Broadmark Realty Capital Inc. - Quarter Report: 2021 September (Form 10-Q)

Basis of Presentation

The accompanying condensed consolidated financial statements include Broadmark Realty Capital Inc. and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. These condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Accordingly, these interim condensed consolidated financial statements should be read in conjunction with the audited financial statements and accompanying notes included in Broadmark Realty Capital Inc.’s Annual Report on Form 10-K/A for the year ended December 31, 2020, which was filed with the SEC on March 2, 2021. The condensed consolidated balance sheet as of December 31, 2020, included herein, was derived from the audited financial statements of Broadmark Realty Capital Inc. as of that date.

The unaudited condensed consolidated interim financial statements, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly our financial position as of September 30, 2021, our results of operations and stockholders’ equity for the nine months ended September 30, 2021 and 2020, and our cash flows for the nine months ended September 30, 2021 and 2020. The results of the nine months ended September 30, 2021 is not necessarily indicative of the results to be expected for the year ending December 31, 2021 or for any interim period or for any other future year.

Principles of Consolidation

Broadmark Realty consolidates those entities in which it has control over significant operating, financial and investing decisions of the entity, as well as those entities deemed to be variable interest entities (“VIEs”), if any, in which Broadmark Realty is determined to be the primary beneficiary. Broadmark Realty is not the primary beneficiary of, and therefore does not consolidate, any VIEs.

The Private REIT was determined to be a voting interest entity for which we, through our wholly-owned subsidiary who previously acted as manager with no significant equity investment, did not hold a controlling interest in and, therefore, did not consolidate. Furthermore, the Private REIT's participation in loans originated by us met the characteristics of a participating interest and the criterion for sale accounting in accordance with GAAP and therefore, was derecognized from our consolidated financial statements.

Reclassifications

Certain amounts in our prior period condensed consolidated financial statements have been reclassified to conform to the presentation of our current period condensed consolidated financial statements. These reclassifications had no effect on our previously reported net income or stockholders’ equity. The reclassification for the separate presentation of accretion of deferred origination and amendment fees resulted in a reclassification of net cash provided by operating activities to net cash provided by investing activities, both as previously reported. The reclassifications also included the separate presentation of amortization of right of use assets and change in lease liabilities and the combined presentation of depreciation and amortization on the condensed consolidated statements of cash flows.

In the course of preparing our second quarter 2021 unaudited condensed consolidated financial statements, we revisited our previous accounting classification for warrants and identified an error related to the presentation of the Private Placement Warrants, resulting in an understatement of liabilities and change in fair value from November 14, 2019 to March 31, 2021. Refer to Note 5 for additional details about the Private Placement Warrants and Public Warrants. The Private Placement Warrants generally have the same terms as the Public Warrants, except that so long as the Private Placement Warrants are held by the original holder or its permitted transferees, (i) the original holder or its permitted transferees may exercise the warrant on a cashless basis and (ii) the Company does not have the right to redeem the Private Placement Warrants. In the case of a change of control in which less than 70 percent of the consideration received is stock listed on an exchange, the Public Warrants and Private Placement Warrants would be subject to an exercise price adjustment calculated on the basis of a capped American call option and uncapped American call option, respectively. If, however, the Private Placement Warrants are transferred to a third party, the basis for the exercise price adjustment changes and is calculated on the basis of a capped American call option, which results in the valuation change being based, in part, on the holder of the Private Placement Warrants. As a result, the Private Placement Warrants do not meet the criteria to be indexed to valuation inputs based on the Company’s own stock and must be classified as a liability measured at fair value. Based on consideration of both the quantitative and qualitative factors within the provisions of SEC Staff Accounting Bulletin No. 99, Materiality, and Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, we determined that the error was not material to our previously issued annual and interim consolidated financial statements. Furthermore, we determined that correcting the error in the second quarter of 2021 would not materially misstate our unaudited condensed consolidated financial statements and therefore, no restatement of our prior period unaudited condensed consolidated financial statements was required.

Use of Estimates

The preparation of the condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts and disclosures at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. The most significant estimates relate to the fair value of financial instruments, such as the expected credit losses on our loans, investments in real property, and Private Placement Warrant liabilities. Accordingly, actual results could differ from those estimates. The COVID-19 pandemic has introduced significant additional uncertainty with respect to estimates, judgments and assumptions, which may materially impact the estimates previously listed, among others.

Certain Significant Risks and Uncertainties

In the normal course of business, we encounter one primary type of economic risk in the form of credit risk. Credit risk is the risk of default on our investment in mortgage notes receivable resulting from a borrower’s inability or unwillingness to make contractually required payments. We believe that the carrying values of our loans reasonably consider this credit risk.

In addition, we are subject to significant tax risks. If we were to fail to qualify as a REIT in any taxable year, we would be subject to U.S. federal corporate income tax, which could be material.

We operate in a dynamic industry and, accordingly, can be affected by a variety of factors. For example, we believe that changes in any of the following areas could have a significant negative effect on us in terms of our future financial position, results of operations or cash flows: public health crises, like the COVID-19 pandemic; the economy in the areas we operate; competition in our market; the stability of the real estate market and the impact of interest rate changes; changes in government regulation affecting our business; natural disasters and catastrophic events; and our ability to attract and retain qualified employees and key personnel, among other things.

Reportable Segments

We operate the business as one reportable segment, which originates, underwrites and services construction loans.

Cash and Cash Equivalents

We consider all highly liquid investments with an original maturity of 90 days or less at the date of purchase to be cash equivalents. We have a cash management sweep account repurchase agreement, whereby our bank nightly sweeps cash in excess of $750,000, sells us specific U.S. government agency securities and then repurchases these securities the next day.

We maintain our cash and cash equivalents with financial institutions, which are insured up to a maximum of $250,000 per account as of September 30, 2021 and December 31, 2020. The balances in these accounts may exceed the insured limits. There were no restrictions on cash as of September 30, 2021 or December 31, 2020.

Mortgage Notes Receivable

Mortgage notes receivable (referred to herein as “mortgage notes receivable”, “construction loans”, “loans”, or “notes”) are classified as held for investment, as we have the intent and ability to hold until maturity or payoff and are carried in the condensed consolidated balance sheets at amortized cost, net of construction holdbacks, interest reserves, allowance for credit losses and deferred origination and amendment fees.

Participations in mortgage notes receivables are accounted for as sales and derecognized from the balance sheet when control over the transferred assets has been surrendered. Control over transferred assets is deemed to be surrendered when: (1) a group of financial assets or a participating interest in an entire financial asset has been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right, beyond a more than trivial benefit) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets. If the sales do not meet these criteria, the sale of the participation is treated as a secured borrowing. A transferred asset is considered to be repurchased if (1) the transfer no longer qualifies for sale accounting (transferor obtains effective control) or (2) the transferor reclaims the transferred financial assets. In either circumstance, the transferred financial assets are accounted for as if purchased new by the transferor at fair value with no gain or loss recognized on the transaction. As of September 30, 2021, there were no outstanding participations in our mortgage notes receivables.

Current Expected Credit Losses Allowance

In the fourth quarter of 2020, we adopted the current expected credit loss (“CECL Standard”) for the full year ended December 31, 2020, as we ceased to qualify as an emerging growth company effective December 31, 2020. As a result, we were no longer permitted an extended transition period for complying with new or revised accounting standards affecting public companies. The initial CECL allowance adjustment of $2.0 million was recorded effective January 1, 2020 as a cumulative-effect of change in accounting principle through a direct charge to accumulated deficit on our condensed consolidated statements of stockholders’ equity; however, subsequent changes to the CECL allowance are recognized through net income on our condensed consolidated statements of income. Our condensed consolidated statement of income for the three and nine months ended September 30, 2020 includes an additional (reversal of) and provision for credit losses of ($2.3) and $2.4 million associated with the adoption of the CECL Standard. As a result, for the three months ended September 30, 2020, our previously reported net income of $23.2 million is higher by $2.3 million and for the nine months ended September 30, 2020 our previous reported net income of $70.3 million is lower by $2.4 million.

The CECL Standard replaced the incurred loss model under existing guidance with an expected loss model for instruments measured at amortized cost. We now record an allowance for credit losses in accordance with the CECL Standard on our loan portfolio, including unfunded construction holdbacks, on a collective basis by assets with similar risk characteristics. In addition, for assets that are classified as collateral dependent based on foreclosure being probable, we continue to record loan specific allowances based on the fair value of the collateral for expected credit losses under the CECL Standard. Given the short-term nature of our loans, we evaluate the most recent external appraisal and, depending on the age of the appraisal, may order a new appraisal or, where available, will evaluate against existing comparable sales or other pertinent information to estimate the fair value of the collateral for such loans.

The CECL Standard requires an entity to consider historical loss experience, current conditions, and a reasonable and supportable forecast of the economic environment. The Company utilizes a probability of default/loss given default (“PD/LGD”) method approach for estimating current expected credit losses.

In accordance with the PD/LGD method, an annual historical loss rate is applied to the amortized cost of an asset or pool of assets over the remaining expected life. The PD/LGD method requires consideration of the timing of expected future funding of existing commitments and repayments over each asset’s remaining life. An annual loss factor, adjusted for macroeconomic estimates, is applied over each subsequent period and aggregated to arrive at the CECL allowance.

In determining the CECL allowance, we considered various factors including (i) historical loss experience in our portfolio, (ii) historical loss experience in the commercial real estate lending market, (iii) timing of expected pay offs including prepayments and extensions where reasonably expected, and (iv) our current and future view of the macroeconomic environment. We utilize a reasonable and supportable forecast period equal to the contractual term of the loan plus short-term extensions of one to three months that are reasonably expected for construction loans.

Management estimates the allowance for credit losses using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts. The allowance for credit losses is maintained at a level sufficient to provide for expected credit losses over the life of the loan based on evaluating historical credit loss experience and making adjustments to historical loss information for differences in the specific risk characteristics in the current loan portfolio. Refer to “Note 3 – Mortgage Notes Receivable” for further information regarding the CECL allowance. The CECL Allowance related to the principal outstanding is presented within mortgage notes receivable, net and for unfunded commitments is within accounts payable and accrued liabilities on our condensed consolidated balance sheets.

We have made an accounting policy election to exclude accrued interest receivable, included in interest and fees receivable, net on our consolidated balance sheets, from the amortized cost basis of the related mortgage notes receivable in determining the CECL allowance, as any uncollected accrued interest receivable is written off in a timely manner. No interest income is recognized on mortgage notes receivable that are in contractual default unless the interest is paid in cash or collectability of all amounts due is reasonably assured. In addition, in certain instances, where the interest reserve on a current loan has been fully depleted and the interest payment is not expected to be collected from the borrower, we may place a current loan on non-accrual status and recognize interest income on a cash-basis.

Deferred Income

Deferred income represents the amount of our origination and amendment fees that have been deferred and will be recognized in income over the contractual maturity of the underlying loan. Origination fees are included in the total commitment to the borrower and financed at the time of loan origination. Amendment fees are either included in the total commitment to the borrower and financed at the time of the loan amendment or are billed to the borrower when the loan is amended and not capitalized into the principal outstanding. Deferred origination and amendment fees capitalized into the principal outstanding are included within mortgage notes receivable, net on the consolidated balance sheets. Deferred amendment fees that are not included in the principal outstanding are presented within interest and fees receivable, net on the condensed consolidated balance sheets.

Interest and Fees Receivable

Interest on performing loans is accrued and recognized as interest income at the contractual rate of interest, or at the contractual rate of monthly minimum interest. Extension fees are charged when we agree to extend the maturity dates of loans. In addition, late fees are charged when borrower payments are contractually past due. We monitor each note’s outstanding interest and fee receivables and, based on historical performance, generally reserve against the balance after a receivable is greater than 60 days past due unless collectability of all amounts due is reasonably assured.

We have made an accounting policy election to exclude accrued interest and fee receivables from the amortized cost basis of the related mortgage notes receivable in determining the CECL allowance as any uncollected accrued interest receivable is written off in a timely manner.

Real Property

Real property owned by us consists of real estate acquired in settlement of loans. Real estate acquired through foreclosure or deed in lieu of foreclosure is recorded at fair market value at the time of acquisition, which generally approximates the carrying value of the loan secured by such property. Costs related to acquisition, development, construction and improvements are capitalized to the extent the investment in the real property does not exceed the fair value less estimated costs to sell. Expenditures for repairs and maintenance are charged to expense when incurred.

As of September 30, 2021 and December 31, 2020, we owned seven and three properties or projects totaling $52.4 and $8.5 million, respectively.

Leases

Our office space in Seattle, Washington is subject to an operating lease. Our operating lease is included in right of use assets and lease liabilities on our consolidated balance sheets. The lease agreement includes both lease components (e.g., fixed rent) and non-lease components (e.g., common-area maintenance). We account for the lease and non-lease components as a single component.

Right of use assets represent our right to use an underlying asset during the lease term and lease liabilities represent our obligation to make lease payments. Right of use assets and lease liabilities are recognized at the lease commencement date based on the present value of the total lease payments not yet paid, including lease incentives not yet received, with the right of use assets further adjusted for any prepaid or accrued lease payments, lease incentives received and/or initial direct costs incurred. Our lease arrangement also includes variable payments for costs such as common-area maintenance, utilities, taxes or other operating costs, which are based on a percentage of actual expenses incurred. These variable lease payments are excluded from the measurement of the right of use assets and lease liabilities.

Our lease term is through January 2032, which includes an option to extend the lease term for an additional five years. When determining if a renewal option is reasonably certain of being exercised at lease commencement, we consider several factors, including, but not limited to, contract-based, asset-based and entity-based factors. We reassess the term of the existing lease if there is a significant event or change in circumstances within our control that affects whether we are reasonably certain to exercise the option to extend the lease. Examples of such events or changes include construction of significant leasehold improvements or other modifications or customizations to the underlying asset, relevant business decisions or subleases. We have concluded that the renewal option is not reasonably certain of being exercised, therefore, the renewal is not included in the right of use asset and lease liability.

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Table of Contents

Broadmark Realty Capital Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

As our lease did not provide an implicit rate, we use our incremental borrowing rate based on the information available at the lease commencement date in determining the present value of the lease payments.

We recognize lease expense for our operating lease on a straight-line basis over the lease term. Variable lease payments are generally recognized when incurred. These expenses are included in general and administrative expenses in the consolidated statements of income.

Goodwill

Goodwill was recognized as of the close of the Business Combination on November 14, 2019 and represents the excess of the cost of an acquired business over the fair value of the assets acquired at the date of acquisition and is not amortized. We assess the impairment of goodwill on an annual basis, in our fourth quarter, or whenever events or changes in circumstances indicate that goodwill may be impaired. In our evaluation of goodwill, we typically first perform a qualitative assessment to determine whether the carrying value of each reporting unit is greater than its fair value. If it is more likely than not that the carrying value of a reporting unit is greater than its fair value, we perform a quantitative assessment and an impairment charge is recorded in our statements of operations for the excess of carrying value of the reporting unit over its fair value. Our annual assessment occurs in the fourth quarter. We continue to monitor the impact of COVID-19 and determined there were no new triggering events to warrant a quantitative assessment of our goodwill during 2021.

In the first quarter of 2020, we recorded a measurement period adjustment to reduce the preliminary fair value of intangible assets in the form of customer relationships by $5.0 million and increased our preliminary value of goodwill by $5.0 million. As a result of this adjustment to preliminary values, $0.9 million of amortization of intangible assets recorded in 2019 was reversed in the first quarter of 2020.

Other Assets

Other assets primarily consist of fixed assets, deferred financing costs, intangible assets, prepaid insurance and other operating receivables.

Fixed Assets

Fixed assets, which are included in other assets in the accompanying condensed consolidated balance sheets are stated at cost, less accumulated depreciation. Repairs and maintenance to these assets are charged to expense as incurred; major improvements enhancing the function and/or useful life are capitalized. When items are sold or retired, the related cost and accumulated depreciation are removed from the accounts and any gains or losses arising from such transactions are recognized. Depreciation is recorded on the straight-line basis over the estimated useful life of the assets. For computer equipment, office equipment, furniture and fixtures the useful lives range from three to seven years. For leasehold improvements, we depreciate over the shorter of expected useful life or lease term.

Deferred Financing Costs

Deferred financing costs represent direct costs associated with the execution of the revolving credit facility. As the revolving credit facility has no principal outstanding as of September 30, 2021 and there is no recognized debt liability, the deferred financing costs are included in other assets on the condensed consolidated balance sheet. These costs are amortized on the straight-line basis over the initial term of our revolving credit facility.

Intangible Assets

We record the intangible assets at fair value at the acquisition date and amortize the value of these finite-lived intangibles into expense over the expected useful life. All of our intangible assets relate to the value of customer relationships. As of September 30, 2021 and December 31, 2020, intangible assets net of accumulated amortization was $0.4 and $0.6 million, respectively.

Interest Income

Interest income on mortgage notes receivable is accrued based on contractual rates applied to the principal balance, unless there is a minimum interest provision in the mortgage note. Certain construction loans provide for minimum interest provisions, to which the contractual rate applies, which are typically between 50% and 70% of the face amount of the note until the actual outstanding principal exceeds the minimum threshold.

Mortgage notes receivable can be placed in contractual default status for any of the following reasons: (1) an interest payment is more than 30 days past due; (2) a note matures and the borrower fails to make payment of all amounts owed or extend the loan; or (3) the collateral becomes impaired in such a way that the ultimate collection of the note is doubtful. The accrual of interest income is suspended when a loan is in contractual default unless the interest is paid in cash or collectability of all amounts due is reasonably assured. In addition, in certain instances, where the interest reserve on a current loan has been fully depleted and the interest payment is not expected to be collected from the borrower, we may place a current loan on non-accrual status and recognize interest income on a cash-basis. Interest previously accrued may be reversed at that time, and such reversal is offset against interest income. The accrual of interest income resumes only when the suspended loan becomes contractually current or a credit analysis supports the ability to collect in accordance with the terms of the loan.

Fee Income

We charge loan origination fees in conjunction with origination. Amendment fees are charged when loan terms are modified, such as increases in interest reserves and construction holdbacks in line with our underwriting criteria or upon modification of a loan for the transition from horizontal development to vertical construction. We defer and amortize loan origination and amendment fees over the contractual terms of the loans.

We charge inspection fees, which we use to hire independent inspectors to report on the status of construction projects. These fees are earned and recognized upon each construction draw request.

Share‑Based Payments

We measure compensation expense for all share-based awards at fair value on the date of grant and recognize compensation expense over the service period on a straight-line basis for awards expected to vest, which is generally three years for employees and one year for directors. Share-based awards are issued under the Broadmark Realty Capital Inc. 2019 Stock Incentive Plan.

Awards made to our employees and directors, typically consist of restricted stock units (“RSUs”). For awards with only a service vesting condition, the fair value of the award is based on the grant date closing price of our common stock less the present value of expected dividends over the requisite service period, as the awards are not entitled to dividends. For these awards, we recognize stock-based compensation expense on a straight-line basis over the requisite service period for the entire award, subject to periodic adjustments to ensure that the cumulative amount of expense recognized through the end of any reporting period is at least equal to the portion of the grant date fair value of the award that has vested through that date, and we account for forfeitures prospectively as they occur. For awards that contain both service vesting and market conditions, referred to as performance restricted stock units (“pRSUs”), we use a Monte Carlo simulation model to calculate the grant date fair value. For these market-condition awards, regardless of the outcome of the market condition, we recognize stock-based compensation expense on a straight-line basis over the longest of explicit and derived service periods, and we account for forfeitures prospectively as they occur. If there are any modifications or cancellations of the underlying unvested share-based awards, we may be required to accelerate or increase any remaining unrecognized or previously recorded stock-based compensation expense.

Income Taxes

We have elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended, for U.S. federal income tax purposes (the “Code”). As a REIT, we generally are not subject to U.S. federal income taxes on net income we distribute to our stockholders. We intend to make timely distributions sufficient to satisfy the annual distribution requirements. If we fail to qualify as a REIT in any taxable year, we will be subject to U.S. federal income tax on our taxable income at regular corporate tax rates. Even if we qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income and property and U.S. federal income and excise taxes on our undistributed income. Our TRSs are subject to U.S. federal income taxes.

Earnings per Share

We present both basic and diluted earnings per common share (“EPS”) amounts in our condensed consolidated financial statements. Basic EPS excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Diluted EPS reflects the maximum potential dilution that could occur from our outstanding warrants and restricted stock units. We utilize the treasury stock method to measure dilution to earnings per share in calculating the net number of shares that would be issued, assuming any related proceeds are used to buy back outstanding shares.

Recent Accounting Pronouncements

There are no recent accounting pronouncements that we have yet to adopt with an expected impact on our financial position, results of operations or cash flows.