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Executives

Timothy Bonang – VP, IR

Adam Portnoy – President and Managing Trustee

John Popeo – Treasurer and CFO

Analysts

Mitch Germain – JMP Securities

John Guinee – Stifel

Dave Rodgers – RBC Capital Markets

Jamie Feldman – Bank of America/Merrill Lynch

Michael Bilerman – Citi

Steve Swett – Morgan Keegan

CommonWealth REIT (CWH) Q2 2011 Earnings Call August 3, 2011 1:00 PM ET

Operator

Welcome to the CommonWealth REIT’s Second Quarter Earnings Conference Call. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions) As a reminder, today’s conference is being recorded.

And I’d now like to turn the conference over to our first speaker, Vice President of Investor Relations, Mr. Tim Bonang. Please go ahead.

Timothy Bonang

Thank you. Joining me on today’s call are Adam Portnoy, President and Managing Trustee; and John Popeo, Chief Financial Officer. The agenda for today’s call includes a presentation by management, followed by a question-and-answer session. I would also note that the recording and retransmission of today’s conference call is strictly prohibited without prior written consent of CommonWealth.

Before we begin today’s call, I’d 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’s present beliefs and expectations as of today, August 3, 2011.

The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today’s conference call, other than through filings with the Securities and Exchange Commission or SEC regarding this reporting period. In addition, this call may contain non-GAAP numbers, including funds from operations or FFO, normalized FFO and cash available for distribution or CAD.

A reconciliation of FFO, normalized FFO and CAD to net income is available in our supplemental package filed in the Investor Relations section of the company’s website. Actual results may differ materially from those projected in any forward-looking statements. Additional information concerning factors that could cause those differences is contained in our Form 10-Q, which we expect to file on a few days with the SEC, and in our Q2 supplemental operating and financial data package found on our website at www.cwhreit.com. Investors are cautioned not to place undue reliance upon any forward-looking statements.

And now, I would like to turn the call over to Adam Portnoy.

Adam Portnoy

Thank you, Tim. Good afternoon and thank you for joining us on today’s call. For the second quarter of 2011 we are reporting fully diluted normalized FFO of $0.91 per share compared to $0.92 per share during the same period last year. The decline in normalized FFO per share primarily reflects the decline in consolidated same store occupancy and the NOI during the quarter.

As of June 30, our consolidated occupancy rate was 87.5% which is flat with the occupancy rate we reported at the end of last quarter. As we have stated on previous earnings calls, we continue to believe that our consolidated occupancy rate for year end 2011 may remain flat with what we recorded at year end 2002 – 2010, excuse me, which is 87.7%.

During the quarter, we sold leases for almost 1.3 million square feet, 56% of our second quarter leasing activity were renewals and 44% renewal leases. Retail activity this quarter resulted in a 2% rollup in rents and $15.71 per square foot in capital commitments. The average lease term was 6.2 years, and the average capital commitment per lease year was $2.53.

Capital commitments per square foot this quarter were higher than initial historical averages because of the higher percentages of new leases versus renewals in the second quarter, particularly in major market CBD locations.

For the three months ended June 30, 2011, about 37% of our consolidated NOI came from 40 CBD office buildings, and about 42% of our NOI came from 279 suburban office buildings, and about 21% of our NOI came from 180 industrial and other properties.

Also, about 43% of our consolidated NOI comes from six major market areas, which include Philadelphia, Oahu, Hawaii, Denver, Chicago, Australia and Washington DC. The remaining 57% of the NOI comes from close to 60 individual market areas located across the United States.

Overall, our CBD office properties are performing better than our suburban office and industrial properties. For example, during the second quarter, same-store occupancy for our CBD office properties increased 10 basis points, and same-store NOI increased by 2.2%.

Suburban office properties experienced same-store occupancy declines of 200 basis points and same-store NOI declined by 10.1%. Industrial and other properties experienced same-store occupancy declines of 160 basis points, and same-store NOI declined by 9.6%.

Also, all six of our major market areas are performing well with roughly flat to increasing same-store occupancy and NOI in each of our major market areas. The general area of weakness in our portfolio continues to be our suburban office in Oahu, Hawaii industrial properties. And these properties largely contributed to decline and consolidate same-store occupancy although down 30 basis points, the 86.1% and the 5.8% decline in consolidated same-store NOI.

As of June 30, we have 3.6 million square feet scheduled to expire during the remainder of 2011. On average, the lease is scheduled to expire to year-end have in place rents that are around 1% over market. Nevertheless, we continue to expect that same-store NOI may decline further until the economy begins to show sustainable growth and the unemployment rate starts to decline significantly.

In part because of the strength of our CBD office properties, the focus on our acquisition activities over the last couple of years has been on CBD office buildings. And we have been largely buying these CBD office buildings at well below replacement cost. For example, in May 2011, we acquired 1.1 million square foot office tower in Downtown Chicago for $162.2 million or about $152 per square foot. This property is currently 85.4% leased to 60 tenants for weighted average lease term of 6.6 years, and then going in cap rate was 9.2%.

Also in July 2011 we acquired a 515,000 square foot office tower in Downtown Birmingham, Alabama through $68.5 million or $133 per square foot. This property is currently 76% leased to 14 tenants for a weighted average lease term of 8.7 years and the growing cap rate is 9.7%.

We also currently have four CBD office buildings with about 2.9 million square feet under agreement to purchase for a combined total purchase price of approximately $531 million. We are currently subject to an agreement to acquire two office buildings located in Downtown Chicago with a combined 1.6 million square feet for $390 million, which includes the assumption of $265 million of mortgage debt.

These properties are 97% leased to 49 tenants for a weighted average lease term of 8.4 years. We expect to acquire these properties during the third quarter pending the assumption of the existing mortgage debt.

As of today, we also have one property located in Downtown Portland, Oregon with about 107,000 square feet under agreement to purchase for approximately $34.1 million. This property is 100% triple net leased to one tenant for about 11 years. We expect to acquire this property during the third quarter.

In addition, we have one property located in Downtown New Orleans with about 1.3 million square feet under agreement to purchase for approximately $107 million. This property is 88% leased to 61 tenants for a weighted average lease term of about five years. We also expect to acquire this property during the third quarter.

Of course all these pending acquisitions are subject to customary closing conditions and no assurance can be given that they will occur. We also currently have 27 non-core office and industrial properties mostly for sale with third party brokers. All these properties are only suburban properties located in tertiary markets with high vacancy rates.

We continue to work with some of these properties and hope to sell the majority of them prior to year end 2011.

Before turning the call over to John Popeo, I would like to discuss some of our recent financing activities. In June 2011, we issued $11 million shares of series E preferred stock, which carry the annual dividend rate of 7.25%. And in July 2011, we issued $11.5 million common shares at $24 per share, raising the combined net proceeds of approximately $530 million.

Since the beginning of 2008, CommonWealth has acquired $2.8 billion worth of properties, and the majority of these acquisitions have been CBD office properties. We have partially funded these acquisitions to sale of $1.4 billion of largely suburban office properties. And the reminder of these acquisitions have been funded to a combination of both equity and debt financings.

Although our recent financings have been expensive, we believe that they were necessary because of recent uncertainties in the capital markets, and because we were financing the transformation of CommonWealth into a higher quality portfolio of properties which will benefit all stakeholders in the company in the long term. I will now turn the call over to John Popeo, our CFO.

John Popeo

Thank you, Adam. Looking first to the income statement, rental income increased by 13.5% reflecting rental income from properties acquired since April 2010 offset by $6 million decline in same-store rents in 15 properties sold between June and September 2010.

Total expenses declined by 1.6% primarily reflecting $21.5 million of impairment losses recognized in the prior year. The 22% increase in general and administrative expense reflects property acquisitions and sales activities.

Current quarter EBITDA increased by 4.9%, interest expense increased by 8% reflecting the issuance of $250 million of 5% and 7%, 8% unsecured senior notes in September 2010 and a five-year term loan of $400 million entered in December 2010 carrying interest at LIBOR plus 200 basis points.

These financing activities were offset by the prepayment of $182.4 million of mortgage debt in August 2010, the repayment of $50 million of senior notes in August and October 2010, the repayment of $168 million of floating rate notes in March 2011, and the repayment of $29.2 million of 7.4% mortgage debt in June 2011.

Since its IPO on June 2009, our investment and growth has been accounted for using the equity method of accounting. Under the equity method, we record our percentage share of net earnings and normalized FFO of GOV in our financial statements.

Our percentage share of GOV’s net income and normalized FFO for the second quarter totaled $2.9 million and $5.2 million respectively. We received over $4 million from GOV dividends during the second quarter of 2011.

The $1 million of losses from discontinued operations reflects operating results from seven office properties and 20 industrial properties classified as held-for-sale as of the end of the second quarter.

Net income available for common shareholders for the second quarter of 2011 was $9.1 million compared to a net loss of $2.7 million for the second quarter of 2010. Normalized diluted FFO available for common shareholders was $0.91 per share for the second quarter of 2011 compared to $0.92 per share for the second quarter of 2010.

Year-over-year per share results primarily reflect the decline in occupancy and the addition of the new common shares in 2010.

In July 2011, we declared a dividend of $0.50 per share, which represents 55% of our second quarter normalized FFO. This dividend is expected to be paid on August 25. During the quarter, we spent $21 million on tenant improvements and leasing costs and $3.7 million or $0.05 per square foot for recurring building improvements.

We paid $7.9 million on development and redevelopment activities during the quarter. We generated approximately $38 million of cash available for distribution or CAD during the second quarter resulting in a CAD payout ratio of 95%. Including the recently completed preferred stock and common stock offerings, we continue to believe that our CAD payout ratio will be below 100% for the full year 2011.

Turning to the balance sheet, on June 30, we held $55 million of unrestricted cash. Rents receivables improved approximately $179 million of accumulated straight-line rent accruals as of June 30. Other assets include approximately $102 million of capitalized leasing and financing costs.

As Adam mentioned, in June we issued 11 million, 7.25% series E preferred shares raising net proceeds of approximately $266 million. And in July, we issued $11.5 million new common shares raising net proceeds of approximately $264 million. We use the net proceeds from both offerings to repay amount outstanding in our revolving credit facility and to fund acquisitions.

In June, we repaid at maturity $29.2 million of 7.4% mortgage debt, and in July, we prepaid $23.2 million of 8.05% mortgage debt due in 2012. On June 30, we had $630 million of floating rate debt, $382 million of mortgage debt and $2.3 billion of fixed rate senior unsecured notes outstanding. The weighted-average contractual interest rate on all of our debt was around 5.5% at the end of the quarter and the weighted average maturity was around five years.

Our senior unsecured notes are rated Baa2 by Moody’s and BBB by Standard & Poor’s. The undepreciated book value of our unencumbered property pool totaled about $7 billion at the end of the quarter. The secured debt represents 6% of total assets and our floating rate debt represents 19% of total debt.

At the end of the second quarter, our ratio of debt-to-book capitalization was 49%. Our EBITDA and fixed charge coverage ratios were 2.6 times and 2.1 times respectively. As of the end of the quarter, we were comfortably within the requirements of our public debt and revolver covenants.

As of June 30th, we had nothing outstanding on our credit facility and as of today, we have $40 million outstanding. Amounts outstanding on our credit facility are projected to be approximately $300 million assuming we close all pending acquisitions.

In summary, this quarter produced results we expected in light of the challenging market environment. Our strong balance sheet, solid annual dividend payout ratios and $710 million of availability on our revolving credit facility position us to opportunistically grow cash flow.

That concludes our prepared remarks. Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Mitch Germain with JMP Securities. Please go ahead. Mr. Germain, your line is open. Please go ahead with your question.

Mitch Germain – JMP Securities

Sorry about that. Just curious about the asset sales. We didn’t see any progress this quarter, Adam, where do we stand on them?

Adam Portnoy

The asset sales continue to progress. We (inaudible) under purchase and sale just because before anything it just means we haven’t signed a purchase and sale agreement regarding anything but that doesn’t mean that we don’t have letters of intent or active discussions with parties. I do think we will sell the majority – if not the majority, half the properties by year end. I just don’t think we are well positioned to have things under contract to report anything as of the quarter end or as of today.

Mitch Germain – JMP Securities

How would you characterize the pricing or the bidding that you’re seeing on the properties relative to your original expectations?

Adam Portnoy

They are coming in within 10% of our expectations. That’s the right way to answer it.

Mitch Germain – JMP Securities

And the Chicago acquisition, I know it’s been in the doing for a while, is it stipulated issues that’s delaying it?

Adam Portnoy

Yes, that’s – we always expect the course on it within the month of August and we don’t really foresee any issues. I expect we’ll close on it once we get the mortgage – once we get through the mortgage assumption process, which is well underway.

Mitch Germain – JMP Securities

And then just last question with regards to your yield pipeline, you keep on cautioning that acquisition activity was slow, yet it’s been pretty substantial year-to-date. How would you characterize the properties right now that are being underwritten for new acquisitions?

Adam Portnoy

Well, keep in mind the $530 million we say we have under contract, only about 100 – and well I guess about 140 of it’s new. Because 390 of it relates to the acquisition in Chicago which you just pointed out has been pending for a couple of quarters.

Now, so we – I think it certainly say, we have been slowing down; it’s just that lot of stuff has been closing or been under – we announced that it’s what we putting under agreement and we also announced it when we close it. And maybe people – I hope people are double counting our acquisition activity. But there is always basically two earnings in our new and represents the building in – we mentioned in Portland, Oregon for about $30 million and the building in New Orleans, which is new.

So our acquisition activity, I think it’s fair to say is slowing down. And I can tell you that we’re very focused on CBD office buildings. That’s principally the only thing we’re looking anymore, and I can’t tell you exactly where acquisition activity is going by the end of the year, but I think it’s safe to say that this is a good segue to what we have been doing in terms of refocusing the company on CBD office properties.

If you just look at the results for the quarter, I mean if we had engaged to buy many of these CBD office properties over the last 2 or 3 years, I think our results would be looking worse than they’ve recorded today. But I think or results, they are actually fairly positive given the expectations from Wall Street.

So I think we are going to continue to try to look at CBD office buildings, but I think it’s fair to say that pace is slowing, and we’ll see where the market goes. I mean we have about eight, nine days of that going down – I mean, if this continues for foreseeable future, it’s going to be hard to imagine much transaction volume at all occurring, not just here but in most companies.

Mitch Germain – JMP Securities

Great. And I actually have one more question for John. In terms of pricing for unsecured, what could we expect if you went to the market today for an index size deal?

John Popeo

That’s a good question. I mean our hope is we still own 6%, maybe even around 5%.

Operator

It looks like we have a question from the line of John Guinee with Stifel. Please go ahead.

John Guinee – Stifel

Hi, we’ve been covering you guys for a long time and while you were giving your introduction, I look back at 2004 to get a good sense on the last seven years. 2004 on a split adjusted basis, the stock was $51.50, at $21.75 now, that’s a 58% drop. Dividend got cut from $3.36 to $2.00, that’s a 40% drop. And FFO went from $4.88 to $3.64, that’s about a 25% drop. What kind of comfort can you give us that you’ve got it right on this go around?

Adam Portnoy

Well John, as you know, when you’re talking about – if you recall, especially in the last few years, many office REITs have had a difficult time. We’re not the only REIT to have a few years ago, and we’re still not the only REIT that stock is below where it was in the mid-2000s.

With that already said, I think the result – I think when you say you’re getting it right this time, I think the results are starting to prove themselves out. I mean I think – I mean we made a point in our prepared remarks to really spread out where what is the top price of the portfolio.

We’re about the amount of building office properties has doubled over the last few years. And it is largely contributing to any of the growth that we’re experiencing in the company, I mean the NOI growth on a same-store basis was positive 2.2% in our CBD properties. Our same-store asset deal was up. Most people think of us as a suburban office REIT and I can’t criticize them for that because we’re still deploying all of the above properties our CBR suburban office.

But our goal in the next foreseeable future is to try to get the company to be – I’d like it to be over 50% CBD office properties, if I could get it there, we may not be able to give them just the cost of financing in the market generally.

But I think it is helping, if we do not engage in the activities that we have engaged in the last two or three years, I can – I think it’s fair to say that our results – I can’t comment on the stock price.

Similarly our FFO and our occupancy and many of the metrics that people use to value the company would be coming in much more than where they are today, if we had not shown many of those suburban properties and bought the CBD property. So I think it’s – I think that’s the best proof to say that we got it right is to look at the short and medium term results, which are starting to show up in our numbers.

John Guinee – Stifel

Okay. It looks like you’re on track to acquiring another $531 million worth of assets against assets for sale and maybe $100 million. How should we model in coming back to the preferred market or coming back for common equity and how should we factor in the fact that the last equity offering was at, I think were $23 or something.

Adam Portnoy

$24.

John Guinee – Stifel

$24, $23 net, which is sort of a high nine, eight imply GAAP. So anything you’re – when you’re investing this money, you’re doing it on a diluted basis. Two questions, how should we factor in your next equity offering or your next preferred offering, and how should we rationalize if these things continue to be diluted?

Adam Portnoy

Well, John, these are all good questions. Look, we are really engaged in our equity offering earlier in July, it was going to be a specialty equity offering. And at the same time, as John reported in his remarks, we still think even though it was diluted, it’s still going to be – payout ratio is still going to be below 100% for 2011.

So I think you have to keep that in mind as well as in the context of the idea that we’re trying to the company by higher quality assets, which is resulting in better performance or better results for the company.

Now going forward, how are we going to continue to finance these acquisitions? I think it’s fair to say we’ve been talking about for a couple of quarters. We have a couple of options, we could sell assets, we could sell our shares in those, which I consider maybe selling assets or we could go back to the equity markets or debt markets or preferred markets.

We’d now tap the preferred, we’d now tap the equity. I would say, I think it’s fair to say that some – I think maybe the first thing in our list of things to do is to think about maybe monetizing some of our investments or assets that we have to help us finance some of the transition – some of the acquisitions we would want to do.

That – acquisitions are going to slow down greatly because at some point, as you pointed out, I don’t want to just keep issuing equity this dilutive. I know that’s not what I’m – that’s not what I continue to do, it’s not what I want to do, I don’t think it helps, it’s very painful to do.

And as we paid for the deal, and we move this equity deal that we did in July, it’s going to be painful. But – and then we had a very (inaudible) and again versus what we will get – what we were going to gain by doing it from the company in long-term. And – well the answer to question is roughly how do you model growth going forward.

It’s very hard for us to do – it will be very hard for us to do another very large equity deal today based on where we’re buying properties at and our payout ratio would not go through 100% on a stable state basis, and I think that’s a for us.

John Guinee – Stifel

And are all these republic and presidential candidates are signing no tax increase pledges, will you sign a no dilutive equity offering pledge?

Adam Portnoy

No, John, I won’t but...

John Guinee – Stifel

It pops up.

Adam Portnoy

What I’m telling is that I’d not – the math is what the math is. If I do, if you I can – I can’t give dilutive equity deals continuously, I know that. If I do that, it will just – it will destroy shareholder value. I did the deal in July because I felt we were immune to – I also felt it might happen. I think we proved right.

I thought we were going into a period of may be a lot of instability in the market places, which I think has actually proved out to be correct, and we were able to actually get into the market, raise the money, one of the last equity deals in the reach space.

And I – in short I haven’t seen much activity in REIT space in the last couple of weeks. So it’s raising equity, and then may not be for sometime. And so in hindsight, to be honest with you I’m actually happy if you buy some, because it has to be a part of the financing to transform the company.

We had to do some equity as part of it, and we delayed it for long time and we talked about for a long time. But eventually it had to be part of the equation, and I think all the four are not simply stands out itself, it’d be very hard for us to do another dilutive equity deals, because some really put pressure on the dividend, and obviously that’s the government for us.

John Guinee – Stifel

Okay, all right thanks.

Operator

(Operator Instructions) Our next question comes from the line of Dave Rodgers with RBC Capital Markets. Please go ahead.

Dave Rodgers – RBC Capital Markets

Hey Adam, to the sales of the existing assets that you own currently in the acquisition of the CBD properties. Have you revised or do you have a number of mind in terms of what type of long-term core NOI growth you’d like to see i.e., what’s the difference between what you are selling and buying on a basis points spread? That’s the question.

Adam Portnoy

Well, we are almost – again the stuff we’ve got up for sale today – the stuff that’s up for sale today is stuff that’s largely vacant or minimal occupancies. So it’s the capital funding much in 2 million times per square foot, the buildings we have sold in the last few years, the $1.4 billion, John do you...

John Popeo

The original $552 million that we sold back in 2008 was that around 7.1% cap rate. The 2010 sales were at around 8.7 and then later on in 2010, and other batch of properties $470 million, which is right around 8.4%.

Adam Portnoy

So you can see the stuff that’s occupied it’s operating properties, well we sell those, there is a cap rate spread, but basically it’s about 100 basis points versus what we’re selling versus what we’re buying.

Dave Rodgers – RBC Capital Markets

Maybe I ask in different way, you’re thinking of yield on the trade, but I guess what do you think you’re picking up yield on the trade, but I guess what do you think you’re picking up in terms of long-term same-store NOI growth?

Adam Portnoy

Well, I think we’re picking up a ton, I mean I think again our goal is gain for the second quarter numbers. Second quarter numbers are CBD office properties, increase same-store NOI by 2.2%. So building office properties we owned declined by 10% same store.

So I mean we are focused on the properties the CBD core office properties, which we think long-term are going to provide a lot more growth in our cash flows throughout different cycles, business cycles. And so I think we are improving the quality of the portfolio going forward simply on the type of properties we’re buying, those are the type of properties we’re selling.

Dave Rodgers – RBC Capital Markets

And with respect to the acquisition that you discussed earlier, you said you expected the pace to slow down. Just to get a little more clarity, was that related more to the capital raising that John mentioned or related to the opportunities?

And I guess if it’s to the opportunities yesterday, David obviously mentioned may be seeing an accelerated pace of acquisitions coming to market. If you’re seeing a slowdown, what’s driving that? I would think the uncertainty might actually take that higher as opposed to take that lower. Is it just that most of the deals you’re closing will distract debt deals, maybe the sellers are now out of the market. Can you give some color around why that slowdown may occur on a market wide basis?

Adam Portnoy

The slowdown, I think, is more specific to CommonWealth than versus the market. We are being incredibly choosy in picking in terms of what we are willing to put under contract. There is not a slowdown in the number of properties that are being offered for sale, there are many.

In fact, I think it’s been picking up over the last couple of quarters, it continues to be very robust. There is a lot of properties to evaluate, I just think that we are being exceptionally picking in terms of what we are deciding to put under contract.

And it relates to our capital structure of our cost of capital, matured the company, but we cannot blame the fact that we have a very high cost of equity. And so we have to be very choosy in what we’re picking, what we’re deciding to put under contract.

Dave Rodgers – RBC Capital Markets

Finally in your discussions regarding leasing with decision makers across your portfolio, have you seen any major trend, you will pick up or slow down since say six or 12 months ago, do you feel any better or worse, or do you feel pretty much the same?

Adam Portnoy

I think it’s pretty universal that in the last six months, things have pretty much stable. I mean there is maybe a little bit of improvement across the country, a little bit of backing up in concessions, a little bit in the form of free rent, if you look across our entire portfolio, things may – it might be safe to say that things are getting slightly, albeit slightly better across the portfolio in terms of our position, our negotiating position with tenants. But I think it’s also fair to say it’s basically been flat for the last six months. And I think it’s also safe to say that it’s not getting any worse either.

Dave Rodgers – RBC Capital Markets

Thank you.

Operator

We have a question from the line of Jamie Feldman with Bank of America/Merrill Lynch. Please go ahead.

Jamie Feldman – Bank of America/Merrill Lynch

Hey, thank you. Can you talk a little bit about your underwriting assumptions and some of the especially the ones that have the larger vacancies, what are your thinking in terms of lease up, I mean cost to spend to get those lease up?

Adam Portnoy

Sure. I guess the one building we have any vacancy and I think, you tried referring to is the Birmingham, Alabama building. Is that right, Jamie?

Jamie Feldman – Bank of America/Merrill Lynch

Correct.

Adam Portnoy

Yeah, well also then we – it’s reached an average of 8.7 years, it’s, many people might call it the Wells Fargo building. It’s got its name printed on the building in Birmingham. We make specific assumptions; we took market rents and we took market TI packages. And market rents, I don’t have it at my fingertips, but I can tell you that’s the way we underwrite it.

The way we look at all of our underwriting, we do a – we do both a five and ten-year analysis, and we put – we run also do some analysis in terms of how long we think it’s going to take to lease it up, and what it’s going to cost to lease it up and what type of concessions we’re going to have to run. And we do an IRR analysis, we do a cap rate analysis, and we do an inflation of cost analysis.

And we do the IRR now just both on a levered and a non-levered basis. And we look at all these things. And so, that’s basically how we do our underwriting. It’s a pretty rigorous underwriting process we go through. And we do it twice; we do it when we initially put it under contract, it’s a very rigorous process, and then we do our diligence and then we stuff in diligence and we change all of our assumptions based on what we learned in diligence.

And I would say 10%, 20% of the time we end up asking for significant price changes or we end up just not closing on the deal because we have to change our assumptions so dramatically that the economics don’t seem – don’t pin up. And so that’s the process by which we go under. I mean specifically with that theme, and keep in mind, at 76.6% occupied, we bought it at $133 per square foot. I think I’m safe in saying that’s well below inflation costs and the existing in-place cap rate on just 76% lease is 9.7%. So that...

Jamie Feldman – Bank of America/Merrill Lynch

So you think that across your acquisition, you pretty much assume the market rent to be flat?

Adam Portnoy

Yeah, we say yes. I mean specifics on how this works, I mean basically – there are inflation factors you can put in based on let’s say from lease trends over in eight years from now, guess market rents apply but they might be growing at 1%, 1.5% or something depending on assumption we put in the model.

Jamie Feldman – Bank of America/Merrill Lynch

Okay. And then I know you mentioned a little bit about your dispositions. Can you give us little more color on the types of buyers that are out there looking for the kind of the assets you’re selling?

Adam Portnoy

The stuff is for sale, if we have to sell, it’s mostly local developers, people are trying to thinking about repositioning the property, and it’s also a lot owner occupiers. People there are going to buy the building and occupy themselves.

Jamie Feldman – Bank of America/Merrill Lynch

Okay. Do you sense you’ll need to provide financing?

Adam Portnoy

I think probably we might need to be provided in a few cases. I don’t think they’re within a few.

Jamie Feldman – Bank of America/Merrill Lynch

Okay. And then, certainly the market suggesting or heading towards weaker targets ahead, how do you think your portfolio reacts if we do head towards the double-deck or at least kind of much slower GDP growth hear about the market, from what we’re all thinking recently?

Adam Portnoy

I think our portfolio similar to most developed competitors in the market. Generally, I mean I think it would be tough slide for all office reach in that environment. It declines and it really does go into a double-deck. I don’t know how else to react.

Jamie Feldman – Bank of America/Merrill Lynch

No, I guess in terms of the different, I mean, do you see CBD slowing down more or do you see warehouse versus suburban?

Adam Portnoy

On everything we see, we’ve been in the business for 25 years, we have owned CBD properties for a good portion of that time; we have owned suburban properties for a good portion of that time. We’ve got a tremendous amount of analysis around this, just on our own portfolios as well as reading a lot of outside of research about it and talking with a lot of people and just our own experience to personally deal with it.

CBD office has held up better and we would expect it to hold up better in a downturn in the suburban office product. Of course the times in any business cycles where people want to leave the CBD and they want to be out in suburbs – I mean, I gave you a good example, there were certain markets, for example today, right now in San Diego it’s one of the few markets that I think you must be better off in the suburbs then you are in the CBD.

So there are – there are where that’s the case, but overall when you look at the entire country, if you generally own number one and number two office tower in a market, you generally fare well in both good times and did do better than most in bad times.

And so I’d ask – again why I have been so focused on, on the last few years on trying to acquire a CBD office properties. And as you can see we virtually have shut down on the acquisitions of suburban and are primarily focused – we really are selling, it’s always been – has been on suburban office.

Jamie Feldman – Bank of America/Merrill Lynch

Okay, thank you.

Adam Portnoy

Yes.

Operator

And we have a question from Michael Bilerman with Citi. Please go ahead.

Michael Bilerman – Citi

Yes, good afternoon. (Inaudible) as well. When you think about the dispositions that you’ve done – I think you said $1.4 billion last two years, what percentage of that went to RMR-related entities? My thought was it was almost 90%, 95%.

Adam Portnoy

Above – that’s above 90%, yes.

Michael Bilerman – Citi

And as you think about the suburban office, your RMR head on for a second, I guess you are saying that’s a product type that you don’t want to own anywhere. You don’t want within the RMR entity.

Adam Portnoy

Well, no, let me share a few – for a long time in CommonWealth we have a very, very large MOV (inaudible) portfolio and we owned a very, very large government-leased portfolio. And we’re sound (inaudible) with it, and in that product type, I think it’s quite opt in that you’ll find the in suburban – you’ll find in suburban office or in suburban locations.

For those two product types, I think it makes a lot of sense to be in the suburban area. We are just not buying or own that type of product in CommonWealth anymore. If I were to own suburban government-leased buildings or suburban MOBs like our office buildings, I think that’s still a very worthwhile investment – but that’s a very – that’s a very tenant-specific type of product versus any I think location type of product. It’s not general office. And so – and for many years we had those two large portfolios sitting in CommonWealth or what – what used to be known as HRPT.

And they didn’t give us credit for us; they just said, hey, you are a suburban office REIT, and generally we don’t – the market didn’t like suburban office REITs. And it was – we talked – we touch on (inaudible) versus we have these huge portfolios of MOBs and government-leased properties that are really worth more and maybe giving us value towards a suburban office REIT, and so they made a lot more sense to be in vehicles that are focused on that product type.

And the market I think is appropriately valued then in those vehicles for what they are. And so that’s – I mean is a long way of answering your question, but yes when I talk about general multi-tenant office buildings, I’m pretty negative on it. If you’re talking about buildings that a majority of single-tenant leased, or single-tenant buildings that are MOBs or government-leased buildings, I think I had a different opinion.

Michael Bilerman – Citi

So the thought process is, you are not going to entertain – we’re not going to – we find out that you are going to split CommonWealth into two, CommonWealth, suburb and CommonWealth CBD. Your focus to grow out of the negativity that the suburban assets that are weighing you down is, one, to keep on acquiring CBD so it lowers the percentage, and two, to sell outright to third-parties the suburban products. We should not expect a trade to another RMR entity?

Adam Portnoy

That is the current focus. Yes, I have to caveat this one caveat, which is that we still own – we don’t own any properties that are leased to government tenants left in CommonWealth. There are still properties that are MOB properties that are still subject to right of first refusal that technically could go to SNH.

Michael Bilerman – Citi

Right, you are done and how much does that make-up at this point?

Adam Portnoy

I’m sorry, what?

Michael Bilerman – Citi

How much does that make-up at this point, what’s left?

Adam Portnoy

I think it’s 15 properties around there.

Michael Bilerman – Citi

With a value of...

Adam Portnoy

Roughly $200 million.

Michael Bilerman – Citi

Okay, so then the majority – so we should be done at this point outside of those assets with other trades to honor RMR entities. We should not expect to have any other transactions, spin-off, sales, at all?

Adam Portnoy

I’m not currently planning anything, Michael but I can tell you, for – and rest of CommonWealth we – we’ll decide to do something with it, I mean or do a spin-off or do something. And I have no plans to do anything like that, and I’m not anticipating it. But I don’t want to go on record saying, I’m never going to do it.

Michael Bilerman – Citi

Well, I’m just trying to piece together, I mean you’re talking pretty negatively about the suburban product and you keep on referencing the – you look out that the results were in the quarter in the suburban product is standing 11%, we don’t want to own it. I don’t want to find out six months from now, we get just the way to enhance the value, the proceed value of CWH’s to split out the suburban product and give us its own focus, which fairly one of the market frustrations as you know is that nothing is leaving the overall RMR, so I’m just trying to put all that stuff together.

Adam Portnoy

There’s no – yeah, there’s no plans if currently take the suburban office product and still, I mean we cannot bring up – the total revenue weighted real estate company with general growth is for example, talked about the office, B class mall, there’s no plan to do something like that with our suburban office properties now.

Michael Bilerman – Citi

And then if you think about the payout ratio and you are sort of figuring on a 100%, I think with our CapEx numbers, even a little bit above and you think about the same-store continuing to decline and the capital needs that you have, the CapEx in the quarter was elevated. How comfortable you feel about keeping that payout ratio below 100%, because you’re certainly adding everything up, it seems like you may – while you have now all as being equal, you may split it?

Adam Portnoy

Well, I don’t know – okay, I think where you’re getting is the heart of this – our securities to dividend and I think the dividend is very secure. I think there’s a good chance that we might go above 100% payout ratio and we might go up about it for a period of time, but I would – I think the only reason that had happened is because if we’re starting to lease up, we gain occupancy across the board and significantly start to grow occupancy.

And so I would see that as a (inaudible) it’s a good thing overall for the company and might be a short term spike in let’s say the payout ratio. But I would see that as temporary (inaudible). I do not imagine that to be a long-term thing, and so if that happens – let’s say for example if 2012 occupancy starts growing and growing nicely at a good clip, I think it’s a good chance that payout ratio grow over 100%.

While will not be a loan for that and I don’t think our dividend would be in jeopardy, I think that would occupancy was staying flat and was consistently growing well above 100% payout ratio, then I think it’s a legitimate question that has dividend sustainable. And we’re not there yet (inaudible), we – I mean our calculations, what we have put in our performance, we’re currently at 95% payout ratio and we kept occupancy basically flat.

Michael Bilerman – Citi

Right. You think about that decline in the dividend back in late ‘08, you should have had effectively gone and the build back up and should have had enough room to grow back into that dividend. Maybe just spending some on the lease expiration schedule, page 29 of the sub, and just going back – you got about 25% of the rents rolling the next, obviously the back half of this year, 10% and then 16% into 2012. What’s your expectation of where those rents are relative to the market? They seem pretty elevated right now.

Adam Portnoy

Yeah, across the portfolio or across our portfolio, mark-to-market, all rents are above – well 2.5%, 3% above the market. Specifically in 2011 with less to expire, we’re actually a little bit below market, the mark-to-market the entire portfolio that expired in 2011 were about 1% below market. If you look at the entire company, everything expiring – recently entire company were about 2% or 3% above market.

Michael Bilerman – Citi

Okay. And then I echo John Guinee’s point as well on the equity. The more equity issue at a huge cost is obviously, I guess, this is one way to narrow any perceived discount, but it clearly – it’s difficult, right, it’s very hard in the position that you’re in to have – to create that value when you have to come back to the market and issue equity in such an excessive price.

Adam Portnoy

I agree with you, I think it’s why we rested what we had to do for many, many – for quarters. I think people are asking us about the equity deal for last three, four quarters. And we worked very hard trying to get this step by step, so it would be less expensive.

Michael Bilerman – Citi

Okay. Thank you.

Adam Portnoy

Okay.

Operator

And we do have a question from the line of Steve Swett with Morgan Keegan. Please go ahead.

Steve Swett – Morgan Keegan

Yeah, thanks. Adam, can you just update me on your thoughts on Australia and how that fits into your plans to sort of shift around the portfolio?

Adam Portnoy

Sure. As you can see, we haven’t found anything in Australia in many months, I think it’s safe to say that we’re not actively looking for many new investments there, and it is a market that we started thinking about whether or not it makes sense to sell some of our assets down there, just given where currency markets are and given the strength of that economy.

It might make sense, I’m not saying we are going to do it, it might make sense to think about selling some of the holdings down there as we think about that market. But we’re not currently focused on growing the portfolio down there.

Steve Swett – Morgan Keegan

Is John still down there?

Adam Portnoy

John Mannix is still down there, yes.

Steve Swett – Morgan Keegan

Okay. And then last question. On the acquisitions that you’ve completed and are pending, can you just kind of give me a general sense of the difference between the GAAP yields and the cash yields?

Adam Portnoy

Sure, overall let me – this might be a good way to answering your question. Everything we have bought since the beginning of 2011, our cash yields are roughly 70 basis points below on average what we have reported on a GAAP basis. Some of that is less than 70, some of it’s more, but on average, it’s 70 basis points less than what we reported on a GAAP rate.

Steve Swett – Morgan Keegan

Okay, thanks.

Adam Portnoy

Yeah.

Operator

And we do have a follow-up question from the line of Mitch Germain with JMP Securities. Please go ahead.

Mitch Germain – JMP Securities

Adam, a couple of your peers have been fairly stepping up their disposition efforts and I know you referenced that the transaction markets were being – were pretty robust. I don’t know if that 27 out of 400 something assets for sale, I mean, could we see or would you entertain possibly starting to sell more of your core suburban assets rather than the non-performing ones?

Adam Portnoy

Yes, that is something that is on the table and we’re considering, in answering Steve Swett’s question just probably this one I mentioned that something that’s one the table, you are thinking about it something not at all, well maybe some of the assets in Australia. Okay.

Operator

And we have a question from the line of Jamie Feldman with Bank of America/Merrill Lynch. Please go ahead.

Jamie Feldman – Bank of America/Merrill Lynch

Thanks, Adam you had mentioned thinking about GOV shares is that the source of capital? Can you just talk about where that falls into your priorities, and what do you think about you are the capital sources? And then if you were to sell those out, do you think it would be – and how you would do and what the process would be – would it be in the relative market or block trade?

Adam Portnoy

The second part of your question, I think it’s pretty simple. We would – we would likely be a block trade, this is how we think about it. And we may not sell, if we did it, we may not sell the whole – or the whole holdings at this – at one time. We look for some more priorities; I think we right now where we are thinking about things is probably thinking about generally asset sales. And if you want to continue to grow again one option is we just don’t continue to buy anything or we slowdown the pace significantly.

If we continue to grow significantly, I think that what are on the top of the list is asset sales and when I say asset sales, I guess it’s equal between the selling share and GOV or we would think about property sales. But again, if we did sell our shares in GOV we would probably be a block trade it would be through, in under – it would be to investment bank, and we would likely and I’m not (inaudible) until we sell everything all at once, it might be small, we might do a small amount, where all might decide to look first to selling some properties first, and then think about the GOV shares, but right now where the markets are today, obviously I will not be very – not too enthusiastic about selling, but today where the market is – probably we’re looking to sell assets properties before I sell the GOV shares.

Jamie Feldman – Bank of America/Merrill Lynch

So I guess the question given your strategy to grow in CBD would you preferred to own GOV shares or more CBD assets?

Adam Portnoy

I guess more CBD assets if I, but I’m not sure that choice is an evolutionary exclusive I think a – can made a (inaudible).

Jamie Feldman – Bank of America/Merrill Lynch

Okay, all right thank you.

Adam Portnoy

Yeah

Operator

And it just appears there are no further questions in queue. At this time. I’d like to turn the conference over to our host Adam Portnoy. Please go ahead sir.

Adam Portnoy

Thank you all for joining us on our second quarter conference call.

Operator

And ladies and gentlemen that does conclude our 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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