**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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**FORM 10-Q**

 

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

 

**FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004**

 

**COMMISSIONFILE NUMBER 001-31962**

 

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**GOVERNMENT PROPERTIES TRUST, INC.**

(EXACT NAME OFREGISTRANT AS SPECIFIED IN ITS CHARTER)

 

| **MARYLAND**                                                     | ** ** | **20-0611663**                                              |
|------------------------------------------------------------------|------------|-------------------------------------------------------------|
| (State or  other jurisdiction of  incorporation or organization) |       | (I.R.S.  Employer  Identification No.)                      |
|                                                             |       |                                                        |
| **10250  REGENCY CIRCLE, SUITE 100  OMAHA, NEBRASKA 68114**      | ** ** | **(402)  391-0010**                                         |
| (Address of  principal executive  offices, including zip code)   |       | (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 theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter 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 ýNo o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes oNo ý

 

As of November 5, approximately 20.7 millionshares of common stock of the registrant were outstanding.

 

 

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TABLE OFCONTENTS

 
|                           | **PAGE**                                                                                                                   |
|--------------------------------|----------------------------------------------------------------------------------------------------------------------------|
| PART I - FINANCIAL INFORMATION |                                                                                                                       |
| Item 1.                        | Consolidated Financial Statements  (unaudited)                                                                             |   |
|                           | Consolidated Balance Sheets as of September 30, 2004 (unaudited) and  December 31, 2003                                    | 3 |
|                           | Consolidated Statements of Operations for  the three months and nine months ended September 30, 2004 and 2003  (unaudited) | 4 |
|                           | Consolidated Statements of Cash Flows for  the nine months ended September 30, 2004 and 2003 (unaudited).                  | 5 |
|                           | Notes to Consolidated Financial Statements  (unaudited)                                                                    | 6 |
| Item 2.                        | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                | 12 |
| Item 3.                        | Quantitative and Qualitative Disclosures  About Market Risk                                                                | 28 |
| Item 4.                        | Controls and Procedures                                                                                                    | 28 |
| PART II - OTHER INFORMATION    |                                                                                                                       |
| Item 1.                        | Not applicable                                                                                                             |   |
| Item  2.                       | Changes in Securities and Use of Proceeds                                                                                  | 28 |
| Item 3.                        | Not applicable                                                                                                             |   |
| Item 4.                        | Not applicable                                                                                                             |   |
| Item 5.                        | Not applicable                                                                                                             |   |
| Item 6.                        | Exhibits  and Reports on Form 8-K                                                                                          | 30 |
| Signatures                     | 31                                                                                                                         |
|                                |                                                                                                                            |  |  |

 

2

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GOVERNMENTPROPERTIES TRUST, INC.

 

CONSOLIDATEDBALANCE SHEETS

 
| ** **                                                                                                                                                                                                                                   | ** ** | **SEPTEMBER 30,  2004** | ** **  | **DECEMBER 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|-------------|------------------------|------------|
| ** **                                                                                                                                                                                                                                   | ** ** | **(UNAUDITED)**         | ** **  | ** **             | ** ** |
| ASSETS                                                                                                                                                                                                                                       |       |                    |        |                   |       |
| Real estate at cost:                                                                                                                                                                                                                         |       |                    |        |                   |       |
| Land                                                                                                                                                                                                                                         |       | $                       | 10,289,237  |                   | $          | 4,545,637 |   |
| Buildings and improvements                                                                                                                                                                                                                   |       | 76,642,285              |        | 24,050,859             |       |
| Tenant origination costs                                                                                                                                                                                                                     |       | 16,774,615              |        | 6,200,441              |       |
| Furniture and equipment                                                                                                                                                                                                                      |       | 181,037                 |        | 34,486                 |       |
|                                                                                                                                                                                                                                         |       | 103,887,174             |        | 34,831,423             |       |
| Accumulated depreciation                                                                                                                                                                                                                     |       | (2,194,390              | )           | (757,400               | )          |
|                                                                                                                                                                                                                                         |       | 101,692,784             |        | 34,074,023             |       |
| Cash and cash equivalents                                                                                                                                                                                                                    |       | 105,934,854             |        | 760,859                |       |
| Restricted cash escrows                                                                                                                                                                                                                      |       | 692,570                 |        | 268,885                |       |
| Restricted cash for letter of credit                                                                                                                                                                                                         |       | 17,426,515              |        | —                 |       |
| Tenant receivables                                                                                                                                                                                                                           |       | 752,719                 |        | 332,651                |       |
| Notes receivable from tenant                                                                                                                                                                                                                 |       | 680,122                 |        | 111,773                |       |
| Deferred costs, net                                                                                                                                                                                                                          |       | 740,694                 |        | 1,948,350              |       |
| Real estate deposits                                                                                                                                                                                                                         |       | 1,950,000               |        | 500,000                |       |
| Property held for sale                                                                                                                                                                                                                       |       | 4,271,071               |        | 4,266,438              |       |
| Other assets                                                                                                                                                                                                                                 |       | 1,260,776               |        | 411,607                |       |
| Total assets                                                                                                                                                                                                                                 |       | $                       | 235,402,105 |                   | $          | 42,674,586 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                    |       |                    |        |                   |       |
| Liabilities:                                                                                                                                                                                                                                 |       |                    |        |                   |       |
| Accounts payable and accrued expenses                                                                                                                                                                                                        |       | $                       | 1,202,655   |                   | $          | 2,116,101 |   |
| Dividend payable                                                                                                                                                                                                                             |       | 3,103,875               |        | 147,536                |       |
| Lines of credit                                                                                                                                                                                                                              |       | —                  |        | 3,047,655              |       |
| Mortgage notes payable                                                                                                                                                                                                                       |       | 53,192,447              |        | 24,647,478             |       |
| Mortgage note payable - affiliate                                                                                                                                                                                                            |       | —                  |        | 1,639,219              |       |
| Liabilities related to property held for  sale                                                                                                                                                                                               |       | 3,136,070               |        | 3,195,359              |       |
| Advances from affiliate                                                                                                                                                                                                                      |       | —                  |        | 102,873                |       |
| Total liabilities                                                                                                                                                                                                                            |       | 60,635,047              |        | 34,896,221             |       |
| Stockholders’ equity:                                                                                                                                                                                                                   |       |                    |        |                   |       |
| Common stock ($0.01 par value at September  30, 2004 and $10 par value at December 31, 2003; 50,000,000 shares  authorized, 20,692,502 and 975,552 shares issued and outstanding at September  30, 2004 and December 31, 2003, respectively) |       | 205,183                 |        | 9,755,527              |       |
| Accumulated deficit                                                                                                                                                                                                                          |       | (3,656,423              | )           | (386,586               | )          |
| Additional paid-in capital                                                                                                                                                                                                                   |       | 188,043,599             |        | (1,073,299             | )          |
| Dividends declared                                                                                                                                                                                                                           |       | (9,825,301              | )           | (517,277               | )          |
| Total stockholders’ equity                                                                                                                                                                                                              |       | 174,767,058             |        | 7,778,365              |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                              |       | $                       | 235,402,105 |                   | $          | 42,674,586 |   |

 

SEEACCOMPANYING NOTES.

 

3

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GOVERNMENTPROPERTIES TRUST, INC.

 

CONSOLIDATEDSTATEMENTS OF OPERATIONS

 
| ** **                                               | ** ** | **(UNAUDITED)**                       | ** ** | **(UNAUDITED)**                      | ** ** |
|----------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                               | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
| ** **                                               | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:                                                 |       |                                  |       |                                 |       |   |   |   |   |
| Rental income                                            |       | $                                     | 2,338,335  |                                 | $          | 998,870 |   | $ | 5,060,076 |   | $ | 1,813,770 |   |
| Tenant reimbursements                                    |       | 41,656                                |       | —                               |       | 205,851 |   | — |   |
| Total revenue                                            |       | 2,379,991                             |       | 998,870                              |       | 5,265,927 |   | 1,813,770 |   |
| Expenses:                                                |       |                                  |       |                                 |       |   |   |   |   |
| Property operations                                      |       | 543,020                               |       | 251,927                              |       | 1,126,570 |   | 387,031 |   |
| Real estate taxes                                        |       | 257,403                               |       | 146,455                              |       | 578,428 |   | 171,749 |   |
| Depreciation and amortization                            |       | 673,396                               |       | 274,604                              |       | 1,436,990 |   | 510,413 |   |
| General and administrative                               |       | 1,037,025                             |       | 94,673                               |       | 3,026,211 |   | 401,513 |   |
| Total expenses                                           |       | 2,510,844                             |       | 767,659                              |       | 6,168,199 |   | 1,470,706 |   |
| Operating (loss) income                                  |       | (130,853                              | )          | 231,211                              |       | (902,272 | ) | 343,064 |   |
| Other income                                             |       | 607,884                               |       | 33,797                               |       | 1,238,417 |   | 42,508 |   |
| Interest expense:                                        |       |                                  |       |                                 |       |   |   |   |   |
| Expense                                                  |       | (660,373                              | )          | (445,317                             | )          | (1,426,521 | ) | (754,776 | ) |
| Expense from issuance of warrant                         |       | —                                |       | —                               |       | (2,097,900 | ) | — |   |
| Amortization of deferred financing fees                  |       | (91,571                               | )          | (10,845                              | )          | (170,085 | ) | (14,460 | ) |
| Loss from continuing operations                          |       | (274,913                              | )          | (191,154                             | )          | (3,358,361 | ) | (383,664 | ) |
| Discontinued operations:                                 |       |                                  |       |                                 |       |   |   |   |   |
| Income from property held for sale                       |       | 42,156                                |       | 11,474                               |       | 88,524 |   | 44,483 |   |
| Net loss                                                 |       | $                                     | (232,757   | )                                    | $          | (179,680 | ) | $ | (3,269,837 | ) | $ | (339,181 | ) |
| Earnings per share (basic and diluted):                  |       |                                  |       |                                 |       |   |   |   |   |
| Loss from continuing operations                          |       | $                                     | (0.01      | )                                    | $          | (0.20 | ) | $ | (0.18 | ) | $ | (0.49 | ) |
| Income from discontinued operations                      |       | —                                |       | 0.01                                 |       | — |   | 0.06 |   |
| Net loss                                                 |       | $                                     | (0.01      | )                                    | $          | (0.19 | ) | $ | (0.18 | ) | $ | (0.43 | ) |
| Distributions declared per share                         |       | $                                     | 0.15       |                                 | $          | 0.15 |   | $ | 0.45 |   | $ | 0.45 |   |
| Weighted average shares outstanding (basic  and diluted) |       | 20,514,716                            |       | 955,433                              |       | 18,585,837 |   | 789,148 |   |
|                                                          |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

SEEACCOMPANYING NOTES.

 

4

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GOVERNMENTPROPERTIES TRUST, INC.

 

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

 
| ** **                                                                   | ** ** | **(UNAUDITED)**                      | ** **  |
|------------------------------------------------------------------------------|------------|--------------------------------------|-------------|
| ** **                                                                   | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** **  |
| ** **                                                                   | ** ** | **2004**                             | ** **  | **2003** | ** ** |
| Cash flows from operating activities:                                        |       |                                 |        |   |   |
| Net loss                                                                     |       | $                                    | (3,269,837  | ) | $ | (339,181 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                 |        |   |   |
| Depreciation and amortization                                                |       | 1,436,990                            |        | 510,413 |   |
| Amortization of deferred financing fees                                      |       | 170,085                              |        | 14,460 |   |
| Compensation expense                                                         |       | 508,997                              |        | — |   |
| Expense from issuance of warrant                                             |       | 2,097,900                            |        | — |   |
| Changes in assets and liabilities:                                           |       |                                 |        |   |   |
| Restricted cash escrows                                                      |       | (423,685                             | )           | (250,392 | ) |
| Tenant receivables                                                           |       | (420,068                             | )           | (316,083 | ) |
| Note receivable from tenant                                                  |       | (568,349                             | )           | (116,733 | ) |
| Other assets                                                                 |       | (913,091                             | )           | (92,057 | ) |
| Accounts payable and accrued expenses                                        |       | 909,425                              |        | 16,627 |   |
| Net cash used in operating activities                                        |       | (471,633                             | )           | (572,946 | ) |
| Cash flows from investing activities:                                        |       |                                 |        |   |   |
| Expenditures for real estate                                                 |       | (68,955,751                          | )           | (34,736,864 | ) |
| Restricted cash for letter of credit                                         |       | (17,426,515                          | )           | — |   |
| Deposits on future real estate purchases                                     |       | (1,550,000                           | )           | — |   |
| Cash used in investing activities                                            |       | (87,932,266                          | )           | (34,736,864 | ) |
| Cash flows from financing activities:                                        |       |                                 |        |   |   |
| Financing fees                                                               |       | (785,300                             | )           | (134,709 | ) |
| Net (repayment) borrowing under lines of  credit                             |       | (3,047,655                           | )           | 2,059,788 |   |
| Proceeds from mortgage notes payable                                         |       | 29,000,000                           |        | 24,839,553 |   |
| Payments on mortgage notes payable -  affiliate                              |       | (1,639,219                           | )           | 1,639,219 |   |
| Repayments of advances from affiliate                                        |       | (102,873                             | )           | (91,337 | ) |
| Principal payments on mortgage notes  payable                                |       | (455,031                             | )           | (141,977 | ) |
| Proceeds from sale of common stock                                           |       | 193,202,100                          |        | 6,036,297 |   |
| Offering costs paid                                                          |       | (16,242,443                          | )           | (631,317 | ) |
| Dividends paid                                                               |       | (6,351,685                           | )           | (222,121 | ) |
| Net cash provided by financing activities                                    |       | 193,577,894                          |        | 33,353,396 |   |
| Net increase in cash and cash equivalents                                    |       | 105,173,995                          |        | (1,956,414 | ) |
| Cash and cash equivalents, beginning of  period                              |       | 760,859                              |        | 2,314,319 |   |
| Cash and cash equivalents, end of period                                     |       | $                                    | 105,934,854 |   | $ | 357,905 |   |

 

SEEACCOMPANYING NOTES.

 

5

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GOVERNMENTPROPERTIES TRUST, INC.

 

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

 

1.  BASIS OF PRESENTATION

 

The accompanying unaudited consolidatedfinancial statements of Government Properties Trust, Inc., a Marylandcorporation (the “Company”), have been prepared pursuant to Securities andExchange Commission (“SEC”) rules and regulations and should be read inconjunction with the consolidated financial statements and notes theretoincluded in the 2003 Form 10-K. The accompanying consolidated financialstatements highlight significant changes to the Notes included in the 2003 Form10-K and present interim disclosures as required by the SEC. The accompanyingconsolidated financial statements reflect, in the opinion of management, alladjustments considered necessary for a fair presentation of the interimfinancial statements. All such adjustments are of a normal and recurringnature.

 

The preparation of the consolidated financialstatements in conformity with U.S. generally accepted accounting principles (“GAAP”)requires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expense during the reporting periods. Our results for the quarterended September 30, 2004 are not necessarily indicative of our results for anyfuture interim period or for the full fiscal year.

 

Certain reclassifications have been made tothe previously reported 2003 consolidated financial statements in order toprovide comparability with the interim period financial statements reportedherein. These reclassifications have not changed the 2003 results of operationsor stockholders’ equity.

 

2.  NATURE OF BUSINESS AND OPERATIONS

 

The Company was incorporated in Michigan in1998. In January 2004, the Company completed a public offering of its commonstock and listed its common stock on the New York Stock Exchange. In connectionwith this offering, the Company reincorporated in Maryland and changed its nameto Government Properties Trust, Inc. The historical operations included in theconsolidated financial statements are those of its predecessor company (Gen-NetLease Income Trust, Inc.). References to the “Company” for periods prior to2004 refer to Gen-Net Lease Income Trust, Inc. and to Government PropertiesTrust, Inc. for subsequent periods. The Company has elected to be taxed as areal estate investment trust (“REIT”) under the Internal Revenue Code of 1986,as amended, beginning in 2003.

 

The Company began formal operations with itsfirst property acquisition in December 2002 and, as of September 30, 2004, theCompany owned ten properties (includes one property held for sale - See Note12) located throughout the United States. The Company acquires propertiesthrough various operating entities, which are wholly owned by the Company. TheCompany operates in one segment.

 

Between October 2002 and August 2003, theCompany sold 955,552 shares of its common stock at $10 per share. In January2004, the Company sold 19.3 million shares of its common stock (the “Offering”)at $10 per share and listed its common stock on the New York Stock Exchange.The Offering raised approximately $177 million in net proceeds.

 

3.  COMMON STOCK AND EARNINGS PER SHARE

 

The Company reports earnings per sharepursuant to Statement of Financial Accounting Standards No. 128, “Earnings PerShare”. Basic and diluted loss per share attributable for all periods presentedis computed by dividing the loss to common stockholders by the weighted averagenumber of common shares and potential common stock outstanding during theperiod. The Company had no common stock equivalents outstanding for the threeand nine months ended September 30, 2003. The Company had nonvested stockgrants of 176,613 and 136,778 shares outstanding during the three and ninemonths ended September 30, 2004, respectively, which were not included in thecomputation of diluted earnings per share because the effect would have beenanti-dilutive.

 

4.  DEFERRED COSTS

 

Deferred costs consist of the following: 

 

6

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| ** **               | ** ** | **SEPTEMBER30,** | ** ** | **DECEMBER31,** | ** ** |
|--------------------------|------------|------------------|------------|-----------------|------------|
| ** **               | ** ** | **2004**         | ** ** | **2003**        | ** ** |
| Financing costs          |       | $                | 920,009    |            | $          | 134,709 |   |
| Offering costs           |       | —           |       | 1,822,871       |       |
| Accumulated amortization |       | (179,315         | )          | (9,230          | )          |
|                     |       | $                | 740,694    |            | $          | 1,948,350 |   |

 

In connection with the completion of theOffering, offering costs of $1.8 million at December 31, 2003 were reclassifiedto Additional Paid-in Capital in the accompanying consolidated balance sheet.

 

5.  RESTRICTED CASH FOR LETTER OF CREDIT

 

During the first quarter of 2004, the Companyplaced approximately $17.4 million of operating cash into a restricted cashaccount to secure a letter of credit in connection with a proposed propertyacquisition.  See Note 14 – SubsequentEvent, for details on property acquisition.

 

6.  EQUITY INCENTIVE PLAN

 

The Company has a 2003 Equity IncentiveCompensation Plan, which has 1,000,000 shares of Common Stock reserved forissuance thereunder. In connection with the original issuance of shares duringthe first quarter of 2004, the Company adopted the fair value recognitionprovisions of SFAS No. 123, “Accounting for Stock Based Compensation” and SFASNo. 148, “Accounting for Stock Based Compensation – Transition and Disclosure –an amendment of FASB Statement No. 123”.

 

The Company recognizes compensation expensefor restricted shares issued based upon the fair market value of the commonstock at the grant date. Compensation expense is recognized on a straight-linebasis over the vesting period. During the nine months ended September 30, 2004,the Company granted 186,950 restricted shares pursuant to the Plan. The fairvalue of the shares at the time of the grants ranged from $10.70 to $13.90 pershare. Of the shares issued, 12,750 shares vested immediately. The remaining174,200 restricted shares were outstanding at September 30, 2004 and vest overperiods of one to five years. Compensation expense recognized and included ingeneral and administrative expense in the accompanying consolidated statementof operations was $248,274 and $508,997 for the three and nine months endedSeptember 30, 2004, respectively. As of September 30, 2004, there are 813,050shares available for grant under the Plan.

 

7. LINES-OF-CREDIT, MORTGAGE NOTES PAYABLEAND MORTGAGE NOTE PAYABLE — AFFILIATE

 

Lines-of-credit, mortgage notes payable, andmortgage note payable — affiliate consisted of the following:

 
| ** **                                                                                                                                                                                                                                                                                                                                                                      | ** ** | **SEPTEMBER 30,  2004** | ** ** | **DECEMBER 31,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| LINES OF CREDIT                                                                                                                                                                                                                                                                                                                                                                 |       |                    |       |                   |       |
| Line-of-credit with a financial institution  for property acquisitions with advances up to $50,000,000, interest at prime  rate (4.25% at September 30, 2004). Line-of-credit expires in April 2005,  interest is due quarterly. No advances have been made on the line-of-credit                                                                                               |       | $                       | —     |                   | $          | — |   |
| Line-of-credit with a financial institution  for property acquisitions, interest at the financial institution’s prime rate  (4.0% at December 31, 2003), plus 50 basis points per annum. Advances were  payable 180 days after the advance and were secured by a subordinated  mortgage on the acquired property. Principal repaid and line retired in  February 2004. (A) |       | —                  |       | 2,287,510              |       |
| Unsecured line-of-credit with a financial  institution (maximum borrowing $150,000), interest at prime rate (4.0% at  December 31, 2003), principal repaid and line retired in February 2004 (A)                                                                                                                                                                                |       | —                  |       | 110,145                |       |
| Unsecured line-of-credit with a financial  institution (maximum borrowing $1,000,000), interest at fixed rate of 20%,  principal repaid and line retired in January 2004 (A)                                                                                                                                                                                                    |       | —                  |       | 650,000                |       |
| Total lines of credit                                                                                                                                                                                                                                                                                                                                                           |       | $                       | —     |                   | $          | 3,047,655 |   |
| MORTGAGE NOTES PAYABLE(B),(C)                                                                                                                                                                                                                                                                                                                                                   |       |                    |       |                   |       |
| Mortgage notes payable to various financial  institutions, collateralized by various properties, interest at fixed rates  ranging from 5.44% to 8.3% per annum, with principal and interest payable  monthly through 2013. The weighted average interest rate at September 30,  2004 and December 31, 2003 was 5.71% and 6.0%, respectively                                     |       | $                       | 53,192,447 |                   | $          | 24,647,478 |   |
| MORTGAGE  NOTE PAYABLE — AFFILIATE(C)                                                                                                                                                                                                                                                                                                                                      |       |                    |       |                   |       |   |   |
| Mortgage note payable to Genesis Financial  Group, Inc. collateralized by a subordinated mortgage on one property,  interest at LIBOR (1.12% at December 31, 2003) plus 250 basis points per  annum payable monthly and principal repaid and line retired in January 2004.  (A)                                                                                                 |       | $                       | —     |                   | $          | 1,639,219 |   |
|                                                                                                                                                                                                                                                                                                                                                                                 |            |                         |            |                        |            |  |  |  |  |

 

7

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(A)  Debt outstanding at December 31, 2003 wasretired with funds received in connection with the Offering.

 

(B)  The mortgages notes payable are subject tovarious operating covenants. In addition, the Company must periodically fundand maintain escrow accounts to fund future real estate taxes, repairs andmaintenance and insurance payments, as well as to fund certain tenant releasingcosts. These escrow accounts are included in restricted cash escrows.

 

(C)  A portion of the Company’s real estate assetshave been pledged as collateral for its mortgage notes payable, certain linesof credit and mortgage note payable — affiliate.

 

Total interest paid on the lines-of-creditand mortgage notes payable was $528,409 and $445,318 for the three months endedSeptember 30, 2004 and 2003, respectively. During the three months endedSeptember 30, 2004 and 2003, the Company incurred interest expense of $660,373and $445,318, respectively.

 

For the nine months ended September 30, 2004and 2003, total interest paid on the lines-of-credit and mortgage notes payablewas $1,395,219 and $754,776, respectively (including interest paid to GenesisFinancial Group, Inc. (“Genesis”) of $1,973 and $44,180 in 2004 and 2003,respectively). During the nine months ended September 30, 2004 and 2003, theCompany incurred interest expense of $1,426,521 and $754,776, respectively(including interest incurred with Genesis of $1,973 and $44,180 in 2004 and2003, respectively).

 

8.  CONCENTRATION OF CREDIT RISK

 

Financial instruments that potentiallysubject the Company to a concentration of credit risk are primarily cashinvestments and accounts receivable from tenants.  In order to limit credit risk, the Companyplaces its cash and investments in investment-grade short-term instruments withhigh quality financial institutions.  Thecash and investment account balances at each financial institution typicallyexceed Federal Deposit Insurance Corporation (“FDIC”) insurance coverage.

 

9.  RELATED PARTY TRANSACTIONS

 

Genesis, the sponsor of the initial publicoffering by the predecessor company Gen-Net Lease Income Trust, Inc., providesthe Company with property acquisition services. A summary of the terms of these services provided by Genesis are asfollows:

 
| **FEE**          | ** ** | **COMPENSATION**                                                                                                                        |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|
| Acquisition Fees |       | Up to 1% of the property purchase price for  an acquisition fee plus up to 2% of the acquisition fee for acquisition  related expenses. |

 

Prior to the January 2004 public offering ofcommon stock, Genesis also provided property disposition services,administration services, and property management services.  A summary of the terms of these servicesprovided by Genesis are as follows:

 
| **FEE**                   | ** ** | **COMPENSATION**                                                                                                     |
|---------------------------|------------|----------------------------------------------------------------------------------------------------------------------|
| Property  Management Fees |       | For  day-to-day property management — 3% of gross rental revenue.                                               |
|                      |       |                                                                                                                 |
| Administrative            |       | For  day-to-day administrative support to the Company — 3% of gross rental revenue  and out-of-pocket expenses. |

 

The following is a summary of the feesincurred and payable: 

 
| ** **                  | ** ** | **SEPTEMBER 30,  2004** | ** ** | **SEPTEMBER 30,  2003** | ** ** |
|-----------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                  | ** ** | **PAYABLE**             | ** ** | **INCURRED**            | ** ** | **PAYABLE** | ** ** | **INCURRED** | ** ** |
| Acquisition fees(A)         |       | $                       | —     |                    | $          | 682,716 |   | $ | — |   | $ | 342,700 |   |
| Property management fees(B) |       | —                  |       | 10,888                  |       | 9,771 |   | 72,279 |   |
| Administrative fees(C)      |       | —                  |       | 10,237                  |       | 50,000 |   | 71,682 |   |
|                             |            |                         |            |                         |            |  |  |  |  |  |  |  |  |

 

8

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(A)  Amounts included in real estate in theConsolidated Balance Sheets.

 

(B)  Amounts included in property operationsexpense in the Consolidated Statements of Operations.

 

(C)  Amounts included in general and administrativeexpense in the Consolidated Statements of Operations.

 

In addition, Genesis owed the Company$310,000 (included in other assets) at September 30, 2004 and December 31, 2003for previous offering costs pursuant to a conditional agreement between Genesisand the Company. The amount owed is non-interest bearing and is secured by anirrevocable letter of credit which expires on June 30, 2005 unless extended tono later than June 30, 2006.

 

10.  PROPERTY ACQUISITIONS

 

The Company acquired the following propertiesduring the nine months ended September 30, 2004 and during the year endedDecember 31, 2003. The results of their operations are included in the Company’sconsolidated statements of operations from their respective dates ofacquisition.

 
| **PROPERTY**                                                      | ** ** | **LOCATION**       | ** ** | **ACQUISITION  COST** | ** ** | **MONTH  ACQUIRED** | ** ** |
|-------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|---------------------|------------|
| 2003 acquisitions(A):                                             |       |               |       |                  |       |                |       |
| USDEA Building (Bakersfield Property)                             |       | Bakersfield,  CA   |       | $                     | 2,385,804  |                | January    |   |
| Social Security Administration Offices  (Charleston Property)     |       | Charleston,  WV    |       | 18,466,705            |       | April               |       |
| General Services Administration Office  (Clarksburg Property)     |       | Clarksburg,  WV    |       | 11,029,266            |       | April               |       |
| Social Security Administration Office  (Kingsport Property)(B)    |       | Kingsport,  TN     |       | 2,992,130             |       | April               |       |
|                                                              |       |               |       | $                     | 34,873,905 |                |       |   |
| 2004 acquisitions(A):                                             |       |               |       |                  |       |                |       |
| Bureau of Public Debt (Mineral Wells  Property)(C)                |       | Mineral  Wells, WV |       | $                     | 5,109,486  |                | March      |   |
| Federal Bureau of Investigation (Pittsburgh  Property)            |       | Pittsburgh,  PA    |       | 28,682,675            |       | May                 |       |
| USDA District Offices (Lenexa Property)                           |       | Lenexa, KS         |       | 10,525,293            |       | June                |       |
| Veterans Administration Outpatient Clinic  (Baton Rouge Property) |       | Baton Rouge,  LA   |       | 5,931,242             |       | September           |       |
| Federal Courthouse (Charleston Property)                          |       | Charleston,  SC    |       | 19,277,829            |       | September           |       |
|                                                              |       |               |       | $                     | 69,526,525 |                |       |   |
|                                                                   |            |                    |            |                       |            |                     |            |  |  |  |

 

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(A)  In accordance with SFAS 141, the Companyallocated the purchase price for these properties to net tangible andidentified intangible assets acquired based on their fair values (includingland, buildings, tenant improvements, acquired above and below market leasesand the origination cost of acquired in-place leases) and acquired liabilities,and allocated the purchase price based on these assessments, including land atappraised value and buildings at replacement costs. The Company assessed fairvalue based on estimated cash flow projections that utilize discount andcapitalization rates deemed appropriate by management and available marketinformation. The value of tenant origination costs are amortized over theremaining term of the respective leases.

 

(B)  In connection with the purchase of thisproperty, the Company assumed a first mortgage note in the amount of $2,308,422and an unsecured note payable in the amount of $188,230.  The Company paid off the unsecured notepayable during the third quarter of 2004.

 

(C)  Included in the acquisition cost amount is anote receivable from tenant in the amount of $694,293 which the Company assumedwith the purchase of this property. The interest on the note receivable isfixed at 8% per annum with principal and interest payable monthly through 2012.

 

11.  UNAUDITED PRO FORMA CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS

 

The accompanying unaudited Pro FormaCondensed Consolidated Statements of Operations are presented as if, at January1, 2003, the Company acquired the properties described in Note 10 — PropertyAcquisitions and the shares outstanding at September 30, 2004 were alsooutstanding at January 1, 2003. In management’s opinion, all adjustmentsnecessary to reflect the effects of the above transactions have been made.

 

9

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The unaudited Pro Forma CondensedConsolidated Statements of Operations are not necessarily indicative of whatthe actual results of operations would have been assuming the above mentionedtransaction had occurred at the dates indicated above, nor do they purport torepresent our future results of operations.

 

PRO FORMACONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 
| ** **                                                | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Total revenue                                             |       | $                                    | 8,382,393  |   | $ | 7,895,305 |   |
| Loss from continuing operations (A)                       |       | $                                    | (2,838,362 | ) | $ | (1,029,580 | ) |
| Loss per diluted common share from  continuing operations |       | $                                    | (0.14      | ) | $ | (0.05 | ) |

 

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(A)  Includes expense of approximately $2.1 millionin the first quarter of 2004 for issuance of warrant - See Note 13.

 

12.  PROPERTY HELD FOR SALE

 

In accordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” the Company reflects thehistorical operating results of properties sold or held for sale, as well asthe gain or loss on sale from these properties, as discontinued operations inthe consolidated statements of operations for periods prior to their sale. AtSeptember 30, 2004, the Harahan property was considered held for sale and therelated assets and liabilities classified as held for sale are comprised of thefollowing at September 30, 2004 and December 31, 2003:

 
| ** **                            | ** ** | **SEPTEMBER 30,  2004** | ** ** | **DECEMBER 31,  2003** | ** ** |
|---------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ASSETS:                               |       |                    |       |                   |       |
| Land                                  |       | $                       | 759,251    |                   | $          | 759,251 |   |
| Buildings and improvements            |       | 3,149,042               |       | 3,149,042              |       |
| Tenant origination costs              |       | 480,017                 |       | 480,017                |       |
| Accumulated depreciation              |       | (151,230                | )          | (121,872               | )          |
| Deferred costs, net                   |       | 33,991                  |       | —                 |       |
| Total assets                          |       | $                       | 4,271,071  |                   | $          | 4,266,438 |   |
| LIABILITIES:                          |       |                    |       |                   |       |
| Accounts payable and accrued expenses |       | $                       | 18,735     |                   | $          | 40,318 |   |
| Mortgage note payable                 |       | 3,117,335               |       | 3,155,041              |       |
| Total liabilities                     |       | $                       | 3,136,070  |                   | $          | 3,195,359 |   |
|                                       |            |                         |            |                        |            |  |  |  |

 

The results of discontinued operationsrelated to the Harahan property were comprised of the following for the threeand nine months ended September 30, 2004 and 2003:

 
| ** **                              | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                              | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Rental income                           |       | $                                     | 90,860     |                                 | $          | 90,860 |   | $ | 272,580 |   | $ | 272,580 |   |
| Property operations                     |       | 3,235                                 |       | 3,775                                |       | 12,853 |   | 9,358 |   |
| Depreciation and amortization           |       | —                                |       | 29,358                               |       | 29,358 |   | 88,075 |   |
| Total expense                           |       | 3,235                                 |       | 33,133                               |       | 42,211 |   | 97,433 |   |
| Operating income                        |       | 87,625                                |       | 57,727                               |       | 230,369 |   | 175,147 |   |
| Amortization of deferred financing fees |       | —                                |       | —                               |       | (422 | ) | — |   |
| Interest expense                        |       | (45,469                               | )          | (46,253                              | )          | (141,423 | ) | (130,664 | ) |
| Income from property held for sale      |       | $                                     | 42,156     |                                 | $          | 11,474 |   | $ | 88,524 |   | $ | 44,483 |   |
|                                         |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |

 

On October 13, 2004, the Company completedthe sale of the Harahan property for approximately $4.6 million in cash.

 

10

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13.  ISSUANCE OF WARRANT

 

In connection with providing a line ofcredit, an affiliate of one of the Company’s underwriters in the Offering wasissued a warrant to purchase up to 210,000 shares of common stock. Theunderwriter’s affiliate exercised the warrant and the Company recognized anexpense of approximately $2.1 million in the first quarter of 2004.

 

14.  Subsequent Events

 

Subsequent to September 30, 2004, the Companycompleted the following acquisitions:

 
| **Property**                                            | ** ** | **Location**      | ** ** | **Approximate  Purchase Price** | ** ** |
|---------------------------------------------------------|------------|-------------------|------------|---------------------------------|------------|
| Food & Drug Administration (College  Park Property) |       | College  Park, MD |       |                            | $          | 22,300,000 |   |   |
| Immigration Services (Pittsburg INS  Property)          |       | Pittsburgh,  PA   |       |                            | 10,500,000 |   |   |
| Bureau of Public Debt (Parkersburg  Property)           |       | Parkersburg,  WV  |       |                            | 19,900,000 |   |   |
|                                                    |       |              |       |                            | $          | 52,700,000 |   |   |

 

The Company acquired the College ParkProperty with cash of approximately $5.6 million and the assumption of amortgage loan in the amount of $16.7 million. The mortgage loan bears interest at a fixed rate of 6.75% with principaland interest due monthly through November 2026. The College Park Property, completed in September 2004, totalsapproximately 79,000 rentable square feet. Approximately 64,000 square feet is occupied by the United States Food& Drug Administration.  The remainingspace, totaling 15,000 rentable square feet is vacant.  Under terms of the acquisition agreement, theCompany will pay an additional amount of $1.2 million should a lease beexecuted for the vacant space within 6 months of the date of acquisition.

 

The Pittsburgh INS Property was acquired withcash.  The Pittsburgh INS Property, completedin March 2004, totals approximately 33,000 rentable square feet and is 100%occupied by the United States Citizenship and Immigration Services.

 

The Parkersburg Property was acquired withcash.  The Parkersburg Property,completed in September 2004, totals approximately 81,000 rentable square feet,and is occupied by the Bureau of Public Debt. In connection with the Parkersburg Property acquisition, the letter ofcredit discussed in Note 5 was drawn upon. The federal government also exercised a consolidation option whereby theCompany will expand the Parkersburg Property by an additional 102,000 rentablesquare feet.  The cost of the expansionto the Property will be approximately $22.5 million and will be paid over theterm of the expansion scheduled for completion during the first half of 2006.

 

In October 2004, the Company completed thesale of the Harahan Property for approximately $4.6 million in cash.  (See Note 12).

 

11

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ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS

 

This report contains forward-lookingstatements. These forward-looking statements include estimates regarding:

 

•    ourestimated general and administrative expense;

 

•    ourrisk mitigation strategy;

 

•    ourpolicy to reserve for operating expenses and capital costs;

 

•    ourdistribution policy;

 

•    ouroperating expenses;

 

•    theadequacy of our available capital for future capital requirements;

 

•    ourcapital expenditures; and

 

•    theimpact of changes in interest rates.

 

Forward-looking statements can be identifiedby the use of words such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,”“believes,” “estimates,” “predicts,” “intends,” “continues,” or the negative ofsuch terms, or other comparable terminology. Forward-looking statements alsoinclude the assumptions underlying or relating to any of the foregoingstatements. Our actual results could differ materially from those anticipatedin these forward-looking statements as a result of various factors, includingthe risks discussed in “Management’s Discussion and Analysis of FinancialCondition and Results of Operations — Risk Factors” and elsewhere in thisreport.

 

All forward-looking statements included inthis report are based on information available to us on the date hereof. Weassume no obligation to update any forward-looking statements.

 

The following is a discussion of our interimresults of operations, financial condition and liquidity and capital resourcesfor the three and nine months ended September 30, 2004 compared to thecorresponding periods in 2003. It should be read in conjunction with theConsolidated Financial Statements and Notes thereto included herein and the2003 Form 10-K.

 

OVERVIEW

 

We primarily invest in single tenantproperties under long-term leases to the U.S. government, state governments,local governments, and government-sponsored enterprises. We are a self-managed,self-administered company that has elected to be taxed as a real estateinvestment trust, or REIT, under the federal tax laws. We believe that we arethe only public company focused solely on investing in government-leasedproperties. We own each of our properties through separate, wholly ownedentities. Our business consists of buying and managing recently built orrenovated office properties primarily leased to the federal government, actingthrough the General Services Administration (“GSA”), under long-term leases. AtSeptember 30, 2004, we owned nine GSA-leased properties that were acquired inearly 2003 and 2004 (one property in the first quarter of 2003, threeproperties in the second quarter of 2003, one property in the first quarter of2004, two properties in the second quarter of 2004 and two properties in thethird quarter of 2004). These properties are 100% occupied. At September 30,2004, we also owned one property in Harahan, LA that was leased to the FederalExpress Corporation. On October 13, 2004, we sold the Harahan Federal Expressproperty for approximately $4.6 million in cash.  Subsequent to September 30, 2004, the Companyacquired three additional GSA-leased properties.  (See Note 14).  The pace of property acquisitions determinesthe speed with which capital is invested in real property and that affectsoperating profit and cash available for distribution.  Management has been focused during thereporting period on increasing the pace of acquisitions.

 

CRITICAL ACCOUNTING POLICIES

 

Refer to our 2003 Annual Report on Form 10-Kfor a discussion of our critical accounting policies, which include our revenuerecognition of related lease agreements, recording of real estate atdepreciated cost and allocation of the purchase price of properties

 

12

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we acquire to net tangible and identifiedintangible assets. During the first nine months of 2004, there were no materialchanges to our critical accounting policies.

 

RESULTS OF OPERATIONS

 

The following table compares our operatingresults for the three months ended September 30, 2004 and 2003.

 
| ** **                                                   | ** ** | **2004**  | ** ** | **2003** | ** ** | **INCREASE  (DECREASE)** | ** ** |
|--------------------------------------------------------------|------------|-----------|------------|----------|------------|--------------------------|------------|
| Revenue:                                                     |       |      |       |     |       |                     |       |
| Rental income                                                |       | $         | 2,338,335  |     | $          | 998,870                  |       | $ | 1,339,465 |   |
| Tenant reimbursements                                        |       | 41,656    |       | —   |       | 41,656                   |       |
| Total revenue                                                |       | 2,379,991 |       | 998,870  |       | 1,381,121                |       |
| Expenses:                                                    |       |      |       |     |       |                     |       |
| Property Operations                                          |       | 543,020   |       | 251,927  |       | 291,093                  |       |
| Real estate taxes                                            |       | 257,403   |       | 146,455  |       | 110,948                  |       |
| Depreciation and Amortization                                |       | 673,396   |       | 274,604  |       | 398,792                  |       |
| General and administrative                                   |       | 1,037,025 |       | 94,673   |       | 942,352                  |       |
| Total expenses                                               |       | 2,510,844 |       | 767,659  |       | 1,743,185                |       |
| Operating (loss) income                                      |       | (130,853  | )          | 231,211  |       | (362,064                 | )          |
| Other income                                                 |       | 607,884   |       | 33,797   |       | 574,087                  |       |
| Interest expense                                             |       | (660,373  | )          | (445,317 | )          | (215,056                 | )          |
| Amortization of deferred financing fees                      |       | (91,571   | )          | (10,845  | )          | (80,726                  | )          |
| Loss from continuing operations                              |       | (274,913  | )          | (191,154 | )          | (83,759                  | )          |
| Discontinued operations: Income from  property held for sale |       | 42,156    |       | 11,474   |       | 30,682                   |       |
| Net loss                                                     |       | $         | (232,757   | )        | $          | (179,680                 | )          | $ | (53,077 | ) |

 

COMPARISON OF THREE MONTHS ENDED SEPTEMBER30, 2004 TO SEPTEMBER 30, 2003

 

Rental income revenue was $2,338,335 for 2004and $998,870 for 2003. The increase was due to our acquisition of fiveadditional properties during 2004.

 

Tenant reimbursements revenue was $41,656 for2004 and $0 for 2003. This amount represents the tenant’s reimbursement for thereal estate tax expense in excess of the real estate tax base amount as definedin the respective lease agreement. During the second quarter of 2004, the Company was able to determine thereal estate tax base amount for those properties acquired in 2003 and therebyrecorded and collected the excess amount of real estate tax expense from thetenant.  The amount of revenue recognizedduring the third quarter of 2004 represents the real estate tax expense inexcess of the real estate base amount for all properties owned as of September30, 2004.

 

Property operations expense was $543,020 for2004 and $251,927 for 2003. The increase was in part due to the expansion ofour operations from four properties owned as of September 30, 2003 to nineproperties owned as of September 30, 2004. In addition, the Company recognized approximately $106,000 in propertyoperations expense in 2004 related to franchise tax expense for properties heldin West Virginia.

 

Real estate tax expense was $257,403 for 2004and $146,455 for 2003. The increase was due to the expansion of our operationsfrom four properties owned as of September 30, 2003 to nine properties owned asof September 30, 2004.

 

Depreciation and amortization was $673,396for 2004 and $274,604 for 2003. The increase was due to the expansion of ouroperations   from four properties ownedas of September 30, 2003 to nine properties owned as of September 30, 2004.

 

General and administrative expense was$1,037,025 for 2004 and $94,673 for 2003. The increase was due to the expansionof our operations to become self-managed and to increase our acquisitionactivity. The increased items were for compensation (salaries, board ofdirector compensation and share grant compensation), directors’ and officers’insurance, rent, professional fees, public company expense, and other corporatelevel activity.

 

Other income, which consists primarily ofinterest income, was $607,884 for 2004 and $33,797 for 2003. The increase wasprimarily due to interest income earned on short-term investments purchasedfrom the proceeds raised in our January 2004 Offering. The amount of short-terminvestments held at September 30, 2004 was $105,934,854 as compared to $760,859at September 30, 2003.

 

13

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Interest expense was $660,373 for 2004 and$445,317 for 2003.  The increase was dueto $29.0 million in new mortgage debt obtained during the third quarter of2004.  This increase was offset by areduction in line of credit debt used for working capital purposes during 2003which was paid off in January 2004 from a portion of the proceeds raised in ourJanuary 2004 Offering.

 

Amortization of deferred financing fees was$91,571 in 2004 and $10,845 in 2003. The increase was primarily due to theamortization of financing fees being recognized of approximately $71,000related to the $50 million revolving credit facility obtained in April 2004.

 

Income from discontinued operations was$42,156 for 2004 and $11,474 in 2003. This represents the operating results forour Harahan property which was deemed held for sale in March 2004. The increaseis due to no depreciation or amortization expense recognized from the dateHarahan was deemed held for sale. In October 2004, we completed the sale of theHarahan property.

 

RESULTS OF OPERATIONS

 

The following table compares our operatingresults for the nine months ended September 30, 2004 and 2003.

 
| ** **                                                   | ** ** | **2004**   | ** ** | **2003**  | ** ** | **INCREASE  (DECREASE)** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|-----------|------------|--------------------------|------------|
| Revenue:                                                     |       |       |       |      |       |                     |       |
| Rental income                                                |       | $          | 5,060,076  |      | $          | 1,813,770                |       | $ | 3,246,306 |   |
| Tenant reimbursements                                        |       | 205,851    |       | —    |       | 205,851                  |       |
| Total revenue                                                |       | 5,265,927  |       | 1,813,770 |       | 3,452,157                |       |
| Expenses:                                                    |       |       |       |      |       |                     |       |
| Property Operations                                          |       | 1,126,570  |       | 387,031   |       | 739,539                  |       |
| Real estate taxes                                            |       | 578,428    |       | 171,749   |       | 406,679                  |       |
| Depreciation and Amortization                                |       | 1,436,990  |       | 510,413   |       | 926,577                  |       |
| General and administrative                                   |       | 3,026,211  |       | 401,513   |       | 2,624,698                |       |
| Total expenses                                               |       | 6,168,199  |       | 1,470,706 |       | 4,697,493                |       |
| Operating (loss) income                                      |       | (902,272   | )          | 343,064   |       | (1,245,336               | )          |
| Other income                                                 |       | 1,238,417  |       | 42,508    |       | 1,195,909                |       |
| Interest expense                                             |       | (1,426,521 | )          | (754,776  | )          | (671,745                 | )          |
| Expense from issuance of warrant                             |       | (2,097,900 | )          | —    |       | (2,097,900               | )          |
| Amortization of deferred financing fees                      |       | (170,085   | )          | (14,460   | )          | (155,625                 | )          |
| Loss from continuing operations                              |       | (3,358,361 | )          | (383,664  | )          | (2,974,697               | )          |
| Discontinued operations: Income from  property held for sale |       | 88,524     |       | 44,483    |       | 44,041                   |       |
| Net loss                                                     |       | $          | (3,269,837 | )         | $          | (339,181                 | )          | $ | (2,930,656 | ) |

 

COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30,2004 TO SEPTEMBER 30, 2003

 

Rental income revenue was $5,060,076 for 2004and $1,813,770 for 2003. The increase was due to our acquisition of fourproperties during 2003 and five additional properties in 2004.

 

Tenant reimbursements revenue was $205,851for 2004 and $0 for 2003. This amount represents the tenant’s reimbursement forthe real estate tax expense in excess of the real estate tax base amount asdefined in the respective lease agreement. During the second quarter of 2004, the Company was able to determine thereal estate tax base amount for those properties acquired in 2003 and therebyrecorded and collected the excess amount of real estate tax expense from thetenant.  The amount of revenue recognizedduring 2004 represents the real estate tax expense in excess of the real estatebase amount for all properties owned as of September 30, 2004.

 

Property operations expense was $1,126,570for 2004 and $387,031 for 2003. The increase was in part due to the expansionof our operations from four properties owned as of September 30, 2003 to nineproperties owned as of September 30, 2004. In addition, the Company recognized approximately $159,000 in propertyoperations expense during 2004 related to franchise tax expense for propertiesheld in West Virginia.

 

Real estate tax expense was $578,428 for 2004and $171,749 for 2003. The increase was due to the expansion of our operationsfrom four properties owned as of September 30, 2003 to nine properties owned asof September 30, 2004.

 

14

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Depreciation and amortization was $1,436,990for 2004 and $510,413 for 2003. The increase was due to the expansion of ouroperations from four properties owned as of September 30, 2003 to nineproperties owned as of September 30, 2004.

 

General and administrative expense was $3,026,211for 2004 and $401,513 for 2003. The increase was due to the expansion of ouroperations to become self-managed and to increase our acquisition activity. Theincreased items were for compensation (salaries, board of director compensationand share grant compensation), directors’ and officers’ insurance, rent,professional fees, public company expenses, and other corporate level activity.

 

Other income, which consists primarily ofinterest income, was $1,238,417 for 2004 and $754,776 for 2003. The increasewas primarily due to interest income earned on short-term investments purchasedfrom the proceeds raised in our January 2004 Offering.

 

Interest expense was $1,426,521 for 2004 and$697,262 for 2003. The increase was due to (*i*) a full ninemonths of interest expense in 2004 as compared to 2003 related to mortgage debtincurred by us in April 2003 for property acquisitions; and (*ii*) an increase of approximately $290,000 from the additionof $29.0 million in mortgage debt obtained during the third quarter of2004.  These increases were offset by areduction in line of credit debt used for working capital purposes during 2003which was paid off in January 2004 from a portion of the proceeds raised in ourJanuary 2004 Offering.

 

In the first quarter of 2004, we recognized$2,097,900 of expense related to the exercise of a warrant to purchase 210,000shares of our common stock. The warrant was issued to an affiliate of one ofour underwriters which provided a line of credit to us.

 

Amortization of deferred financing fees was$170,085 in 2004 and $14,460 in 2003. The increase was primarily due to theamortization of financing fees being recognized of approximately $140,000related to the $50 million revolving credit facility obtained in April 2004.

 

Income from discontinued operations was$88,524 for 2004 and $44,483 in 2003. This represents the operating results forour Harahan property which was deemed held for sale in March 2004. The increaseis due to no depreciation or amortization expense recognized from the dateHarahan was deemed held for sale.  InOctober 2004, we completed the sale of the Harahan property.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Our short-term liquidity requirements consistprimarily of funds to acquire properties and to pay for operating expenses andother expenditures directly associated with our properties, such as:

 

•    propertyand financing acquisition costs, deposits on properties and purchases ofproperties;

 

•    recurringmaintenance, repairs and other operating expenses necessary to maintain ourproperties;

 

•    propertytaxes and insurance expenses;

 

•    interestexpense and scheduled principal payments on outstanding indebtedness;

 

•    capitalexpenditures incurred to facilitate the leasing of space at our properties,including tenant improvements and leasing commissions;

 

•    generaland administrative expenses; and

 

•    distributionspaid to our stockholders.

 

Historically, we have satisfied ourshort-term liquidity requirements through our existing working capital and cashprovided by our operations, borrowings and public offering of common stock.

 

The table below sets forth the debt that wefully repaid from the proceeds of our January 2004 Offering:

 
| **LENDER**                   | ** ** | **USE OF FUNDS**                              | ** ** | **(IN MILLIONS)** | ** ** |
|------------------------------|------------|-----------------------------------------------|------------|-------------------|------------|
| Citizens First Bancorp, Inc  |       | Purchase  Charleston, WV property             |       |              | $          | 2.3 |   |   |
| Friedman Billings Ramsey     |       | Deposits on  acquisitions and working capital |       |              | 1.0        |   |   |
| Genesis Financial Group, Inc |       | Purchase  Bakersfield, CA property            |       |              | 1.6        |   |   |
| Citizens First Savings Bank  |       | Working  capital                              |       |              | 0.1        |   |   |
| Total                        |       |                                          |       |              | $          | 5.0 |   |   |

 

15

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We owed approximately $2.3 million toCitizens First Bancorp, Inc. under a $5 million line of credit. We incurred thedebt in April 2003 and it accrued interest on an annual basis at prime plus 50basis points (4.50% at December 31, 2003).

 

An affiliate of one of our underwriters,Friedman, Billings and Ramsey, provided us with a $1 million line of credit, ofwhich we borrowed approximately $0.7 million during 2003 and an additional $0.3million in January 2004. The total principal on the debt was $ 1.0 million atthe time it was repaid. The debt accrued interest on an annual basis at a rateof 20%.

 

We financed the acquisition of ourBakersfield property in part through an approximately $1.6 million loan fromGenesis Financial Group, Inc. We incurred this debt in January 2003 and itaccrued interest on an annual basis at a rate of LIBOR plus 250 basis points(3.62% at December 31, 2003).

 

We owed approximately $0.1 million under a$0.2 million line of credit with Citizens First Savings Bank. We incurred thedebt in September 2003 and it accrued interest at prime (4.00% at December 31,2003).

 

Our current mortgage debt obligations are setforth below:

 
| **LENDER**                        | ** ** | **COLLATERAL**       | ** ** | **BALANCE AS OF  SEPTEMBER 30,  2004** | ** ** |
|-----------------------------------|------------|----------------------|------------|----------------------------------------|------------|
| * *                          | * *   | * *             | * *   | **(IN MILLIONS)**                      | * *   |
| Operating Properties:             |       |                 |       |                                   |       |
| LaSalle Bank/GEMSA                |       | Charleston  property |       |                                   | $          | 13.8 |   |   |
| LaSalle Bank/GEMSA                |       | Clarksburg  property |       |                                   | 8.2        |   |   |
| Bank of America                   |       | Kingsport  property  |       |                                   | 2.3        |   |   |
| PNC Bank                          |       | Pittsburgh  property |       |                                   | 20.9       |   |   |
| Wachovia Securities               |       | Lenexa  property     |       |                                   | 8.0        |   |   |
| Total operating properties        |       |                 |       |                                   | 53.2       |   |   |
| Property held for sale:           |       |                 |       |                                   |       |   |   |
| Nomura Credit/Wachovia Securities |       | Harahan  property    |       |                                   | 3.1        |   |   |
| Total                             |       |                 |       |                                   | $          | 56.3 |   |   |

 

We financed the acquisition of our Charlestonproperty in April 2003 through a $14 million loan from LaSalle Bank, whichmatures on May 1, 2013. The unpaid principal balance of the note bears interestat a rate of 5.74% per annum. Monthly payments are amortized on a 30-yearschedule, with a balloon payment due May 1, 2013.

 

We financed the acquisition of our Clarksburgproperty in April 2003 through an approximately $8.3 million loan from LaSalleBank, which matures on May 1, 2013. The unpaid principal balance of the notebears interest at a rate of 5.74% per annum. Monthly payments are amortized ona 30-year schedule, with a balloon payment due May 1, 2013.

 

We financed the acquisition of our Kingsportproperty in April 2003 through the assumption of the seller’s first mortgageloan in the amount of $2.3 million from Bank of America, which matures on April1, 2010, and an unsecured loan issued by the seller in the amount of $0.2million, which represents amounts due to the seller for the seller’s escrowfunds that remain on deposit with the first mortgage loan holder. The unpaidprincipal balance of the first mortgage loan bears interest at a rate of 8.23%per annum, with monthly payments being amortized on a 25-year schedule and hasa balloon payment due April 1, 2010. During the third quarter of 2004, werepaid the seller loan in the amount of $0.2 million.

 

We obtained financing related to theacquisition of our Pittsburgh property in July 2004 through a 21.0 million loanfrom PNC Bank, which matures on August 1, 2009. The unpaid principal balance ofthe note bears interest at a rate of 5.5% per annum. Monthly payments areamortized on a 26-year schedule, with a balloon payment due August 1, 2009.

 

We obtained financing related to theacquisition of our Lenexa property in July 2004 through an 8.0 million loanfrom Wachovia Securities, which matures on August 11, 2009. The unpaidprincipal balance of the note bears interest at a rate of 5.44% per annum.Monthly payments are amortized on a 27-year schedule, with a balloon paymentdue August 11, 2009.

 

We financed the acquisition of our Harahanproperty in December 2002 through a $3.2 million loan from Nomura Credit, whichmatures on January 11, 2013. The unpaid principal balance of the note bearsinterest at a rate of 5.70% per annum. Monthly payments

 

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are amortized on a 27-year schedule, with aballoon payment due January 11, 2013. This amount is included in liabilitiesrelated to property held for sale in our consolidated balance sheet. Inconnection with the sale of the Harahan property on October 13, 2004, this loanwas assumed by the buyer.

 

In March 2004, we placed approximately $17.4million of operating cash into a restricted interest-bearing cash account tosecure a letter of credit (face value also of $17.4 million) in connection witha proposed property acquisition. The letter of credit was drawn upon inconnection with the closing of the Parkersburg property acquisition in November2004.

 

In April 2004, we entered into a $50 millionrevolving credit facility led by First National Bank of Omaha. Outstandingamounts under this facility accrue interest at the floating prime rate, aspublished by the Wall Street Journal, which will not be lower than 4%. We paida commitment fee equal to 0.50% of the total commitment and will pay an advancefee of 0.50% of each advance. All amounts provided pursuant to this facilitywill be due in May 2005. The facility contains customary restrictive covenants,including limitations on our ability to purchase properties under developmentor through unconsolidated affiliates. We are also required to maintain aminimum tangible net worth of not less than $90 million, a total liabilities totangible net worth ratio of no more than 4.0 to 1, and a minimum debt servicecoverage ratio of 1.2 to 1. We are not allowed to make distributions thatexceed the greater of (i) such amount as is required to be distributed as acondition our continued status as a REIT, or (ii) $0.25 per common share perquarter. The proceeds of this facility will be used for short-term acquisitionfinancing for the purchase of federal government-leased properties that have aminimum remaining lease term of 10 years. This facility may also be used toprovide deposits for purchase contracts or good faith deposits.

 

The mortgages on our properties containcustomary restrictive covenants, including provisions that may limit theborrowing subsidiary’s ability, without the prior consent of the lender, toincur additional indebtedness, further mortgage or transfer the applicable property, purchase or acquire additional property, discontinueinsurance coverage, change the conduct of its business or make loans oradvances to, enter into any transaction of merger or consolidation with, oracquire the business, assets or equity of, any third party.

 

Our long-term liquidity requirements consistprimarily of funds to pay for property acquisitions, scheduled debt maturities,renovations, expansions and other non-recurring capital expenditures that needto be made periodically to our properties and the costs associated withacquisitions of properties that we pursue. Historically, we have satisfied ourlong-term liquidity requirements through various sources of capital, includingour existing working capital, cash provided by operations, sales of equitysecurities, and long-term mortgage indebtedness. We intend to establish sinkingfund reserves, based on independent third-party reports, for future capitalexpenditures.

 

Since we became self-managed in January 2004,we have increased cash expenditures for general and administrative expenses,including salaries, directors’ and officers’ insurance, rent, professionalfees, public company expense, and other corporate level activity. We estimatethat our annualized general and administrative cash expenses for our first fullyear of operations to be in the range of $3.3 million to $3.6 million(exclusive of any compensation expense from the issuance of stock grants, whichis a non-cash item).

We believe that our existing cash will besufficient to fund our operations for at least the next twelve months.

 

CASH DISTRIBUTION POLICY

 

We have elected to be treated as a REIT underthe federal tax laws commencing as of our taxable year beginning January 1,2003. To qualify as a REIT, we must, among other things, distribute at least90% of our ordinary taxable income to our stockholders. We intend to complywith these requirements and maintain our REIT status. As a REIT, we generallywill not be subject to corporate federal income taxes on taxable income wedistribute (in accordance with the federal tax laws and applicable regulations)to our stockholders. If we fail to qualify as a REIT in any taxable year, wewill be subject to federal income taxes at regular corporate rates and may notbe able to qualify as a REIT for four subsequent tax years. Even as a REIT, wemay be subject to certain state and local taxes on our income and property andto federal income and excise taxes on our undistributed taxable income, i.e.,taxable income not distributed in the amounts and in the time frames prescribedby the federal tax laws and applicable regulations thereunder.

 

We intend to pay to our stockholders, withinthe time periods prescribed by the federal tax laws (in our case by January 31of the following year), all or substantially all of our annual taxable income,including gains from the sale of real estate and recognized gains on sale ofsecurities. We will continue our policy of making sufficient cash distributionsto stockholders in order for us maintain REIT status under the federal tax lawsand to avoid corporate income and excise tax on undistributed income.

 

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INFLATION

 

Our GSA leases generally contain provisionsdesigned to mitigate the adverse impact of inflation. These provisions increaserental rates during the terms of the leases by indexed escalations based on theConsumer Price Index.  This may reduceour exposure to increases in costs and operating expenses resulting frominflation. However, increases in property operating costs above the escalationamount would harm our cash flow and may harm our ability to pay dividends.

 

FUNDS FROM OPERATIONS

 

REIT analysts generally consider funds fromoperations or FFO an alternative measure of performance for an equity REIT. TheNational Association of Real Estate Investment Trusts, or NAREIT, defines fundsfrom operations as net income, computed in accordance with accountingprinciples generally accepted in the United States (“GAAP”), excluding gains orlosses from sales of properties, but including real estate related depreciationand amortization and after adjustments for unconsolidated partnerships andjoint ventures. We believe that FFO is helpful to investors as one of severalmeasures of the performance of an equity REIT. We further believe that byexcluding the effect of depreciation, amortization and gains or losses fromsales of real estate, all of which are based on historical costs, which may beof limited relevance in evaluating current performance, FFO can facilitatecomparison of operating performance between periods and between other equityREITs. Investors should review FFO along with GAAP Net Income Available forCommon Shares and cash flow from operating activities, investing activities andfinancing activities, when evaluating an equity REIT’s operating performance.We compute FFO in accordance with standards established by NAREIT, which maynot be comparable to FFO reported by other REITs that do not define the term inaccordance with the current NAREIT definition or that interpret the currentNAREIT definition differently than us. FFO does not represent cash generatedfrom operating activities in accordance with GAAP, nor does it represent cashavailable to pay distributions and should not be considered as an alternativeto net income, determined in accordance with GAAP, as an indication of ourfinancial performance, or to cash flow from operating activities, determined inaccordance with GAAP, as a measure of our liquidity, nor is it indicative offunds available to fund our cash needs, including our ability to make cashdistributions.

 

The following table presents a reconciliationof GAAP to our funds from operations for the periods presented:

 
| ** **                                         | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** |
|----------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                         | ** ** | **2004**                               | ** ** | **2003**                              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss                                           |       | $                                      | (232,757   | )                                     | $          | (179,680 | ) | $ | (3,269,837 | ) | $ | (339,181 | ) |
| Adjustments to reconcile to funds from Operations: |       |                                   |       |                                  |       |   |   |   |   |
| Real estate depreciation and amortization  (a)     |       | 666,214                                |       | 273,479                               |       | 1,420,729 |   | 507,788 |   |
| Funds from Operations                              |       | $                                      | 433,457    |                                  | 93,799     |   | $ | (1,849,108 | ) | $ | 168,607 |   |
| Funds from Operations per common share             |       | $                                      | 0.02       |                                  | $          | 0.10 |   | $ | (0.10 | ) | $ | 0.21 |   |
| Weighted average common shares outstanding         |       | 20,514,716                             |       | 955,433                               |       | 18,585,837 |   | 789,148 |   |

 

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(a)  Excludes depreciation of non-real estateassets of $7,182 and $1,125 for the three months ended September 30, 2004 and2003, respectively, and $16,261 and $2,625 for the nine months ended September30, 2004 and 2003, respectively.

 

RISK FACTORS

 

RISKS RELATED TO OUR BUSINESS AND PROPERTIES

 

WE COMMENCED OPERATIONS IN DECEMBER 2002. OURMANAGEMENT ONLY RECENTLY JOINED US AND DOES NOT HAVE ANY EXPERIENCE OPERATING AREIT OR A PUBLIC COMPANY.

 

We commencedoperations in December 2002. We are, therefore, subject to the risks associatedwith the operation of any new business. Further, our president and chiefexecutive officer joined us in September 2003, our chief financial officerjoined us in September 2003, our director of asset acquisition joined us in December2003, our director of asset management joined us in December 2003, and theremainder of our management joined us in 2004. Our management does not have anyexperience operating a

 

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REIT or a publicly-ownedcompany. Consequently, you will be unable to fully evaluate our management’spublic company operational abilities. Given our recent organization andmanagement experience, you should be especially cautious in drawing conclusionsabout our ability to execute our business plan.

 

THE PACE OF OUR PROPERTY ACQUISITIONS TO DATEHAS RESULTED IN CASH FLOW THAT IS INSUFFICIENT TO COVER DIVIDENDS AT THEIRCURRENT LEVEL.

 

We acquiredone property for an amount of $5.1 million in the first quarter of 2004, twoproperties for an aggregate amount of $39.2 million in the second quarter of2004 and two properties for an aggregate amount of $25.2 in the third quarterof 2004. Net income from the properties we own has been significantly less thanthe dividends we have paid to date. In order to continue to pay dividends attheir current level the Company will be required to use the equity capital weraised in the Offering which was completed in January 2004.

 

THE CLOSINGS OF OUR PROPERTY ACQUISITIONS ARESUBJECT TO CONDITIONS THAT MAY PREVENT US FROM ACQUIRING SUCH PROPERTIES.

 

Our ability tocomplete acquisitions depends upon many factors, such as the negotiation ofdefinitive purchase agreements, the satisfaction of due diligence, completionof construction, and satisfaction of customary closing conditions. Anyinability to complete acquisitions within our anticipated time frames may harmour financial results and our ability to pay dividends.

 

OUR USE OF DEBT FINANCING COULD DECREASE OURCASH FLOW AND EXPOSE US TO RISK OF DEFAULT UNDER OUR DEBT DOCUMENTS.

 

Our policy isto use debt to finance, on average, approximately 75% of the acquisition costof the properties that we buy. As of September 30, 2004, we had approximately$56.3 million of outstanding indebtedness.

 

Since weanticipate that our cash flow from operations will be insufficient to repay allof our indebtedness prior to maturity, we expect that we will have to repaydebt through refinancings, sale of properties or sale of additional equity. Ifwe are unable to refinance our indebtedness on acceptable terms, or at all, wemight be forced to dispose of one or more of our properties on unfavorableterms, which might result in losses to us and which might adversely affect ourcash available for distribution to our stockholders. If prevailing interestrates or other factors at the time of a refinancing result in higher interestrates on such refinancing, our interest expense would increase, which couldseriously harm our operating results and financial condition and our ability topay dividends.

 

Our debt and any increase in our debt may bedetrimental to our business and financial results by:

 

•    requiringus to use a substantial portion of our cash flow from operations to payinterest, which reduces the amount available for the operation of ourproperties or the payment of dividends;

 

•    violatingrestrictive covenants in our loan documents, which would entitle the lenders toaccelerate our debt obligations and foreclose on our properties;

 

•    placingus at a competitive disadvantage compared to our competitors that have lessdebt;

 

•    makingus more vulnerable to economic and industry downturns and reducing ourflexibility in responding to changing business and economic conditions;

 

•    requiringus to sell one or more properties, possibly on unfavorable terms; and

 

•    limitingour ability to borrow funds for operations or to finance acquisitions in thefuture or to refinance our indebtedness at maturity on terms as or morefavorable than the terms of our original indebtedness.

 

OUR ABILITY TO OBTAIN DEBT FINANCING COULD BEIMPAIRED OR DELAYED DUE TO UNDERWRITING RESTRICTIONS APPLICABLE TO THE TYPE OFPROPERTIES WE ACQUIRE

 

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Our policy isto obtain debt financing related to properties we buy.  Because of the single tenant nature of theproperties we acquire, mortgage underwriters take certain additionalprecautions intended to assure that the remaining mortgage balance is paid atthe end of the loan term.  Also, formortgages which have an amortization schedule longer than the lease term, dueto the high initial per square foot cost of the property being acquired,mortgage lenders consider the high per square foot remaining principal balanceat the end of the mortgage term as a negative with regard to the potentialapproval of the loan.

 

BECAUSE OUR PRINCIPAL TENANT IS THE U.S.GOVERNMENT, OUR PROPERTIES MAY HAVE A HIGHER RISK OF TERRORIST ATTACK THANSIMILAR PROPERTIES THAT ARE LEASED TO NON-GOVERNMENTAL TENANTS.

 

Because ourprincipal tenant is the U.S. government, our properties may have a higher riskof terrorist attack than similar properties that are leased to non-governmentaltenants. Terrorist attacks may negatively affect our operations and aninvestment in our common stock. We cannot assure you that there will not befurther terrorist attacks against the United States or the United Statesgovernment. Some of our properties could be considered “high profile”government buildings, which may make these properties more likely to be viewedas terrorist targets. These attacks or armed conflicts may directly impact thevalue of our properties through damage, destruction, loss or increased securitycosts. Certain losses resulting from these types of events are uninsurable andothers would not be covered by our current terrorism insurance. Additionalterrorism insurance may not be available at a reasonable price or at all.

 

WE DEPEND ON THE U.S. GOVERNMENT FOR MOST OFOUR REVENUES. ANY FAILURE BY THE U.S. GOVERNMENT TO PERFORM ITS OBLIGATIONS ORRENEW ITS LEASES UPON EXPIRATION MAY HARM OUR CASH FLOW AND ABILITY TO PAYDIVIDENDS.

 

Rent from theU.S. government represented 100% of our revenues from continuing operations forthe nine months ended September 30, 2004 and for the year ended December 31,2003. In addition, the U.S. government leased 100% of our total leased squarefeet of property not held for sale as of September 30, 2004. Any default by theU.S. government, or its failure to renew its leases with us upon theirexpiration, could cause interruptions in the receipt of lease revenue or resultin vacancies, or both, which would reduce our revenue until the affectedproperty is leased, and could decrease the ultimate value of the affectedproperty upon sale. Further, failure on the part of a tenant to comply with theterms of a lease may give us the right to terminate the lease, repossess theapplicable property and enforce the payment obligations under the lease;however, we would be required to find another tenant. We cannot assure you thatwe would be able to find another tenant without incurring substantial costs, orat all, or that, if another tenant were found, we would be able to enter into anew lease on favorable terms. Our leases with the U.S. government provide thatthe U.S. government may assign the lease and be relieved from all obligationsunder the lease, other than unpaid rent and other liabilities outstanding onthe date of the assignment, subject to our prior written consent, which we maynot unreasonably withhold. If this were to occur, it is unlikely that asuccessor tenant would have the same credit strength as the U.S. government.

 

AN INCREASE IN THE OPERATING COSTS OF OURGOVERNMENT-LEASED PROPERTIES WOULD HARM OUR CASH FLOW AND ABILITY TO PAYDIVIDENDS.

 

Our objectiveis to acquire government-leased properties in which the tenant is whollyresponsible for any increases in operating costs that apply to the property.However, this type of triple-net lease is not typical of the leases enteredinto through the GSA. Under present practice, most GSA leases cover increasesin real estate taxes above a base amount. These GSA leases also increase thatportion of the rent applicable to other operating expenses by an agreed uponpercentage based upon the Consumer Price Index. To the extent operating costsother than real estate taxes increase at a rate greater than the specifiedpercentage, our cash flow would be harmed and our ability to pay dividends maybe harmed.

 

IF WE ARE UNABLE TO LEASE PROPERTIES THAT AREPARTIALLY OR COMPLETELY VACANT, WE MAY BE REQUIRED TO RECOGNIZE AN IMPAIRMENTLOSS WITH RESPECT TO THE CARRYING VALUES OF THESE PROPERTIES, WHICH MAYSERIOUSLY HARM OUR OPERATING RESULTS AND FINANCIAL CONDITION.

 

We intend toacquire properties that are fully leased to government entities. However, anyof our properties may become partially or completely vacant in the future. Ifwe are unable to lease these properties and generate sufficient cash flow torecover the carrying value of these properties, we may be required to recognizean impairment loss, which could seriously harm our operating results andfinancial condition.

 

RESTRICTIVE COVENANTS IN OUR LOAN DOCUMENTSMAY RESTRICT OUR OPERATING OR ACQUISITION ACTIVITIES, WHICH MAY HARM OURFINANCIAL CONDITION AND OPERATING RESULTS.

 

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The mortgageson our properties contain customary restrictive covenants, including provisionsthat may limit the borrowing subsidiary’s ability, without the prior consent ofthe lender, to incur additional indebtedness, further mortgage or transfer theapplicable property, purchase or acquire additional property, discontinueinsurance coverage, change the conduct of its business or make loans oradvances to, enter into any transaction of merger or consolidation with, oracquire the business, assets or equity of, any third party. In addition, ourfuture lines of credit or loans may contain financial covenants, furtherrestrictive covenants and other obligations. If we breach covenants or obligationsin our debt agreements, the lender can generally declare a default and requireus to repay the debt immediately and, if the debt is secured, can foreclose onthe property securing the loan. In order to meet our debt service obligations,we may have to sell properties either potentially at a loss or at times thatprohibit us from achieving attractive returns. Any failure to pay ourindebtedness when due or failure to cure events of default could result inhigher interest rates during the period of the loan default and couldultimately result in the loss of properties through foreclosure.

 

INCREASING COMPETITION FOR THE ACQUISITION OFGOVERNMENT-LEASED PROPERTIES MAY IMPEDE OUR ABILITY TO MAKE FUTURE ACQUISITIONSOR MAY INCREASE THE COST OF THESE ACQUISITIONS, WHICH COULD HARM OUR OPERATINGRESULTS AND FINANCIAL CONDITION.

 

We competewith many other entities for the acquisition of government-leased properties.Our competitors include financial institutions, institutional pension funds,other REITs, other public and private real estate companies and private realestate investors. These competitors may prevent us from acquiring desirableproperties or increase the price we must pay for our real estate investments.Our competitors may have greater resources than we do, and may be willing topay more for similar property. In particular, larger REITs may enjoysignificant competitive advantages that result from, among other things, alower cost of capital and enhanced operating efficiencies. In addition, the numberof entities and the amount of funds competing for government-leased propertiesmay increase, resulting in increased demand and increased prices paid for theseproperties. If we are forced to pay higher prices for properties, ourprofitability may decrease, and our stockholders may experience a lower returnon their investment. Increased competition for properties may also preclude usfrom acquiring those that would generate attractive returns to us.

 

WE MAY HAVE LIMITED TIME TO PERFORM DUEDILIGENCE ON MANY POTENTIAL PROPERTY ACQUISITIONS, WHICH COULD RESULT IN THELOSS OF ACQUISITION OPPORTUNITIES.

 

When we enterinto an agreement to acquire a property, we often have limited time to completeour due diligence prior to acquiring the property.  Pursuant to Company policy, if we cannotcomplete our full due diligence review process within the time allotted, wewill decline to proceed with an attempt to acquire the property.  Accordingly, we may lose property acquisitionsdue to lack of sufficient time to complete the due diligence utilized under oursystem.

 

OUR CASH FLOW IS NOT ASSURED. WE MAY NOT PAYDIVIDENDS IN THE FUTURE.

 

We intend todistribute to our stockholders all or substantially all of our taxable REITincome each year in order to comply with the distribution requirements of thefederal tax laws and to avoid federal income tax and the nondeductible excisetax. We have not established a minimum dividend payment level. Our ability topay dividends may be adversely affected by the risks described in this report.All distributions will be made at the discretion of our board of directors andwill depend on our earnings, our financial condition, maintenance of our REITstatus and other factors that our board of directors may deem relevant fromtime to time. We cannot assure you that we will be able to pay dividends in thefuture.

 

Our ability topay dividends is based on many factors, including:

 

•    ourability to make additional acquisitions;

 

•    oursuccess in negotiating acceptable mortgage terms;

 

•    oursuccess in negotiating acceptable lease terms;

 

•    ourtenants’ ability to perform under their leases; and

 

•    efficientmanagement of our properties.

 

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We also cannotassure you that the level of our dividends will increase over time or thereceipt of rental revenue in connection with future acquisitions of propertieswill increase our cash available for distribution to stockholders. In the eventof defaults or lease terminations by our tenants, rental payments coulddecrease or cease, which would result in a reduction in cash available fordistribution to our stockholders. If our cash available for distributionsgenerated by our assets is less than our expected dividend distributions, or ifsuch cash available for distribution decreases in future periods from expectedlevels, our ability to make the expected distributions would be adverselyaffected. Any such failure to make expected distributions may result in adecrease in the market price of our stock.

 

OUR BOARD OF DIRECTORS MAY ALTER OURINVESTMENT POLICIES AT ANY TIME WITHOUT STOCKHOLDER APPROVAL.

 

Our board ofdirectors may alter our investment policies at any time without stockholderapproval. Changes to these policies may adversely affect our financialperformance.

 

WE HAVE INCURRED HISTORICAL LOSSES AND MAYINCUR FUTURE LOSSES.

 

We have hadhistorical accounting losses of $3.3 million for the nine months endedSeptember 30, 2004 and $0.4 million for the year ended December 31, 2003, andhad an accumulated deficit of $3.7 million as of September 30, 2004. We cannotassure you that we will not have similar losses in the future.

 

RISKS RELATED TO OUR ORGANIZATION ANDSTRUCTURE

 

WE DEPEND ON KEY PERSONNEL WITH LONG-STANDINGBUSINESS RELATIONSHIPS, THE LOSS OF WHOM COULD THREATEN OUR ABILITY TO OPERATEOUR BUSINESS SUCCESSFULLY.

 

Our futuresuccess depends, to a significant extent, upon the continued services of ThomasD. Peschio, our president and chief executive officer, and of the other membersof our management team. In particular, the relationships that Mr. Peschio andthe other members of our management team have developed with existing andprospective developers of government-leased properties is critically importantto the success of our business. Although we have an employment agreement withMr. Peschio and other key executives, we cannot assure you that Mr. Peschio orthe other executives will remain employed with us. We do not maintain keyperson life insurance on any of our officers. The loss of services of Mr.Peschio or other senior managers would harm our business and our prospects.

 

OUR BOARD OF DIRECTORS MAY AUTHORIZE THEISSUANCE OF ADDITIONAL SHARES THAT MAY CAUSE DILUTION.

 

In connectionwith future equity offerings, the board of directors may authorize the issuanceof additional shares of common stock. The issuance of additional shares couldsubstantially dilute our existing stockholders.

 

OUR BOARD OF DIRECTORS MAY AUTHORIZE THEISSUANCE OF SHARES WITH DIFFERING DIVIDEND RIGHTS THAT COULD HARM OURSTOCKHOLDERS’ RIGHT TO RECEIVE DIVIDENDS.

 

Our board ofdirectors has the power to issue preferred stock or other securities that havedistribution rights senior to that of the common stock. Any superior dividendrights could prevent us from paying dividends to the holders of our commonstock.

 

OUR RIGHTS AND THE RIGHTS OF OUR STOCKHOLDERSTO TAKE ACTION AGAINST DIRECTORS AND OFFICERS ARE LIMITED.

 

Maryland lawprovides that a director has no liability in that capacity if he or sheperforms his or her duties in good faith, in a manner he or she reasonablybelieves to be in our best interests and with the care that an ordinarilyprudent person in a like position would use under similar circumstances. Ourgoverning documents obligate us to indemnify our directors and officers foractions taken by them in those capacities to the extent permitted by Marylandlaw. Generally, Maryland law permits indemnification except in instances wherethe person seeking indemnification acted in bad faith or with active anddeliberate dishonesty, or in instances where the person actually received animproper personal benefit in money, property or services or, in the case of acriminal proceeding, the person had reasonable cause to believe that his or heractions were unlawful. Additionally, we may be obligated to fund the defense

 

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costs incurred by our directorsand officers. In addition, our governing documents limit the liability of ourdirectors and officers for money damages, except for liability resulting from:

 

•    actualreceipt of an improper benefit or profit in money, property or services; or

 

•    afinal judgment based upon a finding of active and deliberate dishonesty by thedirector, trustee or officer that was material to the - cause of actionadjudicated.

 

As a result,we and our stockholders may have more limited rights against our directors andofficers than might otherwise exist.

 

OUR OWNERSHIP LIMITATIONS MAY RESTRICTBUSINESS COMBINATION OPPORTUNITIES.

 

To qualify asa REIT under the federal tax laws, no more than 50% of our outstanding sharesmay be owned, directly or indirectly by five or fewer individuals (as definedin the federal tax laws to include certain entities) during the last half ofeach taxable year (other than our first REIT taxable year). To preserve ourREIT status, our charter generally prohibits direct or indirect ownership byany person of more than 9.8% of the number or value of outstanding shares ofany class of our securities, including our common stock. Generally, commonstock owned by affiliated owners will be aggregated for purposes of theownership limitation. Any transfer of our common stock that would disqualifyour REIT status will be null and void, and the intended transferee will acquireno rights in such stock. The ownership limitation could have the effect ofdelaying, deterring or preventing a change in control or other transaction inwhich holders of common stock might receive a premium for their common stockover the then current market price or which such holders might believe to beotherwise in their best interest. Further, shares that are transferred inexcess of the 9.8% ownership limit will be designated as “excess shares”subject to redemption. The ownership limitation provisions also may make ourcommon stock an unsuitable investment vehicle for any person seeking to obtain,either alone or with others as a group, ownership of more than 9.8% of thenumber or value of outstanding shares of any class of our securities.

 

THE VOTING POWER OVER OUR SHARES IS CURRENTLYCONCENTRATED IN A RELATIVIELY SMALL NUMBER OF UNRELATED INVESTMENT MANAGERS

 

While ourshares are owned beneficially by numerous investors, many of these persons orentities are represented by investment managers.  These investment managers may have beengranted the right by their investor clients to vote our shares.  As a consequence, we believe a relativelysmall number of investment managers could, if acting in concert, vote amajority of the Company’s shares to achieve a common objective.

 

PROVISIONS OF OUR CHARTER DOCUMENTS COULDDETER A TAKEOVER, WHICH COULD INHIBIT OUR STOCKHOLDERS’ ABILITY TO RECEIVE ANACQUISITION PREMIUM FOR THEIR SHARES.

 

Provisions ofour charter and bylaws could make it more difficult for a third party toacquire us, even if doing so would be beneficial to our stockholders.

 

MARYLAND LAW MAY DISCOURAGE A THIRD PARTYFROM ACQUIRING US, WHICH COULD INHIBIT YOUR ABILITY TO RECEIVE AN ACQUISITIONPREMIUM FOR YOUR SHARES.

 

Maryland law providesbroad discretion to our board of directors with respect to its duties inconsidering a change in control of our company, including that our board issubject to no greater level of scrutiny in considering a change in controltransaction than with respect to any other act by our board.

 

Maryland lawrestricts mergers and other business combinations between our company and aninterested stockholder. An “interested stockholder” is defined as any personwho is the beneficial owner of 10% or more of the voting power of our commonstock and also includes any of our affiliates or associates that, at any timewithin the two year period prior to the date of a proposed merger or otherbusiness combination, was the beneficial owner of 10% or more of our voting power.A person is not an interested stockholder if, prior to the most recent time atwhich the person would otherwise have become an interested stockholder, ourboard of directors approved the transaction which otherwise would have resultedin the person becoming an interested stockholder. For a period of five yearsafter the most recent acquisition of shares by an interested stockholder, wemay not engage in any merger or other business combination with that interestedstockholder or any affiliate of that interested stockholder. After the fiveyear period, any merger or other business combination must be approved by ourboard of directors and by at least 80% of all the votes entitled to be cast byholders of outstanding voting stock and two-thirds of all the votes entitled tobe cast by holders of outstanding voting stock

 

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other than the interestedstockholder or any affiliate or associate of the interested stockholder unless,among other things, the stockholders (other than the interested stockholder)receive a minimum price for their common stock and the consideration receivedby those stockholders is in cash or in the same form as previously paid by theinterested stockholder for its common stock. These provisions of the businesscombination statute do not apply to business combinations that are approved orexempted by our board of directors prior to the time that the interestedstockholder becomes an interested stockholder. However, the business combinationstatute could have the effect of discouraging offers from third parties toacquire us and increasing the difficulty of successfully completing this typeof offer.

 

OUR CHIEF EXECUTIVE OFFICER AND CHIEFFINANCIAL OFFICER HAVE EMPLOYMENT AGREEMENTS THAT PROVIDE THEM WITH BENEFITS INTHE EVENT THEIR EMPLOYMENT IS TERMINATED, WHICH COULD PREVENT OR DETER APOTENTIAL ACQUIRER FROM PURSUING A CHANGE OF CONTROL OF OUR COMPANY.

 

We haveentered into employment agreements with Thomas D. Peschio, our president andchief executive officer, and Nancy D. Olson, our treasurer and chief financialofficer, which provide them with severance benefits if their employment endsdue to a termination by us without cause. In the case of such termination, wewould have to pay severance and the vesting of their restricted stock willaccelerate. Mr. Peschio also has the right to terminate his employmentagreement upon a change of control of our company. These agreements couldprevent or deter a change of control of our company that might involve apremium price for our common stock or otherwise be in the best interests of ourstockholders.

 

RISKS RELATED TO THE REAL ESTATE INDUSTRY

 

MORTGAGE DEBT OBLIGATIONS EXPOSE US TOINCREASED RISK OF PROPERTY LOSSES, WHICH COULD HARM OUR FINANCIAL CONDITION,CASH FLOW AND ABILITY TO SATISFY OUR OTHER DEBT OBLIGATIONS AND PAY DIVIDENDS.

 

Our policy isto use debt to finance, on average, approximately 75% of the acquisition costof the properties that we buy. Incurring mortgage debt increases our risk ofproperty losses because defaults on indebtedness secured by properties mayresult in foreclosure actions initiated by lenders and ultimately our loss ofthe property securing any loans for which we are in default. For tax purposes,a foreclosure of any of our properties would be treated as a sale of theproperty for a purchase price equal to the outstanding balance of the debtsecured by the mortgage. The outstanding balance of the debt secured by themortgage could exceed our tax basis in the property. If this occurs, we wouldrecognize taxable income on foreclosure, but would not receive any cashproceeds. As a result, we may be required to identify and utilize other sourcesof cash to pay our taxes, which may result in a decrease in cash available fordistribution to our stockholders.

 

In addition,our default under any one of our mortgage debt obligations may increase therisk of our default on our other indebtedness. If this occurs, our financialcondition, cash flow and ability to satisfy our other debt obligations orability to pay dividends may be harmed.

 

ILLIQUIDITY OF REAL ESTATE INVESTMENTS COULDSIGNIFICANTLY IMPEDE OUR ABILITY TO RESPOND TO ADVERSE CHANGES IN THEPERFORMANCE OF OUR PROPERTIES AND HARM OUR FINANCIAL CONDITION.

 

Because realestate investments are relatively illiquid, our ability to promptly sell one ormore properties in our portfolio in response to changing economic, financialand investment conditions is limited. The real estate market is affected bymany factors that are beyond our control, including:

 

•    adversechanges in national and local economic and market conditions;

 

•    changesin interest rates and in the availability, cost and terms of debt financing;

 

•    changesin governmental laws and regulations, fiscal policies and zoning ordinances andcosts of compliance with laws and regulations, fiscal policies and ordinances;

 

•    theongoing need for capital improvements, particularly in older structures;

 

•    changesin operating expenses; and

 

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•    civilunrest, acts of war and natural disasters, including earthquakes and floods,which may result in uninsured and underinsured losses.

 

We cannotpredict whether we will be able to sell any property for the price or on theterms set by us, or whether any price or other terms offered by a prospectivepurchaser would be acceptable to us. We also cannot predict the length of timeneeded to find a willing purchaser and to close the sale of a property. Thesefactors and any others that would impede our ability to respond to adversechanges in the performance of our properties could harm our operating resultsand financial condition, as well as our ability to pay dividends tostockholders.

 

COMPLIANCE WITH ENVIRONMENTAL LAWS COULDMATERIALLY INCREASE OUR OPERATING EXPENSES.

 

Our propertiesmay be subject to environmental liabilities. An owner of real property can faceliability for environmental contamination created by the presence or dischargeof hazardous substances on the property. We may face liability regardless of:

 

•    ourknowledge of the contamination;

 

•    thetiming of the contamination;

 

•    thecause of the contamination; or

 

•    theparty responsible for the contamination of the property.

 

There may beenvironmental problems associated with our properties of which we are unaware.Some of our properties use, or may have used in the past, underground tanks forthe storage of petroleum-based or waste products that could create a potentialfor release of hazardous substances. If environmental contamination exists onour properties, we could become subject to strict, joint and several liabilityfor the contamination by virtue of our ownership interest.

 

The presenceof hazardous substances on a property may adversely affect our ability to sellthe property and we may incur substantial remediation costs. In addition,although we may require in our leases that tenants operate in compliance withall applicable laws and to indemnify us against any environmental liabilitiesarising from a tenant’s activities on the property, we could nonetheless besubject to strict liability by virtue of our ownership interest, and we cannotbe sure that our tenants would satisfy their indemnification obligations underthe applicable sales agreement or lease. The discovery of environmentalliabilities attached to our properties could harm our results of operations andfinancial condition and our ability to pay dividends to stockholders.

 

OUR PROPERTIES MAY CONTAIN OR DEVELOP HARMFULMOLD, WHICH COULD LEAD TO LIABILITY FOR ADVERSE HEALTH EFFECTS AND COSTS OFREMEDIATING THE PROBLEM.

 

When excessivemoisture accumulates in buildings or on building materials, mold growth mayoccur, particularly if the moisture problem remains undiscovered or is notaddressed over a period of time. Some molds may produce airborne toxins orirritants. Concern about indoor exposure to mold has been increasing asexposure to mold may cause a variety of adverse health effects and symptoms,including allergic or other reactions. As a result, the presence of significantmold at any of our properties could require us to undertake a costlyremediation program to contain or remove the mold from the affected property.In addition, the presence of significant mold could expose us to liability fromour tenants, employees of our tenants and others if property damage for healthconcerns arise.

 

COMPLIANCE WITH THE AMERICANS WITHDISABILITIES ACT AND FIRE, SAFETY AND OTHER REGULATIONS MAY REQUIRE US TO MAKEUNEXPECTED EXPENDITURES THAT ADVERSELY IMPACT OUR ABILITY TO PAY DIVIDENDS.

 

Some or all ofour properties may be required to comply with the Americans with DisabilitiesAct, or the ADA. The ADA has separate compliance requirements for “publicaccommodations” and “commercial facilities,” but generally requires thatbuildings be made accessible to people with disabilities. Compliance with theADA requirements could require removal of access barriers and non-compliancecould result in imposition of fines by the U.S. government or an award ofdamages to private litigants, or both. We will attempt to shift the cost ofcompliance with the ADA to our tenants whenever possible. However, if we areunable to negotiate lease terms to this effect, if required changes involvegreater expenditures than anticipated, or if the changes must be made on a moreaccelerated basis than anticipated, we could be required to expend our ownfunds to comply with the provisions of the ADA, which

 

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could adversely affect our results ofoperations and financial condition and our ability to make distributions tostockholders. In addition, we are required to operate our properties incompliance with fire and safety regulations, building codes and other land useregulations, as they may be adopted by governmental agencies and bodies andbecome applicable to our properties. We may be required to make substantialcapital expenditures to comply with those requirements and these expenditurescould harm our ability to pay dividends to our stockholders.

 

AN UNINSURED LOSS OR A LOSS THAT EXCEEDS THEINSURANCE POLICY LIMITS ON OUR PROPERTIES COULD SUBJECT US TO LOST CAPITAL ORREVENUE ON THOSE PROPERTIES.

 

Some of ourproperties may be covered by flood and earthquake insurance policies obtained byand paid for by the tenants as part of their risk management programs.Additionally, we have obtained blanket liability, flood and property damageinsurance policies to protect us and our properties against loss should theindemnities and insurance policies provided by the tenants fail to restore theproperties to their condition prior to a loss. All of these policies mayinvolve substantial deductibles and certain exclusions. In certain areas, wemay have to obtain earthquake insurance on specific properties as required byour lenders or by law. We have also obtained terrorism insurance on all of ourGSA-leased properties, but this insurance is subject to exclusions for loss ordamage caused by nuclear substances, pollutants, contaminants and biological andchemical weapons. Should a loss occur that is uninsured or in an amountexceeding the combined aggregate limits for the policies noted above, or in theevent of a loss that is subject to a substantial deductible under an insurancepolicy, we could lose all or part of our capital invested in, and anticipatedrevenue from, one or more of the properties, which could harm our operationsresults and financial condition, as well as our ability to pay dividends tostockholders at historical levels or at all.

 

TAX RISKS OF OUR BUSINESS AND STRUCTURE

 

AN INVESTMENT IN OUR COMMON STOCK HAS VARIOUSTAX RISKS THAT COULD AFFECT THE VALUE OF OUR STOCKHOLDERS’ INVESTMENT,INCLUDING THE TREATMENT OF DISTRIBUTIONS IN EXCESS OF EARNINGS, THE TIMING OFDIVIDEND PAYMENTS, AND THE INABILITY TO APPLY “PASSIVE LOSSES” AGAINSTDISTRIBUTIONS.

 

The effects offederal, state and local income tax law on an investment in our common stockare complex, including the treatment of distributions in excess of current andaccumulated earnings and profits, to the extent that they exceed the adjustedbasis of an investor’s common stock, as long-term capital gain (or short-termcapital gain if the shares have been held for less than one year), thetreatment of any dividend declared by us in October, November or December ofany year payable to a stockholder of record on a specific date in any suchmonth as being paid by us and received by the stockholder on December 31 ofsuch year, the treatment of any gain or loss realized upon a taxable dispositionof shares by a stockholder who is not a dealer in securities as a long-termcapital gain or loss if the shares have been held for more than one year,otherwise as short-term capital gain or loss, the treatment of distributionsthat we properly designate as capital gain dividends as taxable to stockholdersas gains (to the extent that they do not exceed our actual net capital gain forthe taxable year) from the sale or disposition of a capital asset held forgreater than one year, and the failure to treat distributions we make and gainarising from the sale or exchange by a stockholder of shares of our stock aspassive income, meaning stockholders generally will not be able to apply any “passivelosses” against such income or gain.

 

FUTURE DISTRIBUTIONS MAY INCLUDE ASIGNIFICANT PORTION AS A RETURN OF CAPITAL. WHILE WE HAVE NOT BORROWED FOR THESPECIFIC PURPOSE OF PAYING DISTRIBUTIONS IN THE PAST, OUR PRIOR BORROWINGSALLOWED US TO PAY DISTRIBUTIONS FROM OUR CASH FLOW FROM OPERATIONS.

 

Ourdistributions to date have exceeded the amount of our income as a REIT.Distributions in excess of our income will be treated as a return of capital tothe extent of the stockholder’s basis in our stock and the stockholder’s basisin our stock will be reduced by such amount. To the extent distributions exceeda stockholder’s basis in our stock, the stockholder will recognize capitalgain, assuming the stock is held as a capital asset. All of our priordistributions consisted of a return of capital.

 

DISTRIBUTION REQUIREMENTS IMPOSED BY LAWLIMIT OUR FLEXIBILITY IN EXECUTING OUR BUSINESS PLAN.

 

As a REIT, wegenerally are required to distribute to our stockholders at least 90% of ourtaxable REIT income each year in order to maintain our status as a REIT forfederal income tax purposes. Taxable REIT income is determined without regardto the deduction for dividends paid and by excluding net capital gains. We arealso required to pay tax at regular corporate rates to the extent that wedistribute less than 100% of our taxable income (including net capital gains)each year. In addition, we are required to pay 4% nondeductible excise tax onthe amount, if any, by which certain distributions we pay with respect to anycalendar year are less than

 

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the sum of 85% of our ordinary income forthat calendar year, 95% of our capital gain net income for the calendar yearand any amount of our income that was not distributed in prior years.

 

We intend todistribute to our stockholders all or substantially all of our taxable REITincome each year in order to comply with the distribution requirements of thefederal tax laws and to avoid federal income tax and the nondeductible excisetax. Differences in timing between the receipt of income and the payment ofexpenses in arriving at taxable REIT income and the effect of required debtamortization payments could require us to borrow funds on a short-term basis tomeet the distribution requirements that are necessary to achieve the taxbenefits associated with qualifying as a REIT.

 

WE MAY INCUR ADDITIONAL INDEBTEDNESS IN ORDERTO MEET OUR DISTRIBUTION REQUIREMENTS. WHILE WE HAVE NOT BORROWED FOR THESPECIFIC PURPOSE OF PAYING DISTRIBUTIONS, OUR PRIOR BORROWINGS ALLOWED US TOPAY DISTRIBUTIONS FROM OUR CASH FLOW FROM OPERATIONS.

 

As a REIT, weare required to distribute at least 90% of our taxable REIT income, whichlimits the amount of cash we will have available for other business purposes,including amounts to fund our growth. It is possible that the differencesbetween the time we actually receive revenue or pay expenses and the period wereport those items for distribution purposes, and potentially insufficientcash, could result in our having to borrow funds on a short-term basis to meetthe 90% distribution requirement. While we have not borrowed for the specificpurpose of paying distributions, our prior borrowings allowed us to paydistributions from our operations. These borrowings may decrease cash availablefor distribution.

 

OUR DISPOSAL OF PROPERTIES MAY HAVE NEGATIVEIMPLICATIONS, INCLUDING UNFAVORABLE TAX CONSEQUENCES.

 

If we make asale of a property directly, and it is deemed to be a sale of dealer propertyor inventory, the sale may be deemed to be a “prohibited transaction” under theprovisions of the federal tax laws applicable to REITs, in which case our gainfrom the sale would be subject to a 100% penalty tax. If we believe that a saleof a property might be treated as a prohibited transaction, we will attempt tostructure a sale through a taxable REIT subsidiary, in which case the gain fromthe sale would be subject to corporate income tax but not the 100% prohibitedtransaction tax. We cannot assure you, however, that the IRS would not assertsuccessfully that sales of properties that we make directly, rather thanthrough a taxable REIT subsidiary, were sales of dealer property or inventory,in which case the 100% penalty tax would apply.

 

IF WE FAIL TO REMAIN QUALIFIED AS A REIT, OURDIVIDENDS WILL NOT BE DEDUCTIBLE BY US, AND OUR INCOME WILL BE SUBJECT TOTAXATION.

 

If we fail toremain qualified as a REIT, our dividends will not be deductible by us and wewill be subject to a corporate level tax on our taxable income. This wouldsubstantially reduce our cash available to pay dividends and the yield on yourinvestment. Incurring corporate income tax liability might cause us to borrowfunds, liquidate some of our investments or take other steps which couldnegatively affect our operating results. If our REIT status is terminatedbecause of our failure to meet a REIT qualification requirement or if wevoluntarily revoke our election, we would be disqualified from electingtreatment as a REIT for the four taxable years following the year in which REITstatus is lost.

 

WE MAY BE SUBJECT TO FEDERAL INCOME TAX,STATE INCOME, FRANCHISE AND OTHER LOCAL TAXES THAT WOULD HARM OUR FINANCIALCONDITION.

 

Even if wemaintain our status as a REIT, we may become subject to federal incometaxes.  For example, if we have netincome from a sale of dealer property or inventory, that income will be subjectto a 100% penalty tax. In addition, we may not be able to pay sufficientdistributions to avoid corporate income tax and the 4% excise tax onundistributed income.

 

We may also besubject to state and local taxes on our income or property, either directly orat the level of our operating entities through which we indirectly own ourproperties that would aversely affect our operating results. We cannot assureyou that we will be able to maintain REIT status, or that it will be in ourbest interests to continue to do so.

 

WE MAY BE SUBJECT TO ADVERSE LEGISLATIVE ORREGULATORY TAX CHANGES THAT COULD REDUCE THE MARKET PRICE OF OUR COMMON STOCK.

 

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The federaltax laws governing REITs and the administrative interpretations of those lawsmay be amended at any time. Any of those new laws or interpretations may takeeffect retroactively. On May 28, 2003, President Bush signed into law a taxbill that reduces the tax rate on both dividends and long-term capital gainsfor most non-corporate taxpayers to 15% until 2008. This reduced tax rategenerally does not apply to ordinary REIT dividends, which will continue to betaxed at the higher tax rates applicable to ordinary income. This legislationcould cause shares in non-REIT corporations to be a more attractive investmentto individual investors than they had been, and could harm the market price ofour common stock.

 

ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Our futureincome, cash flows and fair values relevant to financial instruments dependupon prevailing market interest rates. Market risk refers to the risk of lossfrom adverse changes in market prices and interest rates.

 

Market RiskRelated to Fixed-Rate Debt

 

As ofSeptember 30, 2004, our debt included fixed-rate mortgage notes with a carryingvalue of $53.2 million (excluding $3.1 million related to a property held forsale). Changes in market interest rates on our fixed-rate debt impacts the fairmarket value of the debt, but it has no impact on interest incurred or cashflow. The sensitivity analysis related to our fixed debt assumes an immediate100 basis point move in interest rates from their actual September 30, 2004levels, with all other variables held constant.

 

A 100 basispoint increase in market interest rates would result in a decrease in the fairvalue of our fixed-rate debt by approximately $2.8 million at September 30,2004. A 100 basis point decrease in market interest rates would result in anincrease in the fair market value of our fixed-rate debt by approximately $3.0million at September 30, 2004.

 

INTEREST RATE SENSITIVITY

 

The followingtable provides information about our financial instruments that are subject tointerest rate sensitivity. The table presents our mortgage notes payable byexpected maturity date and weighted average interest rate as of September 30,2004.

 

INTEREST RATESENSITIVITY

 
| ** **                      | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **THEREAFTER** | ** ** | **TOTAL** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| MORTGAGE NOTES  PAYABLE (A):    |       |     |       |     |       |     |       |     |       |     |       |           |       |      |       |
| Fixed rate amount               |       | $        | 818,445    |     | $          | 867,097  |       | $        | 918,676    |     | $          | 965,159        |       | $         | 27,263,478 |   | $ | 22,359,592 |   | $ | 53,192,447 |   |
| Weighted-average  interest rate |       | 5.71     | %          | 5.71     | %          | 5.71     | %          | 5.72     | %          | 5.49     | %          | 5.97           | %          | 5.71      | %          |
|                                 |            |          |            |          |            |          |            |          |            |          |            |                |            |           |            |  |  |  |  |  |  |  |

 

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(a)  We have excluded $3.1 million of mortgage debtrelated to the Harahan Property which was sold on October 13, 2004.

 

ITEM 4.CONTROLS AND PROCEDURES

 

Evaluation ofdisclosure controls and procedures. Our management continues to review ourinternal controls and procedures and the effectiveness of those controls. As ofthe end of the period covered by this report, we carried out an evaluation,under the supervision and with the participation of our CEO and CFO, of theeffectiveness of the design and operation of our disclosure controls andprocedures pursuant to Rule 13a-15(e) of the Securities Exchange Act of 1934.Based upon that evaluation, our CEO and CFO concluded that our disclosurecontrols and procedures are effective in timely alerting them to materialinformation relating to us (including our consolidated subsidiaries) requiredto be included in our periodic SEC filings.

 

Changes ininternal control over financial reporting. There have been no significantchanges in the Company’s internal controls or in other factors that couldsignificantly affect internal controls during the quarter ended September 30,2004.

 

PART II - OTHER INFORMATION

 

ITEM 2.CHANGES IN SECURITIES AND USE OF PROCEEDS

 

We completed a registered public offering onJanuary 26, 2004. The SEC declared the registration statement for this offering(Form S-11, file nos. 333-109565 and 333-112219) effective on January 26, 2004.We registered 19,320,000 shares of common stock, including 2,520,000 sharessubject to the underwriters’ over-allotment option, with an aggregate publicoffering price of $193.2 million. The offering terminated upon its completion.

 

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The initial public offering commenced onJanuary 6, 2004 and we sold all of the shares that we registered for aggregateproceeds of $193.2 million through an underwriting syndicate managed byFriedman, Billings, Ramsey & Co., Inc., BB&T Capital Markets, aDivision of Scott & Stringfellow, Inc., and Flagstone Securities, LLC. Ourexpenses for the offering included approximately $13.5 million for underwritingdiscounts and commissions, $0.7 million for reimbursement of underwriterexpenses, $2.0 million for other expenses, for a total of $16.2 million. All ofthese expenses were paid directly to the recipients and none were paid to anyof our officers, directors, ten percent or greater stockholders, or affiliates.

 

After payment of the foregoing expenses, wereceived approximately $177.0 million in net proceeds from the offering. As ofNovember 15, 2004, we had used the proceeds as follows:

 

•    approximately$5.0 million to repay outstanding indebtedness;

 

•    approximately$76.1 million, net of related mortgages to complete acquisitions;

 

•    approximately$2.0 million for general working capital purposes; and

 

•    approximately$9.3 million for dividend payments.

 

The remainder of the net proceeds aretemporarily invested in money market investments and will ultimately be usedfor acquisitions and working capital.

 

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ITEM 6.EXHIBITS AND REPORTS ON FORM 8-K

 

(a)  Exhibits:

 
| 31.1 |   | Certification of Chief Executive Officer  pursuant to SEC Rule 13a-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002        |
|------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of Chief Financial Officer  pursuant to SEC Rule 13a-14, 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 |
| 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 |

 

(b)  Reports on Form 8-K:

 

On July 16,2004, we filed a current report on Form 8-K/A to file pro forma financial informationin connection with the acquisition of the Pittsburgh FBI and Lenexa FDAproperties.

 

On August 17,2004 we filed a current report on Form 8-K to furnish our earnings pressrelease and Supplemental Operating and Financial Data package of financialresults for the three months and six months ended June 30, 2004.

 

On September15, 2004 we filed a current report on Form 8-K to report the acquisition of theVeteran Administration Outpatient Clinic in Baton Rouge, Louisiana.

 

On September21, 2004 we filed a current report on Form 8-K to report the acquisition of theHollings Judicial Center Annex in Charleston, South Carolina.

 

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SIGNATURE

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                                | GOVERNMENT PROPERTIES TRUST, INC.                                    |
|-------------------------------------|----------------------------------------------------------------------|
| Date: November 15, 2004   | By:                                                                  | /s/ NANCY D. OLSON |   |
|                                | Nancy D. Olson                                                       |
|                                | Chief Financial Officer and Treasurer  (principal financial officer) |

 

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