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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 June 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 July 28, 2015:  71,084,349

 

 

 

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GOVERNMENT PROPERTIES INCOME TRUST

 

FORM 10-Q

 

June 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.

 

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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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GOVERNMENT PROPERTIES INCOME TRUST

CONDENSED CONSOLIDATED STATEMENTS OF 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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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. 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 April 2015, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or 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. This ASU is effective for interim and annual reporting periods beginning after December 15, 2015 and requires retrospective application.  This ASU is not expected to cause any 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.

 

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 apply to certain other transactions such as the sale of real estate or equipment. 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.

 

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):

 

 

 

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Note 4.   Real Estate Properties

 

As of June 30, 2015, we owned 71 properties (91 buildings), with an undepreciated carrying value of $1,687,057,  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 June 30, 2015, we entered into 16 leases for 316,123 rentable square feet for a weighted (by rentable square feet) average lease term of 10.9 years and we made commitments for approximately $5,237 of leasing related costs. During the six months ended June 30, 2015, we entered into 23 leases for 399,101 rentable square feet for a weighted (by rentable square feet) average lease term of 10.2 years and we made commitments for approximately $7,483 of leasing related costs. We have estimated unspent leasing related obligations of $9,248 as of June 30, 2015.

 

Acquisition Activities

 

In June 2015, we entered into an agreement to acquire an office property ( one building) located in Greensburg, PA with 82,889 rentable square feet for a purchase price of $14,300, excluding acquisition costs.  The property is 100% leased to the Commonwealth of Pennsylvania. 

 

In July 2015, we entered into an agreement to acquire an office and warehouse property (one building) located in Braintree, MA with 99,168 rentable square feet.  The purchase price is $11,700, excluding acquisition costs.  This property is 100% leased to the Commonwealth of Massachusetts. 

 

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 the acquisition terms will not change.

 

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 $3,072 as of June 30, 2015.  We have classified this property as held for sale as of June 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 classified as held for sale is as follows:

 

 

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Disposition Activities – Discontinued Operations

 

In April 2014, 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 June 30, 2015.  In May 2015, this agreement was terminated.  In July 2015, we entered an agreement to sell this property to a different purchaser.  The contract sales price is $16,500, excluding closing costs.  We currently expect this sale to close before year end 2015.  However, this sale is subject to conditions and we can provide no assurance that the sale of this property will occur, that it will not be delayed or that its terms will not change.  See Note 8 for further information relating to this property.

 

Results of operations for two properties ( two buildings) we sold in February 2014 and September 2014 and one property ( one building) held for sale at June 30, 2015, which was held for sale prior to our adoption of ASU 2014-08, 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 $1,544 and $1,101 for the three months ended June 30, 2015 and 2014, respectively, and $2,207 and $2,243 for the six months ended June 30, 2015 and 2014, respectively.  Rents receivable include $17,224 and $15,017 of straight line rent receivables at June 30, 2015 and December 31, 2014, respectively. 

 

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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 93.0% of our annualized rental income, excluding properties classified as discontinued operations, as of June 30, 2015 and 2014, respectively. The U.S. Government is our largest tenant by annualized rental income and was responsible for approximately 67.7% and 70.0% of our annualized rental income, excluding properties classified as discontinued operations, as of June 30, 2015 and 2014, respectively.

 

Geographic Concentration

 

At June 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%,  10.5%,  10.3%,  9.1%,  8.5%,  7.5% and 5.7% of our annualized rental income as of June 30, 2015, respectively.

 

Note 7.   Indebtedness

 

At June 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

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of LIBOR plus a premium, which was 125 basis points at June 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 June 30, 2015. Both the interest rate premium and the facility fee are subject to adjustment based upon changes to our credit ratings. As of June 30, 2015, the interest rate payable on borrowings under our revolving credit facility was 1.4% and the weighted average interest rate for borrowings under our revolving credit facility was 1.4% and 1.6%, respectively, for the three and six months ended June 30, 2015 and 1.7% for both the three and six months ended June 30, 2014. As of June 30, 2015 and July 28, 2015, we had $59,000 and $99,000 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 June 30, 2015. The interest rate premium is subject to adjustment based upon changes to our credit ratings. As of June 30, 2015, the interest rate for the amount outstanding under our $300,000 term loan was 1.6%. The weighted average interest rate under our $300,000 term loan was 1.6% for both the three and six months ended June 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 June 30, 2015.  The interest rate premium is subject to adjustment based upon changes to our credit ratings. As of June 30, 2015, the interest rate for the amount outstanding under our $250,000 term loan was 2.0%. The weighted average interest rate under our $250,000 term loan was 2.0% for both the three and six months ended June 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 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, including, in the case of our credit agreement, a change of control of us, which includes 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 June 30, 2015.

 

At June 30, 2015, six of our properties ( eight buildings) with an aggregate net book value of $262,191 secured six mortgage notes that we assumed in connection with the acquisition of such properties. Our mortgage notes are non-recourse and do not contain any material financial covenants.

 

In July 2015, we repaid, at par, a $47,083 mortgage note which was secured by a property ( two buildings) located in Indianapolis, IN. This mortgage was scheduled to mature in October 2015. 

 

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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 June 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.

The table below presents certain of our assets we measured on a non-recurring basis at estimated fair value at June 30, 2015, categorized by the level of input used in the valuation of these assets:

 

 

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(1)We own 24,891,421 common shares of Select Income REIT, or SIR. During the three months ended June 30, 2015, we recorded a $203,297 loss on impairment to reduce the carrying value of this investment to its estimated fair value. We estimated fair value using the closing price of SIR’s common shares on the New York Stock Exchange, or the NYSE, on June 30, 2015 (Level 1 input). See Notes 10 and 11 for further information regarding this investment. 

 

Note 9.    Shareholders’ Equity

 

Distributions

 

On February 26, 2015, we paid a distribution to common shareholders in the amount of $0.43 per share, or $30,252.

 

On May 26, 2015, we paid a distribution to common shareholders in the amount of $0.43 per share, or $30,256.

 

On July 13, 2015, we declared a distribution payable to common shareholders of record on July 24, 2015, in the amount of $0.43 per share, or $30,566. We expect to pay this distribution on or about August 24, 2015 using cash on hand and borrowings under our revolving credit facility.

 

Share Issuances

 

During the three and six months ended June 30, 2015, we issued 12,012 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 and recent amendments to 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 NYSE on that day, to each of our five Trustees as part of their annual compensation.

 

On June 5, 2015, we issued 700,000 shares as partial payment to acquire 1,541,201 shares of Class A common stock of Reit Management & Research Inc., a Maryland corporation, or RMR Inc.  See Note 10 for further details of this transaction.

 

Note 10.   Related Person Transactions

 

We have relationships and historical and continuing transactions with RMR LLC, its parent, 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 the 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, 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 transactions agreements: we contributed to RMR Inc. 700,000 of our common shares, valued at $13,545 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;

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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 member 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:

 

 

 

 

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 1,000,000 shares of class B-1 common stock of RMR Inc., 15,000,000 shares of class B-2 common stock of RMR Inc. and 15,000,000 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

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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 an amended and restated business management agreement, or the amended business management agreement, which amended and restated our previous business management agreement with RMR LLC, and an amended and restated property management agreement, or 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, or 9.6%, of RMR Inc. for $17,462.  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 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 have recorded other liabilities of $22,371.  Our investment is included in other assets in our condensed consolidated balance sheet and the carrying value of our investment is $42,384, including transaction costs as of June 30, 2015.  The other liabilities for these securities is included in accounts payable and other liabilities in our condensed consolidated balance sheet and is being amortized on a straight line basis over the 20 year life of the business and property management agreements with RMR LLC as an allocated 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 other liabilities, included in general and administrative expense and other operating expenses for the three months ended June 30, 2015, totaled $36 and $29, respectively.

 

RMR LLC Management Fees and Reimbursements: We recognized business management fees of $2,512 and $2,534 for the three months ended June 30, 2015 and 2014, respectively, and $5,073 and $4,935 for the six months ended June 30, 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 23,222 and 16,318 of our common shares to RMR LLC for the six months ended June 30, 2015 and 2014, respectively, as payment for portions of

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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 $1,887 and $1,985 for the three months ended June 30, 2015 and 2014, respectively and $3,902 and $3,939 for the six months ended June 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 June 30, 2015 and 2014 were $2,128 and $2,264 respectively, and $5,233 and $3,936 for the six months ended June 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.  The amounts accrued for share grants to RMR LLC employees were $57 and $80, for the three months ended June 30, 2015 and 2014, respectively, and $313 and $349 for the six months ended June 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 earned rental income from RMR LLC for leased office space of approximately $153 and $14 for the three months ended June 30, 2015 and 2014, respectively, and approximately $167 and $33 for the six months ended June 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.  After this purchase and as of June 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.

 

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AIC:  As of June 30, 2015, our investment in Affiliates Insurance Company, or AIC, an Indiana insurance company, had a carrying value of $7,022, which amount is included in other assets on our condensed consolidated balance sheet.  We recognized income of $22 and $118 related to our investment in AIC for the three months ended June 30, 2015 and 2014, respectively, and $95 and $21 for the six months ended June 30, 2015 and 2014, respectively.  Our other comprehensive income includes unrealized gains (losses) on securities held for sale which are owned by AIC of ($64) and $22 for the three months ended June 30, 2015 and 2014, respectively, and ($19) and $41 for the six months ended June 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 currently expect to pay aggregate annual premiums, including taxes and fees, of approximately $1,282 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.

 

Note 11.   Equity Investment in Select Income REIT

 

As described in Notes 8 and 10, as of June 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 six months ended June 30, 2015, we recorded $8,249 and $10,425 of equity in the earnings of SIR, respectively.

 

During the three and six months ended June 30, 2015, SIR issued 915,853 and 29,368,890 common shares, respectively.  We recognized a loss on issuance of shares by SIR of $1,353 and $42,124, respectively, during the three and six months ended June 30, 2015 as a result of the per share issuance price of these SIR common shares being below the 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 as of June 30, 2015, we determined, based on the length of time and the extent to which the market value of our SIR investment has been below our carrying value, that the decline in fair value is 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 of $514,316 as of June 30, 2015.  We estimated fair value using the closing price of SIR common shares on the NYSE on that day.

 

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 $2,177 and $4,742 for the three and six months ended June 30, 2015, respectively.  Our recording the impairment charge has 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

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difference was eliminated and, as of June 30, 2015, a basis difference of ($95,089) will be amortized to earnings over the estimated remaining useful lives of the real estate assets and intangible assets and liabilities owned by SIR.

 

During the three and six months ended June 30, 2015, we received cash distributions from SIR totaling $8,582 and $22,112, respectively.

 

The following summarized financial data of SIR as reported in SIR’s Quarterly Report on Form 10-Q for the three and six months ended June 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:

 

 

 

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Condensed Consolidated Statements of Income:

 

 

 

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Note 12.   Segment Information

 

We operate in two separate reportable business segments: ownership of properties that are primarily leased to government tenants and our equity method investment in SIR.

 

 

 

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