10-Q 1 gov_093018x10qxdocument.htm 10-Q Document


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2018
 
OR
 
☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
Commission File Number 1-34364
 
GOVERNMENT PROPERTIES INCOME TRUST
(Exact Name of Registrant as Specified in Its Charter)
 
Maryland
 
26-4273474
(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)
 
617-219-1440
(Registrant’s Telephone Number, Including Area Code)
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ☒  No ☐
 
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).  Yes ☒  No ☐
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company.  See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. 
 
Large accelerated filer ☒
 
Accelerated filer ☐
 
 
 
Non-accelerated filer ☐
 
Smaller reporting company ☐
 
 
 
Emerging growth company ☐
 
 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes ☐  No ☒
 
Number of registrant’s common shares of beneficial interest, $.01 par value per share, outstanding as of October 30, 2018: 99,205,199




GOVERNMENT PROPERTIES INCOME TRUST
 
FORM 10-Q
 
September 30, 2018
 
INDEX
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
References in this Quarterly Report on Form 10-Q to “the Company”, “GOV”, “we”, “us” or “our” include Government Properties Income Trust and its consolidated subsidiaries unless otherwise expressly stated or the context indicates otherwise.


1


PART I.       Financial Information
 
Item 1.  Financial Statements
 
GOVERNMENT PROPERTIES INCOME TRUST
CONDENSED CONSOLIDATED BALANCE SHEETS
(amounts in thousands, except share data)
(unaudited) 
 
 
September 30,
 
December 31,
 
 
2018
 
2017
ASSETS
 
 

 
 

Real estate properties:
 
 

 
 

Land
 
$
448,714

 
$
627,108

Buildings and improvements
 
2,050,365

 
2,348,613

Total real estate properties, gross
 
2,499,079

 
2,975,721

Accumulated depreciation
 
(363,490
)
 
(341,848
)
Total real estate properties, net
 
2,135,589

 
2,633,873

 
 
 
 
 
Assets of discontinued operations - Equity investment in Select Income REIT
 
453,275

 
467,499

Assets of properties held for sale
 
408,626

 

Investment in unconsolidated joint ventures
 
45,161

 
50,202

Acquired real estate leases, net
 
215,938

 
351,872

Cash and cash equivalents
 
9,644

 
16,569

Restricted cash
 
2,354

 
3,111

Rents receivable, net
 
55,297

 
61,429

Deferred leasing costs, net
 
22,181

 
22,977

Other assets, net
 
136,360

 
96,033

Total assets
 
$
3,484,425

 
$
3,703,565

 
 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 

 
 

Unsecured revolving credit facility
 
$
467,000

 
$
570,000

Unsecured term loans, net
 
548,363

 
547,852

Senior unsecured notes, net
 
945,948

 
944,140

Mortgage notes payable, net
 
176,828

 
183,100

Liabilities of properties held for sale
 
9,998

 

Accounts payable and other liabilities
 
64,868

 
89,440

Due to related persons
 
23,300

 
4,859

Assumed real estate lease obligations, net
 
8,759

 
13,635

Total liabilities
 
2,245,064

 
2,353,026

 
 
 
 
 
Commitments and contingencies
 


 


 
 
 
 
 
Preferred units of limited partnership
 

 
20,496

 
 
 
 
 
Shareholders’ equity:
 
 

 
 

Common shares of beneficial interest, $.01 par value: 150,000,000 shares authorized,
 
 
 
 
99,205,199 and 99,145,921 shares issued and outstanding, respectively
 
992

 
991

Additional paid in capital
 
1,969,168

 
1,968,217

Cumulative net income
 
204,579

 
108,144

Cumulative other comprehensive income
 
265

 
60,427

Cumulative common distributions
 
(935,643
)
 
(807,736
)
Total shareholders’ equity
 
1,239,361

 
1,330,043

Total liabilities and shareholders’ equity
 
$
3,484,425

 
$
3,703,565

See accompanying notes.

2


GOVERNMENT PROPERTIES INCOME TRUST
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(amounts in thousands, except per share data)
(unaudited) 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2018
 
2017
 
2018
 
2017
 
 
 
 
 
 
 
 
Rental income 
$
106,102

 
$
70,179

 
$
322,904

 
$
209,362

 
 
 
 
 
 
 
 
Expenses:
 

 
 

 
 

 
 

Real estate taxes
12,072

 
8,862

 
37,402

 
24,980

Utility expenses
7,783

 
5,408

 
20,490

 
14,186

Other operating expenses
21,785

 
14,867

 
66,221

 
44,046

Depreciation and amortization
42,569

 
20,781

 
129,444

 
61,949

Loss on impairment of real estate

 
230

 
5,800

 
230

Acquisition and transaction related costs
3,813

 

 
3,813

 

General and administrative
22,383

 
3,266

 
36,438

 
12,314

Total expenses
110,405

 
53,414

 
299,608

 
157,705

 
 
 
 
 
 
 
 
Operating income (loss)
(4,303
)
 
16,765

 
23,296

 
51,657

Dividend income
304

 
304

 
912

 
911

Unrealized gain on equity securities
17,425

 

 
40,677

 

Interest income
140

 
1,715

 
405

 
1,843

Interest expense (including net amortization of debt premiums and discounts
 
 
 
 
 
 
 
and debt issuance costs of $893, $990, $2,749 and $2,605, respectively)
(23,374
)
 
(16,055
)
 
(69,444
)
 
(43,599
)
Loss on early extinguishment of debt

 
(1,715
)
 

 
(1,715
)
Income (loss) from continuing operations before income taxes,
 

 
 

 
 

 
 

equity in net earnings (losses) of investees and gain on sale of real estate
(9,808
)
 
1,014

 
(4,154
)
 
9,097

Income tax expense
(9
)
 
(22
)
 
(124
)
 
(65
)
Equity in net earnings (losses) of investees
94

 
31

 
(1,112
)
 
533

Income (loss) from continuing operations
(9,723
)
 
1,023

 
(5,390
)
 
9,565

Income from discontinued operations
9,274

 
9,966

 
23,872

 
20,516

Income (loss) before gain on sale of real estate
(449
)
 
10,989

 
18,482

 
30,081

Gain on sale of real estate

 

 
17,329

 

Net income (loss)
(449
)
 
10,989

 
35,811

 
30,081

Other comprehensive income:
 

 
 

 
 

 
 

Unrealized gain on investment in equity securities

 
3,279

 

 
14,389

Equity in unrealized gain of investees
126

 
1,351

 
119

 
5,634

Other comprehensive income
126

 
4,630

 
119

 
20,023

Comprehensive income
$
(323
)
 
$
15,619

 
$
35,930

 
$
50,104

 
 
 
 
 
 
 
 
Net income (loss)
$
(449
)
 
$
10,989

 
$
35,811

 
$
30,081

Preferred units of limited partnership distributions

 

 
(371
)
 

Net income (loss) available for common shareholders
$
(449
)
 
$
10,989

 
$
35,440

 
$
30,081

 
 
 
 
 
 
 
 
Weighted average common shares outstanding (basic)
99,071

 
$
96,883

 
$
99,055

 
$
79,778

Weighted average common shares outstanding (diluted)
99,071

 
$
96,958

 
$
99,075

 
$
79,852

 
 
 
 
 
 
 
 
Per common share amounts (basic and diluted):
 

 
 

 
 

 
 

Income (loss) from continuing operations
$
(0.10
)
 
$
0.01

 
$
0.12

 
$
0.12

Income from discontinued operations
$
0.09

 
$
0.10

 
$
0.24

 
$
0.26

Net income (loss) available for common shareholders
$
0.00

 
$
0.11

 
$
0.36

 
$
0.38

 
See accompanying notes.

3


GOVERNMENT PROPERTIES INCOME TRUST
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(amounts in thousands)
(unaudited) 
 
 
Nine Months Ended September 30,
 
 
2018
 
2017
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 

 
 

Net income
 
$
35,811

 
$
30,081

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

 
 

Depreciation
 
51,121

 
35,460

Net amortization of debt premiums and discounts and debt issuance costs
 
2,749

 
2,605

Gain on sale of real estate
 
(17,329
)
 

Loss on early extinguishment of debt
 

 
1,715

Straight line rental income
 
(7,825
)
 
(3,115
)
Amortization of acquired real estate leases
 
77,434

 
25,592

Amortization of deferred leasing costs
 
3,524

 
2,790

Other non-cash expenses, net
 
189

 
352

Loss on impairment of real estate
 
5,800

 
230

Unrealized gain on equity securities
 
(40,677
)
 

Increase in carrying value of asset held for sale
 

 
(619
)
Equity in net (earnings) losses of investees
 
1,112

 
(533
)
Equity in earnings of Select Income REIT included in discontinued operations
 
(23,843
)
 
(20,271
)
Net gain on issuance of shares by Select Income REIT included in discontinued operations
 
(29
)
 
(72
)
Distributions of earnings from Select Income REIT
 
23,843

 
20,271

Change in assets and liabilities:
 
 

 
 

Deferred leasing costs
 
(5,937
)
 
(2,846
)
Rents receivable
 
7,535

 
3,839

Other assets
 
(1,393
)
 
(7,045
)
Accounts payable and other liabilities
 
(10,361
)
 
6,703

Due to related persons
 
18,441

 
777

Net cash provided by operating activities
 
120,165

 
95,914

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 

 
 

Real estate acquisitions and deposits
 

 
(666,202
)
Real estate improvements
 
(32,625
)
 
(29,377
)
Distributions in excess of earnings from Select Income REIT
 
14,281

 
17,854

Distributions in excess of earnings from unconsolidated joint ventures
 
3,046

 

Proceeds from sale of properties, net
 
142,189

 
13,198

Net cash provided by (used in) investing activities
 
126,891

 
(664,527
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 

 
 

Repayment of mortgage notes payable
 
(2,732
)
 
(1,150
)
Proceeds from issuance of senior notes, after discounts
 

 
297,954

Proceeds from issuance of common shares, net
 

 
493,936

Borrowings on unsecured revolving credit facility
 
95,000

 
610,000

Repayments on unsecured revolving credit facility
 
(198,000
)
 
(205,000
)
Payment of debt issuance costs
 

 
(2,551
)
Repurchase of common shares
 
(232
)
 
(255
)
Redemption of preferred units of limited partnership
 
(20,221
)
 

Preferred units of limited partnership distributions
 
(646
)
 

Distributions to common shareholders
 
(127,907
)
 
(102,576
)
Net cash (used in) provided by financing activities
 
(254,738
)
 
1,090,358

 
 
 
 
 
Increase (decrease) in cash and cash equivalents and restricted cash
 
(7,682
)
 
521,745

Cash and cash equivalents and restricted cash at beginning of period
 
19,680

 
30,471

Cash and cash equivalents and restricted cash at end of period
 
$
11,998

 
$
552,216

 
Supplemental cash flow information
Interest paid
 
$
72,651

 
$
42,019

Income taxes paid
 
$
44

 
$
100


Supplemental disclosure of cash and cash equivalents and restricted cash
The following table provides a reconciliation of cash and cash equivalents and restricted cash amounts reported within the condensed consolidated balance sheets to the total amount reported in the condensed consolidated statements of cash flows:
 
 
September 30, 2018

 
September 30, 2017

Cash and cash equivalents
 
$
9,644

 
$
551,707

Restricted cash
 
2,354

 
509

Total cash and cash equivalents and restricted cash reported in the statements of cash flows
 
$
11,998

 
$
552,216

See accompanying notes.

4

GOVERNMENT PROPERTIES INCOME TRUST
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 Government Properties Income Trust and its subsidiaries, or the Company, GOV, we, us or our, are unaudited. Certain information and disclosures required by U.S. generally accepted accounting principles, or GAAP, for complete financial statements have been condensed or omitted.  We believe the disclosures made are adequate to make the information presented not misleading.  However, the accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes contained in our Annual Report on Form 10-K for the year ended December 31, 2017, or our Annual Report. In the opinion of management, all adjustments, consisting of normal recurring accruals considered necessary for a fair statement of results for the interim period have been included.  All intercompany transactions and balances with or among our consolidated subsidiaries have been eliminated.  Our operating results for interim periods are not necessarily indicative of the results that may be expected for the full year. Reclassifications have been made to the prior years' condensed consolidated financial statements to conform to the current year’s presentation.
 
The preparation of these financial statements in conformity with GAAP requires us to make estimates and assumptions that affect reported amounts. Actual results could differ from those estimates. Significant estimates in the condensed consolidated financial statements include purchase price allocations, useful lives of fixed assets, assessment of impairment of real estate and equity method investments and the valuation of intangible assets.

Segment Information

We operate in one business segment: direct ownership of real estate properties. Our equity method investment in Select Income REIT, or SIR, has been reclassified as a discontinued operation and is no longer a separate business segment. See below for further information about our equity method investment in SIR.

Merger with Select Income REIT

On September 14, 2018, we and our wholly owned subsidiary, GOV MS REIT, or Merger Sub, entered into an Agreement and Plan of Merger, or the Merger Agreement, with SIR, pursuant to which SIR has agreed to merge with and into Merger Sub, with Merger Sub continuing as the surviving entity in the merger, or the Merger. Pursuant to the terms and subject to the conditions set forth in the Merger Agreement, at the effective time of the Merger, or the Effective Time, each common share of SIR issued and outstanding immediately prior to the Effective Time will be converted into the right to receive 1.04, or the Exchange Ratio, of our newly issued common shares, subject to adjustment as described in the Merger Agreement, with cash paid in lieu of fractional shares. The Exchange Ratio is fixed and will not be adjusted to reflect changes in the market price of our common shares or SIR common shares prior to the Effective Time. At the Effective Time, any outstanding unvested SIR common share awards under SIR’s equity compensation plan will be converted into an award under our equity compensation plan, subject to substantially similar vesting requirements and other terms and conditions, of a number of our common shares determined by multiplying the number of unvested SIR common shares subject to such award by the Exchange Ratio (rounded down to the nearest whole number). Also pursuant to the Merger Agreement, we and SIR agreed that, prior to the Effective Time, we would sell, for cash consideration, all 24,918,421 SIR common shares owned by us, or the Secondary Sale, which Secondary Sale was completed on October 9, 2018 as further described below, and further that, subject to the satisfaction of certain conditions, SIR will declare and, at least one business day prior to the closing date of the Merger, pay a pro rata distribution to its shareholders of all 45,000,000 common shares of its majority owned subsidiary, Industrial Logistics Properties Trust that SIR owns, or the ILPT Distribution. Following the ILPT Distribution and upon the closing of the Merger, we will acquire SIR's remaining property portfolio of 99 properties with approximately 16,538,462 rentable square feet. The aggregate transaction value, based on the closing price of our common shares on September 30, 2018 of $11.29 per share, is approximately $2,738,488, excluding estimated closing costs of $40,000 and including the repayment or assumption of $1,720,000 of SIR debt. The Merger and the other transactions contemplated by the Merger Agreement, including the Secondary Sale and the ILPT Distribution, are collectively referred to herein as the Transactions.

We expect that immediately after the Merger is effective, Merger Sub will then merge with and into us, with us as the surviving entity, and we will change our name to “Office Properties Income Trust,” following which our ticker symbol on The Nasdaq Stock Market LLC, or Nasdaq, will be changed to “OPI”. We also expect that immediately following that second merger, the combined company will effect a reverse stock split of its common shares pursuant to which every four common

5

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

shares of the combined company will be converted into one common share of the combined company. The combined company will continue to be managed by The RMR Group LLC, or RMR LLC, pursuant to our existing business and property management agreements with RMR LLC.

The completion of the Merger is subject to the satisfaction or waiver of various conditions, including, among other things, approval by our shareholders of the issuance of our common shares in the Merger and by SIR’s shareholders of the Merger and the other Transactions to which SIR is a party, the absence of any law or order by any governmental authority prohibiting, making illegal, enjoining or otherwise restricting, preventing or prohibiting the consummation of the Merger and the other Transactions, the effectiveness of the registration statement on Form S-4, as amended, or the Form S-4, filed by us with the Securities and Exchange Commission, or SEC, to register our common shares to be issued in the Merger and the approval of Nasdaq for the listing of such shares on Nasdaq, subject to official notice of issuance, and, subject to the satisfaction of certain other conditions, the payment of the ILPT Distribution at least one business day before the completion of the Merger. We and SIR expect to consummate the Merger by December 31, 2018. The Merger Agreement provides that either party may terminate the Merger Agreement if the Merger is not consummated by the outside closing date of June 30, 2019.

The Merger Agreement contains certain customary representations, warranties and covenants, including, among others, covenants with respect to the conduct of our and SIR’s respective businesses prior to closing, subject to certain consent rights by SIR and us, respectively, and covenants prohibiting us and SIR from soliciting, providing information or entering into discussions concerning competing proposals (generally defined as proposals for 20% or more of the assets, revenues or earnings or equity of the applicable party), subject to certain exceptions. In addition, because we owned the SIR common shares we sold pursuant to the Secondary Sale as of October 1, 2018, the record date set by SIR's board of trustees for shareholders eligible to vote at SIR’s special meeting of shareholders to approve the Merger and the other Transactions to which SIR is a party, or the Record Date, we are entitled to vote those shares at that meeting, unless the Record Date is changed pursuant to the Merger Agreement, we have agreed to vote those shares at that meeting in favor of approval of the Merger and the other Transactions to which SIR is a party.

The Merger Agreement contains certain termination rights for both us and SIR, including that under specified circumstances, either party is entitled to terminate the Merger Agreement to accept a superior proposal (generally defined as proposals for 75% or more of the assets, revenues or earnings or equity of such party, which proposal such party’s board of trustees (or an authorized committee thereof) has determined in good faith, after consultation with outside financial advisors and outside legal counsel, (1) would, if consummated, result in a transaction that is more favorable to the shareholders of such party from a financial point of view than the Merger and the other Transactions, (2) for which the third party has demonstrated that the financing for such offer is fully committed or is reasonably likely to be obtained and (3) which is reasonably likely to receive all required approvals from any governmental authority and otherwise reasonably likely to be consummated on the terms proposed). Neither we nor SIR is entitled to any termination fee under the Merger Agreement. All fees and expenses incurred in connection with the Merger and the other Transactions will be paid by the party incurring those expenses, except that we and SIR will share equally any filing fees incurred in connection with the filing of the Form S-4 and related joint proxy statement/prospectus and, as explained below, we are responsible for all of the costs and expenses incurred in connection with the Secondary Sale, including the costs and expenses of SIR and its affiliates.

Contemporaneously with the execution of the Merger Agreement, and in connection with the Secondary Sale, we entered into a registration agreement with SIR, or the Registration Agreement, pursuant to which we received demand registration rights, subject to certain limitations, with respect to the Secondary Sale. The Registration Agreement provides that we will pay all the costs and expenses incurred in connection with the Secondary Sale, including costs and expenses incurred by SIR and its affiliates. On October 9, 2018, pursuant to the terms of the Registration Agreement, we sold all 24,918,421 SIR common shares in the Secondary Sale that we then owned in an underwritten public offering at a price of $18.25 per share, raising net proceeds of approximately $434,700 after deducting underwriting discounts and estimated offering expenses. We used the net proceeds from the Secondary Sale to repay amounts outstanding under our revolving credit facility.

The transactions contemplated by the Merger Agreement and the terms thereof were evaluated, negotiated and recommended to each of our and SIR’s board of trustees by a special committee of our and SIR’s board of trustees, respectively, each comprised solely of our and SIR’s disinterested, independent trustees, respectively, and were separately approved and adopted by our and SIR’s independent trustees and by our and SIR’s board of trustees. Citigroup Global Markets Inc. acted as financial advisor to the special committee of our board of trustees, and UBS Securities LLC acted as financial advisor to the special committee of SIR’s board of trustees.

6

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

Note 2.    Recent Accounting Pronouncements

On January 1, 2018, we adopted the Financial Accounting Standards Board, or FASB, Accounting Standards Update, or ASU, No. 2014-09 (and related clarifying guidance issued by the FASB), Revenue From Contracts With Customers, which outlines a comprehensive model for entities to use in accounting for revenue arising from contracts with customers. ASU No. 2014-09 states that “an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” While ASU No. 2014-09 specifically references contracts with customers, it may apply to certain other transactions such as the sale of real estate or equipment. A substantial portion of our revenue consists of rental income from leasing arrangements, which is specifically excluded from ASU No. 2014-09. We have adopted ASU No. 2014-09 using the modified retrospective approach, which resulted in an adjustment to reclassify a previous deferred gain on sale of real estate of $712 from accounts payable and other liabilities to cumulative net income. The adoption of ASU No. 2014-09 did not have a material impact on the amount or timing of our revenue recognition in our condensed consolidated financial statements except for profit recognition on real estate sales.
 
On January 1, 2018, we adopted FASB ASU No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, which changes how entities measure certain equity investments and present changes in the fair value of financial liabilities measured under the fair value option that are attributable to their own credit. The implementation of ASU No. 2016-01 resulted in the reclassification of historical changes in the fair value of our available for sale equity securities of $45,116 from cumulative other comprehensive income to cumulative net income. We also reclassified $15,165 from cumulative other comprehensive income to cumulative net income for our share of cumulative other comprehensive income of certain of our equity method investees. Effective January 1, 2018, changes in the fair value of our equity securities are recorded through earnings in accordance with ASU No. 2016-01.

On January 1, 2018, we adopted FASB ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, which clarifies how companies present and classify certain cash receipts and cash payments in the statements of cash flows. The implementation of this update resulted in the reclassification of $2,209 of accretion recorded in our equity in the earnings of SIR from cash flow from investing activities to cash flow from operating activities for the nine months ended September 30, 2017. See Note 12 for further information regarding our investment in SIR.
On January 1, 2018, we adopted FASB ASU No. 2016-18, Restricted Cash, which requires companies to show the changes in the total of cash, cash equivalents, restricted cash and restricted cash equivalents in the statement of cash flows. The implementation of ASU 2016-18 resulted in an increase of $21 of net cash provided by operating activities for the nine months ended September 30, 2017. This update also requires a reconciliation of the totals in the statement of cash flows to the related captions in the balance sheets. As a result, amounts included in restricted cash on our condensed consolidated balance sheets are included with cash and cash equivalents on the condensed consolidated statements of cash flows. Restricted cash, which consists of amounts escrowed for future real estate taxes, insurance, leasing costs, capital expenditures and debt service, as required by certain of our mortgage debts, totaled $2,354 and $509 as of September 30, 2018 and 2017, respectively. The adoption of this update did not change our balance sheet presentation.
In February 2016, the FASB issued ASU No. 2016-02, Leases, which sets out the principles for the recognition, measurement, presentation and disclosure of leases for both parties to a contract (i.e., lessees and lessors). ASU No. 2016-02 requires lessees to apply a dual approach, classifying leases as either finance or operating leases based on the principle of whether or not the lease is effectively a financed purchase of the leased asset by the lessee. This classification will determine whether the lease expense is recognized based on an effective interest method or on a straight line basis over the term of the lease. A lessee is also required to record a right of use asset and a lease liability for all leases with a term of greater than 12 months regardless of their classification. Leases with a term of 12 months or less will be accounted for similar to existing guidance for operating leases today. The new standard requires lessors to account for leases using an approach that is substantially equivalent to existing guidance for sales type leases, direct financing leases and operating leases. ASU No. 2016-02 is effective for reporting periods beginning after December 15, 2018, with early adoption permitted. We are currently assessing the potential impact the adoption of ASU No. 2016-02 will have in our condensed consolidated financial statements.
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which requires that entities use a new forward looking “expected loss” model that generally will result in the earlier recognition of allowance for credit losses. The measurement of expected credit losses is based upon historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. ASU No. 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods

7

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

within those fiscal years. We are currently assessing the potential impact the adoption of ASU No. 2016-13 will have in our condensed consolidated financial statements. We currently expect to adopt the standard using the modified retrospective approach.

In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting, which aligns the measurement and classification guidance for share based payments to nonemployees with the guidance for share based payments to employees, with certain exceptions. ASU No. 2018-07 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We are currently assessing the potential impact the adoption of ASU No. 2018-07 will have in our condensed consolidated financial statements.
Note 3.    Weighted Average Common Shares
 
The following table provides a reconciliation of the weighted average number of common shares used in the calculation of basic and diluted earnings per share (in thousands): 
 
 
For the Three Months
 
For the Nine Months
 
 
Ended September 30,
 
Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Weighted average common shares for basic earnings per share
 
99,071

 
96,883

 
99,055

 
79,778

Effect of dilutive securities: unvested share awards
 

 
75

 
20

 
74

Weighted average common shares for diluted earnings per share (1)
 
99,071

 
96,958

 
99,075

 
79,852


(1) For the three months ended September 30, 2018, 35 unvested common shares were not included in the calculation of diluted earnings per share because to do so would have been antidilutive.

Note 4.   Real Estate Properties
 
As of September 30, 2018, we wholly owned 105 properties (164 buildings), with an aggregate undepreciated carrying value of $2,854,937, and had a noncontrolling ownership interest in two unconsolidated joint ventures that owned two properties (three buildings). We generally lease space at our properties on a gross lease or modified gross lease basis pursuant to fixed term contracts expiring between 2018 and 2038.  Our leases generally require us to pay all or some property operating expenses and to provide all or most property management services.  During the three months ended September 30, 2018, we entered into 24 leases for 182,220 rentable square feet, for a weighted (by rentable square feet) average lease term of 8.1 years and we made commitments for $6,479 of leasing related costs. During the nine months ended September 30, 2018, we entered into 94 leases for 858,998 rentable square feet, for a weighted (by rentable square feet) average lease term of 6.4 years and we made commitments for $21,287 of leasing related costs. As of September 30, 2018, we have estimated unspent leasing related obligations of $34,048.
 
We regularly evaluate whether events or changes in circumstances have occurred that could indicate an impairment in the value of our long lived assets. If there is an indication that the carrying value of an asset is not recoverable, we estimate the projected undiscounted cash flows to determine if an impairment loss should be recognized. We determine the amount of any impairment loss by comparing the historical carrying value to estimated fair value. We estimate fair value through an evaluation of recent financial performance and projected discounted cash flows using standard industry valuation techniques. In addition to evaluating for impairment upon the events or changes in circumstances described above, we regularly evaluate the remaining lives of our long lived assets. If we change our estimate of the remaining lives, we allocate the carrying value of the affected assets over their revised remaining lives.
 
Disposition Activities

In March 2018, we sold an office property (one building) located in Minneapolis, MN with 193,594 rentable square feet for $20,000, excluding closing costs. We recorded a $640 loss on impairment of real estate to reduce the carrying value of this property to its estimated fair value less costs to sell during the three months ended March 31, 2018.

In February 2018, we entered an agreement to sell an office property (one building) located in Safford, AZ with 36,139 rentable square feet for $8,250. We recorded a $2,453 loss on impairment of real estate to reduce the carrying value of the

8

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

property to its estimated fair value less costs to sell in the three months ended March 31, 2018. In April 2018, we terminated the sales agreement and removed this property from held for sale status. We recorded a $322 adjustment to impairment of real estate to increase the carrying value of the property to its estimated fair value during the three months ended June 30, 2018.

In May 2018, we sold an office property (one building) located in New York, NY with 187,060 rentable square feet for $118,500, excluding closing costs. We recorded a $17,329 gain on sale of real estate during the three months ended June 30, 2018 as a result of this sale.

In May 2018, we sold an office property (one building) located in Sacramento, CA with 110,500 rentable square feet for $10,755, excluding closing costs. We recorded a loss on impairment of real estate of $3,023 and $6 to reduce the carrying value of this property to its estimated fair value less costs to sell during the three months ended March 31, 2018 and June 30, 2018, respectively.

The sales of these properties do not represent significant dispositions individually or in the aggregate. The results of operations of these properties are included in continuing operations through the date of sale in our condensed consolidated statements of comprehensive income.

As of September 30, 2018, we had 20 properties (50 buildings) with an aggregate undepreciated carrying value of $355,858 under agreement to sell in three separate transactions, as presented in the table below. We have classified these properties as held for sale in our condensed consolidated balance sheet at September 30, 2018.     
Date of Agreement (1)
 
Number of Properties

 
Number of Buildings

 
Location
 
Square Footage

 
Gross Sale Price (2)

August 2018
 
1

 
1

 
Washington D.C.
 
129,035

 
$
70,000

September 2018
 
8

 
34

 
Northern Virginia and Maryland
 
1,635,868

 
201,500

October 2018
 
11

 
15

 
Southern Virginia
 
1,641,109

 
167,000

 
 
20

 
50

 
 
 
3,406,012

 
$
438,500


(1)
These pending sales are subject to conditions; accordingly, we cannot be sure that we will complete these sales or that these sales will not be delayed or their terms will not change.

(2)
Gross sale price excludes closing costs.

As part of our long term plans to reduce our leverage, we expect to sell additional properties. We are currently marketing or plan to market for sale three properties (three buildings) with an aggregate carrying value of $24,566 as of September 30, 2018. We have determined that these properties did not meet the held for sale criteria as of September 30, 2018. We cannot be sure we will sell any of our properties that we are currently marketing or plan to market for sale or sell them for prices in excess of our carrying values or that we will not recognize impairment losses with respect to these properties.

Pro Forma Financial Information

On October 2, 2017, we acquired First Potomac Realty Trust, or FPO, pursuant to a merger transaction, as a result of which we acquired 35 office properties (72 buildings) with 6,028,072 rentable square feet and FPO's 50% and 51% interests in two joint ventures that own two properties (three buildings) with 443,867 rentable square feet, or collectively, the FPO Transaction. The aggregate value we paid at the closing of the FPO Transaction was $1,370,888.  We financed the FPO Transaction with the assumption of certain FPO mortgage debt, borrowings under our revolving credit facility and cash on hand, including net proceeds from our public offerings of common shares and senior unsecured notes.

The following table presents our pro forma results of operations for the nine months ended September 30, 2017 as if the FPO Transaction and related financing activities had occurred on January 1, 2017. The historical FPO results of operations included in this pro forma financial information have been adjusted to eliminate the results of operations of FPO properties and joint venture interests that were sold from January 1, 2017 to October 2, 2017, the closing date of the FPO Transaction. The effect of these adjustments was a decrease in pro forma rental income of $804 and a decrease in net income of $47,019 for the nine months ended September 30, 2017.

9

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


This pro forma financial information is not necessarily indicative of what our actual financial position or results of operations would have been for the periods presented or for any future period. Differences could result from numerous factors, including future changes in our portfolio of investments, capital structure, property level operating expenses and revenues, including rents expected to be received pursuant to our existing leases or leases we may enter during the remainder of 2018 and thereafter, changes in interest rates and other reasons. Actual future results are likely to be different from amounts presented in this pro forma financial information and such differences could be significant.
 
Nine Months Ended September 30, 2017
Rental income
$
328,255

Net loss
$
(4,733
)
Net loss per share
$
(0.05
)

Unconsolidated Joint Ventures
 
We own noncontrolling interests in two joint ventures that own two properties (three buildings). We account for these investments under the equity method of accounting. As of September 30, 2018, our investment in unconsolidated joint ventures consisted of the following:
Joint Venture
 
GOV Ownership
 
GOV Carrying Value of Investment at September 30, 2018
 
Property Type
 
Number of Buildings
 
Location
 
Square Feet
Prosperity Metro Plaza
 
51%
 
$
24,821

 
Office
 
2
 
Fairfax, VA
 
328,456

1750 H Street, NW
 
50%
 
20,340

 
Office
 
1
 
Washington, DC
 
115,411

Total
 
 
 
$
45,161

 
 
 
3
 
 
 
443,867


The following table provides a summary of the mortgage debt of our unconsolidated joint ventures:
Joint Venture
 
 Interest Rate (1)
 
Maturity Date
 
Principal Balance at September 30, 2018 (2)
Prosperity Metro Plaza
 
4.09%
 
12/1/2029
 
$
50,000

1750 H Street, NW
 
3.69%
 
8/1/2024
 
32,000

Weighted Average/Total
 
3.93%
 
 
 
$
82,000

(1)
Includes the effect of mark to market purchase accounting.
(2)
Reflects the entire balance of the debt secured by the properties and is not adjusted to reflect the interests in the joint venture we do not own. None of the debt is recourse to us.

At September 30, 2018, the aggregate $8,565 unamortized basis difference of our unconsolidated joint ventures is primarily attributable to the difference between the amount we paid to purchase our interest in these joint ventures, including transaction costs, and the historical carrying value of the net assets of these joint ventures. This difference is being amortized over the remaining useful life of the properties owned by these joint ventures and the resulting amortization expense is included in equity in net earnings of investees in our condensed consolidated statements of comprehensive income.


10

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

Note 5.   Revenue Recognition
 
We recognize rental income from operating leases that contain fixed contractual rent changes on a straight line basis over the term of the lease agreements.  Certain of our leases with government tenants provide the tenant the right to terminate before the lease expiration date if the legislature or other funding authority does not appropriate the funding necessary for the government tenant to meet its lease obligations; we have determined the fixed non-cancelable lease term of these leases to be the full term of the lease because we believe the occurrence of early terminations to be remote contingencies based on both our historical experience and our assessments of the likelihood of lease cancellation on a separate lease basis.

We increased rental income to record revenue on a straight line basis by $1,990 and $711 for the three months ended September 30, 2018 and 2017, respectively, and $7,825 and $3,115 for the nine months ended September 30, 2018 and 2017, respectively. Rents receivable include $33,978 (including $1,819 related to properties held for sale) and $27,267 of straight line rent receivables, net of allowance for doubtful accounts of $1,755 (including $976 related to properties held for sale) and $1,503 at September 30, 2018 and December 31, 2017, respectively.

Note 6.   Concentration
 
Tenant and Credit Concentration
 
We define annualized rental income as the annualized contractual base rents from our tenants pursuant to our lease agreements as of the measurement date, plus straight line rent adjustments and estimated recurring expense reimbursements to be paid to us, and excluding lease value amortization. The U.S. Government, 13 state governments and three other government tenants combined were responsible for approximately 62.5% and 87.5% of our annualized rental income as of September 30, 2018 and 2017, respectively. The U.S. Government is our largest tenant by annualized rental income and was responsible for approximately 45.6% and 59.8% of our annualized rental income as of September 30, 2018 and 2017, respectively.
 
Geographic Concentration
 
At September 30, 2018, our 105 consolidated properties (164 buildings) were located in 30 states and the District of Columbia. Consolidated properties located in Virginia, the District of Columbia, Maryland, California and Georgia were responsible for 23.7%, 18.1%, 15.3%, 9.4% and 6.1% of our annualized rental income as of September 30, 2018, respectively. Consolidated properties located in the metropolitan Washington, D.C. market area were responsible for approximately 44.1% of our annualized rental income as of September 30, 2018.
 
Note 7.   Indebtedness
 
Our principal debt obligations at September 30, 2018 were: (1) $467,000 of outstanding borrowings under our $750,000 unsecured revolving credit facility; (2) $550,000 aggregate outstanding principal amount of unsecured term loans; (3) $960,000 aggregate outstanding principal amount of senior unsecured notes; and (4) $180,416 aggregate outstanding principal amount of mortgage notes. 
 
Our $750,000 revolving credit facility, our $300,000 term loan and our $250,000 term loan are governed by a credit agreement, or our credit agreement, with a syndicate of institutional lenders that includes a number of features common to all of these credit arrangements. Our credit agreement also includes a feature under which the maximum aggregate borrowing availability may be increased to up to $2,500,000 on a combined basis in certain circumstances.

Our $750,000 revolving credit facility is available for general business purposes, including acquisitions. The maturity date of our revolving credit facility is January 31, 2019 and, subject to the payment of an extension fee and meeting other conditions, we have an option to extend the stated maturity date of our revolving credit facility by one year to January 31, 2020. We can borrow, repay and reborrow funds available under our revolving credit facility until maturity and no principal repayment is due until maturity. We are required to pay interest at a rate of LIBOR plus a premium, which was 125 basis points per annum at September 30, 2018, on borrowings under our revolving credit facility.  We also pay a facility fee on the total amount of lending commitments under our revolving credit facility, which was 25 basis points per annum at September 30, 2018.  Both the interest rate premium and the facility fee are subject to adjustment based upon changes to our credit ratings.  As of September 30, 2018, the annual interest rate payable on borrowings under our revolving credit facility was 3.4% and the

11

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

weighted average annual interest rate for borrowings under our revolving credit facility was 3.2% and 2.4% for the three months ended September 30, 2018 and 2017, respectively, and 3.0% and 2.2% for the nine months ended September 30, 2018 and 2017, respectively. As of September 30, 2018 and October 30, 2018, we had $467,000 and $32,000 outstanding under our revolving credit facility.
 
Our $300,000 term loan, which matures on March 31, 2020, is prepayable without penalty at any time. We are required to pay interest at a rate of LIBOR plus a premium, which was 140 basis points per annum at September 30, 2018, on the amount outstanding under our $300,000 term loan. The interest rate premium is subject to adjustment based upon changes to our credit ratings.  As of September 30, 2018, the annual interest rate for the amount outstanding under our $300,000 term loan was 3.6%. The weighted average annual interest rate under our $300,000 term loan was 3.5% and 2.6% for the three months ended September 30, 2018 and 2017, respectively, and 3.3% and 2.4% for the nine months ended September 30, 2018 and 2017, respectively.
 
Our $250,000 term loan, which matures on March 31, 2022, is prepayable without penalty at any time. We are required to pay interest at a rate of LIBOR plus a premium, which was 180 basis points per annum as of September 30, 2018, on the amount outstanding under our $250,000 term loan.  The interest rate premium is subject to adjustment based upon changes to our credit ratings. As of September 30, 2018, the annual interest rate for the amount outstanding under our $250,000 term loan was 4.0%. The weighted average annual interest rate under our $250,000 term loan was 3.9% and 3.0% for the three months ended September 30, 2018 and 2017, respectively, and 3.7% and 2.8% for the nine months ended September 30, 2018 and 2017, respectively.
 
Our credit agreement and senior unsecured notes indentures and their supplements provide for acceleration of payment of all amounts due thereunder upon the occurrence and continuation of certain events of default, such as, in the case of our credit agreement, a change of control of us, which includes RMR LLC ceasing to act as our business and property manager.  Our credit agreement and our senior unsecured notes indentures and their supplements also contain a number of covenants, including covenants that restrict our ability to incur debts, require us to maintain certain financial ratios and, in the case of our credit agreement, restrict our ability to make distributions under certain circumstances.  We believe we were in compliance with the terms and conditions of the respective covenants under our credit agreement and senior unsecured notes indentures and their supplements at September 30, 2018.

At September 30, 2018, eight of our consolidated properties (eight buildings) with an aggregate net book value of $417,842 were encumbered by eight mortgages for an aggregate principal amount of $180,416. Our mortgage notes are non-recourse, subject to certain limited exceptions and do not contain any material financial covenants.

Note 8.   Fair Value of Assets and Liabilities
 
The table below presents certain of our assets measured at fair value at September 30, 2018, categorized by the level of inputs, as defined in the fair value hierarchy under GAAP, used in the valuation of each asset:
 
 
 
 
 
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 Assets:
 
 
 
 
 
 
 
 
Investment in RMR Inc. (1)
 
$
112,680

 
$
112,680

 
$

 
$


(1)
Our 1,214,225 shares of class A common stock of The RMR Group Inc., or RMR Inc., which are included in other assets in our condensed consolidated balance sheets, are reported at fair value which is based on quoted market prices (Level 1 inputs as defined in the fair value hierarchy under GAAP). Our historical cost basis for these shares is $26,888 as of September 30, 2018. During the three and nine months ended September 30, 2018, we recorded an unrealized gain of $17,425 and $40,677, respectively, to adjust our investment in RMR Inc. to its fair value.

In addition to the assets described in the table above, our financial instruments include our cash and cash equivalents, restricted cash, rents receivable, mortgage notes receivable, accounts payable, revolving credit facility, term loans, senior

12

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

unsecured notes, mortgage notes payable, amounts due to related persons, other accrued expenses and security deposits.  At September 30, 2018 and December 31, 2017, the fair values of our financial instruments approximated their carrying values in our condensed consolidated financial statements due to their short term nature or variable interest rates, except as follows:
 
 
 
As of September 30, 2018
 
As of December 31, 2017
 
 
Carrying  Amount (1) 
 
Fair Value
 
Carrying  Amount (1) 
 
Fair Value
Senior unsecured notes, 3.75% interest rate, due in 2019
 
$
348,953

 
$
351,468

 
$
348,096

 
$
354,993

Senior unsecured notes, 5.875% interest rate, due in 2046
 
300,490

 
309,380

 
300,232

 
320,416

Senior unsecured notes, 4.000% interest rate, due in 2022
 
296,505

 
296,609

 
295,812

 
302,655

Mortgage note payable, 4.050% interest rate, due in 2030 (2)       
 
64,441

 
62,363

 
64,293

 
65,198

Mortgage note payable, 5.720% interest rate, due in 2020 (2)       
 
35,067

 
34,877

 
36,085

 
36,332

Mortgage note payable, 4.220% interest rate, due in 2022 (2)       
 
27,408

 
27,422

 
27,906

 
28,432

Mortgage note payable, 4.800% interest rate, due in 2023 (2)      
 
25,145

 
25,220

 
25,501

 
25,904

Mortgage note payable, 5.877% interest rate, due in 2021 (2)       
 
13,445

 
13,978

 
13,620

 
14,565

Mortgage note payable, 7.000% interest rate, due in 2019 (2)      
 
8,087

 
8,129

 
8,391

 
8,555

Mortgage note payable, 8.150% interest rate, due in 2021 (2)  
 
3,235

 
3,360

 
4,111

 
4,340

Mortgage note payable, 4.260% interest rate, due in 2020 (2) (3)
 
3,047

 
3,028

 
3,193

 
3,216

 
 
$
1,125,823

 
$
1,135,834

 
$
1,127,240

 
$
1,164,606


(1)
Carrying amount includes certain unamortized debt issuance costs and unamortized premiums and discounts.
(2)
We assumed these mortgages in connection with our acquisitions of the encumbered properties.  The stated interest rates for these mortgage debts are the contractually stated rates.  We recorded the assumed mortgages at estimated fair value on the date of acquisition and we are amortizing the fair value premiums, if any, to interest expense over the respective terms of the mortgages to reduce interest expense to the estimated market interest rates as of the date of acquisition.
(3)
Secured by one property (one building) that is held for sale at September 30, 2018.
 
We estimated the fair value of our senior unsecured notes due 2019 and due 2022 using an average of the bid and ask price of the notes as of the measurement date (Level 2 inputs as defined in the fair value hierarchy under GAAP). We estimated the fair value of our senior unsecured notes due 2046 based on the closing price on Nasdaq as of the measurement date (Level 1 inputs as defined in the fair value hierarchy under GAAP). We estimated the fair values of our mortgage notes payable by using discounted cash flow analyses and currently prevailing market terms as of the measurement date (Level 3 inputs as defined in the fair value hierarchy under GAAP).  Because Level 3 inputs are unobservable, our estimated fair value may differ materially from the actual fair value.

Note 9.   Shareholders’ Equity

Share Awards

On April 3, 2018, in accordance with our Trustee compensation arrangements, and in connection with the election of one of our Managing Trustees, we granted 3,000 of our common shares, valued at $13.59 per share, the closing price of our common shares on Nasdaq on that day, to the Managing Trustee who was elected as a Managing Trustee that day.
    
On May 24, 2018, in accordance with our Trustee compensation arrangements, we granted 3,000 of our common shares, valued at $14.10 per share, the closing price of our common shares on Nasdaq on that day, to each of our six Trustees as part of their annual compensation.

On September 13, 2018, we granted an aggregate of 58,700 of our common shares, valued at $16.95 per share, the closing price of our common shares on Nasdaq on that day, to our officers and certain other employees of RMR LLC under our equity compensation plan.


13

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

Share Purchases

On January 1, 2018, we purchased 617 of our common shares valued at $18.54 per share, the closing price of our common shares on Nasdaq on December 29, 2017, from a former employee of RMR LLC in satisfaction of tax withholding and payment obligations in connection with the vesting of awards of our common shares.

On May 24, 2018, we purchased 450 of our common shares valued at $14.10 per share, the closing price of our common shares on Nasdaq on that day, from one of our Trustees in satisfaction of tax withholding and payment obligations in connection with the vesting of an award of our common shares.

On September 24, 2018, we purchased an aggregate of 18,875 of our common shares, valued at $11.35 per share, the closing price of our common shares on Nasdaq on that day, from our officers and certain other employees of RMR LLC in satisfaction of tax withholding and payment obligations in connection with the vesting of awards of our common shares.

Distributions
 
On February 26, 2018, we paid a regular quarterly distribution to common shareholders of record on January 29, 2018 of $0.43 per share, or $42,632. On May 21, 2018, we paid a regular quarterly distribution to common shareholders of record on April 30, 2018 of $0.43 per share, or $42,634. On August 20, 2018, we paid a regular quarterly distribution to common shareholders of record on July 30, 2018 of $0.43 per share, or $42,641. On October 18, 2018, we declared a regular quarterly distribution payable to common shareholders of record on October 29, 2018 of $0.43 per share, or $42,658. We expect to pay this distribution on or about November 19, 2018.

Cumulative Other Comprehensive Income

Cumulative other comprehensive income represents our share of the comprehensive income of our equity method investees, SIR and Affiliates Insurance Company, or AIC. See Notes 11 and 12 for further information regarding these investments. The following table presents changes in the amounts we recognized in cumulative other comprehensive income by component for the three and nine months ended September 30, 2018:
 
 
Three Months Ended September 30, 2018
 
 
Unrealized Gain
 
Equity in
 
 
 
 
on Investment
 
Unrealized
 
 
 
 
in Equity
 
Gain
 
 
 
 
Securities
 
 of Investees
 
Total
Balance at June 30, 2018
 
$

 
$
139

 
$
139

Other comprehensive income before reclassifications
 

 
143

 
143

Amounts reclassified from cumulative other comprehensive income to net income (1)     
 

 
(17
)
 
(17
)
Net current period other comprehensive income
 

 
126

 
126

Balance at September 30, 2018
 
$

 
$
265

 
$
265

 
 
Nine Months Ended September 30, 2018
 
 
Unrealized Gain
 
Equity in
 
 
 
 
on Investment
 
Unrealized
 
 
 
 
in Equity
 
Gain (Loss)
 
 
 
 
Securities
 
 of Investees
 
Total
Balance at December 31, 2017
 
$
45,116

 
$
15,311

 
$
60,427

Amounts reclassified from cumulative other comprehensive income to cumulative net income
 
(45,116
)
 
(15,165
)
 
(60,281
)
 
 
 
 
 
 
 
Other comprehensive income before reclassifications
 

 
155

 
155

Amounts reclassified from cumulative other comprehensive income to net income (1)
 

 
(36
)
 
(36
)
Net current period other comprehensive income
 

 
119

 
119

Balance at September 30, 2018
 
$

 
$
265

 
$
265


14

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


(1)
Amounts reclassified from cumulative other comprehensive income to net income (loss) are included in equity in net earnings of investees in our condensed consolidated statements of comprehensive income.

Preferred Units of Limited Partnership

On May 1, 2018, one of our subsidiaries redeemed all 1,813,504 of its outstanding 5.5% Series A Cumulative Preferred Units for $11.15 per unit plus accrued and unpaid distributions (an aggregate of $20,310).

Note 10. Business and Property Management Agreements with RMR LLC

We have no employees. The personnel and various services we require to operate our business are provided to us by RMR LLC. We have two agreements with RMR LLC to provide management 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.

Pursuant to our business management agreement with RMR LLC, we recognized net business management fees of $20,575 and $1,891 for the three months ended September 30, 2018 and 2017, respectively, and $30,059 and $8,241 for the nine months ended September 30, 2018 and 2017, respectively. The net business management fees payable to RMR LLC include $16,236 and $16,973 of estimated business management incentive fees for the three and nine months ended September 30, 2018, respectively, based on our common share total return, as defined, as of September 30, 2018. Although we recognized estimated business management incentive fees in accordance with GAAP, the actual amount of business management incentive fees payable by us to RMR LLC for 2018, if any, will be based on our common share total return, as defined, for the three year period ending December 31, 2018, and will be payable in 2019. The net business management fees recognized for the three months ended September 30, 2017 included the reversal of $893 of previously accrued estimated business management incentive fees as of June 30, 2017. As of September 30, 2017, based on our common share total return, as defined, as of such date, no annual business management incentive fees were estimated to be payable by us to RMR LLC for 2017. No incentive management fee was payable by us to RMR LLC for the year ended December 31, 2017. The net business management fees we recognize are included in general and administrative expenses in our condensed consolidated statements of comprehensive income.  

Pursuant to our property management agreement with RMR LLC, we recognized aggregate net property management and construction supervision fees of $3,415 and $2,338 for the three months ended September 30, 2018 and 2017, respectively, and $10,201 and $7,371 for the nine months ended September 30, 2018 and 2017, respectively. These amounts are included in other operating expenses or have been capitalized, as appropriate, in our condensed consolidated financial statements.

We are generally responsible for all our operating expenses, including certain expenses incurred by RMR LLC on our behalf. Our property level operating expenses, including certain payroll and related costs incurred by RMR LLC, are generally incorporated into rents charged to our tenants. We reimbursed RMR LLC $5,100 and $3,436 for property management related expenses for the three months ended September 30, 2018 and 2017, respectively, and $15,121 and $10,482 for property management related expenses for the nine months ended September 30, 2018 and 2017, respectively, which amounts are included in other operating expenses in our condensed consolidated statements of comprehensive income. In addition, we are responsible for our share of RMR LLC’s costs for providing our internal audit function. The amounts we recognized as expense for internal audit costs were $50 and $67 for the three months ended September 30, 2018 and 2017, respectively, and $173 and $202 for the nine months ended September 30, 2018 and 2017, respectively. These amounts are included in general and administrative expenses in our condensed consolidated statements of comprehensive income.

Note 11.   Related Person Transactions

We have relationships and historical and continuing transactions with RMR LLC, RMR Inc., SIR, AIC and others related to them, including other companies to which RMR LLC or its subsidiaries provide management services and which have trustees, directors and officers who are also our Trustees or officers. 

Our Manager, RMR LLC. We have two agreements with RMR LLC to provide management services to us. See Note 10 for further information regarding our management agreements with RMR LLC.


15

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

We lease office space to RMR LLC in certain of our properties for RMR LLC's property management offices. We recognized rental income from RMR LLC for leased office space of $263 and $90 for the three months ended September 30, 2018 and 2017, respectively, and $763 and $272 for the nine months ended September 30, 2018 and 2017, respectively. Our office space leases with RMR LLC are terminable by RMR LLC if our management agreements with RMR LLC are terminated.

We have historically granted share awards to our officers and other RMR LLC employees under our equity compensation plans. In September 2018 and 2017, we granted annual awards of 58,700 and 57,350 of our common shares, respectively, to our officers and other employees of RMR LLC. In September 2018 and 2017, we purchased 18,875 and 13,636 of our common shares, respectively, valued at the closing price of our common shares on Nasdaq on the applicable date of purchase, in satisfaction of tax withholding and payment obligations in connection with the vesting of awards of our common shares to our officers and other employees of RMR LLC. We include amounts recognized as expense for share awards to RMR LLC employees in general and administrative expenses in our condensed consolidated statements of comprehensive income.

RMR Inc. RMR LLC is a majority owned subsidiary of RMR Inc. and RMR Inc. is the managing member of RMR LLC. Adam D. Portnoy, one of our Managing Trustees, is the sole trustee, an officer and the controlling shareholder of ABP Trust, which is the controlling shareholder of RMR Inc., a managing director, president and chief executive officer of RMR Inc. and an officer of RMR LLC. Mark L. Kleifges, our other Managing Trustee and our Chief Financial Officer and Treasurer, and David M. Blackman, our President and Chief Executive Officer, also serve as executive officers of RMR LLC. Mr. Kleifges has announced his retirement from his position with us, effective December 31, 2018, and Mr. Blackman has been elected to be our other Managing Trustee, effective January 1, 2019. RMR LLC provides management services to us. As of September 30, 2018, we owned 1,214,225 shares of class A common stock of RMR Inc. See Note 8 for further information regarding our investment in RMR Inc.

SIR. As of September 30, 2018, we owned 24,918,421 SIR common shares, or approximately 27.8% of its outstanding common shares. As described further in Note 1, on September 14, 2018, we and SIR entered into the Merger Agreement, and on October 9, 2018, we completed the Secondary Sale. Adam D. Portnoy, one of our Managing Trustees, also serves as a managing trustee of SIR, and our President and Chief Executive Officer also serves as a managing trustee and the president and chief executive officer of SIR. RMR LLC provides management services to SIR and us. See Note 1 for further information regarding the Merger Agreement and the Secondary Sale and Notes 12 and 13 for further information regarding our investment in SIR.
AIC. We, ABP Trust, SIR and four other companies to which RMR LLC provides management services currently own AIC in equal amounts. We and the other AIC shareholders participate in a combined property insurance program arranged and reinsured in part by AIC. We paid aggregate annual premiums, including taxes and fees, of approximately $1,211 in connection with the renewal of this insurance program for the policy year ending June 30, 2019, which amount may be adjusted from time to time as we acquire and dispose of properties that are included in this insurance program.
As of September 30, 2018 and December 31, 2017, our investment in AIC had a carrying value of $9,276 and $8,304, respectively. These amounts are included in other assets in our condensed consolidated balance sheets. We recognized income related to our investment in AIC, which is presented as equity in earnings of investees in our condensed consolidated statements of comprehensive income. Our other comprehensive income includes our proportionate part of unrealized gains on securities that are owned by AIC related to our investment in AIC.
For further information about these and other such relationships and certain other related person transactions, refer to our Annual Report.

Note 12.   Equity Investment in Select Income REIT
 
As described in Note 11, as of September 30, 2018, we owned 24,918,421, or approximately 27.8%, of the then outstanding SIR common shares. SIR is a REIT that primarily owns single tenant, net leased properties. As described in Note 1, we completed the Secondary Sale on October 9, 2018. We expect to record a loss on the Secondary Sale of approximately $19,372 in the fourth quarter of 2018.

We accounted for our investment in SIR under the equity method. As a result of the Secondary Sale, our equity method investment in SIR has been reclassified to discontinued operations in our condensed consolidated financial statements as of September 30, 2018. See Note 13 for further information regarding discontinued operations.

16

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)


     Under the equity method, we recorded our proportionate share of SIR’s net income as equity in earnings of SIR included in discontinued operations in our condensed consolidated statements of comprehensive income. We recorded $9,253 and $9,453 of equity in the earnings of SIR for the three months ended September 30, 2018 and 2017, respectively, and $23,843 and $20,271 of equity in the earnings of SIR for the nine months ended September 30, 2018 and 2017, respectively. Our other comprehensive income includes our proportionate share of SIR’s unrealized gains (losses) of ($47) and $1,236 for the three months ended September 30, 2018 and 2017, respectively, and $28 and $5,339 for the nine months ended September 30, 2018 and 2017, respectively.
 
The adjusted GAAP cost basis of our investment in SIR was less than our proportionate share of SIR’s total shareholders’ equity book value on the dates we acquired the shares. As of September 30, 2018 and December 31, 2017, our basis difference was $120,492 and $87,137, respectively, and as required under GAAP, we were accreting this basis difference to earnings over the estimated remaining useful lives of certain real estate assets and intangible assets and liabilities owned by SIR. The increase in the basis difference primarily related to SIR's capital finance activities and changes in its net equity during the nine months ended September 30, 2018. This accretion increased our equity in the earnings of SIR by $1,044 and $736 for the three months ended September 30, 2018 and 2017, respectively, and $3,131 and $2,209 for the nine months ended September 30, 2018 and 2017, respectively.
    
As of September 30, 2018, our investment in SIR had a carrying value of $453,275 and a market value, based on the closing price of SIR common shares on Nasdaq on September 30, 2018, of $546,710.
 
We received aggregate cash distributions from SIR of $12,708 during both the three months ended September 30, 2018 and 2017, and $38,124 and $38,125 during the nine months ended September 30, 2018 and 2017, respectively.

During the three months ended September 30, 2018 and 2017, SIR issued a net amount of 45,774 and 44,724 common shares, respectively. During the nine months ended September 30, 2018 and 2017, SIR issued a net amount of 63,157 and 59,502 common shares, respectively. We recognized a gain on issuance of shares by SIR of $21 and $51 for the three months ended September 30, 2018 and 2017, respectively, and a gain on issuance of shares by SIR of $29 and $72 for the nine months ended September 30, 2018 and 2017, respectively, as a result of the per share issuance price of these SIR common shares being above the then average per share carrying value of our SIR common shares.
 

17

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

The following presents summarized financial data of SIR as reported in SIR’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2018, or the SIR Quarterly Report. References in our condensed consolidated financial statements to the SIR Quarterly Report are included as references to the source of the data only, and the information in the SIR Quarterly Report is not incorporated by reference into our condensed consolidated financial statements.
 
Condensed Consolidated Balance Sheets
 
 
September 30,
 
December 31,
 
 
2018
 
2017
Real estate properties, net
 
$
3,926,606

 
$
3,905,616

Acquired real estate leases, net
 
433,947

 
477,577

Properties held for sale
 
15,289

 
5,829

Cash and cash equivalents
 
25,982

 
658,719

Rents receivable, net
 
131,642

 
127,672

Other assets, net
 
188,033

 
127,617

Total assets
 
$
4,721,499

 
$
5,303,030

 
 
 
 
 
Unsecured revolving credit facility
 
$
108,000

 
$

Industrial Logistics Properties Trust revolving credit facility
 
380,000

 
750,000

Unsecured term loan, net
 

 
348,870

Senior unsecured notes, net
 
1,430,688

 
1,777,425

Mortgage notes payable, net
 
210,624

 
210,785

Assumed real estate lease obligations, net
 
62,176

 
68,783

Other liabilities
 
150,371

 
155,348

Total shareholders' equity attributable to SIR
 
2,061,556

 
1,991,819

Noncontrolling interest in consolidated subsidiary
 
318,084

 

Total liabilities and shareholders' equity
 
$
4,721,499

 
$
5,303,030

 

18

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

Condensed Consolidated Statements of Income
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Rental income
 
$
101,833

 
$
98,635

 
$
298,003

 
$
293,020

Tenant reimbursements and other income
 
20,048

 
19,379

 
60,514

 
57,158

Total revenues
 
121,881

 
118,014

 
358,517

 
350,178

 
 
 
 
 
 
 
 
 
Real estate taxes
 
12,518

 
11,489

 
36,748

 
33,168

Other operating expenses
 
14,814

 
14,649

 
43,714

 
41,039

Depreciation and amortization
 
35,371

 
34,713

 
105,326

 
102,770

Acquisition and transaction related costs
 
3,796

 

 
3,796

 

General and administrative
 
15,331

 
1,608

 
47,353

 
24,697

Write-off of straight line rents, net
 

 

 
10,626

 
12,517

Loss on asset impairment
 

 

 

 
4,047

Loss on impairment of real estate assets
 
9,706

 

 
9,706

 
229

Total expenses
 
91,536

 
62,459

 
257,269

 
218,467

Operating income
 
30,345

 
55,555

 
101,248

 
131,711

 
 
 
 
 
 
 
 
 
Dividend income
 
397

 
397

 
1,190

 
1,190

Unrealized gain on equity securities
 
22,771

 

 
53,159

 

Interest income
 
133

 
19

 
753

 
39

Interest expense
 
(23,287
)
 
(24,383
)
 
(69,446
)
 
(68,278
)
Loss on early extinguishment of debt
 

 

 
(1,192
)
 

Income before income tax expense, equity in earnings of an investee
 


 


 
 
 


and gain on of real estate
 
30,359

 
31,588

 
85,712

 
64,662

Income tax expense
 
(185
)
 
(177
)
 
(446
)
 
(364
)
Equity in earnings of an investee
 
831

 
31

 
882

 
533

Net income before gain on sale of real estate
 
31,005

 
31,442

 
86,148

 
64,831

Gain on sale of real estate
 
4,075

 

 
4,075

 

Net income
 
35,080

 
31,442

 
90,223

 
64,831

Net income allocated to noncontrolling interest
 
(5,597
)
 

 
(15,841
)
 

Net income attributed to SIR
 
$
29,483

 
$
31,442

 
$
74,382

 
$
64,831

 
 
 
 
 
 
 
 
 
Weighted average common shares outstanding (basic)
 
89,410

 
89,355

 
89,395

 
89,341

Weighted average common shares outstanding (diluted)
 
89,437

 
89,379

 
89,411

 
89,364

Net income attributed to SIR per common share (basic and diluted)
 
$
0.33

 
$
0.35

 
$
0.83

 
$
0.73

 
Note 13.   Discontinued Operations

Our equity method investment in SIR has been reclassified to discontinued operations in our condensed consolidated financial statements as of September 30, 2018. See Notes 1 and 12 for further information regarding our equity method investment in SIR and the Secondary Sale.

In August 2017, we sold one vacant office property (one building) in Falls Church, VA with 164,746 rentable square feet and a net book value of $12,901 as of the date of sale for $13,523, excluding closing costs. Results of operations for this property, which qualified as held for sale prior to our adoption in 2014 of ASU No. 2014-8, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity, are classified as discontinued operations in our condensed consolidated financial statements.

19

GOVERNMENT PROPERTIES INCOME TRUST
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)

Below are the components of our income from discontinued operations:
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
2017
 
2018
 
2017
Equity in earnings of Select Income REIT
 
$
9,253

 
$
9,453

 
$
23,843

 
$
20,271

Net gain on issuance of shares by Select Income REIT
 
21

 
51

 
29

 
72

Income from property classified as discontinued operations
 

 
462

 

 
173

Income from discontinued operations
 
$
9,274

 
$
9,966

 
$
23,872

 
$
20,516



20


Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following information should be read in conjunction with our condensed consolidated financial statements and accompanying notes included in Part I, Item 1 of this Quarterly Report on Form 10-Q and with our Annual Report on    Form 10-K for the year ended December 31, 2017, or our Annual Report.
 
OVERVIEW (dollars in thousands, except per share data)
 
We are a real estate investment trust, or REIT, organized under Maryland law. As of September 30, 2018, we wholly owned 105 properties (164 buildings) and had a noncontrolling ownership interest in two properties (three buildings) totaling 443,867 rentable square feet through two unconsolidated joint ventures in which we owned 50% and 51% interests. As of September 30, 2018, our consolidated properties are located in 30 states and the District of Columbia and contain 17,045,951 rentable square feet, of which 42.0% was leased to the U.S. Government, 14.7% was leased to 13 state governments, 1.5% was leased to three other government tenants, 5.8% was leased to government contractor tenants, 29.3% was leased to various other non-governmental organizations and 6.7% was available for lease. In aggregate, government tenants were responsible for 62.5% and 87.5% of our annualized rental income as of September 30, 2018 and 2017, respectively. The term annualized rental income as used herein is defined as the annualized contractual base rents from our tenants pursuant to our lease agreements as of the measurement date, plus straight line rent adjustments and estimated recurring expense reimbursements to be paid to us, and excluding lease value amortization.

In September 2018, we and our wholly owned subsidiary, GOV MS REIT, or Merger Sub, entered into an Agreement and Plan of Merger, or the Merger Agreement, with Select Income REIT, or SIR, pursuant to which SIR has agreed to merge with and into Merger Sub, with Merger Sub continuing as the surviving entity in the merger, or the Merger. The aggregate transaction value, based on the closing price of our common shares on September 30, 2018 of $11.29 per share, is approximately $2,738,488, excluding estimated closing costs of $40,000 and including the repayment or assumption of approximately $1,720,000 of SIR debt. Pursuant to the terms of the Merger Agreement, SIR shareholders will receive 1.04, or the Exchange Ratio, of our newly issued common shares for each common share of SIR. As a condition of the Merger, SIR will declare and, at least one business day prior to the closing date of the Merger, pay a pro rata distribution to SIR's shareholders of all 45,000,000 common shares of beneficial interest of Industrial Logistics Properties Trust, or ILPT, that SIR owns, or the ILPT Distribution, subject to certain conditions. Following completion of the Merger, we will acquire SIR's remaining property portfolio (following the ILPT Distribution) of 99 properties with approximately 16,538,462 rentable square feet.  The combined company is expected to focus its investments in office properties primarily in markets that it believes have strong economic fundamentals to support growth, including (i) properties primarily leased to single tenants that are strategic to the tenants and which may include built-to-suit properties, corporate headquarters and buildings where tenants have invested meaningful capital, with a minimum remaining lease term of at least seven years and (ii) properties leased to government tenants, including single and multi-tenant buildings, with a focus on agencies that have high security needs or a mission strategic to the buildings' locations. The combined company is also expected to seek investments primarily in first generation buildings where it believes that there is a reasonably high likelihood of renewing the tenants in place and where it expects ongoing capital needs to be relatively modest when compared to older buildings. The Merger and the other transactions contemplated by the Merger Agreement, including the Secondary Sale (as defined below) and the ILPT Distribution, are collectively referred to herein as the Transactions. For more information regarding the Merger Agreement and other related Transactions, see Notes 1, 11, 12 and 13 to the Notes to our condensed consolidated financial statements included in Part 1, Item 1 of this Quarterly Report on Form 10-Q.

As of September 30, 2018, we owned 24,918,421 common shares, or approximately 27.8% of the then outstanding common shares, of SIR. SIR is a REIT that owns properties that are primarily net leased to single tenants. In October 2018, we sold our entire investment in SIR, or the Secondary Sale, in an underwritten public offering at a price of $18.25 per share, raising net proceeds of approximately $434,700 after deducting underwriting discounts and estimated offering expenses. We used the net proceeds from the Secondary Sale to repay amounts outstanding under our revolving credit facility. See Notes 1, 11, 12 and 13 to our condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for more information regarding the sale of our investment in SIR and our relationships with SIR. We accounted for our investment in SIR under the equity method. As a result of the Secondary Sale our equity method investment in SIR has been reclassified to discontinued operations in our condensed consolidated financial statements.

On October 2, 2017, we acquired First Potomac Realty Trust, or FPO, pursuant to a merger transaction, as a result of which we acquired 35 office properties (72 buildings) with 6,028,072 rentable square feet and FPO's 50% and 51% interests in two joint ventures that owned two properties (three buildings) with 443,867 rentable square feet, or collectively, the FPO Transaction.  The properties we acquired in the FPO Transaction significantly increased our property portfolio and the

21


proportion of our total annualized revenues that we earn from properties located in the metropolitan Washington, D.C. market area, which includes Washington, D.C., Northern Virginia and suburban Maryland.

Consolidated Property Operations
 
As of September 30, 2018, 93.3% of our consolidated rentable square feet was leased, compared to 95.0% of our consolidated rentable square feet as of September 30, 2017. Occupancy data for our consolidated properties as of September 30, 2018 and 2017 is as follows (square feet in thousands):
 
 
 
 
 
 
Comparable
 
 
All Consolidated Properties (1)
 
Consolidated Properties (2)
 
 
September 30,
 
September 30,
 
 
2018
 
2017
 
2018
 
2017
Total properties
 
105

 
74

 
69

 
69

Total buildings
 
164

 
96

 
91

 
91

Total square feet (3)
 
17,046

 
11,517

 
10,948

 
10,927

Percent leased (4)     
 
93.3
%
 
95.0
%
 
94.6
%
 
95.3
%

(1)
Based on consolidated properties we owned on September 30, 2018 and 2017, respectively.
(2)
Based on consolidated properties we owned on September 30, 2018 and which we owned continuously since January 1, 2017. Our comparable properties decreased from 70 properties (90 buildings) at September 30, 2017 as a result of our sale of four properties (four buildings) since January 1, 2017, partially offset by our acquisition of three properties (five buildings) during 2016.
(3)
Subject to changes when space is re-measured or re-configured for tenants.
(4)
Percent leased includes (i) space being fitted out for tenant occupancy pursuant to our lease agreements, if any, and (ii) space which is leased, but is not occupied or is being offered for sublease by tenants, if any, as of the measurement date.
 
The average annualized effective rental rate per square foot for our consolidated properties for the three and nine months ended September 30, 2018 and 2017 are as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Average annualized effective rental rate per square foot (1):
 
 
 
 
 
 
 
 
  All properties (2)
 
$
26.86

 
$
25.89

 
$
26.81

 
$
25.74

  Comparable properties (3)
 
$
25.70

 
$
25.42

 
$
25.92

 
$
25.43


(1)
Average annualized effective rental rate per square foot represents annualized total rental income during the period specified divided by the average rentable square feet leased during the period specified.
(2)
Based on consolidated properties we owned on September 30, 2018 and 2017, respectively.
(3)
Based on consolidated properties we owned on September 30, 2018 and which we owned continuously since July 1, 2017 and January 1, 2017, respectively.


22


During the three and nine months ended September 30, 2018, changes in rentable square feet leased and available for lease at our consolidated properties were as follows: 
 
 
Three Months Ended September 30, 2018
 
Nine Months Ended September 30, 2018
 
 
 
 
Available
 
 
 
 
 
Available
 
 
 
 
Leased
 
for Lease
 
Total
 
Leased
 
for Lease
 
Total
Beginning of period
 
16,021,566

 
1,024,385

 
17,045,951

 
16,477,339

 
1,021,999

 
17,499,338

Changes resulting from:
 
 

 
 

 
 
 
 

 
 

 
 

Disposition of properties
 

 

 

 
(466,736
)
 
(24,418
)
 
(491,154
)
Lease expirations
 
(306,677
)
 
306,677

 

 
(998,071
)
 
998,071

 

Lease renewals (1)
 
97,670

 
(97,670
)
 

 
573,583

 
(573,583
)
 

New leases (1)
 
84,550

 
(84,550
)
 

 
310,994

 
(285,415
)
 
25,579

Re-measurements (2)
 

 

 

 

 
12,188

 
12,188

End of period
 
15,897,109

 
1,148,842

 
17,045,951

 
15,897,109

 
1,148,842

 
17,045,951


(1)
Based on leases entered into during the three and nine months ended September 30, 2018 and an expansion of 25,579 rentable square feet completed at an existing property during the first quarter of 2018.
(2)
Rentable square feet is subject to changes when space is re-measured or re-configured for tenants.
 
Leases at our consolidated properties totaling 306,677 and 998,071 rentable square feet expired during the three and nine months ended September 30, 2018, respectively. During the three and nine months ended September 30, 2018, we entered leases totaling 182,220 and 858,998 rentable square feet, including lease renewals of 97,670 and 573,583 rentable square feet, respectively. The weighted (by rentable square feet) average rental rates for leases of 18,110 and 274,860 rentable square feet entered with government tenants during the three and nine months ended September 30, 2018 decreased by 8.0% and increased by 6.6%, respectively, when compared to the weighted (by rentable square feet) average prior rents for the same space. The weighted (by rentable square feet) average rental rates for leases of 164,110 and 584,138 rentable square feet entered with non-government tenants during the three and nine months ended September 30, 2018 increased by 0.3% and decreased by 0.7%, respectively, when compared to the weighted (by rentable square feet) average rental rates previously charged for the same space.
 
During the three and nine months ended September 30, 2018, changes in effective rental rates per square foot achieved for new leases and lease renewals at our consolidated properties that commenced during the three and nine months ended September 30, 2018, when compared to prior effective rental rates per square foot in effect for the same space (and excluding space acquired vacant), were as follows: 
 
 
Three Months Ended September 30, 2018
 
Nine Months Ended September 30, 2018
 
 
Old Effective
 
New Effective
 
    
 
Old Effective
 
New Effective
 
    
 
 
Rent Per
 
Rent Per
 
Rentable
 
Rent Per
 
Rent Per
 
Rentable
 
 
Square Foot (1)
 
Square Foot (1)
 
Square Feet
 
Square Foot (1)
 
Square Foot (1)
 
Square Feet
New leases
 
$
22.64

 
$
21.57

 
82,079

 
$
20.82

 
$
24.28

 
290,582

Lease renewals
 
$
28.79

 
$
28.75

 
78,267

 
$
24.47

 
$
25.91

 
694,069

Total leasing activity
 
$
25.64

 
$
25.07

 
160,346

 
$
23.39

 
$
25.43

 
984,651

(1)
Effective rental rate includes contractual base rents from our tenants pursuant to our lease agreements, plus straight line rent adjustments and estimated expense reimbursements to be paid to us, and excluding lease value amortization.


23


During the three and nine months ended September 30, 2018, commitments made for expenditures, such as tenant improvements and leasing costs, in connection with leasing space at our consolidated properties were as follows:
 
 
Three Months Ended September 30, 2018
 
 
Government
 
Non-Government
 
 
 
 
Leases
 
Leases
 
Total
Rentable square feet leased
 
18,110

 
164,110

 
182,220

Tenant leasing costs and concession commitments (1) (in thousands)
 
$
1,181

 
$
5,298

 
$
6,479

Tenant leasing costs and concession commitments per rentable square foot (1)
 
$
65.21

 
$
32.28

 
$
35.56

Weighted (by square feet) average lease term (years)
 
19.7

 
6.8

 
8.1

Total leasing costs and concession commitments per rentable square foot per year (1)
 
$
3.32

 
$
4.76

 
$
4.41


 
 
Nine Months Ended September 30, 2018
 
 
Government
 
Non-Government
 
 
 
 
Leases
 
Leases
 
Total
Rentable square feet leased
 
274,860

 
584,138

 
858,998

Tenant leasing costs and concession commitments (1) (in thousands)
 
$
7,813

 
$
13,474

 
$
21,287

Tenant leasing costs and concession commitments per rentable square foot (1)
 
$
28.43

 
$
23.07

 
$
24.78

Weighted (by square feet) average lease term (years)
 
9.2

 
5.0

 
6.4

Total leasing costs and concession commitments per rentable square foot per year (1)
 
$
3.09

 
$
4.58

 
$
3.89


(1)
Includes commitments made for leasing expenditures and concessions, such as tenant improvements, leasing commissions, tenant reimbursements and free rent.

During the three and nine months ended September 30, 2018 and 2017, amounts capitalized at our consolidated properties for tenant improvements, leasing costs, building improvements and development and redevelopment activities were as follows (dollars in thousands):
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
 
 
2018
 
2017
 
2018
 
2017
Tenant improvements (1)
 
$
2,293

 
$
3,213

 
$
8,990

 
$
6,692

Leasing costs (2)
 
$
1,831

 
$
1,993

 
$
5,443

 
$
4,051

Building improvements (3)
 
$
6,707

 
$
2,640

 
$
13,462

 
$
8,883

Development, redevelopment and other activities (4)
 
$
664

 
$
3,132

 
$
2,814

 
$
16,362


(1)
Tenant improvements include capital expenditures used to improve tenants’ space or amounts paid directly to tenants to improve their space.
(2)
Leasing costs include leasing related costs, such as brokerage commissions and other tenant inducements.
(3)
Building improvements generally include expenditures to replace obsolete building components and expenditures that extend the useful life of existing assets.
(4)
Development, redevelopment and other activities generally include (i) capital expenditures that are identified at the time of a property acquisition and incurred within a short time period after acquiring the property, and (ii) capital expenditure projects that reposition a property or result in new sources of revenue.
 
As of September 30, 2018, we have estimated unspent leasing related obligations of $34,048.
 
We believe that current government budgetary methodology, spending priorities and the current U.S. presidential administration's views on the size and scope of government employment have resulted in a decrease in government employment, government tenants reducing their space utilization per employee and consolidation of government tenants into existing government owned properties, thereby reducing the demand for government leased space. Our historical experience with respect to properties of the type we own that are majority leased to government tenants has been that government tenants frequently renew leases to avoid the costs and disruptions that may result from relocating their operations. However, efforts to reduce space utilization rates may result in our tenants exercising early termination rights under our leases, vacating our properties upon expiration of our leases in order to relocate, or renewing their leases for less space than they currently occupy. Also, our government tenants' desires to reconfigure leased office space to reduce utilization per employee may require us to spend significant amounts for tenant improvements, and tenant relocations have become more prevalent than our past experiences in instances where efforts by government tenants to reduce their space utilization require a significant reconfiguration of currently leased space. Increasing uncertainty with respect to government agency budgets and funding to

24


implement relocations, consolidations and reconfigurations recently has resulted in delayed decisions by some of our government tenants and their reliance on short term lease renewals. At present, we are unable to reasonably project what the financial impact of market conditions or changing government circumstances will be on our financial results for future periods.

As of September 30, 2018, we derived 44.1% of our annualized revenues from our consolidated properties located in the metropolitan Washington, D.C. market area. A downturn in economic conditions in this area could result in reduced demand from tenants for our properties in this area or reduce the rents that our tenants in this area are willing to pay when our leases expire or terminate and when renewal or new terms are negotiated. Additionally, in recent years there has been a decrease in demand for new leased space by the U.S. Government in the metropolitan Washington, D.C. market area, and that could increase competition for government tenants and adversely affect our ability to retain U.S. Government tenants when our leases expire.

The U.S. Internal Revenue Service, or the IRS, has publicly stated that it plans to discontinue its paper tax return processing operations at our property located in Fresno, CA in 2021. The IRS lease for this property, which accounted for approximately 2.1% of our annualized rental income as of September 30, 2018, expires in the fourth quarter of 2021. The IRS has also publicly stated that it plans to discontinue its paper tax return processing operations in Covington, KY in 2019. Our property located in Florence, KY is leased to the IRS and we believe it is used to support the Covington, KY operations. This IRS lease, which accounted for approximately 0.6% of our annualized rental income as of September 30, 2018, expires in the second quarter of 2022, but is subject to possible early termination by our tenant. Despite its public announcements the IRS has not provided us any official notices of its intentions regarding these properties. 

As of September 30, 2018, we had leases at our consolidated properties totaling 2,675,810 rentable square feet that were scheduled to expire through September 30, 2019. As of October 30, 2018, tenants with leases totaling 494,470 rentable square feet that are scheduled to expire through September 30, 2019, have notified us that they do not plan to renew their leases upon expiration and we cannot be sure as to whether other tenants may or may not renew their leases upon expiration.  Based upon current market conditions and tenant negotiations for leases scheduled to expire through September 30, 2019, we expect that the rental rates we are likely to achieve on new or renewed leases for space under leases expiring through September 30, 2019 will, in the aggregate and on a weighted (by annualized revenues) average basis, be lower than the rates currently being paid, thereby generally resulting in lower revenue from the same space. We cannot be sure of the rental rates which will result from our ongoing negotiations regarding lease renewals or any new leases we may enter; also, we may experience material declines in our rental income due to vacancies upon lease expirations or early terminations. Prevailing market conditions and government and other tenants' needs at the time we negotiate and enter leases or lease renewals will generally determine rental rates and demand for leased space at our properties, and market conditions and government and other tenants' needs are beyond our control.
 

25


As of September 30, 2018, lease expirations at our consolidated properties by year are as follows (dollars in thousands):
 
 
 
Number
 
Expirations
 
 
 
 
 
Annualized
 
 
 
 
 
 
of
 
of Leased
 
 
 
Cumulative
 
Rental
 
 
 
Cumulative
 
 
Tenants
 
Square
 
Percent
 
Percent
 
Income
 
Percent
 
Percent
Year (1)
 
Expiring
 
Feet (2)
 
of Total
 
of Total
 
Expiring
 
of Total
 
of Total
2018
 
52

 
819,971

 
5.2
%
 
5.2
%
 
$
27,402

 
6.7
%
 
6.7
%
2019
 
91

 
2,584,697

 
16.3
%
 
21.5
%
 
74,181

 
18.1
%
 
24.8
%
2020
 
99

 
2,232,317

 
14.0
%
 
35.5
%
 
54,766

 
13.4
%
 
38.2
%
2021
 
91

 
1,814,185

 
11.4
%
 
46.9
%
 
37,653

 
9.2
%
 
47.4
%
2022
 
96

 
1,689,207

 
10.6