Table of Contents

 

 

 

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 March 31, 2013

 

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)

 

Maryland

 

04-6558834

(State or Other Jurisdiction of Incorporation or
Organization)

 

(IRS Employer Identification No.)

 

Two Newton Place, 255 Washington Street, Suite 300, Newton, Massachusetts

 

02458-1634

(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):

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

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 May 8, 2013: 118,304,068.

 

 

 



Table of Contents

 

COMMONWEALTH REIT

 

FORM 10-Q

 

March 31, 2013

 

INDEX

 

 

 

Page

PART I

Financial Information

 

 

 

 

Item 1.

Financial Statements (unaudited)

 

 

 

 

 

Condensed Consolidated Balance Sheets — March 31, 2013 and December 31, 2012

1

 

 

 

 

Condensed Consolidated Statements of Operations — Three Months Ended March 31, 2013 and 2012

2

 

 

 

 

Condensed Consolidated Statements of Comprehensive Income — Three Months Ended March 31, 2013 and 2012

3

 

 

 

 

Condensed Consolidated Statements of Cash Flows — Three Months Ended March 31, 2013 and 2012

4

 

 

 

 

Notes to Condensed Consolidated Financial Statements

6

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

24

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

39

 

 

 

Item 4.

Controls and Procedures

42

 

 

 

 

Warning Concerning Forward Looking Statements

43

 

 

 

 

Statement Concerning Limited Liability

46

 

 

 

PART II

Other Information

 

 

 

 

Item 1.

Legal Proceedings

47

 

 

 

Item 1A.

Risk Factors

49

 

 

 

Item 6.

Exhibits

50

 

 

 

 

Signatures

54

 

References in this Quarterly Report on Form 10-Q to the “Company”, “CWH”, “we”, “us” or “our” refer to CommonWealth REIT and its consolidated subsidiaries, including its majority owned consolidated subsidiary, Select Income REIT and its consolidated subsidiaries, or SIR, unless the context indicates otherwise.

 

SIR is itself a public company having common shares registered under the Securities Exchange Act of 1934, as amended.  For further information about SIR, please see SIR’s periodic reports and other filings with the Securities and Exchange Commission, or the SEC, which are available at the SEC’s website at www.sec.gov.  References in this Quarterly Report on Form 10-Q to SIR’s filings with the SEC are included as textual references only, and the information in SIR’s filings with the SEC is not incorporated by reference into this Quarterly Report on Form 10-Q unless otherwise expressly stated herein.

 



Table of Contents

 

PART I.      Financial Information

 

Item 1.         Financial Statements.

 

COMMONWEALTH REIT

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(amounts in thousands, except share data)

(unaudited)

 

 

 

March 31,

 

December 31,

 

 

 

2013

 

2012

 

ASSETS

 

 

 

 

 

Real estate properties:

 

 

 

 

 

Land

 

$

1,548,225

 

$

1,531,416

 

Buildings and improvements

 

6,441,544

 

6,297,993

 

 

 

7,989,769

 

7,829,409

 

Accumulated depreciation

 

(1,047,697

)

(1,007,606

)

 

 

6,942,072

 

6,821,803

 

Properties held for sale

 

159,501

 

171,832

 

Acquired real estate leases, net

 

416,763

 

427,756

 

Equity investments

 

11,394

 

184,711

 

Cash and cash equivalents

 

48,692

 

102,219

 

Restricted cash

 

14,723

 

16,626

 

Rents receivable, net of allowance for doubtful accounts of $9,962

 

267,733

 

253,394

 

Other assets, net

 

221,790

 

211,293

 

Total assets

 

$

8,082,668

 

$

8,189,634

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

Revolving credit facility

 

$

135,000

 

$

297,000

 

SIR revolving credit facility

 

238,000

 

95,000

 

Senior unsecured debt, net

 

2,304,229

 

2,972,994

 

Mortgage notes payable, net

 

980,985

 

984,827

 

Liabilities related to properties held for sale

 

1,994

 

2,339

 

Accounts payable and accrued expenses

 

155,993

 

194,184

 

Assumed real estate lease obligations, net

 

66,576

 

69,304

 

Rent collected in advance

 

34,703

 

35,700

 

Security deposits

 

23,822

 

23,860

 

Due to related persons

 

14,636

 

12,958

 

Total liabilities

 

3,955,938

 

4,688,166

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Shareholders’ equity attributable to CommonWealth REIT:

 

 

 

 

 

Preferred shares of beneficial interest, $0.01 par value:

 

 

 

 

 

50,000,000 shares authorized;

 

 

 

 

 

Series D preferred shares; 6 1/2% cumulative convertible; 15,180,000 shares issued and outstanding, aggregate liquidation preference $379,500

 

368,270

 

368,270

 

Series E preferred shares; 7 1/4% cumulative redeemable on or after May 15, 2016; 11,000,000 shares issued and outstanding, aggregate liquidation preference $275,000

 

265,391

 

265,391

 

Common shares of beneficial interest, $0.01 par value:

 

 

 

 

 

350,000,000 shares authorized; 118,304,068 and 83,804,068 shares issued and outstanding, respectively

 

1,183

 

838

 

Additional paid in capital

 

4,212,082

 

3,585,400

 

Cumulative net income

 

2,412,567

 

2,386,900

 

Cumulative other comprehensive income

 

2,577

 

565

 

Cumulative common distributions

 

(2,993,520

)

(2,972,569

)

Cumulative preferred distributions

 

(540,518

)

(529,367

)

Total shareholders’ equity attributable to CommonWealth REIT

 

3,728,032

 

3,105,428

 

Noncontrolling interest in consolidated subsidiary

 

398,698

 

396,040

 

Total shareholders’ equity

 

4,126,730

 

3,501,468

 

Total liabilities and shareholders’ equity

 

$

8,082,668

 

$

8,189,634

 

 

See accompanying notes.

 

1



Table of Contents

 

COMMONWEALTH REIT

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(amounts in thousands, except per share data)

(unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2013

 

2012

 

 

 

 

 

 

 

Rental income

 

$

275,048

 

$

243,378

 

 

 

 

 

 

 

Expenses:

 

 

 

 

 

Operating expenses

 

109,659

 

97,236

 

Depreciation and amortization

 

66,523

 

58,019

 

General and administrative

 

17,266

 

11,536

 

Acquisition related costs

 

628

 

2,502

 

Total expenses

 

194,076

 

169,293

 

 

 

 

 

 

 

Operating income

 

80,972

 

74,085

 

 

 

 

 

 

 

Interest and other income

 

458

 

285

 

Interest expense (including net amortization of debt discounts, premiums and deferred financing fees of $629 and $746, respectively)

 

(52,344

)

(49,106

)

Loss on early extinguishment of debt

 

(60,027

)

(67

)

Equity in earnings of investees

 

4,262

 

2,958

 

Gain on sale of equity investment

 

66,293

 

 

Income from continuing operations before income tax expense

 

39,614

 

28,155

 

Income tax expense

 

(988

)

(492

)

Income from continuing operations

 

38,626

 

27,663

 

Discontinued operations:

 

 

 

 

 

Loss from discontinued operations

 

(1,912

)

(3,089

)

Loss on asset impairment from discontinued operations

 

(3,946

)

 

Gain on sale of properties from discontinued operations

 

1,260

 

 

Income before gain on sale of properties

 

34,028

 

24,574

 

Gain on sale of properties

 

1,596

 

 

Net income

 

35,624

 

24,574

 

Net income attributable to noncontrolling interest in consolidated subsidiary

 

(9,957

)

(894

)

Net income attributable to CommonWealth REIT

 

25,667

 

23,680

 

Preferred distributions

 

(11,151

)

(13,823

)

Net income available for CommonWealth REIT common shareholders

 

$

14,516

 

$

9,857

 

 

 

 

 

 

 

Amounts attributable to CommonWealth REIT common shareholders:

 

 

 

 

 

Income from continuing operations

 

$

19,114

 

$

12,946

 

Loss from discontinued operations

 

(1,912

)

(3,089

)

Loss on asset impairment from discontinued operations

 

(3,946

)

 

Gain on sale of properties from discontinued operations

 

1,260

 

 

Net income

 

$

14,516

 

$

9,857

 

 

 

 

 

 

 

Weighted average common shares outstanding — basic and diluted

 

94,154

 

83,722

 

 

 

 

 

 

 

Basic and diluted earnings per common share attributable to CommonWealth REIT common shareholders:

 

 

 

 

 

Income from continuing operations

 

$

0.20

 

$

0.15

 

Loss from discontinued operations

 

$

(0.05

)

$

(0.04

)

Net income available for common shareholders

 

$

0.15

 

$

0.12

 

 

See accompanying notes.

 

2



Table of Contents

 

COMMONWEALTH REIT

 

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(amounts in thousands)

(unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2013

 

2012

 

 

 

 

 

 

 

Net income

 

$

35,624

 

$

24,574

 

 

 

 

 

 

 

Other comprehensive income (loss):

 

 

 

 

 

Unrealized gain (loss) on derivative instruments

 

1,051

 

(37

)

Foreign currency translation adjustments

 

973

 

4,528

 

Equity in unrealized loss of an investee

 

(16

)

(1

)

Total comprehensive income

 

37,632

 

29,064

 

 

 

 

 

 

 

Less: comprehensive income attributable to noncontrolling interest in consolidated subsidiary

 

(9,953

)

(894

)

 

 

 

 

 

 

Comprehensive income attributable to CommonWealth REIT

 

$

27,679

 

$

28,170

 

 

See accompanying notes.

 

3



Table of Contents

 

COMMONWEALTH REIT

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(amounts in thousands)

(unaudited)

 

 

 

Three Months Ended March 31,

 

 

 

2013

 

2012

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

35,624

 

$

24,574

 

Adjustments to reconcile net income to cash provided by operating activities:

 

 

 

 

 

Depreciation

 

47,349

 

44,443

 

Net amortization of debt discounts, premiums and deferred financing fees

 

629

 

746

 

Straight line rental income

 

(10,962

)

(8,092

)

Amortization of acquired real estate leases

 

16,903

 

14,411

 

Other amortization

 

4,800

 

4,793

 

Loss on asset impairment

 

3,946

 

 

Loss on early extinguishment of debt

 

60,027

 

67

 

Equity in earnings of investees

 

(4,262

)

(2,958

)

Gain on sale of equity investment

 

(66,293

)

 

Distributions of earnings from investees

 

4,111

 

2,913

 

Gain on sale of properties

 

(2,856

)

 

Change in assets and liabilities:

 

 

 

 

 

Restricted cash

 

3,100

 

(782

)

Rents receivable and other assets

 

(21,203

)

(23,170

)

Accounts payable and accrued expenses

 

(27,769

)

(20,630

)

Rent collected in advance

 

(1,948

)

(3,781

)

Security deposits

 

(42

)

245

 

Due to related persons

 

1,678

 

2,372

 

Cash provided by operating activities

 

42,832

 

35,151

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Real estate acquisitions

 

(149,318

)

(91,535

)

Real estate improvements

 

(26,964

)

(26,430

)

Principal payments received from direct financing lease

 

1,711

 

1,632

 

Proceeds from sale of properties, net

 

2,163

 

 

Proceeds from sale of equity investment, net

 

239,576

 

 

Distributions in excess of earnings from investees

 

168

 

1,266

 

Increase in restricted cash

 

(1,197

)

(8,544

)

Cash provided by (used in) investing activities

 

66,139

 

(123,611

)

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Proceeds from issuance of common shares, net

 

626,991

 

180,954

 

Repurchase and retirement of outstanding debt securities

 

(728,021

)

 

Proceeds from borrowings

 

921,000

 

338,500

 

Payments on borrowings

 

(942,135

)

(369,082

)

Deferred financing fees

 

(1,193

)

(5,767

)

Distributions to common shareholders

 

(20,951

)

(41,861

)

Distributions to preferred shareholders

 

(11,151

)

(13,643

)

Distributions to noncontrolling interest in consolidated subsidiary

 

(7,259

)

 

Cash (used in) provided by financing activities

 

(162,719

)

89,101

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

221

 

183

 

 

 

 

 

 

 

(Decrease) increase in cash and cash equivalents

 

(53,527

)

824

 

Cash and cash equivalents at beginning of period

 

102,219

 

192,763

 

Cash and cash equivalents at end of period

 

$

48,692

 

$

193,587

 

 

See accompanying notes.

 

4



Table of Contents

 

COMMONWEALTH REIT

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(amounts in thousands)

(unaudited)

 

 

 

Three Months Ended March 31,

 

 

 

2013

 

2012

 

 

 

 

 

 

 

SUPPLEMENTAL CASH FLOW INFORMATION:

 

 

 

 

 

Interest paid

 

$

71,368

 

$

66,971

 

Taxes paid

 

507

 

34

 

 

 

 

 

 

 

NON-CASH INVESTING ACTIVITIES:

 

 

 

 

 

Real estate acquisitions

 

$

 

$

(147,872

)

Investment in real estate mortgage receivable

 

(7,688

)

 

 

 

 

 

 

 

NON-CASH FINANCING ACTIVITIES:

 

 

 

 

 

Assumption of mortgage notes payable

 

$

 

$

147,872

 

 

See accompanying notes.

 

5



Table of Contents

 

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 and its subsidiaries, or the Company, CWH, we, us or our, 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, 2012, 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 material intercompany transactions and balances with or among 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.

 

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 the allowance for doubtful accounts, purchase price allocations, useful lives of fixed assets and impairment of real estate and intangible assets.

 

On March 12, 2012, our then wholly owned subsidiary, Select Income REIT, completed an initial public offering of 9,200,000 of its common shares, or the SIR IPO.  We refer to Select Income REIT and its consolidated subsidiaries as SIR.  SIR intends to be taxable as a real estate investment trust, or REIT, commencing with its taxable year ended December 31, 2012.  As of March 31, 2013, SIR owned substantially all of our commercial and industrial properties located on Oahu, HI as well as 43 office and industrial properties located throughout the mainland United States.  As of March 31, 2013, we owned 22,000,000 SIR common shares, or approximately 56.0% of SIR’s outstanding common shares, and SIR remains one of our consolidated subsidiaries.  See Note 14 for additional information regarding SIR.

 

Note 2.  Recent Accounting Pronouncements

 

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

 

Note 3.  Real Estate Properties

 

Completed Acquisitions:

 

During the three months ended March 31, 2013, we acquired five properties with a combined 779,010 square feet for an aggregate purchase price of $158,320, excluding closing costs.  We allocated the purchase prices of these acquisitions based on the estimated fair value of the acquired assets and assumed liabilities.  Details of these completed acquisitions are as follows:

 

6



Table of Contents

 

COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Acquired

 

 

 

 

 

Number

 

 

 

 

 

 

 

 

 

Acquired

 

Real Estate

 

 

 

 

 

of

 

Square

 

Purchase

 

 

 

Buildings and

 

Real Estate

 

Lease

 

Date

 

Location

 

Properties

 

Feet

 

Price(1)

 

Land

 

Improvements

 

Leases

 

Obligations

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

SIR Acquisitions through March 31, 2013:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

January 2013

 

Addison, TX(2)(3)

 

2

 

553,799

 

$

105,000

 

$

10,125

 

$

94,875

 

$

 

$

 

February 2013

 

Provo, UT(2)

 

2

 

125,225

 

34,720

 

3,400

 

25,938

 

5,382

 

 

March 2013

 

San Antonio, TX(2)

 

1

 

99,986

 

18,600

 

3,197

 

12,175

 

3,507

 

(279

)

 

 

 

 

5

 

779,010

 

$

158,320

 

$

16,722

 

$

132,988

 

$

8,889

 

$

(279

)

 


(1)             Purchase price excludes closing costs.

(2)             The allocation of purchase price is based on preliminary estimates and may change upon completion of (i) third party appraisals and (ii) our analysis of acquired in place leases and building valuations.

(3)             This property was acquired and simultaneously leased back to the seller in a sale/leaseback transaction.  SIR accounted for this transaction as an acquisition of assets.  SIR recognized acquisition costs of $188, which SIR capitalized as part of the transaction.

 

In addition, during the three months ended March 31, 2013, we also made improvements totaling $18,130 to our properties.

 

Property Sales:

 

In January 2013, we sold 18 suburban office and industrial properties with a combined 1,060,026 square feet for $10,250, excluding closing costs.  In connection with the sale of these properties, we provided mortgage financing to the buyer, an unrelated third party, totaling $7,688 at 6.0% per annum and recognized a gain on sale of $1,260.  As a result of an eminent domain taking in March 2013, we sold a land parcel adjacent to one of our central business district, or CBD, office buildings located in Boston, MA for $1,806, excluding closing costs, and recognized a gain on sale of $1,596.  In April 2013, we sold an industrial property with 618,000 square feet for a total of $830, excluding closing costs.  In addition, as of May 8, 2013, we have five properties with a combined 1,222,642 square feet under agreement to sell for a total of $39,475, excluding closing costs.  We expect to complete the sale of these five properties during 2013; however, no assurance can be given that these properties will be sold in that time period or at all.

 

As of March 31, 2013, we had 35 office properties and 41 industrial properties with a combined 5,613,825 square feet held for sale.  As of December 31, 2012, we had 37 office properties and 57 industrial properties with a combined 6,673,851 square feet held for sale.  We classify all properties that meet the criteria outlined in the Property, Plant and Equipment Topic of the FASB Accounting Standards CodificationTM, or the Codification, as held for sale in our condensed consolidated balance sheets.  Results of operations for properties sold or held for sale are included in discontinued operations in our condensed consolidated statements of operations once the criteria for discontinued operations in the Presentation of Financial Statements Topic of the Codification are met.  Summarized balance sheet information for all properties classified as held for sale and income statement information for properties held for sale or sold is as follows:

 

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Table of Contents

 

COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

Balance Sheets:

 

 

 

March 31, 2013

 

December 31, 2012

 

Real estate properties

 

$

152,940

 

$

164,041

 

Acquired real estate leases

 

453

 

453

 

Rents receivable

 

2,624

 

2,791

 

Other assets, net

 

3,484

 

4,547

 

Properties held for sale

 

$

159,501

 

$

171,832

 

 

 

 

 

 

 

Assumed real estate lease obligations

 

$

21

 

$

21

 

Rent collected in advance

 

598

 

854

 

Security deposits

 

1,375

 

1,464

 

Liabilities related to properties held for sale

 

$

1,994

 

$

2,339

 

 

Statements of Operations:

 

 

 

Three Months Ended March 31,

 

 

 

2013

 

2012

 

Rental income

 

$

4,807

 

$

7,868

 

Operating expenses

 

(6,035

)

(6,854

)

Depreciation and amortization

 

 

(3,332

)

General and administrative

 

(684

)

(774

)

Operating loss

 

(1,912

)

(3,092

)

 

 

 

 

 

 

Interest and other income

 

 

3

 

Loss from discontinued operations

 

$

(1,912

)

$

(3,089

)

 

Note 4.  Investment in Direct Financing Lease

 

We have an investment in a direct financing lease that relates to a lease with a term that exceeds 75% of the useful life of an office tower located within a mixed use property in Phoenix, AZ.  We recognize income using the effective interest method to produce a level yield on funds not yet recovered.  Estimated unguaranteed residual values at the date of lease inception represent our initial estimates of the fair value of the leased assets at the expiration of the lease, which do not exceed their original cost.  Significant assumptions used in estimating residual values include estimated net cash flows over the remaining lease term and expected future real estate values.  The carrying amount of our net investment is included in other assets in our condensed consolidated balance sheets.  The following table summarizes the carrying amount of our net investment in this direct financing lease:

 

 

 

March 31,

 

December 31,

 

 

 

2013

 

2012

 

Total minimum lease payments receivable

 

$

29,060

 

$

31,084

 

Estimated unguaranteed residual value of leased asset

 

4,951

 

4,951

 

Unearned income

 

(8,989

)

(9,302

)

Net investment in direct financing lease

 

$

25,022

 

$

26,733

 

 

We monitor the payment history and credit profile of the tenant and have determined that no allowance for losses related to our direct financing lease was necessary at March 31, 2013 and December 31, 2012.  Our direct financing lease has an expiration date in 2045.

 

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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 March 31, 2013 and December 31, 2012, we had the following equity investments in Government Properties Income Trust, or GOV, and Affiliates Insurance Company, or AIC (including 100% attribution of SIR’s 12.5% equity ownership interest in AIC):

 

 

 

Ownership Percentage

 

Equity Investments

 

Equity in Earnings

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

 

 

 

March 31,

 

December 31,

 

March 31,

 

December 31,

 

March 31,

 

 

 

2013

 

2012

 

2013

 

2012

 

2013

 

2012

 

GOV

 

%

18.2

%

$

 

$

173,452

 

$

4,111

 

$

2,913

 

AIC

 

25.0

%

25.0

%

11,394

 

11,259

 

151

 

45

 

 

 

 

 

 

 

$

11,394

 

$

184,711

 

$

4,262

 

$

2,958

 

 

On March 15, 2013, we sold all 9,950,000 common shares that we owned of GOV in a public offering for $25.20 per common share, raising gross proceeds of $250,740 ($239,576 after deducting underwriters’ discounts and commissions and estimated expenses).  We recognized a gain on this sale of an equity investment of $66,293 as a result of the per share sales price of this transaction being above our per share carrying value.  GOV is a REIT which primarily owns properties that are majority leased to government tenants and was our wholly owned subsidiary until its initial public offering in June 2009 when it became a separate public entity.

 

During the three months ended March 31, 2013 and 2012, we received cash distributions from GOV totaling $4,279 and $4,179, respectively.

 

The following summarized financial data of GOV is as reported in GOV’s Quarterly Report on Form 10-Q for the period ended March 31, 2013, or the GOV Quarterly Report.  References in our financial statements to the GOV Quarterly Report are included as references to the source of the data only, and the information in the GOV Quarterly Report is not incorporated by reference into our financial statements.

 

Condensed Consolidated Balance Sheet:

 

 

 

December 31,

 

 

 

2012

 

Real estate properties, net

 

$

1,357,986

 

Acquired real estate leases, net

 

144,484

 

Cash and cash equivalents

 

5,255

 

Rents receivable, net

 

29,099

 

Other assets, net

 

25,310

 

Total assets

 

$

1,562,134

 

 

 

 

 

Unsecured revolving credit facility

 

$

49,500

 

Unsecured term loan

 

350,000

 

Mortgage notes payable

 

93,127

 

Assumed real estate lease obligations, net

 

19,129

 

Other liabilities

 

22,927

 

Shareholders’ equity

 

1,027,451

 

Total liabilities and shareholders’ equity

 

$

1,562,134

 

 

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COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

Condensed Consolidated Statements of Income:

 

 

 

Three Months Ended March 31,

 

 

 

2013

 

2012

 

Rental income

 

$

57,678

 

$

49,997

 

Operating expenses

 

(20,068

)

(17,977

)

Depreciation and amortization

 

(13,696

)

(11,910

)

Acquisition related costs

 

(34

)

(49

)

General and administrative

 

(3,249

)

(3,002

)

Operating income

 

20,631

 

17,059

 

 

 

 

 

 

 

Interest and other income

 

11

 

8

 

Interest expense

 

(4,147

)

(4,023

)

Equity in earnings of an investee

 

76

 

45

 

Income before income tax expense

 

16,571

 

13,089

 

Income tax expense

 

(43

)

(45

)

Income from continuing operations

 

16,528

 

13,044

 

Discontinued operations:

 

 

 

 

 

Income from discontinued operations

 

30

 

15

 

Net gain on sale of properties from discontinued operations

 

8,168

 

 

Net income

 

$

24,726

 

$

13,059

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

54,645

 

47,052

 

 

 

 

 

 

 

Per common share:

 

 

 

 

 

Income from continuing operations

 

$

0.30

 

$

0.28

 

Income from discontinued operations

 

$

0.15

 

$

 

Net income

 

$

0.45

 

$

0.28

 

 

As of March 31, 2013, we and SIR have invested a total of $10,544 in AIC, an insurance company owned in equal proportion by Reit Management & Research LLC, our business and property manager, or RMR, us (excluding SIR’s AIC interest), SIR and five other companies to which RMR provides management services, including GOV.  We and SIR may invest additional amounts in AIC in the future if the expansion of this insurance business requires additional capital, but we and SIR are not obligated to do so.  At March 31, 2013, we (without SIR) and SIR each owned 12.5% of AIC with a combined carrying value of $11,394.  We and SIR use the equity method to account for this investment because we and SIR believe that we each have significant influence over AIC because all of our Trustees and all of SIR’s trustees are also directors of AIC.  Under the equity method, we record our and SIR’s percentage share of net earnings from AIC in our condensed consolidated statements of operations.  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 have considered, among other things, the assets and liabilities held by AIC, AIC’s overall financial condition and the financial condition and prospects for AIC’s insurance business.  See Note 14 for additional information about our and SIR’s investment in AIC.

 

Note 6.  Real Estate Mortgages Receivable

 

We provided mortgage financing totaling $7,688 at 6.0% per annum in connection with 18 office and industrial properties sold in January 2013.  This real estate mortgage requires monthly interest payments and matures on January 24, 2023.  As of March 31, 2013 and December 31, 2012, we had real estate mortgages receivable with an aggregate carrying value of $9,107 and $1,419, respectively, included in other assets in our condensed consolidated balance sheets.

 

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COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

Note 7.  Shareholders’ Equity

 

The following is a reconciliation of changes in shareholders’ equity for the three months ended March 31, 2013: 

 

 

 

Shareholders’

 

Shareholders’

 

 

 

 

 

Equity

 

Equity

 

 

 

 

 

Attributable to

 

Attributable to

 

Total

 

 

 

CommonWealth

 

Noncontrolling

 

Shareholders’

 

 

 

REIT

 

Interest

 

Equity

 

Balance at December 31, 2012

 

$

3,105,428

 

$

396,040

 

$

3,501,468

 

Net income

 

25,667

 

9,957

 

35,624

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

Unrealized gain on derivative instruments

 

1,051

 

 

1,051

 

Foreign currency translation adjustments

 

973

 

 

973

 

Equity in unrealized loss of an investee

 

(12

)

(4

)

(16

)

Total comprehensive income

 

27,679

 

9,953

 

37,632

 

 

 

 

 

 

 

 

 

Issuance of common shares, net

 

627,027

 

(36

)

626,991

 

Distributions

 

(32,102

)

(7,259

)

(39,361

)

Balance at March 31, 2013

 

$

3,728,032

 

$

398,698

 

$

4,126,730

 

 

In the remainder of this Note 7, references to we, us, our or CWH refer to CWH and its consolidated subsidiaries other than SIR and its consolidated subsidiaries, unless noted otherwise.

 

CWH Common Share Issuance:

 

In March 2013, we issued 34,500,000 common shares (including 4,500,000 common shares sold pursuant to the underwriters’ option to purchase additional shares) in a public offering for $19.00 per common share, raising gross proceeds of $655,500 ($627,074 after deducting underwriters’ discounts and commissions and estimated expenses).  Net proceeds from this offering were used to repay indebtedness, including amounts borrowed under our revolving credit facility to fund, in part, the purchase of the senior notes that were tendered in the tender offer discussed in Note 9.

 

CWH Common and Preferred Share Distributions:

 

On February 15, 2013, we paid a quarterly distribution on our series D preferred shares of $0.4063 per share, or $6,167, and a quarterly distribution on our series E preferred shares of $0.4531 per share, or $4,984, both of which were paid to shareholders of record as of February 1, 2013.

 

On February 21, 2013, we paid a quarterly distribution on our common shares of $0.25 per share, or $20,951, to shareholders of record on January 22, 2013.

 

In April 2013, we declared a distribution of $0.25 per common share, or approximately $29,600, to be paid on or about May 22, 2013 to shareholders of record on April 23, 2013.  We also announced in April 2013 a quarterly distribution on our series D preferred shares of $0.4063 per share, or $6,167, and a quarterly distribution on our series E preferred shares of $0.4531 per share, or $4,984, both of which we expect to pay on or about May 15, 2013 to our preferred shareholders of record as of May 1, 2013.  Our revolving credit facility agreement and term loan agreement contain a number of financial and other covenants, including a covenant which restricts our ability to make distributions under certain circumstances.

 

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COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

SIR Common Share Distributions:

 

On February 19, 2013, SIR paid a quarterly distribution on its common shares of $0.42 per share, or $16,499, to SIR’s shareholders of record on January 22, 2013.

 

In April 2013, SIR declared a distribution on its common shares of $0.44 per share, or approximately $17,300, to be paid on or about May 20, 2013 to SIR’s shareholders of record on April 23, 2013.  SIR’s revolving credit facility agreement and term loan agreement contain a number of financial and other covenants, including a covenant which restricts SIR’s ability to make distributions under certain circumstances.

 

Note 8.  Cumulative Other Comprehensive Income

 

The following table presents a roll forward of amounts recognized in cumulative other comprehensive income (loss) by component for the three months ended March 31, 2013:

 

 

 

Unrealized

 

Foreign

 

Equity in

 

 

 

 

 

Gain (Loss)

 

Currency

 

Unrealized

 

 

 

 

 

on Derivative

 

Translation

 

Gain (Loss) of

 

 

 

 

 

Instruments

 

Adjustments

 

an Investee

 

Total

 

 

 

 

 

 

 

 

 

 

 

Balance as of December 31, 2012

 

$

(16,624

)

$

17,071

 

$

118

 

$

565

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive (loss) income before reclassifications

 

(185

)

973

 

1

 

789

 

Amounts reclassified from cumulative other comprehensive income (loss) to net income

 

1,236

 

 

(13

)

1,223

 

Net current period other comprehensive income (loss)

 

1,051

 

973

 

(12

)

2,012

 

 

 

 

 

 

 

 

 

 

 

Balance as of March 31, 2013

 

$

(15,573

)

$

18,044

 

$

106

 

$

2,577

 

 

The following table presents reclassifications out of cumulative other comprehensive income (loss) for the three months ended March 31, 2013:

 

 

 

Amounts Reclassifed from

 

 

 

Details about Cumulative Other

 

Cumulative Other Comprehensive

 

Affected Line Items in the

 

Comprehensive Income (Loss) Components

 

Income (Loss) to Net Income

 

Statement of Operations

 

 

 

 

 

 

 

Interest rate swap contracts

 

$

1,236

 

Interest expense

 

 

 

 

 

 

 

Unrealized gains and losses on available for sale securities

 

(13

)

Equity in earnings of investees

 

 

 

$

1,223

 

 

 

 

Note 9.  Indebtedness

 

In this Note 9, references to we, us, our or CWH refer to CWH and its consolidated subsidiaries other than SIR and its consolidated subsidiaries, unless noted otherwise.

 

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Table of Contents

 

COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

CWH Prepayments:

 

In March 2013, we purchased a total of $670,295 of the outstanding principal amount of the following senior notes for $726,151, excluding transaction costs, pursuant to a tender offer:

 

Senior Note

 

Principal

 

Purchase
Price

 

5.75% Senior Notes due February 15, 2014

 

$

145,612

 

$

148,746

 

6.40% Senior Notes due February 15, 2015

 

152,560

 

164,140

 

5.75% Senior Notes due November 1, 2015

 

111,227

 

121,047

 

6.25% Senior Notes due August 15, 2016

 

260,896

 

292,218

 

 

 

$

670,295

 

$

726,151

 

 

In connection with the purchase of these senior notes, we recognized a combined loss on early extinguishment of debt totaling $60,027, which includes the write off of unamortized discounts and deferred financing fees and estimated expenses.

 

CWH Unsecured Revolving Credit Facility and Unsecured Term Loan:

 

We have a $750,000 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 $1,500,000 in certain circumstances.  Borrowings under our revolving credit facility bear interest at LIBOR plus a premium, which was 150 basis points as of March 31, 2013.  We also pay a facility fee of 35 basis points per annum on the total amount of lending commitments under our revolving credit facility.  Both the interest rate premium and the facility fee are subject to adjustment based upon changes to our credit ratings.  As of March 31, 2013, the interest rate payable on borrowings under our revolving credit facility was 1.7%, and the weighted average interest rate for borrowings under our revolving credit facility was 1.7% and 1.5% for the three months ended March 31, 2013 and 2012, respectively.  As of March 31, 2013, we had $135,000 outstanding and $615,000 available under our revolving credit facility.

 

We also have a $500,000 unsecured term loan that matures in December 2016 and is prepayable without penalty at any time.  Our term loan includes a feature under which maximum borrowings may be increased to up to $1,000,000 in certain circumstances.  Our term loan bears interest at a rate of LIBOR plus a premium, which was 185 basis points as of March 31, 2013.  The interest rate premium is subject to adjustment based upon changes to our credit ratings.  As of March 31, 2013, the interest rate for the amount outstanding under our term loan was 2.1%, and the weighted average interest rate for the amount outstanding under our term loan was 2.1% and 1.8% for the three months ended March 31, 2013 and 2012, respectively.

 

Our revolving credit facility agreement and our term loan agreement provide for acceleration of payment of all amounts due thereunder upon the occurrence and continuation of certain events of default, including a change of control of us and the termination of our business management or property management agreements with RMR.

 

SIR Unsecured Revolving Credit Facility and Unsecured Term Loan:

 

SIR has a $750,000 revolving credit facility that is available to SIR for general business purposes, including acquisitions.  The maturity date of the SIR revolving credit facility is March 11, 2016 and, subject to the payment by SIR of an extension fee and SIR meeting certain other conditions, includes an option for SIR to extend the stated maturity date of the SIR revolving credit facility by one year to March 11, 2017.  In February 2013, SIR increased the available borrowing amount under the SIR revolving credit facility from $500,000 to $750,000.  Borrowings under the SIR revolving credit facility bear interest at LIBOR plus a premium, which was 130 basis points as of March 31, 2013.  SIR also pays a facility fee of 30 basis points per annum on the total amount of lending commitments under the SIR revolving credit facility.  Both the interest rate premium and the facility fee are subject to adjustment based upon changes to SIR’s leverage or credit ratings.  As of March 31, 2013, the interest rate payable on borrowings under the SIR revolving credit facility was 1.5%, and the weighted average interest rate for borrowings under the SIR revolving credit facility was 1.5% for the three months ended March 31, 2013 and 1.5% for the period from March 12, 2012 to March 31, 2012.  As of March 31, 2013, SIR had $238,000 outstanding and $512,000 available under the SIR revolving credit facility.

 

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Table of Contents

 

COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

SIR also has a $350,000 unsecured term loan.  The SIR term loan matures on July 11, 2017 and is prepayable without penalty at any time.  In addition, the SIR term loan includes a feature under which maximum borrowings may be increased to up to $700,000 in certain circumstances.  The SIR term loan bears interest at a rate of LIBOR plus a premium, which was 155 basis points as of March 31, 2013.  The interest rate premium is subject to adjustment based upon changes to SIR’s leverage or credit ratings.  As of March 31, 2013, the interest rate for the amount outstanding under the SIR term loan was 1.8%, and the weighted average interest rate for the amount outstanding under the SIR term loan was 1.8% for the three months ended March 31, 2013.

 

The SIR revolving credit facility agreement and the SIR term loan agreement provide for acceleration of payment of all amounts due thereunder upon the occurrence and continuation of certain events of default, including a change of control of SIR and the termination of SIR’s business management or property management agreements with RMR.

 

Credit Facility and Term Loan Debt Covenants:

 

Our public debt indentures and related supplements, our revolving credit facility agreement and our term loan agreement contain a number of financial and other covenants, including covenants that restrict our ability to incur indebtedness or to make distributions under certain circumstances and require us to maintain financial ratios and a minimum net worth.  The SIR revolving credit facility agreement and the SIR term loan agreement also contain a number of financial and other covenants, including covenants that restrict SIR’s ability to incur indebtedness or to make distributions under certain circumstances and require SIR to maintain financial ratios and a minimum net worth.  At March 31, 2013, we believe we and SIR, as applicable, were in compliance with all of our respective covenants under our public debt indentures, our revolving credit facility, our term loan, SIR’s revolving credit facility and SIR’s term loan agreements.

 

Mortgage Debt:

 

At March 31, 2013, 25 of our and SIR’s properties costing $1,329,835 with an aggregate net book value of $1,188,911 were secured by mortgage notes totaling $980,985 (including net premiums and discounts) maturing from 2014 through 2026.

 

Note 10.  Income Taxes

 

We have elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended, and are generally not subject to federal and state income taxes provided we distribute a sufficient amount of our taxable income to our shareholders and meet other requirements for qualifying as a REIT.  However, we are subject to certain state, local and Australian taxes without regard to our REIT status.  Our provision for income taxes for the three months ended March 31, 2013 and 2012 consists of the following:

 

 

 

Three Months Ended March 31,

 

 

 

2013

 

2012

 

Current:

 

 

 

 

 

State

 

$

163

 

$

142

 

Foreign

 

863

 

 

 

 

1,026

 

142

 

 

 

 

 

 

 

Deferred:

 

 

 

 

 

Foreign

 

(38

)

350

 

 

 

(38

)

350

 

 

 

 

 

 

 

Income tax provision

 

$

988

 

$

492

 

 

At March 31, 2013 and December 31, 2012, we had deferred tax assets of $2,266 and $2,329, respectively, of which $2,136 and $2,181, respectively, related to different carrying amounts for financial reporting and for Australian income tax purposes of our

 

14



Table of Contents

 

COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

properties in Australia.  At March 31, 2013 and December 31, 2012, we had deferred tax liabilities of $3,547 and $3,643, respectively.  Because we are uncertain of our ability to realize the future benefit of certain Australian loss carry forwards, we have reduced our net deferred income tax assets by a valuation allowance of $600 and $598 as of March 31, 2013 and December 31, 2012, respectively.

 

Note 11.  Fair Value of Assets and Liabilities

 

The table below presents certain of our assets and liabilities measured at fair value during 2013, categorized by the level of inputs used in the valuation of each asset and liability:

 

 

 

 

 

Fair Value at Reporting Date Using

 

 

 

 

 

Quoted Prices in

 

 

 

Significant

 

 

 

 

 

Active Markets for

 

Significant Other

 

Unobservable

 

 

 

 

 

Identical Assets

 

Observable Inputs

 

Inputs

 

Description

 

Total

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

 

 

 

 

 

 

 

 

Recurring Fair Value Measurements:

 

 

 

 

 

 

 

 

 

Effective portion of interest rate contracts(1)

 

$

(15,573

)

$

 

$

(15,573

)

$

 

 

 

 

 

 

 

 

 

 

 

Non-Recurring Fair Value Measurements:

 

 

 

 

 

 

 

 

 

Properties held for sale(2)

 

$

25,750

 

$

 

$

 

$

25,750

 

 


(1)             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 March 31, 2013, 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.

(2)             As of March 31, 2013, we recorded a loss on asset impairment of $3,675 for six properties in our Suburban Office segment and $271 for one property in our Industrial & Other segment to reduce the aggregate carrying value of these properties from $29,696 to their estimated fair value less costs to sell of $25,750.  All seven properties were classified as held for sale as of March 31, 2013 and December 31, 2012.  We used updated broker information, including recent purchase offers, for all seven properties (level 3 inputs) in determining the fair value of these properties.  The valuation techniques and significant unobservable inputs used for our level 3 fair value measurements at March 31, 2013 were as follows:

 

Description

 

Fair Value
at March 31,
2013

 

Valuation
Techniques

 

Unobservable
Inputs

 

Range

 

Properties held for sale for which we recognized impairment losses

 

$

25,750

 

Purchase Offers

 

N/A

 

N/A

 

 

We are exposed to certain risks relating to our ongoing business operations, including the effect of changes in foreign currency exchange rates and interest rates.  The only risk currently managed by using our derivative instruments is a part of our interest rate risk.  Although we have not done so as of March 31, 2013 and have no present intention to do so, we may manage our Australian currency exchange exposure by borrowing in Australian dollars or using derivative instruments in the future, depending on the relative significance of our business activities in Australia at that time.  We have interest rate swap agreements to manage our

 

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Table of Contents

 

COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

interest rate risk exposure on $174,476 of mortgage debt due 2019, which require interest at a premium 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 increased by $1,051 and decreased by $37 during the three months ended March 31, 2013 and 2012, respectively, based primarily on changes in market interest rates.  As of March 31, 2013 and December 31, 2012, the fair value of these derivative instruments included in accounts payable and accrued expenses and cumulative other comprehensive income in our condensed consolidated balance sheets totaled ($15,573) and ($16,624), respectively. We may enter additional interest rate swaps or hedge agreements to manage some of our additional interest rate risk associated with our floating rate borrowings.  The table below presents the effects of our interest rate derivatives in our condensed consolidated statements of operations and condensed consolidated statements of comprehensive income for the three months ended March 31, 2013 and 2012:

 

 

 

Three Months Ended
March 31,

 

 

 

2013

 

2012

 

Balance at beginning of period

 

$

(16,624

)

$

(15,796

)

Amount of loss recognized in cumulative other comprehensive income

 

(185

)

(1,249

)

Amount of loss reclassified from cumulative other comprehensive income into interest expense

 

1,236

 

1,212

 

Unrealized gain (loss) on derivative instruments

 

1,051

 

(37

)

Balance at end of period

 

$

(15,573

)

$

(15,833

)

 

Over the next 12 months, we estimate that approximately $4,869 will be reclassified from cumulative other comprehensive income as an increase to interest expense.

 

In addition to the assets and liabilities described in the above table, our financial instruments include our cash and cash equivalents, rents receivable, investment in direct financing lease receivable, real estate mortgages receivable, restricted cash, revolving credit facilities, senior notes and mortgage notes payable, accounts payable and accrued expenses, rent collected in advance, security deposits and amounts due to related persons.  At March 31, 2013 and December 31, 2012, the fair values of these additional financial instruments were not materially different from their carrying values, except as follows:

 

 

 

March 31, 2013

 

December 31, 2012

 

 

 

Carrying
Amount

 

Fair
Value

 

Carrying
Amount

 

Fair
Value

 

Senior notes and mortgage notes payable

 

$

2,260,738

 

$

2,453,766

 

$

2,932,951

 

$

3,181,522

 

 

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 (level 3 inputs).

 

Other financial instruments that potentially subject us to concentrations of credit risk consist principally of rents receivable; however, as of March 31, 2013, no single tenant of ours is responsible for more than 2% of our total annualized rents.

 

We maintain derivative financial instruments, including interest rate swaps, with major financial institutions and monitor the amount of credit exposure to any one counterparty.

 

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COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

Note 12.  Earnings Per Common Share

 

As of March 31, 2013, we had 15,180,000 shares of series D cumulative convertible preferred stock that were convertible into 7,298,165 of our common shares.  The effect of our convertible preferred shares on income from continuing operations attributable to CommonWealth REIT common shareholders per share is anti-dilutive for all periods presented.

 

Note 13.  Segment Information

 

Our primary business is the ownership and operation of a nationwide portfolio of commercial properties.  We account for each of our individual properties as separate operating segments.  We have aggregated our separate operating segments into three reportable segments based on our primary method of internal reporting: CBD office properties, suburban office properties and industrial & other properties.  Each of our reportable segments includes properties with similar operating and economic characteristics that are subject to unique supply and demand conditions.  Our operating segments (i.e., our individual properties) are managed and operated consistently in accordance with our standard operating procedures, and our management responsibilities do not vary significantly from location to location based on the size of the property or geographic location within each primary reporting segment.  In addition to our three reportable segments, we aggregate our operating segments into geographic regions for financial reporting purposes.  We define these individual geographic regions as those which currently, or during either of the last two quarters, represent or generate 5% or more of our total square feet, annualized rental income or property net operating income, or NOI, which we define as income from our real estate including lease termination fees received from tenants less our property operating expenses, which expenses include property marketing costs.

 

As of March 31, 2013, we owned 54 CBD office properties, 246 suburban office properties and 145 industrial & other properties, excluding properties classified as held for sale.  Our geographic regions include Oahu, HI, Metro Chicago, IL, Metro Philadelphia, PA, and Other Markets, which includes properties located elsewhere throughout the United States and Australia.  Prior periods have been restated to reflect 40 office properties and 57 industrial properties reclassified to discontinued operations from continuing operations as of December 31, 2012 and three properties reclassified from our Suburban Office segment to our CBD Office segment as of March 31, 2013.

 

Property level information by geographic region and property type as of March 31, 2013 and for the three months ended March 31, 2013 and 2012, is as follows:

 

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COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

 

 

As of March 31, 2013

 

As of March 31, 2012

 

 

 

CBD

 

Suburban

 

Industrial &

 

 

 

CBD

 

Suburban

 

Industrial &

 

 

 

 

 

Office

 

Office

 

Other

 

Totals

 

Office

 

Office

 

Other

 

Totals

 

Property square feet

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Oahu, HI

 

 

 

17,894

 

17,894

 

 

 

17,876

 

17,876

 

Metro Chicago, IL

 

3,601

 

1,164

 

103

 

4,868

 

3,591

 

1,164

 

104

 

4,859

 

Metro Philadelphia, PA

 

4,597

 

255

 

 

4,852

 

4,590

 

256

 

 

4,846

 

Other Markets

 

13,850

 

18,926

 

12,300

 

45,076

 

12,136

 

16,702

 

10,733

 

39,571

 

Totals

 

22,048

 

20,345

 

30,297

 

72,690

 

20,317

 

18,122

 

28,713

 

67,152

 

 

 

 

Three Months Ended March 31, 2013

 

Three Months Ended March 31, 2012

 

 

 

CBD

 

Suburban

 

Industrial &

 

 

 

CBD

 

Suburban

 

Industrial &

 

 

 

 

 

Office

 

Office

 

Other

 

Totals

 

Office

 

Office

 

Other

 

Totals

 

Property rental income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Oahu, HI

 

$

 

$

 

$

21,211

 

$

21,211

 

$

 

$

 

$

19,895

 

$

19,895

 

Metro Chicago, IL

 

25,149

 

6,591

 

111

 

31,851

 

24,575

 

5,863

 

111

 

30,549

 

Metro Philadelphia, PA

 

29,131

 

875

 

 

30,006

 

29,300

 

844

 

 

30,144

 

Other Markets

 

88,471

 

79,667

 

23,842

 

191,980

 

74,264

 

68,436

 

20,090

 

162,790

 

Totals

 

$

142,751

 

$

87,133

 

$

45,164

 

$

275,048

 

$

128,139

 

$

75,143

 

$

40,096

 

$

243,378

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Property NOI:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Oahu, HI

 

$

 

$

 

$

16,737

 

$

16,737

 

$

 

$

 

$

15,514

 

$

15,514

 

Metro Chicago, IL

 

12,269

 

3,670

 

102

 

16,041

 

12,378

 

2,963

 

104

 

15,445

 

Metro Philadelphia, PA

 

15,796

 

205

 

 

16,001

 

15,584

 

203

 

 

15,787

 

Other Markets

 

50,628

 

48,029

 

17,953

 

116,610

 

44,013

 

40,973

 

14,410

 

99,396

 

Totals

 

$

78,693

 

$

51,904

 

$

34,792

 

$

165,389

 

$

71,975

 

$

44,139

 

$

30,028

 

$

146,142

 

 

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Table of Contents

 

COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

The following table includes the reconciliation of NOI to net income, the most directly comparable financial measure under GAAP reported in our condensed consolidated financial statements.  We define NOI as income from our real estate including lease termination fees received from tenants less our property operating expenses, which expenses include property marketing costs.  NOI excludes amortization of capitalized tenant improvement costs and leasing commissions.  We consider NOI to be an appropriate supplemental measure to net income because it may help both investors and management to understand the operations of our properties.  We use NOI internally to evaluate individual, regional and company wide property level performance, and we believe that NOI provides useful information to investors regarding our results of operations because it reflects only those income and expense items that are incurred at the property level and may facilitate comparisons of our operating performance between periods.  The calculation of NOI excludes certain components of net income in order to provide results that are more closely related to our properties’ results of operations.  NOI does not represent cash generated by operating activities in accordance with GAAP and should not be considered as an alternative to net income, net income attributable to CommonWealth REIT, net income available for CommonWealth REIT common shareholders, operating income or cash flow from operating activities, determined in accordance with GAAP, or as an indicator of our financial performance or liquidity, nor is this measure necessarily indicative of sufficient cash flow to fund all of our needs.  We believe that NOI may facilitate an understanding of our consolidated historical operating results.  This measure should be considered in conjunction with net income, net income attributable to CommonWealth REIT, net income available for CommonWealth REIT common shareholders, operating income and cash flow from operating activities as presented in our condensed consolidated statements of operations, condensed consolidated statements of comprehensive income and condensed consolidated statements of cash flows.  Other REITs and real estate companies may calculate NOI differently than we do.  A reconciliation of NOI to net income for the three months ended March 31, 2013 and 2012 is as follows:

 

 

 

Three Months Ended March 31,

 

 

 

2013

 

2012

 

Rental income

 

$

275,048

 

$

243,378

 

Operating expenses

 

(109,659

)

(97,236

)

Property net operating income (NOI)

 

$

165,389

 

$

146,142

 

 

 

 

 

 

 

Property NOI

 

$

165,389

 

$

146,142

 

Depreciation and amortization

 

(66,523

)

(58,019

)

General and administrative

 

(17,266

)

(11,536

)

Acquisition related costs

 

(628

)

(2,502

)

Operating income

 

80,972

 

74,085

 

 

 

 

 

 

 

Interest and other income

 

458

 

285

 

Interest expense

 

(52,344

)

(49,106

)

Loss on early extinguishment of debt

 

(60,027

)

(67

)

Equity in earnings of investees

 

4,262

 

2,958

 

Gain on sale of equity investment

 

66,293

 

 

Income from continuing operations before income tax expense

 

39,614

 

28,155

 

Income tax expense

 

(988

)

(492

)

Income from continuing operations

 

38,626

 

27,663

 

Loss from discontinued operations

 

(1,912

)

(3,089

)

Loss on asset impairment from discontinued operations

 

(3,946

)

 

Gain on sale of properties from discontinued operations

 

1,260

 

 

Income before gain on sale of properties

 

34,028

 

24,574

 

Gain on sale of properties

 

1,596

 

 

Net income

 

$

35,624

 

$

24,574

 

 

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Table of Contents

 

COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

Note 14.  Related Person Transactions

 

We have no employees.  Personnel and various services we require to operate our business are provided to us by RMR.  We have two agreements with RMR to provide management and administrative services to us: (1) a business management agreement, which relates to our business generally, and (2) a property management agreement, which relates to our property level operations.

 

Under our business management agreement with RMR, we acknowledge that RMR also provides management services to other companies, which include GOV and SIR.  One of our Managing Trustees, Mr. Barry Portnoy, is Chairman, majority owner and an employee of RMR.  Our other Managing Trustee, Mr. Adam Portnoy, who is also our President, is the son of Mr. Barry Portnoy, and an owner, President, Chief Executive Officer and a director of RMR.  Each of our other executive officers is also an officer of RMR.  GOV’s and SIR’s executive officers are officers of RMR.  A majority of our Independent Trustees also serve as independent directors or independent trustees of other public companies to which RMR provides management services.  Mr. Barry Portnoy serves as a managing director or managing trustee of those companies and Mr. Adam Portnoy serves as a managing trustee of a majority of those companies.  In addition, officers of RMR serve as officers of those companies.

 

Pursuant to our business management agreement with RMR and the business management agreement between SIR and RMR, the business management fees we and SIR recognized on a consolidated basis were $11,905 and $10,383 for the three months ended March 31, 2013 and 2012, respectively.  Excluding fees recognized by SIR, the business management fees we recognized were $9,738 and $10,136 for the three months ended March 31, 2013 and 2012, respectively.  These amounts are included in general and administrative expenses and loss from discontinued operations, as appropriate, in our condensed consolidated financial statements.

 

In connection with our property management agreement with RMR and the property management agreement between SIR and RMR, the aggregate property management and construction supervision fees we and SIR recognized on a consolidated basis were $8,376 and $7,924 for the three months ended March 31, 2013 and 2012, respectively.  Excluding fees recognized by SIR, the property management fees we recognized were $7,118 and $7,766 for the three months ended March 31, 2013 and 2012, respectively.  These amounts are included in operating expenses or have been capitalized, as appropriate, in our condensed consolidated financial statements.

 

MacarthurCook Fund Management Limited, or MacarthurCook, previously provided us with business and property management services with respect to our investments in Australia.  Our contract with MacarthurCook terminated on January 31, 2013, and on that date we entered into a business and property management agreement, or the Australia Management Agreement, with RMR Australia Asset Management Pty Limited, or RMR Australia, for the benefit of CWH Australia Trust (formerly the MacarthurCook Industrial Property Fund), a subsidiary of ours, or CWHAT.  The terms of the Australia Management Agreement are substantially similar to the terms of the management agreement we had with MacarthurCook. RMR Australia is owned by our Managing Trustees and it has been granted an Australian financial services license by the Australian Securities & Investments Commission.  The Australia Management Agreement provides for fees payable to RMR Australia for business management and real estate investment services at an annual rate equal to 0.5% of the average historical cost, including the cost of capital improvements, of CWHAT’s real estate investments, as described in the Australia Management Agreement.  The Australia Management Agreement also provides for additional compensation to RMR Australia for property management services at an annual rate equal to 50% of the difference between 3.0% of collected gross rents, including reimbursed operating expenses and taxes, and the aggregate of all amounts paid or payable by or on behalf of CWHAT to third party property managers. Additionally, the Australia Management Agreement provides for further compensation to RMR Australia for construction supervision services at an annual rate equal to 50% of the difference between 5.0% of constructions costs and any amounts paid to third parties for construction management and/or supervision.  Similar to our prior arrangement with respect to fees we paid to MacarthurCook, RMR has agreed to waive half of the fees payable by us under our property management agreement with RMR and half of the business management fees otherwise payable by us under our business management agreement with RMR related to real estate investments that are subject to the Australia Management Agreement for so long as the Australia Management Agreement is in effect and we or any of our subsidiaries are paying the fees under that agreement.  Pursuant to the Australia Management Agreement, the business and property management fees we recognized during the first quarter of 2013 totaled $264 and $56, respectively.  The Australia Management Agreement was approved by our Compensation Committee, which is composed solely of Independent Trustees.

 

20



Table of Contents

 

COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

GOV was formerly our 100% owned subsidiary.  Our two Managing Trustees, Mr. Barry Portnoy and Mr. Adam Portnoy, are also managing trustees of GOV, and our President, Mr. Adam Portnoy, was the President of GOV from its formation in 2009 until January 2011.  RMR provides management services to both us and GOV.

 

In 2009, GOV completed an initial public offering pursuant to which GOV ceased to be a majority owned subsidiary of ours.  In connection with this offering, we and GOV entered into a transaction agreement that governs our separation from and relationship with GOV.  Pursuant to this transaction agreement, 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.  This right of first refusal applies in the event of an indirect sale of any such properties as a result of a change of control of us.

 

Until March 15, 2013, we were GOV’s largest shareholder.  On March 15, 2013, we sold all of our 9,950,000 common shares of GOV in a public offering for net proceeds of $239,576 (after deducting underwriters’ discounts and commissions and estimated expenses).  In connection with this public offering, on March 11, 2013, we entered into a registration agreement with GOV under which we agreed to pay all expenses incurred by GOV relating to the registration and sale of our GOV common shares.  In addition, under the registration agreement, GOV agreed to indemnify CWH, our officers, Trustees and controlling persons, and we agreed to indemnify GOV and GOV’s officers, trustees and controlling persons, against certain liabilities related to the public offering, including liabilities under the Securities Act of 1933, as amended; and we and GOV agreed to reimburse payments that the other may make in respect of those liabilities.

 

SIR was formerly our 100% owned subsidiary.  We are SIR’s largest shareholder and SIR continues to be one of our consolidated subsidiaries.  As of March 31, 2013, we owned 22,000,000 common shares of SIR, which represented approximately 56.0% of SIR’s outstanding common shares.  Our two Managing Trustees, Mr. Barry Portnoy and Mr. Adam Portnoy, are also managing trustees of SIR, and Mr. John Popeo, our Treasurer and Chief Financial Officer, also serves as the Treasurer and Chief Financial Officer of SIR.  In addition, one of our Independent Trustees, Mr. William Lamkin, is an independent trustee of SIR.  RMR provides management services to both us and SIR.

 

On March 12, 2012, SIR completed an initial public offering pursuant to which it issued 9,200,000 of its common shares for net proceeds (after deducting underwriters’ discounts and commissions and estimated expenses) of $180,814.  SIR applied those net proceeds, along with proceeds from drawings under SIR’s revolving credit facility, to repay in full a $400,000 demand promissory note that we received from SIR on February 16, 2012.  SIR issued the $400,000 demand promissory note, along with 22,000,000 SIR common shares, in exchange for our transfer to SIR of 251 properties (approximately 21,400,000 rentable square feet).  SIR also reimbursed us for costs that we incurred in connection with SIR’s organization and preparation for its initial public offering.

 

In connection with the SIR IPO, we and SIR entered into a transaction agreement that governs our separation from and relationship with SIR.  The transaction agreement provides that, among other things, (1) the current assets and liabilities of the 251 properties that we transferred to SIR, as of the time of closing of the SIR IPO, were settled between us and SIR so that we will retain all pre-closing current assets and liabilities and SIR will assume all post-closing current assets and liabilities and (2) SIR will indemnify us with respect to any liability relating to any property transferred by us to SIR, including any liability which relates to periods prior to SIR’s formation, other than the pre-closing current assets and current liabilities that we retained with respect to the 251 transferred properties.

 

On March 25, 2013, we entered into a registration agreement with SIR, and pursuant to the registration agreement, SIR filed a Registration Statement on Form S-11 for a possible public offering, or an Offering, by us of up to all of the 22,000,000 common shares of SIR that we own.  Under the registration agreement, SIR agreed to, among other things, file a registration statement with respect to an Offering of up to all of the 22,000,000 common shares of SIR that we own, and we agreed to pay all expenses incurred by SIR relating to the registration and sale of the shares in an Offering.  SIR’s obligation to register the shares for resale in an Offering is subject to certain conditions and may be terminated in certain circumstances, in each case, as described in the registration agreement.  SIR agreed to indemnify us, our officers, Trustees and controlling persons, and we agreed to indemnify SIR and SIR’s officers, trustees and controlling persons, against certain liabilities in connection with an Offering, including liabilities under the Securities Act of 1933, as amended; and we and SIR agreed to reimburse payments that the other may make in respect of those liabilities.  We have not made a decision to sell these shares at this time.

 

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Table of Contents

 

COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

We (excluding SIR), RMR, GOV, SIR and four other companies to which RMR provides management services each currently own 12.5% of AIC, an Indiana insurance company.  All of our Trustees, all of the trustees and directors of the other publicly held AIC shareholders and nearly all of the directors of RMR currently serve on the board of directors of AIC.  RMR provides management and administrative services to AIC pursuant to a management and administrative services agreement with AIC.

 

As of March 31, 2013, we and SIR collectively have invested $10,544 in AIC since AIC’s formation in November 2008.  SIR became a shareholder of AIC during the quarter ended June 30, 2012.  We and SIR each use the equity method to account for this investment because we and SIR believe that we each have significant influence over AIC because all of our Trustees and all of SIR’s trustees are also directors of AIC.  We and the other shareholders of AIC have purchased property insurance providing $500,000 of coverage pursuant to an insurance program arranged by AIC and with respect to which AIC is a reinsurer of certain coverage amounts.  This program was modified and extended in June 2012 for a one year term, and we and SIR collectively paid premiums, including taxes and fees, of $6,560 in connection with that renewal, which amount may be adjusted from time to time as we or SIR acquire or dispose of properties that are included in this program.  We periodically consider the possibilities for expanding our insurance relationships with AIC to include other types of insurance and may in the future participate in additional insurance offerings AIC may provide or arrange.  We and SIR may invest additional amounts in AIC in the future if the expansion of this insurance business requires additional capital, but we are not obligated to do so.  By participating in this insurance business with RMR and the other companies to which RMR provides management services, we expect that we may benefit financially by possibly reducing our insurance expenses or by realizing our pro rata share of any profits of this insurance business.

 

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Table of Contents

 

COMMONWEALTH REIT

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)

 

Note 15.  Other Matters

 

On February 26, 2013, Corvex Management LP, Related Fund Management, LLC and certain of their affiliates, or Corvex/Related, publicly disclosed their recent accumulation of the Company’s common shares. Corvex/Related have since  undertaken a series of actions in an effort to influence and control us, including publishing “open” letters to our Board of Trustees, announcing conditional, unfinanced purported offers to acquire all the common shares of the Company, and commencing a consent solicitation seeking to remove, without cause, all of the members of our Board of Trustees.  Corvex/Related’s most recent purported offer to acquire the Company was made by letter dated March 28, 2013.  In this letter, Corvex/Related made a conditional purported offer to purchase all of the Company’s common shares for $24.50 per share, without disclosing any specific financing plan, and presented the Company with three options:  accept Corvex/Related’s offer to acquire the Company, sell the Company to a higher bidder, or face a consent solicitation to remove the entire Board of Trustees of the Company without cause.  On April 15, 2013, we announced that, after considering the information provided by Corvex/Related, our Board of Trustees unanimously determined not to pursue discussions with Corvex/Related about their conditional, not fully financed, offer.  We also announced on that date that, after carefully considering alternatives, and with the advice and assistance of financial and legal advisors, our Board of Trustees unanimously determined that the interests of the Company and our shareholders would be best served by continued implementation of our current business plan to (i) concentrate investments in CBD office properties, (ii) divest non-core properties and other assets, and (iii) reduce debt, and not to pursue a sale of the Company at the time.

 

On April 10, 2013, Corvex/Related filed a definitive consent solicitation statement for their proposal to remove, without cause, all of the members of our Board of Trustees.  Corvex/Related have publicly stated that they believe the record date for this consent solicitation is April 22, 2013 and are soliciting consents from our shareholders assuming an April 22, 2013 record date.  Our Board of Trustees believes that the Corvex/Related consent solicitation is invalid because, among other things, Corvex/Related have not demonstrated that they are eligible to request a record date for the consent solicitation in accordance with our bylaws and because our Trustees may be removed only for cause as a result of our Board of Trustees’s election to be subject to Section 3-803 of the Maryland Unsolicited Takeovers Act.  Moreover, under the Company’s declaration of trust and bylaws, the power to set a record date for the consent solicitation rests with the Company’s Board of Trustees and our Board of Trustees has not set such a record date.  Corvex/Related have commenced litigation, as described below in Part II, Item 1. “Legal Proceedings” of this Quarterly Report, challenging certain provisions of our bylaws, and we expect Corvex/Related may bring a legal challenge to our position that our Trustees may be removed only for cause.  To date, no court or arbitration panel has ruled that Corvex/Related are eligible to request a record date for their consent solicitation.  Accordingly, the Company has requested that shareholders who receive consent materials from Corvex/Related take no action at this time.

 

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Table of Contents

 

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

 

The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes included elsewhere in this Quarterly Report and in our Annual Report.

 

OVERVIEW

 

We are a REIT organized under Maryland law.  The majority of the properties owned by us (excluding SIR), or our wholly owned properties, are office buildings in CBD and suburban locations throughout the United States.  Our wholly owned property portfolio also includes 8.8 million square feet of industrial and other space as well as 1.8 million square feet of office and industrial buildings located in Australia.  Our consolidated subsidiary, SIR, owns 25.4 million square feet of primarily net leased, single tenant office and industrial properties, including 17.8 million square feet of primarily leasable industrial and commercial lands located in Oahu, HI.

 

SIR was formerly our 100% owned subsidiary.  In March 2012, SIR completed its initial public offering and became a publicly held company with shares listed on the New York Stock Exchange, or NYSE.  We are SIR’s largest shareholder and, as of March 31, 2013, we owned 22,000,000 common shares of SIR, which represented approximately 56.0% of SIR’s outstanding common shares.  SIR has filed a registration statement, and has agreed to register, with the SEC, up to all of our SIR shares for resale.  See Note 14 to the notes to our condensed consolidated financial statements included elsewhere in this Quarterly Report for further information regarding our agreement with SIR regarding this registration and possible resale of the SIR shares.

 

GOV was formerly our 100% owned subsidiary.  In June 2009, GOV completed its initial public offering and became a publicly held company with shares listed on the NYSE.  We used the equity method to account for our ownership of GOV.  On March 15, 2013, we sold all 9,950,000 common shares that we owned of GOV in a public offering for net proceeds of $239.6 million.  We recognized a gain on the sale of this equity investment of $66.3 million as a result of the per share sales price of this transaction being above our per share carrying value.

 

On February 26, 2013, Corvex/Related publicly disclosed their recent accumulation of the Company’s common shares. Corvex/Related have since undertaken a series of actions in an effort to influence and control us, including publishing “open” letters to our Board of Trustees, announcing conditional, unfinanced purported offers to acquire all the common shares of the Company, and commencing a consent solicitation seeking to remove, without cause, all of the members of our Board of Trustees.  Corvex/Related’s most recent purported offer to acquire the Company was made by letter dated March 28, 2013.  In this letter, Corvex/Related made a conditional purported offer to purchase all of the Company’s common shares for $24.50 per share, without disclosing any specific financing plan, and presented the Company with three options:  accept Corvex/Related’s offer to acquire the Company, sell the Company to a higher bidder or face a consent solicitation to remove the entire Board of Trustees of the Company without cause.  On April 15, 2013, we announced that, after considering the information provided by Corvex/Related, our Board of Trustees unanimously determined not to pursue discussions with Corvex/Related about their conditional, not fully financed, offer.  We also announced on that date that, after carefully considering alternatives, and with the advice and assistance of financial and legal advisors, our Board of Trustees unanimously determined that the interests of the Company and our shareholders would be best served by continued implementation of our current business plan to (i) concentrate investments in CBD office properties, (ii) divest non-core properties and other assets, and (iii) reduce debt, and not to pursue a sale of the Company at the time.

 

On April 10, 2013, Corvex/Related filed a definitive consent solicitation statement for their proposal to remove, without cause, all of the members of our Board of Trustees.  Corvex/Related have publicly stated that they believe the record date for this consent solicitation is April 22, 2013 and are soliciting consents from our shareholders assuming an April 22, 2013 record date.  Our Board of Trustees believes that the Corvex/Related consent solicitation is invalid because, among other things, Corvex/Related have not demonstrated that they are eligible to request a record date for the consent solicitation in accordance with our bylaws and because our Trustees may be removed only for cause as a result of our Board of Trustees’s election to be subject to Section 3-803 of the Maryland Unsolicited Takeovers Act.  Moreover, under the Company’s declaration of trust and bylaws, the power to set a record date for the consent solicitation rests with the Company’s Board of Trustees and our Board of Trustees has not set such a record date.  Corvex/Related have commenced litigation, as described below in Part II, Item 1. “Legal Proceedings” of this Quarterly Report, challenging certain provisions of our bylaws, and we expect Corvex/Related may bring a legal challenge to our position that our Trustees may be removed only for cause.  To date, no court or arbitration panel has ruled that Corvex/Related are eligible to request a

 

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record date for their consent solicitation.  Accordingly, the Company has requested that shareholders who receive consent materials from Corvex/Related take no action at this time.

 

References to our properties in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” include our consolidated properties, including SIR’s properties, unless the context otherwise provides.

 

Property Operations

 

As of March 31, 2013, 90.0% of our total square feet was leased, compared to 90.1% leased as of March 31, 2012.  These results reflect a 0.5% decrease in occupancy at properties we owned continuously since January 1, 2012, offset by occupancy at properties acquired since January 1, 2012.  Occupancy data for 2013 and 2012 is as follows (square feet in thousands):

 

 

 

All Properties(1)

 

Comparable Properties(2)

 

 

 

As of March 31,

 

As of March 31,

 

 

 

2013

 

2012 (3)

 

2013

 

2012

 

Total consolidated properties

 

445

 

421

 

418

 

418

 

Total square feet

 

72,690

 

67,152

 

65,242

 

65,242

 

Percent leased(4)

 

90.0

%

90.1

%

89.4

%

89.9

%

 


(1)       Excludes properties classified in discontinued operations.

(2)       Based on properties we owned continuously since January 1, 2012 and excludes properties classified in discontinued operations.

(3)       Excludes 94 properties with a total of approximately 6,674 square feet which were reclassified to discontinued operations from continuing operations as of December 31, 2012.

(4)       Percent leased includes (i) space being fitted out for occupancy pursuant to existing leases and (ii) space which is leased but is not occupied or is being offered for sublease by tenants.

 

As of March 31, 2013, we had 35 office properties and 41 industrial properties with a combined 5,613,825 square feet classified as held for sale.  Results of operations for properties sold or held for sale as of March 31, 2013 are included in discontinued operations in our condensed consolidated statements of operations.  These properties and their operating results are excluded from the data in the preceding paragraph and, except as noted, from the balance of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The average effective rental rate per square foot, as defined below, for our properties for the three months ended March 31, 2013 and 2012 are as follows:

 

 

 

Average Effective Rental Rate Per
Square Foot
(1)

 

 

 

Three Months Ended March 31,

 

 

 

2013

 

2012

 

CBD office buildings

 

$

30.25

 

$

30.59

 

Suburban office buildings

 

$

20.49

 

$

20.10

 

Industrial properties (including Hawaii land leases)

 

$

6.32

 

$

5.93

 

Consolidated portfolio

 

$

17.06

 

$

16.57

 

 


(1)       Average effective rental rate per square foot represents (x) total rental income during the period specified, adjusted for tenant concessions, including free rent and tenant reimbursements, divided by (y) the average rentable square feet leased during the period specified.  Data presented excludes properties classified in discontinued operations.

 

During the three months ended March 31, 2013, we renewed leases for 1,175,000 square feet and entered into new leases for 511,000 square feet, at weighted average cash rental rates that were approximately 1.2% below rents previously charged for the same space.  The weighted average lease term based on square feet for leases entered into during 2013 was 5.9 years.  Commitments for tenant improvements, leasing commissions, tenant concessions, including free rent and tenant reimbursements, for leases entered into

 

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during 2013 totaled $20.0 million, or $11.86 per square foot on average (approximately $2.01 per square foot per year of the lease term).

 

During the past twelve months, leasing market conditions in the majority of our markets appear to be stabilizing but remain weak.  Required tenant concessions, including tenant improvements, leasing brokerage commissions, tenant reimbursements and free rent, have increased in certain markets since 2008, and may continue to increase there or in other markets, depending on market and competitive conditions.  Tenant concessions are generally amortized during the terms of the affected leases.  We believe that the stubbornly high unemployment rate and weak leasing market conditions in the United States may result in stable, or even decreases in, occupancies and effective rents, or gross rents less amortization of landlord funded tenant improvements and leasing costs, at our properties through 2013.  However, there are too many variables for us to reasonably project what the financial impact of changing market conditions will be on our occupancy, rental income or financial results for future periods.

 

We review all of our long lived assets for possible impairments following the end of each quarter and when there is an event or change in circumstances that indicates an impairment in value may have occurred.  As of March 31, 2013, we determined the carrying value of seven properties that were classified as held for sale on that date exceeded their estimated fair value based on purchase offers, resulting in impairment charges aggregating $3.9 million.

 

As of March 31, 2013, approximately 6.9% of our consolidated leased square feet and 7.0% of our consolidated annualized rental income, determined as set forth below, are included in leases scheduled to expire through December 31, 2013. Lease renewals and rental rates at which available space may be relet in the future will depend on prevailing market conditions at the times these renewals are negotiated. Lease expirations by year, as of March 31, 2013, are as follows (square feet and dollars in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cumulative

 

 

 

 

 

 

 

 

 

 

 

 

 

% of

 

% of

 

 

 

 

 

 

 

 

 

Cumulative

 

Annualized

 

Annualized

 

Annualized

 

 

 

Number

 

Square

 

% of

 

% of Square

 

Rental

 

Rental

 

Rental

 

 

 

of Tenants

 

Feet

 

Square Feet

 

Feet

 

Income

 

Income

 

Income

 

Year

 

Expiring

 

Expiring(1)

 

Expiring

 

Expiring

 

Expiring(2)

 

Expiring

 

Expiring

 

2013

 

410

 

4,542

 

6.9

%

6.9

%

$

73,086

 

7.0

%

7.0

%

2014

 

317

 

3,484

 

5.3

%

12.2

%

61,255

 

5.9

%

12.9

%

2015

 

355

 

4,795

 

7.3

%

19.5

%

99,422

 

9.6

%

22.5

%

2016

 

325

 

6,899

 

10.6

%

30.1

%

108,822

 

10.5

%

33.0

%

2017

 

282

 

4,563

 

7.0

%

37.1

%

101,953

 

9.8

%

42.8

%

2018

 

174

 

5,476