2. LEASES

The majority of our properties are leased on a triple-net basis primarily to petroleum distributors and, to a lesser extent, individual operators. Generally our tenants supply fuel and either operate our properties directly or sublet our properties to operators who operate their gas stations, convenience stores, automotive repair service facilities or other businesses at our properties. Our triple-net tenants are responsible for the payment of all taxes, maintenance, repairs, insurance, and other operating expenses relating to our properties, and are also responsible for environmental contamination occurring during the term of their lease and in certain cases also for preexisting environmental contamination. (See note 5 for additional information regarding environmental obligations.) Substantially all of our tenants’ financial results depend on the sale of refined petroleum products and rental income from their subtenants. As a result, our tenants’ financial results are highly dependent on the performance of the petroleum marketing industry, which is highly competitive and subject to volatility. As of September 30, 2013, we owned 891 properties and leased 125 properties from third parties. Our 1,016 properties are located in 21 states across the United States and Washington, D.C., with concentrations in the Northeast and Mid-Atlantic regions.

Approximately 630 of the properties we own or lease as of September 30, 2013 were previously leased to Getty Petroleum Marketing Inc. (“Marketing”) comprising a unitary premises pursuant to a master lease (the “Master Lease”). In December 2011, Marketing filed for Chapter 11 bankruptcy protection in the U.S. Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”). The Master Lease was rejected by Marketing and terminated effective April 30, 2012, and in July 2012, the Bankruptcy Court approved Marketing’s Plan of Liquidation and appointed a trustee (the “Liquidating Trustee”) to oversee liquidation of the Marketing estate (the “Marketing Estate”). The Liquidating Trustee continues to oversee the Marketing Estate and pursue claims for the benefit of its creditors, including those related to the recovery of various deposits, including surety bonds, insurance policy claims and claims made to state funded tank reimbursement programs.

In December 2011, the Marketing Estate filed a lawsuit against Marketing’s former parent, Lukoil Americas Corporation, and certain of its affiliates (collectively, “Lukoil”), as well as the former directors and officers of Marketing (the “Lukoil Complaint”). The Lukoil Complaint asserted, among other allegations, that Marketing’s sale of assets to Lukoil in November 2009 constituted a fraudulent conveyance and that the former directors and officers of Marketing breached their fiduciary obligations. In October 2012, we entered into an agreement with the Marketing Estate to make loans and otherwise fund up to an aggregate amount of $6,725,000 to prosecute the Lukoil Complaint and for certain other expenses incurred in connection with the wind-down of the Marketing Estate (the “Litigation Funding Agreement”). The Litigation Funding Agreement provided that we would receive proceeds from any successful resolution or settlement of the Lukoil Complaint in an amount equal to the sum of (i) all funds advanced for wind-down costs and expert witness and consultant fees plus interest accruing at 15% per annum on such advances; plus (ii) the greater of all funds advanced for legal fees and expenses relating to the prosecution of the Lukoil Complaint plus interest accruing at 15% per annum on such advances, or 24% of the gross proceeds from any settlement or favorable judgment obtained by the Liquidating Trustee from the Lukoil Complaint. We advanced $6,526,000 in the aggregate to the Marketing Estate pursuant to the Litigation Funding Agreement. The Litigation Funding Agreement also provided that we were entitled to be reimbursed for up to $1,300,000 of our legal fees in connection with the Litigation Funding Agreement.

On July 29, 2013, the Bankruptcy Court approved a settlement between Lukoil and certain former directors and officers of Marketing, collectively, and the Marketing Estate, of the claims made in the Lukoil Complaint (the “Lukoil Settlement”). The terms of the Lukoil Settlement included a release of the defendants from the claims alleged in the Lukoil Complaint and a collective payment to the Marketing Estate of $93,000,000. In August 2013, the settlement payment was received by the Marketing Estate of which $25,096,000 was distributed to us pursuant to the Litigation Funding Agreement and $6,585,000 was distributed to us in full satisfaction of our post-petition priority claims related to the Master Lease. Although we believe it is not likely, a portion of the payments we received pursuant to the Litigation Funding Agreement may be subject to federal income taxes. (See “Income Taxes” in note 1 for additional information regarding uncertain tax positions.)

We may realize additional distributions from the Marketing Estate for our remaining general unsecured claims stemming from Marketing’s default of its obligations under the Master Lease as and when assets that remain in the Marketing Estate become available for distribution to Marketing’s creditors. We cannot provide any assurance as to our proportionate interest in any Marketing Estate assets, or the amount or timing of recoveries, if any, with respect to our remaining general unsecured claims against the Marketing Estate.

Of the $25,096,000 received by us in the third quarter of 2013 pursuant to the Litigation Funding Agreement, $7,976,000 was applied to the advances made to the Marketing Estate plus accrued interest; $13,994,000 was applied to unpaid rent and real estate taxes due from Marketing and the related bad debt reserve was reversed; and the remainder of $3,126,000 was recorded as additional income attributed to the partial recovery of damages resulting from Marketing’s default of its obligations under the Master Lease and is reflected in continuing operations in our consolidated statement of operations as other revenue.

In accordance with GAAP, we recognized in revenue from rental properties in our consolidated statements of operations the full contractual rent and real estate obligations due to us by Marketing during the term of the Master Lease and provided bad debt reserves included in general and administrative expenses and in earnings (loss) from discontinued operations in our consolidated statements of operations for our estimate of uncollectible amounts due from Marketing. We reduced previously provided bad debt reserves related to uncollected rent and real estate taxes due from Marketing by $567,000 for the three months ended September 30, 2012, netting to $15,654,000 of bad debt reserves provided for the nine months ended September 30, 2012. We reduced the net reserve of $22,782,000 provided through December 31, 2012 by $8,788,000 in the six months ended June 30, 2013 as a result of receiving cash from the Marketing Estate and our estimate of cash we expected to receive from the Marketing Estate pursuant to our post-petition priority claims. We further reduced, thereby eliminating, the previously provided reserves by $13,994,000 in the three months ended September 30, 2013 as a result of receiving and applying to our remaining trade accounts receivable balance due from Marketing such amount from the proceeds Marketing received from the Lukoil Settlement. The net increase in our bad debt reserve for uncollectible amounts due from Marketing for the nine months ended September 30, 2012 of $15,654,000 is reflected in our consolidated statement of operations by increasing general and administrative expenses in continuing operations by $12,145,000 and decreasing earnings from operating activities included in discontinued operations by $3,509,000.The reduction in our bad debt reserve for uncollectible amounts due from Marketing for the nine months ended September 30, 2013 of $22,782,000 is reflected in our consolidated statement of operations by reducing general and administrative expenses in continuing operations by $17,675,000 and increasing earnings from operating activities included in discontinued operations by $5,107,000.

Following the rejection and termination of the Master Lease in Marketing’s bankruptcy proceedings, we entered into long-term triple-net leases with petroleum distributors for ten separate property portfolios comprising 443 properties in the aggregate and month-to-month license agreements with occupants of approximately 110 properties (substantially all of whom were Marketing’s former subtenants) allowing such occupants to continue to occupy and use these properties as gas stations, convenience stores, automotive repair service facilities or other businesses. Under our month-to-month license agreements, we receive monthly licensing fees and are responsible for the payment of certain Property Expenditures (as defined below) and environmental costs. Approximately 70 properties previously subject to the Master Lease are currently vacant, and are being marketed for sale

The long-term triple-net leases with petroleum distributors for the ten separate property portfolios comprising 443 properties in the aggregate are unitary triple-net lease agreements generally with an initial term of 15 years, and options for successive renewal terms of up to 20 years. Rent is scheduled to increase at varying intervals of up to three years on the anniversary of the commencement date of the leases. The majority of the leases provide for additional rent based on the aggregate volume of petroleum products sold. In addition, the majority of the leases require the tenants to make capital expenditures at our properties substantially all of which are related to the replacement of underground storage tanks (“USTs”) that are owned by our tenants. We have committed to co-invest up to $14,080,000 in the aggregate with our tenants for a portion of such capital expenditures, which deferred expense is recognized on a straight-line basis as amortization expense in our consolidated statements of operations over the terms of the various leases. As part of these triple-net leases, we transferred title of the USTs to our tenants and the obligation to pay for the retirement and decommissioning or removal of USTs at the end of their useful life or earlier if circumstances warranted was fully or partially transferred to our new tenants. We remain contingently liable for this obligation in the event that our tenants do not satisfy their responsibilities. Accordingly, we removed $12,136,000 of asset retirement obligations and $10,269,000 of net asset retirement costs related to USTs from our balance sheet through September 30, 2013. The net amount of $1,867,000 is recorded as deferred rental revenue and is recognized on a straight-line basis as additional revenues from rental properties over the terms of the various leases. We incurred $3,512,000 of lease origination costs through September 30, 2013, which deferred expense is recognized on a straight-line basis as amortization expense in our consolidated statements of operations over the terms of the various leases.

Following the rejection and termination of the Master Lease in Marketing’s bankruptcy proceedings, we increased our effort to dispose of certain properties in order to monetize their value. Gains from dispositions of real estate are generally included in discontinued operations in our consolidated statements of operations. There were 94 and 29 property dispositions during the nine months ended September 30, 2013 and 2012, respectively, of which there were 17 and 14 property dispositions during the three months ended September 30, 2013 and 2012, respectively. In addition, there were 25 property dispositions during the fourth quarter of 2012 and we had 131 properties which met the criteria to be accounted for as held for sale as of September 30, 2013. Substantially all of the properties sold or classified as held for sale were previously leased to Marketing. The timing of pending or anticipated dispositions may be affected by factors beyond our control and we cannot predict when or on what terms sales will ultimately be consummated.

Revenues from rental properties included in continuing operations for the three and nine months ended September 30, 2013 were $25,425,000 and $72,360,000, respectively. Revenues from rental properties included in continuing operations for the three and nine months ended September 30, 2012 were $21,591,000 and $72,078,000, respectively, of which $102,000 and $17,653,000, respectively, was due from Marketing under the Master Lease prior to its rejection on April 30, 2012. Revenues from rental properties and rental property expenses included in continuing operations include $3,827,000 and $10,920,000 for the three and nine months ended September 30, 2013, respectively, and $2,325,000 and $9,769,000 for the three and nine months ended September 30, 2012, respectively, for real estate taxes paid by us which were reimbursable by our tenants. Revenues from rental properties included in continuing operations for the nine months ended September 30, 2013 also include a net loss of $1,339,000 for amounts realized under interim fuel supply agreements, as compared to a net gain of $1,003,000 for the nine months ended September 30, 2012.

In accordance with GAAP, we recognize rental revenue in amounts which vary from the amount of rent contractually due or received during the periods presented. As a result, revenues from rental properties include non-cash adjustments recorded for deferred rental revenue due to the recognition of rental income on a straight-line (or average) basis over the current lease term, net amortization of above-market and below-market leases and recognition of rental income recorded under direct financing leases using the effective interest method which produces a constant periodic rate of return on the net investments in the leased properties (the “Revenue Recognition Adjustments”). Revenue Recognition Adjustments included in continuing operations increased rental revenue by $2,203,000 and $5,947,000 for the three and nine months ended September 30, 2013, respectively, as compared to $1,459,000 and $2,994,000 for the three and nine months ended September 30, 2012, respectively.

The components of the $97,436,000 net investment in direct financing leases as of September 30, 2013 are minimum lease payments receivable of $206,381,000 plus unguaranteed estimated residual value of $13,979,000 less unearned income of $122,924,000.

As of September 30, 2013, we leased 143 properties in two separate unitary leases to subsidiaries of Chestnut Petroleum Dist. Inc. We lease 59 gasoline station and convenience store properties to CPD NY Energy Corp. (“CPD NY”) and, as part of the repositioning of the portfolio of properties previously leased to Marketing, we lease 84 properties to NECG Holdings Corp. (“NECG”). CPD NY and NECG represent 21% and 18% of our revenues for the nine months ended September 30, 2013 and 2012, respectively.

The selected combined unaudited financial data of CPD NY and NECG (from inception on May 1, 2012), which has been prepared by Chestnut Petroleum Dist. Inc.’s management, is provided below.

(in thousands)

Operating Data:


	Three months ended September 30,					Nine months ended September 30,
	2013		2012			2013		2012
Total revenue	$	143,191	$	136,505		$	410,182	$	368,300
Gross profit		10,054		8,201			29,841		26,575
Net income (loss)		1,243		(808	)		2,702		900

Balance Sheet Data:


	September 30,		December 31,
	2013		2012
Current assets	$	16,227	$	9,529
Noncurrent assets		25,323		21,326
Current liabilities		10,372		4,800
Noncurrent liabilities		18,878		21,624

Eviction proceedings are ongoing in the State of Connecticut against approximately 26 of Marketing’s former subtenants (or sub-subtenants) each of whom continue to occupy properties subject to our lease with NECG. These ongoing eviction proceedings have materially adversely impacted our tenant, NECG. The Connecticut Superior Court has ruled in our favor with respect to all of these locations. However, the operators against whom these Superior Court rulings were made have appealed the decisions and remain in occupancy of the subject sites during the pendency of such appeal. We remain confident that we will prevail in the appeal and, although no assurances can be given, we anticipate a favorable resolution of this matter in 2014.

In August 2013, we entered into an agreement to modify the lease with NECG. This lease modification agreement includes provisions under which we can recapture and sever 26 properties from the lease. As a result of the disruption and costs associated with the litigation, NECG was not current in its rent and certain other obligations due to us under its lease. We increased our accounts receivable bad debt reserves by approximately $1,152,000 in the second quarter of 2013 so that the total bad debt reserve related to NECG as of June 30, 2013 and September 30, 2013 is approximately $1,902,000 in aggregate.

We provide reserves for a portion of the recorded deferred rent receivable if circumstances indicate that a tenant will not make all of its contractual lease payments during the current lease term. Our assessments and assumptions regarding the recoverability of the deferred rent receivable are reviewed on an ongoing basis and such assessments and assumptions are subject to change. As a result of the developments with NECG described above, we concluded that it was probable that we would not receive from NECG the entire amount of the contractual lease payments owed to us under the unitary lease for the likely removal of properties and for rent payment deferrals previously agreed to related to the six months ended June 30, 2013. Accordingly, during the second quarter of 2013, we recorded a non-cash allowance for deferred rent receivable of $1,531,000. This non-cash allowance reduced our net earnings for the nine months ended September 30, 2013, but did not impact our cash flow from operating activities.