Franklin BSP Realty Trust, Inc. - Annual Report: 2015 (Form 10-K)
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One) | |
x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2015
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from _________ to __________
Commission file number: 000-55188
REALTY FINANCE TRUST, INC.
(Exact name of registrant as specified in its charter)
Maryland | 46-1406086 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |
405 Park Avenue, 14th Floor New York, NY | 10022 | |
(Address of principal executive offices) | (Zip Code) | |
(212) 415-6500 | ||
(Registrant's telephone number, including area code) | ||
Securities registered pursuant to section 12(b) of the Act: None | ||
Securities registered pursuant to section 12(g) of the Act: Common stock, $0.01 par value per share (Title of class) | ||
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ No
Indicate by check mark whether the registrant submitted electronically and posted on its corporate Web Site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes ¨ No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer ¨ | Accelerated filer ¨ | |
Non-accelerated filer ¨ | (Do not check if a smaller reporting company) | Smaller reporting company x |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes x No
There is no established public market for the registrant's shares of common stock. On November 4, 2015, the board of directors of the registrant , upon the recommendations of the registrant’s external advisor and the Conflicts Committee of the board of directors, unanimously approved and established an estimated net asset value (“NAV”) per share of the registrant’s common stock of $25.27. The estimated NAV per share is based upon the estimated value of the registrant’s assets less the registrant’s liabilities as of September 30, 2015. For a full description of the methodologies used to value the registrant’s assets and liabilities in connection with the calculation of the estimated NAV per share, see Part II, Item 5, “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Market Information.”
The number of outstanding shares of the registrant's common stock on February 29, 2016 was 31,561,665 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive proxy statement to be delivered to stockholders in connection with the registrant's 2016 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K. The registrant intends to file its proxy statement within 120 days after its fiscal year end.
REALTY FINANCE TRUST, INC.
FORM 10-K
Year Ended December 31, 2015
Page | ||
i
Forward-Looking Statements
Certain statements included in this Annual Report on Form 10-K are forward-looking statements. Those statements include statements regarding the intent, belief or current expectations of Realty Finance Trust, Inc. ("we," "our" or "us") and members of our management team, as well as the assumptions on which such statements are based, and generally are identified by the use of words such as "may," "will," "seeks," "anticipates," "believes," "estimates," "expects," "plans," "intends," "should" or similar expressions. Actual results may differ materially from those contemplated by such forward-looking statements. Further, forward-looking statements speak only as of the date they are made, and we undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time, unless required by law.
The following are some of the risks and uncertainties, although not all risks and uncertainties, that could cause our actual results to differ materially from those presented in our forward-looking statements:
• | We have a limited operating history and Realty Finance Advisors, LLC, our affiliated advisor (the "Advisor"), has limited experience operating a public company. This inexperience makes our future performance difficult to predict. |
• | All of our executive officers are also officers, managers or holders of a direct or indirect controlling interest in American Finance Advisors, LLC (our "Advisor") or other entities under common control with AR Global Investments, LLC (the successor business to AR Capital, LLC, "AR Global"), the parent of our sponsor, American Realty Capital VIII, LLC (the "Sponsor"). As a result, our executive officers, our Advisor and its affiliates face conflicts of interest, including significant conflicts created by our Advisor's compensation arrangements with us and other investment programs advised by affiliates of AR Global and conflicts in allocating time among these entities and us, which could negatively impact our operating results. |
• | We terminated our primary offering in January 2016 and therefore, absent raising capital from other sources, will have less cash from financing activities with which to make investments, repay indebtedness, fund our operations or pay distributions. |
• | No public trading market currently exists, or may ever exist, for shares of our common stock and our shares are, and may continue to be, illiquid. |
• | Increases in interest rates could increase the amount of our debt payments and limit our ability to pay distributions to our stockholders. |
• | If we and our Advisor are unable to find sufficient suitable investments, then we may not be able to achieve our investment objectives or pay distributions. |
• | We may be unable to pay or maintain cash distributions or increase distributions over time. Our board of directors may decide that maintaining cash distributions at current levels is not in our best interests given investment opportunities or for other reasons. |
• | We are obligated to pay substantial fees to our Advisor and its affiliates. |
• | We may fail to continue to qualify to be treated as a real estate investment trust ("REIT") for U.S. federal income tax purposes. |
• | We may be deemed to be an investment company under the Investment Company Act of 1940, as amended (the "Investment Company Act"), and thus subject to regulation under the Investment Company Act. |
All forward-looking statements should be read in light of the risks identified in Part I, Item 1A of this Annual Report on Form 10-K.
ii
PART I
Item 1. Business
Realty Finance Trust, Inc. was incorporated in Maryland on November 15, 2012 and conducts its operations to qualify as a REIT for U.S. federal income tax purposes beginning with the taxable year ended December 31, 2013. Substantially all of our business is conducted through Realty Finance Operating Partnership, L.P. (the “OP”), a Delaware limited partnership. Realty Finance Advisors, LLC is our advisor. We are the sole general partner and directly or indirectly hold all of the units of limited partner interests in the OP. Additionally, our Advisor contributed $1,000 to us in exchange for 1,000 convertible shares of Realty Finance Trust, Inc. The convertible shares will automatically convert to shares of our common stock upon the first occurrence of any of the following triggering events, (each a "Triggering Event"): (i) we have paid total distributions on the then-outstanding shares of our common stock in an amount equal to or in excess of the sum of the invested capital (as defined in our charter) plus an aggregate 6.0% cumulative, pre-tax, non-compounded, annual return on such invested capital, (ii) a listing of our shares of common stock on a national securities exchange and (iii) the termination of our advisory agreement under certain circumstances. We did not incur any of the aforementioned trigger events to date.
We are in business to originate, acquire and manage a diversified portfolio of commercial real estate debt secured by properties located both within and outside of the United States. We also invest in commercial real estate securities. Commercial real estate debt investments may include first mortgage loans, subordinated mortgage loans, mezzanine loans and participations in such loans. Commercial real estate securities may include commercial mortgage-backed securities (“CMBS”), senior unsecured debt of publicly traded REITs, debt or equity securities of other publicly traded real estate companies and collateralized debt obligations (“CDOs”).
The Company has no direct employees. The Company has retained the Advisor to manage the Company's affairs on a day-to-day basis. The Advisor is controlled by AR Global Investments, LLC ("AR Global"), the parent of American Realty Capital VIII, LLC (the "Sponsor"), as a result of which they are related parties and each of them has received or will receive compensation and fees for services related to the investment and management of the Company's assets, the operations of the Company and the liquidation of the Company.
Realty Capital Securities, LLC, (the “Former Dealer Manager”) served as the dealer manager of our primary offering and, together with certain of its affiliates, continued to provide us with various services through December 31, 2015. RCS Capital Corporation, the parent company of our Former Dealer Manager and certain of its affiliates that provided us with services, filed for Chapter 11 bankruptcy protection in January 2016, prior to which it was also under common control with AR Global, the parent of our Sponsor.
Investment Objectives
We plan to implement policies and strategies to achieve our primary investment objectives:
• | to pay attractive and stable cash distributions to stockholders; and |
• | to preserve and return stockholders’ invested capital. |
Investment Strategies and Policies
Our strategy is to originate, acquire and manage a diversified portfolio of commercial real estate debt, including first mortgage loans, subordinate loans, mezzanine loans and participations in such loans. We expect that our portfolio of debt investments will be secured by real estate located both within and outside of the United States and diversified by property type and geographic location. We may also invest in commercial real estate securities, such as CMBS, senior unsecured debt of publicly-traded REITs and CDO notes.
We will seek to create and maintain a portfolio of commercial real estate investments that generate stable income to enable us to pay attractive and consistent cash distributions to our stockholders. Our focus on originating and acquiring commercial real estate debt instruments emphasizes the payment of current returns to investors and preservation of invested capital as our primary investment objectives. We also believe our investments may offer the potential for capital appreciation.
Commercial Real Estate Debt
We originate, fund, acquire and structure commercial real estate debt, including first mortgage loans, mezzanine loans, bridge loans, and other loans related to commercial real estate. We may also acquire some equity participations in the underlying collateral of commercial real estate debt. We structure, underwrite, and originate most of our investments. We use conservative underwriting criteria to focus on risk adjusted returns based on several factors which may include, the leverage point, debt service coverage and sensitivity, lease sustainability studies, market and economic conditions, quality of the underlying collateral and location, reputation and track record of the borrower, and a clear exit or refinancing plan for the borrower. Our underwriting process involves comprehensive financial, structural, operational, and legal due diligence to assess any risks in connection with making such investments so that we can optimize pricing and structuring. By originating loans directly, we are able to structure and underwrite loans that satisfy our standards, establish a direct relationship with the
1
borrower, and utilize our own documentation. Described below are some of the types of loans we may originate or acquire. In addition, although we generally prefer the benefits of new origination, market conditions can create situations where holders of commercial real estate debt may be in distress and are therefore willing to sell at prices that compensate the buyer for the lack of control typically associated with directly structured investments.
First Mortgage Loans
First mortgage loans generally finance the acquisition, refinancing or rehabilitation of commercial real estate. First mortgage loans may be either short (one-to-five years) or long (up to ten years) term, may be fixed or floating rate, and are predominantly current-pay loans. We may originate or acquire current-pay first mortgage loans backed by properties that fit our investment strategy. We may selectively syndicate portions of these loans, including senior or junior participations that will effectively provide permanent financing or optimize returns which may include retained origination fees.
First mortgage loans provide for a higher recovery rate and lower defaults than other debt positions due to the lender's favorable control features which at times means control of the entire capital structure. Because of these attributes, this type of investment receives favorable treatment from third-party rating agencies and financing sources, which should increase the liquidity of these investments. However, these loans typically generate lower returns than subordinate debt, such as subordinate loans and mezzanine loans, commonly referred to as B-notes.
B-notes
B- notes consist of subordinate mortgage loans, including structurally subordinated first mortgage loans and junior participations in first mortgage loans or participations in these types of assets. Like first mortgage loans, these loans generally finance the acquisition, refinancing, rehabilitation or construction of commercial real estate. Subordinated mortgage loans or B-notes may be either short (one-to-five years) or long (up to ten years) term, may be fixed or floating rate, and are predominantly current-pay loans. We may originate or acquire current-pay subordinated mortgage loans or B-notes backed by high quality properties that fit our investment strategy. We may create subordinated mortgage loans by tranching our directly originated first mortgage loans generally through syndications of senior first mortgages or buy such assets directly from third party originators. Due to the current credit market disruption and resulting dearth of capital available in this part of the capital structure, we believe that the opportunities to both directly originate and to buy subordinated mortgage investments from third parties on favorable terms will continue to be attractive.
Bridge Loans
We may offer bridge financing products to borrowers who are typically seeking short-term capital to be used in an acquisition, development or refinancing of a given property. From the borrower’s perspective, shorter term bridge financing is advantageous because it allows time to improve the property value through repositioning without encumbering it with restrictive long-term debt. The terms of these loans generally do not exceed three years.
Mezzanine Loans
Mezzanine loans are secured by one or more direct or indirect ownership interests in an entity that directly or indirectly owns commercial real estate and generally finance the acquisition, refinancing, rehabilitation or construction of commercial real estate. Mezzanine loans may be either short (one-to-five years) or long (up to ten years) term and may be fixed or floating rate. We may originate or acquire mezzanine loans backed by properties that fit our investment strategy. We may own such mezzanine loans directly or we may hold a participation in a mezzanine loan or a sub-participation in a mezzanine loan. These loans are predominantly current-pay loans (although there may be a portion of the interest that accrues) and may provide for participation in the value or cash flow appreciation of the underlying property as described below. With the credit market disruption and resulting dearth of capital available in this part of the capital structure, we believe that the opportunities to both directly originate and to buy mezzanine loans from third parties on favorable terms will continue to be attractive.
Equity Participations or “Kickers”
We may pursue equity participation opportunities in connection with our commercial real estate debt originations if we believe that the risk-reward characteristics of the loan merit additional upside participation related to the potential appreciation in value of the underlying assets securing the loan. Equity participations can be paid in the form of additional interest, exit fees, percentage of sharing in refinance or resale proceeds or warrants in the borrower. Equity participation can also take the form of a conversion feature, sometimes referred to as a "kicker," which permits the lender to convert a loan or preferred equity investment into common equity in the borrower at a negotiated premium to the current net asset value of the borrower. We expect to generate additional revenues from these equity participations as a result of excess cash flows being distributed or as appreciated properties are sold or refinanced.
2
Commercial Real Estate Securities
In addition to our focus on origination of and investments in commercial real estate debt, we may also acquire commercial real estate securities, such as CMBS, unsecured REIT debt, CDO notes, and equity investments in entities that own commercial real estate.
CMBS
CMBS are securities that are collateralized by, or evidence ownership interests in, a single commercial mortgage loan or a partial or entire pool of mortgage loans secured by commercial properties. CMBS are generally pass-through certificates that represent beneficial ownership interests in common law trusts whose assets consist of defined portfolios of one or more commercial mortgage loans. They are typically issued in multiple tranches whereby the more senior classes are entitled to priority distributions of specified principal and interest payments from the trust’s underlying assets. The senior classes are often securities which, if rated, would have ratings ranging from low investment grade “BBB” to higher investment grades “A,” “AA” or “AAA.” The junior, subordinated classes typically would include one or more non-investment grade classes which, if rated, would have ratings below investment grade “BBB.” Losses and other shortfalls from expected amounts to be received on the mortgage pool are borne first by the most subordinate classes, which receive payments only after the more senior classes have received all principal and/or interest to which they are entitled. We may invest in senior or subordinated, investment grade or non-investment grade CMBS, as well as unrated CMBS.
Unsecured Publicly-Traded REIT Debt Securities
We may also choose to acquire senior unsecured debt of publicly-traded equity REITs that acquire and hold real estate. Publicly-traded REITs may own large, diversified pools of commercial real estate properties or they may focus on a specific type of property, such as shopping centers, office buildings, multifamily properties and industrial warehouses. Publicly-traded REITs typically employ moderate leverage. Corporate bonds issued by these types of REITs are usually rated investment grade and benefit from strong covenant protection.
CDO Notes
CDOs are multiple class debt notes, secured by pools of assets, such as CMBS, mezzanine loans, and unsecured REIT debt. Like typical securitization structures, in a CDO, the assets are pledged to a trustee for the benefit of the holders of the bonds. CDOs often have reinvestment periods that typically last for five years, during which time, proceeds from the sale of a collateral asset may be invested in substitute collateral. Upon termination of the reinvestment period, the static pool functions very similarly to a CMBS securitization where repayment of principal allows for redemption of bonds sequentially.
Commercial Real Estate Equity Investments
We may acquire: (i) equity interests (including preferred equity) in an entity (including, without limitation, a partnership or a limited liability company) that is an owner of commercial real property (or in an entity operating or controlling commercial real property, directly or through affiliates), which may be structured to receive a priority return or is senior to the owner's equity (in the case of preferred equity); (ii) certain strategic joint venture opportunities where the risk-return and potential upside through sharing in asset or platform appreciation is compelling; and (iii) private issuances of equity securities (including preferred equity securities) of public companies. Our commercial real estate equity investments may or may not have a scheduled maturity and are expected to be of longer duration (five-to-ten year terms) than our typical portfolio investment. Such investments are expected to be fixed rate (if they have a stated investment rate) and may have accrual structures and provide other distributions or equity participations in overall returns above negotiated levels.
Other Possible Investments
Although we expect that most of our investments will be of the types described above, we may make other investments. We may invest in whatever types of interests in real estate-related assets that we believe are in our best interests which may include the commercial real property underlying our debt investments as a result of a loan workout, foreclosure or similar circumstances. Although we can purchase any type of real estate-related assets, our charter does limit our ability to make certain types of investments.
Investment Process
Our Advisor has the authority to make all the decisions regarding our investments consistent with the investment guidelines and borrowing policies approved by our board of directors and subject to the limitations in our charter and the direction and oversight of our board of directors. With respect to investments in commercial real estate debt, our board of directors has adopted investment guidelines that our Advisor must follow when acquiring such assets on our behalf without the approval of our board of directors. We will not, however, purchase assets in which our Sponsor, our Advisor, any of our directors or any of their affiliates has an interest without a determination by a majority of our directors (including a majority of the independent directors) not otherwise interested in the transaction that such transaction is fair and reasonable to us and at a price to us no greater than the cost of the asset to the affiliated seller, unless there is substantial justification for the excess
3
amount and such excess is reasonable. Our charter requires that our independent directors review our investment guidelines at least annually to determine that the policies we are following are in the best interests of our stockholders. Each determination and the basis of such determination shall be set forth in the minutes of the meetings of our board of directors. Our investment guidelines and borrowing policies, except to the extent set forth in our charter, may be altered by a majority of our directors, including a majority of the independent directors, without approval of our stockholders. Our Advisor may not alter our investment guidelines or borrowing policies without the approval of a majority of our directors, including a majority of our independent directors. Our charter provides that the board of directors may not amend provisions of the charter relating to investment guidelines or investment restrictions without the approval of the majority of the shares entitled to vote on such matter.
Borrowing Strategies and Policies
In addition to raising capital through our distribution reinvestment plan (the "DRIP") offering, our financing strategy includes secured repurchase agreement facilities for loans, securities and securitizations. In addition to our current mix of financing sources, we may also access additional forms of financings, including credit facilities, public and private, secured and unsecured debt issuances by us or our subsidiaries.
We expect to use additional debt financing as a source of capital. Under our charter, the maximum amount of our total indebtedness shall not exceed 300% of our total ‘‘net assets’’ as defined by the North American Securities Administrators ("NASAA") Statement of Policy regarding REITs (the "REIT Guidelines") as of the date of any borrowing, which is generally expected to be 75% of the cost of our investments; however, we may exceed that limit if approved by a majority of our independent directors and disclosed to stockholders in our next quarterly report following such borrowing along with justification for exceeding such limit. This charter limitation, however, does not apply to individual real estate assets or investments. At the date of acquisition of each asset, we anticipate that the cost of investment for such asset will be substantially similar to its fair market value, which will enable us to satisfy our requirements under the NASAA Statement of the REIT Guidelines. However, subsequent events, including changes in the fair market value of our assets, could result in our exceeding these limits. We anticipate that adequate cash will be generated from operations to fund our operating and administrative expenses, continuing debt service obligations and the payment of cash distributions.
Income Taxes
We have elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code commencing with the taxable year ended December 31, 2013. As a REIT, we generally will not be subject to federal corporate income tax as long as we distribute at least 90% of our REIT taxable income to our stockholders. REITs are subject to a number of other organizational and operational requirements. Even if we continue to qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income and property and federal income and excise taxes on our undistributed income.
Competition
Our net income depends, in large part, on our ability to originate investments that provide returns in excess of our borrowing cost. In originating these investments, we compete with other mortgage REITs, specialty finance companies, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, private funds, other lenders, governmental bodies, and other entities, many of which have greater financial resources and lower costs of capital available to them than we have. In addition, there are numerous mortgage REITs with asset acquisition objectives similar to ours, and others may be organized in the future, which may increase competition for the investments suitable for us. Competitive variables include market presence and visibility, size of loans offered and underwriting standards. To the extent that a competitor is willing to risk larger amounts of capital in a particular transaction or to employ more liberal underwriting standards when evaluating potential loans than we are, our investment volume and profit margins for our investment portfolio could be impacted. Our competitors may also be willing to accept lower returns on their investments and may succeed in buying or underwriting the assets that we have targeted. Although we believe that we are well positioned to compete effectively in each facet of our business, there is enormous competition in our market sector and there can be no assurance that we will compete effectively or that we will not encounter increased competition in the future that could limit our ability to conduct our business effectively.
Financial Information About Industry Segments
We conduct our business through the following segments:
• | The real estate debt business will be focused on originating, acquiring, and asset managing commercial real estate debt investments, including first mortgage loans, subordinate mortgages, mezzanine loans, and participations in such loans. |
• | The real estate securities business will be focused on investing in and asset managing commercial real estate securities primarily consisting of CMBS and may include unsecured REIT debt, CDO notes and other securities. |
4
Employees
As of December 31, 2015, we had no direct employees. The employees of the Advisor and other affiliates of the Advisor perform a full range of real estate services for us, including acquisitions, accounting, legal, asset management, wholesale brokerage, and investor relations services. We are dependent on these affiliates for services that are essential to us, including the sale of shares of our common stock, asset acquisition decisions, and other general administrative responsibilities. In the event that any of these companies were unable to provide these services to us, we would be required to provide such services ourselves or obtain such services from other sources.
Available Information
We electronically file annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports, and proxy statements, with the U.S. Securities and Exchange Commission (the "SEC"). We also filed with the SEC our Registration Statement in connection with our securities offerings. Individuals may read and copy any materials we file with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, D.C. 20549, or may obtain information by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet address at www.sec.gov that contains reports, proxy statements and information statements, and other information, which may be obtained free of charge. In addition, copies of our filings with the SEC may be obtained from the website maintained for us at www.realtyfinancetrust.com. Access to these filings is free of charge. We are not incorporating our website or any information from the website into this Form 10-K.
Item 1A. Risk Factors
Risks Related to an Investment in Realty Finance Trust, Inc.
We have a limited operating history and the prior performance of other real estate investment programs sponsored by affiliates of our Advisor may not be an indication of our future results.
We have a limited operating history and investors should not rely upon the past performance of other real estate investment programs sponsored by affiliates of our Advisor to predict our future results. We were incorporated in November 2012. The recent real estate experience of the AR Global group of companies principally has focused on real estate equity investments rather than commercial real estate debt and securities. Accordingly, the prior performance of real estate investment programs sponsored by affiliates of the AR Global group of companies and our Advisor may not be indicative of our future results.
Our prospects should be considered in light of the risks, uncertainties and difficulties frequently encountered by companies that are, like us, in their early stage of development. To be successful in this market, we must, among other things:
• | identify and acquire investments that further our investment strategies; |
• | increase awareness of the Realty Finance Trust, Inc. name within the investment products market; |
• | expand and maintain our network of licensed securities brokers and other agents; |
• | attract, integrate, motivate and retain qualified personnel to manage our day-to-day operations; |
• | respond to competition for our targeted real estate properties and other investments as well as for potential investors; and |
• | continue to build and expand our operations structure to support our business. |
There can be no assurance that we will succeed in achieving these goals.
Stockholders may be more likely to sustain a loss on their investment because our Sponsor does not have as strong an economic incentive to avoid losses as does a sponsor who has made significant equity investments in its company.
Our Sponsor has only invested $200,000 in us through the purchase of 8,888 shares of our common stock at $22.50 per share, reflecting no selling commission or dealer manager fees paid in connection with such sale. The Sponsor or any affiliate may not sell this initial investment for so long as an affiliate of our Sponsor remains our Advisor but may transfer the shares to other affiliates. After reimbursement of our Sponsor for our significant organization and offering expenses, our Sponsor will have little exposure to loss in the value of our shares. Without this exposure, our investors may be at a greater risk of loss because our Sponsor does not have as strong an economic incentive to prevent a decrease in the value of our shares as do those sponsors who make more significant equity investments in the investment programs they are sponsoring.
We may be unable to maintain or increase cash distributions over time, or may decide to reduce the amount of distributions for business reasons.
There are many factors that can affect the amount and timing of cash distributions to stockholders. Our board of directors will determine the amount of our distributions based principally on cash available from our operations and alternative uses of such cash, such as to make additional investments or pay down indebtedness. The amount of cash available for distributions is affected by many factors, such as the cash provided by our investments and our obligations to repay indebtedness as well as
5
many other variables. With a limited prior operating history, there is no assurance that we will be able to pay or maintain our current level of distributions or that distributions will increase over time. We cannot give any assurance that returns from the investments that we acquire will increase, that the securities we buy will increase in value or provide constant or increased distributions over time, or that future acquisitions of real properties, mortgage, bridge or mezzanine loans or any investments in securities will increase our cash available for distributions to stockholders. Our actual results may differ significantly from the assumptions used by our board of directors in establishing the distribution rate to stockholders. We may not have sufficient cash from operations to make a distribution required to qualify for or maintain our REIT status, which may materially adversely affect the value of our common stock.
Our organizational documents permit us to pay distributions from any source. Any distributions may reduce the amount of capital we invest in commercial real estate loans and other target investments.
We may pay distributions from unlimited amounts of any source, including borrowing funds, using proceeds from the DRIP offering, issuing additional securities or selling assets. We have not established any limit on the amount of proceeds from equity offerings that may be used to fund distributions, except in accordance with our organizational documents and Maryland law. Distributions from the proceeds of the equity offerings or from borrowings also could reduce the amount of capital we ultimately invest in commercial real estate loans and other targeted investments.
Distributions paid from sources other than our cash flow from operations will result in us having fewer funds available for the acquisition of targeted investments and may dilute our stockholders' interests in us, which may adversely affect our ability to fund future distributions with cash flow from operations and may adversely affect the overall return on an investment in our common stock.
Our cash flows provided by operations were approximately $25.4 million for the year ended December 31, 2015. During the year ended December 31, 2015, we paid distributions of approximately $47.1 million, of which approximately $21.7 million, or 46.0%, was funded from proceeds from common stock issued under the DRIP and offering proceeds. Additionally, we may in the future continue to pay distributions from sources other than from our cash flows from operations.
In the future, we still may not generate sufficient cash flow from operations to pay distributions. Our inability to acquire targeted investments may result in a lower return on our common stock than our investors may expect. If we have not generated sufficient cash flow from our operations and other sources, such as from borrowings, the sale of additional securities, advances from our Advisor, and/or our Advisor’s deferral, suspension and/or waiver of its fees and expense reimbursements, our board of directors may decide to reduce our distributions . Moreover, our board of directors may change our distribution policy, in its sole discretion, at any time.
Challenging economic and financial market conditions could significantly reduce the amount of income we earn and further reduce the value of our investments.
Challenging economic and financial market conditions may cause us to experience an increase in the number of commercial real estate debt and other targeted investments that result in non-payment, foreclosures and non-performing assets and a decrease in the value of assets or other collateral which secures our commercial real estate debt and commercial real estate securities, all of that could adversely affect our results of operations. Loan defaults result in a decrease in interest income and may require the establishment of, or an increase in, loan loss reserves. The decrease in interest income resulting from a loan default may continue for a prolonged period of time as we seek to recover, primarily through legal proceedings, the outstanding principal amount, accrued interest and default interest due on a defaulted commercial real estate debt investment. Legal proceedings, which may include foreclosure actions and bankruptcy proceedings, are expensive and time consuming and may not result in the recovery of our principal. The decrease in interest income, and the costs involved in pursuing our legal remedies will reduce the amount of cash available to meet our expenses and adversely impact our liquidity and operating results.
No established trading market for our shares currently exists, and as a result, it will be difficult to sell our shares and, if our investors are able to sell their shares, they will likely sell them at a substantial discount to their original purchase price.
Our charter does not require our board of directors to seek stockholder approval to liquidate our assets by a specified date, nor does our charter require us to list our shares for trading on a national securities exchange by a specified date or otherwise pursue a transaction to provide liquidity to our stockholders. There is no established trading market for our shares and we currently have no plans to list our shares on a national securities exchange. Until our shares are listed, if ever, our stockholders may not sell their shares unless the buyer meets the applicable suitability and minimum purchase standards. In addition, our charter prohibits the ownership of more than 9.8% in value of our stock or more than 9.8% in value or number of shares, whichever is more restrictive, of any class or series of share of our stock, unless exempted by our board of directors, which may inhibit large investors from purchasing shares. Therefore, it will be difficult to sell shares promptly or at all. If our stockholders are able to sell their shares, they would likely have to sell them at a substantial discount to their original purchase price. It is also likely that our shares would not be accepted as the primary collateral for a loan. Because of the illiquid nature of our
6
shares, investors should purchase our shares only as a long-term investment and be prepared to hold them for an indefinite period of time.
Our amended and restated share repurchase program (the "SRP"), which is subject to numerous restrictions, may be canceled at any time and should not be relied upon as a means of liquidity.
We have adopted a SRP, which became effective on February 28, 2016, that may enable investors to sell their shares to us in limited circumstances. Share repurchases are made at the sole discretion of our board of directors. In its sole discretion, our board of directors could amend, suspend or terminate our SRP upon 30 days prior written notice to stockholders. Further, the SRP includes numerous restrictions that would limit the ability to sell shares. Due to the foregoing, our SRP should not be relied upon as a means of liquidity.
Our stockholders will not have the opportunity to evaluate our investments before we make them, which makes investments in our shares more speculative.
We seek to invest primarily in commercial real estate debt and other commercial real estate investments. However, we are not required to solicit shareholder approval for our investments, and therefore our stockholders will be unable to evaluate the economic merit of assets before we invest in them and will have to rely entirely on the ability of our Advisor to select suitable and successful investment opportunities. Furthermore, our board of directors has broad discretion in implementing policies regarding borrower creditworthiness and our stockholders will not have the opportunity to evaluate potential borrowers.
If we internalize our management functions, we may be unable to obtain key personnel, and our ability to achieve our investment objectives could be delayed or hindered, which could adversely affect our ability to pay distributions to you and the value of our common stock.
We may engage in an internalization transaction and become self-managed in the future. If we internalize our management functions, certain key employees may not become our employees but may instead remain employees of our Advisor or its affiliates. An inability to manage an internalization transaction effectively could thus result in our incurring excess costs and suffering deficiencies in our disclosure controls and procedures or our internal control over financial reporting. Such deficiencies could cause us to incur additional costs, and our management’s attention could be diverted from most effectively managing our investments, which could result in us being sued and incurring litigation-associated costs in connection with the internalization transaction.
If our Advisor loses or is unable to obtain key personnel, including in the event another AR Global sponsored program internalizes its advisor, our ability to implement our investment strategies could be delayed or hindered, which could adversely affect our ability to make distributions and the value of our common stock.
Our success depends to a significant degree upon the contributions of certain of our executive officers and other key personnel of our Advisor, each of whom would be difficult to replace. Our advisor does not have an employment agreement with any of these key personnel and we cannot guarantee that all, or any particular one, will remain affiliated with us and/or our Advisor. If any of our key personnel were to cease their affiliation with our Advisor, our operating results could suffer. This could occur, among other ways, if another AR Global-sponsored program internalizes its advisor. If that occurs, key personnel of our Advisor who also are key personnel of the internalized advisor, could become employees of such other program and would no longer be available to our Advisor. Further, we do not intend to separately maintain key person life insurance on any person. We believe that our future success depends, in large part, upon our Advisor’s ability to hire and retain highly skilled managerial, operational and marketing personnel.
Competition for such personnel is intense, and we cannot assure you that our Advisor will be successful in attracting and retaining such skilled personnel. If our Advisor loses or is unable to obtain the services of key personnel, our ability to implement our investment strategies could be delayed or hindered, and the value of your investment may decline.
The commercial real estate industry may be adversely affected by economic conditions in the United States and the global financial markets generally.
Our business and operations are dependent on the commercial real estate industry generally, which in turn is dependent upon broad economic conditions in the United States and abroad. A worsening of economic conditions would likely have a negative impact on the commercial real estate industry generally and on our business and operations specifically. Additionally, disruptions in the global economy, whether as a result of the Euro-zone debt crisis, regional conflict or otherwise, may also have a negative impact on the commercial real estate market domestically. Adverse conditions in the commercial real estate industry could harm our business and financial condition by, among other factors, reducing the value of our existing assets, limiting our access to debt and equity capital, harming our ability to originate new commercial real estate debt and otherwise negatively impacting our operations.
7
We may be unable to obtain financing required to originate or acquire investments as contemplated in our business plan, which could compel us to restructure or abandon a particular origination or acquisition and harm our ability to make distributions.
We have funded a significant portion of our commercial real estate debt and other commercial real estate investments with financing. There can be no assurance that additional financing will be available on acceptable terms, if at all, or that we will be able to satisfy the conditions precedent required to utilize our credit facility. In addition, we recently terminated our primary offering, which could reduce the number, or alter the type, of investments that we would make otherwise. This may reduce our net interest income. Turmoil in the credit and financial markets has greatly reduced the availability of financing. To the extent that financing proves to be unavailable when needed, we may be compelled to modify our investment strategy to optimize the performance of our portfolio. Any failure to obtain financing could have a material adverse effect on the continued development or growth of the target business and harm our ability to make distributions.
Our rights and the rights of our stockholders to recover claims against our independent directors are limited, which could reduce any recovery against them if they negligently cause us to incur losses.
Maryland law provides that a director has no liability in that capacity if he or she performs their duties in good faith, in a manner he or she reasonably believes to be in our best interests and with the care that an ordinarily prudent person in a like position would use under similar circumstances. We have entered into an indemnification agreement formalizing our indemnification obligations with respect to our officers and directors and certain former officers and directors. Our charter generally provides that: (i) no director shall be liable to us or our stockholders for monetary damages (provided that such director satisfies certain applicable criteria); (ii) we will generally indemnify non-independent directors for losses unless they are negligent or engage in misconduct; and (iii) we will generally indemnify independent directors for losses unless they are grossly negligent or engage in willful misconduct. As a result, our stockholders and we may have more limited rights against our independent directors than might otherwise exist under common law, which could reduce any recovery from these persons if they act in a negligent manner. In addition, we may be obligated to fund the defense costs incurred by our independent directors (as well as by our other directors, officers, employees (if we ever have employees) and agents) in some cases, which would decrease the cash otherwise available for distribution.
The disparity between our most recently calculated estimated per share NAV and our actual per share NAV on a given dividend reinvestment date or stock repurchase date may adversely affect purchasers in our DRIP, or our repurchasing or non-repurchasing stockholders.
Our estimated per share NAV was calculated as of a specific date and is expected to fluctuate over time in response to future events such as developments related to our portfolio and changes in the real estate and financial markets. However, we may only determine an updated estimated per share NAV annually. See Part II, Item 5, “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Market Information” for information regarding how we estimate per share NAV. Since our estimated per share NAV may only be updated annually, there will be changes in the course of the year that are not reflected in the NAV. As a result, the published NAV per share will not reflect changes in value that may have occurred since the prior valuation. Therefore, the next NAV per share published may differ significantly from our current NAV. The disparity between our most recently calculated estimated per share NAV and our actual per share NAV on an given dividend reinvestment date or stock repurchase date may adversely affect purchasers in our DRIP, or our repurchasing or non-repurchasing stockholders. For example, if the actual NAV on a dividend reinvestment date is lower than the estimated per share NAV used to determine the offer price, DRIP purchasers will be diluted. If the actual per share NAV on a stock repurchase date is higher than the estimated per share NAV used to determine the repurchase price, then stockholders having their shares repurchased will be diluted. If the actual per share NAV on a stock repurchase date is lower than the estimated per share NAV used to determine the repurchase price, then stockholders that are not having their shares repurchased will be diluted.
We disclose funds from operations ("FFO") and modified funds from operations (“MFFO”), non-GAAP financial measures, in communications with investors, including documents filed with the SEC; however, FFO and MFFO are not equivalent to our net income or loss as determined under GAAP, and you should consider GAAP measures to be more relevant to our operating performance.
We use, and we disclose to investors, FFO and MFFO, which are non-GAAP financial measures. FFO and MFFO are not equivalents to our net income or loss or cash flow from operations as determined in accordance with GAAP, and investors should consider GAAP measures to be more relevant to evaluating our operating performance or our ability to pay distributions. MFFO and GAAP net income differ because MFFO excludes acquisition related expenses, accretion of discounts and amortization of premiums on debt investments, fair value adjustments on real estate related investments, impairments of real estate related investments, above and below market leases, fair value adjustments of derivative financial instruments, deferred rent receivables and the adjustments of such items related to noncontrolling interests.
8
Because of the differences, FFO and MFFO may not be accurate indicators of our operating performance, especially during periods in which we are making investments. In addition, FFO and MFFO are not necessarily indicative of cash flow available to fund cash needs and investors should not consider FFO or MFFO as alternatives to cash flows from operations or an indication of our liquidity, including our ability to pay distributions to our stockholders.
Our business could suffer in the event our Advisor or any other party that provides us with services essential to our operations experiences system failures or cyber-incidents or a deficiency in cybersecurity.
Despite system redundancy, the implementation of security measures and the existence of a disaster recovery plan for the internal information technology systems of our Advisor and other parties that provide us with services essential to our operations, these systems are vulnerable to damage from any number of sources, including computer viruses, unauthorized access, energy blackouts, natural disasters, terrorism, war and telecommunication failures. Any system failure or accident that causes interruptions in our operations could result in a material disruption to our business.
A cyber-incident is considered to be any adverse event that threatens the confidentiality, integrity or availability of information resources. More specifically, a cyber-incident is an intentional attack or an unintentional event that can result in third parties gaining unauthorized access to systems to disrupt operations, corrupt data, or steal confidential information. As reliance on technology in our industry has increased, so have the risks posed to the systems of our Advisor and other parties that provide us with services essential to our operations, both internal and those that have been outsourced. In addition, the risk of a cyber-incident, including by computer hackers, foreign governments and cyber terrorists, has generally increased as the number, intensity and sophistication of attempted attacks and intrusions from around the world have increased. Even the most well protected information, networks, systems and facilities remain potentially vulnerable because the techniques used in such attempted attacks and intrusions evolve and generally are not recognized until launched against a target, and in some cases are designed not to be detected and, in fact, may not be detected.
The remediation costs and lost revenues experienced by a victim of a cyber-incident may be significant and significant resources may be required to repair system damage, protect against the threat of future security breaches or to alleviate problems, including reputational harm, loss of revenues and litigation, caused by any breaches. In addition, a security breach or other significant disruption involving the IT networks and related systems of our Advisor or any other party that provides us with services essential to our operations could:
• | result in misstated financial reports, violations of loan covenants, missed reporting deadlines and/or missed permitting deadlines; |
• | affect our ability to properly monitor our compliance with the rules and regulations regarding our qualification as a REIT; |
• | result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of, proprietary, confidential, sensitive or otherwise valuable information, which others could use to compete against us or for disruptive, destructive or otherwise harmful purposes and outcomes; |
• | result in our inability to maintain the building systems relied upon by our tenants for the efficient use of their leased space; |
• | require significant management attention and resources to remedy any damages that result; |
• | subject us to claims for breach of contract, damages, credits, penalties or termination of leases or other agreements; or |
• | adversely impact our reputation among our tenants and investors generally. |
Although our Advisor and other parties that provide us with services essential to our operations intend to continue to implement industry-standard security measures, there can be no assurance that those measures will be sufficient, and any material adverse effect experienced by our Advisor and other parties that provide us with services essential to our operations could, in turn, have an adverse impact on us.
Risks Related to Conflicts of Interest
Our Advisor faces conflicts of interest relating to purchasing commercial real estate-related investments, and such conflicts may not be resolved in our favor, which could adversely affect our investment opportunities.
We rely on our Sponsor and the executive officers and other key real estate professionals at our Advisor to identify suitable investment opportunities for us. Several of the other key real estate professionals of our Advisor are also the key real estate professionals at the parent of our Sponsor and its other public programs. Some investment opportunities that are suitable for us may also be suitable for other programs sponsored directly or indirectly by the parent of our Sponsor. Thus, the executive officers and real estate professionals of our Advisor could direct attractive investment opportunities to other entities or
9
investors. Such events could result in us investing in assets that provide less attractive returns, which may reduce our ability to make distributions.
Our Advisor will face conflicts of interest relating to joint ventures, which could result in a disproportionate benefit to the other venture partners at our expense and adversely affect the return on our common stock.
We may enter into joint ventures with other AR Global-sponsored programs for the acquisition of commercial real estate debt and other commercial real estate investments. Our Advisor may have conflicts of interest in determining which AR Global-sponsored program should enter into any particular joint venture agreement. The co-venturer may have economic or business interests or goals that are or may become inconsistent with our business interests or goals. In addition, our Advisor may face a conflict in structuring the terms of the relationship between our interests and the interest of the affiliated co-venturer and in managing the joint venture. Because our Advisor and its affiliates will control both the affiliated co-venturer and, to a certain extent, us, agreements and transactions between the co-venturers with respect to any such joint venture will not have the benefit of arm’s-length negotiation of the type normally conducted between unrelated co-venturers, which may result in the co-venturer receiving benefits greater than the benefits that we receive. In addition, we may assume liabilities related to the joint venture that exceeds the percentage of our investment in the joint venture.
Our Advisor, Sponsor and their officers and employees and certain of our executive officers and other key personnel face competing demands relating to their time, and this may cause our operating results to suffer.
Our Advisor and our Sponsor and their officers and employees and certain of our executive officers and other key personnel and their respective affiliates are key personnel, general partners, sponsors, managers, owners and advisors of other real estate investment programs, including AR Global-sponsored REITs, some of which have investment objectives and legal and financial obligations similar to ours and may have other business interests as well. Additionally, based on our Sponsor’s experience, a significantly greater time commitment is required of senior management during the development stage when the REIT is being organized, funds are initially being raised and funds are initially being invested, and less time is required as additional funds are raised. Because these persons have competing demands on their time and resources, they may have conflicts of interest in allocating their time between our business and these other activities. If this occurs, the returns on our investments may suffer.
All of our executive officers, some of our directors and the key real estate and other professionals assembled by our Advisor face conflicts of interest related to their positions or interests in affiliates of our Sponsor, which could hinder our ability to implement our business strategy and to generate returns to our stockholders.
All of our executive officers, some of our directors and the key real estate and other professionals assembled by our Advisor are also executive officers, directors, managers, key professionals or holders of a direct or indirect controlling interest in our Advisor, or other AR Global-affiliated entities. Through our AR Global’s affiliates, some of these persons work on behalf of programs sponsored directly or indirectly by the parent of our Sponsor that are currently raising capital publicly. As a result, they have loyalties to each of these entities, which loyalties could conflict with the fiduciary duties they owe to us and could result in action or inaction detrimental to our business. Conflicts with our business and interests are most likely to arise from (a) allocation of new investments and management time and services between us and the other entities, (b) investments with affiliates of our Advisor, (c) compensation to our Advisor and (d) our relationship with our Advisor. If we do not successfully implement our business strategy, we may be unable to generate the cash needed to make distributions to our stockholders and to maintain or increase the value of our assets.
Our Advisor faces conflicts of interest relating to the convertible shares it holds in us, which could result in actions that are not necessarily in the long-term best interests of our stockholders.
Our Advisor holds convertible shares in us that are structured in a manner intended to provide incentives to our Advisor to perform in our best interests and in the best interests of our stockholders. However, because our Advisor is entitled to receive substantial minimum compensation regardless of performance, our Advisor’s interests are not wholly aligned with those of our stockholders. Our Advisor could be motivated to recommend riskier or more speculative investments in order for us to generate the specified levels of performance or sales proceeds that would entitle our Advisor to have the convertible shares convert into shares of our common stock. In addition, our Advisor’s convertible shares could result in our Advisor recommending sales of our investments at the earliest possible time at which sales of investments would produce the level of return that would entitle the Advisor to conversion of the convertible shares, even if continued ownership of those investments might be in our best long-term interest. The convertible shares convert to shares of our common stock if we terminate the advisory agreement prior to the listing of our shares for trading on an exchange or, absent such listing, in respect of its participation in net sales proceeds. To avoid this conversion, our independent directors may decide against terminating the advisory agreement prior to our listing of our shares or disposition of our investments even if, but for the termination distribution, termination of the advisory agreement would be in our best interest. In addition, the conversion of the convertible shares into shares of our common stock at termination could cause us to make different investment or disposition decisions than we would otherwise make. Moreover, our Advisor will have the right to terminate the advisory agreement upon a change of control of our company and thereby
10
trigger the conversion of the convertible shares, which could have the effect of delaying, deferring or preventing the change of control.
Risks Related to Our Corporate Structure
The limit on the number of shares a person may own may discourage a takeover that could otherwise result in a premium price to our stockholders.
Our charter, with certain exceptions, authorizes our directors to take such actions as are necessary and desirable to preserve our qualification as a REIT. Unless exempted by our board of directors, no person or entity may own more than 9.8% in value of the aggregate of our outstanding shares of stock or more than 9.8% (in value or in number of shares, whichever is more restrictive) of any class or series of shares of our stock determined after applying certain rules of attribution. This restriction may have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all our assets) that might provide a premium price for holders of our common stock.
Our charter permits our board of directors to issue stock with terms that may subordinate the rights of common stockholders or discourage a third party from acquiring us in a manner that might result in a premium price to our stockholders.
Our charter permits our board of directors to issue up to 1,000,000,000 shares of stock. In addition, our board of directors, without any action by our stockholders, may amend our charter from time to time to increase or decrease the aggregate number of shares or the number of shares of any class or series of stock that we have authority to issue. Our board of directors may classify or reclassify any unissued common stock or preferred stock into other classes or series of stock and establish the preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends or other distributions, qualifications and terms or conditions of redemption of any such stock. Thus, our board of directors could authorize the issuance of preferred stock with terms and conditions that could have a priority as to distributions and amounts payable upon liquidation over the rights of the holders of our common stock. Preferred stock could also have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all our assets) that might provide a premium price for holders of our common stock.
Maryland law prohibits certain business combinations, which may make it more difficult for us to be acquired and may limit our stockholders' ability to exit the investment.
Under Maryland law, “business combinations” between a Maryland corporation and an interested stockholder or an affiliate of an interested stockholder are prohibited for five years after the most recent date on which the interested stockholder becomes an interested stockholder. These business combinations include a merger, consolidation, share exchange or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities. An interested stockholder is defined as:
• | any person who beneficially owns, directly or indirectly, 10% or more of the voting power of the corporation’s outstanding voting stock; or |
• | an affiliate or associate of the corporation who, at any time within the two-year period prior to the date in question, was the beneficial owner, directly or indirectly, of 10% or more of the voting power of the then outstanding stock of the corporation. |
A person is not an interested stockholder under the statute if the board of directors approved in advance the transaction by which he or she otherwise would have become an interested stockholder. However, in approving a transaction, the board of directors may provide that its approval is subject to compliance, at or after the time of approval, with any terms and conditions determined by the board of directors.
After the five-year prohibition, any business combination between the Maryland corporation and an interested stockholder generally must be recommended by the board of directors of the corporation and approved by the affirmative vote of at least:
• | 80% of the votes entitled to be cast by holders of outstanding shares of voting stock of the corporation; and |
• | two-thirds of the votes entitled to be cast by holders of voting stock of the corporation other than shares held by the interested stockholder with whom or with whose affiliate the business combination is to be effected or held by an affiliate or associate of the interested stockholder. |
These super-majority vote requirements do not apply if the corporation’s common stockholders receive a minimum price, as defined under Maryland law, for their shares in the form of cash or other consideration in the same form as previously paid by the interested stockholder for its shares. The business combination statute permits various exemptions from its provisions, including business combinations that are exempted by the board of directors prior to the time that the interested stockholder
11
becomes an interested stockholder. Pursuant to the statute, our board of directors has exempted any business combination involving our Advisor or any affiliate of our Advisor. Consequently, the five-year prohibition and the super-majority vote requirements will not apply to business combinations between us and our Advisor or any affiliate of our Advisor. As a result, our Advisor and any affiliate of our Advisor may be able to enter into business combinations with us that may not be in the best interest of our stockholders, without compliance with the super-majority vote requirements and the other provisions of the statute. The business combination statute may discourage others from trying to acquire control of us and increase the difficulty of consummating any offer.
Maryland law limits the ability of a third-party to buy a large stake in us and exercise voting power in electing directors, which may discourage a takeover that could otherwise result in a premium price to our stockholders.
The Maryland Control Share Acquisition Act provides that holders of “control shares” of a Maryland corporation acquired in a “control share acquisition” have no voting rights except to the extent approved by stockholders by a vote of stockholders entitled to cash at least two-thirds of the votes entitled to be cast on the matter. Shares of stock owned by the acquirer, by officers or by employees who are directors of the corporation, are excluded from shares entitled to vote on the matter. “Control shares” are voting shares of stock which, if aggregated with all other shares of stock owned by the acquirer or in respect of which the acquirer can exercise or direct the exercise of voting power (except solely by virtue of a revocable proxy), would entitle the acquirer to exercise voting power in electing directors within specified ranges of voting power. Control shares do not include shares the acquiring person is then entitled to vote as a result of having previously obtained stockholder approval or shares acquired directly from the corporation. A “control share acquisition” means the acquisition of issued and outstanding control shares.
The control share acquisition statute does not apply (a) to shares acquired in a merger, consolidation or share exchange if the corporation is a party to the transaction, or (b) to acquisitions approved or exempted by the charter or bylaws of the corporation.
Our bylaws contain a provision exempting from the Control Share Acquisition Act any and all acquisitions of our stock by any person. There can be no assurance that this provision will not be amended or eliminated at any time in the future.
The value of our common stock may be reduced if we are required to register as an investment company under the Investment Company Act.
We are not registered, and do not intend to register ourselves, our operating partnership or any of our subsidiaries, as an investment company under the Investment Company Act. If we become obligated to register ourselves, our operating partnership or any of our subsidiaries as an investment company, the registered entity would have to comply with a variety of substantive requirements under the Investment Company Act imposing, among other things:
• | limitations on capital structure; |
• | restrictions on specified investments; |
• | prohibitions on transactions with affiliates; and |
• | compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly change our operations. |
We conduct, and intend to continue to conduct, our operations, directly and through wholly or majority-owned subsidiaries, so that we, our operating partnership and each of our subsidiaries are exempt from registration as an investment company under the Investment Company Act. Under Section 3(a)(1)(A) of the Investment Company Act, a company is an “investment company” if it is, or holds itself out as being, engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities. Under Section 3(a)(1)(C) of the Investment Company Act, a company is deemed to be an “investment company” if it is engaged, or proposes to engage, in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire “investment securities” having a value exceeding 40% of the value of its total assets (exclusive of government securities and cash items) on an unconsolidated basis. “Investment securities” excludes (A) U.S. Government securities, (B) securities issued by employees’ securities companies, and (C) securities issued by majority-owned subsidiaries which (i) are not investment companies, and (ii) are not relying on the exception from the definition of investment company under Section 3(c)(1) or 3(c)(7) of the Investment Company Act.
We expect that we will not fall under the definition of, and will therefore not be required to register as, an investment company. We intend to make investments and conduct our operations so that we are not required to register as an investment company. We are organized as a holding company that conducts business primarily through the operating partnership. Both the Company and the operating partnership intend to conduct operations so that each complies with the 40% test. The securities issued to the operating partnership by any wholly-owned or majority-owned subsidiaries that we may form in the future that are excepted from the definition of “investment company” based on Section 3(c)(1) or 3(c)(7) of the Investment Company Act, together with any other investment securities the operating partnership may own, may not have a value in excess of 40% of the value of the operating partnership's total assets (exclusive of U.S. government securities and cash items) on an unconsolidated
12
basis. We will monitor the Company’s and the operating partnership’s holdings to support continuing and ongoing compliance with these tests but we may be unsuccessful and could fail to comply. We believe neither the Company nor the operating partnership will be considered an investment company under Section 3(a)(1)(A) of the Investment Company Act because neither the Company nor the operating partnership will engage primarily or hold itself out as being engaged primarily in the business of investing, reinvesting or trading in securities. Rather, through the operating partnership's wholly-owned or majority-owned subsidiaries, the Company and the operating partnership are primarily engaged in the non-investment company businesses of these subsidiaries, namely the business of purchasing or otherwise acquiring mortgages and other interests in real estate.
We expect that most of our investments will be held by wholly-owned or majority-owned subsidiaries of the operating partnership and that most of these subsidiaries will rely on the exception from the definition of an investment company under Section 3(c)(5)(C) of the Investment Company Act, which is available for entities “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” This exclusion generally requires that at least 55% of a subsidiary's portfolio be comprised of qualifying real estate assets and at least 80% of its portfolio be comprised of qualifying real estate assets and real estate-related assets (and no more than 20% comprised of miscellaneous assets). For purposes of the exclusions provided by Sections 3(c)(5)(C), we will classify our investments based in large measure on no-action letters issued by the SEC staff and other SEC interpretive guidance and, in the absence of SEC guidance, on our view of what constitutes a qualifying real estate asset and a real estate-related asset. These no-action positions were issued in accordance with factual situations that may be substantially different from the factual situations we may face, and a number of these no-action positions were issued more than twenty years ago. Pursuant to this guidance, and depending on the characteristics of the specific investments, certain mortgage loans, participations in mortgage loans, mortgage-backed securities, mezzanine loans, joint venture investments and the equity securities of other entities may not constitute qualifying real estate investments, and therefore, investments in these types of assets may be limited. The SEC or its staff may not concur with our classification of our assets. Future revisions to the Investment Company Act or further guidance from the SEC or its staff may cause us to lose our exclusion from the definition of investment company or force us to re-evaluate our portfolio and our investment strategy. Such changes may prevent us from operating our business successfully.
In 2011, the SEC solicited public comment on a wide range of issues relating to Section 3(c)(5)(C) of the Investment Company Act, including the nature of the assets that qualify for purposes of the exclusion and whether mortgage REITs should be regulated in a manner similar to investment companies. There can be no assurance that the laws and regulations governing the Investment Company Act status of REITs, including more specific or different guidance regarding these exclusions that may be published by the SEC or its staff, will not change in a manner that adversely affects our operations. In addition, we cannot assure you that the SEC or its staff will not take action that results in our, our operating partnerships or any of our subsidiaries’ failure to maintain an exception or exemption from the Investment Company Act.
We may in the future organize special purpose subsidiaries of the operating partnership that will borrow under or participate in government sponsored incentive programs. We expect that some of these subsidiaries will rely on Section 3(c)(7) for their Investment Company Act exclusion and, therefore, the operating partnership's interest in each of these subsidiaries would constitute an “investment security” for purposes of determining whether the operating partnership passes the 40% test. Also, we may in the future organize one or more subsidiaries that seek to rely on the Investment Company Act exclusion provided to certain structured financing vehicles by Rule 3a-7. Any such subsidiary would need to be structured to comply with any guidance on the restrictions contained in Rule 3a-7 that may be issued by the SEC or its staff. In certain circumstances, compliance with Rule 3a-7 may require, among other things, that the indenture governing the subsidiary include limitations on the types of assets the subsidiary may sell or acquire out of the proceeds of assets that mature, are refinanced or otherwise sold, on the period of time during which such transactions may occur, and on the amount of transactions that may occur. In 2011, the SEC also solicited public comment on issues relating to Rule 3a-7. Accordingly, more specific or different guidance regarding Rule 3a-7 that may be published by the SEC or its staff may affect our ability to rely upon this rule. We expect that the aggregate value of the operating partnership's interests in subsidiaries that seek to rely on Rule 3a-7 will comprise less than 20% of the operating partnership's (and, therefore, the Company's) total assets on an unconsolidated basis.
In the event that the company, or the operating partnership, were to acquire assets that could make either entity fall within the definition of investment company under Section 3(a)(1)(A) or Section 3(a)(1)(C) of the Investment Company Act, we believe that we may still qualify for an exclusion from registration pursuant to Section 3(c)(6). Although the SEC staff has issued little interpretive guidance with respect to Section 3(c)(6), we believe that the Company and the operating partnership may rely on Section 3(c)(6) if 55% of the assets of the operating partnership consist of, and at least 55% of the income of the operating partnership is derived from, qualifying real estate assets owned by wholly-owned or majority-owned subsidiaries of the operating partnership.
To ensure that neither the Company nor any of its subsidiaries, including the operating partnership, are required to register as an investment company, each entity may be unable to sell assets that it would otherwise want to sell and may need to sell assets that it would otherwise wish to retain. In addition, the Company, the operating partnership or its subsidiaries may be required to acquire additional income- or loss-generating assets that we might not otherwise acquire or forgo opportunities to
13
acquire interests in companies that we would otherwise want to acquire. Although we monitor the portfolio of the Company, the operating partnership and its subsidiaries periodically and prior to each acquisition and disposition, any of these entities may not be able to maintain an exclusion from the definition of investment company. If the Company, the operating partnership or any subsidiary is required to register as an investment company but fails to do so, the unregistered entity would be prohibited from engaging in our business, and criminal and civil actions could be brought against such entity. In addition, the contracts of such entity would be unenforceable unless a court required enforcement, and a court could appoint a receiver to take control of the entity and liquidate its business.
We are an “emerging growth company” under the federal securities laws and will be subject to reduced public company reporting requirements.
In April 2012, President Obama signed into law the Jumpstart Our Business Startups Act (the “JOBS Act”). We are an “emerging growth company,” as defined in the JOBS Act, and are eligible to take advantage of certain exemptions from, or reduced disclosure obligations relating to, various reporting requirements that are normally applicable to public companies.
We could remain an “emerging growth company” for up to five years, or until the earliest of (1) the last day of the first fiscal year in which we have total annual gross revenue of $1 billion or more, (2) December 31 of the fiscal year that we become a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act (which would occur if the market value of our common stock held by non-affiliates exceeds $700 million, measured as of the last business day of our most recently completed second fiscal quarter, and we have been publicly reporting for at least 12 months) or (3) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three-year period.
Under the JOBS Act, emerging growth companies are not required to (1) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting, pursuant to Section 404 of the Sarbanes-Oxley Act, (2) comply with new requirements adopted by the Public Company Accounting Oversight Board (the “PCAOB”), which require mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor must provide additional information about the audit and the issuer’s financial statements, (3) comply with new audit rules adopted by the PCAOB after April 5, 2012 (unless the SEC determines otherwise), (4) provide certain disclosures relating to executive compensation generally required for larger public companies or (5) hold stockholder advisory votes on executive compensation. We have not yet made a decision as to whether to take advantage of any or all of the JOBS Act exemptions that are applicable to us. If we do take advantage of any of these exemptions, we do not know if some investors will find our common stock less attractive as a result.
Additionally, the JOBS Act provides that an “emerging growth company” may take advantage of an extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies. This means that an “emerging growth company” can delay adopting certain accounting standards until such standards are otherwise applicable to private companies. However, we have elected to “opt out” of such extended transition period, and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.
If our stockholders do not agree with the decisions of our board of directors, they only have limited control over changes in our policies and operations and may not be able to change our policies and operations.
Our board of directors determines our major policies, including our policies regarding investments, financing, growth, debt capitalization, REIT qualification and distributions. Our board of directors may amend or revise these and other policies without a vote of the stockholders except to the extent that the policies are set forth in our charter. Under the Maryland General Corporation Law (the "MGCL") and our charter, our stockholders have a right to vote only on the following:
• | the election or removal of directors; |
• | any amendment of our charter, except that our board of directors may amend our charter without stockholder approval to (a) increase or decrease the aggregate number of our shares of stock or the number of shares of stock of any class or series that we have the authority to issue, (b) effect certain reverse stock splits and (c) change our name or the name or other designation or the par value of any class or series of our stock and the aggregate par value of our stock; |
• | our liquidation or dissolution; |
• | certain reorganizations of our company, as provided in our charter; and |
• | certain mergers, consolidations or sales or other dispositions of all or substantially all our assets, as provided in our charter. |
All other matters are subject to the discretion of our board of directors.
14
Our board of directors may change our investment policies without stockholder approval, which could alter the nature of our portfolio.
Our charter requires that our independent directors review our investment policies at least annually to determine that the policies we are following are in the best interest of the stockholders. These policies may change over time. The methods of implementing our investment policies also may vary as the commercial debt markets change, new real estate development trends emerge and new investment techniques are developed. Our investment policies, the methods for their implementation, and our other objectives, policies and procedures may be altered by our board of directors without the approval of our stockholders. As a result, the nature of our portfolio could change without our stockholders' consent.
Because our Advisor is wholly-owned by our Sponsor through the Special Limited Partner, the interests of the Advisor and the Sponsor are not separate and as a result the Advisor may act in a way that is not necessarily in the investors’ interest.
Our Advisor is indirectly wholly-owned by our Sponsor through the Special Limited Partner. Therefore, the interests of our Advisor and our Sponsor are not separate, and the Advisor’s decisions may not be independent from the Sponsor and may result in the Advisor making decisions to act in ways that are not in the investors’ interests.
Payment of fees to our Advisor and its affiliates reduces cash available for investment and distributions.
Our Advisor and its affiliates will perform services for us in connection with the offer and sale of the shares, the selection and acquisition of our investments, the servicing of our mortgage, bridge or mezzanine loans and the administration of our other commercial real estate-related investments. They are paid substantial fees for these services, which reduces the amount of cash available for investment in real estate debt and securities or distribution to stockholders.
Because of our holding company structure, we depend on our operating partnership and its subsidiaries for cash flow and we will be structurally subordinated in right of payment to the obligations of such operating subsidiary and its subsidiaries, which could adversely affect our ability to make distributions.
We are a holding company with no business operations of our own. Our only significant asset is and will be the general partnership interests of our operating partnership. We conduct, and intend to continue to conduct, all of our business operations through our operating partnership. Accordingly, our only source of cash to pay our obligations is distributions from our operating partnership and its subsidiaries of their net earnings and cash flows. There can be no assurance that our operating partnership or its subsidiaries will be able to, or be permitted to, make distributions to us that will enable us to make distributions to our stockholders from cash flows from operations. Each of our operating partnership’s subsidiaries is a distinct legal entity and, under certain circumstances, legal and contractual restrictions may limit our ability to obtain cash from such entities. In addition, because we are a holding company, stockholders' claims will be structurally subordinated to all existing and future liabilities and obligations of our operating partnership and its subsidiaries. Therefore, in the event of our bankruptcy, liquidation or reorganization, our assets and those of our operating partnership and its subsidiaries will be able to satisfy stockholders' claims only after all of our and our operating partnerships and its subsidiaries liabilities and obligations have been paid in full.
Although our Advisor is responsible for calculating our NAV, our Advisor will consider independent valuations of our investments, the accuracy of which our Advisor will not independently verify.
In calculating our NAV, our Advisor will include the net value of our commercial real estate debt and other commercial real estate-related investments, taking into consideration valuations of investments obtained from our independent valuer. Our Advisor will review each appraisal by the independent valuer and will compare each appraisal to its own determination of value. If in the Advisor’s opinion the valuation is materially higher or lower than the Advisor’s determination of value, the Advisor will discuss the valuation with the independent valuer. If the Advisor determines that the valuation is still materially higher or lower than its valuation, a valuation committee, comprised of our independent directors, will review the valuation and make a final determination of value. Although our Advisor is responsible for the accuracy of the NAV calculation and will provide our independent valuer with our valuation guidelines, which have been approved by our board of directors, we will not independently verify the appraised value of our investments. As a result, the appraised value of a particular investment may be greater or less than its potential realizable value, which would cause our estimated NAV to be greater or less than the potential realizable NAV.
Our per share NAV may suddenly change if the appraised values of our investments materially change or the actual operating results differ from what we originally budgeted for that quarter.
Valuations of our portfolio investments will probably not be spread evenly throughout the calendar year. We anticipate that such valuations will be conducted near the end of each calendar quarter or each calendar month. Therefore, when these valuations are reflected in our NAV calculation, for which our Advisor is ultimately responsible, there may be a sudden change in our per share NAV. In addition, actual operating results for a given month may differ from our original estimate, which may affect our per share NAV. We will base our calculation of estimated income and expenses on a monthly budget. As soon as
15
practicable after the end of each month, we will adjust the estimated income and expenses to reflect the income and expenses actually earned and incurred. We will not, however, retroactively adjust the per share NAV.
Therefore, because the actual results from operations may be better or worse than what we previously budgeted for a particular month, the adjustment to reflect actual operating results may cause our NAV per share to change, and such change will occur on the day the adjustment is made.
The per share NAV that we publish may not necessarily reflect changes in our NAV and in the value of your shares that we cannot immediately quantify.
We may experience events affecting our investments that may have a material impact on our NAV. For example, if a material borrower becomes insolvent, the value of an investment may materially change. Furthermore, if we cannot immediately quantify the financial impact of any extraordinary events, our NAV per share as published on any given quarter will not reflect such events. As a result, the NAV per share published after the announcement of a material event may differ significantly from our actual NAV per share until we are able to quantify the financial impact of such events and our NAV is appropriately adjusted on a going forward basis. The resulting potential disparity may benefit repurchasing or non-repurchasing stockholders, depending on whether NAV is overstated or understated.
Risks Related to Our Financing Strategy
We use leverage in connection with our investments, which increases the risk of loss associated with our investments.
We finance the origination and acquisition of a portion of our investments with credit facilities, collateralized loan obligations ("CLO") and other borrowings, which may include repurchase agreements to finance commercial real estate debt. Although the use of leverage may enhance returns and increase the number of investments that we can make, it may also substantially increase the risk of loss. Our ability to execute this strategy depends on various conditions in the financing markets that are beyond our control, including liquidity and credit spreads. We may be unable to obtain additional financing on favorable terms or, with respect to our debt and other investments, on terms that parallels the maturities of the debt originated or other investments acquired, if we are able to obtain additional financing at all. If our strategy is not viable, we will have to find alternative forms of long-term financing for our assets, as secured revolving credit facilities and repurchase facilities may not accommodate long-term financing. This could subject us to more restrictive recourse borrowings and the risk that debt service on less efficient forms of financing would require a larger portion of our cash flows, thereby reducing cash available for distribution, for our operations and for future business opportunities. If alternative financing is not available, we may have to liquidate assets at unfavorable prices to pay off such financing. Our return on our investments and cash available for distribution may be reduced to the extent that changes in market conditions cause the cost of our financing to increase relative to the income that we can derive from the assets we originate or acquire.
Lenders may require us to enter into restrictive covenants relating to our operations, which could limit our ability to make distributions.
When providing financing, a lender may impose restrictions on us that affect our distribution and operating policies, and our ability to incur additional borrowings. Financing agreements that we may enter into may contain covenants that limit our ability to further incur borrowings, restrict distributions or that prohibit us from discontinuing insurance coverage or replacing our Advisor. Certain limitations would decrease our operating flexibility and our ability to achieve our operating objectives, including making distributions.
In a period of rising interest rates, our interest expense could increase while the interest we earn on our fixed-rate assets would not change, which would adversely affect our profitability.
Our operating results depend in large part on differences between the income from our assets, reduced by any credit losses and financing costs. Income from our assets may respond more slowly to interest rate fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net income. Increases in these rates will tend to decrease our net income and market value of our assets. Interest rate fluctuations resulting in our interest expense exceeding the income from our assets would result in operating losses for us and may limit our ability to make distributions to our stockholders. In addition, if we need to repay existing borrowings during periods of rising interest rates, we could be required to liquidate one or more of our investments at times that may not permit realization of the maximum return on those investments, which would adversely affect our profitability.
We may not be able to access financing sources on attractive terms, if at all, which could adversely affect our ability to grow our business.
We will require outside capital to significantly grow our business. Historically we have relied on debt financing and equity financing from our primary offering. We terminated our primary offering in January 2016 and this has significantly reduced our access to equity financing. Our business may be adversely affected by disruptions in the debt and equity capital markets
16
and institutional lending market, including the lack of access to capital or prohibitively high costs of obtaining or replacing capital. If we cannot obtain sufficient debt and equity capital on acceptable terms, our business and our ability to operate could be severely impacted.
We have broad authority to utilize leverage and high levels of leverage could hinder our ability to make distributions and decrease the value of our common stock.
Our charter does not limit us from utilizing financing until our borrowings exceed 300% of our "net assets" (as defined by the NASAA REIT Guidelines), which is generally expected to approximate 75% of the aggregate cost of our investments. Further, we can incur financings in excess of this limitation with the approval of our independent directors. High leverage levels would cause us to incur higher interest charges and higher debt service payments and the agreements governing our borrowings may also include restrictive covenants. These factors could limit the amount of cash we have available to distribute to our stockholders and could result in a decline in the value of our common stock.
We use short-term borrowings, such as credit facilities and repurchase agreements to finance our investments, which require us to provide additional collateral in the event the lender determines there is a decrease in the fair value of our collateral, these calls for collateral could significantly impact our liquidity position.
We use short-term borrowing through repurchase agreements, credit facilities and other arrangements that put our assets and financial condition at risk. We may need to use such short-term borrowings for extended periods of time to the extent we are unable to access long-term financing. Repurchase agreements economically resemble short-term, variable-rate financing and usually require the maintenance of specific loan-to-collateral value ratios. If the market value of the assets subject to a repurchase agreement decline, we may be required to provide additional collateral or make cash payments to maintain the loan-to-collateral value ratio. If we are unable to provide such collateral or cash repayments, the lender may accelerate the loan or we liquidate the collateral. In a weakening economic environment, or in an environment of widening credit spreads, we would generally expect the value of the commercial real estate debt or securities that serve as collateral for our short-term borrowings to decline, and in such a scenario, it is likely that the terms of our short-term borrowings would require us to provide additional collateral or to make partial repayment, which amounts could be substantial.
Further, such borrowings may require us to maintain a certain amount of cash reserves or to set aside unleveraged assets sufficient to maintain a specified liquidity position that would allow us to satisfy our collateral obligations. In addition, such short-term borrowing facilities may limit the length of time that any given asset may be used as eligible collateral, and these short-term borrowing arrangements may also be restricted to financing certain types of assets, such as first mortgage loans, which could impact our asset allocation. As a result, we may not be able to leverage our assets as fully as we would choose, which could reduce our return on assets. In the event that we are unable to meet these collateral obligations, our financial condition could deteriorate rapidly.
Risks Related to Our Investments
Our commercial real estate debt and other commercial real estate investments are subject to the risks typically associated with commercial real estate.
Our commercial real estate debt and commercial real estate securities generally are directly or indirectly secured by a lien on real property. The occurrence of a default on a commercial real estate debt investment could result in our acquiring ownership of the property. We do not know whether the values of the properties ultimately securing our commercial real estate debt and loans underlying our securities will remain at the levels existing on the dates of origination of these loans and the dates of origination of the loans ultimately securing our securities, as applicable. If the values of the properties drop, our risk will increase because of the lower value of the security and reduction in borrower equity associated with such loans. In this manner, real estate values could impact the values of our debt and security investments. Therefore, our commercial real estate debt and securities investments are subject to the risks typically associated with real estate.
Our operating results may be adversely affected by a number of risks generally incident to holding real estate, including, without limitation:
• | natural disasters, such as hurricanes, earthquakes and floods; |
• | acts of war or terrorism, including the consequences of terrorist attacks; |
• | adverse changes in national and local economic and real estate conditions; |
• | an oversupply of (or a reduction in demand for) space in the areas where particular properties are located and the attractiveness of particular properties to prospective tenants; |
• | changes in interest rates and availability of permanent mortgage funds that my render the sale of property difficult or unattractive; |
17
• | changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance therewith and the potential for liability under applicable laws; |
• | costs of remediation and liabilities associated with environmental conditions affecting properties; and |
• | the potential for uninsured or underinsured property losses; and |
• | periods of high interest rates and tight money supply. |
The value of each property is affected significantly by its ability to generate cash flow and net income, which in turn depends on the amount of rental or other income that can be generated net of expenses required to be incurred with respect to the property. Many expenses associated with properties (such as operating expenses and capital expenses) cannot be reduced when there is a reduction in income from the properties.
These factors may have a material adverse effect on the ability of our borrowers to pay their loans and the ability of the borrowers on the underlying loans securing our securities to pay their loans, as well as on the value and the return that we can realize from assets we acquire and originate.
The commercial real estate debt we originate and invest in and the commercial real estate loans underlying the commercial real estate securities we invest in could be subject to delinquency, foreclosure and loss, which could result in losses to us.
Commercial real estate loans are secured by commercial real estate and are subject to risks of delinquency, foreclosure, loss and bankruptcy of the borrower, all of which are and will continue to be prevalent if the overall economic environment does not continue to improve. The ability of a borrower to repay a loan secured by commercial real estate is typically dependent primarily upon the successful operation of such property rather than upon the existence of independent income or assets of the borrower. If the net operating income of the property is reduced or is not increased, depending on the borrower’s business plan, the borrower’s ability to repay the loan may be impaired. Net operating income of a property can be affected by each of the following factors, among other things:
• | macroeconomic and local economic conditions; |
• | tenant mix; |
• | success of tenant businesses; |
• | property management decisions; |
• | property location and condition; |
• | property operating costs, including insurance premiums, real estate taxes and maintenance costs; |
• | competition from comparable types of properties; |
• | effects on a particular industry applicable to the property, such as hotel vacancy rates; |
• | changes in governmental rules, regulations and fiscal policies, including environmental legislation; |
• | changes in laws that increase operating expenses or limit rents that may be charged; |
• | any need to address environmental contamination at the property; |
• | the occurrence of any uninsured casualty at the property; |
• | changes in national, regional or local economic conditions and/or specific industry segments; |
• | declines in regional or local real estate values; |
• | branding, marketing and operational strategies; |
• | declines in regional or local rental or occupancy rates; |
• | increases in interest rates; |
• | real estate tax rates and other operating expenses; |
• | acts of God; |
• | social unrest and civil disturbances; |
• | terrorism; and |
• | increases in costs associated with renovation and/or construction. |
Any one or a combination of these factors may cause a borrower to default on a loan or to declare bankruptcy. If a default or bankruptcy occurs and the underlying asset value is less than the loan amount, we will suffer a loss.
18
In the event of any default under a commercial real estate loan held directly by us, we will bear a risk of loss of principal or accrued interest to the extent of any deficiency between the value of the collateral and the principal and accrued interest of the commercial real estate loan, which could have a material adverse effect on our cash flow from operations. In the event of a default by a borrower on a non-recourse commercial real estate loan, we will only have recourse to the underlying asset (including any escrowed funds and reserves) collateralizing the commercial real estate loan. If a borrower defaults on one of our commercial real estate debt investments and the underlying property collateralizing the commercial real estate debt is insufficient to satisfy the outstanding balance of the debt, we may suffer a loss of principal or interest. In addition, even if we have recourse to a borrower’s assets, we may not have full recourse to such assets in the event of a borrower bankruptcy as the loan to such borrower will be deemed to be secured only to the extent of the value of the mortgaged property at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the extent the lien is unenforceable under state law. We are also exposed to these risks though the commercial real estate loans underlying a commercial real estate security we hold may result in us not recovering a portion or all of our investment in such commercial real estate security.
Delays in liquidating defaulted commercial real estate debt investments could reduce our investment returns.
If we originate or acquire commercial real estate debt investments and there are defaults under those debt investments, we may not be able to repossess and sell the properties securing the commercial real estate debt investment quickly. Foreclosure of a loan can be an expensive and lengthy process that could have a negative effect on our return on the foreclosed loan. Borrowers often resist foreclosure actions by asserting numerous claims, counterclaims and defenses, including but not limited to, lender liability claims, in an effort to prolong the foreclosure action. In some states, foreclosure actions can take several years or more to resolve. At any time during the foreclosure proceedings, the borrower may file for bankruptcy, which would have the effect of staying the foreclosure action and further delaying the foreclosure process. The resulting time delay could reduce the value of our assets in the defaulted loans. Furthermore, an action to foreclose on a property securing a loan is regulated by state statutes and regulations and is subject to the delays and expenses associated with lawsuits if the borrower raises defenses or counterclaims. In the event of default by a borrower, these restrictions, among other things, may impede our ability to foreclose on or sell the property securing the loan or to obtain proceeds sufficient to repay all amounts due to us on the loan. In addition, we may be forced to operate any foreclosed properties for a substantial period of time, which could be a distraction for our management team and may require us to pay significant costs associated with such property.
Subordinate commercial real estate debt that we originate or acquire could constitute a significant portion of our portfolio and may expose us to greater losses.
We acquire and originate subordinate commercial real estate debt, including subordinate mortgage and mezzanine loans and participations in such loans. These types of investments could constitute a significant portion of our portfolio and may involve a higher degree of risk than the type of assets that will constitute the majority of our commercial real estate debt investments, namely first mortgage loans secured by real property. In the event a borrower declares bankruptcy, we may not have full recourse to the assets of the borrower or the assets of the borrower may not be sufficient to satisfy the first mortgage loan and our subordinate debt investment. If a borrower defaults on our subordinate debt or on debt senior to ours, or in the event of a borrower bankruptcy, our subordinate debt will be satisfied only after the senior debt is paid in full. Where debt senior to our debt investment exists, the presence of intercreditor arrangements may limit our ability to amend our debt agreements, assign our debt, accept prepayments, exercise our remedies (through “standstill periods”) and control decisions made in bankruptcy proceedings relating to our borrowers. As a result, we may not recover some or all of our investment. In addition, real properties with subordinate debt may have higher loan-to-value ratios than conventional debt, resulting in less equity in the real property and increasing the risk of loss of principal and interest.
We may be subject to risks associated with construction lending, such as declining real estate values, cost overruns and delays in completion.
Our commercial real estate debt portfolio may include loans made to developers to construct prospective projects. The primary risks to us of construction loans are the potential for cost overruns, the developer’s failing to meet a project delivery schedule and the inability of a developer to sell or refinance the project at completion in accordance with its business plan and repay our commercial real estate loan due to declining real estate values. These risks could cause us to have to fund more money than we originally anticipated in order to complete the project. We may also suffer losses on our commercial real estate debt if the developer is unable to sell the project or refinance our commercial real estate debt investment.
Jurisdictions with one action or security first rules or anti-deficiency legislation may limit the ability to foreclose on the property or to realize the obligation secured by the property by obtaining a deficiency judgment.
In the event of any default under our commercial real estate debt investments and in the loans underlying our commercial real estate securities, we bear the risk of loss of principal and nonpayment of interest and fees to the extent of any deficiency between the value of the collateral and the principal amount of the loan. Certain states in which the collateral securing our commercial real estate debt and securities is located may have laws that prohibit more than one judicial action to enforce a
19
mortgage obligation, requiring the lender to exhaust the real property security for such obligation first or limiting the ability of the lender to recover a deficiency judgment from the obligor following the lender’s realization upon the collateral, in particular if a non-judicial foreclosure is pursued. These statutes may limit the right to foreclose on the property or to realize the obligation secured by the property.
Our investments in commercial real estate debt and commercial real estate securities are subject to changes in credit spreads.
Our investments in commercial real estate debt and commercial real estate securities are subject to changes in credit spreads. When credit spreads widen, the economic value of such investments decrease. Even though such investment may be performing in accordance with its terms and the underlying collateral has not changed, the economic value of the investment may be negatively impacted by the incremental interest foregone from the widened credit spread.
Investments in non-conforming or non-investment grade rated loans or securities involve greater risk of loss.
Some of our investments may not conform to conventional loan standards applied by traditional lenders and either will not be rated or will be rated as non-investment grade by the rating agencies. The non-investment grade ratings for these assets typically result from the overall leverage of the loans, the lack of a strong operating history for the properties underlying the loans, the borrowers’ credit history, the properties’ underlying cash flow or other factors. As a result, these investments may have a higher risk of default and loss than investment grade rated assets. Any loss we incur may be significant and may reduce distributions and adversely affect the value of our common stock.
Insurance may not cover all potential losses on the properties underlying our investments which may harm the value of our assets.
We generally require that each of the borrowers under our commercial real estate debt investments obtain comprehensive insurance covering the mortgaged property, including liability, fire and extended coverage. However, there are certain types of losses, generally of a catastrophic nature, such as earthquakes, floods and hurricanes, that may be uninsurable or not economically insurable. We may not require borrowers to obtain certain types of insurance if it is deemed commercially unreasonable. Inflation, changes in building codes and ordinances, environmental considerations and other factors also might make it infeasible to use insurance proceeds to replace a property if it is damaged or destroyed. Under such circumstances, the insurance proceeds, if any, might not be adequate to restore the economic value of the property, which might impair our security and decrease the value of the property.
Investments that are not insured involve greater risk of loss than insured investments.
We may acquire and originate uninsured loans and assets as part of our investment strategy. Such loans and assets may include first mortgage loans, subordinate mortgage and mezzanine loans and participations in such loans and commercial real estate securities. While holding such interests, we are subject to risks of borrower defaults, bankruptcies, fraud, losses and special hazard losses that are not covered by standard hazard insurance. To the extent we suffer such losses with respect to our uninsured investments, the value of our company and the value of our common stock may be adversely affected.
We invest in CMBS, which may include subordinate securities, which entails certain risks.
We invest in a variety of CMBS, which may include subordinate securities that are subject to the first risk of loss if any losses are realized on the underlying mortgage loans. CMBS entitle the holders thereof to receive payments that depend primarily on the cash flow from a specified pool of commercial or multifamily mortgage loans. Consequently, CMBS will be adversely affected by payment defaults, delinquencies and losses on the underlying commercial real estate loans. Furthermore, if the rental and leasing markets deteriorate, it could reduce cash flow from the loan pools underlying our CMBS investments. The CMBS market is dependent upon liquidity for refinancing and will be negatively impacted by a slowdown in the new issue CMBS market.
Additionally, CMBS is subject to particular risks, including lack of standardized terms and payment of all or substantially all of the principal only at maturity rather than regular amortization of principal. Additional risks may be presented by the type and use of a particular commercial property. Special risks are presented by hospitals, nursing homes, hospitality properties and certain other property types. Commercial property values and net operating income are subject to volatility, which may result in net operating income becoming insufficient to cover debt service on the related commercial real estate loan, particularly if the current economic environment continues to deteriorate. The repayment of loans secured by income-producing properties is typically dependent upon the successful operation of the related real estate project rather than upon the liquidation value of the underlying real estate. Furthermore, the net operating income from and value of any commercial property are subject to various risks. The exercise of remedies and successful realization of liquidation proceeds relating to CMBS may be highly dependent upon the performance of the servicer or special servicer. Expenses of enforcing the underlying commercial real estate loans (including litigation expenses) and expenses of protecting the properties securing the commercial real estate loans may be substantial. Consequently, in the event of a default or loss on one or more commercial real estate loans contained in a securitization, we may not recover a portion or all of our investment.
20
The CMBS in which we may invest are subject to the risks of the mortgage securities market as a whole and risks of the securitization process.
The value of CMBS may change due to shifts in the market’s perception of issuers and regulatory or tax changes adversely affecting the mortgage securities market as a whole. Due to our investment in subordinate CMBS, we are also subject to several risks created through the securitization process. Our subordinate CMBS are paid interest only to the extent that there are funds available to make payments. To the extent the collateral pool includes delinquent loans, there is a risk that the interest payment on subordinate CMBS will not be fully paid. Subordinate CMBS are also subject to greater credit risk than those CMBS that are senior and generally more highly rated.
We may not control the special servicing of the mortgage loans underlying the CMBS in which we invest and, in such cases, the special servicer may take actions that could adversely affect our interests.
Overall control over the special servicing of the underlying mortgage loans of the CMBS may be held by a directing certificate holder, which is appointed by the holders of the most subordinate class of such CMBS. We ordinarily do not have the right to appoint the directing certificate holder. In connection with the servicing of the specially serviced mortgage loans, the related special servicer may, at the direction of the directing certificate holder, take actions that could adversely affect our interests.
With respect to certain mortgage loans included in the CMBS, the properties that secure the mortgage loan backing the CMBS may also secure one or more related mortgage loans that are not in the securitized pool, which may conflict with our interests.
Certain mortgage loans included in the CMBS investments may be part of a loan combination or split loan structure that includes one or more additional cross-collateralized mortgage loans (senior, subordinate or pari passu and not included in the CMBS) that are secured by the same mortgage instrument(s) encumbering the same mortgaged property or properties, as applicable, as is the subject mortgage loan. Pursuant to one or more co-lender or similar agreements, a holder, or a group of holders, of a mortgage loan in a subject loan combination or split loan structure may be granted various rights and powers that affect the mortgage loan in that loan combination or split loan structure, including: (i) cure rights; (ii) a purchase option; (iii) the right to advise, direct or consult with the applicable servicer regarding various servicing matters affecting that loan combination; or (iv) the right to replace the directing certificate holder (without cause).
We may invest in collateralized debt obligations ("CDOs") and such investments involve significant risks.
We may invest in CDOs, which are multiple class securities secured by pools of assets, such as CMBS, subordinate mortgage and mezzanine loans and REIT debt. Like typical securities structures, in a CDO, the assets are pledged to a trustee for the benefit of the holders of the bonds. Like CMBS, CDO notes are affected by payments, defaults, delinquencies and losses on the underlying commercial real estate loans. CDOs often have reinvestment periods that typically last for five years during which proceeds from the sale of a collateral asset may be invested in substitute collateral. Upon termination of the reinvestment period, the static pool functions very similarly to a CMBS where repayment of principal allows for redemption of bonds sequentially. To the extent we invest in the equity securities of a CDO, we will be entitled to all of the income generated by the CDO after the CDO pays all of the interest due on the senior securities and its expenses. However, there will be little or no income or principal available to the holders of CDO equity securities if defaults or losses on the underlying collateral exceed a certain amount. In that event, the value of our investment in any equity class of a CDO could decrease substantially. In addition, the equity securities of CDOs are generally illiquid and often must be held by a REIT and because they represent a leveraged investment in the CDO’s assets, the value of the equity securities will generally have greater fluctuations than the values of the underlying collateral.
We have no established investment criteria limiting the size of each investment we make in commercial real estate debt, commercial real estate securities and other commercial real estate-related investments. If we have an investment that represents a material percentage of our assets, and that investment experiences a loss, the value of our common stock could be significantly diminished.
Certain of our commercial real estate debt, commercial real estate-related securities and other commercial real estate investments may represent a significant percentage of our assets. Any such investment may carry the risk associated with a significant asset concentration. Should any investment representing a material percentage of our assets, experience a loss on all or a portion of the investment, we could experience a material adverse effect, which would result in the value of our common stock being diminished.
21
We have no established investment criteria limiting the geographic concentration of our investments in commercial real estate debt, commercial real estate securities and other commercial real estate-related investments. If our investments are concentrated in an area that experiences adverse economic conditions, our investments may lose value and we may experience losses.
Certain commercial real estate debt, commercial real estate securities and other commercial real estate-related investments in which we invest may be secured by a single property or properties in one geographic location. These investments may carry the risks associated with significant geographical concentration. We have not established and do not plan to establish any investment criteria to limit our exposure to these risks for future investments. As a result, properties underlying our investments may be overly concentrated in certain geographic areas, and we may experience losses as a result. A worsening of economic conditions in the geographic area in which our investments may be concentrated could have an adverse effect on our business, including reducing the demand for new financings, limiting the ability of borrowers to pay financed amounts and impairing the value of our collateral.
We have no established investment criteria limiting the industry concentration of our investments in commercial real estate debt and commercial real estate-related securities and other commercial real estate investments. If our investments are concentrated in an industry that experiences adverse economic conditions, our investments may lose value and we may experience losses.
Certain commercial real estate debt and other commercial real estate-related investments in which we invest may be secured by a single property or properties serving a particular industry, such as hotel, office or otherwise. These investments may carry the risks associated with significant industry concentration. We have not established and do not plan to establish any investment criteria to limit our exposure to these risks for future investments. As a result, properties underlying our investments may be overly concentrated in certain industries, and we may experience losses as a result. A worsening of economic conditions in an industry in which we are concentrated could have an adverse effect on our business, including reducing the demand for new financings, limiting the ability of borrowers to pay financed amounts and impairing the value of our collateral.
Adjustable-rate commercial real estate loans may entail greater risks of default to us than fixed-rate commercial real estate loans.
Adjustable-rate commercial real estate loans we originate or acquire or that collateralize our commercial real estate securities may have higher delinquency rates than fixed-rate loans. Borrowers with adjustable-rate mortgage loans may be exposed to increased monthly payments if the related interest rate adjusts upward from the initial fixed-rate or a low introductory rate, as applicable, in effect during the initial period of the loan to the rate computed in accordance with the applicable index and margin. This increase in borrowers’ monthly payments, together with any increase in prevailing market interest rates, after the initial fixed-rate period, may result in significantly increased monthly payments for borrowers with adjustable-rate loans, which may make it more difficult for the borrowers to repay the loan or could increase the risk of default of their obligations under the loan.
Changes in interest rates could negatively affect the value of our investments, which could result in reduced income or losses and negatively affect the cash available for distribution.
We may invest in fixed-rate CMBS and other fixed-rate investments. Under a normal yield curve, an investment in these instruments will decline in value if long-term interest rates increase. We will also invest in floating-rate investments, for which decreases in interest rates will have a negative effect on value and interest income. Declines in fair value may ultimately reduce income or result in losses to us, which may negatively affect cash available for distribution.
Hedging against interest rate exposure may adversely affect our income, limit our gains or result in losses, which could adversely affect cash available for distribution to our stockholders.
We may enter into interest rate swap agreements or pursue other interest rate hedging strategies. Our hedging activity will vary in scope based on interest rate levels, the type of investments held, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:
• | interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates; |
• | available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought; |
• | the duration of the hedge may not match the duration of the related liability or asset; |
• | our hedging opportunities may be limited by the treatment of income from hedging transactions under the rules determining REIT qualification; |
• | the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; |
• | the party owing money in the hedging transaction may default on its obligation to pay; and |
22
• | we may purchase a hedge that turns out not to be necessary. |
Any hedging activity we engage in may adversely affect our income, which could adversely affect cash available for distribution. Therefore, while we may enter into such transactions to seek to reduce interest rate risks, unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions. In addition, the degree of correlation between price movements of the instruments used in a hedging strategy and price movements in the portfolio positions being hedged or liabilities being hedged may vary materially. Moreover, for a variety of reasons, we may not be able to establish a perfect correlation between hedging instruments and the investment being hedged. Any such imperfect correlation may prevent us from achieving the intended hedge and expose us to risk of loss.
Hedging instruments often are not traded on regulated exchanges, guaranteed by an exchange or its clearinghouse or regulated by any U.S. or foreign governmental authorities and involve risks and costs.
The cost of using hedging instruments increases as the period covered by the instrument lengthens and during periods of rising and volatile interest rates. We may increase our hedging activity and thus increase our hedging costs during periods when interest rates are volatile or rising and hedging costs have increased. In addition, hedging instruments involve risk since they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities. Consequently, there are no regulatory or statutory requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions. Furthermore, the enforceability of agreements underlying derivative transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in a default. Default by a party with whom we enter into a hedging transaction may result in the loss of unrealized profits and force us to cover our resale commitments, if any, at the then current market price. It may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. There can be no assurance that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.
Our investments in commercial real estate securities, which may include preferred and common equity, will be subject to the specific risks relating to the particular issuer of the securities and may involve greater risk of loss than secured debt financings.
Our investments in securities, which may include preferred and common equity, will involve special risks relating to the particular issuer of the securities, including the financial condition and business outlook of the issuer. Issuers that are REITs and other real estate companies are subject to the inherent risks associated with real estate and real estate-related investments. Issuers that are finance companies are subject to the inherent risks associated with structured financing investments. Furthermore, securities, including preferred and common equity, may involve greater risk of loss than secured financings due to a variety of factors, including that such investments are generally unsecured and may also be subordinated to other obligations of the issuer. As a result, investments in securities, including preferred and common equity, are subject to risks of: (i) limited liquidity in the secondary trading market; (ii) substantial market price volatility resulting from changes in prevailing interest rates; (iii) subordination to the prior claims of banks and other senior lenders to the issuer; (iv) the operation of mandatory sinking fund or call or redemption provisions during periods of declining interest rates that could cause the issuer to reinvest redemption proceeds in lower yielding assets; (v) the possibility that earnings of the issuer may be insufficient to meet its debt service and distribution obligations; and (vi) the declining creditworthiness and potential for insolvency of the issuer during periods of rising interest rates and economic downturn. These risks may adversely affect the value of outstanding securities, including preferred and common equity, and the ability of the issuers thereof to make principal, interest and distribution payments to us.
Many of our investments are illiquid and we may not be able to vary our portfolio in response to changes in economic and other conditions, which may result in losses to us.
Many of our investments are illiquid. As a result, our ability to sell commercial real estate debt, securities or properties in response to changes in economic and other conditions, could be limited, even at distressed prices. The Internal Revenue Code also places limits on our ability to sell properties held for fewer than four years. These considerations could make it difficult for us to dispose of any of our assets even if a disposition were in the best interests of our stockholders. As a result, our ability to vary our portfolio in response to further changes in economic and other conditions may be relatively limited, which may result in losses to us.
Declines in the fair value of our investments may adversely affect periodic reported results of operations and credit availability, which may reduce earnings and, in turn, cash available for distribution.
Most of our security investments will be classified for accounting purposes as “available-for-sale.” These assets will be carried at estimated fair value and temporary changes in the fair value of those assets will be directly charged or credited to equity with no impact on our statement of operations. If we determine that a decline in the estimated fair value of an available-
23
for-sale security falls below its amortized value and is not temporary, we will recognize a loss on that security on the statement of operations, which will reduce our income in the period recognized.
A decline in the fair value of our assets may adversely affect us particularly in instances where we have borrowed money based on the fair value of those assets. If the fair value of those assets declines, the lender may require us to post additional collateral to support the asset. If we were unable to post the additional collateral, our lenders may refuse to continue to lend to us or reduce the amounts they are willing to lend to us. Additionally, we may have to sell assets at a time when we might not otherwise choose to do so. A reduction in credit available may reduce our income and, in turn, cash available for distribution.
Further, lenders may require us to maintain a certain amount of cash reserves or to set aside unlevered assets sufficient to maintain a specified liquidity position, which would allow us to satisfy our collateral obligations. As a result, we may not be able to leverage our assets as fully as we would choose, which could reduce our return on equity. In the event that we are unable to meet these contractual obligations, our financial condition could deteriorate rapidly.
The fair value of our investments may decline for a number of reasons, such as changes in prevailing market rates, increases in defaults, increases in voluntary prepayments for those investments that we have that are subject to prepayment risk, widening of credit spreads and downgrades of ratings of the securities by ratings agencies.
Some of our investments will be carried at estimated fair value as determined by us and, as a result, there may be uncertainty as to the value of these investments.
Some of our investments will be in the form of securities that are recorded at fair value but have limited liquidity or are not publicly-traded. The fair value of these securities and potentially other investments that have limited liquidity or are not publicly-traded may not be readily determinable. We estimate the fair value of these investments on a quarterly basis. Because such valuations are inherently uncertain, may fluctuate over short periods of time and may be based on numerous estimates and assumptions, our determinations of fair value may differ materially from the values that would have been used if a readily available market for these securities existed. The value of our common stock could be adversely affected if our determinations regarding the fair value of these investments are materially higher than the values that we ultimately realize upon their disposal.
Competition with third parties for originating and acquiring investments may reduce our profitability.
We have significant competition with respect to our origination and acquisition of assets with many other companies, including other REITs, insurance companies, commercial banks, private investment funds, hedge funds, specialty finance companies and other investors, many of which have greater resources than us. We may not be able to compete successfully for investments. In addition, the number of entities and the amount of funds competing for suitable investments may increase. If we pay higher prices for investments or originate loans on more generous terms than our competitors, our returns will be lower and the value of our assets may not increase or may decrease significantly below the amount we paid for such assets. If such events occur, our investors may experience a lower return on their investment.
Our due diligence may not reveal all material issues relating to our origination or acquisition of a particular investment.
Before making an investment, we assess the strength and skills of the management of the borrower or the operator of the property and other factors that we believe are material to the performance of the investment. In making the assessment and otherwise conducting customary due diligence, we rely on the resources available to us and, in some cases, an investigation by third parties. This process is particularly important and subjective with respect to newly organized or private entities because there may be little or no information publicly available about the entity. Even if we conduct extensive due diligence on a particular investment, there can be no assurance that this diligence will uncover all material issues relating to such investment, or that factors outside of our control will not later arise. If our due diligence fails to identify issues specific to investment, we may be forced to write-down or write-off assets, restructure our operations or incur impairment or other charges that could result in our reporting losses. Charges of this nature could contribute to negative market perceptions about us or our shares of common stock.
We depend on borrowers for a substantial portion of our revenue, and accordingly, our revenue and our ability to make distributions is dependent upon the success and economic viability of such borrowers.
The success of our origination or acquisition of commercial real estate debt investments and our acquisition of commercial real estate securities significantly depends on the financial stability of the borrowers underlying such investments. The inability of a single major borrower or a number of smaller borrowers to meet their payment obligations could result in reduced revenue or losses.
A prolonged economic slowdown, a lengthy or severe recession or declining real estate values could harm our operations.
Many of our investments may be susceptible to economic slowdowns or recessions, which could lead to financial losses in our investments and a decrease in revenues, earnings and assets. An economic slowdown or recession, in addition to other non-economic factors, such as an excess supply of properties, could have a material negative impact on the values of commercial real estate properties. Declining real estate values will likely reduce our level of new loan originations, since borrowers often
24
use increases in the value of their existing properties to support the purchase or investment in additional properties. Borrowers may also be less able to pay principal and interest on our loans if the real estate economy weakens. Further, declining real estate values significantly increase the likelihood that we will incur losses on our loans in the event of a default because the value of our collateral may be insufficient to cover our cost on the loan. Any sustained period of increased payment delinquencies, foreclosures or losses could adversely affect both our net interest income from loans in our portfolio as well as our ability to originate, sell and securitize loans, which would significantly harm our revenues, results of operations, financial condition, business prospects and our ability to make distributions.
If we overestimate the value or income-producing ability or incorrectly price the risks of our investments, we may experience losses.
Analysis of the value or income-producing ability of a commercial property is highly subjective and may be subject to error. We value our potential investments based on yields and risks, taking into account estimated future losses on the commercial real estate loans and the property included in the securitization’s pools or commercial real estate investments, and the estimated impact of these losses on expected future cash flows and returns. In the event that we underestimate the risks relative to the price we pay for a particular investment, we may experience losses with respect to such investment.
The leases on the properties underlying our investments may not be renewed on favorable terms.
The properties underlying our investments could be negatively impacted by deteriorating economic conditions and weaker rental markets. Upon expiration or earlier termination of leases on these properties, the space may not be relet or, if relet, the terms of the renewal or reletting (including the cost of required renovations or concessions to tenants) may be less favorable than current lease terms. In addition, the poor economic conditions may reduce a tenant’s ability to make rent payments under their leases. Any of these situations may result in extended periods where there is a significant decline in revenues or no revenues generated by these properties. Additionally, if market rental rates are reduced, property-level cash flows would likely be negatively affected as existing leases renew at lower rates. If the leases for these properties cannot be renewed for all or substantially all of the space at these properties, or if the rental rates upon such renewal or reletting are significantly lower than expected, the value of our investments may be adversely effected.
Our borrowers’ forms of entities may cause special risks or hinder our recovery.
Most of the borrowers for our commercial real estate loan investments will most likely be legal entities rather than individuals. As a result, our risk of loss may be greater than originators of loans made to or leases with individuals. Unlike individuals involved in bankruptcies, these legal entities generally do not have personal assets and creditworthiness at stake. As a result, the bankruptcy of one of our borrowers, or a general partner or managing member of that borrower, may impair our ability to enforce our rights and remedies under the related mortgage.
We are exposed to environmental liabilities with respect to properties to which we take title.
In the course of our business, we may take title to real estate, and if we do take title, we could be subject to environmental liabilities with respect to these properties. In such a circumstance, we may be held liable to a governmental entity or to third parties for property damage, personal injury, and investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases, at a property. The costs associated with investigation or remediation activities could be substantial. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity and results of operations could be materially adversely affected.
Real estate debt restructurings may reduce our net interest income.
Although our commercial real estate debt investments are relatively new and the commercial real estate market has exhibited signs of recovery, we may need to restructure our commercial real estate debt investments if the borrowers are unable to meet their obligations to us and we believe restructuring is the best way to maximize value. In order to preserve long-term value, we may determine to lower the interest rate on our commercial real estate debt investments in connection with a restructuring, which will have an adverse impact on our net interest income. We may also determine to extend the time to maturity and make other concessions with the goal of increasing overall value but there is no assurance that the results of our restructurings will be favorable to us. We may lose some or all of our investment even if we restructure in an effort to increase value.
We may be unable to restructure loans in a manner that we believe maximizes value, particularly if we are one of multiple creditors in large capital structures.
In the current environment, in order to maximize value we may be more likely to extend and work out a loan, rather than pursue foreclosure. However, in situations where there are multiple creditors in large capital structures, it can be particularly difficult to assess the most likely course of action that a lender group or the borrower may take and it may also be difficult to achieve consensus among the lender group as to major decisions. Consequently, there could be a wide range of potential principal recovery outcomes, the timing of which can be unpredictable, based on the strategy pursued by a lender group and/or
25
by a borrower. These multiple creditor situations tend to be associated with larger loans. If we are one of a group of lenders, we may be a lender on a subordinated basis, and may not independently control the decision making. Consequently, we may be unable to restructure a loan in a manner that we believe would maximize value.
We may not be able to realize the benefits of any guarantees we may receive which could harm our ability to preserve our capital upon a default.
We sometimes obtain personal or corporate guarantees, which are not secured, from borrowers or their affiliates. These guarantees are often triggered only upon the occurrence of certain trigger, or “bad boy” events. In cases where guarantees are not fully or partially secured, we typically rely on financial covenants from borrowers and guarantors which are designed to require the borrower or guarantor to maintain certain levels of creditworthiness. As a result of the recent economic recession and persisting market conditions, many borrowers and guarantors face financial difficulties and may be unable to comply with their financial covenants. If the economy does not strengthen, our borrowers could experience additional financial stress. Where we do not have recourse to specific collateral pledged to satisfy such guarantees or recourse loans, we will only have recourse as an unsecured creditor to the general assets of the borrower or guarantor, some or all of which may be pledged to satisfy other lenders. There can be no assurance that a borrower or guarantor will comply with its financial covenants or that sufficient assets will be available to pay amounts owed to us under our commercial real estate debt and related guarantees.
We may be subject to risks associated with future advance obligations, such as declining real estate values and operating performance.
Our commercial real estate debt portfolio may include loans that require us to advance future funds. Future funding obligations subject us to significant risks that the property may have declined in value, projects to be completed with the additional funds may have cost overruns and the borrower may be unable to generate enough cash flow, or sell or refinance the property, in order to repay our commercial real estate loan due. We could determine that we need to fund more money than we originally anticipated in order to maximize the value of our investment even though there is no assurance additional funding would be the best course of action.
While we expect to align the maturities of our liabilities with the maturities on our assets, we may not be successful in that regard which could harm our operating results and financial condition.
Our general financing strategy will include the use of “match-funded” structures. This means that we will seek to align the maturities of our liabilities with the maturities on our assets in order to manage the risks of being forced to refinance our liabilities prior to the maturities of our assets. In addition, we plan to match interest rates on our assets with like-kind borrowings, so fixed-rate assets are financed with fixed-rate borrowings and floating-rate assets are financed with floating-rate borrowings, directly or indirectly through the use of interest rate swaps, caps and other financial instruments or through a combination of these strategies. We may fail to appropriately employ match-funded structures on favorable terms, or at all. We may also determine not to pursue a match-funded structure with respect to a portion of our financings for a variety of reasons. If we fail to appropriately employ match-funded structures, our exposure to interest rate volatility and exposure to matching liabilities prior to the maturity of the corresponding asset may increase substantially which could harm our operating results, liquidity and financial condition.
The use of estimates and valuations may be different from actual results, which could have a material adverse effect on our consolidated financial statements.
We make various estimates that affect reported amounts and disclosures. Broadly, those estimates are used in measuring the fair value of certain financial instruments, establishing provision for loan losses and potential litigation liability. Subsequent valuations, in light of factors then prevailing, may result in significant changes in the values of these financial instruments in future periods. In addition, at the time of any sales and settlements of these assets, the price we ultimately realize will depend on the demand and liquidity in the market at that time and may be materially lower than our estimate of their current fair value. Estimates are based on available information and judgment. Therefore, actual values and results could differ from our estimates, and that difference could have a material adverse effect on our consolidated financial statements.
Provision for loan losses is difficult to estimate.
Our provision for loan losses is evaluated on a quarterly basis. Our determination of provision for loan losses requires us to make certain estimates and judgments. Our estimates and judgments are based on a number of factors, including projected cash flows from the collateral securing our commercial real estate debt, debt structure, including the availability of reserves and recourse guarantees, likelihood of repayment in full at the maturity of a loan, loan-to-value ("LTV"), potential for refinancing and expected market discount rates for varying property types. Our estimates and judgments may not be correct and, therefore, our results of operations and financial condition could be severely impacted.
Our distribution policy is subject to change.
Our board of directors determines an appropriate common stock distribution based upon numerous factors, including our targeted distribution rate, REIT qualification requirements, the amount of cash flows provided by operating activities,
26
availability of existing cash balances, borrowing capacity under existing credit agreements, access to cash in the capital markets and other financing sources, general economic conditions and economic conditions that more specifically impact our business or prospects. Future distribution levels are subject to adjustment based upon any one or more of the risk factors set forth herein, as well as other factors that our board of directors may, from time-to-time, deem relevant to consider when determining an appropriate common stock distribution.
We may not be effective at managing our commercial real estate debt investments.
Managing commercial real estate debt investments requires significant resources, adherence to internal policies, attention to detail and significant judgment, and we may make decisions that result in losses. If we are unable to successfully originate debt investments on favorable terms, or at all, and if we are ineffective in managing those investments, our business, financial condition and results of operations could be materially adversely affected.
We may invest in properties in the healthcare industry, which is heavily regulated and could expose us to increased risk of loss.
Certain of our commercial real estate debt investments may consist of loans to borrowers engaged in various aspects of the healthcare industry. The healthcare industry is heavily regulated by federal, state and local governmental bodies. Healthcare facility operators generally are subject to laws and regulations covering, among other things, licensure, certification for participation in government programs and relationships with physicians and other referral sources. Changes in these laws and regulations could negatively affect the ability of our borrowers that operate healthcare facilities to satisfy their obligations to us and our ability to make distributions.
These and other risks may prevent us from being profitable or from realizing growth or maintaining the value of the real estate properties underlying our commercial real estate debt investments.
With respect to commercial real estate properties, options and other purchase rights may affect value or hinder recovery in the event of a foreclosure.
A borrower, under certain of our commercial real estate loans, may give its tenants or another person a right of first refusal or an option to purchase all or a portion of the related mortgaged property. These rights may impede our ability to sell the related property at foreclosure or may adversely affect the value or marketability of the property.
If we enter into joint ventures, our joint venture partners could take actions that decrease the value of an investment to us and lower our overall return.
We may enter into joint ventures with third parties to make investments. We may also make investments in partnerships or other co-ownership arrangements or participations. Such investments may involve risks not otherwise present with other methods of investment, including, for example, the following risks:
• | that our co-venturer or partner in an investment could become insolvent or bankrupt; |
• | that such co-venturer or partner may at any time have economic or business interests or goals that are or that become inconsistent with our business interests or goals; or |
• | that such co-venturer or partner may be in a position to take action contrary to our instructions or requests or contrary to our policies or objectives. |
Any of the above might subject us to liabilities and thus reduce our returns on our investment with that co-venturer or partner. In addition, disagreements or disputes between us and our co-venturer or partner could result in litigation, which could increase our expenses and potentially limit the time and effort our officers and directors are able to devote to our business.
Our platform may not be as scalable as we anticipate and we could face difficulties growing our business without significant new investment in our infrastructure.
Our platform for operating our lines of business may not be as scalable as we anticipate. If our business grows substantially, we or our Advisor may need to make significant new investment in infrastructure to support that growth. We may be unable to make significant investments in infrastructure on a timely basis or at reasonable costs and failure in this regard could disrupt our business and operations.
U.S. Federal Income Tax Risks
Our failure to continue to qualify as a REIT would subject us to corporate income tax and reduce our net income available for investment or distribution.
We intend to continue to operate in a manner so as to qualify as a REIT for federal income tax purposes. Qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which only a limited number of judicial and administrative interpretations exist. Even an inadvertent or technical mistake could jeopardize our REIT
27
status. Our continued qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis.
Moreover, new tax legislation, administrative guidance or court decisions, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to qualify as a REIT. If we were to fail to qualify as a REIT in any taxable year, we would be subject to federal and applicable state and local income tax on our taxable income at corporate rates. Losing our REIT status would reduce our net income available for investment or distribution to stockholders because of the additional tax liability. In addition, distributions to stockholders would no longer qualify for the dividends-paid deduction, and we would no longer be required to make distributions. If this occurs, we might be required to borrow or liquidate some investments in order to pay the applicable tax.
The failure of a mezzanine loan to qualify as a real estate asset could adversely affect our ability to qualify as a REIT.
The Internal Revenue Service ("IRS") has issued Revenue Procedure 2003-65, which provides a safe harbor pursuant to which a mezzanine loan that is secured by interests in a pass-through entity will be treated by the IRS as a real estate asset for purposes of the REIT tests, and interest derived from such loan will be treated as qualifying mortgage interest for purposes of the REIT 75% gross income test. Although the Revenue Procedure provides a safe harbor on which taxpayers may rely, it does not prescribe rules of substantive tax law. We may originate or acquire mezzanine loans that do not satisfy all of the requirements for reliance on the safe harbor set forth in the Revenue Procedure, in which case, there can be no assurance that the IRS will not challenge the tax treatment of such loans, which could jeopardize our ability to continue to qualify as a REIT.
Investors may have current tax liability on distributions if they elect to reinvest in our common stock.
Investors who participate in our DRIP, will be deemed to have received, for federal income tax purposes, a distribution equal to the amount reinvested in shares of our common stock and an additional distribution to the extent the shares are purchased at a discount to fair market value. Such amounts will be taxable distributions, to the extent of our current or accumulated earnings and profits. As a result, unless such investor is a tax-exempt entity, such investor may have to use cash from other sources to pay the tax liability on the value of the shares of common stock received.
Even if we continue to qualify as a REIT for federal income tax purposes, we may be subject to other tax liabilities that reduce our cash flow and our ability to make distributions.
Even if we continue to qualify as a REIT for federal income tax purposes, we may be subject to some federal, state and local taxes on our income or property. For example:
• | In order to qualify as a REIT, we must distribute annually at least 90% of our REIT taxable income (which is determined without regard to the dividends-paid deduction or net capital gain for this purpose) to our stockholders. To the extent that we satisfy the distribution requirement but distribute less than 100% of our REIT taxable income, we will be subject to federal corporate income tax on our undistributed income. |
• | We will be subject to a 4% nondeductible excise tax on the amount, if any, by which distributions we pay in any calendar year are less than the sum of 85% of our ordinary income, 95% of our capital gain net income and 100% of our undistributed income from prior years. |
• | If we have net income from the sale of foreclosure property that we hold primarily for sale to customers in the ordinary course of business or other non-qualifying income from foreclosure property, we must pay a tax on that income at the highest corporate income tax rate. |
• | If we sell an asset, other than a foreclosure property, that we hold primarily for sale to customers in the ordinary course of business, our gain would be subject to the 100% “prohibited transaction” tax. |
• | Any U.S. taxable REIT subsidiary ("TRS") of ours will be subject to federal corporate income tax on its taxable income, and non-arm’s length transactions between us and any TRS, for example, excessive rents charged to a TRS, could be subject to a 100% tax. |
REIT distribution requirements could adversely affect our ability to execute our business plan.
We generally must distribute annually at least 90% of our REIT taxable income (which for this purpose is determined without regard to the dividends-paid deduction or net capital gain) in order to continue to qualify as a REIT. We intend to continue to make distributions to our stockholders to comply with the REIT requirements of the Internal Revenue Code and to avoid corporate income tax and the 4% excise tax imposed on us if we distribute less than our required distribution in any calendar year. We may be required to make distributions to stockholders at times when it would be more advantageous to reinvest cash in our business or when we do not have cash readily available for distribution. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.
28
To maintain our REIT status, we may be forced to forgo otherwise attractive opportunities, which may delay or hinder our ability to meet our investment objectives and may reduce the overall return of any investment in us.
To continue to qualify as a REIT, we must satisfy certain tests on an ongoing basis concerning, among other things, the sources of our income, nature of our assets and the amounts we distribute to our stockholders. Compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits and the value of our common stock.
As a result of the securitization transaction we entered into in October 2015 and future securitization transactions, the “taxable mortgage pool” rules may increase the taxes that we or our stockholders incur, and may place limitations on the sale of certain interests in those securitization transactions.
In connection with the securitization transaction we entered into on October 19, 2015 (the “CLO Transaction”), we created a taxable mortgage pool for U.S. federal income tax purposes. In addition, securitization transactions we enter into in the future could result in the creation of such taxable mortgage pools. As a result of the CLO Transaction, we have generated “excess inclusion income” and may generate excess inclusion income as a result of future securitization transactions. Certain categories of stockholders, such as non-U.S. stockholders eligible for treaty or other benefits, stockholders with net operating losses, and certain tax-exempt stockholders that are subject to unrelated business income tax, will be subject to increased taxes on a portion of their dividend income from us that is attributable to any such excess inclusion income. In addition, to the extent that our common stock is owned by tax-exempt “disqualified organizations,” such as certain government-related entities and charitable remainder trusts that are not subject to tax on unrelated business income, we will incur a corporate-level tax on a portion of any excess inclusion income. In that case, we may reduce the amount of our distributions to any disqualified organization whose stock ownership gave rise to the tax. Moreover, we could face limitations in selling equity interests in these securitizations to outside investors, or selling any debt securities issued in connection with these securitizations that might be considered to be equity interests for tax purposes. These limitations may prevent us from using certain techniques to maximize our returns from securitization transactions.
The prohibited transactions tax may limit our ability to engage in transactions, including certain methods of securitizing mortgage loans that would be treated as sales for federal income tax purposes.
A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of assets, other than foreclosure property, held primarily for sale to customers in the ordinary course of business. We might be subject to the prohibited transaction tax if we were to dispose of, modify or securitize loans in a manner that is treated as a sale of the loans for federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales or modifications of loans at the REIT level and may limit the structures we utilize for our securitization transactions, even though the sales, modifications or structures might otherwise be beneficial to us. Additionally, we may be subject to the prohibited transaction tax upon a disposition of real property. Although a safe-harbor exception to prohibited transaction treatment is available, there can be no assurance that we can comply with the safe harbor or that we will avoid owning property that may be characterized as held primarily for sale to customers in the ordinary course of business.
It may be possible to reduce the impact of the prohibited transaction tax by conducting certain activities through a TRS. However, to the extent that we engage in such activities through a TRS, the income associated with such activities may be subject to full corporate income tax.
Complying with REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Internal Revenue Code may limit our ability to hedge our assets and operations. Under these provisions, any income that we generate from hedging transactions will be excluded from gross income for purposes of the REIT 75% and 95% gross income tests if the instrument hedges: (i) interest rate risk on liabilities incurred to carry or acquire real estate assets (each such hedge, a “Borrowings Hedge”); or (ii) risk of currency fluctuations with respect to any item of income or gain that would be qualifying income under the REIT 75% or 95% gross income tests (each such hedge, a “Currency Hedge”), and such instrument is properly identified under applicable U.S. Department of Treasury regulations ("Treasury Regulations"). Effective for taxable years beginning after December 31, 2015, this exclusion from the 95% and 75% gross income tests also will apply if we previously entered into a Borrowings Hedge or a Currency Hedge, a portion of the hedged indebtedness or property is disposed of, and in connection with such extinguishment or disposition we enter into a new properly identified hedging transaction to offset the prior hedging position. Income from hedging transactions that do not meet these requirements will generally constitute non-qualifying income for purposes of both the REIT 75% and 95% gross income tests. As a result, we may have to limit our use of hedging techniques that might otherwise be advantageous, which could result in greater risks associated with interest rate or other changes than we would otherwise incur.
29
Complying with REIT requirements may force us to liquidate otherwise attractive investments.
To continue to qualify as a REIT, we must ensure that at the end of each calendar quarter, at least 75% of the value of our assets consists of cash, cash items, government securities and qualifying real estate assets, including certain mortgage loans and mortgage-backed securities. The remainder of our investment in securities (other than government securities and qualified real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of our assets (other than government securities and qualified real estate assets) can consist of the securities of any one issuer, and no more than 25% (20% for taxable years beginning after December 31, 2017) of the value of our total assets can be represented by securities of one or more TRSs, and no more than 25% of the value of the Company’s total assets may be represented by debt instruments issued by publicly offered REITs that are “nonqualified” (e.g., not secured by real property or interests in real property).
If we fail to comply with these requirements at the end of any calendar quarter, we must correct the failure within 30 days after the end of the calendar quarter or qualify for certain statutory relief provisions to avoid losing our REIT qualification and suffering adverse tax consequences. As a result, we may be required to liquidate non-qualifying assets from our portfolio or refrain from making, otherwise attractive investments. These actions could have the effect of reducing our income and amounts available for distribution.
Complying with these requirements may also limit our ability to acquire mortgage loans at a discount. Under applicable Treasury Regulation, and Revenue Procedure 2014-51, a mortgage loan acquired at a discount may be treated as partially secured by real property with the result that only a portion of the loan would be treated as a qualified asset.
Liquidation of assets may jeopardize our REIT qualification.
To continue to qualify as a REIT, we must comply with requirements regarding our assets and our sources of income. If we are compelled to liquidate our investments to repay obligations to our lenders, we may be unable to comply with these requirements, ultimately jeopardizing our qualification as a REIT, or we may be subject to a 100% prohibited transaction tax on any resultant gain if we sell assets that are treated as dealer property or inventory.
Our acquisition of debt instruments may cause us to recognize income for federal income tax purposes even though no cash payments have been received on the debt instruments.
We may acquire debt instruments in the secondary market for less than their par amount. The amount of such discount will generally be treated as a “market discount” for federal income tax purposes. If these debt instruments provide for “payment-in-kind” interest, we may recognize “original issue discount” for federal income tax purposes. Moreover, we may acquire distressed debt investments that are subsequently modified by agreement with the borrower. If the amendments to the outstanding debt are “significant modifications” under the applicable Treasury Regulations, the modified debt may be considered to have been reissued to us in a debt-for-debt exchange with the borrower. In that event, if the debt is considered to be “publicly traded” for federal income tax purposes, the modified debt in our hands may be considered to have been issued with original issue discount to the extent the fair market value of the modified debt is less than the principal amount of the outstanding debt. In the event the debt is not considered to be “publicly traded” for federal income tax purposes, we may be required to recognize taxable income to the extent that the principal amount of the modified debt exceeds our cost of purchasing it. Also, certain loans that we originate and certain previously modified debt we acquire in the secondary market may be considered to have been issued with the original issue discount at the time it was modified.
In general, we will be required to accrue original issue discount on a debt instrument as taxable income in accordance with applicable federal income tax rules even though no cash payments may be received on such debt instrument.
In the event a borrower with respect to a particular debt instrument encounters financial difficulty rendering it unable to pay stated interest as due, we may nonetheless be required to continue to recognize the unpaid interest as taxable income as it accrues. Similarly, we may be required to accrue interest income with respect to subordinate mortgage-backed securities at the stated rate regardless of when their corresponding cash payments are received.
In order to meet the REIT distribution requirements, it might be necessary for us to arrange for short-term, or possibly long-term borrowings, or to pay dividends in the form of our shares or other taxable in-kind distributions of property. We may need to borrow at times when the market conditions are unfavorable. Such borrowings could increase our costs and reduce the value of our common stock. In the event in-kind distributions are made, tax liabilities associated with an investment in our common stock for a given year may exceed the amount of cash we distribute to our stockholders during such year.
30
Modification of the terms of our debt investments and mortgage loans underlying our CMBS in conjunction with reductions in the value of the real property securing such loans could cause us to fail to continue to qualify as a REIT.
Our debt and securities investments may be materially affected by a weak real estate market and economy in general. As a result, many of the terms of our debt and the mortgage loans underlying our securities may be modified to avoid taking title to a property. Under the Internal Revenue Code, if the terms of a loan are modified in a manner constituting a "significant modification," such modification triggers a deemed exchange of the original loan for the modified loan. In general, under applicable Treasury Regulations if a loan is secured by real property and other property and the highest principal amount of the loan outstanding during a taxable year exceeds the fair market value of the real property securing the loan determined as of the date we agreed to acquire the loan or the date we significantly modified the loan, a portion of the interest income from such loan will not be qualifying income for purposes of the 75% gross income test, but will be qualifying income for purposes of the 95% gross income test. Although the law is not entirely clear, a portion of the loan will likely be a non-qualifying asset for purposes of the 75% asset test. The non-qualifying portion of such a loan would be subject to, among other requirements, the requirement that a REIT not hold securities possessing more than 10% of the total value of the outstanding securities of any one issuer ("10% Value Test").
IRS Revenue Procedure 2014-51 provides a safe harbor pursuant to which we will not be required to redetermine the fair market value of real property securing a loan for purposes of the gross income and asset tests discussed above in connection with a loan modification that is: (i) occasioned by a borrower default; or (ii) made at a time when we reasonably believe that the modification to the loan will substantially reduce a significant risk of default on the original loan. No assurance can be provided that all of our loan modifications have or will qualify for the safe harbor in Revenue Procedure 2014-51. To the extent we significantly modify loans in a manner that does not qualify for that safe harbor, we will be required to redetermine the value of the real property securing the loan at the time it was significantly modified. In determining the value of the real property securing such a loan, we generally will not obtain third-party appraisals, but rather will rely on internal valuations. No assurance can be provided that the IRS will not successfully challenge our internal valuations. If the terms of our debt investments and the mortgage loans underlying our CMBS are "significantly modified" in a manner that does not qualify for the safe harbor in Revenue Procedure 2014-51 and the fair market value of the real property securing such loans has decreased significantly, we could fail the 75% gross income test, the 75% asset test and/or the 10% Value Test. Unless we qualified for relief under certain Internal Revenue Code cure provisions, such failures could cause us to fail to continue to qualify as a REIT.
Our qualification as a REIT may depend upon the accuracy of legal opinions or advice rendered or given or statements by the issuers of assets we acquire.
When purchasing securities, we may rely on opinions or advice of counsel for the issuer of such securities, or statements made in related offering documents, for purposes of determining, among other things, whether such securities represent debt or equity securities for U.S. federal income tax purposes, the value of such securities and to what extent those securities constitute qualified real estate assets for purposes of the REIT asset tests and produce qualified income for purposes of the 75% gross income test. The inaccuracy of any such opinions, advice or statements may adversely affect our ability to qualify as a REIT.
Dividends paid by REITs do not qualify for the reduced tax rates that apply to other corporate dividends.
The maximum tax rate for “qualified dividends” paid by corporations to individuals is currently 20%. Dividends paid by REITs, however, generally are taxed at the normal ordinary income rate applicable to the individual recipient (currently subject to a maximum rate of 39.6%). The more favorable rates applicable to regular corporate dividends could cause potential investors who are individuals to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay qualified dividends, which could adversely affect the value of the stock of REITs, including our common stock.
Recharacterization of sale-leaseback transactions may cause us to lose our REIT status.
If we enter into sale-leaseback transactions, we will use commercially reasonable efforts to structure any such sale-leaseback transaction such that the lease will be characterized as a “true lease” for tax purposes, thereby allowing us to be treated as the owner of the property for U.S. federal income tax purposes. However, there can be no assurance that the IRS will not challenge such characterization. In the event that any such sale-leaseback transaction is challenged and recharacterized as a financing transaction or loan for U.S. federal income tax purposes, deductions for depreciation and cost recovery relating to such property would be disallowed. If a sale-leaseback transaction were so recharacterized, we might fail to satisfy the REIT qualification “asset tests” or “income tests” and, consequently, lose our REIT status effective with the year of recharacterization. Alternatively, the amount of our REIT taxable income could be recalculated which might also cause us to fail to meet the distribution requirement for a taxable year.
31
If we were considered to actually or constructively pay a “preferential dividend” to certain of our stockholders, our status as a REIT could be adversely affected.
In order to qualify as a REIT, we must distribute annually to our stockholders at least 90% of our REIT taxable income (which does not equal net income as calculated in accordance with GAAP), determined without regard to the deduction for dividends paid and excluding net capital gain. For taxable years ending on or before December 31, 2014, in order for distributions to be counted as satisfying the annual distribution requirements for REITs, and to provide us with a REIT-level tax deduction, the distributions must not have been “preferential dividends.” A dividend is not a preferential dividend if the distribution is pro rata among all outstanding shares of stock within a particular class and in accordance with the preferences among different classes of stock as set forth in our organizational documents. For the taxable year that began on January 1, 2015 and all future taxable years, so long as we continue to be a "publicly offered REIT" (i.e., a REIT which is required to file annual and periodic reports with the SEC under the Exchange Act), the preferential dividend rule will not apply to us. Currently, there is uncertainty as to the IRS’s position regarding whether certain arrangements that REITs have with their stockholders could give rise to the inadvertent payment of a preferential dividend (e.g., the pricing methodology for stock purchased under a distribution reinvestment plan inadvertently causing a greater than 5% discount on the price of such stock purchased). During calendar years 2013 and 2014, the per share price for our common stock pursuant to our DRIP was $23.75, which was 95% of the primary offering price of $25.00. Currently, the per share price for our common stock pursuant to our DRIP is $25.27, which is our most recently calculated estimated per share NAV
There is no de minimis exception with respect to preferential dividends. Therefore, if the IRS were to take the position that we paid a preferential dividend, we may be deemed either to (a) have distributed less than 100% of our REIT taxable income and be subject to tax on the undistributed portion, or (b) have distributed less than 90% of our REIT taxable income, and our status as a REIT could be terminated for the year in which such determination is made if we were unable to cure such failure.
Non-U.S. stockholders will be subject to U.S. federal withholding tax and may be subject to U.S. federal income tax on distributions received from us and upon the disposition of our shares.
Subject to certain exceptions, distributions received from us will be treated as dividends of ordinary income to the extent of our current or accumulated earnings and profits. Such dividends ordinarily will be subject to U.S. withholding tax at a 30% rate, or such lower rate as may be specified by an applicable income tax treaty, unless the distributions are treated as "effectively connected" with the conduct by the non-U.S. stockholder of a U.S. trade or business. Pursuant to the Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA"), capital gain distributions attributable to sales or exchanges of "U.S. real property interests" ("USRPIs"), generally will be taxed to a non-U.S. stockholder as if such gain were effectively connected with a U.S. trade or business. However, a capital gain distribution will not be treated as effectively connected income if (a) the distribution is received with respect to a class of stock that is regularly traded on an established securities market located in the United States and (b) the non-U.S. stockholder does not own more than 5% of the class of our stock at any time during the one-year period ending on the date the distribution is received. We do not anticipate that our shares will be "regularly traded" on an established securities market for the foreseeable future, and therefore, this exception is not expected to apply.
Gain recognized by a non-U.S. stockholder upon the sale or exchange of our common stock generally will not be subject to U.S. federal income taxation unless such stock constitutes a USRPI under FIRPTA. Our common stock will not constitute a USRPI so long as we are a "domestically-controlled qualified investment entity." A domestically-controlled qualified investment entity includes a REIT if at all times during a specified testing period, less than 50% in value of such REIT's stock is held directly or indirectly by non-U.S. stockholders. We believe, but cannot assure our stockholders, that we will be a domestically-controlled qualified investment entity.
Even if we do not qualify as a domestically-controlled qualified investment entity at the time a non-U.S. stockholder sells or exchanges our common stock, gain arising from such a sale or exchange would not be subject to U.S. taxation under FIRPTA as a sale of a USRPI if: (a) our common stock is "regularly traded," as defined by applicable Treasury regulations, on an established securities market, and (b) such non-U.S. stockholder owned, actually and constructively, 5% or less of our common stock at any time during the five-year period ending on the date of the sale. However, it is not anticipated that our common stock will be "regularly traded" on an established market. We encourage our stockholders to consult their tax advisor to determine the tax consequences applicable to our stockholders if they are non-U.S. stockholders.
Employee Benefit Plan and IRA Risks
If certain investors fail to meet the fiduciary and other standards under the Employment Retirement Income Security Act of 1974 ("ERISA") or the Internal Revenue Code as a result of an investment in our stock, such investors could be subject to criminal and civil penalties.
Special considerations apply to the purchase of shares by employee benefit plans subject to the fiduciary rules of Title I of ERISA, including pension or profit sharing plans and entities that hold assets of such plans ("ERISA Plans") and plans and accounts that are not subject to ERISA, but are subject to the prohibited transaction rules of Section 4975 of the Internal Revenue Code, including IRAs, Keogh Plans and medical savings accounts (collectively, we refer to ERISA Plans and plans
32
subject to Section 4975 of the Internal Revenue Code as “Benefit Plans”). If an investor is investing the assets of any Benefit Plan, such investors should be satisfied that:
• | any investment is consistent with the its fiduciary obligations under ERISA and the Internal Revenue Code, or any other applicable governing authority in the case of a government plan; the investment is made in accordance with the documents and instruments governing the Benefit Plan, including the Benefit Plan’s investment policy; |
• | the investment satisfies the prudence and diversification requirements of Sections 404(a)(1)(B) and 404(a)(1)(C) of ERISA, if applicable, and other applicable provisions of ERISA and the Internal Revenue Code; |
• | the investment will not impair the liquidity of the Benefit Plan; |
• | the investment will not produce unrelated business taxable income for the Benefit Plan; |
• | they will be able to value the assets of the Benefit Plan annually in accordance with the applicable provisions of ERISA and the Internal Revenue Code; and |
• | the investment will not constitute a non-exempt prohibited transaction under Section 406 of ERISA or Section 4975 of the Internal Revenue Code. |
Fiduciaries may be held personally liable under ERISA for losses as a result of failure to satisfy the fiduciary standards of conduct and other applicable requirements of ERISA. In addition, if an investment in our shares constitutes a non-exempt prohibited transaction under ERISA or the Internal Revenue Code, the fiduciary of the Benefit Plan who authorized or directed the investment may be subject to imposition of excise taxes with respect to the amount invested and an IRA investing in our shares may lose its tax-exempt status.
Governmental plans, church plans and foreign plans that are not subject to ERISA or the prohibited transaction rules of the Internal Revenue Code, may be subject to similar restrictions under other laws. A plan fiduciary making an investment in our shares on behalf of such a plan should satisfy themselves that an investment in our shares satisfies both applicable law and is permitted by the governing plan documents.
Item 1B. Unresolved Staff Comments.
None.
Item 2. Properties.
Our headquarters are located in leased space at 405 Park Avenue, 14th Floor, New York, New York 10022.
Item 3. Legal Proceedings.
We are not a party to any material, pending legal proceedings.
Item 4. Mine Safety Disclosures.
Not applicable.
33
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
No public trading market currently exists for our shares of common stock and we currently have no plans to list our shares on a national securities exchange. Until our shares are listed on a national securities exchange, if ever, our stockholders may not sell their shares unless the buyer meets the applicable suitability and minimum purchase requirements. In addition, our charter prohibits the ownership of more than 9.8% in value of the aggregate of our outstanding shares of stock or more than 9.8% (in value or in number of shares, whichever is more restrictive) of any class or series of shares of our stock by a single investor, unless exempted by our board of directors. Consequently, there is the risk that our stockholders may not be able to sell their shares at a time or price acceptable to them. On November 4, 2015, the Board, upon the recommendations of the Advisor and the Board’s Conflicts Committee, unanimously approved and established an estimated NAV per share of the Company’s common stock of $25.27. The estimated per share NAV is based upon the estimated value of the Company’s assets less the Company’s liabilities as of September 30, 2015. This valuation was performed in accordance with the provisions of Practice Guideline 2013-01, Valuations of Publicly Registered Non-Listed REITs, issued by the Investment Program Association in April 2013. See our current report on Form 8-K filed with the SEC on November 12, 2015 for our methodology for calculating our estimated per-share NAV.
There is no public trading market for the shares at this time, and there can be no assurance that stockholders would receive $25.27 per share if such a market did exist and they sold their shares or that they will be able to receive such amount for their shares in the future. Nor does this deemed value reflect the distributions that stockholders would be entitled to receive if our investments were sold and the sale proceeds were distributed upon liquidation of our assets. Such a distribution upon liquidation may be less than $25.27 per share for various reasons including changes in values between the September 30, 2015 valuation date and the date of any liquidation.
We are currently offering our shares for $25.27 pursuant to the DRIP.
Holders
As of February 29, 2016, we had 31,561,665 shares of common stock outstanding held by a total of 16,694 stockholders.
Distributions
We have elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code commencing with the taxable year ended December 31, 2013. As a REIT, we generally will not be subject to federal corporate income tax as long as we distribute at least 90% of our REIT taxable income to our stockholders. REITs are subject to a number of other organizational and operational requirements. Even if we continue to qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income and property and federal income and excise taxes on our undistributed income.
On May 13, 2013, our board of directors authorized, and we declared a distribution, which is calculated based on stockholders of record each day during the applicable period at a rate of $0.00565068493 per day. Our distributions are payable by the fifth day following each month end to stockholders of record at the close of business each day during the prior month. Distribution payments are dependent on the availability of funds. The board of directors may reduce the amount of distributions paid or suspend distribution payments at any time, and therefore, distribution payments are not assured.
The following table reflects distributions paid in cash and through the DRIP to common stockholders during the years ended December 31, 2015 and 2014 (in thousands):
Year Ended December 31, | |||||||||||||
2015 | 2014 | ||||||||||||
Distributions: | |||||||||||||
Cash distributions paid | $ | 26,949 | $ | 7,592 | |||||||||
Distributions reinvested | 20,161 | 5,027 | |||||||||||
Total distributions | $ | 47,110 | $ | 12,619 | |||||||||
Source of distribution coverage: | |||||||||||||
Cash flows provided by operations | $ | 25,433 | 54.0 | % | $ | 2,685 | 21.3 | % | |||||
Proceeds from issuance of common stock | 1,516 | 3.2 | % | 4,907 | 38.9 | % | |||||||
Common stock issued under DRIP | 20,161 | 42.8 | % | 5,027 | 39.8 | % | |||||||
Total sources of distributions | $ | 47,110 | 100.0 | % | $ | 12,619 | 100.0 | % | |||||
Cash flows provided by operations (GAAP) | $ | 25,433 | $ | 2,685 | |||||||||
Net income (GAAP) | $ | 24,933 | $ | 5,415 | |||||||||
34
Share-Based Compensation
Restricted Share Plan
We have an employee and director incentive restricted share plan (the “RSP”), which provides us with the ability to grant awards of restricted shares to our directors, officers, and employees (if we ever have employees), employees of the Advisor and its affiliates, employees of entities that provide services to us, directors of the Advisor or of entities that provide services to us or certain consultants to us and the Advisor and its affiliates. The total number of common shares granted under the RSP shall not exceed 5.0% of our authorized common shares, and in any event, will not exceed 4.0 million shares (as such number may be adjusted for stock splits, stock dividends, combinations, and similar events).
Restricted share awards entitle the recipient to receive common shares from us under terms that provide for vesting over a specified period of time or upon attainment of pre-established performance objectives. Such awards would typically be forfeited with respect to the unvested shares upon the termination of the recipient’s employment or other relationship with us. Restricted shares may not, in general, be sold or otherwise transferred until restrictions are removed and the shares have vested. Holders of restricted shares may receive cash distributions prior to the time that the restrictions on the restricted shares have lapsed. Any distributions payable in common shares shall be subject to the same restrictions as the underlying restricted shares. The fair value of the restricted shares will be expensed over the vesting period of five years.
The RSP also provides for the automatic grant of 1,333 restricted shares of common stock to each of the independent directors, without any further action by our board of directors or the stockholders, on the date of initial election to the board of directors and on the date of each annual stockholder’s meeting. Restricted stock issued to independent directors will vest over a five-year period following the first anniversary of the date of grant in increments of 20.0% per annum.
As of December 31, 2015, we have granted 10,666 restricted shares to our independent directors of which 1,867 shares have vested and 2,399 shares were forfeited. Based on a share price of $22.50, the compensation expense associated with the restricted share grants was $29,588 for the year ended December 31, 2015. Additionally, we recorded a distribution payable of $1,120 at December 31, 2015 in connection with these shares.
The following table provides information about our common stock that may be issued under our RSP as of December 31, 2015:
Plan Category | Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights | Weighted-Average Exercise of Price of Outstanding Options, Warrants, and Rights | Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans | |||
Equity compensation plans approved by security holders | — | — | — | |||
Equity compensation plans not approved by security holders | — | — | 3,989,334 | |||
Total | — | — | 3,989,334 | |||
Recent Sale of Unregistered Equity Securities
None
Use of Proceeds from Sales of Registered Securities
On February 12, 2013, the SEC declared effective our Registration Statement on Form S-11 (File No. 333-186111) filed under the Securities Act, and we commenced a primary offering of our common stock to the public (the "Offering" on a "reasonable best efforts" basis of up to a maximum of $2.0 billion of common stock, consisting of up to 80.0 million shares. The Registration Statement also registered approximately 16.8 million shares of common stock pursuant the DRIP under which common stockholders may elect to have their distributions reinvested in additional shares of common stock. Effective January 2016, the Company terminated the Offering, deregistered 4,069 unsold shares from the Offering and reallocated 49.7 million unsold shares from the Offering to the DRIP offering. As of December 31, 2015, we have issued 31,385,280 shares of our common stock and have raised $780.8 million of offering proceeds, net of redemptions and including shares pursuant to the DRIP and share-based compensation.
35
The following table reflects the offering costs associated with the issuance of common stock (in thousands):
As of December 31, 2015 | ||||
Selling commissions and dealer manager fees | $ | 72,987 | ||
Other offering expenses | 16,080 | |||
Total offering expenses | $ | 89,067 | ||
We are responsible for the organizational and offering costs of the Offering, excluding commissions and dealer manager fees, up to a maximum of 2.0% of the gross proceeds received from the Offering, measured at the end of the Offering. Organizational and offering costs in excess of the 2.0% cap as of the end of the Offering are the Advisor's responsibility. As of December 31, 2015, organizational and offering costs exceeded the 2.0% cap by $0.8 million.
As of December 31, 2015, our net offering proceeds, after deducting the total offering expenses outlined above, were approximately $691.7 million. We used the net offering proceeds from the Offering and other financing sources to acquire 77 loans and 16 investments in CMBS with a total carrying value of $1,125.1 million for our loans, and our CMBS investments had a fair value of $130.8 million as of December 31, 2015.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
Our Board unanimously approved an amended and restated share repurchase program (the “SRP”), which became effective on February 28, 2016. The SRP enables stockholders to sell their shares to us. Subject to certain conditions, stockholders that purchased shares of our common stock or received their shares from us (directly or indirectly) through one or more non-cash transactions and have held their shares for a period of at least one year may request that we repurchase their shares of common stock so long as the repurchase otherwise complies with the provisions of Maryland law. Repurchase requests made following the death or qualifying disability of a stockholder will not be subject to any minimum holding period.
The repurchase price per share for requests other than for death or disability will be equal to the most-recent estimated net asset value per share of our common stock calculated by our Advisor in accordance with our valuation guidelines, or estimated per-share NAV, multiplied by a percentage equal to (i) 92.5%, if the person seeking repurchase has held his or her shares for a period greater than one year and less than two years; (ii) 95%, if the person seeking repurchase has held his or her shares for a period greater than two years and less than three years; (iii) 97.5%, if the person seeking repurchase has held his or her shares for a period greater than three years and less than four years; or (iv) 100%, if the person seeking repurchase has held his or her shares for a period greater than four years. In the case of requests for death or disability, the repurchase price per share will be equal to the estimated per-share NAV at the time of repurchase.
Repurchases pursuant to the SRP, when requested, generally will be made semiannually (each six-month period ending June 30 or December 31, a “fiscal semester”). Repurchases for any fiscal semester will be limited to a maximum of 2.5% of the weighted average number of shares of common stock outstanding during the previous fiscal year, with a maximum for any fiscal year of 5.0% of the weighted average number of shares of common stock outstanding during the previous fiscal year. Funding for repurchases pursuant to the SRP for any given fiscal semester will be limited to proceeds received during that same fiscal semester through the issuance of common stock pursuant to any DRIP in effect from time to time, provided that the Board has the power, in its sole discretion, to determine the amount of shares repurchased during any fiscal semester as well as the amount of funds to be used for that purpose. Due to these limitations, we cannot guarantee that we will be able to accommodate all repurchase requests made during any fiscal semester or fiscal year. However, a stockholder may withdraw its request at any time or ask that we honor the request when funds are available. Pending repurchase requests will be honored on a pro rata basis. We will generally pay repurchase proceeds, less any applicable tax or other withholding required by law, by the 31st day following the end of the fiscal semester during which the repurchase request was made.
Calculations of our estimated per-share NAV will occur periodically, at the discretion of the Board, provided that such calculations will be made at least annually. Following its calculation, our estimated per-share NAV will be disclosed in a periodic report. The most recent calculation of our estimated per-share NAV approved by the Board occurred on November 4, 2015 based on our net asset value as of September 30, 2015 and was equal to $25.27.
When a stockholder requests redemption and the redemption is approved, we will reclassify such obligation from equity to a liability based on the settlement value of the obligation. Shares repurchased under the SRP will have the status of authorized but unissued shares.
We are only authorized to repurchase shares pursuant to the SRP using the proceeds received from the DRIP and will limit the amount spent to repurchase shares in a given quarter to the amount of proceeds received from the DRIP in that same quarter. In addition, the board of directors may reject a request for redemption at any time. Due to these limitations, we cannot guarantee that it will be able to accommodate all repurchase requests. Purchases under the SRP will be limited in any calendar year to 5% of the weighted average number of shares outstanding on December 31 of the previous calendar year.
The following table reflects the number of shares repurchased under the SRP cumulatively through December 31, 2015:
36
Number of Requests | Number of Shares Repurchased (1) | Average Price per Share | |||||||
Cumulative as of January 1, 2013 | — | — | — | ||||||
Year ended December 31, 2013 | 1 | 1,400 | 25.00 | ||||||
Cumulative as of December 31, 2013 | 1 | 1,400 | 25.00 | ||||||
Year ended December 31, 2014 | 9 | 19,355 | 23.94 | ||||||
Cumulative as of December 31, 2014 | 10 | 20,755 | 24.01 | ||||||
Year ended December 31, 2015 (1) | 291 | 360,719 | 23.70 | ||||||
Cumulative as of December 31, 2015 | 301 | 381,474 | 23.72 | ||||||
________________________
1As permitted under the SRP, in January 2016, our board of directors authorized, with respect to redemption requests received during the quarter ended December 31, 2015, the repurchase of shares validly submitted for repurchase in an amount such that the aggregate amount of shares repurchased pursuant to redemption requests received for the year-ended December 31, 2015 equaled 5.0% of the weighted average number of shares of common stock outstanding during the previous fiscal year. Accordingly, 274,921 shares at an average per share of $23.37 (including all shares submitted for death and disability) were approved for repurchase and completed in February 2016, while 1,309,471 shares at an average price per share of $23.38 were not fulfilled. There were no other unfulfilled share repurchases for the period from January 1, 2013 to December 31, 2015.
Item 6. Selected Financial Data.
The following selected financial data as of December 31, 2015 and 2014 and for the years ended December 31, 2015, 2014, 2013 and 2012 should be read in conjunction with the accompanying consolidated financial statements and related notes thereto and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" below:
December 31, | ||||||||
Balance sheet data (in thousands) | 2015 | 2014 | ||||||
Commercial mortgage loans, held for investment, net | $ | 1,124,201 | $ | 456,884 | ||||
Real estate securities, at fair value | 130,754 | 50,234 | ||||||
Total assets | 1,282,484 | 514,220 | ||||||
Collateralized loan obligations | 287,229 | — | ||||||
Repurchase agreements - commercial mortgage loans | 206,239 | 150,169 | ||||||
Repurchase agreements - real estate securities | 117,211 | 26,269 | ||||||
Total liabilities | 628,155 | 183,713 | ||||||
Total equity | 654,329 | 330,507 | ||||||
37
Year Ended December 31, | ||||||||||||||||
Operating data (in thousands) | 2015 | 2014 | 2013 | 2012* | ||||||||||||
Net interest income: | ||||||||||||||||
Interest income | $ | 59,393 | $ | 15,466 | $ | 775 | $ | — | ||||||||
Interest expense | 12,268 | 2,196 | 32 | — | ||||||||||||
Net interest income | 47,125 | 13,270 | 743 | — | ||||||||||||
Expenses: | ||||||||||||||||
Acquisition fees | 7,916 | 4,386 | — | — | ||||||||||||
Loan loss provision | 318 | 570 | — | — | ||||||||||||
Other expenses | 13,958 | 2,802 | 641 | 16 | ||||||||||||
Total expenses | 22,192 | 7,758 | 641 | 16 | ||||||||||||
Gain on sale of loans | — | 112 | — | — | ||||||||||||
Income (loss) before income taxes | 24,933 | 5,624 | 102 | (16 | ) | |||||||||||
Income tax provision | — | 209 | — | — | ||||||||||||
Net income (loss) | 24,933 | 5,415 | 102 | (16 | ) | |||||||||||
Basic net income per share | $ | 1.03 | $ | 0.75 | $ | 0.19 | NM | |||||||||
Diluted net income per share | $ | 1.03 | $ | 0.75 | $ | 0.19 | NM | |||||||||
Basic weighted average shares outstanding | 24,253,905 | 7,227,169 | 526,084 | 8,888 | ||||||||||||
Diluted weighted average shares outstanding | 24,259,169 | 7,232,559 | 530,096 | 8,888 | ||||||||||||
Distributions per common share | $ | 2.06 | $ | 2.06 | $ | 1.22 | $ | — | ||||||||
________________________
* For the period from November 15, 2012 (inception) to December 31, 2012
NM - Not Meaningful
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the accompanying financial statements of Realty Finance Trust, Inc. the notes thereto and other financial information included elsewhere in this Annual Report on Form 10-K. As used herein, the terms "we," "our" and "us" refer to Realty Finance Trust, Inc., a Maryland corporation, and, as required by context, to Realty Finance Operating Partnership, L.P., a Delaware limited partnership, which we refer to as the "OP," and to its subsidiaries. We are externally managed by Realty Finance Advisors, LLC (our "Advisor"), a Delaware limited liability company.
The forward-looking statements contained in this Annual Report on Form 10-K may include, but are not limited to, statements as to:
• | our business and investment strategy; |
• | our ability to make investments in a timely manner or on acceptable terms; |
• | current credit market conditions and our ability to obtain long-term financing for our investments in a timely manner and on terms that are consistent with what we project when we invest; |
• | the effect of general market, real estate market, economic and political conditions, including the recent economic slowdown and dislocation in the global credit markets; |
• | our ability to make scheduled payments on our debt obligations; |
• | our ability to generate sufficient cash flows to make distributions to our stockholders; |
• | our ability to generate sufficient debt and equity capital to fund additional investments; |
• | the degree and nature of our competition; |
• | the availability of qualified personnel; |
• | our ability to maintain our qualification as a REIT; and |
• | other factors set forth under the caption "Risk Factors" in this Annual Report on Form 10-K. |
38
In addition, words such as "anticipate," "believe," "expect" and "intend" indicate a forward-looking statement, although not all forward-looking statements include these words. The forward-looking statements contained in this Annual Report on Form 10-K involve risks and uncertainties. Our actual results could differ materially from those implied or expressed in the forward-looking statements for any reason.
Our investors should not place undue reliance on these forward-looking statements. The forward-looking statements made in this Annual Report on Form 10-K relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date of this Annual Report on Form 10-K.
Overview
We were incorporated in Maryland on November 15, 2012 and conduct our operations to qualify as a REIT for U.S. federal income tax purposes beginning with the taxable year ended December 31, 2013. On May 14, 2013, we commenced business operations after raising in excess of $2.0 million of equity, the amount require for us to release equity proceeds from escrow. We originate, acquire and manage a diversified portfolio of commercial real estate debt secured by properties located both within and outside of the United States. We also invest in commercial real estate securities. Commercial real estate debt investments may include first mortgage loans, subordinated mortgage loans, mezzanine loans and participations in such loans. Commercial real estate securities may include CMBS, senior unsecured debt of publicly traded REITs, debt or equity securities of other publicly traded real estate companies and CDOs. The Company has no direct employees. The Company has retained Advisor to manage the Company's affairs on a day-to-day basis. The Advisor is under common control with the parent of the Sponsor, and will receive compensation and fees for services related to the investment and management of our assets. The Advisor receives fees during the offering, acquisition, operational and liquidation stages.
Prior to January 2016, we were offering for sale a maximum of $2.0 billion of common stock, $0.01 par value per share, on a reasonable best efforts basis, pursuant to a registration statement on Form S-11 filed with the SEC under the Securities Act of 1933, as amended (the "Securities Act"). The Offering also covered the offer and sale of up to approximately $400.0 million in shares of common stock pursuant to a DRIP under which common stockholders may elect to have their distributions reinvested in additional shares of common stock. Effective January 2016, we terminated the Offering, deregistered 4,069 unsold shares from the Offering and reallocated 49.7 million unsold shares from the Offering to the DRIP offering.
Prior to the NAV Pricing Date (as described below), we offered shares of our common stock in the primary offering through Realty Capital Securities, LLC (the "Former Dealer Manager") at a per share price of up to $25.00 per share (including the maximum allowed to be charged for commissions and fees, subject to certain discounts as described in our prospectus). Prior to the NAV pricing date, we offered shares of our common stock pursuant to a the DRIP at a per share price of $23.75. The cost to raise capital for the year ended December 31, 2015 was 11.3% of the gross proceeds (inclusive of DRIP) received during the same period.
On November 4, 2015, our board of directors unanimously determined an estimated NAV per share of our common stock of $25.27 as of September 30, 2015. The estimated NAV per share is based upon the estimated value of our assets less our liabilities as of September 30, 2015. The conflicts committee of the board of directors approved the engagement of Duff & Phelps, LLC, an independent third-party real estate advisory firm, who performed appraisals of our assets in accordance with our valuation guidelines. Our Advisor calculated the estimated NAV per share, and the conflicts committee of our board of directors, which is comprised solely of our independent directors, approved and recommended to our board of directors the estimated NAV per share calculated by our Advisor. The valuation was performed in accordance with the provisions of Practice Guideline 2013-01, Valuations of Publicly Registered Non-Listed REITs, issued by the Investment Program Association in April 2013.
As of close of business on November 10, 2015 (the “NAV pricing date”), pursuant to the net asset value (“NAV”) calculation described herein, we began offering shares of our common stock in the Offering at a price of up to $28.08 per share, inclusive of applicable commissions and Former Dealer Manager fees, and through the DRIP at a price equal to $25.27 per share, the NAV per share. As noted above, we have terminated the Offering. The per share price for our DRIP offering will be equal to our per share NAV, divided by the number of shares of our common stock outstanding as of such date.
We have no direct employees. Our Advisor has been retained by us to manage our affairs on a day-to-day basis. The Advisor is under common control with AR Global, the parent of our Sponsor, as a result of which they are related parties, and each, including our former dealer manager, Realty Capital Securities, LLC (the “Former Dealer Manager”), have received or will receive compensation, fees and expense reimbursements for services related to the Offering, the investment and management of our assets, our operations and our liquidation.
Our Former Dealer Manager served as the dealer manager of our primary offering and, together with certain of its affiliates, continued to provide us with services through December 31, 2015. RCS Capital Corporation, the parent company of
39
the Former Dealer Manager and certain of its affiliates that provided us with services, filed for Chapter 11 bankruptcy protection in January 2016, prior to which it was also under common control with AR Global, the parent of our Sponsor.
Significant Accounting Estimates and Critical Accounting Policies
Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Critical accounting policies are those that require the application of management’s most difficult, subjective or complex judgments, often because of the need to make estimates about the effect of matters that are inherently uncertain and that may change in subsequent periods. In preparing the financial statements, management has made estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. In preparing the financial statements, management has utilized available information, including our past history, industry standards and the current economic environment, among other factors, in forming its estimates and judgments, giving due consideration to materiality. Actual results may differ from these estimates. In addition, other companies may utilize different estimates, which may impact the comparability of our results of operations to those of companies in similar businesses. As our expected operating plans occur, we will describe additional critical accounting policies in the notes to our future financial statements in addition to those discussed below.
Set forth below is a summary of the significant accounting estimates and critical accounting policies that management believes are important to the preparation of our financial statements. Certain of our accounting estimates are particularly important for an understanding of our financial position and results of operations and require the application of significant judgment by our management. As a result, these estimates are subject to a degree of uncertainty.
Acquisition Fees and Expenses
We incur acquisition fees and acquisition expenses payable to the Advisor. We pay the Advisor an acquisition fee based on principal amount funded by us to originate or acquire commercial mortgage loans or on the anticipated net equity funded by us to acquire real estate securities. Acquisition fees paid and acquisition expenses reimbursed to our Advisor in connection with the origination and acquisition of commercial mortgage loans and acquisition of real estate securities are evaluated based on the nature of the expense to determine if they should be expensed in the period incurred or capitalized and amortized over the life of the investment.
Commercial Mortgage Loans
Commercial mortgage loans are held for investment purposes and are anticipated to be held until maturity, and accordingly, are carried at cost, net of unamortized acquisition expenses, discounts or premiums and unfunded commitments. Commercial mortgage loans that are deemed to be impaired will be carried at amortized cost less a specific allowance for loan losses. Interest income is recorded on the accrual basis and related discounts, premiums and acquisition expenses on investments are amortized over the life of the investment using the effective interest method. Amortization is reflected as an adjustment to interest income in our consolidated statements of operations. Guaranteed loan exit fees payable by the borrower upon maturity are accreted over the life of the investment using the effective interest method. The accretion of guaranteed loan exit fees is recognized in interest income in our consolidated statements of operations and the associated receivable is included in the consolidated balance sheet.
Allowance for Loan Losses
The allowance for loan losses reflects management's estimate of loan losses inherent in the loan portfolio as of the balance sheet date. The reserve is increased through the loan loss provision on the Company's consolidated statement of operations and is decreased by charge-offs when losses are confirmed through the receipt of assets, such as cash in a pre-foreclosure sale or upon ownership control of the underlying collateral in full satisfaction of the loan upon foreclosure or when significant collection efforts have ceased. The Company uses a uniform process for determining its allowance for loan losses. The allowance for loan losses includes a general, formula-based component and an asset-specific component.
General reserves are recorded when (i) available information as of each balance sheet date indicates that it is probable a loss has occurred in the portfolio and (ii) the amount of the loss can be reasonably estimated. The Company currently estimates loss rates based on historical realized losses experienced in the industry and takes into account current collateral and economic conditions affecting the probability and severity of losses when establishing the allowance for loan losses. The Company performs a comprehensive analysis of its loan portfolio and assigns risk ratings to loans that incorporate management's current judgments about their credit quality based on all known and relevant internal and external factors that may affect collectability. The Company considers, among other things, payment status, lien position, borrower financial resources and investment in collateral, collateral type, project economics and geographic location as well as national and regional economic factors. This methodology results in loans being segmented by risk classification into risk rating categories that are associated with estimated
40
probabilities of default and principal loss. Ratings range from "1" to "5" with "1" representing the lowest risk of loss and "5" representing the highest risk of loss.
The asset-specific reserve component relates to reserves for losses on individual impaired loans. The Company considers a loan to be impaired when, based upon current information and events, it believes that it is probable that the Company will be unable to collect all amounts due under the contractual terms of the loan agreement. This assessment is made on an individual loan basis each quarter based on such factors as payment status, lien position, borrower financial resources and investment in collateral, collateral type, project economics and geographical location as well as national and regional economic factors. A reserve is established for an impaired loan when the present value of payments expected to be received, observable market prices or the estimated fair value of the collateral (for loans that are dependent on the collateral for repayment) is lower than the carrying value of that loan.
For collateral dependent impaired loans, impairment is measured using the estimated fair value of collateral less the estimated cost to sell. Valuations are performed or obtained at the time a loan is determined to be impaired and designated non-performing, and they are updated if circumstances indicate that a significant change in value has occurred. The Advisor generally will use the income approach through internally developed valuation models to estimate the fair value of the collateral for such loans. In more limited cases, the Advisor will obtain external "as is" appraisals for loan collateral, generally when third party participations exist.
A loan is also considered impaired if its terms are modified in a troubled debt restructuring ("TDR"). A TDR occurs when a concession is granted and the debtor is experiencing financial difficulties. Impairments on TDR loans are generally measured based on the present value of expected future cash flows discounted at the effective interest rate of the original loans.
The Company designates non-performing loans at such time as (i) loan payments become 90-days past due; (ii) the loan has a maturity default; or (iii) in the opinion of the Company, it is probable the Company will be unable to collect all amounts due according to the contractual terms of the loan. Income recognition will be suspended when a loan is designated non-performing and resumed only when the suspended loan becomes contractually current and performance is demonstrated to have resumed. A loan will be written off when it is no longer realizable and legally discharged.
Real Estate Securities
On the acquisition date, all of our commercial real estate securities will be classified as available for sale and will be carried at fair value, with any unrealized gains or losses reported as a component of accumulated other comprehensive income or loss. However, we may elect the fair value option for certain of our real estate securities, and as a result, any unrealized gains or losses on such real estate securities will be recorded as unrealized gains or losses on investments in our consolidated statement of operations. Related discounts, premiums, and acquisition expenses on investments are amortized over the life of the investment using the effective interest method. Amortization is reflected as an adjustment to interest income in the consolidated statements of operations.
Impairment Analysis of Real Estate Securities
Commercial real estate securities for which the fair value option has not been elected will be periodically evaluated for other-than-temporary impairment. If the fair value of a security is less than its amortized cost, the security is considered impaired. Impairment of a security will be considered to be other-than-temporary when (i) the Advisor has the intent to sell the impaired security; (ii) it is more likely than not we will be required to sell the security; or (iii) the Advisor does not expect to recover the entire amortized cost of the security. If the Advisor determines that an other-than-temporary impairment exists and a sale is likely, the impairment charge will be recognized as an impairment of assets on our consolidated statement of operations. If a sale is not expected, the portion of the impairment charge related to credit factors will be recorded as an impairment of assets on our consolidated statement of operations with the remainder recorded as an unrealized gain or loss on investments reported as a component of accumulated other comprehensive income or loss.
Commercial real estate securities for which the fair value option has been elected will not be evaluated for other-than-temporary impairment as changes in fair value are recorded in our consolidated statement of operations.
Income Taxes
We conduct our operations to qualify as a REIT for U.S. federal income tax purposes beginning with the taxable year ended December 31, 2013. As a REIT, we generally will not be subject to federal corporate income tax as long as we distribute at least 90% of our REIT taxable income to our stockholders. REITs are subject to a number of other organizational and operational requirements. However, even if we continue to qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income in addition to federal income and excise taxes on our undistributed income.
41
Per Share Data
The Company calculates basic earnings per share by dividing net income attributable to the Company for the period by the weighted-average number of shares of common stock outstanding for that period. Diluted earnings per share reflects the potential dilution that that could occur from shares issuable in connection with the restricted stock plan and if convertible shares were exercised, except when doing so would be anti-dilutive.
Reportable Segments
The Company conducts its business through the following segments:
• | The real estate debt business which is focused on originating, acquiring and asset managing commercial real estate debt investments, including first mortgage loans, subordinate mortgages, mezzanine loans and participations in such loans. |
• | The real estate securities business which is focused on investing in and asset managing commercial real estate securities primarily consisting of CMBS and may include unsecured REIT debt, CDO notes and other securities. |
See Note 12 - Segment Reporting for further information regarding the Company's segments.
Portfolio
As of December 31, 2015 and 2014, our portfolio consisted of 77 and 38 loans (the "Loans") and 16 and eight investments in CMBS, respectively. The Loans had a total carrying value, net of reserve, of $1,124.2 million and $456.9 million, and our CMBS investments had a fair value of $130.8 million and $50.2 million as of December 31, 2015 and 2014, respectively. The increase in the size of our portfolio is due to investing capital received from the Offering and increased leverage arising from the Master Repurchase Agreements (“MRAs”) that we have entered into with JPMorgan Chase Bank, National Association (the “JPM Repo Facility”) and Barclays Bank PLC (the “Barclays Repo Facility”).
We currently estimate loss rates based on historical realized losses experienced in the industry and take into account current collateral and economic conditions affecting the probability or severity of losses when establishing the allowance for loan losses. We recorded a general allowance for loan losses as of December 31, 2015 and 2014 in the amount of $0.9 million and $0.6 million. There are no impaired or specifically reserved loans in the portfolio as of December 31, 2015 and 2014.
The Loans bear a weighted average coupon of 6.1% and 7.1%, and have a weighted average life of 2.7 and 3.2 years as of December 31, 2015 and 2014, respectively. During the year ended December 31, 2015, we invested $793.7 million in 45 loans including $4.4 million of capitalized acquisition expenses. We recorded interest income of $56.0 million, $14.7 million and $0.8 million on the Loans for the years ended December 31, 2015, 2014 and 2013, respectively.
Our CMBS investments have a weighted average coupon of 4.7% and 3.3% at December 31, 2015 and 2014, respectively. Our CMBS investments have a remaining life of 3.2 and 1.8 years as of December 31, 2015 and 2014, respectively. We recorded interest income of $3.4 million, $0.7 million and $7,700 on our CMBS investments for the years ended December 31, 2015, 2014 and 2013, respectively.
The following charts summarize our portfolio as a percentage of par value, including CMBS, by the collateral type, geographical region and coupon rate type as of December 31, 2015 and 2014:
42
43
An investments region classification is defined according to the below map based on the location of investments secured property.
44
The following charts show the par value by maturity year for the investments in our portfolio as of December 31, 2015 and 2014.
The following table shows selected data from our commercial mortgage loans portfolio as of December 31, 2015 (in thousands):
Loan Type | Property Type | Par Value | Interest Rate (1) | Effective Yield | Loan to Value (2) |
Senior 1 | Retail | $7,460 | 1M LIBOR + 4.75% | 5.32% | 78.0% |
Senior 2 | Office | 8,500 | 1M LIBOR + 4.65% | 5.32% | 70.8% |
Senior 3 | Mixed Use | 11,000 | 1M LIBOR + 9.00% | 10.43% | 70.0% |
Senior 4 | Office | 34,500 | 1M LIBOR + 5.25% | 5.88% | 75.0% |
Senior 5 | Office | 11,750 | 1M LIBOR + 4.75% | 5.24% | 74.4% |
Senior 6 | Retail | 14,600 | 1M LIBOR + 4.25% | 4.77% | 65.0% |
Senior 7 | Retail | 11,636 | 1M LIBOR + 5.00% | 5.58% | 70.0% |
Senior 8 | Office | 19,250 | 1M LIBOR + 4.55% | 4.96% | 70.0% |
45
Loan Type | Property Type | Par Value | Interest Rate (1) | Effective Yield | Loan to Value (2) |
Senior 9 | Multifamily | 16,449 | 1M LIBOR + 4.75% | 5.37% | 75.0% |
Senior 10 | Multifamily | 13,745 | 1M LIBOR + 4.50% | 5.11% | 76.0% |
Senior 11 | Office | 12,000 | 1M LIBOR + 4.75% | 5.16% | 54.1% |
Senior 12 | Multifamily | 21,100 | 1M LIBOR + 4.25% | 4.72% | 69.6% |
Senior 13 | Multifamily | 8,229 | 1M LIBOR + 4.75% | 5.38% | 76.0% |
Senior 14 | Retail | 9,850 | 1M LIBOR + 5.25% | 5.83% | 80.0% |
Senior 15 | Industrial | 18,452 | 1M LIBOR + 4.25% | 4.84% | 68.0% |
Senior 16 | Hospitality | 10,350 | 1M LIBOR + 5.50% | 6.11% | 69.9% |
Senior 17 | Office | 27,490 | 1M LIBOR + 4.65% | 5.36% | 80.0% |
Senior 18 | Retail | 4,725 | 1M LIBOR + 5.50% | 6.21% | 72.0% |
Senior 19 | Retail | 18,350 | 1M LIBOR + 4.75% | 5.49% | 55.0% |
Senior 20 | Multifamily | 39,200 | 1M LIBOR + 4.00% | 4.47% | 77.0% |
Senior 21 | Retail | 7,500 | 1M LIBOR + 5.00% | 5.70% | 59.0% |
Senior 22 | Office | 12,790 | 1M LIBOR + 5.00% | 5.64% | 75.0% |
Senior 23 | Hospitality | 11,482 | 1M LIBOR + 5.75% | 6.26% | 60.0% |
Senior 24 | Hospitality | 11,893 | 1M LIBOR + 5.30% | 5.87% | 73.5% |
Senior 25 | Mixed Use | 26,623 | 1M LIBOR + 5.50% | 5.99% | 55.3% |
Senior 26 | Multifamily | 17,560 | 1M LIBOR + 4.20% | 4.70% | 76.4% |
Senior 27 | Mixed Use | 10,018 | 1M LIBOR + 5.10% | 5.71% | 75.0% |
Senior 28 | Multifamily | 39,200 | 1M LIBOR + 4.25% | 4.87% | 77.0% |
Senior 29 | Retail | 9,450 | 1M LIBOR + 4.90% | 5.42% | 69.2% |
Senior 30 | Industrial | 33,655 | 1M LIBOR + 4.00% | 4.36% | 65.0% |
Senior 31 | Mixed Use | 45,100 | 1M LIBOR + 5.50% | 6.08% | 72.6% |
Senior 32 | Multifamily | 8,850 | 1M LIBOR + 4.70% | 5.27% | 68.8% |
Senior 33 | Office | 24,500 | 1M LIBOR + 4.60% | 5.15% | 65.0% |
Senior 34 | Mixed Use | 7,806 | 1M LIBOR + 4.75% | 5.32% | 78.3% |
Senior 35 | Hospitality | 16,800 | 1M LIBOR + 4.90% | 5.36% | 74.0% |
Senior 36 | Office | 35,000 | 1M LIBOR + 5.00% | 5.41% | 79.0% |
Senior 37 | Office | 6,070 | 1M LIBOR + 4.90% | 5.30% | 80.0% |
Senior 38 | Retail | 11,800 | 1M LIBOR + 4.75% | 5.28% | 79.4% |
Senior 39 | Retail | 13,500 | 1M LIBOR + 5.00% | 5.57% | 78.0% |
Senior 40 | Retail | 11,450 | 1M LIBOR + 4.50% | 4.99% | 74.8% |
Senior 41 | Multifamily | 18,075 | 1M LIBOR + 4.50% | 4.96% | 75.0% |
Senior 42 | Mixed Use | 31,250 | 1M LIBOR + 4.50% | 5.04% | 75.0% |
Senior 43 | Multifamily | 24,000 | 1M LIBOR + 4.25% | 4.85% | 79.7% |
Senior 44 | Office | 9,150 | 1M LIBOR + 5.50% | 6.21% | 75.0% |
Senior 45 | Multifamily | 28,406 | 1M LIBOR + 3.85% | 4.12% | 76.8% |
Senior 46 | Multifamily | 10,785 | 1M LIBOR + 3.95% | 4.23% | 77.5% |
Senior 47 | Multifamily | 12,009 | 1M LIBOR + 3.95% | 4.22% | 78.2% |
Senior 48 | Multifamily | 5,800 | 1M LIBOR + 4.05% | 4.34% | 80.0% |
Senior 49 | Office | 28,000 | 1M LIBOR + 4.25% | 4.77% | 73.3% |
Senior 50 | Multifamily | 13,792 | 1M LIBOR + 5.00% | 5.55% | 76.7% |
Senior 51 | Retail | 26,500 | 1M LIBOR + 4.75% | 5.12% | 67.4% |
Senior 52 | Multifamily | 10,450 | 1M LIBOR + 4.75% | 5.27% | 75.0% |
Mezzanine 1 | Mixed Use | 7,000 | 1M LIBOR + 10.50% | 11.03% | 84.0% |
Mezzanine 2 | Office | 5,000 | 11.00% | 10.76% | 63.6% |
Mezzanine 3 | Hospitality | 12,350 | 1M LIBOR + 10.00% | 10.33% | 74.0% |
Mezzanine 4 | Hospitality | 3,000 | 11.00% | 10.78% | 81.8% |
Mezzanine 5 | Hospitality | 11,000 | 1M LIBOR + 7.05% | 7.14% | 70.0% |
Mezzanine 6 | Office | 22,777 | 1M LIBOR + 7.25% | 7.15% | 76.0% |
Mezzanine 7 | Office | 7,000 | 12.00% | 11.87% | 78.3% |
Mezzanine 8 | Hospitality | 12,000 | 1M LIBOR + 9.00% | 9.06% | 74.2% |
Mezzanine 9 | Retail | 1,962 | 13.00% | 12.91% | 85.0% |
46
Loan Type | Property Type | Par Value | Interest Rate (1) | Effective Yield | Loan to Value (2) |
Mezzanine 10 | Office | 5,100 | 3M LIBOR + 10.00% | 10.38% | 79.5% |
Mezzanine 11 | Hospitality | 45,000 | 1M LIBOR + 10.00% | 10.33% | 75.0% |
Mezzanine 12 | Multifamily | 5,000 | 9.00% | 8.73% | 73.9% |
Mezzanine 13 | Multifamily | 3,480 | 9.50% | 9.42% | 84.5% |
Mezzanine 14 | Office | 10,000 | 1M LIBOR + 8.00% | 8.19% | 80.0% |
Mezzanine 15 | Multifamily | 4,000 | 12.00% | 11.75% | 74.5% |
Mezzanine 16 | Office | 10,000 | 10.00% | 10.92% | 79.0% |
Mezzanine 17 | Office | 10,000 | 1M LIBOR + 10.75% | 15.30% | 80.0% |
Mezzanine 18 | Multifamily | 5,000 | 1M LIBOR + 7.50% | 7.66% | 71.0% |
Mezzanine 19 | Hospitality | 7,140 | 10.00% | 11.50% | 73.9% |
Mezzanine 20 | Hospitality | 3,900 | 10.00% | 11.50% | 73.9% |
Mezzanine 21 | Hospitality | 12,510 | 10.00% | 11.50% | 73.9% |
Mezzanine 22 | Hospitality | 8,050 | 10.00% | 11.50% | 73.9% |
Mezzanine 23 | Office | 9,000 | 10.50% | 10.37% | 85.0% |
Mezzanine 24 | Hospitality | 6,277 | 5.46% | 13.71% | 76.7% |
Subordinate 1 | Retail | 10,000 | 11.00% | 11.00% | 50.1% |
$1,134,446 | 6.30% | 73.0% | |||
________________________
(1) Our floating rate loan agreements contain the contractual obligation for the borrower to maintain an interest rate cap to protect against rising interest rates. In a simple interest rate cap, the borrower pays a premium for a notional principal amount based on a capped interest rate (the “cap rate”). When the floating rate exceeds the cap rate, the borrower receives a payment from the cap counterparty equal to the difference between the floating rate and the cap rate on the same notional principal amount for a specified period of time. When interest rates rise, the value of an interest rate cap will increase, thereby reducing the borrower's exposure to rising interest rates.
(2) Loan to value percentage is from metrics at origination.
Results of Operations
Comparison of the Year Ended December 31, 2015 to the Year Ended December 31, 2014
We conduct our business through the following segments:
• | The real estate debt business focuses on originating, acquiring and asset managing commercial real estate debt investments, including first mortgage loans, subordinate mortgages, mezzanine loans and participations in such loans. |
• | The real estate securities business focuses on investing in and asset managing commercial real estate securities primarily consisting of CMBS and may include unsecured REIT debt, CDO notes and other securities. |
Net Interest Income
Net interest income is generated on our interest-earning assets less related interest-bearing liabilities and is recorded as part of our real estate debt and real estate securities segments.
The following table presents the average balance of interest-earning assets less related interest-bearing liabilities, associated interest income and expense and corresponding yield earned and incurred for the years ended December 31, 2015 and 2014 (dollars in thousands):
47
Years Ended December 31, | ||||||||||||||||||||||
2015 | 2014 | |||||||||||||||||||||
Average Carrying Value(1) | Interest Income/Expense(2) | WA Yield/Financing Cost(3) | Average Carrying Value(1) | Interest Income/Expense(2) | WA Yield/Financing Cost(3) | |||||||||||||||||
Interest-earning assets: | ||||||||||||||||||||||
Real estate debt | $ | 719,206 | $ | 56,040 | 7.8 | % | $ | 199,681 | $ | 14,733 | 7.4 | % | ||||||||||
Real estate securities | 84,803 | 3,353 | 4.0 | % | 24,630 | 733 | 3.0 | % | ||||||||||||||
Total | 804,009 | 59,393 | 7.4 | % | 224,311 | 15,466 | 6.9 | % | ||||||||||||||
Interest-bearing liabilities: | ||||||||||||||||||||||
Repurchase Agreements - Loans | 262,727 | 9,543 | 3.6 | % | 53,953 | 1,985 | 3.7 | % | ||||||||||||||
Repurchase Agreements - Securities | 63,687 | 1,119 | 1.8 | % | 12,286 | 211 | 1.7 | % | ||||||||||||||
Collateralized loan obligations | 58,223 | 1,606 | 2.8 | % | — | — | — | % | ||||||||||||||
Total | 384,637 | 12,268 | 3.2 | % | 66,239 | 2,196 | 3.3 | % | ||||||||||||||
Net interest income/spread | 47,125 | 4.2 | % | $ | 13,270 | 3.6 | % | |||||||||||||||
Average leverage %(4) | 47.8 | % | 29.5 | % | ||||||||||||||||||
Weighted average levered yield(5) | 9.4 | % | 8.0 | % | ||||||||||||||||||
(1) Based on amortized cost for real estate debt and real estate securities and principal amount for repurchase agreements. Amounts are calculated based on daily averages for year ended December 31, 2015 and quarterly averages for the year ended December 31, 2014, respectively.
(2) Includes the effect of amortization of premium or accretion of discount and deferred fees.
(3) Calculated as interest income or expense divided by average carrying value.
(4) Calculated by dividing total average interest-bearing liabilities by total average interest-earning assets.
(5) Calculated by taking the sum of (i) the net interest spread multiplied by the average leverage and (ii) the weighted average yield on interest-earning assets.
Interest income
Interest income for the years ended December 31, 2015 and 2014 totaled $59.4 million and $15.5 million, respectively. As of December 31, 2015, our portfolio consisted of 77 Loans and 16 investments in CMBS. The main driver in the increase in interest income was the increase in the size of our portfolio due to investing capital raised through the Offering. As of December 31, 2015, our Loans had a total carrying value of $1,125.1 million and our CMBS investments had a fair value of $130.8 million, while as of December 31, 2014, the Loans had a total carrying value of $457.5 million and our CMBS investments had a fair value of $50.2 million. In addition to the growth in the portfolio, increase in asset yields also contributed to growth in interest income. During the year ended December 31, 2015 the yield on the interest-earning assets increased by 50 basis points compared to the year ended December 31, 2014.
Interest expense
Interest expense for the year ended December 31, 2015 increased to $12.3 million compared to interest expense for year ended December 31, 2014 of $2.2 million, primarily due to increase in borrowings. During the years ended As of December 31, 2015 and 2014, we had total borrowings outstanding of $384.6 million and $66.2 million, respectively. The increase in interest expense arising from higher average borrowing is partially offset by a decrease in yield of 13 basis point on interest-bearing liabilities during the year ended December 31, 2015 compared to year ended December 31, 2014. The decrease in yield was primarily due to borrowing more on our repurchase agreements for senior loans compared to mezzanine loans.
Expenses from operations
Expenses from operations for the years ended December 31, 2015 and 2014 were made up of the following (in thousands):
48
Year Ended December 31, | ||||||||
2015 | 2014 | |||||||
Acquisition fees | $ | 7,916 | $ | 4,386 | ||||
Asset management and subordinated performance fee | 7,615 | 604 | ||||||
Professional fees | 4,997 | 1,050 | ||||||
Other expenses (*) | 1,346 | 1,148 | ||||||
Loan loss provision | 318 | 570 | ||||||
Total expenses from operations | $ | 22,192 | $ | 7,758 | ||||
________________________
(*) Other expenses includes board of directors and insurance expense, a change in presentation from our Form 10-K for period ending December 31, 2014. The change is applied retrospectively.
The increase in our expenses from operations were primarily related to acquisition fees, asset management and subordinated performance fee and professional fees. During the year ended December 31, 2015 and 2014, we originated and acquired Loans and CMBS with a par value of $860.7 million, and in conjunction with these transactions, we expensed $7.9 million of acquisition fees compared to year ended December 31, 2014, during which we originated and acquired loans and CMBS with a par value of $477.2 million and expensed $4.4 million of acquisition fees. During the year ended December 31, 2015 and 2014, we incurred asset management and subordinated performance fees of $7.6 million and $0.6 million, respectively. This increase was due to the amendment to the advisory agreement. Prior to June 17, 2015, the amount of the asset management fee was reduced to the extent that FFO, as adjusted, during the six month period ending on the last day of the calendar quarter immediately preceding the date such asset management fee was payable, was less than distributions declared during the same period. Another increase in operating expenses is the increase in professional fees of $3.9 million, primarily due to an increase in legal and audit fees.
Comparison of the Year Ended December 31, 2014 to the Year Ended December 31, 2013
Net Interest Income
Net interest income is generated on our interest-earning assets less related interest-bearing liabilities and is recorded as part of our real estate debt and real estate securities segments.
The following table presents the average balance of interest-earning assets less related interest-bearing liabilities, associated interest income and expense and corresponding yield earned and incurred for the years ended December 31, 2014 and 2013 (dollars in thousands):
________________________
Years Ended December 31, | ||||||||||||||||||||||
2014 | 2013 | |||||||||||||||||||||
Average Carrying Value(1) | Interest Income/Expense(2) | WA Yield/Financing Cost(3) | Average Carrying Value(1) | Interest Income/Expense(2) | WA Yield/Financing Cost(3)(4) | |||||||||||||||||
Interest-earning assets: | ||||||||||||||||||||||
Real estate debt | $ | 199,681 | $ | 14,733 | 7.4 | % | $ | 17,650 | $ | 767 | 6.8 | % | ||||||||||
Real estate securities | 24,630 | 733 | 3.0 | % | 5,005 | 8 | 0.3 | % | ||||||||||||||
Total | 224,311 | 15,466 | 6.9 | % | 22,655 | 775 | 5.4 | % | ||||||||||||||
Interest-bearing liabilities: | ||||||||||||||||||||||
Repurchase Agreements - Loans | 53,953 | 1,985 | 3.7 | % | 5,032 | 32 | 1.0 | % | ||||||||||||||
Repurchase Agreements - Securities | 12,286 | 211 | 1.7 | % | — | — | — | % | ||||||||||||||
Total | 66,239 | 2,196 | 3.3 | % | 5,032 | 32 | 1.0 | % | ||||||||||||||
Net interest income/spread | 13,270 | 3.6 | % | $ | 743 | 4.4 | % | |||||||||||||||
Average leverage %(5) | 29.5 | % | 22.2 | % | ||||||||||||||||||
Weighted average levered yield(6) | 8.0 | % | 6.4 | % | ||||||||||||||||||
(1) Based on amortized cost for real estate debt and real estate securities and principal amount for repurchase agreements. All amounts are calculated based on quarterly averages for years ended December 31, 2014 and 2013.
(2) Includes the effect of amortization of premium or accretion of discount and deferred fees.
(3) Calculated as interest income or expense divided by average carrying value.
49
(4) Annualized based on first loan acquisition of May 15, 2013.
(5) Calculated by dividing total average interest-bearing liabilities by total average interest-earning assets.
(6) Calculated by taking the sum of (i) the net interest spread multiplied by the average leverage and (ii) the weighted average yield on interest-earning assets.
Interest income
Interest income for the years ended December 31, 2014 and 2013 totaled $15.5 million and $0.8 million, respectively. As of December 31, 2014, our portfolio consisted of 38 Loans and eight investments in CMBS. The main driver in the increase in interest income was the increase in the size of our portfolio due to investing capital raised through the Offering. As of December 31, 2014, our Loans had a total carrying value of $457.5 million and our CMBS investments had a fair value of $50.2 million, while as of December 31, 2013, the Loans had a total carrying value of $30.8 million and our CMBS investments had a fair value of $5.0 million. In addition to the growth in the portfolio, increase in asset yields also contributed to growth in interest income. During the year ended December 31, 2014 the yield on the interest-earning assets increased by 151 basis points compared to the year ended December 31, 2013.
Interest expense
Interest expense for the year ended December 31, 2014 increased to $2.2 million compared to interest expense for year ended December 31, 2013 of $32,313, primarily due to increase in borrowings. During the years ended As of December 31, 2014 and 2013, we had total borrowing outstanding of $176.4 million and $7.3 million, respectively. In addition, interest expense increased by 230 basis point increase in the yield of interest-bearing liabilities during the year ended December 31, 2014 compared to year ended December 31, 2013. The increase in yield was primarily due to borrowing more on our repurchase agreements for Loans, including our mezzanine Loans which have a higher borrowing spread.
Expenses from operations
Expenses from operations for the years ended December 31, 2014 and 2013 were made up of the following (in thousands):
Year Ended December 31, | ||||||||
2014 | 2013 | |||||||
Acquisition fees | $ | 4,386 | $ | — | ||||
Asset management and subordinated performance fee | 604 | — | ||||||
Professional fees | 1,050 | 71 | ||||||
Other expenses (*) | 1,148 | 570 | ||||||
Loan loss provision | 570 | $ | — | |||||
Total expenses from operations | $ | 7,758 | $ | 641 | ||||
________________________
(*) Other expenses includes board of directors and insurance expense, a change in presentation from our Form 10-K for period ending December 31, 2014 and 2013. The change is applied retrospectively.
The increase in our expenses from operations was primarily related to asset acquisition fees which will trend parallel with the rate of our originations and acquisitions. During the year ended December 31, 2014, we originated and acquired loans and CMBS with a par value of $477.2 million and in conjunction with these transaction we expensed $4.4 million of acquisition fees. During the year ended December 31, 2013, we only made six loan investments with an aggregate par value of $34.4 million.
Liquidity and Capital Resources
Our principal demands for cash will be acquisition costs, including the purchase price of any investments we originate or acquire, the payment of our operating and administrative expenses, continuing debt service obligations and distributions to our stockholders. Prior to January 2016, we generally funded our investments from the net proceeds of the Offering. We can acquire our assets with cash or debt, but we also may acquire assets free and clear of indebtedness by paying the entire purchase price for the asset in cash or in OP units. We currently believe that we have sufficient liquidity and capital resources available for the acquisition of additional investments, repayments on borrowings and the payment of cash dividends, although given the termination of our Offering we expect our new investments to decrease significantly in 2016 unless we are able to raise additional equity capital.
50
Loan Repo Facilities
We entered into the JPM Repo Facility with JP Morgan Chase Bank, National Association (the"JPM Repo Facility"). The JPM Repo Facility provides up to $150.0 million in advances, subject to adjustment, which we expect to use to finance the acquisition or origination of eligible loans, including first mortgage loans, junior mortgage loans, mezzanine loans and participation interests therein. Advances under the JPM Repo Facility accrue interest at per annum rates equal to the sum of (i) the applicable LIBOR index rate plus (ii) a margin of between 2.25% to 4.50%, depending on the attributes of the purchased assets. The initial maturity date of the JPM Repo Facility is June 18, 2016, with a one-year extension at our option, which may be exercised upon the satisfaction of certain conditions. As of December 31, 2015 and 2014, there was $84.3 million and $76.5 million of principal outstanding on the JPM Repo Facility, respectively.
We entered into the Barclays Repo Facility with Barclays Bank PLC ("Barclays Repo Facility"). The Barclays Repo Facility provides up to $150.0 million in advances, subject to adjustment, which we expect to use to finance the acquisition or origination of eligible loans, including first mortgage loans, junior mortgage loans, mezzanine loans and participation interests therein. Advances under the Barclays Repo Facility accrue interest at per annum rates equal to the sum of (i) the applicable LIBOR index rate plus (ii) a margin of between 2.00% to 2.50%, depending on the attributes of the purchased assets. The initial maturity date of the Barclays Repo Facility was September 3, 2015, with four six-month extensions at our option, which may be exercised upon the satisfaction of certain conditions. We exercised our first extension on the Barclays Repo Facility and extended the maturity date to March 3, 2016, with three six-month extensions options remaining, which may be exercised upon the satisfaction of certain conditions. As of December 31, 2015 and 2014, we had $121.9 million and $73.7 million of principal outstanding under the Barclays Repo Facility, respectively.
The JPM Repo Facility and the Barclay’s Repo Facility generally provide that in the event of a decrease in the value of our collateral, the lenders can demand additional collateral. Should the value of our collateral decrease, whether as a result of deteriorating credit quality, an increase in credit market spreads or otherwise, resulting margin calls may cause an adverse change in our liquidity position.
CMBS Master Repurchase Agreements ("MRAs")
We entered into various MRAs that allow us to sell real estate securities while providing a fixed repurchase price for the same real estate securities in the future. The repurchase contracts on each security under an MRA generally mature in 30 to 90 days and terms are adjusted for current market rates as necessary. As of December 31, 2015 and 2014, we entered into six MRAs, of which three were in use, described below (in thousands):
Amount | Weighted Average | |||||||||||||||||
Counterparty | Outstanding | Accrued Interest | Collateral Pledged | Interest Rate | Days to Maturity | |||||||||||||
As of December 31, 2015 | ||||||||||||||||||
J.P. Morgan Securities LLC (*) | $ | 86,898 | $ | 108 | $ | 130,618 | 2.03 | % | 8 | |||||||||
Citigroup Global Markets, Inc. | 26,619 | 71 | 35,528 | 2.00 | % | 45 | ||||||||||||
Wells Fargo Securities, LLC | 3,694 | 3 | 4,925 | 1.67 | % | 13 | ||||||||||||
Total/Weighted Average | $ | 117,211 | 182 | 171,071 | 2.01 | % | 17 | |||||||||||
As of December 31, 2014 | ||||||||||||||||||
J.P. Morgan Securities LLC | $ | 18,528 | 8 | 23,843 | 1.44 | % | 20 | |||||||||||
Citigroup Global Markets, Inc. | 4,010 | 2 | 5,015 | 1.46 | % | 20 | ||||||||||||
Wells Fargo Securities, LLC | 3,731 | 2 | 4,975 | 1.52 | % | 20 | ||||||||||||
Total/Weighted Average | $ | 26,269 | 12 | 33,833 | 1.46 | % | 20 | |||||||||||
________________________
(*) Collateral includes $56,044 of Tranche C of RFT issued CLO to JPM. The investment in Tranche C of the CLO eliminates on the consolidated balance sheets as of December 31, 2015.
We expect to use additional debt financing as a source of capital. Under our charter, the maximum amount of our total indebtedness shall not exceed 300% of our total ‘‘net assets’’ (as defined by the NASAA REIT Guidelines) as of the date of any borrowing, which is generally expected to be 75% of the cost of our investments; however, we may exceed that limit if approved by a majority of our independent directors and disclosed to stockholders in our next quarterly report following such borrowing along with justification for exceeding such limit. This charter limitation, however, does not apply to individual real estate assets or investments. At the date of acquisition of each asset, we anticipate that the cost of investment for such asset will be substantially similar to its fair market value, which will enable us to satisfy our requirements under the North American Securities Administrators ("NASAA") Statement of Policy regarding REITs (the "REIT Guidelines"). However, subsequent
51
events, including changes in the fair market value of our assets, could result in our exceeding these limits. We anticipate that adequate cash will be generated from operations to fund our operating and administrative expenses, continuing debt service obligations and the payment of distributions.
In addition to our current mix of financing sources, we may also access additional forms of financings, including credit facilities, securitizations and public and private, secured and unsecured debt issuances by us or our subsidiaries.
Recently, the Commercial Mortgage Securitization market has experienced a period of widening credit spreads and limited liquidity. This could impact the timing and execution of an additional CLO if we plan to issue one in the near term. We continue to monitor the credit markets to determine the best time to create another CLO financing vehicle. Additionally, this period of widening credit spreads and limited liquidity has affected the fair market value of the CMBS securities we hold in position.
Distributions
On May 13, 2013, our board of directors authorized, and we declared, a distribution, which will be calculated based on stockholders of record each day during the applicable period at a rate of $0.00565068493 per day per share of common stock. The distributions will be payable by the fifth day following the end of each month to stockholders of record at the close of business each day during the prior month.
The below table shows the distributions paid on shares outstanding during the years ended December 31, 2015 and 2014 (in thousands):
Year Ended December 31, 2015 Payment Date | Amount Paid in Cash | Amount Issued under DRIP | ||||||
January 2, 2015 | $ | 1,511 | $ | 1,109 | ||||
February 2, 2015 | 1,618 | 1,182 | ||||||
March 2, 2015 | 1,567 | 1,153 | ||||||
April 1, 2015 | 1,873 | 1,394 | ||||||
May 1, 2015 | 1,972 | 1,478 | ||||||
June 1, 2015 | 2,216 | 1,656 | ||||||
July 1, 2015 | 2,282 | 1,738 | ||||||
August 3, 2015 | 2,510 | 1,907 | ||||||
September 1, 2015 | 2,663 | 2,026 | ||||||
October 2, 2015 | 2,723 | 2,042 | ||||||
November 2, 2015 | 2,962 | 2,218 | ||||||
December 1, 2015 | 3,052 | 2,258 | ||||||
Total | $ | 26,949 | $ | 20,161 | ||||
Year Ended December 31, 2014 Payment Date | Amount Paid in Cash | Amount Issued under DRIP | ||||||
January 2, 2014 | $ | 141 | $ | 74 | ||||
February 3, 2014 | 171 | 85 | ||||||
March 3, 2014 | 213 | 106 | ||||||
April 1, 2014 | 305 | 163 | ||||||
May 1, 2014 | 353 | 206 | ||||||
June 2, 2014 | 452 | 282 | ||||||
July 2, 2014 | 571 | 356 | ||||||
August 2, 2014 | 759 | 485 | ||||||
September 2, 2014 | 951 | 628 | ||||||
October 2, 2014 | 1,073 | 736 | ||||||
November 2, 2014 | 1,249 | 905 | ||||||
December 1, 2014 | 1,354 | 1,001 | ||||||
Total | $ | 7,592 | $ | 5,027 | ||||
52
The following table shows the sources for the payment of distributions to common stockholders for the periods presented (in thousands):
Year Ended December 31, | |||||||||||||
2015 | 2014 | ||||||||||||
Distributions: | |||||||||||||
Cash distributions paid | $ | 26,949 | $ | 7,592 | |||||||||
Distributions reinvested | 20,161 | 5,027 | |||||||||||
Total distributions | $ | 47,110 | $ | 12,619 | |||||||||
Source of distribution coverage: | |||||||||||||
Cash flows provided by operations | $ | 25,433 | 54.0 | % | $ | 2,685 | 21.3 | % | |||||
Proceeds from issuance of common stock | 1,516 | 3.2 | % | 4,907 | 38.9 | % | |||||||
Common stock issued under DRIP | 20,161 | 42.8 | % | 5,027 | 39.8 | % | |||||||
Total sources of distributions | $ | 47,110 | 100.0 | % | $ | 12,619 | 100.0 | % | |||||
Cash flows provided by operations | $ | 25,433 | $ | 2,685 | |||||||||
Net income | $ | 24,933 | $ | 5,415 | |||||||||
The following table compares cumulative distributions paid to cumulative net income (in accordance with GAAP) for the period from November 15, 2012 (date of inception) through December 31, 2015 (in thousands):
For the period from November 15, 2012 (date of inception) to December 31, 2015 | ||||
Distributions paid: | ||||
Common stockholders in cash | $ | 34,827 | ||
Common stockholders pursuant to DRIP / offering proceeds | 25,377 | |||
Total distributions paid | $ | 60,204 | ||
Reconciliation of net income: | ||||
Net interest income | $ | 61,138 | ||
Gain on sale | 112 | |||
Acquisition fees | (12,302 | ) | ||
Other operating expenses | (18,514 | ) | ||
Net income | $ | 30,434 | ||
Cash flows provided by operations | $ | 28,894 | ||
Cash Flows
Cash Flows for the Year Ended December 31, 2015
Net cash provided by operating activities for the year ended December 31, 2015 was $25.4 million. Cash inflows were primarily driven by an increase in net interest income to $47.1 million, but were partially offset by cash outflows mainly for Acquisition fees of $7.9 million.
Net cash used in investing activities for the year ended December 31, 2015 was $749.8 million. Cash outflows were primarily driven by originations and acquisitions with $793.7 million and $85.5 million representing our investment in 45 new loans and eight new CMBS positions, respectively.
Net cash provided by financing activities for the year ended December 31, 2015 was $738.8 million. Cash inflows for the period of $385.2 million from the issuance of common stock, $292.5 million from new borrowings under a CLO and $90.9 million from net borrowings on our CMBS MRAs.
Cash Flows for the Year Ended December 31, 2014
Net cash provided by operating activities for the year ended December 31, 2014 was $2.7 million. Cash inflows were primarily driven by our net interest income of $13.3 million, but were partially offset by cash outflows mainly for Acquisition fees of $4.4 million.
Net cash used in investing activities for the year ended December 31, 2014 was $471.6 million. Cash outflows were primarily driven by the acquisition of 33 and seven new loan and CMBS investments, respectively.
Net cash provided by financing activities for the year ended December 31, 2014 was $469.2 million. Cash inflows for the period were primarily due to $345.9 million of issuance of common stock and $150.2 million from net borrowings on the Loan Repo Facilities and $26.3 million from net borrowing on our CMBS MRAs.
53
Election as a REIT
We elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code commencing with the taxable year ended December 31, 2013. As a REIT, we generally will not be subject to federal corporate income tax as long as we distribute at least 90% of our REIT taxable income to our stockholders. REITs are subject to a number of other organizational and operational requirements. Even if we continue to qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income and property, and federal income and excise taxes on our undistributed income.
Contractual Obligations and Commitments
Our contractual obligations including expected interest payments as of December 31, 2015 are summarized as follows (in thousands):
Less than 1 year | 1 to 3 years | 3 to 5 years | More than 5 years | Total | ||||||||||||||||
Unfunded loan commitments (1) | $ | 890 | $ | 120,500 | $ | 16,939 | $ | — | $ | 138,329 | ||||||||||
Barclays Repo Facility | 121,914 | — | — | — | 121,914 | |||||||||||||||
JPM Repo Facility | 84,325 | — | — | — | 84,325 | |||||||||||||||
CLO | — | — | — | 294,186 | 294,186 | |||||||||||||||
JPM MRA | 86,898 | — | — | — | 86,898 | |||||||||||||||
Citi MRA | 26,619 | — | — | — | 26,619 | |||||||||||||||
Wells MRA | 3,694 | — | — | — | 3,694 | |||||||||||||||
Total | $ | 324,340 | $ | 120,500 | $ | 16,939 | $ | 294,186 | $ | 755,965 | ||||||||||
________________________
(1) The allocation of our unfunded loan commitments is based on the earlier of the commitment expiration date or the loan maturity date.
In addition, we have contractual obligations under our agreements with the Advisor, the Former Dealer Manager and their affiliates, described below.
Related Party Arrangements
Realty Finance Advisors, LLC
Subject to certain restrictions and limitations, our Advisor is responsible for managing our affairs on a day-to-day basis and for identifying, originating, acquiring and asset managing investments on our behalf. For such services, to the extent permitted by law and regulations, our Advisor receives fees and reimbursements from us. Below is a description of the fees and reimbursements incurred to our Advisor.
Organization and Offering Expenses
Our Advisor is entitled to receive reimbursement for organization and offering expenses, which may include reimbursements to our Advisor for other organization and offering expenses it incurs for due diligence fees included in detailed and itemized invoices. We are obligated to reimburse our Advisor for organization and offering costs to the extent the organization and offering expenses do not exceed 2.0% of gross proceeds from the Offering. We shall not reimburse our Advisor for any organization and offering costs that our independent directors determine are not fair and commercially reasonable to us.
Operating Costs
We will reimburse our Advisor’s costs of providing administrative services. We will not reimburse the Advisor for personnel costs in connection with services for which the Advisor receives acquisition fees or disposition fees. The Advisor must pay any expenses in which our operating expenses as defined by North American Securities Administrators Association at the end of the four preceding fiscal quarters exceeds the greater of (i) 2.0% of average invested assets or (ii) 25.0% of net income other than any additions to reserves for depreciation, bad debt or other similar non-cash reserves and excluding any gain from the sale of assets for that period, unless a majority of our independent directors determine the excess expenses were justified based on unusual and nonrecurring factors.
Asset Management Fee
Our Advisor, or its affiliates, receives an annual asset management fee equal to 0.75% of the cost of our assets. Commencing on the NAV pricing date, the asset management fee is based on the lower of 0.75% of the cost of our assets and 0.75% of the fair value of our assets (fair value will consist of the market value of each portfolio investment as determined in accordance with our valuation guidelines). This fee will be paid monthly in arrears, based on assets held by us during the measurement period adjusted for the appropriate closing dates for individual investments. Prior to June 17, 2015, the amount of
54
the asset management fee was reduced to the extent that FFO, as adjusted, during the six month period ending on the last day of the calendar quarter immediately preceding the date such asset management fee was payable, was less than distributions declared during the same period. For purposes of this determination, FFO, as adjusted, is FFO adjusted to (i) include acquisition fees and acquisition expenses; (ii) include non-cash restricted stock grant amortization, if any; and (iii) include impairments and loan loss reserves on investments, if any (including commercial mortgage loans and other debt investments). FFO, as adjusted, is not the same as FFO.
Acquisition Fee
Our Advisor, or its affiliates, receives an acquisition fee equal to 1.0% of the contract purchase price paid for our commercial real estate debt or other commercial real estate investments and 1.0% of the anticipated net equity funded by the us to acquire real estate securities.
Acquisition Expense
Our Advisor, or its affiliates, may receive reimbursements for acquisition expenses incurred including personnel costs related to selecting, evaluating, originating and acquiring investments on our behalf and we may incur third party acquisition expenses. We reimburse the Advisor, or its affiliates, up to 0.5% of the principal amount funded by us to originate or acquire commercial mortgage loans and up to 0.5% of the anticipated net equity funded by us to acquire real estate securities investments. In no event will the total of all acquisition fees and acquisition expenses exceed 4.5% of the principal amount funded with respect to our total portfolio including subsequent fundings to investments in our portfolio.
Asset Disposition Fee
For substantial assistance in connection with the sale of investments, as determined by our board of directors, we will pay our Advisor, or its affiliates, a disposition fee of 1.0% of the contract sales price of each commercial mortgage loan or other investment sold, including real estate securities or collateralized debt obligations issued by our subsidiary as part of a securitization transaction. We will not be obligated to pay a disposition fee upon the maturity, prepayment, workout, modification or extension of commercial real estate debt unless there is a corresponding fee paid by the borrower, in which case the disposition fee will be the lesser of (i) 1.0% of the principal amount of the debt prior to such transaction; or (ii) the amount of the fee paid by the borrower in connection with such transaction. If we take ownership of a property as a result of a workout or foreclosure of a loan, we will pay a disposition fee upon the sale of such property.
Annual Subordinated Performance Fee
We pay the Advisor an annual subordinated performance fee calculated on the basis of our total return to stockholders, payable monthly in arrears, such that for any year in which our total return on stockholders’ capital exceeds 6.0% per annum, the Advisor will be entitled to 15.0% of the excess total return; provided that in no event will the annual subordinated performance fee payable to the Advisor exceed 10.0% of the aggregate total return for such year. This fee will be payable only upon the sale of assets, distributions or other event which results in our return on stockholders’ capital exceeding 6.0% per annum.
Convertible Stock
We have issued 1,000 convertible shares to the Advisor, which will automatically convert to shares of our common stock upon the occurrence of the first to occur of the Triggering Events. In general, but with certain exceptions as outlined in the articles supplementary, each convertible share will convert into a number of common shares equal to 1/1000 of the quotient of (a) the conversion product (the product of 0.15 times the amount, if any, by which (i) the sum of the enterprise value as of the date of the Triggering Event plus total distributions paid to the our stockholders through the date of the Triggering Event exceeds (ii) the sum of our stockholders’ invested capital plus a 6.0% return as of the date of the Triggering Event) divided by (b) the quotient of the enterprise value divided by the number of shares of our common stock outstanding (on an as-converted basis) on the date of the Triggering Event. The conversion product will be reduced by the amounts payable pursuant to the annual subordinated performance fee as realized appreciation in our assets during the time that the Advisor or one of its affiliates acts as our advisor.
Realty Capital Securities, LLC and its Affiliates
Selling Commissions and Former Dealer Manager Fees
Prior to the termination of the Former Dealer Manager, we paid our Former Dealer Manager selling commissions of up to 7.0% of the per share purchase price of shares in our Offering, all of which are reallowed to soliciting dealers. In addition, we paid our Former Dealer Manager a fee of 3.0% of the per share purchase price of shares in our Offering, a portion of which may be reallowed to soliciting dealers. Alternatively, a soliciting dealer may elect to receive a selling commission equal to 7.5% of the gross proceeds from the sale of shares made by such soliciting dealer, with 2.5% thereof paid at the time of such sale and 1.0% thereof paid on each anniversary of such sale up to and including the fifth anniversary of the closing of such sale.
No selling commissions or Former Dealer Manager fees are paid for sales under our DRIP.
55
Additional Fees Incurred to the Sponsor and its Affiliates
The predecessor to AR Global is a party to a services agreement with RCS Advisory Services, LLC, a subsidiary of the parent company of the Former Dealer Manager (“RCS Advisory”), pursuant to which RCS Advisory and its affiliates provided us and certain other companies sponsored by AR Global with services (including, without limitation, transaction management, compliance, due diligence, event coordination and marketing services, financial research, critical thinking and analytical resources, among others) on a time and expenses incurred basis or at a flat rate based on services performed. The predecessor to AR Global instructed RCS Advisory to stop providing such services in November 2015 and no services have since been provided by RCS Advisory.
We are also party to a transfer agency agreement with American National Stock Transfer, LLC, a subsidiary of the parent company of the Former Dealer Manager (“ANST”), pursuant to which ANST provided us with transfer agency services (including broker and stockholder servicing, transaction processing, year-end IRS reporting and other services), and supervisory services overseeing the transfer agency services performed by a third-party transfer agent. AR Global received written notice from ANST on February 10, 2016 that it would wind down operations by the end of the month and would withdraw as the transfer agent effective February 29, 2016. On February 26, 2016, the Company entered into a definitive agreement with DST Systems, Inc., its previous provider of sub-transfer agency services, to provide the Company directly with transfer agency services (including broker and stockholder servicing, transaction processing, yearend IRS reporting and other services). See Note 9 - Related Party Transactions and Arrangements to our consolidated financial statements included in this Annual Report on Form 10-K and Item 13. Certain Relationships and Related Transactions, and Director Independence for a discussion of the various related party transactions, agreements and fees.
Total Costs Incurred Due to Related Party Arrangements
The table below shows the costs incurred due to related party arrangements during the years ended December 31, 2015, 2014 and 2013 and the associated payable as of December 31, 2015 and 2014 (in thousands): See Note 9 - Related Party Transactions and Arrangements for further detail.
Year Ended December 31, | Payable as of December 31, | |||||||||||||||||||
2015 | 2014 | 2013 | 2015 | 2014 | ||||||||||||||||
Total commissions and fees incurred from the Former Dealer Manager in connection with the offering | $ | 37,092 | $ | 33,190 | $ | 2,705 | $ | — | $ | 119 | ||||||||||
Total compensation and reimbursement for services provided by the Advisor and affiliates in connection with the offering | 7,442 | 2,627 | 1,250 | 480 | 1,725 | |||||||||||||||
Acquisition fees and related expense reimbursements in connection with operations | 13,294 | 6,578 | 470 | 55 | — | |||||||||||||||
Advisory and investment banking fee | 56 | 542 | 316 | — | — | |||||||||||||||
Subordinated performance fee and Management Fee | 7,615 | 604 | — | 3,792 | 191 | |||||||||||||||
Total | $ | 65,499 | $ | 43,541 | $ | 4,741 | $ | 4,327 | $ | 2,035 | ||||||||||
The payables as of December 31, 2015 and 2014 in the table above are included in due to affiliates on our consolidated balance sheets.
Off Balance Sheet Arrangements
We currently have no off balance sheet arrangements as of December 31, 2015 and through the date of the filing of this Form 10-K.
Non-GAAP Financial Measures
Funds from Operations and Modified Funds from Operations
Due to certain unique operating characteristics of real estate companies, as discussed below, the National Association of Real Estate Investment Trusts ("NAREIT") and the Investment Program Association ("IPA") industry trade groups, have each promulgated measures respectively known as funds from operations ("FFO") and modified funds from operations ("MFFO"), which we believe to be appropriate supplemental measures to reflect the operating performance of a REIT. The use of FFO and MFFO is recommended by the REIT industry as supplemental performance measures. FFO and MFFO are not equivalents to our net income or loss as determined under generally accepted accounting principles ("GAAP").
We define FFO, a non-GAAP measure, consistent with the standards established by the White Paper on FFO approved by the Board of Governors of NAREIT, as revised in February 2004 (the "White Paper"). The White Paper defines FFO as net income or loss computed in accordance with GAAP, excluding gains or losses from sales of depreciable property, property and asset impairment write-downs, depreciation and amortization, and after adjustments for unconsolidated partnerships and joint
56
ventures. Adjustments for unconsolidated partnerships and joint ventures are calculated to reflect FFO. Our business plan is to operate as a mortgage REIT with our portfolio consisting of commercial mortgage loan investments and investments in real estate securities. We will typically have no FFO adjustments to our net income or loss computed in accordance with GAAP as a result of operating as a mortgage REIT. Although we have the ability to acquire real property, we have not acquired any at this time and as such have not had any FFO adjustments to our net income or loss computed in accordance with GAAP.
Publicly registered, non-listed REITs typically operate differently from exchange traded REITs because they generally have a limited life followed by a liquidity event or other targeted exit strategy. Non-listed REITs typically have a significant amount of acquisition activity and are substantially more dynamic during their initial years of investment and operation as compared to later years when the proceeds from their continuous public offering have been fully invested and when the Company is seeking to implement a liquidity event or other exit strategy. However, it is likely that we will make investments past the acquisition stage, albeit at a substantially lower level.
The origination and acquisition of debt investments is a key operating feature of our business plan that results in the generation of income and cash flows in order to make distributions to stockholders. Acquisition fees paid to our Advisor and acquisition expenses reimbursed to our Advisor in connection with the origination and acquisition of debt investments are evaluated in accordance with GAAP to determine if they should be expensed in the period incurred or capitalized and amortized over the life of the investment. Acquisition fees and acquisition expenses that are deemed to be expensed in the period incurred are included in the computation of net income or loss from operations. The amortization of acquisition fees and acquisition expenses that are able to be capitalized are included in the computation of net income or loss from operations. All such acquisition fees and acquisition expenses are paid in cash when incurred that would otherwise be available to distribute to our stockholders. When proceeds from the Offering have not been sufficient to fund the payment of acquisition fees and the reimbursement of acquisition expenses to our Advisor, such fees and expenses have been paid from other sources, including financings, operating cash flow, net proceeds from the sale of investments or from other cash flows. We believe that acquisition fees and acquisition expenses incurred by us negatively impact our operating performance during the period in which such investments are originated or acquired by reducing cash flows and therefore the potential distributions to stockholders. However, we only add back acquisition fees and acquisition expenses reflected in net income or loss from operations in the current period.
We define MFFO, a non-GAAP measure, consistent with the IPA's Guideline 2010 - 01, Supplemental Performance Measure for Publicly Registered, Non-Listed REITs: Modified Funds from Operations (the "Practice Guideline") issued by the IPA in November 2010. We define MFFO as FFO further adjusted for the following items, as applicable: acquisition fees; accretion of discounts and amortization of premiums and other loan expenses on debt investments; fair value adjustments on real estate related investments such as commercial real estate securities or derivative investments included in net income; impairments of real estate related investments, gains or losses included in net income from the extinguishment or sale of debt, hedges, foreign exchange, derivatives or securities holdings where trading of such holdings is not a fundamental attribute of the business plan, unrealized gains or losses from fair value adjustments on real estate securities, including commercial mortgage backed securities and other securities, interest rate swaps and other derivatives not deemed to be hedges and foreign exchanges holdings; unrealized gains or losses resulting from consolidation from, or deconsolidation to, equity accounting, and after adjustments for consolidated and unconsolidated partnerships and joint ventures, with such adjustments calculated to reflect MFFO on the same basis. The accretion of discounts and amortization of premiums and other loan expenses on debt investments, gains and losses on hedges, foreign exchange, derivatives or securities holdings, unrealized gains and losses resulting from consolidations, as well as other listed cash flow adjustments are adjustments made to net income in calculating the cash flows provided by operating activities and, in some cases, reflect gains or losses which are unrealized and may not ultimately be realized. While we will be responsible for managing interest rate, hedge and foreign exchange risk, we expect to retain an outside consultant to review all our hedging agreements. Inasmuch as interest rate hedges are not a fundamental part of our operations, we believe it is appropriate to exclude such gains and losses in calculating MFFO, as such gains and losses are not reflective of our core operations.
Our MFFO calculation excludes impairments of real estate related investments, including loans. We assess the credit quality of our investments and adequacy of loan loss reserves on a quarterly basis, or more frequently as necessary. For loans classified as held-for-investment, we establish and maintain a general allowance for loan losses inherent in our portfolio at the reporting date and, where appropriate, a specific allowance for loan losses for loans we have determined to be impaired at the reporting date. An individual loan is considered impaired when it is deemed probable that we will not be able to collect all amounts due according to the contractual terms of the loan. Real estate related securities are evaluated for other-than-temporary impairment when the fair value of a security falls below its net amortized cost. Significant judgment is required in this analysis. We consider the estimated net recoverable value of the loan or security as well as other factors, including but not limited to the fair value of any collateral, the amount and the status of any senior debt, the prospects for the borrower and the competitive situation of the region where the borrower does business. Fair value is typically estimated based upon discounting the expected future cash flows of the underlying collateral taking into consideration the discount rate, capitalization rate, occupancy, creditworthiness of major tenants and many other factors. This requires significant judgment and because it is based upon
57
projections of future economic events, which are inherently subjective, the amounts ultimately realized may differ materially from the carrying value as of the balance sheet date. If upon completion of the assessment, the estimated fair value of the underlying collateral is less than the net carrying value of the loan, a specific allowance for loan losses is recorded. In the case of real estate securities, all or a portion of a deemed impairment may be recorded. Due to our limited life, any allowance for loan losses or impairment of real estate securities recorded may be difficult to recover.
MFFO is a metric used by management to evaluate our performance against other non-listed REITs which have limited lives with short and defined acquisition periods and targeted exit strategies shortly thereafter and is not intended to be used as a liquidity measure. Although management uses the MFFO metric to evaluate future operating performance, this metric excludes certain key operating items and other adjustments that may affect our overall operating performance. MFFO is not equivalent to net income or loss as determined under GAAP. We believe that our use of MFFO and the adjustments used to calculate it allow us to present our performance in a manner that reflects certain characteristics that are unique to non-listed REITs, such as their limited life, limited and defined acquisition period and targeted exit strategy, and hence that the use of such measures is useful to investors.
We believe that FFO provides useful context for understanding MFFO, and we believe that MFFO is a useful non-GAAP measure for non-listed REITs. It is helpful to management and stockholders in assessing our future operating performance once our organization and offering and acquisition and development stages are complete, because it eliminates from net income non-cash fair value adjustments on our real estate securities and acquisition fees and acquisition expenses that are incurred as part of our investment activities. However, MFFO may not be a useful measure of our operating performance or as a comparable measure to other typical non-listed REITs if we do not continue to operate in a similar manner to other non-listed REITs, including if we were to extend our acquisition and development stage or if we determined not to pursue an exit strategy.
However, MFFO does have certain limitations. For instance, the effect of any amortization or accretion on investments originated or acquired at a premium or discount, respectively, is not reported in MFFO. In addition, realized gains or losses from acquisitions and dispositions and other adjustments listed above are not reported in MFFO, even though such realized gains or losses and other adjustments could affect our operating performance and cash available for distribution. Stockholders should note that any cash gains generated from the sale of investments would generally be used to fund new investments. Any mark-to-market or fair value adjustments may be based on many factors, including current operational or individual property issues or general market or overall industry conditions.
Neither FFO nor MFFO is equivalent to net income or loss or cash flow provided by operating activities determined in accordance with GAAP and should not be construed to be more relevant or accurate than the GAAP methodology in evaluating our operating performance. Neither FFO nor MFFO is necessarily indicative of cash flow available to fund our cash needs including our ability to make distributions to our stockholders. FFO and MFFO do not represent amounts available for management’s discretionary use because of needed capital replacement or expansion, debt service obligations or other commitments or uncertainties. Furthermore, neither FFO nor MFFO should be considered as an alternative to net income or loss as an indicator of our operating performance.
Neither the SEC, NAREIT nor any other regulatory body has passed judgment on the acceptability of the adjustments that we use to calculate FFO or MFFO. In the future, the SEC, NAREIT or another regulatory body may decide to standardize the allowable adjustments across the non-listed REIT industry and we would have to adjust our calculation and characterization of FFO or MFFO.
The table below reflects the items deducted or added to net income or loss in our calculation of FFO and MFFO for the years ended December 31, 2015, 2014 and 2013 (in thousands):
Year Ended December 31, | ||||||||||||
2015 | 2014 | 2013 | ||||||||||
Funds From Operations: | ||||||||||||
Net income | $ | 24,933 | $ | 5,415 | $ | 102 | ||||||
Funds from operations | $ | 24,933 | $ | 5,415 | $ | 102 | ||||||
Modified Funds From Operations: | ||||||||||||
Funds from operations | $ | 24,933 | $ | 5,415 | $ | 102 | ||||||
Amortization of premiums, discounts and fees on investments, net | (1,561 | ) | (565 | ) | (91 | ) | ||||||
Acquisition fees and acquisition expenses | 7,916 | 4,386 | — | |||||||||
Loan loss provision | 318 | 570 | — | |||||||||
Modified funds from operations | $ | 31,606 | $ | 9,806 | $ | 11 | ||||||
58
Review of our Policies
Our board of directors, including our independent directors, has reviewed our policies described in this Annual Report on Form 10-K, as well as other policies previously reviewed and approved by our board of directors, and determined that they are in the best interests of our stockholders because: (1) they increase the likelihood that we will be able to acquire a diversified portfolio of investments, thereby reducing risk in our portfolio; (2) there are sufficient investment opportunities with the attributes that we seek; (3) our executive officers, directors and affiliates of the Advisor have expertise with the type of real estate-related investments we seek; (4) borrowings should enable us to acquire and originate investments and earn interest income more quickly; and (5) best practices corporate governance and high ethical standards help promote long-term performance, thereby increasing our likelihood of generating income for our stockholders and preserving stockholder capital.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
Our market risk arises primarily from interest rate risk relating to interest rate fluctuations. Many factors including governmental monetary and tax policies, domestic and international economic and political considerations and other factors that are beyond our control contribute to interest rate risk. To meet our short and long-term liquidity requirements, we may borrow funds at fixed and variable rates. Our interest rate risk management objectives are to limit the impact of interest rate changes in earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, from time to time, we may enter into interest rate hedge contracts such as swaps, collars and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. While hedging activities may insulate us against adverse changes in interest rates, they may also limit our ability to participate in benefits of lower interest rates with respect to our portfolio of investments with fixed interest rates. During the periods covered by this report, we did not engage in interest rate hedging activities. We do not hold or issue derivative contracts for trading or speculative purposes. We do not have any foreign denominated investments, and thus, we are not exposed to foreign currency fluctuations.
As of December 31, 2015 and 2014, our portfolio included 77 and 35 variable rate investments, respectively, based on LIBOR for various terms. Borrowings under our repurchase agreements are also based on LIBOR. The following table quantifies the potential changes in interest income net of interest expense should interest rates increase by 25 or 50 basis points or decrease by 25 basis points, assuming that our current balance sheet was to remain constant and no actions were taken to alter our existing interest rate sensitivity (in thousands):
Estimated Percentage Change in Interest Income Net of Interest Expense | ||||||
Change in Interest Rates | December 31, 2015 | December 31, 2014 | ||||
(-) 25 Basis Points | (2.38 | )% | (0.47 | )% | ||
Base Interest Rate | — | % | — | % | ||
(+) 50 Basis Points | 4.81 | % | 4.61 | % | ||
(+) 100 Basis Points | 9.61 | % | 9.22 | % | ||
Item 8. Financial Statements and Supplementary Data.
The information required by this Item 8 is hereby incorporated by reference to our Consolidated Financial Statements beginning on page F-1 of this Annual Report on Form 10-K.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
None.
Item 9A. Controls and Procedures.
Disclosure Controls and Procedures
In accordance with Rules 13a-15(b) and 15d-15(b) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this Annual Report on Form 10-K. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded, as of the end of such period, that our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in our reports that we file or submit under the Exchange Act.
Internal Control Over Financial Reporting
Management's Annual Reporting on Internal Controls over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Exchange Act.
59
In connection with the preparation of our Annual Report on Form 10-K, our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2015. In making that assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework (2013).
Based on its assessment, our management concluded that, as of December 31, 2015, our internal control over financial reporting was effective.
The rules of the SEC do not require, and this Annual Report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting.
Changes in Internal Control Over Financial Reporting
During the fiscal year ended December 31, 2015, there were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B. Other Information.
On March 10, 2016, we entered into an indemnification agreement (the “Indemnification Agreement”) with Matthew Donnelly (the “Indemnitee”) in connection with Mr. Donnelly’s appointment as our President and Chief Operating Officer. The Indemnification Agreement provides that we will indemnify the Indemnitee, to the fullest extent permitted by Maryland law and our charter and subject to the limitations set forth in the Indemnification Agreement, from and against all judgments, penalties, fines and amounts paid in settlement and expenses reasonably incurred by the Indemnitee that may result or arise in connection with the Indemnitee serving in his capacity as a present or former director, officer, employee or agent of us or as a director, trustee, officer, partner, manager, managing member, fiduciary, employee or agent of any other foreign or domestic corporation, partnership, limited liability company, joint venture, trust, employee benefit plan or other enterprise that such person is or was serving in such capacity at our request. The Indemnification Agreement further provides that, subject to the limitations set forth in the Indemnification Agreement, we will, without requiring a preliminary determination of the Indemnitee’s ultimate entitlement of indemnification under the Indemnification Agreement, advance all reasonable expenses to the Indemnitee incurred by or on behalf of the Indemnitee in connection with any proceeding the Indemnitee is or is threatened to be made a party to.
The Indemnification Agreement provides that the Indemnitee is entitled to indemnification unless it is established that (a) the act or omission of the Indemnitee was material to the matter giving rise to the proceeding and (i) was committed in bad faith or (ii) was the result of active and deliberate dishonesty, (b) the Indemnitee actually received an improper personal benefit in money, property or services or (c) in the case of any criminal proceeding, the Indemnitee had reasonable cause to believe that his conduct was unlawful. The Indemnification Agreement further limits the Indemnitee’s entitlement to indemnification in cases where (a) the proceeding was one by or in the right of us and the Indemnitee was adjudged to be liable to us, (b) the Indemnitee was adjudged to be liable on the basis that personal benefit was improperly received in any proceeding charging improper personal benefit to the Indemnitee or (c) the proceeding was brought by the Indemnitee, except in certain circumstances.
The Indemnification Agreement also provides that, except for a proceeding brought by the Indemnitee, we have the right to defend the Indemnitee in any proceeding which may give rise to indemnification under the Indemnification Agreement. The Indemnification Agreement grants the Indemnitee the right to separate counsel in certain proceedings involving separate defenses, counterclaims or other conflicts of interest and in proceedings in which we fail to assume the defense of the Indemnitee in a timely manner. The Indemnification Agreement further provides that we will use our reasonable best efforts to acquire directors and officers liability insurance covering the Indemnitee or any claim made against the Indemnitee by reason of his service to us.
The description of the Indemnification Agreement in this Annual Report on Form 10-K is a summary and is qualified in its entirety by the terms of the Indemnification Agreement attached as Exhibit 10.19 to this Annual Report on Form 10-K and incorporated herein by reference.
60
PART III
Item 10. Directors, Executive Officers and Corporate Governance.
We have adopted a Code of Ethics that applies to all of our executive officers and directors, including but not limited to, our principal executive officer and principal financial officer. A copy of our Code of Ethics may be obtained, free of charge, by sending a written request to our executive office – 405 Park Avenue – 14th Floor, New York, NY 10022, attention Chief Financial Officer.
The information required by this Item is incorporated by reference to our definitive proxy statement to be filed with the SEC with respect to our 2016 annual meeting of stockholders.
Item 11. Executive Compensation.
The information required by this Item is incorporated by reference to our definitive proxy statement to be filed with the SEC with respect to our 2016 annual meeting of stockholders.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by this Item is incorporated by reference to our definitive proxy statement to be filed with the SEC with respect to our 2016 annual meeting of stockholders.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
The information required by this Item is incorporated by reference to our definitive proxy statement to be filed with the SEC with respect to our 2016 annual meeting of stockholders.
Item 14. Principal Accounting Fees and Services.
The information required by this Item is incorporated by reference to our definitive proxy statement to be filed with the SEC with respect to our 2016 annual meeting of stockholders.
61
PART IV
Item 15. Exhibits and Financial Statement Schedules.
(a) Financial Statement Schedules
See the Index to Consolidated Financial Statements on page F-1 of this report.
(b) Exhibits
The following exhibits are included in this Annual Report on Form 10-K for the year ended December 31, 2015 (and are numbered in accordance with Item 601 of Regulation S-K).
Exhibit No. | Description | |
1.1* | Termination Agreement, dated as of December 31, 2015, between the Company, Realty Finance Advisors, LLC and Realty Capital Securities, LLC | |
3.1(2) | Amended and Restated Articles of Amendment and Restatement, dated as of April 12, 2013 | |
3.2(6) | Articles Supplementary, dated as of December 30, 2014 | |
3.3(9) | Articles of Amendment, effective February 10, 2015 | |
3.4(1) | Bylaws | |
4.1(6) | Amended and Restated Agreement of Limited Partnership of Realty Finance Trust, Inc. (formerly ARC Realty Finance Operating Partnership, L.P.), dated as of December 31, 2014 | |
10.1(10) | Amended and Restated Advisory Agreement, dated as of December 20, 2013, by and among the Company, Realty Finance Operating Partnership, L.P. (formerly ARC Realty Finance Operating Partnership, L.P.) and Realty Finance Advisors, LLC (formerly ARC Realty Finance Advisors, LLC) | |
10.2(11) | First Amendment to Amended and Restated Advisory Agreement, entered into as of April 24, 2015, by and among the Company, Realty Finance Operating Partnership, L.P. and Realty Finance Advisors, LLC | |
10.3(12) | Second Amendment to Amended and Restated Advisory Agreement, dated June 23, 2015, by and among the Company, Realty Finance Operating Partnership, L.P. and Realty Finance Advisors, LLC | |
10.4(2) | Employee and Director Incentive Restricted Share Plan | |
10.5(2) | Form of Restricted Share Award Agreement Pursuant to the Employee and Director Incentive Restricted Share Plan | |
10.6(3) | Revolving Line of Credit Agreement, made and entered into as of May 15, 2013, by and between the Company and AR Capital, LLC | |
10.7(3) | First Amendment to Revolving Line of Credit Agreement, made and entered into as of July 17, 2013, by and between the Company and AR Capital, LLC | |
10.8(4) | Uncommitted Master Repurchase Agreement, dated as of June 18, 2014, between the Company JPM Loan, LLC and JPMorgan Chase Bank, National Association | |
10.9(13) | Amendment No.1 to Master Repurchase Agreement, dated as of June 24, 2015, by and between the Company, JPM Loan, LLC and JP Morgan Chase Bank, National Association | |
10.10(14) | Amendment No. 2 to Master Repurchase Agreement, dated as of September 28, 2015, between the Company, JPM Loan, LLC and JPMorgan Chase Bank, National Association | |
10.11* | Amendment No. 3 to Master Repurchase Agreement, dated as of December 30, 2015, between the Company, JPM Loan, LLC and JPMorgan Chase Bank, National Association | |
10.12(5) | Guarantee Agreement, dated as of June 18, 2014, between the Company and JPMorgan Chase Bank, National Association | |
10.13(5) | Master Repurchase Agreement, dated as of September 5, 2014, between ARC RFT BB Loan, LLC and Barclays Bank PLC | |
10.14(5) | Guaranty, dated as of September 5, 2014, between the Company and Barclays Bank PLC | |
10.15* | First Amendment to Guaranty, dated as of December 30, 2015, between the Company and Barclays Bank PLC. | |
10.16(15) | Indenture, dated October 19, 2015, by and among RFT 2015-FL1 Issuer Ltd., as issuer, RFT 2015-FL1 Co-Issuer LLC, as issuer, Realty Finance Operating Partnership L.P., as advancing agent, and U.S. Bank National Association, as trustee, note administrator, paying agent, calculation agent, transfer agent, custodian, securities intermediary, backup advancing agent and notes registrar | |
10.17(7) | Indemnification Agreement, dated as of December 31, 2014, between the Company and certain directors, officers and service providers | |
10.18(13) | Indemnification Agreement, dated May 26, 2015, between the Company and Donald R. Ramon | |
10.19* | Indemnification Agreement, dated March 10, 2016, between the Company and Matthew Donnelly | |
14.1(2) | Code of Ethics, dated as of February 7, 2013 | |
62
16.1(8) | Letter from Grant Thornton LLP to the Securities and Exchange Commission dated January 28, 2015 | |
21* | Subsidiaries of the Registrant | |
31.1* | Certification of the Principal Executive Officer of the Company pursuant to Securities Exchange Act Rule 13a - 14(a) or 15(d) - 14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
31.2* | Certification of the Principal Financial Officer of the Company pursuant to Securities Exchange Act Rule 13a - 14(a) or 15(d) - 14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
32* | Written statements of the Principal Executive Officer and Principal Financial Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
101* | XBRL (eXtensible Business Reporting Language). The following materials from Realty Finance Trust, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2014, formatted in XBRL: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Operations and Comprehensive Income (Loss), (iii) the Consolidated Statement of Changes in Equity, (iv) the Consolidated Statements of Cash Flows and (v) the Notes to the Consolidated Financial Statements. | |
*Filed herewith.
(1) | Filed as an exhibit to Pre-Effective Amendment No. 1 to our Registration Statement on Form S-11/A filed with the SEC on January 23, 2013. |
(2) | Filed as an exhibit to our quarterly report on Form 10-Q for the quarter ended March 31, 2013 filed with the SEC on May 15, 2013. |
(3) | Filed as an exhibit to our quarterly report on Form 10-Q for the quarter ended June 30, 2013 filed with the SEC on August 13, 2013. |
(4) | Filed as an exhibit to Pre-Effective Amendment No. 1 to Post-Effective Amendment No. 7 to our Registration Statement on Form S-11 filed with the SEC on July 11, 2014. |
(5) | Filed as an exhibit to Pre-Effective Amendment No. 1 to Post-Effective Amendment No. 8 to our Registration Statement on Form S-11 filed with the SEC on October 8, 2014. |
(6) | Filed as an exhibit to our current report on Form 8-K filed with the SEC on January 6, 2015. |
(7) | Filed as an exhibit to Pre-Effective Amendment No. 1 to Post-Effective Amendment No. 9 to our Registration Statement on Form S-11 filed with the SEC on January 8, 2015. |
(8) | Filed as an exhibit to our current report on Form 8-K filed with the SEC on January 28, 2015. |
(9) | Filed as an exhibit to our current report on Form 8-K filed with the SEC on February 17, 2015. |
(10) | Filed as an exhibit to Pre-Effective Amendment No. 1 to Post-Effective Amendment No. 11 to our Registration Statement on Form S-11 filed with the SEC on April 8, 2015. |
(11) | Filed as an exhibit to our annual report on Form 10-K for the year ended December 31, 2014 filed with the SEC on April 24, 2015. |
(12) | Filed as an exhibit to our current report on Form 8-K filed with the SEC on June 23, 2015. |
(13) | Filed as an exhibit to Pre-Effective Amendment No.1 to Post-Effective Amendment No.12 to our Registration Statement on Form S-11 filed with the SEC on July 8, 2015. |
(14) | Filed as an exhibit to Pre-Effective Amendment No. 1 to Post-Effective Amendment No. 13 filed with the SEC on October 8, 2015. |
(15) | Filed as an exhibit to our current report on Form 8-K filed with the SEC on October 23, 2015. |
63
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized this 11th day of March, 2016.
Realty Finance Trust, Inc. | ||
By | /s/ Peter M. Budko | |
Peter M. Budko | ||
Chief Executive Officer | ||
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this annual report on Form 10-K has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Name | Capacity | Date | ||
/s/ Peter M. Budko | Chief Executive Officer and Chairman of the Board | March 11, 2016 | ||
Peter M. Budko | (Principal Executive Officer) | |||
/s/ Nicholas Radesca | Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer) | March 11, 2016 | ||
Nicholas Radesca | ||||
/s/ Matt Donnelly | President and Chief Operating Officer | March 11, 2016 | ||
Matt Donnelly | ||||
/s/ Dr. Robert J. Froehlich | Lead Independent Director | March 11, 2016 | ||
Dr. Robert J. Froehlich | ||||
/s/ Elizabeth K. Tuppeny | Independent Director | March 11, 2016 | ||
Elizabeth K. Tuppeny | ||||
64
REALTY FINANCE TRUST, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page | |
Financial Statement Schedule: | |
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Realty Finance Trust, Inc.:
We have audited the accompanying consolidated balance sheets of Realty Finance Trust, Inc. and subsidiaries (the “Company”) as of December 31, 2015 and 2014, and the related consolidated statements of operations, comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the two-year period ended December 31, 2015. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule titled Schedule IV - Mortgage Loans on Real Estate as of December 31, 2015. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Realty Finance Trust, Inc. and subsidiaries as of December 31, 2015 and 2014, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2015, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
/s/ KPMG LLP
New York, New York
March 11, 2016
F-2
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Stockholders and Board of Directors
Realty Finance Trust, Inc.:
We have audited the accompanying consolidated statements of operations, comprehensive income, changes in stockholders’ equity, and cash flows of Realty Finance Trust, Inc. (a Maryland corporation) and subsidiaries (the “Company”) for the year ended December 31, 2013. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Realty Finance Trust, Inc. and subsidiaries for the year ended December 31, 2013 in conformity with accounting principles generally accepted in the United States of America.
/s/ GRANT THORNTON LLP
Philadelphia, Pennsylvania
March 13, 2014
F-3
REALTY FINANCE TRUST, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
December 31, 2015 | December 31, 2014 | ||||||
ASSETS | |||||||
Cash and cash equivalents | $ | 14,807 | $ | 386 | |||
Restricted cash | 5,366 | 68 | |||||
Commercial mortgage loans, held for investment, net (1) (2) | 1,124,201 | 456,884 | |||||
Real estate securities, at fair value | 130,754 | 50,234 | |||||
Receivable for loan repayment | 1,307 | — | |||||
Accrued interest receivable | 5,360 | 2,866 | |||||
Prepaid expenses and other assets | 689 | 3,782 | |||||
Total assets | $ | 1,282,484 | $ | 514,220 | |||
LIABILITIES AND STOCKHOLDERS' EQUITY | |||||||
Collateralized loan obligations | $ | 287,229 | $ | — | |||
Repurchase agreements - commercial mortgage loans | 206,239 | 150,169 | |||||
Repurchase agreements - real estate securities | 117,211 | 26,269 | |||||
Interest payable | 792 | 232 | |||||
Distributions payable | 5,552 | 2,623 | |||||
Accounts payable and accrued expenses | 6,805 | 2,385 | |||||
Due to affiliates | 4,327 | 2,035 | |||||
Total liabilities | $ | 628,155 | $ | 183,713 | |||
Commitment and Contingencies (See Note 8) | |||||||
Preferred stock, $0.01 par value, 50,000,000 authorized, none issued and outstanding as of December 31, 2015 and 2014 | $ | — | $ | — | |||
Convertible stock ("promote shares"); $0.01 par value, 1,000 shares authorized, issued and outstanding as of December 31, 2015 and 2014 | 1 | 1 | |||||
Common stock, $0.01 par value, 949,999,000 shares authorized, 31,385,280 and 15,472,192 shares issued and outstanding as of December 31, 2015 and 2014, respectively | 314 | 155 | |||||
Additional paid-in capital | 691,590 | 340,874 | |||||
Accumulated other comprehensive loss | (2,254 | ) | (307 | ) | |||
Accumulated deficit | (35,322 | ) | (10,216 | ) | |||
Total stockholders' equity | $ | 654,329 | $ | 330,507 | |||
Total liabilities and stockholders' equity | $ | 1,282,484 | $ | 514,220 | |||
_______________________
(1) Includes $426,155 and $0 of loans pledged as collateral on collateralized loan obligations as of December 31, 2015 and 2014, respectively.
(2) Net of allowance for loan loss of $0.9 million and $0.6 million as of December 31, 2015 and 2014, respectively.
The accompanying notes are an integral part of these consolidated financial statements.
F-4
REALTY FINANCE TRUST, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share and per share data)
Years Ended December 31, | |||||||||||
2015 | 2014 | 2013 | |||||||||
Interest Income: | |||||||||||
Interest income | $ | 59,393 | $ | 15,466 | $ | 775 | |||||
Less: Interest expense | 12,268 | 2,196 | 32 | ||||||||
Net interest income | 47,125 | 13,270 | 743 | ||||||||
Expenses: | |||||||||||
Acquisition fees | 7,916 | 4,386 | — | ||||||||
Asset management and subordinated performance fee | 7,615 | 604 | — | ||||||||
Professional fees | 4,997 | 1,050 | 71 | ||||||||
Other expenses | 1,346 | 1,148 | 570 | ||||||||
Loan loss provision | 318 | 570 | — | ||||||||
Total expenses | 22,192 | 7,758 | 641 | ||||||||
Gain on sale of loan | — | 112 | — | ||||||||
Income before income taxes | 24,933 | 5,624 | 102 | ||||||||
Income tax provision | — | 209 | — | ||||||||
Net income | $ | 24,933 | $ | 5,415 | $ | 102 | |||||
Basic net income per share | $ | 1.03 | $ | 0.75 | $ | 0.19 | |||||
Diluted net income per share | $ | 1.03 | $ | 0.75 | $ | 0.19 | |||||
Basic weighted average shares outstanding | 24,253,905 | 7,227,169 | 526,084 | ||||||||
Diluted weighted average shares outstanding | 24,259,169 | 7,232,559 | 530,096 | ||||||||
The accompanying notes are an integral part of these consolidated financial statements.
F-5
REALTY FINANCE TRUST, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
Years Ended December 31, | |||||||||||
2015 | 2014 | 2013 | |||||||||
Net income | $ | 24,933 | $ | 5,415 | $ | 102 | |||||
Unrealized loss on available-for-sale securities | (1,947 | ) | (297 | ) | (10 | ) | |||||
Comprehensive income attributable to Realty Finance Trust, Inc. | $ | 22,986 | $ | 5,118 | $ | 92 | |||||
The accompanying notes are an integral part of these consolidated financial statements.
F-6
REALTY FINANCE TRUST, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(In thousands, except share data)
Convertible Stock | Common Stock | ||||||||||||||||||||||||||||
Number of Shares | Amount | Number of Shares | Par Value | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Accumulated Deficit | Total Stockholders' Equity | ||||||||||||||||||||||
Balance, December 31, 2012 | — | $ | — | 8,888 | $ | — | $ | 200 | $ | — | $ | (16 | ) | $ | 184 | ||||||||||||||
Issuance of common stock | — | — | 1,311,226 | 13 | 32,194 | — | — | 32,207 | |||||||||||||||||||||
Common stock repurchases | — | — | (1,400 | ) | — | (35 | ) | — | — | (35 | ) | ||||||||||||||||||
Common stock offering costs, commissions and dealer manager fees | — | — | — | — | (5,944 | ) | — | — | (5,944 | ) | |||||||||||||||||||
Common stock issued through distribution reinvestment plan | — | — | 7,956 | — | 189 | — | — | 189 | |||||||||||||||||||||
Share-based compensation | — | — | 3,999 | — | 16 | — | — | 16 | |||||||||||||||||||||
Net income | — | — | — | — | — | — | 102 | 102 | |||||||||||||||||||||
Distributions declared | — | — | — | — | — | — | (691 | ) | (691 | ) | |||||||||||||||||||
Other comprehensive loss | — | — | — | — | — | (10 | ) | — | (10 | ) | |||||||||||||||||||
Balance, December 31, 2013 | — | — | 1,330,669 | 13 | 26,620 | (10 | ) | (605 | ) | 26,018 | |||||||||||||||||||
Issuance of common stock | — | — | 13,947,701 | 140 | 346,872 | — | — | 347,012 | |||||||||||||||||||||
Issuance of convertible stock | 1,000 | 1 | — | — | — | — | — | 1 | |||||||||||||||||||||
Common stock repurchases | — | — | (19,355 | ) | — | (464 | ) | — | — | (464 | ) | ||||||||||||||||||
Common stock offering costs, commissions and dealer manager fees | — | — | — | — | (37,206 | ) | — | — | (37,206 | ) | |||||||||||||||||||
Common stock issued through distribution reinvestment plan | — | — | 211,577 | 2 | 5,025 | — | — | 5,027 | |||||||||||||||||||||
Share-based compensation | — | — | 1,600 | — | 27 | — | — | 27 | |||||||||||||||||||||
Net income | — | — | — | — | — | — | 5,415 | 5,415 | |||||||||||||||||||||
Distributions declared | — | — | — | — | — | — | (15,026 | ) | (15,026 | ) | |||||||||||||||||||
Other comprehensive loss | — | — | — | — | — | (297 | ) | — | (297 | ) | |||||||||||||||||||
Balance, December 31, 2014 | 1,000 | 1 | 15,472,192 | 155 | 340,874 | (307 | ) | (10,216 | ) | 330,507 | |||||||||||||||||||
Issuance of common stock | — | — | 15,428,195 | 155 | 385,000 | — | — | 385,155 | |||||||||||||||||||||
Common stock repurchases | — | — | (360,719 | ) | (4 | ) | (8,550 | ) | — | — | (8,554 | ) | |||||||||||||||||
Common stock offering costs, commissions and dealer manager fees | — | — | — | — | (45,917 | ) | — | — | (45,917 | ) | |||||||||||||||||||
Common stock issued through distribution reinvestment plan | — | — | 842,946 | 8 | 20,153 | — | — | 20,161 | |||||||||||||||||||||
Share-based compensation | — | — | 2,666 | — | 30 | — | — | 30 | |||||||||||||||||||||
Net income | — | — | — | — | — | — | 24,933 | 24,933 | |||||||||||||||||||||
Distributions declared | — | — | — | — | — | — | (50,039 | ) | (50,039 | ) | |||||||||||||||||||
Other comprehensive loss | — | — | — | — | — | (1,947 | ) | — | (1,947 | ) | |||||||||||||||||||
Balance, December 31, 2015 | 1,000 | $ | 1 | 31,385,280 | $ | 314 | $ | 691,590 | $ | (2,254 | ) | $ | (35,322 | ) | $ | 654,329 | |||||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
F-7
For the Years Ended December 31, | |||||||||||
2015 | 2014 | 2013 | |||||||||
Cash flows from operating activities: | |||||||||||
Net income | $ | 24,933 | $ | 5,415 | $ | 102 | |||||
Adjustments to reconcile net income to net cash provided by operating activities: | |||||||||||
Premium amortization and (discount accretion), net | (1,561 | ) | (399 | ) | (91 | ) | |||||
Accretion of deferred commitment fees | (1,068 | ) | (166 | ) | — | ||||||
Amortization of deferred financing costs | 2,819 | 479 | — | ||||||||
Realized gain on sale of commercial mortgage loan | — | (112 | ) | — | |||||||
Share-based compensation | 30 | 27 | 16 | ||||||||
Loan loss provision | 318 | 570 | — | ||||||||
Changes in assets and liabilities: | |||||||||||
Accrued interest receivable | (1,426 | ) | (2,574 | ) | (126 | ) | |||||
Prepaid expenses and other assets | 723 | (18 | ) | (229 | ) | ||||||
Accounts payable and accrued expenses | (1,707 | ) | (276 | ) | 1,090 | ||||||
Due to affiliate | 1,812 | (478 | ) | — | |||||||
Interest payable | 560 | 217 | 14 | ||||||||
Net cash provided by operating activities: | $ | 25,433 | $ | 2,685 | $ | 776 | |||||
Cash flows from investing activities: | |||||||||||
Origination and purchase of commercial mortgage loans | $ | (793,731 | ) | $ | (429,941 | ) | $ | (30,787 | ) | ||
Purchase of real estate securities | (85,463 | ) | (45,597 | ) | (5,015 | ) | |||||
Proceeds from sale of commercial mortgage loan | — | 3,692 | — | ||||||||
Principal repayments received on commercial mortgage loans | 126,336 | 136 | 47 | ||||||||
Principal repayments received on real estate securities | 3,010 | 73 | — | ||||||||
Net cash used in investing activities | $ | (749,848 | ) | $ | (471,637 | ) | $ | (35,755 | ) | ||
Cash flows from financing activities: | |||||||||||
Proceeds from issuances of common stock | $ | 385,203 | $ | 345,944 | $ | 32,207 | |||||
Common stock repurchases | (2,555 | ) | (464 | ) | (35 | ) | |||||
Proceeds from issuances of convertible stock | — | 1 | — | ||||||||
Payments of offering costs and fees related to common stock issuances | (45,357 | ) | (35,598 | ) | (4,991 | ) | |||||
Proceeds from issuance of collateralized loan obligations | 292,484 | — | — | ||||||||
Borrowings on repurchase agreements - commercial mortgage loans | 423,538 | 150,169 | — | ||||||||
Repayments of repurchase agreements - commercial mortgage loans | (367,468 | ) | — | — | |||||||
Borrowings on repurchase agreements - real estate securities | 690,406 | 31,598 | — | ||||||||
Repayments of repurchase agreements - real estate securities | (599,464 | ) | (5,329 | ) | — | ||||||
Borrowings on revolving line of credit with affiliate | — | 5,550 | 16,845 | ||||||||
Repayments of revolving line of credit with affiliate | — | (12,855 | ) | (9,540 | ) | ||||||
Increase in restricted cash related to financing activities | (5,298 | ) | (68 | ) | — | ||||||
Advances from affiliate | — | — | 956 | ||||||||
Payments of deferred financing costs | (5,704 | ) | (2,196 | ) | — | ||||||
Distributions paid | (26,949 | ) | (7,592 | ) | (286 | ) | |||||
Net cash provided by financing activities: | $ | 738,836 | $ | 469,160 | $ | 35,156 | |||||
Net change in cash | 14,421 | 208 | 177 | ||||||||
Cash, beginning of period | 386 | 178 | 1 | ||||||||
Cash, end of period | $ | 14,807 | $ | 386 | $ | 178 | |||||
F-8
For the Years Ended December 31, | |||||||||||
2015 | 2014 | 2013 | |||||||||
Supplemental disclosures of cash flow information: | |||||||||||
Income taxes paid | $ | 159 | $ | 50 | $ | — | |||||
Interest paid | 8,889 | 1,500 | — | ||||||||
Supplemental disclosures of non-cash flow information: | |||||||||||
Distributions payable | $ | 5,552 | $ | 2,623 | $ | 216 | |||||
Common stock issued through distribution reinvestment plan | 20,161 | 5,027 | 189 | ||||||||
Receivable for common stock issued | — | 1,068 | 122 | ||||||||
Reclassification of deferred offering costs to additional paid-in capital | — | — | 941 | ||||||||
The accompanying notes are an integral part of these consolidated financial statements.
F-9
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
Note 1 - Organization and Business Operations
Realty Finance Trust, Inc. (the "Company") was incorporated in Maryland on November 15, 2012 and conducts its operations to qualify as a real estate investment trust ("REIT") for U.S. federal income tax purposes beginning with the filing of its tax return for the taxable year ended December 31, 2013. On May 14, 2013, the Company commenced business operations after raising in excess of $2.0 million of equity, the amount required for the Company to release equity proceeds from escrow.
Prior to January 2016 the Company was offering for sale a maximum of 80.0 million shares of common stock, $0.01 par value per share, on a reasonable best efforts basis, pursuant to a registration statement on Form S-11 (the "Offering") filed with the U.S. Securities and Exchange Commission under the Securities Act of 1933, as amended. The Offering also covered the offer and sale of up to approximately 16.8 million shares of common stock pursuant to a distribution reinvestment plan (the "DRIP") under which common stockholders may elect to have their distributions reinvested in additional shares of the Company’s common stock. Effective January 2016, the Company terminated the Offering, deregistered 4,069 unsold shares from the Offering and reallocated 49.7 million unsold shares from the Offering to the DRIP offering.
Prior to the NAV pricing date (as described below), we offered shares of our common stock in the Offering through Realty Capital Securities, LLC (the "Former Dealer Manager") at a per share price of up to $25.00 per share (including the maximum allowed to be charged for commissions and fees, subject to certain discounts as described in the Company's prospectus). Prior to the NAV pricing date, the Company has offered shares of its common stock through the DRIP, at a price equal to $23.75 per share, which is 95% of the primary offering price. As of close of business on November 10, 2015 (the "NAV pricing date"), pursuant to the net asset value ("NAV") as determined by the board of directors, the Company began offering shares of its common stock in the Offering at a price of up to $28.08 per share, inclusive of applicable commissions and dealer manager fees and through the DRIP at a price equal to $25.27, the NAV per share. Beginning with the NAV pricing date, the per share price for shares in the DRIP will vary and will be equal to the Company's most recent reported NAV, divided by the number of shares of the Company's common stock outstanding as of such date the NAV was calculated. As of December 31, 2015, the aggregate gross proceeds from the sale of common stock in the Offering, including DRIP was $789.8 million.
The Company was formed to originate, acquire and manage a diversified portfolio of commercial real estate debt investments secured by properties located both within and outside of the United States. The Company may also invest in commercial real estate securities and commercial real estate properties. Commercial real estate debt investments may include first mortgage loans, subordinated mortgage loans, mezzanine loans and participations in such loans. Real estate securities may include commercial mortgage-backed securities ("CMBS"), senior unsecured debt of publicly traded REITs, debt or equity securities of other publicly traded real estate companies and collateralized debt obligations ("CDOs").
The Company has no direct employees. The Company has retained Realty Finance Advisors, LLC (the "Advisor") to manage the Company's affairs on a day-to-day basis. The Former Dealer Manager served as the dealer manager of the Offering. The Advisor and Former Dealer Manager are under common control with AR Global Investments, LLC (the successor business to AR Capital, LLC, "AR Global"), the parent of American Realty Capital VIII, LLC (the "Sponsor"), as a result they are related parties and each of them has received or will receive compensation and fees for services related to the Offering, the investment and management of the Company's assets, the operations of the Company and the liquidation of the Company.
The Former Dealer Manager served as the dealer manager of our primary offering and, together with certain of its affiliates, continued to provide us with various services through December 31, 2015. RCS Capital Corporation, the parent company of our Former Dealer Manager and certain of its affiliates that provided us with services, filed for Chapter 11 bankruptcy protection in January 2016, prior to which it was also under common control with AR Global, the parent of our Sponsor.
Note 2 - Summary of Significant Accounting Policies
Basis of Accounting
The accompanying consolidated financial statements and related footnotes have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The consolidated financial statements of the Company are prepared on an accrual basis of accounting.
Principles of Consolidation and Basis of Presentation
The accompanying consolidated financial statements include the accounts of the Company, Realty Finance Operating Partnership, L.P. (the "OP") and its subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. In determining whether the Company has a controlling financial interest in a joint venture and the requirement to
F-10
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
consolidate the accounts of that entity, management considers factors such as ownership interest, authority to make decisions and contractual and substantive participating rights of the other partners or members as well as whether the entity is a variable interest entity for which the Company is the primary beneficiary.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management makes significant estimates regarding classification of investments, fair value measurements, credit losses and impairments of investments and derivative financial instruments and hedging activities, as applicable.
Acquisition Fees and Acquisition Expenses
The Company incurs acquisition fees and acquisition expenses payable to the Advisor. The Company pays the Advisor an acquisition fee based on the principal amount funded by the Company to originate or acquire commercial mortgage loan investments or on the anticipated net equity funded by the Company to acquire real estate securities. Acquisition fees paid and acquisition expenses reimbursed to the Company's Advisor in connection with the origination and acquisition of commercial mortgage loan investments and acquisition of real estate securities are evaluated based on the nature of the expense to determine if they should be expensed in the period incurred or capitalized and amortized over the life of the investment.
Commercial Mortgage Loans
Commercial mortgage loans are held for investment purposes and are anticipated to be held until maturity, and accordingly, are carried at cost, net of unamortized acquisition expenses, discounts or premiums and unfunded commitments. Commercial mortgage loans that are deemed to be impaired will be carried at amortized cost less a specific allowance for loan losses. Interest income is recorded on the accrual basis and related discounts, premiums and acquisition expenses on investments are amortized over the life of the investment using the effective interest method. Amortization is reflected as an adjustment to interest income in the Company’s consolidated statements of operations. Guaranteed loan exit fees payable by the borrower upon maturity are accreted over the life of the investment using the effective interest method. The accretion of guaranteed loan exit fees is recognized in interest income in the Company's consolidated statements of operation.
Allowance for Loan Losses
The allowance for loan losses reflects management's estimate of loan losses inherent in the loan portfolio as of the balance sheet date. The reserve is increased through the loan loss provision on the Company's condensed consolidated statement of operations and is decreased by charge-offs when losses are confirmed through the receipt of assets, such as cash in a pre-foreclosure sale or upon ownership control of the underlying collateral in full satisfaction of the loan upon foreclosure or when significant collection efforts have ceased. The Company uses a uniform process for determining its allowance for loan losses. The allowance for loan losses includes a general, formula-based component and an asset-specific component.
General reserves are recorded when (i) available information as of each balance sheet date indicates that it is probable a loss has occurred in the portfolio and (ii) the amount of the loss can be reasonably estimated. The Company currently estimates loss rates based on historical realized losses experienced in the industry and takes into account current collateral and economic conditions affecting the probability and severity of losses when establishing the allowance for loan losses. The Company performs a comprehensive analysis of its loan portfolio and assigns risk ratings to loans that incorporate management's current judgments about their credit quality based on all known and relevant internal and external factors that may affect collectability. The Company considers, among other things, payment status, lien position, borrower financial resources and investment in collateral, collateral type, project economics and geographic location as well as national and regional economic factors. This methodology results in loans being segmented by risk classification into risk rating categories that are associated with estimated probabilities of default and principal loss. Ratings range from "1" to "5" with "1" representing the lowest risk of loss and "5" representing the highest risk of loss.
The asset-specific reserve component relates to reserves for losses on individual impaired loans. The Company considers a loan to be impaired when, based upon current information and events, it believes that it is probable that the Company will be unable to collect all amounts due under the contractual terms of the loan agreement. This assessment is made on an individual loan basis each quarter based on such factors as payment status, lien position, borrower financial resources and investment in collateral, collateral type, project economics and geographical location as well as national and regional economic factors. A reserve is established for an impaired loan when the present value of payments expected to be received, observable market
F-11
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
prices or the estimated fair value of the collateral (for loans that are dependent on the collateral for repayment) is lower than the carrying value of that loan.
For collateral dependent impaired loans, impairment is measured using the estimated fair value of collateral less the estimated cost to sell. Valuations are performed or obtained at the time a loan is determined to be impaired and designated non-performing, and they are updated if circumstances indicate that a significant change in value has occurred. The Advisor generally will use the income approach through internally developed valuation models to estimate the fair value of the collateral for such loans. In more limited cases, the Advisor will obtain external "as is" appraisals for loan collateral, generally when third party participations exist.
A loan is also considered impaired if its terms are modified in a troubled debt restructuring ("TDR"). A TDR occurs when a concession is granted and the debtor is experiencing financial difficulties. Impairments on TDR loans are generally measured based on the present value of expected future cash flows discounted at the effective interest rate of the original loans.
The Company designates non-performing loans at such time as (i) loan payments become 90-days past due; (ii) the loan has a maturity default; or (iii) in the opinion of the Company, it is probable the Company will be unable to collect all amounts due according to the contractual terms of the loan. Income recognition will be suspended when a loan is designated non-performing and resumed only when the suspended loan becomes contractually current and performance is demonstrated to have resumed. A loan will be written off when it is no longer realizable and legally discharged.
Real Estate Securities
On the acquisition date, all of the Company’s commercial real estate securities were classified as available for sale and carried at fair value, and subsequently any unrealized gains or losses are recognized as a component of accumulated other comprehensive income or loss. The Company may elect the fair value option for its real estate securities, and as a result, any unrealized gains or losses on such real estate securities will be recorded in the Company’s consolidated statement of operations. No such election has been made to date. Related discounts, premiums and acquisition expenses on investments are amortized over the life of the investment using the effective interest method. Amortization is reflected as an adjustment to interest income in the Company’s consolidated statements of operations.
Impairment Analysis of Real Estate Securities
Commercial real estate securities for which the fair value option has not been elected are periodically evaluated for other-than-temporary impairment. If the fair value of a security is less than its amortized cost, the security is considered impaired. Impairment of a security is considered other-than-temporary when (i) the Company has the intent to sell the impaired security; (ii) it is more likely than not the Company will be required to sell the security; or (iii) the Company does not expect to recover the entire amortized cost of the security. If the Company determines that an other-than-temporary impairment exists and a sale is likely, the impairment charge is recognized as an impairment of assets on the Company's consolidated statement of operations. If a sale is not expected, the portion of the impairment charge related to credit factors is recorded as an impairment of assets on the Company's consolidated statement of operations with the remainder recorded as an unrealized gain or loss on investments reported as a component of accumulated other comprehensive income or loss. The Company did not have any other-than-temporary impairment for the years ended December 31, 2015 and 2014.
Commercial real estate securities for which the fair value option has been elected are not evaluated for other-than-temporary impairment as changes in fair value are recorded in the Company’s consolidated statement of operations. No such election has been made to date.
Repurchase Agreements
Commercial mortgage loans and real estate securities sold under repurchase agreements have been treated as collateralized financing transactions because the Company maintains effective control over the transferred securities. Commercial mortgage loans and real estate securities financed through a repurchase agreement remain on the Company’s consolidated balance sheet as an asset and cash received from the purchaser is recorded as a liability. Interest paid in accordance with repurchase agreements is recorded in interest expense on the Company's consolidated statements of operations.
Cash and Cash Equivalents
Cash represents deposits with high quality financial institutions. These deposits are guaranteed by the Federal Deposit Insurance Company up to an insurance limit. Cash equivalents include short-term, liquid investments in money market funds.
Restricted Cash
Restricted cash primarily consists of cash pledged as margin on repurchase agreements.
F-12
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
Prepaid Expenses
Prepaid expenses consists of deferred financing cost related to issuance of our revolving debt as well as certain subscription cost. Deferred financing costs are amortized over the terms of the respective financing agreement using the effective interest method and included in the interest expense on the accompanying consolidated statements of operations. Unamortized deferred financing costs are generally expensed when the associated debt is refinanced or repaid before maturity.
Share Repurchase Program
The Company has a Share Repurchase Program (the "SRP"), which was amended as of February 28, 2016, that enables stockholders to sell their shares to the Company.
Subject to certain conditions, stockholders that purchased shares of our common stock or received their shares from us (directly or indirectly) through one or more non-cash transactions and have held their shares for a period of at least one year may request that we repurchase their shares of common stock so long as the repurchase otherwise complies with the provisions of Maryland law. Repurchase requests made following the death or qualifying disability of a stockholder will not be subject to any minimum holding period.
The repurchase price per share for requests other than for death or disability will be equal to the most-recent estimated net asset value per share of our common stock calculated by our Advisor in accordance with our valuation guidelines, or estimated per-share NAV, multiplied by a percentage equal to (i) 92.5%, if the person seeking repurchase has held his or her shares for a period greater than one year and less than two years; (ii) 95%, if the person seeking repurchase has held his or her shares for a period greater than two years and less than three years; (iii) 97.5%, if the person seeking repurchase has held his or her shares for a period greater than three years and less than four years; or (iv) 100%, if the person seeking repurchase has held his or her shares for a period greater than four years. In the case of requests for death or disability, the repurchase price per share will be equal to the estimated per-share NAV at the time of repurchase.
Repurchases pursuant to the SRP, when requested, generally will be made semiannually (each six-month period ending June 30 or December 31, a “fiscal semester”). Repurchases for any fiscal semester will be limited to a maximum of 2.5% of the weighted average number of shares of common stock outstanding during the previous fiscal year, with a maximum for any fiscal year of 5.0% of the weighted average number of shares of common stock outstanding during the previous fiscal year. Funding for repurchases pursuant to the SRP for any given fiscal semester will be limited to proceeds received during that same fiscal semester through the issuance of common stock pursuant to any DRIP in effect from time to time, provided that the Board has the power, in its sole discretion, to determine the amount of shares repurchased during any fiscal semester as well as the amount of funds to be used for that purpose. Due to these limitations, we cannot guarantee that we will be able to accommodate all repurchase requests made during any fiscal semester or fiscal year. However, a stockholder may withdraw its request at any time or ask that we honor the request when funds are available. Pending repurchase requests will be honored on a pro rata basis. We will generally pay repurchase proceeds, less any applicable tax or other withholding required by law, by the 31st day following the end of the fiscal semester during which the repurchase request was made.
Calculations of our estimated per-share NAV will occur periodically, at the discretion of the Board, provided that such calculations will be made at least annually. Following its calculation, our estimated per-share NAV will be disclosed in a periodic report. The most recent calculation of our estimated per-share NAV approved by the Board occurred on November 4, 2015 based on our net asset value as of September 30, 2015 and was equal to $25.27.
When a stockholder requests a redemption and the redemption is approved, we will reclassify such obligation from equity to a liability based on the settlement value of the obligation. Shares repurchased under the SRP will have the status of authorized but unissued shares.
Distribution Reinvestment Plan
Pursuant to the DRIP, stockholders may elect to reinvest distributions by purchasing shares of common stock in lieu of receiving cash. No dealer manager fees or selling commissions are paid with respect to shares purchased pursuant to the DRIP. Participants purchasing shares pursuant to the DRIP have the same rights and are treated in the same manner as if such shares were issued pursuant to the Offering. The board of directors may designate that certain cash or other distributions be excluded from the DRIP. The Company has the right to amend any aspect of the DRIP or terminate the DRIP with ten days’ notice to participants. Shares issued under the DRIP are recorded to equity in the consolidated balance sheet in the period distributions are declared. There have been 1,062,479 shares issued under the DRIP as of December 31, 2015.
F-13
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
Offering and Related Costs
Offering and related costs include all expenses incurred in connection with the Offering. Offering costs (other than selling commissions and the dealer manager fee) of the Company may be paid by the Advisor, the Former Dealer Manager or their affiliates on behalf of the Company. Offering costs were reclassified from deferred costs to stockholders' equity on the day the Company commenced its operations. Offering costs include all expenses incurred by the Company in connection with its Offering as of the balance sheet date presented. These costs include but are not limited to (i) legal, accounting, printing, mailing and filing fees; (ii) escrow service related fees; (iii) reimbursement of the Former Dealer Manager for amounts it may pay to reimburse the bona fide diligence expenses of broker-dealers; and (iv) reimbursement to the Advisor for a portion of the costs of its employees and other costs in connection with preparing supplemental sales materials and related offering activities. The Company is obligated to reimburse the Advisor or its affiliates, as applicable, for organizational and offering costs paid by them on behalf of the Company to the extent organizational and offering costs (excluding selling commissions and the dealer manager fee) incurred by the Company in the Offering do not exceed 2% of gross offering proceeds. The Advisor is required to reimburse the Company to the extent that organization and offering and related costs paid by the Company exceed 2% of gross offering proceeds. As a result, these costs are only a liability of the Company to the extent aggregate selling commissions, the dealer manager fees and other organization and offering costs do not exceed 12% of the gross Offering proceeds determined at the end of the Offering. See Note 9 - Related Party Transactions and Arrangements.
Share-Based Compensation
The Company has a share-based incentive plan for certain of the Company's directors, officers and employees of the Advisor and its affiliates. Share-based awards are measured at the grant date fair value and is recognized as compensation expense on a on a straight line basis over the related vesting period of the award. See Note 10 - Share-Based Compensation.
Income Taxes
The Company conducts its operations to qualify as a REIT for U.S. federal income tax purposes beginning with its tax return for the taxable year ended December 31, 2013. As a REIT, the Company generally will not be subject to federal corporate income tax as long as it distributes at least 90% of its REIT taxable income to its stockholders and a number of other organizational and operational requirements. However, even if we continue to qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income in addition to federal income and excise taxes on our undistributed income. Income tax of $0.2 million for the year ended December 31, 2014 represents the New York City Unincorporated Business Tax.
The Company uses a more-likely-than-not threshold for recognition and derecognition of tax positions taken or to be taken in a tax return. The Company has assessed its tax positions for all open tax years beginning with December 31, 2013 and concluded that there were no material uncertainties to be recognized. The Company’s accounting policy with respect to interest and penalties related to tax uncertainties is to classify these amounts as provision for income taxes. The Company has not recognized any interest and penalties related to tax uncertainties for the years ended December 31, 2015, 2014 and 2013.
The estimated tax character of the $2.06 distributions per common share declared during 2015 was $1.31 ordinary income and $0.75 return of capital.
Per Share Data
The Company calculates basic earnings per share by dividing net income attributable to the Company for the period by the weighted-average number of shares of common stock outstanding for that period. Diluted earnings per share reflects the potential dilution that could occur from shares issuable in connection with the restricted stock plan and if convertible shares were exercised, except when doing so would be anti-dilutive.
Reportable Segments
The Company conducts its business through the following segments:
• | The real estate debt business which is focused on originating, acquiring and asset managing commercial real estate debt investments, including first mortgage loans, subordinate mortgages, mezzanine loans and participations in such loans. |
• | The real estate securities business which is focused on investing in and asset managing commercial real estate securities primarily consisting of CMBS and may include unsecured REIT debt, CDO notes and other securities. |
See Note 13 - Segment Reporting for further information regarding the Company's segments.
F-14
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
Reclassification and Presentation
During the year ended December 31, 2014, the Company previously disclosed common stock repurchase of $0.5 million on the statement of cash flows within Proceeds from issuances of common stock. For the period ended December 31, 2015, the amount is presented separately within Common stock repurchases line within the statement of cash flows.
The Company previously disclosed board and insurance expenses of $0.3 million and $0.2 million respectively for year ended December 31, 2014 and $0.2 million and $0.2 million for year ended December 31, 2013 within the statements of operations. The Company combined the board and insurance expenses of $0.2 million and $0.2 million, respectively for period ending December 31, 2015 within Other Expenses in the statement of operations. The change is applied retrospectively for all periods presented within the financial statements.
Principles of Consolidation
We consolidate all entities that we control through either majority ownership or voting rights. In addition, we consolidate all variable interest entities ("VIE") of which we are considered the primarily beneficiary. VIEs are defined as entities in which equity investors (i) do not have the characteristics of a controlling financial interest and/or (ii) do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The entity that consolidates a VIE is known as its primary beneficiary and is generally the entity with (i) the power to direct the activities that most significantly affect the VIE’s economic performance and (ii) the right to receive benefits from the VIE or the obligation to absorb losses of the VIE that could be significant to the VIE.
Recent Accounting Pronouncements
In April 2015, the FASB issued ASU 2015-03 "Interest - Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs." ASU 2015-03 simplifies the presentation of debt issuance costs by amending the accounting guidance to require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the related debt liability. The amendments are consistent with the accounting guidance related to debt discounts. This guidance is effective for the first interim or annual period beginning after December 15, 2015 and to be applied retrospectively. Early adoption of ASU 2015-03 is permissible. The Company has adopted the ASU and presented the debt arising from issuance of our collateralized debt obligation net of $6.96 million the debt issuance cost on our statements of financial condition as of December 31, 2015. The Company did not have any collateralized debt obligation debt during years prior to December 31, 2015 as such, there were no impact to the Company’s prior year’s balance sheets.
In August 2015, FASB issued ASU 2015-15, Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements, which amends ASC 835-30, Interest - Imputation of Interest. This update clarifies the presentation and subsequent measurement of debt issuance costs associated with lines of credit. These costs may be deferred and presented as an asset and subsequently amortized ratably over the term of the revolving debt arrangement. The Company has adopted this ASU for presentation of debt issuance cost related to the Company’s Master Repurchase Agreements with Barclays Bank PLC and JPM Morgan Chase, N.A. The Company has deferred $0.6 million of debt issuance cost related to the Master Repurchase Agreements as of December 31, 2015 and is reported within Prepaid expenses and other assets line of the balance sheets.
In February 2015, the FASB amended the accounting for consolidation of certain legal entities. The amendments modify the evaluation of whether certain legal entities are variable interest entities ("VIEs") or voting interest entities, eliminate the presumption that a general partner should consolidate a limited partnership and affect the consolidation analysis of reporting entities that are involved with VIEs (particularly those that have fee arrangements and related party relationships). The revised guidance is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted, including adoption in an interim period. The guidance is not expected to have a significant impact on the Company's financial position, results of operations or cash flows.
Note 3 - Commercial Mortgage Loans
F-15
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
The following table is a summary of the Company's commercial mortgage loans by class (in thousands):
December 31, 2015 | December 31, 2014 | ||||||
Senior loans | $ | 894,075 | $ | 250,093 | |||
Mezzanine loans | 221,014 | 191,863 | |||||
Subordinated loans | 10,000 | 15,498 | |||||
Total gross carrying value of loans | 1,125,089 | 457,454 | |||||
Less: Allowance for loan losses | 888 | 570 | |||||
Total commercial mortgage loans, net | $ | 1,124,201 | $ | 456,884 | |||
The following table presents the activity in the Company's allowance for loan losses (in thousands):
Year Ended December 31, | |||||||
2015 | 2014 | ||||||
Beginning of period | $ | 570 | $ | — | |||
Provision for loan losses | 318 | 570 | |||||
Charge-offs | — | — | |||||
Recoveries | — | — | |||||
Ending allowance for loan loss | $ | 888 | $ | 570 | |||
As of December 31, 2015 and 2014, the Company's commercial mortgage loan portfolio comprised of 77 and 38 loans, respectively.
December 31, 2015 | December 31, 2014 | |||||||||||||
Par Value | Percentage | Par Value | Percentage | |||||||||||
Office | $ | 307,876 | 27.2 | % | $ | 217,480 | 47.1 | % | ||||||
Multifamily | 305,129 | 26.9 | % | 22,957 | 5.0 | % | ||||||||
Hospitality | 171,752 | 15.1 | % | 74,566 | 16.2 | % | ||||||||
Retail | 158,784 | 14.0 | % | 45,513 | 9.9 | % | ||||||||
Mixed Use | 138,798 | 12.2 | % | 100,699 | 21.8 | % | ||||||||
Industrial | 52,107 | 4.6 | % | — | — | % | ||||||||
$ | 1,134,446 | 100.0 | % | $ | 461,215 | 100.0 | % | |||||||
Credit Characteristics
As part of the Company's process for monitoring the credit quality of its loans, it performs a quarterly loan portfolio assessment and assigns risk ratings to each of its performing loans. The loans are scored on a scale of 1 to 5 as follows:
Rating | Summary Description | |
1 | Investment exceeding fundamental performance expectations and/or capital gain expected. Trends and risk factors since time of investment are favorable. | |
2 | Performing consistent with expectations and a full return of principal and interest expected. Trends and risk factors are neutral to favorable. | |
3 | Performing investments requiring closer monitoring. Trends and risk factors show some deterioration. | |
4 | Underperforming investment with some loss of interest expected but still expecting a positive return on investment. Trends and risk factors are negative. | |
5 | Underperforming investment with expected loss of interest and some principal. | |
All commercial mortgage loans are assigned an initial risk rating of 2.0. As of December 31, 2015 and 2014, the weighted average risk rating of loans was 2.0 and 2.0. As of December 31, 2015 and 2014, the Company did not have any loans that were past due on their payments, in non-accrual status or impaired.
F-16
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
For the year ended December 31, 2015 and 2014, the activity in the Company's loan portfolio was as follows (in thousands):
Year Ended December 31, | |||||||
2015 | 2014 | ||||||
Balance at Beginning of Year | $ | 456,884 | $ | 30,832 | |||
Acquisitions and originations | 793,731 | 429,941 | |||||
Dispositions | — | (3,580 | ) | ||||
Principal repayments | (127,643 | ) | (136 | ) | |||
Discount accretion and premium amortization* | 1,547 | 397 | |||||
Provision for loan losses | (318 | ) | (570 | ) | |||
Balance at End of Year | $ | 1,124,201 | $ | 456,884 | |||
________________________
* Includes amortization of capitalized acquisition fees and expenses.
Note 4 - Real Estate Securities
The following is a summary of the Company's real estate securities, CMBS (in thousands):
Weighted Average | ||||||||||||||||
Number of Investments | Interest Rate | Maturity | Par Value | Fair Value | ||||||||||||
December 31, 2015 | 16 | 4.71 | % | February 2019 | $ | 133,183 | $ | 130,754 | ||||||||
December 31, 2014 | 8 | 3.28 | % | November 2017 | 50,447 | 50,234 | ||||||||||
The Company classified its CMBS investments as available-for-sale as of December 31, 2015 and 2014. These investments are reported at fair value in the balance sheet with changes in fair value recorded in accumulated other comprehensive income or loss. The following table shows the changes in fair value of the Company's CMBS investments (in thousands):
Amortized Cost | Unrealized Gains | Unrealized Losses | Fair Value | |||||||||||||
December 31, 2015 | $ | 133,008 | $ | — | $ | (2,254 | ) | $ | 130,754 | |||||||
December 31, 2014 | 50,541 | 14 | (321 | ) | 50,234 | |||||||||||
Note 5 - Debt
Repurchase Agreements - Commercial Mortgage Loans
The Company entered into repurchase facilities with JPMorgan Chase Bank, National Association (the "JPM Repo Facility") and Barclays Bank PLC (the "Barclays Repo Facility"). The JPM Repo Facility provides up to $150.0 million in advances. The Barclays Repo Facility provides up to $150.0 million in advances. Both, the JPM Repo Facility and Barclays Repo Facility are subject to adjustment. The Company expects to use advances from the JPM Repo Facility and the Barclays Repo Facility to finance the acquisition or origination of eligible loans, including first mortgage loans, subordinated mortgage loans, mezzanine loans and participation interests therein. The initial maturity date of the JPM Repo Facility is June 18, 2016, with a one-year extension at the Company’s option, which may be exercised upon the satisfaction of certain conditions. The Company exercised its first extension on the Barclays Repo Facility, and extended the maturity date to March 3, 2016, with three six-month extensions remaining at the Company’s option, which may be exercised upon the satisfaction of certain conditions. As of December 31, 2015, the Company is in compliance with all debt covenants.
As of December 31, 2015 and 2014, the Company had $84.3 million and $76.5 million outstanding under the JPM Repo Facility. Advances under the JPM Repo Facility accrue interest at per annum rates equal to the sum of (i) the applicable LIBOR index rate plus (ii) a margin between 2.25% to 4.50%, depending on the attributes of the purchased assets. As of December 31, 2015 and 2014, the weighted average interest rate on advances was 3.11% and 3.84% respectively. The Company incurred $4.2 million and $1.2 million in interest expense on the JPM Repo Facility for the year ended December 31, 2015 and 2014, respectively.
As of December 31, 2015 and 2014, the Company had $121.9 million and $73.7 million outstanding under the Barclays Repo Facility. Advances under the Barclays Repo Facility accrue interest at per annum rates equal to the sum of (i) the applicable LIBOR index rate plus (ii) a margin between 2.00% to 2.50%, depending on the attributes of the purchased assets.
F-17
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
As of December 31, 2015 and 2014 , the weighted average interest rate on advances was 2.39% and 2.16% respectively. The Company incurred $3.0 million and $0.3 million of interest expense on the Barclays Repo Facility for the year ended December 31, 2015 and 2014, respectively.
The JPM Repo Facility and the Barclay’s Repo Facility generally provide that in the event of a decrease in the value of our collateral, the lenders can demand additional collateral. Should the value of the Company’s collateral decrease, whether as a result of deteriorating credit quality, an increase in credit market spreads or otherwise, resulting margin calls may cause an adverse change in the Company’s liquidity position.
Repurchase Agreements - Real Estate Securities
The Company has entered into various Master Repurchase Agreements (the "MRAs") that allow the Company to sell real estate securities while providing a fixed repurchase price for the same real estate securities in the future. The repurchase contracts on each security under an MRA generally mature in 30-90 days and terms are adjusted for current market rates as necessary. Below is a summary of the Company's MRAs as of December 31, 2015 and 2014 (in thousands).
As of December 31, 2015 | Weighted Average | ||||||||||||||||
Counterparty | Amount Outstanding | Accrued Interest | Collateral Pledged (*) | Interest Rate | Days to Maturity | ||||||||||||
JP Morgan Securities LLC | $ | 86,898 | $ | 108 | $ | 130,618 | 2.03 | % | 8 | ||||||||
Citigroup Global Markets, Inc. | 26,619 | 71 | 35,528 | 2.00 | % | 45 | |||||||||||
Wells Fargo Securities, LLC | 3,694 | 3 | 4,925 | 1.67 | % | 13 | |||||||||||
Total/Weighted Average | $ | 117,211 | $ | 182 | $ | 171,071 | 2.01 | % | 17 | ||||||||
________________________
* Includes $56,044 Tranche C of RFT issued CLO held by the Company, which eliminates within the Real estate securities, at fair value line of the consolidated balance sheets as of December 31, 2015.
As of December 31, 2014 | Weighted Average | ||||||||||||||||
Counterparty | Amount Outstanding | Accrued Interest | Collateral Pledged | Interest Rate | Days to Maturity | ||||||||||||
JP Morgan Securities LLC | $ | 18,528 | $ | 8 | $ | 23,843 | 1.44 | % | 20 | ||||||||
Citigroup Global Markets, Inc. | 4,010 | 2 | 5,015 | 1.46 | % | 20 | |||||||||||
Wells Fargo Securities, LLC | 3,731 | 2 | 4,975 | 1.52 | % | 20 | |||||||||||
Total/Weighted Average | $ | 26,269 | $ | 12 | $ | 33,833 | 1.46 | % | 20 | ||||||||
Collateralized Loan Obligation
On October 19, 2015, RFT 2015-FL1 Issuer, Ltd. (the “Issuer”) and RFT 2015-FL1 Co-Issuer, LLC (the “Co-Issuer”), both wholly owned indirect subsidiaries of the Company, entered into an indenture with the Realty Finance Operating Partnership, L.P. (“RFT OP”), as advancing agent, U.S. Bank National Association as note administrator and U.S. Bank National Association as trustee, which governs the issuance of approximately $350.2 million principal balance secured floating rate notes (the “Notes”). In addition, concurrently with the issuance of the Notes, the Issuer also issued 78,188,494 Preferred Shares, par value of $0.001 per share and with an aggregate liquidation preference and notional amount equal to $1,000 per share (the “Preferred Shares”), which were not offered as part of closing the indenture. For U.S. federal income tax purposes, the Issuer and Co-Issuer are disregarded entities.
The Notes are collateralized by interests in a pool of 28 mortgage assets having a total principal balance of $428.4 million (the “Mortgage Assets”) originated by a subsidiary of the Company. The sale of the Mortgage Assets to the Issuer is governed by a Mortgage Asset Purchase Agreement dated as of October 19, 2015, between the Company and the Issuer. In connection with the securitization, the Issuer and Co-Issuer offered and sold the following classes of Notes: Class A, Class B, Class C Notes to third parties. A wholly owned subsidiary of the Company retained approximately $56.0 million of the total $76.0 million of Class C and all of the preferred equity in the Issuer. The retained Class C and the preferred equity as well as the related interest are eliminated in the Company's consolidated financial statements. The Company, as the holder of preferred equity in the Issuer, will absorb the first losses of the collateralized loan obligation, as such may have negative impact to our
F-18
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
result of operations. The issuance of the CLO also results in increase in interest expense within the consolidated statement of operations due to increased interest expense. The following table represents the terms of the CLO issued.
As of December 31, 2015 | ||||||||||||
Facility | Par Value Issued | Par Value Outstanding (*) | Interest Rate | Maturity Date | ||||||||
Tranche A | $ | 231,345 | $ | 231,345 | 1M LIBOR + 175 | 8/1/2030 | ||||||
Tranche B | 42,841 | 42,841 | 1M LIBOR + 388 | 8/1/2030 | ||||||||
Tranche C | 76,044 | 20,000 | 1M LIBOR + 525 | 8/1/2030 | ||||||||
$ | 350,230 | $ | 294,186 | |||||||||
________________________
* Excludes $56,044 of Tranche C of RFT issued CLO held by the Company, which eliminates within the Real estate securities, at fair value line of the consolidated balance sheets as of December 31, 2015.
The below represents the total assets and liabilities of the Company's only CLO. The CLO is considered a VIE and is consolidated into our consolidated financial statements as of December 31, 2015 as the Company is the primary beneficiary of the VIE. The Company is the primary beneficiary of the CLO because (i) the Company has the power to direct the activities that most significantly affect the VIE’s economic performance and (ii) the right to receive benefits from the VIE or the obligation to absorb losses of the VIE that could be significant to the VIE.
Assets | December 31, 2015 | December 31, 2014 | ||||||
Cash | $ | 5 | $ | — | ||||
Commercial mortgage loans, held for investment, net | 426,155 | — | ||||||
Accrued interest receivable | 1,048 | — | ||||||
Total Assets | $ | 427,208 | $ | — | ||||
Liabilities | ||||||||
Notes payable (*) | $ | 348,269 | $ | — | ||||
Accrued interest payable | 513 | — | ||||||
Total Liabilities | $ | 348,782 | $ | — | ||||
________________________
* Includes $55,769 of Tranche C of RFT issued CLO held by the Company, which eliminates within the Collateral loan obligations line of the consolidated balance sheets as of December 31, 2015.
Revolving Line of Credit with Affiliate
On May 15, 2013, the Company entered into an unsecured $5.0 million revolving line of credit with an affiliate of the Sponsor (the "Revolver"). The Revolver bears interest at a per annum fixed rate of 3.25% and provides for quarterly interest payments. The Revolver matures in one year, subject to two successive extension terms by the Company of one year each. Principal may be drawn or repaid from time-to-time, in whole or in part, without premium or penalty and there are no unused facility fees. On July 17, 2013, the Company entered into an amendment to its Revolver. The amendment increased the aggregate financing available under the Revolver from $5.0 million to $10.0 million. The amendment did not change any of the other terms of the Revolver.
The Company did not exercise the extension options provided under the terms of the Revolver and allowed it to mature on May 15, 2014. The Company did not have an outstanding balance on the date of maturity. The Company incurred $0, $16,881 and $30,007 in interest expense on the Revolver for the years ended December 31, 2015, 2014 and 2013, respectively.
F-19
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
Note 6 - Net Income Per Share
The following table is a summary of the basic and diluted net income per share computation for the years ended December 31, 2015, 2014 and 2013, respectively:
Years Ended December 31, | |||||||||||
2015 | 2014 | 2013 | |||||||||
Net income (in thousands) | $ | 24,933 | $ | 5,415 | $ | 102 | |||||
Basic weighted average shares outstanding | 24,253,905 | 7,227,169 | 526,084 | ||||||||
Unvested restricted shares | 5,264 | 5,390 | 4,012 | ||||||||
Diluted weighted average shares outstanding | 24,259,169 | 7,232,559 | 530,096 | ||||||||
Basic net income per share | $ | 1.03 | $ | 0.75 | $ | 0.19 | |||||
Diluted net income per share | $ | 1.03 | $ | 0.75 | $ | 0.19 | |||||
Note 7 - Common Stock
As of December 31, 2015 and 2014, the Company had 31,385,280 and 15,472,192 shares of common stock outstanding, respectively, including shares issued pursuant to the DRIP and unvested restricted shares. As of December 31, 2015 and 2014, the Company had received net proceeds of approximately $755.5 million and $378.9 million, respectively, excluding shares issued pursuant to the DRIP and share-based compensation.
On December 30, 2014, the Company filed with the Maryland State Department of Assessments and Taxation articles supplementary to its charter that reclassified 1,000 authorized but unissued shares of the Company’s common stock as shares of convertible stock and set the terms of such convertible shares. The Company then issued 1,000 convertible shares to the Advisor for $1.00 per share. The convertible shares will automatically convert to shares of common stock upon the first occurrence of any of the following triggering events: (i) the Company has paid total distributions on the then-outstanding shares of common stock in an amount equal to or in excess of the sum of the invested capital (as defined in the Company’s charter) plus an aggregate 6.0% cumulative, pre-tax, non-compounded, annual return on such invested capital, (ii) a listing of the Company’s shares of common stock on a national securities exchange and (iii) the termination of the Company’s advisory agreement under certain circumstances. In general, but with certain exceptions as outlined in the articles supplementary, each convertible share will convert into a number of common shares equal to 1/1000 of the quotient of (a) the conversion product (the product of 0.15 times the amount, if any, by which (i) the sum of the enterprise value as of the date of the triggering event plus total distributions paid to the Company’s stockholders through the date of the triggering event exceeds (ii) the sum of the Company's stockholders’ invested capital plus a 6.0% return as of the date of the triggering event) divided by (b) the quotient of the enterprise value divided by the number of shares of the Company’s common stock outstanding (on an as-converted basis) on the date of the triggering event. The conversion product will be reduced by the amounts payable pursuant to the annual subordinated performance fee as realized appreciation in the Company’s assets during the time that the Advisor or one of its affiliates acts as the Company’s advisor. As of December 31, 2015, the Company did not incur any of the aforementioned trigger events.
Distributions
In order to maintain its election to qualify as a REIT, the Company must currently distribute, at a minimum, an amount equal to 90% of its taxable income, without regard to the deduction for distributions paid and excluding net capital gains. The Company must distribute 100% of its taxable income (including net capital gains) to avoid paying corporate federal income taxes.
On May 13, 2013, the Company's board of directors authorized, and the Company declared a distribution, which is calculated based on stockholders of record each day during the applicable period at a rate of $0.00565068493 per day. The Company's distributions are payable by the fifth day following each month end to stockholders of record at the close of business each day during the prior month. Distribution payments are dependent on the availability of funds. The Board may reduce the amount of distributions paid or suspend distribution payments at any time, and therefore, distributions payments are not assured. The Company distributed $47.1 million during the year ended December 31, 2015, comprised of $27.0 million in cash and $20.2 million in shares of common stock issued under the DRIP. The Company distributed $12.6 million during the year ended December 31, 2014, comprised of $7.6 million in cash and $5.0 million in shares of common stock issued under the DRIP.
F-20
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
Note 8 - Commitments and Contingencies
Unfunded Commitments Under Commercial Mortgage Loans
As of December 31, 2015 and 2014, the Company had the below unfunded commitments which will generally be funded to finance capital expenditures by the Company's borrowers.
Funding Expiration | December 31, 2015 | December 31, 2014 | ||||||
2015 | $ | — | $ | 3,450 | ||||
2016 | 890 | 26,701 | ||||||
2017 | 16,072 | 20,810 | ||||||
2018 | 104,428 | 7,169 | ||||||
2019 | 16,939 | 1,240 | ||||||
2020 | — | 4,175 | ||||||
$ | 138,329 | $ | 63,545 | |||||
Litigation and Regulatory Matters
In the ordinary course of business, the Company may become subject to litigation, claims and regulatory matters. The Company has no knowledge of material legal or regulatory proceedings pending or known to be contemplated against the Company at this time.
Note 9 - Related Party Transactions and Arrangements
As of December 31, 2015, an entity wholly-owned by the Sponsor owned 8,888 shares of the Company’s outstanding common stock.
Fees Paid in Connection with the Offering
The Former Dealer Manager received fees and compensation in connection with the sale of the Company’s common stock in the Offering. The Former Dealer Manager received a selling commission of up to 7.0% of the per share purchase price of the Company's offering proceeds before reallowance of commissions earned by soliciting dealers. In addition, the Former Dealer Manager receives up to 3.0% of the gross proceeds from the sale of shares, before reallowance to soliciting dealers, as a dealer manager fee. The Former Dealer Manager was permitted to reallow its dealer manager fee to such soliciting dealers. A soliciting dealer was permitted to elect to receive a fee equal to 7.5% of the gross proceeds from the sale of shares (not including selling commissions and dealer manager fees) by such soliciting dealer, with 2.5% thereof paid at the time of such sale and 1.0% thereof paid on each anniversary of the closing of such sale up to and including the fifth anniversary of the closing of such sale. If this option was elected, the dealer manager fee was reduced to 2.5% of gross proceeds (not including selling commissions and Former Dealer Manager fees).
The predecessor to AR Global is a party to a services agreement with RCS Advisory Services, LLC, a subsidiary of the parent company of the Former Dealer Manager (“RCS Advisory”), pursuant to which RCS Advisory and its affiliates provided the Company and certain other companies sponsored by AR Global with services (including, without limitation, transaction management, compliance, due diligence, event coordination and marketing services, among others) on a time and expenses incurred basis or at a flat rate based on services performed. The predecessor to AR Global instructed RCS Advisory to stop providing such services in November 2015 and no services have since been provided by RCS Advisory.
The Company is also party to a transfer agency agreement with American National Stock Transfer, LLC, a subsidiary of the parent company of the Former Dealer Manager (“ANST”), pursuant to which ANST provided the Company with transfer agency services (including broker and stockholder servicing, transaction processing, year-end IRS reporting and other services), and supervisory services overseeing the transfer agency services performed by a third-party transfer agent. AR Global received written notice from ANST on February 10, 2016 that it would wind down operations by the end of the month and would withdraw as the transfer agent effective February 29, 2016. Subsequently, effective February 26, 2016, the Company entered into a definitive agreement with DST Systems, Inc., its previous provider of sub-transfer agency services, to provide the Company directly with transfer agency services (including broker and stockholder servicing, transaction processing, year-end IRS reporting and other services).
F-21
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
The table below shows the compensation and reimbursement to the Advisor, its affiliates, entities under common control with the Advisor and the Former Dealer Manager incurred for services relating to the Offering during the years ended December 31, 2015, 2014 and 2013, respectively, and the associated payable as of December 31, 2015 and 2014, respectively (in thousands):
Years Ended December 31, | Payable as of December 31, | |||||||||||||||||||
2015 | 2014 | 2013 | 2015 | 2014 | ||||||||||||||||
Total commissions and fees incurred from the Former Dealer Manager | $ | 37,092 | $ | 33,190 | $ | 2,705 | $ | — | $ | 119 | ||||||||||
Total compensation and reimbursement for services provided by the Advisor, its affiliates, entities under common control with the Advisor and the Former Dealer Manager | $ | 7,442 | $ | 2,627 | $ | 1,250 | $ | 480 | $ | 1,725 | ||||||||||
The payables as of December 31, 2015 and 2014 in the table above are included in "due to affiliate" on the Company's consolidated balance sheets. The fees incurred are recorded within additional paid in capital line in the consolidated balance sheets.
The Company is responsible for organizational and offering costs from the ongoing Offering, excluding commissions and Former Dealer Manager fees, up to a maximum of 2.0% of gross proceeds from its ongoing Offering of common stock, measured at the end of the Offering. Organizational and offering costs in excess of the 2.0% cap as of the end of the Offering are the Advisor's responsibility. As of December 31, 2015, organizational and offering costs exceeded 2.0% of cap of gross proceeds received from the Offering by $0.8 million.
Fees Paid in Connection with the Operations of the Company
The Advisor receives an acquisition fee of 1.0% of the principal amount funded by the Company to originate or acquire commercial mortgage loans and 1.0% of the anticipated net equity funded by the Company to acquire real estate securities. The Company reimburses the Advisor for expenses incurred by the Advisor on behalf of the Company related to selecting, evaluating, originating and acquiring investments in an amount up to 0.5% of the principal amount funded by the Company to originate or acquire commercial mortgage loans and up to 0.5% of the anticipated net equity funded by the Company to acquire real estate securities investments. In no event will the total of all acquisition fees and acquisition expenses exceed 4.5% of the principal amount funded with respect to the Company's total portfolio including subsequent fundings to investments in the Company's portfolio. During the years ended December 31, 2015, 2014 and 2013, acquisition fees of $7.9 million, $4.4 million and $0, respectively, have been recognized in Acquisition fees line within the consolidated statement of operations. In addition, over the same periods, the Company capitalized $4.4 million, $2.2 million and $0.5 million, respectively, of acquisition expenses in Commercial mortgage loans line within the Company's consolidated balance sheets, which will be amortized over the life of each investment using the effective interest method.
The Company will pay the Advisor, or its affiliates, a monthly asset management fee equal to one-twelfth of 0.75% of the cost of the Company's assets. Commencing on the NAV pricing date, the asset management fee is based on the lower of the cost of the Company's assets and the fair value of the Company's assets (fair value consist of the market value of each portfolio investment as determined by the Advisor in accordance with the Company's valuation guidelines). During the year ended December 31, 2015 and 2014, the Company incurred $4.6 million and $0.0 million in asset management fees, respectively, which are recorded in Asset management and subordinated performance fee within the statements of operations. During the year ended December 31, 2013, $29,297 was earned but permanently waived by the Advisor. Prior to June 17, 2015, the amount of the asset management fee was reduced to the extent that funds from operations as defined by the National Association of Real Estate Investment Trusts ("FFO"), as adjusted, during the six month period ending on the last day of the calendar quarter immediately preceding the date such asset management fee was payable, was less than distributions declared during the same period. For purposes of this determination, FFO, as adjusted, is FFO adjusted to (i) include acquisition fees and acquisition expenses; (ii) include non-cash restricted stock grant amortization, if any; and (iii) impairments and loan loss reserves on investments, if any (including commercial mortgage loans and other debt investments). FFO, as adjusted, is not the same as FFO.
The Company will pay the Advisor, an annual subordinated performance fee calculated on the basis of total return to stockholders, payable monthly in arrears, such that for any year in which total return on stockholders’ capital exceeds 6.0% per annum, the Advisor will be entitled to 15.0% of the excess total return; provided that in no event will the annual subordinated performance fee payable to the Advisor exceed 10.0% of the aggregate total return for such year. This fee will be payable only upon the sale of assets, distributions or other event which results in the Company's return on stockholders’ capital exceeding 6.0% per annum. During the years ended December 31, 2015, 2014 and 2013, the Company incurred an annual subordinated
F-22
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
performance fee of $3.0 million, $0.6 million and $0, respectively, which is recorded within Asset management and subordinated performance fee within the consolidated statements of operations.
Effective June 1, 2013, the Company entered into an agreement with the Former Dealer Manager to provide strategic advisory services and investment banking services required in the ordinary course of the Company's business, such as performing financial analysis, evaluating publicly traded comparable companies and assisting in developing a portfolio composition strategy, a capitalization structure to optimize future liquidity options and structuring operations. The Company prepaid the cost of $0.9 million associated with this agreement and amortizes the cost over the estimated life of the Offering into "Other expense" on the Company's consolidated statements of operations. The unamortized cost of less than $0.1 million associated with this agreement is included in "Prepaid expenses and other assets" on the Company's consolidated balance sheets as of December 31, 2015 and 2014.
The table below depicts related party fees and reimbursements in connection with the operations of the Company for the years ended December 31, 2015, 2014 and 2013 and the associated payable as of December 31, 2015 and 2014 (in thousands):
Years Ended December 31, | Payable as of December 31, | |||||||||||||||||||
2015 | 2014 | 2013 | 2015 | 2014 | ||||||||||||||||
Acquisition fees and acquisition expenses (*) | $ | 13,294 | $ | 6,578 | $ | 470 | $ | 55 | $ | — | ||||||||||
Advisory and investment banking fee | 56 | 542 | 316 | — | — | |||||||||||||||
Asset management and subordinated performance fee | 7,615 | 604 | — | 3,792 | 191 | |||||||||||||||
Total related party fees and reimbursements | $ | 20,965 | $ | 7,724 | $ | 786 | $ | 3,847 | $ | 191 | ||||||||||
________________________
* Includes amortization of capitalized acquisition fees and expenses.
The payables as of December 31, 2015 and 2014 in the table above are included in due to affiliate on the Company's consolidated balance sheets.
In order to improve operating cash flows and the ability to pay distributions from operating cash flows, the Advisor may elect to waive certain fees. Because the Advisor may waive certain fees, cash flows from operations that would have been paid to the Advisor may be available to pay distributions to stockholders. The fees that may be forgiven are not deferrals and accordingly, will not be paid to the Advisor. The Advisor earned management fees of $29,297 for the year ended December 31, 2014, and has permanently waived these fees. The Advisor has also permanently waived a portion of the acquisition fees and expenses earned on the acquisition of the Company's CMBS in the amount of $0.8 million, $0.6 million and $0.1 million for the years ended December 31, 2015, 2014 and 2013, respectively.
Subject to the limitations outlined below, the Company will reimburse the Advisor's cost of providing administrative services and personnel costs in connection with other services during the operational stage, in addition to paying an asset management fee; however, the Company will not reimburse the Advisor for personnel costs in connection with services for which the Advisor receives acquisition fees or disposition fees. For the year ended December 31, 2015, $0.6 million was reimbursed in connection with the operations of the Company. The Company did not have any reimbursements for years ended December 31, 2014 and 2013.
The Advisor must pay any expenses in which the Company's operating expenses as defined by North American Securities Administrators Association at the end of the four preceding fiscal quarters exceeds the greater of (i) 2.0% of average invested assets or (ii) 25.0% of net income other than any additions to reserves for depreciation, bad debt or other similar non-cash reserves and excluding any gain from the sale of assets for that period, unless a majority of the Company's independent directors determine the excess expenses were justified based on unusual and nonrecurring factors.
The Advisor at its election may also contribute capital to enhance the Company’s cash position for working capital and distribution purposes. Any contributed capital amounts are not reimbursable to the Advisor. Further, any capital contributions are made without any corresponding issuance of common or preferred shares. The Advisor did not contribute capital to enhance the Company's cash position for working capital or distribution purposes during the years ended December 31, 2015, 2014 or 2013.
F-23
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
Fees Paid in Connection with the Liquidation of Assets or Listing of the Company's Common Stock or Termination of the Advisory Agreement
The Company will pay a disposition fee of 1.0% of the contract sales price of each commercial mortgage loans or other investment sold, including CMBS or CDOs issued by a subsidiary of the Company as part of a securitization transaction. The Company will not be obligated to pay a disposition fee upon the maturity, prepayment, workout, modification or extension of commercial real estate debt unless there is a corresponding fee paid by the borrower, in which case the disposition fee will be the lesser of (i) 1.0% of the principal amount of the debt prior to such transaction; or (ii) the amount of the fee paid by the borrower in connection with such transaction. If the Company takes ownership of a property as a result of a workout or foreclosure of a loan, it will pay a disposition fee upon the sale of such property.
On December 30, 2014, the Company issued 1,000 convertible shares to the Advisor for $1.00 per share. The convertible shares issued to the Advisor will automatically convert to shares of the Company’s common stock upon the first to occur of any of the Triggering Events described in Note 7.
During the years ended December 31, 2015, 2014 and 2013, no fees were paid in connection with the liquidation of assets, listing of the Company's common stock or termination of the advisory agreement.
The Company has also established a restricted share plan for the benefit of employees, directors, employees of the Advisor and its affiliates.
Note 10 - Share-Based Compensation
Restricted Share Plan
The Company has an employee and director incentive restricted share plan (the "RSP"), which provides the Company with the ability to grant awards of restricted shares to the Company’s directors, officers and employees (if the Company ever has employees), employees of the Advisor and its affiliates, employees of entities that provide services to the Company, directors of the Advisor or of entities that provide services to the Company or certain consultants to the Company, the Advisor and its affiliates. The total number of common shares granted under the RSP shall not exceed 5.0% of the Company’s authorized common shares pursuant to the Offering, and in any event, will not exceed 4.0 million shares (as such number may be adjusted for stock splits, stock distributions, combinations and similar events).
Restricted share awards entitle the recipient to receive common shares from the Company under terms that provide for vesting over a specified period of time or upon attainment of pre-established performance objectives. Such awards would typically be forfeited with respect to the unvested shares upon the termination of the recipient’s employment or other relationship with the Company. Restricted shares may not, in general, be sold or otherwise transferred until restrictions are removed and the shares have vested. Holders of restricted shares may receive cash distributions prior to the time that the restrictions on the restricted shares have lapsed. Any distributions payable in common shares shall be subject to the same restrictions as the underlying restricted shares. The fair value of the restricted share awards are expensed over the vesting period of five years.
The RSP also provides for the automatic grant of 1,333 restricted shares of common stock to each of the independent directors, without any further action by the Company’s board of directors or the stockholders, on the date of initial election to the board of directors and on the date of each annual stockholder’s meeting. Restricted stock issued to independent directors will vest over a five years period with 20.0% of the granted shares vesting upon each of the first, second, third, fourth and fifth anniversaries of the applicable grant date.
As of December 31, 2015, the Company had granted 10,666 restricted shares to its independent directors, of which 2,399 were forfeited and 1,867 have vested, leaving a balance of 6,400 unvested restricted shares. As of December 31, 2014, the Company had granted 7,998 restricted shares to its independent directors, of which 2,399 were forfeited and 800 have vested, leaving a balance of 4,799 unvested restricted shares. Based on a share price of $22.50, the compensation expense associated with the restricted share grants was $29,588, $27,281 and $15,876, for the years ended December 31, 2015, 2014 and 2013, respectively and are included within Other expenses line on the statements of operations.
Other Share-Based Compensation
The Company may issue common stock in lieu of cash to pay fees earned by the Company's directors at each director's election. There are no restrictions on the shares issued since these payments in lieu of cash relate to fees earned for services performed. During the year ended December 31, 2014, 39 shares were issued to one of the Company's independent directors for services performed and compensation expense of $876 was incurred. The Company did not issue any common stock in lieu of cash to pay fees earned by the Company's directors for the years ended December 31, 2015 and 2013.
F-24
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
Note 11 - Fair Value of Financial Instruments
GAAP establishes a hierarchy of valuation techniques based on the observability of inputs used in measuring financial instruments at fair values. GAAP establishes market-based or observable inputs as the preferred source of values, followed by valuation models using management assumptions in the absence of market inputs. The three levels of the hierarchy are described below:
• | Level I - Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date. |
• | Level II - Inputs (other than quoted prices included in Level I) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life. |
• | Level III - Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model. |
The determination of where an asset or liability falls in the above hierarchy requires significant judgment and factors specific to the asset or liability. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company evaluates its hierarchy disclosures each quarter and depending on various factors, it is possible that an asset or liability may be classified differently from quarter to quarter.
The Company has implemented valuation control processes to validate the fair value of the Company's financial instruments measured at fair value including those derived from pricing models. These control processes are designed to assure that the values used for financial reporting are based on observable inputs wherever possible. In the event that observable inputs are not available, the control processes are designed to assure that the valuation approach utilized is appropriate and consistently applied and the assumptions are reasonable.
CMBS are valued utilizing both observable and unobservable market inputs. These factors include projected future cash flows, ratings, subordination levels, vintage, remaining lives, credit issues, recent trades of similar real estate securities and the spreads used in the prior valuation. The Company obtains current market spread information where available and uses this information in evaluating and validating the market price of all real CMBS. Depending upon the significance of the fair value inputs used in determining these fair values, these real estate securities are classified in either Level II or Level III of the fair value hierarchy. As of December 31, 2015 and 2014, the Company received broker quotes on each CMBS investment used in determining the fair value and have been classified as Level II due to the observable nature of many of the market inputs.
The following table presents the Company's financial instrument carried at fair value on a recurring basis in the consolidated balance sheets by its level in the fair value hierarchy as of December 31, 2015 and 2014 (in thousands):
Total | Level I | Level II | Level III | ||||||||||||
December 31, 2015 | |||||||||||||||
Real estate securities | $ | 130,754 | $ | — | $ | 130,754 | $ | — | |||||||
December 31, 2014 | |||||||||||||||
Real estate securities | 50,234 | — | 50,234 | — | |||||||||||
A review of the fair value hierarchy classification is conducted on a quarterly basis. Changes in the type of inputs may result in a reclassification for certain assets. There were no transfers between levels within fair value hierarchy during the years ended December 31, 2015 and 2014. There are no financial instruments carried at fair value on a non-recurring basis as of December 31, 2015 and 2014 .
The fair value of cash and cash equivalents and restricted cash measured using observable quoted market prices, or Level I inputs. The fair value of short-term financial instruments, such as accrued interest receivable, prepaid expenses and other assets, accounts payable and accrued expenses, distributions payable, interest payable and due to affiliate are approximated by their carrying value on the consolidated balance sheets due to their short-term nature, and are measured using Level II inputs.
The fair values of the Company's commercial mortgage loans and collateralized loan obligations, which are not reported at fair value on the consolidated balance sheets are reported below as of December 31, 2015 and 2014 (in thousands):
F-25
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
Level | Carrying Amount | Fair Value | |||||||||
December 31, 2015 | |||||||||||
Commercial mortgage loans | Asset | III | $ | 1,125,089 | $ | 1,138,841 | |||||
Collateralized loan obligation | Liability | II | 287,229 | 289,733 | |||||||
Repurchase agreements - loans | Liability | II | 206,239 | 206,239 | |||||||
Repurchase agreements - real estate securities | Liability | II | 117,211 | 117,211 | |||||||
December 31, 2014 | |||||||||||
Commercial mortgage loans | Asset | III | 457,454 | 474,932 | |||||||
Repurchase agreements - loans | Liability | II | 150,169 | 150,169 | |||||||
Repurchase agreements - real estate securities | Liability | II | 26,269 | 26,269 | |||||||
The fair value of the commercial mortgage loans is estimated using a discounted cash flow analysis, based on the Advisor's experience with similar types of investments.
Note 12 - Offsetting Assets and Liabilities
The Company's consolidated balance sheets used a gross presentation of repurchase agreements. The table below provides a gross presentation, the effects of offsetting and a net presentation of the Company's repurchase agreements within the scope of ASC 210-20, Balance Sheet—Offsetting, as of December 31, 2015 and 2014 (in thousands):
Gross Amounts Not Offset on the Balance Sheet | ||||||||||||||||||||||||
Repurchase Agreements | Gross Amounts of Recognized Liabilities | Gross Amounts Offset on the Balance Sheet | Net Amount of Liabilities Presented on the Balance Sheet | Financial Instruments | Cash Collateral Pledged | Net Amount | ||||||||||||||||||
December 31, 2015 | ||||||||||||||||||||||||
Commercial mortgage loans | $ | 206,239 | $ | — | $ | 206,239 | $ | 355,802 | $ | 5,000 | $ | — | ||||||||||||
Real estate securities (*) | 117,211 | — | 117,211 | 171,071 | 366 | — | ||||||||||||||||||
December 31, 2014 | ||||||||||||||||||||||||
Commercial mortgage loans | 150,169 | — | 150,169 | 301,704 | — | — | ||||||||||||||||||
Real estate securities | 26,269 | — | 26,269 | 33,833 | 68 | — | ||||||||||||||||||
________________________
* Includes $56,044 Tranche C of RFT issued CLO held by the Company, which eliminates within the Repurchase agreement-real estate securities line of the consolidated balance sheets as of December 31, 2015.
Note 13 - Segment Reporting
The Company conducts its business through the following segments:
• | The real estate debt business focuses on originating, acquiring and asset managing commercial real estate debt investments, including first mortgage loans, subordinate mortgages, mezzanine loans and participations in such loans. |
• | The real estate securities business focuses on investing in and asset managing commercial real estate securities primarily consisting of CMBS and may include unsecured REIT debt, CDO notes and other securities. |
F-26
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
The following table represents the Company's operations by segment for the years ended December 31, 2015, 2014 and 2013 (in thousands):
December 31, 2015 | Total | Real Estate Debt | Real Estate Securities | |||||||||
Interest income | $ | 59,393 | $ | 56,040 | $ | 3,353 | ||||||
Interest expense | 12,268 | 11,149 | 1,119 | |||||||||
Net income | 24,933 | 24,401 | 532 | |||||||||
Total assets | 1,282,484 | 1,150,858 | 131,626 | |||||||||
December 31, 2014 | ||||||||||||
Interest income | 15,466 | 14,733 | 733 | |||||||||
Interest expense | 2,196 | 1,985 | 211 | |||||||||
Realized gain on sale | 112 | 112 | — | |||||||||
Net income | 5,415 | 5,209 | 206 | |||||||||
Total assets | $ | 514,220 | $ | 463,526 | $ | 50,694 | ||||||
December 31, 2013 | ||||||||||||
Interest income | 775 | 767 | 8 | |||||||||
Interest expense | 32 | 32 | — | |||||||||
Net income | 102 | 94 | 8 | |||||||||
Total assets | $ | 36,370 | $ | 31,357 | $ | 5,013 | ||||||
For the purposes of the table above, any expenses not associated with a specific segment have been allocated to the business segments using a percentage derived by using the sum of commercial mortgage loans, net and real estate securities, at fair value as the denominator and commercial mortgage loans, net and real estate securities, at fair value as the numerators, respectively.
Note 14 - Economic Dependency
Under various agreements, the Company has engaged or will engage the Advisor, its affiliates and entities under common control with the Advisor to provide certain services that are essential to the Company, including asset management services, supervision of the management and leasing of properties owned by the Company, asset acquisition and disposition decisions, the sale of shares of the Company's common stock available for issue, transfer agency services, as well as other administrative responsibilities for the Company including accounting services, transaction management services and investor relations. As a result of these relationships, the Company is dependent upon the Advisor and its affiliates. In the event that these companies are unable to provide the Company with the respective services, the Company will be required to find alternative providers of these services.
Note 15 - Subsequent Events
The Company has evaluated subsequent events through the filing of this Annual Report on Form 10-K and determined that there have not been any events that have occurred that would require adjustments to disclosures in the consolidated financial statements except for the following transactions:
Distributions Paid
On January 4, 2016, the Company paid a distribution of $5.5 million to stockholders of record during the month of December 2015. Approximately $3.2 million of the distribution was paid in cash, while $2.3 million was used to purchase 91,837 shares for those stockholders that chose to reinvest distributions through the DRIP.
Share Repurchase Program
On January 28, 2016, the Board unanimously approved an amended and restated share repurchase program (the “ SRP”) which became effective on February 28, 2016. Under the SRP, subject to certain conditions, stockholders that purchased shares of common stock of the Company or received their shares from the Company (directly or indirectly) through one or more non-cash transactions and have held their shares for a period of at least one year may request that the Company repurchase their shares of common stock of the Company so long as the repurchase otherwise complies with the provisions of Maryland law. Repurchase requests made following the death or qualifying disability of a stockholder will not be subject to any minimum holding period.
F-27
REALTY FINANCE TRUST, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2015
The repurchase price per share for requests other than for death or disability will be equal to the most-recent estimated net asset value per share of the Company’s common stock calculated by the Company’s advisor in accordance with the Company’s valuation guidelines (the “Estimated Per-Share NAV”) multiplied by a percentage equal to (i) 92.5%, if the person seeking repurchase has held his or her shares for a period greater than one year and less than two years; (ii) 95%, if the person seeking repurchase has held his or her shares for a period greater than two years and less than three years; (iii) 97.5%, if the person seeking repurchase has held his or her shares for a period greater than three years and less than four years; or (iv) 100%, if the person seeking repurchase has held his or her shares for a period greater than four years. In the case of requests for death or disability, the repurchase price per share will be equal to the Estimated Per-Share NAV at the time of repurchase.
Repurchases pursuant to the SRP, when requested, generally will be made semiannually (each six-month period ending June 30 or December 31, a “fiscal semester”). Repurchases for any fiscal semester will be limited to a maximum of 2.5% of the weighted average number of shares of common stock outstanding during the previous fiscal year, with a maximum for any fiscal year of 5.0% of the weighted average number of shares of common stock outstanding during the previous fiscal year. Funding for repurchases pursuant to the SRP for any given fiscal semester will be limited to proceeds received during that same fiscal semester through the issuance of common stock pursuant to any distribution reinvestment plan in effect from time to time, provided that the Board has the power, in its sole discretion, to determine the amount of shares repurchased during any fiscal semester as well as the amount of funds to be used for that purpose. Due to these limitations, the Company cannot guarantee that it will be able to accommodate all repurchase requests made during any fiscal semester or fiscal year. The Company will generally pay repurchase proceeds, less any applicable tax or other withholding required by law, by the 31st day following the end of the fiscal semester during which the repurchase request was made.
As previously announced, the Company's Board unanimously determined to change the frequency with which the Company calculates its Estimated Per-Share NAV. Pursuant to the Board’s determination, calculation of the Company's Estimated Per-Share NAV will occur periodically, at the discretion of the Board, provided that such calculations will be made at least annually. Following its calculation, the Company's Estimated Per-Share NAV will be disclosed in a periodic report. The most recent calculation of the Company's Estimated Per-Share NAV approved by the Board occurred on November 4, 2015 based on its NAV as of September 30, 2015.
Sponsor Transaction
In January 2016, AR Global became the successor business to AR Capital, LLC and became the parent of the Company's current Sponsor.
RCS Capital Corporation Bankruptcy
RCS Capital Corporation, the parent company of the Former Dealer Manager and certain of its affiliates that provided us with services through December 31, 2015, filed for Chapter 11 bankruptcy protection in January 2016, prior to which it was also under common control with AR Global, the parent of the Company's sponsor.
American National Stock Transfer, LLC Termination
On February 10, 2016, AR Global received written notice from ANST, the Company's transfer agent and an affiliate of the Company's Former Dealer Manager,that it would wind down operations by the end of the month. ANST withdrew as the transfer agent effective February 29, 2016.
On February 26, 2016, the Company entered into a definitive agreement with DST Systems, Inc., its previous provider of sub-transfer agency services, to provide the Company directly with transfer agency services (including broker and stockholder servicing, transaction processing, year-end IRS reporting and other services).
F-28
REALTY FINANCE TRUST, INC.
SCHEDULE IV - MORTGAGE LOANS ON REAL ESTATE
December 31, 2015
(In thousands)
Face | Carrying | Interest | Payment | Maturity | ||||||||||||
Description | Property Type | Amount | Amount | Rate | Terms | Date | ||||||||||
Senior 1 | Retail | $ | 7,460 | $ | 7,430 | 1M LIBOR + 4.75% | Interest Only | 10/9/2017 | ||||||||
Senior 2 | Office | 8,500 | 8,433 | 1M LIBOR + 4.65% | Interest Only | 6/9/2018 | ||||||||||
Senior 3 | Mixed Use | 11,000 | 10,967 | 1M LIBOR + 9.00% | Interest Only | 4/9/2016 | ||||||||||
Senior 4 | Office | 34,500 | 34,220 | 1M LIBOR + 5.25% | Interest Only | 12/9/2018 | ||||||||||
Senior 5 | Office | 11,750 | 11,694 | 1M LIBOR + 4.75% | Interest Only | 3/9/2019 | ||||||||||
Senior 6 | Retail | 14,600 | 14,537 | 1M LIBOR + 4.25% | Interest Only | 5/9/2018 | ||||||||||
Senior 7 | Retail | 11,636 | 11,595 | 1M LIBOR + 5.00% | Interest Only | 6/9/2017 | ||||||||||
Senior 8 | Office | 19,250 | 19,209 | 1M LIBOR + 4.55% | Interest Only | 12/9/2018 | ||||||||||
Senior 9 | Multifamily | 16,449 | 16,338 | 1M LIBOR + 4.75% | Interest Only | 6/9/2018 | ||||||||||
Senior 10 | Multifamily | 13,745 | 13,659 | 1M LIBOR + 4.50% | Interest Only | 5/9/2018 | ||||||||||
Senior 11 | Office | 12,000 | 11,967 | 1M LIBOR + 4.75% | Interest Only | 11/9/2019 | ||||||||||
Senior 12 | Multifamily | 21,100 | 21,021 | 1M LIBOR + 4.25% | Interest Only | 11/9/2018 | ||||||||||
Senior 13 | Multifamily | 8,229 | 8,174 | 1M LIBOR + 4.75% | Interest Only | 5/9/2018 | ||||||||||
Senior 14 | Retail | 9,850 | 9,799 | 1M LIBOR + 5.25% | Interest Only | 3/9/2018 | ||||||||||
Senior 15 | Industrial | 18,452 | 18,339 | 1M LIBOR + 4.25% | Interest Only | 7/9/2018 | ||||||||||
Senior 16 | Hospitality | 10,350 | 10,281 | 1M LIBOR + 5.50% | Interest Only | 7/9/2018 | ||||||||||
Senior 17 | Office | 27,490 | 27,303 | 1M LIBOR + 4.65% | Interest Only | 11/9/2017 | ||||||||||
Senior 18 | Retail | 4,725 | 4,682 | 1M LIBOR + 5.50% | Interest Only | 8/9/2018 | ||||||||||
Senior 19 | Retail | 18,350 | 18,178 | 1M LIBOR + 4.75% | Interest Only | 6/9/2018 | ||||||||||
Senior 20 | Multifamily | 39,200 | 39,053 | 1M LIBOR + 4.00% | Interest Only | 11/9/2018 | ||||||||||
Senior 21 | Retail | 7,500 | 7,434 | 1M LIBOR + 5.00% | Interest Only | 7/9/2018 | ||||||||||
Senior 22 | Office | 12,790 | 12,713 | 1M LIBOR + 5.00% | Interest Only | 1/9/2018 | ||||||||||
Senior 23 | Hospitality | 11,482 | 11,449 | 1M LIBOR + 5.75% | Interest Only | 10/9/2017 | ||||||||||
Senior 24 | Hospitality | 11,893 | 11,826 | 1M LIBOR + 5.30% | Interest Only | 7/9/2018 | ||||||||||
Senior 25 | Mixed Use | 26,623 | 26,484 | 1M LIBOR + 5.50% | Interest Only | 9/9/2019 | ||||||||||
Senior 26 | Multifamily | 17,560 | 17,488 | 1M LIBOR + 4.20% | Interest Only | 7/9/2018 | ||||||||||
Senior 27 | Mixed Use | 10,018 | 9,965 | 1M LIBOR + 5.10% | Interest Only | 1/9/2018 | ||||||||||
Senior 28 | Multifamily | 39,200 | 38,922 | 1M LIBOR + 4.25% | Interest Only | 8/9/2018 | ||||||||||
Senior 29 | Retail | 9,450 | 9,421 | 1M LIBOR + 4.90% | Interest Only | 9/9/2017 | ||||||||||
Senior 30 | Industrial | 33,655 | 33,625 | 1M LIBOR + 4.00% | Interest Only | 11/9/2018 | ||||||||||
Senior 31 | Mixed Use | 45,100 | 44,836 | 1M LIBOR + 5.50% | Interest Only | 7/9/2018 | ||||||||||
Senior 32 | Multifamily | 8,850 | 8,808 | 1M LIBOR + 4.70% | Interest Only | 2/9/2018 | ||||||||||
Senior 33 | Office | 24,500 | 24,345 | 1M LIBOR + 4.60% | Interest Only | 2/9/2019 | ||||||||||
Senior 34 | Mixed Use | 7,806 | 7,769 | 1M LIBOR + 4.75% | Interest Only | 2/9/2018 | ||||||||||
Senior 35 | Hospitality | 16,800 | 16,752 | 1M LIBOR + 4.90% | Interest Only | 4/9/2018 | ||||||||||
Senior 36 | Office | 35,000 | 34,926 | 1M LIBOR + 5.00% | Interest Only | 11/9/2018 | ||||||||||
Senior 37 | Office | 6,070 | 6,064 | 1M LIBOR + 4.90% | Interest Only | 8/9/2017 | ||||||||||
Senior 38 | Retail | 11,800 | 11,759 | 1M LIBOR + 4.75% | Interest Only | 11/9/2017 | ||||||||||
Senior 39 | Retail | 13,500 | 13,460 | 1M LIBOR + 5.00% | Interest Only | 4/9/2017 | ||||||||||
F-29
Senior 40 | Retail | 11,450 | 11,396 | 1M LIBOR + 4.50% | Interest Only | 2/9/2019 | ||||||||||
Senior 41 | Multifamily | 18,075 | 18,013 | 1M LIBOR + 4.50% | Interest Only | 12/9/2018 | ||||||||||
Senior 42 | Mixed Use | 31,250 | 31,144 | 1M LIBOR + 4.50% | Interest Only | 9/9/2017 | ||||||||||
Senior 43 | Multifamily | 24,000 | 23,854 | 1M LIBOR + 4.25% | Interest Only | 5/9/2018 | ||||||||||
Senior 44 | Office | 9,150 | 9,121 | 1M LIBOR + 5.50% | Interest Only | 11/9/2016 | ||||||||||
Senior 45 | Multifamily | 28,406 | 28,452 | 1M LIBOR + 3.85% | Interest Only | 11/9/2018 | ||||||||||
Senior 46 | Multifamily | 10,785 | 10,800 | 1M LIBOR + 3.95% | Interest Only | 11/9/2018 | ||||||||||
Senior 47 | Multifamily | 12,009 | 12,030 | 1M LIBOR + 3.95% | Interest Only | 11/9/2018 | ||||||||||
Senior 48 | Multifamily | 5,800 | 5,807 | 1M LIBOR + 4.05% | Interest Only | 11/9/2018 | ||||||||||
Senior 49 | Office | 28,000 | 27,921 | 1M LIBOR + 4.25% | Interest Only | 1/9/2019 | ||||||||||
Senior 50 | Multifamily | 13,792 | 13,731 | 1M LIBOR + 5.00% | Interest Only | 2/9/2018 | ||||||||||
Senior 51 | Retail | 26,500 | 26,474 | 1M LIBOR + 4.75% | Interest Only | 6/9/2018 | ||||||||||
Senior 52 | Multifamily | 10,450 | 10,407 | 1M LIBOR + 4.75% | Interest Only | 4/9/2018 | ||||||||||
Mezzanine 1 | (1) | Mixed Use | 7,000 | 6,980 | 1M LIBOR + 10.50% | Interest Only | 7/9/2017 | |||||||||
Mezzanine 2 | (1) | Office | 5,000 | 5,066 | 11.0% | Interest Only | 1/6/2024 | |||||||||
Mezzanine 3 | (1) | Hospitality | 12,350 | 12,350 | 1M LIBOR + 10.00% | Interest Only | 7/9/2017 | |||||||||
Mezzanine 4 | (1) | Hospitality | 3,000 | 3,015 | 11.0% | Interest Only | 8/1/2018 | |||||||||
Mezzanine 5 | (1) | Hospitality | 11,000 | 11,005 | 1M LIBOR + 7.05% | Interest Only | 3/9/2016 | |||||||||
Mezzanine 6 | (1) | Office | 22,777 | 22,836 | 1M LIBOR + 7.25% | Interest Only | 8/9/2016 | |||||||||
Mezzanine 7 | (1) | Office | 7,000 | 7,025 | 12.0% | Interest Only | 5/1/2019 | |||||||||
Mezzanine 8 | (1) | Hospitality | 12,000 | 12,022 | 1M LIBOR + 9.00% | Interest Only | 9/9/2016 | |||||||||
Mezzanine 9 | (1) | Retail | 1,962 | 1,971 | 13.0% | Interest Only | 6/1/2024 | |||||||||
Mezzanine 10 | (1) | Office | 5,100 | 5,100 | 3M LIBOR + 10.00% | Interest Only | 10/31/2017 | |||||||||
Mezzanine 11 | (1) | Hospitality | 45,000 | 45,000 | 1M LIBOR + 10.00% | Interest Only | 5/9/2017 | |||||||||
Mezzanine 12 | (1) | Multifamily | 5,000 | 5,032 | 9.0% | Interest Only | 9/1/2018 | |||||||||
Mezzanine 13 | (1) | Multifamily | 3,480 | 3,496 | 9.5% | Interest Only | 7/1/2024 | |||||||||
Mezzanine 14 | (1) | Office | 10,000 | 10,005 | 1M LIBOR + 8.00% | Interest Only | 5/9/2016 | |||||||||
Mezzanine 15 | (1) | Multifamily | 4,000 | 4,053 | 12.0% | Interest Only | 1/6/2024 | |||||||||
Mezzanine 16 | (1) | Office | 10,000 | 9,490 | 10.0% | Interest Only | 9/6/2024 | |||||||||
Mezzanine 17 | (1) | Office | 10,000 | 9,079 | 1M LIBOR + 10.75% | Interest Only | 7/10/2018 | |||||||||
Mezzanine 18 | (1) | Multifamily | 5,000 | 5,005 | 1M LIBOR + 7.50% | Interest Only | 8/9/2016 | |||||||||
Mezzanine 19 | (1) | Hospitality | 7,140 | 6,543 | 10.0% | Interest Only | 11/1/2024 | |||||||||
Mezzanine 20 | (1) | Hospitality | 3,900 | 3,574 | 10.0% | Interest Only | 11/1/2024 | |||||||||
Mezzanine 21 | (1) | Hospitality | 12,510 | 11,463 | 10.0% | Interest Only | 11/1/2024 | |||||||||
Mezzanine 22 | (1) | Hospitality | 8,050 | 7,377 | 10.0% | Interest Only | 11/1/2024 | |||||||||
Mezzanine 23 | (1) | Office | 9,000 | 9,036 | 10.5% | Interest Only | 10/6/2019 | |||||||||
Mezzanine 24 | (1) | Hospitality | 6,277 | 4,491 | 5.5% | 30 Year Amortization | 5/6/2023 | |||||||||
Mezzanine 25 | (1) | Retail | 10,000 | 10,000 | 11.0% | Interest Only | 4/1/2024 | |||||||||
$ | 1,134,446 | $ | 1,125,089 | |||||||||||||
________________
(1) Subject to prior liens.
F-30