10-Q 1 sir_63017x10qxdocument.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 June 30, 2017

OR

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
Commission File Number 1-35442 

SELECT INCOME REIT
(Exact Name of Registrant as Specified in Its Charter)

Maryland
 
45-4071747
(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)

617-796-8303
(Registrant’s Telephone Number, Including Area Code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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.  (Check One): 
Large accelerated filer ☒
 
Accelerated filer ☐
 
 
 
Non-accelerated filer ☐
 
Smaller reporting company ☐
(Do not check if a 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 in 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 July 24, 2017: 89,442,647



SELECT INCOME REIT
 
FORM 10-Q
 
June 30, 2017
 
INDEX
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
References in this Quarterly Report on Form 10-Q to the Company, SIR, we, us or our include Select Income REIT and its consolidated subsidiaries unless otherwise expressly stated or the context indicates otherwise.


2


PART I Financial Information
 
Item 1.  Financial Statements
 
SELECT INCOME REIT
 
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except per share data)
(unaudited)
 
 
 
June 30,
 
December 31,
 
 
2017
 
2016
ASSETS
 
 
 
 
Real estate properties:
 
 
 
 
Land
 
$
1,035,579

 
$
1,038,686

Buildings and improvements
 
3,132,584

 
3,103,734

 
 
4,168,163

 
4,142,420

Accumulated depreciation
 
(275,434
)
 
(242,628
)
 
 
3,892,729

 
3,899,792

Properties held for sale
 
23,089

 

Acquired real estate leases, net
 
496,792

 
506,298

Cash and cash equivalents
 
21,683

 
22,127

Restricted cash
 
69

 
44

Rents receivable, including straight line rents of $111,821 and $117,008, respectively, net of allowance for doubtful accounts of $895 and $873, respectively
 
114,430

 
124,089

Deferred leasing costs, net
 
11,380

 
10,051

Other assets, net
 
113,418

 
77,281

Total assets
 
$
4,673,590

 
$
4,639,682

 
 
 
 
 
LIABILITIES AND SHAREHOLDERS' EQUITY
 
 
 
 
Unsecured revolving credit facility
 
$
67,000

 
$
327,000

Unsecured term loan, net
 
348,622

 
348,373

Senior unsecured notes, net
 
1,774,769

 
1,430,300

Mortgage notes payable, net
 
245,235

 
245,643

Accounts payable and other liabilities
 
95,353

 
101,605

Assumed real estate lease obligations, net
 
73,200

 
77,622

Rents collected in advance
 
16,436

 
18,815

Security deposits
 
8,332

 
11,887

Due to related persons
 
13,389

 
4,475

Total liabilities
 
2,642,336

 
2,565,720

 
 
 
 
 
Commitments and contingencies
 


 


 
 
 
 
 
Shareholders' equity:
 
 
 
 
Common shares of beneficial interest, $.01 par value: 125,000,000 shares authorized; 89,442,647 and 89,427,869 shares issued and outstanding, respectively
 
894

 
894

Additional paid in capital
 
2,180,054

 
2,179,669

Cumulative net income
 
474,696

 
441,307

Cumulative other comprehensive income
 
35,206

 
20,472

Cumulative common distributions
 
(659,596
)
 
(568,380
)
Total shareholders' equity
 
2,031,254

 
2,073,962

Total liabilities and shareholders' equity
 
$
4,673,590

 
$
4,639,682

 
See accompanying notes

3


SELECT INCOME REIT
 
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(amounts in thousands, except per share data)
(unaudited)
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
 
 
 
 
REVENUES:
 
 
 
 
 
 
 
 
Rental income
 
$
97,041

 
$
96,615

 
$
194,385

 
$
194,475

Tenant reimbursements and other income
 
18,829

 
18,289

 
37,779

 
37,661

Total revenues
 
115,870

 
114,904

 
232,164

 
232,136

 
 
 
 
 
 
 
 
 
EXPENSES:
 
 

 
 

 
 

 
 

Real estate taxes
 
10,836

 
10,522

 
21,679

 
20,810

Other operating expenses
 
13,523

 
12,635

 
26,390

 
25,593

Depreciation and amortization
 
34,317

 
33,405

 
68,057

 
66,874

Acquisition related costs
 

 

 

 
58

General and administrative
 
8,181

 
7,374

 
23,069

 
14,350

Write-off of straight line rents receivable, net
 

 

 
12,517

 

Loss on asset impairment
 

 

 
4,047

 

Loss on impairment of real estate assets
 
229

 

 
229

 

Total expenses
 
67,086

 
63,936

 
155,988

 
127,685

 
 
 
 
 
 
 
 
 
Operating income
 
48,784

 
50,968

 
76,176

 
104,451

 
 
 
 
 
 
 
 
 
Dividend income
 
396

 
475

 
793

 
475

Interest expense (including net amortization of debt issuance costs, premiums and discounts of $1,568, $1,376, $2,972 and $2,750, respectively)
 
(22,808
)
 
(20,584
)
 
(43,895
)
 
(41,193
)
Income before income tax expense and equity in earnings of an investee
 
26,372

 
30,859

 
33,074

 
63,733

Income tax expense
 
(85
)
 
(124
)
 
(187
)
 
(263
)
Equity in earnings of an investee
 
374

 
17

 
502

 
94

Net income
 
26,661

 
30,752

 
33,389

 
63,564

Net income allocated to noncontrolling interest
 

 

 

 
(33
)
Net income attributed to SIR
 
26,661

 
30,752

 
33,389

 
63,531

 
 
 

 
 

 
 
 
 
Other comprehensive income (loss):
 
 
 
 
 
 

 
 

Unrealized gain (loss) on investment in available for sale securities
 
(1,348
)
 
9,457

 
14,520

 
26,278

Unrealized gain (loss) on interest rate swap
 
(97
)
 
(308
)
 
34

 
(1,210
)
Equity in unrealized gain of an investee
 
58

 
43

 
180

 
95

Other comprehensive income (loss)
 
(1,387
)
 
9,192

 
14,734

 
25,163

Comprehensive income
 
25,274

 
39,944

 
48,123

 
88,727

Comprehensive income allocated to noncontrolling interest
 

 

 

 
(33
)
Comprehensive income attributed to SIR
 
$
25,274

 
$
39,944

 
$
48,123

 
$
88,694

 
 
 
 
 
 
 
 
 
Weighted average common shares outstanding - basic
 
89,338

 
89,292

 
89,334

 
89,289

Weighted average common shares outstanding - diluted
 
89,362

 
89,315

 
89,356

 
89,306

 
 
 
 
 
 
 
 
 
Net income attributed to SIR per common share - basic and diluted
 
$
0.30

 
$
0.34

 
$
0.37

 
$
0.71

 

See accompanying notes


4


SELECT INCOME REIT
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(unaudited)
 
 
Six Months Ended June 30,
 
2017
 
2016
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
33,389

 
$
63,564

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation
39,927

 
38,931

Net amortization of debt issuance costs, premiums and discounts
2,972

 
2,750

Amortization of acquired real estate leases and assumed real estate lease obligations
26,520

 
26,510

Amortization of deferred leasing costs
792

 
676

Write-off of straight line rents and provision for losses on rents receivable
12,564

 
150

Straight line rental income
(10,780
)
 
(12,571
)
Impairment losses
4,276

 

Other non-cash expenses, net
(359
)
 
(236
)
Equity in earnings of an investee
(502
)
 
(94
)
Change in assets and liabilities:
 
 
 
Restricted cash
(25
)
 
1,127

Rents receivable
4,136

 
1,443

Deferred leasing costs
(2,005
)
 
(3,408
)
Other assets
(270
)
 
1,233

Accounts payable and other liabilities
(2,873
)
 
(3,973
)
Rents collected in advance
(2,379
)
 
(1,976
)
Security deposits
184

 
(21
)
Due to related persons
8,914

 
564

Net cash provided by operating activities
114,481

 
114,669

 
 
 
 
CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Real estate acquisitions and deposits
(80,205
)
 
(1,000
)
Real estate improvements
(8,177
)
 
(4,255
)
Net cash used in investing activities
(88,382
)
 
(5,255
)
 
 
 
 
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of senior unsecured notes, after discounts
345,394

 

Proceeds from borrowings
145,000

 
65,000

Payments of borrowings
(422,534
)
 
(88,127
)
Payment of debt issuance costs
(3,187
)
 

Distributions to common shareholders
(91,216
)
 
(89,374
)
Purchase of noncontrolling interest

 
(3,908
)
Distributions to noncontrolling interest

 
(66
)
Net cash used in financing activities
(26,543
)
 
(116,475
)
 
 
 
 
Decrease in cash and cash equivalents
(444
)
 
(7,061
)
Cash and cash equivalents at beginning of period
22,127

 
17,876

Cash and cash equivalents at end of period
$
21,683

 
$
10,815

 
 
 
 
SUPPLEMENTAL DISCLOSURES:
 
 
 
Interest paid
$
39,359

 
$
38,408

Income taxes paid
$
373

 
$
391



See accompanying notes

5


SELECT INCOME REIT
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share data)
 
Note 1. Basis of Presentation

The accompanying condensed consolidated financial statements of Select Income REIT and its subsidiaries, or SIR, 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, 2016, or our Annual Report. In the opinion of our management, all adjustments, which include only normal recurring adjustments considered necessary for a fair presentation, have been included. All intercompany transactions and balances with or among our consolidated subsidiaries have been eliminated. Our operating results for interim periods are not necessarily indicative of the results that may be expected for the full year.

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect reported amounts. Actual results could differ from those estimates. Significant estimates in the condensed consolidated financial statements include the allowance for doubtful accounts, purchase price allocations, useful lives of fixed assets and the assessments of the carrying values and impairments of long lived assets.

Note 2. Recent Accounting Pronouncements

On January 1, 2017, we adopted the Financial Accounting Standards Board, or FASB, Accounting Standards Update, or ASU, No. 2017-01, Clarifying the Definition of a Business. This update provides additional guidance on evaluating whether transactions should be accounted for as an acquisition (or disposal) of assets or of a business. This update defines three requirements for a set of assets and activities (collectively referred to as a “set”) to be considered a business: inputs, processes and outputs. As a result of the implementation of this update, certain property acquisitions which under previous guidance were accounted for as business combinations are now accounted for as acquisitions of assets. In an acquisition of assets, certain acquisition costs are capitalized as opposed to expensed under previous guidance.

On January 1, 2017, we adopted FASB ASU No. 2016-09, Compensation - Stock Compensation, which identifies areas for simplification involving several aspects of accounting for share based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, an option to recognize gross stock compensation expense with actual forfeitures recognized as they occur, as well as certain classifications on the statement of cash flows. The adoption of ASU No. 2016-09 did not have a material impact in our condensed consolidated financial statements.

In May 2014, the FASB issued ASU No. 2014-09, Revenue From Contracts With Customers, which outlines a comprehensive model for entities to use in accounting for revenue arising from contracts with customers. 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. In August 2015, the FASB provided for a one-year deferral of the effective date for ASU No. 2014-09, which is now effective for us beginning January 1, 2018. A substantial portion of our revenue consists of rental income from leasing arrangements, which is specifically excluded from ASU No. 2014-09. We are continuing to evaluate ASU No. 2014-09 (and related clarifying guidance issued by the FASB); however, we do not expect its adoption to have a significant impact on the amount or timing of our revenue recognition in our condensed consolidated financial statements. We currently expect to adopt the standard using the modified retrospective approach.

In January 2016, the FASB issued 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. This update is effective for interim and annual periods beginning after December 15, 2017, with early adoption permitted subject to certain conditions. Currently, changes in fair value of these investments are recorded through other comprehensive income. ASU No. 2016-01 states that these changes will be recorded through earnings. We are continuing to evaluate this guidance, but we expect the implementation of this guidance will affect how changes in the fair value of available for sale securities we hold are presented in our condensed consolidated financial statements.


6


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 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.

In August 2016, the FASB issued 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 statement of cash flows. ASU No. 2016-15 is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. We are currently assessing the potential impact the adoption of ASU No. 2016-15 will have in our condensed consolidated financial statements.

In November 2016, the FASB issued ASU No. 2016-18, Restricted Cash, which clarifies how companies should present restricted cash and restricted cash equivalents. Companies will show the changes in the total of cash, cash equivalents, restricted cash and restricted cash equivalents in the statement of cash flows. The new standard requires a reconciliation of the totals in the statement of cash flows to the related captions in the balance sheets. ASU No. 2016-18 is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Upon the adoption of ASU No. 2016-18, we will reconcile both cash and cash equivalents and restricted cash and restricted cash equivalents, whereas under the current guidance we explain the changes during the period for cash and cash equivalents only.

In May 2017, the FASB issued ASU No. 2017-09, Scope of Modification Accounting, which clarifies which changes to the terms or conditions of a share based payment award are subject to the guidance on modification accounting under FASB Accounting Standards Codification Topic 718. Entities would apply the modification accounting guidance unless the value, vesting requirements and classification of a share based payment award are the same immediately before and after a change to the terms or conditions of the award. ASU No. 2017-09 is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. We are continuing to evaluate ASU No. 2017-09; however, we do not expect its adoption to have a material impact in our condensed consolidated financial statements.

Note 3. Real Estate Properties

As of June 30, 2017, we owned properties (364 buildings, leasable land parcels and easements) with approximately 45,186,000 rentable square feet, including 229 buildings, leasable land parcels and easements with approximately 17,778,000 rentable square feet that we own in Hawaii.

Acquisitions:

On January 13, 2017, we acquired a land parcel adjacent to one of our properties located in McAlester, OK for $281, including $55 of acquisition related costs. We are currently developing a 35,000 square foot expansion of the building we own for an existing tenant on this acquired adjacent land.

During the six months ended June 30, 2017, we also acquired two properties (two buildings) with a combined 372,812 rentable square feet for an aggregate purchase price of $75,924, including acquisition related costs of $516. These acquisitions were accounted for as acquisitions of assets. We allocated the purchase prices of these acquisitions based on the estimated fair values of the acquired assets as follows:


7


 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Number of
 
Rentable
 
 
 
 
 
 
 
Acquired
 
 
 
 
Properties/
 
Square
 
Purchase
 
 
 
Building and
 
Real Estate
Date
 
Location
 
Buildings
 
Feet
 
Price
 
Land
 
Improvements
 
Leases
April 2017
 
Norfolk, VA
 
1 / 1
 
288,662

 
$
55,465

 
$
4,497

 
$
32,464

 
$
18,504

May 2017
 
Houston, TX
 
1 / 1
 
84,150

 
20,459

 
887

 
12,594

 
6,978

 
 
 
 
2 / 2
 
372,812

 
$
75,924

 
$
5,384

 
$
45,058

 
$
25,482


On July 19, 2017, we acquired a single tenant, net leased office property (two buildings) located in Indianapolis, IN with approximately 275,000 rentable square feet for a purchase price of $41,050, excluding acquisition related costs.

Dispositions:

On April 26, 2017, we entered an agreement to sell one mainland office property (one building) located in Maynard, MA with 287,037 rentable square feet for $18,000, excluding closing costs. This sale is expected to occur by year end, but is subject to conditions; accordingly, we cannot be sure that we will sell this property or that the sale will not be delayed or that the terms will not change. In June 2017, we also began marketing for sale a land parcel in Kapolei, HI with 417,610 rentable square feet. As of June 30, 2017, both of these real estate properties totaling $23,089 were classified as held for sale in our condensed consolidated balance sheets and included in continuing operations in our condensed consolidated statements of comprehensive income.

Note 4. Tenant Concentration and Segment Information

We operate in one business segment: ownership of properties that include buildings and leased industrial lands that are primarily net leased to single tenants. During the periods presented in this report, no single tenant accounted for more than 10% of our total revenues. A “net leased property” or a property being “net leased” means that the building or land lease requires the tenant to pay rent and pay, or reimburse us, for all, or substantially all, property level operating expenses and capital expenditures, such as real estate taxes, insurance, utilities, maintenance and repairs, other than, in certain circumstances, roof and structural element related expenditures; however, in some instances, tenants reimburse us for all expenses in excess of certain amounts included in the stated rent. We define a single tenant leased building or land parcel as a building or land parcel with at least 90% of its rentable square footage leased to one tenant. Our buildings and lands are primarily leased to single tenants; however, we also own some multi-tenant buildings on the island of Oahu, HI, and one mainland multi-tenant office building.

For the three months ended June 30, 2017 and 2016, approximately 20.1% and 19.6%, respectively, and for the six months ended June 30, 2017 and 2016, approximately 20.2% and 19.7%, respectively, of total revenues were from 229 buildings, leasable land parcels and easements with a combined approximately 17,778,000 rentable square feet that we own on Oahu, HI.

Note 5. Derivatives and Hedging Activities

We are exposed to certain risks relating to our ongoing business operations, including the effect of changes in interest rates. We use derivative instruments to manage only a part of our interest rate risk. We have an interest rate swap agreement to manage our interest rate risk exposure on a $41,000 mortgage note due 2020, with interest payable at a rate equal to LIBOR plus a premium.

We record all derivatives on our balance sheet at fair value. The following table summarizes the terms of our outstanding interest rate swap agreement, which we designate as a cash flow hedge:
 
 
 
 
 
 
 
 
 
 
 
 
Fair Value
 
 
 
 
Notional
 
 
 
 
 
 
 
of Liability
 
 
 
 
Amount as of
 
Interest
 
Effective
 
Maturity
 
as of
 
 
Balance Sheet Location
 
June 30, 2017
 
Rate (1)
 
Date
 
Date
 
June 30, 2017
Interest rate swap
 
Accounts payable and other liabilities
 
$
41,000

 
4.16
%
 
1/29/2015
 
8/3/2020
 
$
614

(1)
The interest rate consists of the underlying index swapped to a fixed rate rather than floating rate LIBOR, plus a premium.


8


The table below presents the effects of our interest rate derivative on our condensed consolidated statements of comprehensive income for the three and six months ended June 30, 2017 and 2016:

 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
Amount of loss recognized in cumulative other comprehensive income (effective portion)
 
$
(148
)

$
(405
)
 
$
(87
)

$
(1,401
)
Amount of gain reclassified from cumulative other comprehensive income into interest expense (effective portion)
 
$
51


$
97

 
$
121


$
191


We may enter into additional interest rate swaps or hedge agreements to manage some of our interest rate risk associated with other floating rate borrowings.

Note 6. Indebtedness

Our principal debt obligations at June 30, 2017 were: (1) our $67,000 of outstanding borrowings under our $750,000 unsecured revolving credit facility; (2) our $350,000 unsecured term loan; (3) an aggregate outstanding principal amount of $1,800,000 of public issuances of senior unsecured notes; and (4) an aggregate outstanding principal amount of $244,800 of mortgage notes.

Our $750,000 revolving credit facility and our $350,000 term loan are governed by a credit agreement with a syndicate of institutional lenders. This credit agreement includes a feature under which the maximum aggregate borrowing availability under our revolving credit facility and term loan may be increased to up to $2,200,000 on a combined basis under certain circumstances.

Our $750,000 revolving credit facility has a maturity date of March 29, 2019, interest payable on borrowings of LIBOR plus 105 basis points and a facility fee of 20 basis points per annum, based on the total amount of lending commitments. Both the interest rate premium and the facility fee for our revolving credit facility are subject to adjustment based on changes to our credit ratings. Upon the payment of an extension fee and meeting other conditions, we have the option to extend the maturity date of our revolving credit facility to March 29, 2020. As of June 30, 2017 and December 31, 2016, the interest rate payable on borrowings under our revolving credit facility was 2.24% and 1.76%, respectively. The weighted average interest rate for borrowings under our revolving credit facility was 2.01% and 1.45% for the three months ended June 30, 2017 and 2016, respectively, and 1.89% and 1.45% for the six months ended June 30, 2017 and 2016, respectively. We can borrow, repay and reborrow funds available under our revolving credit facility until maturity, and no principal repayment is due until maturity. As of June 30, 2017 and July 24, 2017, we had $67,000 and $82,000, respectively, outstanding under our revolving credit facility, and $683,000 and $668,000, respectively, available to borrow under our revolving credit facility.

Our $350,000 term loan has a maturity date of March 31, 2020 and interest payable on the amount outstanding of LIBOR plus 115 basis points. The interest rate premium for our term loan is subject to adjustment based on changes to our credit ratings. As of June 30, 2017 and December 31, 2016, the interest rate payable for the amount outstanding under our term loan was 2.20% and 1.77%, respectively. The weighted average interest rate for the amount outstanding under our term loan was 2.16% and 1.59% for the three months ended June 30, 2017 and 2016, respectively, and 2.05% and 1.58% for the six months ended June 30, 2017 and 2016, respectively.

On May 15, 2017, we issued $350,000 aggregate principal amount of 4.250% senior unsecured notes due 2024 in an underwritten public offering. Net proceeds from this offering were $342,207 after discounts and expenses.

Our credit agreement and our senior unsecured notes indenture and its 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 The RMR Group LLC, or RMR LLC, ceasing to act as our business and property manager. Our senior unsecured notes indenture and its supplements and our credit agreement also contain a number of covenants, including covenants that restrict our ability to incur debts or to make distributions under certain circumstances, and generally require us to maintain certain financial ratios. We believe we were in compliance with the terms and conditions of the respective covenants under our senior unsecured notes indenture and its supplements and our credit agreement at June 30, 2017.


9


At June 30, 2017, 11 of our buildings with a net book value of $389,622 were encumbered by mortgages we assumed in connection with our acquisition of those buildings. The aggregate principal amount outstanding under these mortgage notes as of June 30, 2017 was $244,800. These mortgage notes are non-recourse, subject to certain limited exceptions, and do not contain any material financial covenants.
    
On July 3, 2017, we repaid at par, a $17,361 5.95% mortgage note which was secured by two buildings with a net book value of $19,184 located in Carlsbad, CA. This mortgage note was scheduled to mature on September 1, 2017.

Note 7. Fair Value of Assets and Liabilities

The table below presents certain of our assets and liabilities measured at fair value at June 30, 2017, categorized by the level of inputs, as defined in the fair value hierarchy under GAAP, used in the valuation of each asset and liability:

 
 
 
 
Fair Value at Reporting Date Using
 
 
 
 
Quoted Prices in
 
 
 
Significant
 
 
 
 
Active Markets for
 
Significant Other
 
Unobservable
 
 
 
 
Identical Assets
 
Observable Inputs
 
Inputs
Description
 
Total
 
(Level 1)
 
(Level 2)
 
(Level 3)
Recurring Fair Value Measurements:
 
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
 
Investment in RMR Inc. (1)
 
$
77,200

 
$
77,200

 
$

 
$

 
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 

 
 

Interest rate swap (2)
 
$
(614
)
 
$

 
$
(614
)
 
$

 
 
 
 
 
 
 
 
 
Non-Recurring Fair Value Measurements:
 
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
 
Properties held for sale (3)
 
$
17,260

 
$

 
$

 
$
17,260

(1)
Our 1,586,836 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). Our historical cost basis for these shares is $42,686. The unrealized gain of $34,514 for these shares as of June 30, 2017 is included in cumulative other comprehensive income in our condensed consolidated balance sheet.
(2)
As discussed in Note 5, we have an interest rate swap agreement in connection with a $41,000 mortgage note. This interest rate swap agreement is carried at fair value and is included in accounts payable and other liabilities in our condensed consolidated balance sheets and is valued using Level 2 inputs. The fair value of this instrument is determined using interest rate pricing models. Considerable judgment is necessary to develop estimated fair values of financial assets and liabilities. Accordingly, the estimate presented in the table above is not necessarily indicative of the amount for which we could be liable upon extinguishment of the liability.
(3)
As of June 30, 2017, we recorded a loss on impairment of real estate assets of $229 to reduce the carrying value of one vacant property located in Maynard, MA from $17,489 to its estimated fair value less costs to sell of $17,260. We estimated the fair value of this property based upon a negotiated sale agreement less estimated sale costs.


10


In addition to the assets and liability described in the table above, our financial instruments include cash and cash equivalents, restricted cash, rents receivable, a revolving credit facility, a term loan, senior unsecured notes, mortgage notes payable, accounts payable, rents collected in advance, security deposits and amounts due to related persons. At June 30, 2017 and December 31, 2016, the fair value 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:

 
 
At June 30, 2017
 
At December 31, 2016
 
 
Carrying
 
Estimated
 
Carrying
 
Estimated
 
 
Value (1)
 
Fair Value
 
Value (1)
 
Fair Value
Senior unsecured notes, due 2018 at 2.85%
 
$
349,277

 
$
351,474

 
$
348,667

 
$
352,074

Senior unsecured notes, due 2020 at 3.60%
 
$
396,578

 
$
405,344

 
$
395,955

 
$
400,656

Senior unsecured notes, due 2022 at 4.15%
 
$
295,718

 
$
303,132

 
$
295,301

 
$
297,186

Senior unsecured notes, due 2024 at 4.250%
 
$
342,326

 
$
347,870

 
$

 
$

Senior unsecured notes, due 2025 at 4.50%
 
$
390,870

 
$
401,616

 
$
390,377

 
$
387,030

Mortgage notes payable
 
$
245,235

 
$
245,812

 
$
245,643

 
$
243,845

(1)
Includes unamortized debt issuance costs, premiums and discounts.

We estimate the fair value of our senior unsecured notes using an average of the bid and ask prices of the notes as of the measurement date (Level 2 inputs). We estimate the fair value of our mortgage notes payable using discounted cash flow analyses and currently prevailing market rates as of the measurement date (Level 3 inputs). Because Level 3 inputs are unobservable, our estimated fair value may differ materially from the actual fair value.

Note 8. Shareholders’ Equity

Share Awards:

On May 23, 2017, we granted 3,000 of our common shares, valued at $24.13 per share, the closing price of our common shares on The NASDAQ Stock Market LLC, or Nasdaq, on that day, to each of our five Trustees as part of their annual compensation.

Share Purchases:

On June 30, 2017, we purchased 222 of our common shares, valued at $24.03 per share, the closing price of our common shares on Nasdaq on that day, from a former employee of RMR LLC in satisfaction of that person's tax withholding and payment obligations in connection with the vesting of awards of common shares.

Distributions:

On February 21, 2017, we paid a regular quarterly distribution of $0.51 per common share, or $45,608, to shareholders of record on January 23, 2017. On May 18, 2017, we paid a regular quarterly distribution of $0.51 per common share, or $45,608, to shareholders of record on April 21, 2017. On July 12, 2017, we declared a regular quarterly distribution of $0.51 per common share, or approximately $45,600, to shareholders of record on July 24, 2017. We expect to pay this distribution on or about August 17, 2017.


11


Note 9. Cumulative Other Comprehensive Income
 
The following table presents changes in the amounts we recognized in cumulative other comprehensive income by component for the three and six months ended June 30, 2017:

 
 
Three Months Ended June 30, 2017
 
 
Unrealized Gain (Loss)
 
Unrealized
 
Equity in
 
 
 
 
on Investment
 
Gain (Loss)
 
Unrealized Gain
 
 
 
 
in Available for
 
on Derivative
 
(Loss) of an
 
 
 
 
Sale Securities
 
Instruments (1)
 
an Investee (2)
 
Total
Balance at March 31, 2017
 
$
35,862

 
$
500

 
$
231

 
$
36,593

 
 
 
 
 
 
 
 
 
Other comprehensive income (loss) before reclassifications
 
(1,348
)
 
(148
)
 
73

 
(1,423
)
Amounts reclassified from cumulative other comprehensive income to net income
 

 
51

 
(15
)
 
36

Net current period other comprehensive income (loss)
 
(1,348
)
 
(97
)
 
58

 
(1,387
)
Balance at June 30, 2017
 
$
34,514

 
$
403

 
$
289

 
$
35,206


(1)
Amounts reclassified from cumulative other comprehensive income are included in interest expense in our condensed consolidated statements of comprehensive income.
(2)
Amounts reclassified from cumulative other comprehensive income are included in equity in earnings of an investee in our condensed consolidated statements of comprehensive income.

 
 
Six Months Ended June 30, 2017
 
 
Unrealized Gain
 
Unrealized
 
Equity in
 
 
 
 
on Investment
 
Gain (Loss)
 
Unrealized Gain
 
 
 
 
in Available for
 
on Derivative
 
(Loss) of an
 
 
 
 
Sale Securities
 
Instruments (1)
 
Investee (2)
 
Total
Balance at December 31, 2016
 
$
19,994

 
$
369

 
$
109

 
$
20,472

 
 
 
 
 
 
 
 
 
Other comprehensive income (loss) before reclassifications
 
14,520

 
(87
)
 
197

 
14,630

Amounts reclassified from cumulative other comprehensive income to net income
 

 
121

 
(17
)
 
104

Net current period other comprehensive income
 
14,520

 
34

 
180

 
14,734

Balance at June 30, 2017
 
$
34,514

 
$
403

 
$
289

 
$
35,206


(1)
Amounts reclassified from cumulative other comprehensive income are included in interest expense in our condensed consolidated statements of comprehensive income.
(2)
Amounts reclassified from cumulative other comprehensive income are included in equity in earnings of an investee in our condensed consolidated statements of comprehensive income.

Note 10. 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):
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
Weighted average common shares for basic earnings per share
 
89,338

 
89,292

 
89,334

 
89,289

Effect of dilutive securities: unvested share awards
 
24

 
23

 
22

 
17

Weighted average common shares for diluted earnings per share
 
89,362

 
89,315

 
89,356

 
89,306



12


Note 11. 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 $6,496 and $5,441 for the three months ended June 30, 2017 and 2016, respectively, and $19,883 and $10,448 for the six months ended June 30, 2017 and 2016, respectively. The business management fees for the three and six months ended June 30, 2017 include estimated 2017 incentive fees of $920 and $8,766, respectively, based on our common share total return, as defined, as of June 30, 2017. Although we recognized estimated incentive fees in accordance with GAAP, the actual amount of incentive fees payable to RMR LLC for 2017, if any, will be based on our common share total return, as defined, for the three year period ending December 31, 2017, and will be payable in 2018. The net business management fees we recognized 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 $3,268 and $3,184 for the three months ended June 30, 2017 and 2016, respectively, and $6,426 and $6,298 for the six months ended June 30, 2017 and 2016, 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 of 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 $1,961 and $1,699 for property management related expenses for the three months ended June 30, 2017 and 2016, respectively, and $3,943 and $3,320 for the six months ended June 30, 2017 and 2016, 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 recognized as expense for internal audit costs were $67 for both the three months ended June 30, 2017 and 2016, and $134 for both the six months ended June 30, 2017 and 2016. These amounts are included in general and administrative expenses in our condensed consolidated statements of comprehensive income for these periods.

Note 12. Related Person Transactions

We have relationships and historical and continuing transactions with RMR LLC, RMR Inc., Government Properties Income Trust, or GOV, and others related to them, including other companies to which RMR LLC provides management services and which have trustees, directors and officers who are also our Trustees or officers.

Our Manager, RMR LLC. See Note 11 for further information regarding our management agreements with RMR LLC.

RMR Inc. RMR LLC is a subsidiary of RMR Inc. and RMR Inc. is the managing member of RMR LLC. The controlling shareholder of RMR Inc., ABP Trust, is owned by our Managing Trustees. As of June 30, 2017, we owned 1,586,836 shares of class A common stock of RMR Inc. See Note 7 for further information regarding our investment in RMR Inc.

GOV. GOV is our largest shareholder. As of June 30, 2017, GOV owned 24,918,421, or approximately 27.9%, of our outstanding common shares. Our Managing Trustees are also managing trustees of GOV and our President and Chief Operating Officer also serves as the president and chief operating officer of GOV. RMR LLC provides management services to GOV and us.

AIC. We, ABP Trust, GOV and four other companies to which RMR LLC provides management services currently own Affiliates Insurance Company, an Indiana insurance company, or 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 currently expect to pay aggregate annual premiums, including taxes and fees, of approximately $2,029 in connection with this insurance program for the policy year ending June 30, 2018, 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 June 30, 2017 and December 31, 2016, our investment in AIC had a carrying value of $7,798 and $7,116, respectively. These amounts are included in other assets in our condensed consolidated balance sheets. We recognized income

13


related to our investment in AIC, which amounts are presented as equity in earnings of an investee in our condensed consolidated statements of comprehensive income. Our other comprehensive income includes our proportionate part of unrealized gains (losses) on securities which are owned and held for sale by AIC.

For further information about these and certain other related person relationships and transactions, please refer to our Annual Report.

Note 13. Contingencies

We believe some of our properties may contain asbestos. We believe any asbestos on our properties is contained in accordance with applicable laws and regulations and we have no current plans to remove it. If we removed the asbestos or demolished the affected properties, certain environmental regulations govern the manner in which the asbestos must be handled and removed, and we could incur substantial costs complying with such regulations. Due to the uncertainty of the timing and amount of costs we may incur, we cannot reasonably estimate the fair value and we have not recognized a liability in our financial statements for these costs. Certain of our industrial lands in Hawaii may require environmental remediation, especially if the use of those lands is changed; however, we do not have any present plans to change the use of those lands or to undertake this environmental cleanup. In general, we do not have any insurance designated to limit any losses that we may incur as a result of known or unknown environmental conditions which are not caused by an insured event, such as, for example, fire or flood, although some of our tenants may maintain such insurance. However, as of both June 30, 2017 and December 31, 2016, accrued environmental remediation costs of $8,160 were included in accounts payable and other liabilities in our condensed consolidated balance sheets. These accrued environmental remediation costs relate to maintenance of our properties for current uses, and, because of the indeterminable timing of the remediation, these amounts have not been discounted to present value. Although we do not believe that there are environmental conditions at any of our properties that will have a material adverse effect on us, we cannot be sure that such conditions or costs are not present in our properties or that other costs we incur to remediate contamination will not have a material adverse effect on our business or financial condition. Charges for environmental remediation costs, if any, are included in other operating expenses in our condensed consolidated statements of comprehensive income.

In March 2017, one of our tenants filed for bankruptcy and rejected two leases with us; one for a property located in Huntsville, AL with approximately 1,400,000 rentable square feet and an original lease term until August 2032; and one for a property in Hanover, PA with approximately 502,000 rentable square feet and an original lease term until September 2028. The Huntsville, AL property is occupied by a subtenant that continues to pay rent to us in an amount equal to the rent under the former tenant’s lease. The sublease term runs concurrently with the former tenant’s original lease term, subject to certain termination rights by the subtenant. We expect that the lost rents plus carrying costs, such as real estate taxes, insurance, security and other operating costs, from a fully vacant Hanover, PA property may total approximately $3,800 per year. We are holding a security deposit of $3,739 from the tenant with respect to the Hanover, PA property, which we expect to retain and, therefore, have offset the amount of the security deposit against our damages incurred. During the three months ended March 31, 2017, we recorded a non-cash charge of $12,517 to write off straight line rents receivable (net of the $3,739 security deposit) related to the rejected leases with the former tenant at both properties plus an impairment charge of $4,047 related to the write-off of lease intangibles related to the property located in Hanover, PA.

On June 29, 2016, we received an assessment from the State of Washington for real estate excise tax, interest and penalties of $2,837 on certain properties we acquired in connection with our acquisition of Cole Corporate Income Trust, Inc. in January 2015. We believe we are not liable for this tax and are disputing the assessment. As of June 30, 2017, we have not recorded a loss related to this matter.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following information should be read in conjunction with our condensed consolidated financial statements and accompanying notes included in this Quarterly Report on Form 10-Q and with our Annual Report.

OVERVIEW
 
We are a real estate investment trust, or REIT, organized under Maryland law. As of June 30, 2017, we owned 364 buildings (including leasable land parcels and easements) located in 35 states that contain approximately 45.2 million rentable square feet and were approximately 95.9% leased (based on rentable square feet). For the six months ended June 30, 2017, approximately 79.8% of our total revenue was from 135 buildings located throughout the U.S. mainland, or our Mainland Properties. The remainder of our total revenue for the six months ended June 30, 2017, or 20.2%, was from 229 buildings, leasable land parcels and easements with approximately 17.8 million rentable square feet we own on the island of Oahu, HI, or

14


our Hawaii Properties. As of June 30, 2017, our properties were leased to 313 different tenants, with a weighted average remaining lease term (based on annualized rental revenue) of approximately 9.7 years. We define the term annualized rental revenue as used in this section as the annualized contractual rents, as of June 30, 2017, from tenants pursuant to existing leases, including straight line rent adjustments but excluding lease value amortization. Annualized rental revenue also includes amortization of tenant concessions, including free rent and amounts reimbursed to tenants, and estimated recurring expense reimbursements from tenants pursuant to existing leases.

Property Operations
 
As of June 30, 2017, 95.9% of our rentable square feet was leased, compared to 96.8% of our rentable square feet as of June 30, 2016. Occupancy data for our buildings as of June 30, 2017 and 2016 is as follows (square feet in thousands):
 
 
 
All Properties
 
Comparable Properties(1)
 
 
As of June 30, 
 
As of June 30, 
 
    
2017
 
2016
 
2017
 
2016
Total buildings, leasable land parcels and easements (2)
 
364

 
360

 
360

 
360

Total rentable square feet (3)
 
45,186

 
44,706

 
44,706

 
44,706

Percent leased (4)
 
95.9
%
 
96.8
%
 
95.9
%
 
96.8
%

(1)
Consists of 360 buildings, leasable land parcels and easements that we owned continuously since January 1, 2016.
(2)
Includes 229 buildings, leasable land parcels and easements with approximately 17,778 square feet which are primarily leasable industrial and commercial lands located in Hawaii.
(3)
Subject to modest adjustments when space is re-measured or re-configured for new tenants and when land leases are converted to building leases.
(4)
Percent leased includes (i) space being fitted out for occupancy pursuant to existing leases as of June 30, 2017, if any, and (ii) space which is leased but is not occupied or is being offered for sublease by tenants, if any.
 
The average annualized effective rental rates per square foot leased, as defined below, for our properties for the three and six months ended June 30, 2017 and 2016 are as follows: 
 
 
Three Months Ended
 
Six Months Ended
 
 
June 30,
 
June 30,
 
 
2017
 
2016
 
2017
 
2016
Average annualized effective rental rates per square foot leased: (1)
 
 
 
 
 
 
 
 
All properties
 
$
10.60

 
$
10.56

 
10.66

 
10.65

Comparable properties (2)
 
$
10.48

 
$
10.56

 
10.59

 
10.65


(1)
Average annualized effective rental rates per square foot leased represent annualized total revenue during the period specified divided by the average rentable square feet leased during the period specified.
(2)
Comparable properties for the three months ended June 30, 2017 and 2016 consist of 360 buildings, leasable land parcels and easements that we owned continuously since April 1, 2016. Comparable properties for the six months ended June 30, 2017 and 2016 consist of 360 buildings, leasable land parcels and easements that we owned continuously since January 1, 2016.
 
During the three months ended June 30, 2017, we entered lease renewals and new leases for approximately 202,000 square feet at weighted average rental rates (by square feet) that were approximately 2.6% lower than prior rates for the same space. The weighted average lease term by square footage for new and renewal leases entered into during the three months ended June 30, 2017 was 31.1 years. Commitments for tenant improvements, leasing costs and concessions for leases entered into during the three months ended June 30, 2017 totaled approximately $2.5 million, or approximately $0.40 per square foot per year of the weighted average lease term. During the three months ended June 30, 2017, we also executed a rent reset at one of our Hawaii Properties for approximately 79,000 square feet of land at a rental rate that was approximately 48.9% higher than the prior rental rate.


15


     Revenues from our Hawaii Properties, which represented approximately 20.2% of our total revenue for the six months ended June 30, 2017, have generally increased under our ownership as rents under the leases for those properties have been reset or renewed. Because of the increased rents and the strong demand to lease our Hawaii Properties in the past and the expected economic conditions where our Hawaii Properties are located, we believe that the rents we may realize from our Hawaii Properties may increase in the future. We expect to realize increases in the future from similar rent resets or renewals, although the impact of such future increases through 2018 is expected to be modest because fewer leases are subject to rent resets than during the past few years.
 
As shown in the table below, approximately 0.8% of our total rented square feet and approximately 0.7% of our total annualized rental revenue as of June 30, 2017, are included in leases scheduled to expire by December 31, 2017. As of June 30, 2017, our lease expirations by year are as follows (square feet and dollars in thousands):
 
 
 
 
 
 
 
 
 
Cumulative
 
 
 
Percent of
 
 
 
 
 
 
 
 
Percent of
 
Percent of
 
 
 
Total
 
Cumulative
 
 
 
 
 
 
Total
 
Total
 
Annualized
 
Annualized
 
Percent of Total
 
 
 
 
Rented
 
Rented
 
Rented
 
Rental
 
Rental
 
Annualized
 
 
Number of
 
Square Feet
 
Square Feet
 
Square Feet
 
Revenue
 
Revenue
 
Rental Revenue
Period/Year
 
Tenants
 
Expiring (1)
 
Expiring (1)
 
Expiring (1)
 
Expiring
 
Expiring
 
Expiring
7/1/2017 - 12/31/2017
 
6

 
339

 
0.8
%
 
0.8
%
 
$
3,430

 
0.7
%
 
0.7
%
2018
 
26

 
1,038

 
2.4
%
 
3.2
%
 
12,038

 
2.6
%
 
3.3
%
2019
 
21

 
1,954

 
4.5
%
 
7.7
%
 
9,061

 
2.0
%
 
5.3
%
2020
 
18

 
937

 
2.2
%
 
9.9
%
 
7,623

 
1.6
%
 
6.9
%
2021
 
20

 
1,400

 
3.2
%
 
13.1
%
 
12,833

 
2.8
%
 
9.7
%
2022
 
71

 
3,839

 
8.9
%
 
22.0
%
 
49,468

 
10.7
%
 
20.4
%
2023
 
25

 
3,043

 
7.0
%
 
29.0
%
 
40,269

 
8.7
%
 
29.1
%
2024
 
23

 
7,001

 
16.2
%
 
45.2
%
 
69,021

 
14.9
%
 
44.0
%
2025
 
17

 
1,770

 
4.1
%
 
49.3
%
 
26,474

 
5.7
%
 
49.7
%
2026
 
8

 
1,701

 
3.9
%
 
53.2
%
 
26,403

 
5.7
%
 
55.4
%
Thereafter
 
108

 
20,318

(2) 
46.8
%
 
100.0
%
 
205,843

 
44.6
%
 
100.0
%
Total
 
343

 
43,340

 
100.0
%
 
 
 
$
462,463

 
100.0
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted average remaining lease term (in years):
 
 
 
10.2

 
 
 
 
 
9.7

 
 
 
 
(1)
Rented square feet is pursuant to existing leases as of June 30, 2017, and includes (i) space being fitted out for occupancy, if any, and (ii) space which is leased but is not occupied or is being offered for sublease by tenants, if any.
(2)
Rented square feet excludes a 35 square foot expansion to be constructed prior to the commencement of the lease.

A significant portion of our Hawaii Properties are lands leased for rents that are periodically reset based on then current fair market values, generally every five to ten years. The following chart shows the annualized rental revenue as of June 30, 2017 scheduled to reset at our Hawaii lands:

Scheduled Rent Resets at Hawaii Lands
(dollars in thousands)
 
 
 
Annualized
 
 
Rental Revenue
 
 
as of June 30, 2017
 
 
Scheduled to Reset
7/1/2017 - 12/31/2017
 
$
868

2018
 
2,525

2019
 
10,811

2020 and thereafter
 
19,608

Total
 
$
33,812


As rent reset dates or lease expirations approach at our Hawaii lands, we generally negotiate with existing or new tenants for new lease terms. If we are unable to reach an agreement with a tenant on a rent reset, our Hawaii land leases typically provide that rent is reset based on an appraisal process. Despite our prior experience with new leases and rent resets in

16


Hawaii, our ability to increase rents when rents reset or leases expire depends upon market conditions, which are beyond our control. Accordingly, we cannot be sure that the historical increases achieved at our Hawaii lands will be repeated in the future.
 
We may also seek to redevelop certain of our Hawaii lands. Since our Hawaii land leases were originally entered, in some cases as long as 40 to 50 years ago, the characteristics of the neighborhoods in the vicinity of some of these properties have changed. Some of our Hawaii lands currently used for industrial purposes may now be suitable for redevelopment for different purposes that could generate higher rents than we currently receive. Since we and our predecessor acquired these properties, we have selectively engaged in redevelopment activities. We expect to continue these internal growth activities.

We generally will seek to renew or extend the terms of leases relating to our Mainland Properties when they expire. Because of the capital improvements many of the tenants in our Mainland Properties have invested in the properties they lease from us and because many of these properties appear to be of strategic importance to the tenants’ businesses, we believe that it is likely that these tenants will renew or extend their leases when they expire. If we are unable to extend or renew our leases, it may be time consuming and expensive to relet some of our properties.

Lease renewal rents, rent resets and rental rates for which available space may be leased in the future will depend on prevailing market conditions at the times these renewals, rent reset rates and new leases are negotiated. Whenever we extend, renew or enter into new leases for our properties, we intend to seek rents which are equal to or higher than our historical rents for the same properties; however, our ability to maintain or increase the rents for our current properties will depend in large part upon market conditions, which are beyond our control.

In March 2017, one of our tenants filed for bankruptcy and rejected two leases with us; one for a property located in Huntsville, AL with approximately 1.4 million rentable square feet and an original lease term until August 2032; and one for a property in Hanover, PA with approximately 502,000 rentable square feet and an original lease term until September 2028. The Huntsville, AL property is occupied by a subtenant that continues to pay rent to us in an amount equal to the rent under the former tenant’s lease. The sublease term runs concurrently with the former tenant’s original lease term, subject to certain termination rights by the subtenant. We expect that the lost rents plus carrying costs, such as real estate taxes, insurance, security and other operating costs, from a fully vacant Hanover, PA property may total approximately $3.8 million per year. We are holding a security deposit of approximately $3.7 million from the tenant with respect to the Hanover, PA property, which we expect to retain and, therefore, have offset the amount of the security deposit against our damages incurred. During the three months ended March, 31, 2017, we recorded a non-cash charge of $12.5 million to write off straight line rents receivable (net of the $3.7 million security deposit) related to the rejected leases with the former tenant at both properties plus an impairment charge of $4.0 million related to the write-off of lease intangibles related to the property located in Hanover, PA.

17



We generally receive rents from our tenants monthly in advance. As of June 30, 2017, tenants representing 1% or more of our total annualized rental revenue were as follows (square feet in thousands):
 
 
 
 
 
 
 
 
% of
 
 
 
 
Rented
 
% of Total
 
Annualized Rental
Tenant
    
Property Type
    
Sq. Ft. (1)
     
Rented Sq. Ft. (1)
     
Revenue
1.
Shook, Hardy & Bacon L.L.P.
 
Mainland Office
 
596

 
1.4
%
 
3.9
%
2.
Tellabs, Inc.
 
Mainland Office
 
820

 
1.9
%
 
3.6
%
3.
Amazon.com, Inc.
 
Mainland Industrial
 
3,048

 
7.0
%
 
3.5
%
4.
Noble Energy, Inc.
 
Mainland Office
 
497

 
1.1
%
 
3.2
%
5.
Bank of America, National Association
 
Mainland Office
 
554

 
1.3
%
 
3.1
%
6.
Tesoro Corporation
 
Mainland Office
 
618

 
1.4
%
 
3.0
%
7.
F5 Networks, Inc.
 
Mainland Office
 
299

 
0.7
%
 
2.9
%
8.
WestRock Company
 
Mainland Office
 
311

 
0.7
%
 
2.4
%
9.
Orbital ATK, Inc.
 
Mainland Office
 
337

 
0.8
%
 
2.2
%
10.
Technicolor SA
 
Mainland Industrial
 
1,371

 
3.2
%
 
2.1
%
11.
Tyson Foods, Inc.
 
Mainland Office
 
248

 
0.6
%
 
2.1
%
12.
Novell, Inc.
 
Mainland Office
 
406

 
0.9
%
 
1.7
%
13.
FedEx Corporation
 
Mainland Office; Mainland Industrial
 
795

(2) 
1.8
%
 
1.7
%
14.
PNC Bank, National Association
 
Mainland Office
 
441

 
1.0
%
 
1.4
%
15.
ServiceNow, Inc.
 
Mainland Office
 
149

 
0.3
%
 
1.3
%
16.
Allstate Insurance Company
 
Mainland Office
 
458

 
1.1
%
 
1.3
%
17.
Church & Dwight Co., Inc.
 
Mainland Office
 
250

 
0.6
%
 
1.3
%
18.
Compass Group USA, Inc.
 
Mainland Office
 
267

 
0.6
%
 
1.3
%
19.
Restoration Hardware, Inc.
 
Mainland Industrial
 
1,195

 
2.8
%
 
1.3
%
20.
Tailored Brands, Inc.
 
Mainland Office
 
206

 
0.5
%
 
1.2
%
21.
Automatic Data Processing, Inc.
 
Mainland Office
 
289

 
0.7
%
 
1.2
%
22.
Primerica Life Insurance Company
 
Mainland Office
 
344

 
0.8
%
 
1.1
%
23.
United Launch Alliance, LLC
 
Mainland Industrial
 
168

 
0.4
%
 
1.1
%
24.
American Tire Distributors, Inc.
 
Mainland Office
 
722

 
1.7
%
 
1.1
%
25.
The Southern Company
 
Mainland Office
 
448

 
1.0
%
 
1.1
%
26.
Red Hat, Inc.
 
Mainland Office
 
175

 
0.4
%
 
1.0
%
 
Total
 
 
 
15,012

 
34.7
%
 
51.1
%
(1)
Rented square feet is pursuant to existing leases as of June 30, 2017, and includes (i) space being fitted out for occupancy, if any, and (ii) space which is leased but is not occupied or is being offered for sublease by tenants, if any.
(2)
Square feet excludes a 35 square foot expansion to be constructed prior to the commencement of the lease.

Investment Activities (dollars in thousands)
 
During the six months ended June 30, 2017, we acquired two properties (two buildings) with a combined 372,812 rentable square feet for an aggregate purchase price of $75,408, excluding acquisition related costs of $516. We also acquired a land parcel adjacent to one of our properties located in McAlester, OK for $226, excluding $55 of acquisition related costs. We are currently developing a 35,000 square foot expansion of the building we own for an existing tenant on this acquired adjacent land. On July 19, 2017, we acquired a single tenant, net leased office property (two buildings) located in Indianapolis, IN with approximately 275,000 rentable square feet for a purchase price of $41,050, excluding acquisition related costs.

On April 26, 2017, we entered an agreement to sell one mainland office property (one building) located in Maynard, MA with 287,037 rentable square feet for $18,000, excluding closing costs. This sale is expected to occur by year end, but is subject to conditions; accordingly, we cannot be sure that we will sell this property or that the sale will not be delayed or that the terms will not change. In June 2017, we also began marketing for sale a land parcel in Kapolei, HI with 417,610 rentable square feet.

Our strategy related to property acquisitions and dispositions is materially unchanged from that disclosed in our Annual Report. We currently intend to expand our investments by primarily acquiring single tenant, net leased properties throughout the mainland United States, and we expect to use the extensive nationwide resources of RMR LLC to locate and acquire such properties. One of our goals in acquiring properties will be to further diversify our sources of rents and thus improve the security of our revenues. Another goal will be to purchase properties that produce rents, less property operating

18


expenses, that are greater than our capital costs for the properties and, accordingly, allow us to increase distributions to our shareholders over time. We expect that most of our acquisition efforts will focus on office and industrial properties; however, we may consider acquiring other types of properties, including properties which are net leased to single tenants for retail uses and special purpose properties specifically suited to particular tenants’ requirements. We also may acquire properties in Hawaii, but we currently expect this will not be a significant part of our future acquisitions because there are limited opportunities to acquire properties in Hawaii, especially to acquire lands which are leased to third party tenants. We may periodically identify properties that we own for sale based on future changes in market conditions, changes in property performance, our expectations regarding lease renewals, our plans with regard to particular properties or alternative opportunities we may wish to pursue. Our plans for particular properties and other strategic considerations may cause us to change our acquisition and disposition strategies, and we may do so at any time and without shareholder approval.

For more information regarding our investment activities, see Note 3 to the Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.
 
Financing Activities
 
On May 15, 2017, we issued $350,000 aggregate principal amount of 4.250% senior unsecured notes due 2024 in an underwritten public offering. Net proceeds from this offering were $342,207 after discounts and expenses and were used to repay amounts outstanding under our revolving credit facility and for general business purposes.

On July 3, 2017, we repaid at par, a $17,361 5.95% mortgage note using cash on hand and borrowings under our revolving credit facility.

For more information regarding our financing activities, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Our Investment and Financing Liquidity and Resources” of this Quarterly Report on Form 10-Q.


19


RESULTS OF OPERATIONS
 
Three Months Ended June 30, 2017, Compared to Three Months Ended June 30, 2016 (dollars and share amounts in thousands, except per share data)
 
 
Comparable Properties Results (1)
 
Acquired Properties Results (2)
 
Consolidated Results
 
Three Months Ended June 30,
 
Three Months Ended June 30,
 
Three Months Ended June 30,
 
 
 
 
 
$
 
%
 
 
 
 
 
$
 
 
 
 
 
$
 
%
 
2017
 
2016
 
Change
    
Change
 
2017
 
2016
 
Change
 
2017
 
2016
 
Change
 
Change
Revenues:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Rental income
$
95,392

 
$
96,615

 
$
(1,223
)
 
(1.3
)%
 
$
1,649

 
$

 
$
1,649

 
$
97,041

 
$
96,615

 
$
426

 
0.4
 %
Tenant reimbursements and other income
18,210

 
18,289

 
(79
)
 
(0.4
)%
 
619

 

 
619

 
18,829

 
18,289

 
540

 
3.0
 %
Total revenues
113,602

 
114,904

 
(1,302
)
 
(1.1
)%
 
2,268

 

 
2,268

 
115,870

 
114,904

 
966

 
0.8
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate taxes
10,661

 
10,522

 
139

 
1.3
 %
 
175

 

 
175

 
10,836

 
10,522

 
314

 
3.0
 %
Other operating expenses
13,169

 
12,635

 
534

 
4.2
 %
 
354

 

 
354

 
13,523

 
12,635

 
888

 
7.0
 %
Total operating expenses
23,830

 
23,157

 
673

 
2.9
 %
 
529

 

 
529

 
24,359

 
23,157

 
1,202

 
5.2
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net operating income (3)
$
89,772

 
$
91,747

 
$
(1,975
)
 
(2.2
)%
 
$
1,739

 
$

 
$
1,739

 
91,511

 
91,747

 
(236
)
 
(0.3
)%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Depreciation and amortization
 
34,317

 
33,405

 
912

 
2.7
 %
General and administrative
 
8,181

 
7,374

 
807

 
10.9
 %
Loss on impairment of real estate assets
 
229

 

 
229

 
100.0
 %
Total other expenses
 
42,727

 
40,779

 
1,948

 
4.8
 %
Operating income
 
48,784

 
50,968

 
(2,184
)
 
(4.3
)%
Dividend income
 
396

 
475

 
(79
)
 
(16.6
)%
Interest expense
 
(22,808
)
 
(20,584
)
 
(2,224
)
 
10.8
 %
Income before income tax expense and equity in earnings of an investee
 
26,372

 
30,859

 
(4,487
)
 
(14.5
)%
Income tax expense
 
(85
)
 
(124
)
 
39

 
(31.5
)%
Equity in earnings of an investee
 
374

 
17

 
357

 
2,100.0
 %
Net income
 
26,661

 
30,752

 
(4,091
)
 
(13.3
)%
Net income allocated to noncontrolling interest
 

 

 

 
 %
Net income attributed to SIR
 
$
26,661

 
$
30,752

 
$
(4,091
)
 
(13.3
)%
 
 
 
 
 
 
 
 
 
Weighted average common shares outstanding - basic
 
89,338

 
89,292

 
46

 
0.05
 %
Weighted average common shares outstanding - diluted
 
89,362

 
89,315

 
47

 
0.05
 %
 
 
 
 
 
 
 
 
 
Net income attributed to SIR per common share - basic and diluted
 
$
0.30

 
$
0.34

 
$
(0.04
)
 
(11.8
)%
 
 
 
 
 
Reconciliation of Net Income to Net Operating Income (3):
 
 
Net income
$
26,661

 
$
30,752

 
 
 
 
Equity in earnings of an investee
(374
)
 
(17
)
 
 
 
 
Income tax expense
85

 
124

 
 
 
 
Income before income tax expense and equity in earnings of an investee
26,372

 
30,859

 
 
 
 
Interest expense
22,808

 
20,584

 
 
 
 
Dividend income
(396
)
 
(475
)
 
 
 
 
Operating income
 
48,784

 
50,968

 
 
 
 
 
 
 
 
 
 
 
 
Loss on impairment of real estate assets
 
229

 

 
 
 
 
General and administrative
8,181

 
7,374

 
 
 
 
Depreciation and amortization
34,317

 
33,405

 
 
 
 
Net operating income
 
$
91,511

 
$
91,747

 
 
 
 





20


 
2017
 
2016
 
 
 
 
Reconciliation of Net Income Attributed to SIR to Funds From Operations Attributed to SIR and Normalized Funds From Operations Attributed to SIR (4):
 
 
 
 
 
 
 
Net income attributed to SIR
$
26,661

 
$
30,752

 
 
 
 
Plus: depreciation and amortization
34,317

 
33,405

 
 
 
 
Plus: loss on impairment of real estate assets
229

 

 
 
 
 
FFO attributed to SIR
61,207

 
64,157

 
 
 
 
Plus: estimated business management incentive fees (5)
920

 

 
 
 
 
Normalized FFO attributed to SIR
$
62,127

 
$
64,157

 
 
 
 
 
 
 
 
 
 
 
 
FFO attributed to SIR per common share - basic
$
0.69

 
$
0.72