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Executives

Timothy A. Bonang - Vice President of Investor Relations

Adam David Portnoy - Principal Executive Officer and President

John Christopher Popeo - Chief Financial Officer, Principal Accounting Officer, Assistant Secretary and Treasurer

Analysts

Joshua Attie - Citigroup Inc, Research Division

Michael Bilerman - Citigroup Inc, Research Division

Richard C. Moore - RBC Capital Markets, LLC, Research Division

CommonWealth REIT (CWH) Q2 2013 Earnings Call August 7, 2013 1:00 PM ET

Operator

Good day, and welcome to the CommonWealth REIT Second Quarter Financial Results Conference Call. This call is being recorded.

At this time, for opening remarks and introductions, I would like to turn the call over to Vice President of Investor Relations, Mr. Tim Bonang. Please go ahead, sir.

Timothy A. Bonang

Thank you, and good afternoon. Joining me on today's call are Adam Portnoy, President and Managing Trustee; and John Popeo, Treasurer and Chief Financial Officer.

Before we begin today’s call, I would like to read our Safe Harbor statement. Today’s conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based on CommonWealth REIT's present beliefs and expectations as of today, August 7, 2013.

Forward-looking statements are not guaranteed to occur. Actual results may differ materially from those projected or implied by any forward-looking statements. Information concerning factors that could cause those differences is contained in our annual report on Form 10-K; our first quarter quarterly report on Form 10-Q and our current reports on Form 8-K filed with the Securities and Exchange Commission, or SEC; our second quarter quarterly report on Form 10-Q, which we expect to file with the SEC later this week; and in our Q2 supplemental operating and financial data package, which can be found in the Investor Relations section of our website at www.cwhreit.com.

Any matters described in forward-looking statements are not guaranteed to occur. The company undertakes no obligation to revise or publicly release the results of any revisions of the forward-looking statements made in today's conference call as a result of new information, future events or otherwise. Investors are cautioned not to place undue reliance upon any forward-looking statements.

In addition, this call may contain non-GAAP numbers, including funds from operations, or FFO; Normalized FFO; cash available for distribution, or CAD; earnings before interest, taxes, depreciation and amortization, or EBITDA; property net operating income or NOI; and cash NOI. The definition of each of these non-GAAP measures and a reconciliation of each of them to net income, and a reconciliation of normalized FFO to FFO are available in our Q2 supplemental operating and financial data package.

I would also note that the transcription, recording and retransmission of today's conference call is strictly prohibited without the prior written consent of CommonWealth REIT.

Now I would like to turn the call over to Adam.

Adam David Portnoy

Thank you, Tim. Before I review our second quarter results, I want to remind everyone that the company, its manager and its trustees are still involved in various lawsuits, including litigation concerning the ability of certain shareholders to undertake a written consent solicitation to remove our board of trustees.

During today's call, we will only be discussing matters relating to the company's results of operations, and we will not be commenting on or answering questions regarding pending litigation, the purported consent solicitation or any purported offer to acquire the company. The purpose of today's call is to discuss the company's second quarter results. When we open the call up for Q&A, I ask that you please focus your questions on the company's results of operations.

The one comment I will make regarding pending litigation is that, with respect to Corvex and Related, the legal disputes are being resolved as provided in our bylaws by arbitration. The arbitration panel held a hearing regarding certain motions on July 26. As of today, there has not been a ruling by the arbitration panel regarding these motions, and we do not know when the panel will rule.

Also, I wanted to let you know that in response to shareholder requests, we have increased our disclosure in our supplemental operating and financial data package this quarter. In order to provide more details about our portfolio, we have added an exhibit, which provides individual property level data for our entire 345-property wholly-owned portfolio. We hope this additional information will help investors to better analyze and value the company.

Turning now to our second quarter results. For the quarter ended June 30, we are reporting fully diluted normalized FFO of $0.63 per share compared to $0.83 per share during the same period last year. During the quarter, we continued to implement our business plan of focusing on the ownership and operation of high-quality central business district, or CBD, office properties and selling suburban properties and other assets. As of June 30, CBD office properties accounted for 58.4% of wholly-owned property NOI. On a consolidated basis during the quarter, we signed over 130 individual leases for 1.6 million square feet with 60% of the square feet representing renewals and 40% representing new leases. The average term for the leases entered into or renewed during the quarter were 6.9 years, and the weighted average cash rental rates were essentially unchanged from prior rents for the same space, down about 0.2%.

Capital cost commitments associated with leasing activity this quarter were $31.35 per square foot or about $4.54 per square foot per lease year. A large part of the increase in leasing capital commitments per square foot this quarter compared to last quarter reflects 354,000 square feet of new leases signed in our CBD office portfolio, which typically has longer lease terms but higher CapEx commitments. Of the 1.6 million square feet of leasing activity during the second quarter, 39% of the square feet involved CBD office properties, which had a 7% roll-up in cash rents and 32% involved industrial properties, which had a 0% change in cash rents. The remaining 29% of our square feet leased during the quarter involved our suburban office properties, which had a 10% roll-down in cash rents.

As of June 30, our consolidated occupancy was 89.2%, which was 80 basis points lower than our first quarter 2013 occupancy rate. The principal reason for the decline in occupancy was there was 608,000-square-foot vacancy at One Franklin Plaza in Philadelphia as a result of the GlaxoSmithKline lease expiration that occurred during the quarter. Negotiations to re-lease this property to a full building user fell through during the second quarter, and we are now weighing various options, including retrofitting this building to accommodate multiple tenants or listing this property for sale. This property accounted for roughly 84 basis points of consolidated occupancy and $2.8 million of NOI per quarter.

On a consolidated same property basis, our occupancy declined by 130 basis points to 88.4% and cash NOI increased by 2.3%. The principal reason for the decrease in same property occupancy was increased vacancy in our CBD office portfolio, which was driven by the GlaxoSmithKline vacancy during the quarter. The principal reason for the increase in same property cash NOI was the result of rent increases in Oahu, Hawaii, contractual rent increases in our wholly-owned portfolio and lower-than-expected operating costs. Overall, our CBD office properties continue to outperform our suburban office properties in terms of leasing activity, occupancy rates and NOI growth.

The Chicago market represents the company's largest market area with 10.1% of our consolidated NOI, followed by our Oahu, Hawaii and Philadelphia markets, which represents 10.1% and 8% of consolidated NOI, respectively. Almost 90% of our NOI from our Chicago and Philadelphia markets comes from CBD office properties. Within our other markets segment, the strongest leasing areas for our portfolio are Australia; Austin, Texas; Seattle, Washington; Pittsburgh, Pennsylvania; Boston, Massachusetts; the San Francisco Bay Area; and Southern California. About 22% of our wholly-owned property NOI in the second quarter was generated from these 7 market areas.

In addition, we are starting to see improvements in office market fundamentals in other areas across the country. Through year-end 2013, we have 2.7 million consolidated square feet scheduled to expire, which represents about 4% of our annualized rental income as of June 30. About 63% of our 2013 consolidated expiring square feet is located in our CBD office or industrial portfolios. We are hopeful that we will be able to renew or lease the space in these CBD and industrial properties at rental rates that are on average equal to or higher than current in-place rents.

Our occupancy and NOI from our wholly-owned properties, which excludes properties from our majority-owned consolidated subsidiary, Select Income REIT, or SIR, was 85.8% as of quarter end and $128.1 million for the quarter ended June 30, respectively. This compares to 86.9% occupancy at the end of the first quarter and $129.4 million of NOI for the quarter ended March 31. Excluding the GlaxoSmithKline vacancy during the quarter, both occupancy and NOI for our wholly-owned portfolio would have increased sequentially between Q1 and Q2.

As mentioned earlier for the last several years, we have been executing on our business plan to reposition the company's portfolio into high-value office properties located in CBD locations. Since January 1, 2008, we have acquired $3.7 billion worth of property and the majority of these acquisitions have been high-quality CBD office buildings. During the same period, we have sold $1.5 billion worth of properties largely consisting of suburban office buildings.

Since the middle of 2012, and excluding transactions at SIR, the company has not entered into any agreements to purchase properties. During the 6 months ended June 30, the company completed the sale of 24 properties with a combined 2.3 million square feet for a total of $42.6 million. As of June 30, we had 70 properties with a combined 4.4 million square feet located throughout the United States listed for sale with third-party brokers and classified as held for sale. As of today, 49 of these properties with a combined 2.3 million square feet are under agreements to be sold for a total of $67.5 million. We currently expect to complete the sale of the 49 properties currently under agreement to be sold and the remaining 21 properties listed for sale before year-end 2013. However, no assurance can be given that any of these properties will be sold in that time period or at all.

As you can likely tell from the sales price per square foot, the properties we have sold or agreed to sell to date are among the properties we consider to have very weak long-term prospects. I think it may be important to point out that the prices achieved for these properties should not be considered to be representative of the value of our portfolio as a whole or even the values of our remaining noncore suburban properties generally.

Before turning the call over to John Popeo, I want to point out that the company has made substantial progress in implementing its business plan in the last few years. Today, almost 60% of the company's NOI from wholly-owned properties comes from CBD office buildings, which is more than double the percentage of NOI it received from CBD office properties a few years ago. We continue to be focused on executing the company's business plan and we are making good progress selling the weakest suburban noncore properties and simplifying the company's operations. As the market conditions for the purchase and sale of office properties has evolved during the past year, the company has shifted its focus from buying CBD office buildings to selling our noncore suburban properties. Both of these activities are intended to serve our business plan to become a nationwide owner of high-quality CBD office buildings. Also, as a result of our first quarter capital raising activities, the company's balance sheet is well positioned to allow us a reasonable time to complete our business plan.

I will now turn the call over to John Popeo, our CFO.

John Christopher Popeo

Thank you, Adam. Net income available for CommonWealth REIT common shareholders for the second quarter of 2013 was $7.7 million compared to net income of $2.2 million for the second quarter of 2012. The 10% increase in rental income and 6.5% increase in operating expenses primarily reflect property acquisitions since April 2012. The $9 million or 72% increase in general and administrative costs primarily reflects legal and consulting fees related to ongoing litigation. Current quarter adjusted EBITDA increased by 2.1% compared to the prior year. Interest expense decreased by 12.9% primarily reflecting interest on $670.3 million of unsecured senior notes repaid pursuant to the tender offer completed during March 2013. The decrease in equity and earnings of investees reflects the sale during March 2013 of all 9,950,000 of our common shares of Government Properties Income Trust, or GOV, for approximately $240 million net of commissions and expenses.

Loss from discontinued operations includes NOI plus G&A expenses related to the 94 properties classified as held for sale at the beginning of the year, including the 24 properties sold since then. Loss on asset impairment from discontinued operations of $4.6 million reflects the additional net write-down to estimated fair value of 15 properties sold or classified as held for sale as of June 30, 2013, based on recent purchase offers.

In addition, gains on sales of properties of $2.1 million reflect sales proceeds in excess of pre-impairment book values at 6 properties sold during the quarter. Net income in Normalized FFO attributable to the noncontrolling interest in SIR totaled $10 million and $13.3 million, respectively, during the second quarter. CWH ceased to own a majority of SIR's common shares after SIR completed a common share offering in early July. Accordingly, beginning with the filing of CWH's third quarter Form 10-Q, CWH will deconsolidate its investment in SIR and account for its investment in SIR under the equity method. CommonWealth REIT continues to own $22 million or 44.2% of SIR's common shares.

Normalized FFO available for CommonWealth REIT common shareholders was $0.63 per share for the second quarter of 2013 compared to $0.83 per share for the second quarter of 2012. Year-over-year per share results primarily reflect the issuance of new common shares in March 2013, the increase in G&A expenses and the sale of our GOV shares, partially offset by property acquisitions during 2012 and 2013 and interest savings resulting from the purchase of notes pursuant to our debt tender offer during the first quarter.

During the second quarter, we spent $35 million on recurring capital expenditures, which includes tenant improvements, leasing costs and recurring building improvements. We generated $37.3 million of cash available for distribution, or CAD, during the second quarter, resulting in a rolling 4-quarter CAD payout ratio of about 69.4% based on an annual dividend of $1 per share.

Turning to the balance sheet. On June 30, 2013, we held $77.5 million of unrestricted cash. A portion of this cash will be used later this month to pay the dividends we previously declared on our preferred and common shares outstanding. Rents receivable includes approximately $245 million of accumulated straight line rent accruals as of June 30, 2013. Other assets include approximately $155 million of capitalized leasing and financing costs. The $128.5 million worth of properties held for sale represents the net book value of 70 properties held for sale as of June 30, 2013.

On June 30, 2013, we had $1.2 billion of floating rate debt, including the $350 million SIR term loan and $235 million outstanding on SIR's revolving credit facility. At the end of the second quarter, we had $947 million of mortgage debt and $1.5 billion of fixed rate senior unsecured notes outstanding. The weighted average contractual interest rate on all of our debt was around 4.6% at the end of the quarter and the weighted average maturity was around 5 years.

At the end of the second quarter, our ratio of debt-to-book capitalization was 47%. Our adjusted EBITDA-to-interest and our fixed charge coverage ratios were at 3.3x and 2.6x, respectively. Also, our debt-to-adjusted-EBITDA ratio was 6.4x. These strong credit metrics primarily reflect the repayment of approximately $670 million of unsecured senior notes with proceeds from our equity offering and the sale of all of our common shares of GOV in March 2013. In conclusion, we believe CommonWealth REIT is well positioned to benefit from the slow recovery in the office markets during the next couple of years as the company continues its transition from an owner of suburban properties to a nationwide owner of CBD office properties.

Before we turn to the Q&A portion of today's call, I want to reiterate that the purpose of today's call is to discuss our second quarter financial and operating results. We will not be answering any questions related to the pending litigation, the purported consent solicitation or any purported offers to acquire the company, and I ask for and appreciate your cooperation in this regard.

Operator, we are now ready for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question today comes from the line of Josh Attie with Citigroup.

Joshua Attie - Citigroup Inc, Research Division

John, can you tell us exactly how much legal and consulting fees were included in G&A in the quarter? Just to help us think about the underlying G&A run rate going forward.

Adam David Portnoy

Josh, this is Adam. I'll take that question. I think it's just about $9 million. It's probably somewhere between $8 million and $9 million with just legal and consulting fees. But I want -- I think in answering that question, I want you to keep in mind that CommonWealth did not start this litigation. It was started when Corvex and Related brought litigations to stop the CommonWealth equity offering during the first quarter. That litigation has spawned copycat litigation from others repeating various false charges made by Corvex and Related, so we now have cases pending in 3 different courts and an arbitration proceeding. Also, I think you should keep in mind that a few years ago, the shareholders of CommonWealth adopted an amendment to our declaration of trust, which makes shareholders who assert false claims against the company liable to indemnify the company for the expenses CommonWealth incurs defending these claims, including legal fees. We believe the litigation to stop the equity offering and the alleged consent solicitation undertaken by Corvex and Related were improper. And when we win, we expect Corvex and Related may be required to indemnify CommonWealth for some of these costs. We have asserted a counterclaim in the pending arbitration for that reimbursement based upon our declaration and our bylaws. The bottom line is we did not start this litigation. In the present circumstances, we intend to defend against the false charges, which are being made against us and against the improper consent solicitation by Corvex and Related.

Joshua Attie - Citigroup Inc, Research Division

I appreciate that. But just help us think about earnings going forward. Is the $8 million to $9 million, is that something we should expect every quarter when we think about your FFO going forward, or is -- are most of the costs behind you? What's the right way for us to think about that?

John Christopher Popeo

Josh, that's a really difficult question to answer. It all depends on the volume of the activity related to the various cases that are currently in play.

Joshua Attie - Citigroup Inc, Research Division

Well, is it fair to say that there'll be some element of that costs going forward for at least the next several quarters?

John Christopher Popeo

I think that's a fair statement.

Adam David Portnoy

Again, Josh, not to change what John said, but it all depends on where this goes. I mean, yes, through the third quarter, there'll be some legal expenses because we're already in August. And I can tell you that things are still going forward through July, but it all depends on what happens.

Joshua Attie - Citigroup Inc, Research Division

And the second question, separately. Your interest in SIR has come down as a result of their equity issuance. As you think about that longer term, is there any -- is there a strategic reason for you to continue owning the stock of that company? How do you think about your long-term ownership?

Adam David Portnoy

Josh, today, we're currently under a lock-up that expires sometime in -- late in the third quarter. So we can't even do anything with the shares even if we wanted to today. But I can tell you our current -- we have no current plans to dispose of those shares as of today.

Michael Bilerman - Citigroup Inc, Research Division

Adam, it's Michael Bilerman, and I agree with Josh's comment in terms of getting the additional detail on the assets in there. I had a question, and this is not in regards to litigation or the consent solicitation or the purported offer. And it was a comment that you had made in the New York Times article back in late July. And you had said that -- at the end you said, "Everything we've always done has been in the best interest of shareholders. When we come in to work every day, our focus is on the common shareholders and executing our business plan." And I'm trying to reconcile that comment and the way that you talk about that relative to your share ownership. You currently own 40,000 shares. Your father owns just under 240,000 shares. So it's combined 0.25% which is probably the lowest insider ownership out of any of the companies we follow. And I'm just trying to figure out the alignment of interest that on one hand, where you say you come work for a common shareholder. Wouldn't you want to be a much more material shareholder in sort of saying that? And a lot of that stock had been either through the drip plan, either through the comp plan, through board fees, so it wasn't even like it was bought. I'm just trying to really understand the comment relative to the ownership.

Adam David Portnoy

Well, a couple of things in response to that. One, I stand by all the comments that I've said in that article. The second thing I'd point out is that many of our competing REITs, they were formed largely through up REIT structures where existing owners or families that owned real estate then took their business public. And so when they took it public, they owned a large percentage of the company prior to it going public, and then it got diluted down through the offering itself. As you may know, CommonWealth was not formed that way. And so there's no large number of properties that were held privately, which were then taken public per se through an offering. So we were formed a little differently than many other companies. And so that's the only other thing I would add. That may be part of the reason for the discrepancy between share ownership in some of the -- some other of our -- some of our competitors and us.

Michael Bilerman - Citigroup Inc, Research Division

Yes. No, I think that's a fair point, but it hasn't stopped others from buying and accumulating large sums of stock in, certainly, at the RMR entity, which is -- we don't have much purview into in terms of the profitability or either [indiscernible] capital there, that some of that could have been rotated back into the underlying companies, which you look at the ownership of each of the RMR entity that fall around the same sort of level in terms of percent of ownership. So I'm just trying to get a better understanding whether there's a change in the way you're thinking about ownership and trying to align yourself more with the common shareholders from an ownership perspective?

Adam David Portnoy

Is there a change? There has been no change. I mean, I stand by the comments we said in that newspaper -- that I made in that newspaper article, and I think the large reason that there's a big difference in the share ownership is principally how we were formed versus others. And I think I would just leave it there.

Operator

And we do have a question from the line of Rich Moore with RBC Capital Markets.

Richard C. Moore - RBC Capital Markets, LLC, Research Division

The rough cap rate, I mean, you may not want to give exact numbers at the moment. But on the $67.5 million that you guys have under contract, a rough cap rate range on that would be probably what?

John Christopher Popeo

It's probably not the right way to look at it, Rich, because it's really -- many of those buildings are perhaps vacant and are negative cash flow. So it's not really – we, unfortunately, as we stated in the prepared remarks, they're not really representative of the portfolio. These are really the weakest properties in the portfolio, many of which have negative cash flow. And so cap rate is not something -- I think the more relevant metric might be price per foot.

Richard C. Moore - RBC Capital Markets, LLC, Research Division

Okay, do you have a number for that? And I assume the cap rate would just be very low, so price per foot would be probably low as well?

Adam David Portnoy

Yes. If there's cash flow at the property, yes, it's very low because it's probably just barely breaking even if it's a property cash flowing in those groups. But the price per foot, you can do the math very simply. It's about $35 a foot.

Richard C. Moore - RBC Capital Markets, LLC, Research Division

Fair enough. Yes, fair enough. And then none of those I assume, Adam, are included in the exhibits you gave us at the back, which I liked as well. None of the assets held for sale I assume are back in there, right?

Adam David Portnoy

That's correct. We only included the wholly-owned from continuing operations. That's correct. So none of the assets held for sale are in that list.

Richard C. Moore - RBC Capital Markets, LLC, Research Division

Okay, great. And then you have -- you sold 6 this quarter by my calculation, and then you have 49 in the contract, 21 to go. And then we've talked about this before, but is there another wave behind this? I mean, you had indicated a couple quarters ago that there would be other waves behind this, and it looks like you've made excellent progress on the first wave. It's just about wrapped up. I mean, are we teeing up a second wave here, or are we done with dispositions for a while?

Adam David Portnoy

I don't think a final decision has been made, but we are seriously considering, I guess you could call it a second wave. I think when we talked about it in the past, we said we wanted to see how this first wave of dispositions went. I think it's gone reasonably well, and I think that's leading us to have some serious discussions internally whether or not there'll be a second wave. So no final decisions has been made, but I can tell you that we are seriously thinking about it.

Richard C. Moore - RBC Capital Markets, LLC, Research Division

Okay. And then when you think about CapEx and TIs and leasing commissions, et cetera, for the going forward, was there a lot of TI type dollars, leasing commission dollars, sales commission dollars associated with what you've been working on this first 100-or-so properties that you've been working to get rid of? And then we see a lessening of that, or is that really not what happened? I mean, and we'll just see the same sort of level of TIs going forward?

Adam David Portnoy

Yes. No, it's a good question, Rich. What's happening in the TIs and LCs is a few quarters ago I'd characterized that portfolio and sort of broke it out between noncore and core. And we talked about how in the noncore, we might do some fairly aggressive leasing to get it leased up. What we have ended up doing over the first 6 months of this year is actually a little bit less of that aggressive leasing in that noncore portfolio and been more focused on the core portfolio. So I think the vast majority of the numbers you're seeing run through our leasing commitments is really what you would consider the core portfolio. Maybe less of what we might have -- we have past described as the noncore portfolio. So I know a few quarters ago, we talked about how we might get very aggressive on leasing in some of that. We've ended up not being as aggressive as I think we originally intended to be and being more focused on making sure that we kept the core portfolio well leased. And in that noncore portfolio decided that in some cases, when we were looking at leases that really just did not make economic sense for the building, weren't going to add value to the building, weren't going to enable us to get maybe a higher price if we sold it, we decided not to move forward with the lease. So that's really what's going on in those numbers.

Operator

And at this time, there are no further questions in queue. I'd like to turn the conference over to Adam Portnoy for closing comments. Please go ahead.

Adam David Portnoy

That concludes our presentation. Thank you, everyone, for joining us today.

Operator

And ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using the AT&T Executive TeleConference Service. You may now disconnect.

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