CLARION COMMERCIAL HOLDINGS, INC. FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1999 Commission File Number: 1-14167 CLARION COMMERCIAL HOLDINGS, INC. (Exact name of registrant as specified in its charter) Maryland 13-3988895 - ---------------------------------------------- ------------------------------------------- (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 335 Madison Avenue, New York, New York 10017 - ---------------------------------------------- ------------------------------------------- (Address of principal executive offices) (Zip Code) (Registrant's telephone number including area code): (212) 883-2500 NOT APPLICABLE (Former name, former address, and former fiscal year if changed since last report) 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. Yes (X) No ( ) As of November 9, 1999, 4,272,363 shares of Class A Common Stock ($.001 par value) were outstanding. CLARION COMMERCIAL HOLDINGS, INC. FORM 10-Q INDEX PART I FINANCIAL INFORMATION.......................................................3 Item 1: Financial Statements......................................................3 Consolidated Statements of Financial Condition...................................3 Consolidated Statements of Operations............................................4 Consolidated Statement of Changes in Stockholders' Equity........................5 Consolidated Statements of Cash Flows............................................6 NOTES TO FINANCIAL STATEMENTS....................................................7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations....................................................11 Item 3. Quantitative and Qualitative Disclosures About Market Risk...............15 PART II - OTHER INFORMATION..........................................................16 Item 1. Legal Proceedings.........................................................16 Item 2. Changes in Securities and Use of Proceeds.................................16 Item 3. Defaults Upon Senior Securities...........................................16 Item 4. Submission of Matters to a Vote of Security Holders.......................16 Item 5. Other Information.........................................................16 Item 6. Exhibits and Reports on Form 8-K..........................................16 SIGNATURES...........................................................................17 2 PART I. FINANCIAL INFORMATION Item 1: Financial Statements Clarion Commercial Holdings, Inc. & Subsidiaries Consolidated Statements Of Financial Condition (unaudited) September 30, December 31, Assets: 1999 1998 ------------- ------------- Cash and cash equivalents $ 1,164,698 $ 565,684 Securities - trading, at fair value 69,121,221 80,731,788 Commercial mortgage loan receivable -- 12,949,224 Other investments 4,856,250 4,856,250 Deposits with brokers as collateral for securities sold short 23,979,451 46,830,041 Accrued interest receivable and other assets 598,040 2,089,891 ------------- ------------- Total assets $ 99,719,660 $ 148,022,878 ============= ============= Liabilities And Stockholders' Equity: Repurchase agreements $ 32,204,000 $ 58,924,000 Government securities sold short 23,803,835 45,578,695 Dividends payable 858,853 689,348 Treasury stock payable -- 577,851 Other liabilities 843,482 2,336,160 ------------- ------------- Total liabilities 57,710,170 108,106,054 ------------- ------------- Stockholders' equity: Preferred Stock, par value $.01 per share, 25,000,000 shares authorized; no shares issued -- -- Class A Common Stock, par value $.001 per share 74,000,000 sharers authorized; 5,000,750 issued; 4,294,263 and 4,451,050 shares outstanding in 1999 and 1998 Respectively 5,001 5,001 Class B Common Stock, par value $.001 per share 1,000,000 shares authorized; 175,000 issued and outstanding 175 175 Additional paid-in capital 98,197,339 98,197,339 Net loss and distributions (49,191,720) (52,303,201) Treasury stock - (706,487 and 549,700 shares in 1999 and 1998, respectively) at cost (7,001,305) (5,982,490) ------------- ------------- Total stockholders' equity 42,009,490 39,916,824 ------------- ------------- Total liabilities and stockholders' equity $ 99,719,660 $ 148,022,878 ============= ============= The accompanying notes are an integral part of these consolidated financial statements. 3 Clarion Commercial Holdings, Inc. & Subsidiaries Consolidated Statements of Operations (Unaudited) For the period June 2, 1998 For The Three For The Nine For The Three (commencement Months Ended Months Ended Months Ended of operations) to September 30, September 30, September 30, September 30, 1999 1999 1998 1998 ---------------------------------------------------------------------- Income: Interest income from securities -- trading $ 2,855,674 $ 8,549,377 $ 7,358,168 $ 8,992,934 Income from commercial mortgage loan 230,649 702,699 231,599 304,389 Income from other investments 136,185 404,805 150,776 181,634 Interest income from cash and cash equivalents 28,961 57,035 16,372 30,826 ---------------------------------------------------------------------- Total income 3,251,469 9,713,916 7,756,915 9,509,783 ---------------------------------------------------------------------- Expenses: Interest 1,700,119 5,106,395 5,544,220 6,364,944 Management fee 144,329 439,791 241,326 320,686 Other expenses 139,939 534,226 1,001,661 1,021,956 ---------------------------------------------------------------------- Total expenses 1,984,387 6,080,412 6,787,207 7,707,586 ---------------------------------------------------------------------- Other operating gains and losses: Gain (loss) from securities -- trading 210,004 3,036,795 (49,140,545) (49,216,337) Provision to adjust commercial loan to market value -- (1,500,633) -- -- Realized gain on sale of commercial mortgage loan 549,467 549,467 -- -- ---------------------------------------------------------------------- Total other operating gains 759,471 2,085,629 (49,140,545) (49,216,337) ---------------------------------------------------------------------- Net Income (Loss) $ 2,026,553 $ 5,719,133 $(48,170,837) $(47,414,140) ====================================================================== Net Income (Loss) per share: Basic $ 0.45 $ 1.26 $ (9.80) $ (9.52) ====================================================================== Diluted $ 0.45 $ 1.26 $ (9.80) $ (9.52) ====================================================================== Weighted average shares Basic 4,497,649 4,547,397 4,916,584 4,978,336 ====================================================================== Diluted 4,497,649 4,547,397 4,916,584 4,978,336 ====================================================================== The accompanying notes are an integral part of these consolidated financial statements. 4 Clarion Commercial Holdings, Inc. & Subsidiaries Consolidated Statement Of Changes In Stockholders' Equity For The Nine Months Ended September 30, 1999 (Unaudited) Additional Common Stock Paid-in Net Income and Treasury Class A Class B Capital Distributions Stock Total ------------------------------------------------------------------------------------------------------- Balance at January 1, 1999 $ 5,001 $ 175 $ 98,197,339 $(52,303,201) $ (5,982,490) $ 39,916,824 Dividend declared: Class A common stock -- -- -- (2,607,652) -- (2,607,652) Net income -- -- -- 5,719,133 -- 5,719,133 Treasury Stock -- -- -- -- (1,018,815) (1,018,815) ----------------------------------------------------------------------------------------- Balance at September 30, 1999 $ 5,001 $ 175 $ 98,197,339 $(49,191,720) $ (7,001,305) $ 42,009,490 ========================================================================================= The accompanying notes are an integral part of these consolidated financial statements. 5 Clarion Commercial Holdings, Inc. & Subsidiaries Consolidated Statements of Cash Flows (Unaudited) For the period For the Nine June 2, 1998 Months Ended (commencement of September 30, Operations) to 1999 September 30, 1998 -------------------------------- Cash flows from operating activities: Net income (loss) $ 5,719,133 $ (47,414,140) Adjustments to reconcile net income to net cash used by Operating activities: Discount accretion, net (425,838) (100,935) Change in unrealized gain on commercial mortgage-backed securities (4,399,818) 35,684,823 Change in unrealized (gain) loss on short sales of government securities (2,944,597) 12,221,618 (Decrease) Increase in accrued interest receivable & other assets 1,491,851 (1,991,066) Decrease/(Increase) in other liabilities (1,901,024) 6,337,450 Provision to adjust commercial mortgage loan receivable to market value 1,500,633 -- Gain on commercial mortgage loan receivable (549,467) -- Investment in commercial mortgage backed securities (18,597,001) (222,576,008) Sale of commercial mortgage backed securities 35,033,224 -- Decrease (Increase) in deposits with broker as collateral for securities sold short 22,850,590 (185,482,488) (Decrease) Increase in government securities sold short (18,830,263) 172,074,308 -------------------------------- Net cash provided in operating activities 18,947,423 (231,246,438) -------------------------------- Cash flows from investing activities: Investment in commercial mortgage loan receivable -- (13,014,690) Principal payments received on commercial mortgage loan 152,282 -- Proceeds from sale of commercial mortgage loan receivable 11,845,776 -- Investment in other assets -- (3,809,168) -------------------------------- Net cash provided by investing activities 11,998,058 (16,823,858) -------------------------------- Cash flows from financing activities: (Repayments) borrowings under reverse repurchase agreements, net (26,720,000) 159,903,000 Dividends paid (2,607,652) (724,605) Purchases of treasury stock (1,018,815) (5,232,705) Proceeds from issuance of common stock, net of offering costs -- 94,590,973 -------------------------------- Net cash used by financing activities (30,346,467) 248,536,663 -------------------------------- Net increase in cash and cash equivalents 599,014 466,367 Cash and cash equivalents at beginning of period 565,684 -- -------------------------------- Cash and cash equivalents at end of period $ 1,164,698 $ 466,367 ================================ Supplemental information: Interest paid $ 6,100,706 $ 3,563,575 ================================ Supplemental disclosures of cash flow information: * Distributions in the amount of $858,853 were declared on September 23, 1999 and paid on October 15, 1999. * Distributions in the amount of $2,165,288 were declared on September 23, 1998 and paid on October 15, 1998. The accompanying notes are an integral part of these consolidated financial statements. 6 NOTES TO FINANCIAL STATEMENTS NOTE 1 ORGANIZATION AND BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared in conformity with the instructions to Form 10-Q and Article 10, Rule 10-01 of Regulation S-X for interim financial statements. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements and should be read in conjunction with the annual financial statements and notes thereto included in the Company's annual report on Form 10-K filed with the Securities and Exchange Commission. The consolidated financial statements include the accounts of Clarion Commercial Holdings, Inc. ("Clarion") and its consolidated subsidiaries (together with Clarion, the "Company"). All intercompany transactions and balances are eliminated in consolidation. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments, consisting of normal and recurring accruals, necessary for a fair presentation of the consolidated financial condition of the Company at September 30, 1999 and December 31, 1998, the results of its operations for the three months and nine months ended September 30, 1999, and for the three months ended and the period from commencement of operations (June 2, 1998) to September 30, 1998, the changes in its stockholders' equity for the nine months ended September 30, 1999 and its cash flows for the nine months ended September 30, 1999 and for the period from commencement of operations (June 2, 1998) to September 30, 1998. Operating results for the period ended September 30, 1999 are not necessarily indicative of the results that may be expected for any other interim periods or the year ending December 31, 1999. Clarion was incorporated in Maryland in February 1998 and commenced its operations on June 2, 1998. The Company is a specialty finance company organized to invest in commercial mortgage-backed securities (primarily subordinate securities) commercial mortgage loans, mezzanine investments, equity investments and other real estate related investments. NOTE 2 SIGNIFICANT ACCOUNTING POLICIES In preparing the consolidated financial statements, management is required 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 consolidated statement of financial condition and revenues and expenses for the periods covered. Actual results could differ from those estimates and assumptions. A summary of the Company's significant accounting policies follows: SECURITIES -- TRADING At the date of acquisition, the Company elected to designate its government securities and commercial mortgage-backed securities ("CMBS") as trading assets. Such securities are carried at their estimated fair value, with the net unrealized gains or losses included in earnings. For a description of the methodology used in determining fair value of the Company's CMBS investments, refer to Note 3. Interest income is recognized as it becomes receivable, and includes amortization of premiums and accretion of discounts, computed using the effective yield method, after considering estimated prepayments and credit losses. Actual credit loss and prepayment experience is reviewed periodically and effective yields adjusted if necessary. The Company may, in the future, acquire assets that will be held for longer periods of time, and will therefore, not be held principally for the purpose of selling them in the near term. In this case, the Company may elect to designate these assets as "Available-For-Sale" and any subsequent unrealized gains and losses on the assets would be reported in other comprehensive income. SHORT SALES The Company enters into contracts to sell securities that it does not own at the time of the sale, at a specified price at a specified time (short sales). The Company utilizes these contracts as a means of mitigating ("hedging") the 7 potential financial statement impact of changes in the fair value of its portfolio of CMBS due to changes in interest rates. These contracts involve the sale of U.S. Treasury securities borrowed from a broker. The broker retains the proceeds from the sale until the Company replaces the borrowed securities. Risks in these contracts arise from the possible inability of counterparties to meet the terms of their contracts and from movements in securities values and interest rates. If the market value of the securities involved in the short sale increases, the Company may be required to meet a "margin call". The Company accounts for its liability to return the borrowed securities under short sales contracts at their market values, with unrealized gains or losses recorded in earnings. Income earned on the proceeds on deposit with brokers is included in interest income from securities - trading and interest due under the short sales is included in interest expense. COMMERCIAL MORTGAGE LOAN In September 1999 the Company sold its investment in the commercial mortgage loan for cash of $11,845,776. The Company recorded a reserve for loan impairment in the amount of $1,500,633 at June 30, 1999 based on its estimated valuation of $11,346,168, at that time. The Company adjusted that value by recording principal and market premium amortization of $49,858 prior to sale. Therefore, the Company recognized a gain on sale of $549,466 for the three months ended September 30, 1999. OTHER INVESTMENTS The Company's 10% interest in Clarion Capital, LLC (the "Manager") and the preferred interest in a limited partnership are accounted for at cost, with income from distributions recognized as distributions are declared. The Company periodically reviews these investments for other-than-temporary impairment. Any such impairment would be recognized in income by reducing the investment to its estimated fair value. COMPREHENSIVE INCOME SFAS No. 130, "Reporting Comprehensive Income" defines comprehensive income as the change in equity of a business enterprise during a period from transactions and other events and circumstances, excluding those resulting from investments by and distributions to owners. The Company had no items of other comprehensive income during any of the periods presented. NEW ACCOUNTING PRONOUNCEMENT In June of 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that the Company recognize all derivatives as either assets or liabilities in the statement of financial condition and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as a hedge of the exposure to changes in the fair value of a recognized asset or liability or a hedge exposure to variable cash flows of a forecasted transaction. The accounting for changes in the fair value of a derivative (e.g. through earnings or outside earnings, through comprehensive income) depends on the intended use of the derivative and the resulting designation. The Company is required to implement SFAS 133 on January 1, 2001. Company management is evaluating the impact that this statement will have on its hedging strategies and use of derivative instruments and is currently unable to predict the effect, if any, it will have on the Company's financial statements. NET INCOME PER SHARE Net income per share is computed in accordance with Statement of Financial Accounting Standards ("SFAS") No. 128, Earnings Per Share, and is calculated on the basis of the weighted average number of common shares outstanding during the period plus the additional dilutive effect of common stock equivalents. The dilutive effect of outstanding stock options is calculated using the treasury stock method. For the three months and nine months ending September 30, 1999 and the three months ending September 30, 1998 and the period from commencement of operations (June 2, 1998) to September 30, 1998, diluted net income per share was the same as basic net income per share, because all outstanding stock options were antidilutive. 8 DISTRIBUTIONS On October 15, 1999, the Company made a distribution of $0.20 per share to stockholders of record at the close of business on September 30, 1999. The character of the distribution to the stockholders for income tax purposes has not been determined at this time. INCOME TAXES The Company has elected to be taxed as a Real Estate Investment Trust ("REIT") and has complied with the provisions of the Internal Revenue Code of 1986, as amended (the "Code"), with respect thereto. Accordingly, the Company is not subject to federal income tax to the extent of its distributions to stockholders as long as certain asset, income and stock ownership tests are met. The Company has elected mark-to market valuation treatment for its investment portfolio under Internal Revenue Code Section 475. Under this election the Company must treat all unrealized trading gains and losses as realized for income tax purposes as well as treating all trading transactions as operating gains and losses. NOTE 3 SECURITIES -- TRADING AND SHORT SALES The Company's securities -- trading consist of CMBS with an estimated fair value of $69,121,221 and an amortized cost of $83,659,207 at September 30, 1999, resulting in an unrealized loss of $14,537,986 at that date. At December 31, 1998, the Company's securities - trading consisted of CMBS with an estimated fair value of $80,731,788 and an amortized cost of $99,669,591, resulting in an unrealized loss of $18,937,803 at that date. The portion of the loss from securities-trading that relates to CMBS still held at September 30, 1999 was $256,647 and $808,305 for the three months and nine months ended September 30, 1999, respectively. The portion of the loss from securities-trading that relates to CMBS still held at September 30, 1998 was $37,005,731 and $35,684,823 for the three months ended September 30, 1998 and for the period from commencement of operations (June 2, 1998) to September 30, 1998, respectively. The aggregate estimated fair value by underlying credit rating of the Company's CMBS at September 30, 1999 and December 31, 1998 are as follows: September 30, 1999 December 31, 1998 ------------------ ----------------- Security Rating Estimated Fair Value % of Total Estimated Fair Value % of Total --------------- -------------------- ---------- -------------------- ---------- BBB $21,506,107 31.1% $ -- -- BBB- 15,608,629 22.6 -- -- BB 10,524,300 15.2 58,252,658 72.2% B 14,780,256 21.4 15,695,359 19.4 B- 2,569,757 3.7 2,819,988 3.5 NR 4,132,172 6.0 3,963,783 4.9 ----------- ------ ----------- ----- $69,121,221 100.00% $80,731,788 100.0% =========== ====== =========== ====== As of September 30, 1999, the mortgage loans underlying the CMBS interests held by the Company were secured by properties of the types and in the states identified below: Property Type Percentage (1) State Percentage (1) ---------------------------------- ------------------------------- Retail 35.7% CA 22.0% Hotel 19.4 NJ 12.9 Multifamily 19.2 TX 9.1 Office 18.0 FL 8.2 Other 7.7 MO 7.8 All others (2) 40.0 (1) Based on a percentage of the total unpaid principal balance of the underlying loans. (2) No other state comprises more than 5% of the total. 9 As of September 30, 1999, the weighted average unpaid principal balance of loans that are (1) underlying the CMBS investments of the Company and (2) more than 60 days delinquent is 0.12% of the unpaid principal balance of the total collateral as of that date. The fair value of the Company's portfolio of CMBS is generally estimated by management based on market prices provided by third party market participants. The market for the Company's CMBS periodically suffers from a lack of liquidity, accordingly, the fair values reported reflect estimates and may not necessarily be indicative of the amounts the Company could realize in a current market exchange. At September 30, 1999, the un-leveraged, un-hedged, weighted average yield to maturity (excluding default and prepayment estimates) of the Company's CMBS portfolio was 11.91%. The yield to maturity on the Company's CMBS interests depends on, among other things, the amount and timing of principal payments, the pass-through rate and interest rate fluctuations. The subordinated CMBS interests owned by the Company provide credit support to the more senior interests of the related commercial securitization. Cash flow from the mortgages underlying the CMBS interests generally is allocated first to the senior interests, with the most senior interest having a priority entitlement to cash flow. Remaining cash flow is allocated generally among the other CMBS interests in order of their relative seniority. To the extent that there are defaults and unrecoverable losses on the underlying mortgages, resulting in reduced cash flows, the most subordinate CMBS interest will bear this loss first. To the extent there are losses in excess of the most subordinated interest's stated entitlement to principal and interest, then the remaining CMBS interests will bear such losses in order of their relative subordination. There is, therefore no assurance that the yield to maturity discussed above will be achieved. At September 30, 1999, the Company had open contracts to sell U.S. Treasury securities with face amounts totaling $22,764,000 and a fair value of $23,803,835. Although the Company generally does not settle these contracts at expiration, but instead rolls them over into new contracts, if the Company had settled its open contracts at September 30, 1999, the Company would have been required to pay the counterparty $161,079. The unrealized gain (loss) on these contracts for the three months and nine months ended September 30, 1999 was ($845,448) and $2,944,597, respectively, which is included in unrealized gains from securities-trading in the consolidated statement of operations. The realized gains on these contracts for the three months and nine months ended September 30, 1999 was $1,766,946, which is included in realized loss from securities-trading in the consolidated statement of operations. The Company earned $575,794 and $1,747,764 on short sale proceeds held by brokers and incurred interest of $769,938 and $2,384,192 on the short sales contracts for the three months and nine months ending September 30, 1999, respectively. NOTE 4 COMMON STOCK On June 30, 1998, the Board of Directors of Clarion authorized a program to repurchase up to 400,000 shares of Class A Common Stock (the "Stock Repurchase Program"). Pursuant to the Stock Repurchase Program, purchases of Class A Common Stock have been and will be made at the sole discretion of management in the open market or in privately negotiated transactions until the earlier to occur of (i) the date on which the Company acquires, in the aggregate, 400,000 shares of Class A Common Stock, or (ii) June 30, 1999. On September 8, 1998, the Board of Directors authorized management to repurchase an additional 400,000 shares prior to September 30, 1999, at a price not to exceed $13.60. On August 18, 1999 the Board of Directors extended the expiration date of the Stock Repurchase Program by one year to September 30, 2000. As of January 1, 1999, the Company had acquired a total of 549,700 shares of Class A Common Stock in the open market at a cost of $5,982,490. In the nine months ended September 30, 1999, the Company acquired an additional 160,300 shares of Class A Common Stock in the open market at a cost of $1,026,180. In the nine months ended September 30, 1999 the independent members of the Board of Directors received 3,513 shares of Class A Common Stock as compensation for their service to the company. 10 NOTE 5 TRANSACTIONS WITH AFFILIATES Clarion has entered into a Management Agreement (the "Management Agreement") with the Manager, under which the Manager manages the Company's day-to-day operations, subject to the direction and oversight of Clarion's Board of Directors. The Company pays the Manager an annual base management fee equal to 1% of the average stockholders' equity in the company, excluding any mark to market adjustments to the Company's assets. The Company will also pay the Manager, as incentive compensation, an amount equal to 25% of the Adjusted Net Income of Clarion, before incentive compensation, in excess of the amount that would produce an annualized return on equity equal to 2.5% over the Ten-Year U.S. Treasury. In accordance with the terms of the Management Agreement, the Company paid $144,329 and $439,791 in base management fees for the three months and nine months ended September 30, 1999, respectively. The Company has not accrued for, or paid, the Manager any incentive compensation since inception. NOTE 6 REPURCHASE AGREEMENTS As of September 30, 1999, the Company had entered into repurchase agreements in the amount of $32,204,000 to finance a portion of its investments. The weighted average maturity of the agreements as of September 30, 1999 was 18.81 days, with no agreement having a maturity greater than 30 days, and the weighted average interest rate was 6.02%, based on one-month LIBOR plus a weighted average spread of 0.64%. The repurchase agreements are collateralized by the Company's portfolio of CMBS investments. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company was organized in February 1998 to invest in commercial mortgage-backed securities (primarily subordinate securities), commercial mortgage loans, mezzanine investments, equity investments, and other real estate related investments. Substantially all of the $94.7 million of net proceeds received from the sale of 5,000,000 shares of its Class A Common Stock in June 1998 together with the net proceeds of other financing arrangements were used to acquire the Company's portfolio of investments. The following discussion of the Company's financial condition, results of operations, and capital resources and liquidity should be read in conjunction with the Company's financial statements and related notes. MARKET CONDITIONS: The three months ended September 30, 1999 were relatively calm for the Company, as spreads on subordinate classes of CMBS did not move dramatically in either direction. The price of a fixed income security (such as a CMBS) or a commercial loan is often determined by adding an interest rate spread to a benchmark interest rate, such as the U.S. Treasury rate. As the spread on a security tightens (or decreases), the price (or value) of the security rises. While spreads on the subordinate classes of CMBS moved very little in the three months ended September 30, 1999, interest rates did increase slightly. The ten-year U.S Treasury rate rose approximately 0.10% in the three months ended September 30, 1999. In the same way that a widening (increasing) spread for CMBS and commercial loans causes their value to fall, increasing interest rates also causes their value to decline. In order to offset this potential loss in CMBS and commercial loan value due to increasing interest rates, the Company "sells short" U.S. Treasury securities that increase in value as interest rates rise. In the three months ended September 30, 1999, the Company's short positions in U.S. Treasury securities effectively offset the decline in value of the Company's CMBS and commercial loan positions due to the increase in interest rates. 11 RESULTS OF OPERATIONS General: Net income for the three months and nine months ending September 30, 1999 amounted to $2,026,553 or $0.45 per share, basic and diluted, and $5,719,133 or $1.26 per share, basic and diluted, respectively. Net loss for the quarter ended September 30, 1998 and for the period from commencement of operations (June 2, 1998) to September 30, 1998 amounted to $48,170,837 or $9.80 per share, basic and diluted and $47,414,140 or $9.52 per share, basic and diluted, respectively. The net income for the three months ending September 30, 1999 was attributable primarily to income from investments of $3.3 million and net realized and unrealized gains from securities-trading of $0.8 million. This was offset by interest expense of $1.7 million, and other expenses of $0.3 million. The net income for the nine months ending September 30, 1999 was attributable primarily to income from investments of $9.7 million and net realized and unrealized gains of $2.1 million. This was offset by interest expense of $5.1 million and other expenses of $1.0 million. The net loss for the three months ending September 30, 1998 was attributable primarily to net realized and unrealized losses from securities-trading of $49.1 million. This was offset by income from investments of $7.8 million, interest expense of $5.5 million and other expenses of $1.2 million. The net loss for the period from commencement of operations (June 2, 1998) to September 30, 1998 was attributable primarily to net realized and unrealized losses from securities-trading of $47.4 million. This was offset by income from investments of $9.5 million, interest expense of $6.4 million and other expenses of $1.3 million. The results of operations realized during the period ending September 30, 1999 are not necessarily indicative of the results that may be expected for future periods. Investment Income: For the three months and nine months ending September 30, 1999 and the three months ending September 30, 1998 and the period from commencement of operations (June 2, 1998) to September 30, 1998, the Company earned income of $3,251,469, $9,713,916, $7,756,915 and $9,509,783 from investments, respectively, as follows: Period from Commencement Three Months Nine Months Three Months of Operations Ending Ending Ending (June 2, 1998) to September 30, September 30, September 30, September 30, Investment 1999 1999 1998 1998 - ----------------------------------------------------------------------------------------------- CMBS $ 2,279,880 $ 6,801,613 $ 4,579,729 $ 6,059,652 Deposits with brokers as collateral for securities sold short 575,794 1,747,764 2,778,439 2,933,282 Commercial mortgage loan 230,649 702,699 231,599 304,389 Mezzanine investment 136,185 404,805 150,776 181,634 Cash and cash equivalents 28,961 57,035 16,372 30,826 ---------------------------------------------------------- TOTAL $ 3,251,469 $ 9,713,916 $ 7,756,915 $ 9,509,783 ========================================================== Interest Expense: For the three months and nine months ending September 30, 1999, the Company incurred interest expense of $930,182 and $2,722,203 from repurchase agreements and $769,938 and $2,384,192 from government securities sold short, respectively. For the three months ending September 30, 1998 and for the period from commencement of operations (June 2, 1998) to September 30, 1998, the Company incurred interest expense of $2,430,560 and $3,080,679 from repurchase agreements and $3,113,660 and $3,284,266 from government securities sold short, respectively. As of September 30, 1999, the Company had entered into repurchase agreements in the amount of $32,204,000. The weighted average interest rate was 6.02%, and is a variable rate, based on one-month LIBOR plus a weighted average spread 0.64%. 12 As of September 30, 1999, the Company had the following open short positions in U.S. Treasury securities: $3,881,000 (face) of U.S. Treasury 6.50%, 11/15/2026 and $18,883,000 (face) of U.S. Treasury 7.00%, 07/15/2006. Other Expenses: In accordance with the terms of the Management Agreement, an expense of $144,329 and $439,791 in base management fees was incurred for the three months and nine months ending September 30, 1999, respectively. The base management fees for the three months ending September 30, 1998 and for the period from commencement of operations (June 2, 1998) to September 30, 1998 were $241,326 and $320,686, respectively. The Company has not accrued for or paid any incentive compensation to the Manager since inception. Other Operating Gains & Losses For the three months and nine months ended September 30, 1999, the Company recorded gains of $210,004 and $3,036,795, respectively, on its securities portfolio. This compares to losses of $49,140,545 and $49,216,337 for the three months ended September 30, 1998 and the period from commencement of operations (June 2, 1998) to September 30, 1998, respectively. In September 1999 the Company sold its investment in the commercial mortgage loan for cash of $11,845,776. The Company recorded a reserve for loan impairment in the amount of $1,500,633 at June 30, 1999 based on its estimated valuation of $11,346,168, at that time. The company adjusted that value by recording principal and market premium amortization of $49,858 prior to sale. Therefore, the company recognized a gain on sale of $549,466 for the three months ended September 30, 1999. In August and September the Company sold five of its CMBS investments for total proceeds of $28,958,658. In addition, the Company closed out the related short treasury hedges. These transactions resulted in realized losses of $4,307,620. The closing of short treasury hedge transactions in the three months ended September 30, 1998 and the period from commencement of operations (June 2, 1998) to September 30, 1998 resulted in realized losses of $1,099,396 and $1,309,897, respectively. CHANGES IN FINANCIAL CONDITION General: Total assets as of September 30, 1999 amounted to $99.7 million and were comprised primarily of $69.1 million of CMBS, $24.0 million of deposits with brokers as collateral for securities sold short and a mezzanine investment of $3.9 million. Total liabilities of the Company as of September 30, 1999 amounted to $57.7 million and were comprised primarily of repurchase agreements in the amount of $32.2 million and government securities sold short in the amount of $23.8 million. During the three months ended September 30, 1999, the Company sold five CMBS investments for $29.0 million and the commercial loan receivable for $11.8 million. There was a corresponding decrease in repurchase agreements of $26.7 million. Deposits with brokers as collateral for securities sold short decreased by $22.9 million, mirroring the decrease in government securities sold short. The Company decreased its short positions as a result of the sale of the related CMBS investments and commercial mortgage loan receivable. CAPITAL RESOURCES AND LIQUIDITY: Liquidity is a measurement of the Company's ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund investments, loan acquisition and lending activities and for other general business purposes. The Company's primary sources of funds for liquidity consist of repurchase agreements and maturities and principal payments on securities and loans, and proceeds from sales thereof. Market observations suggests that buyers of CMBS and sources of repurchase agreement financing may adopt a more conservative position in their business practices as Year 2000 approaches. This may affect the Company's ability to sell securities and/or obtain financing and also may affect the value of the Company's assets and the cost of its debt. If the company were unable to replace its short term financing, it may be forced to sell its assets in order to pay down its repurchase agreements at a time when the market for the sale of such assets is unfavorable. If this were to occur, the company could realize substantial losses. 13 The Company's operating activities generated cash flows of $18.9 million during the nine months ending September 30, 1999. This was due primarily to an excess of interest income on investments over financing costs of approximately $4.6 million and net proceeds from trading in commercial mortgage backed securities of $11.6 million. This compares with the Company's operating activities during the period from commencement of operations (June 2, 1998) to September 30, 1998 which used cash flows of $231.2 million. This was primarily due to investment in commercial mortgage backed securities of $222.6 million. The Company's investing activities generated cash flows totaling $12.0 million during the nine months ending September 30, 1999 primarily through the proceeds from the sale of the commercial mortgage loan receivable. This compares with cash flows used for investing activities of $16.8 million for the period from commencement of operations (June 2, 1998) to September 30, 1998. These funds were used to purchase the commercial mortgage loan receivable and investment in other assets. The Company's financing activities used $30.3 million during the nine months ending September 30, 1999 and consisted primarily of payments made on repurchase agreements of $26.7 million, purchases of treasury stock of $1.0 million and distributions to shareholders of $2.6 million. The Company's financing activities for the period from commencement of operations (June 2, 1998) to September 30, 1998 generated $248.5 million through proceeds from issuance of common stock of $94.6 million and proceeds from repurchase agreements of $159.9 million. The Manager is currently evaluating investment opportunities on behalf of the Company. In the event that the Manager identifies an investment opportunity consistent with the Company's investment objectives, the Company may seek sources of additional capital, including various third-party borrowings or the issuance of preferred equity. The Company may also elect to increase its borrowings under repurchase agreements or may elect to dispose of an existing asset. The Company, in order to avoid corporate income taxation of the earnings that it distributes, is required to distribute annually at least 95% if its taxable income to stockholders. It is possible that the Company may experience timing differences between the actual receipt of income and the inclusion of that income in the calculation of taxable income. In the event that the cash generated by the Company's investments is insufficient to fund the distributions to stockholders that are required to maintain the Company status as a REIT, the Company may access cash reserves or seek sources of additional capital in order to fund the distributions. Except as discussed herein, management is not aware of any other trends, events, commitments or uncertainties that may have a significant effect on liquidity. STOCKHOLDERS' EQUITY: Stockholders' equity as of September 30, 1999 was $42.0 million. In the nine months ending September 30, 1999, stockholders' equity increased by $2.1 million due to net income of $5.7 million, offset by a decrease of $1.0 million due to the repurchase of stock and a decrease of $2.6 million due to distributions of $0.20 per share to stockholders of record on September 30, 1999, June 30, 1999 and March 31, 1999. YEAR 2000 COMPLIANCE: Substantially all of the Company's computer systems are supplied by the Manager. In 1998, an affiliate of the Manager formed an internal team ("the team") of information technology professionals to identify the risks to the business operations of the Manager, and the Company, that may arise from the transition to the Year 2000 and beyond. The team also assumed responsibility for increasing awareness of the potential risks to the business operations through presentations to employees and management of the Manager. The team has also completed a written plan that identifies corrective steps to mitigate these risks. The Manager's plan for Year 2000 compliance covers mission-critical systems, physical facilities and communications systems. It also addresses external interfaces with third-party computer systems that communicate with the systems of the Manager. The Manager has allocated approximately $50,000 to cover expenses associated with the assessment of potential Year 2000 issues. The Company has not allocated any funds to cover Year 2000 compliance; however, the Company may bear a portion of the costs incurred by the Manager in this regard. Mission Critical Systems: 14 The Manager advised the Company that, as of September 30, 1999, the team had completed an inventory of all systems, and had identified all mission-critical systems that were not Year 2000 compliant. The team had also developed remediation and testing plans to address Year 2000 issues. As of September 30, 1999, the team had advised the Company that it had completed remediation and testing of substantially all internal mission-critical systems. Assessment of Year 2000 Readiness of Third Parties: On September 30, 1999, the Manager advised the Company that it had identified and had contact with all third parties upon which the Manager relies for mission-critical and non-mission-critical systems. All of the third parties contacted by the team had documented their plans for addressing Year 2000 issues and their progress in achieving Year 2000 compliance. Development of Contingency Plan: As of September 30, 1999, the team had advised the Company that it had created a written disaster recovery plan that addresses contingency plans for the Manager in the event of internal and external computer failures. Risks Associated with Achieving Year 2000 Compliance: Based upon the Manager's representations regarding the team's efforts and responses from third parties, the Company believes that the Manager is substantially Year 2000 compliant. There can be no assurance that the assessments or remediation measures made by the Manager or significant third parties with whom the Manager's systems interface have been or will be accurate. There is a risk that failure by the Manager or those significant third parties to achieve Year 2000 compliance will have an adverse effect on the business operations of the Company. FORWARD-LOOKING STATEMENTS: Certain statements contained herein are not, and certain statements contained in future filings by the Company with the SEC, in the Company's press releases or in the Company's other public or shareholder communications may not be, based on historical facts and are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements which are based on various assumptions (some of which are beyond the Company's control), may be identified by reference to a future period or periods, or by the use of forward-looking terminology, such as "may," "will," "believe," "expect," "anticipate," "continue," or similar terms or variations on those terms, or the negative of those terms. Actual results could differ materially from those set forth in forward-looking statements due to a variety of factors, including, but not limited to, those related to the economic environment, particularly in the market areas in which the Company operates, competitive products and pricing, fiscal and monetary policies of the U.S. Government, changes in prevailing interest rates, acquisitions and the integration of acquired businesses, credit risk management, asset/liability management, the financial and securities markets and the availability of and costs associated with sources of liquidity. The Company does not undertake, and specifically disclaims any obligation, to publicly release the result of any revisions, which may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the exposure to loss resulting from changes in interest rates, lending environments, changes in spreads on CMBS, real estate cash flows and values, foreign currency exchange rates, commodity prices and equity prices. The primary market risks to which the investments of the Company are exposed are lending environments, interest rate risk and CMBS spread risk, which are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond the control of the Company. Changes in the general level of interest rates can also affect the net interest income of the Company. The Company is further exposed to interest rate risk through its short term financing through repurchase agreements at rates that are based on 30-day LIBOR. The repurchase agreements into which the Company has entered are for 15 terms of less than, or equal to 30 days. Changes in interest rates may increase the Company's cost of financing its investments. Furthermore, if the company were unable to replace its short term financing, it may be forced to sell its assets in order to pay down its repurchase agreements at a time when the market for the sale of such assets is unfavorable. If this were to occur, the company could realize substantial losses. The investments of the Company are also exposed to spread risk. The price of a fixed income security is generally determined by adding an interest rate spread to a benchmark interest rate, such as the U.S. Treasury rate. As the spread on a security widens (or increases), the price (or value) of the security falls. As spreads on CMBS widen, the fair value of the Company's portfolio falls. Spread widening in the market for CMBS can occur as a result of market concerns over the stability of the commercial real estate market, excess supply of CMBS, or general credit or liquidity concerns in other markets. The Company enters into contracts to sell securities that it does not own at the time of the sale, at a specified price at a specified time (short sales). The Company utilizes these contracts as a means of mitigating ("hedging") the potential financial statement impact of changes in the fair value of its portfolio of CMBS due to changes in interest rates. As the value of the Company's CMBS declines (increases) with increases (decreases) in interest rates, the value of the contracts increases (decreases). There can be no guarantee, however, that the change in value of the contract will completely offset the change in value of the fixed-rate interest-earning asset. Risks in these contracts arise from the possible inability of counterparties to meet the terms of their contracts and from movements in securities values and interest rates. Furthermore, if the market value of the securities involved in the short sale increases, the Company may be required to meet a "margin call". PART II -- OTHER INFORMATION Item 1. Legal Proceedings At September 30, 1999 there were no legal proceedings to which the Company was a party or of which any of its property was subject. Item 2. Changes in Securities and Use of Proceeds Not applicable Item 3. Defaults Upon Senior Securities Not applicable Item 4. Submission of Matters to a Vote of Security Holders Not applicable Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 27.1 -- Financial Data Schedule (b) Reports on Form 8-K None 16 SIGNATURES Pursuant to the requirements 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. CLARION COMMERCIAL HOLDINGS, INC, Dated: November 12, 1999 By: /s/ Fredrick D. Arenstein ------------------------------------- Name: Fredrick D. Arenstein Title: Treasurer 17