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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2014

OR

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

Commission File Number 1-34364

GOVERNMENT PROPERTIES INCOME TRUST

(Exact Name of Registrant as Specified in Its Charter)

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

(Address of Principal Executive Offices)  (Zip Code)

617-219-1440

(Registrant’s Telephone Number, Including Area Code)

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

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

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

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

Number of registrant’s common shares of beneficial interest, $.01 par value per share, outstanding as of August 5, 2014: 70,279,206

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GOVERNMENT PROPERTIES INCOME TRUST

FORM 10-Q

June 30, 2014

INDEX

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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.

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CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

(amounts in thousands, except per share data)

(unaudited)

See accompanying notes.

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GOVERNMENT PROPERTIES INCOME TRUST

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(amounts in thousands)

(unaudited)

See accompanying notes.

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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, 2013, 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 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

In April 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity.  This update amends the criteria for reporting discontinued operations to, among other things, raise the threshold for disposals to qualify as discontinued operations. This update is effective for interim and annual reporting periods, beginning after December 15, 2014, with early adoption permitted.  We currently expect, that when adopted, this update will reduce the number of any future property dispositions we make to be presented as discontinued operations in our consolidated financial statements.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which provides guidance for revenue recognition. This update is effective for interim and annual reporting periods beginning after December 15, 2016.  We are currently in the process of evaluating the impact, if any, the adoption of this ASU will have on our consolidated financial statements.

Note 3. Real Estate Properties

As of June 30, 2014, we owned 71 properties (91 buildings), excluding two properties (two buildings) classified as discontinued operations, with an undepreciated carrying value of $1,697,796. We generally lease space in our properties on a gross lease or modified gross lease basis pursuant to fixed term operating leases expiring between 2014 and 2029. 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, 2014, we entered into 17 leases for 204,326 rentable square feet for a weighted (by rentable square feet) average lease term of 5.1 years and we made commitments for approximately $5,336 of leasing related costs. During the six months ended June 30, 2014, we entered into 30 leases for 266,796 rentable square feet for a weighted (by rentable square feet) average lease term of 5.3 years and we made commitments for approximately $6,994 of leasing related costs.  We have estimated unspent leasing related obligations of $16,654 as of June 30, 2014.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

Acquisition Activities

During the six months ended June 30, 2014, we acquired three office properties (four buildings) for an aggregate purchase price of $154,525, including the assumption of $97,524 of mortgage debt and excluding acquisition costs.  We allocated the purchase prices of these acquisitions based on the estimated fair values of the acquired assets and assumed liabilities as follows:

(1)             Purchase price excludes acquisition related costs.

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

In June 2014, we entered into an agreement to acquire an office property (one building) located in Lacey, WA with 109,576 rentable square feet. This property is 100% leased to the State of Washington. The contract purchase price is $19,200, excluding acquisition costs.

Also in June 2014, we entered into an agreement to acquire an office property (one building) located in Lorton, VA with 54,721 rentable square feet. This property is 100% leased to the U.S. Government. The contract purchase price is $20,500, excluding acquisition costs.

In August 2014, we entered into an agreement to acquire an office property (one building) located in Phoenix, AZ with 66,743 rentable square feet.  This property is 100% leased to the State of Arizona.  The contract purchase price is $13,000, excluding acquisition costs.

These pending acquisitions are subject to closing conditions; accordingly, we can provide no assurance that we will acquire these properties or that these acquisitions will not be delayed or that their terms will not change.

Disposition Activities

During the year ended December 31, 2013, we began marketing for sale an office property (one building) located in Phoenix, AZ with 97,145 rentable square feet and recognized a loss on asset impairment of $8,344 to reduce the carrying value of this asset to its estimated fair value of $2,300.  During the three months ended March 31, 2014, we increased the carrying value of this asset by $2,344 to its estimated fair value of $4,644.  In February 2014, we sold this property for $5,000, excluding closing costs.  We recognized no gain or loss on this sale.

In April 2014, we entered 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 $12,286 at June 30, 2014.  The contract sales price is $16,500, excluding closing costs.  The closing of this sale is subject to conditions, including the purchaser obtaining certain zoning entitlements and is currently expected to occur in 2015.  In July 2014, we entered an agreement to sell an office property (one building) located in San Diego, CA with 94,272 rentable square feet and a net book value of $11,008 at June 30, 2014. The contract sales price is $12,500, excluding closing costs.  The closing of this sale is subject to conditions and is currently expected to occur later in 2014. We can provide no assurance that sales of these two properties will occur. See Note 7 regarding the fair value of our assets and liabilities.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

Results of operations for two properties (two buildings) we sold February 2013 and March 2013, one property (one building) we sold in February 2014 and two properties (two buildings) held for sale at June 30, 2014 are classified as discontinued operations in our condensed consolidated financial statements. Summarized balance sheet and income statement information for properties classified as discontinued operations is as follows:

Balance Sheets:

Statements of Operations:

Note 4.  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 its lease 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 termination to be a remote contingency based on both our historical experience and our assessment of the likelihood of lease cancellation.

We increased rental income to record revenue on a straight line basis by $1,101 and $609 for the three months ended June 30, 2014 and 2013, respectively, and $2,243 and $1,347 for the six months ended June 30, 2014 and 2013, respectively.  Rents receivable include $12,730 and $10,515 of straight line rent receivables at June 30, 2014 and December 31, 2013, 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, 11 state governments and the United Nations combined were responsible for approximately 93.0% and 93.9% of our annualized rental income, excluding properties classified as discontinued operations, as of June 30, 2014 and 2013, respectively. The U.S. Government is our largest tenant by annualized rental income and

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

was responsible for approximately 70.0% and 70.9% of our annualized rental income, excluding properties classified as discontinued operations, as of June 30, 2014 and 2013, respectively.

Geographic Concentration

At June 30, 2014, our 71 properties (91 buildings), excluding properties classified as discontinued operations, were located in 31 states and the District of Columbia.  Properties located in Maryland, California, Virginia, the District of Columbia, Georgia, New York and Massachusetts were responsible for approximately 12.3%, 10.6%, 9.9%, 9.7%, 8.8%, 8.3% and 5.3% of our annualized rental income as of June 30, 2014, respectively.

Note 6.  Indebtedness

At June 30, 2014 and December 31, 2013, our outstanding indebtedness consisted of the following:

(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.

In March 2014, we assumed a mortgage with a balance of $14,524 in connection with a property acquisition.  This mortgage note is secured by the acquired property, bears interest at 5.88% per annum and is amortized on a 30 year schedule (which commenced upon the original issuance of the note by its former obligor) until maturity in August 2021.  We did not record a premium or discount on this assumed debt because we believed the interest rate payable under this mortgage was equal to the rate we would have had to pay for debt with the same maturity at the time we assumed this obligation.

In May 2014, we assumed a mortgage with a balance of $83,000 in connection with a property acquisition.  This mortgage note is secured by the acquired property, bears interest at 5.55% per annum and monthly payments of interest only are due until maturity in April 2016.  We recorded a $3,147 premium on this assumed debt, which reduced its effective interest rate to 3.50%, because we believed the interest rate payable under this mortgage was above the rate we would have had to pay for debt with the same maturity at the time we assumed this obligation.

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, 2014. 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, 2014, 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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

both the three and six months ended June 30, 2014, and 1.7% for both the three and six months ended June 30, 2013. As of June 30, 2014, we had $195,500 outstanding and $354,500 available under our revolving credit facility.

We have a $350,000 unsecured term loan, or our existing term loan. Our existing term loan matures on January 11, 2017, and is prepayable without penalty at any time. In addition, our existing term loan includes a feature under which maximum borrowings may be increased to up to $700,000 in certain circumstances. Our existing term loan bears interest at a rate of LIBOR plus a premium, which was 175 basis points as of June 30, 2014. The interest rate premium is subject to adjustment based upon changes to our credit ratings. As of June 30, 2014, the interest rate for the amount outstanding under our existing term loan was 1.9% and the weighted average interest rate for the amount outstanding under our existing term loan was 1.9% for both the three and six months ended June 30, 2014, and 1.9% for both the three and six months ended June 30, 2013.

On July 9, 2014, we entered into a new $500,000 unsecured term loan, or our new term loan.  Our new term loan matures on July 8, 2015, and is prepayable without penalty at any time.  Our new term loan bears interest at a rate of LIBOR plus a premium, which was 175 basis points as of July 9, 2014.  The interest rate premium is subject to adjustment based upon changes to our credit ratings.  We used the net proceeds of our new term loan to fund a portion of the purchase price of the Select Income REIT, or SIR, common shares we acquired on July 9, 2014.  In July 2014, we sold 15,525,000 common shares in a public offering at a price of $23.50 per share for net proceeds of approximately $349,731.  The net proceeds from this offering were used to partially repay amounts outstanding under our new term loan. See Notes 8 and 9 for further information regarding these transactions.

Our revolving credit facility agreement and our term loan agreements provide for acceleration of payment of all amounts due thereunder upon the occurrence and continuation of certain events of default, such as a change of control of us, which includes Reit Management & Research LLC, or RMR, ceasing to act as our business manager and property manager. Our revolving credit facility agreement and our term loan agreements 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.  On July 9, 2014, we amended the agreements governing our revolving credit facility and our existing term loan to modify certain covenants and associated defined terms to accommodate our acquisition of the SIR common shares and our new term loan. We believe we were in compliance with the terms and conditions of our revolving credit facility agreement and our then existing term loan agreement at June 30, 2014.

At June 30, 2014, six of our properties (eight buildings) with an aggregate net book value of $264,679 secured six 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.

Note 7. Fair Value of Assets and Liabilities

Our assets and liabilities at June 30, 2014 include cash and cash equivalents, restricted cash, rents receivable, mortgage notes payable, accounts payable, our revolving credit facility and our then existing term loan, amounts due to related persons, other accrued expenses and security deposits. At June 30, 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:

(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.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

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.

The table below presents one of our assets measured on a non-recurring basis at fair value at June 30, 2014, categorized by the level of inputs used in the valuation of the asset:

(1)       The estimated fair value at June 30, 2014 of the property, for which a loss on asset impairment was recognized during the year ended December 31, 2013, is based upon broker estimates of value less estimated sales costs (Level 3 inputs as defined in the fair value hierarchy under GAAP).

During the three months ended March 31, 2014, we increased the carrying value of a property held for sale due to an increase in its estimated fair value.  We sold this property in February 2014.  See Note 3 for additional information regarding this property.

Note 8. Shareholders’ Equity

Distributions

On February 21, 2014, we paid a distribution to common shareholders of $0.43 per share, or approximately $23,530, that was declared on January 3, 2014 and was payable to shareholders of record on January 13, 2014.

On May 21, 2014, we paid a distribution to common shareholders of $0.43 per share, or approximately $23,535, that was declared on April 8, 2014 and was payable to shareholders of record on April 25, 2014.

On July 14, 2014, we declared a distribution payable to common shareholders of record on July 25, 2014 of $0.43 per share, or approximately $23,541.  We expect to pay this distribution on or about August 22, 2014 using cash on hand and borrowings under our revolving credit facility.

Share Issuances

During the three and six months ended June 30, 2014 and the period July 1, 2014 to August 5, 2014, we issued 9,943, 16,318, and 3,370, respectively, of our common shares to RMR as part of the business management fee payable by us under our business management agreement.  See Note 9 for further information regarding this agreement.

On May 2, 2014, we granted 2,500 of our common shares, valued at $25.43 per share, the closing price of our common shares on the New York Stock Exchange, or the NYSE, on that day, to each of our five Trustees as part of their annual compensation.

In July 2014, we sold 15,525,000 common shares in a public offering at a price of $23.50 per share for net proceeds of approximately $349,731.  The net proceeds from this offering were used to partially repay amounts outstanding under our new term loan.

We have no dilutive securities.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

Note 9. Related Person Transactions

RMR:  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: (i) a business management agreement, which relates to our business generally, and (ii) a property management agreement, which relates to our property level operations.

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. 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 a majority of the companies that RMR or its affiliates provide management services to 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.

On May 9, 2014, we and RMR entered into amendments to our business management agreement and property management agreement.  As amended, RMR may terminate the agreements upon 120 days’ written notice.  Prior to the amendments, RMR could terminate the agreements upon 60 days’ written notice and could also terminate the property management agreement upon five business days’ notice if we underwent a change of control.  The amendments also provide for certain termination payments by us to RMR in the event that we terminate the agreements other than for cause, including certain proportional adjustments to the termination fees if we merge with another real estate investment trust to which RMR is providing management services or if we spin-off a subsidiary of ours to which we contributed properties and to which RMR is providing management services both at the time of the spin-off and on the date of the expiration or termination of the agreement.  Also, as amended, RMR agrees to provide certain transition services to us for 120 days following an applicable termination by us or notice of termination by RMR.

Pursuant to our business management agreement with RMR, we recognized business management fees of $2,534 and $2,528 for the three months ended June 30, 2014 and 2013, respectively, and $4,935 and $4,982 for the six months ended June 30, 2014 and 2013, respectively.  These amounts are included in general and administrative expenses in our condensed consolidated financial statements. In accordance with the terms of our business management agreement, as amended in December 2013, we issued 16,318 of our common shares to RMR for the six months ended June 30, 2014 as payment for 10% of the base business management fee we recognized for such period.

In connection with our property management agreement with RMR, the aggregate property management and construction supervision fees we recognized were $1,985 and $1,799 for the three months ended June 30, 2014 and 2013, respectively, and $3,939 and $3,615 for the six months ended June 30, 2014 and 2013, respectively. These amounts are included in other operating expenses or have been capitalized, as appropriate, in our condensed consolidated financial statements.

RMR leases from us office space for two of its regional offices. We earned approximately $14 and $8 in rental income from RMR for leased office space for the three months ended June 30, 2014 and 2013, respectively, and $33 and $15 for the six months ended June 30, 2014 and 2013, respectively. Our office space leases with RMR are terminable by RMR if our management agreements with RMR are terminated.

On July 8, 2014, we and RMR entered into an agreement with Equity Commonwealth (formerly known as CommonWealth REIT), or EQC, pursuant to which we and RMR purchased shares of SIR from EQC on July 9, 2014.  For more information regarding this transaction, see below under “- EQC”.  RMR provides management services to SIR; our Managing Trustees serve as managing trustees of SIR; one of our Independent Trustees, Mr. Jeffrey Somers, serves as an independent trustee of SIR; our President and Chief Operating Officer serves as an officer of SIR; and SIR’s other executive officer is an officer of RMR.  SIR was not a contracting party to this transaction.

EQC:  EQC organized us as a 100% owned subsidiary. One of our Managing Trustees, Mr. Barry Portnoy, was a managing trustee of EQC until March 25, 2014. Our other Managing Trustee, Mr. Adam Portnoy, was the President of EQC until May 23, 2014 and was a managing trustee of EQC until March 25, 2014. RMR provides management services to both us and EQC.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

In 2009, we completed our initial public offering, or our IPO, pursuant to which we ceased to be a majority owned subsidiary of EQC. To facilitate our IPO, we and EQC entered into a transaction agreement that governs our separation from and relationship with EQC. Pursuant to this transaction agreement and subject to certain conditions, among other things, EQC granted us a right of first refusal to acquire any property owned by EQC that EQC determines to divest if the property is then majority leased to a government tenant, which right of first refusal also applied in the event of an indirect sale of any such properties resulting from a change of control of EQC.  On July 23, 2014, this provision of the transaction agreement was terminated.

On March 15, 2013, EQC 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 EQC under which EQC agreed to pay all expenses incurred by us relating to the registration and sale of our common shares owned by EQC in the offering, pursuant to which EQC paid us $310 during 2013. In addition, under the registration agreement, EQC agreed to indemnify us and our officers, Trustees and controlling persons, and we agreed to indemnify EQC and 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.

On July 8, 2014, we and RMR entered into a stock purchase agreement, or the purchase agreement, with EQC, pursuant to which, on July 9, 2014, we acquired from EQC 21,500,000 common shares of beneficial interest, par value $.01 per share, of SIR, and RMR acquired from EQC 500,000 SIR common shares. Our cash purchase price was equal to approximately $677,500, or $31.51 per share, plus approximately $11,300, or $0.53 per share, of accrued dividends as defined in the purchase agreement, for a total of approximately $688,800. RMR purchased its 500,000 SIR common shares on the same terms that we paid. The SIR common shares that we and RMR purchased represent 35.9% and 0.8%, respectively, of SIR’s outstanding common shares. Under the purchase agreement, in the event that we or RMR consummates any sale of SIR common shares prior to July 9, 2015 and the price per share paid by the purchaser is greater than $31.51, we or RMR, as applicable, are required to pay to EQC an amount equal to 50% of the product of (i) the number of SIR common shares sold in the transaction times (ii) the excess of (x) the price per share paid by the purchaser and (y) $31.51. The foregoing requirement applies to any SIR common shares we or RMR own. In addition, we and RMR agreed, among other things, to indemnify EQC for certain claims related to the acquisition. In connection with the indemnity, we and RMR entered into an allocation agreement with regard to our respective liabilities in the event of a claim for indemnification.

AIC:  We, RMR, SIR and four other companies to which RMR provides management services currently own Affiliates Insurance Company, or AIC, an Indiana insurance company. All of our Trustees and most of the trustees and directors of the other AIC shareholders 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.

On March 25, 2014, as a result of the removal, without cause, of all of the trustees of EQC, this shareholder of AIC underwent a change in control, as defined in the shareholders’ agreement among us, the other shareholders of AIC and AIC.  As a result of that change in control and in accordance with the terms of the shareholders agreement, on May 9, 2014, we and those other shareholders purchased pro rata the AIC shares EQC owned.  Pursuant to that purchase, we purchased 2,857 AIC shares from EQC for $825.  Following these purchases, we and the other remaining six shareholders each own approximately 14.3% of AIC.

In June 2014, 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 one-year property insurance policy providing $500,000 of coverage, with respect to which AIC is a reinsurer of certain coverage amounts.  We paid AIC a premium, including taxes and fees, of approximately $526 in connection with that policy, which amount may be adjusted from time to time as we acquire or dispose of properties that are covered in the policy.  As of June 30, 2014, we had invested $6,019 in AIC since we became an equity owner of AIC in 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 as all of our Trustees are also directors of AIC. Our investment in AIC had a carrying value of $6,918 and $6,031 as of June 30, 2014 and December 31, 2013, respectively, which amounts are included in other assets on our condensed consolidated balance sheet. We recognized income of $118 and $79 for the three months ended June 30, 2014 and 2013, respectively, and $21 and $155 for the six months ended June 30, 2014 and 2013, respectively, related to our investment in AIC.

Directors’ and Officers’ Liability Insurance: In June 2014, we, RMR and four other companies to which RMR provides management services extended our and their combined directors’ and officers’ liability insurance policy, and we extended our separate

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

directors’ and officers’ liability insurance policy, in each case for an interim period.  We paid an aggregate premium of approximately $50 for these extensions.  Further information about those policies is contained in Note 5 to our audited financial statements contained in our Annual Report.

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

The following information should be read in conjunction with our condensed consolidated financial statements and accompanying notes included in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2013, or our Annual Report.

OVERVIEW

We are a real estate investment trust, or REIT, organized under Maryland law. As of June 30, 2014, we owned 71 properties (91 buildings), excluding two properties (two buildings) classified as discontinued operations, located in 31 states and the District of Columbia containing approximately 11.0 million rentable square feet, of which 66.8% was leased to the U.S. Government, 19.1% was leased to 11 state governments, 1.7% was leased to the United Nations, an international intergovernmental organization, 7.9% was leased to various non-governmental tenants and 4.5% was available for lease.  The U.S. Government, 11 state governments and the United Nations combined were responsible for 93.0% and 93.9% of our annualized rental income, as defined below, as of June 30, 2014 and 2013, respectively.

Property Operations

As of June 30, 2014, excluding properties classified as discontinued operations, 95.5% of our rentable square feet were leased, compared to 94.1% of our rentable square feet as of June 30, 2013.  Occupancy data for our properties as of June 30, 2014 and 2013 is as follows (square feet in thousands):

(1)       Based on properties we owned on June 30, 2014 and excludes properties classified as discontinued operations.

(2)       Based on properties we owned on June 30, 2014 and which we owned continuously since January 1, 2013, and excludes properties classified as discontinued operations.  Our comparable properties increased from 56 properties (69 buildings) at June 30, 2013 as a result of our acquisition of 10 properties (13 buildings) during the year ended December 31, 2012 less two properties (two buildings) classified as discontinued operations during the year ended December 31, 2013, and our sale of one property (one building) during the six months ended June 30, 2014.

(3)       Square feet measurements are subject to modest changes when space is re-measured or re-configured for tenants.

(4)       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, 2014 and 2013 are as follows:

(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. Excludes properties classified as discontinued operations.

(2)       Based on properties we owned on June 30, 2014 and excludes properties classified as discontinued operations.

(3)       Based on properties we owned on June 30, 2014 and which we owned continuously since April 1, 2013 and January 1, 2013, respectively, and excludes properties classified as discontinued operations.

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We currently believe that U.S. property leasing market conditions are slowly improving, but remain weak in many parts of the U.S. Our historical experience 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 government budgetary pressures may cause an increased demand for leased space by government tenants, as opposed to new buildings built on behalf of government tenants. However, these same budgetary pressures could also result in a decrease in government employment, government tenants reducing their space utilization or consolidation into government owned properties, thereby reducing the demand for government leased space. We believe the U.S. Government is actively trying to reduce the square foot per employee in its owned and leased buildings and trying to consolidate out of leased space and into government owned space, which could have an impact of reducing the space the U.S. Government leases from us.  At the same time, we believe that efforts by the U.S. Government to consolidate certain operations have resulted in the U.S. Government leasing additional space in some of our properties.  Accordingly, we are unable to reasonably project what the financial impact of market conditions or changing government financial circumstances or building or space needs will be on our financial results for future periods.

As of June 30, 2014, excluding properties classified as discontinued operations, we had leases totaling 874,078 rentable square feet that were scheduled to expire through June 30, 2015. Based upon current market conditions and tenant negotiations for leases scheduled to expire through June 30, 2015, we expect that rental rates we are likely to achieve on new or renewed leases will, in the aggregate and on a weighted (by rentable square feet) average basis, be slightly lower than the rates currently being paid, thereby generally resulting in slightly lower revenue from the same space. However, we can provide no assurance that the rental rates we expect will occur or that we will not experience material declines in our rental income due to vacancies upon lease expirations. Prevailing market conditions and government tenants’ needs at the time we negotiate our leases will generally determine rental rates and other terms for leased space in our properties; and market conditions and government tenants’ needs are beyond our control. As of June 30, 2014, lease expirations at our properties, excluding properties classified as discontinued operations, by year are as follows (square feet and dollars in thousands):

(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, 2014, government tenants occupying approximately 7.5% of our rentable square feet and responsible for approximately 6.2% of our annualized rental income as of June 30, 2014 have currently exercisable rights to terminate their leases before the stated expirations. Also in 2014, 2015, 2016, 2017, 2018, 2019, 2020, 2022 and 2023, early termination rights become exercisable by other tenants who currently occupy an additional approximately 0.9%, 5.7%, 6.3%, 2.6%, 1.0%, 4.3%, 2.3%, 1.2% and 1.3% of our rentable square feet, respectively, and contribute an additional approximately 0.8%, 3.9%, 8.7%, 3.4%, 1.3%, 4.9%, 2.4%, 0.7% and 1.1% of our annualized rental income, respectively, as of June 30, 2014.  In June 2014, we were notified by one of our tenants, representing 1.0% of our rentable square feet and responsible for approximately 1.3% of our annualized rental income as of June 30, 2014, that it intends to exercise its right to vacate its space in December 2014.  In addition, as of June 30, 2014, 12 of our government tenants have currently exercisable rights to terminate their leases if their respective legislature or other funding authority does not appropriate rent in their respective annual budgets. These 12 tenants occupy approximately 12.3% of our rentable square feet and contribute approximately 12.7% of our annualized rental income as of June 30, 2014.

(2)                                     Leased square feet is pursuant to leases existing as of June 30, 2014, 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, 2014, plus straight line rent adjustments and estimated recurring expense reimbursements to be paid to us, and excluding lease value amortization.

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Acquisition and Disposition Activities (dollar amounts in thousands)

During the six months ended June 30, 2014, we acquired three office properties (four buildings) for a purchase price of $154,525, including the assumption of $97,524 of mortgage debt and excluding acquisition costs.  We acquired these properties at a range of capitalization rates of 8.3% to 9.3%, with a weighted (by purchase price) average capitalization rate of 8.5%.  We calculate the capitalization rate for property acquisitions as the ratio of (x) annual straight line rental income, excluding the impact of above and below market lease amortization, based on leases in effect on the acquisition date, less estimated annual property operating expenses as of the acquisition date, excluding depreciation and amortization expense, to (y) the acquisition purchase price, including the principal amount of assumed debt, if any, and excluding acquisition costs.  In June 2014 and August 2014, we entered into three agreements to acquire three office properties (three buildings) for an aggregate purchase price of $52,700, excluding acquisition costs. These pending acquisitions are subject to closing conditions; accordingly, we can provide no assurance that we will acquire these properties or that these acquisitions will not be delayed or that their terms will not change.

In February 2014, we sold an office property (one building) located in Phoenix, AZ with 97,145 rentable square feet for $5,000, excluding closing costs.  In April 2014, we entered 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 $12,286 at June 30, 2014.  The contract sales price is $16,500, excluding closing costs.  The closing of this sale is subject to conditions, including the purchaser obtaining certain zoning entitlements and is currently expected to occur in 2015. In July 2014, we entered an agreement to sell an office property (one building) located in San Diego, CA with 94,272 rentable square feet and a net book value of $11,008 at June 30, 2014.  The contract sales price is $12,500, excluding closing costs.  The closing of this sale is subject to conditions and is expected to occur later in 2014. We can provide no assurance that sales of these two properties will occur.  For more information about these transactions, please see Note 3 to our Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Our strategy related to property acquisitions and dispositions is materially unchanged from that disclosed in our Annual Report. We continue to explore and evaluate for possible acquisition additional properties that are majority leased to government tenants; however, we 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 any acquisitions. Although we have not identified other properties for disposition, we expect to periodically identify properties for sale based on identifying future changes in market conditions, changes in property performance, our expectation regarding lease renewals or our plans with regard to particular properties.  Our plans for particular properties and other strategic considerations may cause us to change our acquisition and disposition strategies, and we may do so at any time and without shareholder approval.

On July 9, 2014, we acquired from EQC 21,500,000 common shares of Select Income REIT, or SIR, for a cash purchase price equal to approximately $677,500, or $31.51 per share, plus approximately $11,300, or $0.53 per share, of accrued dividends as defined in the purchase agreement, for a total of approximately $688,800. We funded this acquisition with borrowings under our $550,000 revolving credit facility and under our new $500,000 term loan.  For more information about these transactions, please see Notes 6 and 9 to our Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

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

Three Months Ended June 30, 2014, Compared to Three Months Ended June 30, 2013