OFFICE PROPERTIES INCOME TRUST - Quarter Report: 2015 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2015

 

OR

 

☐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 ☒  No ☐

 

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 ☒  No ☐

 

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 ☐  No ☒

 

Number of registrant’s common shares of beneficial interest, $.01 par value per share, outstanding as of October 27, 2015:  71,126,308

 

 

 

GOVERNMENT PROPERTIES INCOME TRUST

 

FORM 10-Q

 

September 30, 2015

 

INDEX

 

 

 

 

References in this Quarterly Report on Form 10-Q to “GOV”, ”we”, “us” or “our” include Government Properties Income Trust and its consolidated subsidiaries unless otherwise expressly stated or the context indicates otherwise.

 

PART I.       Financial Information

 

Item 1.  Financial Statements

 

GOVERNMENT PROPERTIES INCOME TRUST

CONDENSED CONSOLIDATED BALANCE SHEETS

(amounts in thousands, except share data)

(unaudited)

 

 

 

 

See accompanying notes.

GOVERNMENT PROPERTIES INCOME TRUST

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(amounts in thousands, except per share data)

(unaudited)

 

 

 

 

See accompanying notes.

GOVERNMENT PROPERTIES INCOME TRUST

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(amounts in thousands)

(unaudited)

 

 

 

 

See accompanying notes.

 

 

Note 1.    Basis of Presentation

 

The accompanying condensed consolidated financial statements of Government Properties Income Trust and its subsidiaries, or the Company, we, us or our, are unaudited. 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, 2014, 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 intercompany transactions and balances with or among our consolidated 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 these 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, impairment of real estate and equity method investments and the valuation of intangible assets.

 

 

Note 2.    Recent Accounting Pronouncements

 

 

In February 2015, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, No. 2015-02, Consolidation.  Among other things, this update changes how an entity determines the primary beneficiary of a variable interest entity.  This update is effective for interim and annual periods beginning after December 15, 2015, with early adoption permitted.  The implementation of this update is not expected to have a material impact on our condensed consolidated financial statements.

 

In April 2015, the FASB issued ASU, No. 2015-03, Simplifying the Presentation of Debt Issuance Costs, which requires debt issuance costs to be presented in the balance sheet as a direct deduction from the associated debt liability. In August 2015, the FASB clarified the previous ASU and issued ASU No. 2015-15,  Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements—Amendments to SEC Paragraphs Pursuant to Staff Announcement at June 18, 2015 EITF Meeting, which addresses the presentation of debt issuance costs related to line of credit arrangements. These updates are effective for interim and annual reporting periods beginning after December 15, 2015 and require retrospective application. The implementation of these updates is not expected to cause any material changes to our condensed consolidated financial statements other than the reclassification of certain debt issuance costs from assets to contra liabilities on our condensed consolidated balance sheets.  Debt issuance costs related to line of credit arrangements will remain classified as assets in accordance with ASU No. 2015-15. When these updates are adopted, deferred financing costs of $10,587 and $12,782 as of September 30, 2015 and December 31, 2014, respectively, will be reclassified from assets to the related debt obligations on our condensed consolidated balance sheets.   

 

In May 2014, the FASB issued ASU No. 2014-09, Revenue From Contracts With Customers, which outlines a comprehensive model for entities to use in accounting for revenue arising from contracts with customers. This ASU states that “an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” While this ASU specifically references contracts with customers, it may also apply to certain other transactions such as the sale of real estate.  In July 2015, the FASB approved a one year deferral of the effective date for this ASU to interim and annual reporting periods beginning after December 15, 2017.  We are continuing to evaluate this guidance; however, we do not expect its adoption to have a material impact on our condensed consolidated financial statements, as a substantial portion of our revenue consists of rental income from leasing arrangements, which are specifically excluded from this ASU.

 

In September 2015, the FASB issued ASU No. 2015-16, Simplifying the Accounting for Measurement-Period Adjustments, which eliminates the requirement for an acquirer in a business combination to account for measurement-period adjustments retrospectively. Instead, acquirers must recognize measurement-period adjustments during the period in which they determine the amounts, including the effect on earnings of any amounts that would have been recorded in previous periods if the accounting had been completed at the acquisition date. This update is effective for interim and annual periods beginning after

December 15, 2015, with early adoption permitted.  The implementation of this update is not expected to have a material impact on our condensed consolidated financial statements.

 

Note 3.    Per Common Share Amounts

 

We calculate basic earnings per common share by dividing net income (loss) by the weighted average number of common shares outstanding during the period. We calculate diluted earnings per common share by using the more dilutive of the two class method or the treasury stock method. Unvested share awards and other potentially dilutive common shares and the related impact on earnings, are considered when calculating diluted earnings per share. The following table provides a reconciliation of the weighted average number of common shares used in the calculation of basic and diluted earnings per share (in thousands):

 

 

 

 

 

 

Note 4.   Real Estate Properties

 

As of September 30, 2015, we owned 71 properties (91 buildings), with an undepreciated carrying value of $1,690,397,  excluding one property (one building) classified as discontinued operations with an undepreciated carrying value of $12,260. We generally lease space in our properties on a gross lease or modified gross lease basis pursuant to fixed term operating leases expiring between 2015 and 2030. 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 September 30, 2015, we entered into 18 leases for 207,256 rentable square feet for a weighted (by rentable square feet) average lease term of 3.3 years and we made commitments for approximately $1,748 of leasing related costs. During the nine months ended September 30, 2015, we entered into 41 leases for 606,357 rentable square feet for a weighted (by rentable square feet) average lease term of 7.9 years and we made commitments for approximately $9,230 of leasing related costs. We have estimated unspent leasing related obligations of $8,629 as of September 30, 2015.

 

Acquisition Activities

 

In August 2015, we terminated two previously disclosed agreements to acquire two office properties  (two buildings) for an aggregate purchase price of $25,950.

 

Disposition Activities – Continuing Operations

 

In February 2015, one of our U.S. Government tenants exercised its option to acquire the office property (one building) it leased from us located in Riverdale, MD with 337,500 rentable square feet.  The sales price was $30,600, excluding closing costs.  We recognized no gain or loss on this sale.

 

In May 2015, we began marketing for sale an office property (one building) located in Savannah, GA with 35,228 rentable square feet and a net book value of $3,071 as of September 30, 2015.  We can provide no assurance that the sale of this property will occur or what the terms for any such sale would be.  We have classified this property as held for sale as of September 30, 2015.  The results of operations for this property are included in continuing operations in our condensed consolidated financial statements.  Summarized balance sheet information for the property is as follows:

 

 

Disposition Activities – Discontinued Operations

 

In July 2015, we entered into an agreement to sell an office property (one building) located in Falls Church, VA with 164,746 rentable square feet and a net book value of $12,282 at September 30, 2015, for a contract price of $16,500, excluding closing costs.  In September 2015, this agreement was terminated.  We continue to market this property for sale.  We can provide no assurance that the sale of this property will occur or what the terms for any such sale would be.

 

Results of operations for two properties ( two buildings) we sold in February 2014 and September 2014 and the Falls Church, VA property ( one building) disclosed above which was held for sale prior to our adoption of ASU No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity, are classified as discontinued operations in our condensed consolidated financial statements. Summarized balance sheet and income statement information for the properties classified as discontinued operations is as follows:

 

Balance Sheets:

 

 

 

Statements of Operations

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Note 5.   Revenue Recognition

 

We recognize rental income from operating leases that contain fixed contractual rent changes on a straight line basis over the term of the lease agreements.  Certain of our leases with government tenants provide the tenant the right to terminate before the lease expiration date if its respective legislature or other funding authority does not appropriate the funding necessary for the

government tenant to meet its lease obligations.  We have determined the fixed non-cancelable lease term of these leases to be the fully executed term of the lease because we believe the occurrence of early terminations to be remote contingencies based on both our historical experience and our assessment of the likelihood of lease cancellation on a separate lease basis.

 

We increased rental income to record revenue on a straight line basis by $613 and $1,135 for the three months ended September 30, 2015 and 2014, respectively, and $2,820 and $3,378 for the nine months ended September 30, 2015 and 2014, respectively.  Rents receivable include $17,837 and $15,017 of straight line rent receivables at September 30, 2015 and December 31, 2014, respectively.

 

Note 6.   Concentration

 

Tenant and Credit Concentration

 

We define annualized rental income as the annualized contractual base rents from our tenants pursuant to our lease agreements 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, 12 state governments and the United Nations combined were responsible for approximately 92.8% and 93.2% of our annualized rental income, excluding properties classified as discontinued operations, as of September 30, 2015 and 2014, respectively. The U.S. Government is our largest tenant by annualized rental income and was responsible for approximately 67.5% and 69.6% of our annualized rental income, excluding properties classified as discontinued operations, as of September 30, 2015 and 2014, respectively.

 

Geographic Concentration

 

At September 30, 2015, our 71 properties (91 buildings), excluding one property (one building) classified as discontinued operations, were located in 31 states and the District of Columbia.  Properties located in California, Virginia, the District of Columbia, Georgia, New York, Maryland and Massachusetts were responsible for approximately 11.5%, 10.6%, 10.3%, 8.7%, 8.7%, 7.4% and 5.7% of our annualized rental income as of September 30, 2015, respectively.

 

Note 7.   Indebtedness

 

At September 30, 2015 and December 31, 2014, our outstanding indebtedness consisted of the following:

 

 

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Our $750,000 unsecured revolving credit facility is available for general business purposes, including acquisitions. The maturity date of our revolving credit facility is January 31, 2019 and, subject to the payment of an extension fee and meeting certain other conditions, we have an option to extend the stated maturity date of our revolving credit facility by one year to January 31, 2020. Borrowings under our revolving credit facility bear interest at a rate of LIBOR plus a premium, which was 125 basis points at September 30, 2015.  We also pay a facility fee on the total amount of lending commitments under our revolving credit facility, which was 25 basis points per annum at September 30, 2015. Both the interest rate premium and the facility fee are subject to adjustment based upon changes to our credit ratings. As of September 30, 2015, the annual interest rate payable on borrowings under our revolving credit facility was 1.4% and the weighted average annual interest rate for borrowings under our revolving credit facility was 1.4% and 1.5%, respectively, for the three and nine months ended September 30, 2015 and 1.7% for both the three and nine months ended September 30, 2014. As of September 30, 2015 and October 27, 2015, we had $114,000 and $107,000 outstanding under our revolving credit facility, respectively.

 

Our $300,000 unsecured term loan, which matures on March 31, 2020, is prepayable without penalty at any time. The amount outstanding under our $300,000 term loan bears interest at LIBOR plus a premium, which was 140 basis points at September 30, 2015. The interest rate premium is subject to adjustment based upon changes to our credit ratings. As of September 30, 2015, the annual interest rate for the amount outstanding under our $300,000 term loan was 1.6%. The weighted average annual interest rate under our $300,000 term loan was 1.6% for both the three and nine months ended September 30, 2015.

 

Our $250,000 unsecured term loan, which matures on March 31, 2022, is prepayable at any time. If our $250,000 term loan is repaid prior to November 22, 2015, a prepayment premium of 2.0% of the amount repaid will be payable. If our $250,000 term loan is repaid during the period from November 22, 2015 to November 21, 2016, a prepayment premium of 1.0% of the amount repaid will be payable. Subsequent to November 21, 2016, no prepayment premium will be payable. The amount outstanding under our $250,000 term loan bears interest at LIBOR plus a premium, which was 180 basis points at September 30, 2015.  The interest rate premium is subject to adjustment based upon changes to our credit ratings. As of September 30, 2015, the annual interest rate for the amount outstanding under our $250,000 term loan was 2.0%. The weighted average annual interest rate under our $250,000 term loan was 2.0% for both the three and nine months ended September 30, 2015.

 

Our $750,000 revolving credit facility, our $300,000 term loan and our $250,000 term loan are governed by a credit agreement with a syndicate of institutional lenders that includes a number of features common to all of these credit arrangements. This credit agreement also includes a feature under which the maximum aggregate borrowing availability may be increased to up to $2,500,000 on a combined basis in certain circumstances.

 

Our $350,000 of 3.75% senior unsecured notes due in 2019 are governed by an indenture and a supplement to the indenture, and require semi-annual payments of interest only through maturity.  The outstanding amount of these notes may be prepaid at par (plus accrued and unpaid interest) on or after July 15, 2019 or before that date together with a make whole premium.

 

Our credit agreement and senior notes indenture and its supplement provide for acceleration of payment of all amounts due thereunder upon the occurrence and continuation of certain events of default, such as, in the case of our credit agreement, a change of control of us, which includes The RMR Group LLC (formerly known as Reit Management & Research LLC), or RMR LLC, ceasing to act as our business manager and property manager. Our senior notes indenture and its supplement and our credit 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 certain financial ratios.  We believe we were in compliance with the terms and conditions of the respective covenants under our senior unsecured notes indenture and its supplement and our credit agreement at September 30, 2015.

 

In July 2015, we repaid, at par, a $47,083 mortgage note bearing interest at 5.73% which was secured by a property ( two buildings) located in Indianapolis, IN. This mortgage was scheduled to mature in October 2015.  As a result of this repayment, we recorded a gain on extinguishment of debt of $34 in the three months ended September 30, 2015, which represented the unamortized debt premium and deferred finance fees related to this note.

 

At September 30, 2015, five of our properties (six buildings) with an aggregate net book value of $200,435 secured five mortgage notes that we assumed in connection with the acquisition of such properties. Our mortgage notes are non-recourse, subject to certain limited exceptions and do not contain any material financial covenants.

 

Note 8.   Fair Value of Assets and Liabilities

 

Our financial instruments include cash and cash equivalents, restricted cash, rents receivable,  mortgage notes payable, accounts payable, senior unsecured notes, an unsecured revolving credit facility, unsecured term loans, amounts due to related persons, other accrued expenses and security deposits. At September 30, 2015 and December 31, 2014, the fair values of our financial instruments approximated their carrying values in our condensed consolidated financial statements due to their short term nature or variable interest rates, except as follows:

 

 

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We estimate the fair value of our senior unsecured notes using an average of the bid and ask price of the notes as of the measurement date (Level 2 inputs as defined in the fair value hierarchy under GAAP). 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 9.   Shareholders’ Equity

 

Distributions

 

On February 26, 2015, we paid a distribution to common shareholders of $0.43 per share, or $30,252.    On May 26, 2015, we paid a distribution to common shareholders of $0.43 per share, or $30,256.    On August 24, 2015, we paid a distribution to common shareholders of $0.43 per share, or $30,566.    On October 12, 2015, we declared a distribution payable to common shareholders of record on October 23, 2015 of $0.43 per share, or $30,584. We expect to pay this distribution on or about November 23, 2015 using cash on hand and borrowings under our revolving credit facility.

 

Share Issuances and Repurchases

 

During the three and nine months ended September 30, 2015, we issued zero and 23,222, respectively, of our common shares to RMR LLC, as part of the business management fee payable by us under our business management agreement with RMR LLC.  See Note 10 for further information regarding this agreement.

 

On May 12, 2015, we granted 2,500 of our common shares, valued at $19.75 per share, the closing price of our common shares on the New York Stock Exchange, or NYSE, on that day, to each of our five Trustees as part of their annual compensation.

 

On June 5, 2015, we issued 700,000 of our common shares in connection with our acquisition of an interest in The RMR Group Inc. (formerly known as Reit Management & Research Inc.), or RMR Inc., as further described in Note 10.  RMR Inc. is the parent company of  RMR LLC, our manager.

 

On September 2, 2015, pursuant to our 2009 Incentive Share Award Plan, we granted an aggregate of 53,100 of our common shares to our officers and certain other employees of our manager, RMR LLC, valued at $15.84 per share, the closing price of our common shares on the NYSE on that day.  On September 24, 2015, we purchased an aggregate of 10,721 of our common shares for $16.12 per share, the closing price of our common shares on the NYSE on that day, from our officers and certain other employees of RMR LLC in satisfaction of tax withholding and payment obligations in connection with the vesting of awards of restricted common shares.

 

Note 10.   Related Person Transactions

 

We have relationships and historical and continuing transactions with RMR LLC, RMR Inc., and others related to them, including other companies to which RMR LLC provides management services and which have trustees, directors and officers who are also trustees, directors or officers of us, RMR Inc. or RMR LLC. For further information about these and other such relationships and certain other related person transactions, please refer to our Annual Report and our Current Report on Form 8-K filed with the Securities and Exchange Commission, or SEC, on June 8, 2015.      

Acquisition of Interest in our Manager:  On June 5, 2015, we and three other real estate investment trusts, or REITs, to which RMR LLC provides management services – Hospitality Properties Trust, or HPT, Select Income REIT, or SIR, and Senior Housing Properties Trust, or SNH, and collectively with HPT and SIR, the Other REITs – participated in a transaction, or the Up-C Transaction, by which we and the Other REITs each acquired an ownership interest in RMR Inc.

 

The Up-C Transaction was completed pursuant to a transaction agreement by and among us, our manager, RMR LLC, its then sole member, Reit Management & Research Trust, or RMR Trust, and RMR Inc. and similar transaction agreements that each Other REIT entered into with RMR LLC, RMR Trust and RMR Inc. RMR Trust is owned by our Managing Trustees, Barry and Adam Portnoy. Pursuant to these transaction agreements: we contributed to RMR Inc. 700,000 of our common shares and $3,917 in cash;  HPT contributed to RMR Inc. 1,490,000 of its common shares and $12,622 in cash; SIR contributed to RMR Inc. 880,000 of its common shares and $15,880 in cash; SNH contributed to RMR Inc. 2,345,000 of its common shares and $13,967 in cash; RMR Trust contributed to RMR Inc. $11,520 in cash, which RMR Inc. contributed to RMR LLC; RMR LLC issued 1,000,000 of its class B membership units to RMR Inc.; RMR Inc. issued 1,541,201 shares of its class A common stock to us, 5,019,121 shares of its class A common stock to HPT, 3,166,891 shares of its class A common stock to SIR, 5,272,787 shares of its class A common stock to SNH and 1,000,000 shares of its class B-1 common stock and 15,000,000 shares of its class B-2 common stock to RMR Trust; RMR Trust delivered 15,000,000 of the 30,000,000 class A membership units of RMR LLC which RMR Trust then owned to RMR Inc.; and RMR Inc. delivered to RMR Trust our common shares, the common shares of the Other REITs and the cash which had been contributed by us and the Other REITs to RMR Inc. 

 

The class A common stock and class B-1 common stock of RMR Inc. share ratably as a single class in dividends and other distributions of RMR Inc. when and if declared by the board of directors of RMR Inc. and have the same rights in a liquidation of RMR Inc. The class B-1 common stock of RMR Inc. is convertible into class A common stock of RMR Inc. on a 1:1 basis. The class A common stock of RMR Inc. has one vote per share. The class B-1 common stock of RMR Inc. has 10 votes per share. The class B-2 common stock of RMR Inc. has no economic interest in RMR Inc., but has 10 votes per share and is paired with the class A membership units of RMR LLC owned by RMR Trust. The class A membership units of RMR LLC owned by RMR Trust are required to be redeemed by RMR LLC upon request by RMR Trust for class A common stock of RMR Inc. on a 1:1 basis, or if RMR Inc. elects, cash. Under the governing documents of RMR Inc., upon the redemption of a class A membership unit of RMR LLC, the class B-2 common stock of RMR Inc. “paired” with an equal number of class A membership units are cancelled for no additional consideration.

 

As part of the Up-C Transaction and concurrently with entering the transaction agreements, on June 5, 2015:

 

We entered into a lock up and registration rights agreement with RMR Trust and Barry and Adam Portnoy pursuant to which RMR Trust and Barry and Adam Portnoy agreed not to transfer the 700,000 of our common shares RMR Trust received in the Up-C Transaction for a period of 10 years and we granted them certain registration rights, subject to certain limited exceptions. Each Other REIT also entered into a similar lock up and registration rights agreement with RMR Trust and Barry and Adam Portnoy.

 

As a result of the Up-C Transaction: RMR LLC became a subsidiary of RMR Inc.; RMR Inc. became the managing member of RMR LLC; through our ownership of class A common stock of RMR Inc., we currently have an indirect 5.0% economic interest in RMR LLC; through their ownership of class A common stock of RMR Inc., HPT, SIR and SNH currently have an indirect 16.2%, 10.2% and 17.0% economic interest in RMR LLC, respectively; and RMR Trust through its ownership of class B-1 common stock of RMR Inc.,  class B-2 common stock of RMR Inc. and class A membership units of RMR LLC currently directly and indirectly has a 51.6% economic interest in RMR LLC and controls 91.4% of the voting power of outstanding capital stock of RMR Inc.

 

Pursuant to the transaction agreements, we and each Other REIT agreed to distribute approximately half of the shares of class A common stock of RMR Inc. received in the Up-C Transaction to our respective shareholders as a special distribution, and RMR Inc. agreed to facilitate this distribution by filing a registration statement with the SEC to register the shares of class A common stock of RMR Inc. to be distributed and by seeking a listing of those shares on a national stock exchange upon the registration statement being declared effective by the SEC.  The distribution of class A common stock of RMR Inc. that we and the Other REITs have agreed to make to our and the Other REITs’ shareholders will be made only after a registration statement, including a prospectus, is declared effective by the SEC.

Amendment and Restatement of Management Agreements with RMR LLC: As part of the Up-C Transaction, on June 5, 2015, we and RMR LLC entered into the amended business management agreement, which amended and restated our previous business management agreement with RMR LLC, and the amended property management agreement, which amended and restated our previous property management agreement with RMR LLC. Our amended business management agreement and amended property management agreement are referred to together in this Note as our amended management agreements. Our amended management agreements were effective as of June 5, 2015.

Our amended management agreements have terms that end on December 31, 2035, and automatically extend on December 31st of each year for an additional year, so that the terms of the agreements thereafter end on the 20th anniversary of the date of the extension. We have the right to terminate each amended management agreement: (i) at any time on 60 days’ written notice for convenience, (ii) immediately upon written notice for cause, as defined therein, (iii) on 60 days’ written notice given within 60 days after the end of any calendar year for a performance reason, as defined therein, and (iv) by written notice during the 12 months following a change of control of RMR LLC, as defined therein. RMR LLC has the right to terminate the amended management agreements for good reason, as defined therein.

If we terminate one or both of our amended management agreements for convenience, or if RMR LLC terminates one or both of our amended management agreements for good reason, we have agreed to pay RMR LLC a termination fee in an amount equal to the sum of the present values of the monthly future fees, as defined therein, for the terminated amended management agreement(s) for the remaining term. If we terminate one or both of our amended management agreements for a performance

reason, as defined therein, we have agreed to pay RMR LLC the termination fee calculated as described above, but assuming a remaining term of 10 years.  We are not required to pay any termination fee if we terminate our amended management agreements for cause or as a result of a change of control of RMR LLC.

Accounting for Investment in RMR Inc.: On June 5, 2015, we acquired 1,541,201 shares of class A common stock of RMR Inc. for $17,462, excluding transaction costs.  We have concluded, for accounting purposes, that the consideration paid for this investment in RMR Inc.’s shares of class A common stock represented a discount to the fair value of these shares.  We account for this investment under the cost method of accounting and have recorded this investment at its estimated fair value of $39,833 as of June 5, 2015 using Level 3 inputs as defined in the fair value hierarchy under GAAP.  As a result, we recorded a liability for the amount by which the estimated fair value exceeded the price we paid for these shares and which amount we are amortizing as described below.  As of September 30, 2015, the unamortized balance of this liability was $22,025 and it is included in accounts payable and other liabilities in our condensed consolidated balance sheet.  Our investment is included in other assets in our condensed consolidated balance sheet and the carrying value of our investment was $42,384, including transaction costs, as of September 30, 2015.  We believe the carrying value of our investment in RMR Inc. as of September 30, 2015 approximates its estimated fair value for accounting purposes.  The liability related to the acquisition of these shares is being amortized on a straight line basis over the 20 year life of the business and property management agreements with RMR LLC as a reduction to business management fees and property management fees, which are included in general and administrative and other operating expenses, respectively, in our condensed consolidated statements of comprehensive income.  Amortization of the liability, included in general and administrative expense and other operating expenses for the three and nine months ended September 30, 2015, totaled $281 and $346, respectively.

 

RMR LLC Management Fees and Reimbursements: We recognized business management fees of $2,438 and $2,643 for the three months ended September 30, 2015 and 2014, respectively, and $7,482 and $7,578 for the nine months ended September 30, 2015 and 2014, respectively.  As of September 30, 2015 and 2014, no incentive fees were estimated to be payable to RMR LLC for 2015 and 2014, respectively.  The business management fees we recognized for the 2015 and 2014 periods are included in general and administrative expenses in our condensed consolidated financial statements.  In accordance with the terms of our previous business management agreement, we issued 19,339 and 27,103 of our common shares to RMR LLC for the nine months ended September 30, 2015 and 2014, respectively, as payment for portions of the base business management fees we recognized for those periods.  Our amended business management agreement requires that 100% of the management fee due to RMR LLC be paid by us in cash.

Pursuant to our property management agreement with RMR LLC, the property management fees, including construction supervision fees, we recognized were $1,930 and $2,095 for the three months ended September 30, 2015 and 2014, respectively, and $5,861 and $6,034 for the nine months ended September 30, 2015 and 2014, respectively. These amounts are included in operating expenses or have been capitalized, as appropriate, in our condensed consolidated financial statements.

Pursuant to our previous and amended management agreements with RMR LLC, we are responsible for paying all of the property level operating costs which costs are generally incorporated into rents charged to our tenants, including certain payroll and related costs incurred by RMR LLC.  The total of those property management related reimbursements paid to RMR LLC for the three months ended September 30, 2015 and 2014 were $3,011 and $2,312 respectively, and $8,478 and $6,332 for the nine months ended September 30, 2015 and 2014, respectively, and these amounts are included in property operating expenses in our condensed consolidated financial statements for these periods.  In addition, we have historically awarded share grants to certain RMR LLC employees under our equity compensation plan and we accrue estimated amounts for such share grants based upon historical practices throughout the year.  In September 2015 and 2014, we made annual share grants to RMR LLC employees of 53,100 and 51,150 of our common shares, respectively.  In September 2015, we purchased 10,721 of our common shares, at the closing price for our common shares on the NYSE on the date of purchase, from certain of our officers and other employees of RMR LLC in satisfaction of tax withholding and payment obligations in connection with the vesting of awards of restricted common shares.  In addition, under our business management agreement we reimburse RMR LLC for our allocable costs for internal audit services.  The amounts accrued for share grants to RMR LLC employees and internal audit costs were $292 and $508 for the three months ended September 30, 2015 and 2014, respectively, and $725 and $973 for the nine months ended September 30, 2015 and 2014, respectively, and these amounts are included in our general and administrative expenses for these periods.

 

Leases with RMR LLC: We lease office space to RMR LLC in certain of our properties for its property management offices.  Pursuant to our lease agreements with RMR LLC, we recognized rental income from RMR LLC for leased office space of approximately $111 and $14 for the three months ended September 30, 2015 and 2014, respectively, and approximately $278 and $47  for the nine months ended September 30, 2015 and 2014, respectively.

 

SIR:  On February 28, 2015, we entered into a share purchase agreement, or the GOV Purchase Agreement, with Lakewood Capital Partners, LP, or Lakewood, the other persons who are members of a group with Lakewood, or, together with Lakewood, the Lakewood Parties, and, for the purpose of specified sections, SIR, pursuant to which, on March 4, 2015, we acquired 3,418,421 common shares of SIR from Lakewood for a cash purchase price equal to approximately $95,203.  On February 28, 2015, the SIR common shares that we acquired pursuant to the GOV Purchase Agreement represented approximately 3.9% of SIR’s outstanding common shares.  We funded our acquisition of these SIR common shares with cash on hand and borrowings under our revolving credit facility.  As of September 30, 2015, we owned 24,918,421 SIR common shares, or approximately 27.9% of SIR’s total outstanding common shares.

   

The GOV Purchase Agreement contains (i) standstill provisions, pursuant to which the Lakewood Parties agreed not to take certain actions with respect to our securities, or those of SIR, for a 50-year period and (ii) voting provisions, pursuant to which the Lakewood Parties agreed to cause our securities, or those of SIR, that they or any of their affiliates own as of a record date for a meeting of our or SIR’s shareholders to be present and voted at such meeting in favor of all actions recommended by the board of trustees of such company.

   

On February 28, 2015, our Managing Trustees, Messrs. Barry and Adam Portnoy, entered into separate share purchase agreements with the Lakewood Parties, with provisions similar to the GOV Purchase Agreement, including the per share purchase price, pursuant to which, on March 4, 2015, Messrs. Barry Portnoy and Adam Portnoy acquired 107,606 and 87,606 SIR common shares, respectively, from Lakewood and, on March 5, 2015, Messrs. Barry Portnoy and Adam Portnoy acquired 2,429 and 2,429 SIR common shares, respectively, from Mr. William H. Lenehan, one of the Lakewood Parties.  Concurrently with entering into the agreements among us, Messrs. Barry Portnoy and Adam Portnoy and the Lakewood Parties, Lakewood withdrew its nomination of Mr. Lenehan for election to SIR’s board of trustees at SIR’s 2015 annual meeting of shareholders. See Note 11 for further information regarding our investment in SIR.

 

AIC:  As of September 30, 2015, our investment in Affiliates Insurance Company, or AIC, an Indiana insurance company, had a carrying value of $6,926, which amount is included in other assets on our condensed consolidated balance sheet.  We recognized income (loss) of ($24) and $38 related to our investment in AIC for the three months ended September 30, 2015 and 2014, respectively, and $70 and $59 for the nine months ended September 30, 2015 and 2014, respectively.  Our other comprehensive income (loss) includes unrealized gains (losses) on securities held for sale which are owned by AIC of ($72) and ($33)  for the three months ended September 30, 2015 and 2014, respectively, and ($91) and $8 for the nine months ended September 30, 2015 and 2014, respectively.

 

In June 2015, we and the other shareholders of AIC renewed our participation in an insurance program arranged by AIC.  In connection with that renewal, we purchased a three year combined property insurance policy providing $500,000 of coverage annually with the premium to be paid annually and a one year combined policy providing terrorism coverage of $200,000 for our properties which policies were arranged by AIC.  We paid aggregate annual premiums, including taxes and fees, of approximately $1,277 in connection with these policies for the policy year ending June 30, 2016, and this amount may be adjusted from time to time as we acquire and dispose of properties that are included in this insurance program.

 

Directors’ and Officers’ Liability Insurance:  In August 2015, we extended through September 2017 our combined directors' and officers' insurance policy with RMR LLC and five other companies managed by RMR LLC that provides $10,000 in aggregate primary coverage.  At that time, we also extended through September 2016 our separate additional directors' and officers' liability insurance policies that provide $20,000 of aggregate excess coverage plus $5,000 of excess non-indemnifiable coverage.  The total premium payable by us for these extensions was approximately $338.

 

 

Note 11.   Equity Investment in Select Income REIT

 

As described in Note 10, as of September 30, 2015, we owned 24,918,421, or approximately 27.9%, of the then outstanding SIR common shares.  SIR is a REIT that is primarily focused on owning and investing in net leased, single tenant properties. 

 

We account for our investment in SIR under the equity method. Under the equity method, we record our proportionate share of SIR’s net income as equity in earnings of an investee in our condensed consolidated statements of comprehensive income. For the three and nine months ended September 30, 2015, we recorded $8,425 and $18,850 of equity in the earnings of SIR, respectively.

 

During the three and nine months ended September 30, 2015, SIR issued 45,389 and 29,414,279 common shares, respectively.  We recognized a loss on issuance of shares by SIR of $21 and $42,145, respectively, during the three and nine months ended September 30, 2015 as a result of the per share issuance price of these SIR common shares being below the then average per share carrying value of our SIR common shares.

 

We periodically evaluate our equity investment in SIR for possible indicators of other than temporary impairment whenever events or changes in circumstances indicate the carrying amount of the investment might not be recoverable. These indicators may include the length of time and the extent to which the market value of our investment is below our carrying value, the financial condition of SIR, our intent and ability to be a long term holder of the investment and other considerations. If the decline in fair value is judged to be other than temporary, we record an impairment charge to adjust the basis of the investment to its estimated fair value.  In performing our periodic evaluation of other than temporary impairment of our investment in SIR during the second quarter of 2015, we determined, based on the length of time and the extent to which the market value of our SIR investment was below our carrying value, that the decline in fair value was other than temporary.  Accordingly, we recorded a $203,297 loss on impairment to reduce the carrying value of our SIR investment to its estimated fair value during the second quarter of 2015.  We estimated fair value using the closing price of SIR common shares on the NYSE as of June 30, 2015.

 

The cost of our investments in SIR exceeded our proportionate share of SIR’s total shareholders’ equity book value on their dates of acquisition by an aggregate of $166,272. As required under GAAP, we were amortizing this difference to equity in earnings of investees over the average remaining useful lives of the real estate assets and intangible assets and liabilities owned by SIR as of the respective dates of our acquisition.  This amortization decreased our equity in the earnings of SIR by zero and $4,742 for the three and nine months ended September 30, 2015, respectively, and $2,637 for both the three and nine months ended September 30, 2014.  Recording the loss on impairment noted above resulted in the carrying value of our SIR investment to be less than our proportionate share of SIR’s total shareholders’ book equity as of June 30, 2015.  As a result, the previous basis difference was eliminated and we are currently amortizing a basis difference of ($95,035) to earnings over the estimated remaining useful lives of the real estate assets and intangible assets and liabilities owned by SIR as of June 30, 2015.  This amortization increased our equity in the earnings of SIR by $1,893 for both the three and nine months ended September 30, 2015.

 

During the three and nine months ended September 30, 2015, we received cash distributions from SIR totaling $12,459 and $34,571, respectively, and $10,320 for both the three and nine months ended September 30, 2014.

 

The following summarized financial data of SIR as reported in SIR’s Quarterly Report on Form 10-Q for the three and nine months ended September 30, 2015, or the SIR Quarterly Report, includes the results of operations for periods prior to July 9, 2014 (the date on which we acquired our initial interest in SIR). References in our financial statements to the SIR Quarterly Report are included as references to the source of the data only, and the information in the SIR Quarterly Report is not incorporated by reference into our financial statements.

 

Condensed Consolidated Balance Sheets:

 

 

 

Condensed Consolidated Statements of Income: