformationItem 1. Financial StatementsCondensed
Consolidated Balance Sheets as of June 30, 2004 (unaudited) and December 31, 2003
    
    
    3Condensed, Consolidated and Combined Statements of Operations (unaudited) for the Three and Six Months
Ended June 30, 2004 and 2003
    
    
    4Condensed, Consolidated, and Combined Statements of Cash Flows (unaudited) for the Six Months Ended
June 30, 2004 and 2003
    
    
    5Notes to Condensed, Consolidated, and Combined Financial Statements (unaudited)
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    12Item 3. Quantitative and Qualitative Disclosure about Market Risk
    
    
    20Item 4. Controls and Procedures
    
    
    20Part II: Other InformationItem 1. Legal Proceedings
    
    
    21Item 2. Changes in Securities and Use of Proceeds
    
    
    21Item 3. Defaults upon Senior Securities
    
    
    21Item 4. Submission of Matters to a Vote of Security Holders
    
    
    21Item 5. Other Information
    
    
    22Item 6. Exhibits and Reports on Form 8-K
    
    
    22Signatures
    
    
    23
 2




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##### 



FIRST POTOMAC REALTY TRUST  (Unaudited)June 30, 2004
    
    December 31, 2003Assets:Rental property, net
    
    $
    234,888,935
    
    
    $
    208,334,677Cash and cash equivalents
    
    
    75,549,781
    
    
    
    16,307,508Escrows and reserves
    
    
    3,004,503
    
    
    
    3,422,473Accounts and other receivables, net of
allowance for doubtful accounts of
$235,701 and $144,711, respectively
    
    
    850,106
    
    
    
    575,362Accrued straight-line rents, net
    
    
    1,955,074
    
    
    
    1,805,679Deferred costs, net
    
    
    3,211,365
    
    
    
    3,205,534Prepaid expenses and other assets
    
    
    6,514,297
    
    
    
    773,040Intangible assets, net
    
    
    11,505,827
    
    
    
    9,723,735Total assets
    
    $
    337,479,888
    
    
    $
    244,148,008Liabilities:Accounts payable and accrued expenses
    
    $
    2,595,177
    
    
    $
    1,525,992Accrued interest
    
    
    390,096
    
    
    
    151,861Rents received in advance
    
    
    1,002,204
    
    
    
    801,640Tenant security deposits
    
    
    1,797,508
    
    
    
    1,025,645Mortgage loans
    
    
    130,208,986
    
    
    
    127,840,126Deferred market rent, net
    
    
    938,521
    
    
    
    803,428Total liabilities
    
    
    136,932,492
    
    
    
    132,148,692Minority interests
    
    
    19,415,839
    
    
    
    19,866,928Shareholders equity:Common stock, $0.001 par value, 100,000,000
shares authorized: 14,154,000 and
8,634,000 issued and outstanding,
respectively
    
    
    14,154
    
    
    
    8,634Additional paid-in capital
    
    
    209,337,952
    
    
    
    117,525,629Deficit
    
    
    (28,220,549
    )
    
    
    (25,401,875
    )Total shareholders equity
    
    
    181,131,557
    
    
    
    92,132,388Total liabilities and shareholders equity
    
    $
    337,479,888
    
    
    $
    244,148,008
 See accompanying notes to condensed, consolidated, and combined financial statements. 3




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##### 



FIRST POTOMAC REALTY TRUST   Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003Revenues:Rental
    
    $
    7,282,745
    
    
    $
    3,714,902
    
    
    $
    13,934,549
    
    
    $
    7,403,185Tenant reimbursements and other
    
    
    1,116,490
    
    
    
    801,550
    
    
    
    2,177,185
    
    
    
    1,427,207Total revenue
    
    
    8,399,235
    
    
    
    4,516,452
    
    
    
    16,111,734
    
    
    
    8,830,392Operating expenses:Property operating
    
    
    1,581,943
    
    
    
    401,185
    
    
    
    3,213,737
    
    
    
    1,049,446Real estate taxes and insurance
    
    
    825,886
    
    
    
    388,046
    
    
    
    1,535,022
    
    
    
    787,929General and administrative
    
    
    1,171,734
    
    
    
    678,280
    
    
    
    1,891,832
    
    
    
    1,221,022Depreciation and amortization
    
    
    2,674,508
    
    
    
    1,123,084
    
    
    
    5,279,420
    
    
    
    2,187,327Total operating expenses
    
    
    6,254,071
    
    
    
    2,590,595
    
    
    
    11,920,011
    
    
    
    5,245,724Operating income
    
    
    2,145,164
    
    
    
    1,925,857
    
    
    
    4,191,723
    
    
    
    3,584,668Other expenses (income):Interest expense
    
    
    2,236,903
    
    
    
    2,990,481
    
    
    
    4,304,509
    
    
    
    5,739,508Interest and other income
    
    
    (29,068
    )
    
    
    53,467
    
    
    
    (64,130
    )
    
    
    (46,150
    )Equity in losses of investees
    
    
    
    
    
    
    66,428
    
    
    
    
    
    
    
    66,482Loss from early retirement of debt
    
    
    
    
    
    
    
    
    
    
    212,250
    
    
    
    Total other expenses
    
    
    2,207,835
    
    
    
    3,110,376
    
    
    
    4,452,629
    
    
    
    5,759,840Minority interests
    
    
    (4,803
    )
    
    
    (68,706
    )
    
    
    (32,432
    )
    
    
    (151,464
    )Net loss
    
    
    (57,868
    )
    
    
    (1,115,813
    )
    
    
    (228,474
    )
    
    
    (2,023,708
    )Weighted average shares outstanding 
basic and diluted
    
    
    9,119,275
    
    
    
    
    
    
    
    8,876,637Net loss per share  basic and diluted
    
    $
    (0.01
    )
    
    
    
    
    
    $
    (0.03
    )
 See accompanying notes to condensed, consolidated, and combined financial statements. 4




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##### 



FIRST POTOMAC REALTY TRUST   Six Months Ended June 30,2004
    
    2003Cash flow from operating activitiesNet loss
    
    $
    (228,474
    )
    
    $
    (2,023,708
    )Adjustments to reconcile net loss to net cash provided
by
operating activities:Depreciation and amortization
    
    
    5,615,262
    
    
    
    2,722,319Deferred market rent
    
    
    135,093
    
    
    
    Minority interests
    
    
    (32,432
    )
    
    
    (151,464
    )Loss from early retirement of debt
    
    
    212,250
    
    
    
    Equity in losses of investees
    
    
    
    
    
    
    66,482Changes in assets and liabilities:Escrows and reserves
    
    
    417,970
    
    
    
    1,307,014Accounts and other receivables, net
    
    
    (274,744
    )
    
    
    (331,858
    )Accrued straight-line rents
    
    
    (149,395
    )
    
    
    (489,835
    )Prepaid expenses and other assets
    
    
    (741,257
    )
    
    
    (31,683
    )Tenant security deposits
    
    
    771,863
    
    
    
    (33,415
    )Accounts payable and accrued expenses
    
    
    1,069,185
    
    
    
    2,020,424Accrued interest
    
    
    238,235
    
    
    
    317,455Rent received in advance
    
    
    200,564
    
    
    
    (219,025
    )Deferred costs
    
    
    (189,779
    )
    
    
    (705,719
    )Total adjustments
    
    
    7,272,815
    
    
    
    4,470,695Net cash provided by operating activities
    
    
    7,044,341
    
    
    
    2,446,987Cash flows from investing activitiesDistributions from investments in real estate entities
    
    
    
    
    
    
    2,243,069Purchase deposit on future acquisitions
    
    
    (5,000,000
    )
    
    
    Additions to rental property and other assets
    
    
    (23,540,011
    )
    
    
    (997,984
    )Net cash (used in) provided by investing activities
    
    
    (28,540,011
    )
    
    
    1,245,085Cash flows from financing activitiesDeferred financing costs
    
    
    (460,837
    )
    
    
    Proceeds from debt
    
    
    18,000,000
    
    
    
    Repayments of debt
    
    
    (25,610,206
    )
    
    
    (2,474,598
    )Dividends to shareholders
    
    
    (2,590,200
    )
    
    
    Distributions to minority interests
    
    
    (418,657
    )
    
    
    Proceeds from issuance of stock, net
    
    
    91,817,843
    
    
    
    Net cash provided by (used in) financing activities
    
    
    80,737,943
    
    
    
    (2,474,598
    )Net increase in cash and cash equivalents
    
    
    59,242,273
    
    
    
    1,217,474Cash and cash equivalents at beginning of year
    
    
    16,307,508
    
    
    
    670,277Cash and cash equivalents at end of period
    
    $
    75,549,781
    
    
    $
    1,887,751
 See accompanying notes to condensed, consolidated and combined financial statements. 5




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##### 



FIRST POTOMAC REALTY TRUST NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies (a) Description of Business First Potomac Realty Trust (the Company) is a self-managed,
self-administered Maryland real estate investment trust (REIT). The Company
owns and operates industrial and flex properties in the Washington, D.C.
metropolitan area and other major markets in Virginia and Maryland, which we
collectively refer to as the southern Mid-Atlantic region. The results of operations for the three and six months ended June 30,
2004, represent the Companys second complete quarter of earnings and
activities subsequent to its initial public offering completed in the fourth
quarter of 2003. The results of operations for the three and six months ended
June 30, 2003, are based on the combined historical statements of operations of
the First Potomac Predecessor (as defined below). The Company was formed in July 2003 to be the successor general partner to
First Potomac Realty Investment Trust, Inc. (Trust, Inc.), the former general
partner of First Potomac Realty Investment Limited Partnership (FPR), the
Companys operating partnership (Operating Partnership). The operations of
Trust, Inc., the Operating Partnership and First Potomac Management, Inc.
(FPM), the property management company that managed all of the Companys
assets prior to the initial public offering are referred to herein as First
Potomac Predecessor. The Company owns all of its properties and conducts its
business through the Operating Partnership. At June 30, 2004, the Company was
the sole general partner of and owns a 91% interest in the Operating
Partnership. The remaining interests in the Operating Partnership consist of
limited partnership interests that are presented as minority interests. As of June 30, 2004, the Company owned a 19-property portfolio consisting
of 42-buildings totaling approximately 3 million square feet. On July 16,
2004, the Company acquired a 14-property, 26 building, 1.4 million square-foot
portfolio located primarily in the Maryland suburbs of Washington, D.C. for
total consideration of $123 million consisting of cash proceeds from the
follow-on offering of $45 million and the assumption of $78 million of mortgage
debt. On August 5, 2004, the Company also acquired a 3-building, 82,200
square-foot flex property located in the Maryland suburbs of Washington, D.C.
for total consideration of $9.8 million consisting of cash proceeds from the
follow-on offering, increasing the Companys portfolio to 71 buildings totaling
approximately 4.5 million square feet. On October 28, 2003, the Company closed its initial public offering. The
Company sold 7.5 million common shares of beneficial interest at $15.00 per
share, raising net proceeds of approximately $102 million. On November 21,
2003, the Company sold an additional 1.125 million shares to cover
over-allotments resulting in additional net proceeds of approximately $15.5
million. As of June 30, 2004, the Company had fully used the net proceeds from
the IPO to (i) acquire additional properties ($67 million); (ii) repay debt,
accrued interest and prepayment fees ($48 million) including $7 million of debt
in the first quarter of 2004; and (iii) acquire joint venture interests held by
an institutional partner in four of the Companys properties ($3 million). On
June 23, 2004, the Company closed on a follow-on offering of 5.5 million common
shares at $17.60 per share, resulting in net proceeds of approximately $92
million. Through July 16, 2004, the Company had used $63 million of the
proceeds from the follow-on offering to (i) acquire properties ($45 million)
and (ii) repay borrowings in the second quarter of 2004 on the Companys
revolving line of credit ($18 million). The Company intends to use the
remaining proceeds for general corporate and working capital purposes,
including possible future acquisitions. (b) Principles of Consolidation and Combination Financial statements for the Companys operations in 2003 relate to First
Potomac Predecessor. The combined financial statements of First Potomac
Predecessor include the financial statements of Trust, Inc., FPR and FPM as
these entities were under the common control of a single group of owners, Louis
and Douglas Donatelli, father and son (the Control Group). Prior to the
initial public offering, Trust, Inc. was the sole general partner of FPR. FPM
managed all the properties held by FPR. The Control Group owned 80 percent of
Trust, Inc., 48 percent of FPR (representing 100 percent of the voting
interests) and 64 percent of FPM. All intercompany balances and transactions
have been eliminated in consolidation. The 2004 consolidated financial statements of the Company include the
accounts of the Company, the Operating Partnership, the subsidiaries of the
Operating Partnership and FPM Management LLC. Ownership interests acquired
from the 6




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Control Group were recorded at their historical cost basis. Acquisitions
of ownership interests of other parties were recorded at fair value and
allocated between building, tenant improvements, intangible assets and in-place
leases in accordance with SFAS No. 141 Business Combinations. We have condensed or omitted certain information and footnote disclosures
normally included in financial statements presented in accordance with U.S.
generally accepted accounting principles, or GAAP, in the accompanying
unaudited condensed consolidated financial statements. We believe the
disclosures made are adequate to prevent the information presented from being
misleading. However, the unaudited condensed consolidated financial statements
should be read in conjunction with the consolidated financial statements and
notes thereto included in our Annual Report on Form 10-K for the year ended
December 31, 2003 and as amended from time to time in other filings with the
Securities and Exchange Commission. In our opinion, the accompanying unaudited condensed consolidated
financial statements reflect all adjustments necessary to present fairly our
financial position as of June 30, 2004 and the results of our operations for
the quarter and year-to-date ended June 30, 2004 and 2003 and cash flows for
year-to-date June 30, 2004 and 2003. Interim results are not necessarily
indicative of full year performance because of the impact of mid-year
acquisitions. (c) Revenue Recognition The Company generates substantially all of its revenue from leases on its
industrial and flex properties. The Company recognizes rental revenue on a
straight-line basis over the life of the respective leases in accordance with
SFAS No. 13, Accounting for Leases. Accrued straight-line rents represent
the difference between rental revenue recognized on a straight-line basis over
the term of the respective lease agreements and the rental payments
contractually due for leases that contain abatement or fixed periodic
increases. The Company considers current information and events regarding the
tenants ability to pay their obligations in determining if accrued
straight-line rents are ultimately collectible. The uncollectible portion of
accrued straight-line rents is charged to rental revenues in the period in
which the determination is made. Tenant leases generally contain provisions under which the tenants
reimburse the Company for a portion of property operating expenses and real
estate taxes incurred by the Company. The Company records a provision for
losses on estimated uncollectible accounts receivable based on its analysis of
risk of loss on specific accounts. (d) Intangibles Other intangible assets include the value of tenant or customer
relationships, and the origination value of leases in accordance with SFAS No.
141, Business Combinations. Customer relationship values are determined
based on our evaluation of the specific characteristics of each tenants lease
and our overall relationship with the tenant. Characteristics we consider
include the nature and extent of our existing business relationships with the
tenant, growth prospects for developing new business with the tenant, the
tenants credit quality and expectations of lease renewals. The value of
customer relationship intangibles is amortized to expense over the lesser of
the initial lease term and any expected renewal periods or the remaining useful
life of the building. We determine the fair value of the cost of acquiring
existing tenants by estimating the lease commissions avoided by having in-place
tenants and avoided lost operating income for the estimated period required to
lease the space occupied by existing tenants at the acquisition date. The cost
of acquiring existing tenants is amortized to expense over the initial term of
the respective leases. Should a tenant terminate its lease, the unamortized
portion of the in-place lease value is charged to expense. Deferred market rent liability consists of the net effect of leases with
above or below market rents. Above market and below market in-place lease
values are determined on a lease by lease basis based on the present value
(using an interest rate which reflects the risks associated with the leases
acquired) of the difference between (a) the contractual amounts to be paid
under the lease and (b) our estimate of the fair market lease rate for the
corresponding space over the remaining non-cancellable terms of the related
leases. The capitalized below market lease values are amortized as an increase
to rental income over the initial term and any below market renewal periods of
the related leases. Capitalized above market lease values are amortized as a
decrease to rental income over the initial term of the related leases. In conjunction with the initial public offering and related formation
transactions, First Potomac Management, Inc. contributed all of the capital
interests in FPM Management LLC, the entity that manages our properties, to
the operating partnership. The $2.1 million fair value of the in-place
workforce acquired has been classified as goodwill from third parties in
accordance with SFAS No. 141, Business Combinations. Goodwill is assessed
for impairment annually and in interim 7




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periods if certain events occur indicating the carrying value is
impaired. The Company will recognize an impairment loss when the discounted
expected future cash flows associated with management contracts is less than
the carrying cost of the goodwill in accordance with SFAS
No. 142, Goodwill
and Other Intangibles. No impairment loss was incurred or recorded for the
three and six months ended June 30, 2004. (e) Income Taxes Prior to the initial public offering, the combined companies operated as a
limited partnership or elected to be taxed as subchapter S corporations for
federal income tax purposes. As a result, the Company was not subject to
federal income taxation at the corporate level as taxable income was the direct
responsibility of the partners or shareholders. Accordingly, no provision was
made for state or federal income taxes in the accompanying combined financial
statements for periods prior to the IPO. In conjunction with its initial public offering, the Company elected to be
taxed as a REIT. To maintain its status as a REIT, the Company is required to
distribute at least 90% of its ordinary taxable income annually to its
shareholders. The Company intends to make timely distributions sufficient to
satisfy the annual distribution requirements and to avoid corporate income tax
and any nondeductible excise tax. Through June 30, 2004, the Company has not
generated any taxable income or loss through a taxable REIT subsidiary.
Accordingly, no provision was made for state or federal income taxes in the
accompanying combined financial statements for periods subsequent to the IPO. On May 10, 2004, the Company paid a dividend of $0.20 per common share for
the quarter ended March 31, 2004. On July 20, 2004, the Company declared a
dividend of $0.21 per common share for the Companys second quarter ended June
30, 2004. The dividend is payable on August 10, 2004 to shareholders of record
on July 30, 2004. There were no accrued dividends at June 30, 2004 (f) Minority Interests Minority interests relates to the interests in the Operating Partnership
not owned by the Company. Upon completion of the initial public offering and
contribution of the net proceeds to the Operating Partnership, the Company
owned 86% of the outstanding Operating Partnership units. Subsequent to the
completion of the follow-on offering that closed on June 23, 2004, the Company
owned 91% of the units outstanding. The remaining interests in the Operating
Partnership are owned by limited partners who contributed properties and other
assets to the Operating Partnership in exchange for Operating Partnership
units. Limited partners will have the right to tender their units for
redemption beginning 12 months after the closing of the initial public offering
in exchange for, at the Companys option, common shares of the Company or an
equivalent amount of cash. Unitholders receive distributions per unit
equivalent to the dividend per common share. (g) Earnings Per Share Basic earnings per share (EPS) is calculated by dividing net income by
the weighted average number of the Companys common shares outstanding.
Diluted EPS is computed after adjusting the basic EPS computation for the
effect of diluted common equivalent shares outstanding during the period. The
effect of stock options, if dilutive, is computed using the treasury stock
method. At June 30, 2004, the Company had outstanding 555,000 stock options
that are not included in the computation of EPS as they are anti-dilutive due
to losses for the quarter and year to date periods. (h) Stock Based Compensation In compliance with SFAS No. 123, Accounting for Stock Based
Compensation, the Company has elected to follow the intrinsic value-based
method of accounting prescribed by the Accounting Principles Board Opinion No.
25, Accounting for Stock Issued to Employees, and related interpretations, in
accounting for its fixed plan share options. As such, compensation expense
would be recorded only if the current market price of the underlying shares on
the date of grant exceeded the exercise price. No compensation expense has been recognized for the three and six months
ended June 30, 2004 for options granted under the Equity Compensation Plan
adopted by the Board of Trustees in 2003. Under SFAS No. 123, compensation
expense of $44,024 and 88,048 would have been recorded during the three and six
months ended June 30, 2004 for the Equity Compensation Plan based upon the fair
value of the option awards. 8




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##### 



Pro forma net loss and net loss per share would have been as follows
(unaudited): Three Months Ended
    
    Six Months EndedJune 30, 2004
    
    June 30, 2004Net loss, as reported
    
    $
    (57,868
    )
    
    $
    (228,474
    )Add: stock-based compensation included in reported
net loss
    
    
    
    
    
    
    Deduct: total stock-based employee compensation
expense determined under fair value based method
for all awards, net of minority interests
    
    
    (44,024
    )
    
    
    (88,048
    )Pro forma net loss
    
    $
    (101,892
    )
    
    $
    (316,522
    )Net loss per share, as reported  basic and diluted
    
    $
    (0.01
    )
    
    $
    (0.03
    )Pro forma net loss per share  basic and diluted
    
    $
    (0.01
    )
    
    $
    (0.04
    )
 (i) Use of Estimates The preparation of financial statements requires management of the Company
to make a number of estimates and assumptions relating to the reported amounts
of assets and liabilities and the disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the period. Actual results could differ from those
estimates. (j) Reclassifications Certain prior year amounts have been reclassified to conform to the
current year presentation. (2) Rental Property Rental property represents 19 industrial and flex rental properties
located in Maryland and Virginia. Rental property is comprised of the
following: June 30,2004
    
    December 31,(unaudited)
    
    2003Land
    
    $
    52,231,285
    
    
    $
    46,329,766Buildings and improvements
    
    
    189,675,419
    
    
    
    166,366,219Tenant improvements
    
    
    4,710,247
    
    
    
    3,410,698Furniture, fixtures and equipment
    
    
    10,273,658
    
    
    
    10,253,915256,890,609
    
    
    
    226,360,598Less: accumulated depreciation
    
    
    (22,001,674
    )
    
    
    (18,025,921
    )$
    234,888,935
    
    
    $
    208,334,677
 On April 27, 2004, the Company acquired Herndon Corporate Center, a
127,353-square-foot, single-story flex property in Herndon, Virginia, for $20.5
million. The acquisition was financed with the Companys available cash,
borrowings under the Companys revolving line of credit and the assumption of a
$9.1 million, fixed-rate first mortgage loan, fair valued at $8.9 million. The
property is currently 100% leased to 14 tenants, with the U.S. Government being
the largest tenant, occupying 23% of the space. On June 4, 2004, the Company acquired Aquia Commerce Center I & II, a
64,000-square-foot, two-building flex property in Stafford, Virginia, for $11.2
million. The acquisition was financed with the Companys available cash,
borrowings under the Companys revolving line of credit and the assumption of a
$1.0 million, fixed-rate first mortgage loan which approximated its fair value.
The property is currently 100% leased to the U.S. Government. 9




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##### 



The aggregate purchase cost of properties acquired in 2004 was allocated as
follows: Herndon Corporate
    
    Aquia CommerceCenter
    
    Center I & II
    
    TotalLand
    
    $
    4,100,000
    
    
    $
    1,772,960
    
    
    $
    5,872,960In-place lease intangibles
    
    
    1,963,143
    
    
    
    1,137,137
    
    
    
    3,100,280Building and tenant
improvements
    
    
    14,466,870
    
    
    
    8,477,399
    
    
    
    22,944,269Deferred revenue and other
    
    
    (30,013
    )
    
    
    (187,496
    )
    
    
    (217,509
    )Total
    
    $
    20,500,000
    
    
    $
    11,200,000
    
    
    $
    31,700,000
 Pro Forma Financial Information (unaudited) The unaudited pro forma financial information set forth below presents
results as if all of the Companys 2004 and 2003 acquisitions, the initial
public offering and the follow-on offering occurred on January 1, 2003. The unaudited pro forma information is not necessarily indicative of the
results that actually would have occurred nor does it intend to indicate future
operating results. For the Three Months Ended June 30,2004
    
    2003Pro forma total revenues
    
    $
    8,637,480
    
    
    $
    8,398,505Pro forma net income
    
    
    (93,943
    )
    
    
    (940,714
    )Pro forma diluted earnings per share
    
    $
    (0.01
    )
    
    $
    (0.07
    )
 For the Six Months Ended June 30,2004
    
    2003Pro forma total revenues
    
    $
    17,274,960
    
    
    $
    16,797,009Pro forma net income (loss)
    
    
    (187,886
    )
    
    
    (1,881,428
    )Pro forma diluted earnings (loss) per share
    
    $
    (0.01
    )
    
    $
    (0.13
    )
 (3) Mortgage Loans The Companys borrowings consist of the following: June 30,
    
    December 31,2004
    
    2003Fixed-rate mortgage debt
with interest rates ranging
from 5.3% to 8.5% maturing
at various dates through
February 2013
    
    $
    104,708,986
    
    
    $
    95,340,126Floating rate mortgage debt
with interest rates of LIBOR
+ 2.35% to 2.45%, with
$10,500,000 maturing in
November 2005 and
$15,000,000 ($22,000,000 at
December 31, 2003) maturing
December 2006
    
    
    25,500,000
    
    
    
    32,500,000$
    130,208,986
    
    
    $
    127,840,126
 (a) Lines of Credit On December 31, 2003 the Company entered into a $50 million secured
revolving credit facility agreement with Fleet National Bank as managing
administrative agent. The facility has a three-year term with a one-year
extension option. The Company has the option to increase the facility by up to
an additional $50 million prior to December 31, 2005. Availability 10




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##### 



under the facility is based upon the value of unencumbered assets that the
Company pledges to secure the facility. The Company had available credit of
$35 million under this facility at June 30, 2004. Borrowings under the
facility bear interest at LIBOR plus 190 to 250 basis points. The exact
interest rate payable under the facility depends upon the ratio of the
Companys total indebtedness to the Companys total asset value. The acquisition of Herndon Corporate Center on April 27, 2004 was financed
in part by a $4.5 million borrowing on the Companys revolving line of credit.
With the acquisition of Aquia Commerce Center I & II on June 4, 2004, the
Company borrowed an additional $9.0 million on the revolving line of credit.
The Company also borrowed $4.5 million to partially finance the earnest money
deposit for the 14-property portfolio located primarily in suburban Maryland.
On June 23, 2004, the Company closed on its follow-on offering of 5,520,000
common shares and raised net proceeds of approximately $92 million. The Company
used $18 million of the proceeds to pay down the outstanding balance on the
revolving line of credit. Interest expense on the revolving line of credit was
$109,022 for the three and six months ended June 30, 2004. Interest expense on
the line of credit borrowings ranged from 3.25% to 3.29% for the three and six
months ended June 30, 2004. There were no outstanding borrowings on the
Companys revolving line of credit as of August 9, 2004. (b) Mortgage Debt The Companys mortgage debt is recourse solely to specific assets. The
Company had 12 properties that secured mortgage debt at June 30, 2004. Future minimum principal payments on the Companys mortgage loans as of
June 30, 2004 are as follows: 2004
    
    $
    805,5462005
    
    
    12,116,9102006
    
    
    16,717,1292007
    
    
    1,676,9812008
    
    
    10,026,516Thereafter
    
    
    88,865,904$
    130,208,986
 (4) Segment Information The Company operates in one segment, industrial and flex office
properties. All of the Companys properties are located in the southern
Mid-Atlantic region of the United States of America. (5) Supplemental Disclosure of Cash Flow Information Supplemental disclosures of cash flow information for the six months ended
June 30 are as follows: 2004
    
    2003Cash paid for interest on indebtedness
    
    $
    3,789,259
    
    
    $
    2,481,221
 On April 27, 2004, the Company acquired Herndon Corporate Center for $20.5
million net of the assumption of a $9.1 million mortgage with the balance paid
in cash. On June 4, 2004, the Company acquired Aquia Commerce Center I & II
for $11.2 million net of the assumption of a $1.0 million with the balance paid
in cash. The $23.5 million additions to rental property and other assets is
net of the non-cash assumption of these mortgages. (6) Subsequent Event On July 16, 2004, the Company acquired a 14-property, 26 building, 1.4
million-square-foot portfolio concentrated in the Maryland suburbs of
Washington, D.C. for total consideration of $123 million. The portfolio is
comprised primarily of industrial and flex properties and was 94% leased at
acquisition. The acquisition was financed, in part, by the assumption of a $78
million fixed-rate first mortgage loan collateralized by all of the properties
in the portfolio. The loan bears interest at 6.7% and matures in September
2008. The remaining balance of the purchase price was funded through proceeds
raised from the follow-on offering that closed on June 23, 2004. On August 5, 2004, the Company
acquired a 3-building, 82,200 square-foot
property concentrated in the Maryland suburbs of Washington, D.C. for total
consideration of $9.8 million. The flex property was 95% leased to 23 tenants
at acquisition. The acquisition was financed through proceeds raised from the
follow-on offering that closed on June 23, 2004. 11




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##### 



ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS The following discussion and analysis of the Companys and the First
Potomac Predecessors financial condition and results of operations should be
read in conjunction with the financial statements and notes thereto appearing
elsewhere in this Form 10-Q. The discussion and analysis is derived from the
consolidated and combined operating results and activities of First Potomac
Realty Trust and First Potomac Predecessor (as defined below). The Company is a self-managed, self-administered Maryland real estate
investment trust (REIT). The Company owns and operates industrial and flex
properties in the Washington, D.C. metropolitan area and other major markets in
Virginia and Maryland, which we collectively refer to as the southern
Mid-Atlantic region. The Company strategically focuses on acquiring properties
that management believes can benefit from the Companys intensive property
management and seeks to reposition these properties to increase their
profitability and value. The Companys portfolio of properties primarily
contains a mix of single-tenant and multi-tenant industrial and flex
properties. Industrial properties generally are used as warehouse, distribution
and manufacturing facilities, while flex properties combine office building
features with industrial property space. As of June 30, 2004, the Companys
properties were approximately 90% leased to a total of 168 tenants. The
Companys largest tenant is the U.S. Government, which occupies 20.2% of the
Companys owned square footage. The Company derives substantially all of its
revenue from leases on its industrial and flex properties. The Company was formed in July 2003 to be the successor general partner to
First Potomac Realty Investment Trust, Inc. (Trust, Inc.), the former general
partner of First Potomac Realty Investment Limited Partnership (FPR), the
Companys operating partnership (Operating Partnership). The operations of
Trust, Inc., the Operating Partnership and First Potomac Management, Inc.
(FPM), the property management company that managed all of its assets, prior
to the initial public offering are referred to herein as First Potomac
Predecessor. The Company owns all of its properties and conducts its business
through the Operating Partnership. At June 30, 2004, the Company was the sole
general partner of and owns a 91% interest in the Operating Partnership. The
remaining interests in the Operating Partnership consist of limited partnership
interests that are presented as minority interests. The Company generates substantially all of its revenue from leases on its
industrial and flex properties. The net loss for the Company for the second
quarter of 2004 was $0.1 million, or $0.01 per share, compared with a net loss
of $1.1 million for the First Potomac Predecessor for the prior-year period.
For the three months ended June 30, 2004, the Companys funds from operations
were $2.6 million, or $0.25 per diluted share. In addition, the per share
amount reflects a higher weighted average share count resulting from its
follow-on offering of 5,520,000 common shares completed on June 23, 2004. In
total, the Company estimates these expenses and the higher share count
accounted for a reduction in funds from operations of approximately $0.03 per
diluted share in the second quarter of 2004. The net loss for the Company for the first six months of 2004 was $0.2
million, or $0.03 per diluted share, compared with a net loss of $2.0 million
for the First Potomac Predecessor for the prior-year period. The 2004
year-to-date results include a non-cash charge of $0.2 million, or $0.02 per
diluted share, for the write-off of deferred financing costs associated with
the restructuring of a mortgage loan. On April 27, 2004, the Company acquired Herndon Corporate Center, a
127,353-square-foot, single-story flex property in Herndon, Virginia, for $20.5
million. The acquisition was financed with the Companys available cash,
borrowings under the Companys revolving line of credit and the assumption of a
$9.1 million, fixed-rate first mortgage loan. The property is currently 100%
leased to 14 tenants, with the U.S. Government being the largest tenant,
occupying 23% of the space. Based upon leases in place, Herndon Corporate
Center is expected to generate first year net operating income of $1.9 million,
representing a 9.3% return on the purchase price. On June 4, 2004, the Company acquired Aquia Commerce Center I & II, a
64,000-square-foot, two-building flex property in Stafford, Virginia, for $11.2
million. The acquisition was financed with the Companys available cash,
borrowings under the Companys revolving line of credit and the assumption of a
$1.0 million, fixed-rate first mortgage loan. The property is currently 100%
leased to the U.S. Government. Based upon leases in place, Aquia Commerce
Center I & II is expected to generate first year net operating income of $1.2
million, representing a 10.4% return on the purchase price. 12




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##### 



Critical Accounting Policies and Estimates The Companys consolidated and combined financial statements are prepared
in accordance with accounting principles generally accepted in the United
States of America (GAAP) that require the Company to make certain estimates
and assumptions. Critical accounting policies and estimates are those that
require subjective or complex judgments and are the policies and estimates that
the Company deems most important to the portrayal of its financial condition
and results of operations. The use of different reasonable estimates or
assumptions in making these judgments could result in materially different
amounts being reported in our Consolidated Financial Statements. The
Companys critical accounting policies relate to revenue recognition, including
evaluation of the collectibility of accounts receivable, impairment of
long-lived assets and purchase accounting for acquisitions of real estate. The following section is a summary of certain aspects of these critical
accounting policies. Revenue Recognition Rental income with scheduled rent increases is recognized using the
straight-line method over the term of the leases. Accrued straight-line rents
included in the Companys consolidated and combined balance sheets represents
the aggregate excess of rental revenue recognized on a straight-line basis over
cash received under applicable lease provisions. The Companys leases generally
contain provisions under which the tenants reimburse the Company for a portion
of property operating expenses and real estate taxes incurred by it. Such
reimbursements are recognized in the period that the expenses are incurred.
Lease termination fees are recognized when the related leases are canceled and
the Company has no continuing obligation to provide services to such former
tenants. The Company must make estimates related to the collectibility of its
accounts receivable related to minimum rent, deferred rent, tenant
reimbursements, lease termination fees and other income. The Company
specifically analyzes accounts receivable and historical bad debts, tenant
concentrations, tenant creditworthiness and current economic trends when
evaluating the adequacy of the allowance for doubtful accounts receivable,
however, the Company cannot be certain its estimates regarding the
collectibility of its accounts receivable will be accurate. These estimates
have a direct impact on the Companys net income because a higher bad debt
allowance would result in lower net income and a lower bad debt allowance would
result in higher net income. Investments in Real Estate and Real Estate Entities Investments in real estate are recorded at cost. Improvements and
replacements are capitalized when they extend the useful life, increase
capacity, or improve the efficiency of the asset. Repairs and maintenance are
charged to expense as incurred. Depreciation and amortization are recorded on a straight-line basis over
the estimated useful lives as follows: Buildings and improvements
    
    39 yearsTenant improvements
    
    Shorter of the useful lives or the terms of the related leasesFurniture, fixtures, and equipment
    
    5 to 15 years
 The Company is required to make subjective assessments as to the useful
lives of its properties for purposes of determining the amount of depreciation
to record on an annual basis with respect to its rental properties. These
assessments have a direct impact on the Companys net income because if it were
to shorten the expected useful lives of its rental properties, the Company
would depreciate such investments over fewer years, resulting in more
depreciation expense and lower net income on an annual basis. When circumstances such as adverse market conditions indicate a possible
impairment of the value of a property, the Company reviews the recoverability
of the propertys carrying value. The review of recoverability is based on an
estimate of the future undiscounted cash flows (excluding interest charges)
expected to result from the real estate investments use and eventual
disposition. These cash flows consider factors such as expected future
operating income, trends and prospects, as well as the effects of leasing
demand, competition and other factors. If impairment exists due to the
inability to recover the carrying value of a real estate investment, an
impairment loss is recorded to the extent that the carrying value exceeds the
estimated fair value of the property. The Company is required to make
subjective assessments as to whether there are impairments in the values of its
investments in real estate, including any indirect investments in real estate
through entities that the Company does not control and which it accounts for
using the equity method of accounting. These assessments have a direct impact
on the Companys net income because recording an impairment loss results in an
immediate negative adjustment to net income. 13




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##### 



The Company estimates the fair value of rental properties utilizing a
discounted cash flow analysis that includes projections of future revenues,
expenses and capital improvement costs, similar to the income approach that is
commonly used by appraisers. The Company will classify a building as held for sale in the period in
which it has made the decision to dispose of the building, a binding agreement
to purchase the property has been signed under which the buyer has committed a
significant amount of nonrefundable cash and no significant financing
contingencies exist which could cause the transaction not to be completed in a
timely manner. If these criteria are met, the Company will record an
impairment loss if the fair value reduced by selling costs is lower than the
carrying amount of the building, and the Company will cease incurring
depreciation. The Company will classify the impairment loss, together with the
buildings operating results, as discontinued operations on its statement of
operations and classify the assets and related liabilities as held for sale on
the balance sheet. Purchase Accounting The Company is required to make subjective assessments as to the fair
value of assets and liabilities in connection with purchase accounting
adjustments recorded related to rental properties and additional interests in
real estate entities acquired by it. These assessments include allocating the
purchase price of real estate acquired to the fair value of the building, land,
tenant improvements, in-place leases and other intangibles. The Company allocates the components of real estate acquisitions using
relative fair values computed that are based on its estimates and assumptions.
These estimates and assumptions affect the amount of costs allocated between
land, building, tenant improvements, furniture, fixtures and equipment and
certain intangible assets. These allocations also impact depreciation expense
and gains or losses recorded on sales of real estate. The Company also values
in-place operating leases carrying rents above or below market as of the date
of the acquisition; it then amortizes such values over the lives of the related
leases. The Companys determination of these values requires it to estimate
market rents for each of the leases and make certain other assumptions. These
estimates and assumptions affect the rental revenue, depreciation expense and
amortization expense it recognizes for these leases and associated intangibles. Results of Operations Comparison of the Three and Six Months Ended June 30, 2004 to the Three
and Six Months Ended June 30, 2003 The results of operations for the three and six months ended June 30,
2004, represent the Companys second complete quarter of earnings and
activities subsequent to the initial public offering completed in the fourth
quarter of 2003. The results of operations for the three and six months ended
June 30, 2003, are based on the combined historical statements of operations of
the First Potomac Predecessor. The Company acquired the remaining joint venture interests in the entities
that owned interests in Rumsey Center, Snowden Center, Greenbrier Technology II
and Norfolk Business Center (the IPO acquisitions) in connection with the
initial public offering. Acquisition of these ownership interests increased
the Companys ownership to 100 percent of the interests in these properties,
and it therefore began consolidating the results of operations of these
properties effective November 1, 2003. Prior to this date, and throughout the
second quarter of 2003, the Company accounted for its interests in these
properties using the equity method of accounting. The Company acquired four properties, Virginia Center, Interstate Plaza,
Alexandria Corporate Park and 6251 Ammendale Road, in the fourth quarter of
2003 subsequent to the closing of its initial public offering. During the
second quarter of 2004, the Company acquired Herndon Corporate Center and Aquia
Commerce Center I & II; collectively these six acquired properties are referred
to as (the Post-IPO acquisitions). 14




---



##### 



Total Revenues Rental revenue is summarized as follows: Three Months
    
    Six MonthsThree Months Ended June 30,
    
    Six Months Ended June 30,
    
    
    
    
    
    Percent
    
    
    
    
    
    Percent2004
    
    2003
    
    2004
    
    2003
    
    Increase
    
    Change
    
    Increase
    
    ChangeRental income
    
    $
    7,282,745
    
    
    $
    3,714,902
    
    
    $
    13,934,549
    
    
    $
    7,403,185
    
    
    $
    3,567,843
    
    
    
    96
    %
    
    $
    6,531,364
    
    
    
    88
    %Tenant reimbursements & other
    
    $
    1,116,490
    
    
    $
    801,550
    
    
    $
    2,177,185
    
    
    $
    1,427,207
    
    
    $
    314,940
    
    
    
    39
    %
    
    $
    749,978
    
    
    
    53
    %
 Rental Revenues Rental revenue is comprised of contractual rent, including the impacts of
straight-line revenue, and deferred market rental revenue. Rental revenue
increased $3,567,843 and $6,531,364, respectively, for the three and six months
ended June 30, 2004 compared to 2003 primarily as a result of the Post-IPO
acquisitions, which, in aggregate, contributed $2,341,381 and $4,038,789,
respectively, in rental revenue. The increase can also be attributed to the
consolidation of the results of the IPO acquisitions, subsequent to acquisition
of the remaining joint venture interests in the entities that owned these
properties in the fourth quarter of 2003, resulting in additional rental
revenue of $1,299,260 and $2,602,186 during the three and six months ended June
30, 2004, respectively. These investments were accounted for under the equity
method in 2003. Average rental rates on new leases and on renewal leases
increased 0.6% and 3.7%, respectively, for leases executed during the three
months ended June 30, 2004, and 0.6% and 3.1%, respectively, for new and
renewal leases executed during the six months ended June 30, 2004. Prior to its initial public offering, the Companys portfolio was 93%
leased, and overall occupancy of the Companys properties, including Post-IPO
acquisitions subsequent to its initial public offering, was 90% at June 30,
2004 compared to 92% at June 30, 2003. Tenant Reimbursement and Other Revenues Tenant reimbursement revenue includes operating and common area
maintenance costs reimbursed by the Companys tenants as well as incidental
other revenues such as late fees. Tenant reimbursements and other revenues
increased $314,940 and $749,978, respectively, during the three and six months
ended June 30, 2004 compared with the same periods in 2003 due primarily to the
Post-IPO acquisitions. These acquisitions collectively resulted in $250,712
and $508,507 of additional tenant reimbursement revenue during the three and
six months ended June 30, 2004, respectively. The consolidation of the IPO
acquisitions contributed the majority of the remaining increase in tenant
reimbursement and other revenue from 2003 to 2004. Total Expenses Property Operating Expenses Property operating expenses are summarized as follows: Three Months
    
    Six MonthsThree Months Ended June 30,
    
    Six Months Ended June 30,
    
    
    
    
    
    Percent
    
    
    
    
    
    Percent2004
    
    2003
    
    2004
    
    2003
    
    Increase
    
    Change
    
    Increase
    
    ChangeProperty operating expenses
    
    $
    1,581,943
    
    
    $
    401,185
    
    
    $
    3,213,737
    
    
    $
    1,049,446
    
    
    $
    1,180,758
    
    
    
    294
    %
    
    $
    2,164,291
    
    
    
    206
    %Real estate taxes & insurance
    
    $
    825,886
    
    
    $
    388,046
    
    
    $
    1,535,022
    
    
    $
    787,929
    
    
    $
    437,840
    
    
    
    113
    %
    
    $
    747,093
    
    
    
    95
    %
 Property Operating Expenses.Property operating expenses increased
$1,180,758 and $2,164,291 for the three and six months ended June 30, 2004,
respectively, compared to 2003 due in part, to $517,727 and $951,673 of
property operating expenses for the Post-IPO acquisitions during the respective
periods. The consolidation of the IPO acquisitions resulted in an increase of
$255,603 and $577,914 in property operating expenses during the three and six
months ended June 30, 2004, respectively. The Company allocated $336,398 and
$630,643 of overhead and administrative costs to property operating expense
during the three and six months ended June 30, 2004, respectively, whereas no
allocation of overhead expense was made in 2003. 15




---



##### 



Real Estate Taxes and Insurance.Real estate taxes and insurance
increased $437,840 and $747,093 for the three and six months ended June 30,
2004, respectively, compared to 2003 due primarily to $275,704 and $412,083 in
real estate taxes and insurance costs for the Post-IPO acquisitions during the
respective periods. The remaining increase is due to the consolidation of the
IPO acquisitions, which resulted in $156,957 and $312,681 of additional real
estate taxes and insurance costs during the three and six months ended June 30,
2004, respectively. Other Operating Expenses General and administrative expenses are summarized as follows: Three Months
    
    Six MonthsThree Months Ended June 30,
    
    Six Months Ended June 30,
    
    
    
    
    
    Percent
    
    
    
    
    
    Percent2004
    
    2003
    
    2004
    
    2003
    
    Increase
    
    Change
    
    Increase
    
    ChangeGeneral & administrative
    
    $
    1,171,734
    
    
    $
    678,280
    
    
    $
    1,891,832
    
    
    $
    1,221,022
    
    
    $
    493,454
    
    
    
    73
    %
    
    $
    670,810
    
    
    
    55
    %
 General and administrative expenses increased in 2004 from 2003 due
primarily to increased personnel resulting in additional compensation expense,
increased professional fees and increased investor and shareholder related
costs and accounting services associated with being a publicly-held company.
The number of employees of the Company increased to 38 as of June 30, 2004
compared to 17 as of June 30, 2003. Real estate depreciation and amortization expenses are summarized as
follows: Three Months
    
    Six MonthsThree Months Ended June 30,
    
    Six Months Ended June 30,
    
    
    
    
    
    Percent
    
    
    
    
    
    Percent2004
    
    2003
    
    2004
    
    2003
    
    Increase
    
    Change
    
    Increase
    
    ChangeDepreciation & amortization
    
    $
    2,674,508
    
    
    $
    1,123,084
    
    
    $
    5,279,420
    
    
    $
    2,187,327
    
    
    $
    1,551,424
    
    
    
    138
    %
    
    $
    3,092,093
    
    
    
    141
    %
 Depreciation and amortization expense increased $1,551,424 and $3,092,093,
respectively, for the three and six months ended June 30, 2004 compared to 2003
due primarily to the consolidation of the IPO acquisitions, resulting in
$861,665 and $1,790,219, respectively, in depreciation and amortization
expense. The remaining increase was due primarily to $811,535 and $1,421,704,
respectively, of depreciation and amortization expense for the Post-IPO
acquisitions during the three and six months ended June 30, 2004. Interest Expense Interest expense on indebtedness is summarized as follows: Three Months
    
    Six MonthsThree Months Ended June 30,
    
    Six Months Ended June 30,
    
    
    
    
    
    Percent
    
    
    
    
    
    Percent2004
    
    2003
    
    2004
    
    2003
    
    Decrease
    
    Change
    
    Decrease
    
    ChangeInterest expense
    
    $
    2,236,903
    
    
    $
    2,990,481
    
    
    $
    4,304,509
    
    
    $
    5,739,508
    
    
    $
    (753,578
    )
    
    
    25
    %
    
    $
    (1,434,999
    )
    
    
    25
    %
 Interest expense decreased $753,578 and $1,439,999, respectively, for the
three and six months ended June 30, 2004 compared to 2003 due primarily to a
decrease of $1,187,990 and $2,339,373, respectively, in interest expense from
mezzanine indebtedness that was paid in full in October 2003 with proceeds from
the initial public offering. This was partially offset by $276,699 and
$562,181 in mortgage interest and amortized debt costs arising from the
consolidation of the IPO acquisitions as well as $257,966 and $426,314 of
mortgage interest and amortized debt costs associated with debt assumed to
finance the acquisitions of Interstate Plaza, Herndon Corporate Center and
Aquia Commerce Center I & II during the three and six months ended June 30,
2004, respectively. However, interest expense, including amortized debt costs,
arising from borrowings on the Companys revolving line of credit during the
three and six months ended June 30, 2004 decreased $158,345 and $334,302,
respectively, compared to the various line of credit agreements in place during
the same periods in 2003. The Company repaid all line of credit indebtedness
in June 2004 using proceeds from the follow-on offering that closed June 23,
2004. There were no borrowings outstanding on the line of credit as of June
30, 2004. Loss From Early Retirement of Debt The loss from early retirement of debt incurred in 2004 resulted from the
write-off of unamortized debt costs associated with the repayment in January
2004 of $7 million of the $22 million first mortgage loan encumbering the
Rumsey and Snowden properties. 16




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##### 



Minority Interests Minority interests subsequent to the initial public offering reflect the
ownership of the Operating Partnership held by parties other than the Company.
At June 30, 2004, 9% of the interests in the Operating Partnership were owned
by limited partners, or minority interests. Minority interest expense for 2004
represents the limited partners allocable share of the Companys loss.
Minority interests at June 30, 2003, reflect interests held by parties other
than the Company in the joint venture entities that owned Crossways Commerce
Center I, Crossways Commerce Center II, Coast Guard Building and Newington
Business Park Center. The minority interests share of losses decreased by $119,032 in 2004 from
2003 primarily as a result of allocating the net loss incurred for the six
months ended June 30, 2004, to the limited partnership interests in the
Operating Partnership. Minority interests for the three and six months ended
June 30, 2003, represented the allocation of net loss to the minority owners of
the joint venture entities that owned Crossways Commerce Center I, Crossways
Commerce Center II, Coast Guard Building and Newington Business Park Center. Liquidity and Capital Resources The Company expects to meet short-term liquidity requirements generally
through working capital, net cash provided by operations, and, if necessary,
borrowings on its revolving credit facility. As a REIT, the Company is
required to distribute at least 90% of its taxable income to its stockholders
on an annual basis. The Company also regularly requires capital to invest in
its existing portfolio of properties for capital projects. These capital
projects include routine capital improvements and leasing-related costs,
including tenant improvements and leasing commissions. As of June 30, 2004, the Company had used the net proceeds from the
initial public offering to (i) repay debt, including accrued interest and
prepayment fees ($48 million), including $7 million of debt in the first
quarter of 2004 associated with the partial paydown and restructuring of the
mortgage encumbering its Rumsey Center and Snowden Center properties; (ii)
acquire joint venture interests held by an institutional partner in four of the
Companys properties ($3 million); and (iii) acquire additional properties
($67 million). The Company closed on a follow-on offering of 5,520,000 common
shares on June 23, 2004, raising additional net proceeds of approximately $92
million. Through July 16, 2004, the Company had used approximately $63 million
of the proceeds from the follow-on offering to (i) acquire properties ($45
million) and (ii) repay borrowings in the second quarter of 2004 on the
Companys revolving line of credit ($18 million). The Company intends to use
the remaining proceeds for general corporate and working capital purposes,
including possible future acquisitions. All of the Companys outstanding debt contains customary, affirmative
covenants including financial reporting, standard lease requirements and
certain negative covenants, all of which the Company met as of June 30, 2004.
The Company is also subject to cash management agreements with most of its
lenders. These agreements generally require that income generated by the
subject property be deposited into a clearing account and then swept into a
cash collateral account for the benefit of the lender from which cash is
distributed only after funding of improvement, leasing and maintenance reserves
and payment of debt service, insurance, taxes, capital expenditures and leasing
costs. On December 31, 2003, the Company entered into a $50 million secured
revolving credit facility agreement with Fleet National Bank as managing
administrative agent. The facility has a three-year term with a one-year
extension option. The Company has the option to increase the facility by up to
an additional $50 million prior to December 31, 2005. Availability under the
facility is based upon the value of unencumbered assets that the Company
pledges to secure the facility. Alexandria Corporate Park and Virginia Center
were the first assets pledged as security, and the Company had $35 million
available under this facility at June 30, 2004. Borrowings under the facility
bear interest at LIBOR plus 190 to 250 basis points. The exact interest rate
payable under the facility depends upon the ratio of the Companys total
indebtedness to the Companys total asset value. On April 27, 2004 the Company
borrowed $4.5 million to partially fund the acquisition of Herndon Corporate
Center, a 127,353 square-foot, single-story flex property located in Herndon,
Virginia. With the acquisition of Aquia Commerce Center I & II on June 4,
2004, the Company borrowed an additional $9 million on the revolving line of
credit. The Company also borrowed $4.5 million to partially finance the
earnest money deposit for the 14-property portfolio acquired by the Company on
July 16, 2004. The Company paid off the $18 million line of credit borrowings
using proceeds from the follow-on offering that closed on June 23, 2004, and
there were no outstanding borrowings on the Companys revolving line of credit
as of June 30, 2004. 17




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The Company intends to meet long-term liquidity requirements for the
funding of property acquisitions and other non-recurring capital improvements through net cash from operations, long-term
secured and unsecured indebtedness, including borrowings under its revolving
credit facility, and the issuance of equity and debt securities. The
Companys ability to raise funds through sales of debt and equity securities is
dependent on, among other things, general economic conditions, general market
conditions for REITs, rental rates, occupancy levels, market perceptions and
the trading price of the Companys shares. The Company will continue to
analyze which source of capital is most advantageous to it at any particular
point in time, but the capital markets may not be consistently available on
terms that are attractive. The Company also intends to fund property acquisitions and other
non-recurring capital improvements using borrowings, by potentially refinancing
properties in connection with their acquisition, and by assuming existing
indebtedness on acquired properties as well as potentially raising equity
through joint ventures. The Company could also issue units of limited
partnership interest in its Operating Partnership to fund a portion of the
purchase prices for some of its future property acquisitions. Cash Flows Consolidated cash flow information is summarized as follows: Six Months Ended June 30,2004
    
    2003
    
    ChangeCash and cash equivalents
    
    $
    75,549,781
    
    
    $
    1,887,751
    
    
    $
    73,662,030Cash provided by operating activities
    
    
    7,044,341
    
    
    
    2,446,987
    
    
    
    4,597,354Cash (used in) provided by investing activities
    
    
    (28,540,011
    )
    
    
    1,245,085
    
    
    
    (29,785,096
    )Cash provided (used in) by financing
activities
    
    
    80,737,943
    
    
    
    (2,474,598
    )
    
    
    83,212,541
 Comparison of the Six Months Ended June 30, 2004 to the Six Months Ended
June 30, 2003 Net cash provided by operating activities increased $4,597,354 in 2004.
This increase was due largely improved operating results. The increase in
prepaid and other assets was substantially offset by cash provided by the
operations of the Post-IPO acquisitions, as well as cash flow from the IPO
acquisitions, which were consolidated beginning in the fourth quarter of 2003. Cash used in investing activities increased $29,785,096 in 2004 due
primarily to the acquisition of Herndon Corporate Center and Aquia Commerce
Center I & II during the second quarter of 2004 for $22,212,916, net of the
$9,979,067 mortgage debt assumed and the $5,000,000 earnest money deposit
(4,500,000 of which was funded through borrowings on the line of credit) paid
in June 2004 for the 14-property portfolio acquired by the Company on July 16,
2004, the deposit is included in prepaid expenses and other assets at June 30,
2004. $1,328,186 was spent on capital improvements for the remaining
properties during the six months ended June 30, 2004. In 2003, the Company
received $2,243,069 in distributions from investments in real estate entities
(reflecting the Companys joint venture interests in the IPO acquisitions prior
to the initial public offering). The Company currently owns no joint venture
interests. Net cash provided by financing activities increased $83,212,541 in 2004
due primarily to the $91,817,843 net proceeds from the follow-on offering of
5,520,000 common shares that closed on June 23, 2004. Borrowings of
$18,000,000 under the Companys revolving line of credit were used to finance
the acquisition of Herndon Corporate Center, Aquia Commerce Center I & II and
to partially finance the earnest money for the 14-property portfolio acquired
by the Company on July 16, 2004. In the first quarter of 2004, the Company
repaid debt of $25,610,206 including a $7,000,000 partial paydown of the
$22,000,000 of mortgage debt that encumbers the Companys Rumsey Center and
Snowden Center properties and $18,000,000 to pay off the Companys revolving
line of credit. Additionally, the Company paid dividends and distributions to
minority interests of $3,008,857 in 2004. Funds From Operations Investors and analysts following the real estate industry utilize funds
from operations (FFO) as a supplemental performance measure. The Company
considers FFO an appropriate supplemental measure given its wide use by and
relevance to investors and analysts. FFO, reflecting the assumption that real
estate asset values rise or fall with market conditions, principally adjusts
for the effects of GAAP depreciation and amortization of real estate assets,
which assume that the value of real estate diminishes predictably over time. 18




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##### 



As defined by the National Association of Real Estate Investment Trusts,
or NAREIT, FFO represents net income (loss) (computed in accordance with GAAP),
excluding gains (losses) on sales of real estate, plus real estate-related
depreciation and amortization and after adjustments for unconsolidated
partnerships and joint ventures. FFO should not be viewed as a substitute
measure of the Companys operating performance since it does not reflect either
depreciation and amortization costs or the level of capital expenditures and
leasing costs necessary to maintain the operating performance of the Companys
properties, which are significant economic costs that could materially impact
the Companys results of operations. The following table presents a reconciliation of net loss to FFO available
to common share and unitholders for the three and six month period ended June
30, 2004. Funds From OperationsThree Months Ended
    
    Six Months EndedJune 30, 2004
    
    June 30, 2004Net loss
    
    $
    (57,868
    )
    
    $
    (228,474
    )Add: Real estate depreciation
and amortization
    
    
    2,674,508
    
    
    
    5,279,420Add: Minority interests
    
    
    (4,803
    )
    
    
    (32,432
    )FFO available to common share and
unitholders
    
    $
    2,611,837
    
    
    $
    5,018,514
 Forward Looking Statements This report contains forward-looking statements within the meaning of the
federal securities laws. Forward-looking statements, which are based on
certain assumptions and describe future plans, strategies and expectations of
the Company, are generally identifiable by use of the words believe,
expect, intend, anticipate, estimate, project or similar expressions.
The Companys ability to predict results or the actual effect of future plans
or strategies is inherently uncertain. Certain factors that could cause actual
results to differ materially from the Companys expectations include changes in
general or regional economic conditions; the Companys ability to timely lease
or re-lease space at current or anticipated rents; changes in interest rates;
changes in operating costs; the Companys ability to complete current and
future acquisitions; the Companys ability to sell additional common Shares;
and other risks detailed in the Companys Annual Report on Form 10-K. Many of
these factors are beyond the Companys ability to control or predict.
Forward-looking statements are not guarantees of performance. For
forward-looking statements herein, the Company claims the protection of the
safe harbor for forward-looking statements contained in the Private Securities
Litigation Reform Act of 1995. The Company assumes no obligation to update or
supplement forward-looking statements that become untrue because of subsequent
events. 19




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##### 



ITEM 3: QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT
MARKET RISK The Companys future income, cash flows and fair values relevant to
financial instruments are dependent upon prevailing market interest rates.
Market risk refers to the risk of loss from adverse changes in market interest
rates. The Company uses derivative financial instruments to manage, or hedge,
interest rate risks related to its borrowings. The Company does not use
derivatives for trading or speculative purposes and only enters into contracts
with major financial institutions based on their credit rating and other
factors. The Company had $25.5 million in variable rate debt, or 20%, of the total
$130.2 million debt outstanding as of June 30, 2004. For fixed rate debt, changes in interest rates generally affect the fair
value of debt but not the earnings or cash flow of the Company. The Company
estimates the fair value of its fixed rate mortgage debt outstanding at June
30, 2004 to be $109.9 million compared to the $104.7 million carrying value at
that date. The Company uses interest rate protection, or cap agreements to reduce
the impact of interest rate changes on its variable rate debt. The Company had
interest rate cap agreements in the notional amount of $25.5 million as of June
30, 2004. The fair value of the cap agreement at June 30, 2004, approximated
its carrying value. Under the terms of these agreements, the Company made an
initial premium payment to a counterparty in exchange for the right to receive
payments from the counterparty if interest rates exceed specified levels during
the term of the agreement. The Company is subject to market risk for changes
in interest rates and credit risk in the event of non-performance by the
counterparty. The Company will only enter into these agreements with highly
rated institutional counterparts and does not expect that any counterparties
will fail to meet contractual obligations. ITEM 4: CONTROLS AND PROCEDURES The Company carried out an evaluation, with the participation of the
Companys management, including the Companys Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the Companys disclosure controls
and procedures (pursuant to Rule 13a-15(e) under the Securities Exchange Act of
1934) as of the end of the period covered by this report. Based upon that
evaluation, the Companys Chief Executive Officer and Chief Financial Officer
concluded that the Companys disclosure controls and procedures are effective
in timely alerting them to material information relating to the Company
(including its consolidated subsidiaries) required to be included in the
Companys periodic SEC filings. There has been no change in the Companys
internal control over financial reporting during the quarter ended June 30,
2004, that has materially affected, or is reasonably likely to materially
affect, the Companys internal control over financial reporting. 20




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##### 



PART II: OTHER INFORMATION Item 1. Legal Proceedings None Item 2. Changes in Securities and Use of Proceeds None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders On May 13, 2004, the Companys Annual Meeting of Shareholders was held and
the following matters were submitted to the common shareholders for a vote.
There were 7,352,802 Common Shares present, in person or by proxy. Set forth
below is a brief description of the matters voted on and the number of votes
cast for, against or withheld, as well as the number of abstentions and broker
non-votes. Election of Directors: Number ofVotes Against
    
    BrokerName
    
    Votes For
    
    or Withheld
    
    Non-Votes
    
    TotalsDouglas J. Donatelli
    
    
    7,239,642
    
    
    
    113,160
    
    
    
    0
    
    
    
    7,352,802Louis T. Donatelli
    
    
    7,239,642
    
    
    
    113,160
    
    
    
    0
    
    
    
    7,352,802Robert H. Arnold
    
    
    7,239,642
    
    
    
    113,160
    
    
    
    0
    
    
    
    7,352,802Richard B. Chess
    
    
    7,239,642
    
    
    
    113,160
    
    
    
    0
    
    
    
    7,352,802J. Roderick Heller, III
    
    
    7,209,046
    
    
    
    143,756
    
    
    
    0
    
    
    
    7,352,802R. Michael McCullough
    
    
    7,164,646
    
    
    
    188,156
    
    
    
    0
    
    
    
    7,352,802Terry L. Stevens
    
    
    7,164,646
    
    
    
    188,156
    
    
    
    0
    
    
    
    7,352,802
 21




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##### 



Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits No.
    
    Description31.1
    
    Certification of Chief Executive Officer pursuant to Rule 13a 
14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant to Rule 13a 
14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (This exhibit shall not be deemed filed
for purposes of Section 18 of the Securities Exchange Act of 1934, as
amended, or otherwise subject to the liability of that section.
Further, this exhibit shall not be deemed to be incorporated by
reference into any filing under the Securities Act of 1933, as
amended, or the Securities Exchange Act of 1934, as amended.)32.2
    
    Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (This exhibit shall not be deemed filed
for purposes of Section 18 of the Securities Exchange Act of 1934, as
amended, or otherwise subject to the liability of that section.
Further, this exhibit shall not be deemed to be incorporated by
reference into any filing under the Securities Act of 1933, as
amended, or the Securities Exchange Act of 1934, as amended.)
 (b) Reports on Form 8-K The following Current Reports on Form 8-K were filed or furnished, as
noted in the applicable Form 8-K, during the second quarter of 2004.  1.
    
    Report on Form 8-K furnished pursuant to Item 12 and Item 7 regarding
the Companys first quarter of 2004 financial results and quarterly
supplemental information dated May 7, 2004.2.
    
    Report on Form 8-K filed pursuant to Item 2, Item 7 and Item 9
regarding purchase agreements entered into by the Company for the
acquisition of the Suburban Maryland Portfolio and Aquia Commerce Center
I & II and the filing of the Companys Registration Statement on Form
S-11 under the Securities Act of 1933, as amended, dated May 28, 2004.3.
    
    Report on Form 8-K filed pursuant to Item 2 and Item 7 regarding the
acquisition of Aquia Commerce Center I & II dated June 7, 20044.
    
    Report on Form 8-K filed pursuant to Item 5 and Item 7 regarding the
pricing of a follow-on offering and the underwriting agreement entered
into by the Company in connection with such offering, dated June 18,
2004. 22




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##### 



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. Date: August 9, 2004
    
    /s/ Douglas J. Donatelli
Douglas J. Donatelli
President and Chief Executive OfficerDate: August 9, 2004
    
    /s/ Barry H. Bass
Barry H. Bass
Senior Vice President and Chief
Financial Officer
 23




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##### 



EXHIBIT INDEX
 No.
    
    Description31.1
    
    Certification of Chief Executive Officer pursuant to Rule 13a 
14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant to Rule 13a 
14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (This exhibit shall not be deemed filed
for purposes of Section 18 of the Securities Exchange Act of 1934, as
amended, or otherwise subject to the liability of that section.
Further, this exhibit shall not be deemed to be incorporated by
reference into any filing under the Securities Act of 1933, as
amended, or the Securities Exchange Act of 1934, as amended.)32.2
    
    Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (This exhibit shall not be deemed filed
for purposes of Section 18 of the Securities Exchange Act of 1934, as
amended, or otherwise subject to the liability of that section.
Further, this exhibit shall not be deemed to be incorporated by
reference into any filing under the Securities Act of 1933, as
amended, or the Securities Exchange Act of 1934, as amended.)