STARWOOD PROPERTY TRUST, INC. - Quarter Report: 2012 March (Form 10-Q)

 

 

 

Special Note Regarding Forward Looking Statements

 

This Quarterly Report on Form 10-Q contains certain forward-looking statements, including without limitation, statements concerning our operations, economic performance and financial condition. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are developed by combining currently available information with our beliefs and assumptions and are generally identified by the words “believe,” “expect,” “anticipate” and other similar expressions. Forward-looking statements do not guarantee future performance, which may be materially different from that expressed in, or implied by, any such statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates.

 

These forward-looking statements are based largely on our current beliefs, assumptions and expectations of our future performance taking into account all information currently available to us. These beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to us or within our control, and which could materially affect actual results, performance or achievements. Factors that may cause actual results to vary from our forward-looking statements include, but are not limited to:

 

·                  factors described in our Annual Report on Form 10-K for the year ended December 31, 2011 and in this Form 10-Q for the quarter ended March 31, 2012, including those set forth under the captions “Risk Factors” and “Business”

 

·                  defaults by borrowers in paying debt service on outstanding items;

 

·                  impairment in the value of real estate property securing our loans;

 

·                  availability of mortgage origination and acquisition opportunities acceptable to us;

 

·                  potential mismatches in the timing of asset repayments and the maturity of the associated financing agreements;

 

·                  national and local economic and business conditions;

 

·                  general and local commercial real estate property conditions;

 

·                  changes in federal government policies;

 

·                  changes in federal, state and local governmental laws and regulations;

 

·                  increased competition from entities engaged in mortgage lending;

 

·                  changes in interest rates;

 

·                  the availability of and costs associated with sources of liquidity;

 

·                  factors associated with the ownership of residential real estate assets acquired by us directly or indirectly in settlement of loans, or residential REO, and held for lease and potentially for sale, including: macroeconomic shifts in demand for, and competition in the supply of, residential rental properties; the inability to lease or re-lease properties to tenants on attractive terms or at all; the failure of tenants to pay rent when due or otherwise perform their lease obligations; unanticipated repairs, capital expenditures or other costs; uninsured damages; increases in property taxes and insurance costs; our ability to dispose of the residential REO in a timely manner in response to changes in market conditions; and potential tax liabilities owed, and limitations imposed, upon disposition of the residential REO; and

 

·                  factors relating to our investment in distressed or non-performing residential mortgage loans acquired with the expectation of their conversion into residential REO or other commercial resolution, including our ability to convert such investments into residential REO or to effect another commercial resolution in a timely manner or at all, the costs relating thereto, and the additional real estate investment trust, or REIT, qualification issues associated with the investment in distressed or non-performing residential mortgage loans.

 

In light of these risks and uncertainties, there can be no assurances that the results referred to in the forward-looking statements contained in this Quarterly Report on Form 10-Q will in fact occur. Except to the extent required by applicable law or regulation, we undertake no obligation to, and expressly disclaim any such obligation to, update or revise any forward-looking statements to reflect changed assumptions, the occurrence of anticipated or unanticipated events, changes to future results over time or otherwise.

 

2

 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

Starwood Property Trust, Inc. and Subsidiaries

 

Condensed Consolidated Balance Sheets

(Unaudited, amounts in thousands, except share and per share data)

 

		As of March 31, 2012			As of December 31, 2011
Assets:
Cash and cash equivalents		$	132,565		$	114,027
Loans held for investment		2,333,507			2,268,599
Loans held-for-sale at fair value		—			128,593
Loans held in securitization trust		50,290			50,316
Mortgage-backed securities, available-for-sale, at fair value		644,138			341,734
Other investments		44,144			44,379
Accrued interest receivable		15,851			15,176
Derivative assets		9,455			12,816
Other assets		11,564			21,807
Total Assets		$	3,241,514		$	2,997,447
Liabilities and Equity
Liabilities:
Accounts payable and accrued expenses		$	5,053		$	5,051
Related-party payable		13,350			8,348
Dividends payable		41,439			41,431
Derivative liabilities		16,307			19,652
Secured financing agreements, net		1,308,860			1,103,517
Collateralized debt obligation in securitization trust		52,978			53,199
Other liabilities		11,096			1,102
Total Liabilities		1,449,083			1,232,300
Commitments and contingencies (Note 14)
Equity:
Starwood Property Trust, Inc. Stockholders’ Equity:
Preferred stock, $0.01 per share, 100,000,000 shares authorized, no shares issued and outstanding		—			—
Common stock, $0.01 per share, 500,000,000 shares authorized, and 94,004,892 issued and 93,379,042 outstanding as of March 31, 2012 and 93,811,351 issued and 93,185,501 outstanding as of December 31, 2011		940			938
Additional paid-in capital		1,832,082			1,828,319
Treasury stock (625,850 shares as of March 31, 2012 and 625,850 shares as of December 31, 2011, respectively)		(10,642		)	(10,642		)
Accumulated other comprehensive income (loss)		10,863			(3,998		)
Accumulated deficit		(46,409		)	(55,129		)
Total Starwood Property Trust, Inc. Stockholders’ Equity		1,786,834			1,759,488
Non-controlling interests in consolidated subsidiaries		5,597			5,659
Total Equity		1,792,431			1,765,147
Total Liabilities and Equity		$	3,241,514		$	2,997,447

 

See notes to condensed consolidated financial statements.

 

3

 

Starwood Property Trust, Inc. and Subsidiaries

 

Condensed Consolidated Statements of Operations

(Unaudited, amounts in thousands, except per share data)

 

		For the Three-Months Ended March 31
		2012			2011
Net interest margin:
Interest income from mortgage-backed securities		$	8,675		$	6,860
Interest income from loans		69,077			32,717
Interest expense		(11,852		)	(8,144		)
Net interest margin		65,900			31,433
Expenses:
Management fees (including $3,649 and $3,844 for the three-months ended March 31, 2012 and 2011 of non-cash stock-based compensation)		15,167			9,346
Acquisition and investment pursuit costs		861			88
General and administrative (including $116 and $40 for the three-months ended March 31, 2012 and 2011 of non-cash stock-based compensation)		3,023			2,104
Total expenses		19,051			11,538
Income before other income (expense) and income taxes		46,849			19,895
Interest income from cash balances		49			144
Other income (expense)		754			(472		)
Other-than-temporary impairment (“OTTI”), net of $1,439 and $0 recognized in other comprehensive income (loss) for the three months ended March 31, 2012 and 2011, respectively		(656		)	(434		)
Net gains on sales of investments		7,333			8,104
Net realized foreign currency gains (losses)		8,834			(30		)
Net losses on currency hedges		(6,257		)	(3,916		)
Net gains on interest rate hedges		566			1,450
Net losses on credit hedges		—			(187		)
Net change in unrealized (losses) gains on loans held-for-sale at fair value		(5,760		)	3,187
Unrealized foreign currency remeasurement (losses) gains		(1,025		)	3,984
Income before income taxes		50,687			31,725
Income tax provision		(399		)	—
Net Income		50,288			31,725
Net income attributable to non-controlling interests		(129		)	(278		)
Net income attributable to Starwood Property Trust, Inc.		$	50,159		$	31,447
Net income per share of common stock:
Basic		$	0.53		$	0.44
Diluted		$	0.53		$	0.43
Distributions declared per common share		$	0.44		$	0.42

 

See notes to condensed consolidated financial statements.

 

4

 

Starwood Property Trust, Inc. and Subsidiaries

 

Condensed Consolidated Statements of Comprehensive Income

(Unaudited, amounts in thousands)

 

 

		For the Three-Months Ended March 31
		2012			2011
Net Income		$	50,288		$	31,725
Other comprehensive income:
Change in fair value of cash flow hedges		(252		)	595
Unrealized gain (loss) in fair value of available-for-sale securities		14,457			(454		)
Reclassification adjustment for net realized gains on sale of securities		—			(5,995		)
Reclassification for OTTI		656			434
Comprehensive income		65,149			26,305
Less: Comprehensive income attributable to non-controlling interests		(129		)	(25		)
Comprehensive income attributable to Starwood Property Trust, Inc.		$	65,020		$	26,280

 

See notes to condensed consolidated financial statements.

 

5

 

Starwood Property Trust, Inc. and Subsidiaries

 

Condensed Consolidated Statements of Equity

(Unaudited, amounts in thousands, except share data)

 

		Common Stock					Additional											Accumulated Other Comprehensive			Total Starwood Property Trust, Inc.			Non-
				Par			Paid-In			Treasury Stock					Accumulated			Income			Stockholders’			Controlling			Total
		Shares		Value			Capital			Shares		Amount			Deficit			(Loss)			Equity			Interests			Equity
Balance, January 1, 2011		71,021,342		$	706		$	1,337,953		—		$	—		$	(19,302	)	$	8,203		$	1,327,560		$	9,669		$	1,337,229
Stock-based compensation		11,082					3,884														3,884						3,884
Net income															31,447						31,447			278			31,725
Dividends declared, $0.42 per share															(30,539		)				(30,539		)				(30,539		)
Other comprehensive loss, net																		(5,117		)	(5,117		)	(303		)	(5,420		)
Distribution to non-controlling interests																								(851		)	(851		)
Balance, March 31, 2011		71,032,424		$	706		$	1,341,837		—		$	—		$	(18,394	)	$	3,086		$	1,327,235		$	8,793		$	1,336,028
Balance, January 1, 2012		93,811,351		$	938		$	1,828,319		625,850		$	(10,642	)	$	(55,129	)	$	(3,998	)	$	1,759,488		$	5,659		$	1,765,147
Stock-based compensation		193,541		2			3,763														3,765						3,765
Net income															50,159						50,159			129			50,288
Dividends declared, $0.44 per share															(41,439		)				(41,439		)				(41,439		)
Other comprehensive income, net																		14,861			14,861						14,861
Distribution to non-controlling interests																								(191		)	(191		)
Balance, March 31, 2012		94,004,892		$	940		$	1,832,082		625,850		$	(10,642	)	$	(46,409	)	$	10,863		$	1,786,834		$	5,597		$	1,792,431

 

See notes to condensed consolidated financial statements

 

6

 

Starwood Property Trust, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited, amounts in thousands)

 

		For the Three-Months ended March 31
		2012			2011
Cash Flows from Operating Activities:
Net Income		$	50,288		$	31,725
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Amortization of deferred financing costs		1,132			394
Accretion of net discount on mortgage-backed securities		(5,616		)	(3,241		)
Accretion of net deferred loan fees and discounts		(21,622		)	(4,697		)
Amortization of premium from collateralized debt obligations		(221		)	(216		)
Stock-based compensation		3,765			3,884
Gain on sale of available-for-sale securities		(46		)	(6,163		)
Gain on sale of loans		(7,287		)	(1,914		)
Gain on sale of other investments		—			(27		)
Gain on foreign currency remeasurement		(9,146		)	—
Net change in unrealized losses (gains) on loans held-for-sale at fair value		5,760			(3,187		)
Unrealized gains on interest rate hedges		(9,779		)	(1,688		)
Unrealized losses on credit hedges		—			187
Unrealized losses on currency hedges		8,573			3,916
Unrealized foreign currency remeasurement losses (gains)		1,025			(3,984		)
OTTI		656			434
Changes in operating assets and liabilities:
Related-party payable		5,002			2,159
Accrued interest receivable, less purchased interest		(1,870		)	(2,180		)
Other assets		11,388			(2,846		)
Accounts payable and accrued expenses		2			(79		)
Other liabilities		9,995			(4,577		)
Origination of held-for-sale loans		—			(110,431		)
Proceeds from sale of held-for-sale loans		132,128			56,312
Net cash provided by (used in) operating activities		174,127			(46,219		)
Cash Flows from Investing Activities:
Purchase of mortgage-backed securities		(301,772		)	(92,493		)
Proceeds from sale of mortgage-backed securities		46			92,669
Proceeds from mortgage-backed securities maturities		—			6,160
Mortgage-backed securities principal repayments		20,099			34,033
Origination and purchase of loans held for investment		(218,872		)	(292,685		)
Loan maturities		147,707			—
Proceeds from sale of loans held for investment		28,786			—
Loan investment repayments		6,211			5,753
Purchased interest on investments		(437		)	(287		)
Investments in other investments		(99		)	(8,726		)
Return of investment from other investments		303			—
Proceeds from sale of other investments		—			2,843
Return of investment basis in purchased derivative asset		968			—
Proceeds from sale of treasury securities		—			112,741
Cash deposited as collateral under treasury securities loan agreement		—			(112,741		)
Net cash used in investing activities		(317,060		)	(252,733		)
Cash Flows from Financing Activities:
Borrowings under secured financing agreements		383,037			322,927
Principal repayments on borrowings under secured financing arrangements		(177,694		)	(98,028		)
Payment of deferred financing costs		(2,250		)	(177		)
Payment of dividends		(41,431		)	(29,081		)
Distributions to non-controlling interest owners		(191		)	(851		)
Net cash provided by financing activities		161,471			194,790
Net increase (decrease) in cash and cash equivalents		18,538			(104,162		)
Cash and cash equivalents, beginning of period		114,027			226,854
Cash and cash equivalents, end of period		$	132,565		$	122,692
Supplemental disclosure of cash flow information:
Cash paid for interest		$	13,143		$	7,613
Income taxes paid		$	—		$	174
Supplemental disclosure of non-cash investing and financing activity:
Dividends declared, but not yet paid		$	41,439		$	30,539

 

See notes to condensed consolidated financial statements.

 

7

 

Starwood Property Trust, Inc. and Subsidiaries

 

Notes to Condensed Consolidated Financial Statements

 

As March 31, 2012

(Unaudited)

 

1. Business and Organization

 

Starwood Property Trust, Inc. (“the Trust” together with its subsidiaries, “we” or the “Company”) is a Maryland corporation that commenced operations on August 17, 2009 (“Inception”) upon the completion of its initial public offering (“IPO”). We are focused primarily on originating, investing in, financing and managing commercial mortgage loans and other commercial real estate debt investments. We also invest in residential mortgage-backed securities (“RMBS”), certain commercial mortgage-backed securities (“CMBS”), and other real estate related investments. We are externally managed and advised by SPT Management, LLC (the “Manager”).

 

We are organized and conduct our operations to qualify as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). As such, the Trust will generally not be subject to U.S. federal corporate income tax on that portion of net income that is distributed to stockholders if we distribute at least 90% of our taxable income to our stockholders by prescribed dates and comply with various other requirements.

 

We are organized as a holding company that conducts our business primarily through three wholly-owned subsidiaries. In 2009, we formed joint ventures (the “Joint Ventures”) with Starwood Hospitality Fund II (“Hotel II”) and Starwood Opportunity Fund VIII (“SOF VIII”) in accordance with the co-investment and allocation agreement with our Manager. The Joint Ventures are owned 75% (and controlled) by us and are therefore consolidated into our condensed consolidated financial statements. As of March 31, 2012, the investments held by the Joint Ventures had been sold and there were no remaining substantive investments in these entities.

 

As of March 31, 2012, investments with collateral in the hospitality, retail, and office property sectors represented 47.9%, 16.5%, and 20.2% of our investment portfolio, respectively. Such allocations could materially change in the future.

 

2. Summary of Significant Accounting Policies

 

Basis of Accounting and Principles of Consolidation

 

The accompanying condensed consolidated financial statements include our accounts and those of our consolidated subsidiaries. Intercompany amounts have been eliminated. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires us 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, as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.  The most significant and subjective estimate that we make is estimating the cash flows that we expect to receive on our investments, which has a significant impact on the amounts of interest income, credit losses (if any), and estimated fair values that we report and/or disclose.  In addition, our estimated fair value of certain financial instruments is significantly impacted by the rates we select to discount the respective cash flows.

 

A non-controlling interest in a consolidated subsidiary is defined as “the portion of the equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent”. Non-controlling interests are presented as a separate component of equity in the condensed consolidated balance sheets. In addition, the presentation of net income attributes earnings to controlling and non-controlling interests.

 

These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the period ended December 31, 2011, as filed with the Securities and Exchange Commission (“SEC”). The results of operations for the three months ended March 31, 2012 are not necessarily indicative of the operating results for the full year.

 

Segment Reporting

 

We are focused on originating and acquiring real estate-related debt investments and currently operate in one reportable segment.

 

8

 

Cash and Cash Equivalents

 

Cash and cash equivalents include cash in banks and short-term investments. Short-term investments are comprised of highly liquid instruments with original maturities of three months or less. We maintain our cash and cash equivalents in multiple financial institutions and at times these balances exceed federally insurable limits.

 

Debt Securities

 

GAAP requires that at the time of purchase, we designate debt securities as held-to-maturity, available-for-sale, or trading depending on our investment strategy and ability to hold such securities to maturity. Held-to-maturity securities are stated at cost plus any premiums or discounts, which are amortized or accreted through the condensed consolidated statements of operations using the effective interest method.  Securities we (i) do not hold for the purpose of selling in the near-term, or (ii) may dispose of prior to maturity, are classified as available-for-sale and are carried at fair value in the accompanying financial statements.  Unrealized gains or losses on available-for-sale securities are reported as a component of accumulated other comprehensive income (loss) in stockholders’ equity. As of March 31, 2012, our CMBS and RMBS were classified as available-for-sale.  The classification of each investment involves management’s judgment, which is subject to change.

 

When the estimated fair value of a security is less than its amortized cost, we consider whether there is other-than-temporary impairment (“OTTI”) in the value of the security. An impairment is deemed an OTTI if (i) we intend to sell the security, (ii) it is more likely than not that we will be required to sell the security before recovering our cost basis, or (iii) we do not expect to recover the entire amortized cost basis of the security even if we do not intend to sell the security or believe it is more likely than not that we will be required to sell the security before recovering our cost basis. If the impairment is deemed to be an OTTI, the resulting accounting treatment depends on the factors causing the OTTI. If the OTTI has resulted from (i) our intention to sell the security, or (ii) our judgment that it is more likely than not that we will be required to sell the security before recovering our cost basis, an impairment loss is recognized in current earnings equal to the entire difference between our amortized cost basis and fair value. Whereas, if the OTTI has resulted from our conclusion that (i) we will not recover our cost basis even if we do not intend to sell the security or (ii) it is not more likely than not that we will be required to sell the security before recovering our cost basis, only the credit loss portion of the impairment is recorded in current earnings, and the portion of the loss related to other factors, such as changes in interest rates, continues to be recognized in accumulated other comprehensive income (loss). Following the recognition of an OTTI through earnings, a new cost basis is established for the security. Determining whether there is an OTTI may require us to exercise significant judgment and make significant assumptions, including, but not limited to, estimated cash flows, estimated prepayments, and loss assumptions. As a result, actual OTTI losses could differ from reported amounts. Such judgments and assumptions are based upon a number of factors, including (i) credit of the issuer or the underlying borrowers, (ii) credit rating of the security, (iii) key terms of the security, (iv) performance of the underlying loans, including debt service coverage and loan-to-value ratios, (v) the value of the collateral for the underlying loans, (vi) the effect of local, industry, and broader economic factors, and (vii) the historical and anticipated trends in defaults and loss severities for similar securities.

 

Loans Held for Investment

 

Loans that are held for investment are carried at cost, net of unamortized acquisition premiums or discounts, loan fees, and origination and acquisition costs as applicable, unless the loans are deemed impaired.

 

We evaluate each loan classified as held for investment for impairment at least quarterly.  Impairment occurs when it is deemed probable that we will not be able to collect all amounts due according to the contractual terms of the loan. If a loan is considered to be impaired, we record an allowance to reduce the carrying value of the loan to the present value of expected future cash flows discounted at the loan’s contractual effective rate or the fair value of the collateral if repayment is expected solely from the collateral.

 

Our loans are typically collateralized by real estate. As a result, we regularly evaluate the extent and impact of any credit deterioration associated with the performance and/or value of the underlying collateral property, as well as the financial and operating capability of the borrower. Specifically, a property’s operating results and any cash reserves are analyzed and used to assess (i) whether cash from operations are sufficient to cover the debt service requirements currently and into the future, (ii) the ability of the borrower to refinance the loan, and/or (iii) the property’s liquidation value. We also evaluate the financial wherewithal of any loan guarantors as well as the borrower’s competency in managing and operating the properties. In addition, we consider the overall economic environment, real estate sector, and geographic sub-market in which the borrower operates. Such impairment analyses are completed and reviewed by asset management and finance personnel, who utilize various data sources, including (i) periodic financial data such as property occupancy, tenant profile, rental rates, operating expenses, the borrower’s exit plan, and capitalization and discount rates, (ii) site inspections, and (iii) current credit spreads and discussions with market participants.

 

In addition, for all of the loans that are deemed to not be individually impaired from the evaluation process described above, we consider whether there are any specific characteristics of such loans indicating that it is probable that a loss has been incurred in a group of loans with those same characteristics.

 

9

 

Upon completion of the process above, we concluded that no allowance for loan losses was necessary as of March 31, 2012 and December 31, 2011. Significant judgment is required when evaluating loans for impairment; therefore, actual results over time could be materially different.

 

Loans Held-for-sale

 

Loans that we intend to sell or liquidate in the short-term are classified as held-for-sale and are carried at the lower of amortized cost or fair value, unless we have elected to record any such loans at fair value at the time they were acquired under Financial Accounting Standards Board (“FASB”) Topic 825, Financial Instruments.  Upfront costs and fees related to loans for which the fair value option is elected are recognized in earnings as incurred and not deferred.  Refer to Note 7 of the condensed consolidated financial statements for further disclosure regarding loans sold.

 

U.S. Treasury Securities Sold Short

 

In February 2011, in order to hedge the impact of interest rate increases on the fair value of our RMBS portfolio, we took short positions on U.S. Treasury securities with durations similar to those expected within our RMBS portfolio. To execute our hedging strategy, we sold to a third party $112.7 million in U.S. Treasury securities that were simultaneously borrowed from our prime broker. The entire cash sale proceeds from the third party were then immediately deposited with our prime broker as collateral for the U.S. Treasury securities borrowing. On March 31, 2011, we purchased from a third party the same series of U.S. Treasury securities that had been borrowed. The securities were then immediately delivered to the prime broker in repayment of the securities borrowing, thereby settling the short position. We realized a gain from this strategy of approximately $122 thousand, which is comprised of the $194 thousand favorable movement in the prices of U.S. Treasury securities (from our short position), offset by $72 thousand of interest that accrued on the securities during the term of the borrowing and transaction costs.

 

Revenue Recognition

 

Interest income is accrued based on the outstanding principal amount and the contractual terms of our loans and securities. Discounts or premiums associated with the purchase of loans and investment securities are amortized into interest income as a yield adjustment on the effective interest method, based on expected cash flows through the expected maturity date of the security. For loans that we have not elected to record at fair value under FASB Topic 825, origination fees and direct loan origination costs are also recognized in interest income over the loan term as a yield adjustment using the effective interest method. When we elect to record a loan at fair value, origination fees and direct loan costs are recorded directly in income and are not deferred.

 

Upon the sale of loans or securities, the excess (or deficiency) of net proceeds over the amortized cost of such loans or securities is recognized as a realized gain (or loss).

 

Investments in Unconsolidated Entities

 

We own non-controlling equity interests in various privately-held partnerships and limited liability companies. We use the cost method to account for investments when we (i) own five percent or less of and (ii) do not have significant influence over, the underlying investees.  We use the equity method to account for all other non-controlling interests in partnerships and limited liability companies.  Cost method investments are initially recorded at cost and income is generally recorded when distributions are received.  Equity method investments are initially recorded at cost and subsequently adjusted for our share of income or loss, as well as contributions made or distributions received.

 

We also own publicly-traded equity securities of certain companies in the real estate industry.  We have no influence over the activities of these companies due to our minimal percentage ownership.  These investments are classified as available-for-sale and reported at fair value in the balance sheet, with unrealized gains and losses reported as a component of other comprehensive income (loss).  Dividends on our available-for-sale equity securities are recorded in the statement of operations on the record date.

 

Investments in unconsolidated entities are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.  When the fair value of an equity investment in an unconsolidated entity is less than its cost basis, we consider whether there is an OTTI.  OTTI analyses are based on current plans, intended holding periods and other available information at the time the analyses are prepared.

 

Securitization/Sale and Financing Arrangements

 

We periodically sell our financial assets, such as commercial mortgage loans, CMBS and other assets. In connection with these transactions, we may retain or acquire senior or subordinated interests in the related assets. Gains and losses on such transactions are recognized using the guidance in FASB Topic 860, Transfers and Servicing, which is based on a financial components approach that focuses on control. Under this approach, after a transfer of financial assets that meets the criteria for treatment as a sale—legal isolation, ability of transferee to pledge or exchange the transferred assets without constraint, and transferred control—an entity recognizes the financial assets it retains and any liabilities it has incurred, derecognizes the financial assets it has sold, and

 

10

 

derecognizes liabilities when extinguished. We determine the gain or loss on sale of mortgage loans by allocating the carrying value of the underlying mortgage between securities or loans sold and the interests retained based on their fair values, as applicable. The gain or loss on sale is the difference between the cash proceeds from the sale and the amount allocated to the securities or loans sold.

 

Acquisition and Investment Pursuit Costs

 

Net costs incurred in connection with acquiring investments, as well as in pursuing unsuccessful investment acquisitions and loan originations, are charged to current earnings and not deferred.

 

Foreign Currency Transactions

 

Our assets and liabilities denominated in foreign currencies are translated into U.S. dollars using foreign currency exchange rates at the end of the reporting period. Income and expenses are translated at the weighted-average exchange rates for each reporting period. As of March 31, 2012 and December 31, 2011, the U.S. dollar was the functional currency of all investments denominated in foreign currencies. The effects of translating the assets, liabilities and income of our foreign investments are included in unrealized foreign currency remeasurement (loss) gain in the statements of operations.

 

Concentration of Credit Risk

 

Financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash investments, CMBS, RMBS, loan investments, and interest receivable. We may place cash investments in excess of insured amounts with high quality financial institutions. We perform an ongoing analysis of credit risk concentrations in our investment portfolio by evaluating exposure to various counterparties, markets, underlying property types, contract terms, tenant mix, and other credit metrics.

 

Derivative Instruments and Hedging Activities

 

GAAP provides the disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of (a) how and why an entity uses derivative instruments, (b) how the entity accounts for derivative instruments and related hedged items, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Further, we must provide qualitative disclosures that explain our objectives and strategies for using derivatives, as well as quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

 

We record all derivatives in the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether we have elected to designate a derivative in a hedging relationship and have satisfied the criteria necessary to apply hedge accounting under GAAP. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. We regularly enter into derivative contracts that are intended to economically hedge certain of our risks, even though the transactions may not qualify for, or we may not elect to pursue, hedge accounting. In such cases, changes in the fair value of the derivatives are recorded in earnings.

 

Deferred Financing Costs

 

Costs incurred in connection with obtaining secured financing arrangements are capitalized and amortized over the respective loan terms of the respective facilities as a component of interest expense. As of March 31, 2012 and December 31, 2011, we had approximately $6.1 million and $5.0 million, respectively, of capitalized financing costs, net of amortization. For the three months ended March 31, 2012 and March 31, 2011, approximately $1.1 million and $0.4 million, respectively, of amortization was included in interest expense on the statement of operations.

 

Earnings per share

 

We calculate basic earnings per share by dividing net income (loss) attributable to the Company for the period by the weighted-average of shares of common stock outstanding for that period after consideration of the earnings allocated to our restricted stock and restricted stock units, which are participating securities as defined in GAAP. Diluted earnings per share takes into effect any dilutive instruments, such as restricted stock and restricted stock units, except when doing so would be anti-dilutive.

 

Share-based payments

 

We recognize the cost of share-based compensation and payment transactions using the same expense category as would be charged for payments in cash. The fair value of the restricted stock or restricted stock units granted is recorded to expense on a straight-line basis over the vesting period for the award, with an offsetting increase in stockholders’ equity. For grants to employees

 

11

 

and directors, the fair value is determined based upon the stock price on the grant date. For non-employee grants, the fair value is based on the stock price when the shares vest, which requires the amount to be adjusted in each reporting period based on the fair value of the award at the end of the reporting period until the award has vested.

 

Income Taxes

 

We have elected to be taxed as a REIT and intend to comply with the Code with respect thereto. Accordingly, we will not be subject to federal income tax as long as certain asset, income, dividend distribution and stock ownership tests are met. Many of these requirements are technical and complex and if we fail to meet these requirements we may be subject to federal, state, and local income tax and penalties. A REIT’s net income from prohibited transactions is subject to a 100% penalty tax. We have two taxable REIT subsidiaries (the “TRSs”) where certain investments may be made and activities conducted that (i) may have otherwise been subject to the prohibited transaction tax and (ii) may not be favorably treated for purposes of complying with the various requirements for REIT qualification.  The income, if any, within the TRSs is subject to federal and state income taxes as a domestic C corporation based upon the TRSs’ net income. For the three months ended March 31, 2012, we recorded a provision for income taxes of $0.4 million related to the activities in our TRSs.  These provisions were determined using a Federal income tax rate of 34% and state income tax rate of 7.5%.  For the three months ended March 31, 2011, we recorded no provision for income taxes related to the activities in our TRSs.

 

Underwriting Commissions and Offering Costs

 

Underwriting and offering costs incurred totaled approximately $1.1 million in connection with our equity offering in May 2011, approximately $18.9 million in connection with the equity offering in December 2010, and approximately $57.6 million in connection with our initial public offering in 2009. Underwriting and offering costs are reflected as a reduction in additional paid-in capital in the statement of equity.

 

Recent Accounting Pronouncements

 

In December 2011, the FASB issued amended guidance which will enhance disclosures required by GAAP by requiring improved information about financial instruments and derivative instruments that are either (1) offset or (2) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset. This information will enable users of an entity’s financial statements to evaluate the effect or potential effect of netting arrangements on an entity’s financial position, including the effect or potential effect of rights of setoff associated with certain financial instruments and derivative instruments. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. We are in the process of evaluating the impact that this guidance will have on our financial statement disclosures.

 

Reclassifications

 

After the first quarter of 2011, we began separately reporting the amount of acquisition and investment pursuit costs in the statement of operations. In prior periods, such amounts were included in general administrative expenses but have been reclassified to conform to the new presentation.  Additionally, after the first quarter of 2011 we began combining unrealized and realized gains and losses on interest rate and currency hedges, as well as for loans held for sale at fair value, which had been presented separately in prior periods.

 

3. Debt Securities

 

We classified all CMBS and RMBS investments as available-for-sale as of March 31, 2012 and December 31, 2011. The CMBS and RMBS classified as available-for-sale are reported at fair value in the balance sheet with changes in fair value recorded in accumulated other comprehensive (loss) income. The tables below summarize various attributes of our investments in mortgage-backed securities (“MBS”) available-for-sale as of March 31, 2012 and December 31, 2011 (amounts in thousands):

 

								Unrealized Gains or (Losses) Recognized in Accumulated Other Comprehensive Income (Loss)
March 31, 2012		Purchased Amortized Cost		Credit OTTI		Recorded Amortized Cost		Non-Credit OTTI		Unrealized Gains		Unrealized Losses		Net Fair Value Adjustment		Fair Value
CMBS		$478,971		$—		$478,971		$—		$7,981		$—		$7,981		$486,952
RMBS		156,722		(6,657	)	150,065		(1,439	)	8,663		(103	)	7,121		157,186
Total		$635,693		$(6,657	)	$629,036		$(1,439	)	$16,644		$(103	)	$15,102		$644,138

 

12

 

March 31, 2012		Weighted Average Coupon(1)		Weighted Average Rating		Weighted Average Life  (“WAL”) (Years)(3)		Weighted Average Yield (4)
CMBS		3.8	%	(2)		3.8		7.15	%
RMBS		1.0	%	B-		5.0		10.85	%

(1)          Calculated using the one-month LIBOR rate as of March 31, 2012 of 0.24125%.

(2)          Includes a $388 million investment  in senior securities that were not rated, that are secured by substantially all of the assets of a worldwide operator of hotels, resorts, and timeshare properties, and which had an estimated loan-to-value ratio as of March 31, 2012 in the range of 39%-44%. The remaining $99.3 CMBS investment position is rated BB+.

(3)          Represents the WAL of each respective group of MBS. The WAL of each individual security is calculated as a fraction, the numerator of which is the sum of the timing (in years) of each expected future principal payment multiplied by the balance of the respective payment, and with the denominator equal to the sum of the expected principal payments. This calculation was made as of March 31, 2012. Assumptions for the calculation of the WAL are adjusted as necessary for changes in projected principal repayments and/or maturity dates of the security.

(4)          Most of the CMBS and all of the RMBS were purchased at a discount that will be accreted into income over the expected remaining life of the security.  The majority of the income from these securities is earned from the accretion of these discounts.

 

Within the hospitality sector, as of March 31, 2012 we have in aggregate investment of $503.1 million in senior debt secured by substantially all of the assets of a worldwide operator of hotels, resorts and timeshare properties. The debt investment is comprised of $115.5 million in loans and $387.6 million in securities. As of March 31, 2012, the aggregate face value of $539.7 million represents 7.2% of the total face value of the senior debt outstanding, and the aggregate carrying value of our investment represents 15.5% of our total assets. See disclosure in Note 15 to the condensed consolidated financial statements regarding an additional interest in the senior debt that we purchased subsequent to March 31, 2012.

 

											Unrealized Gains or (Losses) Recognized in Accumulated Other Comprehensive Income (Loss)
December 31, 2011		Purchased Amortized Cost			Credit OTTI			Recorded Amortized Cost			Non-Credit OTTI			Unrealized Gains			Unrealized Losses			Net Fair Value Adjustment			Fair Value
CMBS		$	177,353		$	—		$	177,353		$	—		$	—		$	(567	)	$	(567	)	$	176,786
RMBS		170,424			(6,001		)	164,423			(1,310		)	3,367			(1,532		)	525			164,948
Total		$	347,777		$	(6,001	)	$	341,776		$	(1,310	)	$	3,367		$	(2,099	)	$	(42	)	$	341,734

 

December 31, 2011		Weighted Average Coupon(1)		Weighted Average Rating		WAL (3)
CMBS		2.1	%	NR(2)		3.5
RMBS		1.0	%	B-		4.8

 

(1)          Generally calculated using the one-month LIBOR rate as of December 31, 2011 of 0.2953% for floating rate securities.

(2)         Represents senior securities that were not rated, that are secured by substantially all of the assets of a worldwide operator of hotels, resorts, and timeshare properties, and which had an estimated loan-to-value ratio as of December 31, 2011 in the range of 39%-44%.

(3)          Represents the WAL of each respective group of MBS. The WAL of each individual security or loan is calculated as a fraction, the numerator of which is the sum of the timing (in years) of each expected future principal payment multiplied by the balance of the respective payment, and with the denominator equal to the sum of the expected principal payments. This calculation was made as of December 31, 2011. Assumptions for the calculation of the WAL are adjusted as necessary for changes in projected principal repayments and/or maturity dates of the security.

 

During the three-months ended March 31, 2012, purchases and sales executed, as well as the principal payments received, were as follows (amounts in thousands):

 

		RMBS			CMBS
Purchases		$	—		$	301,772
Sales/Maturities		—			—
Principal payments received		16,539			3,560

 

 

During the three-months ended March 31, 2012, we have not sold any CMBS positions. There have been no maturities during the three-months ended March 31, 2012.

 

During the first quarter 2011, the purchases, sales, and principal pay-downs were as follows:

 

		RMBS			CMBS
Purchases		$	45,315		$	0
Sales		35,336			29,150
Principal pay-downs		19,412			14,621

 

13

 

As of March 31, 2012, 79.6%, of the CMBS are variable rate and pay interest at LIBOR plus a weighted average spread of 1.75%.  As of December 31, 2011, 100.0% of the CMBS were variable rate and paid interest at LIBOR plus a weighted average spread of 1.75%.

 

Subject to certain limitations on durations, we have allocated an amount to invest in RMBS that cannot exceed 10% of our total assets. We have engaged a third party manager who specializes in RMBS to execute the trading of RMBS, the cost of which was $0.3 million and $0.2 million for the three-months ended March 31, 2012 and March 31, 2011, respectively, which has been recorded as an offset to interest income in the accompanying condensed consolidated statements of operations.  As of March 31, 2012, approximately $146.9 million, or 93.4%, of the RMBS are variable rate and pay interest at LIBOR plus a weighted average spread of 0.43%. As of December 31, 2011, approximately $154.7 million, or 93.8%, of the RMBS were variable rate and pay interest at LIBOR plus a weighted average spread of 0.43%.  We purchased all of the RMBS at a discount that will be accreted into income over the expected remaining life of the security. The majority of the income from this strategy is earned from the accretion of these discounts.

 

The following table presents the gross unrealized losses and estimated fair value of our securities that are in an unrealized loss position as of March 31, 2012 and for which OTTIs (full or partial) have not been recognized in earnings (amounts in thousands):

 

		Estimated Fair Value						Unrealized Losses
As of March 31, 2012		Securities with a loss less than 12 months			Securities with a loss greater than 12 months			Securities with a loss less than 12 months			Securities with a loss greater than 12 months
CMBS		$	—		$	—		$	—		$	—
RMBS		14,839			1,355			(1,193		)	(349		)
Total		$	14,839		$	1,355		$	(1,193	)	$	(349	)

 

As of March 31, 2012 there were 15 securities with unrealized losses.  After evaluating each security we determined that the impairments on 13 of these securities, all of which are non-agency and whose impairments totaled $2.1 million, were other-than-temporary. Credit losses represented $0.7 million of this total, which we calculated by comparing (i) the estimated future cash flows of each security discounted at the yield determined as of the initial acquisition date or, if since revised, as of the last date previously revised to (ii) our amortized cost basis.  For the three months ended March 31, 2012, our aggregate MBS credit losses (as reported in the condensed consolidated statement of operations) were $0.7 million.  We further determined that neither of the two remaining securities were other-than-temporarily impaired.  We considered a number of factors in reaching this conclusion, including that we did not intend to sell any individual security, it was not considered more likely than not that we would be forced to sell any individual security prior to recovering our amortized cost, and there were no material credit events that would have caused us to otherwise conclude that we would not recover our cost.  Significant judgment is required is used in projecting cash flows for our non-agency RMBS. As a result, actual income and/or impairments could be materially different from what is currently projected and/or reported.

 

The following table presents the gross unrealized losses and estimated fair value of our securities that are in an unrealized loss position as of December 31, 2011 and for which OTTIs (full or partial) have not been recognized in earnings (amounts in thousands):

 

		Estimated Fair Value						Unrealized Losses
As of December 31, 2011		Securities with a loss less than 12 months			Securities with a loss greater than 12 months			Securities with a loss less than 12 months			Securities with a loss greater than 12 months
CMBS		$	176,786		$	—		$	(567	)	$	—
RMBS		70,103			2,684			(2,444		)	(399		)
Total		$	246,889		$	2,684		$	(3,011	)	$	(399	)

 

4. Loans

 

Our investments in loans held-for-investment are accounted for at amortized cost and the loans held-for-sale are accounted for at the lower of cost or fair value, unless we elect (upon origination or acquisition) to record such loans at fair value. The following table summarizes our investments in mortgages and loans by subordination class as of March 31, 2012 and December 31, 2011 (amounts in thousands):

 

March 31, 2012		Carrying Value			Face Amount			Weighted Average Coupon		Weighted Average Life (years) (2)
First mortgages		$	1,375,766		$	1,428,505		6.2	%	3.3
Subordinated mortgages (1)		313,688			348,072			9.4	%	4.5
Mezzanine loans		644,053			655,199			8.6	%	3.0
Total loans held for investment		2,333,507			2,431,776
Loans held in securitization trust		50,290			50,604			5.0	%	3.0
Total Loans		$	2,383,797		$	2,482,380

 

14

 

December 31, 2011		Carrying Value			Face Amount			Weighted Average Coupon		Weighted Average Life (years) (2)
First mortgages		$	1,202,611		$	1,248,549		6.6	%	3.2
Subordinated mortgages (1)		437,163			487,175			7.4	%	4.1
Mezzanine loans		628,825			642,831			8.4	%	3.0
Total loans held for investment		2,268,599			2,378,555
First mortgages held-for-sale at fair value		128,593			122,833			5.9	%	8.9
Loans held in securitization trust		50,316			50,632			5.0	%	3.7
Total Loans		$	2,447,508		$	2,552,020

 

As of March 31, 2012, approximately $1.2 billion, or 50.1%, of the loans are variable rate and pay interest at LIBOR plus a weighted-average spread of 4.62%. The following table summarizes our investments in floating rate loans (amounts in thousands):

 

		March 31, 2012					December 31, 2011
Index		Rate		Carrying Value			Rate		Carrying Value
1 Month LIBOR		0.2413%		$	382,145		0.2953%		$	264,030
3 Month LIBOR		0.4682%		14,641			0.5810%		143,371
1 Month Citibank LIBOR(1)		0.2250%		134,589			0.2700%		134,041
3 Month Citibank LIBOR(1)		0.4550%		7,132			0.5600%		7,102
6 Month Citibank LIBOR(1)		0.7200%		6,081			0.7800%		6,039
LIBOR Floor		0.5% - 2.0%		648,578			0.5% - 2.0%		551,275
Total				$	1,193,166				$	1,105,858

(1)          The Citibank LIBOR rate is equal to the rate per annum at which deposits in United States dollars are offered by the principal office of Citibank, N.A. in London, England to prime banks in the London interbank market.

 

As described in Note 2, we evaluate each of our loans for impairment at least quarterly.  Our loans are typically collateralized by real estate. As a result, we regularly evaluate the extent and impact of any credit deterioration associated with the performance and/or value of the underlying collateral property, as well as the financial and operating capability of the borrower. Specifically, a property’s operating results and any cash reserves are analyzed and used to assess (i) whether cash flow from operations is sufficient to cover the debt service requirements currently and into the future, (ii) the ability of the borrower to refinance the loan at maturity, and/or (iii) the property’s liquidation value. We also evaluate the financial wherewithal of any loan guarantors as well as the borrower’s competency in managing and operating the properties. In addition, we consider the overall economic environment, real estate sector, and geographic sub-market in which the borrower operates. Such impairment analyses are completed and reviewed by asset management and finance personnel who utilize various data sources, including (i) periodic financial data such as property operating statements, occupancy, tenant profile, rental rates, operating expenses, the borrower’s exit plan, and capitalization and discount rates, (ii) site inspections, and (iii) current credit spreads and discussions with market participants.

 

Our evaluation process as described above produces an internal risk rating of between 1 and 5, which is a weighted-average of the numerical ratings in the following categories: (i) sponsor capability and financial condition, (ii) loan and collateral performance relative to underwriting, (iii) quality and stability of collateral cash flows, and (iv) loan structure. We utilize the overall risk ratings as a concise means to monitor any credit migration on a loan as well as on the whole portfolio.  While the overall risk rating is not the sole factor we use in determining whether a loan is impaired, a loan with a higher overall risk rating would tend to have more adverse indicators of impairment, and therefore would be more likely to experience a credit loss.

 

The rating categories generally include the characteristics described below, but these are utilized as guidelines and therefore not every loan will have all of the characteristics described in each category:

 

15

 

Rating			Characteristics
1		·	Sponsor capability and financial condition—Sponsor is highly rated or investment grade or, if private, the equivalent thereof with significant management experience.
		·	Loan collateral and performance relative to underwriting—The collateral has surpassed underwritten expectations.
		·	Quality and stability of collateral cash flows—Occupancy is stabilized, the property has had a history of consistently high occupancy, and the property has a diverse and high quality tenant mix.
		·	Loan structure—Loan-to-collateral value ratio (“LTV”) does not exceed 65%. The loan has structural features that enhance the credit profile.
2		·	Sponsor capability and financial condition—Strong sponsorship with experienced management team and a responsibly leveraged portfolio.
		·	Loan collateral and performance relative to underwriting—Collateral performance equals or exceeds underwritten expectations and covenants and performance criteria are being met or exceeded.
		·	Quality and stability of collateral cash flows—Occupancy is stabilized with a diverse tenant mix.
		·	Loan structure—LTV does not exceed 70% and unique property risks are mitigated by structural features.
3		·	Sponsor capability and financial condition—Sponsor has historically met its credit obligations, routinely pays off loans at maturity, and has a capable management team.
		·	Loan collateral and performance relative to underwriting—Property performance is consistent with underwritten expectations.
		·	Quality and stability of collateral cash flows—Occupancy is stabilized, near stabilized, or is on track with underwriting.
		·	Loan structure—LTV does not exceed 80%.
4		·	Sponsor capability and financial condition—Sponsor credit history includes missed payments, past due payment, and maturity extensions. Management team is capable but thin.
		·	Loan collateral and performance relative to underwriting—Property performance lags behind underwritten expectations. Performance criteria and loan covenants have required occasional waivers. A sale of the property  may be necessary in order for the borrower to pay off the loan at maturity.
		·	Quality and stability of collateral cash flows—Occupancy is not stabilized and the property has a large amount of rollover.
		·	Loan structure—LTV is 80% to 90%.
5		·	Sponsor capability and financial condition—Credit history includes defaults, deeds-in-lieu, foreclosures, and/or bankruptcies.
		·	Loan collateral and performance relative to underwriting—Property performance is significantly worse than underwritten expectations. The loan is not in compliance with loan covenants and performance criteria and may be in default. Sale proceeds would not be sufficient to pay off the loan at maturity.
		·	Quality and stability of collateral cash flows—The property has material vacancy and significant rollover of remaining tenants.
		·	Loan structure—LTV exceeds 90%.

 

As of March 31, 2012, the risk ratings by class of loan were as follows (amounts in thousands):

 

		Balance Sheet Classification at March 31, 2012
Risk		Loans Held for Investment									Loans held in
Rating Category		First Mortgages			Subordinated Mortgages			Mezzanine Loans			Securitization Trust			Total
1		$	—		$	—		$	—		$	—		$	—
2		224,136			2,445			128,175			13,172			367,928
3		1,112,302			256,661			515,878			37,118			1,921,959
4		39,328			54,582			—			—			93,910
5		—			—			—			—			—
		$	1,375,766		$	313,688		$	644,053		$	50,290		$	2,383,797

 

16