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, 2023, our wholly owned properties were comprised of 152 properties and we had noncontrolling ownership interests of 51% and 50% in two unconsolidated joint ventures that owned three properties containing approximately 468,000 rentable square feet. As of December 31, 2023, our properties are located in 30 states and the District of Columbia and contain approximately 20,541,000 rentable square feet. As of December 31, 2023, our properties were leased to 258 different tenants, with a weighted average remaining lease term (based on annualized rental
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income) of approximately 6.4 years. The U.S. government is our largest tenant, representing approximately 19.5% of our annualized rental income as of December 31, 2023.
Leases representing approximately 15.5% and 10.6% of our annual rental income are scheduled to expire in each of 2024 and 2025, respectively, and we may be unable to renew leases or find replacement tenants. Certain changes in office space utilization, including increased remote work arrangements and tenants consolidating their real estate footprint, continue to impact the market. The utilization and demand for office space continues to face headwinds and the duration and 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 or the long-term outlook for leasing our properties. Higher interest rates, inflationary pressures, geopolitical hostilities and tensions, and concerns that the U.S. economy may enter an economic recession have caused disruptions in the financial markets and these factors could adversely affect our and our tenants’ financial condition and the ability or willingness of our tenants to renew our leases or pay rent to us. We have a significant amount of debt maturing in the next twelve months. Deteriorating office fundamentals, high interest rates and market sentiment towards the office sector may restrict our access to, and likely increase our cost of, capital as we seek to refinance our debts.
For more information about the risks relating to these dynamics and conditions 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, 2023 and excludes three properties owned by two unconsolidated joint ventures in which we owned 51% and 50% interests as of December 31, 2023. 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, 2023 and 2022 was as follows (square feet in thousands):
All Properties (1)
Comparable Properties (2)
December 31, December 31,
2023 2022 2023 2022
Total properties 152 160 146 146
Total rentable square feet (3)
20,541 20,969 19,290 19,310
Percent leased (4)
86.9 % 90.6 % 89.5 % 94.6 %
(1) Based on properties we owned on December 31, 2023 and 2022, respectively.
(2) Based on properties we owned continuously since January 1, 2022; excludes one property classified as held for sale, five properties undergoing significant redevelopment and three properties owned by two unconsolidated joint ventures in which we owned 51% and 50% interests as of December 31, 2023.
(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, 2023 and 2022 were as follows:
Year Ended December 31,
Average effective rental rate per square foot (1) :
2023 2022
All properties (2)
$ 29.41 $ 29.03
Comparable properties (3)
$ 28.99 $ 28.51
(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, 2023 and 2022, respectively.
(3) Based on properties we owned continuously since January 1, 2022; excludes one property classified as held for sale, five properties undergoing significant redevelopment and three properties owned by two unconsolidated joint ventures in which we owned 51% and 50% interests as of December 31, 2023.
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During the year ended December 31, 2023, changes in rentable square feet leased and available for lease at our properties were as follows (square feet in thousands):
Year Ended December 31, 2023
Leased Available
for Lease Total
Beginning of year 19,004 1,965 20,969
Changes resulting from:
Disposition of properties (168) (385) (553)
Lease expirations (2,686) 2,686 —
Redevelopment expansion (1)
— 87 87
Lease renewals (2)
1,296 (1,296) —
New leases (2)
402 (402) —
Remeasurements (3)
— 38 38
End of year 17,848 2,693 20,541
(1) Represents additional rentable square feet resulting from the redevelopment of a property in Washington, D.C., which was completed in June 2023.
(2) Based on leases entered during the year ended December 31, 2023.
(3) Rentable square feet are subject to changes when space is remeasured or reconfigured for tenants.
During the year ended December 31, 2023, we entered into new and renewal leases as summarized in the following table (square feet in thousands):
Year Ended December 31, 2023
New Leases Renewals Total
Rentable square feet leased 402 1,296 1,698
Weighted average rental rate change (by rentable square feet) (1.7 %) (2.9 %) (2.6 %)
Tenant leasing costs and concession commitments (1)
$ 35,425 $ 46,777 $ 82,202
Tenant leasing costs and concession commitments per rentable square foot (1)
$ 88.35 $ 36.10 $ 48.45
Weighted (by square feet) average lease term (years) 8.6 8.4 8.5
Total leasing costs and concession commitments per rentable square foot per year (1)
$ 10.22 $ 4.28 $ 5.71
(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, 2023, 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, 2023, 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, 2023
Old Effective
Rent Per
Square Foot (1)
New Effective
Rent Per
Square Foot (1)
Rentable
Square Feet
New leases $ 28.91 $ 29.56 584
Lease renewals $ 31.33 $ 30.41 1,550
Total leasing activity $ 30.66 $ 30.18 2,134
(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, 2023 and 2022, amounts capitalized at our properties for lease related costs, building improvements and development, redevelopment and other activities were as follows:
Year Ended December 31,
2023 2022
Lease related costs (1)
$ 75,467 $ 66,868
Building improvements (2)
29,330 33,393
Recurring capital expenditures 104,797 100,261
Development, redevelopment and other activities (3)
137,603 159,189
Total capital expenditures $ 242,400 $ 259,450
(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. Includes capitalized interest and other operating costs of $10,159 and $7,456 for the years ended December 31, 2023 and 2022, respectively.
In addition to the capital expenditures described above, we contributed $5,213 and $3,851 to one of our unconsolidated joint ventures during the years ended December 31, 2023 and 2022, respectively. Also, as of December 31, 2023, we had estimated unspent leasing related obligations of $109,309, of which we expect to spend $67,705 over the next 12 months.
As of December 31, 2023, we had leases at our properties totaling approximately 2,983,000 rentable square feet that were scheduled to expire during 2024. As of February 14, 2024, we expect tenants with leases totaling approxim ately 1,881,000 r entable square feet that are scheduled to expire during 2024, excluding space that has been re-leased and space for which we are in advanced negotiations to re-lease, not to renew or to downsize their leased space upon expiration, and we cannot be sure as to whether other tenants will renew their leases upon expiration. However, we continue to proactively engage with our existing tenants and are focused on overall tenant retention. Prevailing market conditions and our 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 that 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, 2023, 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
2024 66 2,983 16.7% 16.7% $ 79,245 15.5% 15.5%
2025 40 2,131 11.9% 28.6% 54,208 10.6% 26.1%
2026 37 1,445 8.1% 36.7% 40,974 8.0% 34.1%
2027 36 2,059 11.5% 48.2% 52,316 10.2% 44.3%
2028 18 659 3.7% 51.9% 30,219 5.9% 50.2%
2029 31 1,122 6.3% 58.2% 31,761 6.2% 56.4%
2030 28 940 5.3% 63.5% 27,043 5.3% 61.7%
2031 20 1,038 5.8% 69.3% 29,828 5.8% 67.5%
2032 11 325 1.8% 71.1% 12,165 2.4% 69.9%
2033 and thereafter 50 5,146 28.9% 100.0% 155,092 30.1% 100.0%
Total 337 17,848 100.0% $ 512,851 100.0%
Weighted average remaining lease term (in years) 6.0 6.4
(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, 2023, tenants occupying approximately 4.0% of our rentable square feet and responsible for approximately 4.1% of our annualized rental income as of December 31, 2023, had exercisable rights to terminate their leases before the stated terms of their leases expire. Also, in 2024, 2025, 2026, 2027, 2028, 2029, 2030, 2031, 2032, 2034, 2035, 2036, 2037 and 2040 early termination rights become exercisable by other tenants who occupied an additional approximately 2.0%, 2.6%, 1.6%, 1.3%, 3.9%, 0.8%, 1.4%, 0.6%, 0.3%, 0.2%, 0.9%, 0.1%, 0.1% and 0.3% of our rentable square feet, respectively, and contributed an additional approximately 2.2%, 5.2%, 2.2%, 1.7%, 4.6%, 1.4%, 2.0%, 0.6%, 0.5%, 0.6%, 1.2%, 0.3%, 0.2% and 0.4% of our annualized rental income, respectively, as of December 31, 2023. In addition, as of December 31, 2023, pursuant to leases with eight 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 eight tenants occupied approximately 4.2% of our rentable square feet and contributed approximately 4.4% of our annualized rental income as of December 31, 2023.
(2) Leased square feet is pursuant to leases existing as of December 31, 2023, 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.
As of December 31, 2023, we derived 22.2% 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. Current economic conditions in this area or a possible recession, including as a result of current inflationary conditions or otherwise, could reduce 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 decrease in demand for new leased office space by the U.S. government, including 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 or maintain or increase our rents 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, 2023, tenants contributing 54.0% 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 9.7% of annualized rental income were subsidiaries of an investment grade rated parent (although these parent entities were not liable for the payment of rents).
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As of December 31, 2023, 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 3,534 19.8 % $ 99,876 19.5 %
2 Alphabet Inc. (Google) Investment Grade 386 2.2 % 22,119 4.3 %
3 Shook, Hardy & Bacon L.L.P. Not Rated 596 3.3 % 19,216 3.7 %
4 Bank of America Corporation Investment Grade 577 3.2 % 18,159 3.5 %
5 IG Investments Holdings LLC Not Rated 339 1.9 % 17,303 3.4 %
6 State of California Investment Grade 467 2.6 % 14,021 2.7 %
7 Tyson Foods, Inc. (1)
Investment Grade 248 1.4 % 11,954 2.3 %
8 Northrop Grumman Corporation Investment Grade 337 1.9 % 10,795 2.1 %
9 Sonesta International Hotels Corporation Not Rated 234 1.3 % 9,778 1.9 %
10 Micro Focus International plc Non Investment Grade 215 1.2 % 7,915 1.5 %
11 Sonoma Biotherapeutics, Inc. (2)
Not Rated 107 0.6 % 7,634 1.5 %
12 State of Georgia Investment Grade 308 1.7 % 7,345 1.4 %
13 Commonwealth of Massachusetts Investment Grade 212 1.2 % 7,269 1.4 %
14 CommScope Holding Company Inc. Non Investment Grade 162 0.9 % 7,199 1.4 %
15 PNC Bank Investment Grade 441 2.5 % 6,960 1.4 %
16 Compass Group plc Investment Grade 267 1.5 % 6,697 1.3 %
17 ServiceNow, Inc. Investment Grade 149 0.8 % 6,675 1.3 %
18 Allstate Insurance Corporation Investment Grade 468 2.6 % 6,484 1.3 %
19 Automatic Data Processing, Inc. Investment Grade 289 1.6 % 6,079 1.2 %
20 Church & Dwight Co., Inc. Investment Grade 250 1.4 % 6,043 1.2 %
21 Leidos Holdings Inc. Investment Grade 159 0.9 % 5,950 1.2 %
22 Primerica, Inc. Investment Grade 344 1.9 % 5,737 1.1 %
23 Science Applications International Corp Non Investment Grade 159 0.9 % 5,228 1.0 %
10,248 57.3 % $ 316,436 61.6 %
(1) In July 2023, we received notice from Tyson Foods, Inc. exercising its option to terminate its lease at a property we owned in Chicago, IL effective January 2025, prior to the stated lease expiration date of January 31, 2028. We are amortizing termination fees of approximately $1,400 per quarter through January 2025 as a result of this early termination.
(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 first quarter of 2024.
Acquisition Activities
During the year ended December 31, 2023, we acquired a vacant land parcel adjacent to an office park we own for a purchase price of $2,750, excluding acquisition related costs.
Disposition Activities
During the year ended December 31, 2023, we sold eight properties containing approximately 553,000 rentable square feet for an aggregate sales price of $44,874, excluding closing costs. The net proceeds from these sales were used to repay amounts outstanding under our prior $750,000 unsecured revolving credit facility, or our prior revolving credit facility.
W e continue to evaluate our portfolio and are currently in various stages of marketing certain of our properties for sale, and we may seek to sell additional properties in the future. However, we cannot be sure we will sell any properties we are marketing for sale for prices in excess of their carrying values or otherwise. As of February 14, 2024, we have entered into an agreement to sell one property containing approximately 248,000 rentable square feet for a sales price of $39,000, 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 addition, our pending sale is subject to conditions; accordingly, we cannot be sure that we will complete this sale or that this sale 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.
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Financing Activities
Mortgage Note Repayment
In June 2023, we repaid at maturity, a mortgage note secured by one property with an outstanding principal balance of $50,000 and an annual interest rate of 3.70%, using cash on hand and borrowings under our prior revolving credit facility.
Mortgage Notes Issuances
During the year ended December 31, 2023, we issued six fixed rate, interest-only mortgage notes with an aggregate principal balance of $177,320 and a weighted average interest rate of 7.8%. The net proceeds from these mortgage loans were used to repay amounts outstanding under our prior revolving credit facility.
Amended and Restated Credit Agreement
In January 2024, we entered into our credit agreement governing a new $325,000 secured revolving credit facility and a $100,000 secured term loan. Our credit agreement replaced our prior revolving credit facility, which had a maturity date of January 31, 2024. As collateral for all loans and other obligations under our credit agreement, certain of our subsidiaries pledged all of their respective equity interests in certain of our direct and indirect property owning subsidiaries, and our pledged subsidiaries provided first mortgage liens on 19 properties that had an undepreciated carrying value, including lease intangibles, other assets and other liabilities, of $941,937 as of December 31, 2023. We can borrow, repay, and reborrow funds available under our revolving credit facility until maturity and no principal repayments on borrowings under our credit agreement are due until maturity. The maturity date of our credit agreement is January 29, 2027 and, subject to the payment of an extension fee and meeting certain other requirements, we can extend the stated maturity date of our revolving credit facility by one year. Our credit agreement contains a number of covenants, including covenants that require us to maintain certain financial ratios, restrict our ability to incur additional debt in excess of calculated amounts and, subject to limited exceptions, restrict our ability to increase our distribution rate above the current level of $0.01 per common share per quarter and enter into share repurchases, through the maturity date of the agreement. Availability of borrowings under our credit agreement is subject to ongoing minimum performance and market values of the 19 collateral properties, our satisfying certain financial covenants and other credit facility conditions. Interest payable on borrowings under our credit agreement is at a rate of the secured overnight financing rate, or SOFR, plus a margin of 350 basis points. On January 29, 2024, we borrowed the full amount of our term loan and $132,000 under our revolving credit facility. We used the proceeds from these borrowings to repay all outstanding borrowings under our prior revolving credit facility, to fund transaction related costs relating to our credit agreement and for general business purposes.
Senior Secured Notes Issuance
In February 2024, we issued $300,000 of the 2029 Notes. The aggregate net proceeds from this offering were $271,500, after initial purchaser discounts and other estimated offering expenses. The 2029 Notes are fully and unconditionally guaranteed on a joint, several and senior secured basis by certain of our subsidiaries and secured by a pledge of all of the respective equity interests of the subsidiary guarantors and first mortgage liens on 17 properties with an undepreciated carrying value, including lease intangibles, other assets and other liabilities, of $574,291 as of December 31, 2023. The notes require semi-annual payments of interest only and are prepayable, at par plus accrued interest, after March 31, 2028.
Senior Unsecured Notes Redemption
In February 2024, we issued a notice of early redemption, at par plus accrued interest, of all of our $350,000 of 4.25% senior unsecured notes due May 2024. The redemption is expected to take place in March 2024 using the net proceeds from the offering of the 2029 Notes and borrowings under our revolving credit facility and the redemption is conditioned upon our borrowing an amount under our revolving credit facility sufficient, together with the net proceeds from the offering of the 2029 Notes, to pay the redemption price on or prior to the redemption date.
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, 2023, Compared to Year Ended December 31, 2022
Comparable Properties (1) Results
Year Ended December 31,
Non-Comparable Properties Results Year Ended December 31, Consolidated Results
Year Ended December 31,
2023 2022 $
Change %
Change 2023 2022 2023 2022 $
Change %
Change
Rental income $ 512,595 $ 508,719 $ 3,876 0.8 % $ 20,958 $ 45,556 $ 533,553 $ 554,275 $ (20,722) (3.7 %)
Operating expenses:
Real estate taxes 59,143 49,941 9,202 18.4 % 3,688 7,903 62,831 57,844 4,987 8.6 %
Utility expenses 25,690 24,409 1,281 5.2 % 1,088 2,596 26,778 27,005 (227) (0.8 %)
Other operating expenses
104,717 99,627 5,090 5.1 % 5,166 10,739 109,883 110,366 (483) (0.4 %)
Total operating expenses
189,550 173,977 15,573 9.0 % 9,942 21,238 199,492 195,215 4,277 2.2 %
Net operating income (loss) (2)
$ 323,045 $ 334,742 $ (11,697) (3.5 %) $ 11,016 $ 24,318 334,061 359,060 (24,999) (7.0 %)
Other expenses:
Depreciation and amortization 209,254 222,564 (13,310) (6.0 %)
Loss on impairment of real estate 11,299 21,820 (10,521) (48.2 %)
Acquisition and transaction related costs 31,816 292 31,524 n/m
General and administrative 22,731 25,134 (2,403) (9.6 %)
Total other expenses 275,100 269,810 5,290 2.0 %
Gain on sale of real estate 3,780 11,001 (7,221) (65.6 %)
Interest and other income 1,039 217 822 n/m
Interest expense (110,647) (103,480) (7,167) 6.9 %
Gain on early extinguishment of debt — 682 (682) n/m
Loss before income tax expense and equity in net losses of investees (46,867) (2,330) (44,537) n/m
Income tax expense (351) (270) (81) 30.0 %
Equity in net losses of investees (3,031) (3,509) 478 (13.6 %)
Loss on impairment of equity method investment (19,183) — (19,183) n/m
Net loss $ (69,432) $ (6,109) $ (63,323) n/m
Weighted average common shares outstanding (basic and diluted) 48,389 48,278 111 0.2 %
Per common share amounts (basic and diluted):
Net loss $ (1.44) $ (0.14) $ (1.30) n/m
n/m - not meaningful
(1) Comparable properties consists of 146 properties we owned on December 31, 2023 and which we owned continuously since January 1, 2022 and excludes one property classified as held for sale, five properties undergoing significant redevelopment and three properties owned by two unconsolidated joint ventures in which we owned 51% and 50% interests as of December 31, 2023.
(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, 2023 compared to the year ended December 31, 2022. For a comparison of consolidated results for the year ended December 31, 2022 compared to the year ended December 31, 2021, 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, 2022.
Rental income. Rental income for non-comparable properties declined $22,210 related to our property disposition activities and $2,388 for properties undergoing significant redevelopment due to termination fee revenue in 2022 and increased vacancy
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at a property that began a redevelopment project in February 2022, partially offset by the lease-up of our 20 Mass Ave. redevelopment in Washington, D.C. Rental income for comparable properties increased $3,876 due to the impact of real estate tax appeals and the related reimbursement income in the 2022 period, partially offset by increased vacancies at certain of our properties in 2023 and lower termination fee revenue. Rental income includes non-cash straight line rent adjustments totaling $26,194 in 2023 and $10,830 in 2022, and amortization of acquired real estate leases and assumed real estate lease obligations totaling $252 in 2023 and ($975) in 2022.
Real estate taxes. Real estate taxes for non-comparable properties declined $3,876 related to our property disposition activities and $339 as a result of successful tax appeals at certain properties undergoing significant redevelopment, partially offset by an increase of $9,202 for comparable properties due to the favorable impact of real estate tax appeals recorded in 2022.
Utility expenses. Utility expenses for non-comparable properties declined $1,842 related to our property disposition activities, partially offset by an increase of $334 for properties undergoing significant redevelopment due to the related lease-up of those properties. Utility expenses for comparable properties increased $1,281 primarily due to the impact of inflation in 2023, as well as utility expenses that were previously paid directly by certain of our tenants that are now being paid by us.
Other operating expenses. Other operating expenses for non-comparable properties declined $6,148 related to our property disposition activities, partially offset by an increase of $575 for properties undergoing significant redevelopment due to the lease-up of our 20 Mass Ave. redevelopment in Washington, D.C. Other operating expenses for comparable properties increased $5,090 due to higher repairs and maintenance costs and higher insurance costs, as well as other operating expenses that were previously paid directly by certain of our tenants that are now being paid by us.
Depreciation and amortization. The decline in depreciation and amortization reflects a decrease of $12,043 for comparable properties due to certain leasing related assets becoming fully depreciated since January 1, 2022, partially offset by depreciation and amortization of improvements made to certain of our properties since January 1, 2022. Depreciation and amortization for non-comparable properties declined $1,889 related to our property disposition activities, partially offset by an increase of $622 for properties undergoing significant redevelopment due to the substantial completion of our 20 Mass Ave. redevelopment in Washington, D.C.
Loss on impairment of real estate . We recorded an $11,299 loss on impairment of real estate in 2023 to reduce the carrying value of one property to its estimated fair value less costs to sell. 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.
Acquisition and transaction related costs. Acquisition and transaction related costs in 2023 are primarily related to our terminated merger with Diversified Healthcare Trust, or DHC, and related transactions. For more information regarding our terminated merger with DHC, see Note 7 to the Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K.
General and administrative. 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 and a decrease in share based compensation in 2023 compared to 2022, partially offset by a state franchise tax refund received in 2022.
Gain on sale of real estate. We recorded a $3,780 net gain on sale of real estate resulting from the sale of eight properties in 2023. We recorded a $11,001 net gain on sale of real estate in 2022 resulting from the sale of 18 properties, including one leasable land parcel.
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 2023 compared to 2022.
Inter est expense. Th e increase in interest expense reflects higher average amounts outstanding and higher average interest rates on borrowings under our prior revolving credit facility, as well as the issuance of six mortgage notes with an aggregate principal balance of $177,320 and a weighted average interest rate of 7.8% during 2023, partially offset by the redemption of our $300,000 of senior unsecured notes with an interest rate of 4.0% in June 2022, higher capitalized interest in 2023 and the repayment of three mortgage notes since January 1, 2022 with an aggregate principal balance of $98,000 and a weighted average interest rate of 4.1%.
Gain 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
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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.
Income tax expense. Income tax expense is primarily the result of operating income earned in jurisdictions where we are subject to state income taxes and can fluctuate based on the timing of our income, including as a result of gains or losses on the sale of real estate.
Equity in net losses of investees. Equity in net losses of investees represents our proportionate share of losses from our equity method investments in two unconsolidated joint ventures.
Loss on impairment of equity method investment . We recorded a $19,183 loss on impairment of equity method investment in 2023 to fully write off the carrying value of one of our unconsolidated joint ventures. For further information, see Note 4 to the Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K.
Net loss. Net loss and net loss per basic and diluted common share increased in 2023 compared to 2022 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, funds from operations, or 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 loss as indicators of our operating performance or as measures of our liquidity. These measures should be considered in conjunction with net 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 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 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.
The following table presents the reconciliation of net loss to NOI for the years ended December 31, 2023 and 2022:
Year Ended December 31,
2023 2022
Net loss $ (69,432) $ (6,109)
Equity in net losses of investees 3,031 3,509
Loss on impairment of equity method investment 19,183 —
Income tax expense 351 270
Loss before income tax expense and equity in net losses of investees (46,867) (2,330)
Gain on early extinguishment of debt — (682)
Interest expense 110,647 103,480
Interest and other income (1,039) (217)
Gain on sale of real estate (3,780) (11,001)
General and administrative 22,731 25,134
Acquisition and transaction related costs 31,816 292
Loss on impairment of real estate 11,299 21,820
Depreciation and amortization 209,254 222,564
NOI $ 334,061 $ 359,060
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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 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. 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.
The following table presents the reconciliation of net loss to FFO and Normalized FFO for the years ended December 31, 2023 and 2022:
Year Ended December 31,
2023 2022
Net loss $ (69,432) $ (6,109)
Add (less): Depreciation and amortization:
Consolidated properties 209,254 222,564
Unconsolidated joint venture properties 3,395 3,058
Loss on impairment of real estate 11,299 21,820
Loss on impairment of equity method investment 19,183 —
Gain on sale of real estate (3,780) (11,001)
FFO 169,919 230,332
Add (less): Acquisition and transaction related costs 31,816 292
Gain on early extinguishment of debt — (682)
Normalized FFO $ 201,735 $ 229,942
Weighted average common shares outstanding (basic and diluted) 48,389 48,278
FFO per common share (basic and diluted) $ 3.51 $ 4.77
Normalized FFO per common share (basic and diluted) $ 4.17 $ 4.76
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
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• 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.
We plan to selectively sell certain properties from time to time to manage leverage levels and to improve 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. During the year ended December 31, 2023, we sold eight properties for an aggregate sales price of $44,874, excludin g closing costs. We continue to evaluate our portfolio and are currently in various stages of marketing certain of our properties for sale. As of February 14, 2024, we have entered into an agreement to sell one property containing approximately 248,000 rentable square feet for a sales price of $39,000, 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 addition, our pending sale is subject to conditions; accordingly, we cannot be sure that we will complete this sale or that this sale will not be delayed or the terms will not change.
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,
2023 2022
Cash, cash equivalents and restricted cash at beginning of period $ 12,249 $ 84,515
Net cash provided by (used in):
Operating activities 141,726 192,614
Investing activities (194,821) (4,624)
Financing activities 67,560 (260,256)
Cash, cash equivalents and restricted cash at end of period $ 26,714 $ 12,249
The decrease in cash provided by operating activities in 2023 compared to 2022 was primarily due to decreases in NOI in 2023 due to property dispositions, reductions in occupied space at certain of our properties and an increase in costs incurred in connection with the terminated merger with DHC and related transactions. The increase in cash used in investing activities in 2023 compared to 2022 is primarily due to lower proceeds received from property sales in 2023 and increased capital expenditures in 2023 related to our redevelopment activities. The change from cash flows used in financing activities in 2022 to cash flows provided by financing activities in 2023 was primarily due to the redemption of $300,000 of our senior unsecured notes in 2022 as compared with the issuance of $177,320 of mortgage notes and decreased distributions to our common shareholders in 2023.
Our Investment and Financing Liquidity and Resources (dollar amounts in thousands, except per share amounts)
In order to meet cash needs that may result from our desire or need to make distributions or pay operating or capital expenses or to fund acquisitions, we maintain a revolving credit facility which is governed by our credit agreement. Our credit agreement replaced our prior revolving credit facility, which had a maturity date of January 31, 2024. Our obligations under our credit agreement are secured by a pledge by certain of our subsidiaries of all of their respective equity interests in certain of our direct and indirect property owning subsidiaries and first mortgage liens on 19 properties owned by the pledged subsidiaries with an undepreciated carrying value, including lease intangibles, other assets and other liabilities, of $941,937 as of December 31, 2023. We can borrow, repay, and reborrow funds available under our revolving credit facility until maturity and no principal repayments are due until maturity. The maturity date of our credit agreement is January 29, 2027, and, subject to the payment of an extension fee and meeting certain other requirements, we can extend the stated maturity date of our revolving credit facility by one year. Our credit agreement contains a number of covenants, including covenants that require us to maintain certain financial ratios, restrict our ability to incur additional debt in excess of calculated amounts and, subject to limited exceptions, restrict our ability to increase our distribution rate above the current level of $0.01 per common share per quarter and enter into share repurchases. Availability of borrowings under our credit agreement is subject to ongoing minimum performance and market values of the 19 collateral properties, our satisfying certain financial covenants and other credit facility conditions.
Interest payable on borrowings under our credit agreement is based on a rate of SOFR plus a margin of 350 basis points. We are also required to pay an unused facility fee on the amount of total lending commitments, which was 35 basis points per annum at February 14, 2024. As of February 14, 2024, the annual interest rate payable on borrowings under our credit agreement was 8.8%. As of February 14, 2024, we had $132,000 outstanding under our revolving credit facility, $100,000 outstanding under our term loan and $193,000 available for borrowing under our revolving credit facility.
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Prior Revolving Credit Facility
Under our prior revolving credit facility, we were required to pay interest at a rate of SOFR plus a premium, which was 145 basis points per annum at December 31, 2023, on the amount outstanding under our prior revolving credit facility, as well as a facility fee on the total amount of lending commitments, which was 30 basis points per annum at December 31, 2023. As of December 31, 2023 and 2022, the annual interest rate payable on borrowings under our prior revolving credit facility was 6.9% and 5.4%, respectively. The weighted average annual interest rate for borrowings under our prior revolving credit facility was 6.5%, 4.0% and 1.2% for the years ended December 31, 2023, 2022 and 2021, respectively. As of December 31, 2023, we had $205,000 outstanding under our prior revolving credit facility.
Mortgage Notes Issuances
During the year ended December 31, 2023, we issued six mortgage notes with an aggregate principal balance of $177,320 and a weighted average interest rate of 7.8%. The net proceeds from these mortgage notes were used to repay amounts outstanding under our prior revolving credit facility. See Note 9 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 our mortgage note issuances.
Mortgage Note Repayment
In June 2023, we repaid at maturity, a mortgage note secured by one property with an outstanding principal balance of $50,000 and an annual interest rate of 3.7% using cash on hand and borrowings under our prior revolving credit facility.
As of December 31, 2023, our debt maturities (other than our prior revolving credit facility), consisting of senior unsecured notes and mortgage notes, were as follows:
Year Debt Maturities
2024 $ 350,000
2025 650,000
2026 300,000
2027 350,000
2028 123,487
Thereafter 615,833
Total $ 2,389,320
Senior Secured Notes Issuance
In February 2024, we issued $300,000 of the 2029 Notes. The aggregate net proceeds from this offering were $271,500, after initial purchaser discounts and other estimated offering expenses. The 2029 Notes are fully and unconditionally guaranteed on a joint, several and senior secured basis by certain of our subsidiaries and secured by a pledge of all of the respective equity interests of the subsidiary guarantors and first mortgage liens on 17 properties with an undepreciated carrying value, including lease intangibles, other assets and other liabilities, of $574,291 as of December 31, 2023. The 2029 Notes require semi-annual payments of interest only and are prepayable, at par plus accrued interest, after March 31, 2028.
Senior Unsecured Notes Redemption
In February 2024, we issued a notice of early redemption, at par plus accrued interest, of all of our $350,000 of 4.25% senior unsecured notes due 2024. The redemption is expected to take place in March 2024 using the net proceeds from the offering of the 2029 Notes and borrowings under our revolving credit facility and the redemption is conditioned upon our borrowing an amount under our revolving credit facility sufficient, together with the net proceeds from the offering of the 2029 Notes, to pay the redemption price on or prior to the redemption date.
None of our unsecured debt obligations require sinking fund payments prior to their maturity dates. Our mortgage notes currently require monthly payments of interest only; however, certain of our mortgage notes will require payments of principal and interest after a specified date through maturity.
In addition to our debt obligations, as of December 31, 2023, we had estimated unspent leasing related obligations of $109,309, of which we expect to spend $67,705 over the next 12 months.
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We are currently 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 first quarter of 2024. As of December 31, 2023, we had incurred $133,270 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 credit agreement 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 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 ventures 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 capital expenditures and to pay our obligations or fund future acquisitions. 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.
We currently do not have sufficient sources of liquidity to repay our $650,000 senior unsecured notes due 2025 and are evaluating market-based alternatives to obtain debt financing. Based on the significant number of unencumbered properties in our portfolio, our successful history of obtaining new debt financings and our current financing metrics, we believe it is probable that we can obtain new debt financing that will allow us to satisfy the 2025 unsecured notes as they become due. We have also engaged Moelis & Company LLC as our financial advisor to assist in evaluating our options to address our upcoming debt maturities.
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, sustained high 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, 2023, we paid quarterly cash distributions to our shareholders totaling $63,187 using cash on hand and borrowings under our prior revolving credit facility. On January 11, 2024, we declared a quarterly cash distribution payable to shareholders of record on January 22, 2024 in the amount of $0.01 per share, or approximately $490. We expect to pay this distribution on or about February 15, 2024 using cash on hand and borrowings under our revolving credit facility. We determine our distribution payout ratio with consideration for restrictions under our credit agreement, our expected capital expenditures, cash flows from operations and payment of debt obligations. For more information regarding the distributions we paid during 2023, see Note 11 to the Notes to Consolidated Financial Statements included in Part IV, Item 15 of this Annual Report on Form 10-K.
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We owned 51% and 50% interests in two unconsolidated joint ventures which owned three properties at December 31, 2023. As of December 31, 2023, the properties owned by these joint ventures were encumbered by an aggregate $82,000 principal amount of mortgage indebtedness, none of which was recourse to us. In July 2023, the maturity date of the mortgage loan secured by one property owned by our 1750 H Street, NW joint venture, in which we had a 50% interest, was extended by three years at the same interest rate. In October 2023, our joint venture partner that had a 50% equity interest in our 1750 H Street, NW joint venture failed to fund a $600 capital call and was in default of the joint venture agreement at December 31, 2023. As of December 31, 2023, we did not control the activities that are most significant to these joint ventures and, as a result, we accounted for our investments in these joint ventures under the equity method of accounting. We are currently in discussions with the lender to this joint venture regarding the property. During the year ended December 31, 2023, we recorded an impairment charge of $19,183 to reduce the carrying value of our equity method investment in this joint venture to its estimated fair value. 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, 2023, 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 as of December 31, 2023 consisted of $205,000 of borrowings outstanding under our prior revolving credit facility, an outstanding principal balance of $2,212,000 of public issuances of senior notes and mortgage notes with an outstanding principal balance of $177,320. Also, the three properties owned by two joint ventures in which we owned 51% and 50% interests secured two additional mortgage notes as of December 31, 2023. Our publicly issued senior notes are governed by indentures and their supplements. Our credit agreement and our senior 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 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 increase our distribution rate above the current level of $0.01 per common share per quarter. At December 31, 2023, we believe we were in compliance with the terms and conditions of our respective covenants under our credit agreement and our senior notes indentures and their supplements. Our mortgage notes are non-recourse, subject to certain limited exceptions, and do not contain any material financial covenants.
Neither our credit agreement nor our senior notes indentures and their supplements contain provisions for acceleration which could be triggered by our credit ratings. However, under our prior revolving credit facility, our highest senior credit rating was used to determine the fees and interest rates we paid. Accordingly, if that credit rating was downgraded, our interest expense and related costs under our prior revolving credit facility would increase. As a result of ratings downgrades in March 2023 by Moody’s Investor Service, or Moody’s, and S&P Global Ratings, or S&P, the interest rate premium under our prior revolving credit facility increased 35 basis points effective April 1, 2023. On February 13, 2024, S&P assigned a rating of B- to our 2029 Notes. As of February 14, 2024, our senior unsecured debt ratings were Caa1 and CCC from Moody’s and S&P, respectively.
Our credit agreement and our senior notes indentures and their supplements contain cross default provisions to any other debts of more than $25,000 (or more than $50,000 in certain circumstances).
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 2024 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, 2023. 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.
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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 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
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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 employed by RMR and its clients, including us. 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.