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SIR > SEC Filings for SIR > Form 10-Q on 2-Nov-2012All Recent SEC Filings

Show all filings for SELECT INCOME REIT

Form 10-Q for SELECT INCOME REIT


2-Nov-2012

Quarterly Report


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

The following discussion of our financial condition and results of operations should be read together with our condensed consolidated financial statements and notes thereto included in this Quarterly Report on Form 10-Q and with the Combined Financial Statements of Selected Properties of CommonWealth REIT as of December 31, 2011 and 2010 and for the three years in the period ended December 31, 2011 and notes thereto contained in our Prospectus.

OVERVIEW

As of September 30, 2012, we owned 260 properties, located in 17 states, that contain approximately 23.9 million rentable square feet and were approximately 94.9% leased (based upon rentable square feet). For the three months ended September 30, 2012, approximately 58.3% of our total revenue was from 228 properties with 17.7 million rentable square feet we own on the island of Oahu, Hawaii. The remainder of our total revenue for the three months ended September 30, 2012 was from 32 properties located throughout the mainland United States.

Property Operations



As of September 30, 2012, 94.9% of our rentable square feet was leased, compared
to 95.2% of our rentable square feet as of September 30, 2011.  Occupancy data
for 2012 and 2011 is as follows (square feet and dollars in thousands):



                                 All Properties         Comparable Properties (1)
                               As of September 30,         As of September 30,
                                2012         2011          2012            2011
Total properties                    260          251            250             250
Total rentable square feet       23,907       21,424         21,274          21,326
Percent leased (2)                94.9%        95.2%          94.3%           95.2%



(1) Includes properties that were owned continuously since January 1, 2011 by CWH until contributed to us on February 16, 2012.

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

The average annualized effective rental rate per square foot, as defined below, for our properties for the periods ended September 30, 2012 and 2011 are as follows:

                                              Three Months Ended          Nine Months Ended
                                                September 30,               September 30,
                                              2012          2011          2012          2011
Average annualized effective rental

rate per square foot (1) $ 5.75 $ 5.16 $ 5.51 $ 5.21



(1) Average annualized effective rental rate per square foot represents annualized total revenue during the period specified divided by the average rentable square feet leased during the period specified.

During the three months ended September 30, 2012, we executed a rent reset at a property located in Hawaii for approximately 105,000 square feet of land, which had a reset rate that was approximately 42.9% higher than the prior rate. In addition, we entered lease renewals and new leases for approximately 134,000 square feet during the quarter ended September 30, 2012. The weighted average lease term for lease renewals and new leases entered into during the third quarter of 2012 was 5.6 years. Commitments for tenant improvement, leasing commission costs and concessions for leases entered during the quarter ended September 30, 2012 totaled approximately $252,000, or approximately $0.34 per square foot per year of the weighted average lease term. All renewal and new leasing activity during the quarter ended September 30, 2012 occurred at our properties located in Hawaii.

We currently believe that U.S. leasing market conditions are slowly improving, but remain weak in many U.S. markets. However, because our weighted average remaining lease term (based on annualized rental revenue, as defined below) was approximately 12.1 years as of September 30, 2012, we do not expect our occupancy rate to materially change through the end of 2012. In addition, despite the recent recession and incomplete recovery of the U.S. economy, revenues from our properties located in Hawaii, which represented approximately 58.3% of our total rental revenue for the three months ended September 30, 2012, have generally increased under CWH's prior ownership as leases for those properties have reset or renewed. Nevertheless, because of the current U.S. and global economic uncertainty, there are too many variables for us to reasonably project what the financial impact of changing market conditions will be on our occupancy, rents or financial results.


As shown in the table below, approximately 2.5% of our rented square feet and approximately 1.2% of total annualized rental revenue are included in leases scheduled to expire by December 31, 2012. Lease renewals and rental rates for which available space may be relet in the future will depend on prevailing market conditions at the times these renewals, new leases and rent reset rates are negotiated. However, all of our leases scheduled to expire through December 31, 2014 relate to properties located in Oahu, Hawaii, and, as stated above, revenues from our properties in Hawaii have generally increased during our and CWH's prior ownership as the leases for those properties have been reset or renewed. As of September 30, 2012, lease expirations by year are as follows (square feet and dollars in thousands):

                                                                                                                 Cumulative
                                                                      Cumulative                   Percent of    Percent of
                                                        Percent of    Percent of                      Total         Total
                            Number of                      Total         Total       Annualized    Annualized    Annualized
                           Tenants with     Rented        Rented        Rented         Rental        Rental        Rental
                             Expiring     Square Feet   Square Feet   Square Feet     Revenue        Revenue       Revenue
Year                          Leases      Expiring(1)   Expiring(1)   Expiring(1)   Expiring(2)    Expiring(2)   Expiring(2)
2012                                 16           565          2.5%          2.5%   $      1,702          1.2%          1.2%
2013                                 12           267          1.2%          3.7%          1,589          1.2%          2.4%
2014                                 11           153          0.7%          4.4%            795          0.6%          3.0%
2015                                 20           549          2.4%          6.8%          5,491          4.0%          7.0%
2016                                 20         1,285          5.7%         12.5%          8,846          6.5%         13.5%
2017                                  9           411          1.8%         14.3%          5,730          4.2%         17.7%
2018                                  9         1,510          6.7%         21.0%         14,241         10.4%         28.1%
2019                                 12         1,765          7.8%         28.8%          6,807          5.0%         33.1%
2020                                  5           318          1.4%         30.2%          4,348          3.2%         36.3%
2021                                  5           566          2.5%         32.7%          2,072          1.5%         37.8%
Thereafter                          136        15,295         67.3%        100.0%         84,743         62.2%        100.0%
                                    255        22,684        100.0%                 $    136,364        100.0%

Weighted average
remaining lease term (in
years)                                           12.9                                                     12.1



(1) Rented square feet is pursuant to existing leases as of September 30, 2012, and includes (i) space being fitted out for occupancy pursuant to existing leases and (ii) space which is leased but is not occupied or is being offered for sublease by tenants.

(2) Annualized rental revenue is the annualized contractual rents from our tenants pursuant to existing leases as of September 30, 2012, including straight line rent adjustments and estimated recurring expense reimbursements, but excluding lease value amortization.

A majority of our Hawaii properties are lands leased for rents that are periodically reset based on fair market values, generally every five to ten years. The following chart shows the annualized rental revenue as of September 30, 2012 scheduled to reset at our Hawaii lands.


                     Scheduled Rent Resets At Hawaii Lands

                             (dollars in thousands)



                           Annualized
                        Rental Revenue(1)
                       as of September 30,
                              2012
                            Scheduled
                            to Reset
2012                  $               2,839
2013                                  9,150
2014                                  7,494
2015 and thereafter                  17,572
Total                 $              37,055



(1) Annualized rental revenue is the annualized contractual rents from our tenants pursuant to existing leases as of September 30, 2012, including straight line rent adjustments and estimated recurring expense reimbursements, but excluding lease value amortization.

We intend to continue to negotiate with our tenants as rents under their leases are scheduled to reset in order to achieve new rents based on the then current fair market values. If we are unable to reach agreement with a tenant on a rent reset, our Hawaii land leases typically provide that rent is reset based on an appraisal process, and many of the previous rent resets at our Hawaii lands which have resulted in an increase in rent have been determined by an appraisal process during our and CWH's prior ownership. Despite CWH's and our prior experience with rent resets in Hawaii, our ability to increase rents when rent resets occur depends upon market conditions which are beyond our control. Accordingly, we can provide no assurance that the historical increases in rents which we and CWH have achieved in the past will be repeated in the future, and it is possible that rents could reset to a lower level if fair market values decrease.

We intend to seek to renew or extend the terms of leases relating to our mainland properties when they expire. Because these properties are each leased to a single tenant, because of the capital many of these tenants have invested into the improvements and because our properties may be of strategic importance to the each tenant's business, we believe that there is a greater likelihood that these tenants will renew or extend their leases when they expire as compared to tenants in a property with multiple tenants. However, we also believe that if a building previously occupied by a single tenant becomes vacant, it may take longer and cost more to locate a new tenant than when space becomes vacant in a multi-tenant property. 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.

Our principal source of funds for our operations to pay our debt service and our distributions to shareholders is rents from tenants at our properties. Rents are generally received from our tenants monthly in advance. As of September 30, 2012, tenants representing 1% or more of our total annualized rental revenues were as follows (square feet in thousands):


Tenants Representing 1% or More of Our Total Annualized Rental Revenues:



                                                                                  % of
                                                              % of Total    Annualized Rental
Tenant                          Property Type   Sq. Ft. (1)   Sq. Ft. (1)      Revenue (2)          Expiration
                                Mainland
 1   Cinram Group, Inc.         Properties            1,371          6.0%                6.8%       8/30/2032
                                Mainland
 2   Novell, Inc.               Properties              406          1.8%                5.8%       11/30/2024
                                Mainland
 3   The Southern Company       Properties              448          2.0%                3.5%       12/31/2018
                                                                                                    4/30/2019;
     Tesoro Hawaii              Hawaii                                                             12/31/2019;
 4   Corporation                Properties            3,148         13.9%                3.1%       3/31/2024
                                Mainland
 5   Bookspan                   Properties              502          2.2%                2.7%       9/23/2028
     Shurtape Technologies,     Mainland
 6   LLC                        Properties              645          2.8%                2.6%       5/28/2024
     Stratus                    Mainland
 7   Technologies, Inc.         Properties              287          1.3%                2.5%       5/31/2016
                                Mainland
 8   Micron Technology, Inc     Properties               96          0.4%                2.4%       4/30/2020
                                Hawaii                                                              1/31/2029;
 9   Servco Pacific, Inc.       Properties              537          2.4%                2.2%       2/29/2032
     Colgate - Palmolive        Mainland
10   Company                    Properties              142          0.6%                2.2%       1/31/2024
     Arrowhead General          Mainland
11   Insurance Agency, Inc      Properties               95          0.4%                1.8%       7/26/2019
     Valassis                   Mainland
12   Communications, Inc.       Properties              268          1.2%                1.8%       9/30/2023
     Sprint Nextel              Mainland
13   Corporation                Properties              140          0.6%                1.7%       7/31/2018
     Allied Building Products   Hawaii
14   Corporation                Properties              310          1.4%                1.7%       12/31/2028
     BCI Coca-Cola Bottling     Hawaii                                                             12/31/2022;
15   Company                    Properties              351          1.5%                1.7%       7/31/2039
                                Hawaii
16   Safeway Stores, Inc.       Properties              146          0.6%                1.6%       10/31/2018
     Manheim Services           Hawaii
17   Corporation                Properties              338          1.5%                1.6%       5/31/2016
                                Mainland
18   Mattson Technology, Inc.   Properties              101          0.4%                1.5%       5/31/2017
                                Mainland
19   Cisco Systems, Inc.        Properties              149          0.7%                1.5%       12/31/2015
                                Hawaii
20   AES Hawaii, Inc.           Properties            1,242          5.5%                1.5%       3/31/2040
     Kaiser Foundation Health   Hawaii                                                              4/30/2026;
21   Plan                       Properties              217          1.0%                1.3%       6/30/2046
     Waikiki Pearl              Hawaii
22   Company, Inc.              Properties              278          1.2%                1.2%       12/31/2029
                                Mainland
23   Element K                  Properties               95          0.4%                1.1%       12/31/2017
                                Hawaii
24   Pahounui Partners, LLC     Properties              191          0.8%                1.1%       6/30/2027
                                Mainland
25   US Airways Group, Inc.     Properties              101          0.4%                1.1%       8/31/2015
                                Mainland
26   Trex Company, Inc.         Properties              308          1.4%                1.0%       12/31/2021
                                Mainland
27   TPI Composites, Inc.       Properties              317          1.4%                1.0%       7/31/2018
     Total                                           12,229         53.9%               58.0%



(1) Square feet is pursuant to existing leases as of September 30, 2012, and includes (i) space being fitted out for occupancy and (ii) space which is leased but is not occupied or is being offered for sublease.

(2) Annualized rental revenue is the annualized contractual rents from our tenants pursuant to existing leases as of September 30, 2012, including straight line rent adjustments and estimated recurring expense reimbursements, but excluding lease value amortization.

Investment Activities

On February 16, 2012, CWH contributed the Properties to us. In return, we issued to CWH: (i) 22,000,000 common shares (including 1,000 common shares initially issued to CWH on December 21, 2011 in connection with our formation) and
(ii) the CWH Note.

Since February 16, 2012, we have acquired nine properties with a combined 2,534,979 square feet for an aggregate purchase price of $260.7 million, excluding closing costs. As of November 1, 2012, we have agreed to acquire five properties with a combined 506,592 rentable square feet for an aggregate purchase price of $132.4 million, excluding closing costs. Our agreements to acquire additional properties are subject to conditions typical of commercial real estate transactions, including completion of our diligence. Accordingly there can be no assurance that we will acquire all or any of these properties. For more information regarding properties that we have acquired, see Note 4 to our Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q, which is incorporated herein by reference.

Our strategy related to property acquisitions and dispositions is materially unchanged from that disclosed in our Prospectus. We anticipate seeking to negotiate with tenants at our Hawaii properties as rents under their leases are scheduled to reset. We may explore redevelopment opportunities at some of our Hawaii properties as leases expire. We also intend to seek to expand our portfolio by acquiring additional single tenant properties. We expect that most of our acquisition efforts will focus on office and industrial properties; however, we may consider acquiring other types of properties, including properties which are net leased to single tenants for retail uses and properties specifically suited to particular tenants' requirements.


Financing Activities

On February 16, 2012, CWH contributed the Properties to us. In return, we issued to CWH: (i) 22,000,000 common shares (including 1,000 common shares initially issued to CWH on December 21, 2011 in connection with our formation) and
(ii) the CWH Note.

On March 12, 2012, we issued 9,200,000 common shares in connection with our IPO, including 1,200,000 shares issued when the underwriters exercised in full their over allotment option, at a price of $21.50 per share, raising net proceeds of approximately $180.8 million. We used the net proceeds from our IPO and drawings under our revolving credit facility to repay in full the CWH Note.

Simultaneous with the closing of our IPO, we entered into a $500.0 million revolving credit facility that is available for general business purposes, including acquisitions. The revolving credit facility is scheduled to mature on March 11, 2016, and, subject to our payment of an extension fee and meeting certain other conditions, we have an option to extend the stated maturity date by one year. Borrowings under the revolving credit facility bear interest at LIBOR plus a spread. We also pay a per annum facility fee on the total amount of lending commitments under our revolving credit facility. Both the interest rate spread and the facility fee are subject to adjustment based upon changes to our debt leverage or credit ratings. As of September 30, 2012, our revolving credit facility spread was 130 basis points and our facility fee was 30 basis points. As of September 30, 2012, the interest rate payable on borrowings under the revolving credit facility was 1.52%, and we had $92.0 million of borrowings and $408.0 million available for additional borrowings under the revolving credit facility.

On July 12, 2012, we amended the revolving credit facility. As a result of this amendment, the pledge agreement that we and certain of our subsidiaries had previously entered into was terminated, and the equity of our subsidiaries that had been pledged pursuant to that pledge agreement as collateral for our and our subsidiary guarantors' obligations under the revolving credit facility was released.

Simultaneous with amending the revolving credit agreement, we entered into a five year $350.0 million unsecured term loan with a group of institutional lenders. The term loan matures on July 11, 2017 and is prepayable without penalty at any time. In addition, the term loan includes a feature under which maximum borrowings may be increased to up to $700.0 million in certain circumstances. The amount outstanding under the term loan bears interest at LIBOR plus a spread that is subject to adjustment based upon changes to our debt leverage or credit ratings. As of September 30, 2012, the term loan spread was 155 basis points and the interest rate payable on the amount outstanding under the term loan was 1.78%. We used the net proceeds of our term loan to repay amounts outstanding under our revolving credit facility and deposited excess proceeds into interest bearing cash accounts to fund general business activities, including acquisitions.

There have been recent governmental inquires regarding the setting of LIBOR, which may result to changes to the process that could have the effect of increasing LIBOR. Increases in LIBOR would increase the amount of interest we pay under our revolving credit facility and term loan.

Our revolving credit facility and our term loan include various financial and other covenants that generally restrict our ability to incur debts in excess of calculated amounts, restrict our ability to make distributions under certain circumstances and require us to maintain certain financial ratios. We believe we were in compliance with the terms of our revolving credit facility and term loan covenants at September 30, 2012.

In September 2012, we assumed a mortgage totaling $18.5 million, which was recorded at a fair value of approximately $20.0 million, in connection with our acquisition in Carlsbad, CA. This mortgage bears interest at a rate of 5.950%, requires monthly principal and interest payments and matures in 2017.

Also in September 2012, we assumed a mortgage totaling $7.5 million, which was recorded at a fair value of approximately $7.9 million, in connection with our acquisition in Chelmsford, MA. This mortgage bears interest at a rate of 5.689%, requires monthly interest only payments and matures in 2016 with the ability to prepay at our option beginning in 2014.


RESULTS OF OPERATIONS



Three Months Ended September 30, 2012, Compared to Three Months Ended
September 30, 2011 (dollars in thousands, except per share data)



                                Comparable Properties Results (1)              Acquired Properties Results (2)                    Consolidated Results
                                Three Months Ended September 30,              Three Months Ended September 30,              Three Months Ended September 30,
                                                        $         %                                   $         %                                  $          %
                              2012         2011      Change    Change       2012         2011       Change    Change      2012        2011       Change    Change
Revenues
Rental income              $   22,450    $  22,338   $   112      0.5%   $     3,994    $     -    $  3,994        -   $   26,444   $  22,338   $  4,106     18.4%
Tenant reimbursements
and other income                4,058        4,583      (525 ) (11.5)%           376          -         376        -        4,434       4,583       (149 )  (3.3)%
Total revenues             $   26,508    $  26,921   $  (413 )  (1.5)%   $     4,370    $     -    $  4,370        -   $   30,878   $  26,921   $  3,957     14.7%

Operating expenses
Real estate taxes               3,732        3,912      (180 )  (4.6)%           163          -         163        -        3,895       3,912        (17 )  (0.4)%
Other operating expenses        1,568        2,223      (655 ) (29.5)%           247          -         247        -        1,815       2,223       (408 ) (18.4)%
Total operating expenses        5,300        6,135      (835 ) (13.6)%           410          -         410        -        5,710       6,135       (425 )  (6.9)%

Net operating income (3)   $   21,208    $  20,786   $   422      2.0%   $     3,960    $     -    $  3,960        -       25,168      20,786      4,382     21.1%

Other expenses
Depreciation and
amortization                                                                                                                3,888       2,884      1,004     34.8%
Acquisition related
costs                                                                                                                         583           -        583         -
General and
administrative                                                                                                              2,626       1,405      1,221     86.9%
Total other expenses                                                                                                        7,097       4,289      2,808     65.5%
Operating income                                                                                                           18,071      16,497      1,574      9.5%
Interest expense                                                                                                           (2,467 )         -     (2,467 )       -
Equity in earnings of an
. . .
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