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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2010

OR

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

Commission File Number 1-9317

COMMONWEALTH REIT

(Exact Name of Registrant as Specified in Its Charter)

400 Centre Street, Newton, Massachusetts 02458

(Address of Principal Executive Offices)  (Zip Code)

617-332-3990

(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 (§232.405 of this chapter) 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, $0.01 par value per share, outstanding as of November 1, 2010: 72,138,686

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COMMONWEALTH REIT

FORM 10-Q

September 30, 2010

INDEX

References in this Form 10-Q to “we”, “us” and “our” refers to CommonWealth REIT and its consolidated subsidiaries, unless otherwise noted.  All share amounts in this Form 10-Q give effect to the reverse stock split that resulted in a one for four combination of our common shares effective July 1, 2010.

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PART I          Financial Information

Item 1.  Financial Statements

COMMONWEALTH REIT

CONDENSED CONSOLIDATED BALANCE SHEETS

(amounts in thousands, except share data)

(unaudited)

See accompanying notes

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COMMONWEALTH REIT

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(amounts in thousands, except per share data)

(unaudited)

See accompanying notes

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COMMONWEALTH REIT

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(amounts in thousands)

(unaudited)

See accompanying notes

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COMMONWEALTH REIT

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(amounts in thousands)

(unaudited)

See accompanying notes

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COMMONWEALTH REIT

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

Note 1.  Basis of Presentation

The accompanying condensed consolidated financial statements of CommonWealth REIT, or CWH, we or us, and its subsidiaries have been prepared without audit.  Certain information and footnote 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 consolidated financial statements and notes contained in our Annual Report on Form 10-K for the year ended December 31, 2009, 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 our subsidiaries have been eliminated.  Operating results for interim periods are not necessarily indicative of the results that may be expected for the full year.  Reclassifications have been made to the prior years’ financial statements to conform to the current year’s presentation.

Note 2.  New Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board, or the FASB, issued an accounting standards update requiring additional disclosures regarding fair value measurements.  The update requires entities to disclose additional information regarding assets and liabilities that are transferred between levels within the fair value hierarchy.  The update also clarifies the level of disaggregation at which fair value disclosures should be made and the requirements to disclose information about the valuation techniques and inputs used in estimating Level 2 and Level 3 fair values.  The update is effective for interim and annual reporting periods beginning after December 15, 2009 except for the requirement to separately disclose purchases, sales, issuances and settlements in the Level 3 roll forward that becomes effective for fiscal periods beginning after December 15, 2010.

The adoption of this update does not, and is not expected to, cause any material changes to the disclosures in our condensed consolidated financial statements.

Note 3.  Securities Held to Maturity

Until August 2, 2010, we held $8,000 of marketable commercial mortgage pass through certificates, or certificates, which were backed by our mortgage notes payable due January 2011 that were purchased in 2009 for $6,760. We classified these certificates as investments held to maturity rather than available for sale or trading because we had the intent and ability to hold these certificates until maturity.  We followed the amortized cost method of accounting for these certificates.  Under this method, we amortized the difference between the face value of the certificates and their purchase price to income using the interest method over the expected remaining term of the certificates.  As of December 31, 2009, these certificates had a carrying value of $7,267 and were included in other assets in our consolidated balance sheet.  As of December 31, 2009, these certificates had an estimated fair market value of $7,443.  On August 2, 2010, we prepaid the underlying mortgage notes payable, received $8,000 from our investment in these certificates and recorded a gain of $376 from the recognition of unamortized interest income.  This gain is included in interest and other income in our condensed consolidated statements of income.

Note 4.  Real Estate Properties

Since January 1, 2010, we acquired 32 properties for aggregate purchase prices of $552,625, excluding closing costs; we have also sold 16 properties for aggregate sales prices of $240,750, excluding closing costs.

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COMMONWEALTH REIT

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

In April 2010, we acquired an office property located in Denver, CO with 248,493 square feet.  The purchase price was $75,000, excluding closing costs.  We allocated $4,720 to land, $58,890 to buildings and improvements and $11,390 to acquired real estate leases.

In April 2010, we acquired an office property located in Colorado Springs, CO with 77,411 square feet.  The purchase price was $10,800, excluding closing costs.  We allocated $1,250 to land, $7,982 to buildings and improvements, $1,576 to acquired real estate leases and $8 to acquired real estate lease obligations.

In June 2010, we acquired two office properties located in Ann Arbor, MI with a combined 410,410 square feet.  The aggregate purchase price was $65,200, excluding closing costs.  We allocated $6,760 to land, $46,988 to buildings and improvements, $11,875 to acquired real estate leases and $423 to acquired real estate lease obligations.

In June 2010, we acquired two office properties located in Carson, CA with a combined 212,000 square feet.  The aggregate purchase price was $27,925, excluding closing costs.  We allocated $7,460 to land, $18,033 to buildings and improvements, $3,415 to acquired real estate leases and $983 to acquired real estate lease obligations.

In July 2010, we acquired two office properties located in Stafford, VA with a combined 117,949 square feet.  The aggregate purchase price was $18,750, excluding closing costs.  We allocated $1,929 to land, $15,656 to buildings and improvements, $1,182 to acquired real estate leases and $17 to acquired real estate lease obligations.

In August 2010, we acquired one office property located in Milwaukee, WI with 432,092 square feet.  The purchase price was $80,200, excluding closing costs.  We allocated $3,150 to land, $70,124 to buildings and improvements, $7,795 to acquired real estate leases and $869 to acquired real estate lease obligations.

In August 2010, we acquired seven properties located in Monterey, CA, consisting of approximately 1,155 acres of triple net leased agricultural land and related fixtures and improvements.  The aggregate purchase price was $28,000, excluding closing costs.  We allocated $9,657 to land and $18,343 to fixtures and improvements based on currently available information.  These preliminary allocations are subject to change pending an evaluation by an independent real estate appraisal firm that is expected to be finalized during the fourth quarter of 2010.

In September 2010, we acquired one office property located in Greensboro, NC with 323,773 square feet.  The purchase price was $44,650, excluding closing costs.  We allocated $2,070 to land, $37,073 to buildings and improvements, $5,663 to acquired real estate leases and $156 to acquired real estate lease obligations.

In October 2010, we acquired MacarthurCook Industrial Property Fund, an Australian property trust that owns 10 industrial properties with approximately 1,400,000 square feet.  The purchase price for these properties was approximately $83,200, excluding acquired positive working capital and closing costs.

In October 2010, we acquired three office properties located in Carson, CA with a combined 190,000 square feet.  The aggregate purchase price was $22,650, excluding closing costs.

In October 2010, we acquired a two tower office property located in Chicago, IL with 631,445 square feet.  The purchase price was $96,250, excluding closing costs.

In October 2010, we entered a purchase and sale agreement to acquire seven office properties located in Birmingham, AL with a combined 904,109 square feet.  We expect to acquire these properties during the fourth quarter of 2010; however, this acquisition is subject to customary closing conditions and no assurance can be given that this acquisition will be consummated in that time period or at all.

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COMMONWEALTH REIT

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

In June 2010, we entered agreements to sell 15 properties to our former subsidiary, Government Properties Income Trust, or GOV, that contain approximately 1,900,000 square feet for an aggregate sales price of $231,000, excluding closing costs.  All 15 of these properties have been sold as of September 30, 2010, and we recognized total gains of $34,336, exclusive of deferred gains of $14,588 attributable to our ownership interest in GOV.  In addition, the net book value for four of these properties exceeded their allocated sales prices, and we recorded impairment charges of $21,491 during the second quarter of 2010.

In September 2010, we sold an office property located in Irondequoit (Rochester), NY with approximately 310,000 square feet for $9,750, excluding closing costs.  In connection with this sale, we provided mortgage financing to the buyer, a not for profit hospital entity, totaling $8,288 at 4.75% per annum and recognized a gain on sale of $4,568 during the three months ended September 30, 2010.

During the nine months ended September 30, 2010, we funded $43,599 of improvements to our owned properties.

As of September 30, 2010 and December 31, 2009, we had one office property located in Los Angeles, CA with approximately 79,000 square feet classified as held for sale in our consolidated balance sheets.  This property was under contract for sale since June 2008; however, the purchase contract expired and we recognized the $750 nonrefundable deposit previously paid by the buyer in other income when the buyer was unable to meet its obligation to close on January 26, 2010.  We continue to actively market this property for sale.

We classify all properties actively marketed, under contract, in active negotiations or otherwise probable for sale within one year as held for sale in our consolidated balance sheets.  Results of operations for properties sold or held for sale are included in discontinued operations in our consolidated statements of income, except for properties sold to GOV.  Properties sold to GOV are not considered discontinued operations under GAAP because of our retained equity interest in this former subsidiary.  Summarized balance sheet information for all properties classified as held for sale and income statement information for properties sold or held for sale, except for properties sold to GOV, is as follows:

Balance Sheets:

Income Statements:

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COMMONWEALTH REIT

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

Note 5.  Equity Investments

At September 30, 2010 and December 31, 2009, we had the following equity investments in GOV and Affiliates Insurance Company, or AIC:

At September 30, 2010, we owned 9,950,000, or approximately 24.6%, of the common shares of beneficial interest of GOV, with a carrying value of $168,663 and a market value, based on quoted market prices, of $265,665 ($26.70 per share).  GOV is a real estate investment trust, or REIT, which owns properties that are majority leased to government tenants and was our wholly owned subsidiary until its initial public offering, or IPO, in June 2009 when it became a separate public entity.  In January 2010, GOV issued 9,775,000 common shares in a public offering for $21.50 per common share, raising net proceeds of approximately $199,300.  As a result of this transaction, our ownership percentage in GOV was reduced from 46.3% prior to this transaction to 31.8% after this transaction, and we recognized a gain of $16,418.  In August 2010, GOV issued an additional 9,200,000 common shares in a public offering for $25.00 per common share, raising net proceeds of approximately $219,900.  As a result of this transaction, our ownership percentage in GOV was reduced from 31.8% prior to this transaction to 24.6% after this transaction, and we recognized a gain of $18,390.

In connection with GOV’s IPO, we and GOV entered into a transaction agreement in which, among other things, we granted GOV the right of first refusal to acquire any property owned by us that we determine to divest, if the property is then majority leased to a government tenant, including the 15 properties we sold to GOV during 2010.  The sales for these 15 properties were negotiated by special committees of our and GOV’s boards of trustees composed solely of independent trustees who are not also trustees of the other party.

Since GOV’s IPO, our investment in it has been accounted for using the equity method.  Under the equity method, we record our percentage share of net earnings of GOV in our consolidated statements of income.  Prior to its IPO, the operating results and assets of GOV were included in our results of operations and balance sheet.  If we determine there is an “other than temporary” decline in the fair value of this investment, we would record a charge to earnings.

During the nine months ended September 30, 2010, we received cash distributions totaling $12,039 from GOV.

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COMMONWEALTH REIT

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

The following summarized financial data of GOV, as reported in its Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2010 includes results of operations prior to June 8, 2009 (the date GOV became a separate public company) which are included in our consolidated results of operations when GOV was our wholly owned subsidiary.  References in our financial statements to the Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2010 for GOV are included as textual references only, and the information in GOV’s Quarterly Report for the quarterly period ended September 30, 2010 is not incorporated by reference into our financial statements.

As of September 30, 2010, we have invested $5,208 in AIC, an insurance company organized by Reit Management & Research LLC, or RMR, and companies to which RMR provides management services.  All of our trustees serve on the board of directors of AIC.  At September 30, 2010, we owned approximately 14.3% of the common shares of AIC, with a carrying value of $5,058.  Although we own less than 20% of AIC, we use the equity method to account for this investment because we believe that we have significant influence over AIC because each of our trustees is a director of AIC.  Under the equity method, we record our percentage share of net earnings from AIC in our consolidated statements of income.  If we determine there is an “other than temporary” decline in the fair value of this investment, we would record a charge to earnings.  In evaluating the fair value of this investment, we

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COMMONWEALTH REIT

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

have considered, among other things, the assets and liabilities held by AIC, AIC’s overall financial condition, and the financial condition and prospects for the insurance industry generally.

In June 2010, we, RMR and other companies to which RMR provides management services purchased property insurance pursuant to an insurance program arranged by AIC.  Our annual premiums for this property insurance are expected to be approximately $5,328.  We are currently investigating the possibilities to expand our insurance relationships with AIC to include other types of insurance.

Note 6.  Real Estate Mortgage Receivable

We provided mortgage financing for $8,288 at 4.75% per annum in connection with an office property sold in September 2010.  This real estate mortgage requires monthly principal and interest payments and matures on September 30, 2020.  As of September 30, 2010, this mortgage had a carrying value of $8,288 and was included in other assets in our condensed consolidated balance sheet.

Note 7.  Indebtedness

In August 2010, we entered a new $750,000 unsecured revolving credit facility that we use for acquisitions, working capital and general business purposes.  The new facility replaces our previous $750,000 unsecured revolving credit facility, which had a maturity date of August 22, 2010.  The maturity date of the new facility is August 8, 2013 and includes an option for us to extend the facility for one year to August 8, 2014.  The new facility also includes a feature under which the maximum borrowing may be increased to up to $1,500,000 in certain circumstances.  Interest paid under the new facility is set at LIBOR plus 200 basis points, subject to adjustments based on our credit ratings.  The interest rate on our revolving credit facilities averaged 1.5% and 1.0% per annum for the nine months ended September 30, 2010 and 2009, respectively.  As of September 30, 2010, we had zero outstanding and $750,000 available under our new revolving credit facility.

In August 2010, we repaid at maturity all $30,000 of our 8.875% senior notes due in 2010.  We also prepaid at par $266,674 of mortgage debt that was scheduled to mature in 2011 and 2029.  In connection with the prepayment of this mortgage debt, we recorded a loss on early extinguishment of debt of $1,044 from the write off of unamortized discounts and deferred financing fees during the third quarter of 2010.  We funded these payments with borrowings under our revolving credit facility.

In September 2010, we issued $250,000 of unsecured senior notes in a public offering, raising net proceeds of approximately $242,483.  These notes bear interest at 5.875% per annum, require semi-annual interest payments and mature in September 2020.  Net proceeds from these notes were used to repay amounts then outstanding under our revolving credit facility.

Our public debt indentures and credit facility agreement contain a number of financial and other covenants, including a credit facility covenant which restricts our ability to make distributions under certain circumstances.  At September 30, 2010, we believe that we are in compliance with these financial and other covenants.

At September 30, 2010, 15 of our properties costing $598,225 with an aggregate net book value of $493,032 were secured by $352,575 of mortgage debt maturing between 2011 and 2027.

In October 2010, we repaid at maturity, all $20,000 of our 8.625% senior notes due in 2010 using cash on hand.

Note 8.  Shareholders’ Equity

During the nine months ended September 30, 2010, we issued 16,125,000 common shares in two public offerings, raising net proceeds of $430,778.

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COMMONWEALTH REIT

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

Other comprehensive income includes unrealized gains or losses on the fair value of our interest rate swap agreements and other investments.  Our interest rate swap agreements qualify as cash flow hedges and convert the floating interest rate on a $175,000 mortgage note payable to a fixed interest rate.  The following is a reconciliation of net income to total comprehensive income for the three and nine months ended September 30, 2010 and 2009:

On April 14, 2010, we issued 1,250 common shares, valued at $32.44 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 September 17, 2010, pursuant to our equity compensation plan, we granted an aggregate of 42,375 common shares of beneficial interest, par value $0.01 per share, valued at $27.30 per share, the closing price of our common shares on the NYSE, on that day, to our officers and certain employees of our manager, RMR.

On June 14, 2010, our board of trustees approved a reverse stock split that resulted in a one for four combination of our common shares of beneficial interest, $0.01 par value per share, effective July 1, 2010.  The reverse stock split reduced the number of our issued and outstanding common shares from 258,385,241 to 64,596,311.  The number of our authorized common shares did not change.  As required, common share amounts presented for all periods have been restated to reflect the reverse stock split.  As a result of the reverse stock split, the conversion rate of our 15,180,000 outstanding series D cumulative convertible preferred shares, or series D preferred shares, automatically changed from 1.9231 common shares per series D preferred share to 0.480775 common share per series D preferred share (the equivalent of a change in conversion price from $13.00 per common share to $52.00 per common share).

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COMMONWEALTH REIT

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

Note 9.  Fair Value of Assets and Liabilities

The table below presents certain of our assets and liabilities measured at fair value at September 30, 2010, categorized by the level of inputs used in the valuation of each asset and liability:

(1)   Properties held for sale are reported at the lower of carrying value or fair value less costs to sell and consists of one property that we expect to sell within one year.  We used our estimate of fair value less estimated closing costs to determine the fair value of this property (level 2 inputs).

(2)   The fair value of our interest rate swap contracts is determined using the net discounted cash flows of the expected cash flows of each derivative based on the market based interest rate curve (level 2 inputs) and adjusted for our credit spread and the actual and estimated credit spreads of the counterparties (level 3 inputs).  Although we have determined that the majority of the inputs used to value our derivatives fall within level 2 of the fair value hierarchy, the credit valuation adjustments associated with our derivatives utilize level 3 inputs, such as estimates of current credit spreads, to evaluate the likelihood of default by us and the counterparties.  As of September 30, 2010, we have assessed the significance of the impact of the credit valuation adjustments on the overall valuation of our derivative positions and have determined that the credit valuation adjustments are not significant to the overall valuation of our derivatives.  As a result, we have determined that our derivative valuations in their entirety are classified as level 2 inputs in the fair value hierarchy.

(3)   The fair value of our investment in available for sale securities is based on quoted prices at September 30, 2010 in active markets (level 1 inputs) and is included in other assets in our condensed consolidated balance sheet.

We are exposed to certain risks relating to our ongoing business operations.  The primary risk managed by using our derivative instruments is interest rate risk.  We enter into interest rate swaps to manage interest rate risk associated with our floating rate borrowings.  We have interest rate swap agreements to manage our interest rate risk exposure on $175,000 of mortgage notes due 2019, which require interest at a spread over LIBOR.  The interest rate swap agreements utilized by us qualify as cash flow hedges and effectively modify our exposure to interest rate risk by converting our floating interest rate debt to a fixed interest rate basis for this loan through December 1, 2016, thus reducing the impact of interest rate changes on future interest expense.  These agreements involve the receipt of floating interest rate amounts in exchange for fixed rate interest payments over the life of the agreements without an exchange of the underlying principal amount.  The fair value of our derivative instruments decreased by $5,150 and $15,965 during the three and nine months ended September 30, 2010, respectively, based primarily on changes in market interest rates.  As of September 30, 2010, the fair value of these derivative instruments included in accounts payable and accrued expenses and cumulative other comprehensive income (loss) in our consolidated balance sheet totaled ($13,418).  As of December 31, 2009, the fair value of these derivative instruments included in other assets and cumulative other comprehensive income (loss) in our consolidated balance sheet totaled $2,547.

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COMMONWEALTH REIT

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

In addition to the assets and liabilities described in the above table, our financial instruments include our cash and cash equivalents, rents receivable, equity investments, real estate mortgage receivable, marketable pass through certificates, restricted cash, revolving credit facility, senior notes and mortgage notes payable, accounts payable and other accrued expenses, rent collected in advance, security deposits and amounts due to affiliates.  At September 30, 2010 and December 31, 2009, the fair values of these additional financial instruments were not materially different from their carrying values, except as follows:

At September 30, 2010 and December 31, 2009, the fair values of our equity investment in GOV are based on quoted market prices of $26.70 and $22.98, respectively.  At December 31, 2009, the fair values of our marketable pass through certificates are based on quoted market prices of $93.04.  The fair values of our senior notes and mortgage notes payable are based on estimates using discounted cash flow analyses and currently prevailing interest rates adjusted by credit risk spreads.

Other financial instruments that potentially subject us to concentrations of credit risk consist principally of rents receivable; however, none of our tenants are responsible for more than 2% of our total rents.

Note 10.  Earnings Per Common Share

The effect of our convertible preferred shares on income from continuing operations available for common shareholders per share is anti-dilutive for the periods presented.

Note 11.  Segment Information

As of September 30, 2010, we owned 285 suburban office properties, 41 central business district, or CBD, office properties and 193 industrial & other properties, excluding one property classified as held for sale and included in discontinued operations.  We account for all of these properties in geographic operating segments for financial reporting purposes based on our method of internal reporting.  We account for our properties by property type (i.e. suburban office, CBD office and industrial & other) and by geographic regions.  We define these individual geographic segments as those which currently, or during either of the last two quarters, represent or generate 5% or more of our total square feet, revenues or property net operating income, or NOI, which we define as rental income less property level operating expenses.  Prior periods have been restated to reflect one office property reclassified from discontinued operations during the fourth quarter of 2009 and one office property reclassified from continuing operations during the third quarter of 2010.  Property level information as of and for the three and nine months ended September 30, 2010 and 2009, excluding discontinued operations, is as follows:

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COMMONWEALTH REIT

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)