OFFICE PROPERTIES INCOME TRUST - Quarter Report: 2013 June (Form 10-Q)

Table of Contents

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

 

For the quarterly period ended June 30, 2013

 

OR

 

 

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 August 1, 2013:  54,674,118

 

 

Table of Contents

 

GOVERNMENT PROPERTIES INCOME TRUST

 

FORM 10-Q

 

June 30, 2013

 

INDEX

 

PART I	Financial Information
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets — June 30, 2013 and December 31, 2012	1
	Condensed Consolidated Statements of Income and Comprehensive Income — Three and Six Months Ended June 30, 2013 and 2012	2
	Condensed Consolidated Statements of Cash Flows —Six Months Ended June 30, 2013 and 2012	3
	Notes to Condensed Consolidated Financial Statements	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	9
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	21
Item 4.	Controls and Procedures	22
	Warning Concerning Forward Looking Statements	23
	Statement Concerning Limited Liability	25
PART II	Other Information
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	26
Item 6.	Exhibits	27
	Signatures	28

 

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)

 

		June 30,			December 31,
		2013			2012
ASSETS
Real estate properties:
Land		$	243,584		$	243,611
Buildings and improvements		1,283,094			1,279,343
		1,526,678			1,522,954
Accumulated depreciation		(190,581		)	(175,052		)
		1,336,097			1,347,902
Assets of discontinued operations		—			10,278
Acquired real estate leases, net		132,233			144,401
Cash and cash equivalents		3,119			5,255
Restricted cash		1,736			1,553
Rents receivable, net		30,812			28,997
Deferred leasing costs, net		9,191			7,661
Deferred financing costs, net		4,822			5,718
Other assets, net		9,194			10,369
Total assets		$	1,527,204		$	1,562,134
LIABILITIES AND SHAREHOLDERS’ EQUITY
Unsecured revolving credit facility		$	25,000		$	49,500
Unsecured term loan		350,000			350,000
Mortgage notes payable		91,939			93,127
Liabilities of discontinued operations		—			102
Accounts payable and accrued expenses		18,927			19,106
Due to related persons		2,849			3,719
Assumed real estate lease obligations, net		17,370			19,129
Total liabilities		506,085			534,683
Commitments and contingencies
Shareholders’ equity:
Common shares of beneficial interest, $.01 par value: 70,000,000 shares authorized, 54,674,118 and 54,643,888 shares issued and outstanding, respectively		547			547
Additional paid in capital		1,104,803			1,103,982
Cumulative net income		177,223			137,293
Cumulative other comprehensive income		18			99
Cumulative common distributions		(261,472		)	(214,470		)
Total shareholders’ equity		1,021,119			1,027,451
Total liabilities and shareholders’ equity		$	1,527,204		$	1,562,134

 

See accompanying notes.

 

1

Table of Contents

 

GOVERNMENT PROPERTIES INCOME TRUST

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

(amounts in thousands, except per share data)

(unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2013			2012			2013			2012
Rental income		$	57,261		$	49,808		$	114,939		$	99,805
Expenses:
Real estate taxes		6,648			5,899			13,151			11,378
Utility expenses		3,993			3,793			7,980			7,524
Other operating expenses		10,016			9,232			19,594			17,999
Depreciation and amortization		13,972			11,995			27,668			23,905
Acquisition related costs		105			245			139			294
General and administrative		3,299			2,680			6,548			5,682
Total expenses		38,033			33,844			75,080			66,782
Operating income		19,228			15,964			39,859			33,023
Interest and other income		5			6			16			14
Interest expense (including net amortization of debt premiums and deferred financing fees of $332, $335, $663 and $659, respectively)		(4,065		)	(4,096		)	(8,212		)	(8,119		)
Equity in earnings of an investee		79			76			155			121
Income from continuing operations before income tax expense		15,247			11,950			31,818			25,039
Income tax expense		(43		)	(44		)	(86		)	(89		)
Income from continuing operations		15,204			11,906			31,732			24,950
Discontinued operations:
Income from discontinued operations		—			48			30			63
Net gain on sale of properties from discontinued operations		—			—			8,168			—
Net income		15,204			11,954			39,930			25,013
Other comprehensive income (loss):
Equity in unrealized loss of an investee		(73		)	(1		)	(81		)	(4		)
Other comprehensive income (loss)		(73		)	(1		)	(81		)	(4		)
Comprehensive income		$	15,131		$	11,953		$	39,849		$	25,009
Weighted average common shares outstanding		54,669			47,098			54,657			47,075
Per common share amounts:
Income from continuing operations		$	0.28		$	0.25		$	0.58		$	0.53
Income from discontinued operations		—			—			0.15			—
Net income		$	0.28		$	0.25		$	0.73		$	0.53

 

See accompanying notes.

 

2

Table of Contents

 

GOVERNMENT PROPERTIES INCOME TRUST

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(amounts in thousands)

(unaudited)

 

		Six Months Ended June 30,
		2013			2012
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	39,930		$	25,013
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation		17,273			15,656
Net amortization of debt premium and deferred financing fees		663			659
Straight line rental income		(1,654		)	(1,564		)
Amortization of acquired real estate leases		10,413			9,274
Amortization of deferred leasing costs		590			387
Other non-cash expenses		1,046			646
Net gain on sale of properties		(8,168		)	—
Equity in earnings of an investee		(155		)	(121		)
Change in assets and liabilities:
Restricted cash		(183		)	(2,234		)
Deferred leasing costs		(2,075		)	(811		)
Rents receivable		(59		)	3,478
Other assets		1,258			2,162
Accounts payable and accrued expenses		397			486
Due to related persons		(787		)	(463		)
Cash provided by operating activities		58,489			52,568
CASH FLOWS FROM INVESTING ACTIVITIES:
Real estate acquisitions and deposits		—			(38,850		)
Real estate improvements		(6,542		)	(4,711		)
Proceeds from sale of properties, net		18,374			—
Cash provided by (used in) investing activities		11,832			(43,561		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of mortgage notes payable		(955		)	(881		)
Borrowings on unsecured revolving credit facility		46,500			27,000
Repayments on unsecured revolving credit facility		(71,000		)	(345,500		)
Proceeds from unsecured term loan		—			350,000
Financing fees		—			(1,964		)
Distributions to common shareholders		(47,002		)	(39,540		)
Cash used in financing activities		(72,457		)	(10,885		)
Decrease in cash and cash equivalents		(2,136		)	(1,878		)
Cash and cash equivalents at beginning of period		5,255			3,272
Cash and cash equivalents at end of period		$	3,119		$	1,394
Supplemental cash flow information:
Interest paid		$	7,610		$	7,695
Income taxes paid		128			86
Non-cash financing activities:
Issuance of common shares		$	821		$	1,165

 

See accompanying notes.

 

3

Table of Contents

 

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 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, 2012, Items 6, 7 and 15 of which were subsequently amended and restated to make reclassifications to reflect properties we sold in 2013 as discontinued operations (See Note 3) and are included in our Current Report on Form 8-K dated July 12, 2013.  We refer in this Quarterly Report to our Annual Report on Form 10-K for the year ended December 31, 2012, as amended and restated in part by our Current Report on Form 8-K dated July 12, 2013, as 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 purchase price allocations, useful lives of fixed assets and impairment of real estate and intangible assets.

 

Note 2.   Recent Accounting Pronouncements

 

Effective January 2013, we adopted Financial Accounting Standards Board, or FASB, Accounting Standards Update No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. This update is the culmination of the FASB’s deliberation on reporting reclassification adjustments from accumulated other comprehensive income, or AOCI. This standard did not change the requirements for reporting net income or other comprehensive income. However, it requires disclosure of amounts reclassified out of AOCI in their entirety, by component, on the face of the statement of income and comprehensive income or in the notes thereto. Amounts that are not required to be reclassified in their entirety to net income must be cross-referenced to other disclosures that provide additional detail. This update was effective prospectively for annual and interim reporting periods beginning after December 15, 2012. The implementation of this update did not cause any changes to the disclosures in, or the presentation of, our condensed consolidated financial statements.

 

Note 3. Real Estate Properties

 

As of June 30, 2013, we owned 82 properties with an undepreciated carrying value of $1,526,678. We generally lease space in our properties on a gross lease or modified gross lease basis pursuant to fixed term operating leases expiring between 2013 and 2033. Certain of our government tenants have the right to terminate their leases before the lease term expires. 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 June 30, 2013, we entered into 16 leases for 314,527 rentable square feet for a weighted average (by square feet) lease term of 13.4 years and we made commitments for approximately $5,191 of leasing related costs. During the six months ended June 30, 2013, we entered into 22 leases for 513,045 rentable square feet for a weighted average (by square feet) lease term of 9.7 years and we made commitments for approximately $9,802 of leasing related costs. We have unspent leasing related obligations of approximately $13,600 as of June 30, 2013.

 

In February 2013, we sold an office property located in Oklahoma City, OK with 185,881 rentable square feet and a net book value of $8,069 for $16,300, excluding closing costs, and recognized a gain on sale of $8,198.  In March 2013, we sold an office property located in Tucson, AZ with 31,051 rentable square feet and a net book value of $2,080 for $2,189, excluding closing costs, and recognized a loss on sale of $30.

 

4

Table of Contents

 

GOVERNMENT PROPERTIES INCOME TRUST

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

 

Results of operations for properties sold are included in discontinued operations in our condensed consolidated statements of income and comprehensive income once the criteria for discontinued operations in the Presentation of Financial Statements Topic of the FASB Accounting Standards Codification TM are met.  Summarized income statement information for properties sold is as follows:

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2013			2012			2013			2012
Rental income		$	—		$	465		$	244		$	923
Real estate taxes		—			(50		)	(35		)	(104		)
Utility expenses		—			(77		)	(48		)	(181		)
Other operating expenses		—			(93		)	(61		)	(179		)
Depreciation and amortization		—			(158		)	(45		)	(320		)
General and administrative		—			(39		)	(25		)	(76		)
Income from discontinued operations		$	—		$	48		$	30		$	63

 

In July 2013, we entered an agreement to acquire a warehouse property located in Chester, Virginia with 228,108 rentable square feet.  This property is 100% leased to the U.S. Government and occupied by the United States Army.  The contract price is $12,750, 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 or that the acquisition will not be delayed or that the terms will not change.

 

Note 4.  Revenue Recognition

 

Rental income from operating leases is recognized on a straight line basis over the life of lease agreements. We increased rental income to record revenue on a straight line basis by $745 and $694 for the three months ended June 30, 2013 and 2012, respectively, and $1,654 and $1,564 for the six months ended June 30, 2013 and 2012, respectively.  Rents receivable include $9,076 and $7,455 of straight line rent receivables at June 30, 2013 and December 31, 2012, respectively.

 

Note 5.  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 combined were responsible for approximately 94.0% and 92.7% of our annualized rental income as of June 30, 2013 and 2012, respectively. The U.S. Government is our largest tenant by annualized rental income and was responsible for approximately 71.5% and 67.7% of our annualized rental income as of June 30, 2013 and 2012, respectively.

 

Geographic Concentration

 

At June 30, 2013, our 82 properties were located in 31 states and the District of Columbia.  Properties located in Maryland, California, the District of Columbia, Georgia, New York and Massachusetts were responsible for approximately 12.3%, 12.2%, 10.9%, 9.6%, 8.8% and 6.0% of our annualized rental income as of June 30, 2013, respectively.

 

5

Table of Contents

 

GOVERNMENT PROPERTIES INCOME TRUST

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

 

Note 6.  Indebtedness

 

At June 30, 2013 and December 31, 2012, our outstanding indebtedness consisted of the following: 

 

		June 30,			December 31,
		2013			2012
Unsecured revolving credit facility, due in 2015		$	25,000		$	49,500
Unsecured term loan, due in 2017		350,000			350,000
Mortgage note payable, 5.73% interest rate, including unamortized premium of $516, due in 2015(1)		48,827			49,274
Mortgage note payable, 6.21% interest rate, due in 2016(1)		24,294			24,441
Mortgage note payable, 7.00% interest rate, including unamortized premium of $814, due in 2019(1)		10,086			10,247
Mortgage note payable, 8.15% interest rate, including unamortized premium of $587, due in 2021(1)		8,732			9,165
		$	466,939		$	492,627

 

(1)         We assumed these mortgages in connection with our acquisitions 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 general business purposes, including acquisitions. The maturity date of our revolving credit facility is October 19, 2015 and, subject to the payment of an extension fee and meeting certain other conditions, includes an option for us to extend the stated maturity date of our revolving credit facility by 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 a rate of LIBOR plus a premium, which was 150 basis points as of June 30, 2013. 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 premium and the facility fee are subject to adjustment based upon changes to our credit ratings. As of June 30, 2013, the interest rate payable on borrowings under our revolving credit facility was 1.7% and the weighted average annual interest rate for borrowings under our revolving credit facility was 1.7% for both the three and six months ended June 30, 2013. As of June 30, 2013, we had $25,000 outstanding and $525,000 available under our revolving credit facility.

 

We have a $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. Our term loan bears interest at a rate of LIBOR plus a premium, which was 175 basis points as of June 30, 2013. The interest rate premium is subject to adjustment based upon changes to our credit ratings. As of June 30, 2013, the interest rate for the amount outstanding under our term loan was 2.0% and the weighted average interest rate for the amount outstanding under our term loan was 1.9% for both the three and six months ended June 30, 2013.

 

Our revolving credit facility agreement and our term loan agreement provide for acceleration of payment of all amounts due thereunder upon the occurrence and continuation of certain events of default, including a change of control of us and the termination of our business management agreement or property management agreement with Reit Management & Research LLC, or RMR. Our revolving credit facility agreement and our term loan agreement also contain a number of covenants, including covenants that restrict our ability to incur debts or to make distributions under certain circumstances and require us to maintain financial ratios and a minimum net worth.  We believe we were in compliance with the terms and conditions of our revolving credit facility agreement and our term loan agreement at June 30, 2013.

 

At June 30, 2013, five of our properties with an aggregate net book value of $121,417 secured four mortgage notes that were assumed in connection with the acquisition of such properties. Our mortgage notes are non-recourse and do not contain any material financial covenants.

 

6

Table of Contents

 

GOVERNMENT PROPERTIES INCOME TRUST

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

 

Note 7. Fair Value of Financial Instruments

 

Our financial instruments at June 30, 2013 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 June 30, 2013, the fair values 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 $516, due in 2015		$	48,827		$	50,291
Mortgage note payable, 6.21% interest rate, due in 2016		24,294			26,438
Mortgage note payable, 7.00% interest rate, including unamortized premium of $814, due in 2019		10,086			10,626
Mortgage note payable, 8.15% interest rate, including unamortized premium of $587, due in 2021		8,732			9,669
		$	91,939		$	97,024

 

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 Level 3 inputs are unobservable, our estimated fair value may differ materially from the actual fair value.

 

Note 8. Shareholders’ Equity

 

Distributions

 

On February 22, 2013, we paid a distribution to common shareholders in the amount of $0.43 per share, or $23,497, that was declared on January 10, 2013 and was payable to shareholders of record on January 25, 2013.

 

On May 24, 2013, we paid a distribution to common shareholders in the amount of $0.43 per share, or $23,505, that was declared on April 10, 2013 and was payable to shareholders of record on April 26, 2013.

 

On July 10, 2013, we declared a distribution payable to common shareholders of record on July 26, 2013, in the amount of $0.43 per share, or $23,510.  We expect to pay this distribution on or about August 23, 2013 using cash on hand and borrowings under our revolving credit facility.

 

Share Issuances

 

As further described in Note 9, on March 27, 2013, under the terms of our business management agreement with RMR, we issued 20,230 of our common shares of beneficial interest, $.01 par value per share, or common shares, to RMR in payment of an incentive fee of approximately $485 for services rendered to us by RMR during 2012.

 

On May 21, 2013, we granted 2,000 of our common shares, valued at $26.60 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.

 

We have no dilutive securities.

 

Note 9. 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, which relates to our business generally, and (2) a property management agreement, which relates to our property level operations.

 

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

 

7

Table of Contents

 

GOVERNMENT PROPERTIES INCOME TRUST

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

 

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.  In addition, officers of RMR serve as officers of those companies.

 

Pursuant to our business management agreement with RMR, we recognized business management fees of $2,528 and $2,028 for the three months ended June 30, 2013 and 2012, respectively, and $4,982 and $4,258 for the six months ended June 30, 2013 and 2012, respectively.  These amounts are included in general and administrative expenses in our condensed consolidated financial statements.  In March 2013, we issued 20,230 of our common shares to RMR for the incentive fee payable to RMR for 2012, in accordance with the terms of our business management agreement.

 

In connection with our property management agreement with RMR, we recognized aggregate property management and construction supervision fees of $1,799 and $1,610 for the three months ended June 30, 2013 and 2012, respectively, and $3,615 and $3,205 for the six months ended June 30, 2013 and 2012, 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.  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.

 

In 2009, we completed our initial public offering, or our IPO, pursuant to which we ceased to be a majority owned subsidiary of CWH.  In connection with our IPO, we and CWH entered into a transaction agreement that 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, which right of first refusal will also apply in the event of an indirect sale of any such properties resulting from a change of control of CWH.

 

Until March 15, 2013, CWH was our largest shareholder.  On March 15, 2013, CWH sold all 9,950,000 of our common shares it owned in a public offering.  In connection with this public offering, on March 11, 2013, we entered into a registration agreement with CWH under which CWH agreed to pay all expenses incurred by us relating to the registration and sale of our common shares owned by CWH in the offering, pursuant to which CWH paid us $303. In addition, under the registration agreement, CWH agreed to indemnify us and our officers, Trustees and controlling persons, and we agreed to indemnify CWH, its officers, trustees and controlling persons, against certain liabilities related to the public offering, including liabilities under the Securities Act of 1933, as amended, or the Securities Act; and we and CWH agreed to reimburse payments that the other may make in respect of those liabilities.

 

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.

 

As of June 30, 2013, we have invested $5,194 in AIC since we became an equity owner of AIC in December 2009.  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 $5,823 and $5,747 as of June 30, 2013 and December 31, 2012, respectively, which amounts are included in other assets on our condensed consolidated balance sheet.  We recognized income of $79 and $76 for the three months ended June 30, 2013 and 2012, respectively, and $155 and $121 for the six months ended June 30, 2013 and 2012, respectively, related to our investment in AIC.  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 2013 for a one year term, and we paid a premium, including taxes and fees, of $1,161 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 this program.  We periodically consider the possibilities for expanding our insurance relationships with AIC to include other types of insurance and may in the future participate in additional insurance offerings AIC may provide or arrange.  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.

 

8

Table of Contents

 

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

 

We are a real estate investment trust, or REIT, organized under Maryland law. As of June 30, 2013, we owned 82 properties located in 31 states and the District of Columbia containing approximately 10 million rentable square feet, of which 67.3% was leased to the U.S. Government, 17.9% was leased to 10 state governments, 1.9% was leased to the United Nations, an international intergovernmental organization, and 6.3% was leased to various non-governmental organizations.  The U.S. Government, 10 state governments and the United Nations combined were responsible for 94.0% and 92.7% of our annualized rental income, as defined below, as of June 30, 2013 and 2012, respectively.

 

Property Operations

 

As of June 30, 2013, 93.4% of our rentable square feet were leased, compared to 92.6% of our rentable square feet as of June 30, 2012.  Occupancy data for our properties as of June 30, 2013 and 2012 is as follows (square feet in thousands):

 

						Comparable
		All Properties(1)				Properties(2)
		June 30,				June 30,
		2013		2012		2013		2012
Total properties (end of period)		82		72		69		69
Total square feet		10,000		8,909		8,733		8,733
Percent leased(3)		93.4	%	92.6	%	92.4	%	92.5	%

 

(1)         Based on properties we owned on June 30, 2013.

(2)         Based on properties we owned on June 30, 2013 and which we owned continuously since January 1, 2012.  Our comparable properties increased from 55 properties at June 30, 2012 as a result of 16 acquisitions we completed during the year ended December 31, 2011 and the sale of two properties during the six months ended June 30, 2013.

(3)         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 annualized effective rental rate per square foot for our properties for the periods ended June 30, 2013 and 2012 are as follows:

 

		Three Months Ended						Six Months Ended
		June 30,						June 30,
		2013			2012			2013			2012
Average annualized effective rental rate per square foot:(1)
All properties(2)		$	24.70		$	24.86		$	24.79		$	24.81
Comparable properties(3)		$	25.24		$	24.87		$	25.38		$	24.81

 

(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)         Based on properties we owned on June 30, 2013.

(3)         Based on properties we owned on June 30, 2013 and which we owned continuously since January 1, 2012.

 

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 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, an increase in

 

9

Table of Contents

 

space utilization rates by government tenants or 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 or changing government financial circumstances will be on our financial results for future periods.

 

As of June 30, 2013, we had leases totaling 585,879 rentable square feet that were scheduled to expire through September 30, 2013. Based upon current market conditions and tenant negotiations for leases scheduled to expire through September 30, 2013, 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 (based on revenues), 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 cannot assure 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 and government tenants’ needs at the time our leases expire will generally determine lease renewals and rental rates for space in our properties; and market conditions and government tenants’ needs are generally beyond our control. As of June 30, 2013, 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
2013		30		609		6.5	%	6.5	%	$	16,277		7.3	%	7.3	%
2014		33		449		4.8	%	11.3	%	8,697			3.9	%	11.2	%
2015		36		1,193		12.8	%	24.1	%	27,293			12.3	%	23.5	%
2016		36		775		8.3	%	32.4	%	25,052			11.3	%	34.8	%
2017		30		617		6.6	%	39.0	%	12,587			5.7	%	40.5	%
2018		29		1,057		11.3	%	50.3	%	27,788			12.5	%	53.0	%
2019		15		1,286		13.8	%	64.1	%	29,883			13.4	%	66.4	%
2020		15		793		8.5	%	72.6	%	22,352			10.1	%	76.5	%
2021		8		839		9.0	%	81.6	%	16,122			7.2	%	83.7	%
2022 and thereafter		21		1,721		18.4	%	100.0	%	36,328			16.3	%	100.0	%
Total		253		9,339		100.0	%			$	222,379		100.0	%
Weighted average remaining lease term (in years)				5.6						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 June 30, 2013, government tenants occupying approximately 7.5% of our rentable square feet and responsible for approximately 5.6% of our annualized rental income as of June 30, 2013 have currently exercisable rights to terminate their leases before the stated expirations. Also in 2013, 2014, 2015, 2016, 2017, 2018, 2019,  2020 and 2023, early termination rights become exercisable by other tenants who currently occupy an additional approximately 0.7%, 4.1%, 3.3%, 6.6%, 2.6%, 1.1%, 3.6%, 0.6% and 1.5% of our rentable square feet, respectively, and contribute an additional approximately 0.6%, 4.6%, 2.7%, 9.4%, 3.6%, 1.4%, 4.2%, 0.7% and 1.3% of our annualized rental income, respectively, as of June 30, 2013.  In addition, as of June 30, 2013, 12 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 12 tenants occupy approximately 7.7% of our rentable square feet and contribute approximately 7.5% of our annualized rental income as of June 30, 2013.

 

(2)                                 Occupied square feet is pursuant to leases existing as of June 30, 2013, 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 June 30, 2013, plus straight line rent adjustments and estimated recurring expense reimbursements to be paid to us, and excluding lease value amortization.

 

Acquisition and Disposition Activities (dollar amounts in thousands)

 

In July 2013, we entered an agreement to acquire a warehouse property located in Chester, Virginia with 228,108 rentable square feet.  This property is 100% leased to the U.S. Government and occupied by the United States Army.  The contract price is $12,750, 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 or that the acquisition will not be delayed or that the terms will not change.

 

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;

 

10

Table of Contents

 

however, we cannot assure that we will reach any agreement to acquire such properties, or that if we do reach any such agreement, that we will complete the acquisitions.

 

In February 2013, we sold an office property located in Oklahoma City, OK with 185,881 rentable square feet for $16,300, excluding closing costs, and recognized a gain on sale of $8,198. In March 2013, we sold an office property located in Tucson, AZ with 31,051 rentable square feet for $2,189, excluding closing costs, and recognized a loss on sale of $30.

 

We do not currently plan to dispose of any of our properties, however, we may on occasion offer for sale additional properties. Future changes in market conditions, property performance, our expectation regarding lease renewals or our plans with regard to particular properties may change our disposition strategy.

 

11

Table of Contents

 

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

 

Three Months Ended June 30, 2013, Compared to Three Months Ended June 30, 2012

 

		Comparable Properties Results (1)											Acquired Properties Results (2)						Consolidated Results
		Three Months Ended June 30,											Three Months Ended June 30,						Three Months Ended June 30,
								$			%														$			%
		2013			2012			Change			Change		2013			2012			2013			2012			Change			Change
Rental income		$	50,533		$	49,763		$	770		1.5	%	$	6,728		$	45		$	57,261		$	49,808		$	7,453		15.0	%
Operating expenses:
Real estate taxes		6,075			5,894			181			3.1	%	573			5			6,648			5,899			749			12.7	%
Utility expenses		3,582			3,793			(211		)	(5.6	)%	411			—			3,993			3,793			200			5.3	%
Other operating expenses		8,958			9,228			(270		)	(2.9	)%	1,058			4			10,016			9,232			784			8.5	%
Total operating expenses		18,615			18,915			(300		)	(1.6	)%	2,042			9			20,657			18,924			1,733			9.2	%
Net operating income (3)		$	31,918		$	30,848		$	1,070		3.5	%	$	4,686		$	36		36,604			30,884			5,720			18.5	%
Other expenses
Depreciation and amortization																			13,972			11,995			1,977			16.5	%
Acquisition related costs																			105			245			(140		)	(57.1	)%
General and administrative																			3,299			2,680			619			23.1	%
Total other expenses																			17,376			14,920			2,456			16.5	%
Operating income																			19,228			15,964			3,264			20.4	%
Interest and other income																			5			6			(1		)	(16.7	)%
Interest expense (including net amortization of debt premiums and deferred financing fees of $332 and $335, respectively)																			(4,065		)	(4,096		)	31			(0.8	)%
Equity in earnings of an investee																			79			76			3			3.9	%
Income from continuing operations before income tax expense																			15,247			11,950			3,297			27.6	%
Income tax expense																			(43		)	(44		)	1			(2.3	)%
Net income from continuing operations																			15,204			11,906			3,298			27.7	%
Discontinued operations:
Income from discontinued opertations																			—			48			(48		)	—
Net income																			$	15,204		$	11,954		$	(48	)	(0.4	)%
Weighted average common shares outstanding																			54,669			47,098			7,571			16.1	%
Net income from continuing operations per common share																			$	0.28		$	0.25		$	0.03		11.9	%
Net income from discontinued operations per common share																			—			—			—			––
Net income per common share																			$	0.28		$	0.25		$	0.03		11.9	%
Calculation of Funds From Operations and Normalized Funds From Operations (4)
Net income																			$	15,204		$	11,954
Plus: Depreciation and amortization from continuing operations																			13,972			11,995
Plus: Depreciation and amortization from discontinued operations																			—			158
Funds from operations																			29,176			24,107
Acquisition related costs																			105			245
Normalized funds from operations																			$	29,281		$	24,352

 

(1)                                 Comparable properties consist of 69 properties we owned on June 30, 2013 and which we owned continuously since April 1, 2012.

 

(2)                                 Acquired properties consist of the 13 and three (which three are included in the previously referenced 13) properties we owned on June 30, 2013 and 2012, respectively, which we acquired during the period from April 1, 2012 to June 30, 2013.

 

(3)                                 We calculate net operating income, or NOI, as shown above. We define NOI as income from our real estate less our property operating expenses. NOI excludes amortization of capitalized tenant improvement costs and leasing commissions. We consider NOI to be an appropriate supplemental measure 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 that 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

 

12

Table of Contents

 

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 this measure 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. This measure 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.

 

(4)                                 We calculate funds from operations, or FFO, and Normalized FFO as shown above. FFO is calculated on the basis defined by The National Association of Real Estate Investment Trusts, or NAREIT, which is net income, calculated in accordance with GAAP, plus real estate depreciation and amortization, excluding any gain or loss on sale of properties, as well as other adjustments currently not applicable to us. Our calculation of Normalized FFO differs from NAREIT’s definition of FFO because we exclude acquisition related costs. We consider FFO and Normalized FFO to be appropriate measures of operating performance for a REIT, along with net income, operating income and cash flow from operating activities. We believe that FFO and Normalized FFO provide useful information to investors because by excluding the effects of certain historical amounts, such as depreciation expense, FFO and Normalized FFO may facilitate a comparison of our operating performance between periods and between us and other REITs. FFO and Normalized FFO are among the factors considered by our Board of Trustees when determining the amount of distributions to our shareholders. Other factors include, but are not limited to, requirements to maintain our status as a REIT, limitations in our revolving credit facility and term loan agreements, the availability of debt and equity capital to us, our expectation of our future capital requirements and operating performance, and our expected needs and availability of cash to pay our obligations. FFO and Normalized FFO do not represent cash generated by operating activities in accordance with GAAP and should not be considered as alternatives to net income, operating income or cash flow from operating activities, determined in accordance with GAAP, or as indicators of our financial performance or liquidity, nor are these measures necessarily indicative of sufficient cash flow to fund all of our needs. We believe that FFO and Normalized FFO may facilitate an understanding of our consolidated historical operating results. These measures 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 Condensed Comprehensive Income and Consolidated Statements of Cash Flows. Other REITs and real estate companies may calculate FFO and Normalized FFO differently than we do.

 

We refer to the 69 properties we owned on June 30, 2013 and which we have owned continuously since April 1, 2012 as comparable properties.  We refer to the 13 and three (which three are included in the previously referenced 13) properties that we owned as of June 30, 2013 and 2012, respectively, which we purchased during the period from April 1, 2012 to June 30, 2013 as acquired properties.  Our condensed consolidated income statement for the three months ended June 30, 2013 includes the operating results of all of the acquired properties for the entire period, as we purchased all of the acquired properties prior to April 1, 2013 and our condensed consolidated income statement for the three months ended June 30, 2012 includes the operating results of three acquired properties for less than the entire period, as those properties were purchased during that period.

 

References to changes in the income and expense categories below relate to the comparison of consolidated results for the three month period ended June 30, 2013, compared to the three month period ended June 30, 2012.

 

Rental income.  The increase in rental income reflects the effects of acquired properties and an increase in rental income for comparable properties.  Rental income for acquired properties increased $5,753 from properties acquired after June 30, 2012 and $930 from properties acquired during the 2012 period.  Rental income for comparable properties increased $770 primarily due to increases in base rental income and real estate tax expense reimbursement income, partially offset by lower operating expense reimbursement income and a decrease in straight line rent adjustments. Rental income includes non-cash straight line rent adjustments totaling $745 in the 2013 period and $694 in the 2012 period and amortization of acquired leases and assumed lease obligations totaling ($306) in the 2013 period and ($538) in the 2012 period.

 

Real estate taxes. The increase in real estate taxes reflects the effects of acquired properties and an increase in real estate taxes for comparable properties. Real estate taxes for acquired properties increased $483 from properties acquired after June 30, 2012 and $85 from properties acquired during the 2012 period.  Real estate taxes for comparable properties increased $181 due primarily to the effect of higher tax assessments at certain of our properties.

 

Utility expenses.  The increase in utility expenses reflects the effects of acquired properties, partially offset by lower utility expenses for comparable properties.  Utility expenses for acquired properties increased $409 from properties acquired after June 30, 2012 and $2 from properties acquired during the 2012 period.  Utility expenses at comparable properties declined $211 primarily due to lower electricity rates at certain of our properties, partially offset by higher usage at certain of our properties.

 

13