Item 1.

Business.

 

General Description of Business

 

We are a Maryland real estate investment trust (“REIT”) organized in December 2003 for the purpose of merging with Hartman Commercial Properties REIT, a Texas real estate investment trust organized in August 1998. We are the surviving entity resulting from the merger, which was consummated on July 28, 2004. We have elected to be taxed as a REIT trust under federal income tax laws. We invest in and operate retail, office and warehouse properties located primarily in the Houston, Dallas and San Antonio, Texas metropolitan areas. In the future, we plan to expand our investments to similar properties in major metropolitan cities in the United States. Each of our properties is leased to one or more tenants.

 

Substantially all of our business is conducted through Hartman REIT Operating Partnership, L.P., a Delaware limited partnership organized in 1998 (the “Operating Partnership”). We are the sole general partner of the Operating Partnership. As of December 31, 2006, we owned a 62.34% interest in the Operating Partnership.

 

On December 31, 2006, we owned 36 properties. All of our properties are located in the Houston, Dallas and San Antonio, Texas metropolitan areas. The properties consist of 19 retail, 6 office and 11 warehouse properties, and each is designed to meet the needs of surrounding local communities. As of December 31, 2006, our properties contained approximately 3,093,000 square feet of gross leasable area in the aggregate.

 

As of December 31, 2006, our properties were approximately 83.3% leased. Substantially all of our revenues consist of base rents received under long-term leases. For the year ended December 31, 2006, our total revenues were approximately $29.8 million. Approximately 84.7% of our existing leases contain “step up” rental clauses that provide for increases in the base rental payments.

 

Business Objectives and Strategy

 

Our strategy is to remain focused on being a value-added commercial property REIT that acquires and expands its ownership of primarily C-class retail, office and warehouse properties. We will look for properties that are under leased and/or under managed in markets with potential upside, and add-value through our management and leasing expertise. The key elements of our strategy include:

 

·

Capitalize on Our Value-Added Acquisition Strategy . We invest in a mixture of (i) properties that we perceive are undervalued due to low occupancy, poor management, market inefficiencies and/or inadequate capitalization where we can create value by using our leasing and property management expertise, and (ii) stabilized properties that are relatively well occupied and managed and provide steady current net operating income with lower growth potential.

 

·

Take Advantage of Economic Cycles . We diversify our property and tenant mixes in order to take advantage of opportunities in, and manage the risks resulting from, different economic cycles that occur among various property types.

 

·

Investment Outside of Texas Market. We seek to invest in similar properties outside of Texas   in cities with exceptional demographics to diversify market risk.

 

·

Selectively Develop Properties . We intend to selectively develop properties where land prices and economic trends indicate higher potential future returns from development than from acquisitions.

 

·

Strengthen Our Balance Sheet. We intend to selectively dispose of assets that have little or no growth potential and recycle the capital into assets having potential for greater returns.

 

Recent Developments

 

Property Management and Advisory Agreements

 

On October 2, 2006, our Board of Trustees (our “Board”) terminated for cause our amended and restated property management agreement, dated September 1, 2004, with Hartman Management, L.P. (“Hartman Management”). Our Board determined that it was in the best interests of HCP and our shareholders to terminate this agreement because of numerous unresolved issues and conflicts of interest between Allen R. Hartman, Hartman Management and HCP. In addition, our Board believed that it was in the best interests of HCP and our shareholders to move forward as a self-managed, self-administered REIT with a new, fully integrated management team.

    In addition, our Board elected not to renew our advisory agreement, dated August 31, 2004, with Hartman Management. This agreement had been extended on a month-to-month basis and ultimately expired on September 30, 2006.

Pursuant to these agreements, Hartman Management had acted as our advisor and manager of our day-to-day operations and portfolio of properties. Mr. Hartman, our former President, Secretary, Chief Executive Officer, and Chairman of the Board, is the sole limited partner of Hartman Management, as well as the president, secretary, sole trustee and sole shareholder of the general partner of Hartman Management. As described below, Mr. Hartman was removed by our Board as our President, Secretary, and Chief Executive Officer on October 2, 2006, and he resigned from our Board on October 27, 2006.

Departure of Directors or Principal Officers; Election of Directors; Appointment of Principal Officer

 

On October 2, 2006, our Board voted to terminate Mr. Hartman from his positions as our President, Secretary and Chief Executive Officer and appointed James C. Mastandrea to serve as our interim Chief Executive Officer and Chairman of our Board. Mr. Mastandrea had served as an independent member of our Board since July 5, 2006. There are no arrangements or understandings between Mr. Mastandrea and any other person pursuant to which Mr. Mastandrea was selected as an officer. Since the beginning of our last fiscal year, Mr. Mastandrea has had no direct or indirect interest in any transaction to which we were a party. On October 27, 2006, Mr. Hartman resigned from our Board.

Litigation between HCP and Allen R. Hartman and Hartman Management

 

In October 2006, we initiated an action in the 333 ^rd Judicial District Court of Harris County, Texas against Mr. Hartman and Hartman Management. We are seeking damages for breach of contract, fraudulent inducement and breach of fiduciary duties.

 

In November 2006, Mr. Hartman and Hartman Management filed a counterclaim against us, the members of our Board, and our Chief Operating Officer, John J. Dee. The counterclaim has since been amended to drop the claims against the individual defendants with the exception of Messrs. Mastandrea and Dee. The amended counterclaim asserts claims against us for alleged breach of contract and alleges that we owe Mr. Hartman and Hartman Management fees for the termination of an advisory agreement. The amended counterclaim asserts claims against Messrs. Mastandrea and Dee for tortious interference with the advisory agreement and a management agreement and conspiracy to seize control of us for their own financial gains. We have indemnified Messrs. Mastandrea and Dee to the extent allowed by our governing documents and Maryland law. The amended counterclaim also asserts claims against our prior outside law firm and one of its partners.

 

Limited discovery has been conducted in this case as of the date of this filing. The case is set for trial in July 2007.

 

It is too early to express an opinion concerning the likelihood of an adverse outcome on the counterclaim, although we intend to vigorously defend against those claims and vigorously prosecute our affirmative claims.

 

In December 2006, we also initiated an action   in the United States District Court for the Southern District of Texas complaining of the attempts by Mr. Hartman and Hartman Management to solicit written consents from shareholders to replace our Board.

 

Mr. Hartman and Hartman Management have filed a counterclaim claiming that changes to our bylaws and declaration of trust are invalid and that their enactment is a breach of fiduciary duty. They are seeking a declaration that the changes to our bylaws and declaration of trust are invalid and an injunction barring their enforcement. These changes, among other things, stagger the terms of our Board members over three years, require two-thirds vote of the outstanding common shares to remove a Board member and provide that our secretary may call a special meeting of shareholders only upon the written request of a majority of outstanding common shares. We believe the changes to our bylaws and declaration of trust are valid under Maryland law and in the best interest of our shareholders. We have filed a motion to dismiss the counterclaims. A group of shareholders has filed a request to intervene in this action to assert claims similar to those asserted by Mr. Hartman and Hartman Management. We have opposed the intervention.

 

There has been limited discovery in this case as of the date of this report. Documents have been produced and interrogatory responses exchanged. We have produced the members of our Board for deposition as well as Mr. Dee. The Court has conducted a hearing on the parties’ cross request for preliminary injunction, but has not yet ruled on that request.

 

It is too early to express an opinion concerning the likelihood of an adverse outcome on the counterclaim, although we intend to vigorously defend against those claims and vigorously prosecute our affirmative claim.

 

Public Offering

 

On September 15, 2004, our Registration Statement on Form S-11, with respect to a public offering of up to 10,000,000 common shares of beneficial interest offered at a price of $10 per share was declared effective under the Securities Act of 1933. The Registration Statement also covered up to 1,000,000 shares available pursuant to our dividend reinvestment plan offered at a price of $9.50 per share. The shares were offered to investors on a best efforts basis. Post-Effective Amendments No. 1, 2 and 3 to the Registration Statement were declared effective by the SEC on June 27, 2005, March 9, 2006 and May 3, 2006, respectively.

 

On October 2, 2006, our Board terminated the public offering. On March 27, 2006, we gave the required ten days notice to our participants informing them that we intend to terminate our dividend reinvestment plan. As a result our dividend reinvestment program will terminate on April 6, 2007.

 

As of December 31, 2006, 2,831,184 shares had been issued pursuant to our public offering with net offering proceeds received of approximately $24.6 million. An additional 138,033 shares had been issued pursuant to the dividend reinvestment plan in lieu of dividends totaling approximately $1.3 million. Shareholders that received shares pursuant to our dividend reinvestment plan on or after October 2, 2006 may have recission rights. See “ Dividend Reinvestment Plan ”   in Item 5 of this report.

 

Investment Objectives and Criteria

 

The following is an overview of our current policies with respect to investments, borrowing, affiliate transactions, equity capital and certain other activities. All of these policies have been established in our governance documents or by our management and may be amended or revised from time to time (and at any time) by our management or trustees without a vote or the approval of our shareholders. We cannot assure you that our policies or investment objectives will be attained or that the value of our common shares will not decrease.

 

General

 

We invest in commercial real estate properties, primarily retail centers, office buildings and warehouse properties. Our primary business and investment objectives are:

 

·

to maximize cash dividends paid to our shareholders;

 

·

to obtain and preserve long-term capital appreciation in the value of our properties to be realized upon our ultimate sale of our properties; and

 

·

to provide our shareholders with liquidity for their investment in us by listing our shares on a national exchange.

 

In addition, to the extent we determine that it is advantageous to make or invest in mortgage loans, we will also seek to obtain fixed income through the receipt of payments on mortgage loans. Our management intends to limit mortgage investments to 15% of our total investment portfolio unless prevailing economic or portfolio circumstances require otherwise. We cannot assure you that we will attain these objectives or that our capital will not decrease. We currently have no investment in mortgage loans.

 

We may not materially change our investment objectives, except upon approval of shareholders holding a majority of our common shares of beneficial interest. Our independent trustees will review our investment objectives at least annually to determine that our policies are in the best interests of our shareholders. Decisions relating to the purchase or sale of our investments will be made by our management, subject to approval by our Board, including a majority of our independent trustees.

 

Acquisition and Investment Policies

 

Although the Company acquired no properties in 2006, we intend to continue to acquire community retail centers, office and warehouse properties for long-term ownership and for the purpose of producing income and generating value growth. We seek to acquire and own properties that generally have business addresses in desirable locations. These properties generally are of high quality construction, offer personalized tenant amenities and attract higher quality tenants. We generally intend to hold our properties for an extended period of time, which we believe is optimal to enable us to capitalize on the potential for increased income and capital appreciation of our properties. However, economic or market conditions may influence us to hold our investments for different periods of time. Also our management believes that targeting this type of property for investment will enhance our ability to enter into joint ventures with other institutional real property investors (such as pension funds, public REITs and other large institutional real estate investors), allowing us greater diversity of investment by increasing the number of properties in which we invest. Our management also believes that by owning a portfolio consisting largely of the diverse types of properties described above we enhance our liquidity opportunities for investors by making the sale of individual properties or multiple properties attractive to purchasers.

 

We acquire properties primarily for income. Historically we have invested in properties that have been constructed and have operating histories. We may in the future, however, become more active in investing in land for development or in properties that are under development or construction where we see the properties having the potential for greater returns than those attainable from completed properties. To the extent feasible, we will invest in a portfolio of properties that will satisfy our investment objectives of maximizing cash available for payment of dividends, preserving our capital and realizing capital appreciation upon the ultimate sale of our properties.

 

Our policy is to acquire properties that are under leased and/or under managed, in markets with potential upside, and add-value through our management and leasing expertise. We anticipate that we will focus on properties in the $1 million to $15 million-value range. We typically lease our properties to a wide variety of tenants on a “triple-net” basis, which means that the tenant is responsible for paying the cost of all maintenance and minor repairs, property taxes and insurance relating to its leased space.

 

Although we currently intend to invest in or develop retail, office and warehouse properties, our future investment or redevelopment activities are not limited to any specified property type or use. We may invest in other commercial properties such as manufacturing facilities, and warehouse and distribution facilities in order to reduce overall portfolio risk, enhance overall portfolio returns, or respond to changes in the real estate market if we believe it would be advantageous to do so.

 

Although we are not limited as to the form our investments may take, all of our properties are owned by the Operating Partnership or by a wholly owned subsidiary of the Operating Partnership in fee simple title. We expect to continue to pursue our investment objectives through the direct ownership of properties. However, in the future, we may also participate with other entities in property ownership, through joint ventures, limited liability companies, partnership, co-tenancies or other types of common ownership. We presently have no plans to own any property jointly with another entity or entities. In addition, we may purchase properties and lease them back to the sellers of these properties. While we will use our best efforts to structure any sale-leaseback transaction so that the lease will be characterized as a “true lease” and we will be treated as the owner of the property for federal income tax purposes, we cannot assure you that the Internal Revenue Service will not challenge this characterization. In the event that a sale-leaseback transaction is re-characterized as a financing transaction for federal income tax purposes, deductions for depreciation and cost recovery relating to that property would be disallowed.

 

Terms of Leases and Tenant Credit Worthiness

 

While the terms and conditions of any lease that we enter into with our tenants may vary substantially from those described herein, we expect that a majority of our leases will be a form of lease customarily used between landlords and tenants in the geographic area where the property is located. These leases generally provide for terms of three to five years and require the tenant to pay a pro rata share of building expenses. In typical leases, the landlord is directly responsible for all real estate taxes, certain sales and use taxes, special assessments, utilities, insurance and building repairs, and other building operation and management costs.

 

Borrowing Policies

 

Our organizational and governance documents generally limit the maximum amount of indebtedness that we may incur to 300% of our net assets as of the date of any borrowing. Notwithstanding the foregoing, we may exceed this borrowing limit if any excess in borrowing over the 300% level is approved by a majority of our independent trustees and disclosed to our shareholders in a subsequent quarterly report. Further, we do not have a policy limiting the amount of indebtedness we may incur or the amount of mortgages which may be placed on any one piece of property. As a general policy, however, we intend to maintain a ratio of total liabilities to total assets that is less than 60%. As of December 31, 2006, we had a ratio of total liabilities to total assets of 45.8%. However, we may not be able to continue to achieve this objective.

 

We will refinance properties during the term of a loan only in limited circumstances, such as when a decline in interest rates makes it beneficial to prepay an existing mortgage, when an existing mortgage matures or if an attractive investment becomes available and the proceeds from the refinancing can be used to purchase that investment. The benefits of the refinancing may include an increased cash flow resulting from reduced debt service requirements, an increase in dividend distributions from proceeds of the refinancing and an increase in property ownership if refinancing proceeds are reinvested in real estate.

 

We may not borrow money from any of our trustees unless the loan is approved by a majority of the trustees, including a majority of the independent trustees not otherwise interested. The trustees must determine that such loan is fair, competitive and commercially reasonable and no less favorable to us than a comparable loan between unaffiliated parties.

 

Disposition Policies

 

Currently we are evaluating all of our properties to determine the best long term course of action for each property. We may determine it is best to sell certain properties and reinvest the proceeds in properties that we believe have greater upside. We might sell a property if we believe the value of the property is expected to decline substantially, an opportunity has arisen to improve other properties that have better long-term prospects for appreciation, we can increase cash flow through the disposition of the property and reinvestment of the net proceeds or the sale of the property is otherwise in our best interests. We generally intend to hold our investments long-term. Economic or market conditions may, however, influence us to hold our investments for different periods of time. The determination of whether a particular property should be sold or otherwise disposed of will be made after consideration of relevant factors including prevailing economic conditions, with a view to achieving maximum capital appreciation. The selling price of a leased property is determined in large part by the amount of rent payable by the tenants.

 

Pursuant to our declaration of trust, if our shares are not listed for trading on the New York Stock Exchange, the American Stock Exchange, the NASDAQ National Market or another national exchange by October 2, 2018, unless this date is extended by the majority vote of both our Board and our independent trustees, we will be required to begin the sale of all of our properties and to distribute to our shareholders the net sale proceeds resulting from our liquidation. If at any time after that date, we are not in the process of either (i) listing our shares for trading on a national securities exchange or including our shares for quotation on the NASDAQ Stock Market or (ii) liquidating our assets, investors holding a majority of our shares may vote to require our liquidation. It is our intention to consider the process of listing or liquidation prior to October 2, 2018. In making the decision to apply for listing, our Board will try to determine whether listing our shares or liquidating our assets will result in greater value for our shareholders. The circumstances, if any, under which our Board would agree to list our shares cannot be determined at this time. Even if our shares are not listed or included for quotation, we are under no obligation to actually sell our portfolio within this period since the precise timing will depend on real estate and financial markets, economic conditions of the areas in which our properties are located and federal income tax effects on shareholders that may prevail in the future. We may not be able to liquidate our assets. We will continue in existence until all of our properties are sold and our other assets are liquidated.

 

Dispositions

 

We sold one property in 2006. On December 1, 2006, we sold Northwest Place II, a 27,974 square foot office/warehouse building located in Houston, Texas for a sales price of $1,175,000. A gain of $197,000 was generated from this sale, which is reflected in our consolidated financial statements for the year ended December 31, 2006. It is anticipated that the funds received from this sale will be used for future acquisitions and/or capital improvements to properties we believe have upside.

 

Securities of or Interests in Persons Primarily Engaged in Real Estate Activities and Other Issuers

 

Consistent with the requirements necessary to maintain our qualification as a REIT, we may acquire securities of entities engaged in real estate activities or securities of other issuers, including for the purpose of exercising control over those entities. We may acquire all or substantially all of the securities or assets of REITs or similar entities where the investments would be consistent with our investment policies. We anticipate that we will only acquire securities or other interests in issuers engaged in commercial real estate activities involving retail, office or office-warehouse properties. We may also invest in entities owning undeveloped acreage. Neither our declaration of trust nor our bylaws place any limit or restriction on the percentage of our assets that may be invested in securities of or interests in other issuers. The governance documents of the Operating Partnership also do not contain any such restrictions.

 

We may also invest in limited partnerships and other ownership interests in entities that own real property. We expect that we may make these investments when we consider it more efficient to acquire an entity owning real property rather than to acquire the properties directly. We also may acquire less than all of the ownership interests of these entities if we determine that their interests are undervalued and that a liquidation event in respect of their interests are expected within the investment holding periods consistent with that of property investments.

 

Other than our interest in the Operating Partnership, we currently do not own any securities of other entities. We do not presently intend to acquire securities of any entities.

 

Equity Capital

 

If our Board determines that it is advisable and in our best interests to raise additional equity capital, it has the authority, without shareholder approval, to authorize us to issue additional common shares or preferred shares of beneficial interests up to the 400,000,000 authorized shares. Additionally, our Board could cause the Operating Partnership to issue units that are convertible into our common shares. Subject to limitations contained in the organizational and governance documents of the Operating Partnership, our Board could issue, or cause to be issued, securities in any manner (and on terms and for consideration) they deem appropriate, including in exchange for real estate. We have issued securities in exchange for real estate and we expect to continue to do so in the future. Existing shareholders have no preemptive right to purchase shares in any offering, and any offering might cause dilution of an existing shareholder’s investment in our company.

 

Environmental Matters

 

All real property and the operations conducted on real property are subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. These laws and regulations generally govern wastewater discharges, air emissions, the operation and removal of underground and above-ground storage tanks, the use, storage, treatment, transportation and disposal of solid and hazardous materials, and the remediation of contamination associated with disposals. Under these laws and regulations, a current or previous owner or operator of real property may be liable for the cost of removal or remediation of hazardous or toxic substances on, under or in its property. Some of these laws and regulations may impose joint and several liability on tenants, owners or operators for the costs of investigation or remediation of contaminated properties, regardless of fault or the legality of the original disposal and whether or not the owner or operator knew of, or was responsible for, the presence of any hazardous or toxic substances.

 

Environmental laws also may impose restrictions on the manner in which property may be used or businesses may be operated, and complying with these restrictions may require substantial expenditures. Environmental laws provide for sanctions in the event of noncompliance and may be enforced by governmental agencies or, in certain circumstances, by private parties. Certain environmental laws and common law principles could be used to impose liability for release of and exposure to hazardous substances, including asbestos-containing materials into the air, and third parties may seek recovery from owners or operators of real property for personal injury or property damage associated with exposure to released hazardous substances. Additionally, concern about indoor exposure to mold has been increasing as it may cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of significant mold at any of our properties could require us to undertake a costly remediation program to contain or remove the mold from the affected property, and could expose us to liability to our tenants, their employees and others. The cost of defending against claims of liability, of compliance with environmental regulatory requirements, of remediating any contaminated property, or of paying personal injury claims could materially adversely affect our business, assets or results of operations and, consequently, amounts available for payments of dividends to our shareholders. In addition, the presence of these substances, or the failure to properly remediate these substances, may adversely affect our ability to sell or rent a property or to use the property as collateral for future borrowing.

 

Some of these laws and regulations have been amended so as to require compliance with new or more stringent standards as of future dates. Compliance with new or more stringent laws or regulations or stricter interpretation of existing laws may require material expenditures by us. We cannot assure you that future laws, ordinances or regulations will not impose any material environmental liability, or that the current environmental condition of our properties will not be affected by the operations of the tenants, by the existing condition of the land, by operations in the vicinity of the properties, such as the presence of underground storage tanks, or by the activities of unrelated third parties. In addition, there are various local, state and federal fire, health, life-safety and similar regulations that we may be required to comply with, and which may subject us to liability in the form of fines or damages for noncompliance.

 

We will not purchase any property unless and until we obtain what is generally referred to as a “Phase I” environmental site assessment and are generally satisfied with the environmental status of the property. A Phase I environmental site assessment basically consists of a visual survey of the building and the property in an attempt to identify areas of potential environmental concerns, visually observing neighboring properties to assess surface conditions or activities that may have an adverse environmental impact on the property, and contacting local governmental agency personnel and performing a regulatory agency file search in an attempt to determine any known environmental concerns in the immediate vicinity of the property. A Phase I environmental site assessment does not generally include any sampling or testing of soil, groundwater or building materials from the property. Certain properties that we have acquired contain, or contained, dry-cleaning establishments utilizing solvents. Where believed to be warranted, samplings of building materials or subsurface investigations were undertaken with respect to these and other properties. To date, the costs associated with these investigations and any subsequent remedial measures taken have not been material to us.

 

We believe that our properties are in compliance in all material respects with all federal, state and local ordinances and regulations regarding the handling, discharge and emission of hazardous or toxic substances. We have not been notified by any governmental authority, and are not otherwise aware, of any material noncompliance, liability or claim relating to hazardous or toxic substances in connection with any of our present or former properties. We have not recorded in our financial statements any material liability in connection with environmental matters. Nevertheless, it is possible that the environmental assessments we have obtained or reviewed have not revealed all potential environmental liabilities. It is also possible that subsequent environmental assessments or investigations will identify material contamination, that adverse environmental conditions have arisen subsequent to the performance of the environmental assessments, or that there are material environmental liabilities of which our management is unaware.

 

Competition

 

All of our properties are located in areas that include competing properties. The amount of competition in a particular area could impact our ability to acquire additional real estate, sell current real estate, lease space and the amount of rent we are able to charge. We may be competing with owners, including but not limited to, other REITs, insurance companies and pension funds with access to greater resources than those available to us.

 

Employees

 

As of December 31, 2006, we had 41 employees, one of whom was part-time.

 

Financial Information About Segments

 

Our management historically has not differentiated by property types and therefore does not presented segment information.

 

Web Site Address

 

We electronically file our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports with the Securities and Exchange Commission (the “SEC”). Copies of our filings with the SEC may be obtained at the SEC’s website, at http://www.sec.gov . Access to these filings is free of charge. We are currently in the process of reviewing and updating our business code of ethics. Once finalized, it may be viewed at http://www.hcpreit.com . We are also in the process of posting other corporate governance documentation to our website. The information on our website is not, and should not be considered, a part of this report.

 

Item 1A.

Risk Factors.

 

There can be no assurance that we will be able to pay or maintain cash dividends or that dividends will increase over time.

 

There are many factors that can affect the availability and timing of cash dividends to shareholders. Dividends will be based principally on cash available from our properties, real estate securities, mortgage loans and other investments. The amount of cash available for dividends will be affected by many factors, such as our ability to buy properties, the yields on securities of other real estate programs that we invest in, and our operating expense levels, as well as many other variables. In 2006, our Board voted to decrease our dividend rate for the second quarter of 2006 to $0.15 per common share, as compared to $0.1768 per common share for the first quarter of 2006. This quarterly dividend rate continued for the third and fourth quarters of 2006. We can give no assurance that we will be able to pay or maintain dividends or that dividends will increase over time. In addition, we can give no assurance that rents from the properties will increase, that the securities we buy will increase in value or provide constant or increased dividends over time, or that future acquisitions of real properties, mortgage loans or our investments in securities will increase our cash available for dividends to shareholders. Our actual results may differ significantly from the assumptions used by our Board in establishing the dividend rate to shareholders.

 

If we experience decreased cash flows, we may need to use other sources of cash to fund dividends or we may be unable to pay dividends.

 

Actual cash available for dividends may vary substantially from estimates. If our cash dividends exceed the amount of cash available for dividends, we may need to fund the shortage out of working capital, borrowings under our lines of credit or by obtaining other debt, which would reduce the amount of proceeds available for real estate investments.

 

We may need to incur additional borrowings to meet REIT minimum distribution requirements.

 

In order to maintain our qualification as a REIT, we are required to distribute to our shareholders at least 90% of our annual net taxable income (excluding any net capital gain). In addition, the Internal Revenue Code will subject us to a 4% nondeductible excise tax on the amount, if any, by which certain distributions paid by us with respect to any calendar year are less than the sum of (i) 85% of our ordinary income for that year, (ii) 95% of our net capital gain for that year and (iii) 100% of our undistributed taxable income from prior years. Although we intend to pay dividends to our shareholders in a manner that allows us to meet the distribution requirement and avoid this 4% excise tax, we cannot assure you that we will always be able to do so.

 

Our income consists almost solely of our share of the Operating Partnership’s income, and the cash available for distribution by us to our shareholders consists of our share of cash distributions made by the Operating Partnership. Because we are the sole general partner of the Operating Partnership, our Board determines the amount of any distributions made by it. Our Board may consider a number of factors in making distributions, including:

 

·

the amount of the cash available for distribution;

 

·

the Operating Partnership’s financial condition;

 

·

the Operating Partnership’s capital expenditure requirements; and

 

·

our annual distribution requirements necessary to maintain our qualification as a REIT.

 

Differences in timing between the actual receipt of income and actual payment of deductible expenses and the inclusion of income and deduction of expenses when determining our taxable income, as well as the effect of nondeductible capital expenditures and the creation of reserves or required debt amortization payments could require us to borrow funds on a short-term or long-term basis to meet the REIT distribution requirement and to avoid the 4% excise tax described above. In these circumstances, we may need to borrow funds to avoid adverse tax consequences even if our management believes that the then prevailing market conditions generally are not favorable for borrowings or that borrowings would not be advisable in the absence of the tax consideration.

 

We may incur mortgage indebtedness and other borrowings, which may increase our business risks.

 

If it is determined to be in our best interests, we may, in some instances, acquire real properties by using either existing financing or borrowing new funds. In addition, we may incur or increase our current mortgage debt to obtain funds to acquire additional real properties. We may also borrow funds if necessary to satisfy the REIT distribution requirement described above, or otherwise as may be necessary or advisable to assure that we maintain our qualification as a REIT for federal income tax purposes.

 

We may incur mortgage debt on a particular piece of real property if we believe the property’s projected cash flow is sufficient to service the mortgage debt. If there is a shortfall in cash flow, however, the amount available for dividends to shareholders may be affected. In addition, incurring mortgage debt increases the risk of loss because defaults on such indebtedness may result in loss of property in foreclosure actions initiated by lenders. For tax purposes, a foreclosure of any of our properties would be treated as a sale of the property for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the property, we would recognize taxable income on foreclosure, but would not receive any cash proceeds. We may give lenders full or partial guarantees for mortgage debt incurred by the entities that own our properties. When we give a guaranty on behalf of an entity that owns one of our properties, we will be responsible to the lender for satisfaction of the debt if it is not paid by that entity. If any mortgages contain cross-collateralization or cross-default provisions, there is a risk that more than one real property may be affected by a default. If any of our properties are foreclosed upon due to a default, our ability to pay cash dividends to our shareholders will be adversely affected.

 

If we fail to qualify as a REIT, our operations and dividends to shareholders would be adversely impacted.

 

We intend to continue to operate so as to qualify as a REIT under the Internal Revenue Code. A REIT generally is not taxed at the corporate level on income it currently distributes to its shareholders. Qualification as a REIT involves the application of highly technical and complex rules for which there are only limited judicial or administrative interpretations. The determination of various factual matters and circumstances not entirely within our control may affect our ability to continue to qualify as a REIT. In addition, new legislation, new regulations, administrative interpretations or court decisions could significantly change the tax laws with respect to qualification as a REIT or the federal income tax consequences of qualification.

 

If we were to fail to qualify as a REIT in any taxable year:

 

·

we would not be allowed to deduct our distributions to shareholders when computing our taxable income;

 

·

we would be subject to federal income tax (including any applicable alternative minimum tax) on our taxable income at regular corporate rates;

 

·

we would be disqualified from being taxed as a REIT for the four taxable years following the year during which qualification was lost, unless entitled to relief under certain statutory provisions;

 

·

our cash available for dividends would be reduced and we would have less cash to pay dividends to shareholders; and

 

 

·

we may be required to borrow additional funds or sell some of our assets in order to pay corporate tax obligations we may incur as a result of our disqualification.

 

Our debt agreements impose limits on our operations and our ability to make distributions to our shareholders.

The agreements relating to the debt we incur contain financial and operating covenants that may limit our ability to make distributions or other payments to our shareholders. Our existing credit facilities contain financial and operating covenants, including:

·

debt service coverage of at least 1.5 to 1.0;

 

·

loan-to-value ratio of a borrowing base pool to total funded loan balance of at least 1.67 to 1.00;

 

·

total debt not to exceed 60% of fair market value of our real estate assets;

 

·

the ratio of secured debt to fair market value of our real estate assets not to exceed 40%;

 

·

interest coverage ratio of at least 2.0 to 1.0;

 

·

we must hedge certain amounts of variable interest rate debt;

 

·

maintenance of specific levels of insurance; and

 

·

limitations on our ability to make distributions or other payments to our shareholders, sell assets or engage in mergers, consolidation or make certain acquisitions.

 

Failure to comply with these covenants could result from, among other things, changes in our results of operations, incurrence of debt or changes in general economic conditions. These covenants may restrict our ability to fund our operations and conduct our business. Failure to comply with any of these covenants could result in a default under our credit agreement or other debt agreements we may enter into in the future. A default could cause one or more of our lenders to accelerate the timing of payments which could force us to dispose of one or more of our properties, possibly on disadvantageous terms. For more discussion, see Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.

Because of the lack of geographic diversification of our portfolio, an economic downturn in the Houston, Dallas or San Antonio, Texas metropolitan areas could adversely impact our operations and ability to pay dividends to our shareholders.

 

All of our assets and revenues are currently derived from properties located in the Houston, Dallas and San Antonio, Texas metropolitan areas. Our results of operations are directly contingent on our ability to attract financially sound commercial tenants. If Houston, Dallas or San Antonio experiences a significant economic downturn, our ability to locate and retain financially sound tenants may be adversely impacted. Likewise, we may be required to lower our rental rates to attract desirable tenants in such an environment. Consequently, because of the lack of geographic diversity among our current assets, if Houston, Dallas or San Antonio experiences an economic downturn, our operations and ability to pay dividends to our shareholders could be adversely impacted.

 

There is no public trading market for our shares of common stock, making it difficult for shareholders to sell their shares.

 

There is no current public market for our common shares of beneficial interest. If you are able to find a buyer for your shares, you may not sell your shares to that buyer unless the buyer meets the suitability standards applicable to him or her, including any suitability standards imposed by the potential purchaser’s state of residence. Our declaration of trust also imposes restrictions on the ownership of common shares that will apply to potential transferees that may restrict your ability to sell your shares.   In addition, our Board has delayed the implementation of our share redemption program. Even if this program is implemented in the future, our Board may reject any request for redemption of shares or amend, suspend or terminate the program at any time. Therefore, it will be difficult for you to sell your shares promptly or at all. You may not be able to sell your shares in the event of an emergency, and, if you are able to sell your shares, you may have to sell them at a substantial discount.

 

We have acquired a majority of our properties, on a non “arms-length” basis, from entities controlled by the previous advisor and CEO, Allen R. Hartman.

 

We acquired 27 of the 36 properties we owned as of December 31, 2006, from entities controlled by Mr. Hartman. We acquired these properties by paying cash or issuing our commons shares of beneficial interest or units of the Operating Partnership that are convertible into our common shares. No third parties were retained to represent or advise these selling entities or us, and the transactions were not conducted on an “arm’s-length” basis.

 

Mr. Hartman had interests that differed from, and in certain cases conflicted with, his co-investors in these entities. Mr. Hartman received the following as a result of these transactions:

 

·

897,117.19 units of the Operating Partnership that are convertible into our common shares, as adjusted to reflect the recapitalization, in consideration of Mr. Hartman’s general partner interest in the selling entities;

 

·

the ability to limit his future exposure to general partner liability as a result of Mr. Hartman no longer serving as the general partner to certain of the selling entities; and

 

·

the repayment of debt encumbering several of our properties that was personally guaranteed by Mr. Hartman.

 

Mr. Hartman might not have been able to negotiate all of these benefits if the transactions were negotiated at arm’s length. Further, Mr. Hartman did not make any representations or warranties in regard to the properties or the selling entities (neither personally nor in his capacity as a general partner) in the documents evidencing the transactions. Consequently, we essentially acquired the properties on an “as is” basis. Therefore, we will bear the risk associated with any characteristics of or deficiencies in these properties unknown at the closing of the acquisitions that may affect their valuation or revenue potential.

 

Approximately 43.6% of our gross leasable area is subject to leases that expire prior to December 31, 2009.

 

As of December 31, 2006, approximately 43.6% of the aggregate gross leasable area of our properties is subject to leases that expire prior to December 31, 2009. We are subject to the risk that:

 

·

tenants may choose not to renew these leases;

 

·

we may not be able to re-lease the space subject to these leases; and

 

·

the terms of any renewal or re-lease may be less favorable than the terms of the current leases.

 

If any of these risks materialize, our cash flow and ability to pay dividends could be adversely affected.

 

The value of investments in our common shares will be directly affected by general economic and regulatory factors we cannot control or predict.

 

We only own commercial real estate. Investments in real estate typically involve a high level of risk as the result of factors we cannot control or predict. One of the risks of investing in real estate is the possibility that our properties will not generate income sufficient to meet operating expenses or will generate income and capital appreciation, if any, at rates lower than those anticipated or available through investments in comparable real estate or other investments. The following factors may affect income from properties and yields from investments in properties and are generally outside of our control:

 

·

conditions in financial markets;

 

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over-building in our markets;

 

·

a reduction in rental income as the result of the inability to maintain occupancy levels;

 

·

adverse changes in applicable tax, real estate, environmental or zoning laws;

 

·

changes in general economic conditions;

 

·

a taking of any of our properties by eminent domain;

 

·

adverse local conditions (such as changes in real estate zoning laws that may reduce the desirability of real estate in the area);

 

·

acts of God, such as earthquakes or floods and other uninsured losses;

 

·

changes in supply of or demand for similar or competing properties in an area;

 

·

changes in interest rates and availability of permanent mortgage funds, which may render the sale of a property difficult or unattractive; and

 

·

periods of high interest rates and tight money supply.

 

Some or all of these factors may affect our properties, which could adversely affect our operations and ability to pay dividends to shareholders.

 

We operate in a competitive business and many of our competitors have greater resources and operating flexibility than we do.

 

Numerous real estate companies that operate in the Houston, Dallas and San Antonio, Texas metropolitan areas compete with us in developing and acquiring office, retail and warehouse properties and seeking tenants to occupy their properties. Moreover, as we seek to expand our investments and operations into other geographic locations and other asset types, we will encounter significantly more competition from entities that have more financial and other resources, and more operating experience, than we do. This competition could adversely affect our business. In addition, the number of entities and the amount of funds competing for suitable investments may increase. Such an increase would result in a heightened demand for these assets that would increase their selling prices. If we pay higher prices for properties and other investments our profitability will be reduced.

 

 

We depend on tenants for our revenue and on anchor tenants to attract non-anchor tenants.  

 

As rental income from real property comprises substantially all of our income, the inability of a single major tenant or a number of smaller tenants to meet their obligations to us would adversely affect our income. Tenants may have the right to terminate their leases upon the occurrence of certain customary events of default. In addition, in some cases, tenants may have the right to terminate if the lease held by an anchor tenant or other principal tenant expires, is terminated or the property subject to the lease is vacated, even if rent continues to be paid under the lease. The weakening of a significant tenant’s financial condition or the loss of an anchor tenant may adversely affect our cash flow and amounts available for distribution to our shareholders.

 

The bankruptcy or insolvency of major tenants would adversely impact our operations .

 

As of December 31, 2006, our five largest tenants generated approximately 9.3% of the combined rent of our properties. The bankruptcy or insolvency of a major tenant or a number of small tenants would have an adverse impact on our income and dividends. Generally, under bankruptcy law, a tenant has the option of continuing or terminating any unexpired lease. If the tenant continues its current lease, the tenant must cure all defaults under the lease and provide adequate assurance of its future performance under the lease. If the tenant terminates the lease, our claim for breach of the lease (absent collateral securing the claim) will be treated as a general unsecured claim. General unsecured claims are the last claims paid in a bankruptcy, and funds may not be available to pay these claims. As of December 31, 2006, none of our major tenants were in bankruptcy or had materially defaulted on their lease. However, any of our tenants could become insolvent or declare bankruptcy in the future.

 

We may have difficulty selling our real estate investments, which may have an adverse impact on our ability to pay dividends.  

 

Equity real estate investments are relatively illiquid. We have a limited ability to vary our portfolio in response to changes in economic or other conditions. The real estate market is affected by many factors, such as general economic conditions, availability of financing, interest rates, supply and demand and other factors, all of which are beyond our control. We cannot predict whether we will be able to sell any property for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We cannot predict the length of time needed to find a willing purchaser and to close the sale of a property. We are especially vulnerable to these risks because all but three of our current properties are located in Houston, Texas. In addition, mortgage payments and, to the extent a property is not occupied entirely by tenants subject to triple net leases, certain significant expenditures such as real estate taxes and maintenance costs generally are not reduced when circumstances cause a reduction in income from the investment. The occurrence of these events would adversely affect our income and ability to pay dividends to our shareholders.

 

Uninsured losses relating to real property or excessively expensive premiums for insurance coverage may adversely affect our returns.  

 

We will attempt to ensure that all of our properties are adequately insured to cover casualty losses. However, there are types of losses, generally catastrophic in nature, such as losses due to wars, acts of terrorism, earthquakes, floods, hurricanes, pollution or environmental matters, which are uninsurable or not economically insurable, or may be insured subject to limitations, such as large deductibles or co-payments. Insurance risks associated with potential terrorism acts could sharply increase the premiums we pay for coverage against property and casualty claims. In some instances, we may be required to provide other financial support, either through financial assurances or self-insurance, to cover potential losses. We cannot assure you that we will have adequate coverage for these losses. In the event that any of our properties incurs a casualty loss that is not fully covered by insurance, the value of our assets will be reduced by these uninsured losses. In addition, other than any reserves we may establish, we have no source of funding to repair or reconstruct any uninsured damaged property, and we cannot assure you that any sources of funding will be available to us for this purpose in the future. Also, to the extent we must pay unexpectedly large insurance premiums, we could suffer reduced earnings that would result in less cash dividends to be distributed to shareholders.

Discovery of previously undetected environmentally hazardous conditions may adversely affect our operating results.

 

Under various federal, state and local environmental laws, ordinances and regulations, a current or previous owner or operator of real property may be liable for the cost of removal or remediation of hazardous or toxic substances on, under or in its property. The costs of removal or remediation could be substantial. These laws often impose liability whether or not the owner or operator knew of, or was responsible for, the presence of any hazardous or toxic substances. Environmental laws also may impose restrictions on the manner in which property may be used or businesses may be operated, and these restrictions may require substantial expenditures. Environmental laws provide for sanctions in the event of noncompliance and may be enforced by governmental agencies or, in certain circumstances, by private parties. Certain environmental laws and common law principles could be used to impose liability for release of and exposure to hazardous substances, including asbestos containing materials into the air. In addition, third parties may seek recovery from owners or operators of real properties for personal injury or property damage associated with exposure to released hazardous substances. The cost of defending against claims of liability, of compliance with environmental regulatory requirements, of remediating any contaminated property, or of paying personal injury claims could materially adversely affect our business, assets or results of operations and, consequently, amounts available for payments of dividends to our shareholders.

 

Litigation with Allen R. Hartman and Hartman Management.

 

We are currently involved in litigation with our former Chief Executive Officer, Allen R. Hartman, and manager and advisor, Hartman Management, L.P. While we intend to vigorously defend against claims brought by Mr. Hartman and Hartman Management and vigorously prosecute our claims against Mr. Hartman and Hartman Management, there can be no assurances that we will ultimately prevail. Even if we do ultimately prevail in these lawsuits, we may continue to incur significant legal costs to do so. For more discussion, see Legal Proceedings and   Management’s Discussion and Analysis of Financial Condition and Results of Operations - Commitments and Contingencies.  

 

Inability to retain key personnel may adversely impact our ability to implement our strategic plan.

 

Our success depends to a significant degree upon the continued contributions of certain executive officers and other key personnel, including James C. Mastandrea and John J. Dee. We do not have employment agreements with Messrs. Mastandrea or Dee, and we cannot guarantee that they will remain employed by us. We have not purchased “key person” life insurance for Messrs. Mastandrea or Dee. If Messrs. Mastandrea or Dee or any of our other key personnel were to cease their employment with us, our operating results could suffer. We believe that our future success depends, in large part, upon our ability to retain and hire highly skilled managerial, operational and marketing personnel. Competition for skilled personnel is intense, and we cannot assure you that we will be successful in attracting and retaining skilled personnel. If we lose or are unable to obtain the services of key personnel, our ability to implement our business strategies could be delayed or hindered.

 

Shareholders that received shares under our dividend reinvestment plan on or after October 2, 2006, could be entitled to recission rights.

 

Our dividend reinvestment plan allowed our shareholders to elect to have dividends from our common shares reinvested in additional common shares at a purchase price per share of $9.50. Our dividend reinvestment plan will terminate on April 6, 2007. Shares issued under our dividend reinvestment plan were registered on our Registration Statement on Form S-11. We did not amend or supplement our Registration Statement following our change in management on October 2, 2006, and the events that occurred thereafter. As a result, shareholders that received approximately 64,000 shares issued under our dividend reinvestment plan, on or after that date could be entitled to recission rights. These rights would entitle these holders to recovery of their purchase price less any income received on their shares. If these rights are successfully exercised, the repayment of the purchase price and associated expenses could adversely affect our cash flow and ability to pay dividends to our shareholders.