Lakewood Capital Issues Letter to Select Income REIT Board of Trustees

In our seven years in business, we have never been pushed to the point of publicly expressing opposition to the governance of any company in which we have invested, so we do not take the contents of this letter lightly.  During the past five weeks, we have witnessed a sickening series of events unfold whereby the SIR Trustees have deliberately taken multiple steps to protect their own interests at the expense of shareholders in clear breach of their fiduciary duties.  We have spoken with several other significant SIR shareholders and they share our outrage.  We believe SIR's shares are substantially undervalued (please see the attached Exhibit A: SIR's Undervaluation), and we urge the Board to start minding the interests of the shareholders they were elected to represent and immediately cease any activities that further entrench the Board and management including, but not limited to, (1) diluting existing shareholders through any further equity offerings at prices below the fair value of the Company's underlying assets, (2) expanding the size of SIR's Board and (3) offering to repurchase shares directly from SIR's largest shareholder, CommonWealth REIT ("CommonWealth"), thereby reducing its ability to exercise influence over SIR, without making such offer available to all shareholders on equal terms. 

Background

As you are certainly aware, there is a long, established history of shareholder concerns related to entities affiliated with SIR's external manager, Reit Management & Research ("RMR"), a privately-held company controlled by SIR Trustees Barry and Adam Portnoy (please see the attached Exhibit B: RMR – A Track Record of Governance Abuses).  As you are also aware, SIR's largest shareholder, CommonWealth, an RMR-managed publicly-traded company, was recently the subject of a consent solicitation to remove its Board of Trustees, resulting from shareholder frustration with RMR and corporate governance.  Prior to last month's SIR common equity offering, CommonWealth owned a 44.1% interest in SIR, which has since been diluted down to 37.4%. 

In September 2013, SIR announced it was taking steps to improve its own corporate governance, ostensibly in response to the mounting pressures to replace the CommonWealth Board.  These steps included tying a portion of RMR's management fees to share price performance and proposing an amendment to SIR's Declaration of Trust that would eliminate the current three-year staggered terms and permit the annual election of all Trustees.  The SIR Independent Trustees stated in a press release that the Board was "considering additional governance enhancements which may be announced during the next several months."[1]  The preliminary shareholder proxy filed in March 2014 highlighted that "these changes reflect our commitment to our shareholders' interests and best practices."  The proxy went on to assure shareholders that the Board will "continue to work hard to make meaningful changes to incorporate our shareholders' feedback."[2],[3]  Like many shareholders, we viewed these changes positively and were hopeful the Board's interest in improved governance was genuine.

On March 25, 2014, CommonWealth announced that its shareholders had voted to remove its entire Board of Trustees (including SIR Trustees Barry Portnoy, Adam Portnoy and William Lamkin, who together hold 60% of the seats on the SIR Board) and that a new CommonWealth Board would be selected in late May 2014.[4]  At this point, it was clear that RMR's days were numbered as the manager of CommonWealth.  As CommonWealth held 44.1% of SIR shares, these changes had clear implications for SIR's future governance.

On April 3, 2014, the week following the CommonWealth shareholder vote, we met with SIR's President David Blackman, Chief Financial Officer John Popeo and Investor Relations Director Jason Fredette (all three are RMR employees) at Morgan Stanley's "Triple Net REIT Day" conference in New York City.  At that meeting, we expressed concern that SIR might schedule its shareholders' meeting before the selection of the new CommonWealth Board, thereby disenfranchising CommonWealth with respect to the shareholder vote on the amendment proposal permitting annual election of the Trustees.  We recognized such a maneuver would be viewed negatively by shareholders and would be a major step backward from the governance enhancements to which the Board appeared committed.  Mr. Blackman explained to us that they would "not be caught in a limbo period" because CommonWealth management (i.e., RMR) could vote those shares at the SIR shareholders' meeting prior to the election of the new CommonWealth Board.  Furthermore, Mr. Blackman reasoned that if there were any issues with RMR voting those shares then the Company "would probably be forced to delay the meeting because of quorum."   Mr. Blackman further assured us that RMR was in favor of the proposed amendment.  This struck us as plausible at the time as Barry and Adam Portnoy had already approved the amendment proposal in their capacity as SIR Trustees. 

After we gained comfort that CommonWealth would be entitled to exercise its vote on this important governance matter, we raised our other major concern, a common equity offering.  We outlined our view that SIR's stock was trading significantly below the fair value of the Company's assets, largely due to concerns around corporate governance.  Given the stock's discounted valuation and underleveraged balance sheet, we expressed our stark opposition to issuing equity at or near the levels where the stock was trading.  We further expressed our view that diluting shareholders (specifically, CommonWealth) would only exacerbate shareholder concerns about corporate governance and undermine the governance enhancements that appeared to be underway.  Both Mr. Blackman and Mr. Popeo agreed that the shares were undervalued, and Mr. Blackman specifically stated that "the team is pretty focused on narrowing the gap of where we trade and NAV [Net Asset Value]."  Mr. Popeo noted that "[SIR] might want to go to the rating agencies at some point" to get an investment grade rating, but stressed that the Company had "$450 million to $600 million in firepower" for acquisitions before an equity deal was necessary due to the Company's low leverage levels.  Mr. Blackman added that he "was not a big fan of where pricing is for acquisitions" and the Company "was passing on a lot of deals right now."  Both Mr. Blackman and Mr. Popeo expressed agreement with our point of view that issuing equity in the near- or intermediate-term made no sense in light of these facts.

During the subsequent five weeks, as RMR and the SIR Board of Trustees felt the looming threat from the removal and replacement of the CommonWealth Board, SIR shareholders were subjected to some of the most brazen corporate governance transgressions that we have ever seen.  It sadly was about to become abundantly clear that the supposed governance enhancements were nothing more than a ruse designed to persuade shareholders to have a more favorable view of RMR in a desperate last plea to salvage its lucrative management agreements with CommonWealth.  When RMR lost the battle with CommonWealth shareholders, the SIR Trustees abruptly lost their commitment to their fiduciary duties and their focus swiftly turned to entrenching their positions at SIR.

The SIR Annual Meeting of Shareholders (May 2, 2014)

On April 7, 2014, four days after our meeting with SIR management, SIR set its annual meeting date for May 2, 2014, less than three weeks before the new CommonWealth Board was to be selected.[5]  On May 2, 2014, the Company issued a press release announcing that the vote on the amendment to de-stagger the Board did not pass.[6]  On May 7, 2014, we held a conference call with SIR management to try to understand what had just happened.   We were told that CommonWealth's management, represented by SIR Trustee and RMR President Adam Portnoy, chose to vote only on so-called "routine" matters but not on special items such as the amendment.  The fears we expressed to SIR management in the April 3, 2014 meeting were being realized.  Because the approval of two-thirds of shares outstanding was required for the amendment to pass, the amendment never had a chance without CommonWealth's 44.1% participation.  Shareholders who did vote cast 18,788,329 votes "for" the amendment and only 317,084 votes "against" (98% "for" and 2% "against").[7] 

When we asked why the meeting was not simply delayed a few weeks to allow the Company's largest shareholder to participate in this critical vote, Mr. Blackman told us that "SIR had a quorum and conducted business" because CommonWealth was technically represented at the meeting by Adam Portnoy as evidenced by his vote on CommonWealth's behalf to ratify the appointment of the Company's auditor.  So, Adam Portnoy elected to vote CommonWealth's shares on one matter to ensure a quorum at the meeting, but he somehow did not see it fit to vote on a separate matter that was specifically intended to protect SIR shareholders from the oppression of his own company, RMR.  Simply put, the SIR Board of Trustees and RMR knowingly held a banana republic-style election to ensure the proposal to de-stagger the Board did not pass to protect their own interests rather than take simple and obvious steps to allow a proper vote on a proposal that the voting SIR shareholders nearly unanimously supported (again, 98% in favor).

We would also like to point out that during our May 7, 2014 conference call we asked Mr. Blackman if the proposal to de-stagger the Board would be on the agenda for next year's shareholders' meeting, to which he replied, "If there are no changes, the annual election of directors should be on the agenda next year."  We urge the Board to be mindful of its fiduciary duties and put the proposal for the annual election of Trustees on the agenda for the 2015 shareholders' meeting.

Finally, after expressing our displeasure with these developments to SIR management on the conference call, we reiterated our view that we saw no reason for SIR to issue common equity given the discounted stock price and SIR's low leverage levels.  Mr. Blackman responded, "We understand your perspective."

The RMR Termination Payment (May 9, 2014)

On May 12, 2014, less than two weeks before the new CommonWealth Board was to be selected and just five days after our conference call with SIR management, the Company filed a Form 8-K disclosing that on May 9, 2014, it amended its management agreements with RMR to obligate the Company to pay a termination fee to RMR if the Company terminated or failed to renew the management agreements.[8]  We calculate that this fee payable to RMR would end up amounting to more than $30 million.[9]  The only mentioned consideration given by RMR in return for the right to this egregious payment was a meaningless 60 day increase to the advance notice period in the highly improbable event that RMR elects to terminate the management agreements.

On May 30, 2014, we held another conference call with SIR management to try to understand what had happened.  Mr. Blackman attempted to explain to us that following the changes at CommonWealth, the Independent Trustees were "concerned that RMR could potentially be disincentivized to invest in technologies to allow us to efficiently manage the business or that RMR would have a difficult time hiring and retaining the best and brightest employees."[10] 

Let us be clear – this is complete nonsense.  If SIR's Independent Trustees genuinely believe that RMR would dare refuse to fully invest in the proper technologies or put the right people on the job to fulfill its obligations under its management agreements, then the Independent Trustees should simply fire RMR.  RMR is well paid for its services, and there is not a shred of doubt in anyone's mind that RMR would in fact go to extraordinary lengths to maintain its grip on this fee stream (again, please see attached Exhibit B: RMR – A Track Record of Governance Abuses).  Given the Independent Trustees are actually the only ones with the power to terminate RMR, their concerns for RMR are not credible; in fact, introducing this obstacle to removing RMR makes it clear that the Independent Trustees are fearful that one day they are the ones who will be terminated by frustrated shareholders.  Sadly, this outrageous termination provision was nothing more than another blatant step to entrench RMR and the Board. 

The Common Equity Offering (May 14, 2014)

On May 14, 2014, less than two weeks before the new CommonWealth Board was to be selected and just one week after our conference call with SIR management where we reiterated our opposition to a common equity offering, the Company announced a public offering of 8,000,000 common shares.[11]  SIR completed the offering within a matter of hours at a discount to SIR's market price.  After SIR upsized the deal to 9,000,000 shares, the offering amounted to an astounding 18% of the outstanding common shares.[12]  Furthermore, this offering amounted to a staggering 32% of the freely-tradable outstanding shares not held by CommonWealth and represented 53 times the trailing 20-day average daily trading volume in SIR shares at the time.[13]  By any measure, the scale of this deal was enormous.  Following the deal, SIR had diluted CommonWealth's stake from 44.1% down to 37.4% and Lakewood's stake from 6.8% down to 5.8%.

On our May 30, 2014 conference call with SIR management, Mr. Blackman stated, "We presented financing alternatives to the Board… and based upon the timing to execute those strategies as well as the effect on our long-term cost of capital and the Company's desire to have an investment grade rating, the Board elected that raising common equity would be the best alternative to achieve the Company's goals and so that's what we did."  When we inquired why the Board was in a hurry to do such a substantial equity offering, Mr. Popeo pointed to the Company's rising leverage levels which stood at 37% debt-to-total capitalization following an increase in the revolving credit facility during the first quarter, presumably to fund $208 million of acquisitions announced in April 2014.  Recall just weeks earlier in our April 3, 2014 meeting with SIR management, Mr. Popeo agreed the Company had a low degree of leverage and specifically stated that the Company had "$450 million to $600 million in firepower" for acquisitions before an equity deal was necessary.

Mr. Popeo's statements in our April 3, 2014 meeting were consistent with public statements he had made up until that point on the Company's quarterly earnings calls.  On the October 31, 2013 third quarter 2013 earnings call, Mr. Popeo stated, "We are running at, I would say, an atypical debt to total capitalization or leverage ratio right now.  If you assume now, and this is back of the envelope, that we acquire enough property to get ourselves back up to 40%, 40% to 45% [debt-to-total capitalization], I think is what we discussed in prior calls as sort of the sweet spot before we may feel the need to go back to the capital markets."[14]  On the February 20, 2014 fourth quarter 2013 earnings call, Mr. Popeo stated, "As of today, our $750 million revolving credit facility has $170 million outstanding, leaving $580 million available to support our acquisition activity and other working capital needs… We plan to begin exploring various options to add longer-term fixed-rate debt to the balance sheet, a capital stack strategy more in line with our longer-term business plans. We may also consider moving corporate leverage higher than in prior quarters in order to capitalize on today's attractive borrowing rates and to minimize shareholder equity dilution."[15]

After emphasizing to shareholders that SIR would look to increase corporate leverage and minimize shareholder dilution on that February 20, 2014 earnings call, SIR's management suddenly changed its tone after RMR lost its battle with the CommonWealth shareholders on March 25, 2014.  In his prepared remarks on the April 25, 2014 first quarter 2014 earnings call, Mr. Popeo stated, "Moving on, our total debt-to-book capitalization ratio at March 31 was 37.3% and our fixed charge coverage ratio was 12 times…  As of the end of the first quarter, we have $345 million drawn on our revolving credit facility.  Considering our revolver was approximately 50% drawn, we will likely explore various options to reduce amounts outstanding on our revolver with fixed rate debt, equity or a mix of both in order to free-up capacity for future investment opportunities."[16]  The Company drew on its revolving credit facility by the end of the first quarter 2014 and saw its cash balance increase by $184 million as a result.[17]  In hindsight, management's choice to draw on its revolving credit facility appears to have been introduced as a justification for an equity offering in stark contrast to prior statements regarding increasing leverage and minimizing shareholder dilution.

Simply, after the Board felt threatened by the removal of the CommonWealth Board, the common equity offering was just another tool to further entrench RMR and the Board. 

Finally, after expressing our complete objection to this series of developments to SIR management on our May 30, 2014 conference call, we raised a new concern, the prospect that SIR might attempt to directly repurchase shares from CommonWealth, thereby reducing its stake and further entrenching RMR and the Board.  We noted the SIR prospectus for the May 14, 2014 common equity offering ominously stated, "We are not prohibited from voluntarily negotiating with [CommonWealth] with respect to any potential resale of all or a portion of our common shares that it owns."[18]  When we highlighted our concern to Mr. Blackman, he responded that while there was no "specific agreement" or "direct path at this point… it is certainly something that makes sense to get those shares out of the hands of CommonWealth if in fact they don't have a long-term interest in being an owner but at this point we don't have a specific view."

Let us once again be clear – this is preposterous.  After SIR management went to great lengths to justify to us an illogical and corrupted equity issuance, in nearly the same breath, they entertained the logic of actually doing the opposite: a repurchase of what would likely amount to an extraordinary number of shares.  It is wholly apparent to us that the Company is contemplating making an offer to CommonWealth for a portion of its shareholdings without making that offer available to other shareholders.  Such an act would be yet one more egregious step to further entrench RMR and the Board.  There is little doubt that SIR shareholders are better off with a large shareholder like CommonWealth to keep RMR and the SIR Board in check, and we again urge the Trustees to be mindful of their fiduciary duties and cease any consideration of repurchasing any of CommonWealth's shares without making such offer available to all shareholders on equal terms.

In closing, we greatly regret the actions that the Board has taken over the past five weeks.  We hope this letter will encourage other shareholders to also express their concerns to the Board.  There is a substantial amount of value in SIR's assets, and you have an obligation to maximize that value (again, please see the attached Exhibit A: SIR's Undervaluation).  Any further actions to entrench RMR and the Board will not be viewed favorably.  We are committed to protecting our investment and ensuring that SIR shareholders are treated fairly, and we are committed to holding each of you personally responsible for any failure to fully live up to your fiduciary duties.[19] 

Sincerely,

/S/ Anthony T. Bozza

Anthony T. Bozza
Managing Partner
Lakewood Capital Management, LP

Exhibit A:  SIR's Undervaluation

Shares of Select Income REIT ("SIR") trade at a deep discount to their reasonable fair value by any measure.  We believe SIR has an extremely valuable asset in its Hawaiian properties, where periodic rent resets provide for substantial organic growth in rental income and therefore net operating income (NOI).  For example, over the past five quarters rental resets in Hawaii have been between 29.4% and 57.0% above the prior rents.[20]  We believe SIR's stock is worth over $40 per share or more than 40% above the current trading price.  This undervaluation is particularly notable in light of SIR's low leverage levels of just 24% Net Debt / Gross Real Estate Value (roughly half of its peer group), providing it with ample capacity to increase financial returns to shareholders above our estimates.

I.     Based on peer FFO trading multiples, we think SIR's stock could be worth over $40 per share (more than 40% above the current share price) even after adjusting SIR's FFO to reflect normalized interest expense from an eventual higher mix of longer-term, fixed-rate debt.  This undervaluation is particularly striking since SIR has considerably lower leverage than its peers.  Prior to the dilutive May 2014 equity offering, our estimate of fair value was even higher.

	Pre-Equity Offering[21]	May 2014 Equity Offering	Post-Equity Offering[22]	% Change Post-Equity Offering
(A) SIR 2014 Projected EBITDA (Street Consensus)	$167		$167
(B) Q1 2014 Pro Forma Net Debt	$723	($250)	$473	(35%)
(C) Current Weighted Average Cost of Debt[23]	1.69%	1.69%	1.69%
(D) Annual Interest Expense at Current Cost of Debt (B x C)	$12	($4)	$8
(E) Estimated SIR Normalized Cost of Debt[24]	4.50%	4.50%	4.50%
(F) Incremental Interest at Normalized Cost of Debt ((B x E) - D)	$20	($7)	$13
(G) Normalized FFO (A - D - F)	$134	$11	$145	8%
(H) SIR Share Count (millions of shares)	50	9	59	18%
(I) FFO per share with Normalized Interest Expense (G / H)	$2.69	($0.22)	$2.47	(8%)
(J) Target SIR FFO Trading Multiple (Peer 2014 Median)[25]	16.5x		16.5x
Implied SIR Share Price (I x J)	$44.55	($3.66)	$40.90	(8%)
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