WASHINGTON, D.C. 20549
(Address of Principal Executive Offices) (Zip Code)
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”company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
The aggregate market value of the voting common shares of beneficial interest, $.01 par value, or common shares, of the registrant held by non-affiliates was approximately $1.3$1.2 billion based on the $18.31$26.27 closing price per common share on The Nasdaq Stock Market LLC on June 30, 2017.28, 2019. For purposes of this calculation, an aggregate of 1,942,816797,807 common shares held directly by, or by affiliates of, the trustees and the executive officers of the registrant have been included in the number of common shares held by affiliates.
We are a real estate investment trust, or REIT, formed in 2009 under Maryland law. As of December 31, 2017, we2019, our wholly owned 108 properties (167 buildings)were comprised of 189 properties with approximately 25.7 million rentable square feet (all square footage amounts included within this Annual Report on Form 10-K are unaudited) and we had a noncontrolling ownership interest in twothree properties (three buildings) through two unconsolidated joint ventures in which we own 50%51% and 51%50% interests. As of December 31, 2017,2019, our consolidated properties have an undepreciated carrying value of approximately $3.0$3.5 billion and a depreciated carrying value of approximately $2.6 billion. Our 108 consolidated$3.1 billion, excluding properties have approximately 17.5 million rentable square feet.
Our principal executive offices are located at Two Newton Place, 255 Washington Street, Suite 300, Newton, Massachusetts 02458-1634, and our telephone number is (617) 219-1440.
On October 2, 2017, we completed our acquisition of First Potomac Realty Trust, or FPO, pursuant to merger transactions, as a result of which we acquired 35 office72 properties (72 buildings) with approximately 6.0 million rentable square feet, and twothree properties (three buildings) with approximately 0.4 million rentable square feet owned by joint ventures in which we acquired FPO'sFPO’s 51% and 50% and 51% interests, or collectively, the FPO Transaction. The aggregate value we paid for FPO was approximately $1.4 billion, including approximately $651.7 million in cash to FPO shareholders, the repayment of approximately $483.0 million of FPO corporate debt and the assumption of approximately$167.5approximately $167.5 million of FPO mortgage debt; this amount excludes our share of the $82.0 million of mortgage debt that encumbers the twothree joint venture properties and the payment of certain transaction fees and expenses, net of FPO cash on hand. See Note 3 to the Notes 5, 9 and 11 to our Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K for more information regarding the FPO Transaction and our related financing activities.
Our internal growth strategy is to attempt to increase the rents we receive from our current properties. To achieve rent increases we may invest in our properties to make improvements requested by existing tenants or to induce lease renewals or new tenant leases when our current leases expire or vacant space is leased. However, as noted above, our ability to maintain or increase the rents we receive from our current properties will depend in large part upon market conditions which are beyond our control.
Our external growth strategy is defined by our investment policies, including our capital recycling program, and our acquisition, disposition and financing policies. Our investment, acquisition, disposition and financing policies are established by our Board of Trustees and may be changed by our Board of Trustees at any time without shareholder approval.
We expect to use the extensive nationwide resources of our manager, The RMR Group LLC, a Maryland limited liability company, or RMR LLC, to locate and acquiremanage the acquisition of such properties. We believe that current government budgetary methodology, spending priorities, and the current U.S. presidential administration's views on the size and scopeexpect most of government employment have resulted in a decrease in government employment, government tenants reducing their space utilization per employee and consolidation into existing government owned properties, thereby reducing the demand for government leased space. Although we believe that weour future acquisitions will be able to locate and acquire additionaloffice properties; however, we may consider acquiring other types of properties, that are majority leased to government tenants, our acquisitionincluding properties which have a mix of FPO enabled us to expand our business strategy to include the acquisition, ownership and operation of office properties leased to both government and private sector tenants in the metropolitan Washington, D.C. market area. The metropolitan Washington, D.C. market area is one of the largest office markets in the United States and the nation’s largest beneficiary of spending by the U.S. government.retail or housing uses. We also expect to acquire additional properties primarily forfurther diversify our sources of rents, which we expect would improve the purposesecurity of realizing income from the operationsour revenues.
In implementing our acquisition strategy, we consider a range of factors relating to proposed property purchases including:
the historic and projected rents received and likely to be received from the property;
the historic and expected operating expenses, including real estate taxes, incurred and expected to be incurred at the property;
We have no policies which specifically limit the percentage of our assets that may be invested in any individual property, in any one type of property, in properties managed by or leased to any one entity, in properties managed by or leased to any affiliated group of entities or in securities of one or more other persons.
Our Board of Trustees may change our acquisition policies without a vote of, or notice to, our shareholders.
our expectation regarding tenant lease renewals or the likelihood of finding (a) replacement tenant(s) if the property has significant vacancies or is likely to become substantially vacant;
the existence of alternative sources, uses or needs for capital, including our debt leverage.
To qualify for taxation as a REIT under the United States Internal Revenue Code of 1986, as amended, or the IRC, we must distribute at least 90% of our annual REIT taxable income (excluding net capital gains). Accordingly, we generally will not be able to retain sufficient cash to fund our operations, repay our debts, invest in our properties and fund acquisitions and
development or redevelopment efforts. Instead, weWe expect to use proceeds from our capital recycling program to fund acquisitions and to maintain leverage consistent with our current investment grade ratings. We also expect to repay our debts, invest in our properties and fund acquisitions and development or redevelopment efforts with borrowings under our revolving credit facility (as defined below), proceeds from equitydebt or debtequity securities we may issue cash distributions we may receive on our SIR common shares or retained cash from operations that may exceed our distributions paid. To the extent we obtain additional debt financing, we may do so on an unsecured or a secured basis. We may seek to obtain lines of credit or to issue securities senior to our common shares, including preferred shares or debt securities, which may be convertible into our common shares or be accompanied by warrants to purchase our common shares. We may also finance acquisitions by assuming debt or through the issuance of equity or other securities. The proceeds from any of our financings may be used to pay distributions, to provide working capital, to refinance existing indebtedness or to finance acquisitions and expansions of existing or new properties.
Although there are no limitations in our organizational documents on the type or amount of indebtedness we may incur, the borrowing limitations established by the covenants in the credit agreement governing our revolving credit facility, and term loans, or our credit agreement, and our senior unsecured notes indentures and their supplements currently restrict our ability to incur indebtedness and require us to maintaincomply with certain financial ratios.and other covenants. However, we may seek to amend these covenants or seek replacement financings with less restrictive covenants. In the future, we may decide to seek changes in the financial covenants which currently restrict our debt leverage based upon then current economic conditions, the relative availability and costs of debt versus equity capital and our need for capital to take advantage of acquisition opportunities or otherwise.
Generally, we intend to manage our leverage in a way that may allow us to maintain “investment grade” ratings from nationally recognized statistical rating organizations. As parta result of the FPO Transaction and the SIR Merger, our leverage increased through our assumption and issuance of additional debt. As noted above,During 2019, we intend to disposesuccessfully reduced our leverage by disposing of certain properties, in order to reduce our debt leverage.completing the Secondary Sale and selling all of the approximately 2.8 million shares of class A common stock of RMR Inc. that we previously owned. However, we cannot be sure that we will be successful in these efforts or be able to maintain our investment grade ratings.
Our Board of Trustees may change our financing policies at any time without a vote of, or notice to, our shareholders.
For additional information about competition and other risks associated with our business, please see “Risk Factors” included in Part I, Item 1A of this Annual Report on Form 10-K.
The following summary of material United States federal income tax considerations is based on existing law, and is limited to investors who own our shares as investment assets rather than as inventory or as property used in a trade or business. The summary does not discuss all of the particular tax considerations that might be relevant to you if you are subject to special rules under federal income tax law, for example if you are:
a person who marks-to-market our shares for U.S. federal income tax purposes;
a U.S. shareholder (as defined below) that has a functional currency other than the U.S. dollar;
a person who acquires or owns our shares in connection with employment or other performance of services;
a person who acquires or owns our shares as part of a straddle, hedging transaction, constructive sale transaction, constructive ownership transaction or conversion transaction, or as part of a “synthetic security” or other integrated financial transaction;
a person who owns 10% or more (by vote or value, directly or constructively under the IRC) of any class of our shares;
a U.S. expatriate;
a non-U.S. shareholder (as defined below) whose investment in our shares is effectively connected with the conduct of a trade or business in the United States;
a nonresident alien individual present in the United States for 183 days or more during an applicable taxable year;
a “qualified foreign pension fund” (as defined in Section 897(l)(2) of the IRC) or any entity wholly owned by one or more qualified foreign pension funds;
a person subject to special tax accounting rules as a result of their use of applicable financial statements (within the meaning of Section 451(b)(3) of the IRC); or
except as specifically described in the following summary, a trust, estate, tax-exempt entity or foreign person.
Your federal income tax consequences generally will differ depending on whether or not you are a “U.S. shareholder.” For purposes of this summary, a “U.S. shareholder” is a beneficial owner of our shares that is:
an individual who is a citizen or resident of the United States, including an alien individual who is a lawful permanent resident of the United States or meets the substantial presence residency test under the federal income tax laws;
an entity treated as a corporation for federal income tax purposes that is created or organized in or under the laws of the United States, any state thereof or the District of Columbia;
an estate the income of which is subject to federal income taxation regardless of its source; or
a trust if a court within the United States is able to exercise primary supervision over the administration of the trust and one or more U.S. persons have the authority to control all substantial decisions of the trust, or, to the extent provided in Treasury regulations, a trust in existence on August 20, 1996 that has elected to be treated as a domestic trust;
If any entity (or other arrangement) treated as a partnership for federal income tax purposes holds our shares, the tax treatment of a partner in the partnership generally will depend upon the tax status of the partner and the activities of the partnership. Any entity (or other arrangement) treated as a partnership for federal income tax purposes that is a holder of our shares and the partners in such a partnership (as determined for federal income tax purposes) are urged to consult their own tax advisors about the federal income tax consequences and other tax consequences of the acquisition, ownership and disposition of our shares.
we have been organized and have operated, and will continue to be organized and to operate, in a manner that qualified us and will continue to qualify us to be taxed as a REIT under the IRC.
our available current or accumulated earnings and profits. Our dividends are not generally entitled to the preferential tax rates on qualified dividend income, but a portion of our dividends may be treated as capital gain dividends or as qualified dividend income, all as explained below. However,In addition, for taxable years beginning after 2017 and before 2026 and pursuant to the deduction-without-outlay mechanism of Section 199A of the IRC, our noncorporate U.S. shareholders will beare generally eligible for lower effective tax rates on our dividends that are not treated as capital gain dividends or as qualified dividend income. No portion of any of our dividends is eligible for the dividends received deduction for corporate shareholders. Distributions in excess of our current or accumulated earnings and profits generally are treated for federal income tax purposes as returns of capital to the extent of a recipient shareholder’s basis in our shares, and will reduce this basis. Our current or accumulated earnings and profits are generally allocated first to distributions made on our preferred shares, of which there are none outstanding at this time,andthereafter to distributions made on our common shares. For all these purposes, our distributions include cash distributions, any in kind distributions of property that we might make, and deemed or constructive distributions resulting from capital market activities (such as some redemptions), as described below.
Our continued qualification and taxation as a REIT will depend upon our compliance with various qualification tests imposed under the IRC and summarized below. While we believe that we have satisfied and will satisfy these tests, our counsel does not review compliance with these tests on a continuing basis. If we fail to qualify for taxation as a REIT in any year, we will be subject to federal income taxation as if we were a corporation taxed under subchapter C of the IRC, or a C corporation, and our shareholders will be taxed like shareholders of regular C corporations, meaning that federal income tax generally will be applied at both the corporate and shareholder levels. In this event, we could be subject to significant tax liabilities, and the amount of cash available for distribution to our shareholders could be reduced or eliminated.
We will be taxed at regular corporate income tax rates on any undistributed “real estate investment trust taxable income,” determined by including our undistributed ordinary income and net capital gains, if any.
If we have net income from the disposition of “foreclosure property,” as described in Section 856(e) of the IRC, that is held primarily for sale to customers in the ordinary course of a trade or business or other nonqualifying income from foreclosure property, we will be subject to tax on this income at the highest regular corporate income tax rate.
If we have net income from “prohibited transactions”—that is, dispositions at a gain of inventory or property held primarily for sale to customers in the ordinary course of a trade or business other than dispositions of foreclosure property and other than dispositions excepted by statutory safe harbors—harbors — we will be subject to tax on this income at a 100% rate.
If we fail to satisfy the 75% gross income test or the 95% gross income test discussed below, due to reasonable cause and not due to willful neglect, but nonetheless maintain our qualification for taxation as a REIT because of specified cure
provisions, we will be subject to tax at a 100% rate on the greater of the amount by which we fail the 75% gross income test or the 95% gross income test, with adjustments, multiplied by a fraction intended to reflect our profitability for the taxable year.
If we fail to satisfy any of the REIT asset tests described below (other than a de minimis failure of the 5% or 10% asset tests) due to reasonable cause and not due to willful neglect, but nonetheless maintain our qualification for taxation as a REIT because of specified cure provisions, we will be subject to a tax equal to the greater of $50,000 or the highest regular corporate income tax rate multiplied by the net income generated by the nonqualifying assets that caused us to fail the test.
If we fail to satisfy any provision of the IRC that would result in our failure to qualify for taxation as a REIT (other than violations of the REIT gross income tests or violations of the REIT asset tests described below) due to reasonable cause and not due to willful neglect, we may retain our qualification for taxation as a REIT but will be subject to a penalty of $50,000 for each failure.
If we fail to distribute for any calendar year at least the sum of 85% of our REIT ordinary income for that year, 95% of our REIT capital gain net income for that year and any undistributed taxable income from prior periods, we will be subject to a 4% nondeductible excise tax on the excess of the required distribution over the amounts actually distributed.
If we acquire a REIT asset where our adjusted tax basis in the asset is determined by reference to the adjusted tax basis of the asset in the hands of a C corporation, under specified circumstances we may be subject to federal income taxation on all or part of the built-in gain (calculated as of the date the property ceased being owned by the C corporation) on such asset. We generally do not expect to sell assets if doing so would result in the imposition of a material built-in gains tax liability; but if and when we do sell assets that may have associated built-in gains tax exposure, then we expect to make appropriate provision for the associated tax liabilities on our financial statements.
If we acquire a corporation in a transaction where we succeed to its tax attributes, to preserve our qualification for taxation as a REIT we must generally distribute all of the C corporation earnings and profits inherited in that acquisition, if any, no later than the end of our taxable year in which the acquisition occurs. However, if we fail to do so, relief provisions would allow us to maintain our qualification for taxation as a REIT provided we distribute any subsequently discovered C corporation earnings and profits and pay an interest charge in respect of the period of delayed distribution.
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• | Our subsidiaries that are C corporations, includingour“taxable REIT subsidiaries”, as defined in Section 856(l) of the IRC, orTRSs, generally will be required to pay federal corporate income tax on their earnings, and a 100% tax may be imposed on any transaction between us and one of our TRSs that does not reflect arm’s length terms. |
If it is determined that SIR or FPO failed to satisfy one or more of the REIT tests described below before their respective mergers into us, the IRS might allow us, as FPO’s successor to SIR or FPO, the same opportunity for relief as though we were the remediating REIT. In such case, SIR or FPO, as applicable, would be deemed to have retained its qualification for taxation as a REIT and the relevant penalties or sanctions for remediation would fall upon us in a manner comparable to the above.
As discussed below, we are invested in real estate through a subsidiary that we believe qualifies for taxation as a REIT. If it is determined that this entity failed to qualify for taxation as a REIT, we may fail one or more of the REIT asset tests. In such case, we expect that we would be able to avail ourselves of the relief provisions described below, but would be subject to a tax equal to the greater of $50,000 or the highest regular corporate income tax rate multiplied by the net income we earned from this subsidiary.
If we fail to qualify for taxation as a REIT in any year, then we will be subject to federal income tax in the same manner as a regular C corporation. Further, as a regular C corporation, distributions to our shareholders will not be deductible by us, nor will distributions be required under the IRC. Also, to the extent of our current and accumulated earnings and profits, all distributions to our shareholders will generally be taxable as ordinary dividends potentially eligible for the preferential tax rates discussed below under the heading “—Taxation of Taxable U.S. Shareholders” and, subject to limitations in the IRC, will be potentially eligible for the dividends received deduction for corporate shareholders. Finally, we will generally be disqualified from taxation as a REIT for the four taxable years following the taxable year in which the termination of our REIT status is effective. Our failure to qualify for taxation as a REIT for even one year could result in us reducing or eliminating distributions to our shareholders, or in us incurring substantial indebtedness or liquidating substantial investments in order to pay the resulting corporate-level income taxes. Relief provisions under the IRC may allow us to continue to qualify for taxation as a REIT even if we fail to comply with various REIT requirements, all as discussed in more detail below. However, it is impossible to state whether in any particular circumstance we would be entitled to the benefit of these relief provisions.
REIT Qualification Requirements
General Requirements. Section 856(a) of the IRC defines a REIT as a corporation, trust or association:
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(1) | that is managed by one or more trustees or directors; |
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(2) | the beneficial ownership of which is evidenced by transferable shares or by transferable certificates of beneficial interest; |
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(3) | that would be taxable, but for Sections 856 through 859 of the IRC, as a domestic C corporation; |
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(4) | that is not a financial institution or an insurance company subject to special provisions of the IRC; |
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(5) | the beneficial ownership of which is held by 100 or more persons; |
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(6) | that is not “closely held,” meaning that during the last half of each taxable year, not more than 50% in value of the outstanding shares are owned, directly or indirectly, by five or fewer “individuals” (as defined in the IRC to include specified tax-exempt entities); and |
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(7) | that meets other tests regarding the nature of its income and assets and the amount of its distributions, all as described below. |
Section 856(b) of the IRC provides that conditions (1) through (4) must be met during the entire taxable year and that condition (5) must be met during at least 335 days of a taxable year of 12 months, or during a proportionate part of a taxable year of less than 12 months. Although we cannot be sure, we believe that we have met conditions (1) through (7) during each of the requisite periods ending on or before the close of our most recently completed taxable year, and that we will continue to meet these conditions in our current and future taxable years.
To help comply with condition (6), our declaration of trust restricts transfers of our shares that would otherwise result in concentrated ownership positions. These restrictions, however, do not ensure that we have previously satisfied, and may not ensure that we will in all cases be able to continue to satisfy, the share ownership requirements described in condition (6). If we comply with applicable Treasury regulations to ascertain the ownership of our outstanding shares and do not know, or by exercising reasonable diligence would not have known, that we failed condition (6), then we will be treated as having met condition (6). Accordingly, we have complied and will continue to comply with these regulations, including by requesting annually from holders of significant percentages of our shares information regarding the ownership of our shares. Under our declaration of trust, our shareholders are required to respond to these requests for information. A shareholder that fails or refuses to comply with the request is required by Treasury regulations to submit a statement with its federal income tax return disclosing its actual ownership of our shares and other information.
For purposes of condition (6), an “individual” generally includes a natural person, a supplemental unemployment compensation benefit plan, a private foundation, or a portion of a trust permanently set aside or used exclusively for charitable purposes, but does not include a qualified pension plan or profit-sharing trust. As a result, REIT shares owned by an entity that is not an “individual” are considered to be owned by the direct and indirect owners of the entity that are individuals (as so defined), rather than to be owned by the entity itself. Similarly, REIT shares held by a qualified pension plan or profit-sharing trust are treated as held directly by the individual beneficiaries in proportion to their actuarial interests in such plan or trust. Consequently, five or fewer such trusts could own more than 50% of the interests in an entity without jeopardizing that entity’s qualification for taxation as a REIT.
The IRC provides that we will not automatically fail to qualify for taxation as a REIT if we do not meet conditions (1) through (6), provided we can establish that such failure was due to reasonable cause and not due to willful neglect. Each such excused failure will result in the imposition of a $50,000 penalty instead of REIT disqualification. This relief provision may apply to a failure of the applicable conditions even if the failure first occurred in a year prior to the taxable year in which the failure was discovered.
Our Wholly Owned Subsidiaries and Our Investments Through Partnerships. Except in respect of a TRS as discussed below, Section 856(i) of the IRC provides that any corporation, 100% of whose stock is held by a REIT and its disregarded subsidiaries, is a qualified REIT subsidiary and shall not be treated as a separate corporation for U.S. federal income tax purposes. The assets, liabilities and items of income, deduction and credit of a qualified REIT subsidiary are treated as the REIT’s. We believe that each of our direct and indirect wholly owned subsidiaries, other than the TRSs discussed below (and entities owned
in whole or in part by the TRSs), will be either a qualified REIT subsidiary within the meaning of Section 856(i)(2) of the IRC or a noncorporate entity that for federal income tax purposes is not treated as separate from its owner under Treasury regulations issued under Section 7701 of the IRC, each such entity referred to as a QRS. Thus, in applying all of the REIT qualification requirements described in this summary, all assets, liabilities and items of income, deduction and credit of our QRSs are treated as ours, and our investment in the stock and other securities of such QRSs will be disregarded.
We have invested and may in the future invest in real estate through one or more entities that are treated as partnerships for federal income tax purposes. In the case of a REIT that is a partner in a partnership, Treasury regulations under the IRC provide that, for purposes of the REIT qualification requirements regarding income and assets described below, the REIT is generally deemed to own its proportionate share, based on respective capital interests, of the income and assets of the partnership (except that for purposes of the 10% value test, described below, the REIT’s proportionate share of the partnership’s assets is based on its proportionate interest in the equity and specified debt securities issued by the partnership). In addition, for these purposes, the character of the assets and items of gross income of the partnership generally remains the same in the hands of the REIT. In contrast, for purposes of the distribution requirements discussed below, we must take into account as a partner our share of the partnership’s income as determined under the general federal income tax rules governing partners and partnerships under Sections 701 through 777Subchapter K of the IRC.
Subsidiary REITs.REITs. We have invested and may invest in real estate through one or more entities that are intended to qualify for taxation as REITs. When a subsidiary qualifies for taxation as a REIT separate and apart from its REIT parent, the subsidiary’s shares are qualifying real estate assets for purposes of the REIT parent’s 75% asset test described below. However, failure of the subsidiary to separately satisfy the various REIT qualification requirements described in this summary or that are otherwise applicable (and failure to qualify for the applicable relief provisions) would generally result in (a) the subsidiary being subject to regular U.S. corporate income tax, as described above, and (b) the REIT parent’s ownership in the subsidiary (i) ceasing to be qualifying real estate assets for purposes of the 75% asset test, (ii) becoming subject to the 5% asset test, the 10% vote test and the 10% value test generally applicable to a REIT’s ownership in corporations other than REITs and TRSs, and (iii) thereby jeopardizing the REIT parent’s own REIT qualification and taxation on account of the subsidiary’s failure cascading up to the REIT parent, all as described below under the heading “—Asset Tests” below.
We own a substantial amount of the outstanding common shares of SIR, which we believe has qualified and will remain qualified for taxation as a REIT under the IRC. In addition, we have invested and may in the future invest in real estate through one or more other subsidiary entities that have intended and are intended to qualify for taxation as REITs.. We have made and expect to make protective TRS elections with respect to our subsidiary REITs and have implementedmay implement other protective arrangements intended to avoid a cascading REIT failure if any of our intended subsidiary REITs didwere not to qualify for taxation as a REIT, but we cannot be sure that such protective elections and other arrangements will be effective in every instance so as to avoid or mitigate the resulting adverse consequences to us. For example, we joined with SIR in filing a protective TRS election, effective for the third quarter of 2014, and we have reaffirmed this protective election with SIR every January thereafter, and we may continue to do so unless and until our ownership of SIR falls below 10%. Pursuant to this protective TRS election, we believe that if SIR is not a REIT for some reason, then it would instead be considered one of our TRSs, and as such its value would either fit within our REIT gross asset tests described below or would be such that any penalty taxes associated with our remediation of a REIT asset test failure for which there is reasonable cause, as described below, would be much lower than if no such TRS election were in place, though any applicable penalty taxes might still be substantial. Protective TRS elections will not impact our compliance with the 75% and 95% gross income tests described below, because we do not expect our gains and dividends from a subsidiary REIT’s shares to jeopardize compliance with these tests even if for some reason the subsidiary is not a REIT.
Taxable REIT Subsidiaries.As a REIT, we are permitted to own any or all of the securities of a TRS, provided that no more than 20% (25% before our 2018 taxable year) of the total value of our assets, at the close of each quarter, is comprised of our investments in the stock or other securities of our TRSs. Very generally, a TRS is a subsidiary corporation other than a REIT in which a REIT directly or indirectly holds stock and that has made a joint election with its affiliated REIT to be treated as a TRS. Our ownership of stock and other securities in our TRSs is exempt from the 5% asset test, the 10% vote test and the 10% value test discussed below.
In addition, any corporation (other than a REIT) in which a TRS directly or indirectly owns more than 35% of the voting power or value of the outstanding securities is automatically a TRS. Subject to the discussion below, we believe that we and each of our TRSs have complied with, and will continue to comply with, the requirements for TRS status at all times during which we intend for the subsidiary’s TRS election to be in effect, and we believe that the same will be true for any TRS that we later form or acquire.
We acquired in the second quarter of 2015, and owned until the fourth quarter of 2015, an ownership position in RMR Inc. that was in excess of 10% of RMR Inc.’s outstanding securities by vote or value. Accordingly, we elected to treat RMR Inc. as a TRS effective as of June 5, 2015. RMR Inc., through its principal subsidiary, RMR LLC, has provided and continues to provide
business and property management and other services to us and to other public and private companies, including other public REITs. Among these clients were and are operators of lodging facilities, operators of health care facilities, and owners of such facilities. Our counsel, Sullivan & Worcester LLP, has provided to us an opinion that the activities proscribed to TRSs under Section 856(l)(3) of the IRC relating to operating or managing lodging facilities or health care facilities should include only regular onsite services or day-to-day operational activities at or for lodging facilities or health care facilities. To the best of our knowledge, neither RMR Inc. nor RMR LLC has been or is involved in proscribed activities at or for lodging facilities or health care facilities. Thus, we do not believe that Section 856(l)(3) of the IRC precluded or precludes RMR Inc. from being treated as our TRS. In addition, because we acquired a significant portion of our investment in RMR Inc. in exchange for our common shares that were newly issued, our counsel, Sullivan & Worcester LLP, is of the opinion that our investment in RMR Inc. should have qualified as a “temporary investment of new capital” under Section 856(c)(5)(B) of the IRC to the extent related to such issuance of our common shares. To the extent our investment in RMR Inc. so qualified, it constituted a “real estate asset” under Section 856(c) of the IRC and did not constitute a security subject to the REIT asset test limitations discussed below for a one-year period that ended in June 2016. If the IRS or a court determines, contrary to the opinion of our counsel, that RMR Inc. was or is precluded from being treated as our TRS, then our ownership position in RMR Inc. in excess of 10% of RMR Inc.’s outstanding securities by vote or value, except to the extent and for the period that such ownership qualified as a “temporary investment of new capital,” would have been and would be in violation of the applicable REIT asset tests described below. Under those circumstances, however, we expect that we would qualify for the REIT asset tests’ relief provision described below, and thereby would preserve our qualification for taxation as a REIT. If the relief provision below were to apply to us, we would be subject to tax at the highest regular corporate income tax rate on the net income generated by our investment in RMR Inc. in excess of a 10% ownership position in that company.
As discussed below, TRSs can perform services for our tenants without disqualifying the rents we receive from those tenants under the 75% gross income test or the 95% gross income test discussed below. Moreover, because our TRSs are taxed as C corporations that are separate from us, their assets, liabilities and items of income, deduction and credit generally are not imputed to us for purposes of the REIT qualification requirements described in this summary. Therefore, our TRSs may generally conduct activities that would be treated as prohibited transactions or would give rise to nonqualified income if conducted by us directly. As regular C corporations, TRSs may generally utilize net operating losses and other tax attribute carryforwards to reduce or otherwise eliminate federal income tax liability in a given taxable year. Net operating losses and other carryforwards are subject to limitations, however, including limitations imposed under Section 382 of the IRC following an “ownership change” (as defined in applicable Treasury regulations) and a limitation stemming from December 2017 amendments to the IRC providing that carryforwards of net operating losses arising in taxable years beginning after 2017 generally cannot offset more than 80% of the current year’s taxable income. Moreover, pursuant to the December 2017 amendments to the IRC, net operating losses arising in taxable years beginning after 2017 may not be carried back, but may be carried forward indefinitely. As a result, we cannot be sure that our TRSs will be able to utilize, in full or in part, any net operating losses or other carryforwards that they may generate in the future.
Restrictions and sanctions are imposed on TRSs and their affiliated REITs to ensure that the TRSs will be subject to an appropriate level of federal income taxation. For example, if a TRS pays interest, rent or other amounts to its affiliated REIT in an amount that exceeds what an unrelated third party would have paid in an arm’s length transaction, then the REIT generally will be subject to an excise tax equal to 100% of the excessive portion of the payment. Further, if in comparison to an arm’s length transaction, a third-party tenant has overpaid rent to the REIT in exchange for underpaying the TRSfor services rendered, and if the REIT has not adequately compensated the TRS for services provided to or on behalf of the third-party tenant, then the REIT may be subject to an excise tax equal to 100% of the undercompensation to the TRS. A safe harbor exception to this excise tax applies if the TRS has been compensated at a rate at least equal to 150% of its direct cost in
furnishing or rendering the service. Finally, beginning with our 2016 taxable year, the 100% excise tax also applies to the underpricing of services provided by one of our TRSsa TRS to usits affiliated REIT in contexts where the services are unrelated to services for ourREIT tenants. We cannot be sure that arrangements involving our TRSs will not result in the imposition of one or more of these restrictions or sanctions, but we do not believe that we or our TRSs are or will be subject to these impositions.
Income Tests. There areWe must satisfy two gross income requirements fortests annually to maintain our qualification for taxation as a REIT under the IRC:
AtREIT. First, at least 75% of our gross income for each taxable year (excluding: (a) gross income from sales or other dispositions of property subject to the 100% tax on prohibited transactions; (b) any income arising from “clearly identified” hedging transactions that we enter into to manage interest rate or price changes or currency fluctuations with respect to borrowings we incur to acquire or carry real estate assets; (c) any income arising from “clearly identified” hedging transactions that we enter into primarily to manage risk of currency fluctuations relating to any item that qualifies under the 75% gross income test or the 95% gross income test (or any property that generates such income or gain); (d) beginning with our 2016 taxable year, any income from “clearly identified” hedging transactions that we enter into to manage risk associated with extant, qualified hedges of liabilities or properties that have been extinguished or disposed; (e) real estate foreign
exchange gain (as defined in Section 856(n)(2) of the IRC); and (f) income from the repurchase or discharge of indebtedness) must be derived from investments relating to real property, including “rents from real property” as defined underwithin the meaning of Section 856856(d) of the IRC, interest and gain from mortgages on real property or on interests in real property, income and gain from foreclosure property, gain from the sale or other disposition of real property (including specified ancillary personal property treated as real property under the IRC), or dividends on and gain from the sale or disposition of shares in other REITs (but excluding in all cases any gains subject to the 100% tax on prohibited transactions). When we receive new capital in exchange for our shares or in a public offering of our five-year or longer debt instruments, income attributable to the temporary investment of this new capital in stock or a debt instrument, if received or accrued within one year of our receipt of the new capital, is generally also qualifying income under the 75% gross income test.
At Second, at least 95% of our gross income for each taxable year (excluding: (a) grossmust consist of income from sales or other dispositionsthat is qualifying income for purposes of property subject to the 100% tax on prohibited transactions; (b) any income arising from “clearly identified” hedging transactions that we enter into to manage interest rate or price changes or currency fluctuations with respect to borrowings we incur to acquire or carry real estate assets; (c) any income arising from “clearly identified” hedging transactions that we enter into primarily to manage risk of currency fluctuations relating to any item that qualifies under the 75% gross income test, other types of interest and dividends, gain from the sale or the 95% grossdisposition of stock or securities, or any combination of these. Gross income test (or anyfrom our sale of property that generateswe hold primarily for sale to customers in the ordinary course of business, income and gain from specified “hedging transactions” that are clearly and timely identified as such, income or gain); (d) beginning with our 2016 taxable year, any income from “clearly identified” hedging transactions that we enter into to manage risk associated with extant, qualified hedges of liabilities or properties that have been extinguished or disposed; (e) passive foreign exchange gain (as defined in Section 856(n)(3) of the IRC); and (f) income from the repurchase or discharge of indebtedness) must be derivedindebtedness is excluded from a combination of items of real property income that satisfyboth the 75%numerator and the denominator in both gross income test described above, dividends, interest, ortests. In addition, specified foreign currency gains from the sale or disposition of stock, securities or real property (but excluding in all cases any gains subject to the 100% tax on prohibited transactions).
Although we will use our best efforts to ensure that the income generated by our investments will be of a type that satisfies both the 75% and 95%excluded from gross income tests, we cannot be sure in this regard.
for purposes of one or both of the gross income tests.
In order to qualify as “rents from real property” underwithin the meaning of Section 856856(d) of the IRC, several requirements must be met:
The amount of rent received generally must not be based on the income or profits of any person, but may be based on a fixed percentage or percentages of receipts or sales.
Rents generally do not qualify if the REIT owns 10% or more by vote or value of stock of the tenant (or 10% or more of the interests in the assets or net profits of the tenant, if the tenant is not a corporation), whether directly or after application of attribution rules. We generally do not intend to lease property to any party if rents from that property would not qualify as “rents from real property,” but application of the 10% ownership rule is dependent upon complex attribution rules and circumstances that may be beyond our control. Our declaration of trust generally disallows transfers or purported acquisitions, directly or by attribution, of our shares to the extent necessary to maintain our qualification for taxation as a REIT under the IRC. Nevertheless, we cannot be sure that these restrictions will be effective to prevent our qualification for taxation as a REIT from being jeopardized under the 10% affiliated tenant rule. Furthermore, we cannot be sure that we will be able to monitor and enforce these restrictions, nor will our shareholders necessarily be aware of ownership of our shares attributed to them under the IRC’s attribution rules.
There is a limited exception to the above prohibition on earning “rents from real property” from a 10% affiliated tenant where the tenant is a TRS. If at least 90% of the leased space of a property is leased to tenants other than TRSs and 10% affiliated tenants, and if the TRS’s rent to the REIT for space at that property is substantially comparable to the rents paid by nonaffiliated tenants for comparable space at the property, then otherwise qualifying rents paid by the TRS to the REIT will not be disqualified on account of the rule prohibiting 10% affiliated tenants.
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• | In order for rents to qualify, a REIT generally must not manage the property or furnish or render services to the tenants of the property, except through an independent contractor from whom it derives no income or through one of its TRSs. There is an exception to this rule permitting a REIT to perform customary management and tenant services of the sort that a tax-exempt organization could perform without being considered in receipt of “unrelated business taxable income” as defined in Section 512(b)(3) of the IRC, or UBTI. In addition, a de minimis amount of noncustomary services provided to tenants will not disqualify income as “rents from real property” as long as the value of the impermissible tenant services does not exceed 1% of the gross income from the property. |
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• | If rent attributable to personal property leased in connection with a lease of real property is 15% or less of the total rent received under the lease, then the rent attributable to personal property will qualify as “rents from real property”; if this 15% threshold is exceeded, then the rent attributable to personal property will not so qualify. The portion of rental income treated as attributable to personal property is determined according to the ratio of the fair market valueof the personal property to the total fair market value of the real and personal property that is rented. |
In order for rents to qualify, we generally must not manage the property or furnish or render services to the tenants of the property, except through an independent contractor from whom we derive no income or through one of our TRSs. There is an exception to this rule permitting a REIT to perform customary management and tenant services of the sort that a tax-exempt organization could perform without being considered in receipt of “unrelated business taxable income,” or UBTI, under Section 512(b)(3) of the IRC. In addition, a de minimis amount of noncustomary services provided to tenants will not disqualify income as “rents from real property” as long as the value of the impermissible tenant services does not exceed 1% of the gross income from the property.
If rent attributable to personal property leased in connection with a lease of real property is 15% or less of the total rent received under the lease, then the rent attributable to personal property qualifies as “rents from real property.” None of the rent attributable to personal property received under a lease will qualify if this 15% threshold is exceeded. The portion
of rental income treated as attributable to personal property is determined according to the ratio of the fair market value of the personal property to the total fair market value of the real and personal property that is rented.
In addition, “rents from real property” includes both charges we receive for services customarily rendered in connection with the rental of comparable real property in the same geographic area, even if the charges are separately stated, as well as charges we receive for services provided by our TRSs when the charges are not separately stated. Whether separately stated charges received by a REIT for services that are not geographically customary and provided by a TRS are included in “rents from real property” has not been addressed clearly by the IRS in published authorities; however, our counsel, Sullivan & Worcester LLP, is of the opinion that, although the matter is not free from doubt, “rents from real property” also includes charges we receive for services provided by our TRSs when the charges are separately stated, even if the services are not geographically customary. Accordingly, we believe that our revenues from TRS-provided services, whether the charges are separately stated or not, qualify as “rents from real property” because the services satisfy the geographically customary standard, because the services have been provided by a TRS, or for both reasons.
We believe that all or substantially all of our rents and related service charges have qualified and will continue to qualify as “rents from real property” for purposes of Section 856 of the IRC.
In order to qualify as mortgage interest on real property for purposes of the 75% gross income test, interest must derive from a loan secured by a mortgage on real property or on interests in real property (including, in the case of a loan secured by both real property and personal property, such personal property to the extent that it does not exceed 15% of the total fair market value of all of the property securing the loan) with a fair market value at the time the loan is made (reduced by any senior liens on the property) at least equal to the amount of such loan. If the amount of the loan exceeds the fair market value of the real property (as so reduced by senior liens), then a part of the interest income from such loan equal to the percentage amount by which the loan exceeds the value of the real property (as so reduced by senior liens) will not be qualifying income for purposes of the 75% gross income test, but will be qualifying income for purposes of the 95% gross income test.
Absent the “foreclosure property” rules of Section 856(e) of the IRC, a REIT’s receipt of active, nonrental gross income from a property would not qualify under the 75% and 95% gross income tests. But as foreclosure property, the active, nonrental gross income from the property would so qualify. Foreclosure property is generally any real property, including interests in real property, and any personal property incident to such real property:
that is acquired by a REIT as a result of the REIT having bid on such property at foreclosure, or having otherwise reduced such property to ownership or possession by agreement or process of law, after there was a default or when default was imminent on a lease of such property or on indebtedness that such property secured;
for which any related loan acquired by the REIT was acquired at a time when the default was not imminent or anticipated; and
for which the REIT makes a proper election to treat the property as foreclosure property.
Any gain that a REIT recognizes on the sale of foreclosure property held as inventory or primarily for sale to customers, plus any income it receives from foreclosure property that would not otherwise qualify under the 75% gross income test in the absence of foreclosure property treatment, reduced by expenses directly connected with the production of those items of income, would be subject to income tax at the highest regular corporate income tax rate under the foreclosure property income tax rules of Section 857(b)(4) of the IRC. Thus, if a REIT should lease foreclosure property in exchange for rent that qualifies as “rents from real property” as described above, then that rental income is not subject to the foreclosure property income tax.
Property generally ceases to be foreclosure property at the end of the third taxable year following the taxable year in which the REIT acquired the property, or longer if an extension is obtained from the IRS. However, this grace period terminates and foreclosure property ceases to be foreclosure property on the first day:
on which a lease is entered into for the property that, by its terms, will give rise to income that does not qualify for purposes of the 75% gross income test (disregarding income from foreclosure property), or any amountnonqualified income under the 75% gross income test is received or accrued by the REIT, directly or indirectly, pursuant to a lease entered into on or after such day that will give rise to income that does not qualify for purposes of the 75% gross income test;
day;
on which any construction takes place on the property, other than completion of a building or any other improvement where more than 10% of the construction was completed before default became imminent and other than specifically exempted forms of maintenance or deferred maintenance; or
which is more than 90 days after the day on which the REIT acquired the property and the property is used in a trade or business which is conducted by the REIT, other than through an independent contractor from whom the REIT itself does not derive or receive any income or a TRS.
Other than sales of foreclosure property, any gain that we realize on the sale of property held as inventory or other property held primarily for sale to customers in the ordinary course of a trade or business, together known as dealer gains, may be treated as income from a prohibited transaction that is subject to a penalty tax at a 100% rate. The 100% tax does not apply to gains from the sale of property that is held through a TRS, butalthough such income will be subject to tax in the hands of the TRS at regular corporate income tax rates; we may therefore utilize our TRSs in transactions in which we might otherwise recognize dealer gains. Whether property is held as inventory or primarily for sale to customers in the ordinary course of a trade or business is a question of fact that depends on all the facts and circumstances surrounding each particular transaction.
Sections 857(b)(6)(C) and (E) of the IRC provide safe harbors pursuant to which limited sales of real property held for at least two years and meeting specified additional requirements will not be treated as prohibited transactions. However, compliance with the safe harbors is not always achievable in practice. We attempt to structure our activities to avoid transactions that are prohibited transactions, or otherwise conduct such activities through TRSs. WeTRSs; but, we cannot be sure whether or not the IRS might successfully assert that one or more of our dispositions is subject to the 100% penalty tax. Gains subject to the 100% penalty tax are excluded from the 75% and 95% gross income tests, whereas real property gains that are not dealer gains or that are exempted from the 100% penalty tax on account of the safe harbors are considered qualifying gross income for purposes of the 75% and 95% gross income tests.
We believe that any gain from dispositions of assets that we have made, or that we might make in the future, including through any partnerships, will generally qualify as income that satisfies the 75% and 95% gross income tests, to the extent that such assets qualify as real property, and will not be dealer gains or subject to the 100% penalty tax,tax. This is because our general intent has been and is to:
(a) own our assets for investment with a view to long-term income production and capital appreciation;
(b) engage in the business of developing, owning, leasing and managing our existing properties and acquiring, developing, owning, leasing and managing new properties; and
(c) make occasional dispositions of our assets consistent with our long-term investment objectives.
If we fail to satisfy one or both of the 75% gross income test or the 95% gross income test in any taxable year, we may nevertheless qualify for taxation as a REIT for that year if we satisfy the following requirements:
(a) our failure to meet the test is due to reasonable cause and not due to willful neglect; and
(b) after we identify the failure, we file a schedule describing each item of our gross income included in the 75% gross income test or the 95% gross income test for that taxable year.
Even if this relief provision does apply, a 100% tax is imposed upon the greater of the amount by which we failed the 75% gross income test or the amount by which we failed the 95% gross income test, with adjustments, multiplied by a fraction intended to reflect our profitability for the taxable year. This relief provision may apply to a failure of the applicable income tests even if the failure first occurred in a year prior to the taxable year in which the failure was discovered.
Based on the discussion above, we believe that we have satisfied, and will continue to satisfy, the 75% and 95% gross income tests outlined above on a continuing basis beginning with our first taxable year as a REIT.
Asset Tests.Tests. At the close of each calendar quarter of each taxable year, we must also satisfy the following asset percentage tests in order to qualify for taxation as a REIT for federal income tax purposes:
At least 75% of the value of our total assets must consist of “real estate assets,” defined as real property (including interests in real property and interests in mortgages on real property or on interests in real property), ancillary personal property to the extent that rents attributable to such personal property are treated as rents from real property in accordance with the rules described above, (beginning with our 2016 taxable year), cash and cash items, shares in other REITs, debt instruments issued by “publicly offered REITs” as defined in Section 562(c)(2) of the IRC, (beginning with our 2016 taxable year), government securities and temporary investments of new capital (that is, any stock or debt instrument that we hold that is attributable to any amount received by us (a) in exchange for our stock or (b) in a public offering of our five-year or longer debt instruments, but in each case only for the one-year period commencing with our receipt of the new capital).
Not more than 25% of the value of our total assets may be represented by securities other than those securities that count favorably toward the preceding 75% asset test.
Of the investments included in the preceding 25% asset class, the value of any one non-REIT issuer’s securities that we own may not exceed 5% of the value of our total assets. In addition, we may not own more than 10% of the vote or value of any one non-REIT issuer’s outstanding securities, unless the securities are “straight debt” securities or otherwise excepted as discussed below. Our stock and other securities in a TRS are exempted from these 5% and 10% asset tests.
Not more than 20% (25% before our 2018 taxable year) of the value of our total assets may be represented by stock or other securities of our TRSs.
Beginning with our 2016 taxable year, notNot more than 25% of the value of our total assets may be represented by “nonqualified publicly offered REIT debt instruments” as defined in Section 856(c)(5)(L)(ii) of the IRC.
Our counsel, Sullivan & Worcester LLP, is of the opinion that, although the matter is not free from doubt, our investments in the equity or debt of a TRS of ours, to the extent that and during the period in which theyqualify as temporary investments of new capital, will be treated as real estate assets, and not as securities, for purposes of the above REIT asset tests.
If we own a loan secured by a mortgage on real property or on interests in real property (including, in the case of a loan secured by both real property and personal property, such personal property to the extent that it does not exceed 15% of the total fair market value of all of the property securing the loan) with a fair market value at the time the loan is made (reduced by any senior liens on the property) at least equal to the amount of such loan, the mortgage loan will generally be treated as a real estate asset for purposes of the 75% asset test above. But if the loan is undersecured when made, then the portion adequately secured by
the real property (or the interests in real property) will generally be treated as a real estate asset for purposes of the 75% asset test above and the remaining portion will generally be treated as a separate security that must satisfy applicable asset tests.
The above REIT asset tests must be satisfied at the close of each calendar quarter of each taxable year as a REIT. After a REIT meets the asset tests at the close of any quarter, it will not lose its qualification for taxation as a REIT in any subsequent
quarter solely because of fluctuations in the values of its assets. This grandfathering rule may be of limited benefit to a REIT such as us that makes periodic acquisitions of both qualifying and nonqualifying REIT assets. When a failure to satisfy the above asset tests results from an acquisition of securities or other property during a quarter, the failure can be cured by disposition of sufficient nonqualifying assets within30days after the close of that quarter.
In addition, if we fail the 5% asset test, the 10% vote test or the 10% value test at the close of any quarter and we do not cure such failure within 30days after the close of that quarter, that failure will nevertheless be excused if (a) the failure is de minimis and (b) within six months after the last day of the quarter in which we identify the failure, we either dispose of the assets causing the failure or otherwise satisfy the 5% asset test, the 10% vote test and the 10% value test. For purposes of this relief provision, the failure will be de minimis if the value of the assets causing the failure does not exceed $10,000,000. If our failure is not de minimis, or if any of the other REIT asset tests have been violated, we may nevertheless qualify for taxation as a REIT if (a) we provide the IRS with a description of each asset causing the failure, (b) the failure was due to reasonable cause and not willful neglect, (c) we pay a tax equal to the greater of (1) $50,000 or (2) the highest regular corporate income tax rate imposed on the net income generated by the assets causing the failure during the period of the failure, and (d) within six months after the last day of the quarter in which we identify the failure, we either dispose of the assets causing the failure or otherwise satisfy all of the REIT asset tests. These relief provisions may apply to a failure of the applicable asset tests even if the failure first occurred in a year prior to the taxable year in which the failure was discovered.
The IRC also provides an excepted securities safe harbor to the 10% value test that includes among other items (a) “straight debt” securities, (b) specified rental agreements in which payment is to be made in subsequent years, (c) any obligation to pay “rents from real property,” (d) securities issued by governmental entities that are not dependent in whole or in part on the profits of or payments from a nongovernmental entity, and (e) any security issued by another REIT. In addition, any debt instrument issued by an entity classified as a partnership for federal income tax purposes, and not otherwise excepted from the definition of a security for purposes of the above safe harbor, will not be treated as a security for purposes of the 10% value test if at least 75% of the partnership’s gross income, excluding income from prohibited transactions, is qualifying income for purposes of the 75% gross income test.
We have maintained and will continue to maintain records of the value of our assets to document our compliance with the above asset tests and intend to take actions as may be required to cure any failure to satisfy the tests within 30days after the close of any quarter or within the six month periods described above.
Based on the discussion above, we believe that we have satisfied, and will continue to satisfy, the REIT asset tests outlined above on a continuing basis beginning with our first taxable year as a REIT.
Annual Distribution Requirements.Requirements. In order to qualify for taxation as a REIT under the IRC, we are required to make annual distributions other than capital gain dividends to our shareholders in an amount at least equal to the excess of:
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(1) | the sum of 90% of our “real estate investment trust taxable income” and 90% of our net income after tax, if any, from property received in foreclosure, over |
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(2) | the amount by which our noncash income (e.g., imputed rental income or income from transactions inadvertently failing to qualify as like-kind exchanges) exceeds 5% of our “real estate investment trust taxable income.” |
For these purposes, our “real estate investment trust taxable income” is as defined under Section 857 of the IRC and is computed without regard to the dividends paid deduction and our net capital gain and will generally be reduced by specified corporate-level income taxes that we pay (e.g., taxes on built-in gains or foreclosure property income).
The December 2017 amendments to the IRC generally limitlimits the deductibility of net interest expense paid or accrued on debt properly allocable to a trade or business to 30% of “adjusted taxable income,” subject to specified exceptions. Any deduction in excess of the limitation is carried forward and may be used in a subsequent year, subject to that year’s 30% limitation. Provided a taxpayer makes an election to be treated as a real property trade or business (which is irrevocable), the 30% limitation does not apply to a trade or business involving real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage, within the meaning of Section 469(c)(7)(C) of the IRC. Legislative history indicatesand proposed Treasury regulations indicate that a real property trade or business includes a trade or business conducted by a corporation or a
REIT. We intend to makehave made an election to be treated as a real property trade or business and accordingly do not expect the foregoing interest deduction limitations to apply to us or to the calculation of our "real“real estate investment trust taxable income."
For our 2014 and prior taxable years, a distribution of ours that was not pro rata within a class of our beneficial interests entitled to a distribution, or which was not consistent with the rights to distributions among our classes of beneficial interests, would have been a preferential distribution that would not have been taken into consideration for purposes of the distribution requirements, and accordingly the payment of a preferential distribution would have affected our ability to meet the distribution requirements. Taking into account our distribution policies, including any dividend reinvestment plan we adopted, we do not believe that we made any preferential distributions in 2014 or prior taxable years. From and after our 2015 taxable year, the preferential distribution rule has not applied to us because we have been and expect to remain a “publicly offered REIT” (as defined in Section 562(c)(2) of the IRC) that is required to file annual and periodic reports with the SEC under the Exchange Act.
”
Distributions must be paid in the taxable year to which they relate, or in the following taxable year if declared before we timely file our federal income tax return for the earlier taxable year and if paid on or before the first regular distribution payment after that declaration. If a dividend is declared in October, November or December to shareholders of record during
one of those months and is paid during the following January, then for federal income tax purposes such dividend will be treated as having been both paid and received on December 31 of the prior taxable year.
year to the extent of any undistributed earnings and profits.
The 90% distribution requirements may be waived by the IRS if a REIT establishes that it failed to meet them by reason of distributions previously made to meet the requirements of the 4% excise tax discussed below. To the extent that we do not distribute all of our net capital gain and all of our “real estate investment trust taxable income,” as adjusted, we will be subject to federal income tax at regular corporate income tax rates on undistributed amounts. In addition, we will be subject to a 4% nondeductible excise tax to the extent we fail within a calendar year to make required distributions to our shareholders of 85% of our ordinary income and 95% of our capital gain net income plus the excess, if any, of the “grossed up required distribution” for the preceding calendar year over the amount treated as distributed for that preceding calendar year. For this purpose, the term “grossed up required distribution” for any calendar year is the sum of our taxable income for the calendar year without regard to the deduction for dividends paid and all amounts from earlier years that are not treated as having been distributed under the provision. We will be treated as having sufficient earnings and profits to treat as a dividend any distribution by us up to the amount required to be distributed in order to avoid imposition of the 4% excise tax.
If we do not have enough cash or other liquid assets to meet the 90% distribution requirements, or if we so choose, we may find it necessary or desirable to arrange for new debt or equity financing to provide funds for required distributions in order to maintain our qualification for taxation as a REIT. We cannot be sure that financing would be available for these purposes on favorable terms, or at all.
We may be able to rectify a failure to pay sufficient dividends for any year by paying “deficiency dividends” to shareholders in a later year. These deficiency dividends may be included in our deduction for dividends paid for the earlier year, but an interest charge would be imposed upon us for the delay in distribution. While the payment of a deficiency dividend will apply to a prior year for purposes of our REIT distribution requirements and our dividends paid deduction, it will be treated as an additional distribution to the shareholders receiving it in the year such dividend is paid.
In addition to the other distribution requirements above, to preserve our qualification for taxation as a REIT we are required to timely distribute all C corporation earnings and profits that we inherit from acquired corporations, as described below.
Acquisitions of C Corporations
Wemay in the future engage in transactions where we acquire all of the outstanding stock of a C corporation. Upon these acquisitions, except to the extent wemake an applicable TRS election, each of our acquired entities and their various wholly-owned corporate and noncorporate subsidiaries will become our QRSs. Thus, after such acquisitions, all assets, liabilities and items of income, deduction and credit of the acquired and then disregarded entities will be treated as ours for purposes of the various REIT qualification tests described above. In addition, we generallywill be treated as the successor to the acquired and(and then disregardeddisregarded) entities’ federal income tax attributes, such as those entities’ (a) adjusted tax bases in their assets and their depreciation schedules; and (b) earnings and profits for federal income tax purposes, if any. The carryover of these attributes creates REIT implications such as built-in gains tax exposure and additional distribution requirements, as described below. However, when wemake an election under Section 338(g) of the IRC with respect to corporations that we acquire,we generally will not be subject to such attribute carryovers in respect of attributes existing prior to such election.
Built-in Gains from C Corporations.Notwithstanding our qualification and taxation as a REIT, under specified circumstances we may be subject to corporate income taxation if we acquire a REIT asset where our adjusted tax basis in the asset
is determined by reference to the adjusted tax basis of the asset as owned by a C corporation. For instance, we may be subject to federal income taxation on all or part of the built-in gain that was present on the last date an asset was owned by a C corporation, if we succeed to a carryover tax basis in that asset directly or indirectly from such C corporation and if we sell the asset during the five year period beginning on the day the asset ceased being owned by such C corporation. To the extent of our income and gains in a taxable year that are subject to the built-in gains tax, net of any taxes paid on such income and gains with respect to that taxable year, our taxable dividends paid in the following year will be potentially eligible for taxation to noncorporate U.S. shareholders at the preferential tax rates for “qualified dividends” as described below under the heading “—Taxation of Taxable U.S. Shareholders”. We generally do not expect to sell assets if doing so would result in the imposition of a material built-in gains tax liability; but if and when we do sell assets that may have associated built-in gains tax exposure, then we expect to make appropriate provision for the associated tax liabilities on our financial statements.
Earnings and Profits. Following a corporate acquisition, we must generally distribute all of the C corporation earnings and profits inherited in that transaction, if any, no later than the end of our taxable year in which the transaction occurs, in order to preserve our qualification for taxation as a REIT. However, if we fail to do so, relief provisions would allow us to maintain our
qualification for taxation as a REIT provided we distribute any subsequently discovered C corporation earnings and profits and pay an interest charge in respect of the period of delayed distribution. C corporation earnings and profits that we inherit are, in general, specially allocated under a priority rule to the earliest possible distributions following the event causing the inheritance, and only then is the balance of our earnings and profits for the taxable year allocated among our distributions to the extent not already treated as a distribution of C corporation earnings and profits under the priority rule. The distribution of these C corporation earnings and profits is potentially eligible for taxation to noncorporate U.S. shareholders at the preferential tax rates for “qualified dividends” as described below under the heading “—Taxation of Taxable U.S. Shareholders”.
Our Acquisitions
On December 31, 2018, we acquired SIR in a transaction that was intended to qualify as a “reorganization” within the meaning of Section 368(a) of the IRC, and our counsel, Sullivan & Worcester LLP, so opined. In 2017, we acquired FPO in a transaction that was intended to be treated as an asset sale for federal income tax purposes. We believe that each of SIR and FPO qualified for taxation as a REIT for the period prior to the date we acquired it. As a result of these acquisitions, we are generally liable for unpaid taxes, including penalties and interest (if any), of SIR and FPO. If either SIR or FPO is deemed to have lost its qualification for taxation as a REIT prior to the date of our acquisition and no relief is available, we would face the following tax consequences:
as a successor, we would generally inherit any corporate income tax liabilities of the acquired entity, including penalties and interest;
we would be subject to tax on the built-in gain on each asset of the acquired entity existing at the time we acquired it if we were to dispose of such an asset during the five-year period following the date that we acquired the entity; and
we could be required to pay a special distribution and/or employ applicable deficiency dividend procedures (including interest payments to the IRS) to eliminate any earnings and profits accumulated by the acquired entity for taxable periods that it did not qualify for taxation as a REIT.
Finally, if there is an adjustment to SIR’s real estate investment trust taxable income or dividends paid deductions, we could elect to use the deficiency dividend procedure described above to preserve our predecessor SIR’s qualification for taxation as a REIT. It is unclear whether this deficiency dividend procedure would be available to remediate an issue arising from FPO. If and to the extent the remedial provisions are available to us to address SIR or FPO’s REIT qualification and taxation for the applicable periods prior to or including our acquisitions of these entities, we may incur significant cash outlays in connection with such remediation, possibly including (a) required distribution payments to shareholders and associated interest payments to the IRS and (b) tax and interest payments to the IRS and state and local tax authorities.
Depreciation and Federal Income Tax Treatment of Leases
Our initial tax bases in our assets will generally be our acquisition cost. As described above and pursuant to the December 2017 amendments to the IRC, we intend to make an election to be treated as an electing real property trade or business pursuant to Section 163(j)(7)(B) of the IRC; depreciable real property (including specified improvements) held by electing real property trades or businesses must be depreciated under the alternative depreciation system under the IRC, which generally imposes a class life for depreciable real property as long as 40 years. We will generally depreciate our depreciable real property on a straight-line basis over 40 years and our personal property over the applicable shorter periods. These depreciation schedules, and our initial tax bases, may vary for properties that we acquire through tax-free or carryover basis acquisitions (for example, the properties we acquired from SIR), or that are the subject of cost segregation analyses.
We are entitled to depreciation deductions from our facilities only if we are treated for federal income tax purposes as the owner of the facilities. This means that the leases of our facilities must be classified for U.S. federal income tax purposes as true leases, rather than as sales or financing arrangements, and we believe this to be the case.
Distributions to our Shareholders
As described above, we expect to make distributions to our shareholders from time to time. These distributions may include cash distributions, in kind distributions of property, and deemed or constructive distributions resulting from capital market activities. The U.S. federal income tax treatment of our distributions will vary based on the status of the recipient shareholder as more fully described below under the headings “—Taxation of Taxable U.S. Shareholders,” “—Taxation of Tax-Exempt U.S. Shareholders,” and “—Taxation of Non-U.S. Shareholders.”
ASection 302 of the IRC treats a redemption of our shares for cash only will be treated as a distribution under Section 302301 of the IRC, and hence taxable as a dividend to the extent of our available current or accumulated earnings and profits, unless the redemption satisfies one of the tests set forth in Section 302(b) of the IRC enabling the redemption to be treated as a sale or exchange of the shares. The redemption for cash only will be treated as a sale or exchange if it (a) is “substantially disproportionate” with respect to the surrendering shareholder’s ownership in us, (b) results in a “complete termination” of the surrendering
shareholder’s entire share interest in us, or (c) is “not essentially equivalent to a dividend” with respect to the surrendering shareholder, all within the meaning of Section 302(b) of the IRC. In determining whether any of these tests have been met, a shareholder must generally take into account shares considered to be owned by such shareholder by reason of constructive ownership rules set forth in the IRC, as well as shares actually owned by such shareholder. In addition, if a redemption is treated as a distribution under the preceding tests, then a shareholder’s tax basis in the redeemed shares generally will be transferred to the shareholder’s remaining shares in us, if any, and if such shareholder owns no other shares in us, such basis generally may be transferred to a related person or may be lost entirely. Because the determination as to whether a shareholder will satisfy any of the tests of Section 302(b) of the IRC depends upon the facts and circumstances at the time that our shares are redeemed, we urge you to consult your own tax advisor to determine the particular tax treatment of any redemption.
Taxation of Taxable U.S. Shareholders
For noncorporate U.S. shareholders, to the extent that their total adjusted income does not exceed applicable thresholds, the maximum federal income tax rate for long-term capital gains and most corporate dividends is generally 15%. For those noncorporate U.S. shareholders whose total adjusted income exceeds the applicable thresholds, the maximum federal income tax rate for long-term capital gains and most corporate dividends is generally 20%. However, because we are not generally subject to federal income tax on the portion of our “real estate investment trust taxable income” distributed to our shareholders, dividends on our shares generally are not eligible for these preferential tax rates, except that any distribution of C corporation earnings and profits and taxed built-in gain items will potentially be eligible for these preferential tax rates. As a result, our ordinary dividends generally aretaxed at the higher federal income tax rates applicable to ordinary income (subject to the lower effective tax rates applicable to qualified REIT dividends via the deduction-without-outlay mechanism of Section 199A of the IRC, which is generally available to our noncorporate U.S. shareholders for taxable years after 2017 and before 2026). To summarize, the preferential federal income tax rates for long-term capital gains and for qualified dividends generally apply to:
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(1) | long-term capital gains, if any, recognized on the disposition of our shares; |
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(2) | our distributions designated as long-term capital gain dividends (except to the extent attributable to real estate depreciation recapture, in which case the distributions are subject to a maximum 25% federal income tax rate); |
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(3) | our dividends attributable to dividend income, if any, received by us from C corporations such as TRSs; |
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(4) | our dividends attributable to earnings and profits that we inherit from C corporations; and |
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(5) | our dividends to the extent attributable to income upon which we have paid federal corporate income tax (such as taxes on foreclosure property income or on built-in gains), net of the corporate income taxes thereon. |
As long as we qualify for taxation as a REIT, a distribution to our U.S. shareholders that we do not designate as a capital gain dividend generally will be treated as an ordinary income dividend to the extent of our available current or accumulated earnings and profits (subject to the lower effective tax rates applicable to qualified REIT dividends via the deduction-without-outlay mechanism of Section 199A of the IRC, which is available to our noncorporate U.S. shareholders for taxable years after 2017 and before 2026). Distributions made out of our current or accumulated earnings and profits that we properly designate as capital gain dividends generally will be taxed as long-term capital gains, as discussed below, to the extent they do not exceed our actual net capital gain for the taxable year. However, corporate shareholders may be required to treat up to 20% of any capital gain dividend as ordinary income under Section 291 of the IRC.
In addition, we may elect to retain net capital gain income and treat it as constructively distributed. In that case:
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(1) | we will be taxed at regular corporate capital gains tax rates on retained amounts; |
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(2) | each of our U.S. shareholders will be taxed on its designated proportionate share of our retained net capital gains as though that amount were distributed and designated as a capital gain dividend; |
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(3) | each of our U.S. shareholders will receive a credit or refund for its designated proportionate share of the tax that we pay; |
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(4) | each of our U.S. shareholders will increase its adjusted basis in our shares by the excess of the amount of its proportionate share of these retained net capital gains over the U.S. shareholder’s proportionate share of the tax that we pay; and |
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(5) | both we and our corporate shareholders will make commensurate adjustments in our respective earnings and profits for federal income tax purposes. |
If we elect to retain our net capital gains in this fashion, we will notify our U.S. shareholders of the relevant tax information within 60days after the close of the affected taxable year.
If for any taxable year we designate capital gain dividends for our shareholders, then a portion of the capital gain dividends we designate will be allocated to the holders of a particular class of shares on a percentage basis equal to the ratio of the amount of the total dividends paid or made available for the year to the holders of that class of shares to the total dividends paid or made available for the year to holders of all outstanding classes of our shares. We will similarly designate the portion of any dividend
that is to be taxed to noncorporate U.S. shareholders at preferential maximum rates (including any qualified dividend income and any capital gains attributable to real estate depreciation recapture that are subject to a maximum 25% federal income tax rate) so that the designations will be proportionate among all outstanding classes of our shares.
Distributions in excess of our current or accumulated earnings and profits will not be taxable to a U.S. shareholder to the extent that they do not exceed the shareholder’s adjusted tax basis in our shares, but will reduce the shareholder’s basis in such shares. To the extent that these excess distributions exceed a U.S. shareholder’s adjusted basis in such shares, they will be included in income as capital gain, with long-term gain generally taxed to noncorporate U.S. shareholders at preferential maximum rates. No U.S. shareholder may include on its federal income tax return any of our net operating losses or any of our capital losses. In addition, no portion of any of our dividends is eligible for the dividends received deduction for corporate shareholders.
If a dividend is declared in October, November or December to shareholders of record during one of those months and is paid during the following January, then for federal income tax purposes the dividend will be treated as having been both paid and received on December 31 of the prior taxable year.
A U.S. shareholder will generally recognize gain or loss equal to the difference between the amount realized and the shareholder’s adjusted basis in our shares that are sold or exchanged. This gain or loss will be capital gain or loss, and will be long-term capital gain or loss if the shareholder’s holding period in our shares exceeds one year. In addition, any loss upon a sale or exchange of our shares held for six months or less will generally be treated as a long-term capital loss to the extent of any long-term capital gain dividends we paid on such shares during the holding period.
U.S. shareholders who are individuals, estates or trusts are generally required to pay a 3.8% Medicare tax on their net investment income (including dividends on our shares (without regard to any deduction allowed by Section 199A of the IRC) and gains from the sale or other disposition of our shares), or in the case of estates and trusts on their net investment income that is not distributed, in each case to the extent that their total adjusted income exceeds applicable thresholds. U.S. shareholders are urged to consult their tax advisors regarding the application of the 3.8% Medicare tax, including the applicability of the deduction-without-outlay mechanism of Section 199A of the IRC to the calculation of their net investment income.
tax.
If a U.S. shareholder recognizes a loss upon a disposition of our shares in an amount that exceeds a prescribed threshold, it is possible that the provisions of Treasury regulations involving “reportable transactions” could apply, with a resulting requirement to separately disclose the loss-generating transaction to the IRS. These Treasury regulations are written quite broadly, and apply to many routine and simple transactions. A reportable transaction currently includes, among other things, a sale or exchange of our shares resulting in a tax loss in excess of (a) $10 million in any single year or $20 million in a prescribed combination of taxable years in the case of our shares held by a C corporation or by a partnership with only C corporation partners or (b) $2 million in any single year or $4 million in a prescribed combination of taxable years in the case of our shares held by any other partnership or an S corporation, trust or individual, including losses that flow through pass through entities to individuals. A taxpayer discloses a reportable transaction by filing IRS Form 8886 with its federal income tax return and, in the first year of filing, a copy of Form 8886 must be sent to the IRS’s Office of Tax Shelter Analysis. The annual maximum penalty for failing to disclose a reportable transaction is generally $10,000 in the case of a natural person and $50,000 in any other case.
Noncorporate U.S. shareholders who borrow funds to finance their acquisition of our shares could be limited in the amount of deductions allowed for the interest paid on the indebtedness incurred. Under Section 163(d) of the IRC, interest paid or accrued on indebtedness incurred or continued to purchase or carry property held for investment is generally deductible only to the extent of the investor’s net investment income. A U.S. shareholder’s net investment income will include ordinary income dividend distributions received from us and, only if an appropriate election is made by the shareholder, capital gain dividend distributions and qualified dividends received from us, and it is possible that ordinary REIT dividends received from us. In addition, a U.S. shareholder that utilizes the deduction under Section 199A of the IRC with respect to qualified REIT dividends received from us may also be required to make a similar election in order to include such qualified REIT dividends in the calculation of net investment income. Distributionsus; however, distributions treated as a nontaxable return of the shareholder’s basis will not enter into the computation of net investment income.
Taxation of Tax-Exempt U.S. Shareholders
The rules governing the federal income taxation of tax-exempt entities are complex, and the following discussion is intended only as a summary of material considerations of an investment in our shares relevant to such investors. If you are a
tax-exempt shareholder, we urge you to consult your own tax advisor to determine the impact of federal, state, local and foreign tax laws, including any tax return filing and other reporting requirements, with respect to your acquisition of or investment in our shares.
Our distributions made to shareholders that are tax-exempt pension plans, individual retirement accounts or other qualifying tax-exempt entities should not constitute UBTI, provided that the shareholder has not financed its acquisition of our shares with “acquisition indebtedness” within the meaning of the IRC, that the shares are not otherwise used in an unrelated trade or business of the tax-exempt entity, and that, consistent with our present intent, we do not hold a residual interest in a real estate mortgage investment conduit or otherwise hold mortgage assets or conduct mortgage securitization activities that generate “excess inclusion” income.
Taxation of Non-U.S. Shareholders
The rules governing the U.S. federal income taxation of non-U.S. shareholders are complex, and the following discussion is intended only as a summary of material considerations of an investment in our shares relevant to such investors. If you are a non-U.S. shareholder, we urge you to consult your own tax advisor to determine the impact of U.S. federal, state, local and foreign tax laws, including any tax return filing and other reporting requirements, with respect to your acquisition of or investment in our shares.
We expect that a non-U.S. shareholder’s receipt of (a) distributions from us, and (b) proceeds from the sale of our shares, will not be treated as income effectively connected with a U.S. trade or business and a non-U.S. shareholder will therefore not be subject to the often higher federal tax and withholding rates, branch profits taxes and increased reporting and filing requirements that apply to income effectively connected with a U.S. trade or business. This expectation and a number of the determinations below are predicated on our shares being listed on a U.S. national securities exchange, such as The NASDAQNasdaq Stock Market LLC, or Nasdaq. Although we cannot be sure, we expect that eachEach class of our shares has been and will remain listed on a U.S. national securities exchange; however, we cannot be sure that our shares will continue to be so listed in future taxable years or that any class of our shares that we may issue in the future will be so listed.
Distributions.Distributions. A distribution by us to a non-U.S. shareholder that is not designated as a capital gain dividend will be treated as an ordinary income dividend to the extent that it is made out of our current or accumulated earnings and profits. A distribution of this type will generally be subject to U.S. federal income tax and withholding at the rate of 30%, or at a lower rate if the non-U.S. shareholder has in the manner prescribed by the IRS demonstrated to the applicable withholding agent its entitlement to benefits under a tax treaty. Because we cannot determine our current and accumulated earnings and profits until the end of the taxable year, withholding at the statutory rate of 30% or applicable lower treaty rate will generally be imposed on the gross amount of any distribution to a non-U.S. shareholder that we make and do not designate as a capital gain dividend. Notwithstanding this potential withholding on distributions in excess of our current and accumulated earnings and profits, these excess portions of distributions are a nontaxable return of capital to the extent that they do not exceed the non-U.S. shareholder’s adjusted basis in our shares, and the nontaxable return of capital will reduce the adjusted basis in these shares. To the extent that distributions in excess of our current and accumulated earnings and profits exceed the non-U.S. shareholder’s adjusted basis in our shares, the distributions will give rise to U.S. federal income tax liability only in the unlikely event that the non-U.S. shareholder would otherwise be subject to tax on any gain from the sale or exchange of these shares, as discussed below under the heading “—Dispositions of Our Shares.” A non-U.S. shareholder may seek a refund from the IRS of amounts withheld on distributions to it in excess of such shareholder’s allocable share of our current and accumulated earnings and profits.
For so long as a class of our shares is listed on a U.S. national securities exchange, capital gain dividends that we declare and pay to a non-U.S. shareholder on those shares, as well as dividends to a non-U.S. shareholder on those shares attributable to our sale or exchange of “United States real property interests” within the meaning of Section 897 of the IRC, or USRPIs, will not be subject to withholding as though those amounts were effectively connected with a U.S. trade or business, and non-U.S. shareholders will not be required to file U.S. federal income tax returns or pay branch profits tax in respect of these dividends. Instead, these dividends will generally be treated as ordinary dividends and subject to withholding in the manner described above.
Tax treaties may reduce the withholding obligations on our distributions. Under some treaties, however, rates below 30% that are applicable to ordinary income dividends from U.S. corporations may not apply to ordinary income dividends from a REIT or may apply only if the REIT meets specified additional conditions. A non-U.S. shareholder must generally use an applicable IRS Form W-8, or substantially similar form, to claim tax treaty benefits. If the amount of tax withheld with respect to a distribution to a non-U.S. shareholder exceeds the shareholder’s U.S. federal income tax liability with respect to the distribution, the non-U.S. shareholder may file for a refund of the excess from the IRS. Treasury regulations also provide special rules to determine whether, for purposes of determining the applicability of a tax treaty, our distributions to a non-U.S.
shareholder that is an entity should be treated as paid to the entity or to those owning an interest in that entity, and whether the entity or its owners are entitled to benefits under the tax treaty.
If, contrary to our expectation, a class of our shares was not listed on a U.S. national securities exchange and we made a distribution on those shares that was attributable to gain from the sale or exchange of a USRPI, then a non-U.S. shareholder
holding those shares would be taxed as if the distribution was gain effectively connected with a trade or business in the United States conducted by the non-U.S.non-U.S. shareholder. In addition, the applicable withholding agent would be required to withhold from a distribution to such a non-U.S.non-U.S. shareholder, and remit to the IRS, up to 21% of the maximum amount of any distribution that was or could have been designated as a capital gain dividend. The non-U.S. shareholder also would generally be subject to the same treatment as a U.S. shareholder with respect to the distribution (subject to any applicable alternative minimum tax and a special alternative minimum tax in the case of a nonresident alien individual), would be subject to fulsome U.S. federal income tax return reporting requirements, and, in the case of a corporate non-U.S. shareholder, may owe the up to 30% branch profits tax under Section 884 of the IRC (or lower applicable tax treaty rate) in respect of these amounts.
Dispositions of Our Shares. Shares. If as expected our shares are not USRPIs, then a non-U.S. shareholder’s gain on the sale of these shares generally will not be subject to U.S. federal income taxation or withholding. We expect that our shares will not be USRPIs because one or both of the following exemptions will be available at all times.
First, for so long as a class of our shares is listed on a U.S. national securities exchange, a non-U.S. shareholder’s gain on the sale of those shares will not be subject to U.S. federal income taxation as a sale of a USRPI. Second, our shares will not constitute USRPIs if we are a “domestically controlled” REIT. A domestically controlledWe will be a “domestically controlled” REIT if less than 50% of the value of our shares (including any future class of shares that we may issue) is a REIT in whichheld, directly or indirectly, by non-U.S. shareholders at all times during the preceding five-year period less than 50%five years, after applying specified presumptions regarding the ownership of our shares as described in Section 897(h)(4)(E) of the fair market value of its outstanding shares was directly or indirectly held by foreign persons. From and after December 18, 2015, a person who at all relevant times holds less than 5% of a REIT’s shares that are “regularly traded” on a domestic “established securities market” is deemed to be a U.S. person in making the determination of whether a REIT is domestically controlled, unless the REIT has actual knowledge that the person is not a U.S. person. Other presumptions apply in making the determination with respect to other classes of REIT shareholders. As a result of applicable presumptions, we expect to be able to demonstrate from and after December 18, 2015 that we are less than 50% foreign owned.IRC. For periods prior to December 18, 2015,these purposes, we believe that we were less than 50% foreign owned, but that may not be possiblethe statutory ownership presumptions apply to demonstrate unless and until technical corrections legislation expressly expands application of the ownership presumptions.validate our status as a “domestically controlled” REIT. Accordingly, although we cannot be sure, we believe that we are and will remain a “domestically controlled” REIT.
If, contrary to our expectation, a gain on the sale of our shares is subject to U.S. federal income taxation (for example, because neither of the above exemptions were then available, i.e., that class of our shares were not then listed on a U.S. national securities exchange and we were not a “domestically controlled” REIT), then (a) a non-U.S. shareholder would generally be subject to the same treatment as a U.S. shareholder with respect to its gain (subject to any applicable alternative minimum tax and a special alternative minimum tax in the case of nonresident alien individuals), (b) the non-U.S. shareholder would also be subject to fulsome U.S. federal income tax return reporting requirements, and (c) a purchaser of that class of our shares from the non-U.S. shareholder may be required to withhold 15% of the purchase price paid to the non-U.S. shareholder and to remit the withheld amount to the IRS.
Information Reporting, Backup Withholding, and Foreign Account Withholding
Information reporting, backup withholding, and foreign account withholding may apply to distributions or proceeds paid to our shareholders under the circumstances discussed below. If a shareholder is subject to backup or other U.S. federal income tax withholding, then the applicable withholding agent will be required to withhold the appropriate amount with respect to a deemed or constructive distribution or a distribution in kind even though there is insufficient cash from which to satisfy the withholding obligation. To satisfy this withholding obligation, the applicable withholding agent may collect the amount of U.S. federal income tax required to be withheld by reducing to cash for remittance to the IRS a sufficient portion of the property that the shareholder would otherwise receive or own, and the shareholder may bear brokerage or other costs for this withholding procedure.
Amounts withheld under backup withholding are generally not an additional tax and may be refunded by the IRS or credited against the shareholder’s federal income tax liability, provided that such shareholder timely files for a refund or credit with the IRS. A U.S. shareholder may be subject to backup withholding when it receives distributions on our shares or proceeds upon the sale, exchange, redemption, retirement or other disposition of our shares, unless the U.S. shareholder properly executes, or has previously properly executed, under penalties of perjury an IRS Form W-9 or substantially similar form that:
provides the U.S. shareholder’s correct taxpayer identification number;
certifies that the U.S. shareholder is exempt from backup withholding because (a) it comes within an enumerated exempt category, (b) it has not been notified by the IRS that it is subject to backup withholding, or (c) it has been notified by the IRS that it is no longer subject to backup withholding; and
certifies that it is a U.S. citizen or other U.S. person.
If the U.S. shareholder has not provided and does not provide its correct taxpayer identification number and appropriate certifications on an IRS Form W-9 or substantially similar form, it may be subject to penalties imposed by the IRS, and the applicable withholding agent may have to withhold a portion of any distributions or proceeds paid to such U.S. shareholder. Unless the U.S. shareholder has established on a properly executed IRS Form W-9 or substantially similar form that it comes within an enumerated exempt category, distributions or proceeds on our shares paid to it during the calendar year, and the amount of tax withheld, if any, will be reported to it and to the IRS.
Distributions on our shares to a non-U.S. shareholder during each calendar year and the amount of tax withheld, if any, will generally be reported to the non-U.S. shareholder and to the IRS. This information reporting requirement applies regardless of whether the non-U.S. shareholder is subject to withholding on distributions on our shares or whether the withholding was reduced or eliminated by an applicable tax treaty. Also, distributions paid to a non-U.S. shareholder on our shares will generally be subject to backup withholding, unless the non-U.S. shareholder properly certifies to the applicable withholding agent its non-U.S. shareholder status on an applicable IRS Form W-8 or substantially similar form. Information reporting and backup withholding will not apply to proceeds a non-U.S. shareholder receives upon the sale, exchange, redemption, retirement or other disposition of our shares, if the non-U.S. shareholder properly certifies to the applicable withholding agent its non-U.S. shareholder status on an applicable IRS Form W-8 or substantially similar form. Even without having executed an applicable IRS Form W-8 or substantially similar form, however, in some cases information reporting and backup withholding will not apply to proceeds that a non-U.S. shareholder receives upon the sale, exchange, redemption, retirement or other disposition of our shares if the non-U.S. shareholder receives those proceeds through a broker’s foreign office.
Non-U.S. financial institutions and other non-U.S. entities are subject to diligence and reporting requirements for purposes of identifying accounts and investments held directly or indirectly by U.S. persons. The failure to comply with these additional information reporting, certification and other requirements could result in a 30% U.S. withholding tax on applicable payments to non-U.S. persons, notwithstanding any otherwise applicable provisions of an income tax treaty. In particular, a payee that is a foreign financial institution that is subject to the diligence and reporting requirements described above must enter into an agreement with the U.S. Department of the Treasury requiring, among other things, that it undertake to identify accounts held by “specified United States persons” or “United States owned foreign entities” (each as defined in the IRC)IRC and administrative guidance thereunder), annually report information about such accounts, and withhold 30% on applicable payments to noncompliant foreign financial institutions and account holders. Foreign financial institutions located in jurisdictions that have an intergovernmental agreement with the United States with respect to these requirements may be subject to different rules. The foregoing withholding regime generally applies to payments of dividends on our shares, and is expected to generally apply to other “withholdable payments” (including payments of gross proceeds from a sale, exchange, redemption, retirement or other disposition of our shares) made after December 31, 2018.shares. In general, to avoid withholding, any non-U.S. intermediary through which a shareholder owns our shares must establish its compliance with the foregoing regime, and a non-U.S. shareholder must provide specified documentation (usually an applicable IRS Form W-8) containing information about its identity, its status, and if required, its direct and indirect U.S. owners. Non-U.S. shareholders and shareholders who hold our shares through a non-U.S. intermediary are encouraged to consult their own tax advisors regarding foreign account tax compliance.
Other Tax Considerations
Our tax treatment and that of our shareholders may be modified by legislative, judicial or administrative actions at any time, which actions may have retroactive effect. The rules dealing with federal income taxation are constantly under review by the U.S. Congress, the IRS and the U.S. Department of the Treasury, and statutory changes, new regulations, revisions to existing regulations and revised interpretations of established concepts are issued frequently; in fact, both technical corrections legislation and administrative guidance may someday be enacted or promulgated in response to the substantial December 2017 amendments to the IRC.frequently. Likewise, the rules regarding taxes other than U.S. federal income taxes may also be modified. No prediction can be made as to the likelihood of passage of new tax legislation or other provisions, or the direct or indirect effect on us and our shareholders. Revisions to tax laws and interpretations of these laws could adversely affect our ability to qualify and be taxed as a REIT, as well as the tax or other consequences of an investment in our shares. We and our shareholders may also be subject to taxation by state, local or other jurisdictions, including those in which we or our shareholders transact business or reside. These tax consequences may not be comparable to the U.S. federal income tax consequences discussed above.
ERISA PLANS, KEOGH PLANS AND INDIVIDUAL RETIREMENT ACCOUNTSPlans, Keogh Plans and Individual Retirement Accounts
General Fiduciary Obligations
The Employee Retirement Income Security Act of 1974, as amended, or ERISA, the IRC and similar provisions to those described below under applicable foreign or state law, individually and collectively, impose certain duties on persons who are fiduciaries of any employee benefit plan subject to Title I of ERISA, or an ERISA Plan, or an individual retirement account or annuity, or an IRA, a Roth IRA, a tax-favored account (such as an Archer MSA, Coverdell education savings account or health savings account), a Keogh plan or other qualified retirement plan not subject to Title I of ERISA, each a Non-ERISA Plan.
Under ERISA and the IRC, any person who exercises any discretionary authority or control over the administration of, or the management or disposition of the assets of, an ERISA Plan or Non-ERISA Plan, or who renders investment advice for a fee or other compensation to an ERISA Plan or Non-ERISA Plan, is generally considered to be a fiduciary of the ERISA Plan or Non-ERISA Plan.
Fiduciaries of an ERISA Plan must consider whether:
their investment in our shares or other securities satisfies the diversification requirements of ERISA;
the investment is prudent in light of possible limitations on the marketability of our shares;
they have authority to acquire our shares or other securities under the applicable governing instrument and Title I of ERISA; and
the investment is otherwise consistent with their fiduciary responsibilities.
Fiduciaries of an ERISA Plan may incur personal liability for any loss suffered by the ERISA Plan on account of a violation of their fiduciary responsibilities. In addition, these fiduciaries may be subject to a civil penalty of up to 20% of any amount recovered by the ERISA Plan on account of a violation. Fiduciaries of any Non-ERISA Plan should consider that the Non-ERISA Plan may only make investments that are authorized by the appropriate governing instrument and applicable law.
Fiduciaries considering an investment in our securities should consult their own legal advisors if they have any concern as to whether the investment is consistent with the foregoing criteria or is otherwise appropriate. The sale of our securities to an ERISA Plan or Non-ERISA Plan is in no respect a representation by us or any underwriter of the securities that the investment meets all relevant legal requirements with respect to investments by the arrangements generally or any particular arrangement, or that the investment is appropriate for arrangements generally or any particular arrangement.
Prohibited Transactions
Fiduciaries of ERISA Plans and persons making the investment decision for Non-ERISA Plans should consider the application of the prohibited transaction provisions of ERISA and the IRC in making their investment decision. Sales and other transactions between an ERISA Plan or a Non-ERISA Plan and disqualified persons or parties in interest, as applicable, are prohibited transactions and result in adverse consequences absent an exemption. The particular facts concerning the sponsorship, operations and other investments of an ERISA Plan or Non-ERISA Plan may cause a wide range of persons to be treated as disqualified persons or parties in interest with respect to it. A non-exempt prohibited transaction, in addition to imposing potential personal liability upon ERISA Plan fiduciaries, may also result in the imposition of an excise tax under the IRC or a penalty under ERISA upon the disqualified person or party in interest. If the disqualified person who engages in the transaction is the individual on behalf of whom an IRA, Roth IRA or other tax-favored account is maintained (or his beneficiary), the IRA, Roth IRA or other tax-favored account may lose its tax-exempt status and its assets may be deemed to have been distributed to the individual in a taxable distribution on account of the non-exempt prohibited transaction, but no excise tax will be imposed. Fiduciaries considering an investment in our securities should consult their own legal advisors as to whether the ownership of our securities involves a non-exempt prohibited transaction.
“Plan Assets” Considerations
The U.S. Department of Labor has issued a regulation defining “plan assets.” The regulation, as subsequently modified by ERISA, generally provides that when an ERISA Plan or a Non-ERISA Plan otherwise subject to Title I of ERISA and/or Section 4975 of the IRC acquires an interest in an entity that is neither a “publicly offered security” nor a security issued by an investment company registered under the Investment Company Act of 1940, as amended, the assets of the ERISA Plan or Non-ERISA Plan
include both the equity interest and an undivided interest in each of the underlying assets of the entity, unless it is established either that the entity is an operating company or that equity participation in the entity by benefit plan investors is not significant. We are not an investment company registered under the Investment Company Act of 1940, as amended.
Each class of our equity (that is, our common shares and any other class of equity that we may issue) must be analyzed separately to ascertain whether it is a publicly offered security. The regulation defines a publicly offered security as a security that is “widely held,” “freely transferable” and either part of a class of securities registered under the Exchange Act,or sold under an effective registration statement under the Securities Act of 1933, as amended, or the Securities Act, provided the securities are registered under the Exchange Act within 120 days after the end of the fiscal year of the issuer during which the offering occurred. Each class of our outstanding shares has been registered under the Exchange Act within the necessary time frame to satisfy the foregoing condition.
The regulation provides that a security is “widely held” only if it is part of a class of securities that is owned by 100 or more investors independent of the issuer and of one another. However, a security will not fail to be “widely held” because the number of independent investors falls below 100 subsequent to the initial public offering as a result of events beyond the issuer’s control. Although we cannot be sure, we believe our common shares have been and will remain widely held, and we expect the same to be true of any future class of equity that we may issue.
The regulation provides that whether a security is “freely transferable” is a factual question to be determined on the basis of all relevant facts and circumstances. The regulation further provides that, where a security is part of an offering in which the minimum investment is $10,000 or less, some restrictions on transfer ordinarily will not, alone or in combination, affect a finding that these securities are freely transferable. The restrictions on transfer enumerated in the regulation as not affecting that finding include:
any restriction on or prohibition against any transfer or assignment that would result in a termination or reclassification for federal or state tax purposes, or would otherwise violate any state or federal law or court order;
any requirement that advance notice of a transfer or assignment be given to the issuer and any requirement that either the transferor or transferee, or both, execute documentation setting forth representations as to compliance with any restrictions on transfer that are among those enumerated in the regulation as not affecting free transferability, including those described in the preceding clause of this sentence;
any administrative procedure that establishes an effective date, or an event prior to which a transfer or assignment will not be effective; and
any limitation or restriction on transfer or assignment that is not imposed by the issuer or a person acting on behalf of the issuer.
We believe that the restrictions imposed under our declaration of trust on the transfer of shares do not result in the failure of our shares to be “freely transferable.” Furthermore, we believe that there exist no other facts or circumstances limiting the transferability of our shares that are not included among those enumerated as not affecting their free transferability under the regulation, and we do not expect or intend to impose in the future, or to permit any person to impose on our behalf, any limitations or restrictions on transfer that would not be among the enumerated permissible limitations or restrictions.
Assuming that each class of our shares will be “widely held” and that no other facts and circumstances exist that restrict transferability of these shares, our counsel, Sullivan & Worcester LLP, is of the opinion that our shares will not fail to be “freely transferable” for purposes of the regulation due to the restrictions on transfer of our shares in our declaration of trust and that under the regulation each class of our currently outstanding shares is publicly offered and our assets will not be deemed to be “plan assets” of any ERISA Plan or Non-ERISA Plan that acquires our shares in a public offering. This opinion is conditioned upon certain assumptions and representations, as discussed above inunder the heading “Material United States Federal Income Tax Considerations—Taxation as a REIT.”
Item 1A. Risk Factors
Our business is subject to a number of risks and uncertainties. Investors and prospective investors should carefully consider the risks described below, together with all of the other information in this Annual Report on Form 10-K. The risks described below may not be the only risks we face but are risks we believe aremay be material at this time. Additional risks that we do not yet know of, or that we currently think are immaterial, also may impair our business operations or financial results. If any of the events or circumstances described below occurs, our business, financial condition, results of operations liquidity, prospects or ability to make or sustain distributions to our shareholders, could be adversely affected and the value of our securities could decline.be adversely affected. Investors and prospective investors should consider the following risks, described below, the information contained under the heading “Warning Concerning Forward Looking
Statements” and the risks described elsewhere in this Annual Report on Form 10-K before deciding whether to invest in our securities.
Risks Related to Our Business
We may be unable to lease our properties when our leases expire.
The weighted average remaining term of our leases in effect as of December 31, 20172019 is 4.75.7 years based upon annualized rental income and 4.86.0 years based upon occupied consolidated square footage. As of December 31, 2017,2019, leases representing approximately 60.2%38.3% of our annualized rental income and 60.8%36.2% of our occupied consolidated square footage will expire by December 31, 2022. 2023. Our leases with government tenants typically have shorter terms than our leases with nongovernment tenants, although the terms of
our leases with government contractor tenants tend to be for terms consistent with the tenants’ with government contracts, which are generally three to five years. These shorter terms require more frequent lease renewal or releasing.
Although we typically will seek to renew our leases with current tenants when they expire, we cannot be sure that we will be successful in doing so. If our tenants do not renew their leases, we may be unable to obtain new tenants to maintain or increase the historical occupancy rates of, or rents from, our properties.
Leases with government contractor tenants tend to be for terms consistent with the tenant’s government contracts which are generally three to five years. If a government contractor tenant does not retain its contract, the tenant may not renew its lease. Government contractors are dependent upon government spending. A reduction in government spending can have a negative effect on the contractor’s business and the renewal of leases for our properties.
We may experience declining rents or incur significant costs to renew our leases or to lease our properties to new tenants.
When we renew our leases with current tenants or lease to new tenants, we may experience rent decreases, and we may have to spend substantial amounts for leasing commissions, tenant improvements or other tenant inducements. Moreover, many of our properties have been specially designed for the particular businesses of our tenants; if the current leases for such properties are terminated or are not renewed, we may be required to renovate such properties at substantial costs, decrease the rents we charge or provide other concessions in order to lease such properties to new tenants.
Further, laws and regulations applicable to government leasing often require public solicitations of bids when new or renewal leases are being considered. Market conditions may require us to lower our rents to retain government or other tenants. Some of our current rents include payments to amortize the cost of tenant improvements which government or other tenants may be unwilling to pay or contractually allowed to eliminate when leases are renewed.
Current government tenantoffice space utilization trends may adversely impact our business.
GovernmentThere is a general trend in office real estate for tenants have been reducing theirto decrease the space they occupy per employee. This increase in office utilization per employee when renewing or entering new leases. Thisrates may result in aour office tenants renewing governmenttheir leases for less area than they currently occupy, which could increase the vacancy and decrease rental income at our properties. The need to reconfigure leased office space to increase utilization also may require us to spend increased amounts for tenant occupying less space in our property. If that renewing government tenant is the sole occupant of the property, the vacant space may become unleasable.improvements. If substantial reconfiguration of the government tenant’s space is required to achieve the increase in space utilized, the government tenant may find it more advantageous to relocate than to renew its lease and renovate the existing space.
Current and future governmentSome of our properties depend upon a single tenant for all or a majority of their rental income; therefore, our financial condition, including our ability to make distributions to shareholders, may be adversely affected by the bankruptcy or insolvency, a downturn in the business, or a lease termination of a single tenant.
As of December 31, 2019, 46.9% of our annualized rental revenue is from our properties leased to private sector single tenants. The value of our private sector single tenant properties is materially dependent on the performance of those tenants under their respective leases. These tenants face competition within their industries and other circumstancesfactors that could reduce their ability to pay us rent. Lease payment defaults by such tenants could cause us to reduce the amount of distributions that we pay to our shareholders. A default by a single or major tenant, the failure of a guarantor to fulfill its obligations or other premature termination of a lease to such a tenant or such tenant’s election not to extend a lease upon its expiration could have an adverse effect on our financial condition, results of operations, liquidity and ability to pay distributions to our shareholders.
Government budgetary pressures and priorities and trends in technologygovernment employment and office leasing may adversely impact our business.
We believe that current government budgetary pressures, enhancements in technology and policy and administrative decisions have resulted in a decrease in government employment, in government tenants reducing their space utilization per employee and in 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 in renewing their leases for less space than they currently occupy. Also, our government tenants’ desire to reconfigure leased office space to reduce utilization per employee may require us to spend significant amounts for tenant improvements, and tenant relocations in such circumstances are more prevalent now than in our past experience. Increasing uncertainty with respect to government agency budgets and funding to implement relocations, consolidations and reconfigurations have recently resulted in delayed decisions by some of our government tenants and their reliance on short term lease renewals.renewals; however, recent activity suggests that the government has begun to shift its leasing strategy to include longer term leases and is actively exploring 10 to 20 year lease terms at renewal, in some instances. Although we believe the recent focus and efforts to reduce government tenant space utilization and to consolidate government tenants into government owned real estate is substantially complete, these activities may continue to impact us for some time and could again increase in the future. At present, we are unable to reasonably project
what the financial impact of market conditions or changing government financial and other circumstances will be on our financial results for future periods.
For example, reduction in paper tax return processing has resulted in the IRS publicly stating that it plans to discontinue its tax return processing operations at our property located in Fresno, CA in 2021. The IRS lease for this property, which accounted for approximately 2.0% of our annualized rental income as of December 31, 2017, 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 December 31, 2017, 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 sent any official notices of its intentions regarding these properties.
We currently have a concentration of properties in the metropolitan Washington, D.C. market area and are exposed to changes in market conditions in this area.
Approximately 43.3%As of December 31, 2019, approximately 24.1% of our annualized rental income as of December 31, 2017 was receivedis from our consolidated properties located in the metropolitan Washington, D.C. market area. In addition, the twothree properties owned by two joint ventures in which we own 50%51% and 51%50% interests are also 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 or lower 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 government tenants when our leases expire.
We may also be subject to changes in the regulatory environment of the metropolitan Washington, D.C. market area (such as increases in real estate and other taxes, costs of complying with government regulations or increased regulation and other factors) or other adverse conditions or events (such as natural disasters). Thus, adverse developments and/or conditions in the metropolitan Washington, D.C. market area could reduce demand for space, impact the credit worthiness of our tenants or force our tenants to curtail operations, which could impair their ability to meet their rent obligations to us and, accordingly, could have a materialan adverse effect on our financial condition, results of operations.
We may be unableoperations, liquidity and ability to grow our business by acquisitions of additional properties, and we might encounter unanticipated difficulties and expenditures relatingpay distributions to our acquired properties, including those acquired as part of the FPO Transaction.shareholders.
Our business plans involve the acquisition of additionalto recycle our capital by strategically and opportunistically selling properties that are majority leasedfrom time to government tenants and government contractor tenants, as well as other properties located in the metropolitan Washington, D.C. market area. There are a limited number of such properties, which may limit our acquisition opportunities. In addition, our ability to make profitable acquisitions is subject to risks, including, but not limited to, risks associated with:
competition from other investors, including publicly traded and private REITs, numerous financial institutions, individuals, foreign investors and other public and private companies;
our long term cost of capital;
contingencies in our acquisition agreements; and
the availability and terms of financing.
We might encounter unanticipated difficulties and expenditures relating to our acquired properties, including those acquired as part of the FPO Transaction. For example:
we do not believe that it is possible to understand fully a property before it is owned and operated for a reasonable period of time and notwithstanding pre-acquisition due diligence, we couldto use sales proceeds to acquire a property that contains undisclosed defects in design or construction;
the market in which an acquired property is located may experience unexpected changes that adversely affect the property’s value;
the occupancy of and rents fromnew properties that we acquire may decline during our ownership;
property operating costs for our acquired properties may be higher than anticipated and our acquired properties may not yield expected returns;
we may acquire properties subject to unknown liabilities and without any recourse, or with limited recourse, such as liability forbelieve will help us reduce the cleanup of undisclosed environmental contamination or for claims by tenants, vendors or other persons related to actions taken by former owners of the properties;
acquired properties might require significant management attention that would otherwise be devoted to our other business activities; and
we may encounter unexpected costs and delays in the transition of business and property management functions of FPO properties to us and RMR LLC.
The FPO Transaction was a significant acquisition for us. Until we have fully integrated the properties we acquired as part of the FPO Transaction into our business and fully implement our long term financing plan for the acquisition, we expect that our acquisition activities may be reduced. As a result, our growth by acquisitions will likely be delayed and thereafter could be further delayed or unattained for the reasons noted above or otherwise.
For these reasons, among others, we might not realize the anticipated benefitsaverage age of our acquisitions andproperties, increase our business planweighted average lease term, reduce our ongoing capital requirements and/or increase our distributions to acquire additional properties may not succeed or may cause us to experience losses.
Our plan to sell propertiesshareholders may not be successful.
An element of our business plan involves the salestrategically and opportunistically selling properties from time to time as part of properties. We cannot be sure that we will be ableour capital recycling program to find attractive sale opportunities or that any sale will be completed in a timely manner, if at all.improve our property portfolio, increase our returns and operating results, and enable us to increase our distributions to shareholders. Our ability to sell certain of our properties we identify for sale, and the prices we receive upon a sale, may be affected by many factors, and we may be unable to execute our strategy. In particular, these factors could arise from weakness in or the lack of an established market for a property, changes in the financial condition or prospects of prospective purchasers and the availability of financing to potential purchasers on reasonable terms, the number of prospective purchasers, the number of competing properties on the market, unfavorable local, national or international economic conditions, industry trends, and changes in laws, regulations or fiscal policies of jurisdictions in which the property is located. We may not succeed in selling properties that we identify for sale, the terms of any such sales may not meet our expectations and we may incur losses in connection with those sales. Further, we may not succeed in identifying and acquiring properties that improve our property portfolio, increase our returns and operating results, and enable us to increase our distributions to shareholders. As a result, our plans to strategically and opportunistically sell properties from time to time and to reinvest the proceeds from those sales in acquiring additional properties that improve our property portfolio, increase our returns and operating results, and enable us to increase our distributions to shareholders may not be successful.
We may be unable to grow our business by acquisitions of additional properties, and we might encounter unanticipated difficulties and expenditures relating to our acquired properties.
Our business plans involve the acquisition of additional properties. Our ability to make profitable acquisitions is subject to risks, including, but not limited to, risks associated with:
competition from other investors, including publicly traded and private REITs, numerous financial institutions, individuals, foreign investors and other public and private companies;
our long term cost of capital;
contingencies in our acquisition agreements; and
the availability and terms of financing.
We might encounter unanticipated difficulties and expenditures relating to our acquired properties. For example:
we do not believe that it is possible to understand fully a property before it is owned and operated for a reasonable period of time, and, notwithstanding pre-acquisition due diligence, we could acquire a property that contains undisclosed defects in design or construction;
the market in which an acquired property is located may experience unexpected changes that adversely affect the property’s value;
the occupancy of and rents from properties that we acquire may decline during our ownership;
property operating costs for our acquired properties may be higher than anticipated and our acquired properties may not yield expected returns; and
we may acquire properties subject to unknown liabilities and without any recourse, or with limited recourse, such as liability for the cleanup of undisclosed environmental contamination or for claims by tenants, vendors or other persons related to actions taken by former owners of the properties.
For these potential sales.reasons, among others, we might not realize the anticipated benefits of our acquisitions and our business plan to acquire additional properties may not succeed or may cause us to experience losses.
REIT distribution requirements and limitations on our ability to access reasonably priced capital may adversely impact our ability to carry out our business plan.
To maintain our qualification for taxation as a REIT under the IRC, we are required to distribute at least 90%satisfy distribution requirements imposed by the IRC. See “Material United States Federal Income Tax Considerations—REIT Qualification Requirements—Annual Distribution Requirements” included in Part I, Item 1 of our annual REIT taxable income (excluding capital gains).this Annual Report on Form 10-K. Accordingly, we may not be able to retain sufficient cash to fund our operations, repay our debts, invest in our properties or fund our acquisitions or development or redevelopment efforts. Our business strategies therefore depend, in part, upon our ability to raise additional capital at reasonable costs. The volatility in the availability of capital to businesses on a global basis in most debt and equity markets generally may limit our ability to raise reasonably priced capital. We may also be unable to raise reasonably priced capital because of reasons related to our business, market perceptions of our prospects, the terms of our indebtedness, the extent of our leverage or for reasons beyond our control, such as market conditions. Because the earnings we are permitted to retain are limited by the rules governing REIT qualification and taxation, if we are unable to raise reasonably priced capital, we may not be able to carry out our business plan.
We face significant competition.
We face significant competition for acquisition opportunities from other investors, including publicly traded and private REITs, numerous financial institutions, individuals, foreign investors and other public and private companies. Some of our competitors may have greater financial and other resources than us. Because of competition for acquisitions, we may be unable to acquire desirable properties or we may pay higher prices for, and realize lower net cash flows than we hope to achieve from, acquisitions.
We also face competition for tenants at our properties. Some competing properties may be newer, better located or more attractive to tenants. Competing properties may have lower rates of occupancy than our properties, which may result in competing owners offering available space at lower rents than we offer at our properties. Development activities may increase the supply of properties of the type we own in the leasing markets in which we own properties and increase the competition we face. Competition may make it difficult for us to attract and retain tenants and may reduce the rents we are able to charge. GovernmentFor example, government tenants are generally viewed as desirable tenants and are therefore particularly difficult to attract and retain.
We also face significant competition for acquisition opportunities from other investors, including publicly traded and private REITs, numerous financial institutions, individuals, foreign investors and other public and private companies. Some of our competitors may have greater financial and other resources than us. Because of competition for acquisitions, we may be unable to acquire desirable properties or we may pay higher prices for, and realize lower net cash flows than we hope to achieve from, acquisitions.
The U.S. Government’s “green lease” policies may adversely affect us.
In recent years, the U.S. Government has instituted “green lease” policies which allow a government tenant to require leadershipLeadership in energyEnergy and environmental designEnvironmental Design for commercial interiors, or LEED®-CI, designation in selecting new premises or renewing leases at existing premises. In addition, the Energy Independence and Security Act of 2007 allows the GSA to give preference to buildings for lease that have received an “Energy Star” label. Obtaining and maintaining such designation and labels may be costly and time consuming, but our failure to do so may result in our competitive disadvantage in acquiring new or retaining existing government tenants.
Some government tenants have the right to terminate their leases prior to their lease expiration date and changes in the U.S. Government’s and state governments’ requirements for leased space may adversely affect us.
A majorityAs of December 31, 2019, 35.5% of our current rents comeannualized rental income was from government tenants.tenants, which includes the U.S. government, state governments and municipalities. Some of our leases with government tenants allow the tenants to vacate the leased premises before the stated terms of the leases expire with little or no liability. In particular:
TenantsGovernment tenants occupying approximately 8.6%4.0% of our consolidated rentable square feet and contributing approximately 6.8%3.7% of our annualized rental income as of December 31, 20172019 have currently exercisable rights to terminate their leases before the stated term of their leases expire.
In 2018, 2019, 2020, 2021, 2022, 2023, 2024, 2025, 2026, 2028, 2030 and 2027,2034, early termination rights become exercisable by othergovernment tenants who currently occupy an additional approximately 2.2%3.0%, 5.2%0.7%, 7.2%0.8%, 1.4%0.9%, 3.4%, 0.5%0.3%, 0.2%, 0.4%, 0.4%, 0.1% and 0.1%, 0.6% and 0.4% of our consolidated rentable square feet, respectively, and contribute an additional approximately 3.6%3.8%, 4.9%0.8%, 7.0%0.9%, 1.4%, 2.9%1.1%, 0.6%, 0.3%0.4%, 0.2%0.6%, 0.8%0.4%, 0.1% and 0.4%0.1% of our annualized rental income, respectively, as of December 31, 2017.2019.
Pursuant to leases with 2611 of our government tenants, these tenants have currently exercisable rights to terminate their leases if their respective legislature or other funding authority does not appropriate rent amounts in their respective annual budgets. These 2611 tenants represent approximately 12.9%4.4% of our consolidated rentable square feet and 12.3%4.6% of our annualized rental income as of December 31, 2017.2019.
For fiscal policy reasons, security concerns or other reasons, some or all of our government tenants may decide to exercise early termination rights under our leases or vacate our properties upon expiration of our leases. We believeAlso, the U.S. Government is actively tryingmay continue to seek to reduce their space utilization per employee and consolidate into existing government owned properties.See “Risks Related to Our Business —Government budgetary pressures and priorities and trends in government employment and office leasing may adversely impact our business” included in Part I, Item1A of this Annual Report on Form 10-K. If a significant number of such events occur, our income and cash flow may materially decline and our ability to make or sustain distributions to our shareholders may be jeopardized.
We may be unable to realize our expected expense savings.
We currently expect to realize annual general and administrative expense savings compared to what we and FPO incurred or would have incurred if we had not acquired FPO. Our management agreement with RMR LLC sets the fees that we pay in lieu of certain general and administrative expenses pursuant to a formula based upon the lower of our market capitalization or the historical cost of certain of our assets. Also, we may pay incentive fees to RMR LLC in certain circumstances based upon total returns realized by our shareholders compared to an index of total returns of certain other REITs. Some of these calculations will depend upon future market prices of our securities and other REITs’ securities which are beyond our control. Accordingly, the amount of annual general and administrative expense savings which we may realize, if any, cannot be precisely calculated; and, in fact we may realize more or less savings or no savings, and our annual general and administrative expenses incurred as a result of the FPO Transaction may be higher than the aggregate amounts we and FPO incurred or would have incurred if we had not acquired FPO.
We currently anticipate being able to realize property level cost savings at the FPO properties as the management and operations of the FPO properties are combined with our property level operations and those of other companies managed by RMR LLC. However, we may be unable to realize or sustain these property level cost savings or our doing so may take longer than we now anticipate.
Real estate construction and redevelopment creates risks.
We may develop new properties or redevelop some of our existing properties as the existing leases expire, as our tenants’ needs change or to pursue any other opportunities that we believe are desirable. The development and redevelopment of new and existing buildings involves significant risks in addition to those involved in the ownership and operation of leased
properties, including the risks that construction may not be completed on schedule or within budget, resulting in increased construction costs and delays in leasing such properties and generating cash flows. Development activities are also subject to risks relating to the inability to obtain, or delays in obtaining, all necessary zoning, land use, building, occupancy, and other required government permits and authorizations. Once completed, any new properties may perform below anticipated financial results. The occurrence of one or more of these circumstances in connection with our development or redevelopment activities could have an adverse effect on our financial condition, results of operations and the value of our securities.
We have debt and we may incur additional debt.
As of December 31, 2017,2019, our consolidated indebtedness was $2.2 billion, our consolidated total debt to total gross assets ratio, with our SIR common shares included in gross assets at market value, was 53.4%$2.4 billion. We had $750.0 million and we had $180.0$415.0 million available for borrowing under our $750.0 million revolving credit facility. The agreement governing our revolving credit facility as of December 31, 2019 and our $300.0 million term loan and our $250.0 million term loan, or ourFebruary 19, 2020, respectively. Our credit agreement includes a feature under which the maximum aggregate borrowing availability may be increased to up to $2.5$1.95 billion on a combined basis in certain circumstances.
We are subject to numerous risks associated with our debt, including the risk that our cash flows could be insufficient for us to make required payments on our debt. There are no limits in our organizational documents on the amount of debt we may incur, and we may incur substantial debt. Our debt obligations could have important consequences to our securityholders. Our incurringincurrence of debt may increase our vulnerability to adverse economic, market and industry conditions, limit our flexibility in planning for, or reacting to, changes in our business, and place us at a disadvantage in relation to competitors that have lower debt levels. Our incurring debt could also increase the costs to us of incurring additional debt, increase our exposure to floating interest rates or expose us to potential events of default (if not cured or waived) under covenants contained in debt instruments that could have a material adverse effect on our business, financial condition and operating results. Excessive debt could reduce the available cash flow to fund, or limit our ability to obtain financing for, working capital, capital expenditures, acquisitions, construction projects, refinancing, lease obligations or other purposes, and hinder our ability to maintain investment grade ratings from nationally recognized credit rating agencies or to make or sustain distributions to our shareholders.
If we default under any of our debt obligations, we may be in default under the agreements governing other debt obligations of ours which have cross default provisions, including our credit agreement and our senior unsecured notes indentures and their supplements. In such case, our lenders or bondholders may demand immediate payment of any outstanding indebtedness and we could be forced to liquidate our assets for less than the values we would receive in a more orderly process.
We may fail to comply with the terms of our credit agreement and our senior unsecured notes indentures and their supplements, which could adversely affect our business and may prevent our making distributions to our shareholders.
Our credit agreement and our senior unsecured notes indentures and their supplements include various conditions, covenants and events of default. We may not be able to satisfy all of these conditions or may default on some of these covenants for various reasons, including for reasons beyond our control. For example, our credit agreement and our senior unsecured notes indentures and their supplements require us to maintaincomply with certain debt service ratios.financial and other covenants. Our ability to comply with such covenants will depend upon the net rental income we receive from our properties. If the occupancy at our properties declines or if our rents decline, we may be unable to borrow under our revolving credit facility. Complying with these covenants may limit our ability to take actions that may be beneficial to us and our securityholders.
If we are unable to borrow under our revolving credit facility, we may be unable to meet our obligations or grow our business by acquiring additional properties. If we default under our credit agreement, our lenders may demand immediate payment and may elect not to fund future borrowings. During the continuance of any event of default under our credit agreement, we may be limited or in some cases prohibited from making distributions to our shareholders. Any default under our credit agreement that results in acceleration of our obligations to repay outstanding indebtedness or in our no longer being permitted to borrow under our revolving credit facility would likely have serious adverse consequences to us and would likely cause the value of our securities to decline.
In the future, we may obtain additional debt financing, and the covenants and conditions which apply to any such additional debt may be more restrictive than the covenants and conditions that are contained in our credit agreement or our senior unsecured notes indentures and their supplements.
Amounts recoverable under our leases with government tenants for increased operating costs may be less than the actual increased costs.
Under mostsome of our leases with government tenants, the tenant’s obligation to pay us adjusted rent for increased operating costs (e.g., the costs of cleaning services, supplies, materials, maintenance, trash removal, landscaping, snow removal, water, sewer charges, heating, electricity and certain administrative expenses) is increased annually based on a cost of living index rather than the actual amount of our costs. Accordingly, the amount of any rent adjustment may not fully offset any increased costs we may incur in
providing these services,services.
Changes in market interest rates, including any increased costs whichchanges that may result from climate change laws designed to reduce carbon emissions or otherwise.
Increasing interest ratesthe expected phase out of LIBOR, may adversely affect us.
Since the most recent U.S. recession, the Board of Governors of the U.S. Federal Reserve System, or the U.S. Federal Reserve, has taken actions thatwhich have resulted in low interest rates prevailing in the marketplace for a historically long period of time. Since December 2016, theThe U.S. Federal Reserve has raised its benchmark intereststeadily increased the targeted federal funds rate by one percentage point,over the last several years, but recently took action to decrease the federal funds rate and there are some market expectations that market interest rates will rise furthermay continue to make adjustments in the near future. In addition, as noted in Part II, Item 7A of this Annual Report on Form 10-K, LIBOR is expected to intermediate term. Marketbe phased out in 2021. The interest rate under our revolving credit facility is based on LIBOR and the interest we may pay on any future debt that we may incur may also be based on LIBOR. We currently expect that the determination of interest under our revolving credit facility would be based on the alternative rates provided under our credit agreement or would be revised as provided under our credit agreement or amended as necessary to provide for an interest rate that approximates the existing interest rate as calculated in accordance with LIBOR. Despite our current expectations, we cannot be sure that, if LIBOR is phased out or transitioned, the changes to the determination of interest under our credit agreement would approximate the current calculation in accordance with LIBOR. An alternate interest rate index that may continue to increase, and thosereplace LIBOR may result in our paying increased interest. Interest rate increases may materially and negatively affect us in several ways, including:
Investors may consider whether to buy or sell our common shares based upon the distribution rate on our common shares relative to the then prevailing market interest rates. If market interest rates go up, investors may expect a higher distribution rate than we are able to pay, which may increase our cost of capital, or they may sell our common shares and seek alternative investments that offer higher distribution rates. Sales of our common shares may cause a decline in the value of our common shares.
Amounts outstanding under our revolving credit facility and term loans require interest to be paid at variablea floating interest rates.rate. When interest rates increase, our interest costs will increase, which could adversely affect our cash flows, our ability to pay principal and interest on our debt, our cost of refinancing our fixed rate debts when they become due and our ability to make or sustain distributions to our shareholders.
Property values are often determined, in part, based upon a capitalization of rental income formula. When market interest rates increase, property investors often demand higher capitalization rates and that causes property values to decline. Increases in interest rates could lower the value of our properties and cause the value of our securities to decline.
Low market interest rates, particularly if they remain over a sustained period, may increase our use of debt capital to fund property acquisitions, lower capitalization rates for property purchases and increased competition for property purchases, which may reduce our ability to acquire new properties.
Ownership of real estate is subject to environmental risks.risks and liabilities.
Ownership of real estate is subject to risks associated with environmental hazards. WeUnder various laws, owners as well as tenants and operators of real estate may be liable for environmental hazardsrequired to investigate and clean up or remove hazardous substances present at or migrating from our properties including those created by prior ownersthey own, lease or occupants, existing tenants, abuttersoperate and may be held liable for property damage or other persons. Various federal and statepersonal injuries that result from hazardous substances. These laws impose liabilities upon property owners, includingalso expose us for environmental damages arising at, or migrating from, owned properties, andto the possibility that we may bebecome liable for the costs of environmental investigation and clean up at, or near, our properties. As an owner or previous owner of properties, we also may be liable to pay damages to government agencies or third parties for costs and damages they incur arising from environmental hazards at, or migrating from, such properties.in connection with hazardous substances. The costs and damages that may arise from environmental hazards are often difficult to project and may be substantial.
In addition, we believe some of our properties may contain asbestos. We believe any asbestos on our properties is contained in accordance with applicable lawssubstantial 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.
Environmental liabilities could adversely affect our financial condition and result in losses.
Our leases with non-government tenants generally require our tenants to operate in compliance with applicable law and to indemnify us against any environmental liabilities arising from their activities on our properties; however, applicable law may subject us to strict liability by virtue of our property ownership interests. The U.S. Government is not required to indemnify us for environmental hazards they create at our properties and therefore could hold us liable for environmental hazards they create at our properties and we could have no recourse to them.
We do not have any insurance to limit losses that we may incur as a result of known or unknown environmental conditions. However, environmental exposures are difficult to assess and estimate for numerous reasons, including uncertainty about the extent of contamination, alternative treatment methods that may be applied, the location of the property which subjects it to differing local laws and regulations and their interpretations, as well as the time it may take to remediate contamination. In addition, these laws also impose various requirements regarding the operation and maintenance of properties and recordkeeping and reporting requirements relating to environmental matters that require us or the tenants of our properties to incur costs to comply with. We may incur substantial liabilities and costs for environmental matters.
We may incur environmental liabilities at our leased properties and our tenants may not indemnify us for those costs.
our property ownership interests, and our tenants may fail to indemnify us for environmental liabilities we incur. The U.S. Government is not required to indemnify us for environmental hazards they create at our properties and therefore could hold us liable for environmental hazards they create at our properties and we could have no recourse to them.
Ownership of real estate is subject to climate change andrisks from adverse weather risks.and climate events.
Some observers believe severe weather in different parts of the world over the last few years is evidence of global climate change. Severe weather may have an adverse effect on certain properties we own. Flooding caused by rising sea levels and severe weather events, including hurricanes, tornadoes and widespread fires, may have an adverse effect on properties we own and result in significant losses to us and interruption of our business. When major weather or climate-related events, such as hurricanes, floods and wildfires, occur at or near our properties, our tenants may need to suspend operations of the impacted property until the event has ended and the property is then ready for operation. We or the tenants of our properties may incur significant costs and losses as a result of these activities, both in terms of operating, preparing and repairing our properties in anticipation of, during and after a severe weather or climate-related event and in terms of potential lost business due to the interruption in operating our properties. Our insurance and our tenants’ insurance may not adequately compensate us or them for these costs and losses.
Also, the political debateconcerns about climate change hashave resulted in various treaties, laws and regulations that are intended to limit carbon emissions.emissions and address other environmental concerns. These or futureand other laws may cause operatingenergy or other costs at our properties to increase. Laws enacted to mitigate climate change may make some of our buildings obsolete or requirecause us to make material investments in our properties, which could materially and adversely affect our financial condition or the financial condition of our tenants and results of operationstheir ability to pay rent to us and cause the value of our securities to decline. In addition, concerns about climate change and increasing storm intensities may increase the cost of our insurance for our properties or potentially render it unavailable to obtain.
Real estate ownership creates risks and liabilities.
In addition to the risks discussed above, our business is subject to other risks associated with real estate ownership, including:
the illiquid nature of real estate markets, which limits our ability to sell our assets rapidly to respond to changing market conditions;
the subjectivity of real estate valuations and changes in such valuations over time;
current and future adverse national and local real estate trends, including increasing vacancy rates, declining rental rates and
general deterioration of market conditions;
costs that may be incurred relating to property maintenance and repair, and the need to make expenditures due to changes in government regulations; and
liabilities and litigations arising from injuries on our properties or otherwise incidental to the ownership of our properties.
RMR LLC relies on information technology and systems in its operations, and any material failure, inadequacy, interruption or security failure of that technology or those systems could materially and adversely affect us.
RMR LLC relies on information technology and systems, including the Internet and cloud-based infrastructures, commercially available software and its internally developed applications, to process, transmit, store and safeguard information and to manage or support a variety of its business processes (including managing our building systems), including financial transactions and maintenance of records, which may include personal identifying information of employees and tenants and lease data. If RMR LLC experiences material security or other failures, inadequacies or interruptions of its information technology, it could incur material costs and losses and our operations could be disrupted as a result. Further, third party vendors could experience similar events with respect to their information technology and systems that impact the products and services they provide to RMR LLC or us. RMR LLC relies on commercially available systems, software, tools and monitoring, as well as its internally developed applications and internal procedures and personnel, to provide security for processing, transmitting, storing and safeguarding confidential tenant, customer and vendor information, such as personally identifiable information related to its employees and others and information regarding its and our financial accounts. RMR LLC takes various actions, and incurs significant costs, to maintain and protect the operation and security of its information technology and systems, including the data maintained in those systems. However, it is possible that these measures will not prevent the systems’ improper functioning or a compromise in security, such as in the event of a cyberattack or the improper disclosure of personally identifiable information.
Security breaches, computer viruses, attacks by hackers, online fraud schemes and similar breaches can create significant system disruptions, shutdowns, fraudulent transfer of assets or unauthorized disclosure of confidential information. For example, in June 2017, RMR LLC became aware that it had been a victim of criminal fraud in which a person pretending to be a representative of a seller in a property acquisition transaction provided fraudulent money wire instructions that caused money to be wire transferred to an account that was believed to be, but was not, the seller’s account. We were not involved in that transaction and we did not incur any loss from that transaction; however, there may be a risk that similar fraudulent activities could be attempted against us, RMR LLC or others with respect to our assets. The cybersecurity risks to RMR LLC, us and third party vendors are heightened by, among other things, the evolving nature of the threats faced, advances in computer capabilities, new discoveries in the field of cryptography and new and increasingly sophisticated methods used to perpetuateperpetrate illegal or fraudulent activities against RMR LLC, including cyberattacks, email or wire fraud and other attacks
exploiting security vulnerabilities in RMR LLC’s or other third parties’ information technology networks and systems or operations. Any failure to maintain the security, proper function and availability of RMR LLC’s information technology and systems, or certain third party vendors’ failure to similarly protect their information technology and systems that are relevant to RMR LLC’s or our operations, or to safeguard RMR LLC’s or our business processes, assets and information could result in financial losses, interrupt RMR LLC’s operations, damage RMR LLC’s reputation, cause RMR LLC to be in default of material contracts and subject RMR LLC to liability claims or regulatory penalties. Any or allpenalties, any of the foregoingwhich could materially and adversely affect our business and the value of our securities.
Current government policies regarding interest rates and trade policiesBankruptcy law may cause a recession.adversely impact us.
The U.S. Federal Reserve policy regarding the timing and amount of future increases in interest rates and changing U.S. and other countries’ trade policies may hinder the growth of the U.S. economy. It is unclear whether the U.S. economy will be able to withstand these challenges and continue sustained growth. Economic weakness in the U.S. economy generally or a new U.S. recession would likely adversely affect our financial condition and that of our tenants, could adversely impact the ability of our tenants to renew our leases or pay rent to us, and may cause the values of our properties and of our securities to decline.
Some of our tenants do not have credit ratings.
As a result of the FPO Transaction, a greater number of our tenants are non-government tenants and are not rated by any nationally recognized credit rating organization. It is more difficult to assess the abilityoccurrence of a tenant that is not rated to meetbankruptcy could reduce the rent we receive from such tenant’s lease. If a tenant becomes bankrupt, federal law may prohibit us from evicting such tenant based solely upon its obligations than that ofbankruptcy. In addition, a rated tenant. Moreover, tenantsbankrupt tenant may be rated when we enter leasesauthorized to reject and terminate its lease with them but their ratingsus. Any claims against a bankrupt tenant for unpaid future rent would be subject to statutory limitations that may be later lowered or terminated duringsubstantially less than the termcontractually specified rent we are owed under the lease, and any claim we have for unpaid past rent may not be paid in full.
Our use of joint ventures may limit our flexibility with jointly owned investments.
As part of the FPO Transaction, we acquired two properties (three buildings) whichWe are owned byparty to joint ventures with unrelated third parties that own three properties, and we may in the future acquire, develop or recapitalize properties in joint ventures with other persons or entities. Our participation in these joint ventures is subject to risks, including the following:
we may share approval rights over major decisions affecting the ownership or operation of the joint venture and any property owned by the joint venture;
we may be required to contribute additional capital if our partners fail to fund their share of any required capital contributions;
our joint venture partners may have economic or other business interests or goals that are inconsistent with our business interests or goals and that could affect our ability to lease or release the property, operate the property or maintain our qualification for taxation as a REIT;
our joint venture partners may be subject to different laws or regulations than us, or may be structured differently than us for tax purposes, which could create conflicts of interest and/or affect our ability to maintain our qualification for taxation as a REIT;
our ability to sell the interest on advantageous terms when we so desire may be limited or restricted under the terms of the applicable joint venture agreements; and
disagreements with our joint venture partners could result in litigation or arbitration that could be expensive and distracting to management and could delay important decisions.
Any of the foregoing risks could have a material adverse effect on our business, financial condition and results of operations.
Insurance may not adequately cover our losses.losses, and the cost of obtaining such insurance may continue to increase.
We or our tenants are generally responsible for the costs of insurance coverage for our properties, including for casualty, liability, fire, extended coverage and extended coverage.rental or business interruption loss insurance. Recently, we have experienced increases in the cost of providing such insurance, and these increased costs have had an adverse effect on our financial condition and results of operations. In the future, we may acquire additional properties for which we are responsible for the costs of insurance. Losses of a catastrophic nature, such as those caused by hurricanes, flooding, volcanic eruptions and
earthquakes, among other things, or losses from terrorism, may be covered by insurance policies with limitations such as large deductibles or co-payments that we may not be able to pay. Insurance proceeds may not be adequate to restore an affected property to its condition prior to a loss or to compensate us for our losses, including the loss of future revenues from an affected property. Similarly, our other insurance, including our general liability insurance, may not provide adequate insurance to cover our losses. In addition, we do not have any insurance to limit losses that we may incur as a result of known or unknown environmental conditions. Further, there is no assurance that certain types of risks that are currently insurable will continue to be insurable on an economically feasible basis, and we may discontinue certain insurance coverage on some or all of our properties in the future if we determine that the cost of premiums for any of these policies exceeds the value of the coverage. If an uninsured loss or a loss in excess of insured limits occurs, we may have to incur uninsured costs to mitigate such losses or lose all or a portion of the capital invested in a property, as well as the anticipated future revenue from the property. We might also remain obligated for any financial obligations related to the property, even if the property is irreparably damaged. In addition, future changes in the insurance industry’s risk assessment approach and pricing structure could further increase the cost of insuring our properties or decrease the scope of insurance coverage, either of which could have an adverse effect on our financial condition, results of operations, liquidity and ability to pay distributions to our shareholders.
We may incur significant costs complying with the Americans with Disabilities Act and similar laws.
Under the Americans with Disabilities Act and certain similar state statutes, many commercial properties must meet specified requirements related to access and use by disabled persons. In addition, our properties are subject to various laws and regulations relating to fire, safety and other regulations. The tenants of our leased properties are generally responsible for compliance with these requirements pursuant to our lease agreements. In addition, although our tenants may be responsible for complying with these requirements for our properties, we could be held liable as the owner of the properties for our tenants’ failure to comply. We may be required to make substantial capital expenditures at our properties to comply with these laws. In addition, non-compliance could result in the imposition of fines or an award of damages and costs to private litigants. These expendituresFurther,
with respect to our leased properties, we may have an adverse impact onnot be able to recoup these amounts from our financial results and the value of our securities.tenants if they are unable or unwilling to pay.
Changes in lease accounting standards may materially and adversely affect us.
The Financial Accounting Standards Board, or FASB, adopted new accounting rules to be effective for fiscal years ending after December 2018, which will require companies to capitalize substantially all leases on their balance sheets by recognizing a lessee’s rights and obligations. When the final rules are effective, many companies that account for certain leases on an “off balance sheet” basis will be required to account for such leases “on balance sheet.” This change will remove many of the differences in the way companies account for owned property and leased property and could have a material effect on various aspects of our tenants’ businesses, including the appearance of their credit quality and other factors they consider in deciding whether to own or lease properties. When the rules are effective, or as the effective date approaches, these rules could cause companies that lease properties to prefer shorter lease terms in an effort to reduce the leasing liability required to be recorded on their balance sheets or some companies may decide to prefer property ownership to leasing. Such decisions by our current or prospective tenantsA prolonged U.S. government shutdown may adversely impact our business and cash position.
Under our leases with the valueU.S. government, the tenants pay us rent monthly in arrears. If the U.S. government experiences a prolonged shutdown, these tenants may not pay us rent during the pendency of the shutdown. Although we expect that these tenants would pay us any outstanding rents after the shutdown ends, our available cash and leverage targets may be adversely impacted during the period we do not receive rents from these tenants. In addition, the impact of a prolonged government shutdown on government personnel resources could hinder our ability to renew expiring leases or initiate or complete renovation, construction and other capital maintenance of the affected properties. During the pendency of any shutdown, we may need to borrow amounts under our revolving credit facility or seek alternative financing, which we may not be able to receive timely or on reasonable terms. A failure to receive rents from our government tenants during a government shutdown may impair our ability to fund our operations and investments, pay our debt obligations, make capital expenditures and pay distributions to our shareholders. Moreover, some of our securities.tenants are government contractors that rely on government business. If a government shutdown results in our government contractor tenants not paying us rent, the negative impact on us from a government shutdown may be compounded.
Our business could be adversely impacted if there are deficiencies in our disclosure controls and procedures or our internal control over financial reporting.
The design and effectiveness of our disclosure controls and procedures and our internal control over financial reporting may not prevent all errors, misstatements or misrepresentations. While management will continue to review the effectiveness of our disclosure controls and procedures and our internal control over financial reporting, we cannot guarantee that our disclosure controls and procedures and internal control over financial reporting will be effective in accomplishing all control objectives all of the time. Deficiencies, including any material weaknesses, in our disclosure controls and procedures or internal control over financial reporting could result in misstatements of our results of operations or our financial statements or could otherwise materially and adversely affect our business, reputation, results of operations, financial condition or liquidity.
Risks Related to Our Relationships with RMR Inc., and RMR LLC and SIR.
We are dependent upon RMR LLC to manage our business and implement our growth strategy.
We have no employees. Personnel and services that we require are provided to us by RMR LLC pursuant to our management agreements with RMR LLC. Our ability to achieve our business objectives depends on RMR LLC and its ability to effectively manage our properties, to appropriately identify and complete our acquisitions and dispositions and to execute our growth strategy. Accordingly, our business is dependent upon RMR LLC’s business contacts, its ability to successfully hire, train, supervise and manage its personnel and its ability to maintain its operating systems. If we lose the services provided by RMR LLC or its key personnel, our business and growth prospects may decline. We may be unable to duplicate the quality and depth of management available to us by becoming internally managed or by hiring another manager. In the event RMR LLC is unwilling or unable to continue to provide management services to us, our cost of obtaining substitute services may be greater than the fees we pay RMR LLC under our management agreements, and as a result our expenses may increase.
Our management structure and agreements and relationships with RMR LLC and RMR LLC’s and its controlling shareholders’ relationships with others may create conflicts of interest, or the appearance of such conflicts, and may restricthas broad discretion in operating our investment activities.day to day business.
Our manager, RMR LLC, is authorized to follow broad operating and investment guidelines and therefore, has discretion in determiningidentifying the properties that will be appropriate investments for us, as well as our individual operating and investment decisions. Our Board of Trustees periodically reviews our operating and investment guidelines and our operating activities and investments but it does not review or approve each decision made by RMR LLC on our behalf. In addition, in conducting periodic reviews, our Board of Trustees relies primarily on information provided to it by RMR LLC. RMR LLC may exercise its discretion in a manner that results in investment returns that are substantially below expectations or that results in losses.
interest, or the appearance of such conflicts, and may restrict our investment activities.
RMR LLC is a subsidiary of RMR Inc. OurThe Chair of our Board of Trustees and one of our Managing Trustee,Trustees, Adam Portnoy, as the current sole trustee of ABP Trust, is the controlling shareholder of RMR Inc. and as the current sole trustee of ABP Trust beneficially owns all the class A membership units of RMR LLC not owned by RMR Inc. Adam Portnoy, is thea managing director and the president and chief executive officer of RMR Inc. and an officer and employee of RMR LLC. Barry Portnoy was our other Managing Trustee and a director and an officer of RMR Inc. until his death on February 25, 2018. RMR LLC or its subsidiary also acts as the manager for fivefour other Nasdaq listed REITs: HPT, which owns hotels and travel centers; ILPT, which primarily owns industrial and logistics properties; SNH,DHC, which
primarily owns healthcare, senior living properties and medical office buildings; SIR,SVC, which primarily owns a diverse portfolio of hotels, travel centers and invests in net leased, single tenantlease service and necessity-based retail properties; and TRMT, which primarily originates and invests in first mortgage loans secured by middle market and transitional commercial real estate. RMR LLC also provides services to other publicly and privately owned companies, including: Five Star, which operates senior living communities; TA, which operates and franchises travel centers, convenience storestruck repair facilities and restaurants; and Sonesta, which operates, manages and franchises hotels, resorts and cruise ships. An affiliateboats. A subsidiary of RMR LLC is an investment adviser to the RMR Real Estate Income Fund, or RIF, a closed end investment company listed on the NYSE American, which primarily invests in securities of REITsreal estate companies that are not managed by RMR LLC.
Each Mr. Portnoy serves as chair of our executive officers is also an officerthe board of trustees or board of directors, as applicable, of SVC, ILPT, DHC, Five Star and TA and as managing director, managing trustee, director or trustee, as applicable, of the companies managed by RMR LLC includingor its subsidiaries.
David Blackman, our other Managing Trustee and our President and Chief OperatingExecutive Officer, David Blackman, who is also the president and chief operating officer of SIR and the chief executive officer of TRMT, andMatthew Brown, our Chief Financial Officer and Treasurer, Mark Kleifges, whoand Christopher Bilotto, our Vice President, are also officers and employees of RMR LLC. David Blackman is also thea managing trustee, president and chief financialexecutive officer of TRMT. Messrs. Blackman, Brown and treasurer of HPT and of RIF. Because our executive officersBilotto have duties to RMR LLC, and DavidMr. Blackman and Mark Kleifges havehas duties to SIR and TRMT, and HPT and RIF, respectively, as well as to us, and we do not have their undivided attention. They and other RMR LLC personnel may have conflicts in allocating their time and resources between us and RMR LLC and other companies to which RMR LLC providesor its subsidiaries provide services. OurSome of our Independent Trustees also serve as independent directors or independent trustees of other public companies to which RMR LLC or its subsidiary providessubsidiaries provide management services, including one of our Independent Trustees also serving as an independent trustee of SIR.services.
In addition, we may in the future enter into additional transactions with RMR LLC, its affiliates, or entities managed by it or its subsidiaries. In addition to his investmentinvestments in RMR Inc. and RMR LLC, our Managing TrusteeAdam Portnoy holds equity investments in other companies to which RMR LLC providesor its subsidiaries provide management services and some of these companies including us, have significant cross ownership interests, including, for example: as of February 23, 2018, our Managing Trustee and BarryDecember 31, 2019, Adam Portnoy our former Managing Trustee,beneficially owned, directly or indirectly, in aggregate, 1.8%1.5% of our outstanding common shares, 36.4%35.3% of Five Star's outstanding common stock 1.5%(6.3% as of HPT’sJanuary 1, 2020) (including through ABP Trust), 1.2% of ILPT’s outstanding common shares, 1.3%1.1% of SNH’sDHC's outstanding common shares, 1.9% of SIR’s outstanding common shares and 9.1%2.3% of RIF’s outstanding common shares; we own 27.8%shares, 1.1% of SIR’sSVC’s outstanding common shares; SIR owns 69.2% of ILPT’s outstanding common shares; HPT owns 8.6%shares, 4.0% of TA’s outstanding common shares; SNH owns 8.4% of Five Star’s outstanding common stock;shares (including through RMR LLC) and Tremont Realty Advisors LLC, a subsidiary of RMR LLC, owns 19.2%19.5% of TRMT’s outstanding common shares.shares (including through Tremont Realty Advisors LLC). Our executive officers may also own equity investments in other companies to which RMR LLC or its subsidiary providessubsidiaries provide management services. These multiple responsibilities, relationships and cross ownerships could create competition for the time and efforts of RMR LLC, Adam Portnoy and other RMR LLC personnel, including our executive officers, and give rise to conflicts of interest or the appearanceperception of such conflicts of interest with respect to matters involving us, RMR Inc., RMR LLC, our Managing Trustee,Trustees, the other companies to which RMR LLC or its subsidiary providessubsidiaries provide management services and their related parties. Conflicts of interest or the appearanceperception of conflicts of interest could have a material adverse impact on our reputation, business and the market price of our common shares and other securities and we may be subject to increased risk of litigation as a result.
In our management agreements with RMR LLC, we acknowledge that RMR LLC may engage in other activities or businesses and act as the manager to any other person or entity (including other REITs) even though such person or entity has investment policies and objectives similar to our policies and objectives and we are not entitled to preferential treatment in receiving information, recommendations and other services from RMR LLC. Accordingly, we may lose investment opportunities to, and may compete for tenants with, other businesses managed by RMR LLC or its subsidiary.subsidiaries. We cannot be sure that our Code of Conduct or our Governance Guidelines,governance guidelines, or other procedural protections we adopt will be sufficient to enable us to identify, adequately address or mitigate actual or alleged conflicts of interest or ensure that our transactions with related persons are made on terms that are at least as favorable to us as those that would have been obtained with an unrelated person.
Our management agreements were not negotiated on an arm’s length basis and their fee and expense structure may not create proper incentives for RMR LLC, which may increase the risk of an investment in our common shares.
As a result of our relationships with RMR LLC and its current and former controlling shareholder(s), our management agreements were not negotiated on an arm’s length basis between unrelated parties, and therefore, while such agreements were negotiated with the use of a special committee and disinterested Trustees, the terms, including the fees payable to RMR LLC, may not be as favorable to us as they would have been if they were negotiated on an arm’s length basis between unrelated parties. Our property management fees are calculated based on rents we receive and construction supervision fees for construction at our properties
overseen and managed by RMR LLC, and our base business management fee is calculated based upon the lower of the historical costs of our real estate investments and our market capitalization. We pay RMR LLC substantial base management fees regardless of our financial results. These fee arrangements could incentivize RMR LLC to pursue acquisitions, capital transactions, tenancies and construction projects or to avoid disposing of our assets in order to increase or maintain its management fees.fees and might reduce RMR LLC’s incentive to devote its time and effort to seeking investments that provide attractive returns for us. If we do not effectively manage our investment, disposition and capital
transactions and leasing, construction and other property management activities, we may pay increased management fees without proportional benefits to us. In addition, we payare obligated under our management agreements to reimburse RMR LLC substantial base management fees regardlessfor employment and related expenses of our financial results. RMR LLC’s entitlementemployees assigned to a base management fee mightwork exclusively or partly at our properties, our share of the wages, benefits and other related costs of RMR LLC’s centralized accounting personnel and our share of RMR LLC’s costs for providing our internal audit function. We are also required to pay for third party costs incurred with respect to us. Our obligation to reimburse RMR LLC for certain of its costs and to pay third party costs may reduce itsRMR LLC’s incentive to devote its time and effort to seeking investments that provide attractive returns for us.efficiently manage those costs, which may increase our costs.
The termination of our management agreements may require us to pay a substantial termination fee, including in the case of a termination for unsatisfactory performance, which may limit our ability to end our relationship with RMR LLC.
The terms of our management agreements with RMR LLC automatically extend on December 31st of each year so that such terms thereafter end on the 20th anniversary of the date of the extension. We have the right to terminate these agreements: (1) at any time on 60 days’ written notice for convenience, (2) immediately upon written notice for cause, as defined in the agreements, (3) on written notice given within 60 days after the end of any applicable calendar year for a performance reason, as defined in the agreements, and (4) by written notice during the 12 months following a manager change of control, as defined in the agreements. However, if we terminate a management agreement for convenience, or if RMR LLC terminates a management agreement with us for good reason, as defined in such agreement, we are obligated to pay RMR LLC a termination fee in an amount equal to the sum of the present values of the monthly future fees, as defined in the applicable agreement, payable to RMR LLC for the thenterm that was remaining term,before such termination, which, depending on the time of termination, would be between 19 and 20 years. Additionally, if we terminate a management agreement for a performance reason, as defined in the agreement, we are obligated to pay RMR LLC the termination fee calculated as described above, but assuming a remaining term of 10 years. These provisions substantially increase the cost to us of terminating the management agreements without cause, which may limit our ability to end our relationship with RMR LLC as our manager. The payment of the termination fee could have a material adverse effect on our financial condition, including our ability to pay dividends to our shareholders.
Our management arrangements with RMR LLC may discourage a change of control of us.
Our management agreements with RMR LLC have continuing 20 year terms that renew annually. As noted in the preceding risk factor, if we terminate either of these management agreements other than for cause or upon a change of control of our manager, we are obligated to pay RMR LLC a substantial termination fee. For these reasons, our management agreements with RMR LLC may discourage a change of control of us, including a change of control which might result in payment of a premium for our common shares.
We are and have been party to transactions with related parties that may not realize the expected benefits of our acquisition of an interest in RMR Inc.
On June 5, 2015, we participated in a transaction with RMR Inc., RMR LLC, ABP Trust, SIR and two other REITs to which RMR LLC provides management services in which, among other things, we acquired 1,541,201 shares of RMR Inc.’s class A common stock, ABP Trust acquired 700,000 of our common shares and we amended our management agreements with RMR LLC and extended them for continuing 20 year terms, or the Up-C Transaction. In December 2015, we distributed 768,032 of the shares of RMR Inc.’s class A common stock that we received in the Up-C Transaction pro rata to our shareholders. SIR also distributed shares of RMR Inc.’s class A common stock pro rata to its shareholders from which we received 441,056 shares of RMR Inc.’s class A common stock as a shareholder of SIR. We believe the Up-C Transaction provided several benefits to us, including an attractive investment in the equity securities of RMR Inc., the further alignment of the interests of RMR LLC and Adam Portnoy with our interests and greater transparency for us and our shareholders into the compensation practices and financial and operating results of RMR LLC. However, our investment in RMR Inc. is subject to various risks, including the highly competitive nature of RMR LLC’s business and the limited public market for RMR Inc.’s securities, among others, which may result in us losing some or all of our investment in RMR Inc. or otherwise not realizing the benefits we expect from the Up-C Transaction. For further information on the Up-C Transaction, see Note 7 to our Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K.
The Up-C Transaction and the agreements entered into as part of the Up-C Transaction are among related persons, which increasesincrease the risk of allegations of conflicts of interest, and such allegations may impair our ability to realize the benefits we expect from the Up-C Transaction. these transactions.
Because of the various relationships among us, RMR Inc., RMR LLCWe are and the other REITshave been party to transactions with related parties, including with entities controlled by Adam Portnoy or to which RMR LLC providesor its subsidiaries provide or provided management services,services. Our agreements with related parties or in respect of transactions among related parties may not be or have been on terms as favorable to us as they would have been if they had been negotiated among unrelated parties. We are subject to the Up-C Transactionrisk that our shareholders or the shareholders of RMR Inc. or other related parties may challenge any such related party transactions and the agreements entered into as part of them. If such a challenge were to be successful, we might not realize the Up-C Transaction, includingbenefits expected from the amendment and extension of our management agreements for continuing 20 year terms, are among related
persons. The Up-C Transaction and the terms thereof were negotiated and reviewed by a Joint Special Committee comprised solely of our Independent Trustees and the independent trustees of the other REITs to which RMR LLC then provided management services, or the Joint Special Committee, and were separately approved and adopted by our Independent Trustee who did not serve as an independent trustee oftransactions being challenged. Moreover, any of the other REITs, by a Special Committee of our Board of Trustees, comprised solely of our Independent Trustees, or our Special Committee, and by our Board of Trustees. Morgan Stanley & Co. LLC acted as financial advisor to the Joint Special Committee and Reynolds Advisory Partners, LLC acted as financial advisor to our Special Committee. Nonetheless, because of these various relationships, the Up-C Transaction was not negotiated on an arm’s length basis among unrelated third parties, and therefore may not be on terms as favorable to us or the other applicable REITs to which RMR LLC provides management services as it would have been if it was negotiated on an arm’s length basis among unrelated parties. As a result of these relationships, we may be subject to increased risk that our shareholders or the shareholders of the other REITs to which RMR LLC provides management services may challenge the Up-C Transaction and the agreements entered into as part of the Up-C Transaction. Any such challenge could result in substantial costs and be a diversion toof our management’s attention, could have a material adverse effect on our reputation, business and growth and could adversely affect our ability to realize the benefits we expectexpected from the Up-C Transaction,transactions, whether or not the allegations have merit or are substantiated.
We may be at an increased risk for dissident shareholder activities due to perceived conflicts of interest arising from our management structure.structure and relationships.
InCompanies with business dealings with related persons and entities may more often be the past, in particular following periodstarget of volatility in the overall market or declines in the market price of a company’s securities, shareholder litigation, dissident shareholder trustee nominations, and dissident shareholder proposals have often been instituted against companiesand shareholder litigation alleging conflicts of interest in their business dealings with affiliated and related persons and entities.dealings. Our relationships with RMR Inc., RMR LLC, SIR, AIC, the other businesses and entitiescompanies to which RMR LLC or its subsidiaries provide management services, Adam Portnoy and other related persons of RMR LLC have precipitated and may precipitate such activities.activities, including shareholder litigation which results in substantial costs for us even if the shareholder litigation is without merit or unsuccessful. Certain proxy advisory firms which have significant influence over the voting by shareholders of public companies have, in the past, recommended, and in the future may recommend that shareholders withhold votes for the election of our incumbent Trustees, and vote against our say on pay vote or other management proposals.proposals or vote for shareholder proposals that we oppose. These recommendations by proxy advisory firms in the future may affect the outcome of ourfuture Board of
Trustees elections and impactvotes on our governance,say on pay, which may increase shareholder activism and litigation. These activities, if instituted against us, could result in substantial costs, and a diversion of our management’s attention and could have a material adverse impact on our reputation and business.
We may experience losses from our business dealings with AIC.We, ABP Trust, SIR and four other companies to which RMR LLC provides management services each own 14.3% of AIC, and we have invested $6.0 million in AIC. We and those other AIC shareholders participate in a combined property insurance program arranged and reinsured in part by AIC and we periodically consider the possibilities for expanding our relationship with AIC to other types of insurance. Our principal reason for investing in AIC and for purchasing insurance in these programs is to seek to improve our financial results by obtaining improved insurance coverages at lower costs than may be otherwise available to us or by participating in any profits which we may realize as an owner of AIC. While we believe we have in the past benefitted from these arrangements, these beneficial financial results may not occur in the future, and we may need to invest additional capital in order to continue to pursue these results. AIC’s business involves the risks typical of an insurance business, including the risk that it may not operate profitably. Accordingly, financial benefits from our business dealings with AIC may not be achieved in the future, and we may experience losses from these dealings.
Risks Related to Our Ownership Interest in SIR
The market price of our ownership in SIR may decline.
We own 24,918,421 SIR common shares. As of December 31, 2017, the carrying value of our SIR common shares was $467.5 million, and the market price of those common shares was $626.2 million based on the closing price of SIR’s common shares on Nasdaq on that day. The market price for SIR’s common shares will vary. If it appears that the market price of our SIR common shares is persistently below the carrying value of our SIR common shares, we may be required to record an impairment charge with regard to our ownership of the SIR common shares, and the amount of this charge may be material.
We may be unable to realize the market price or the carrying value of our SIR common shares at the time of sale.
As of the date of this Annual Report on Form 10-K, we own 27.8% of SIR’s total outstanding common shares. Because we own such a large number of SIR common shares which represents such a large percentage of SIR’s outstanding common shares, any effort we make to sell our SIR common shares may depress the market price of SIR’s common shares and
we may be unable to realize an otherwise market price for our SIR common shares. Speculation by the press, stock analysts, our shareholders or others regarding our intention with respect to our investment in SIR could adversely affect the market price of SIR’s common shares. Also, we may be unable to sell our SIR common shares for an amount equal to their carrying value because of the significance of our SIR holdings, a reduced market price of SIR common shares or otherwise; we may realize a loss on our investment in SIR common shares.
SIR’s cash distributions may change from time to time, and we cannot provide assurance that SIR will declare cash distributions in any particular amounts or at all. A reduction in SIR’s cash distributions would have a negative effect on us.
SIR’s board of trustees may lower the amount of distributions that SIR pays to its shareholders, including us, which would reduce the cash flow we realize by owning our SIR common shares and could adversely impact our ability to make payments of principal and interest on our indebtedness and future distributions on our common shares.
The ability of SIR to pay regular cash distributions is out of our control and made at the discretion of SIR’s board of trustees. The declaration of any distribution will depend upon various factors that SIR’s board of trustees deems relevant, including its results of operations, its financial condition, the debt and equity capital available to it, the expectation of its capital requirements, the funds from operations attributed to SIR, the normalized funds from operations attributed to SIR, the restrictive covenants in its financial or other contractual arrangements (including those contained in its credit agreement), tax law requirements to maintain its qualification for taxation as a REIT, restrictions under Maryland law and its expected needs for and availability of cash to pay its obligations.
SIR’s board of trustees may also amend or revise SIR’s operational, financing and investment policies, including its policies with respect to its intention to qualify for taxation as a REIT, acquisitions, dispositions, growth, operations, indebtedness, capitalization and distributions, or to approve transactions that deviate from these policies, without a vote of, or notice to, SIR’s shareholders.
Although we own a large percentage of SIR’s outstanding common shares, we do not control SIR’s day to day activities, some of which may adversely impact us.
Although we own a large percentage of SIR’s outstanding common shares and may have significant influence over SIR’s board of trustees and the outcome of shareholder actions, we do not control SIR’s day to day activities. Certain activities by SIR could adversely impact us or the market price of our investment in SIR. For example:
SIR may incur substantial amounts of indebtedness, which may adversely impact the market price of SIR’s common shares, including our SIR common shares;
SIR may determine to issue significant amounts of equity capital, which would dilute our ownership interest in SIR;
SIR may issue additional common shares at a per share price below the per share carrying value of our SIR common shares, which may require us to reduce our cost basis for our SIR common shares and recognize losses on our SIR investment;
SIR may incur losses if it is unable to maintain the occupancy or rents it now receives from its properties or its operating expenses increase or otherwise, and any such losses may reduce the market price of our SIR common shares;
SIR’s board of trustees may change or revise SIR’s business plans and policies from time to time without shareholder approval, and any such changes could adversely affect SIR’s financial condition, results of operations, the market price of SIR’s common shares and SIR’s ability to make distributions to its shareholders; and
our relationship with SIR may create conflicts of interest or the perception of such conflicts.
Risks Related to Our Organization and Structure
Ownership limitations and certain provisions in our declaration of trust, bylaws and bylaws,agreements as well as certain provisions of Maryland law, may deter, delay or prevent a change in our control or unsolicited acquisition proposals.
Our declaration of trust prohibits any shareholder other than RMR LLC and its affiliates (as defined under Maryland law) and certain persons who have been exempted by our Board of Trustees from owning, directly and by attribution, more than 9.8% of the number or value of shares (whichever is more restrictive) of any class or series of our outstanding shares of beneficial interest, including our common shares. This provision of our declaration of trust is intended to, among other purposes, assist with our REIT compliance under the IRC and otherwise promote our orderly governance. However, this provision may also inhibit acquisitions of a significant stake in us and may deter, delay or prevent a change in control of us or unsolicited acquisition proposals that a shareholder may consider favorable. Additionally, provisions contained in our declaration of trust and bylaws or under Maryland law may have a similar impact, including, for example, provisions relating to:
the division of our Trustees into three classes, with the term of one class expiring each year, which could delay a change of control of us;
limitations on shareholder voting rights with respect to certain actions that are not approved by our Board of Trustees;
the authority of our Board of Trustees, and not our shareholders, to adopt, amend or repeal our bylaws and to fill vacancies on our Board of Trustees;
shareholder voting standards which require a supermajority for approval of certain actions;
the fact that only our Board of Trustees, or, if there are no Trustees, our officers, may call shareholder meetings and that shareholders are not entitled to act without a meeting;
required qualifications for an individual to serve as a Trustee and a requirement that certain of our Trustees be “Managing Trustees” and other Trustees be “Independent Trustees”,Trustees,” as defined in our governing documents;
limitations on the ability of our shareholders to propose nominees for election as Trustees and propose other business to be considered at a meeting of our shareholders;
limitations on the ability of our shareholders to remove our Trustees; and
the authority of our Board of Trustees to create and issue new classes or series of shares (including shares with voting rights and other rights and privileges that may deter a change in control) and issue additional common shares. shares;
In addition, our shareholders agreement with respect to AIC providesrestrictions on business combinations between us and an interested shareholder that AIC and the other shareholders of AIC may have rights to acquire our interests in AIC in the event that anyone acquires more than 9.8% of our shares or we experience some other change in control.
Our ownership interest in AIC may prevent shareholders from accumulating a large share stake in us, from nominating or serving as Trustees, or from taking actions to otherwise control our business.
As an owner of AIC, we are licensed and approved as an insurance holding company; and any shareholder who owns or controls 10% or more of our securities or anyone who wishes to solicit proxies for election of, or to serve as, one of our Trustees or for another proposal of business not first been approved by our Board of Trustees may be required(including a majority of Trustees not related to receive pre-clearance from the concerned insurance regulators. These pre-approval procedures may discourage or prevent investors from purchasinginterested shareholder); and
the authority of our securities, from nominating personsBoard of Trustees, without shareholder approval, to serve as our Trustees or from taking other actions.implement certain takeover defenses.
Our rights and the rights of our shareholders to take action against our Trustees and officers are limited.
Our declaration of trust limits the liability of our Trustees and officers to us and our shareholders for money damages to the maximum extent permitted under Maryland law. Under current Maryland law, our Trustees and officers will not have any liability to us and our shareholders for money damages other than liability resulting from:
actual receipt of an improper benefit or profit in money, property or services; or
active and deliberate dishonesty by the Trustee or officer that was established by a final judgment as being material to the cause of action adjudicated.
Our declaration of trust authorizes us, and our bylaws and indemnification agreements require us, to indemnify, any present or former Trustee or officer, to the maximum extent permitted by Maryland law, any present or former Trustee or officer who is made or threatened to be made a party to a proceeding by reason of his or her service in those and certain other capacities. In addition, we may be obligated to
pay or reimburse the expenses incurred by our present and former Trustees and officers without requiring a preliminary determination of their ultimate entitlement to indemnification. As a result, we and our shareholders may have more limited rights against our present and former Trustees and officers than might otherwise exist absent the provisions in our declaration of trust, bylaws and indemnification agreements or that might exist with other companies, which could limit our shareholders' recourse in the event of actions not in their best interest.
Disputes with RMR LLC and shareholderShareholder litigation against us or our Trustees, and officers, manager, other agents or employees may be referred to bindingmandatory arbitration proceedings.proceedings, which follow different procedures than in-court litigation and may be more restrictive to shareholders asserting claims than in-court litigation.
Our contracts with RMR LLC provideshareholders agree, by virtue of becoming shareholders, that any dispute arising under those contractsthey are bound by our governing documents, including the arbitration provisions of our declaration of trust and bylaws, as they may be referredamended from time to binding arbitration proceedings. Similarly, our bylawstime. Our governing documents provide that certain actions by one or more of our shareholders against us or againstany of our Trustees, and officers, manager or other agents or employees, other than disputes, or any portion thereof, regarding the meaning, interpretation or validity of any provision of our declaration of trust or bylaws, maywill be referred to mandatory, binding and final arbitration proceedings.proceedings if we, or any other party to such dispute, including any of our Trustees, officers, manager, other agents or employees unilaterally so demands. As a result, we and our shareholders would not be able to pursue litigation in courtsstate or federal court against RMR LLCus or our Trustees, officers, manager, other agents or employees, including, for example, claims alleging violations of federal securities laws or breach of fiduciary duties or similar director or officer duties under Maryland law, if we or any of our Trustees, officers, manager, other agents or employees against whom the claim is made unilaterally demands the matter be resolved by arbitration. Instead, our shareholders would be required to pursue such claims through binding and officers for disputes referredfinal arbitration.
Our governing documents provide that such arbitration proceedings would be conducted in accordance with the procedures of the Commercial Arbitration Rules of the American Arbitration Association, as modified in our bylaws. These procedures may provide materially more limited rights to our shareholders than litigation in a federal or state court. For example, arbitration in accordance with our bylaws.these procedures does not include the opportunity for a jury trial, document discovery is limited, arbitration hearings generally are not open to the public, there are no witness depositions in advance of arbitration hearings and arbitrators may have different qualifications or experiences than judges. In addition, the ability to collect attorneys’ fees or other damagesalthough our governing documents’ arbitration provisions contemplate that arbitration may be limitedbrought in a representative capacity or on behalf of a class of our shareholders, the rules governing such representation or class arbitration may be different from, and less favorable to shareholders than, the rules governing representative or class action litigation in courts. Our governing documents also generally provide that each party to such an arbitration is required to bear its own costs in the arbitration, proceedings, whichincluding attorneys’ fees, and that the arbitrators may not render an award that includes shifting of such costs or, in a derivative or class proceeding, award any portion of our award to any shareholder or such shareholder’s attorneys. The arbitration provisions of our governing documents may discourage our shareholders from bringing, and attorneys from agreeing to represent partiesour shareholders wishing to commence suchbring, litigation against us or our Trustees, officers, manager, other agents or employees. Our agreements with RMR LLC have similar arbitration provisions to those in our governing documents.
We believe that the arbitration provisions in our governing documents are enforceable under both state and federal law, including with respect to federal securities laws claims. We are a proceeding.Maryland real estate investment trust and Maryland courts have upheld the enforceability of arbitration provisions in governing documents. In addition, the United States Supreme Court has repeatedly upheld agreements to arbitrate other federal statutory claims, including those that implicate important federal policies. However, some academics, legal practitioners and others are of the view that charter or bylaw provisions mandating arbitration are not enforceable with respect to federal securities laws claims. It is possible that the arbitration provisions of our governing documents may ultimately be determined to be unenforceable.
By agreeing to the arbitration provisions of our governing documents, shareholders will not be deemed to have waived compliance by us with federal securities laws and the rules and regulations thereunder.
Our bylaws designate the Circuit Court for Baltimore City, Maryland as the sole and exclusive forum for certain actions and proceedings that may be initiated by our shareholders, which could limit our shareholders’ ability to obtain a favorable judicial forum for disputes with us or our Trustees, officers, manager, agents or employees.
Our bylaws currently provide that, unless the dispute has been referred to binding arbitration, the Circuit Court for Baltimore City, Maryland will be the sole and exclusive forum for: (1) any derivative action or proceeding brought on our behalf; (2) any action asserting a claim for breach of a fiduciary duty owed by any Trustee, officer, manager, agent or employee of ours to us or our shareholders; (3) any action asserting a claim against us or any Trustee, officer, manager, agent or employee of ours arising pursuant to Maryland law, our declaration of trust or bylaws brought by or on behalf of a shareholder;shareholder, either on his, her or its own behalf, on our behalf or on behalf of any series or class of shares of beneficial interest of ours or shareholders against us or any Trustee, officer, manager, agent or employee of ours, including any disputes, claims or controversies relating
to the meaning, interpretation, effect, validity, performance or enforcement of the declaration of trust or these bylaws; or (4) any action asserting a claim against us or any Trustee, officer, manager, agent or employee of ours that is governed by the internal affairs doctrine. Our bylaws currently also provide that the Circuit Court for Baltimore City, Maryland will be the sole and exclusive forum for any dispute, or portion thereof, regarding the meaning, interpretation or validity of any provision of our declaration of trust or bylaws. The exclusive forum provision of our bylaws does not apply to any action for which the Circuit Court for Baltimore City, Maryland does not have jurisdiction or to a dispute that has been referred to binding arbitration in accordance with our bylaws. The exclusive forum provision of our bylaws does not establish exclusive jurisdiction in the Circuit Court for Baltimore City, Maryland for claims that arise under the Securities Act, the Exchange Act or other federal securities laws if there is exclusive or concurrent jurisdiction in the federal courts. Any person or entity purchasing or otherwise acquiring or holding any interest in our shares of beneficial interest shall be deemed to have notice of and to have consented to these provisions of our bylaws, as they may be amended from time to time. These choiceThe arbitration and exclusive forum provisions of forum provisionsour bylaws may limit a shareholder’s ability to bring a claim in a judicial forum that the shareholder believes is favorable for disputes with us or our Trustees, officers, manager, other agents or employees, which may discourage lawsuits against us and our Trustees, officers, manager, other agents or agents.employees. SIR’s former bylaws had similar exclusive forum provisions to those in our bylaws.
We may change our operational, financing and investment policies without shareholder approval and we may become more highly leveraged, which may increase our risk of default under our debt obligations.
Our Board of Trustees determines our operational, financing and investment policies and may amend or revise our policies, including our policies with respect to our intention to qualifyremain qualified for taxation as a REIT, acquisitions, dispositions, growth, operations, indebtedness, capitalization and distributions, or approve transactions that deviate from these policies, without a vote of, or notice to, our shareholders. Policy changes could adversely affect the market price of our common shares and our ability to make distributions to our shareholders. Further, our organizational documents do not limit the amount or percentage of indebtedness, funded or otherwise, that we may incur. Our Board of Trustees may alter or eliminate our current policy on borrowing at any time without shareholder approval. If this policy changes, we could become more highly leveraged, which could result in an increase in our debt service costs. Higher leverage also increases the risk of default on our obligations. In addition, a change in our investment policies, including the manner in which we allocate our resources across our portfolio or the types of assets in which we seek to invest, may increase our exposure to interest rate risk, real estate market fluctuations and liquidity risk.
Risks Related to Our Taxation
Our failure to remain qualified for taxation as a REIT under the IRC could have significant adverse consequences.
As a REIT, we generally do not pay federal or most state income taxes as long as we distribute all of our REIT taxable income and meet other qualifications set forth in the IRC. However, actual qualification for taxation as a REIT under the IRC depends on our satisfying complex statutory requirements, for which there are only limited judicial and administrative interpretations. We believe that we have been organized and have operated, and will continue to be organized and to operate, in a manner that qualified and will continue to qualify us to be taxed as a REIT under the IRC. However, we cannot be sure that the IRS, upon review or audit, will agree with this conclusion. Furthermore, we cannot be sure that the federal government, or any state or other taxation authority, will continue to afford favorable income tax treatment to REITs and their shareholders.
Maintaining our qualification for taxation as a REIT under the IRC will require us to continue to satisfy tests concerning, among other things, the nature of our assets, the sources of our income and the amounts we distribute to our shareholders. In order to meet these requirements, it may be necessary for us to sell or forgo attractive investments.
If we cease to qualify for taxation as a REIT under the IRC, then our ability to raise capital might be adversely affected, we will be in breach under our credit agreement, we may be subject to material amounts of federal and state income taxes, our cash available for distribution to our shareholders could be reduced, and the market price of our common shares could decline. In addition, if we lose or revoke our qualification for taxation as a REIT under the IRC for a taxable year, we will generally be prevented from requalifying for taxation as a REIT for the next four taxable years.
Distributions to shareholders generally will not qualify for reduced tax rates applicable to “qualified dividends.”
Dividends payable by U.S. corporations to noncorporate shareholders, such as individuals, trusts and estates, are generally eligible for reduced federal income tax rates applicable to “qualified dividends.” Distributions paid by REITs generally are not treated as “qualified dividends” under the IRC and the reduced rates applicable to such dividends do not generally apply. However, for tax years beginning after 2017 and before 2026, REIT dividends paid to noncorporate shareholders are generally taxed at an effective tax rate lower than applicable ordinary income tax rates due to the availability of a deduction under the IRC for
specified forms of income from passthrough entities. More favorable rates will nevertheless continue to apply to regular corporate “qualified” dividends, which may cause some investors to perceive that an investment in a REIT is less attractive than an investment in a non-REIT entity that pays dividends, thereby reducing the demand and market price of our common shares.
REIT distribution requirements could adversely affect us and our ability to execute our business plan.shareholders.
We generally must distribute annually at least 90% of our REIT taxable income, subject to specified adjustments and excluding any net capital gain, in order to maintain our qualification for taxation as a REIT under the IRC. To the extent that we satisfy this distribution requirement, federal corporate income tax will not apply to the earnings that we distribute, but if we distribute less than 100% of our REIT taxable income, then we will be subject to federal corporate income tax on our undistributed taxable income. We intend to make distributions to our shareholders to comply with the REIT requirements of the IRC. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our shareholders in a calendar year is less than a minimum amount specified under federal tax laws.
From time to time, we may generate taxable income greater than our income for financial reporting purposes prepared in accordance with U.S. generally accepted accounting principles, or GAAP, or differences in timing between the recognition of taxable income and the actual receipt of cash may occur. If we do not have other funds available in these situations, among other things, we may borrow funds on unfavorable terms, sell investments at disadvantageous prices or distribute amounts that would otherwise be invested in future acquisitions in order to make distributions sufficient to enable us to pay out enough of our taxable income to satisfy the REIT distribution requirement and to avoid corporate income tax and the 4% excise tax in a particular year. These alternatives could increase our costs or reduce our shareholders’ equity. Thus, compliance with the REIT distribution requirements may hinder our ability to grow, which could cause the market price of our common shares to decline.
Even if we remain qualified for taxation as a REIT under the IRC, we may face other tax liabilities that reduce our cash flow.
Even if we remain qualified for taxation as a REIT under the IRC, we may be subject to federal, state and local taxes on our income and assets, including taxes on any undistributed income, excise taxes, state or local income, property and transfer taxes, and other taxes. Also, some jurisdictions may in the future limit or eliminate favorable income tax deductions, including the dividends paid deduction, which could increase our income tax expense. In addition, in order to meet the requirements for qualification and taxation as a REIT under the IRC, prevent the recognition of particular types of non-cash
income, or avert the imposition of a 100% tax that applies to specified gains derived by a REIT from dealer property or inventory, we may hold or dispose of some of our assets and conduct some of our operations through our TRSs or other subsidiary corporations that will be subject to corporate level income tax at regular rates. In addition, while we intend that our transactions with our TRSs will be conducted on arm’s length bases, we may be subject to a 100% excise tax on a transaction that the IRS or a court determines was not conducted at arm’s length. Any of these taxes would decrease cash available for distribution to our shareholders.
We may incur adverse tax consequences if FPO failed to qualify for taxation as a REIT under the IRC prior to the FPO Transaction.result of our merger and acquisition transactions.
We received an opinion from FPO’sopinions of counsel that each of SIR and FPO, wasrespectively, were organized and operated in conformity with the requirements for qualification and taxation as a REIT under the IRC prior to the FPO Transaction.time that we acquired those entities. If, contrary to that opinion,those opinions, either SIR or FPO failed to qualify for taxation as a REIT under the IRC, then we may inherit significant tax liabilities as a result of the FPO Transactionthose transactions because, as the successor by merger to SIR and FPO, we would generally inherit any corporate income tax liabilities of FPO,those entities, including penalties and interest.
ItIf it is unclear whether the IRC provisionsdetermined that are generally available to remediate REIT compliance failures will be available to us as a successor in respectone or both of any determination thatSIR and FPO failed to qualify for taxationsatisfy one or more of the REIT qualification requirements before the applicable merger into us, the IRS might allow us, as a REITsuccessor, to utilize remedial provisions under the IRC. IfIRC to remediate the REIT compliance failure. However, if and to the extent the remedial provisions are available to us to address FPO’sany REIT qualification and taxation as a REIT undermatter stemming from the IRC for the applicable period prior toperiods before we acquired SIR or including the FPO, Transaction, we may have to expend significant resources in connection with thesuch remediation, including, among other things, (a) required distribution payments to shareholders and associated interest payments to the IRS, and (b) tax and interest payments to the IRS and state and local tax authorities.
FPO’sThe failure of SIR or FPO to qualify for taxation as a REIT under the IRC for the applicable periodperiods prior to or including the FPO Transactiontime we acquired these entities and our efforts to remedy any such failure could have a material adverse effect on our financial condition and results of operations.
Legislative or other actions affecting REITs could materially and adversely affect us and our shareholders.
The rules dealing with U.S. federal, state, and local taxation are constantly under review by persons involved in the legislative process and by the IRS, the U.S. Department of the Treasury, and other taxation authorities. Changes to the tax laws, with or without retroactive application, could materially and adversely affect us and our shareholders. We cannot predict how changes in the tax laws might affect us or our shareholders. New legislation, Treasury regulations, administrative interpretations or court decisions could significantly and negatively affect our ability to qualifyremain qualified for taxation as a REIT or the tax consequences of such qualification.
In addition, December 2017 legislation has made substantial changesqualification to the IRC. Among those changes are a significant permanent reduction in the generally applicable corporate income tax rate, changes in the taxation of individualsus and other noncorporate taxpayers that generally reduce their taxes on a temporary basis subject to “sunset” provisions, the elimination or modification of various deductions (including substantial limitation of the deduction for personal state and local taxes imposed on individuals), and preferential taxation of income derived by individuals from passthrough entities in comparison to earnings received directly by individuals. This legislation also imposes additional limitations on the deduction of net operating losses, which may in the future cause us to make additional distributions that will be taxable to our shareholders to the extent of our current or accumulated earnings and profits in order to comply with the REIT distribution requirements. The effect of these and other changes made in this legislation is highly uncertain, both in terms of their direct effect on the taxation of an investment in our common shares and their indirect effect on the value of properties owned by us. Furthermore, many of the provisions of the new law will require guidance through the issuance of Treasury regulations in order to assess their effect. There may be a substantial delay before such regulations are promulgated, increasing the uncertainty as to the ultimate effect of the statutory amendments on us or our shareholders. It is also possible that there will be technical corrections legislation proposed with respect to the new law, the effect of which cannot be predicted and may be adverse to us or our shareholders.
Risks Related to ourOur Securities
Our distributions to our shareholders may decline.
We intend to continue to make regular quarterly distributions to our shareholders. However:
our ability to make or sustain the rate of distributions will be adversely affected if any of the risks described in this Annual Report on Form 10-K occur;
our making of distributions is subject to compliance with restrictions contained in our credit agreement and may be subject to restrictions in future debt obligations we may incur;
our ability to make future distributions is dependent on a number of factors, including our future earnings, the capital costs we incur to lease our properties and our working capital requirements; and
the timing and amount of any distributions will be determined at the discretion of our Board of Trustees sets and resets our distribution rate from time to time after considering many factors, including cash available for distribution. Accordingly, future distribution rates may be increased or decreased and there is no assurance as to the rate at which future distributions will depend on various factors that our Board of Trustees deems relevant, including our financial condition, our results of operations, our liquidity, our capital requirements, our FFO, our Normalized FFO, restrictive covenants in our financial or other contractual arrangements, general economic conditions in the United States, requirements of the IRC to remain qualified for taxation as a REIT and restrictions under the laws of Maryland.
be paid.
For thesethe above reasons, among others, our distribution rate may decline or we may cease making distributions to our shareholders.
Changes in market conditions could adversely affect the value of our securities.
As with other publicly traded equity securities and REIT securities, the value of our common shares and other securities depends on various market conditions that are subject to change from time to time, including:
the extent of investor interest in our securities;
the general reputation of REITs and externally managed companies and the attractiveness of our equity securities in comparison to other equity securities, including securities issued by other real estate based companies or by other issuers less sensitive to rises in interest rates;
our underlying asset value;
investor confidence in the stock and bond markets, generally;
market interest rates;
national economic conditions;
changes in tax laws;
changes in our credit ratings; and
general market conditions.
We believe that one of the factors that investors consider important in deciding whether to buy or sell equity securities of a REIT is the distribution rate, considered as a percentage of the price of the equity securities, relative to market interest rates. Interest rates have been at historically low levels for an extended period of time. There is a general market perception that REIT shares outperform in low interest rate environments and underperform in rising interest rate environments when compared to the broader market. Since December 2016, theThe U.S. Federal Reserve has raised its benchmark intereststeadily increased the targeted federal funds rate by one percentage point,over the last several years, but recently took action to decrease the federal funds rate and there are some market expectations that market interest rates will rise furthermay continue to make adjustments in the near to intermediate term.future. If marketthe U.S.
Federal Reserve increases interest rates continue to increase, or if there continues to beis a market expectation of such increases, prospective purchasers of REIT equity securities may want to achieve a higher distribution rate. Thus, higher market interest rates, or the expectation of higher interest rates, could cause the value of our securities to decline.
Further issuances of equity securities may be dilutive to current shareholders.
The interests of our existing shareholders could be diluted if we issue additional equity securities to finance future acquisitions, or to repay indebtedness.indebtedness or for other reasons. For example, in the SIR Merger, we issued a significant number of additional common shares of beneficial interest. Our ability to execute our business strategy depends on our access to an appropriate blend of debt financing, which may include secured and unsecured debt, and equity financing, which may include common and preferred shares.
The Notes are structurally subordinated to the payment of all indebtedness and other liabilities and any preferred equity of our subsidiaries.
We are the sole obligor on our outstanding senior unsecured notes, and our outstanding senior unsecured notes and any notes or other debt securities we may issue in the future, or, together with our outstanding senior unsecured notes, or the Notes, and such Notes are not, and any Notes we may issue in the future may not be guaranteed by any of our subsidiaries. Our
subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay any amounts due on the Notes, or to make any funds available therefor, whether by dividend, distribution, loan or other payments. The rights of holders of Notes to benefit from any of the assets of our subsidiaries are subject to the prior satisfaction of claims of our subsidiaries’ creditors and any preferred equity holders. As a result, the Notes are, and, except to the extent that future Notes are guaranteed by our subsidiaries, will be, structurally subordinated to all of the debt and other liabilities and obligations of our subsidiaries, including guarantees of other indebtedness of ours, payment obligations under lease agreements, trade payables and preferred equity. As of December 31, 2017,2019, our subsidiaries had total indebtedness and other liabilities (excluding security and other deposits and guaranties) of $238.5$404.9 million.
The Notes are unsecured and effectively subordinated to all of our existing and future secured indebtedness to the extent of the value of the assets securing such indebtedness.
The outstanding Notes are not secured and any Notes we may issue in the future may not be secured. Upon any distribution to our creditors in a bankruptcy, liquidation, reorganization or similar proceeding relating to us or our property, the holders of our secured debt will be entitled to exercise the remedies available to a secured lender under applicable law and pursuant to the instruments governing such debt and to be paid in full from the assets securing that secured debt before any payment may be made with respect to Notes that are not secured by those assets. In that event, because such Notes will not be secured by any of our assets, it is possible that there will be no assets from which claims of holders of such Notes can be satisfied or, if any assets remain, that the remaining assets will be insufficient to satisfy those claims in full. If the value of such remaining assets is less than the aggregate outstanding principal amount of such Notes and accrued interest and all future debt ranking equally with such Notes, we will be unable to fully satisfy our obligations under such Notes. In addition, if we fail to meet our payment or other obligations under our secured debt, the holders of that secured debt would be entitled to foreclose on our assets securing that secured debt and liquidate those assets. Accordingly, we may not have sufficient funds to pay amounts due on such Notes. As a result, noteholders may lose a portion or the entire value of their investment in such Notes. Further, the terms of the outstanding Notes permit, and the terms of any Notes we may issue in the future may permit us to incur additional secured indebtedness subject to compliance with certain debt ratios. The Notes that are not secured will be effectively subordinated to any such additional secured indebtedness. As of December 31, 2017,2019, we had $183.1$326.2 million in secured mortgage debt.
There may be no public market for certain of the Notes, and one may not develop, be maintained or be liquid.
We have not applied for listing of certain of the Notes on any securities exchange or for quotation on any automatic dealer quotation system, and we may not do so for Notes issued in the future. We can give no assurances concerningcannot be sure that the liquidity of any market that may develop for such Notes, the ability of any holder to sell such Notes or the price at which holders would be able to sell such Notes. If a market for such Notes does not develop, holders may be unable to resell such Notes for an extended period of time, if at all. If a market for such Notes does develop, it may not continue or it may not be sufficiently liquid to allow holders to resell such Notes. Consequently, holders of suchthe Notes may not be able to liquidate their investment readily, and lenders may not readily accept such Notes as collateral for loans.
The Notes may trade at a discount from their initial issue price or principal amount, depending upon many factors, including prevailing interest rates, the ratings assigned by rating agencies, the market for similar securities and other factors, including general economic conditions and our financial condition, performance and prospects. Any decline in market prices, regardless of cause, may adversely affect the liquidity and trading markets for the Notes.
A downgrade in credit ratings could materially adversely affect the market price of the Notes and may increase our cost of capital.
The outstanding Notes are rated by two rating agencies and any Notes we may issue in the future may be rated by one or more rating agencies. These credit ratings are continually reviewed by rating agencies and may change at any time based upon, among other things, our results of operations and financial condition. In June 2017, both Moody’s Investors Service, or Moody’s, andSeptember 2018, following our announcement that we had entered into the merger agreement with SIR for the SIR Merger, Standard & Poor’s Ratings Services,Poor's Global, or S&P, published reviews ofaffirmed our credit ratings and assigned negative outlooksrevised its outlook on our debt to our ratings. These negative outlooks imply thatstable, and Moody's Investors Service, or Moody's, affirmed our credit ratings may be downgraded to below “investment grade.” Ifand maintained its negative outlook on our debt. In October 2019, S&P reaffirmed our credit ratings are downgraded, we may have difficulty accessing debt capital markets to meet our obligations and the costs of any debt we do obtain may be increased. For example, the interest rates we are required to paywith a stable outlook on our revolving credit facility and our other floating rate debt obligations will increase ifdebt. In December 2019, Moody's reaffirmed our credit ratings are downgraded. We intendand adjusted our outlook from negative to sell some assets, to pay certain debt, to otherwise adjuststable on our capital structure and to take other actions which we believe may avoid any credit ratings downgrade; however, we can provide no assurance that these efforts will be successful to avoid our credit ratings being downgraded.debt. Negative changes in the ratings assigned to our debt securities could have an adverse effect on the market price of the Notes and our costscost and availability of capital, including the interest rate on our revolving credit facility, which could in turn have a material adverse effect on our results of operations and our ability to satisfy our debt service obligations.
Redemption may adversely affect noteholders’ return on the Notes.
We have the right to redeem some or all of the outstanding Notes prior to maturity and may have such a right with respect to any Notes we issue in the future. We may redeem such Notes at times when prevailing interest rates may be relatively low compared to the interest rate of such Notes. Accordingly, noteholders may not be able to reinvest the redemption proceeds in a comparable security at an effective interest rate as high as that of the Notes.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
General.As of December 31, 2017, we2019, our wholly owned 108 properties (167 buildings)were comprised of 189 properties located in 3035 states and the District of Columbia containing approximately 17.525.7 million consolidated rentable square feet and we had a noncontrolling ownership interest in twothree properties (three buildings) containing approximately 0.4 million rentable square feet through two unconsolidated joint ventures in which we own 51% and 50% and 51% interests. As of December 31, 2017, 49 of our consolidated properties (64 buildings), with approximately 7.8 million rentable square feet, were majority leased to the U.S. Government, 21 of our consolidated properties (28 buildings), with approximately 3.1 million rentable square feet, were majority leased to 13 state governments, three of our consolidated properties (three buildings), with approximately 0.4 million rentable square feet were majority leased to other government tenants, two of our consolidated properties (four buildings), with approximately 0.5 million rentable square feet, were majority leased to government contractor tenants, 31 of our consolidated properties (66 buildings), with approximately 5.5 million rentable square feet, were majority leased to other non-government tenants and two of our consolidated properties (two buildings), with approximately 0.1 million rentable square feet, were available for lease.
The following table provides certain information about our properties as of December 31,
20172019 (dollars in thousands):
|
| | | | | | | | | | | | | | |
State | | Number of Properties | | Undepreciated Carrying Value (1) | | Depreciated Carrying Value (1) | | Annualized Rental Income |
Alabama | | 7 | | $ | 88,398 |
| | $ | 83,146 |
| | $ | 16,631 |
|
Arizona | | 5 | | 29,450 |
| | 27,779 |
| | 6,440 |
|
California | | 24 | | 475,992 |
| | 408,716 |
| | 71,011 |
|
Colorado | | 7 | | 97,731 |
| | 77,572 |
| | 20,123 |
|
District of Columbia | | 7 | | 535,471 |
| | 474,843 |
| | 62,317 |
|
Florida | | 3 | | 56,630 |
| | 46,959 |
| | 9,846 |
|
Georgia | | 10 | | 203,568 |
| | 167,007 |
| | 30,392 |
|
Hawaii (2) | | 1 | | 2,008 |
| | 2,008 |
| | — |
|
Idaho | | 3 | | 33,351 |
| | 27,667 |
| | 4,647 |
|
Illinois | | 4 | | 93,577 |
| | 88,903 |
| | 28,513 |
|
Indiana | | 5 | | 98,864 |
| | 82,711 |
| | 13,131 |
|
Iowa | | 1 | | 10,646 |
| | 10,425 |
| | 3,283 |
|
Kentucky | | 2 | | 17,442 |
| | 15,288 |
| | 3,858 |
|
Maryland | | 14 | | 249,873 |
| | 223,770 |
| | 39,492 |
|
Massachusetts | | 7 | | 110,264 |
| | 92,250 |
| | 17,957 |
|
Michigan | | 2 | | 27,570 |
| | 23,026 |
| | 4,235 |
|
Minnesota | | 1 | | 8,243 |
| | 4,484 |
| | 1,126 |
|
Mississippi | | 1 | | 26,156 |
| | 21,396 |
| | 3,986 |
|
Missouri | | 3 | | 83,761 |
| | 75,431 |
| | 23,134 |
|
Nebraska | | 2 | | 19,477 |
| | 19,131 |
| | 4,223 |
|
New Jersey | | 3 | | 48,434 |
| | 47,485 |
| | 14,433 |
|
New York | | 4 | | 37,418 |
| | 31,668 |
| | 9,223 |
|
North Carolina | | 2 | | 21,796 |
| | 21,209 |
| | 6,619 |
|
Ohio | | 1 | | 1,034 |
| | 1,024 |
| | 765 |
|
Oregon | | 1 | | 31,141 |
| | 25,237 |
| | 4,908 |
|
Pennsylvania | | 1 | | 28,259 |
| | 27,630 |
| | 6,897 |
|
South Carolina | | 1 | | 3,778 |
| | 3,696 |
| | 793 |
|
Tennessee | | 1 | | 14,710 |
| | 11,714 |
| | 3,001 |
|
Texas | | 16 | | 252,978 |
| | 242,415 |
| | 47,514 |
|
Utah | | 3 | | 64,339 |
| | 62,762 |
| | 12,626 |
|
Vermont | | 1 | | 9,256 |
| | 7,166 |
| | 1,141 |
|
Virginia | | 31 | | 567,671 |
| | 528,858 |
| | 88,769 |
|
Washington | | 7 | | 126,880 |
| | 111,039 |
| | 20,078 |
|
Wisconsin | | 1 | | 5,587 |
| | 4,589 |
| | 807 |
|
Wyoming | | 1 | | 11,478 |
| | 6,571 |
| | 2,003 |
|
Subtotal | | 183 | | 3,493,231 |
| | 3,105,575 |
| | 583,922 |
|
|
| | | | | | | | | | | | | | | | |
Consolidated Properties | | | | | | | | | | |
Property Location | | Number of Properties | | Number of Buildings | | Undepreciated Carrying Value (1) | | Depreciated Carrying Value (1) | | Annualized Rental Income (2) |
Alabama | | 2 | | 2 | | $ | 23,065 |
| | $ | 20,421 |
| | $ | 3,086 |
|
Arizona | | 2 | | 2 | | 22,305 |
| | 19,446 |
| | 2,351 |
|
California | | 11 | | 11 | | 302,492 |
| | 244,081 |
| | 40,844 |
|
Colorado | | 3 | | 5 | | 68,945 |
| | 49,118 |
| | 10,653 |
|
District of Columbia | | 8 | | 8 | | 567,256 |
| | 526,055 |
| | 75,416 |
|
Florida | | 2 | | 2 | | 48,817 |
| | 41,424 |
| | 6,824 |
|
Georgia | | 5 | | 9 | | 167,163 |
| | 140,537 |
| | 23,720 |
|
Idaho | | 1 | | 3 | | 33,218 |
| | 29,159 |
| | 4,669 |
|
Illinois | | 1 | | 1 | | 15,340 |
| | 12,594 |
| | 1,987 |
|
Indiana | | 1 | | 3 | | 76,880 |
| | 65,223 |
| | 9,730 |
|
Kansas | | 1 | | 1 | | 15,171 |
| | 12,612 |
| | 2,920 |
|
Kentucky | | 1 | | 1 | | 13,501 |
| | 12,032 |
| | 2,554 |
|
Maryland | | 18 | | 43 | | 426,417 |
| | 384,601 |
| | 63,419 |
|
Massachusetts | | 4 | | 4 | | 84,436 |
| | 71,068 |
| | 13,554 |
|
Michigan | | 1 | | 1 | | 18,990 |
| | 15,530 |
| | 2,731 |
|
Minnesota | | 2 | | 2 | | 26,153 |
| | 22,959 |
| | 4,327 |
|
Mississippi | | 1 | | 1 | | 25,946 |
| | 22,487 |
| | 3,974 |
|
Missouri | | 2 | | 2 | | 26,586 |
| | 21,080 |
| | 4,275 |
|
New Hampshire | | 1 | | 1 | | 18,597 |
| | 15,641 |
| | 2,433 |
|
New Jersey | | 1 | | 1 | | 45,823 |
| | 38,874 |
| | 6,469 |
|
New York | | 4 | | 4 | | 170,369 |
| | 144,029 |
| | 18,945 |
|
Oregon | | 1 | | 1 | | 28,761 |
| | 24,694 |
| | 5,147 |
|
South Carolina | | 1 | | 3 | | 17,385 |
| | 13,667 |
| | 2,192 |
|
Tennessee | | 1 | | 1 | | 9,783 |
| | 8,349 |
| | 2,858 |
|
Texas | | 1 | | 1 | | 13,293 |
| | 8,584 |
| | 2,993 |
|
Vermont | | 1 | | 1 | | 9,236 |
| | 7,580 |
| | 1,118 |
|
Virginia | | 26 | | 46 | | 634,449 |
| | 615,674 |
| | 98,962 |
|
Washington | | 2 | | 4 | | 44,001 |
| | 32,322 |
| | 5,537 |
|
West Virginia | | 1 | | 1 | | 5,074 |
| | 2,964 |
| | — |
|
Wisconsin | | 1 | | 1 | | 5,587 |
| | 4,824 |
| | 801 |
|
Wyoming | | 1 | | 1 | | 10,682 |
| | 6,244 |
| | 2,156 |
|
Total Consolidated | | 108 | | 167 | | $ | 2,975,721 |
| | $ | 2,633,873 |
| | $ | 426,645 |
|
|
| | | | | | | | | | | | | | |
| | | | | | | | |
State | | Number of Properties | | Undepreciated Carrying Value (1) | | Depreciated Carrying Value (1) | | Annualized Rental Income |
Properties Held for Sale | | | | | | | | |
Connecticut | | 1 | | 2,016 |
| | 2,003 |
| | 1,281 |
|
Illinois | | 1 | | 5,316 |
| | 5,305 |
| | 1,693 |
|
New Jersey | | 1 | | 27,917 |
| | 27,917 |
| | 6,653 |
|
Virginia | | 3 | | 26,651 |
| | 23,122 |
| | 4,264 |
|
Subtotal | | 6 | | 61,900 |
| | 58,347 |
| | 13,891 |
|
Grand Total | | 189 | | $ | 3,555,131 |
| | $ | 3,163,922 |
| | $ | 597,813 |
|
(1)Excludes value assigned to real estate intangibles in purchase price allocations.
| |
(1) | Excludes value assigned to real estate intangibles in purchase price allocation. |
| |
(2) | Annualized rental income is defined as the annualized contractual base rents from our tenants pursuant to our lease agreements as of December 31, 2017, plus straight line rent adjustments and estimated recurring expense reimbursements to be paid to us, and excluding lease value amortization. |
(2)Property is a leasable land parcel.
At December 31, 2017, eight2019, 11 of our consolidated properties (eight buildings) with an aggregate undepreciated carrying value of $375.2$513.7 million were encumbered by eight mortgages totaling $183.1$323.1 million. One of these properties with an undepreciated carrying value of $16.3 million is included in assets of properties held for sale in our consolidated balance sheet as of December 31, 2019. Accordingly, the carrying value of the mortgage encumbering that property totaling $13.1 million is included in liabilities of properties held for sale in our consolidated balance sheet as of December 31, 2019. The twothree properties (three buildings) owned by our two unconsolidated joint ventures in which we own 51% and 50% interests were encumbered by two mortgages totaling $82.0 million at December 31, 2017. See Note 52019. For more information regarding our mortgages and our two unconsolidated joint ventures, see Notes 3 and 7 to ourthe Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K for more information regarding our unconsolidated joint ventures.10-K.
Item 3. Legal Proceedings
From time to time, we may become involved in litigation matters incidental to the ordinary course of our business. Although we are unable to predict with certainty the eventual outcome of any litigation, we are currently not a party to any litigation which we expect to have a material adverse effect on our business.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common shares were traded on the New York Stock Exchange, or the NYSE (symbol: GOV), through June 30, 2016. Beginning on July 1, 2016, our common shares are traded on Nasdaq (symbol: GOV)OPI). The following table sets forth for the periods indicated the high and low sale prices for our common shares as reported by the NYSE or Nasdaq, as applicable.
|
| | | | | | | | |
| | High | | Low |
2017 | | | | |
First Quarter | | $ | 21.08 |
| | $ | 18.84 |
|
Second Quarter | | 22.99 |
| | 18.26 |
|
Third Quarter | | 18.83 |
| | 17.36 |
|
Fourth Quarter | | 19.60 |
| | 17.79 |
|
2016 | | | | |
First Quarter | | $ | 17.90 |
| | $ | 12.33 |
|
Second Quarter | | 23.07 |
| | 17.59 |
|
Third Quarter | | 24.61 |
| | 21.82 |
|
Fourth Quarter | | 22.67 |
| | 17.66 |
|
The closing price of our common shares on Nasdaq on February 1, 2018, was $16.92 per common share.
As of February 1, 2018,11, 2020, there were 1962,191 shareholders of record of our common shares.
InformationIssuer purchases of equity securities. The following table provides information about cash distributions declared on our common shares is summarized in the table below. Common share cash distributions are generally paid inpurchases of our equity securities during the quarter following the quarter to which they relate.ended December 31, 2019:
|
| | | | | | | | |
| | Cash Distributions Per Common Share |
| | 2017 | | 2016 |
First Quarter | | $ | 0.43 |
| | $ | 0.43 |
|
Second Quarter | | 0.43 |
| | 0.43 |
|
Third Quarter | | 0.43 |
| | 0.43 |
|
Fourth Quarter | | 0.43 |
| | 0.43 |
|
Total | | $ | 1.72 |
| | $ | 1.72 |
|
|
| | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | Maximum |
| | | | | | | | Total Number of | | | Approximate Dollar |
| | | | | | | | Shares Purchased | | | Value of Shares that |
| | Number of | | | | | | as Part of Publicly | | | May Yet Be Purchased |
| | Shares | | Average Price | | | Announced Plans | | | Under the Plans or |
Calendar Month | | Purchased (1) | | Paid per Share | | or Programs | | Programs |
December 2019 | | 131 | | $ | 31.54 | | | — | | $ | — |
Total | | 131 | | $ | 31.54 | | | — | | $ | — |
| |
(1) | These common share withholdings and purchases were made to satisfy tax withholding and payment obligations of certain former employees of RMR LLC in connection with the vesting of awards of our common shares. We withheld and purchased these shares at their fair market value based upon the trading price of our common shares at the close of trading on Nasdaq on the purchase date. |
We currently intend to continue to declare and pay common share distributions on a quarterly basis in cash. However, the timing, amount and form of future distributions are determined at the discretion of our Board of Trustees and will depend upon various factors that our Board of Trustees deems relevant, including our results of operations, our financial condition, debt and equity capital available to us, our expectation of our future capital requirements and operating performance, our FFO, our Normalized FFO, our receipt of distributions from SIR, restrictive covenants in our financial or other contractual arrangements (including those in our credit agreement and our senior unsecured notes indentures and their supplements), tax law requirements to maintain our qualification for taxation as a REIT, restrictions under Maryland law and our expected needs for and availability of cash to pay our obligations. Therefore, we cannot be sure that we will continue to pay distributions in the future or that the amount of any distributions we do pay will not decrease.
Item 6. Selected Financial Data
The following table setstables set forth selected financial data for the periods and dates indicated. This data should be read in conjunction with, and is qualified in its entirety by reference to, Management’s“Management’s Discussion and Analysis of Financial Condition and Results of OperationsOperations” included in Part II, Item 7 of this Annual Report on Form 10-K and the Consolidated Financial Statements and accompanying notes included in Part IV, Item 15 of this Annual Report on Form 10-K. Amounts10-K (amounts are in thousands, except per share data.data).
| | | | Year Ended December 31, | | Year Ended December 31, | |
| | 2017 | | 2016 | | 2015 | | 2014 | | 2013 | | 2019 | | 2018 | | 2017 | | 2016 | | 2015 | |
Income statement data: | | | | | | | | | | | |
Income Statement Data: | | | | | | | | | | | | |
Rental income | | $ | 316,532 |
| | $ | 258,180 |
| | $ | 248,549 |
| | $ | 251,031 |
| | $ | 226,910 |
| | $ | 678,404 |
| | $ | 426,560 |
| | $ | 316,532 |
| | $ | 258,180 |
| | $ | 248,549 |
| |
| | | | | | | | | | | | | | | | | | | | | |
Expenses: | | | | | | | | | | | | | | | | | | | | | |
Real estate taxes | | 37,942 |
| | 30,703 |
| | 29,906 |
| | 28,389 |
| | 25,710 |
| | 73,717 |
| | 49,708 |
| | 37,942 |
| | 30,703 |
| | 29,906 |
| |
Utility expenses | | 20,998 |
| | 17,269 |
| | 17,916 |
| | 19,369 |
| | 17,116 |
| | 34,302 |
| | 26,425 |
| | 20,998 |
| | 17,269 |
| | 17,916 |
| |
Other operating expenses | | 65,349 |
| | 54,290 |
| | 50,425 |
| | 45,982 |
| | 41,134 |
| | 120,943 |
| | 89,610 |
| | 65,349 |
| | 54,290 |
| | 50,425 |
| |
Depreciation and amortization | | 109,588 |
| | 73,153 |
| | 68,696 |
| | 66,593 |
| | 55,699 |
| | 289,885 |
| | 162,488 |
| | 109,588 |
| | 73,153 |
| | 68,696 |
| |
Loss on impairment of real estate | | 9,490 |
| | — |
| | — |
| | 2,016 |
| | — |
| | 22,255 |
| | 8,630 |
| | 9,490 |
| | — |
| | — |
| |
Acquisition related costs | | — |
| | 1,191 |
| | 811 |
| | 1,344 |
| | 2,439 |
| |
Acquisition and transaction related costs | | | 682 |
| | 14,508 |
| | — |
| | 1,191 |
| | 811 |
| |
General and administrative | | 18,847 |
| | 14,897 |
| | 14,826 |
| | 15,809 |
| | 12,710 |
| | 32,728 |
| | 24,922 |
| | 18,847 |
| | 14,897 |
| | 14,826 |
| |
Total expenses | | 262,214 |
| | 191,503 |
| | 182,580 |
| | 179,502 |
| | 154,808 |
| | 574,512 |
| | 376,291 |
| | 262,214 |
| | 191,503 |
| | 182,580 |
| |
| | | | | | | | | | | | | | | | | | | | | |
Operating income | | 54,318 |
| | 66,677 |
| | 65,969 |
| | 71,529 |
| | 72,102 |
| |
Gain on sale of real estate | | | 105,131 |
| | 20,661 |
| | — |
| | 79 |
| | — |
| |
Dividend income | | 1,216 |
| | 971 |
| | 811 |
| | — |
| | — |
| | 1,960 |
| | 1,337 |
| | 1,216 |
| | 971 |
| | 811 |
| |
Loss on equity securities, net | | | (44,007 | ) | | (7,552 | ) | | — |
| | — |
| | — |
| |
Interest income | | 1,962 |
| | 158 |
| | 14 |
| | 69 |
| | 37 |
| | 1,045 |
| | 639 |
| | 1,962 |
| | 158 |
| | 14 |
| |
Interest expense | | (65,406 | ) | | (45,060 | ) | | (37,008 | ) | | (28,048 | ) | | (16,831 | ) | | (134,880 | ) | | (89,865 | ) | | (65,406 | ) | | (45,060 | ) | | (37,008 | ) | |
Gain (loss) on early extinguishment of debt | | (1,715 | ) | | 104 |
| | 34 |
| | (1,307 | ) | | — |
| | (769 | ) | | (709 | ) | | (1,715 | ) | | 104 |
| | 34 |
| |
Loss on distribution to common shareholders of The RMR Group Inc. common stock | | — |
| | — |
| | (12,368 | ) | | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | (12,368 | ) | |
Net gain (loss) on issuance of shares by Select Income REIT | | 72 |
| | 86 |
| | (42,145 | ) | | (53 | ) | | — |
| |
Loss on impairment of Select Income REIT investment | | — |
| | — |
| | (203,297 | ) | | — |
| | — |
| |
Income (loss) from continuing operations before income taxes and equity | | | | | | | | | | | |
in earnings of investees and gain on sale of real estate | | (9,553 | ) | | 22,936 |
| | (227,990 | ) | | 42,190 |
| | 55,308 |
| |
Income (loss) from continuing operations before income tax expense and equity in net earnings (losses) of investees | | | 32,372 |
| | (25,220 | ) | | (9,625 | ) | | 22,929 |
| | 17,452 |
| |
Income tax expense | | (101 | ) | | (101 | ) | | (86 | ) | | (117 | ) | | (133 | ) | | (778 | ) | | (117 | ) | | (101 | ) | | (101 | ) | | (86 | ) | |
Equity in earnings of investees | | 21,571 |
| | 35,518 |
| | 18,640 |
| | 10,963 |
| | 334 |
| |
Equity in net earnings (losses) of investees | | | (1,259 | ) | | (2,269 | ) | | (13 | ) | | 137 |
| | 20 |
| |
Income (loss) from continuing operations | | 11,917 |
| | 58,353 |
| | (209,436 | ) | | 53,036 |
| | 55,509 |
| | 30,335 |
| | (27,606 | ) | | (9,739 | ) | | 22,965 |
| | 17,386 |
| |
Income (loss) from discontinued operations | | 173 |
| | (589 | ) | | (525 | ) | | 3,498 |
| | (889 | ) | | — |
| | 5,722 |
| | 21,829 |
| | 34,878 |
| | (227,347 | ) | |
Income (loss) before gain on sale of real estate | | 12,090 |
| | 57,764 |
| | (209,961 | ) | | 56,534 |
| | 54,620 |
| |
Gain on sale of real estate | | — |
| | 79 |
| | — |
| | — |
| | — |
| |
Net income (loss) | | 12,090 |
| | 57,843 |
| | (209,961 | ) | | 56,534 |
| | 54,620 |
| | 30,335 |
| | (21,884 | ) | | 12,090 |
| | 57,843 |
| | (209,961 | ) | |
Preferred units of limited partnership distributions | | (275 | ) | | — |
| | — |
| | — |
| | — |
| | — |
| | (371 | ) | | (275 | ) | | — |
| | — |
| |
Net income (loss) available for common shareholders | | $ | 11,815 |
| | $ | 57,843 |
| | $ | (209,961 | ) | | $ | 56,534 |
| | $ | 54,620 |
| | $ | 30,335 |
| | $ | (22,255 | ) | | $ | 11,815 |
| | $ | 57,843 |
| | $ | (209,961 | ) | |
| | | | | | | | | | | | | | | | | | | | | |
Weighted average shares outstanding (basic) | | 84,633 |
| | 71,050 |
| | 70,700 |
| | 61,313 |
| | 54,606 |
| |
Weighted average shares outstanding (diluted) | | 84,653 |
| | 71,071 |
| | 70,700 |
| | 61,399 |
| | 54,685 |
| |
Per common share data: | | | | | | | | | | | |
Income (loss) from continuing operations (basic) | | $ | 0.14 |
| | $ | 0.82 |
| | $ | (2.96 | ) | | $ | 0.87 |
| | $ | 1.02 |
| |
Income (loss) from continuing operations (diluted) | | $ | 0.14 |
| | $ | 0.82 |
| | $ | (2.96 | ) | | $ | 0.86 |
| | $ | 1.02 |
| |
Income (loss) from discontinued operations (basic and diluted) | | $ | — |
| | $ | (0.01 | ) | | $ | (0.01 | ) | | $ | 0.06 |
| | $ | (0.02 | ) | |
Net income (loss) available for common shareholders (basic and diluted) | | $ | 0.14 |
| | $ | 0.81 |
| | $ | (2.97 | ) | | $ | 0.92 |
| | $ | 1.00 |
| |
Weighted average common shares outstanding (basic) | | | 48,062 |
| | 24,830 |
| | 21,158 |
| | 17,763 |
| | 17,675 |
| |
Weighted average common shares outstanding (diluted) | | | 48,062 |
| | 24,830 |
| | 21,158 |
| | 17,768 |
| | 17,675 |
| |
| | | | | | | | | | | | |
Per common share amounts (basic and diluted): | | | | | | | | | | | | |
Income (loss) from continuing operations | | | $ | 0.63 |
| | $ | (1.13 | ) | | $ | (0.47 | ) | | $ | 1.29 |
| | $ | 0.98 |
| |
Income (loss) from discontinued operations | | | $ | — |
| | $ | 0.23 |
| | $ | 1.03 |
| | $ | 1.96 |
| | $ | (12.86 | ) | |
Net income (loss) available for common shareholders | | | $ | 0.63 |
| | $ | (0.90 | ) | | $ | 0.56 |
| | $ | 3.26 |
| | $ | (11.88 | ) | |
Common distributions paid | | $ | 1.72 |
| | $ | 1.72 |
| | $ | 1.72 |
| (1) | $ | 1.72 |
| | $ | 1.72 |
| | $ | 2.20 |
| | $ | 6.88 |
| | $ | 6.88 |
| | $ | 6.88 |
| | $ | 6.88 |
| (1) |
| | | | | | | | | | | |
| | As of December 31, | |
Balance sheet data: | | 2017 | | 2016 | | 2015 | | 2014 | | 2013 | |
Total real estate investments, gross (2) | | $ | 2,975,721 |
| | $ | 1,888,760 |
| | $ | 1,696,132 |
| | $ | 1,682,480 |
| | $ | 1,568,562 |
| |
Real estate investments, net (2) | | 2,633,873 |
| | 1,591,956 |
| | 1,440,253 |
| | 1,462,689 |
| | 1,380,927 |
| |
Total assets | | 3,703,565 |
| | 2,385,066 |
| | 2,168,510 |
| | 2,419,908 |
| | 1,630,789 |
| |
Debt, net | | 2,245,092 |
| | 1,381,852 |
| | 1,145,598 |
| | 1,077,410 |
| | 596,063 |
| |
Shareholders' equity | | 1,330,043 |
| | 935,004 |
| | 956,651 |
| | 1,297,449 |
| | 989,675 |
| |
| |
(1) | Excludes a non-cash distribution of $0.1284$0.5136 per share related to the distribution of shares of RMR Inc. class A common stock to our shareholders on December 14, 2015. |
|
| | | | | | | | | | | | | | | | | | | | |
| | As of December 31, |
| | 2019 | | 2018 | | 2017 | | 2016 | | 2015 |
Balance Sheet Data: | | | | | | | | | | |
Total real estate investments, gross (1) | | $ | 3,493,231 |
| | $ | 3,944,636 |
| | $ | 2,975,721 |
| | $ | 1,888,760 |
| | $ | 1,696,132 |
|
Real estate investments, net (1) | | 3,105,575 |
| | 3,569,489 |
| | 2,633,873 |
| | 1,591,956 |
| | 1,440,253 |
|
Total assets | | 4,193,136 |
| | 5,238,583 |
| | 3,703,565 |
| | 2,385,066 |
| | 2,168,510 |
|
Debt, net (2) | | 2,327,325 |
| | 3,254,890 |
| | 2,245,092 |
| | 1,381,852 |
| | 1,145,598 |
|
Shareholders’ equity | | 1,705,754 |
| | 1,778,968 |
| | 1,330,043 |
| | 935,004 |
| | 956,651 |
|
| |
(2)(1) | Excludes properties classified as assets held for sale or discontinued operations at the end of each respective period and properties owned by unconsolidated joint ventures. |
| |
(2) | Excludes one mortgage with a carrying value of $13,128 net of unamortized issuance costs totaling $38 that is included in liabilities of properties held for sale in our consolidated balance sheet as of December 31, 2019. |
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following information should be read in conjunction with our Consolidated Financial Statements and accompanying notes included elsewhere in Part IV, Item 15 of this Annual Report on Form 10-K.
OVERVIEW (dollars in thousands, except per share and per square foot data)
We are a REIT organized under Maryland law. As of December 31, 2017, we2019, our wholly owned 108 properties (167 buildings)were comprised of 189 properties and we had a noncontrolling ownership interest in twothree properties (three buildings) totaling 443,8670.4 million rentable square feet through two unconsolidated joint ventures in which we own 50%51% and 51%50% interests. As of December 31, 2017,2019, our consolidated properties are located in 3035 states and the District of Columbia and contain 17,499,338approximately 25.7 million rentable square feet,feet. As of which 41.2% wasDecember 31, 2019, our properties were leased to the U.S. Government, 14.9% was leased to 13 state governments, 2.6% was leased to five other government374 different tenants, 5.8% was leased to government contractor tenants, 29.7% was leased to various other non-governmental organizations and 5.8% was available for lease.with a weighted average remaining lease term (based on annualized rental income) of approximately 5.7 years. The U.S. Government 13 state governments and five other government tenants combined were responsible for 62.6% and 87.9%is our largest tenant, representing approximately 25.0% of our annualized rental income as of December 31, 2017 and 2016, respectively. The term annualized rental income as used in this section 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.2019.
Merger with Select Income REIT
On October 2, 2017,December 31, 2018, we completed the FPO Transaction, pursuant toSIR Merger, as a result of which we acquired 35 office99 properties (72 buildings) with 6,028,072approximately 16.5 million rentable square feetfeet. The aggregate transaction value for the SIR Merger was $2,409,740, excluding closing costs of $27,497 ($14,508 of which was paid by us and two$12,989 of which was paid by SIR) and including the repayment or assumption of $1,719,772 of SIR debt.
As a condition of the SIR Merger, on October 9, 2018, we completed the Secondary Sale, raising net proceeds of $435,125, after deducting underwriting discounts and offering expenses. As a result of the Secondary Sale, our former investment in SIR that was accounted for under the equity method, is classified in discontinued operations in our consolidated statements of comprehensive income (loss).
The completion of the SIR Merger significantly increased our property portfolio as of December 31, 2018 and the operating results of the properties (three buildings) with 443,867 rentable square feet owned by joint ventures in which we acquired FPO's 50% and 51% interests. The aggregate value we paidin the SIR Merger are reflected in our results of operations beginning in 2019. Accordingly, our financial results reported for FPO was $1,370,888, including $651,696the year ended December 31, 2019 do not provide a meaningful comparison to our results reported in cash consideration paid to FPO shareholders,prior periods.
For more information regarding the repayment of $483,000 of FPO corporate debt, the assumption of $167,548 of FPO mortgage debt; this amount excludes the $82,000 of mortgage debt that encumbers the two properties that were owned by joint ventures that FPO had 50% and 51% interests in,SIR Merger and the payment of certain transaction fees and expenses, net of FPO cash on hand.
We financed the cash portion of the FPO Transaction consideration with borrowings under our revolving credit facility and with cash on hand, which included net proceeds from our public offerings of common shares and senior unsecured notes, as described further inother SIR Transactions, see Notes 91, 3, 5, 10 and 11 to ourthe Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K.
Property Operations
AsUnless otherwise noted, the data presented in this section includes properties classified as held for sale as of December 31, 2017,2019 and excludes three properties owned by two unconsolidated joint ventures in which we owned 24,918,421 common shares, or approximately 27.8% ofown 51% and 50% interests. For more information regarding our properties classified as held for sale and our two unconsolidated joint ventures, see Note 3 to the then outstanding common shares, of SIR. SIR is a REIT which primarily owns single tenant, net leased properties. See Notes 7 and 12 to our Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K for more information regarding our investment in SIR. We account for our investment in SIR under the equity method.10-K.
Consolidated Property Operations
As of December 31, 2017, 94.2%2019, 92.4% of our consolidated rentable square feet was leased, compared to 95.1%91.0% of our consolidated rentable square feet as of December 31, 2016, which excludes one property (one building) classified as discontinued operations which was sold on August 31, 2017.2018. Occupancy data for our consolidated properties as of December 31, 20172019 and 20162018 was as follows (square feet in thousands): |
| | | | | | | | | | | | |
| | All Properties (1) | | Comparable Properties (2) |
| | December 31, | | December 31, |
| | 2019 | | 2018 | | 2019 | | 2018 |
Total properties (3) | | 189 |
| | 247 |
| | 96 |
| | 96 |
|
Total rentable square feet (4) | | 25,726 |
| | 31,900 |
| | 11,515 |
| | 11,507 |
|
Percent leased (5) | | 92.4 | % | | 91.0 | % | | 92.9 | % | | 94.0 | % |
|
| | | | | | | | | | | | |
| | | | | | Comparable |
| | All Consolidated Properties (1) | | Consolidated Properties (2) |
| | December 31, | | December 31, |
| | 2017 | | 2016 | | 2017 | | 2016 |
Total properties | | 108 |
| | 73 |
| | 69 |
| | 69 |
|
Total buildings | | 167 |
| | 95 |
| | 89 |
| | 89 |
|
Total square feet (3) | | 17,499 |
| | 11,443 |
| | 10,572 |
| | 10,583 |
|
Percent leased (3)(4) | | 94.2 | % | | 95.1 | % | | 94.9 | % | | 95.4 | % |
| |
(1) | Based on consolidated properties we owned on December 31, 20172019 and 2016, respectively, and excludes one property (one building) classified as discontinued operations which was sold on August 31, 2017.2018, respectively. |
| |
(2) | Based on consolidated properties we owned on December 31, 2017 and which we owned continuously since January 1, 2016. Our comparable2018; excludes properties decreased from 70classified as held for sale, properties (90 buildings) at December 31, 2016 as a result of the sale of one property (one building) during the year ended December 31, 2017.undergoing significant redevelopment, if any, and three properties owned by two unconsolidated joint ventures in which we own 51% and 50% interests. |
| |
(3) | Includes one leasable land parcel as of December 31, 2019 and two leasable land parcels as of December 31, 2018. |
| |
(4) | Subject to changes when space is re-measuredremeasured or re-configuredreconfigured for tenants. |
| |
(4)(5) | 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 years ended December 31, 20172019 and 20162018 are as follows:
| | | | Year Ended December 31, | | Year Ended December 31, |
| | 2017 | | 2016 | |
Average annualized effective rental rate per square foot (1): | | | | | |
Average effective rental rate per square foot (1): | | | 2019 | | 2018 |
All properties (2) | | $ | 25.99 |
| | $ | 25.26 |
| | $ | 27.02 |
| | $ | 29.23 |
|
Comparable properties (3) | | $ | 25.37 |
| | $ | 25.04 |
| | $ | 29.55 |
| | $ | 29.71 |
|
| |
(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. Excludes one property (one building) classified as discontinued operations which was sold on August 31, 2017. |
| |
(2) | Based on consolidated properties we owned on December 31, 20172019 and 2016, respectively, and excludes one property (one building) classified as discontinued operations which was sold on August 31, 2017.2018, respectively. |
| |
(3) | Based on consolidated properties we owned on December 31, 2017 and which we owned continuously since January 1, 2016.2018; excludes properties classified as held for sale, properties undergoing significant redevelopment, if any, and three properties owned by two unconsolidated joint ventures in which we own 51% and 50% interests. |
During the year ended December 31, 2017,2019, changes in rentable square feet leased and available for lease at our consolidated properties excluding one property (one building) classified as discontinued operations which was sold on August 31, 2017, were as follows:follows (square feet in thousands):
| | | | Year Ended December 31, 2017 | | | | | | | |
| | | | Available | | | | Year Ended December 31, 2019 |
| | Leased (1) | | for Lease | | Total | | Leased | | Available for Lease | | Total |
Beginning of year | | 10,881,289 |
| | 561,224 |
| | 11,442,513 |
| | 29,024 |
| | 2,876 |
| | 31,900 |
|
Changes resulting from: | | |
| | |
| | |
| | | | | | |
|
Acquisition of properties | | 5,655,477 |
| | 441,969 |
| | 6,097,446 |
| |
Disposition of properties | | — |
| | (29,045 | ) | | (29,045 | ) | | (4,422 | ) | | (1,756 | ) | | (6,178 | ) |
Lease expirations | | (1,664,210 | ) | | 1,664,210 |
| | — |
| | (3,777 | ) | | 3,777 |
| | — |
|
Lease renewals (1) | | 1,468,301 |
| | (1,468,301 | ) | | — |
| | 2,555 |
| | (2,555 | ) | | — |
|
New leases (1)(2) | | 136,482 |
| | (136,482 | ) | | — |
| |
Re-measurements (3) | | — |
| | (11,576 | ) | | (11,576 | ) | |
New leases (1) | | | 379 |
| | (379 | ) | | — |
|
Remeasurements (2) | | | 2 |
| | 2 |
| | 4 |
|
End of year | | 16,477,339 |
| | 1,021,999 |
| | 17,499,338 |
| | 23,761 |
| | 1,965 |
| | 25,726 |
|
| |
(1) | Rentable square footage excludes an expansion being constructed at an existing property we own prior to the commencement of the lease. |
| |
(2) | Based on leases entered during the year ended December 31, 2017.2019. |
| |
(3)(2) | Rentable square footage isfeet are subject to changes when space is re-measuredremeasured or re-configuredreconfigured for tenants. |
Leases at our consolidated properties totaling 1,664,210approximately 3.8 million rentable square feet expired during the year ended December 31, 2017.2019. During the year ended December 31, 2017,2019, we entered leases totaling 1,604,7832.9 million rentable square feet, including lease renewals of 1,468,3012.6 million rentable square feet and new leases of approximately 0.4 million rentable square feet. The weighted (by rentable square feet) average rental ratesrents were 4.2% above prior rents for leases of 1,232,389 rentable square feet entered with government tenants during the year ended December 31, 2017 increased by 4.9% when compared tosame space and the weighted (by rentable square feet) average prior rentslease term for the same space. The weighted (by rentable square feet) average rental rates fornew and renewal leases of 372,394 rentable square feet entered with non-government tenants during the year ended December 31, 2017 decreased by 2.1% when compared to the weighted (by rentable square feet) average rental rates previously charged for the same space.2019 was 8.6 years.
During the year ended December 31, 2017,2019, changes in effective rental rates per square foot achieved for new leases and lease renewals at our consolidated properties that commenced during the year ended December 31, 2017,2019, when compared to prior effective rental rates per square foot in effect for the same space (and excluding space acquired vacant), were as follows: follows (square feet in thousands):
| | | | Year Ended December 31, 2017 | |
| | Old Effective | | New Effective | | | | | | | | | |
| | Rent Per | | Rent Per | | Rentable | | Year Ended December 31, 2019 |
| | Square Foot (1) | | Square Foot (1) | | Square Feet | | Old Effective Rent Per Square Foot (1) | | New Effective Rent Per Square Foot (1) | | Rentable Square Feet |
New leases | | $ | 22.76 |
| | $ | 22.25 |
| | 142,665 |
| | $30.86 | | $30.94 | | 266 |
|
Lease renewals | | $ | 23.42 |
| | $ | 23.87 |
| | 1,320,675 |
| | $29.90 | | $31.30 | | 2,529 |
|
Total leasing activity | | $ | 23.35 |
| | $ | 23.71 |
| | 1,463,340 |
| | $29.99 | | $31.27 | | 2,795 |
|
| |
(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. |
During the year ended December 31, 2017,2019, commitments made for expenditures, such as tenant improvements and leasing costs, in connection with leasing space at our consolidated properties were as follows:follows (square feet in thousands):
|
| | | | | | | | | | | | |
| | Year Ended December 31, 2019 |
| | New Leases | | Renewals | | Total |
Rentable square feet leased | | 379 |
| | 2,555 |
| | 2,934 |
|
Tenant leasing costs and concession commitments (1) | | $ | 32,746 |
| | $ | 44,795 |
| | $ | 77,541 |
|
Tenant leasing costs and concession commitments per rentable square foot (1) | | $ | 86.59 |
| | $ | 17.52 |
| | $ | 26.43 |
|
Weighted (by square feet) average lease term (years) | | 8.3 |
| | 8.6 |
| | 8.6 |
|
Total leasing costs and concession commitments per rentable square foot per year (1) | | $ | 10.44 |
| | $ | 2.03 |
| | $ | 3.08 |
|
|
| | | | | | | | | | | | |
| | Year Ended December 31, 2017 |
| | Government | | Non-Government | | |
| | Leases | | Leases | | Total |
Rentable square feet leased during the year | | 1,232,389 |
| | 372,394 |
| | 1,604,783 |
|
Tenant leasing costs and concession commitments (1) (in thousands) | | $ | 11,062 |
| | $ | 7,187 |
| | $ | 18,249 |
|
Tenant leasing costs and concession commitments per rentable square foot (1) | | $ | 8.98 |
| | $ | 19.30 |
| | $ | 11.37 |
|
Weighted (by square feet) average lease term (years) | | 8.4 |
| | 5.0 |
| | 7.6 |
|
Total leasing costs and concession commitments per rentable square foot per year (1) | | $ | 1.07 |
| | $ | 3.87 |
| | $ | 1.50 |
|
| |
(1) | Includes commitments made for leasing expenditures and concessions, such as tenant improvements, leasing commissions, tenant reimbursements and free rent. |
During the years ended December 31, 20172019 and 2016,2018, amounts capitalized at our consolidated properties excluding one property (one building) classified as discontinued operations which was sold on August 31, 2017, for tenant improvements, leasing costs, building improvements and development and redevelopment activities were as follows (dollars in thousands):follows:
| | | | Year Ended | | | | | |
| | December 31, | | Year Ended December 31, |
| | 2017 | | 2016 | | 2019 | | 2018 |
Tenant improvements (1) | | $ | 16,050 |
| | $ | 15,856 |
| | $ | 25,590 |
| | $ | 14,440 |
|
Leasing costs (2) | | $ | 5,796 |
| | $ | 9,949 |
| | 26,769 |
| | 11,078 |
|
Building improvements (3) | | $ | 15,435 |
| | $ | 11,261 |
| | 33,383 |
| | 24,712 |
|
Recurring capital expenditures | | | 85,742 |
| | 50,230 |
|
Development, redevelopment and other activities (4) | | $ | 21,553 |
| | $ | 7,818 |
| | 5,880 |
| | 3,962 |
|
Total capital expenditures | | | $ | 91,622 |
| | $ | 54,192 |
|
| |
(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 December 31, 2017,2019, we have estimated unspent leasing related obligations of $31,310.$55,984.
As of December 31, 2019, we had leases at our properties totaling 1.9 million rentable square feet that were scheduled to expire during 2020. As of February 19, 2020, tenants with leases totaling 0.6 million rentable square feet that are scheduled to expire during 2020 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 December 31, 2020, we expect that the rental rates we are likely to achieve on new or renewed leases for space under leases expiring through December 31, 2020 will, in the aggregate and on a weighted (by annualized revenues) average basis, be higher than the rates currently being paid, thereby generally resulting in higher rent
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 or renewed 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 our tenants’ needs are beyond our control. 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.
As of December 31, 2019, our lease expirations by year are as follows (square feet in thousands):
|
| | | | | | | | | | | | | | | | | |
Year (1) | | Number of Leases Expiring | | Leased Square Feet Expiring (2) | | Percent of Total | | Cumulative Percent of Total | | Annualized Rental Income Expiring | | Percent of Total | | Cumulative Percent of Total |
2020 | | 81 | | 1,896 |
| | 8.0% | | 8.0% | | $ | 55,982 |
| | 9.4% | | 9.4% |
2021 | | 56 | | 1,692 |
| | 7.1% | | 15.1% | | 39,660 |
| | 6.6% | | 16.0% |
2022 | | 82 | | 2,378 |
| | 10.0% | | 25.1% | | 64,085 |
| | 10.7% | | 26.7% |
2023 | | 62 | | 2,624 |
| | 11.1% | | 36.2% | | 69,639 |
| | 11.6% | | 38.3% |
2024 | | 54 | | 3,692 |
| | 15.5% | | 51.7% | | 96,072 |
| | 16.1% | | 54.4% |
2025 | | 42 | | 2,045 |
| | 8.6% | | 60.3% | | 44,264 |
| | 7.4% | | 61.8% |
2026 | | 30 | | 1,711 |
| | 7.2% | | 67.5% | | 45,754 |
| | 7.7% | | 69.5% |
2027 | | 29 | | 1,953 |
| | 8.2% | | 75.7% | | 48,872 |
| | 8.2% | | 77.7% |
2028 | | 12 | | 872 |
| | 3.7% | | 79.4% | | 24,724 |
| | 4.1% | | 81.8% |
2029 and thereafter | | 47 | | 4,897 |
| | 20.6% | | 100.0% | | 108,761 |
| | 18.2% | | 100.0% |
Total | | 495 | | 23,760 |
| | 100.0% | | | | $ | 597,813 |
| | 100.0% | | |
| | | | | | | | | | | | | | |
Weighted average remaining lease term (in years) | | | | 6.0 |
| | | | | | 5.7 |
| | | | |
| |
(1) | The year of lease expiration is pursuant to current contract terms. Some of our leases allow the tenants to vacate the leased premises before the stated expirations of their leases with little or no liability. As of December 31, 2019, tenants occupying approximately 9.4% of our rentable square feet and responsible for approximately 5.5% of our annualized rental income as of December 31, 2019, currently have exercisable rights to terminate their leases before the stated terms of their leases expire. Also, in 2020, 2021, 2022, 2023, 2024, 2025, 2026, 2027, 2028, 2030, and 2034 early termination rights become exercisable by other tenants who currently occupy an additional approximately 4.5%, 1.5%, 2.1%, 1.0%, 1.0%, 2.1%, 0.9%, 0.5%, 1.0%, 0.1% and 0.1% of our rentable square feet, respectively, and contribute an additional approximately 6.3%, 1.7%, 2.2%, 1.2%, 1.6%, 3.5%, 1.2%, 0.6%, 1.2%, 0.3% and 0.1% of our annualized rental income, respectively, as of December 31, 2019. In addition, as of December 31, 2019, pursuant to leases with 13 of our tenants, these tenants have rights to terminate their leases if their respective legislature or other funding authority does not appropriate rent amounts in their respective annual budgets. These 13 tenants occupy approximately 5.0% of our rentable square feet and contribute approximately 5.3% of our annualized rental income as of December 31, 2019. |
| |
(2) | Leased square feet is pursuant to leases existing as of December 31, 2019, and 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. Square feet measurements are subject to changes when space is remeasured or reconfigured for new tenants. |
We generally will seek to renew or extend the terms of leases in our single tenant properties when they expire. Because of the capital many of the tenants in these properties have invested in the properties 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 prior to when they expire. If we are unable to extend or renew our leases, it may be time consuming and expensive to relet some of these properties.
We believe that current government budgetary methodology, spending priorities and the current U.S. presidential administration'sadministration’s views on the size and scope of government employment have resulted in a decrease in government employment,employment. Furthermore, for the past six years, government tenants reducinghave reduced their space utilization per employee and consolidation ofconsolidated government tenants into existing government owned properties, thereby reducingproperties. This activity has reduced 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'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 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.renewals; however, recent activity suggests that the government has begun to shift its leasing strategy to include longer term leases and is actively exploring 10 to 20 year lease terms at renewal, in some instances. We believe the reduction in government tenant space utilization and the consolidation of government tenants into government owned real estate is substantially complete; however, these activities may impact us for some time into the future. 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 December 31, 2017,2019, we derive 43.3%24.1% of our annualized revenuesrental income from our consolidated properties located in the metropolitan Washington, D.C. market area, which includes Washington, D.C., Northern Virginia and suburban Maryland. A downturn in economic conditions in this area could result in reduced demand from tenants for our properties 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 government tenants when our leases expire.
The IRS hasOur manager, RMR LLC, employs a tenant review process for us. RMR LLC assesses tenants on an individual basis based on various applicable credit criteria. In general, depending on facts and circumstances, RMR LLC evaluates the creditworthiness of a tenant based on information concerning the tenant that is provided by the tenant and, in some cases, information that is publicly statedavailable or obtained from third party sources. RMR LLC also often uses a third party service to monitor the credit ratings of debt securities of our existing tenants whose debt securities are rated by a nationally recognized credit rating agency. We consider investment grade tenants to include: (a) investment grade rated tenants; (b) tenants with investment grade rated parent entities that it plans to discontinue its paper tax return processing operations at our property located in Fresno, CA in 2021. The IRSguarantee the tenant’s lease for this property, which accounted for approximately 2.0%obligations; and/or (c) tenants with investment grade rated parent entities that do not guarantee the tenant’s lease obligations. As of ourDecember 31, 2019, tenants contributing 53.4% of annualized rental income aswere investment grade rated (or their payment obligations were guaranteed by an investment grade rated parent) and tenants contributing an additional 9.5% of December 31, 2017, 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 aswere subsidiaries of December 31, 2017, expires inan investment grade rated parent (although these parent entities were not liable for the second quarterpayment 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.
rents).
As of December 31, 2017, we had leases at2019, tenants representing 1% or more of our consolidated properties totaling 1,666,566 rentable square feet that were scheduled to expire during 2018. As of February 23, 2018, tenants with leases totaling 630,788 rentable square feet that are scheduled to expire during 2018 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 December 31, 2018, we expect that the rental rates we are likely to achieve on new or renewed leases for space under leases expiring through December 31, 2018 will, in the aggregate and on a weighted (bytotal 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.
were as follows:
|
| | | | | | | | | | | |
| Tenant | | Credit Rating | | Annualized Rental Income | | % of Total Annualized Rental Income |
1 |
| U.S. Government | | Investment Grade | | $ | 149,491 |
| | 25.0 | % |
2 |
| State of California | | Investment Grade | | 19,092 | | 3.2 | % |
3 |
| Shook, Hardy & Bacon L.L.P. | | Not Rated | | 18,854 | | 3.2 | % |
4 |
| Bank of America Corporation | | Investment Grade | | 16,604 | | 2.8 | % |
5 |
| F5 Networks, Inc. | | Not Rated | | 14,416 | | 2.4 | % |
6 |
| WestRock Company | | Investment Grade | | 12,865 | | 2.2 | % |
7 |
| CareFirst Inc. | | Non Investment Grade | | 11,619 | | 1.9 | % |
8 |
| Northrop Grumman Corporation | | Investment Grade | | 11,346 | | 1.9 | % |
9 |
| Tyson Foods, Inc. | | Investment Grade | | 10,253 | | 1.7 | % |
10 |
| Technicolor SA | | Non Investment Grade | | 10,034 | | 1.7 | % |
11 |
| Commonwealth of Massachusetts | | Investment Grade | | 9,693 | | 1.6 | % |
12 |
| Micro Focus International plc | | Non Investment Grade | | 8,710 | | 1.5 | % |
13 |
| CommScope Holding Company Inc | | Non Investment Grade | | 7,931 | | 1.3 | % |
14 |
| PNC Bank | | Investment Grade | | 6,897 | | 1.2 | % |
15 |
| State of Georgia | | Investment Grade | | 6,790 | | 1.1 | % |
16 |
| ServiceNow, Inc. | | Not Rated | | 6,335 | | 1.1 | % |
17 |
| Allstate Insurance Co. | | Investment Grade | | 6,270 | | 1.0 | % |
18 |
| Compass Group plc | | Investment Grade | | 6,264 | | 1.0 | % |
19 |
| Church & Dwight Co., Inc. | | Investment Grade | | 6,018 | | 1.0 | % |
| | | | | $ | 339,482 |
| | 56.8 | % |
As of December 31, 2017, 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 | | 128 |
| | 1,666,566 |
| | | | 10.1 | % | | 10.1 | % | | $ | 48,215 |
| | 11.3 | % | | 11.3 | % |
2019 | | 97 |
| | 2,567,338 |
| | | | 15.6 | % | | 25.7 | % | | 73,723 |
| | 17.3 | % | | 28.6 | % |
2020 | | 110 |
| | 2,415,770 |
| | | | 14.7 | % | | 40.4 | % | | 63,570 |
| | 14.9 | % | | 43.5 | % |
2021 | | 90 |
| | 1,728,712 |
| | | | 10.5 | % | | 50.9 | % | | 34,102 |
| | 8.0 | % | | 51.5 | % |
2022 | | 91 |
| | 1,630,325 |
| | | | 9.9 | % | | 60.8 | % | | 36,985 |
| | 8.7 | % | | 60.2 | % |
2023 | | 46 |
| | 1,173,462 |
| | | | 7.1 | % | | 67.9 | % | | 34,434 |
| | 8.1 | % | | 68.3 | % |
2024 | | 40 |
| | 1,405,259 |
| | | | 8.5 | % | | 76.4 | % | | 35,541 |
| | 8.3 | % | | 76.6 | % |
2025 | | 34 |
| | 1,090,044 |
| | | | 6.6 | % | | 83.0 | % | | 25,023 |
| | 5.9 | % | | 82.5 | % |
2026 | | 27 |
| | 820,395 |
| | | | 5.0 | % | | 88.0 | % | | 23,621 |
| | 5.5 | % | | 88.0 | % |
2027 and thereafter | | 48 |
| | 1,979,468 |
| | (3) | | 12.0 | % | | 100.0 | % | | 51,431 |
| | 12.0 | % | | 100.0 | % |
Total | | 711 |
| | 16,477,339 |
| | | | 100.0 | % | | | | $ | 426,645 |
| | 100.0 | % | | |
| | | | | | | | | | | | | | | | |
Weighted average remaining lease term (in years) | | 4.8 | | | | | | | | 4.7 | | | | |
| |
(1) | The year of lease expiration is pursuant to current contract terms. Some government tenants have the right to vacate their space before the stated expirations of their leases. As of December 31, 2017, government tenants occupying approximately 8.6% of our consolidated rentable square feetInvestment and responsible for approximately 6.8% of our annualized rental income as of December 31, 2017 have currently exercisable rights to terminate their leases before the stated terms of their leases expire. Also, in 2018, 2019, 2020, 2021, 2022, 2023, 2024, 2025, 2026 and 2027, early termination rights become exercisable by other tenants who currently occupy an additional approximately 2.2%, 5.2%, 7.2%, 1.4%, 3.4%, 0.5%, 0.2%, 0.1%, 0.6% and 0.4% of our consolidated rentable square feet, respectively, and contribute an additional approximately 3.6%, 4.9%, 7.0%, 1.4%, 2.9%, 0.6%, 0.3%, 0.2%, 0.8% and 0.4% of our annualized rental income, respectively, as of December 31, 2017. In addition, as of December 31, 2017, 26 of our government tenants have currently exercisable rights to terminate their leases if the legislature or other funding authority does not appropriate rent amounts in their respective annual budgets. These 26 tenants occupy approximately 12.9% of our consolidated rentable square feet and contribute approximately12.3% of our annualized rental income as of December 31, 2017. |
| |
(2) | Leased square feet is pursuant to leases existing as of December 31, 2017, and 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. Square feet measurements are subject to changes when space is re-measured or re-configured for new tenants. |
| |
(3) | Leased square footage excludes an expansion being constructed at an existing property we own prior to the commencement of the lease. |
Acquisition Activities (dollar amounts
On July 1, 2019, we sold all of the shares of class A common stock of RMR Inc. we owned in thousands)
In January 2017, we acquired an office property (one building) located in Manassas, VA with 69,374 rentable square feet for a purchase price of $12,620, excluding capitalized acquisition costs of $37, using cash on hand and borrowings under our revolving credit facility. We acquired this propertyunderwritten public offering at a capitalization rateprice to the public of 8.6%.$40.00 per share pursuant to an underwriting agreement among us, RMR Inc., certain other REITs managed by RMR LLC that also sold their class A common stock of RMR Inc. in the offering and the underwriters named therein. We calculate the capitalization rate for property acquisitions as the ratioreceived net proceeds of (x) annual straight line rental income, excluding the impact of above$104,674 from this sale, after deducting underwriting discounts and below market lease amortization, based on leases in effect on the acquisition date, less estimated annual property operatingcommissions and other offering expenses, that we expectused to pay as of the acquisition date, excluding depreciation and amortization expense, to (y) the acquisition purchase price, including the principal amount of assumed debt, if any, andrepay amounts outstanding under our term loan due in 2020.
On November 8, 2019, we acquired a land parcel for $2,900, excluding acquisition costs.
In September 2017,related costs, and in January 2020, we acquired transferable development rights that would allow usentered into an agreement to expandacquire a property for $11,500, excluding acquisition related costs, both of which are adjacent to a property we own in Washington, D.C. for a purchase price of $2,030, excluding acquisition costs.
As described above, we completed the FPO Transaction on October 2, 2017. Pursuant to that transaction, we acquired 35 office properties (72 buildings) with 6,028,072 rentable square feet, and two properties (three buildings) with 443,867 rentable square feet owned by joint ventures in which we acquired FPO's 50% and 51% interests. The total consideration for our acquisition of FPO was $1,370,888.
Boston, MA.
Disposition Activities (dollar amounts in thousands)
In August 2017,During the year ended December 31, 2019, we sold 58 properties with a vacant office property (one building) located in Falls Church, VA with 164,746 rentable square feet and a net book value of $12,901 as of the sale date for $13,523, excluding closing costs.
In October 2017, we sold a vacant office property (one building) located in Albuquerque, NM with 29,045 rentable square feet and a net book value of $1,885, as of the sale date for $2,000, excluding closing costs.
In January 2018, we entered an agreement to sell an office property (one building) located in Minneapolis, MN with 193,594combined 6.2 million rentable square feet for $20,000,an aggregate sales price of $848,853, excluding closing costs. This sale is expected to occur inSince January 1, 2020, we have sold three of the first quarter of 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, excluding closing costs. This sale is expected to occur in the second quarter of 2018.
In February 2018, we entered an agreement to sell an office property (one building) located in Sacramento, CA with 110,500 rentable square feet for $10,755, excluding closing costs. This sale is expected to occur in the second quarter of 2018.
As part of our long term financing plans for the FPO Transaction and to reduce our financial leverage, we expect to dispose of certain additional properties. We are marketing or plan to marketsix properties classified as held for sale 28 properties (61 buildings) including properties acquired as part of the FPO Transaction, with a carrying value of $658,190 as of December 31, 2017.2019 for an aggregate sales price of $21,063, excluding closing costs. In addition, we are currently marketing for sale four properties containing approximately 0.2 million rentable square feet. We cannot be sure we will sell any properties or sell themwe are marketing for prices in excess of their carrying values or otherwise. With our carrying values.
Our pending dispositions are subjectdisposition program substantially completed, we expect to conditions; accordingly,pursue accretively growing our property portfolio through our capital recycling program. Pursuant to our capital recycling program, we cannot be sure that we will complete these transactions or that these transactions will not be delayed orplan to sell certain properties from time to time to fund future acquisitions and to maintain leverage consistent with our current investment grade ratings with a goal of (1) improving the termsasset quality of these transactions will not change.
our portfolio by reducing the average age of our properties, lengthening the weighted average term of our leases and increasing the likelihood of retaining our tenants and (2) increasing our distributions to shareholders.
For more information about our property acquisition and disposition activities, please see “Business—Acquisition Policies” and “Business —Disposition Policies” in Part 1, Item 1 of this Annual Report on Form 10-K and Note 53 to ourthe Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K.
Financing Activities
In March 2019, we repaid at maturity, at par plus accrued interest, a mortgage note secured by one property with an outstanding principal balance of $7,890 using cash on hand.
During the year ended December 31, 2019, we repaid, without penalty, (i) the remaining principal balance of $88,000 then outstanding on our $250,000 term loan due in 2022 and (ii) the entire principal balance outstanding on our $300,000 term loan due in 2020 using cash on hand, proceeds from property sales and proceeds from the sale of our shares of class A common stock of RMR Inc.
In July 2019, we redeemed, at par plus accrued interest, all $350,000 of our 3.75% senior unsecured notes due 2019 using cash on hand and borrowings under our revolving credit facility.
In January 2020, we redeemed, at par plus accrued interest, all $400,000 of our 3.60% senior unsecured notes due 2020 using cash on hand, proceeds from property sales and borrowings under our revolving credit facility.
Segment Information
We operate in twoone business segments: directsegment: ownership of real estate properties and our equity method investment in SIR.properties.
RESULTS OF OPERATIONS (amounts in thousands, except per share amounts)
Year Ended December 31, 2017,2019, Compared to Year Ended December 31, 20162018
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | Acquired Properties Results (2) | | Disposed Properties Results (3) | | | | | | | | |
| | Comparable Properties Results (1) | | Year Ended | | Year Ended | | Consolidated Results |
| | Year Ended December 31, | | December 31, | | December 31, | | Year Ended December 31, |
| | | | | | $ | | % | | | | | | | | | | | | | | $ | | % |
| | 2017 | | 2016 | | Change | | Change | | 2017 | | 2016 | | 2017 | | 2016 | | 2017 | | 2016 | | Change | | Change |
Rental income | | $ | 253,197 |
| | $ | 249,429 |
| | $ | 3,768 |
| | 1.5 | % | | $ | 63,335 |
| | $ | 8,751 |
| | $ | — |
| | $ | — |
| | $ | 316,532 |
| | $ | 258,180 |
| | $ | 58,352 |
| | 22.6 | % |
Operating expenses: | | | | | | | | | | | | | | | | | | | | | | | | |
Real estate taxes | | 30,814 |
| | 29,725 |
| | 1,089 |
| | 3.7 | % | | 7,128 |
| | 978 |
| | — |
| | — |
| | 37,942 |
| | 30,703 |
| | 7,239 |
| | 23.6 | % |
Utility expenses | | 16,535 |
| | 16,652 |
| | (117 | ) | | (0.7 | %) | | 4,463 |
| | 617 |
| | — |
| | — |
| | 20,998 |
| | 17,269 |
| | 3,729 |
| | 21.6 | % |
Other operating expenses | | 54,027 |
| | 52,129 |
| | 1,898 |
| | 3.6 | % | | 11,173 |
| | 1,936 |
| | 149 |
| | 225 |
| | 65,349 |
| | 54,290 |
| | 11,059 |
| | 20.4 | % |
Total operating expenses | | 101,376 |
| | 98,506 |
| | 2,870 |
| | 2.9 | % | | 22,764 |
| | 3,531 |
| | 149 |
| | 225 |
| | 124,289 |
| | 102,262 |
| | 22,027 |
| | 21.5 | % |
Net operating income (4) | | $ | 151,821 |
| | $ | 150,923 |
| | $ | 898 |
| | 0.6 | % | | $ | 40,571 |
| | $ | 5,220 |
| | $ | (149 | ) | | $ | (225 | ) | | 192,243 |
| | 155,918 |
| | 36,325 |
| | 23.3 | % |
| | | | | | | | | | | | | | | | | | | | | | | | |
Other expenses: | | | | | | | | | | | | | | | | | | | | | | | | |
Depreciation and amortization | | | | | | 109,588 |
| | 73,153 |
| | 36,435 |
| | 49.8 | % |
Loss on impairment of real estate | | | | | | 9,490 |
| | — |
| | 9,490 |
| | nm |
|
Acquisition related costs | | | | | | — |
| | 1,191 |
| | (1,191 | ) | | nm |
|
General and administrative | | | | | | 18,847 |
| | 14,897 |
| | 3,950 |
| | 26.5 | % |
Total other expenses | | | | | | | | | | | | | | | | | | 137,925 |
| | 89,241 |
| | 48,684 |
| | 54.6 | % |
Operating income | | | | | | | | | | | | | | | | | | 54,318 |
| | 66,677 |
| | (12,359 | ) | | (18.5 | %) |
Dividend income | | | | | | | | | | | | | | | | | | 1,216 |
| | 971 |
| | 245 |
| | 25.2 | % |
Interest income | | | | | | | | | | | | | | | | | | 1,962 |
| | 158 |
| | 1,804 |
| | nm |
|
Interest expense (including net amortization of debt premium and discounts and debt issuance costs of $3,420 and $2,832, respectively) | | (65,406 | ) | | (45,060 | ) | | (20,346 | ) | | 45.2 | % |
Gain (loss) on early extinguishment of debt | | | | | | (1,715 | ) | | 104 |
| | (1,819 | ) | | nm |
|
Net gain on issuance of shares by Select Income REIT | | 72 |
| | 86 |
| | (14 | ) | | (16.3 | %) |
Income (loss) from continuing operations before income taxes, equity in earnings of investees and gain on sale of real estate | | (9,553 | ) | | 22,936 |
| | (32,489 | ) | | (141.7 | %) |
Income tax expense | | (101 | ) | | (101 | ) | | — |
| | — | % |
Equity in earnings of investees | | 21,571 |
| | 35,518 |
| | (13,947 | ) | | (39.3 | %) |
Income from continuing operations | | 11,917 |
| | 58,353 |
| | (46,436 | ) | | (79.6 | %) |
Income (loss) from discontinued operations | | 173 |
| | (589 | ) | | 762 |
| | nm |
|
Income before gain on sale of real estate | | 12,090 |
| | 57,764 |
| | (45,674 | ) | | (79.1 | %) |
Gain on sale of real estate | | — |
| | 79 |
| | (79 | ) | | nm |
|
Net income | | 12,090 |
| | 57,843 |
| | (45,753 | ) | | (79.1 | %) |
Preferred units of limited partnership distributions | | (275 | ) | | — |
| | (275 | ) | | nm |
|
Net income available for common shareholders | | $ | 11,815 |
| | $ | 57,843 |
| | $ | (46,028 | ) | | (79.6 | %) |
| | | | | | | | |
Weighted average common shares outstanding (basic) | | 84,633 |
| | 71,050 |
| | 13,583 |
| | 19.1 | % |
Weighted average common shares outstanding (diluted) | | 84,653 |
| | 71,071 |
| | 13,582 |
| | 19.1 | % |
| | | | | | | | |
Per common share amounts (basic and diluted): | | | | | | | | |
Income from continuing operations | | $ | 0.14 |
| | $ | 0.82 |
| | $ | (0.68 | ) | | (82.9 | %) |
Income (loss) from discontinued operations | | $ | — |
| | $ | (0.01 | ) | | $ | 0.01 |
| | — | % |
Net income available for common shareholders | | $ | 0.14 |
| | $ | 0.81 |
| | $ | (0.67 | ) | | (82.7 | %) |
| | | | | | | | | | | | |
Reconciliation of Net Income Available for Common Shareholders to Consolidated Property NOI: | | | | | | | | | | | | |
Net income available for common shareholders | | | | | | $ | 11,815 |
| | $ | 57,843 |
| | | | |
Preferred units of limited partnership distributions | | | | | | 275 |
| | — |
| | | | |
Net income | | | | | | 12,090 |
| | 57,843 |
| | | | |
Gain on sale of real estate | | | | | | — |
| | (79 | ) | | | | |
Income before gain on sale of real estate | | | | | | 12,090 |
| | 57,764 |
| | | | |
(Income) loss from discontinued operations | | | | | | (173 | ) | | 589 |
| | | | |
Income from continuing operations | | | | | | 11,917 |
| | 58,353 |
| | | | |
Equity in earnings of investees | | | | | | (21,571 | ) | | (35,518 | ) | | | | |
Income tax expense | | | | | | 101 |
| | 101 |
| | | | |
Net gain on issuance of shares by SIR | | | | | | (72 | ) | | (86 | ) | | | | |
(Gain) loss on early extinguishment of debt | | | | | | 1,715 |
| | (104 | ) | | | | |
Interest expense | | | | | | 65,406 |
| | 45,060 |
| | | | |
Interest income | | | | | | (1,962 | ) | | (158 | ) | | | | |
Dividend income | | | | | | (1,216 | ) | | (971 | ) | | | | |
Operating income | | | | | | 54,318 |
| | 66,677 |
| | | | |
General and administrative | | | | | | 18,847 |
| | 14,897 |
| | | | |
Acquisition related costs | | | | | | — |
| | 1,191 |
| | | | |
Loss on impairment of real estate | | | | | | 9,490 |
| | — |
| | | | |
Depreciation and amortization | | | | | | 109,588 |
| | 73,153 |
| | | | |
Net operating income | | | | | | $ | 192,243 |
| | $ | 155,918 |
| | | | |
| | | | | | | | | | | | |
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | Non-Comparable | | | | | | | | |
| | | | Properties Results | | |
| | Comparable Properties Results (1) | | Year Ended | | Consolidated Results |
| | Year Ended December 31, | | December 31, | | Year Ended December 31, |
| | | | | | $ | | % | | | | | | | | | | $ | | % |
| | 2019 | | 2018 | | Change | | Change | | 2019 | | 2018 | | 2019 | | 2018 | | Change | | Change |
Rental income | | $ | 311,664 |
| | $ | 315,845 |
| | $ | (4,181 | ) | | (1.3 | %) | | $ | 366,740 |
| | $ | 110,715 |
| | $ | 678,404 |
| | $ | 426,560 |
| | $ | 251,844 |
| | 59.0 | % |
Operating expenses: | | | | | | | | | | | | | | | | | | | | |
Real estate taxes | | 38,517 |
| | 36,689 |
| | 1,828 |
| | 5.0 | % | | 35,200 |
| | 13,019 |
| | 73,717 |
| | 49,708 |
| | 24,009 |
| | 48.3 | % |
Utility expenses | | 19,909 |
| | 20,337 |
| | (428 | ) | | (2.1 | %) | | 14,393 |
| | 6,088 |
| | 34,302 |
| | 26,425 |
| | 7,877 |
| | 29.8 | % |
Other operating expenses | | 69,055 |
| | 66,291 |
| | 2,764 |
| | 4.2 | % | | 51,888 |
| | 23,319 |
| | 120,943 |
| | 89,610 |
| | 31,333 |
| | 35.0 | % |
Total operating expenses | | 127,481 |
| | 123,317 |
| | 4,164 |
| | 3.4 | % | | 101,481 |
| | 42,426 |
| | 228,962 |
| | 165,743 |
| | 63,219 |
| | 38.1 | % |
Property net operating income (2) | | $ | 184,183 |
| | $ | 192,528 |
| | $ | (8,345 | ) | | (4.3 | %) | | $ | 265,259 |
| | $ | 68,289 |
| | 449,442 |
| | 260,817 |
| | 188,625 |
| | 72.3 | % |
| | | | | | | | | | | | | | | | | | | | |
Other expenses: | | | | | | | | | | | | | | | | | | | | |
Depreciation and amortization | | 289,885 |
| | 162,488 |
| | 127,397 |
| | 78.4 | % |
Loss on impairment of real estate | | 22,255 |
| | 8,630 |
| | 13,625 |
| | 157.9 | % |
Acquisition and transaction related costs | | 682 |
| | 14,508 |
| | (13,826 | ) | | (95.3 | %) |
General and administrative | | 32,728 |
| | 24,922 |
| | 7,806 |
| | 31.3 | % |
Total other expenses | | 345,550 |
| | 210,548 |
| | 135,002 |
| | 64.1 | % |
Gain on sale of real estate | | 105,131 |
| | 20,661 |
| | 84,470 |
| | n/m |
|
Dividend income | | 1,960 |
| | 1,337 |
| | 623 |
| | 46.6 | % |
Loss on equity securities, net | | (44,007 | ) | | (7,552 | ) | | (36,455 | ) | | n/m |
|
Interest income | | 1,045 |
| | 639 |
| | 406 |
| | 63.5 | % |
Interest expense | | (134,880 | ) | | (89,865 | ) | | (45,015 | ) | | 50.1 | % |
Loss on early extinguishment of debt | | (769 | ) | | (709 | ) | | (60 | ) | | 8.5 | % |
Income (loss) from continuing operations before income tax expense and equity in net losses of investees | | 32,372 |
| | (25,220 | ) | | 57,592 |
| | n/m |
|
Income tax expense | | (778 | ) | | (117 | ) | | (661 | ) | | n/m |
|
Equity in net losses of investees | | (1,259 | ) | | (2,269 | ) | | 1,010 |
| | (44.5 | %) |
Income (loss) from continuing operations | | 30,335 |
| | (27,606 | ) | | 57,941 |
| | n/m |
|
Income from discontinued operations | | — |
| | 5,722 |
| | (5,722 | ) | | n/m |
|
Net income (loss) | | 30,335 |
| | (21,884 | ) | | 52,219 |
| | n/m |
|
Preferred units of limited partnership distributions | | — |
| | (371 | ) | | 371 |
| | n/m |
|
Net income (loss) available for common shareholders | | $ | 30,335 |
| | $ | (22,255 | ) | | $ | 52,590 |
| | n/m |
|
| | | | | | | | |
Weighted average common shares outstanding (basic and diluted) | | 48,062 |
| | 24,830 |
| | 23,232 |
| | 93.6 | % |
| | | | | | | | |
Per common share amounts (basic and diluted): | | | | | | | | |
Income (loss) from continuing operations | | $ | 0.63 |
| | $ | (1.13 | ) | | $ | 1.76 |
| | (155.8 | %) |
Income from discontinued operations | | $ | — |
| | $ | 0.23 |
| | $ | (0.23 | ) | | n/m |
|
Net income (loss) available for common shareholders | | $ | 0.63 |
| | $ | (0.90 | ) | | $ | 1.53 |
| | (170.0 | %) |
n/m - not meaningful
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Calculation of Funds From Operations Available for Common Shareholders and Normalized Funds From Operations Available for Common Shareholders (5) |
| | | | | | | | | | | | | | | | | | 2017 | | 2016 | | | | |
Net income available for common shareholders | | | | | | $ | 11,815 |
| | $ | 57,843 |
| | | | |
Plus: Depreciation and amortization: | | | | | | | | | | | | |
Consolidated properties | | | | | | 109,588 |
| | 73,153 |
| | | | |
Unconsolidated joint venture properties | | | | | | 2,185 |
| | — |
| | | | |
Plus: FFO attributable to Select Income REIT investment | | | | | | 58,279 |
| | 71,227 |
| | | | |
Plus: Loss on impairment of real estate | | | | | | 9,490 |
| | — |
| | | | |
Less: Equity in earnings from Select Income REIT | | | | | | (21,584 | ) | | (35,381 | ) | | | | |
Less: Increase in carrying value of property included in discontinued operations | | | | | | (619 | ) | | — |
| | | | |
Less: Gain on sale of real estate | | | | | | — |
| | (79 | ) | | | | |
Funds from operations available for common shareholders | | | | | | 169,154 |
| | 166,763 |
| | | | |
Plus: Acquisition related costs | | | | | | — |
| | 1,191 |
| | | | |
Plus: Normalized FFO attributable to Select Income REIT investment | | | | | | 58,580 |
| | 71,313 |
| | | | |
Less: FFO attributable to Select Income REIT investment | | | | | | (58,279 | ) | | (71,227 | ) | | | | |
Less: (Gain) loss on early extinguishment of debt | | | | | | 1,715 |
| | (104 | ) | | | | |
Less: Net gain on issuance of shares by Select Income REIT | | | | | | (72 | ) | | (86 | ) | | | | |
Normalized funds from operations available for common shareholders | | | | | | $ | 171,098 |
| | $ | 167,850 |
| | | | |
| | | | | | | | | | | | |
Funds from operations per common share available for common shareholders (basic and diluted) | | | | | | $ | 2.00 |
| | $ | 2.35 |
| | | | |
Normalized funds from operations per common share available for common shareholders (basic and diluted) | | | | | | $ | 2.02 |
| | $ | 2.36 |
| | | | |
| |
(1) | Comparable properties consistconsists of 69 consolidated96 properties (89 buildings) we owned on December 31, 20172019 and which we owned continuously since January 1, 2016.2018; excludes properties classified as held for sale, properties undergoing significant redevelopment, if any, and three properties owned by two unconsolidated joint ventures in which we own 51% and 50% interests. |
| |
(2) | Acquired properties consistOur definition of 39 consolidated properties (78 buildings) we acquired since January 1, 2016. In October 2017, we acquired 35 of these properties (72 buildings) in connection with the FPO Transaction. We acquired one of these properties (one building) in a separate transaction during 2017. The remaining three properties (five buildings) were acquired during 2016. |
| |
(3) | Disposed properties consist of one consolidated property (one building) which we sold during 2016 and one consolidated property (one building) we sold during the year ended December 31, 2017 and excludes one property (one building) classified as discontinued operations which was sold in August 2017. |
| |
(4) | The calculations of Consolidated Property Net Operating Income,net operating income, or NOI, exclude certain componentsand our reconciliation of net income available for common shareholders in order to provide results that are more closely related to our consolidated property level results of operations. We define Consolidated Property NOI as consolidated income from our rental of real estate less our consolidated property operating expenses. Consolidated Property NOI excludes amortization of capitalized tenant improvement costs and leasing commissions that we record as depreciation and amortization. We consider Consolidated Property NOI to be an appropriate supplemental measure to net income available for common shareholders because it may help both investors and management to understand the operations of our consolidated properties. We use Consolidated Property NOI to evaluate individual and company wide consolidated property level performance, and we believe that Consolidated Property NOI provides useful information to investors regarding our results of operations because it reflects only those income and expense items that are generated and incurred at the property level and may facilitate comparisons of our operating performance between periods and with other REITs. Consolidated Property NOI does not represent cash generated by operating activities in accordance with GAAP and should not be considered alternatives to net income, net income available for common shareholders or operating income as indicators of our operating performance or as measures of our liquidity. This measure should be considered in conjunction with net income, net income available for common shareholders and operating income as presented in our consolidated statements of comprehensive income (loss). Other real estate companies and REITs may calculate Consolidated Property NOI differently than we do. |
| |
(5) | We calculate FFO available for common shareholders and Normalized FFO available for common shareholders as shown above. FFO is calculated on the basis defined by The National Association of Real Estate Investment Trusts, or Nareit, which is net income available for common shareholders calculated in accordance with GAAP, plus real estate depreciation and amortization of consolidated properties and our proportionate share of the real estate depreciation and amortization of unconsolidated joint venture properties and the difference between FFO attributable to an equity investment and equity in earnings of an equity investee but excluding impairment charges on and increases in the carrying value of real estate assets, any gain or loss on sale of real estate, as well as certain other adjustments currently not applicable to us. Our calculation of Normalized FFO available for common shareholders differs from Nareit's definition of FFO available for common shareholders because we include SIR's Normalized FFO attributable to our equity investment in SIR (net of FFO attributable to our equity investment in SIR), we include business management incentive fees, if any, only in the fourth quarter versus the quarter when they are recognized as expense in accordance with GAAP due to their quarterly volatility not necessarily being indicative of our core operating performance and the uncertainty as to whether any such business management incentive fees will be payable when all contingencies for determining such fees are known at the end of the calendar year and we exclude acquisition related costs expensed under GAAP, gains and losses on issuance of shares by SIR and gains and losses on early extinguishment of debt. We consider FFO available for common shareholders and Normalized FFO available for common shareholders to be appropriate supplemental measures of operating performance for a REIT, along with net income, net income available for our common shareholders and operating income. We believe that FFO available for common shareholders and Normalized FFO available for common shareholders provide useful information to investors because by excludingProperty NOI are included below under the effects of certain historical amounts, such as depreciation expense, FFO available for common shareholders and Normalized FFO available for common shareholders may facilitate a comparison of our operating performance between periods and with other REITs. FFO available for common shareholders and Normalized FFO available for common shareholders are among the factors considered by our Board of Trustees when determining the amount of distributions to our shareholders. Other factors include, but are not limited to, requirements to maintain our qualification for taxation as a REIT, limitations in our credit agreement and public debt covenants, the availability to us of debt and equity capital, our expectation of our future capital requirements and operating performance, our receipt of distributions from SIR and our expected needs for and availability of cash to pay our obligations. FFO available for common shareholders and Normalized FFO available for common shareholders do not represent cash generated by operating activities in accordance with GAAP and should not be considered alternatives to net income, net income available for common shareholders or operating income as indicators of our operating performance or as measures of our liquidity. These measures should be considered in conjunction with net income, net income available for common shareholders and operating income as presented in our consolidated statements of comprehensive income (loss). Other real estate companies and REITs may calculate FFO available for common shareholders and Normalized FFO available for common shareholders differently than we do.heading “Non-GAAP Financial Measures.” |
We refer to the 69 consolidated properties (89 buildings) we owned on December 31, 2017 and which we have owned continuously since January 1, 2016 as comparable properties. We refer to the 39 consolidated properties (78 buildings) that we acquired during the period from January 1, 2016 to December 31, 2017 as the acquired properties. We refer to the two properties (two buildings) we sold during the period from January 1, 2016 to December 31, 2017 as the disposed properties.
Our consolidated statements of comprehensive income for the year ended December 31, 2017 include the operating results of three acquired properties (five buildings) for the entire year, as we acquired those properties during 2016, include 36 properties (73 buildings) for less than the entire year, as we acquired those properties during 2017, exclude the operating results of one disposed property (one building) for the entire year, as we sold that property during 2016, and include the operating results of one disposed property (one building) for less than the entire year, as we sold the property during 2017. Our consolidated statements of comprehensive income for the year ended December 31, 2016 exclude the operating results of 36 acquired properties (73 buildings) for the entire year, as we acquired these properties during 2017, include three acquired properties (five buildings) for less than the entire year, as we acquired these properties during 2016, include the operating results of one disposed property (one building) for the entire year, as we sold that property during 2017, and include the operating results of one disposed property (one building) for less than the entire year, as we sold that property during 2016.
References to changes in the income and expense categories below relate to the comparison of consolidated results for the year ended December 31, 2017,2019, compared to the year ended December 31, 2016.2018. For a comparison of consolidated results for the year ended December 31, 2018 compared to the year ended December 31, 2017, see Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2018.
Rental income. The increase in rental income primarily reflects an increase in rental income for comparableassociated with the properties andacquired in the SIR Merger of $284,790, partially offset by a decrease in rental income from the acquired properties. Rentalof $28,506 as a result of property dispositions as well as a decline in rental income for comparable properties increased $3,768 due primarily to increasesof $4,181. The decrease in rental rates andincome for comparable properties is primarily due to reductions in occupied space at certain of our properties in 2017. Rental income increased $54,584 as a result of the acquired properties.2019. Rental income includes non-cash straight line rent adjustments totaling $5,582$27,507 in 20172019 and $2,691$10,164 in 2016,2018, and amortization of acquired leases and assumed lease obligations totaling ($2,764)2,710) in 20172019 and ($1,457)2,903) in 2016. 2018.
Real estate taxes. The increase in real estate taxes reflects the increase in real estate taxes associated with the properties acquired in the SIR Merger of $26,417 as well as an increase for comparable properties of $1,828, partially offset by a decrease in real estate taxes as a result of property dispositions of $3,326 and the taxesa decrease of $977 at one property classified as held for acquired properties.sale resulting from a successful real estate tax appeal. Real estate taxes for comparable properties increased $1,089primarily due primarily to the effect of higher real estate tax valuation assessments at certain of our properties in 2017. Real estate taxes increased $6,150 as a result of the acquired properties. 2019.
Utility expenses. The increase in utility expenses reflects an increase in utility expenses associated with the properties acquired in the SIR Merger of $9,412, partially offset by a decrease in utility expenses for comparable properties offset by the utility expenses of the acquired properties.$428, as well as a decrease as a result of property dispositions of $1,176. Utility expenses atfor comparable properties declined $117 primarily due to a decrease in electricity and water usage and ratesas a result of energy savings initiatives at certain of our properties during 2017. Utility expenses increased $3,846 as a result of the acquired properties. in 2019.
Other operating expenses. Other operating expenses consist of salaries and benefit costs of property level personnel, repairs and maintenance expense, cleaning expense, other direct costs of operating our properties and property management fees. The increase in other operating expenses reflects an increase in expenses associated with the properties acquired in the SIR Merger of $36,858 and an increase for comparable properties and the net effect of the acquired properties and the disposed properties.$2,764, partially offset by a decrease in other operating expenses as a result of property dispositions of $8,108. Other operating expenses atfor comparable properties increased $1,898 primarily as a result of higher repairs and maintenance and snow removal costs at certain of our properties in 2017. Other operating expenses increased $9,237 as a result of the acquired properties. We also realized a decrease of $76 in other operating expenses as a result of the disposed properties.2019.
Depreciation and amortization. The increase in depreciation and amortization primarily reflects the increase in depreciation and amortization fromrelated to properties acquired in the acquired properties and the effectSIR Merger of improvements made to certain of our comparable properties,$154,365, partially offset by the effecta decrease for comparable properties of $10,961 and a decrease related to property dispositions of $16,772. Depreciation and amortization for comparable properties declined due to certain leasing related assets becoming fully depreciated. Depreciation and amortization at comparable properties increased $1,477 due primarily todepreciated in 2019, partially offset by depreciation and amortization of improvements made to certain of our properties after January 1, 2016, partially offset by certain leasing related assets becoming fully depreciated in 2016 and 2017. Depreciation and amortization increased $34,958 as a result of the acquired properties.2019.
Loss on impairment of real estate. We recorded a $9,490$22,255 loss on impairment of real estate in 20172019 to reduce the carrying value of two45 properties (two buildings) to their estimated fair value.value less costs to sell. We recorded an $8,630 loss on impairment of real estate in 2018 to reduce the carrying value of 37 properties to their estimated fair value less costs to sell.
Acquisition and transaction related costs.Acquisition and transaction related costs include legal and due diligence costs incurred in connection with our 2016 property acquisition activities that were expensedthe SIR Merger and the other SIR Transactions, including certain post-merger activity costs incurred during 2019. For more information regarding the SIR Merger and the other SIR Transactions, see Notes 1, 3, 10 and 11 to the Notes to Consolidated Financial Statements included in accordance with GAAP. Pursuant to changes in GAAP, beginning in 2017, we generally capitalize our property acquisition related costs.Part IV, Item 15 of this Annual Report on Form 10-K.
General and administrative. General and administrative expenses consist of fees pursuant to our business management agreement, equity compensation expense, legal and accounting fees, Trustees’ fees and expenses, securities listing and transfer agency fees and other costs relating to our status as a publicly traded company. The increase in general and
administrative expenses is primarily the result of an increase in business management fees in 20172019 as a result of the SIR Merger and increased equity compensation expenses, legal fees, including fees associated with the execution of our leases required to be expensed beginning January 1, 2019 in accordance with GAAP, and other professional services costs.
Gain on sale of real estate. We recorded a $105,131 gain on sale of real estate in 2019, resulting from our acquisition activity, increasesthe sale of 17 properties in accounting expense, higher stock compensation and an2019. We recorded a $20,661 gain on sale of real estate in 2018 resulting from the sale of 17 properties in 2018.
Dividend income. The increase in other professional service costs.
Dividend income. Dividenddividend income consistsin 2019 is a result of dividends received fromthe additional shares of class A common stock of RMR Inc. SIR owned which we acquired as a result of the SIR Merger and a higher dividend rate paid by RMR Inc., partially offset by the sale of our investment in RMR Inc. on July 1, 2019. As a result of this sale, we did not record any dividend income during the period beginning July 1, 2019 through December 31, 2019.
Loss on equity securities, net. Loss on equity securities, net represents a realized loss in 2019 for the sale of our 2.8 million shares of class A common stock of RMR Inc. on July 1, 2019, and an unrealized loss in 2018 to adjust our former investment in RMR Inc. to its fair value.
Interest income. The increase in interest income is primarily the result of the combination of higher average cash balances and higher stated interest rates in 2017 due2019 compared to our financing activities related to the FPO Transaction.2018.
Interest expense. The increase in interest expense reflectsis primarily due to higher average outstanding debt balances as a result of the debt assumed in conjunction with the SIR Merger and higher weightedthe associated additional interest expense of $74,233 during 2019, which was partially offset by decreases in interest expense resulting from debt repayment activity in 2019, including the repayment of the remaining $388,000 outstanding on our term loans and the redemption of our $350,000 3.75% senior unsecured notes in July 2019, resulting in decreases in interest expense of $14,304 and $6,633, respectively. In addition, we had a lower average balance outstanding on our revolving credit facility of $161,903 in 2019 compared to $418,511 in 2018 at average interest rates on borrowingsof 3.3% and 3.0%, respectively, resulting in 2017.a decrease in interest expense of $7,341.
Loss (gain) on early extinguishment of debt. We recorded a loss on early extinguishment of debt of $1,715$769 in 2017 in connection2019 from the write-off of unamortized debt issuance costs and discounts associated with the terminationrepayments of the bridge loan facility described in Note 9 to our Consolidated Financial Statements included in Part IV, Item 15term loans and redemption of this Annual Report on Form 10-K.our senior unsecured notes due 2019. We recorded a $104 gainloss on early extinguishment of debt of $709 in 2016 in connection2018 from the write-off of debt issuance costs associated with the prepaymentpartial paydown of one of our term loans and the amendment to our revolving credit facility in December 2018.
Income tax expense. Income tax expense increased as a result of properties acquired in the SIR Merger, reflecting higher operating income in certain jurisdictions in 2019 that was subject to state income taxes.
Equity in net losses of investees. Equity in net losses of investees represents our proportionate share of earnings and losses from our investments in AIC and our two mortgage notes. unconsolidated joint ventures.
Net gainIncome from discontinued operations. Income from discontinued operations in 2018 consists of our proportionate share of earnings from our former equity method investment in SIR, the loss on issuance of shares by SIR. Netthe Secondary Sale and the gain on issuance of shares by SIR isas a result of the issuance of common shares by SIR at prices which were in the aggregate above ourthe then per share carrying value of our SIR common shares.
Income tax expense. Income tax expense is the result of operating income we earned in certain jurisdictions that is subject to state income taxes.
Equity in earnings of investees. Equity in earnings of investees represents For more information about our proportionate share of earnings from our investmentsequity method investment in SIR, AICsee Notes 1, 10 and two unconsolidated joint ventures.
Income (loss) from discontinued operations. Income (loss) from discontinued operations reflects operating results for one property (one building) included in discontinued operations. During 2017, we recorded an adjustment of $619 to increase the carrying value of this property to its estimated fair value less costs to sell. We sold this property on August 31, 2017.
Gain on sale of real estate. Gain on sale of real estate represents the portion of the gain recognized from the sale of one of the disposed properties (one building) during 2016.
Preferred units of limited partnership distributions. Preferred units of limited partnership distributions represent distributions11 to the holders of 5.5% Series A Cumulative Preferred Units of FPO's former operating partnership. See Note 5Notes to our Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K for more information regarding these preferred10-K.
Preferred units of limited partnership.partnership distributions. Preferred units of limited partnership distributions in 2018 represent distributions to the holders of the previously outstanding 5.5% Series A Cumulative Preferred Units of one of our subsidiaries that were fully redeemed in May 2018.
Net income (loss) and net income (loss) available for common shareholders. Our net income (loss), net income (loss) available for common shareholders and net income (loss) available for common shareholders per basic and diluted common share decreasedincreased in 20172019 compared to 20162018 primarily as a result of the changes noted above. The percentage decrease in net income available for
Weighted average common shareholders per common shareshares outstanding (basic and diluted) is higher primarily as a result of the higher number of. The increase in weighted average common shares outstanding as(basic and diluted) is primarily a result of our issuance of common23,281,738 shares in an underwritten public offering during 2017.
Year Ended December 31, 2016, Compared to Year Ended December 31, 2015
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | Acquired Properties Results (2) | | Disposed Property Results (3) | | | | | | | | |
| | Comparable Properties Results (1) | | Year Ended December 31, | | Year Ended December 31, | | Consolidated Results |
| | Year Ended December 31, | | | | Year Ended December 31, |
| | | | | | $ | | % | | | | | | | | | | | | | | $ | | % |
| | 2016 | | 2015 | | Change | | Change | | 2016 | | 2015 | | 2016 | | 2015 | | 2016 | | 2015 | | Change | | Change |
Rental income | | $ | 249,430 |
| | $ | 246,747 |
| | $ | 2,683 |
| | 1.1 | % | | $ | 8,750 |
| | $ | — |
| | $ | — |
| | $ | 1,802 |
| | $ | 258,180 |
| | $ | 248,549 |
| | $ | 9,631 |
| | 3.9 | % |
Operating expenses: | | |
| | |
| | | | | | |
| | |
| | |
| | |
| | |
| | |
| | |
| | |
|
Real estate taxes | | 29,757 |
| | 29,633 |
| | 124 |
| | 0.4 | % | | 918 |
| | — |
| | 28 |
| | 273 |
| | 30,703 |
| | 29,906 |
| | 797 |
| | 2.7 | % |
Utility expenses | | 16,667 |
| | 17,750 |
| | (1,083 | ) | | (6.1 | %) | | 578 |
| | — |
| | 24 |
| | 166 |
| | 17,269 |
| | 17,916 |
| | (647 | ) | | (3.6 | %) |
Other operating expenses | | 52,212 |
| | 49,946 |
| | 2,266 |
| | 4.5 | % | | 2,019 |
| | — |
| | 59 |
| | 479 |
| | 54,290 |
| | 50,425 |
| | 3,865 |
| | 7.7 | % |
Total operating expenses | | 98,636 |
| | 97,329 |
| | 1,307 |
| | 1.3 | % | | 3,515 |
| | — |
| | 111 |
| | 918 |
| | 102,262 |
| | 98,247 |
| | 4,015 |
| | 4.1 | % |
Net operating income (4) | | $ | 150,794 |
| | $ | 149,418 |
| | $ | 1,376 |
| | 0.9 | % | | $ | 5,235 |
| | $ | — |
| | $ | (111 | ) | | $ | 884 |
| | 155,918 |
| | 150,302 |
| | 5,616 |
| | 3.7 | % |
| | | | | | | | | | | | | | | | | | | | | | | | |
Other expenses: | | |
| | |
| | | | |
| | |
| | |
| | | | | | |
| | |
| | | | |
|
Depreciation and amortization - consolidated properties | | | | | | 73,153 |
| | 68,696 |
| | 4,457 |
| | 6.5 | % |
Acquisition related costs | | | | | | 1,191 |
| | 811 |
| | 380 |
| | 46.9 | % |
General and administrative | | | | | | 14,897 |
| | 14,826 |
| | 71 |
| | 0.5 | % |
Total other expenses | | | | | | 89,241 |
| | 84,333 |
| | 4,908 |
| | 5.8 | % |
Operating income | | | | | | 66,677 |
| | 65,969 |
| | 708 |
| | 1.1 | % |
Dividend income | | | | | | 971 |
| | 811 |
| | 160 |
| | 19.7 | % |
Interest income | | | | | | 158 |
| | 14 |
| | 144 |
| | nm |
|
Interest expense (including net amortization of debt premium and discounts and debt issuance costs of $2,832, and $1,376, respectively) | | (45,060 | ) | | (37,008 | ) | | (8,052 | ) | | 21.8 | % |
Gain on early extinguishment of debt | | 104 |
| | 34 |
| | 70 |
| | nm |
|
Loss on distribution to common shareholders of The RMR Group Inc. common stock | | — |
| | (12,368 | ) | | 12,368 |
| | nm |
|
Net gain (loss) on issuance of shares by Select Income REIT | | 86 |
| | (42,145 | ) | | 42,231 |
| | nm |
|
Loss on impairment of Select Income REIT investment | | — |
| | (203,297 | ) | | 203,297 |
| | nm |
|
Income (loss) from continuing operations before income taxes, equity in earnings of investees and gain on sale of real estate | | 22,936 |
| | (227,990 | ) | | 250,926 |
| | nm |
|
Income tax expense | | (101 | ) | | (86 | ) | | (15 | ) | | 17.4 | % |
Equity in earnings of investees | | 35,518 |
| | 18,640 |
| | 16,878 |
| | 90.5 | % |
Income (loss) from continuing operations | | 58,353 |
| | (209,436 | ) | | 267,789 |
| | nm |
|
Loss from discontinued operations | | (589 | ) | | (525 | ) | | (64 | ) | | 12.2 | % |
Income (loss) before gain on sale of real estate | | 57,764 |
| | (209,961 | ) | | 267,725 |
| | nm |
|
Gain on sale of real estate | | 79 |
| | — |
| | 79 |
| | nm |
|
Net income (loss) | | $ | 57,843 |
| | $ | (209,961 | ) | | $ | 267,804 |
| | nm |
|
| | | | | | | | |
Weighted average common shares outstanding (basic) | | 71,050 |
| | 70,700 |
| | 350 |
| | 0.5 | % |
Weighted average common shares outstanding (diluted) | | 71,071 |
| | 70,700 |
| | 371 |
| | 0.5 | % |
| | | | | | | | |
Per common share amounts (basic and diluted): | | | | | | | | |
Income (loss) from continuing operations | | $ | 0.82 |
| | $ | (2.96 | ) | | $ | 3.78 |
| | nm |
|
Loss from discontinued operations | | $ | (0.01 | ) | | $ | (0.01 | ) | | $ | — |
| | — | % |
Net income (loss) | | $ | 0.81 |
| | $ | (2.97 | ) | | $ | 3.78 |
| | nm |
|
| | | | | | | | | | | | |
Reconciliation of Net Income (Loss) to Consolidated Property NOI: | | | | | | | | | | | | |
Net income (loss) | | | | | | $ | 57,843 |
| | $ | (209,961 | ) | | | | |
Gain on sale of real estate | | | | | | (79 | ) | | — |
| | | | |
Income (loss) before gain on sale of real estate | | | | | | 57,764 |
| | (209,961 | ) | | | | |
Loss from discontinued operations | | | | | | 589 |
| | 525 |
| | | | |
Income (loss) from continuing operations | | | | | | 58,353 |
| | (209,436 | ) | | | | |
Equity in earnings of investees | | | | | | (35,518 | ) | | (18,640 | ) | | | | |
Income tax expense | | | | | | 101 |
| | 86 |
| | | | |
Loss on impairment of SIR investment | | | | | | — |
| | 203,297 |
| | | | |
Net (gain) loss on issuance of shares by SIR | | | | | | (86 | ) | | 42,145 |
| | | | |
Loss on distribution to common shareholders of The RMR Group Inc. common stock | | | | | | — |
| | 12,368 |
| | | | |
Gain on early extinguishment of debt | | | | | | (104 | ) | | (34 | ) | | | | |
Interest expense | | | | | | 45,060 |
| | 37,008 |
| | | | |
Interest income | | | | | | (158 | ) | | (14 | ) | | | | |
Dividend income | | | | | | (971 | ) | | (811 | ) | | | | |
Operating income | | | | | | 66,677 |
| | 65,969 |
| | | | |
General and administrative | | | | | | 14,897 |
| | 14,826 |
| | | | |
Acquisition related costs | | | | | | 1,191 |
| | 811 |
| | | | |
Depreciation and amortization | | | | | | 73,153 |
| | 68,696 |
| | | | |
Consolidated Property NOI | | | | | | $ | 155,918 |
| | $ | 150,302 |
| | | | |
| | | | | | | | | | | | |
|
|
|
|
|
|
|
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Calculation of Funds From Operations and Normalized Funds From Operations(5) |
| | | | | | | | | | | | | | | | | | 2016 | | 2015 | | | | |
Net income (loss) | | | | | | $ | 57,843 |
| | $ | (209,961 | ) | | | | |
|
Plus: Depreciation and amortization - consolidated properties | | | | | | 73,153 |
| | 68,696 |
| | | | |
|
Plus: FFO attributable to Select Income REIT investment | | | | | | 71,227 |
| | 56,105 |
| | | | |
|
Less: Equity in earnings from Select Income REIT | | | | | | (35,381 | ) | | (18,620 | ) | | | | |
|
Less: Gain on sale of real estate | | | | | | (79 | ) | | — |
| | | | |
Funds from operations | | | | | | 166,763 |
| | (103,780 | ) | | | | |
|
Plus: Acquisition related costs | | | | | | 1,191 |
| | 811 |
| | | | |
|
Plus: Loss on distribution to common shareholders of The RMR Group Inc. common stock | | | | | | — |
| | 12,368 |
| | | | |
Plus: Net loss on issuance of shares by Select Income REIT | | | | | | — |
| | 42,145 |
| | | | |
|
Plus: Loss on impairment of Select Income REIT investment | | | | | | — |
| | 203,297 |
| | | | |
Plus: Normalized FFO attributable to Select Income REIT investment | | | | | | 71,313 |
| | 70,012 |
| | | | |
|
Less: FFO attributable to Select Income REIT investment | | | | | | (71,227 | ) | | (56,105 | ) | | | | |
|
Less: Gain on early extinguishment of debt | | | | | | (104 | ) | | (34 | ) | | | | |
Less: Net gain on issuance of shares by Select Income REIT | | | | | | (86 | ) | | — |
| | | | |
Normalized funds from operations | | | | | | $ | 167,850 |
| | $ | 168,714 |
| | | | |
|
| | | | | | | | | | | | |
Funds from operations (basic and diluted) | | | | | | $ | 2.35 |
| | $ | (1.47 | ) | | | | |
|
Normalized funds from operations (basic and diluted) | | | | | | $ | 2.36 |
| | $ | 2.39 |
| | | | |
| |
(1) | Comparable properties consist of 70 consolidated properties (90 buildings) we owned on December 31, 2016 and which we owned continuously since January 1, 2015, and excludes one property (one building) classified as discontinued operations. |
| |
(2) | Acquired properties consist of three consolidated properties (five buildings) we acquired during the year ended December 31, 2016. |
| |
(3) | Disposed properties consist of one consolidated property (one building) we sold during the year ended December 31, 2015 and one consolidated property (one building) we sold during the year ended December 31, 2016. |
| |
(4) | See footnote (4) on page 60 for the definition of NOI. |
| |
(5) | See footnote (5) on page 60 for the definition of FFO and Normalized FFO. |
We refer to the 70 consolidated properties (90 buildings) we ownedSIR shareholders on December 31, 2016 and which we have owned continuously since January 1, 2015, excluding one property (one building) classified2018 in connection with the SIR Merger.
Non-GAAP Financial Measures
We present certain "non-GAAP financial measures" within the meaning of applicable SEC rules, including the calculations below of Property NOI, as discontinuedwell as funds from operations, as comparable properties. We refer toor FFO, available for common shareholders, normalized funds from operations, or Normalized FFO, available for common shareholders, for the three consolidated properties (five buildings) that we acquired during the period from January 1, 2015 toyears ended December 31, 20162019 and 2018. These measures do not represent cash generated by operating activities in accordance with GAAP and should not be considered alternatives to income (loss) from continuing operations, net income (loss) or net income (loss) available for common shareholders as the acquired properties. We refer to the two consolidated properties (two buildings) we sold during the periodindicators of our operating performance or as measures of our liquidity. These measures should be considered in conjunction with income (loss) from January 1, 2015 to December 31, 2016continuing operations, net income (loss) and net income (loss) available for common shareholders as the disposed properties.
Ourpresented in our consolidated statements of comprehensive income (loss). We consider these non-GAAP measures to be appropriate supplemental measures of operating performance for a REIT, along with income (loss) from
continuing operations, net income (loss) and net income (loss) available for common shareholders. We believe these measures provide useful information to investors because by excluding the effects of certain historical amounts, such as depreciation and amortization expense, they may facilitate a comparison of our operating performance between periods and with other REITs and, in the case of Property NOI, reflecting only those income and expense items that are generated and incurred at the property level may help both investors and management to understand the operations of our properties.
Property Net Operating Income
The calculation of Property NOI excludes certain components of net income (loss) available for common shareholders in order to provide results that are more closely related to our property level results of operations. We calculate Property NOI as shown below. We define Property NOI as income from our rental of real estate less our property operating expenses. Property NOI excludes amortization of capitalized tenant improvement costs and leasing commissions that we record as depreciation and amortization expense. We use Property NOI to evaluate individual and company-wide property level performance. Other real estate companies and REITs may calculate Property NOI differently than we do.
The following table presents the reconciliation of net income (loss) available for common shareholders to Property NOI for the yearyears ended December 31, 2016 include2019 and 2018.
|
| | | | | | | | |
| | Year Ended December 31, |
| | 2019 | | 2018 |
Net income (loss) available for common shareholders | | $ | 30,335 |
| | $ | (22,255 | ) |
Preferred units of limited partnership distributions | | — |
| | 371 |
|
Net income (loss) | | 30,335 |
| | (21,884 | ) |
Income from discontinued operations | | — |
| | (5,722 | ) |
Income (loss) from continuing operations | | 30,335 |
| | (27,606 | ) |
Equity in net losses of investees | | 1,259 |
| | 2,269 |
|
Income tax expense | | 778 |
| | 117 |
|
Loss on early extinguishment of debt | | 769 |
| | 709 |
|
Interest expense | | 134,880 |
| | 89,865 |
|
Interest income | | (1,045 | ) | | (639 | ) |
Loss on equity securities, net | | 44,007 |
| | 7,552 |
|
Dividend income | | (1,960 | ) | | (1,337 | ) |
Gain on sale of real estate | | (105,131 | ) | | (20,661 | ) |
General and administrative | | 32,728 |
| | 24,922 |
|
Acquisition and transaction related costs | | 682 |
| | 14,508 |
|
Loss on impairment of real estate | | 22,255 |
| | 8,630 |
|
Depreciation and amortization | | 289,885 |
| | 162,488 |
|
Property NOI | | $ | 449,442 |
| | $ | 260,817 |
|
Funds From Operations Available for Common Shareholders and Normalized Funds From Operations Available for Common Shareholders
We calculate FFO available for common shareholders and Normalized FFO available for common shareholders as shown below. FFO available for common shareholders is calculated on the operating resultsbasis defined by The National Association of the acquired properties for less than the entire year, as we acquired those properties during 2016, include the operating results of one disposed property (one building) for less than the entire year, as we sold that property during 2016, and exclude the operating results of one disposed property (one building) for the entire year, as we sold that property during 2015. Our consolidated statements of comprehensiveReal Estate Investment Trusts, which is net income (loss) available for the year ended December 31, 2015 exclude the operating results of the acquired properties for the entire year, as we acquired those properties during 2016, and include the operating results of one disposed property (one building) for the entire year, as we sold that property during 2016, and include the operating results of one disposed property for less than the entire year, as we sold that property during 2015.
References to changescommon shareholders, calculated in the income and expense categories below relate to the comparison of consolidated results for the year ended December 31, 2016, compared to the year ended December 31, 2015.
Rental income. The increase in rental income reflects an increase in rental income for comparable properties and the net effect of the acquired properties and the disposed properties. Rental income for comparable properties increased $2,683 due primarily to increases in rental rates and occupied space at certain of our properties in 2016. Rental income increased $8,735 as a result of the acquired properties. Rental income declined $1,787 as a result of the disposed properties. Rental income includes non-cash straight line rent adjustments totaling $2,691 in 2016 and $3,978 in 2015, and amortization of acquired leases and assumed lease obligations totaling ($1,457) in 2016 and ($1,155) in 2015.
Real estate taxes. The increase inaccordance with GAAP, plus real estate taxes reflects the increase in real estate taxes for comparable properties and the net effect of the acquired properties and the disposed properties. Real estate taxes for comparable properties increased $124 due primarily to the effect of higher real estate tax valuation assessments at certain of our properties in 2016. Real estate taxes increased $918 as a result of the acquired properties. Real estate taxes declined $245 as a result of the disposed properties.
Utility expenses. The decrease in utility expenses reflects a decrease in utility expenses for comparable properties, partially offset by the net effect of the acquired properties and the disposed properties. Utility expenses at comparable properties declined $1,083 primarily due to milder temperatures experienced in certain parts of the United States during 2016
compared to 2015. Utility expenses increased $578 as a result of the acquired properties. Utility expenses declined $142 as a result of the disposed properties.
Other operating expenses. The increase in other operating expenses reflects the increase in expenses for comparable properties and the net effect of acquired properties and the disposed properties. Other operating expenses at comparable properties increased $2,266 primarily as a result of higher employee compensation, cleaning and insurance costs at certain of our properties, partially offset by lower snow removal costs at certain of our properties. Other operating expenses increased $2,019 as a result of the acquired properties. Other operating expenses declined $420 as a result of the disposed properties.
Depreciation and amortization. The increase in depreciation and amortization reflects the effect of the acquired properties and improvements made to certain of our comparable properties, partially offset by the effect of certain assets becoming fully depreciated. Depreciation and amortization at comparable properties increased $167 due primarily to certain depreciable leasing related assets becoming fully depreciated after January 1, 2015, partially offset by depreciation and amortization of improvements made to certainconsolidated properties and our proportionate share of our properties after January 1, 2015. Depreciationthe real estate depreciation and amortization increased $4,290 as a result of the acquired properties.
Acquisition related costs. Acquisition related costs include legalunconsolidated joint venture properties, and due diligence costs incurred in connection with our property acquisition activities.
General and administrative. The increase in general and administrative expenses primarily reflects an increase in equity compensation expense, partially offset by a decrease in professional fees.
Dividend income. Dividend income consists of dividends received from our investment in RMR Inc.
Interest income. The increase in interest income is primarily the result of interest earned from the mortgage financing we provided to the purchaser of one of our disposed properties (one building) in 2016.
Interest expense. The increase in interest expense reflects higher average outstanding debt balances and higher weighted average interest rates on borrowings in 2016.
Gain on early extinguishment of debt. We recorded a $104 gain on early extinguishment of debt in 2016 in connection with the prepayment of two mortgage notes. We recorded a $34 gain on early extinguishment of debt in 2015 in connection with the prepayment of a mortgage note.
Loss on distribution to common shareholders of RMR Inc. common shares. We recorded a $12,368 loss on the distribution of RMR Inc. shares we distributed to our shareholders in December 2015, which represents the difference between the carrying valueFFO attributable to an equity investment and the fair value of the RMR Inc. shares on the distribution date.
Net gain (loss) on issuance of shares by SIR. Net gain (loss) on issuance of shares by SIR is a result of the issuance of common shares by SIR at prices above or below our then per share carrying value of our SIR common shares.
Loss on impairmentequity in earnings of SIR investment. We recorded a $203,297 lossincluded in discontinued operations, but excluding impairment charges on impairmentand increases in 2015 to reduce the carrying value of our SIR investment to its estimated fair value.
Income tax expense. The increase in income tax expense reflects higher operating income in certain jurisdictions in 2016 that is subject to state income taxes.
Equity in earnings of investees. Equity in earnings of investees represents our proportionate share of earnings from our investments in SIR and AIC.
Loss from discontinued operations. Loss from discontinued operations reflects operating results for one property (one building) included in discontinued operations during 2016 and 2015.
Gain on sale of real estate. Gainestate assets, any gain or loss on sale of real estate representsand equity securities, as well as certain other adjustments currently not applicable to us. In calculating Normalized FFO available for common shareholders, we adjust for the portiondifference between Normalized FFO attributable to an equity investment and FFO attributable to an equity investment and for the other items shown below and include business management incentive fees, if any, only in the fourth quarter versus the quarter when they are recognized as an expense in accordance with GAAP due to their quarterly volatility not necessarily being indicative of our core operating performance and the uncertainty as to whether any such business management incentive fees will be payable when all contingencies for determining such fees are known at the end of the gain recognized fromcalendar year. FFO available for common shareholders and Normalized FFO available for common shareholders are among the salefactors considered by our Board of oneTrustees when determining the amount of distributions to our shareholders. Other factors include, but are not limited to, requirements to maintain our qualification for taxation as a REIT, limitations in our
credit agreement and public debt covenants, the disposed properties (one building) during 2016.availability to us of debt and equity capital, our expectation of our future capital requirements and operating performance and our expected needs for and availability of cash to pay our obligations. Other real estate companies and REITs may calculate FFO available for common shareholders and Normalized FFO available for common shareholders differently than we do.
Net income (loss). OurThe following table presents the reconciliation of net income (loss) available for common shareholders to FFO available for common shareholders and net income perNormalized FFO available for common share in 2016 compared to our net loss in 2015 primarily reflectshareholders for the changes noted above.years ended December 31, 2019 and 2018. |
| | | | | | | | |
| | Year Ended December 31, |
| | 2019 | | 2018 |
Net income (loss) available for common shareholders | | $ | 30,335 |
| | $ | (22,255 | ) |
Add (less): Depreciation and amortization: | | | | |
Consolidated properties | | 289,885 |
| | 162,488 |
|
Unconsolidated joint venture properties | | 5,903 |
| | 8,203 |
|
FFO attributable to Select Income REIT | | — |
| | 51,773 |
|
Loss on impairment of real estate | | 22,255 |
| | 8,630 |
|
Equity in earnings from Select Income REIT included in discontinued operations | | — |
| | (24,358 | ) |
Gain on sale of real estate | | (105,131 | ) | | (20,661 | ) |
Loss on equity securities, net | | 44,007 |
| | 7,552 |
|
FFO available for common shareholders | | 287,254 |
| | 171,372 |
|
Add (less): Acquisition and transaction related costs | | 682 |
| | 14,508 |
|
Loss on early extinguishment of debt | | 769 |
| | 709 |
|
Normalized FFO attributable to Select Income REIT | | — |
| | 44,006 |
|
FFO attributable to Select Income REIT | | — |
| | (51,773 | ) |
Net gain on issuance of shares by Select Income REIT included in discontinued operations | | — |
| | (29 | ) |
Loss on sale of Select Income REIT shares included in discontinued operations | | — |
| | 18,665 |
|
Normalized FFO available for common shareholders | | $ | 288,705 |
| | $ | 197,458 |
|
| | | | |
FFO available for common shareholders per common share (basic and diluted) | | $ | 5.98 |
| | $ | 6.90 |
|
Normalized FFO available for common shareholders per common share (basic and diluted) | | $ | 6.01 |
| | $ | 7.95 |
|
LIQUIDITY AND CAPITAL RESOURCES
Our Operating Liquidity and Resources (dollar amounts in thousands)
Our principal sources of funds to meet operating and capital expenses, pay debt service obligations and paymake distributions onto our common sharesshareholders are the operating cash flows we generate as rental income from our properties, the distributions we receivenet proceeds from our investments in SIR and RMR Inc.property sales and borrowings under our revolving credit facility. We believe that these sources of funds will be sufficient to meet our operating and capital expenses, andpay debt service obligations and paymake distributions onto our common sharesshareholders for the next 12 months and for the foreseeable future thereafter.
As of December 31, 2018, including certain assets acquired from SIR in the SIR Merger, we had identified certain assets to be sold by us. Since that date, we have sold 61 properties for an aggregate sales price of $869,916, excluding closing costs. In addition, on July 1, 2019, we sold all of the 2.8 million shares of class A common stock of RMR Inc. we owned, raising net proceeds of $104,674, after deducting underwriting discounts and commissions and other offering expenses. As of February 19, 2020, we have entered agreements to sell three properties for $64,300, excluding closing costs, and we are actively marketing for sale an additional four properties. With our disposition program substantially complete, we expect to pursue accretively growing our property portfolio through our capital recycling program. Pursuant to our capital recycling program, we plan to sell certain properties from time to time to fund future acquisitions and to maintain leverage consistent with our current investment grade ratings with a goal of (1) improving the asset quality of our portfolio by reducing the average age of our properties, lengthening the weighted average term of our leases and increasing the likelihood of retaining our tenants and (2) increasing our distributions to shareholders. Our future cash flows from operating activities will depend primarily upon:
•our ability to maintain or increase the occupancy of, and the rental rates at, our properties;
•our ability to control operating and capital expenses at our properties;
our ability to successfully complete our pending property sales and to sell properties that we market for sale; and
our ability to purchase additional properties which produce cash flows from operations in excess of our cost of acquisition capital and property operating expenses;expenses and capital expenses.
Following the SIR Merger, we announced a regular quarterly distribution of $0.55 per common share ($2.20 per common share per year), based on a target payout ratio of 75% of projected cash available for distribution. We determine our receipt of distributionsdistribution payout ratio with consideration for our expected capital expenditures, as well as cash flows from our investments in SIRoperations and RMR Inc.debt obligations.
Our future purchases of properties cannot be accurately projected because such purchases depend upon purchase opportunities which come to our attention and our ability to successfully complete the acquisitions. We generally do not intend to purchase “turn around” properties, or properties which do not generate positive cash flows.
Our changes in cash flows for the year ended December 31, 20172019 compared to the prior year were as follows: (i) cash provided by operating activities increased from $124,258$144,916 in 20162018 to $133,047$215,329 in 2017;2019; (ii) cash used inflows provided by investing activities increased from $215,157$738,656 in 20162018 to $1,186,213$877,819 in 2017;2019; and (iii) cash provided byflows used in financing activities increased from $112,055$864,309 in 20162018 to $1,039,794$1,031,395 in 2017.
2019.
The increase in cash provided by operating activities for the year ended December 31, 2017 as2019 compared to the prior year was due primarily to an increase in consolidated propertyProperty NOI and favorableprimarily due to the SIR Merger, partially offset by unfavorable changes in working capital partially offset byin 2019 as we assumed operations and paid outstanding liabilities, including $25,817 of the SIR business management incentive fee, as a decrease in distributions from our investment in SIR.result of the SIR Merger. The increase in cash used inprovided by investing activities for the year ended December 31, 2017 as2019 compared to the prior year was primarily due primarily to our receipt of cash proceeds from the FPO Transactionsale of 58 properties and the sale of 2.8 million shares of class A common stock of RMR Inc. in 2017.2019, in excess of the cash proceeds received from our sale of properties and our sale of SIR shares in 2018. The increase in cash provided byused in financing activities for the year ended December 31, 2017 as2019 compared to the prior year wasis primarily due primarily to our FPO Transaction related financing activities during 2017,an increase in debt repayments, including issuancesthe repayment of common shares$388,000 of term loans and $350,000 of senior unsecured notes in 2019 and borrowings undernet repayment activity on our revolving credit facility.
facility, partially offset by a decrease in distributions paid to common shareholders in 2019 and the redemption of the preferred units of one of our subsidiaries in 2018.
Our Investment and Financing Liquidity and Resources (dollar amounts in thousands, except per share and per square foot amounts)
In order to fund acquisitions and to meet cash needs that may result from our desire or need to make distributions or pay operating or capital expenses, we maintain a $750,000 revolving credit facility. The maturity date of our revolving credit facility is January 31, 20192023 and, subject to our payment of an extension fee and meeting certain other conditions, we have anthe option to extend the stated maturity date of our revolving credit facility by one year to January 31, 2020.two additional six month periods. 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 125110 basis points per annum at December 31, 2017,2019, on the amount outstanding under our revolving credit facility.facility, if any. 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 December 31, 2017.2019. Both the interest rate premium and the facility fee are subject to adjustment based upon changes to our credit ratings. 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 December 31, 2017,2019, the annual interest rate payable on borrowings under our revolving credit facility was 2.7%. As of December 31, 2017 and February 23, 2018,2019, we had $570,000 and $595,000, respectively,no amounts outstanding under our revolving credit facility and $750,000 available for borrowing. As of February 19, 2020, we had $335,000 outstanding under our revolving credit facility and $415,000 available for borrowing under our revolving credit facility.
Our revolving credit facility is governed by aour credit agreement, which is with a syndicate of institutional lenders, and which also governsgoverned our two unsecuredformer term loans:
OurDuring the year ended December 31, 2019, we repaid in full our $300,000 term loan, which matureswas scheduled to mature on March 31, 2020, is prepayable without penalty, at any time. We are required to pay interest at LIBOR plus a premium, which was 140 basis points per annum at December 31, 2017,using cash on hand, proceeds from property sales and proceeds from the amount outstanding undersale of our $300,000 term loan. The interest rate premium is subject to adjustmentshares of class A common stock of RMR Inc.
based upon changes to our credit ratings. As ofDuring the year ended December 31, 2017,2019, we repaid the annual interest rate for the amountremaining $88,000 outstanding underon our $300,000 term loan was 3.0%.
Our $250,000 term loan, which matureswas scheduled to mature on March 31, 2022, is prepayable without penalty, at any time. We are required to pay interest at LIBOR plususing proceeds from the sale of a premium, which was 180 basis points per annum at December 31, 2017, 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 December 31, 2017, the annual interest rate for the amount outstanding under our $250,000 term loan was 3.4%.property portfolio.
Our credit agreement also includes a feature under which the maximum borrowing availability may be increased to up to $2,500,000 on a combined basis$1,950,000 in certain circumstances.
Our credit agreement provides that, with certain exceptions, a subsidiary of ours is required to guaranty our obligations under theour $750,000 revolving credit facility and term loans only if that subsidiary has separately incurred debt (other than nonrecourse debt), within the meaning specified in theour credit agreement, or provided a guarantee of debt incurred by us or any of our other subsidiaries.
OurIn July 2019, we redeemed, at par plus accrued interest, all $350,000 of our 3.75% senior unsecured notes due 2019, are governed by an indentureusing cash on hand, proceeds from property sales and a supplement to that indenture and require semi-annual payments of interest only through maturity in August 2019 and may be repaid at par (plus accrued and unpaid interest) on or after July 15, 2019 or before that date together with a make whole premium.
Our $300,000 of 4.000% senior unsecured notes due 2022 are governed by an indenture and a supplement to that indenture and require semi-annual payments of interest only through maturity in July 2022 and may be repaid at par (plus accrued and unpaid interest) on or after June 15, 2022 or before that date together with a make whole premium.
Our $310,000 of 5.875% senior unsecured notes due 2046 are governed by an indenture and a supplement to that indenture and require quarterly payments of interest only through maturity in May 2046 and may be repaid at par (plus accrued and unpaid interest) on or after May 26, 2021.
borrowings under our revolving credit facility.
As of December 31, 2017,2019, our debt maturities (other than our revolving credit facility)facility which had no amounts outstanding), consisting of senior unsecured notes and mortgage notes, are as follows: $3,672 in 2018, $361,541 in 2019, $338,433 in
|
| | | | |
Year | | Debt Maturities |
2020 | | $ | 475,707 |
|
2021 | | 14,420 |
|
2022 | | 625,518 |
|
2023 | | 143,784 |
|
2024 | | 350,000 |
|
2025 and thereafter | | 776,780 |
|
Total | | $ | 2,386,209 |
|
In January 2020, $14,420 in 2021, $575,518 in 2022we redeemed, at par plus accrued interest, all $400,000 of our 3.60% senior unsecured notes due 2020 using cash on hand, proceeds from property sales and $399,563 thereafter.
borrowings under our revolving credit facility.
None of our unsecured debt obligations require sinking fund payments prior to their maturity dates. Our $183,147$326,209 in mortgage debts, including one mortgage note with an outstanding principal balance of $13,166 classified in liabilities of properties held for sale in our consolidated balance sheet as of December 31, 2019, generally require monthly payments of principal and interest through maturity.
In addition to our debt obligations, as of December 31, 2017,2019, we have estimated unspent leasing related obligations of $31,310.
In connection with the FPO Transaction, we assumed five mortgage notes with an aggregate principal balance of $167,548. These mortgage notes are secured by five properties (five buildings). In November 2017, we repaid $10,000 of principal of one of these mortgage notes as part of our assumption agreement with the lender. Also, in connection with the FPO Transaction, we acquired FPO's 50% and 51% interests in two unconsolidated joint ventures having two mortgage notes with an aggregate principal balance of $82,000, which are secured by two properties (three buildings) owned by such joint ventures.
To partially finance the FPO Transaction, we entered into a commitment letter with Citigroup Global Markets Inc., or Citigroup, pursuant to which, on and subject to the terms and conditions of the commitment letter, Citigroup and a group of institutional lenders committed to provide us a bridge loan facility. In July 2017, we and the lenders terminated this commitment letter and bridge loan facility after we raised the necessary funding for the FPO Transaction from the sale of our common shares and our issuance of senior unsecured notes in July 2017, each as described below. As a result of the termination of this bridge loan facility we recognized a loss on extinguishment of debt of $1,715.
Pursuant to the terms of the FPO Transaction, each unit of limited partnership interest in FPO's operating partnership that was not liquidated on the effective date of the FPO Transaction was exchanged on a one-for-one basis for 5.5% Series A Cumulative Preferred Units of the surviving subsidiary. As of December 31, 2017, there were 1,814 of 5.5% Series A Cumulative Preferred Units outstanding. Beginning on October of each year and ending January 15 of the following year, with the first such period beginning October 1, 2019, holders have the right to redeem their 5.5% Series A Cumulative Preferred Units for cash at $11.15 per unit. Beginning on April 1 of each year and ending June 30 of that year, with the first such period beginning April 1, 2018, we have the right to redeem all or any portion of the outstanding 5.5% Series A Cumulative Preferred
Units for cash at $11.15 per unit. As of December 31, 2017, the carrying value of these 5.5% Series A Cumulative Preferred Units was $20,496 and is recorded as temporary equity on our consolidated balance sheets.
$55,984.
We currently expect to use cash balances, borrowings under our revolving credit facility, net proceeds from our property sales, distributions received from our investments in SIR and RMR Inc., assumptionincurrences or assumptions of mortgage debt and net proceeds from offerings of equitydebt or debtequity securities to fund our future operations, capital expenditures, distributions to our shareholders and property acquisitions. When significant amounts are outstanding under our revolving credit facilitiesfacility or the maturities of our indebtedness approach, we expect to explore refinancing alternatives. Such alternatives may include incurring additional term debt, issuing equitydebt or debtequity securities, extending the maturity date of our revolving credit facility and entering into a new revolving credit facility. We may assume additional mortgage debt in connection with our acquisitions or elect to place new mortgages on properties we own as a source of financing. We may also seek to participate in additional joint venture or other arrangements that may provide us with additional sources of financing. Although we cannot be sure that we will be successful in consummating any particular type of financing, we believe that we will have access to financing, such as debt and equity offerings, to fund future acquisitions and capital expenditures and to pay our obligations. We currently have an effective shelf registration statement that allows us to issue public securities on an expedited basis, but it does not assure that there will be buyers for such securities.
Our ability to obtain, and the costs of, our future debt financings will depend primarily on credit market conditions and our creditworthiness. We have no control over market conditions. Potential investors and lenders likely will evaluate our ability to pay distributions to shareholders, fund required debt service and repay debts when they become due by reviewing our business practices and plans to balance our use of debt and equity capital so that our financial profile and leverage ratios afford us flexibility to withstand any reasonably anticipated adverse changes. Similarly, our ability to raise equity capital in the future will depend primarily upon equity capital market conditions and our ability to conduct our business to maintain and grow our
operating cash flows. We intend to conduct our business in a manner whichthat will afford us reasonable access to capital for investment and financing activities, but we cannot be sure that we will be able to successfully carry out this intention.
In June 2017, both Moody's andSeptember 2018, following our announcement that we entered into a merger agreement for the SIR Merger, S&P updatedaffirmed our credit ratings and revised its outlook to negative as a result of uncertainties arising from the FPO Transaction. Negative outlooks may imply thaton our debt to stable. At the time, Moody’s affirmed our credit ratings may be downgraded unless we areand maintained its negative outlook on our debt. With the substantial completion of our disposition program and successful reduction of our leverage levels, S&P reaffirmed our credit ratings with a stable outlook on our debt in reorganizingOctober 2019 and Moody’s reaffirmed our financial profile.credit ratings and revised its outlook on our debt to stable in December 2019.
On February 23, 2017 and May 22, 2017,During the year ended December 31, 2019, we paid a regular quarterly distributioncash distributions to commonour shareholders of record on January 23, 2017 and April 21, 2017, of $0.43 per share, or $30,606 on each of those dates. On August 21, 2017, we paid a regular quarterly distribution to common shareholders of record on July 24, 2017, of $0.43 per share, or $41,364. On November 20, 2017, we paid a regular quarterly distribution payable to common shareholders of record on October 23, 2017 of $0.43 per share, or $42,633. We funded these distributionstotaling $105,868 using cash on hand and borrowings under our revolving credit facility. On January 19, 2018,16, 2020, we declared a regular quarterly distribution payable to common shareholders of record on January 29, 201827, 2020 in the amount of $0.43$0.55 per share, or $42,633.approximately $26,511. We expect to pay this distribution on or about February 26, 201820, 2020 using cash on hand and borrowings under our revolving credit facility.
On July 5, 2017, For more information regarding the distributions we sold 25,000,000 of our common shares at a price of $18.50 per share in an underwritten public offering. On August 3, 2017, we sold 2,907,029 of our common shares at a price of $18.50 per share pursuant to an overallotment option grantedpaid during 2019, see Note 9 to the underwriters for the July offering. The aggregate net proceeds from these offerings were $493,866, after paymentsNotes to Consolidated Financial Statements included in Part IV, Item 15 of the underwriters' discounts and other offering expenses.this Annual Report on Form 10-K.
On July 20, 2017, we issued $300,000 of 4.000% senior unsecured notes due 2022 in an underwritten public offering. The net proceeds from this offering were $295,399, after payments of the underwriters' discounts and other offering expenses.
The aggregate net proceeds from these equity and debt offerings were used to finance, in part, the FPO Transaction.
As of December 31, 2017,2019, our contractual obligations were as follows: | | | | Payments Due by Period | | | | | | | | | | | |
| | | | Less than | | 1-3 | | 3-5 | | More than | | Payments Due by Period |
Contractual Obligations | | Total | | 1 Year | | Years | | Years | | 5 Years | | Total | | Less than 1 Year | | 1-3 Years | | 3-5 Years | | More than 5 Years |
Long term debt obligations | | $ | 2,263,147 |
| | $ | 3,672 |
| | $ | 1,269,974 |
| | $ | 589,938 |
| | $ | 399,563 |
| | $ | 2,386,209 |
| | $ | 475,707 |
| | $ | 639,938 |
| | $ | 493,784 |
| | $ | 776,780 |
|
Tenant related obligations (1) | | 31,311 |
| | 21,867 |
| | 6,861 |
| | 2,583 |
| | — |
| | 55,984 |
| | 28,252 |
| | 12,858 |
| | 3,610 |
| | 11,264 |
|
Operating leases (2) | | 4,893 |
| | 1,543 |
| | 3,211 |
| | 139 |
| | — |
| |
Operating lease (2) | | | 1,766 |
| | 1,627 |
| | 139 |
| | — |
| | — |
|
Projected interest expense (3) | | 683,284 |
| | 85,549 |
| | 112,834 |
| | 75,471 |
| | 409,430 |
| | 750,211 |
| | 88,395 |
| | 152,850 |
| | 100,855 |
| | 408,111 |
|
Total | | $ | 2,982,635 |
| | $ | 112,631 |
| | $ | 1,392,880 |
| | $ | 668,131 |
| | $ | 808,993 |
| | $ | 3,194,170 |
| | $ | 593,981 |
| | $ | 805,785 |
| | $ | 598,249 |
| | $ | 1,196,155 |
|
their supplements. Our mortgage notes are non-recourse, subject to certain limited exceptions, and do not contain any material financial covenants.
Neither our credit agreement nor our senior unsecured notes indentures and their supplements contain provisions for acceleration which could be triggered by our debtcredit ratings. However, under our credit agreement our highest senior debtcredit rating is used to determine the fees and interest rates we pay. Accordingly, if that debtcredit rating is downgraded, our interest expense and related costs under our credit agreement would increase. As noted above, in June 2017, both Moody's and S&P updated our
Our credit agreement has cross default provisions to other indebtedness that is recourse of $25,000 or more and indebtedness that is non-recourse of $50,000 or more. Similarly, our senior unsecured notes indentures and their supplements contain cross default provisions to any other debts of more than $25,000 (or up to $50,000 in certain circumstances).
We have relationships and historical and continuing transactions with RMR LLC, RMR Inc. and others related to them. For example: we have no employees and the personnel and various services we require to operate our business are provided to us by RMR LLC pursuant to our business management agreement and property management agreementagreements with RMR LLC; RMR Inc. is the managing member of RMR LLC; Adam Portnoy, the Chair of our Board of Trustees and one of our Managing Trustees, is the sole trustee, an officer and the controlling shareholder of ABP Trust, which is controlled by its current sole trustee, our Managing Trustee, is the controlling shareholder of RMR Inc.;, a managing director, the president and chief executive officer of RMR Inc. and an officer and employee of RMR LLC; David Blackman, our other Managing Trustee and our President and Chief Executive Officer, also serves as an officer and employee of RMR LLC, and each of our other officers is also an officer and employee of RMR LLC; and, until July 1, 2019 we ownowned shares of class A common stock of RMR Inc. We also have relationships and historical and continuing transactions with other companies to which RMR LLC providesor its subsidiaries provide management services and some of which may have trustees, directors andor officers who are also trustees, directors or officers of us, RMR LLC or RMR Inc., including: SIR, of which we are the largest shareholder and at December 31, 2017 and February 26, 2018, owned approximately 27.8% of the outstanding SIR common shares; and AIC, of which we, ABP Trust, SIR and four other companies to which RMR LLC provides management services each own 14.3% and which arranges and insures or reinsures in part a combined property insurance program for us and its six other shareholders.
Our critical accounting policies are those that will have the most impact on the reporting of our financial condition and results of operations and those requiring significant judgments and estimates. We believe that our judgments and estimates have been and will be consistently applied and produce financial information that fairly presents our results of operations. Our most critical accounting policies involve our investments in real property and equity securities.property. These policies affect our:
allocation of purchase prices between various asset categories, including allocations to above and below market leases and the related impact on the recognition of rental income and depreciation and amortization expenses; and
We allocate the acquisition cost of each property investment to various property components such as land, buildings and improvements and intangibles based on their relative fair values, and each component generally has a different useful life. For acquired real estate, we record building, land and improvements, and, if applicable, the value of in place leases, the fair market value of above or below market leases and customertenant relationships at fair value. For transactions that qualify as business combinations, we allocate the excess, if any, of the consideration over the fair value of assets acquired to goodwill. We base purchase price allocations and the determination of useful lives on our estimates and, under some circumstances, studies from independent real estate appraisers to provide market information and evaluations, which may involve estimated cash flows that are based on a number of factors, including capitalization rates and discount rates, among others, that are relevant to our purchase price allocations and determinations of useful lives; however, our management is ultimately responsible for the purchase price allocations and determination of useful lives.
We compute depreciation expense using the straight line method over estimated useful lives of up to 40 years for buildings and improvements, and up to 12 years for personal property. We do not depreciate the allocated cost of land. We amortize capitalized above market lease values as a reduction to rental income over the terms of the respective leases. We
amortize capitalized below market lease values as an increase to rental income over the terms of the respective leases. We amortize the value of acquired in place leases exclusive of the value of above market and below market acquired leases to expense over the periods of the respective leases. If a lease is terminated prior to its stated expiration, all unamortized amounts relating to that lease are written off. Purchase price allocations require us to make certain assumptions and estimates. Incorrect assumptions and estimates may result in inaccurate depreciation and amortization charges over future periods.
We periodically evaluate our properties for impairment. Impairment indicators may include declining tenant occupancy, our concerns about a tenant’s financial condition (which may be endangered by a rent default or other information which comes to our attention) or our decision to dispose of an asset before the end of its estimated useful life and legislative, as well as market or industry changes that could permanently reduce the value of a property. If indicators of impairment are present, we evaluate the carrying value of the related property by comparing it to the expected future undiscounted cash flows to be generated from that property. If the sum of these expected future cash flows is less than the carrying value, we reduce the net carrying value of the property to its fair value. This analysis requires us to judge whether indicators of impairment exist and to estimate likely future cash flows. The future net undiscounted cash flows are subjective and are based in part on assumptions regarding hold periods, market rents and terminal capitalization rates. If we misjudge or estimate incorrectly or if future tenant operations, market or industry factors differ from our expectations we may record an impairment charge that is inappropriate or fail to record a charge when we should have done so, or the amount of any such charges may be inaccurate.
These accounting policies involve significant judgments made based upon our experience and the experience of our management and our Board of Trustees, including judgments about current valuations, ultimate realizable value, estimated useful lives, salvage or residual value, the ability and willingness of our tenants to perform their obligations to us, current and future economic conditions and competitive factors in the markets in which our properties are located. Competition, economic conditions, changing government priorities and other factors may cause occupancy declines in the future. In the future, we may need to revise our carrying value assessments to incorporate information which is not now known, and such revisions could increase or decrease our depreciation expense related to properties we own or decrease the carrying values of our assets.
Inflation in the past several years in the United States has been modest, but recently there have been indications of inflation in the U.S. economy and some market forecasts indicate an expectation of increased inflation in the near to intermediate term. Future inflation might have both positive and negative impacts on our business. Inflation might cause the value of our real estate assets to increase. Our government leases generally provide for annual rent increases based on a cost of living index calculation which may mitigate the impact upon us of increased costs as a result of inflation. Further, inflation may permit us to increase rents upon renewal or enter new leases for the leased space for increased rent amounts.
Increases in operating costs as a result of inflation are likely to have modest, if any, impacts on our operating results. This is because most of the operating costs arising in our business are incurred at our properties and our tenants pay most of the property operating cost increases directly or indirectly when we pass through such costs as additional rent under our leases. Increased debt capital costs as a result of inflation are not directly or immediately paid by, or passed through, to our tenants; therefore, such cost increases are more likely to impact our financial results. Over time, however, inflationary debt capital cost increases may be mitigated as leases at our properties expire and new leases are entered which reflect inflationary increases in market rents.
To mitigate the adverse impact of any increased cost of debt capital in the event of material inflation, we may enter into interest rate hedge arrangements in the future. The decision to enter into these agreements will be based on various factors, including the amount of our floating rate debt outstanding, our belief that material interest rate increases are likely to occur, the costs of, and our expected benefit from, these agreements and upon possible requirements of our borrowing arrangements.
Generally, we do not expect inflation to have a material impact on our financial results for the next 12 months or for the current foreseeable future thereafter.
In an effort to reduce the effects of any increased energy costs in the future, we continuously study ways to improve the energy efficiency at all of our properties. Our property manager, RMR LLC, is a member of the Energy Star PartnerENERGY STAR program, a joint program of the U.S. Environmental Protection Agency and the U.S. Department of Energy that is focused on promoting energy efficiency at commercial properties through its “ENERGY STAR” label program, and a member of the U.S. Green Building Council, a nonprofit organization focused on promoting energy efficiency at commercial properties through its LEED® green building program.
Some observers believe severe weather in different parts of the world over the last few years is evidence of global climate change. Severe weather may have an adverse effect on certain properties we own. Rising sea levels could cause flooding at some of our properties, which may have an adverse effect on individual properties we own. We mitigate these risks by procuring, or requiring our tenants to procure, insurance coverage we believe adequate to protect us from material damages and losses resulting from the consequences of losses caused by climate change. However, we cannot be sure that our mitigation efforts will be sufficient or that future storms, rising sea levels or other changes that may occur due to future climate change could not have a material adverse effect on our financial results.
We are exposed to risks associated with market changes in interest rates. We manage our exposure to this market risk by monitoring available financing alternatives. Other than as described below, we do not currently foresee any significant changes in our exposure to fluctuations in interest rates or in how we manage this exposure in the near future.
Changes in market interest rates also would affect the fair value of our fixed rate debt obligations; increases in market interest rates decrease the fair value of our fixed rate debt, while decreases in market interest rates increase the fair value of our fixed rate debt. Based on the balances outstanding at December 31, 2017,2019, and discounted cash flow analyses through the respective maturity dates, and assuming no other changes in factors that may affect the fair value of our fixed rate debt obligations, a hypothetical immediate 100 basisone percentage point increase in interest rates would change the fair value of those obligations by approximately $9,590.
Some of our fixed rate secured debt arrangements allow us to make repayments earlier than the stated maturity date. In some cases, we are not allowed to make early repayment prior to a cutoff date and we are generally allowed to make prepayments only at a premium equal to a make whole amount, as defined, which is generally designed to preserve a stated yield to the note holder. These prepayment rights may afford us opportunities to mitigate the risk of refinancing our debts at maturity at higher rates by refinancing prior to maturity.
The information required by this item is included in Item 15 of this Annual Report on Form 10-K.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
As of the end of the period covered by this Annual Report on Form 10-K, our management carried out an evaluation, under the supervision and with the participation of our then Managing Trustees, our President and Chief OperatingExecutive Officer and our Chief Financial Officer and Treasurer, of the effectiveness of our disclosure controls and procedures pursuant to Rules 13a-15 and 15d-15 under the Exchange Act. Based upon that evaluation, our then Managing Trustees, our President and Chief Executive Officer and our Chief Financial Officer and Treasurer concluded that our disclosure controls and procedures are effective.
There have been no changes in our internal control over financial reporting during the quarter ended December 31, 20172019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
We are responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system is designed to provide reasonable assurance to our management and Board of Trustees regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Ernst & Young LLP, the independent registered public accounting firm that audited our 20172019 Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K, has issued an attestation report on our internal control over financial reporting. Its report appears elsewhere herein.
None.
We have a Code of Conduct that applies to our officers and Trustees, RMR Inc. and RMR LLC, senior level officers of RMR LLC, senior level officers and directors of RMR Inc. and certain other officers and employees of RMR LLC. Our Code of Conduct is posted on our website, www.govreit.com.www.opireit.com. A printed copy of our Code of Conduct is also available free of charge to any person who requests a copy by writing to our Secretary, GovernmentOffice Properties Income Trust, Two Newton Place, 255 Washington Street, Suite 300, Newton, MA 02458-1634. We intend to disclosesatisfy the requirements under Item 5.05 of Form 8-K regarding disclosure of any amendments to, or waivers tofrom, our Code of Conduct applicablethat apply to our principal executive officer, principal financial officer, principal accounting officer or controller, (or any personor persons performing similar functions)functions, on our website.
The remainder of the information required by Item 10 is incorporated by reference to our definitive Proxy Statement.
The information required by Item 11 is incorporated by reference to our definitive Proxy Statement.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by Item 13 is incorporated by reference to our definitive Proxy Statement.
The information required by Item 14 is incorporated by reference to our definitive Proxy Statement.
The following consolidated financial statements and financial statement schedule of GovernmentOffice Properties Income Trust are included on the pages indicated:
All other schedules for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions, or are inapplicable, and therefore have been omitted.
(+) Management contract or compensatory plan or arrangement.
Item 16. Form 10-K Summary
None.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’sCompany's internal control over financial reporting as of December 31, 2017,2019, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework), and our report dated February 26, 201820, 2020 expressed an unqualified opinion thereon.
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 20172019 and 2016,2018, the related consolidated statements of comprehensive income (loss), shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2017,2019, and the related notes and financial statement schedule listed in the Index at item 15(a), and our report dated February 26, 201820, 2020 expressed an unqualified opinion thereon.
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Assessment of Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.
Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.