Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following information should be read in conjunction with our Consolidated Financial Statements and accompanying notes included in Part IV, Item 15 of this Annual Report on Form 10-K.
OVERVIEW (dollars in thousands, except per share and per square foot data)
We are a REIT organized under Maryland law. As of December 31, 2022, our wholly owned properties were comprised of 160 properties and we had noncontrolling ownership interests of 51% and 50% in two unconsolidated joint ventures that own three properties containing approximately 444,000 rentable square feet. As of December 31, 2022, our properties are located in 30 states and the District of Columbia and contain approximately 20,969,000 rentable square feet. As of December 31, 2022, our properties were leased to 274 different tenants, with a weighted average remaining lease term (based on annualized rental income) of approximately 6.6 years. The U.S. government is our largest tenant, representing approximately 19.7% of our annualized rental income as of December 31, 2022.
Certain changes in office space utilization accelerated during the COVID-19 pandemic, including increased remote work arrangements, continue to impact the market. The utilization and demand for office space continues to evolve and the ultimate impact of current trends on the demands for office space at our properties remains uncertain and subject to change. Accordingly, we do not yet know what the full extent of the impacts will be on our or our tenants’ businesses and operations.
In response to inflationary pressures, the U.S. Federal Reserve has increased the federal funds rate by 450 basis points since January 1, 2022 and has signaled that further increases are likely to occur throughout 2023. The inflationary pressures and rising interest rates in the United States and globally have given rise to increasing concerns that the U.S. economy may soon enter an economic recession and they have caused disruptions in the financial markets. Sustained inflationary pressures, increased interest rates, an economic recession or continued or intensified disruptions in the financial markets could adversely
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affect our financial condition and that of our tenants, could adversely impact the ability or willingness of our tenants to renew our leases or pay rent to us, would impair our ability to effectively deploy our capital or realize upon investments on favorable terms, may restrict our access to, and would likely increase our cost of, capital and may cause the values of our properties and our securities to decline.
For more information and risks relating to the COVID-19 pandemic, inflation and changes in market interest rates and their impacts on us and our business, see elsewhere in this Annual Report on Form 10-K, including “Warning Concerning Forward-Looking Statements” and Part I, Item 1A, “Risk Factors”.
Property Operations
Unless otherwise noted, the data presented in this section includes properties classified as held for sale as of December 31, 2022 and excludes three properties owned by two unconsolidated joint ventures in which we own 51% and 50% interests. For more information regarding our properties classified as held for sale and our two unconsolidated joint ventures, see Note 4 to the Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K.
Occupancy data for our properties as of December 31, 2022 and 2021 was as follows (square feet in thousands):
All Properties (1)
Comparable Properties (2)
December 31, December 31,
2022 2021 2022 2021
Total properties 160 178 149 149
Total rentable square feet (3)
20,969 23,271 19,006 19,001
Percent leased (4)
90.6 % 89.5 % 93.5 % 93.7 %
(1) Based on properties we owned on December 31, 2022 and 2021, respectively. Includes one leasable land parcel as of December 31, 2021.
(2) Based on properties we owned continuously since January 1, 2021; excludes properties classified as held for sale and properties undergoing significant redevelopment, if any, and three properties owned by two unconsolidated joint ventures in which we own 51% and 50% interests.
(3) Subject to changes when space is remeasured or reconfigured for tenants.
(4) Percent leased includes (i) space being fitted out for tenant occupancy pursuant to our lease agreements, if any, and (ii) space which is leased, but is not occupied or is being offered for sublease by tenants, if any, as of the measurement date.
The average effective rental rate per square foot for our properties for the years ended December 31, 2022 and 2021 were as follows:
Year Ended December 31,
Average effective rental rate per square foot (1) :
2022 2021
All properties (2)
$ 29.03 $ 27.55
Comparable properties (3)
$ 27.79 $ 27.17
(1) Average effective rental rate per square foot represents total rental income during the period specified divided by the average rentable square feet leased during the period specified.
(2) Based on properties we owned on December 31, 2022 and 2021, respectively.
(3) Based on properties we owned continuously since January 1, 2021; excludes properties classified as held for sale and properties undergoing significant redevelopment, if any, and three properties owned by two unconsolidated joint ventures in which we own 51% and 50% interests.
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During the year ended December 31, 2022, changes in rentable square feet leased and available for lease at our properties were as follows (square feet in thousands):
Year Ended December 31, 2022
Leased Available
for Lease Total
Beginning of year 20,817 2,454 23,271
Changes resulting from:
Disposition of properties (1,489) (837) (2,326)
Lease expirations (2,884) 2,884 —
Lease renewals (1)
1,974 (1,974) —
New leases (1)
588 (588) —
Remeasurements (2)
(2) 26 24
End of year 19,004 1,965 20,969
(1) Based on leases entered during the year ended December 31, 2022.
(2) Rentable square feet are subject to changes when space is remeasured or reconfigured for tenants.
Leases at our properties totaling approximately 2,884,000 rentable square feet expired during the year ended December 31, 2022. During the year ended December 31, 2022, we entered into new and renewal leases as summarized in the following table (square feet in thousands):
Year Ended December 31, 2022
New Leases Renewals Total
Rentable square feet leased 588 1,974 2,562
Weighted average rental rate change (by rentable square feet) 28.3 % (1.2 %) 5.6 %
Tenant leasing costs and concession commitments (1)
$ 72,224 $ 101,195 $ 173,419
Tenant leasing costs and concession commitments per rentable square foot (1)
$ 122.91 $ 51.28 $ 67.72
Weighted (by square feet) average lease term (years) 9.7 9.2 9.3
Total leasing costs and concession commitments per rentable square foot per year (1)
$ 12.63 $ 5.60 $ 7.29
(1) Includes commitments made for leasing expenditures and concessions, such as tenant improvements, leasing commissions, tenant reimbursements and free rent.
During the year ended December 31, 2022, changes in effective rental rates per square foot achieved for new leases and lease renewals at our properties that commenced during the year ended December 31, 2022, when compared to prior effective rental rates per square foot in effect for the same space (and excluding space acquired vacant), were as follows (square feet in thousands):
Year Ended December 31, 2022
Old Effective
Rent Per
Square Foot (1)
New Effective
Rent Per
Square Foot (1)
Rentable
Square Feet
New leases $ 22.61 $ 21.37 595
Lease renewals $ 28.97 $ 28.97 1,976
Total leasing activity $ 27.50 $ 27.21 2,571
(1) Effective rental rates include contractual base rents from our tenants pursuant to our lease agreements, plus straight line rent adjustments and estimated expense reimbursements to be paid to us, and exclude lease value amortization.
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During the years ended December 31, 2022 and 2021, amounts capitalized at our properties for lease related costs, building improvements and development, redevelopment and other activities were as follows:
Year Ended December 31,
2022 2021
Lease related costs (1)
$ 66,868 $ 42,751
Building improvements (2)
33,393 30,103
Recurring capital expenditures 100,261 72,854
Development, redevelopment and other activities (3)
159,189 56,243
Total capital expenditures $ 259,450 $ 129,097
(1) Lease related costs generally include capital expenditures used to improve tenants’ space or amounts paid directly to tenants to improve their space and leasing related costs, such as brokerage commissions and other tenant inducements.
(2) Building improvements generally include expenditures to replace obsolete building components and expenditures that extend the useful life of existing assets.
(3) Development, redevelopment and other activities generally include capital expenditure projects that reposition a property or result in new sources of revenue.
In addition to the capital expenditures described above, we contributed $3,851 to one of our unconsolidated joint ventures during the year ended December 31, 2022. We did not make any contributions to this unconsolidated joint venture during the year ended December 31, 2021. Also, as of December 31, 2022, we had estimated unspent leasing related obligations of $156,693, of which we expect to spend $86,031 over the next 12 months.
As of December 31, 2022, we had leases at our properties totaling approximately 1,886,000 rentable square feet that were scheduled to expire during 2023. As of February 14, 2023, we expect tenants with leases totaling approxim ately 1,120,000 r entable square feet that are scheduled to expire during 2023 not to renew or to downsize their leases upon expiration and we cannot be sure as to whether other tenants will renew their leases upon expiration. However, we are in advanced discussions to re-lease certain of this space to new tenants and we continue to proactively engage with our existing tenants and are focused on our overall tenant retention. Prevailing market conditions and government and other tenants’ needs at the time we negotiate and enter leases or lease renewals will generally determine rental rates and demand for leased space at our properties, all of which factors are beyond our control. Whenever we 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. We cannot be sure of the rental rates which will result from our ongoing negotiations regarding lease renewals or any new or renewed leases we may enter. Also, we may experience material declines in our rental income due to vacancies upon lease expirations or early terminations or lower rents upon lease renewal or reletting. Additionally, we may incur significant costs and make significant concessions to renew our leases with current tenants or lease our properties to new tenants.
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As of December 31, 2022, our lease expirations by year were as follows (square feet in thousands):
Year (1)
Number of Leases Expiring Leased Square Feet Expiring (2)
Percent of Total Cumulative Percent of Total Annualized Rental Income Expiring Percent of Total Cumulative Percent of Total
2023 74 1,886 9.9% 9.9% $ 61,049 11.2% 11.2%
2024 49 3,030 15.9% 25.8% 79,893 14.7% 25.9%
2025 42 1,959 10.3% 36.1% 41,510 7.6% 33.5%
2026 36 1,489 7.8% 43.9% 39,702 7.3% 40.8%
2027 35 2,055 10.8% 54.7% 52,078 9.6% 50.4%
2028 18 1,294 6.8% 61.5% 47,017 8.6% 59.0%
2029 20 760 4.0% 65.5% 23,308 4.3% 63.3%
2030 23 852 4.5% 70.0% 25,279 4.6% 67.9%
2031 15 876 4.6% 74.6% 24,494 4.5% 72.4%
2032 and thereafter 45 4,803 25.4% 100.0% 149,694 27.6% 100.0%
Total 357 19,004 100.0% $ 544,024 100.0%
Weighted average remaining lease term (in years) 6.2 6.6
(1) The year of lease expiration is pursuant to current contract terms. Some of our leases allow the tenants to vacate the leased premises before the stated expirations of their leases with little or no liability. As of December 31, 2022, tenants occupying approximately 2.4% of our rentable square feet and responsible for approximately 2.3% of our annualized rental income as of December 31, 2022, had exercisable rights to terminate their leases before the stated terms of their leases expire. Also, in 2023, 2024, 2025, 2026, 2027, 2028, 2029, 2030, 2031, 2035, 2037 and 2040 early termination rights become exercisable by other tenants who occupied an additional approximately 4.6%, 2.8%, 4.5%, 0.9%, 0.9%, 3.3%, 0.8%, 0.7%, 0.1%, 0.8%, 0.1% and 0.3% of our rentable square feet, respectively, and contributed an additional approximately 4.8%, 3.1%, 7.9%, 1.2%, 1.3%, 3.8%, 1.3%, 0.9%, 0.1%, 1.2%, 0.2% and 0.4% of our annualized rental income, respectively, as of December 31, 2022. In addition, as of December 31, 2022, pursuant to leases with 10 of our tenants, these tenants had rights to terminate their leases if their respective legislature or other funding authority does not appropriate rent amounts in their respective annual budgets. These 10 tenants occupied approximately 5.5% of our rentable square feet and contributed approximately 6.1% of our annualized rental income as of December 31, 2022.
(2) Leased square feet is pursuant to leases existing as of December 31, 2022, and includes (i) space being fitted out for tenant occupancy pursuant to our lease agreements, if any, and (ii) space which is leased, but is not occupied or is being offered for sublease by tenants, if any. Square feet measurements are subject to changes when space is remeasured or reconfigured for new tenants.
We generally will seek to renew or extend the terms of leases at properties with tenants when they expire. However, market and economic factors, along with increases in remote work, changes in space utilization and government spending and budget priorities may cause our tenants not to renew or extend their leases when they expire, or to seek to renew their leases for less space than they currently occupy. If we are unable to extend or renew our leases, or we renew leases for reduced space, it may be time consuming and expensive to relet some of these properties.
Over the past several years, government tenants have reduced their space utilization per employee and consolidated government tenants into existing government owned properties. This activity has reduced the demand for government leased space. Our historical experience with respect to properties of the type we own that are majority leased to government tenants has been that government tenants have generally renewed leases for mission critical space to avoid the costs and disruptions that may result from relocating their operations. However, efforts to manage space utilization rates may result in our tenants exercising early termination rights under our leases, vacating our properties upon expiration of our leases in order to relocate to government owned properties or consolidated leased space within a market, or renewing their leases for less space than they currently occupy. Also, our government tenants’ desire to reconfigure leased office space to manage utilization per employee may require us to spend significant amounts for tenant improvements, and tenant relocations are often more prevalent in those circumstances. Increasing uncertainty with respect to government agency budgets and funding to implement relocations, consolidations and reconfigurations has, in some instances, resulted in delayed decisions by some of our government tenants and greater focus on short term lease renewals. Given the significant uncertainties, including the extent to which remote or alternative work arrangements may continue or increase, we are unable to reasonably project what the financial impact of market conditions or changing government circumstances will be on the demand for leased space at our properties and our financial results for future periods.
As of December 31, 2022, we derive 22.6% of our annualized rental income from our properties located in the metropolitan Washington, D.C. market area, which includes Washington, D.C., Northern Virginia and suburban Maryland. A downturn in economic conditions in this area or a possible recession, including as a result of current inflationary conditions or otherwise, could result in reduced demand from tenants for our properties, reduce rents that our tenants in this area are willing to pay when our leases expire and increase lease concessions for new leases and renewals. Additionally, there has been a
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decrease in demand for new leased office space by the U.S. government in the metropolitan Washington, D.C. market area, and that could increase competition for government tenants and adversely affect our ability to retain government tenants when our leases expire.
Our manager, RMR, employs a tenant review process for us. RMR assesses tenants on an individual basis based on various applicable credit criteria. In general, depending on facts and circumstances, RMR evaluates the creditworthiness of a tenant based on information concerning the tenant that is provided by the tenant and, in some cases, information that is publicly available or obtained from third party sources. We consider investment grade tenants to include: (a) investment grade rated tenants; (b) tenants with investment grade rated parent entities that guarantee the tenant’s lease obligations; and/or (c) tenants with investment grade rated parent entities that do not guarantee the tenant’s lease obligations. As of December 31, 2022, tenants contributing 52.8% of annualized rental income were investment grade rated (or their payment obligations were guaranteed by an investment grade rated parent) and tenants contributing an additional 9.9% of annualized rental income were subsidiaries of an investment grade rated parent (although these parent entities were not liable for the payment of rents).
As of December 31, 2022, tenants representing 1% or more of our total annualized rental income were as follows (square feet in thousands):
Tenant Credit Rating Sq. Ft. % of Leased Sq. Ft. Annualized
Rental Income % of Total Annualized Rental Income
1 U.S. Government Investment Grade 3,894 20.5 % $ 107,158 19.7 %
2 Alphabet Inc. (Google) Investment Grade 386 2.0 % 21,192 3.9 %
3 Shook, Hardy & Bacon L.L.P. Not Rated 596 3.1 % 19,336 3.6 %
4 IG Investments Holdings LLC Not Rated 338 1.8 % 16,788 3.1 %
5 State of California Investment Grade 519 2.7 % 15,865 2.9 %
6 Bank of America Corporation Investment Grade 577 3.0 % 15,765 2.9 %
7 Commonwealth of Massachusetts Investment Grade 311 1.6 % 12,260 2.3 %
8 CareFirst Inc. Not Rated 207 1.1 % 11,498 2.1 %
9 Tyson Foods, Inc. Investment Grade 248 1.3 % 11,042 2.0 %
10 Sonesta International Hotels Corporation (1)
Not Rated 230 1.2 % 10,745 2.0 %
11 Northrop Grumman Corporation Investment Grade 337 1.8 % 10,639 2.0 %
12 CommScope Holding Company Inc. Non Investment Grade 228 1.2 % 9,370 1.7 %
13 Sonoma Biotherapeutics, Inc. (2)
Not Rated 84 0.4 % 7,468 1.4 %
14 State of Georgia Investment Grade 308 1.6 % 7,383 1.4 %
15 PNC Bank Investment Grade 441 2.3 % 6,924 1.3 %
16 Micro Focus International plc Non Investment Grade 215 1.1 % 6,905 1.3 %
17 Compass Group plc Investment Grade 267 1.4 % 6,703 1.2 %
18 ServiceNow, Inc. Investment Grade 149 0.8 % 6,637 1.2 %
19 Allstate Insurance Co. Investment Grade 468 2.5 % 6,479 1.2 %
20 Leidos Holdings Inc. Investment Grade 159 0.8 % 6,117 1.1 %
21 Automatic Data Processing, Inc. Investment Grade 289 1.5 % 6,087 1.1 %
22 Church & Dwight Co., Inc. Investment Grade 250 1.3 % 6,037 1.1 %
23 Primerica, Inc. Investment Grade 344 1.8 % 5,442 1.0 %
10,845 56.8 % $ 333,840 61.5 %
(1) In June 2021, we entered into a 30-year lease with Sonesta. The lease relates to the redevelopment of a property we own in Washington, D.C to a mixed use and Sonesta's lease relates to the planned hotel component of the property. The term of the lease commences upon our delivery of the completed hotel, which is estimated to occur in the second quarter of 2023. For more information about our lease with Sonesta, see Note 7 to the Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K.
(2) In August 2022, we entered into an approximately 10-year lease with Sonoma Biotherapeutics, Inc. at a property we own in Seattle, WA that is currently undergoing redevelopment. The term of the lease is estimated to commence in the fourth quarter of 2023.
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Disposition Activities
During the year ended December 31, 2022, we sold 18 properties, including one leasable land parcel, containing approximately 2,326,000 rentable square feet for an aggregate sales price of $211,020, excluding closing costs.
As a result of current commercial real estat e market conditions, including rising interest rates, the pace of our dispositions has moderated and we expect that trend to continue until commercial real estate industry conditions generally, and office market conditions specifically, improve. However, we continue to evaluate our portfolio to strategically recycle capital and are currently in various stages of marketing certain of our properties for sale, and we may decide to seek to sell additional properties in the future. As of February 14, 2023, we have entered into agreements to sell two properties containing approximately 207,000 rentable square feet for an aggregate sales price of $7,600, excluding closing costs. We cannot be sure we will sell any properties we are marketing for sale for prices in excess of their carrying values or otherwise. In a ddition, our pending sales are subject to conditions; accordingly, we cannot be sure that we will complete these sales or that these sales will not be delayed or the terms will not change.
For more information about our disposition activities, see “Business —Disposition Policies” in Part I, Item 1 of this Annual Report on Form 10-K and Note 4 to the Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K.
Financing Activities
Senior Unsecured Note Redemption
In June 2022, we redeemed, at par plus accrued interest, all $300,000 of our 4.00% senior unsecured notes due July 2022 using cash on hand and borrowings under our revolving credit facility.
Mortgage Note Prepayments
In April 2022, we prepaid, at par plus accrued interest, a mortgage note secured by one property with an outstanding principal balance of $24,863, an annual interest rate of 4.22% and a maturity date in July 2022 using cash on hand.
In October 2022, we prepaid, at a discounted amount of $22,176 plus accrued interest, a mortgage note secured by one property with an outstanding principal balance of $22,901, an annual interest rate of 4.80% and a maturity date in June 2023 using cash on hand and borrowings under our revolving credit facility.
Revolving Credit Facility
In November 2022, we exercised our option to extend the maturity date of our revolving credit facility by six months to July 31, 2023. Subject to the payment of an extension fee and meeting certain other conditions, we may extend the maturity date of our revolving credit facility by one additional six month period.
For more information about our financing activities, see “Business —Our Financing Policies” in Part I, Item 1 of this Annual Report on Form 10-K and Note 9 to the Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K.
Segment Information
We operate in one business segment: ownership of real estate properties.
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RESULTS OF OPERATIONS (amounts in thousands, except per share amounts)
Year Ended December 31, 2022, Compared to Year Ended December 31, 2021
Comparable Properties (1) Results
Year Ended December 31,
Non-Comparable Properties Results Year Ended December 31, Consolidated Results
Year Ended December 31,
2022 2021 $
Change %
Change 2022 2021 2022 2021 $
Change %
Change
Rental income $ 484,943 $ 477,801 $ 7,142 1.5 % $ 69,332 $ 98,681 $ 554,275 $ 576,482 $ (22,207) (3.9 %)
Operating expenses:
Real estate taxes 52,076 50,912 1,164 2.3 % 5,768 21,058 57,844 71,970 (14,126) (19.6 %)
Utility expenses 23,713 20,461 3,252 15.9 % 3,292 4,790 27,005 25,251 1,754 6.9 %
Other operating expenses
93,995 85,815 8,180 9.5 % 16,371 20,010 110,366 105,825 4,541 4.3 %
Total operating expenses
169,784 157,188 12,596 8.0 % 25,431 45,858 195,215 203,046 (7,831) (3.9 %)
Net operating income (2)
$ 315,159 $ 320,613 $ (5,454) (1.7 %) $ 43,901 $ 52,823 359,060 373,436 (14,376) (3.8 %)
Other expenses:
Depreciation and amortization 222,564 241,494 (18,930) (7.8 %)
Loss on impairment of real estate 21,820 62,420 (40,600) (65.0 %)
Acquisition and transaction related costs 292 — 292 n/m
General and administrative 25,134 26,858 (1,724) (6.4 %)
Total other expenses 269,810 330,772 (60,962) (18.4 %)
Gain on sale of real estate 11,001 78,354 (67,353) (86.0 %)
Interest and other income 217 7 210 n/m
Interest expense (103,480) (112,385) 8,905 (7.9 %)
Gain (loss) on early extinguishment of debt 682 (14,068) 14,750 (104.8 %)
Loss before income tax expense and equity in net losses of investees (2,330) (5,428) 3,098 (57.1 %)
Income tax expense (270) (251) (19) 7.6 %
Equity in net losses of investees (3,509) (2,501) (1,008) 40.3 %
Net loss $ (6,109) $ (8,180) $ 2,071 (25.3 %)
Weighted average common shares outstanding (basic and diluted) 48,278 48,195 83 0.2 %
Per common share amounts (basic and diluted):
Net loss $ (0.14) $ (0.17) $ 0.03 (17.6 %)
n/m - not meaningful
(1) Comparable properties consists of 149 properties we owned on December 31, 2022 and which we owned continuously since January 1, 2021 and excludes properties classified as held for sale, properties undergoing significant redevelopment, if any, and three properties owned by two unconsolidated joint ventures in which we own 51% and 50% interests.
(2) Our definition of net operating income, or NOI, and our reconciliation of net loss to NOI are included below under the heading “Non-GAAP Financial Measures.”
References to changes in the income and expense categories below relate to the comparison of consolidated results for the year ended December 31, 2022 compared to the year ended December 31, 2021. For a comparison of consolidated results for the year ended December 31, 2021 compared to the year ended December 31, 2020, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2021.
Rental income. The decrease in rental income reflects decreases in rental income of $29,470 related to property disposition activities and $12,939 related to properties undergoing significant redevelopment, partially offset by increases in rental income of $13,060 for acquired properties and $7,142 for comparable properties. Rental income for acquired properties reflects a reduction to reimbursement revenue of $8,715 resulting from the reversal of previously estimated real estate taxes at two
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properties we acquired in 2021 due to favorable real estate tax assessments and successful appeals received in 2022. The decrease in rental income for properties undergoing significant redevelopment is primarily due to the reduction in occupied space at properties located in Washington, D.C. and Seattle, WA that began redevelopment projects during April 2021 and February 2022, respectively, partially offset by termination fee revenue at the Seattle, WA property related to the termination of the former tenant’s lease in February 2022 prior to commencement of the redevelopment. The increase in rental income for comparable properties is primarily due to higher reimbursement revenue resulting from increased operating expenses due to higher building utilization levels in 2022 and operating expenses that were previously paid directly by certain of our tenants now being paid by and reimbursed to us pursuant to lease amendments with those tenants executed in 2022, as well as lease termination fee revenue received and higher parking income as a result of higher parking volumes, partially offset by reductions in occupied space at certain of our properties in 2022. Rental income includes non-cash straight line rent adjustments totaling $10,830 in 2022 and $15,368 in 2021, and amortization of acquired real estate leases and assumed real estate lease obligations totaling ($975) in 2022 and ($2,288) in 2021.
Real estate taxes. The decrease in real estate taxes reflects decreases in real estate taxes of $9,472 for acquired properties, $3,432 related to property disposition activities and $2,386 related to properties undergoing significant redevelopment, partially offset by an increase in real estate taxes of $1,164 for comparable properties. The decrease in real estate taxes for acquired properties reflects the reversal of previously estimated real estate taxes at two properties we acquired in 2021 due to favorable real estate tax assessments and successful appeals received in 2022. Real estate taxes for comparable properties increased primarily due to real estate taxes that were previously paid by certain of our tenants that are now being paid by us pursuant to lease amendments with those tenants executed in 2022.
Utility expenses. The increase in utility expenses reflects increases in utility expenses of $3,252 for comparable properties and $805 for acquired properties, partially offset by decreases in utility expenses of $1,999 related to property disposition activities and $304 for properties undergoing significant redevelopment. The increase in utility expenses for comparable properties is primarily due to increases in electricity usage as a result of higher building utilization levels at certain of our properties and the impact of inflation in 2022, as well as utility expenses that were previously paid directly by certain of our tenants that are now being paid by us pursuant to lease amendments with those tenants executed in 2022.
Other operating expenses. Other operating expenses consist of salaries and benefit costs of property level personnel, repairs and maintenance expense, cleaning expense, other direct costs of operating our properties and property management fees. The increase in other operating expenses reflects increases of $8,180 for comparable properties and $4,564 for acquired properties, partially offset by decreases of $6,982 related to property disposition activities and $1,221 related to properties undergoing significant redevelopment. The increase in other operating expenses for comparable properties is primarily due to higher repairs and maintenance costs, higher cleaning expenses due to increased building utilization levels and the impact of inflation in 2022, increased insurance costs and an increase related to other operating expenses that were previously paid by certain of our tenants that are now being paid by us pursuant to lease amendments with those tenants executed in 2022.
Depreciation and amortization. The decrease in depreciation and amortization reflects decreases of $18,921 related to property disposition activities, $9,990 for comparable properties and $2,656 related to properties undergoing significant redevelopment, partially offset by an increase of $12,637 for acquired properties. Depreciation and amortization for comparable properties declined due to certain leasing related assets becoming fully depreciated since January 1, 2021, partially offset by depreciation and amortization of improvements made to certain of our properties since January 1, 2021.
Loss on impairment of real estate . We recorded a $21,820 loss on impairment of real estate in 2022 to reduce the carrying value of seven properties to their estimated fair values less costs to sell. We recorded a $62,420 loss on impairment of real estate in 2021 to reduce the carrying value of eight properties to their estimated fair values less costs to sell.
Acquisition and transaction related costs. Acquisition and transaction related costs consist of costs related to our evaluation of potential acquisitions, dispositions and other strategic transactions.
General and administrative. General and administrative expenses consist of fees pursuant to our business management agreement, equity compensation expense, legal and accounting fees, Trustees’ fees and expenses, securities listing and transfer agency fees and other costs relating to our status as a publicly traded company. The decrease in general and administrative expenses is primarily the result of a decrease in base business management fees resulting from a decrease in average total market capitalization in 2022 compared to 2021 and a state franchise tax refund received in 2022.
Gain on sale of real estate. We recorded an $11,001 net gain on sale of real estate in 2022 resulting from the sale of 18 properties, including one leasable land parcel. We recorded a $78,354 net gain on sale of real estate in 2021 resulting from the sale of six properties, a warehouse facility and two vacant land parcels.
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Interest and other income. The increase in interest and other income is primarily due to the effect of higher interest rates earned on cash balances invested in 2022 compared to 2021.
Inter est expense. Th e decrease in interest expense reflects financing activities since January 1, 2021, which included the redemption of $910,000 of senior unsecured notes with a weighted average interest rate of 4.7% and the repayment of three mortgage notes totaling approximately $119,000 with a weighted average interest rate of 3.9%, as well as higher capitalized interest in 2022, partially offset by the issuance of $1,050,000 of senior unsecured notes with a weighted average interest rate of 2.9%, as well as a higher average balance outstanding and higher weighted average interest rate on borrowings under our revolving credit facility during 2022 compared to 2021.
Gain (loss) on early extinguishment of debt . We recorded a net gain on early extinguishment of debt of $682 in 2022 resulting from the prepayment of a mortgage note due in 2023 at a discounted principal amount and the write off of the unamortized portion of certain premiums, discounts and debt issuance costs resulting from the prepayment of this mortgage note and the June 2022 redemption of our senior unsecured notes due July 2022. We recorded a loss on early extinguishment of debt of $14,068 in 2021 from prepayment fees incurred and the write off of unamortized discounts and debt issuance costs associated with the prepayment of one mortgage note due in 2023 and the redemption of our senior unsecured notes due in 2022 and 2046.
Income tax expense. The increase in income tax expense reflects higher operating income in certain jurisdictions in 2022 where we are subject to state income taxes.
Equity in net losses of investees. Equity in net losses of investees represents our proportionate share of losses from our investments in two unconsolidated joint ventures. The increase in equity in net losses of investees was primarily due to reductions in occupied space at properties owned by our unconsolidated joint ventures in 2022.
Net loss. Our net loss and net loss per basic and diluted common share decreased in 2022 compared to 2021 primarily as a result of the changes noted above.
Non-GAAP Financial Measures
We present certain “non-GAAP financial measures” within the meaning of the applicable SEC rules, including the calculations below of NOI, FFO and Normalized FFO. These measures do not represent cash generated by operating activities in accordance with GAAP and should not be considered alternatives to net income (loss) as indicators of our operating performance or as measures of our liquidity. These measures should be considered in conjunction with net income (loss) as presented in our consolidated statements of comprehensive income (loss). We consider these non-GAAP measures to be appropriate supplemental measures of operating performance for a REIT, along with net income (loss). We believe these measures provide useful information to investors because by excluding the effects of certain historical amounts, such as depreciation and amortization expense, they may facilitate a comparison of our operating performance between periods and with other REITs and, in the case of NOI, reflecting only those income and expense items that are generated and incurred at the property level may help both investors and management to understand the operations of our properties.
Net Operating Income
The calculation of NOI excludes certain components of net income (loss) in order to provide results that are more closely related to our property level results of operations. We calculate NOI as shown below. We define NOI as income from our rental of real estate less our property operating expenses. NOI excludes amortization of capitalized tenant improvement costs and leasing commissions that we record as depreciation and amortization expense. We use NOI to evaluate individual and company-wide property level performance. Other real estate companies and REITs may calculate NOI differently than we do.
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The following table presents the reconciliation of net loss to NOI for the years ended December 31, 2022 and 2021:
Year Ended December 31,
2022 2021
Net loss $ (6,109) $ (8,180)
Equity in net losses of investees 3,509 2,501
Income tax expense 270 251
Loss before income tax expense and equity in net losses of investees (2,330) (5,428)
(Gain) loss on early extinguishment of debt (682) 14,068
Interest expense 103,480 112,385
Interest and other income (217) (7)
Gain on sale of real estate (11,001) (78,354)
General and administrative 25,134 26,858
Acquisition and transaction related costs 292 —
Loss on impairment of real estate 21,820 62,420
Depreciation and amortization 222,564 241,494
NOI $ 359,060 $ 373,436
Funds From Operations and Normalized Funds From Operations
We calculate FFO and Normalized FFO as shown below. FFO is calculated on the basis defined by The National Association of Real Estate Investment Trusts, which is net income (loss), calculated in accordance with GAAP, plus real estate depreciation and amortization of consolidated properties and our proportionate share of the real estate depreciation and amortization of unconsolidated joint venture properties, but excluding impairment charges on real estate assets and any gain or loss on sale of real estate, as well as certain other adjustments currently not applicable to us. In calculating Normalized FFO, we adjust for the other items shown below and include business management incentive fees, if any, only in the fourth quarter versus the quarter when they are recognized as an expense in accordance with GAAP due to their quarterly volatility not necessarily being indicative of our core operating performance and the uncertainty as to whether any such business management incentive fees will be payable when all contingencies for determining such fees are known at the end of the calendar year. FFO and Normalized FFO are among the factors considered by our Board of Trustees when determining the amount of distributions to our shareholders. Other factors include, but are not limited to, requirements to maintain our qualification for taxation as a REIT, limitations in our credit agreement and public debt covenants, the availability to us of debt and equity capital, our expectation of our future capital requirements and operating performance and our expected needs for and availability of cash to pay our obligations. Other real estate companies and REITs may calculate FFO and Normalized FFO differently than we do.
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The following table presents the reconciliation of net loss to FFO and Normalized FFO for the years ended December 31, 2022 and 2021:
Year Ended December 31,
2022 2021
Net loss $ (6,109) $ (8,180)
Add (less): Depreciation and amortization:
Consolidated properties 222,564 241,494
Unconsolidated joint venture properties 3,058 3,427
Loss on impairment of real estate 21,820 62,420
Gain on sale of real estate (11,001) (78,354)
FFO 230,332 220,807
Add (less): Acquisition and transaction related costs 292 —
(Gain) loss on early extinguishment of debt (682) 14,068
Normalized FFO $ 229,942 $ 234,875
Weighted average common shares outstanding (basic and diluted) 48,278 48,195
FFO per common share (basic and diluted) $ 4.77 $ 4.58
Normalized FFO per common share (basic and diluted) $ 4.76 $ 4.87
LIQUIDITY AND CAPITAL RESOURCES
Our Operating Liquidity and Resources (dollar amounts in thousands, except per share amounts)
Our principal sources of funds to meet operating and capital expenses, pay debt service obligations and make distributions to our shareholders are the operating cash flows we generate from our properties, net proceeds from property sales and borrowings under our revolving credit facility. We believe that these sources of funds will be sufficient to meet our operating and capital expenses, pay debt service obligations and make distributions to our shareholders for the next 12 months and for the foreseeable future thereafter. Our future cash flows from operating activities will depend primarily upon:
• our ability to collect rent from our tenants;
• our ability to maintain or increase the occupancy of, and the rental rates at, our properties;
• our ability to control operating and capital expenses at our properties;
• our ability to successfully sell properties that we market for sale;
• our ability to develop, redevelop or reposition properties to produce cash flows in excess of our cost of capital and property operating and capital expenses; and
• our ability to purchase additional properties which produce cash flows from operations in excess of our cost of acquisition capital and property operating and capital expenses.
On January 12, 2023, we announced a regular quarterly cash distribution of $0.55 per common share ($2.20 per common share per year). We determine our distribution payout ratio with consideration for our expected capital expenditures, as well as cash flows from operations and payment of debt obligations.
We expect to accretively grow our property portfolio through our capital recycling program, pursuant to which we plan to selectively sell certain properties from time to time to manage leverage levels and to acquire new properties or portfolios with a goal of improving our asset diversification, our geographical footprint and the average age of our properties, lengthening the weighted average term of our leases and increasing tenant retention, and increasing our distributions to shareholders. During the year ended December 31, 2022, we sold 18 properties, including one leasable land parcel, for an aggregate sales price of $211,020, excludin g closing costs. Since January 1, 2023, we sold three properties for a sales price of $5,350 , excluding closing costs. As a result of current real estate market conditions, including rising interest rates, the pace of our dispositions has moderated and we expect that trend to continue until commercial real estate industry conditions generally, and office market conditions specifically, improve. However, we continue to evaluate our portfolio to strategically recycle capital and are
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current ly in various stages of marketing certain of our properti es for sale. As of February 14, 2023, we have entered into agreements to sell two properties for an aggregate sales price of $7,600, excluding closing costs. W e continue to carefully consider our capital allocation strategy and believe we are well positioned to opportunistically recycle and deploy capital.
Our future purchases of properties cannot be accurately projected because such purchases depend upon purchase opportunities which come to our attention and our ability to successfully complete the acquisitions. We generally do not intend to purchase “turn around” properties, or properties which do not generate positive cash flows.
The following is a summary of our sources and uses of cash flows for the periods presented, as reflected in our consolidated statements of cash flows:
Year Ended December 31,
2022 2021
Cash, cash equivalents and restricted cash at beginning of period $ 84,515 $ 56,855
Net cash provided by (used in):
Operating activities 192,614 221,492
Investing activities (4,624) (442,985)
Financing activities (260,256) 249,153
Cash, cash equivalents and restricted cash at end of period $ 12,249 $ 84,515
The decrease in cash provided by operating activities in 2022 compared to 2021 was primarily a result of higher deferred leasing costs incurred as a result of leasing activity, disposition activities and unfavorable changes in working capital in 2022. The decrease in cash used in investing activities in 2022 compared to 2021 is primarily due to higher acquisition activity in 2021, partially offset by increased capital expenditures in 2022 related to our two redevelopment projects in Washington, D.C. and Seattle, WA. The increase in cash used in financing activities in 2022 compared to 2021 is a result of net debt repayment activity in 2022 that included the redemption of all $300,000 of our 4.00% senior unsecured notes due July 2022 and the repayment of two mortgage notes with an aggregate principal balance of approximately $48,000, which was partially offset by borrowing activity under our revolving credit facility to facilitate these payments, compared to the aggregate issuance of $1,050,000 of senior unsecured notes in 2021, partially offset by the aggregate redemption of $610,000 of senior unsecured notes and the repayment of $71,000 of mortgage debt in 2021.
Our Investment and Financing Liquidity and Resources (dollar amounts in thousands, except per share amounts)
In order to fund acquisitions and to meet cash needs that may result from our desire or need to make distributions or pay operating or capital expenses, we maintain a $750,000 revolving credit facility. In November 2022, we exercised our option to extend the maturity date of our revolving credit facility by six months to July 31, 2023 and, subject to our payment of an extension fee and meeting certain other conditions, we have the option to extend the maturity date of our revolving credit facility by one additional six month period. We can borrow, repay and reborrow funds available under our revolving credit facility until maturity, and no principal repayment is due until maturity. We are required to pay interest at a rate of LIBOR plus a premium, which was 110 basis points per annum at December 31, 2022, on the amount outstanding under our revolving credit facility, if any. We also pay a facility fee on the total amount of lending commitments under our revolving credit facility, which was 25 basis points per annum at December 31, 2022. Both the interest rate premium and facility fee are subject to adjustment based upon changes to our credit ratings. As of December 31, 2022, the annual interest rate payable on borrowings under our revolving credit facility was 5.4%. As of December 31, 2022 and February 14, 2023, we had $195,000 an d $220,000 outstanding under our revolving credit facility and $555,000 and $530,000 available for borrowing.
Our credit agreement includes a feature under which the maximum borrowing availability may be increased to up to $1,950,000 in certain circumstances.
Our credit agreement provides that, with certain exceptions, a subsidiary of ours is required to guaranty our obligations under our $750,000 revolving credit facility only if that subsidiary has separately incurred debt (other than non-recourse debt), within the meaning specified in our credit agreement, or provided a guarantee of debt incurred by us or any of our other subsidiaries.
During the year ended December 31, 2022, we repaid the following senior unsecured notes and mortgage notes:
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Senior Unsecured Note Redemption
In June 2022, we redeemed, at par plus accrued interest, all $300,000 of our 4.00% senior unsecured notes due July 2022 using cash on hand and borrowings under our revolving credit facility.
Mortgage Note Prepayments
In April 2022, we prepaid, at par plus accrued interest, a mortgage note secured by one property with an outstanding principal balance of $24,863, an annual interest rate of 4.22% and a maturity date in July 2022 using cash on hand.
In October 2022, we prepaid, at a discounted amount of $22,176 plus accrued interest, a mortgage note secured by one property with an outstanding principal balance of $22,901, an annual interest rate of 4.80% and a maturity date in June 2023 using cash on hand and borrowings under our revolving credit facility.
As of December 31, 2022, our debt maturities (other than our revolving credit facility), consisting of senior unsecured notes and one mortgage note, were as follows:
Year Debt Maturities
2023 $ 50,000
2024 350,000
2025 650,000
2026 300,000
2027 350,000
Thereafter 562,000
Total $ 2,262,000
None of our unsecured debt obligations require sinking fund payments prior to their maturity dates. Our $50,000 mortgage note requires monthly payments of interest only through maturity.
In addition to our debt obligations, as of December 31, 2022, we had estimated unspent leasing related obligations of $156,693, of which we expect to spend $86,031 over the next 12 months.
We are currently in the process of redeveloping a property located in Washington, D.C. containing approximately 340,000 rentable square feet. We currently estimate the total project costs associated with this redevelopment will be approximately $215,000 and completion of the redevelopment in the second quarter of 2023. As of December 31, 2022, we had incurred $148,107 related to this project. In June 2021, we entered into a 30-year lease for approximately 230,000 rentable square feet at this property that is approximately 25.1% higher than the prior rental rate for the same space, making the redevelopment project 54% pre-leased. See Note 7 to the Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K for more information regarding this lease and related redevelopment costs.
We are also in the process of redeveloping a three-property campus located in Seattle, WA containing approximately 300,000 rentable square feet. This project includes the repositioning of two properties from office to life science and maintaining the third property for office use. We currently estimate the total project costs associated with this redevelopment will be approximately $162,000 and completion of the redevelopment in the fourth quarter of 2023. As of December 31, 2022, we had incurred $48,824 related to this project. In August 2022, we entered into an approximately 10-year lease for approximately 84,000 rentable square feet at one of the life science properties that is approximately 109.0% higher than the prior rental rate for the same space, making the redevelopment project 28% pre-leased.
We currently expect to use cash balances, borrowings under our revolving credit facility, net proceeds from property sales, incurrences or assumptions of mortgage debt and net proceeds from offerings of debt or equity securities to fund our future operations, capital expenditures, distributions to our shareholders and property acquisitions. When significant amounts are outstanding under our revolving credit facility or the maturities of our indebtedness approach, we expect to explore refinancing alternatives. Such alternatives may include incurring term debt, issuing debt or equity securities, extending the maturity date of our revolving credit facility and entering into a new revolving credit facility. We may assume additional mortgage debt in connection with our acquisitions or elect to place new mortgages on properties we own as a source of financing. We may also seek to participate in additional joint venture or other arrangements that may provide us with additional sources of financing. Although we cannot be sure that we will be successful in consummating any particular type of financing, we believe that we will have access to financing, such as debt and equity offerings, to fund future acquisitions and capital expenditures and to pay
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our obligations. We currently have an effective shelf registration statement that allows us to issue public securities on an expedited basis, but it does not assure that there will be buyers for such securities.
Our ability to obtain, and the costs of, our future debt financings will depend primarily on credit market conditions and our creditworthiness. We have no control over market conditions. Potential investors and lenders likely will evaluate our ability to pay distributions to shareholders, fund required debt service and repay debts when they become due by reviewing our business practices and plans to balance our use of debt and equity capital so that our financial profile and leverage ratios afford us flexibility to withstand any reasonably anticipated adverse changes. Similarly, our ability to raise equity capital in the future will depend primarily upon equity capital market conditions and our ability to conduct our business to maintain and grow our operating cash flows. We intend to conduct our business in a manner that will afford us reasonable access to capital for investment and financing activities, but we cannot be sure that we will be able to successfully carry out this intention. For instance, it is uncertain what the ultimate impacts of inflationary pressures, rising interest rates or any economic recession will be. A protracted and extensive economic recession or continued or intensified disruptions in capital markets could limit our access to financing from public sources and would likely increase our cost of capital.
During the year ended December 31, 2022, we paid quarterly distributions to our shareholders totaling $106,630 using cash on hand and borrowings under our revolving credit facility. On January 12, 2023, we declared a regular quarterly distribution payable to shareholders of record on January 23, 2023 in the amount of $0.55 per share, or approximately $26,700. We expect to pay this distribution on or about February 16, 2023 using cash on hand and borrowings under our revolving credit facility. For more information regarding the distributions we paid during 2022, see Note 11 to the Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K.
We own 51% and 50% interests in two unconsolidated joint ventures which own three properties. The properties owned by these joint ventures are encumbered by an aggregate $82,000 principal amount of mortgage indebtedness, none of which is recourse to us. We do not control the activities that are most significant to these joint ventures and, as a result, we account for our investments in these joint ventures under the equity method of accounting. For more information on the financial condition and results of operations of these joint ventures, see Note 4 to the Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K. Other than these joint ventures, as of December 31, 2022, we had no off balance sheet arrangements that have had or that we expect would be reasonably likely to have a material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Debt Covenants (dollars in thousands)
Our principal debt obligations at December 31, 2022 consisted of $195,000 of borrowings outstanding under our $750,000 revolving credit facility, an outstanding principal balance of $2,212,000 of public issuances of senior unsecured notes and a mortgage note with an outstanding principal balance of $50,000 that was assumed in connection with an acquisition. Also, the three properties owned by two joint ventures in which we own 51% and 50% interests secure two additional mortgage notes. Our publicly issued senior unsecured notes are governed by indentures and their supplements. Our credit agreement and our senior unsecured notes indentures and their supplements provide for acceleration of payment of all amounts outstanding upon the occurrence and continuation of certain events of default, such as, in the case of our credit agreement, a change of control of us, which includes RMR ceasing to act as our business and property manager. Our credit agreement and our senior unsecured notes indentures and their supplements also contain a number of covenants, including those that restrict our ability to incur debts, including debts secured by mortgages on our properties, in excess of calculated amounts, require us to comply with certain financial covenants and, in the case of our credit agreement, restrict our ability to make distributions to our shareholders under certain circumstances. As of December 31, 2022, we believe we were in compliance with the terms and conditions of our respective covenants under our credit agreement and senior unsecured notes indentures and their supplements. Our mortgage note is non-recourse, subject to certain limited exceptions, and does not contain any material financial covenants.
Neither our credit agreement nor our senior unsecured notes indentures and their supplements contain provisions for acceleration which could be triggered by our credit ratings. However, under our credit agreement, our highest senior credit rating, as defined in our credit agreement, is used to determine the fees and interest rates we pay. Accordingly, if that credit rating is downgraded, our interest expense and related costs under our credit agreement would increase. In November 2022, Moody’s downgraded our senior unsecured debt rating from Baa3 to Ba 1. However, as of February 14, 2023, our highest senior credit rating, as defined in our credit agreement, remains unchanged and therefore, the fees and interest rates we pay under our credit agreement have not increased as a result of the downgrade to our senior unsecured debt rating.
Our credit agreement has cross default provisions to other indebtedness that is recourse of $25,000 or more and indebtedness that is non-recourse of $50,000 or more. Similarly, our senior unsecured notes indentures and their supplements contain cross default provisions to any other debts of more than $25,000 (or up to $50,000 in certain circumstances).
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Related Person Transactions
We have relationships and historical and continuing transactions with RMR, RMR Inc. and others related to them. For more information about these and other such relationships and related person transactions, see Notes 6 and 7 to the Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K, which are incorporated herein by reference, and our other filings with the SEC, including our definitive Proxy Statement for our 2023 Annual Meeting of Shareholders, or our definitive Proxy Statement, to be filed with the SEC within 120 days after the fiscal year ended December 31, 2022. For more information about the risks that may arise as a result of these and other related person transactions and relationships, see elsewhere in this Annual Report on Form 10-K, including “Warning Concerning Forward Looking Statements,” Part I, Item 1, “Business” and Part I, Item 1A, “Risk Factors.” We may engage in additional transactions with related persons, including businesses to which RMR or its subsidiaries provide management services.
Critical Accounting Estimates
Our critical accounting policies are those that will have the most impact on the reporting of our financial condition and results of operations and those requiring significant judgments and estimates. We believe that our judgments and estimates have been and will be consistently applied and produce financial information that fairly presents our results of operations. Our most critical accounting policies involve our investments in real property. These policies affect our:
• allocation of purchase prices between various asset categories, including allocations to above and below market leases and the related impact on the recognition of rental income and depreciation and amortization expenses; and
• assessment of the carrying values and impairments of long lived assets.
We allocate the acquisition cost of each property investment to various property components such as land, buildings and improvements and intangibles based on their fair values, and each component generally has a different useful life. For acquired real estate, we record land, buildings and improvements, and, if applicable, the value of in place leases, the fair market value of above or below market leases and tenant relationships at fair value. For transactions that qualify as business combinations, we allocate the excess, if any, of the consideration over the fair value of assets acquired to goodwill. We base purchase price allocations and the determination of useful lives on our estimates and, under some circumstances, studies from independent real estate appraisers to provide market information and evaluations, which may involve estimated cash flows that are based on a number of factors, including capitalization rates and discount rates, among others, that are relevant to our purchase price allocations and determinations of useful lives; however, our management is ultimately responsible for the purchase price allocations and determination of useful lives.
We compute depreciation expense using the straight line method over estimated useful lives of up to 40 years for buildings and improvements, and up to seven years for personal property. We do not depreciate the allocated cost of land. We amortize capitalized above market lease values as a reduction to rental income over the terms of the respective leases. We amortize capitalized below market lease values as an increase to rental income over the terms of the respective leases. We amortize the value of acquired in place leases exclusive of the value of above market and below market acquired leases to expense over the periods of the respective leases. If a lease is terminated prior to its stated expiration, all unamortized amounts relating to that lease are written off. Purchase price allocations require us to make certain assumptions and estimates. Incorrect assumptions and estimates may result in inaccurate depreciation and amortization charges over future periods.
We periodically evaluate our properties for impairment. Impairment indicators may include declining tenant occupancy, our concerns about a tenant’s financial condition (which may be endangered by a rent default or other information which comes to our attention) or our decision to dispose of an asset before the end of its estimated useful life and legislative, as well as market or industry changes that could permanently reduce the value of a property. If indicators of impairment are present, we evaluate the carrying value of the related property by comparing it to the expected future undiscounted cash flows to be generated from that property. If the sum of these expected future cash flows is less than the carrying value, we reduce the net carrying value of the property to its fair value. This analysis requires us to judge whether indicators of impairment exist and to estimate likely future cash flows. The future net undiscounted cash flows are subjective and are based in part on assumptions regarding hold periods, market rents and terminal capitalization rates. If we misjudge or estimate incorrectly or if future tenant operations, market or industry factors differ from our expectations we may record an impairment charge that is inappropriate or fail to record a charge when we should have done so, or the amount of any such charges may be inaccurate.
These accounting policies involve significant judgments made based upon our experience and the experience of our management and our Board of Trustees, including judgments about current valuations, ultimate realizable value, estimated useful lives, salvage or residual value, the ability and willingness of our tenants to perform their obligations to us, current and future economic conditions and competitive factors in the markets in which our properties are located. Competition, economic
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conditions, changing government priorities and other factors may cause occupancy declines in the future. In the future, we may need to revise our carrying value assessments to incorporate information which is not now known, and such revisions could increase or decrease our depreciation expense related to properties we own or decrease the carrying values of our assets.
Impact of Climate Change
Concerns about climate change have resulted in various treaties, laws and regulations that are intended to limit carbon emissions and address other environmental concerns. These and other laws may cause energy or other costs at our properties to increase. We do not expect the direct impact of these increases to be material to our results of operations, because the increased costs either would be the responsibility of our tenants directly or in the longer term, passed through and paid by tenants of our properties. Although we do not believe it is likely in the foreseeable future, laws enacted to mitigate climate change may make some of our properties obsolete or cause us to make material investments in our properties, which could materially and adversely affect our financial condition or the financial condition of our tenants and their ability to pay rent to us.
In an effort to reduce the effects of any increased energy costs in the future, we continuously study ways to improve the energy efficiency at all of our properties. Our manager, RMR, is a member of the ENERGY STAR program, a joint program of the U.S. Environmental Protection Agency and the U.S. Department of Energy that is focused on promoting energy efficiency at commercial properties through its “ENERGY STAR” program, and a member of the U.S. Green Building Council, a nonprofit organization focused on promoting energy efficiency at commercial properties through its LEED® green building program. RMR’s annual Sustainability Report summarizes the environmental, social and governance initiatives RMR and its clients, including OPI, employ. RMR’s Sustainability Report may be accessed on RMR Inc.’s website at www.rmrgroup.com/corporate-sustainability/default.aspx. The information on or accessible through RMR Inc.’s website is not incorporated by reference into this Annual Report on Form 10-K. For more information, see “Business—Corporate Sustainability” in Part I, Item 1 of this Annual Report on Form 10-K.
Some observers believe severe weather in different parts of the world over the last few years is evidence of global climate change. Severe weather may have an adverse effect on certain properties we own. Rising sea levels could cause flooding at some of our properties, which may have an adverse effect on individual properties we own. We mitigate these risks by procuring, or requiring our tenants to procure, insurance coverage we believe adequate to protect us from material damages and losses resulting from the consequences of losses caused by climate change. However, we cannot be sure that our mitigation efforts will be sufficient or that future storms, rising sea levels or other changes that may occur due to future climate change could not have a material adverse effect on our financial results.