OFFICE PROPERTIES INCOME TRUST - Quarter Report: 2012 September (Form 10-Q)

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2012

 

OR

 

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

 

Commission File Number 1-34364

 

GOVERNMENT PROPERTIES INCOME TRUST

(Exact Name of Registrant as Specified in Its Charter)

 

 

Two Newton Place, 255 Washington Street, Suite 300, Newton, Massachusetts 02458-1634

 (Address of Principal Executive Offices)  (Zip Code)

 

617-219-1440

(Registrant’s Telephone Number, Including Area Code)

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

 

 

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

 

Number of registrant’s common shares of beneficial interest, $.01 par value per share, outstanding as of October 31, 2012:  54,643,888

 

 

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GOVERNMENT PROPERTIES INCOME TRUST

 

FORM 10-Q

 

September 30, 2012

 

INDEX

 

PART I	Financial Information
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets — September 30, 2012 and December 31, 2011	1
	Condensed Consolidated Statements of Income and Comprehensive Income — Three and Nine Months Ended September 30, 2012 and 2011	2
	Condensed Consolidated Statements of Cash Flows — Nine Months Ended September 30, 2012 and 2011	3
	Notes to Condensed Consolidated Financial Statements	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	22
Item 4.	Controls and Procedures	23
	Warning Concerning Forward Looking Statements	24
	Statement Concerning Limited Liability	26
PART II	Other Information
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	27
Item 6.	Exhibits	28
	Signatures	29

 

Table of Contents

 

PART I       Financial Information

 

Item 1.  Financial Statements

 

GOVERNMENT PROPERTIES INCOME TRUST

CONDENSED CONSOLIDATED BALANCE SHEETS

(amounts in thousands, except share data)

(unaudited)

 

		September 30,			December 31,
		2012			2011
ASSETS
Real estate properties:
Land		$	241,294		$	224,674
Buildings and improvements		1,268,730			1,129,994
		1,510,024			1,354,668
Accumulated depreciation		(172,066		)	(156,618		)
		1,337,958			1,198,050
Acquired real estate leases, net		131,159			117,596
Cash and cash equivalents		3,169			3,272
Restricted cash		2,189			1,736
Rents receivable, net		26,806			29,000
Deferred leasing costs, net		5,696			3,074
Deferred financing costs, net		6,169			5,550
Other assets, net		11,641			10,297
Total assets		$	1,524,787		$	1,368,575
LIABILITIES AND SHAREHOLDERS’ EQUITY
Unsecured revolving credit facility		$	167,000		$	345,500
Unsecured term loan		350,000			—
Mortgage notes payable		93,709			95,383
Accounts payable and accrued expenses		21,816			20,691
Due to related persons		7,231			4,071
Assumed real estate lease obligations, net		14,038			11,262
Total liabilities		653,794			476,907
Commitments and contingencies
Shareholders’ equity:
Common shares of beneficial interest, $.01 par value: 70,000,000 shares authorized, 47,143,888 and 47,051,650 shares issued and outstanding, respectively		471			471
Additional paid in capital		937,285			935,438
Cumulative net income		124,102			87,333
Cumulative other comprehensive income		108			77
Cumulative common distributions		(190,973		)	(131,651		)
Total shareholders’ equity		870,993			891,668
Total liabilities and shareholders’ equity		$	1,524,787		$	1,368,575

 

See accompanying notes.

 

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GOVERNMENT PROPERTIES INCOME TRUST

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

(amounts in thousands, except per share data)

(unaudited)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2012			2011			2012			2011
Rental income		$	54,083		$	45,889		$	154,811		$	127,224
Expenses:
Real estate taxes		5,728			4,853			17,210			13,947
Utility expenses		5,140			4,375			12,845			11,422
Other operating expenses		9,565			7,893			27,743			22,074
Depreciation and amortization		13,056			10,379			37,281			27,862
Acquisition related costs		763			1,008			1,057			2,846
General and administrative		3,637			2,746			9,395			7,655
Total expenses		37,889			31,254			105,531			85,806
Operating income		16,194			14,635			49,280			41,418
Interest and other income		7			54			21			89
Interest expense (including net amortization of debt premiums and deferred financing fees of $339, $266, $998 and $787, respectively)		(4,530		)	(3,162		)	(12,649		)	(8,775		)
Equity in earnings of an investee		115			28			236			111
Income before income tax benefit (expense)		11,786			11,555			36,888			32,843
Income tax benefit (expense)		(30		)	8			(119		)	(94		)
Net income		11,756			11,563			36,769			32,749
Other comprehensive income:
Equity in unrealized gain of an investee		35			15			31			71
Other comprehensive income		35			15			31			71
Comprehensive income		$	11,791		$	11,578		$	36,800		$	32,820
Weighted average common shares outstanding		47,108			45,322			47,086			42,127
Net income per common share		$	0.25		$	0.26		$	0.78		$	0.78

 

See accompanying notes.

 

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GOVERNMENT PROPERTIES INCOME TRUST

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(amounts in thousands)

(unaudited)

 

		Nine Months Ended September 30,
		2012			2011
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	36,769		$	32,749
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation		23,897			19,258
Net amortization of debt premium and deferred financing fees		998			787
Straight line rental income		(2,669		)	(451		)
Amortization of acquired real estate leases		14,352			8,116
Amortization of deferred leasing costs		636			367
Other non-cash expenses		1,477			721
Equity in earnings of an investee		(236		)	(111		)
Change in assets and liabilities:
Restricted cash		(453		)	(310		)
Deferred leasing costs		(2,123		)	(424		)
Rents receivable		4,863			(2,445		)
Other assets		(1,077		)	(3,111		)
Accounts payable and accrued expenses		2,690			3,234
Due to related persons		3,336			5,285
Cash provided by operating activities		82,460			63,665
CASH FLOWS FROM INVESTING ACTIVITIES:
Real estate acquisitions and deposits		(180,976		)	(327,402		)
Real estate improvements		(10,474		)	(4,113		)
Cash used in investing activities		(191,450		)	(331,515		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common shares, net		—			157,894
Repayment of mortgage notes payable		(1,327		)	(624		)
Borrowings on unsecured revolving credit facility		173,000			376,500
Repayments on unsecured revolving credit facility		(351,500		)	(212,000		)
Proceeds from unsecured term loan		350,000			—
Financing fees		(1,964		)	(3		)
Distributions to common shareholders		(59,322		)	(50,630		)
Cash provided by financing activities		108,887			271,137
(Decrease) increase in cash and cash equivalents		(103		)	3,287
Cash and cash equivalents at beginning of period		3,272			2,437
Cash and cash equivalents at end of period		$	3,169		$	5,724
Supplemental cash flow information
Interest paid		$	11,787		$	7,065
Income taxes paid		167			43
Non-cash financing activities
Issuance of common shares		$	1,847		$	721

 

See accompanying notes.

 

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GOVERNMENT PROPERTIES INCOME TRUST

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

 

Note 1.   Basis of Presentation

 

The accompanying condensed consolidated financial statements of Government Properties Income Trust and its subsidiaries, or GOV, the Company, we or us, are unaudited.  We operate in one business segment: ownership of properties that are primarily leased to government tenants.  Certain information and disclosures required by U.S. generally accepted accounting principles, or GAAP, for complete financial statements have been condensed or omitted.  We believe the disclosures made are adequate to make the information presented not misleading.  However, the accompanying condensed consolidated financial statements should be read in conjunction with the financial statements and notes contained in our Annual Report on Form 10-K for the year ended December 31, 2011, or our Annual Report.  In the opinion of our management, all adjustments, which include only normal recurring adjustments considered necessary for a fair presentation, have been included.  All material intercompany transactions and balances between the Company and its subsidiaries have been eliminated.  Our operating results for interim periods are not necessarily indicative of the results that may be expected for the full year.

 

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect reported amounts. Actual results could differ from those estimates.  Significant estimates in the condensed consolidated financial statements include the allowance for doubtful accounts, purchase price allocations, useful lives of fixed assets and impairment of real estate and intangible assets.

 

Note 2.   Recent Accounting Pronouncements

 

In January 2012, we adopted Financial Accounting Standards Board, or FASB, Accounting Standards Update No. 2011-04, Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRS.  This update clarified the application of existing fair value measurement requirements.  This update also required reporting entities to disclose additional information regarding fair value measurements categorized within Level 3 of the fair value hierarchy.  This update was effective for interim and annual reporting periods beginning after December 15, 2011.  The implementation of this update did not cause any material changes to the disclosures in, or presentation of, our condensed consolidated financial statements.

 

In January 2012, we adopted FASB Accounting Standards Update No. 2011-05, Presentation of Comprehensive Income.  This update eliminated the option to report other comprehensive income and its components in the statement of shareholders’ equity.  This update was intended to enhance comparability between entities that report under GAAP and to provide a more consistent method of presenting non-owner transactions that affect an entity’s equity.  This standard was effective for interim and annual reporting periods beginning after December 15, 2011.  The implementation of this update did not cause any changes to our condensed consolidated financial statements other than the presentation of the condensed consolidated statements of comprehensive income.

 

Note 3.   Real Estate Properties

 

As of September 30, 2012, we owned 82 properties representing an aggregate investment of approximately $1,672,117.  We generally lease space in our properties on a gross lease or modified gross lease basis pursuant to fixed term operating leases expiring between 2012 and 2027.  Certain of our government tenants have the right to cancel their leases before the lease term expires, although we currently expect that few will do so.  Our leases generally require us to pay all or some property operating expenses and to provide all or most property management services.  During the three months ended September 30, 2012, we entered into 10 leases for 311,557 rentable square feet for a weighted average (by revenue) lease term of 9.3 years and made commitments for approximately $6,721 of leasing related costs.  During the nine months ended September 30, 2012, we entered into 31 leases for 555,182 rentable square feet for a weighted average (by revenue) lease term of 6.9 years and made commitments for approximately $10,372 of leasing related costs. We have unspent leasing related obligations of approximately $7,945 as of September 30, 2012.

 

During the nine months ended September 30, 2012, we acquired 10 office properties and one office warehouse property located in seven states for an aggregate purchase price of $181,051, excluding acquisition costs.  We allocated the purchase prices of these acquisitions based on the estimated fair values of the acquired assets and assumed liabilities as follows:

 

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GOVERNMENT PROPERTIES INCOME TRUST

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

 

														Buildings						Acquired
Acquisition				Number of		Square		Purchase						and			Acquired			Lease
Date		Location		Properties		Feet		Price(1) (2)			Land			Improvements			Leases			Obligations
June 2012		Everett, WA		2		111,908		$	20,425		$	3,360		$	15,376		$	2,449		$	(760	)
June 2012		Albany, NY		1		64,000		8,525			790			6,400			1,578			(243		)
July 2012		Stockton, CA		1		22,012		8,251			580			6,598			1,073			—
July 2012		Atlanta, GA		1		90,688		23,666			1,380			20,782			5,495			(3,991		)
July 2012		Ellenwood, GA		1		352,064		33,020			3,940			22,372			6,708			—
July 2012		Jackson, MS		1		109,819		31,314			450			25,768			5,204			(108		)
September 2012		Boise, ID		3		180,952		40,150			3,391			29,025			7,734			—
September 2012		Kansas City, MO		1		86,739		15,700			2,730			12,970			—			—
				11		1,018,182		$	181,051		$	16,621		$	139,291		$	30,241		$	(5,102	)

 

(1)        Purchase price excludes acquisition related costs.

(2)        The allocation of purchase price is based upon preliminary estimates and may change based upon the completion of our analysis of acquired in place leases.

 

In June 2012, we acquired two office properties located in Everett, WA with 111,908 rentable square feet.  These properties are 100% leased to the State of Washington and occupied by the Department of Social and Health Services.  The purchase price was $20,425, excluding acquisition costs.

 

Also in June 2012, we acquired an office property located in Albany, NY with 64,000 rentable square feet.  This property is 100% leased to the State of New York and occupied by the Department of Agriculture.  The purchase price was $8,525, excluding acquisition costs.

 

In July 2012, we acquired an office property located in Stockton, CA with 22,012 rentable square feet.  This property is 100% leased to the U.S. Government and occupied by the Department of Immigration and Customs Enforcement.  The purchase price was $8,251, excluding acquisition costs.

 

Also in July 2012, we acquired two office properties located in Atlanta, GA and Jackson, MS and an office warehouse property located in Ellenwood, GA with a combined total of 552,571 rentable square feet.  These properties are 100% leased to the U.S. Government and occupied by the Department of Homeland Security, Immigration and Customs Enforcement, the Federal Bureau of Investigation and the National Archives and Records Administration.  The aggregate purchase price was $88,000, excluding acquisition costs.

 

In September 2012, we acquired three office properties located in Boise, ID with 180,952 rentable square feet.  These properties are 100% leased to the U.S. Government and occupied by the Natural Resource Center and the Department of Homeland Security.  The aggregate purchase price was $40,150, excluding acquisition costs.

 

Also in September 2012, we acquired an office property located in Kansas City, MO with 86,739 rentable square feet.  This property is 100% leased to the U.S. Government and occupied by the Federal Bureau of Investigation.  The purchase price was $15,700, excluding acquisition costs.

 

In October 2012, we entered an agreement to acquire an office property located in Windsor Mill, MD with 78,131 rentable square feet.  This property is 100% leased to two tenants, of which 97% is leased to the U.S. Government and occupied by the Centers for Medicare and Medicaid.  The contract purchase price is $14,450, excluding acquisition costs.  This pending acquisition is subject to our satisfactory completion of diligence and other customary closing conditions; accordingly, we can provide no assurance that we will acquire this property.

 

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GOVERNMENT PROPERTIES INCOME TRUST

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

 

Note 4.   Concentration

 

Tenant and Credit Concentration

 

We define annualized rental income as the annualized contractual base rents from our tenants pursuant to our lease agreements with them as of the measurement date, plus straight line rent adjustments and estimated recurring expense reimbursements to be paid to us, and excluding lease value amortization. The U.S. Government, 10 state governments and the United Nations, an international intergovernmental organization, combined were responsible for approximately 93.9% and 93.1% of our annualized rental income as of September 30, 2012 and 2011, respectively. The U.S. Government is our largest tenant by annualized rental income and was responsible for approximately 71.0% and 71.3% of our annualized rental income as of September 30, 2012 and 2011, respectively.

 

Geographic Concentration

 

At September 30, 2012, our 82 properties were located in 31 states and the District of Columbia.  Properties located in California, Maryland, Georgia, the District of Columbia, New York, Massachusetts, and Colorado were responsible for approximately 12.3%, 11.9%, 9.9%, 9.4%, 9.2%, 6.3%, and 5.0% of our annualized rental income as of September 30, 2012, respectively.

 

Note 5.   Indebtedness

 

At September 30, 2012 and December 31, 2011, our outstanding indebtedness consisted of the following:

 

		September 30,			December 31,
		2012			2011
Unsecured revolving credit facility, due in 2015		$	167,000		$	345,500
Unsecured term loan, due in 2017		350,000			—
Mortgage note payable, 5.73% interest rate, including unamortized premium of $673, due in 2015(1)		49,493			50,118
Mortgage note payable, 6.21% interest rate, due in 2016(1)		24,513			24,713
Mortgage note payable, 7.00% interest rate, including unamortized premium of $910, due in 2019(1)		10,327			10,559
Mortgage note payable, 8.15% interest rate, including unamortized premium of $683, due in 2021(1)		9,376			9,993
		$	610,709		$	440,883

 

(1)       Assumed in connection with our acquisition of certain properties.  The stated interest rates for these mortgage debts are the contractually stated rates.  We recorded the assumed mortgages at estimated fair value on the date of acquisition and we are amortizing the fair value premiums, if any, to interest expense over the respective terms of the mortgages to reduce interest expense to the estimated market interest rates as of the date of acquisition.

 

We have a $550,000 unsecured revolving credit facility that is available for acquisitions, working capital and general business purposes.  Our revolving credit facility has a maturity date of October 19, 2015 and, subject to meeting certain conditions and our payment of a fee, we may extend the maturity date for one year to October 19, 2016.   In addition, our revolving credit facility includes a feature under which maximum borrowings may be increased to up to $1,100,000 in certain circumstances.  Borrowings under our revolving credit facility bear interest at LIBOR plus a spread of 150 basis points.  We also pay a facility fee of 35 basis points per annum on the total amount of lending commitments under our revolving credit facility.  Both the interest rate spread and the facility fee are subject to adjustment based upon changes to our credit ratings.  The weighted average annual interest rate for borrowings under our revolving credit facility was 1.77% and 1.75% for the three and nine months ended September 30, 2012, respectively.  As of September 30, 2012 we had $167,000 outstanding and $383,000 available under our revolving credit facility.

 

On January 12, 2012, we entered into a five year $350,000 unsecured term loan. Our term loan matures on January 11, 2017, and is prepayable without penalty at any time.  In addition, our term loan includes a feature under which maximum borrowings may be increased to up to $700,000 in certain circumstances. The amount outstanding under our term loan bears interest at LIBOR plus a spread of 175 basis points that is subject to adjustment based upon changes to our credit ratings.  We used the net proceeds of our term loan to repay amounts outstanding under our revolving credit facility and to fund general business activities.  The weighted average annual interest rate for the amount outstanding under our term loan was 2.02% for the three months ended September 30, 2012 and 2.00% for the period from January 12, 2012 to September 30, 2012.

 

Our revolving credit facility agreement and our term loan agreement contain a number of covenants that restrict our ability to incur debt in excess of calculated amounts, restrict our ability to make distributions under certain circumstances and generally require

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

 

us to maintain certain financial ratios.  We believe we were in compliance with the terms and conditions of our revolving credit facility agreement and our term loan agreement at September 30, 2012.

 

At September 30, 2012, five of our properties with an aggregate net book value of $122,575 were encumbered by four mortgages with a then aggregate principal amount outstanding of $91,443.  We assumed these mortgage notes in connection with certain of our acquisitions. Our mortgage notes are non-recourse and do not contain any material financial covenants.

 

Note 6.   Fair Value of Financial Instruments

 

Our financial instruments at September 30, 2012 include cash and cash equivalents, restricted cash, rents receivable, mortgage notes payable, accounts payable, our revolving credit facility and our term loan, amounts due to related persons, other accrued expenses and security deposits.  At September 30, 2012, the fair value of our financial instruments approximated their carrying values in our condensed consolidated financial statements, except as follows:

 

		Carrying Amount			Fair Value
Mortgage note payable, 5.73% interest rate, including unamortized premium of $673, due in 2015		$	49,493		$	51,007
Mortgage note payable, 6.21% interest rate, due in 2016		24,513			27,009
Mortgage note payable, 7.00% interest rate, including unamortized premium of $910, due in 2019		10,327			11,066
Mortgage note payable, 8.15% interest rate, including unamortized premium of $683, due in 2021		9,376			10,604
		$	93,709		$	99,686

 

We estimate the fair values of our mortgage notes payable by using discounted cash flow analyses and currently prevailing market terms as of the measurement date (Level 3 inputs as defined in the fair value hierarchy under GAAP).  Because our inputs are unobservable, our estimated fair value may differ materially from the actual fair value.

 

Note 7.   Shareholders’ Equity

 

Distributions

 

On February 24, 2012, we paid a distribution to common shareholders in the amount of $0.42 per share, or $19,762, that was declared on January 9, 2012 and was payable to shareholders of record on January 26, 2012.

 

On May 24, 2012, we paid a distribution to common shareholders in the amount of $0.42 per share, or $19,778, that was declared on April 9, 2012 and was payable to shareholders of record on April 26, 2012.

 

On August 22, 2012, we paid a distribution to common shareholders in the amount of $0.42 per share, or $19,782, that was declared on July 9, 2012 and was payable to shareholders of record on July 23, 2012.

 

On October 9, 2012, we declared a distribution payable to common shareholders of record on October 22, 2012, in the amount of $0.43 per share, or $23,497.  We expect to pay this distribution on or about November 21, 2012.

 

Share Issuances

 

As further described in Note 8, under the terms of our business management agreement with Reit Management & Research LLC, or RMR, on March 29, 2012 we issued 39,141 of our common shares of beneficial interest, $.01 par value per share, or our common shares, to RMR in payment of an incentive fee of approximately $833 for services rendered to us by RMR during 2011.

 

On May 16, 2012, pursuant to our equity compensation plan, we granted 2,000 of our common shares, valued at $22.43 per share, the closing price of our common shares on the New York Stock Exchange, or the NYSE, on that day, to each of our five Trustees as part of their annual compensation.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

 

On September 14, 2012, pursuant to our equity compensation plan, we granted an aggregate of 43,917 of our common shares, valued at $23.76 per share, the closing price of our common shares on the NYSE on that day to our officers and certain employees of our manager, RMR.

 

On October 19, 2012, we issued 7,500,000 common shares in a public offering at a price of $23.25 per share, raising net proceeds of approximately $166,564.  We used the net proceeds of this offering to repay amounts outstanding under our revolving credit facility.  We also granted the underwriters of the offering a 30-day option to purchase up to an additional 1,125,000 common shares, which option expires on November 15, 2012.

 

We have no dilutive securities.

 

Note 8.   Related Person Transactions

 

We have no employees.  Personnel and various services we require to operate our business are provided to us by RMR.  We have two agreements with RMR to provide management and administrative services to us: (1) a business management agreement and (2) a property management agreement.  Under our business management agreement with RMR, we acknowledge that RMR also provides management services to other companies, which include CommonWealth REIT, or CWH.  One of our Managing Trustees, Mr. Barry Portnoy, is Chairman, majority owner and an employee of RMR.  Our other Managing Trustee, Mr. Adam Portnoy, is the son of Mr. Barry Portnoy, and an owner, President, Chief Executive Officer and a director of RMR.  Each of our executive officers is also an officer of RMR.  CWH’s executive officers are officers of RMR.  Our Independent Trustees also serve as independent directors or independent trustees of other public companies to which RMR provides management services.  Mr. Barry Portnoy serves as a managing director or managing trustee of those companies and Mr. Adam Portnoy serves as a managing trustee of a majority of those companies.

 

Pursuant to our business management agreement with RMR, we incurred expenses of $2,742 and $2,015 for the three months ended September 30, 2012 and 2011, respectively, and $7,001 and $5,494 for the nine months ended September 30, 2012 and 2011, respectively.  These amounts are included in general and administrative expenses in our condensed consolidated financial statements.  In March 2012, we issued 39,141 of our common shares to RMR in satisfaction of the incentive fee RMR earned for services provided to us during 2011, in accordance with the terms of our business management agreement.  In connection with our property management agreement with RMR, we incurred property management and construction supervision fees of $1,829 and $1,352 for the three months ended September 30, 2012 and 2011, respectively, and $5,034 and $3,716 for the nine months ended September 30, 2012 and 2011, respectively.  These amounts are included in other operating expenses or have been capitalized, as appropriate, in our condensed consolidated financial statements.

 

CWH organized us as a 100% owned subsidiary.  In 2009, we completed our initial public offering, or the GOV IPO, pursuant to which we ceased to be a majority owned subsidiary of CWH.  In connection with the GOV IPO, we and CWH entered into a transaction agreement which governs our separation from and relationship with CWH.  Pursuant to this transaction agreement, among other things, CWH granted us a right of first refusal to acquire any property owned by CWH that CWH determines to divest, if the property is then majority leased to a government tenant, including 15 properties that we bought from CWH during 2010.

 

CWH is our largest shareholder and, as of the date of this report, CWH owned 9,950,000 of our common shares, or approximately 18.2% of our outstanding common shares.  One of our Managing Trustees, Mr. Barry Portnoy, is a managing trustee of CWH.  Our other Managing Trustee, Mr. Adam Portnoy, is a managing trustee and the President of CWH.  RMR provides management services to both us and CWH.

 

We, RMR, CWH and five other companies to which RMR provides management services each currently own 12.5% of Affiliates Insurance Company, or AIC, an Indiana insurance company.  All of our Trustees, all of the trustees and directors of the other publicly held AIC shareholders and nearly all of the directors of RMR currently serve on the board of directors of AIC.  RMR provides management and administrative services to AIC pursuant to a management and administrative services agreement with AIC.  Although we own less than 20% of AIC, we use the equity method to account for this investment because we believe that we have significant influence over AIC because all of our Trustees are also directors of AIC.  Our investment in AIC had a carrying value of $5,677 and $5,409 as of September 30, 2012 and December 31, 2011, respectively.  We recognized income of $115 and $28 for the three months ended September 30, 2012 and 2011, respectively, and $236 and $111 for the nine months ended September 30, 2012 and 2011, respectively, related to this investment.  We and the other shareholders of AIC have purchased property insurance providing $500,000 of coverage pursuant to an insurance program arranged by AIC and with respect to which AIC is a reinsurer of certain coverage amounts.  This program was modified and extended in June 2012 for a one year term and we paid a premium, including

 

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GOVERNMENT PROPERTIES INCOME TRUST

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

 

taxes and fees, of $410 in connection with that renewal, which amount may be adjusted from time to time as we acquire or dispose of properties that are included in that program.  We are also currently investigating the possibilities to expand our insurance relationships with AIC to include other types of insurance.  We may invest additional amounts in AIC in the future if the expansion of this insurance business requires additional capital, but we are not obligated to do so.  By participating in this insurance business with RMR and the other companies to which RMR provides management services, we expect that we may benefit financially by possibly reducing our insurance expenses or by realizing our pro-rata share of any profits of this insurance business.

 

For further information about these and other such relationships and related person transactions, please see elsewhere in this Quarterly Report on Form 10-Q, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Related Person Transactions” in Part I, Item 2 and “Warning Concerning Forward Looking Statements,” and our Annual Report, our Proxy Statement for our 2012 Annual Meeting of Shareholders dated February 23, 2012, or our Proxy Statement, and our other filings with the Securities and Exchange Commission, or SEC, including Note 5 to our Consolidated Financial Statements included in our Annual Report, the sections captioned “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Related Person Transactions” and “Warning Concerning Forward Looking Statements” of our Annual Report and the section captioned “Related Person Transactions and Company Review of Such Transactions” and the information regarding our Trustees and executive officers in our Proxy Statement.  In addition, please see the section captioned “Risk Factors” of our Annual Report for a description of risks that may arise from these transactions and relationships.  Our filings with the SEC, including our Annual Report and our Proxy Statement, are available at the SEC’s website at www.sec.gov.  In addition, copies of certain of our agreements with our related parties, including our business management agreement and property management agreement with RMR, various agreements we have with CWH and our shareholders agreement with AIC and its shareholders, are also publicly available as exhibits to our public filings with the SEC and accessible at the SEC’s website.

 

Note 9.   Pro Forma Information

 

During the nine months ended September 30, 2012, we purchased 11 properties for an aggregate purchase price of $181,051, excluding acquisition costs.  In January 2012, we entered into a $350,000 unsecured term loan to, among other things, repay amounts outstanding under our unsecured revolving credit facility.  During 2011, we purchased 16 properties for an aggregate purchase price of $444,050, including the assumption of $49,395 of mortgage debt and excluding acquisition costs.  Also in 2011, we amended our $500,000 revolving credit facility, to, among other things, increase maximum borrowings under the facility to $550,000 and we issued 6,500,000 of our common shares.  The following table presents our pro forma results of operations as if these acquisitions and financing activities were completed on January 1, 2011. This pro forma data is not necessarily indicative of what our actual results of operations would have been for the periods presented, nor does it represent the results of operations for any future period. Differences could result from various factors, including but not limited to, additional property acquisitions, property sales, changes in interest rates and changes in our debt or equity capital structure, and such differences could be significant.

 

		For the Nine Months Ended
		September 30,
		2012			2011
Total revenues		$	166,940		$	170,704
Net income		39,751			41,679
Per share data:
Net income		$	0.84		$	0.89

 

During the nine months ended September 30, 2012 and 2011, we recognized revenues of $42,234 and $10,580 respectively, and operating income of $13,560 and $1,820 respectively, arising from our 2011 and 2012 acquisitions.

 

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and tables should be read in conjunction with the financial statements and notes thereto included in this Quarterly Report on Form 10-Q and in our Annual Report.

 

OVERVIEW

 

As of September 30, 2012, we owned 82 properties located in 31 states and the District of Columbia containing approximately 10.0 million rentable square feet, of which 66.7% was leased to the U.S. Government, 17.4% was leased to 10 state governments, and 1.9% was leased to the United Nations, an international intergovernmental organization.  The U.S. Government, 10 state governments and the United Nations combined were responsible for 93.9% and 93.1% of our annualized rental income, as defined below, as of September 30, 2012 and 2011, respectively.

 

Property Operations

 

As of September 30, 2012, 92.4% of our rentable square feet were leased, compared to 96.1% of our rentable square feet as of September 30, 2011. Occupancy data for our properties as of September 30, 2012 and 2011 is as follows (square feet in thousands):

 

						Comparable
		All Properties				Properties(1)
		September 30,				September 30,
		2012		2011		2012		2011
Total properties (end of period)		82		67		55		55
Total square feet		9,969		8,286		6,805		6,805
Percent leased(2)		92.4	%	96.1	%	91.0	%	96.2	%

 

(1)                                     Based on properties we owned on September 30, 2012 and which we owned continuously since January 1, 2011.  Our comparable properties increased from 33 properties at September 30, 2011 as a result of acquisitions we completed during the year ended December 31, 2010.

 

(2)                                     Percent leased includes (i) space being fitted out for tenant occupancy pursuant to our lease agreements, if any, and (ii) space which is leased, but is not occupied or is being offered for sublease by tenants, if any, as of the measurement date.

 

The average effective rental rates per square foot for our properties for the periods ended September 30, 2012 and 2011 were as follows:

 

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2012			2011			2012			2011
Average effective rental rate per square foot:(1)
All properties		$	24.59		$	24.91		$	24.47		$	24.20
Comparable properties(2)		$	25.35		$	24.92		$	24.03		$	23.79

(1)                                     Average annualized effective rental rate per square foot represents annualized total rental income during the period specified divided by the average rentable square feet leased during the period specified.

 

(2)                                     Comparable properties for the three months ended September 30, 2012 consist of 64 properties we owned on September 30, 2012 and which we owned continuously since July 1, 2011.  Comparable properties for the nine months ended September 30, 2012 consist of 55 properties we owned on September 30, 2012 and which we owned continuously since January 1, 2011.

 

We currently believe that U.S. property leasing market conditions are slowly improving, but remain weak in many U.S. markets. Our historical experience, including that of our predecessor, CWH, with respect to properties of the type we own that are

 

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majority leased to government tenants has been that government tenants frequently renew leases to avoid the costs and disruptions that may result from relocating their operations. We believe that current budgetary pressures may cause increased demand for leased space by government tenants, as opposed to new buildings built on behalf of government tenants. However, these same increased budgetary pressures upon the U.S. Government and state governments could also result in a decrease in government employment and consolidation of operations into government owned properties, thereby reducing the need for government leased space. Accordingly, we are unable to reasonably project what the financial impact of market conditions will be on our financial results for future periods.

 

As of September 30, 2012, leases totaling 633,635 rentable square feet are scheduled to expire through December 31, 2012. Based upon current market conditions and tenant negotiations for leases scheduled to expire through December 31, 2012, we expect that rental rates we are likely to achieve on new or renewed leases will, in the aggregate and on a weighted average basis, be higher than the rates currently being paid, thereby generally resulting in higher revenue from the same space absent an increase in vacancies.  However, we can provide no assurance that the rental rates we expect will occur or that we will not experience material declines in our rental income due to vacancies upon lease expirations.  Prevailing market conditions at the time our leases expire will generally determine lease renewals and rental rates for space in our properties; and market conditions are generally beyond our control. As of September 30, 2012, lease expirations at our properties by year are as follows (square feet and dollars in thousands):

 

										Annualized
		Number of		Expirations of				Cumulative		Rental					Cumulative
		Tenants		Occupied Square		Percent		Percent		Income			Percent		Percent
Year(1)		Expiring		Feet(2)		of Total		of Total		Expiring(3)			of Total		of Total
2012		17		634		6.9	%	6.9	%	$	17,725		8.3	%	8.3	%
2013		34		958		10.4	%	17.3	%	14,407			6.7	%	15.0	%
2014		33		459		5.0	%	22.3	%	8,366			3.9	%	18.9	%
2015		39		1,298		14.1	%	36.4	%	29,416			13.7	%	32.6	%
2016		35		603		6.5	%	42.9	%	14,482			6.8	%	39.4	%
2017		29		618		6.7	%	49.6	%	12,560			5.9	%	45.3	%
2018		12		670		7.3	%	56.9	%	24,681			11.5	%	56.8	%
2019		15		1,365		14.8	%	71.7	%	31,594			14.8	%	71.6	%
2020		13		668		7.3	%	79.0	%	19,260			9.0	%	80.6	%
2021 and thereafter		21		1,939		21.0	%	100.0	%	41,587			19.4	%	100.0	%
Total		248		9,212		100.0	%			$	214,078		100.0	%
Weighted average remaining lease term (in years)				5.3						5.4

 

(1)                                     The year of lease expiration is pursuant to current contract terms. Some government tenants have the right to vacate their space before the stated expirations of their leases. As of September 30, 2012, government tenants occupying approximately 13.4% of our rentable square feet and responsible for approximately 9.8% of our annualized rental income as of September 30, 2012 have currently exercisable rights to terminate their leases before the stated expirations. Also in 2012, 2013, 2014, 2015, 2016, 2017, 2018, 2019 and 2020, early termination rights become exercisable by other tenants who currently occupy an additional approximately 0.1%, 3.6%, 4.0%, 0.6%, 5.8%, 0.7%, 1.1%, 3.7% and 0.6% of our rentable square feet, respectively, and contribute an additional approximately 0.1%, 3.1%, 4.7%, 0.5%, 8.8%, 2.3%, 1.4%, 4.3% and 0.7% of our annualized rental income, respectively, as of September 30, 2012.  In addition, as of September 30, 2012, 14 of our state government tenants have currently exercisable rights to terminate their leases if these states do not appropriate rent in their respective annual budgets. These 14 tenants occupy approximately 7.8% of our rentable square feet and contribute approximately 7.9% of our annualized rental income as of September 30, 2012.

 

(2)                                     Occupied square feet is pursuant to leases existing as of September 30, 2012, and includes (i) space being fitted out for tenant occupancy pursuant to our lease agreements, if any, and (ii) space which is leased, but is not occupied or is being offered for sublease by tenants, if any.

 

(3)                                     Annualized rental income is the annualized contractual base rents from our tenants pursuant to our lease agreements as of September 30, 2012, including straight line rent adjustments and estimated recurring expense reimbursements to be paid to us, and excluding lease value amortization.

 

Acquisition Activities (dollar amounts in thousands)

 

During the nine months ended September 30, 2012, we acquired 11 properties for an aggregate purchase price of $181,051, excluding acquisition related costs.  We acquired these properties at a range of capitalization rates from 7.4% to 9.3%, with a weighted average (by purchase price) capitalization rate of 8.1%.  We calculate the capitalization rate for property acquisitions as the ratio of (x) annual straight line rental income, excluding the impact of above and below market lease amortization, based on leases then in

 

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effect at the acquisition date, less estimated annual property operating expenses, excluding depreciation and amortization expense, to (y) the acquisition purchase price, including assumed debt and excluding acquisition costs.  For more information about these acquisitions, please see Note 3 to our Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

 

In October 2012, we entered an agreement to acquire an office property located in Windsor Hill, MD with 78,131 rentable square feet.  This property is 100% leased to two tenants, of which 97% is leased to the U.S. Government and occupied by the Centers for Medicare and Medicaid.  The contract purchase price is $14,450, excluding acquisition costs.  This pending acquisition is subject to our satisfactory completion of diligence and other customary closing conditions; accordingly, we can provide no assurance that we will acquire this property.

 

Our strategy related to property acquisitions and dispositions is materially unchanged from that disclosed in our Annual Report.  We continue to explore and evaluate for possible acquisition additional properties that are majority leased to government tenants; however, we can provide no assurance that we will reach agreements to acquire, or that if we do reach such agreements that we will complete the acquisitions of, such properties.

 

Although we may sell properties on occasion, we do not currently plan to dispose of any of our properties.  Future changes in market conditions, property performance or our plans with regard to particular properties may change our disposition strategy.

 

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RESULTS OF OPERATIONS (amounts in thousands, except per share amounts)

 

Three Months Ended September 30, 2012, Compared to Three Months Ended September 30, 2011

 

		Comparable Properties Results (1)											Acquired Properties Results (2)											Consolidated Results
		Three Months Ended September 30,											Three Months Ended September 30,											Three Months Ended September 30,
								$			%								$			%								$			%
		2012			2011			Change			Change		2012			2011			Change			Change		2012			2011			Change			Change
Rental income		$	43,533		$	45,409		$	(1,876	)	(4.1	)%	$	10,550		$	480		$	10,070		2097.9	%	$	54,083		$	45,889		$	8,194		17.9	%
Operating expenses:
Real estate taxes		4,824			4,808			16			0.3	%	904			45			859			1,908.9	%	5,728			4,853			875			18.0	%
Utility expenses		3,946			4,313			(367		)	(8.5	)%	1,194			62			1,132			1,825.8	%	5,140			4,375			765			17.5	%
Other operating expenses		7,500			7,811			(311		)	(4.0	)%	2,065			82			1,983			2,418.3	%	9,565			7,893			1,672			21.2	%
Total operating expenses		16,270			16,932			(662		)	(3.9	)%	4,163			189			3,974			2,102.6	%	20,433			17,121			3,312			19.3	%
Net operating income (3)		$	27,263		$	28,477		$	(1,214	)	(4.3	)%	$	6,387		$	291		$	6,096		2,094.8	%	33,650			28,768			4,882			17.0	%
Other expenses
Depreciation and amortization																								13,056			10,379			2,677			25.8	%
Acquisition related costs																								763			1,008			(245		)	(24.3	)%
General and administrative																								3,637			2,746			891			32.4	%
Total other expenses																								17,456			14,133			3,323			23.5	%
Operating income																								16,194			14,635			1,559			10.7	%
Interest and other income																								7			54			(47		)	(87.0	)%
Interest expense (including net amortization of debt premiums and deferred financing fees of $339 and $330, respectively)																								(4,530		)	(3,162		)	(1,368		)	43.3	%
Equity in earnings of an investee																								115			28			87			310.7	%
Income before income tax benefit (expense)																								11,786			11,555			231			2.0	%
Income tax benefit (expense)																								(30		)	8			(38		)	(475.0	)%
Net income																								$	11,756		$	11,563		$	193		1.7	%
Weighted average common shares outstanding																								47,108			45,322			1,786			3.9	%
Net income per common share																								$	0.25		$	0.26		$	(0.01	)	(3.8	)%
Calculation of Funds From Operations and Normalized Funds From Operations (4)
Net income																								$	11,756		$	11,563
Depreciation and amortization																								13,056			10,379
Funds from operations																								24,812			21,942
Acquisition related costs																								763			1,008
Normalized funds from operations																								$	25,575		$	22,950
Funds from operations per common share																								$	0.53		$	0.48
Normalized funds from operations per common share																								$	0.54		$	0.51

 

(1)                                     Comparable properties consist of 64 properties we owned on September 30, 2012 and which we owned continuously since July 1, 2011.

 

(2)                                     Acquired properties consist of the 18 and three (which three are included in the previously referenced 18) properties we owned on September 30, 2012 and September 30, 2011, respectively, and which we acquired during the period from July 1, 2011 to September 30, 2012.

 

(3)                                     We calculate net operating income, or NOI, as shown above.  We define NOI as rental income from real estate less our property operating expenses.  We consider NOI to be appropriate supplemental information to net income because it may help both investors and management to understand the operations of our properties.  We use NOI internally to evaluate individual and company wide property level performance and we believe NOI provides useful information to investors regarding our results of operations because it reflects only those income and expense items that are incurred at the property level and may facilitate comparisons of our operating performance between periods.  The calculation of NOI excludes certain components of net income in order to provide results that are more closely related to our properties’ results of operations. NOI does not represent cash generated by operating activities in accordance with GAAP and should not be considered as an alternative to net income, operating income or cash flow from operating activities, determined in accordance with GAAP, or as an indicator of our financial performance or liquidity, nor is NOI necessarily indicative of sufficient cash flow to fund all of our needs.  We believe that NOI may facilitate an understanding of our consolidated historical operating results.  NOI should be considered in conjunction with net income, operating income and cash flow from operating activities as presented in our Condensed Consolidated Statements of Income and Comprehensive Income and Condensed Consolidated Statements of Cash Flows.  Other real estate investment trusts, or REITs, and real estate companies may calculate NOI differently than we do.

 

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