Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended June 30, 2014

 

OR

 

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

 

Commission File Number 1-9317

 

EQUITY COMMONWEALTH

(Exact Name of Registrant as Specified in Its Charter)

 

Maryland

 

04-6558834

(State or Other Jurisdiction of Incorporation or
Organization)

 

(IRS Employer Identification No.)

 

Two North Riverside Plaza, Suite 600, Chicago, IL

 

60606

(Address of Principal Executive Offices)

 

(Zip Code)

 

(312) 646-2800

(Registrant’s Telephone Number, Including Area Code)

 

CommonWealth REIT

Two Newton Place, 255 Washington Street

Suite 300, Newton, MA  02458

(Former Name or Former Address, if Changed Since Last Report)

 

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

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check One):

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

 

Number of registrant’s common shares of beneficial interest, $0.01 par value per share, outstanding as of August 5, 2014:  128,870,903.

 

 

 



Table of Contents

 

EQUITY COMMONWEALTH

 

FORM 10-Q

 

June 30, 2014

 

INDEX

 

 

 

Page

 

 

 

PART I

Financial Information

 

 

 

 

Item 1.

Financial Statements (unaudited)

 

 

 

 

 

Condensed Consolidated Balance Sheets — June 30, 2014 and December 31, 2013

1

 

 

 

 

Condensed Consolidated Statements of Operations — Three and Six Months Ended June 30, 2014 and 2013

2

 

 

 

 

Condensed Consolidated Statements of Comprehensive Income (Loss) — Three and Six Months Ended June 30, 2014 and 2013

3

 

 

 

 

Condensed Consolidated Statements of Cash Flows — Six Months Ended June 30, 2014 and 2013

4

 

 

 

 

Notes to Condensed Consolidated Financial Statements

6

 

 

 

Item 2.

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

26

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

47

 

 

 

Item 4.

Controls and Procedures

50

 

 

 

PART II

Other Information

 

 

 

 

Item 1.

Legal Proceedings

51

 

 

 

Item 1A.

Risk Factors

55

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

56

 

 

 

Item 3.

Defaults Upon Senior Securities

56

 

 

 

Item 4.

Mine Safety Disclosures

57

 

 

 

Item 5.

Other Information

57

 

 

 

Item 6.

Exhibits

57

 

 

 

 

Signatures

61

 



Table of Contents

 

References in this Quarterly Report on Form 10-Q to the “Company”, “EQC”, “we”, “us” or “our” refer to Equity Commonwealth and its consolidated subsidiaries, as of June 30, 2014, unless the context indicates otherwise.

 

EXPLANATORY NOTE

 

The financial information presented in this Quarterly Report on Form 10-Q includes the results of operations of Select Income REIT, or SIR, for periods prior to July 2, 2013 when SIR was EQC’s consolidated subsidiary, unless the context indicates otherwise.  SIR is itself a public company that has common shares registered under the Securities Exchange Act of 1934, as amended.  On July 2, 2013, SIR completed an underwritten public offering of its common shares, at which time we ceased to own a majority of SIR’s common shares.  Accordingly, following July 2, 2013, we did not consolidate our investment in SIR, but instead accounted for such investment under the equity method.  On July 9, 2014, we sold our entire stake of 22,000,000 common shares of SIR and thus no longer hold any interest in SIR.

 

For further information about SIR, please see SIR’s periodic reports and other filings with the Securities and Exchange Commission, or the SEC, which are available at the SEC’s website at www.sec.gov.  References in this Quarterly Report on Form 10-Q to SIR’s filings with the SEC are included as textual references only, and the information in SIR’s filings with the SEC is not incorporated by reference into this Quarterly Report on Form 10-Q.

 

i



Table of Contents

 

PART I.      Financial Information

 

Item 1.         Financial Statements.

 

EQUITY COMMONWEALTH

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(amounts in thousands, except share data)

(unaudited)

 

 

 

June 30,

 

December 31,

 

 

 

2014

 

2013

 

ASSETS

 

 

 

 

 

Real estate properties:

 

 

 

 

 

Land

 

$

748,302

 

$

699,135

 

Buildings and improvements

 

5,146,617

 

4,838,030

 

 

 

5,894,919

 

5,537,165

 

Accumulated depreciation

 

(956,057

)

(895,059

)

 

 

4,938,862

 

4,642,106

 

Properties held for sale

 

 

573,531

 

Acquired real estate leases, net

 

227,197

 

255,812

 

Equity investments

 

531,862

 

517,991

 

Cash and cash equivalents

 

428,373

 

222,449

 

Restricted cash

 

22,829

 

22,101

 

Rents receivable, net of allowance for doubtful accounts of $7,451 and $7,885, respectively

 

238,033

 

223,769

 

Other assets, net

 

206,204

 

188,675

 

Total assets

 

$

6,593,360

 

$

6,646,434

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

Revolving credit facility

 

$

235,000

 

$

235,000

 

Senior unsecured debt, net

 

1,856,373

 

1,855,900

 

Mortgage notes payable, net

 

895,231

 

914,510

 

Liabilities related to properties held for sale

 

 

28,734

 

Accounts payable and accrued expenses

 

138,412

 

165,855

 

Assumed real estate lease obligations, net

 

31,354

 

33,935

 

Rent collected in advance

 

29,266

 

27,553

 

Security deposits

 

13,852

 

11,976

 

Due to related persons

 

22,984

 

9,385

 

Total liabilities

 

3,222,472

 

3,282,848

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Preferred shares of beneficial interest, $0.01 par value: 50,000,000 shares authorized;

 

 

 

 

 

Series D preferred shares; 6 1/2% cumulative convertible; 4,916,997 and 15,180,000 shares issued and outstanding, respectively, aggregate liquidation preference of $122,925 and $379,500, respectively

 

119,286

 

368,270

 

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

 

265,391

 

265,391

 

Common shares of beneficial interest, $0.01 par value: 350,000,000 shares authorized; 128,859,923 and 118,386,918 shares issued and outstanding, respectively

 

1,289

 

1,184

 

Additional paid in capital

 

4,483,653

 

4,213,474

 

Cumulative net income

 

2,235,673

 

2,209,840

 

Cumulative other comprehensive loss

 

(21,205

)

(38,331

)

Cumulative common distributions

 

(3,111,868

)

(3,082,271

)

Cumulative preferred distributions

 

(601,331

)

(573,971

)

Total shareholders’ equity

 

3,370,888

 

3,363,586

 

Total liabilities and shareholders’ equity

 

$

6,593,360

 

$

6,646,434

 

 

See accompanying notes.

 

1



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EQUITY COMMONWEALTH

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(amounts in thousands, except per share data)

(unaudited)

 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

Revenues:

 

 

 

 

 

 

 

 

 

Rental income

 

$

172,407

 

$

210,013

 

$

344,447

 

$

421,313

 

Tenant reimbursements and other income

 

42,787

 

52,175

 

88,007

 

103,487

 

Total revenues

 

215,194

 

262,188

 

432,454

 

524,800

 

 

 

 

 

 

 

 

 

 

 

Expenses:

 

 

 

 

 

 

 

 

 

Operating expenses

 

92,701

 

104,105

 

194,432

 

208,235

 

Depreciation and amortization

 

59,831

 

63,459

 

111,480

 

126,029

 

General and administrative

 

24,097

 

21,049

 

48,945

 

37,712

 

Loss on asset impairment

 

22,683

 

 

17,922

 

 

Acquisition related costs

 

 

145

 

5

 

773

 

Total expenses

 

199,312

 

188,758

 

372,784

 

372,749

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

15,882

 

73,430

 

59,670

 

152,051

 

 

 

 

 

 

 

 

 

 

 

Interest and other income

 

281

 

249

 

665

 

704

 

Interest expense (including net amortization of debt discounts, premiums and deferred financing fees of ($300), $265, ($609) and $873, respectively)

 

(37,899

)

(43,320

)

(75,834

)

(95,216

)

Loss on early extinguishment of debt

 

 

 

 

(60,027

)

(Loss) gain on sale of equity investments

 

(33

)

 

(33

)

66,293

 

Gain on issuance of shares by an equity investee

 

16,911

 

 

17,020

 

 

(Loss) income from continuing operations before income tax expense and equity in earnings of investees

 

(4,858

)

30,359

 

1,488

 

63,805

 

Income tax expense

 

(908

)

(754

)

(1,463

)

(1,742

)

Equity in earnings of investees

 

12,454

 

159

 

23,388

 

4,421

 

Income from continuing operations

 

6,688

 

29,764

 

23,413

 

66,484

 

Discontinued operations:

 

 

 

 

 

 

 

 

 

Income from discontinued operations

 

4,114

 

1,643

 

8,125

 

1,637

 

Loss on asset impairment from discontinued operations

 

(2,072

)

(4,589

)

(2,360

)

(8,535

)

Loss on early extinguishment of debt from discontinued operations

 

(3,345

)

 

(3,345

)

 

Net gain on sale of properties from discontinued operations

 

 

2,099

 

 

3,359

 

Income before gain on sale of properties

 

5,385

 

28,917

 

25,833

 

62,945

 

Gain on sale of properties

 

 

 

 

1,596

 

Net income

 

5,385

 

28,917

 

25,833

 

64,541

 

Net income attributable to noncontrolling interest in consolidated subsidiary

 

 

(10,028

)

 

(19,985

)

Net income attributable to Equity Commonwealth

 

5,385

 

18,889

 

25,833

 

44,556

 

Preferred distributions

 

(6,982

)

(11,151

)

(18,133

)

(22,302

)

Distribution on conversion of preferred shares

 

(16,205

)

 

(16,205

)

 

Net (loss) income available for Equity Commonwealth common shareholders

 

$

(17,802

)

$

7,738

 

$

(8,505

)

$

22,254

 

 

 

 

 

 

 

 

 

 

 

Amounts attributable to Equity Commonwealth common shareholders:

 

 

 

 

 

 

 

 

 

(Loss) income from continuing operations

 

$

(16,499

)

$

8,585

 

$

(10,925

)

$

25,793

 

Income from discontinued operations

 

4,114

 

1,643

 

8,125

 

1,637

 

Loss on asset impairment from discontinued operations

 

(2,072

)

(4,589

)

(2,360

)

(8,535

)

Loss on early extinguishment of debt from discontinued operations

 

(3,345

)

 

(3,345

)

 

Net gain on sale of properties from discontinued operations

 

 

2,099

 

 

3,359

 

Net (loss) income

 

$

(17,802

)

$

7,738

 

$

(8,505

)

$

22,254

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding — basic and diluted

 

123,812

 

118,309

 

121,121

 

106,298

 

 

 

 

 

 

 

 

 

 

 

Basic and diluted earnings per common share attributable to Equity Commonwealth common shareholders:

 

 

 

 

 

 

 

 

 

(Loss) income from continuing operations

 

$

(0.13

)

$

0.07

 

$

(0.09

)

$

0.24

 

(Loss) income from discontinued operations

 

$

(0.01

)

$

(0.01

)

$

0.02

 

$

(0.03

)

Net (loss) income available for common shareholders

 

$

(0.14

)

$

0.07

 

$

(0.07

)

$

0.21

 

 

 

 

 

 

 

 

 

 

 

Distributions declared per common share

 

$

 

$

0.25

 

$

0.25

 

$

0.50

 

 

See accompanying notes.

 

2



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EQUITY COMMONWEALTH

 

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(amounts in thousands)

(unaudited)

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

5,385

 

$

28,917

 

$

25,833

 

$

64,541

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss), net of tax:

 

 

 

 

 

 

 

 

 

Unrealized gain on derivative instruments

 

627

 

2,782

 

1,627

 

3,833

 

Foreign currency translation adjustments

 

4,961

 

(37,821

)

15,548

 

(36,848

)

Equity in unrealized income (loss) of an investee

 

(69

)

(146

)

(49

)

(162

)

Total comprehensive income (loss)

 

10,904

 

(6,268

)

42,959

 

31,364

 

 

 

 

 

 

 

 

 

 

 

Less: comprehensive income attributable to noncontrolling interest in consolidated subsidiary

 

 

(9,996

)

 

(19,949

)

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss) attributable to Equity Commonwealth

 

$

10,904

 

$

(16,264

)

$

42,959

 

$

11,415

 

 

See accompanying notes.

 

3



Table of Contents

 

EQUITY COMMONWEALTH

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(amounts in thousands)

(unaudited)

 

 

 

Six Months Ended June 30,

 

 

 

2014

 

2013

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

25,833

 

$

64,541

 

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

 

 

 

 

 

Depreciation

 

80,512

 

96,006

 

Net amortization of debt discounts, premiums and deferred financing fees

 

(612

)

913

 

Straight line rental income

 

(7,201

)

(19,798

)

Amortization of acquired real estate leases

 

27,806

 

33,060

 

Other amortization

 

9,579

 

9,806

 

Loss on asset impairment

 

20,282

 

8,535

 

Loss on early extinguishment of debt

 

3,345

 

60,027

 

Equity in earnings of investees

 

(23,388

)

(4,421

)

Loss (gain) on sale of equity investments

 

33

 

(66,293

)

Gain on issuance of shares by an equity investee

 

(17,020

)

 

Distributions of earnings from investees

 

20,680

 

4,111

 

Net gain on sale of properties

 

 

(4,955

)

Other non-cash expenses

 

18,402

 

 

Change in assets and liabilities:

 

 

 

 

 

Restricted cash

 

641

 

966

 

Rents receivable and other assets

 

(19,856

)

(22,449

)

Accounts payable and accrued expenses

 

(7,833

)

(15,737

)

Rent collected in advance

 

(2,339

)

(7,730

)

Security deposits

 

241

 

122

 

Due to related persons

 

47

 

(3

)

Cash provided by operating activities

 

129,152

 

136,701

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Real estate acquisitions

 

 

(165,110

)

Real estate improvements

 

(60,437

)

(53,908

)

Principal payments received from direct financing lease

 

3,612

 

3,444

 

Proceeds from sale of properties, net

 

185,179

 

33,863

 

Proceeds from sale of equity investments, net

 

5,776

 

239,576

 

Distributions in excess of earnings from investees

 

 

168

 

Increase in restricted cash

 

(1,369

)

(2,349

)

Cash provided by investing activities

 

132,761

 

55,684

 

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Proceeds from issuance of common shares, net

 

 

626,809

 

Repurchase and retirement of outstanding debt securities

 

 

(728,021

)

Proceeds from borrowings

 

 

936,000

 

Payments on borrowings

 

(15,998

)

(962,207

)

Deferred financing fees

 

 

(1,200

)

Distributions to common shareholders

 

(29,597

)

(50,527

)

Distributions to preferred shareholders

 

(11,151

)

(22,302

)

Distributions to noncontrolling interest in consolidated subsidiary

 

 

(14,863

)

Cash used in financing activities

 

(56,746

)

(216,311

)

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

757

 

(773

)

 

 

 

 

 

 

Increase (decrease) in cash and cash equivalents

 

205,924

 

(24,699

)

Cash and cash equivalents at beginning of period

 

222,449

 

102,219

 

Cash and cash equivalents at end of period

 

$

428,373

 

$

77,520

 

 

See accompanying notes.

 

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Table of Contents

 

EQUITY COMMONWEALTH

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(amounts in thousands)

(unaudited)

 

 

 

Six Months Ended June 30,

 

 

 

2014

 

2013

 

 

 

 

 

 

 

SUPPLEMENTAL CASH FLOW INFORMATION:

 

 

 

 

 

Interest paid

 

$

77,120

 

$

109,108

 

Taxes paid

 

2,732

 

1,134

 

 

 

 

 

 

 

NON-CASH INVESTING ACTIVITIES:

 

 

 

 

 

Investment in real estate mortgage receivable

 

$

 

$

(7,688

)

 

See accompanying notes.

 

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Table of Contents

 

EQUITY COMMONWEALTH

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Note 1.  Basis of Presentation

 

The accompanying condensed consolidated financial statements of Equity Commonwealth and its subsidiaries, or the Company, EQC, we, us or our, have been prepared without audit.  Certain information and footnote disclosures required by U.S. generally accepted accounting principles, or GAAP, for complete financial statements have been condensed or omitted.  We believe the disclosures made are adequate to make the information presented not misleading.  However, the accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes contained in our Annual Report on Form 10-K for the year ended December 31, 2013, or our Annual Report.  In the opinion of our management, all adjustments, which include only normal recurring adjustments considered necessary for a fair presentation, have been included.  All intercompany transactions and balances with or among our subsidiaries have been eliminated.  Operating results for interim periods are not necessarily indicative of the results that may be expected for the full year.  Reclassifications have been made to the prior years’ financial statements to conform to the current year’s presentation.

 

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

 

Note 2.  Recent Accounting Pronouncements

 

In April 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, No. 2014-08, Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity, or ASU 2014-08.  ASU 2014-08 changes the criteria for reporting a discontinued operation.  Under the new pronouncement, a disposal of a part of an organization that has a major effect on its operations and financial results is a discontinued operation.  We are required to adopt ASU 2014-08 prospectively for all disposals of components of our business classified as held for sale during fiscal periods beginning after December 15, 2014 and are currently evaluating what impact, if any, its adoption will have to the presentation of our condensed consolidated financial statements.

 

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which provides guidance for revenue recognition. This update is effective for interim and annual reporting periods beginning after December 15, 2016.  We are currently in the process of evaluating the impact, if any, the adoption of this ASU will have on our condensed consolidated financial statements.

 

Note 3.  Board of Trustees

 

On March 18, 2014, Related Fund Management, LLC, or Related, and Corvex Management LP, or together, Related/Corvex, delivered to us written consents which they represented were from a sufficient number of holders of our outstanding common shares to remove all of our then Trustees and any other person or persons elected or appointed to our Board of Trustees prior to the effective time of the Related/Corvex removal proposal. After inspection, our then Board of Trustees determined that holders of more than two-thirds of our outstanding common shares as of the February 18, 2014 record date consented to the Related/Corvex proposal, reaching the threshold required to remove all of our then Trustees and any other person or persons appointed as a Trustee prior to the effective time of the Related/Corvex removal proposal. Accordingly, on March 25, 2014, all of our then Trustees, or our Prior Trustees, certified their removal as Trustees of EQC.

 

On May 23, 2014, at a special meeting of our shareholders, or the Special Meeting, the following seven individuals were elected to serve on our Board of Trustees, or the New Board of Trustees: Sam Zell, who serves as the Chairman of the New Board of Trustees, James S. Corl, Edward A. Glickman, David A. Helfand, Peter Linneman, James L. Lozier, Jr. and Kenneth Shea.  Each of the foregoing individuals was nominated to serve on the New Board of Trustees by Related/Corvex.

 

Note 4.  Real Estate Properties

 

During the six months ended June 30, 2014, we made improvements to our properties totaling $47.0 million.

 

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Table of Contents

 

EQUITY COMMONWEALTH

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

Property Sales:

 

We classify all properties that meet the criteria outlined in the Property, Plant and Equipment Topic of the FASB Accounting Standards Codification, or the Codification, as held for sale, as such on our condensed consolidated balance sheets.  As of June 30, 2014, we had no properties classified as held for sale.  On June 27, 2014, we sold one central business district, or CBD, property (two buildings) and 13 suburban properties (41 buildings) with a combined 2,784,098 square feet for an aggregate sales price of $215.9 million, excluding mortgage debt repayments and closing costs.  In conjunction with this transaction, we recognized a loss on asset impairment of $2.4 million and a loss on early extinguishment of debt of $3.3 million.  These properties were previously classified as held for sale as of both March 31, 2014 and December 31, 2013.

 

During March 2014, we ceased to actively market two CBD properties (two buildings) and 29 suburban properties (65 buildings) with a combined 5,641,450 square feet that we had previously classified as held for sale as of December 31, 2013.  These properties were not under agreement for sale when our Prior Trustees were removed in March 2014.  These properties were reclassified to properties held and used in operations because they no longer meet the requirements under GAAP for classification as held for sale.  Operating results for these properties were reclassified from discontinued operations to continuing operations for all periods presented herein.  In connection with this reclassification, we reversed previously recorded impairment losses totaling $4.8 million, which includes the elimination of estimated costs to sell.

 

Results of operations for properties sold or held for sale are included in discontinued operations in our condensed consolidated statements of operations once the criteria for discontinued operations in the Presentation of Financial Statements Topic of the Codification are met.  Summarized balance sheet information for all properties classified as held for sale and income statement information for all properties sold is as follows (in thousands):

 

Balance Sheet:

 

 

 

December 31,
2013

 

 

 

 

 

 

 

Real estate properties

 

$

536,552

 

 

 

 

 

 

 

Acquired real estate leases

 

6,937

 

 

 

 

 

 

 

Rents receivable

 

14,180

 

 

 

 

 

 

 

Other assets, net

 

15,862

 

 

 

 

 

 

 

Properties held for sale

 

$

573,531

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Mortgage notes payable

 

$

20,018

 

 

 

 

 

 

 

Assumed real estate lease obligations

 

2,070

 

 

 

 

 

 

 

Rent collected in advance

 

4,043

 

 

 

 

 

 

 

Security deposits

 

2,603

 

 

 

 

 

 

 

Liabilities related to properties held for sale

 

$

28,734

 

 

 

 

 

 

 

 

Income Statements:

 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

Rental income

 

$

6,962

 

$

15,122

 

$

14,236

 

$

30,634

 

Tenant reimbursements and other income

 

801

 

2,081

 

1,323

 

3,812

 

Total revenues

 

7,763

 

17,203

 

15,559

 

34,446

 

 

 

 

 

 

 

 

 

 

 

Operating expenses

 

3,375

 

10,028

 

6,854

 

21,592

 

Depreciation and amortization

 

 

3,930

 

 

7,883

 

General and administrative

 

 

1,169

 

3

 

2,456

 

Total expenses

 

3,375

 

15,127

 

6,857

 

31,931

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

4,388

 

2,076

 

8,702

 

2,515

 

 

 

 

 

 

 

 

 

 

 

Interest and other income

 

 

9

 

 

12

 

Interest expense

 

(274

)

(442

)

(577

)

(890

)

Income from discontinued operations

 

$

4,114

 

$

1,643

 

$

8,125

 

$

1,637

 

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

Note 5.  Investment in Direct Financing Lease

 

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

 

 

 

June 30,

 

December 31,

 

 

 

2014

 

2013

 

Total minimum lease payments receivable

 

$

18,937

 

$

22,986

 

Estimated unguaranteed residual value of leased asset

 

4,951

 

4,951

 

Unearned income

 

(7,737

)

(8,174

)

Net investment in direct financing lease

 

$

16,151

 

$

19,763

 

 

We monitor the payment history and credit profile of the tenant and have determined that no allowance for losses related to our direct financing lease was necessary at June 30, 2014 and December 31, 2013.  The direct financing lease has an expiration date in 2045.

 

Note 6.  Equity Investments

 

At June 30, 2014 and December 31, 2013, we had the following equity investments in Select Income REIT, or SIR, Government Properties Income Trust, or GOV, and Affiliates Insurance Company, or AIC (dollars in thousands):

 

 

 

Ownership Percentage

 

Equity Investments

 

Equity in Earnings (Loss)

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

December 31,

 

June 30,

 

December 31,

 

June 30,

 

June 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

2014

 

2013

 

2014

 

2013

 

SIR

 

36.7

%

44.2

%

$

531,862

 

$

512,078

 

$

12,412

 

$

 

$

23,444

 

$

 

GOV

 

0.0

%

0.0

%

 

 

 

 

 

4,111

 

AIC

 

0.0

%

12.5

%

 

5,913

 

42

 

159

 

(56

)

310

 

 

 

 

 

 

 

$

531,862

 

$

517,991

 

$

12,454

 

$

159

 

$

23,388

 

$

4,421

 

 

At June 30, 2014, we owned 22,000,000, or approximately 36.7%, of the common shares of beneficial interest of SIR, with a carrying value of $531.9 million and a market value, based on quoted market prices, of $652.1 million ($29.64 per share).  SIR is a real estate investment trust, or REIT, that is primarily focused on owning and investing in net leased, single tenant properties and was one of our consolidated subsidiaries until July 2, 2013.  On July 2, 2013, our ownership percentage of SIR was reduced to below 50% and we began accounting for our investment in SIR under the equity method.  Under the equity method, we record our percentage share of net earnings of SIR in our consolidated statements of operations.  Prior to July 2, 2013, the operating results and investments

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

of SIR were included in our consolidated results of operations and financial position.  On July 2, 2013, our share of the underlying equity of SIR exceeded our carrying value by $17.6 million.  As required under GAAP, we are amortizing this difference to equity in earnings of investees over a 34 year period, which approximates the average remaining useful lives of the buildings owned by SIR as of July 2, 2013.  If we determine there is an “other than temporary” decline in the fair value of this investment, we would record a charge to earnings as determined under applicable accounting standards.

 

During the second quarter of 2014, SIR issued 10,000,000 common shares in a public offering for $29.00 per common share, raising net proceeds (after deducting underwriters’ discounts and commissions and expenses) of approximately $277.4 million.  We recognized a gain on this sale by an equity investee of $16.9 million as a result of the per share sales price of this transaction being above our per share carrying value.  Our ownership percentage in SIR was reduced to 36.7% after this transaction.

 

During the six months ended June 30, 2014, we received cash distributions from SIR totaling $20.7 million.

 

The following summarized financial data of SIR as reported in SIR’s Quarterly Report on Form 10-Q for the period ended June 30, 2014, or the SIR Quarterly Report, includes the results of operations for periods prior to July 2, 2013 (the date on which SIR ceased to be our consolidated subsidiary), which are included on a consolidated basis in our condensed consolidated results of operations when SIR was our consolidated subsidiary.  References in our financial statements to the SIR Quarterly Report are included as references to the source of the data only, and the information in the SIR Quarterly Report is not incorporated by reference into our financial statements.  Amounts are in thousands, except per share data.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

Condensed Consolidated Balance Sheets:

 

 

 

June 30,

 

December 31,

 

 

 

 

 

 

 

2014

 

2013

 

 

 

 

 

Real estate properties, net

 

$

1,773,316

 

$

1,579,234

 

 

 

 

 

Acquired real estate leases, net

 

125,571

 

129,426

 

 

 

 

 

Cash and cash equivalents

 

20,804

 

20,025

 

 

 

 

 

Rents receivable, net

 

59,557

 

55,335

 

 

 

 

 

Other assets, net

 

17,643

 

17,839

 

 

 

 

 

Total assets

 

$

1,996,891

 

$

1,801,859

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revolving credit facility

 

$

74,000

 

$

159,000

 

 

 

 

 

Term loan

 

350,000

 

350,000

 

 

 

 

 

Mortgage notes payable

 

19,103

 

27,147

 

 

 

 

 

Assumed real estate lease obligations, net

 

27,020

 

26,966

 

 

 

 

 

Other liabilities

 

40,465

 

40,055

 

 

 

 

 

Shareholders’ equity

 

1,486,303

 

1,198,691

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

1,996,891

 

$

1,801,859

 

 

 

 

 

 

Condensed Consolidated Statements of Income:

 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

Rental income

 

$

48,465

 

$

38,706

 

$

93,528

 

$

76,164

 

Tenant reimbursements and other income

 

8,092

 

7,240

 

16,057

 

13,642

 

Total revenues

 

56,557

 

45,946

 

109,585

 

89,806

 

 

 

 

 

 

 

 

 

 

 

Operating expenses

 

9,985

 

9,011

 

19,964

 

16,885

 

Depreciation and amortization

 

10,495

 

7,295

 

19,789

 

13,960

 

Acquisition related costs

 

136

 

156

 

374

 

689

 

General and administrative

 

2,198

 

2,957

 

7,374

 

5,676

 

Total expenses

 

22,814

 

19,419

 

47,501

 

37,210

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

33,743

 

26,527

 

62,084

 

52,596

 

 

 

 

 

 

 

 

 

 

 

Interest expense

 

(3,634

)

(3,779

)

(6,992

)

(7,252

)

Gain on early extinguishment of debt

 

 

 

243

 

 

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

 

30,109

 

22,748

 

55,335

 

45,344

 

Income tax expense

 

(19

)

(40

)

(90

)

(80

)

Equity in earnings of an investee

 

118

 

79

 

21

 

155

 

Net income

 

$

30,208

 

$

22,787

 

$

55,266

 

$

45,419

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

54,178

 

39,288

 

52,021

 

39,285

 

 

 

 

 

 

 

 

 

 

 

Net income per common share

 

$

0.56

 

$

0.58

 

$

1.06

 

$

1.16

 

 

On July 9, 2014, we sold our entire stake of 22,000,000 common shares of SIR, for $32.04 per share, raising aggregate gross proceeds of $704.8 million.  As a result of this sale, we no longer hold any interest in SIR.  See Note 15 for additional information regarding SIR.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

As of May 9, 2014, we had a net investment of $5.8 million in AIC, an insurance company that was owned in equal proportion until May 9, 2014 by us, our manager Reit Management & Research LLC, or RMR, GOV, SIR and four other companies to which RMR provides management services.  On May 9, 2014, as a result of the removal of the Prior Trustees and in accordance with the terms of the shareholders agreement between us and the other AIC shareholders, the other AIC shareholders exercised their right to purchase all of the 20,000 shares of AIC we then owned.  We received $5.8 million in aggregate proceeds from this sale.  We no longer own any interest in AIC.  Our participation in the AIC property insurance program expired in June 2014.  See Note 15 for additional information about our investment in AIC.

 

Note 7.  Real Estate Mortgages Receivable

 

As of June 30, 2014 and December 31, 2013, we had total real estate mortgages receivable with an aggregate carrying value of $8.1 million included in other assets in our condensed consolidated balance sheets.  We provided mortgage financing totaling $7.7 million at 6.0% per annum in connection with our sale of three suburban office and industrial properties (18 buildings) in January 2013 in Dearborn, MI; this real estate mortgage requires monthly interest payments and matures on January 24, 2023.  We also provided mortgage financing totaling $0.4 million at 6.0% per annum in connection with our sale of a suburban office property in Salina, NY in April 2012; this real estate mortgage requires monthly interest payments and matures on April 30, 2019.

 

Note 8.  Shareholders’ Equity

 

Common Share Issuances:

 

On January 28, 2014, we granted 2,000 common shares of beneficial interest, par value $0.01 per share, valued at $23.46 per share, the closing price of our common shares on the New York Stock Exchange, or NYSE, on that day, to two of our former Trustees as part of their then annual compensation.

 

On February 7, 2014, March 7, 2014, April 7, 2014, May 7, 2014, June 6, 2014 and July 8, 2014, we issued 12,187, 10,625, 11,410, 11,275, 11,729 and 10,980 common shares, respectively, to RMR pursuant to the amended and restated business management agreement discussed in Note 15.

 

On May 14, 2014, we issued 10,411,779 common shares to holders of 10,263,003 series D preferred shares who elected to exercise their Fundamental Change Conversion Right, as discussed below, and converted their series D preferred shares into our common shares.

 

Share Awards:

 

As a result of the removal of our Prior Trustees on March 25, 2014, the vesting of 130,914 common shares previously issued to our former officers and certain employees of RMR pursuant to our equity compensation plans accelerated in accordance with the terms of their governing share grants.  During the six months ended June 30, 2014, we recorded $3.4 million of compensation expense related to the vesting of these shares.

 

Common and Preferred Share Distributions:

 

On February 15, 2014, we paid a quarterly distribution on our series D cumulative convertible preferred shares, or series D preferred shares, of $0.4063 per share, or $6.2 million, and a quarterly distribution on our series E preferred shares of $0.4531 per share, or $5.0 million, both of which were paid to shareholders of record as of February 1, 2014.

 

On February 21, 2014, we paid a quarterly distribution on our common shares of $0.25 per share, or $29.6 million, to shareholders of record as of January 13, 2014.

 

Under our governing documents and Maryland law, distributions to our shareholders are to be authorized and declared by our Board of Trustees, and our Prior Trustees were removed on March 25, 2014.  Additionally, the removal of our Prior Trustees constituted an event of default under our term loan and revolving credit facility agreements, under which we generally are prevented from making any distributions or paying any dividends during the pendency of an event of default.  As a result of the foregoing, we

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

were unable to declare and pay dividends between March 25, 2014 and June 6, 2014, the date on which we obtained waivers of the aforementioned events of default from our lenders.  As of June 30, 2014, distributions in arrears for our series D preferred shares and our series E preferred shares totaled $3.0 million, or $0.6094 per share, and $7.5 million, or $0.6797 per share, respectively.

 

On July 25, 2014, our Board of Trustees declared a dividend of $0.8125 per series D preferred share to be paid on August 15, 2014 to shareholders of record on August 5, 2014.  This dividend includes the accrued dividend of $0.40625 per share for the period from February 15, 2014 to May 14, 2014 and the accrued dividend of $0.40625 per share for the period from May 15, 2014 to August 14, 2014.  On July 25, 2014, our Board of Trustees also declared a dividend of $0.90625 per series E preferred share to be paid on August 15, 2014 to shareholders of record on August 5, 2014.  This dividend includes the accrued dividend of $0.453125 per share for the period from February 15, 2014 to May 14, 2014 and the accrued dividend of $0.453125 per share for the period from May 15, 2014 to August 14, 2014.  The aggregate amounts of $0.8125 and $0.90625 that will be paid to the holders of series D preferred shares and series E preferred shares, respectively, represent the full amounts of accrued and unpaid dividends under the series D preferred shares and the series E preferred shares, respectively.

 

Series D Preferred Shares:

 

The removal of our Prior Trustees on March 25, 2014 triggered a Fundamental Change Conversion Right of the series D preferred shares, as defined in our Articles Supplementary dated October 10, 2006, setting forth the terms of the series D preferred shares.  Pursuant to such right, the holders of series D preferred shares had the option to elect to convert all or any portion of their series D preferred shares at any time from April 9, 2014 until the close of business on May 14, 2014 into a number of common shares per $25.00 liquidation preference of the series D preferred shares equal to the sum of such $25.00 liquidation preference plus accrued and unpaid dividends to, but not including, May 14, 2014, divided by 98% of the average of the closing sale prices of the common shares for the five consecutive trading days ending on May 9, 2014, or the Fundamental Change Conversion Rate.  We calculated the Fundamental Change Conversion Rate as 1.0145 common shares per $25.00 liquidation preference.  May 14, 2014 was the last day upon which holders of the series D preferred shares could exercise their Fundamental Change Conversion Right.  As of the close of business on May 14, 2014, the holders of 10,263,003 series D preferred shares elected to exercise their Fundamental Change Conversion Right and converted their series D preferred shares into 10,411,779 of our common shares.  As a result of this transaction, we recorded a distribution of $16.2 million, for the excess of the market value of the common shares issued above the carrying value of the series D preferred shares redeemed.  As of June 30, 2014, we had 4,916,997 outstanding series D preferred shares that were convertible into 2,363,969 of our common shares.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

Note 9.  Cumulative Other Comprehensive Income (Loss)

 

The following tables presents the amounts recognized in cumulative other comprehensive income (loss) by component for the three and six months ended June 30, 2014 (in thousands):

 

 

 

Three Months Ended June 30, 2014

 

 

 

Unrealized

 

Foreign

 

Equity in

 

 

 

 

 

Gain (Loss)

 

Currency

 

Unrealized

 

 

 

 

 

on Derivative

 

Translation

 

Gain (Loss) of

 

 

 

 

 

Instruments

 

Adjustments

 

an Investee

 

Total

 

 

 

 

 

 

 

 

 

 

 

Balances as of March 31, 2014

 

$

(10,706

)

$

(16,060

)

$

42

 

$

(26,724

)

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss) before reclassifications

 

(632

)

4,961

 

15

 

4,344

 

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

 

1,259

 

 

(84

)

1,175

 

Net current period other comprehensive income (loss)

 

627

 

4,961

 

(69

)

5,519

 

 

 

 

 

 

 

 

 

 

 

Balances as of June 30, 2014

 

$

(10,079

)

$

(11,099

)

$

(27

)

$

(21,205

)

 

 

 

Six Months Ended June 30, 2014

 

 

 

Unrealized

 

Foreign

 

Equity in

 

 

 

 

 

Gain (Loss)

 

Currency

 

Unrealized

 

 

 

 

 

on Derivative

 

Translation

 

Gain (Loss) of

 

 

 

 

 

Instruments

 

Adjustments

 

an Investee

 

Total

 

 

 

 

 

 

 

 

 

 

 

Balances as of December 31, 2013

 

$

(11,706

)

$

(26,647

)

$

22

 

$

(38,331

)

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss) before reclassifications

 

(861

)

15,548

 

42

 

14,729

 

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

 

2,488

 

 

(91

)

2,397

 

Net current period other comprehensive income (loss)

 

1,627

 

15,548

 

(49

)

17,126

 

 

 

 

 

 

 

 

 

 

 

Balances as of June 30, 2014

 

$

(10,079

)

$

(11,099

)

$

(27

)

$

(21,205

)

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

The following tables presents reclassifications out of cumulative other comprehensive income (loss) for the three and six months ended June 30, 2014 (in thousands):

 

Three Months Ended June 30, 2014

 

 

 

Amounts Reclassified from

 

 

 

Details about Cumulative Other

 

Cumulative Other Comprehensive

 

Affected Line Items in the

 

Comprehensive Income (Loss) Components

 

Income (Loss) to Net Income

 

Statement of Operations

 

 

 

 

 

 

 

Interest rate swap contracts

 

$

1,259

 

Interest expense

 

 

 

 

 

 

 

Unrealized gains and losses on available for sale securities

 

(7

)

Equity in earnings of investees

 

 

 

 

 

 

 

Realized gains and losses on available for sale securities

 

(77

)

(Loss) gain on sale of equity investments

 

 

 

$

1,175

 

 

 

 

Six Months Ended June 30, 2014

 

 

 

Amounts Reclassified from

 

 

 

Details about Cumulative Other

 

Cumulative Other Comprehensive

 

Affected Line Items in the

 

Comprehensive Income (Loss) Components

 

Income (Loss) to Net Income

 

Statement of Operations

 

 

 

 

 

 

 

Interest rate swap contracts

 

$

2,488

 

Interest expense

 

 

 

 

 

 

 

Unrealized gains and losses on available for sale securities

 

(14

)

Equity in earnings of investees

 

 

 

 

 

 

 

Realized gains and losses on available for sale securities

 

(77

)

(Loss) gain on sale of equity investments

 

 

 

$

2,397

 

 

 

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

Note 10.  Indebtedness

 

Prepayments:

 

On March 11, 2014, we prepaid $12.0 million of 4.95% mortgage debt using cash on hand.

 

On June 27, 2014, we repaid $11.2 million of 6.14% mortgage debt and $8.5 million of 5.78% mortgage debt in connection with the sale of the related properties and recognized a loss on early extinguishment of debt of $3.3 million from prepayment premiums and the write-off of unamortized discounts and deferred financing fees.

 

Unsecured Revolving Credit Facility and Unsecured Term Loan:

 

We have a $750.0 million unsecured revolving credit facility that matures on October 19, 2015, that is used for general business purposes, including acquisitions.  We also have a $500.0 million unsecured term loan that matures on December 15, 2016.  The removal of our Prior Trustees on March 25, 2014 constituted an event of default under our revolving credit facility and term loan agreements.  As a consequence, the lenders under each of these agreements became entitled to exercise certain remedies, including the right to accelerate their loans and to require that their loans bear interest at the post-default rate.  Effective as of April 11, 2014, we entered into separate forbearance agreements regarding our revolving credit facility and term loan agreements.  Pursuant to each forbearance agreement, the applicable lenders agreed, on and subject to the terms and conditions set forth therein, to forbear during the period (which period would have expired on June 13, 2014, but for the waivers and amendments described below) from exercising certain of their rights and remedies under the revolving credit facility or term loan, as applicable, including, without limitation, their right to accelerate repayment of the loans thereunder and to require that the loans bear interest at the post-default rate.  Following the election of our New Board of Trustees on May 23, 2014, we requested that the lenders provide waivers of these events of default.  Effective as of June 6, 2014, we obtained such waivers and amended the revolving credit facility and term loan agreements.  Pursuant to these amendments and waivers, the lenders waived the events of default arising from the removal of our Prior Trustees, and each of the revolving credit facility and term loan agreements was amended to:

 

·                  remove as “Material Contracts” (i) the Business Management Agreement, dated as of June 8, 2009, as amended, by and between us and RMR, and (ii) the Amended and Restated Property Management Agreement, dated as of January 21, 2010, by and between us and RMR;

 

·                  revise the change of control Event of Default (as defined in each of the revolving credit facility and term loan agreements) so that failure of RMR to act as sole business and property manager no longer constitutes a change of control thereunder; and

 

·                  revise the change of control Event of Default to increase from 25% to 35% the level of voting power with respect to the Company’s shares that constitutes a change of control if acquired by any person or group.

 

In addition, the forbearance agreements were deemed to be terminated upon effectiveness of these amendments and waivers, other than certain provisions thereof relating to the release of claims against, and confirming no waivers by, the lenders.

 

Borrowings under our revolving credit facility bear interest at LIBOR plus a premium, which was 150 basis points as of June 30, 2014.  We also pay a facility fee of 35 basis points per annum on the total amount of lending commitments under our revolving credit facility.  Both the interest rate premium and the facility fee are subject to adjustment based upon changes to our credit ratings.  As of June 30, 2014, the interest rate payable on borrowings under our revolving credit facility was 1.6%.  The weighted average interest rate for borrowings under our revolving credit facility was 1.7% for both the six months ended June 30, 2014 and 2013, respectively.   As of June 30, 2014, we had $235.0 million outstanding under our revolving credit facility.  On July 18, 2014, we paid off the entire balance of $235.0 million on our revolving credit facility.

 

Our term loan bears interest at a rate of LIBOR plus a premium, which was 185 basis points as of June 30, 2014.  The interest rate premium is subject to adjustment based upon changes to our credit ratings.  As of June 30, 2014, the interest rate for the amount outstanding under our term loan was 2.0%.  The weighted average interest rate for the amount outstanding under our term loan was 2.0% and 2.1% for the six months ended June 30, 2014 and 2013, respectively.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

Credit Facility and Term Loan Debt Covenants:

 

Our public debt indenture and related supplements, our revolving credit facility agreement and our term loan agreement contain a number of financial and other covenants, including covenants that restrict our ability to incur indebtedness or to make distributions under certain circumstances and require us to maintain financial ratios and a minimum net worth.  At June 30, 2014, we believe we were in compliance with all of our respective covenants under our public debt indenture and related supplements, our revolving credit facility and our term loan agreements.

 

Mortgage Debt:

 

At June 30, 2014, 12 of our properties (17 buildings) costing $1,220.5 million with an aggregate net book value of $1,059.1 million secured mortgage notes totaling $895.2 million (including net premiums and discounts) maturing from 2015 through 2026.

 

During the quarter ended June 30, 2014, we made the decision to cease making loan servicing payments on One Enterprise Center in Jacksonville, Florida.  The first payment we determined not to make for this property was due on June 11, 2014.  The property is secured by a non-recourse mortgage loan, with a current principal balance of $40.1 million.

 

On August 1, 2014, we prepaid at par the $265.0 million non-recourse mortgage loan on two buildings in Chicago, IL.

 

Note 11.  Income Taxes

 

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

 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

State

 

$

227

 

$

162

 

$

261

 

$

325

 

Foreign

 

681

 

592

 

1,202

 

1,417

 

Income tax provision

 

$

908

 

$

754

 

$

1,463

 

$

1,742

 

 

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EQUITY COMMONWEALTH

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

Note 12.  Fair Value of Assets and Liabilities

 

The table below presents certain of our assets and liabilities measured at fair value during 2014, categorized by the level of inputs used in the valuation of each asset and liability (dollars in thousands):

 

 

 

 

 

Fair Value at Reporting Date Using

 

 

 

 

 

Quoted Prices in

 

 

 

Significant

 

 

 

 

 

Active Markets for

 

Significant Other

 

Unobservable

 

 

 

 

 

Identical Assets

 

Observable Inputs

 

Inputs

 

Description

 

Total

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

 

 

 

 

 

 

 

 

Recurring Fair Value Measurements:

 

 

 

 

 

 

 

 

 

Effective portion of interest rate swap contracts(1)

 

$

(10,079

)

$

 

$

(10,079

)

$

 

 

 

 

 

 

 

 

 

 

 

Non-Recurring Fair Value Measurements:

 

 

 

 

 

 

 

 

 

Properties held and used(2)

 

$

19,589

 

$

 

$

 

$

19,589

 

 


(1)         The fair value of our interest rate swap contracts is determined using the net discounted cash flows of the expected cash flows of each derivative based on the market based interest rate curve (level 2 inputs) and adjusted for our credit spread and the actual and estimated credit spreads of the counterparties (level 3 inputs).  Although we have determined that the majority of the inputs used to value our derivatives fall within level 2 of the fair value hierarchy, the credit valuation adjustments associated with our derivatives utilize level 3 inputs, such as estimates of current credit spreads, to evaluate the likelihood of default by us and the counterparties.  As of June 30, 2014, we have assessed the significance of the impact of the credit valuation adjustments on the overall valuation of our derivative positions and have determined that the credit valuation adjustments are not significant to the overall valuation of our derivatives.  As a result, we have determined that our derivative valuations in their entirety are classified as level 2 inputs in the fair value hierarchy.

(2)         As discussed in Note 10, we made the decision to cease making loan servicing payments on one of our CBD properties in Jacksonville, Florida.  As a result, as of June 30, 2014, we recorded a loss on asset impairment totaling $22.7 million to reduce the aggregate carrying value of this property from $42.3 million to its estimated fair value of $19.6 million.  We used discounted cash flow analysis and third party broker information (level 3 inputs) in determining the fair value of this property.  The valuation techniques and significant unobservable inputs used for our level 3 fair value measurements at June 30, 2014 were as follows:

 

Description

 

Fair Value at 
June 30, 2014

 

Primary
Valuation 
Techniques

 

Unobservable Inputs

 

Range
(Weighted
Average)

 

Properties held and used on which we recognized impairment losses

 

$

19,589

 

Discounted cash flows

 

Discount rate

Exit capitalization rate

 

8% (N/A)

8% (N/A)

 

 

We are exposed to certain risks relating to our ongoing business operations, including the effect of changes in foreign currency exchange rates and interest rates.  The only risk we currently manage by using derivative instruments is a part of our interest rate risk.  Although we have not done so as of June 30, 2014, and have no present intention to do so, we may manage our Australian currency exchange exposure by borrowing in Australian dollars or using derivative instruments in the future, depending on the relative significance of our business activities in Australia at that time.  We have interest rate swap agreements to manage our interest rate risk exposure on $172.4 million of mortgage debt due 2019, which require interest at a premium over LIBOR.  The interest rate swap agreements utilized by us qualify as cash flow hedges and effectively modify our exposure to interest rate risk by converting our floating interest rate debt to a fixed interest rate basis for this loan through December 1, 2016, thus reducing the impact of interest rate changes on future interest expense.  These agreements involve the receipt of floating interest rate amounts in exchange for fixed rate interest payments over the life of the agreements without an exchange of the underlying principal amount.  The fair value of our derivative instruments increased by $0.6 million and $1.6 million during the three and six months ended June 30, 2014, respectively,

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

based primarily on changes in market interest rates.  The fair value of our derivative instruments increased by $2.8 million and $3.8 million during the three and six months ended June 30, 2013, respectively, based primarily on changes in market interest rates.  As of June 30, 2014 and December 31, 2013, the fair value of these derivative instruments included in accounts payable and accrued expenses and cumulative other comprehensive loss in our condensed consolidated balance sheets totaled ($10.1) million and ($11.7) million, respectively. We may enter additional interest rate swaps or hedge agreements to manage some of our additional interest rate risk associated with our floating rate borrowings.  The table below presents the effects of our interest rate derivatives on our condensed consolidated statements of operations and condensed consolidated statements of comprehensive income (loss) for the three and six months ended June 30, 2014 and 2013 (in thousands):

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

Balance at beginning of period

 

$

(10,706

)

$

(15,573

)

$

(11,706

)

$

(16,624

)

Amount of income (loss) recognized in cumulative other comprehensive (loss) income

 

(632

)

1,546

 

(861

)

1,361

 

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

 

1,259

 

1,236

 

2,488

 

2,472

 

Unrealized gain on derivative instruments

 

627

 

2,782

 

1,627

 

3,833

 

Balance at end of period

 

$

(10,079

)

$

(12,791

)

$

(10,079

)

$

(12,791

)

 

Over the next 12 months, we estimate that approximately $4.9 million will be reclassified from cumulative other comprehensive income as an increase to interest expense.

 

In addition to the assets and liabilities described in the above table, our financial instruments include our cash and cash equivalents, rents receivable, investment in direct financing lease receivable, real estate mortgages receivable, restricted cash, revolving credit facility, senior notes and mortgage notes payable, accounts payable and accrued expenses, rent collected in advance, security deposits and amounts due to related persons.  At June 30, 2014 and December 31, 2013, the fair values of these additional financial instruments, excluding mortgage debt related to properties held for sale, were not materially different from their carrying values, except as follows (in thousands):

 

 

 

June 30, 2014

 

December 31, 2013

 

 

 

Carrying

 

Fair

 

Carrying

 

Fair

 

 

 

Amount

 

Value

 

Amount

 

Value

 

Senior notes and mortgage notes payable

 

$

2,079,215

 

$

2,207,239

 

$

2,097,164

 

$

2,143,834

 

 

The fair values of our senior notes and mortgage notes payable are based on estimates using discounted cash flow analyses and currently prevailing interest rates adjusted by credit risk spreads (level 3 inputs).

 

Other financial instruments that potentially subject us to concentrations of credit risk consist principally of rents receivable; however, as of June 30, 2014, no single tenant of ours is responsible for more than 3% of our total annualized rents.

 

Our derivative financial instruments, including interest rate swaps, are entered with major financial institutions and we monitor the amount of credit exposure to any one counterparty.

 

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EQUITY COMMONWEALTH

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

Note 13.  Earnings Per Common Share

 

As of June 30, 2014, we had 4,916,997 series D preferred shares outstanding that were convertible into 2,363,969 of our common shares.  The effect of our convertible preferred shares on income from continuing operations attributable to the Company’s common shareholders per share is anti-dilutive for all periods presented.

 

As discussed in Note 8 above, the removal of our Prior Trustees on March 25, 2014 triggered a Fundamental Change Conversion Right of the series D preferred shares, as defined in our Articles Supplementary dated October 10, 2006, setting forth the terms of the series D preferred shares.  Pursuant to such right, as of the close of business on May 14, 2014, the holders of 10,263,003 series D preferred shares opted to convert their series D preferred shares into 10,411,779 of our common shares.  The issuance of such common shares as a result of this exercise had a dilutive effect on income from continuing operations attributable to Equity Commonwealth common shareholders per share for the three and six months ended June 30, 2014.

 

Note 14.  Segment Information

 

Our primary business is the ownership and operation of a nationwide portfolio of properties.  We account for each of our individual properties as a separate operating segment.  We have aggregated our separate operating segments into two reportable segments based on our primary method of internal reporting: CBD properties and suburban properties.  More than 90% of our CBD and suburban properties are office properties.  Each of our reportable segments includes properties with similar operating and economic characteristics that are subject to unique supply and demand conditions.  Our operating segments (i.e., our individual properties) are managed and operated consistently in accordance with our standard operating procedures, and our management responsibilities do not vary significantly from location to location based on the size of the property or geographic location within each primary reporting segment.  We use property net operating income, or NOI, to evaluate the performance of our operating segments.  We define NOI as income from our real estate including lease termination fees received from tenants less our property operating expenses, which expenses include property marketing costs.  NOI excludes amortization of capitalized tenant improvement costs and leasing commissions.  See Note 6 for financial information relating to SIR.

 

As of June 30, 2014, we owned 40 CBD properties (53 buildings) and 116 suburban properties (209 buildings).  The prior period has been restated to reflect properties reclassified from discontinued operations to continuing operations during 2014.  See Note 4 for additional information regarding our properties and the reasons for this reclassification.

 

Property level information by operating segment for properties classified as held and used in operations as of June 30, 2014, and for the three and six months ended June 30, 2014 and 2013, is as follows (in thousands):

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

 

 

As of June 30,

 

 

 

 

 

 

 

2014

 

2013

 

 

 

 

 

Square feet:

 

 

 

 

 

 

 

 

 

CBD properties

 

21,892

 

22,149

 

 

 

 

 

Suburban properties

 

21,028

 

46,114

 

 

 

 

 

Total properties

 

42,920

 

68,263

 

 

 

 

 

 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

Rental income:

 

 

 

 

 

 

 

 

 

CBD properties

 

$

106,094

 

$

109,600

 

$

216,333

 

$

221,771

 

Suburban properties

 

66,313

 

100,413

 

128,114

 

199,542

 

Total properties

 

$

172,407

 

$

210,013

 

$

344,447

 

$

421,313

 

 

 

 

 

 

 

 

 

 

 

Tenant reimbursements and other income:

 

 

 

 

 

 

 

 

 

CBD properties

 

$

28,465

 

$

30,847

 

$

58,706

 

$

61,955

 

Suburban properties

 

14,322

 

21,328

 

29,301

 

41,532

 

Total properties

 

$

42,787

 

$

52,175

 

$

88,007

 

$

103,487

 

 

 

 

 

 

 

 

 

 

 

NOI:

 

 

 

 

 

 

 

 

 

CBD properties

 

$

71,996

 

$

75,529

 

$

145,166

 

$

154,514

 

Suburban properties

 

50,497

 

82,554

 

92,856

 

162,051

 

Total properties

 

$

122,493

 

$

158,083

 

$

238,022

 

$

316,565

 

 

As of June 30, 2014, our investments in CBD properties and suburban properties, net of accumulated depreciation, were $3,039.2 million and $1,899.7 million, respectively, including $148.9 million of CBD properties and $94.6 million of suburban properties located in Australia.

 

The following table includes the reconciliation of NOI to net income, the most directly comparable financial measure under GAAP reported in our condensed consolidated financial statements.  We consider NOI to be an appropriate supplemental measure to net income because it may help both investors and management to understand the operations of our properties.  We use NOI internally to evaluate individual, regional and combined property level performance, and we believe that NOI provides useful information to investors regarding our results of operations because it reflects only those income and expense items that are incurred at the property level and may facilitate comparisons of our operating performance between periods and with other REITs.  The calculation of NOI excludes certain components of net income in order to provide results that are more closely related to our properties’ results of operations.  NOI does not represent cash generated by operating activities in accordance with GAAP and should not be considered as an alternative to net income, net income attributable to Equity Commonwealth, net income available for Equity Commonwealth common shareholders, operating income or cash flow from operating activities, determined in accordance with GAAP, or as an indicator of our financial performance or liquidity, nor is this measure necessarily indicative of sufficient cash flow to fund all of our needs.  This measure should be considered in conjunction with net income, net income attributable to Equity Commonwealth, net income available for Equity Commonwealth common shareholders, operating income and cash flow from operating activities as presented in our condensed consolidated statements of operations, condensed consolidated statements of comprehensive income (loss) and condensed consolidated statements of cash flows.  Other REITs and real estate companies may calculate NOI differently than we do.  A reconciliation of NOI to net income for the three and six months ended June 30, 2014 and 2013, is as follows (in thousands):

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

Rental income

 

$

172,407

 

$

210,013

 

$

344,447

 

$

421,313

 

Tenant reimbursements and other income

 

42,787

 

52,175

 

88,007

 

103,487

 

Operating expenses

 

(92,701

)

(104,105

)

(194,432

)

(208,235

)

NOI

 

$

122,493

 

$

158,083

 

$

238,022

 

$

316,565

 

 

 

 

 

 

 

 

 

 

 

NOI

 

$

122,493

 

$

158,083

 

$

238,022

 

$

316,565

 

Depreciation and amortization

 

(59,831

)

(63,459

)

(111,480

)

(126,029

)

General and administrative

 

(24,097

)

(21,049

)

(48,945

)

(37,712

)

Loss on asset impairment

 

(22,683

)

 

(17,922

)

 

Acquisition related costs

 

 

(145

)

(5

)

(773

)

Operating income

 

15,882

 

73,430

 

59,670

 

152,051

 

 

 

 

 

 

 

 

 

 

 

Interest and other income

 

281

 

249

 

665

 

704

 

Interest expense

 

(37,899

)

(43,320

)

(75,834

)

(95,216

)

Loss on early extinguishment of debt

 

 

 

 

(60,027

)

(Loss) gain on sale of equity investments

 

(33

)

 

(33

)

66,293

 

Gain on issuance of shares by an equity investee

 

16,911

 

 

17,020

 

 

(Loss) income from continuing operations before income tax expense and equity in earnings of investees

 

(4,858

)

30,359

 

1,488

 

63,805

 

Income tax expense

 

(908

)

(754

)

(1,463

)

(1,742

)

Equity in earnings of investees

 

12,454

 

159

 

23,388

 

4,421

 

Income from continuing operations

 

6,688

 

29,764

 

23,413

 

66,484

 

Income from discontinued operations

 

4,114

 

1,643

 

8,125

 

1,637

 

Loss on asset impairment from discontinued operations

 

(2,072

)

(4,589

)

(2,360

)

(8,535

)

Loss on early extinguishment of debt from discontinued operations

 

(3,345

)

 

(3,345

)

 

Net gain on sale of properties from discontinued operations

 

 

2,099

 

 

3,359

 

Income before gain on sale of properties

 

5,385

 

28,917

 

25,833

 

62,945

 

Gain on sale of properties

 

 

 

 

1,596

 

Net income

 

$<