Easterly Government Properties, Inc. 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion of our results of operations and financial condition in conjunction with the audited consolidated financial statements and related notes thereto as of December 31, 2020 and 2019 and for the years ended December 31, 2020, 2019 and 2018 and the sections entitled “Risk Factors,” “Forward Looking Statements,” “Business,” and “Properties” contained elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those discussed in the sections of this Annual Report on Form 10-K entitled “Risk Factors” and “Forward Looking Statements.” Our Company References to “Easterly,” “we,” “our,” “us” and “our company” refer to Easterly Government Properties, Inc., a Maryland corporation, together with our consolidated subsidiaries including Easterly Government Properties LP, a Delaware limited partnership, which we refer to herein as our operating partnership. We are an internally managed real estate investment trust, or REIT, focused primarily on the acquisition, development and management of Class A commercial properties that are leased to U.S. Government agencies that serve essential functions. We generate substantially all of our revenue by leasing our properties to such agencies, either directly or through the U.S. General Services Administration, which we refer to herein as the GSA. Our objective is to generate attractive risk-adjusted returns for our stockholders over the long term through dividends and capital appreciation. We focus on acquiring, developing and managing U.S. Government-leased properties that are essential to supporting the mission of the tenant agency and strive to be a partner of choice for the U.S. Government, working closely with the tenant agency to meet its needs and objectives. As of December 31, 2020, we wholly owned 79 operating properties in the United States, encompassing approximately 7.3 million leased square feet in the aggregate, including 77 operating properties that were leased primarily to U.S. Government tenant agencies and two operating properties that were entirely leased to private tenants. As of December 31, 2020, our operating properties were 99% leased. For purposes of calculating percentage leased, we exclude from the denominator total square feet that was unleased and to which we attributed no value at the time of acquisition. In addition, we wholly owned one property under development that we expect will encompass approximately 0.2 million leased square feet upon completion. Our operating partnership holds substantially all of our assets and conducts substantially all of our business. We are the sole general partner of our operating partnership and owned approximately 88.8% of the aggregate limited partnership interests in our operating partnership, which we refer to herein as common units, as of December 31, 2020. We have elected to be taxed as a REIT and believe that we have operated and have been organized in conformity with the requirements for qualification and taxation as a REIT for U.S. federal income tax purposes commencing with our taxable year ended December 31, 2015. Impact of the COVID-19 Pandemic The novel coronavirus, or COVID-19, pandemic, has caused and continues to cause significant disruptions to the U.S., regional and global economies and has contributed to significant volatility and negative pressure in financial markets. We continue to carefully monitor the COVID-19 pandemic and its potential impact on our business. We are following guidelines established by the Centers for Disease Control and the World Health Organization and orders issued by the state and local governments where we operate. In addition, we have taken a number of precautionary steps to safeguard our business and our employees from the COVID-19 pandemic, including, but not limited to, implementing non-essential travel restrictions and facilitating telecommuting arrangements for our employees. We have taken these precautionary steps while maintaining business continuity so 35 that we can continue to deliver service to and meet the demands of our tenants, including our U.S. Government tenant agencies. Since March 13, 2020, nearly all of our employees have been working remotely, with only certain operationally critical employees working on site. The operations of many of our U.S. Government tenant agencies are deemed essential. We are working closely with our tenants to follow directions from the various federal government tenant agencies with respect to building operations within our portfolio, and have issued guidance for our vendors and building engineers grounded in applicable federal, state and local guidelines. Whenever we learn of a confirmed case of COVID-19 involving an individual known to have been in one of our buildings, we immediately take additional steps in collaboration with our tenants and vendors to disinfect and sanitize the affected spaces and all common areas in the building. To date, the impact of the COVID-19 pandemic on our business and financial condition has not been significant. Substantially all of our revenue continues to be generated through the receipt of rental payments from U.S. Government tenant agencies, which accounted for 98.5% of our annualized lease income as of December 31, 2020. We expect that leases to agencies of the U.S. Government will continue to be the primary source of our revenues for the foreseeable future. Notwithstanding the recent volatility in the financial markets, we also believe that our capital structure will continue to provide us with the resources, financial flexibility and the capacity to support the continued growth of our business. Since January 1, 2020, we have issued an aggregate of 6,996,824 shares of our common stock, including in settlement of forward sales transactions, through our March 2019 ATM Program and December 2019 ATM Program (each as described below). As of February 16, 2021, there are 4,106,521 shares underlying forward sale transactions that have not yet been settled, including an aggregate of 359,289 shares sold on a forward basis subsequent to the year ended December 31, 2020. Subject to our right to elect net share settlement, we expect to physically settle the forward sales transactions between April 2021 and February 2022. As of December 31, 2020, we also had $370.7 million available under our $450.0 million senior unsecured revolving credit facility. The future impact of the COVID-19 pandemic on our operations and financial condition will, however, depend on future developments, which are highly uncertain and cannot be predicted with confidence, including the scope, severity and duration of the pandemic, the actions taken to contain the pandemic or mitigate its impact, and the direct and indirect economic effects of the pandemic and containment measures, among others. See “Item 1A Risk Factors” for a discussion of the potential adverse impact of the COVID-19 pandemic on our business, results of operations and financial condition . Financial information analyzed below reflects the audited financial statements as of December 31, 2020, included in the F pages of this Annual Report on Form 10-K. Results of Operations Comparison of Results of Operations for the Years Ended December 31, 2020 and December 31, 2019 The financial information presented below summarizes the results of operations of our company for the years ended December 31, 2020 and 2019. For the years ended December 31, (Amounts in thousands) 2020 2019 Change Revenues Rental income $ 238,131 $ 208,544 $ 29,587 Tenant reimbursements 4,497 10,210 (5,713 ) Other income 2,450 2,968 (518 ) Total revenues 245,078 221,722 23,356 Expenses Property operating 48,430 48,279 151 Real estate taxes 27,125 23,643 3,482 Depreciation and amortization 93,803 92,439 1,364 Acquisition costs 2,087 1,738 349 Corporate general and administrative 20,630 20,184 446 Total expenses 192,075 186,283 5,792 Other income (expense) Interest expense, net (35,480 ) (33,460 ) (2,020 ) Gain (loss) on the sale of operating property (3,995 ) 6,245 (10,240 ) Net income $ 13,528 $ 8,224 $ 5,304 36 Revenues Total revenues increased $23.4 million to $245.1 million for the year ended December 31, 2020 compared to $221.7 million for the year ended December 31, 2019. The $29.6 million increase in Rental income is primarily attributable to an increase in revenues from the nine operating properties acquired and one development property placed in service since December 31, 2019 as well as a full period of operations from the eight operating properties acquired and one development property placed in service during the year ended December 31, 2019, offset by a decrease in revenues attributable to the disposal of two operating properties, one in the fourth quarter of 2020 and one in the second quarter of 2019. The $5.7 million decrease in Tenant reimbursements and $0.5 million decrease in Other income are primarily attributable to a decrease in tenant project reimbursements and the associated project management income. Expenses Total expenses increased by $5.8 million to $192.1 million for the year ended December 31, 2020 compared to $186.3 million for the year ended December 31, 2019. The $0.2 million increase in Property operating expenses is primarily attributable to an increase in property operating expenses associated with the nine operating properties acquired and one development property placed in service since December 31, 2019, as well as a full period of operations from the eight operating properties acquired and one development property placed in service during the year ended December 31, 2019, offset by a decrease in expenses associated with tenant project reimbursements. The $3.5 million increase in Real estate taxes is also primarily attributable to the nine operating properties acquired and one development property placed in service since December 31, 2019 as well as a full period of operations from the eight operating properties acquired and one development property placed in service during the year ended December 31, 2019. Additionally, the $1.4 million increase in Depreciation and amortization is primarily attributable to the nine operating properties acquired and one development property placed in service since December 31, 2019, as well as a full period of operations from the eight operating properties acquired and one development property placed in service during the year ended December 31, 2019, offset by a decrease in depreciation related to the timing of intangible amortization. The $0.3 million increase in Acquisition costs was primarily due to an increase in employee costs. The $0.4 million increase in Corporate and general administrative costs was also primarily due to an increase in employee costs. Interest Expense Interest expense increased $2.0 million to $35.5 million for the year ended December 31, 2020 compared to $33.5 million for the year ended December 31, 2019. The increase is primarily due to additional interest expense attributable to the $275.0 million fixed rate, senior unsecured notes issued in the third quarter of 2019. This increase is offset by a decrease in interest owed on our revolving credit facility primarily due to a decrease in the weighted average interest rate and weighted average borrowings for the year ended December 31, 2020 compared to the year ended December 31, 2019. Gain (Loss) on the sale of operating property On November 24, 2020, we sold DEA – Otay to a third party. Net proceeds from the sale of the operating property were approximately $3.5 million and we recognized the full loss on the sale of the operating property of approximately $4.0 million for the year ended December 31, 2020. On May 8, 2019, we sold CBP – Chula Vista to a third party. Net proceeds from the sale of the operating property were approximately $19.9 million and we recognized the full gain on the sale of the operating property of approximately $6.2 million for the year ended December 31, 2019. 37 Comparison of Results of Operations for the Years Ended December 31, 20 19 and December 31, 20 18 Information pertaining to fiscal year 2018 was included in our Annual Report on Form 10-K for the year ended December 31, 2019 on page 35 under Part II, Item 7, “Management’s Discussion and Analysis of Financial Position and Results of Operations”, which was filed with the Securities and Exchange Commission, or SEC, on February 25, 2020. Liquidity and Capital Resources We anticipate that our cash flows from the sources listed below will provide adequate capital for the next 12 months for all anticipated uses, including all scheduled principal and interest payments on our outstanding indebtedness, current and anticipated tenant improvements, stockholder distributions to maintain our qualification as a REIT and other capital obligations associated with conducting our business. At December 31, 2020, we had approximately $8.5 million available in cash and cash equivalents and there was $370.7 million available under our revolving credit facility. Our primary expected sources of capital are as follows: • cash and cash equivalents; • operating cash flow; • available borrowings under our revolving credit facility; • issuance of long-term debt; • issuance of equity, including under our ATM Programs (as described below); and • asset sales. Our short-term liquidity requirements consist primarily of funds to pay for the following: • development and redevelopment activities, including major redevelopment, renovation or expansion programs at individual properties; • property acquisitions under contract; • tenant improvements allowances and leasing costs; • recurring maintenance and capital expenditures; • debt repayment requirements; • corporate and administrative costs; • interest payments on our outstanding indebtedness; • interest swap payments; and • distribution payments. Our long-term liquidity needs, in addition to recurring short-term liquidity needs as discussed above, consist primarily of funds necessary to pay for acquisitions, non-recurring capital expenditures, and scheduled debt maturities. Although we may be able to anticipate and plan for certain of our liquidity needs, unexpected increases in uses of cash that are beyond our control and which affect our financial condition and results of operations may arise, or our sources of liquidity may be fewer than, and the funds available from such sources may be less than, anticipated or required. As of the date of this filing, there were no known commitments or events that would have a material impact on our liquidity. Equity Shelf Registration Statement on Form S-3 On March 16, 2018, we filed an automatic universal shelf registration statement on Form S-3 with the SEC, which was deemed automatically effective and which provides for the registration of unspecified amounts of securities. However, there can be no assurance that we will be able to complete any such offerings of securities in the future. 38 ATM Program s On each of March 4, 2019 and December 20, 2019, we entered into separate equity distribution agreements with each of C itigroup Global Markets Inc., BMO Capital Markets Corp., BTIG, LLC, Capital One Securities, Inc., Jefferies LLC, Raymond James & Associates, Inc., RBC Capital Markets, LLC, SunTrust Robinson Humphrey, Inc. and Wells Fargo Securities, LLC, pursuant to which we may issue and sell shares of our common stock having an aggregate offering price of up to $200.0 million and $300.0 million, respectively, from time to time, which we refer to herein as the ATM Programs, in negotiated transactions or transactions that are deemed to be “at the market” offerings as defined in Rule 415 under the Securities Act. The ATM Programs implemented on March 4, 2019 and December 20, 2019 are referred to as the “March 2019 ATM Program” and “December 2019 ATM Program” respectively. Under each of the ATM Programs, we may also enter into one or more forward transactions (each, a “forward sale transaction”) under separate master forward sale confirmations and related supplemental confirmations with each of Citibank, N.A., Bank of Montreal, Jefferies LLC, Raymond James & Associates, Inc., Royal Bank of Canada and Wells Fargo Bank, National Association for the sale of shares of our common stock on a forward basis. The following table sets forth certain information with respect to issuances, including in settlement of forward sales transactions, made under each of the ATM Programs as of December 31, 2020 (amounts in thousands except share amounts): March 2019 ATM Program December 2019 ATM Program For the Three Months Ended: Number of Shares Issued (1) Net Proceeds (1) Number of Shares Issued (1) Net Proceeds (1) March 31, 2020 200,000 $ 4,835 — $ — June 30, 2020 3,920,992 88,939 551,200 14,455 September 30, 2020 — — 1,475,991 33,541 December 31, 2020 — — 848,641 18,634 Total 4,120,992 $ 93,774 2,875,832 $ 66,630 (1) Includes shares issued by the Company, including in settlement of forward sales transactions. Additionally, as of December 31, 2020, we had entered into forward sales transactions under the March 2019 ATM Program and December 2019 ATM Program for the sale of an additional 3,747,232 shares of our common stock that had not yet been settled. Subject to our right to elect net share settlement, we expect to physically settle the forward sales transactions by the maturity dates set forth in each applicable forward sale transaction placement notice, which dates range from April 2021 to September 2021. Assuming the forward sales transactions are physically settled in full utilizing a net weighted average initial forward sales price of $25.96 per share, we expect to receive net proceeds of approximately $97.3 million, after deducting offering costs, subject to adjustments in accordance with the applicable forward sale transactions. We accounted for the forward sale agreements as equity. We have used the net proceeds received from such sales for general corporate purposes. As of December 31, 2020, we had approximately $140.6 million of gross sales of our common stock available under the December 2019 ATM Program and no remaining availability under the March 2019 ATM Program. Debt Amended and Restated Credit Facility We had a $400.0 million senior unsecured credit facility, which we amended and restated in 2018, which we refer to as our senior unsecured credit facility. Our senior unsecured credit facility includes a total borrowing capacity of $600.0 million, consisting of two components: (i) a $450.0 million revolving credit facility, which we refer to as the revolving credit facility, and (ii) a $150.0 million term loan facility, which we refer to as the 2018 term loan facility. The revolving credit facility also includes an accordion feature that will provide us with additional capacity, subject to the satisfaction of customary terms and conditions, of up to $250.0 million. As of December 31, 2020, we had $370.7 million in available capacity available under the revolving credit facility. We also have a $100.0 million senior unsecured term loan facility, which we refer to as the 2016 term loan facility. 39 Indebtedness Outstanding The following table sets forth certain information with respect to our outstanding indebtedness as of December 31, 2020 (dollars in thousands): Principal Outstanding Interest Current Loan December 31, 2020 Rate (1) Maturity Revolving credit facility: Revolving credit facility (2) $ 79,250 L + 130bps June 2022 (3) Total revolving credit facility 79,250 Term loan facilities: 2016 term loan facility 100,000 2.67% (4) March 2024 2018 term loan facility 150,000 3.96% (5) June 2023 Total term loan facilities 250,000 Less: Total unamortized deferred financing fees (1,034 ) Total term loan facilities, net 248,966 Notes payable: 2017 series A senior notes 95,000 4.05% May 2027 2017 series B senior notes 50,000 4.15% May 2029 2017 series C senior notes 30,000 4.30% May 2032 2019 series A senior notes 85,000 3.73% September 2029 2019 series B senior notes 100,000 3.83% September 2031 2019 series C senior notes 90,000 3.98% September 2034 Total notes payable 450,000 Less: Total unamortized deferred financing fees (2,829 ) Total notes payable, net 447,171 Mortgage notes payable: DEA - Pleasanton 15,700 L + 150bps (6) October 2023 VA - Golden 9,011 5.00% (6) April 2024 MEPCOM - Jacksonville 7,926 4.41% (6) October 2025 USFS II - Albuquerque 15,914 4.46% (6) July 2026 ICE - Charleston 16,150 4.21% (6) January 2027 VA - Loma Linda 127,500 3.59% (6) July 2027 CBP - Savannah 11,991 3.40% (6) July 2033 Total mortgage notes payable 204,192 Less: Total unamortized deferred financing fees (1,441 ) Less: Total unamortized premium/discount 120 Total mortgage notes payable, net 202,871 Total debt $ 978,258 (1) At December 31, 2020 the one-month LIBOR (“L”) was 0.14%. The current interest rate is not adjusted to include the amortization of deferred financing fees or debt issuance costs incurred in obtaining debt or any unamortized fair market value premiums. The spread over the applicable rate for each of our revolving credit facility, our 2018 term loan facility, and our 2016 term loan facility is based on our consolidated leverage ratio, as defined in the respective loan agreements. (2) Our revolving credit facility had available capacity of $370.7 million at December 31, 2020, with an accordion feature that permits us to request additional lender commitments for up to $250.0 million of additional capacity, subject to the satisfaction of customary terms and conditions. (3) Our revolving credit facility has two six-month as-of-right extension options subject to certain conditions and the payment of an extension fee. (4) Entered into two interest rate swaps with an effective date of March 29, 2017 with an aggregate notional value of $100.0 million to effectively fix the interest rate at 2.67% annually, based on our consolidated leverage ratio, as defined in our 2016 term loan facility agreement. 40 (5) Entered into four interest rate swaps with an effective date of December 13, 2018 with an aggregate notional value of $150.0 million to effectively fix the interest rate at 3.9 6 % annually, based on our consolidate d leverage ratio, as defined in our 2018 term loan facility agreement . (6) Effective interest rates are as follows: DEA – Pleasanton 1.8%, VA – Golden 5.03%, MEPCOM – Jacksonville 3.89%, USFS II – Albuquerque 3.92%, ICE – Charleston 3.93%, VA – Loma Linda 3.78%, CBP – Savannah 4.12%. Our revolving credit facility, term loan facilities, notes payable, and mortgage notes payable are subject to ongoing compliance with a number of financial and other covenants. As of December 31, 2020, we were in compliance with all applicable financial covenants. The chart below details our debt capital structure as of December 31, 2020 (dollars in thousands): Debt Capital Structure December 31, 2020 Total principal outstanding $ 983,442 Weighted average maturity 6.6 years Weighted average interest rate 3.6 % % Variable debt 9.7 % % Fixed debt (1) 90.3 % % Secured debt 20.8 % (1) Our 2016 term loan facility and 2018 term loan facility are swapped to be fixed and as such are included as fixed rate debt in the table above. Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2020 (dollars in thousands): Payments due by period Total 2021 2022 2023 2024 2025 Thereafter Mortgage principal and interest $ 246,905 $ 11,831 $ 12,690 $ 28,341 $ 20,348 $ 13,359 $ 160,336 Revolving credit facility principal and interest 82,071 1,923 80,148 — — — — Term loan facilities principal and interest 273,416 8,640 8,640 155,480 100,656 — — Senior unsecured notes payable principal and interest 624,402 17,795 17,795 17,795 17,795 17,795 535,427 Development property obligations (1) 6,569 2,334 1,412 2,823 — — — Corporate office lease 2,258 457 278 312 446 456 309 Total $ 1,235,621 $ 42,980 $ 120,963 $ 204,751 $ 139,245 $ 31,610 $ 696,072 (1) Due to the long-term nature of certain construction and development contracts included in this line, the amounts reported in the table represent our estimate of the timing for the related obligations being paid. Dividend Policy In order to qualify as a REIT, we are required to distribute to our stockholders, on an annual basis, at least 90% of our REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gains. We anticipate distributing all of our taxable income. We expect to make quarterly distributions to our stockholders in a manner intended to satisfy this requirement. Prior to making any distributions for U.S. federal tax purposes or otherwise, we must first satisfy our operating and debt service obligations. It is possible that it would be necessary to utilize cash reserves, liquidate assets at unfavorable prices or incur additional indebtedness in order to make required distributions. It is also possible that our board of directors could decide to make required distributions in part by using shares of our common stock. 41 A summary of dividends declared by the board of directors per share of common stock and per common unit of our operating partnership at the date of record is as follows: Quarter Declaration Date Record Date Pay Date Dividend Q1 2020 April 29, 2020 May 14, 2020 June 25, 2020 0.26 Q2 2020 July 29, 2020 August 13, 2020 September 11, 2020 0.26 Q3 2020 October 27,2020 November 11, 2020 December 11, 2020 0.26 Q4 2020 February 18, 2021 March 5, 2021 March 17, 2021 0.26 We use long-term investment partnership units in our operating partnership, which we refer to herein as LTIP units, as a form of performance-based award and service-based award for annual long-term incentive equity compensation. LTIP units are convertible into common units upon the satisfaction of certain conditions. Prior to the end of the performance period as set forth in the applicable LTIP unit award, holders of performance-based LTIP units are entitled to receive dividends per LTIP unit equal to 10% of the dividend paid per common unit of our operating partnership. After the end of the performance period, the number of LTIP units, both vested and unvested, that LTIP award recipients have earned, if any, are entitled to receive dividends in an amount per LTIP unit equal to dividends, both regular and special, payable per common unit of our operating partnership. Holders of LTIP units that are not subject to the attainment of performance goals are entitled to receive dividends per LTIP unit equal to 100% of the dividend paid per common unit beginning on the grant date. Cash Flow Comparison of Cash Flow for the Years Ended December 31, 2020 and December 31, 2019 The following table sets forth a summary of cash flows for our company for the years ended December 31, 2020 and 2019: For the years ended December 31, 2020 2019 Change (Amounts in thousands) Net cash (used in) provided by: Operating activities $ 145,197 $ 142,315 $ 2,882 Investing activities (290,175 ) (442,341 ) 152,166 Financing activities 144,098 304,470 (160,372 ) Operating Activities We generated $145.2 million and $142.3 million of cash from operating activities during the years ended December 31, 2020 and 2019, respectively. Net cash provided by operating activities for the year ended December 31, 2020 included $105.0 million in net cash from rental activities net of expenses and $40.2 million related to the changes in rents receivable, accounts receivable, prepaid and other assets, deferred revenue associated with operating leases, and accounts payable, accrued expenses and other liabilities. Net cash provided by operating activities for the year ended December 31, 2019 included $91.1 million in net cash from rental activities net of expenses, and $51.3 million related to the changes in rents receivable, accounts receivable, prepaid and other assets, deferred revenue associated with operating leases, and accounts payable, accrued expenses and other liabilities . Investing Activities We used $290.2 million and $442.3 million in cash for investing activities during the years ended December 31, 2020 and 2019, respectively. Net cash used in investing activities for the year ended December 31, 2020 primarily included $232.7 million in real estate acquisitions, $43.0 million in additions to development properties and $18.0 million in additions to operating properties, offset by $3.5 million in proceeds from the sale of DEA – Otay in the fourth quarter of 2020. Net cash used in investing activities for the year ended December 31, 2019 primarily included $394.5 million in real estate acquisitions, $60.6 million in additions to development properties and $7.2 million in additions to operating properties, offset by $19.9 million in proceeds from the sale of CBP – Chula Vista in the second quarter of 2019. Financing Activities We generated $144.1 million and $304.5 million in cash from financing activities during the years ended December 31, 2020 and 2019, respectively. Net cash provided by financing activities for the year ended December 31, 2020 included $162.0 million in gross proceeds from issuance of shares of our common stock and $79.3 million in net draws under the revolving credit facility, offset by $91.7 million in dividends, $3.6 million in mortgage debt repayment, and $1.9 million in payment of deferred offering costs. Net cash provided by financing activities for the year ended December 31, 2019 included $258.6 million in gross proceeds from issuance 42 of shares of our common stock, $275.0 million in issuance of notes payable, offset by $ 134.8 million in net paydowns under the revolving credit facility , $ 81.9 million in dividends, $ 7.1 million in payment of deferred offering costs, $ 3.4 million in mortgage debt repayment and $ 2.0 million in payment of deferred financing costs . Comparison of Cash Flow for the Years Ended December 31, 2019 and December 31, 2018 Information pertaining to fiscal year 2018 was included in our Annual Report on Form 10-K for the year ended December 31, 2019 on page 42 under Part II, Item 7, “Management’s Discussion and Analysis of Financial Position and Results of Operations”, which was filed with SEC on February 25, 2020. Non-GAAP Financial Measures We use and present Funds From Operations, or FFO, and FFO, as Adjusted as supplemental measures of our performance. The summary below describes our use of FFO and FFO, as Adjusted, provides information regarding why we believe these measures are meaningful supplemental measures of our performance and reconciles these measures from net income (loss), presented in accordance with GAAP. Funds From Operations and Funds From Operations, as Adjusted FFO is a supplemental measure of our performance. We present FFO calculated in accordance with the current National Association of Real Estate Investment Trusts, or Nareit, definition set forth in the Nareit FFO White Paper – Restatement 2018. In addition, we present FFO, as Adjusted for certain other adjustments that we believe enhance the comparability of our FFO across periods and to the FFO reported by other publicly traded REITs. FFO is a supplemental performance measure that is commonly used in the real estate industry to assist investors and analysts in comparing results of REITs. FFO is defined by Nareit as net income, (calculated in accordance with GAAP), excluding: • Depreciation and amortization related to real estate. • Gains and losses from the sale of certain real estate assets. • Gains and losses from change in control. • Impairment write-downs of certain real estate assets and investments in entities when the impairment is directly attributable to decreases in the value of depreciable real estate held by the entity. W e present FFO because we consider it an important supplemental measure of our operating performance, and we believe it is frequently used by securities analysts, investors and other interested parties in the evaluation of REITs, many of which present FFO when reporting results. We adjust FFO to present FFO, as Adjusted as an alternative measure of our operating performance, which, when applicable, excludes the impact of acquisition costs, straight-line rent, amortization of above-/below-market leases, amortization of deferred revenue (which results from landlord assets funded by tenants), non-cash interest expense, non-cash compensation and other non-cash items. By excluding these income and expense items from FFO, as Adjusted, we believe we provide useful information as these items have no cash impact. In addition, by excluding acquisition related costs we believe FFO, as Adjusted provides useful information that is comparable across periods and more accurately reflects the operating performance of our properties. Certain prior year amounts have been updated to conform to the current year FFO, as Adjusted definition. FFO and FFO, as Adjusted are presented as supplemental financial measures and do not fully represent our operating performance. Other REITs may use different methodologies for calculating FFO and FFO, as Adjusted or use other definitions of FFO and FFO, as Adjusted and, accordingly, our presentation of these measures may not be comparable to other REITs. Neither FFO nor FFO, as Adjusted is intended to be a measure of cash flow or liquidity. Please refer to our financial statements, prepared in accordance with GAAP, for purposes of evaluating our financial condition, results of operations and cash flows. 43 The following table sets forth a reconciliation of our net income to FFO and FFO, as Adjusted for the years ended December 31, 20 20 , 201 9 , and 201 8 ( dollars in thousands): For the years ended December 31, 2020 2019 2018 Net income $ 13,528 $ 8,224 $ 6,659 Depreciation and amortization 93,803 92,439 66,403 (Gain) loss on the sale of operating property 3,995 (6,245 ) — FFO 111,326 94,418 73,062 Adjustments to FFO: Acquisition costs 2,087 1,738 1,579 Straight-line rent and other non-cash adjustments (3,432 ) (2,276 ) (5,640 ) Amortization of above-/below-market leases (5,894 ) (6,320 ) (8,593 ) Amortization of deferred revenue (3,528 ) (1,007 ) (191 ) Non-cash interest expense 1,441 1,333 1,197 Non-cash compensation 4,093 4,909 3,039 FFO, as Adjusted $ 106,093 $ 92,795 $ 64,453 Factors That May Influence Future Results of Operations Revenue Our revenues primarily arise from the rental of space to tenants in our properties and tenant reimbursements, which include reimbursement for operating expenses, which are determined by the base year operating expenses and are subject to reimbursement in subsequent years based on changes in the Consumer Price Index for Urban Wage Earners and Clerical Workers, or urban CPI. Our revenue also includes amounts due from tenants for real estate taxes, projects and other reimbursements. Real estate taxes over the base year are reimbursed by the tenant. Substantially all of our rental income comes from U.S. Government tenants. We expect that leases to agencies of the U.S. Government will continue to be our primary source of revenues for the foreseeable future. Due to such concentration, adverse events or conditions that affect the U.S. Government could have a more negative effect on our financial condition and operations than if our tenant base was more diverse. However, positive or negative changes in conditions in local markets, such as changes in economic or other conditions, employment rates, local tax and budget conditions, recession, competition for real property investments in these markets, uncertainty about the future and other factors are significantly less likely to impact our overall performance. Operating Expenses Our operating expenses generally consist of repairs and maintenance, utilities, roads and grounds, property management fees, insurance, janitorial and other operating expenses. Factors that may impact our ability to control these operating expenses include increases in utilities, increases in third party management expenses, increases in insurance premiums, increases in repair and maintenance costs and expenses related to inclement weather. Additionally, the cost of compliance with zoning and building codes as well as local, state and federal tax laws may impact our expenses. As a public company our annual general and administrative expenses are meaningfully higher due to legal, insurance, accounting, audit and other expenses related to corporate governance, SEC reporting, other compliance matters and the costs of operating as a public company. Increases in costs from any of the foregoing factors may adversely affect our future results and cash flows. Circumstances such as declines in market rental rates or increased competition may cause revenues to decrease, although the expenses of owning and operating a property will not necessarily decline. For certain of our properties, expenses may vary with occupancy, while costs arising from our property investments, interest expense and general maintenance will not be materially reduced even if a property is not fully occupied. As a result, our future cash flow and results of operations may be adversely affected and losses could be incurred if revenues decrease in the future. Cost of Funds and Interest Rates We expect future changes in interest rates will impact our overall performance. We manage and may continue to manage our market risk on variable rate debt by entering into interest rate swap agreements or similar instruments, subject to maintaining our qualification as a REIT for U.S. federal income tax purposes. Although we may seek to cost-effectively manage our exposure to future rate increases through such means, a portion of our overall debt may at various times float at then current rates. 44 Development Activities As of December 31, 2020, we had one property under development. We intend to continue to engage in development and redevelopment activities with respect to our properties, including build-to-suit new developments and redevelopments for existing U.S. Government tenant agencies. These development activities may include some risks such as: • the availability and timely receipt of zoning and other regulatory approvals; • development costs exceeding expectations; • cost overruns and untimely completion of construction (including risks beyond our control, such as weather or labor conditions, or material shortages); • the inability to complete construction and leasing of a property on schedule, resulting in increased debt service expense and development and redevelopment costs; and • the availability and pricing of financing on favorable terms or at all. Off-Balance Sheet Arrangements We had no material off-balance sheet arrangements as of December 31, 2020. Inflation Substantially all of our leases provide for operating expense escalations. We believe inflationary increases in expenses may be at least partially offset by the contractual expense escalations described above. We do not believe inflation has had a material impact on our historical financial position or results of operations. Critical Accounting Policies of the Company The preparation of financial statements in conformity with GAAP requires management to use judgment in the application of accounting policies, including making estimates and assumptions. If our judgment or interpretation of the facts and circumstances relating to various transactions had been different, or different assumptions were made, it is possible that different accounting policies would have been applied, resulting in different financial results or a different presentation of our financial statements. Below is a discussion of the accounting policies that we consider critical to an understanding of our financial condition and operating results that may require complex or significant judgment in their application or require estimates about matters which are inherently uncertain. A discussion of our significant accounting policies, including further discussion of the accounting policies described below, can be found in Note 2, “Significant Accounting Policies,” of our consolidated financial statements. Real Estate Properties Real estate properties comprise all tangible assets we hold for rent or development. Real property is recognized at cost less accumulated depreciation. Acquisition costs related to business combinations, including third party transaction and direct internal costs are expensed as incurred. Third party costs related to asset acquisitions are capitalized. Development, re-development and certain costs directly related to the improvement of real properties are capitalized. Maintenance and repair expenses are charged to expense as incurred. When we acquire properties, we allocate the purchase price to numerous tangible and intangible components. Our process for determining the allocation to these components requires many estimates and assumptions, including the following: (1) determination of market rental, discount and capitalization rates; (2) estimation of leasing and tenant improvement costs associated with the remaining term of acquired leases; (3) assumptions used in determining the in-place lease and if-vacant value including the rental rates, period of time that it would take to lease vacant space and estimated tenant improvement and leasing costs; (4) renewal probabilities; and (5) allocation of the if-vacant value between land and building. A change in any of the above key assumptions can materially change not only the presentation of acquired properties in our consolidated financial statements but also our reported results of operations. The allocation to different components affects the following: • the amount of the purchase price allocated among different categories of assets and liabilities on our consolidated balance sheets; and the amount of costs assigned to individual properties in multiple property acquisitions; • where the amortization of the components appear over time in our consolidated statements of operations. Allocations to above- and below-market leases are amortized into rental revenue, whereas allocations to most of the other tangible and intangible assets are amortized into depreciation and amortization expense. As a REIT, this is important to us since much 45 of the investment community evaluates our operating performance using non-GAAP measures such as F unds F rom O perations, the computation of which includes rental revenue but does not include depreciation and amortization expense; and • the timing over which the items are recognized as revenue or expense in our consolidated statements of operations. For example, for allocations to the as-if vacant value, the land portion is not depreciated and the building portion is depreciated over a longer period of time than the other components (generally 40 years). Allocations to above- and below-market leases and in-place lease value are amortized over significantly shorter timeframes, and if individual tenants’ leases are terminated early, any unamortized amounts remaining associated with those tenants are written off upon termination. These differences in timing can materially affect our reported results of operations. Tenant improvements are capitalized in real property when we own the improvement. When we are required to provide improvements under the terms of a lease, we need to determine whether the improvements constitute landlord assets or tenant assets. If the improvements are considered landlord assets, we capitalize the cost of the improvements and recognize depreciation expense associated with such improvements over the shorter of the useful life of the assets or the term of the lease and recognize any payments from the tenant as rental revenue over the term of the lease. If the improvements are considered tenant assets, we defer the cost of improvements funded by us as a lease incentive asset and amortize it as a reduction of rental revenue over the term of the lease. Our determination of whether improvements are landlord assets or tenant assets also may affect when we commence revenue recognition in connection with a lease. In determining whether improvements constitute landlord or tenant assets, we consider numerous factors that may require subjective or complex judgments, including: whether the improvements are unique to the tenant or reusable by other tenants; whether the tenant is permitted to alter or remove the improvements without our consent or without compensating us for any lost fair value; whether the ownership of the improvements remains with us or remains with the tenant at the end of the lease term; and whether the economic substance of the lease terms is properly reflected. We capitalize pre-development costs incurred in pursuit of new development opportunities for which we currently believe future development is probable. Additionally, we capitalize interest expense, real estate taxes and direct and indirect project costs (including related compensation and other indirect costs) associated with properties, or portions thereof, undergoing construction, development and redevelopment activities. In capitalizing interest expense, if there is a specific borrowing for the property undergoing construction, development and redevelopment activities, we apply the interest rate of that borrowing to the average accumulated expenditures that do not exceed such borrowing; for the portion of expenditures exceeding any such specific borrowing, we apply our weighted average interest rate on other borrowings to the expenditures. We continue to capitalize costs while construction, development or redevelopment activities are underway until the building is substantially complete and ready for its intended use, at which time rental income recognition can commence and rental operating costs, real estate taxes, insurance, and other subsequent carrying costs are expensed as incurred. Depreciation of an asset begins when it is available for use and is calculated using the straight-line method over the estimated useful lives. Each period, depreciation is charged to expense and credited to the related accumulated depreciation account. A used asset acquired is depreciated over its estimated remaining useful life, not to exceed the life of a new asset. Range of useful lives for depreciable assets are as follows: Category Term Buildings 40 years Building improvements 5 - 40 years Tenant improvements Shorter of remaining life of the lease or useful life Furniture and equipment 3 - 7 years We regularly evaluate whether events or changes in circumstances have occurred that could indicate an impairment in the value of long lived assets. If there is an indication that the carrying value of an asset is not recoverable, we estimate the projected undiscounted cash flows to determine if an impairment loss should be recognized. We determine the amount of any impairment loss by comparing the historical carrying value to estimated fair value. We estimate fair value through an evaluation of recent financial performance and projected discounted cash flows using standard industry valuation techniques. In addition to consideration of impairment upon the events or changes in circumstances described above, we regularly evaluate the remaining lives of our long lived assets. If we change our estimate of the remaining lives, we allocate the carrying value of the affected assets over their revised remaining lives. Revenue Recognition Rental income includes base rents paid by each tenant in accordance with its lease agreement conditions. We recognize rental income on a straight-line basis over the lease term of the respective leases. For acquisitions of existing buildings, we recognize rental 46 income from leases already in place coincident with the date of property closing. Lease incentives are recorded as a deferred asset and amortized as a reduction of revenue on a straight-line basis over the respective lease term. Above- and below-market leases are amortized into rental income over the terms of the respective leases. Further, Rental income includes certain tenant reimbursement income (real estate taxes, operating expenses, utility usage, and other reimbursements), which are accrued as variable lease payments in the same periods as the related expenses are incurred in accordance with Accounting Standards Codification Topic 842, Leases (“ASC 842”) which we adopted on January 1, 2019. Tenant reimbursement income includes income from tenant construction projects. We recognize revenue from tenant construction projects using the percentage of completion method when the revenue and costs for such projects can be estimated with reasonable accuracy; when these criteria do not apply to a project, we recognize revenue from that project using the completed contract method. Under the percentage of completion method, we recognize a percentage of the total estimated revenue on a project based on the cost of services provided on the project as of a point in time relative to the total estimated costs on the project. Fully reimbursed income was included within Tenant reimbursements and associated expenses were included in Property operating expenses. Income on these projects was included in Other income. Other income includes income on the associated tenant reimbursement construction projects, parking income and other miscellaneous income. Deferred Revenue Deferred revenue consists primarily of lump sum reimbursements made by tenants to us for landlord improvements in excess of a tenant improvement allowance. Lump sum reimbursements are recorded as Deferred revenue on the Consolidated Balance Sheets and are amortized over the life of the lease through Rental income. Deferred revenue also includes rent received in advance, which is recognized within Rental income once earned. Recent Accounting Pronouncements For a discussion concerning new accounting pronouncements that may have an effect on our Consolidated Financial Statements see Note 2 to the Consolidated Financial Statements.