UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2002
----------------------------------------
or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
------------------- -----------------------
Commission File Number: 001-31458
------------------------------------------------------
Newcastle Investment Corp.
- -------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Maryland 81-0559116
- -------------------------------------------- ------------------------------------
(State or other jurisdiction of incorporation (I.R.S. Employer Identification No.)
or organization)
1251 Avenue of the Americas, New York, NY 10020
- -------------------------------------------------------------------------------
(Address of principal executive offices) (Zip Code)
(212) 798-6100
- -------------------------------------------------------------------------------
(Registrant's telephone number, including area code)
- -------------------------------------------------------------------------------
(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
- ----- ----
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the last practicable date.
Common stock, $0.01 per value per share: 23,488,517 outstanding as of November
15, 2002.
NEWCASTLE INVESTMENT CORP.
FORM 10-Q
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2002 (unaudited)
and December 31, 2001 1
Consolidated Statements of Income (unaudited) for the three and nine
months ended September 30, 2002 and 2001 2
Consolidated Statements of Stockholders' Equity and Redeemable Preferred Stock
(unaudited) for the nine months ended September 30, 2002 and 2001 3
Consolidated Statements of Cash Flows (unaudited) for the nine months
ended September 30, 2002 and 2001 4
Notes to Consolidated Financial Statements (unaudited) 6
Item 2. Management's Discussion and Analysis of Pro Forma Financial
Condition and Results of Operations 19
Management's Discussion and Analysis of Historical Financial
Condition and Results of Operations 26
Item 3. Quantitative and Qualitative Disclosures About Market Risk 32
Item 4. Controls and Procedures 36
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 36
Item 2. Changes in Securities and Use of Proceeds 36
Item 3. Defaults upon Senior Securities 36
Item 4. Submission of Matters to a Vote of Security Holders 36
Item 5. Other Information 36
Item 6. Exhibits and Reports on Form 8-K 36
SIGNATURES 37
CERTIFICATIONS 38
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)
SEPTEMBER 30, 2002
(UNAUDITED) DECEMBER 31, 2001
------------------- -----------------
ASSETS
CBO collateral, net $ 1,088,742 $ 522,258
Operating real estate, net 111,387 524,834
Real estate held for sale 2,052 --
Marketable securities, available for sale 7,184 14,467
Loans and mortgage pools receivable, net -- 10,675
Investments in unconsolidated subsidiaries -- 73,208
Cash and cash equivalents 7,119 31,360
Restricted cash 13,198 34,508
Due from (to) affiliates (1,839) 11,334
Deferred costs, net 7,925 17,988
Receivables and other assets 15,248 21,487
----------- -----------
$ 1,251,016 $ 1,262,119
=========== ===========
LIABILITIES, MINORITY INTEREST , REDEEMABLE PREFERRED STOCK AND
STOCKHOLDERS' EQUITY
LIABILITIES
CBO bonds payable $ 867,770 $ 445,514
Other bonds payable 37,078 319,303
Notes payable 50,618 111,116
Repurchase agreements 1,457 1,457
Credit facility -- 20,000
Derivative liabilities 54,454 11,732
Dividends payable 6,595 8,882
Accrued expenses and other liabilities 7,137 10,633
----------- -----------
1,025,109 928,637
----------- -----------
MINORITY INTEREST -- 2,527
Redeemable preferred stock, $.01 par value, 100,000,000 shares authorized,
1,020,517 shares issued and outstanding at December 31, 2001 -- 20,410
STOCKHOLDERS' EQUITY
Common stock, $.01 par value, 500,000,000 shares authorized,
16,488,517 shares issued and outstanding at
September 30, 2002 and December 31, 2001 165 165
Additional paid-in capital 210,978 309,356
Dividends in excess of earnings (13,548) (7,767)
Accumulated other comprehensive income 28,312 8,791
----------- -----------
225,907 310,545
----------- -----------
$ 1,251,016 $ 1,262,119
=========== ===========
See notes to consolidated financial statements.
1
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (dollars in thousands, except
share data)
THREE MONTHS THREE MONTHS NINE MONTHS NINE MONTHS
ENDED 9/30/02 ENDED 9/30/01 ENDED 9/30/02 ENDED 9/30/01
------------- ------------- ------------- -------------
REVENUES:
Interest and dividend income $ 20,197 $ 11,740 $ 51,253 $ 36,848
Rental and escalation income 5,178 4,880 15,196 15,503
Gain on settlement of investments 2,604 30 7,605 7,451
Management fee from affiliate -- 2,235 4,470 6,705
Incentive income from affiliate -- 28,846 (1,218) 28,846
Other income 5 23 17 42
---------- ---------- ---------- ----------
27,984 47,754 77,323 95,395
---------- ---------- ---------- ----------
EXPENSES:
Interest expense 13,483 8,546 34,992 27,060
Property operating expense 2,190 1,922 6,554 6,670
Loan servicing expense 126 65 327 181
General and administrative expense 670 467 2,248 1,080
Management fees to affiliate 917 3,775 8,085 10,996
Preferred incentive return to affiliate 614 16,075 1,441 16,075
Depreciation and amortization 705 919 2,520 2,655
---------- ---------- ---------- ----------
18,705 31,769 56,167 64,717
---------- ---------- ---------- ----------
Income before equity in earnings of
unconsolidated subsidiaries 9,279 15,985 21,156 30,678
Equity in earnings of unconsolidated
subsidiaries -- 760 362 1,885
---------- ---------- ---------- ----------
Income from continuing operations 9,279 16,745 21,518 32,563
Income (loss) from discontinued operations (1,775) 1,451 245 5,870
---------- ---------- ---------- ----------
NET INCOME 7,504 18,196 21,763 38,433
Preferred dividends and related accretion -- (638) (1,162) (1,902)
---------- ---------- ---------- ----------
INCOME AVAILABLE FOR COMMON STOCKHOLDERS $ 7,504 $ 17,558 $ 20,601 $ 36,531
========== ========== ========== ==========
NET INCOME PER COMMON SHARE, BASIC AND DILUTED $ 0.46 $ 1.06 $ 1.25 $ 2.21
========== ========== ========== ==========
Income from continuing operations per common
share, after preferred dividends and related
accretion, basic and diluted $ 0.56 $ 0.98 $ 1.23 $ 1.86
========== ========== ========== ==========
Income (loss) from discontinued operations per
common share, basic and diluted $ (0.10) $ 0.08 $ 0.02 $ 0.35
========== ========== ========== ==========
WEIGHTED AVERAGE NUMBER OF COMMON SHARES
OUTSTANDING, BASIC AND DILUTED 16,488,517 16,494,203 16,488,517 16,494,120
========== ========== ========== ==========
DIVIDENDS DECLARED PER COMMON SHARE $ 0.40 $ 0.50 $ 1.60 $ 1.50
========== ========== ========== ==========
See notes to consolidated financial statements.
2
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND REDEEMABLE PREFERRED STOCK
(Unaudited) FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2002
(dollars in thousands)
REDEEMABLE PREFERRED
STOCK COMMON STOCK
---------------------------------------------
SHARES AMOUNT SHARES AMOUNT
--------- -------- ----------- --------
STOCKHOLDERS' EQUITY - DECEMBER 31, 2001 1,020,517 $ 20,410 16,488,517 $165
Dividends declared by predecessor prior to commencement
of our operations -- -- -- --
Distribution to predecessor upon commencement of our operations -- -- -- --
Dividends declared to predecessor after commencement of our
operations, but prior to our initial public offering -- -- -- --
Redemption of redeemable preferred stock (1,020,517) (20,410) -- --
Comprehensive income:
Net income -- -- -- --
Unrealized gain on securities -- -- -- --
Realized (gain) on securities: reclassification adjustment -- -- -- --
Foreign currency translation -- -- -- --
Foreign currency translation: reclassification adjustment -- -- -- --
Unrealized (loss) on derivatives designated as cash flow hedges -- -- -- --
Realized (gain) on derivatives designated as cash flow
hedges: reclassification adjustment -- -- -- --
Total comprehensive income
--------- -------- ---------- ----
Stockholders' equity - September 30, 2002 -- $ -- 16,488,517 $165
========= ======== ========== ====
STOCKHOLDERS' EQUITY - DECEMBER 31, 2000 1,020,517 $ 20,167 16,499,765 $165
Dividends declared -- -- -- --
Redemption of common stock -- -- (11,248) --
Accretion of redeemable preferred stock -- 243 -- --
Transition adjustment - deferred hedge gains and losses -- -- -- --
Comprehensive income:
Net income -- -- -- --
Unrealized gain on securities -- -- -- --
Unrealized loss on securities: reclassification adjustment -- -- -- --
Foreign currency translation -- -- -- --
Unrealized (loss) on derivatives designated as cash flow hedges -- -- -- --
Total comprehensive income
--------- -------- ---------- ----
Stockholders' equity - September 30, 2001 1,020,517 $ 20,410 16,488,517 $165
========= ======== ========== ====
ACCUM.
ADDITIONAL DIVIDENDS OTHER TOTAL STOCK-
PD. IN IN EXCESS OF COMP. HOLDERS'
CAPITAL EARNINGS INCOME EQUITY
--------- -------- -------- ----------
STOCKHOLDERS' EQUITY - DECEMBER 31, 2001 $ 309,356 $ (7,767) $ 8,791 $ 310,545
Dividends declared by predecessor prior to commencement
of our operations -- (20,949) -- (20,949)
Distribution to predecessor upon commencement of our operations (98,378) -- (11,075) (109,453)
Dividends declared to predecessor after commencement of our
operations, but prior to our initial public offering -- (6,595) -- (6,595)
Redemption of redeemable preferred stock -- -- -- --
Comprehensive income:
Net income -- 21,763 -- 21,763
Unrealized gain on securities -- -- 80,799 80,799
Realized (gain) on securities: reclassification adjustment -- -- (2,550) (2,550)
Foreign currency translation -- -- 3,364 3,364
Foreign currency translation: reclassification adjustment -- -- (258) (258)
Unrealized (loss) on derivatives designated as cash flow hedges -- -- (50,629) (50,629)
Realized (gain) on derivatives designated as cash flow
hedges: reclassification adjustment -- -- (130) (130)
----------
Total comprehensive income 52,359
--------- -------- -------- ----------
Stockholders' equity - September 30, 2002 $ 210,978 $(13,548) $ 28,312 $ 225,907
========= ======== ======== ==========
STOCKHOLDERS' EQUITY - DECEMBER 31, 2000 $ 309,551 $ (7,666) $ (1,395) $ 300,655
Dividends declared -- (26,403) -- (26,403)
Redemption of common stock (195) -- -- (195)
Accretion of redeemable preferred stock -- (243) -- (243)
Transition adjustment - deferred hedge gains and losses -- -- 4,064 4,064
Comprehensive income:
Net income -- 38,433 -- 38,433
Unrealized gain on securities -- -- 36,492 36,492
Unrealized loss on securities: reclassification adjustment -- -- 954 954
Foreign currency translation -- -- (2,516) (2,516)
Unrealized (loss) on derivatives designated as cash flow hedges -- -- (15,578) (15,578)
Total comprehensive income ----------
57,785
--------- -------- -------- ----------
Stockholders' equity - September 30, 2001 $ 309,356 $ 4,121 $ 22,021 $ 335,663
========= ======== ======== ==========
See notes to consolidated financial statements.
3
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(dollars in thousands)
NINE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2002 SEPTEMBER 30, 2001
------------------ ------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 21,763 $ 38,433
Adjustments to reconcile net income to net cash provided by operating
activities
(inclusive of amounts related to discontinued operations):
Depreciation and amortization 7,882 10,383
Accretion of discount and other amortization (3,135) (2,515)
Equity in earnings of unconsolidated subsidiaries (362) (1,885)
Accrued incentive income from affiliate 1,218 (14,423)
Minority interest 14 (89)
Deferred rent (1,149) (1,523)
Gain on settlement of investments (5,935) (9,388)
Change in:
Restricted cash (5,880) (956)
Receivables and other assets (3,956) 1,571
Accrued expenses and other liabilities 5,876 2,452
Due from affiliates (1,002) (1,205)
-------- ------
Net cash provided by operating activities: 15,334 20,855
-------- ------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase and improvement of operating real estate (2,254) (3,826)
Proceeds from sale of operating real estate 42,826 --
Repayments of loan principal 12,055 29,730
Proceeds from settlement of loans and foreclosed real estate 364 28,652
Contributions to unconsolidated subsidiaries (19,991) (22,588)
Distributions from unconsolidated subsidiaries 8,265 19,787
Purchase of CBO collateral (646,420) (47,509)
Proceeds from sale of CBO collateral 225,923 67,531
Payment of deferred transaction costs (1,432) (4,174)
Purchase of marketable securities (6,941) --
Proceeds from sale of marketable securities -- 10,052
-------- ------
Net cash provided by (used in) investing activities: (387,605) 77,655
-------- ------
See notes to consolidated financial statements. Continuing on Page 5
4
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(dollars in thousands)
NINE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2002 SEPTEMBER 30, 2001
------------------ ------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings under repurchase agreements -- 10,000
Repayments of repurchase agreements -- (15,840)
Repayments of notes payable (65,840) (771)
Issuance of CBO bonds payable 438,787 --
Repayments of CBO bonds payable (17,742) --
Issuance of other bonds payable 37,169 --
Repayments of other bonds payable (8,151) (35,156)
Draws under credit facility 20,000 11,000
Repayments of credit facility (1,750) (34,000)
Minority interest distributions -- (5,078)
Redemption of common stock -- (195)
Redemption of redeemable preferred stock (20,410) --
Dividends paid (19,938) (26,552)
Distribution of cash to predecessor (12,423) --
Payment of deferred financing costs (1,672) (366)
------- -------
Net cash provided by (used in) financing activities 348,030 (96,958)
------- -------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (24,241) 1,552
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 31,360 10,575
------- -------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 7,119 $ 12,127
========= ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the period for interest expense $ 42,608 $ 44,138
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
Common stock dividends declared but not paid $ 6,595 $ --
Contribution of assets to unconsolidated subsidiary $ (1,454) $ --
Deposit used in acquisition of CBO collateral $ 23,631 $ --
Distribution of non-cash assets and liabilities to predecessor $(109,453) $ --
See notes to consolidated financial statements.
5
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) SEPTEMBER 30, 2002
(tables in thousands, except per share data)
1. GENERAL
Newcastle Investment Corp. and subsidiaries ("Newcastle") was formed in
June 2002 as a wholly owned subsidiary of Newcastle Investment Holdings
Corp. ("Newcastle Holdings") for the purpose of separating the real
estate securities and credit leased real estate businesses from
Newcastle Holdings' other investments. In July 2002, Newcastle Holdings
contributed to Newcastle certain assets and liabilities in exchange for
16,488,517 shares of Newcastle's common stock. However, for accounting
purposes this transaction is presented as a reverse spin-off. Under a
reverse spin-off, Newcastle is treated as the continuing entity and the
assets that were retained by Newcastle Holdings and not contributed to
Newcastle are accounted for as if they were distributed at their
historical book basis through a spin-off to Newcastle Holdings.
Newcastle's operations commenced on July 12, 2002.
Newcastle is a Maryland corporation that invests in real estate
securities and other real estate-related assets. Newcastle conducts its
business through two primary segments: (i) real estate securities and
(ii) revenue producing real estate, primarily credit leased real
estate.
Newcastle is organized and conducts its operations to qualify as a REIT
for federal income tax purposes. As such, Newcastle will generally not
be subject to federal income tax on that portion of its income that is
distributed to shareholders if it distributes at least 90% of its REIT
taxable income to its shareholders by the due date of its federal
income tax return and complies with various other requirements.
In October 2002, Newcastle sold 7 million shares of its common stock in
a public offering at a price to the public of $13.00 per share, for net
proceeds of approximately $80 million after deducting the underwriters'
discount and other offering expenses. A portion of the proceeds of this
offering were used to purchase a portfolio of mortgage loans and to
make additional investments. Subsequent to this offering, Newcastle has
23,488,517 common shares outstanding.
Newcastle Holdings is a Maryland corporation that invests in real
estate-related assets on a global basis. Its primary businesses are (1)
investing in marketable real estate-related securities, (2) investing
in commercial properties leased to third parties, (3) investing in
Fortress Investment Fund LLC ("Fund I") and (4) investing in
distressed, sub-performing and performing residential and commercial
mortgage loans, or portfolios thereof, and related properties acquired
in foreclosure or by deed-in-lieu of foreclosure. At the date of the
commencement of Newcastle's operations, Newcastle Holdings had
16,488,517 common shares and no preferred shares issued and
outstanding.
Newcastle has entered into a management agreement (the "Management
Agreement") with Fortress Investment Group LLC (the "Manager"), an
affiliate, under which the Manager advises Newcastle on various aspects
of its business and manages its day-to-day operations, subject to the
supervision of Newcastle's board of directors. For its services, the
Manager receives an annual management fee and a preferred incentive
return, both as defined in the Management Agreement. The Manager also
manages Newcastle Holdings and Fund I.
The consolidated financial statements include the accounts of Newcastle
and its controlled subsidiaries, subsequent to the date of commencement
of its operations, and also include the accounts of its predecessor,
Newcastle Holdings, prior to such date.
Newcastle Holdings' investments in real estate securities and a portion
of its investments in revenue-producing real estate were transferred to
Newcastle. The real estate (GSA portfolio) and real estate loans
operations treated as being distributed to Newcastle Holdings have been
accounted for as discontinued operations, because they constituted a
component of an entity, while the other operations treated as being
distributed to Newcastle Holdings, including the investment in Fund I,
have not been accounted for as such, because they did not constitute a
component of an entity as defined in SFAS No. 144 "Accounting for the
Impairment or Disposal of Long-Lived Assets."
6
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2002
The accompanying consolidated financial statements and related notes of
Newcastle have been prepared in accordance with accounting principals
generally accepted in the United States for interim financial reporting
and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.
Accordingly, certain information and footnote disclosures normally
included in financial statements prepared under accounting principals
generally accepted in the United States have been condensed or omitted.
In the opinion of management, all adjustments considered necessary for
a fair presentation of Newcastle's financial position, results of
operations and cash flows have been included and are of a normal and
recurring nature. The operating results presented for interim periods
are not necessarily indicative of the results that may be expected for
any other interim period or for the entire year. These financial
statements should be read in conjunction with Newcastle's registration
statement on Form S-11 (File No. 333-90578), which was declared
effective by the Securities and Exchange Commission on October 9, 2002.
2. INFORMATION REGARDING BUSINESS SEGMENTS
Newcastle conducts its business through two primary segments: real
estate securities and revenue-producing real estate.
Newcastle Holdings conducted its business in four primary segments:
real estate securities, revenue-producing real estate, real estate
loans, and its investment in Fund I.
The real estate securities segment was retained by Newcastle. The
revenue-producing real estate segment, which comprised three portfolios
of properties, was split as follows: the Bell (Canadian) and LIV
(Belgian) properties were retained by Newcastle while the GSA (U.S.)
properties were distributed to Newcastle Holdings. The real estate
loans and Fund I segments were distributed to Newcastle Holdings.
Certain amounts have been reclassified from the Unallocated segment to
the Fund I segment; such amounts did not effect net income or total
assets in either segment.
7
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2002
Summary financial data on Newcastle's segments is given below, together
with a reconciliation to the same data for Newcastle as a whole
(including its predecessor, as applicable, as described in Note 1) (in
thousands):
Real Estate
Debt Real Estate
Securities Real Estate Loans Fund I Unallocated Total
---------- ----------- --------- -------- ----------- -----------
September 30, 2002 and the Nine Months then Ended
Gross revenues $ 58,728 $ 15,138 $ -- $ 3,287 $ 170 $ 77,323
Operating expenses (370) (7,133) -- (3,861) (7,291) (18,655)
----------- --------- -------- -------- -------- -----------
Operating income (loss) 58,358 8,005 -- (574) (7,121) 58,668
Interest expense (28,864) (3,792) -- -- (2,336) (34,992)
Depreciation and amortization -- (2,090) -- (329) (101) (2,520)
Equity in earnings of unconsolidated subsidiaries -- -- -- 303 59 362
----------- --------- -------- -------- -------- -----------
Income (loss) from continuing operations 29,494 2,123 -- (600) (9,499) 21,518
Income (loss) from discontinued operations -- 744 (499) -- -- 245
----------- --------- -------- -------- -------- -----------
Net Income (Loss) $ 29,494 $ 2,867 $ (499) $ (600) $ (9,499) $ 21,763
=========== ========= ======== ======== ======== ===========
Revenue derived from non-US sources:
Canada $ -- $ 10,198 $ -- $ -- $ -- $ 10,198
=========== ========= ======== ======== ======== ===========
Belgium $ -- $ 3,736 $ -- $ -- $ -- $ 3,736
=========== ========= ======== ======== ======== ===========
Italy $ -- $ -- $ 180 $ -- $ -- $ 180
=========== ========= ======== ======== ======== ===========
Total assets $ 1,117,126 $ 128,201 $ -- $ -- $ 5,689 $ 1,251,016
=========== ========= ======== ======== ======== ===========
Long-lived assets outside the US:
Canada $ -- $ 57,220 $ -- $ -- $ -- $ 57,220
=========== ========= ======== ======== ======== ===========
Belgium $ -- $ 70,981 $ -- $ -- $ -- $ 70,981
=========== ========= ======== ======== ======== ===========
December 31, 2001
Total assets $ 560,155 $ 565,481 $ 12,920 $ 97,562 $ 26,001 $ 1,262,119
=========== ========= ======== ======== ======== ===========
Long-lived assets outside the US:
Canada $ -- $ 51,060 $ -- $ -- $ -- $ 51,060
=========== ========= ======== ======== ======== ===========
Belgium $ -- $ 68,399 $ -- $ -- $ -- $ 68,399
=========== ========= ======== ======== ======== ===========
8
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2002
Real Estate
Debt Real Estate
Securities Real Estate Loans Fund I Unallocated Total
---------- ----------- ----- ------ ----------- -----
Three Months Ended September 30, 2002
Gross revenues $ 22,870 $ 5,109 $ -- $ -- $ 5 $ 27,984
Operating expenses (137) (2,287) -- -- (2,093) (4,517)
-------- -------- ------- -------- ------- --------
Operating income (loss) 22,733 2,822 -- -- (2,088) 23,467
Interest expense (12,197) (1,286) -- -- -- (13,483)
Depreciation and amortization -- (705) -- -- -- (705)
-------- -------- ------- -------- ------- --------
Income (loss) from continuing operations 10,536 831 -- -- (2,088) 9,279
Income (loss) from discontinued operations -- (1,775) -- -- -- (1,775)
-------- -------- ------- -------- ------- --------
Net Income (Loss) $ 10,536 $ (944) $ -- $ -- $(2,088) $ 7,504
======== ======== ======= ======== ======= ========
Revenue derived from non-US sources:
Canada $ -- $ 2,446 $ -- $ -- $ -- $ 2,446
======== ======== ======= ======== ======= ========
Belgium $ -- $ 1,101 $ -- $ -- $ -- $ 1,101
======== ======== ======= ======== ======= ========
Nine Months Ended September 30, 2001
Gross revenues $ 42,081 $ 15,661 $ -- $ 36,068 $ 1,585 $ 95,395
Operating expenses (181) (7,152) -- (21,128) (6,541) (35,002)
-------- -------- ------- -------- ------- --------
Operating income (loss) 41,900 8,509 -- 14,940 (4,956) 60,393
Interest expense (20,519) (4,234) -- -- (2,307) (27,060)
Depreciation and amortization -- (1,918) -- (395) (342) (2,655)
Equity in earnings of unconsolidated
subsidiaries -- -- -- 3,540 (1,655) 1,885
-------- -------- ------- -------- ------- --------
Income (loss) from continuing operations 21,381 2,357 -- 18,085 (9,260) 32,563
Income from discontinued operations -- 3,913 1,957 -- -- 5,870
-------- -------- ------- -------- ------- --------
Net Income (Loss) $ 21,381 $ 6,270 $ 1,957 $ 18,085 $(9,260) $ 38,433
======== ======== ======= ======== ======= ========
Revenue derived from non-US sources:
Canada $ -- $ 12,034 $ 124 $ -- $ -- $ 12,158
======== ======== ======= ======== ======= ========
Belgium $ -- $ 5,448 $ -- $ -- $ -- $ 5,448
======== ======== ======= ======== ======= ========
Italy $ -- $ -- $ 653 $ -- $ -- $ 653
======== ======== ======= ======== ======= ========
Three Months Ended September 30, 2001
Gross revenues $ 11,577 $ 4,918 $ -- $ 31,164 $ 95 $ 47,754
Operating expenses (65) (2,033) -- (16,658) (3,548) (22,304)
-------- -------- ------- -------- ------- --------
Operating income (loss) 11,512 2,885 -- 14,506 (3,453) 25,450
Interest expense (6,571) (1,394) -- -- (581) (8,546)
Depreciation and amortization -- (640) -- (164) (115) (919)
Equity in earnings of unconsolidated
subsidiaries -- -- -- 630 130 760
-------- -------- ------- -------- ------- --------
Income (loss) from continuing operations 4,941 851 -- 14,972 (4,019) 16,745
Income from discontinued operations -- 1,423 28 -- -- 1,451
-------- -------- ------- -------- ------- --------
Net Income (Loss) $ 4,941 $ 2,274 $ 28 $ 14,972 $(4,019) $ 18,196
Revenue derived from non-US sources:
======== ======== ======= ======== ======= ========
Canada $ -- $ 3,660 $ 45 $ -- $ -- $ 3,705
======== ======== ======= ======== ======= ========
Belgium $ -- $ 1,812 $ -- $ -- $ -- $ 1,812
======== ======== ======= ======== ======= ========
Italy $ -- $ -- $ (64) $ -- $ -- $ (64)
======== ======== ======= ======== ======= ========
9
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2002
The following table summarizes the activity affecting the equity held by
Newcastle in unconsolidated subsidiaries.
Fortress Investment
Austin Holdings Fund LLC Total
--------------- -------- --------
Balance 12/31/01 $ 4,977 $ 68,231 $ 73,208
Contributions to unconsolidated subsidiaries 3,237 16,754 19,991
Contribution of assets to unconsolidated
subsidiaries 1,454 -- 1,454
Distributions from unconsolidated
subsidiaries (522) (7,743) (8,265)
Equity in earnings of unconsolidated
subsidiaries 59 303 362
Equity in OCI of unconsolidated subsidiaries -- (15) (15)
Other -- (329) (329)
Distribution to Newcastle Holdings (9,205) (77,201) (86,406)
------ ------- -------
Balance 9/30/02 $ -- $ -- $ --
======= ======= ========
Summarized financial information related to Newcastle's unconsolidated
subsidiaries was as follows (in thousands).
Austin Holdings Fortress Investment Fund LLC (A)
--------------------------------------------------------
12/31/2001 12/31/2001
---------- ----------
Assets $ 7,947 $612,083
Liabilities (2,353) --
Minority interest (352) --
---------- ----------
Equity $ 5,242 $612,083
========== ==========
Equity held by Newcastle (B) $ 4,977 $ 68,231
========== ==========
Period from Period from
January 1, 2002 January 1, 2002
through Nine months ended through Nine months ended
July 12, 2002 9/30/01 July 12, 2002 9/30/01
------------- ------------------ --------------- -----------------
Revenues $ 585 $ (506) $ 9,740 $ 139,927
Expenses (477) (1,234) (4,470) (7,705)
Minority interest (45) (3) -- --
------- --------- --------- -----------
Net income (loss) $ 63 $(1,743) $ 5,270 $ 132,222
======= ========= ========= ===========
Newcastle's equity in net income (loss) $ 59 $(1,655) $ 303 $ 3,540
======= ========= ========= ===========
(A) Fortress Investment Fund LLC's summary financial information is presented on
a fair value basis, consistent with its internal basis of accounting, while
Newcastle's equity is presented on a GAAP basis. Newcastle's equity in net
income excludes its incentive income.
(B) Newcastle also had a $3.2 million receivable from Austin at December 31,
2001.
10
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2002
3. 2002 ACTIVITIES PRIOR TO COMMENCEMENT OF OUR OPERATIONS
Consistent with the treatment of Newcastle's formation as a reverse
spin-off (Note 1), the transactions described below were completed by
Newcastle's predecessor, Newcastle Holdings, but are described as being
completed by Newcastle.
In June 2002, Newcastle declared a common dividend of $0.60 per common
share which was paid in July 2002. In March 2002, Newcastle declared a
common dividend of $0.60 per common share which was paid in April 2002.
In April 2002, Newcastle completed the CBO II Transaction whereby a
consolidated subsidiary issued $444.0 million of investment grade
senior securities and $56.0 million of non-investment grade
subordinated securities (the "CBO II Securities") in a private
placement. The senior securities were issued for net proceeds of $438.8
million after issue costs. The subordinated securities have been
retained by Newcastle. The CBO II Securities are primarily
collateralized by a portfolio of CMBS, unsecured REIT debt,
asset-backed securities, and a limited amount of other securities,
which was acquired with the proceeds from the CBO II Securities and
with the deposit Newcastle had made on such securities. At September
30, 2002, the $439.0 million carrying amount of senior securities,
which bore interest at a weighted average effective rate, including
discount and cost amortization, of approximately 3.48%, had an expected
weighted average life of approximately 7.61 years. One class of the
senior securities bears a floating interest rate. Newcastle obtained an
interest rate swap and cap in order to hedge its exposure to the
changes in market interest rates with respect to this security, at an
initial cost of $1.2 million.
In April 2002, Newcastle repurchased the $17.5 million Class E Note
(the "Class E Note") which was issued from its CBO I securitization.
The repurchase of the Class E Note represents a repayment of debt and
was recorded as a reduction of CBO Bonds Payable. The Class E Note is
included in the CBO II Collateral which was purchased in connection
with the CBO II Transaction. The Class E Note is eliminated in
consolidation. In April 2002, Newcastle refinanced the Bell Canada
Properties through a securitization transaction. The issued securities
are secured by the Bell Canada Properties and lease payments
thereunder. At September 30, 2002, the $37.1 million carrying amount of
outstanding securities, which bore interest at a weighted average
effective rate, including cost amortization, of approximately 6.72%,
had an expected weighted average life of approximately 2.7 years.
Newcastle has retained one class of the issued securities. The proceeds
from the issued securities were used, in part, to repay the Bell Canada
Mortgage.
In May 2002, Newcastle sold one of its GSA Properties with a net basis
of $33.0 million for a net purchase price of approximately $34.1
million, at a gain of $1.1 million.
In May 2002, it sold a commercial property located in Brussels, Belgium
for gross proceeds of approximately $8.9 million, at a loss of
approximately $1.1 million. Pursuant to Statement of Financial
Accounting Standards ("SFAS") No. 144 "Accounting for the Impairment or
Disposal of Long-Lived Assets," Newcastle has retroactively recorded
the operations of such properties in Income from Discontinued
Operations for all periods presented.
In June 2002, Newcastle redeemed the remaining $20.4 million of its
outstanding redeemable preferred stock.
Newcastle Holdings created $62.3 million face of mezzanine bonds issued
by its subsidiaries which indirectly own the GSA Properties. The bonds
are not entitled to any scheduled interest or amortization prior to
their maturity date in May 2011. None of the bonds are secured by
mortgages on the GSA Properties; the bonds are secured by equity
interests in the direct or indirect owners of the GSA Properties. These
bonds, which were included in the CBO Collateral and CBO II Collateral,
were retained by Newcastle. These bonds were sold by Newcastle at a
loss of $0.3 million in September 2002.
11
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2002
4. RECENT ACTIVITIES
The following is a summary of Newcastle's real estate securities at
September 30, 2002, all of which are classified as available for sale
and are therefore marked to market through other comprehensive income
pursuant to SFAS No. 115 "Accounting for Certain Investments in Debt
and Equity Securities." Unrealized losses that are considered other
than temporary are recognized currently in income. There were no such
losses incurred during the nine months ended September 30, 2002.
Gross Unrealized
----------------
Principal Amortized
CBO I Balance Cost Basis Gains Losses
- ----- ------- ---------- ----- ------
CMBS $ 311,367 $268,799 $34,513 $(1,720)
Unsecured REIT debt 231,615 229,906 24,302 --
------- ------- ------ ------
Subtotal - CBO I 542,982 498,705 58,815 (1,720)
------- ------- ------ ------
CBO II
CMBS 268,943 255,601 21,123 (245)
Unsecured REIT debt 93,710 93,907 9,226 --
Other 78,030 74,772 3,253 (133)
------- ------- ------ ------
Subtotal - CBO II 440,683 424,280 33,602 (378)
------- ------- ------ ----
Non-CBO securities 19,326 7,184 -- --
------- ------- ------ ------
Total/Average* $1,002,991 $930,169 $92,417 $(2,098)
========== ======== ======= =======
Weighted Average
------------------------------------------
Term to
Moody's Maturity
Carrying Value Rating Coupon Yield (Years)
-------------- ------ ------ ----- -------
CBO I
CMBS $ 301,592 Ba1 6.64% 9.67% 7.06
Unsecured REIT debt 254,208 Baa2 7.26% 7.64% 5.61
------- ---- ----- ----- ----
Subtotal - CBO I 555,800 Ba1 6.90% 8.89% 6.44
------- ---- ----- ----- ----
CBO II
CMBS 276,479 Baa3 6.29% 6.92% 7.14
Unsecured REIT debt 103,133 Baa3 7.64% 7.54% 6.50
Other 77,892 A3 7.60% 8.35% 10.11
------- ---- ----- ----- ----
Subtotal - CBO II 457,504 Baa3 6.81% 7.31% 7.53
------- ---- ----- ----- ----
Non-CBO securities 7,184 N/A 7.40% 18.94% 7.60
------- ---- ----- ----- ----
Total/Average* $1,020,488 Baa3 6.87% 8.25% 6.94
========== ==== ==== ==== ====
*Carrying value excludes restricted cash of $75.4 million included in
CBO Collateral pending its reinvestment in securities. Average rating
excludes non-CBO securities. The total carrying value of fixed rate
securities is $941.1 million, and of variable rate securities is $79.4
million, at September 30, 2002.
In July 2002, Newcastle entered into an agreement with a major
investment bank whereby such bank will purchase up to $450 million of
commercial mortgage backed securities, unsecured REIT debt, real estate
loans and asset backed securities (the "CBO III Collateral"), subject
to Newcastle's right to purchase such securities from them. This
agreement is treated as a non-hedge derivative for accounting purposes
and is therefore marked-to-market through current income; no material
mark has been booked through September 30, 2002. The CBO III Collateral
is expected to be included in a securitization transaction in which
Newcastle would acquire the equity interest (the "CBO III
Transaction"). As of September 30, 2002, $123.7 million of the $450
million had been accumulated. If the CBO III Transaction is not
consummated as a result of Newcastle's failure to acquire the equity
interest or otherwise as a result of Newcastle's gross negligence or
willful misconduct, Newcastle would be required to either purchase the
CBO III Collateral or pay the difference between the original purchase
price of the CBO III Collateral and the price at which the CBO III
Collateral is sold to a third-party (a "Collateral Loss"). If the CBO
III Transaction fails to close for any other reason, Newcastle would be
required to either purchase the CBO III Collateral or pay the lesser of
$15 million and the Collateral Loss or, if Newcastle had paid a deposit
on the CBO III Collateral in exchange for a portion of the interest
12
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2002
payments on such securities, the lesser of the Collateral Loss and any
such deposit. Although Newcastle currently anticipates completing the
CBO III Transaction during the first quarter of 2003, there is no
assurance that the CBO III Transaction will be consummated. As of
September 30, 2002, Newcastle estimates that the fair value of the
securities purchased by such bank is in excess of the purchase price
paid by such bank. In November 2002, Newcastle made deposits
aggregating $24.9 million under such agreement (the "CBO III Deposit").
In August 2002, Newcastle entered into a contract to sell a commercial
property located in Canada for gross proceeds of approximately $1.4
million, at a loss of approximately $1.5 million including the write
off of accumulated other comprehensive income related to foreign
currency translation. The sale is contracted to occur in April 2003.
Pursuant to SFAS No. 144, Newcastle has reclassified the net carrying
value of this property to Real Estate Held for Sale and has
retroactively recorded the operations of such property in Income from
Discontinued Operations for all periods presented.
In September 2002, Newcastle declared a common dividend of $0.40 per
common share, for the third quarter of 2002, which was paid to
Newcastle Holdings in October 2002. In October 2002, Newcastle declared
a common dividend of $0.06 per common share, for the period from
October 1 to October 15, 2002, which was paid to Newcastle Holdings in
October 2002.
In October 2002, Newcastle sold 7 million shares of its common stock in
a public offering at a price to the public of $13.00 per share, for net
proceeds of approximately $80 million after deducting the underwriters'
discount and other offering expenses. A portion of the proceeds of this
offering were used to purchase a portfolio of mortgage loans, as
described below, and to make additional investments, including the CBO
III Deposit. Subsequent to this offering, Newcastle has 23,488,517
common shares outstanding.
In November 2002, Newcastle utilized $13.5 million of its offering
proceeds to purchase a $260.2 million portfolio of mortgage loans
subject to $246.7 million of financing. The mortgage loans bore
interest at a net weighted average rate of approximately 3.44% on the
date of purchase, and the financing bore interest at a weighted average
rate of approximately LIBOR + 0.37% on such date.
In November 2002, Newcastle refinanced its Belgian portfolio for
proceeds of EUR 60 million or approximately $60.6 million. The
refinancing bears interest at a rate of Euribor + 1.45% and matures in
November 2006. The proceeds of the refinancing were primarily used to
repay the existing financing on such portfolio. Newcastle has hedged
its exposure to the risk of changes in market interest rates with
respect to this refinancing by obtaining an interest rate swap.
At September 30, 2002 Due From (To) Affiliates is comprised of $1.8
million due to Newcastle Holdings representing Newcastle's pro rata
share of certain general and administrative expenses, management fees
and incentive return.
13
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2002
5. DERIVATIVE INSTRUMENTS
The following table summarizes the notional amounts and fair (carrying)
values of Newcastle's derivative financial instruments as of September 30,
2002 (amounts in thousands).
Longest
Notional Amount Fair Value Maturity
--------------- ---------- -------
Interest rate caps treated as hedges, net (A) $198,764 $5,720 October 2015
Interest rate swaps, treated as hedges, net (B) $451,736 ($51,685) April 2011
Non-hedge derivative obligations (B) (C) ($511) July 2038
(A) Included in Deferred Costs, Net.
(B) Included in Derivative Liabilities.
(C) Represents two essentially offsetting interest rate caps and two
essentially offsetting interest rate swaps, each with notional amounts of
$32.5 million, an interest rate cap with a notional amount of $17.5
million, and an interest rate cap with a notional amount of approximately
$58.7 million. Also includes the CBO III agreement which has a notional
amount of $123.7 million at September 30, 2002.
6. SUMMARY PRO FORMA CONSOLIDATED STATEMENTS OF INCOME
The unaudited pro forma consolidated statements of income are presented as if
the distribution to Newcastle Holdings and the commencement of Newcastle's
operations had been consummated on January 1, 2002 and 2001, respectively.
The historical results of operations of the assets and liabilities treated as
being distributed to Newcastle Holdings for the period prior to the
commencement of Newcastle's operations have been presented as discontinued
operations for those operations that constitute a component of an entity. Of
the assets treated as being distributed to Newcastle Holdings, the GSA
portfolio and the mortgage loans qualify as a component of an entity. The
remaining operations (the "Eliminated Operations") related to the other
assets and the liabilities treated as being distributed to Newcastle Holdings
which are not a component of an entity have been eliminated.
The unaudited pro forma consolidated statements of income are presented for
comparative purposes only, and are not necessarily indicative of what
Newcastle's actual consolidated results of operations would have been for the
periods presented, nor do they purport to represent the results of any future
periods. In the opinion of management, all adjustments necessary to present
fairly the unaudited pro forma financial information have been made.
14
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2002
CONSOLIDATED PRO FORMA STATEMENT OF INCOME
For the Nine Months Ended September 30, 2002
Distributed to
Newcastle
Holdings
----------
Eliminated
Historical (A) Operations Pro Forma
-------------- ---------- ---------
REVENUES
Interest and dividend income $ 51,253 $ (226) (B) $51,027
Rental and escalation income 15,196 -- 15,196
Gain (loss) on settlement of
investments 7,605 29 (B) 7,634
Management fee from affiliate 4,470 (4,470) (B) --
Incentive income from affiliate (1,218) 1,218 (B) --
Other income 17 (3) (B) 14
-------- -------- -------
77,323 (3,452) 73,871
-------- -------- -------
EXPENSES
Interest expense 34,992 (2,336) (B) 32,656
Property operating expense 6,554 -- 6,554
Loan servicing expense 327 -- 327
General and administrative expense 2,248 (100) (B) 2,148
Management fees to affiliates 8,085 (5,345) (C) 2,740
Incentive return to affiliates 1,441 (827) (C) 614
Depreciation and amortization 2,520 (430) (B) 2,090
-------- -------- -------
56,167 (9,038) 47,129
-------- -------- -------
INCOME BEFORE EQUITY IN EARNINGS
OF UNCONSOLIDATED SUBSIDIARIES 21,156 5,586 26,742
Equity in earnings (losses) of unconsolidated
subsidiaries 362 (362) (B) --
-------- -------- -------
INCOME FROM CONTINUING OPERATIONS $ 21,518 $ 5,224 $26,742
======== ======== =======
Income from continuing operations per common
share, basic and diluted $ 1.30 $ 1.58
====== =======
Weighted average number of common shares outstanding,
basic and diluted 16,489 16,969 (D)
====== =======
15
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2002
(A) Historical amounts were derived from Newcastle's unaudited
historical consolidated financial statements as of and for the nine
months ended September 30, 2002.
(B) Adjustments represent historical results of operations related to
other investments treated as being distributed to Newcastle
Holdings, which have been eliminated, as they will have no
continuing impact on Newcastle's operations, as follows:
RELATED INVESTMENT
----------------------------------------------------
FORTRESS
AUSTIN INVESTMENT
CAPTION HOLDINGS FUND ICH (i) CORPORATE TOTAL
- ------- -------- ---- ------- --------- -----
Interest and dividend income $-- $ (35) $-- $ (191) $ (226)
Gain on settlement of investments -- -- 29 -- 29
Management fee from affiliate -- -- -- (4,470) (ii) (4,470)
Incentive income from affiliate -- 1,218 -- -- 1,218
Other income -- -- -- (3) (3)
Interest expense -- -- -- (2,336) (iii) (2,336)
General and administrative expense -- -- -- (100) (iv) (100)
Depreciation and amortization -- (329) -- (101) (v) (430)
Equity in earnings of unconsolidated subsidiaries (59) (303) -- -- (362)
(i) Relates to assets acquired in the ICH transaction which were
sold prior to the commencement of Newcastle's operations.
(ii) Represents the management fee received by the Fund I Managing
Member related to Fund I which is paid directly to the Manager
and will have no continuing impact on Newcastle's operations.
(iii) Represents interest on Newcastle Holdings' line of credit.
(iv) Represents data processing expenses, state and local taxes,
and professional fees related directly to entities and assets
treated as being distributed to Newcastle Holdings.
(v) Represents depreciation of furniture, fixtures and equipment
treated as being distributed to Newcastle Holdings.
(C) Management fees related to the Fund I Managing Member's agreement with
Fund I ($4.5 million) have been eliminated as they will have no continuing
impact on Newcastle's operations. Management fees related to Newcastle
Holdings' management agreement with the Manager have been allocated pro
rata between continuing operations and operations related to assets
distributed to Newcastle Holdings, based on pro forma equity; incentive
return has been allocated based on the investments which generated such
return. Newcastle notes that it will not be responsible for management
fees or incentive return related to the investments or equity distributed
to Newcastle Holdings. The actual management fee charged to Newcastle is
based upon actual equity, as defined. Accordingly, management fees have
been allocated between the operations treated as being distributed to
Newcastle Holdings and Newcastle's continuing operations based upon the
same methodology.
(D) Includes 0.5 million shares deemed to be issued for pro forma statement of
income purposes only, which would generate incremental proceeds sufficient
to offset Newcastle Holdings' dividends in excess of earnings for the
period from January 1, 2002 through July 12, 2002 of $6.7 million.
16
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2002
CONSOLIDATED PRO FORMA STATEMENT OF INCOME
For the Nine Months Ended September 30, 2001
Distributed to
Newcastle
Holdings
----------
Eliminated
Historical (A) Operations Pro Forma
-------------- ---------- ---------
REVENUES
Interest and dividend income $36,848 $ (1,017) (B) $ 35,831
Rental and escalation income 15,503 -- 15,503
Gain (loss) on settlement of investments 7,451 (1,061) (B) 6,390
Management fee from affiliate 6,705 (6,705) (B) --
Incentive income from affiliate 28,846 (28,846) (B) --
Other income 42 (24) (B) 18
------- -------- --------
95,395 (37,653) 57,742
------- -------- --------
EXPENSES
Interest expense 27,060 (2,234) (B) 24,826
Property operating expense 6,670 -- 6,670
Loan servicing expense 181 -- 181
General and administrative expense 1,080 (221) (B) 859
Management fees to affiliates 10,996 (8,641) (C) 2,355
Incentive return to affiliates 16,075 (16,075) (C) --
Depreciation and amortization 2,655 (737) (B) 1,918
------- -------- --------
64,717 (27,908) 36,809
------- -------- --------
INCOME BEFORE EQUITY IN EARNINGS
OF UNCONSOLIDATED SUBSIDIARIES 30,678 (9,745) 20,933
Equity in earnings (losses) of unconsolidated subsidiaries 1,885 (1,885) (B) --
------- -------- --------
INCOME FROM CONTINUING OPERATIONS $32,563 $(11,630) $ 20,933
======= ======== ========
Income from continuing operations per common
share, basic and diluted $ 1.97 $ 1.23
======= ========
Weighted average number of common shares outstanding,
basic and diluted 16,494 16,974 (D)
======= ========
17
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2002
(A) Historical amounts were derived from Newcastle's unaudited
historical consolidated financial statements as of and for the nine
months ended September 30, 2001.
(B) Adjustments represent historical results of operations related to
other investments treated as being distributed to Newcastle
Holdings, which have been eliminated, as they will have no
continuing impact on Newcastle's operations, as follows:
RELATED INVESTMENT
-------------------------------------------------
FORTRESS
AUSTIN INVESTMENT
CAPTION HOLDINGS FUND ICH (i) CORPORATE TOTAL
- ------- -------- ---- ------- --------- -----
Interest and dividend income $ -- $ (517) $ -- $ (500) (ii) $ (1,017)
Gain on settlement of investments -- -- (2,012) 951 (iii) (1,061)
Management fee from affiliate -- -- -- (6,705) (iv) (6,705)
Incentive income from affiliate -- (28,846) -- -- (28,846)
Other income -- -- -- (24) (24)
Interest expense -- -- -- (2,234) (v) (2,234)
General and administrative expense -- -- -- (221) (vi) (221)
Depreciation and amortization -- (395) -- (342) (vii) (737)
Equity in earnings of unconsolidated subsidiaries 1,655 (3,540) -- -- (1,885)
(i) Relates to assets acquired in the ICH transaction which were sold
prior to the commencement of Newcastle's operations.
(ii) Represents interest on corporate cash balances and dividends on
equity investments sold prior to the commencement of Newcastle's
operations.
(iii) Represents a loss on the sale of equity investments sold prior to
the commencement of Newcastle's operations.
(iv) Represents the management fee received by the Fund I Managing Member
related to Fund I which is paid directly to the Manager and will
have no continuing impact on Newcastle's operations.
(v) Represents interest on Newcastle Holdings' line of credit.
(vi) Represents data processing expenses, state and local taxes, and
professional fees related directly to entities and assets treated as
being distributed to Newcastle Holdings.
(vii) Represents depreciation of furniture, fixtures and equipment treated
as being distributed to Newcastle Holdings.
(C) Management fees related to the Fund I Managing Member's agreement with
Fund I ($6.7 million) have been eliminated as they will have no continuing
impact on Newcastle's operations. Management fees related to Newcastle
Holdings' management agreement with the Manager have been allocated pro
rata between continuing operations and operations related to assets
distributed to Newcastle Holdings, based on pro forma equity; incentive
return has been allocated based on the investments which generated such
return. Newcastle notes that it will not be responsible for management
fees or incentive return related to the investments or equity distributed
to Newcastle Holdings. The actual management fee charged to Newcastle is
based upon actual equity, as defined. Accordingly, management fees have
been allocated between the operations treated as being distributed to
Newcastle Holdings and Newcastle's continuing operations based upon the
same methodology.
(D) Includes 0.5 million shares deemed to be issued for pro forma statement of
income purposes only, which would generate incremental proceeds sufficient
to offset Newcastle Holdings' dividends in excess of earnings for the
period from January 1, 2002 through July 12, 2002 of $6.7 million.
18
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PRO FORMA FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The following should be read in conjunction with the unaudited consolidated
financial statements and notes, and in particular with the unaudited pro forma
consolidated statements of income included in Note 6 to our consolidated
financial statements.
GENERAL
We were formed in June 2002 as a wholly owned subsidiary of Newcastle Investment
Holdings Corp. (referred to as Newcastle Holdings) for the purpose of separating
the real estate securities and credit leased real estate businesses from
Newcastle Holdings' other investments. In July 2002, Newcastle Holdings
contributed to us certain assets and liabilities in exchange for 16,488,517
shares of our common stock (as adjusted for an October stock dividend).
Although we were formed as a wholly owned subsidiary of Newcastle Holdings, for
accounting purposes this transaction is presented as a reverse spin-off. Under a
reverse spin-off, Newcastle Investment Corp. is treated as the continuing entity
and the assets that were retained by Newcastle Holdings and not contributed to
us are accounted for as if they were distributed at their historical book basis
through a spin-off to Newcastle Holdings. Our operations commenced on July 12,
2002. The following is a discussion and analysis of our operations on a stand
alone basis, without regard to the operations treated as if they were
distributed to Newcastle Holdings (i.e. without regard to the assets retained by
Newcastle Holdings). Certain activities described herein occurred prior to our
formation and were consummated by Newcastle Holdings.
The unaudited pro forma consolidated statements of income are presented as if
the distribution to Newcastle Holdings and the commencement of our operations
had been consummated on January 1, 2002 and 2001, respectively. The historical
results of operations of the assets and liabilities distributed to Newcastle
Holdings for the period prior to the commencement of our operations have been
presented as discontinued operations for those operations that constitute a
component of an entity. Of the assets treated as being distributed to Newcastle
Holdings, a portfolio of properties located in the U.S. and primarily leased to
the General Services Administration, which we refer to as the GSA portfolio, and
the mortgage loans each qualify as a component of an entity. The remaining
operations related to the other assets and the liabilities treated as being
distributed to Newcastle Holdings which are not a component of an entity have
been eliminated.
The unaudited pro forma consolidated statements of income are presented for
comparative purposes only, and are not necessarily indicative of what our actual
consolidated results of operations would have been for the periods presented,
nor do they purport to represent the results of any future periods. In the
opinion of management, all adjustments necessary to present fairly the unaudited
pro forma financial information have been made.
In October 2002, we sold 7 million shares of our common stock (referred to
herein as our common shares) in a public offering at a price to the public of
$13.00 per share, for net proceeds of approximately $80 million after deducting
the underwriters' discount and other offering expenses. A portion of the
proceeds of this offering were used to purchase a portfolio of mortgage loans
and to make additional investments. Subsequent to this offering, we have
23,488,517 common shares outstanding.
We are organized and conduct our operations to qualify as a REIT for federal
income tax purposes. As such, we will generally not be subject to federal income
tax on that portion of our income that is distributed to shareholders if we
distribute at least 90% of our REIT taxable income to our shareholders by the
due date of our federal income tax return and comply with various other
requirements.
We conduct our business through two primary segments: (i) real estate
securities, including our first two CBO securitization transactions, which we
refer to as CBO I and CBO II, and (ii) revenue-producing real estate, primarily
credit leased real estate, including a portfolio of properties located in
Canada, which we refer to as our Bell Canada portfolio, and a portfolio of
properties located in Belgium, which we refer to as our LIV portfolio. Revenues
attributable to each segment are disclosed below on a pro forma basis
(unaudited) (in thousands).
19
Real Estate
Securities Real Estate Unallocated Total
---------- ----------- ----------- -----
For the nine months ended September 30, 2002 $58,728 $15,138 $5 $73,871
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Management's discussion and analysis of financial condition and results of
operations is based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States ("GAAP"). The preparation of financial statements in conformity
with GAAP requires the use of estimates and assumptions that could affect the
reported amounts of assets and liabilities, the disclosure of contingent assets
and liabilities and the reported amounts of revenue and expenses. Actual results
could differ from these estimates.
We have classified our real estate securities as available for sale. As such,
they are carried at market value with net unrealized gains or losses reported as
a component of accumulated other comprehensive income. Market value is based
primarily upon multiple broker quotations, which provide valuation estimates
based upon reasonable market order indications or a good faith estimate thereof.
These quotations are subject to significant variability based on market
conditions, such as interest rates and spreads. Changes in market conditions, as
well as changes in the assumptions or methodology used to determine market
value, could result in a significant increase or decrease in our book equity.
Similarly, our derivative instruments, held for hedging purposes, are carried at
market value pursuant to Statement of Financial Accounting Standards ("SFAS")
No. 133 "Accounting for Derivative Instruments and Hedging Activities," as
amended. Market value is based on counterparty quotations. To the extent they
qualify as hedges under SFAS No. 133, net unrealized gains or losses are
reported as a component of accumulated other comprehensive income; otherwise,
they are reported as a component of current income. Market values of such
derivatives are subject to significant variability based on many of the same
factors as the securities discussed above. The results of such variability could
be a significant increase or decrease in our book equity and/or earnings.
RESULTS OF OPERATIONS
COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 2002 TO THE NINE MONTHS ENDED
SEPTEMBER 30, 2001 ON A PRO FORMA BASIS
Interest and dividend income increased by $15.2 million or 42.4%, from $35.8
million to $51.0 million. This increase is primarily the result of interest
earned on a deposit made on the collateral for our CBO II transaction prior to
its consummation, which we refer to as the CBO II deposit, of $2.5 million and
interest earned on the CBO II collateral of $14.9 million.
Rental and escalation income decreased by $0.3 million or 2.0%, from $15.5
million to $15.2 million. This decrease is primarily the result of foreign
currency fluctuations related to our Bell Canada and LIV portfolios. Escalation
income represents contractual increases in rental income to offset increases in
expenses or general price increases over a base amount.
Gain on settlement of investments increased by $1.2 million, from $6.4 million
to $7.6 million, primarily as a result of an increase in the volume of sales of
certain CBO collateral securities. Sales of CBO securities are based on a number
of factors including credit, asset type and industry and can be expected to
increase or decrease from time to time. Periodic fluctuations in the volume of
sales of securities is dependent upon, among other things, management's
assessment of credit risk, asset concentration, portfolio balance and other
factors. The increased volume of sales of securities during this period reflects
management's determination that the portfolio required more adjustment than in
prior periods.
Interest expense increased by $7.9 million or 31.5%, from $24.8 million to $32.7
million. This increase is primarily the result of interest on the CBO II
securitization ($11.8 million), partially offset by lower interest rates being
paid on the variable rate CBO I securities classes.
Property operating expense decreased by $0.1 million or 1.7%, from $6.7 million
to $6.6 million, primarily as the result of foreign currency fluctuations
related to our Bell Canada and LIV portfolios.
20
Loan servicing expense increased by $0.1 million, from $0.2 million to $0.3
million, primarily as a result of the acquisition of the CBO II collateral.
General and administrative expense increased by $1.2 million, from $0.9 million
to $2.1 million, primarily as a result of our increased size.
Management fee expense increased by $0.3 million, from $2.4 million to $2.7
million, based on our increased equity.
Depreciation and amortization increased by $0.2 million or 9.0%, from $1.9
million to $2.1 million, primarily as the result of depreciation on the capital
expenditures we made with respect to our real estate assets.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity is a measurement of our ability to meet potential cash requirements,
including ongoing commitments to repay borrowings, fund and maintain
investments, and other general business needs. Additionally, to maintain our
status as a REIT under the Internal Revenue Code, we must distribute annually at
least 90% of our taxable income. Our primary sources of funds for liquidity, in
addition to our initial public offering, consist of net cash provided by
operating activities, borrowings under loans and the issuance of debt
securities. Our loans and debt securities are generally secured directly by our
investment assets. As of September 30, 2002, our CBO I and CBO II collateral as
well as our Bell Canada portfolio were securitized, while our LIV portfolio and
one our marketable real estate securities served as collateral for loans.
Our ability to execute our business strategy, particularly the growth of our
investment portfolio, depends to a significant degree on our ability to obtain
additional capital. Our CBO strategy is dependent upon our ability to place the
match funded debt we create in the market at spreads that provide a positive
arbitrage. If spreads for CBO liabilities widen or if demand for such
liabilities ceases to exist, then our ability to execute future CBO transactions
will be severely restricted.
We expect to meet our short-term liquidity requirements generally through our
cash flow provided by operations, as well as investment specific borrowings. Our
real estate investments are financed long-term and primarily leased to credit
tenants with long-term leases and are therefore expected to generate generally
stable current cash flows. Our real estate securities are also financed
long-term and their credit status is continuously monitored; therefore, these
investments are also expected to generate a generally stable current return,
subject to interest rate fluctuations. See "Item 3. Quantitative and Qualitative
Disclosures About Market Risk -- Interest Rate Exposure" below. We consider our
ability to generate cash to be adequate and expect it to continue to be adequate
to meet operating requirements both in the short- and long-terms.
We expect to meet our long-term liquidity requirements, specifically the
repayment of our debt and our investment funding needs, through additional
borrowings, the issuance of debt and/or equity securities and the liquidation or
refinancing of our assets at maturity. We believe that the value of these assets
is, and will continue to be, sufficient to repay our debt at maturity under
either scenario.
We expect that our cash flow provided by operations, our financing from Bear
Stearns Mortgage Capital Corporation relating to our purchase of a mortgage loan
portfolio (as described below) and our financing from Bear, Stearns
International Limited in connection with our purchase of securities for our
third CBO transaction (as described below) and our subsequent CBO issuance will
satisfy our liquidity needs for our business plan over the next twelve months.
With respect to our real estate assets, we expect to incur approximately $1.1
million of tenant improvements in connection with the inception of leases and
capital expenditures during the fifteen months ending December 31, 2003.
21
Our long-term debt existing at September 30, 2002 (gross of $14.5 million of
discounts) is expected to mature as follows:
Period from October 1, 2002 through
December 31, 2002 $3.2 million
2003 3.3 million
2004 3.3 million
2005 3.3 million
2006 3.3 million
2007 3.3 million
Thereafter 951.7 million
-------------
Total $971.4 million
In July 1999, we completed our first CBO securitization, CBO I, whereby the CBO
I collateral was contributed to a consolidated subsidiary which issued $437.5
million face amount of investment grade senior securities and $62.5 million face
amount of non-investment grade subordinated securities in a private placement.
At September 30, 2002, the subordinated securities were retained by us, except
for the Class E Note as described below, and the $428.8 million carrying amount
of senior securities (all of which are still outstanding), which bore interest
at a weighted average effective rate, including discount and cost amortization,
of approximately 4.42%, had an expected weighted average life of approximately
5.51 years. Two classes of the senior securities bear floating interest rates.
We have obtained an interest rate swap and cap in order to hedge our exposure to
the risk of changes in market interest rates with respect to these securities,
at an initial cost of approximately $14.3 million. In addition, in connection
with the sale of two classes of securities, we entered into two interest rate
swaps and three interest rate cap agreements that do not qualify for hedge
accounting.
In March 1999, we obtained the Bell Canada mortgage secured by the Bell Canada
properties. In April 2002, we refinanced the Bell Canada properties through a
securitization transaction. At September 30, 2002, the $37.1 million carrying
amount of outstanding securities, which bore interest at a weighted average
effective rate, including discount and cost amortization, of approximately
6.72%, had an expected weighted average life of approximately 2.7 years. We have
retained one class of the issued securities.
In November 1999, we obtained the LIV mortgage, which had an outstanding
carrying amount of $50.6 million and bore interest at 4.89% as of September 30,
2002, and is due in November 2016. We hedged our exposure to the risk of changes
in market interest rates with respect to the LIV mortgage by obtaining an
interest rate cap.
We utilize repurchase agreements for short-term financings of investments. As of
September 30, 2002 we had a $1.5 million repurchase agreement outstanding,
bearing interest at approximately 3.17% with a short-term maturity.
In April 2002, we completed our second CBO securitization, CBO II, whereby the
CBO II collateral was contributed to a consolidated subsidiary which issued
$444.0 million face amount of investment grade senior securities and $56.0
million face amount of non-investment grade subordinated securities, in a
private placement. The subordinated securities have been retained by us. At
September 30, 2002, the $439.0 million carrying amount of senior securities,
which bore interest at a weighted average effective rate, including discount and
cost amortization, of approximately 3.48%, had an expected weighted average life
of approximately 7.61 years. One class of the senior securities bears a floating
interest rate. We obtained an interest rate swap and cap in order to hedge our
exposure to the changes in market interest rates with respect to this security,
at an initial cost of $1.2 million.
In November 2001, we sold the retained subordinated $17.5 million Class E Note
from CBO I to a third party for approximately $18.5 million. The Class E Note
bore interest at a fixed rate of 8.0% and had a stated maturity of June 2038.
The sale of the Class E Note represented an issuance of debt and was recorded as
additional CBO bonds payable. In April 2002, a wholly owned subsidiary of ours
repurchased the Class E Note. The repurchase of the Class E Note represents a
repayment of debt and was recorded as a reduction of CBO bonds payable. The
Class E Note is included in the CBO II collateral. The Class E Note is
eliminated in consolidation.
Pursuant to an agreement entered into in July 2002, Bear, Stearns International
Limited (BSIL) will purchase up to $450 million of commercial mortgage backed
securities, REIT debt, real estate loans and asset backed securities (the CBO
III collateral), subject to our right to purchase such securities from BSIL.
This agreement is treated as a non-hedge derivative for accounting purposes and
is therefore marked-to-market through current income; no material mark
22
has been booked through September 30, 2002. The CBO III collateral is expected
to be included in a securitization transaction in which we would acquire the
equity interest (the CBO III transaction). Pursuant to the agreement, Bear,
Stearns & Co. Inc. also has been engaged to structure and serve as lead manager
for the CBO III transaction for which it will receive customary fees. As of
September 30, 2002, approximately $123.7 million of the $450 million has been
accumulated. If the CBO III transaction is not consummated as a result of our
failure to acquire the equity interest or otherwise as a result of our gross
negligence or willful misconduct, we would be required to either purchase the
CBO III collateral from BSIL or pay BSIL the difference between the price it
paid for the CBO III collateral and the price at which it sold the CBO III
collateral to a third party (a collateral loss). If the CBO III transaction
fails to close for any other reason, other than as a result of BSIL's gross
negligence or willful misconduct, we would be required to either purchase the
CBO III collateral from BSIL or pay BSIL the lesser of $15 million and the
collateral loss or, if we have paid a deposit on the CBO III collateral in
exchange for a portion of the interest payments on the securities, the lesser of
the collateral loss and any such deposit. Although we currently anticipate
completing the CBO III transaction during the first quarter of 2003, there is no
assurance that the CBO III transaction will be consummated. As of September 30,
2002, we estimate that the fair value of the securities purchased by BSIL is in
excess of the purchase price paid by BSIL. In November 2002, we made deposits
aggregating $24.9 million under such agreement, known as the CBO III deposit.
In October 2002, we sold 7 million shares of our common stock in a public
offering at a price to the public of $13.00 per share, for net proceeds of
approximately $80 million after deducting the underwriters' discount and other
offering expenses. A portion of the proceeds of this offering were used to
purchase a portfolio of mortgage loans, as described below, and to make other
investments, including the CBO III deposit. Subsequent to this offering, we have
23,488,517 common shares outstanding.
In November 2002, we utilized $13.5 million of our offering proceeds to purchase
a $260.2 million portfolio of mortgage loans subject to $246.7 million of
financing. The mortgage loans bore interest at a net weighted average rate of
approximately 3.44% on the date of purchase, and the financing bore interest at
a weighted average rate of approximately LIBOR + 0.37% on such date.
In November 2002, we refinanced the LIV portfolio for proceeds of EUR 60 million
or approximately $60.6 million. The refinancing bears interest at a rate of
Euribor + 1.45% and matures in November 2006. The proceeds of the refinancing
were primarily used to repay the existing financing on such portfolio. We have
hedged our exposure to the risk of changes in market interest rates with respect
to this refinancing by obtaining an interest rate swap.
We declared a distribution of $0.40 per common share to our stockholders of
record at the close of business on September 27, 2002, Newcastle Holdings and
Fortress Principal Investment Holdings LLC, for the quarter ending September 30,
2002. In addition, in October 2002 we declared a distribution of $0.06 per
common share to our stockholders of record at the close of business on October
15, 2002, Newcastle Holdings and Fortress Principal Investment Holdings LLC, for
the period commencing on October 1, 2002 and ending October 15, 2002. Both
dividends were paid in October 2002.
CREDIT AND INTEREST RATE RISK
We are subject to credit and interest rate risk with respect to our investments
in real estate securities.
The collateralized mortgage-backed securities (CMBS) we invest in are generally
junior in right of payment of interest and principal to one or more senior
classes, but benefit from the support of one or more subordinate classes of
securities or other form of credit support within a securitization transaction.
The REIT securities we invest in reflect comparable credit risk. We believe,
based on our intensive due diligence process, that these securities offer
attractive risk-adjusted returns with long-term principal protection under a
variety of default and loss scenarios. While the expected yield on these
securities is sensitive to the performance of the underlying assets, the more
subordinated securities or other features of the securitization transaction, in
the case of mortgage backed securities, and the issuer's underlying equity and
subordinated debt, in the case of REIT securities, are designed to bear the
first risk of default and loss. We further minimize credit risk by actively
monitoring our investment portfolio and the underlying credit quality of our
holdings and, where appropriate, repositioning our investments to upgrade the
credit quality and yield on our investments.
Our portfolio is diversified by asset type, industry, location and issuer. We
expect that diversification will minimize the risk of capital loss.
23
At September 30, 2002, our CBO collateral, which consists primarily of real
estate securities, has an overall weighted average credit rating of
approximately Baa3, and approximately 72% of these securities have an investment
grade rating (Baa3 or higher).
Returns on these investments are sensitive to interest rate volatility. We
minimize exposure to interest rate fluctuation through the use of match-funded
financing structures and hedges. In particular, we finance our real estate
securities investments through the issuance of debt securities in the form of
CBOs to take advantage of the structural flexibility offered by CBO transactions
to buy and sell certain investment positions to manage risk and, subject to
certain limitations, to optimize returns. We also utilize interest rate swaps
and caps to minimize this risk. As of September 30, 2002, a 100 basis point
change in short term interest rates would affect our earnings by no more than
$2.4 million per annum. See "Item 3. Quantitative and Qualitative Disclosures
About Market Risk - Interest Rate Exposure" below.
INFLATION
Substantially all of our office leases provide for separate escalations of real
estate taxes and operating expenses over a base amount, and/or increases in the
base rent based on changes in the Consumer Price Index ("CPI"). We believe that
inflationary increases in expenses will generally be offset by the expense
reimbursements and contractual rent increases described above.
We believe that our risk of increases in the market interest rates on our
floating rate debt as a result of inflation is largely offset by our use of
match funding and hedging instruments as described above. See "Item 3.
Quantitative and Qualitative Disclosure About Market Risk -- Interest Rate
Exposure" below.
PRO FORMA FUNDS FROM OPERATIONS
We believe Funds from Operations (FFO) is one appropriate measure of the
performance of real estate companies because it provides investors with an
understanding of our ability to incur and service debt and make capital
expenditures. Funds from Operations (FFO), for our purposes, represents net
income available for common shareholders (computed in accordance with accounting
principles generally accepted in the United States ("GAAP"), excluding
extraordinary items, plus real estate depreciation and amortization, and after
adjustments for unconsolidated subsidiaries, if any. We consider gains and
losses on resolution of our investments to be a normal part of our recurring
operations and therefore do not exclude such gains and losses when arriving at
FFO. Adjustments for unconsolidated subsidiaries, if any, are calculated to
reflect FFO on the same basis. FFO does not represent cash generated from
operating activities in accordance with GAAP and therefore should not be
considered an alternative to net income as an indicator of our operating
performance or as an alternative to cash flow as a measure of liquidity and is
not necessarily indicative of cash available to fund cash needs.
24
Funds from Operations (FFO), on a pro forma basis after giving effect to the
transactions related to our formation, is calculated as follows (unaudited) (in
thousands):
For the Nine
Months Ended
September 30,
2002
----
Income from continuing operations $ 26,742
Real estate depreciation and amortization 1,970
--------
Funds from Operations (FFO) from continuing operations $ 28,712
========
Pro forma funds from operations was derived from the Company's segments as
follows (unaudited) (in thousands):
Average Book
Equity for the FFO from Return on
Book Equity Nine Months continuing Equity
9/30/02(1) Ended 9/30/02(1) operations (ROE)(2)
---------- ---------- ---------- ---------
Real estate securities $ 157,913 $143,605 $29,494 27.4%
Revenue-producing real estate 49,777 52,953 4,093 10.3%
Unallocated (1,481) 527 (4,875) N/A
--------- -------- ------- ----
Total 206,209 $197,085 $28,712 19.4%
======== ======= ====
Accumulated depreciation (8,614)
Accumulated other comprehensive income 28,312
---------
Net $ 225,907
=========
(1) Gross of accumulated depreciation and accumulated other comprehensive
income.
(2) FFO divided by average book equity, annualized.
25
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF HISTORICAL FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following should be read in conjunction with the consolidated financial
statements and notes thereto included herein.
GENERAL
We were formed in June 2002 as a wholly owned subsidiary of Newcastle Investment
Holdings Corp. (referred to as Newcastle Holdings) for the purpose of separating
the real estate securities and credit leased real estate businesses from
Newcastle Holdings' other investments. In July 2002, Newcastle Holdings
contributed to us certain assets and liabilities in exchange for shares of our
common stock.
Although we were formed as a wholly owned subsidiary of Newcastle Holdings, for
accounting purposes this transaction is presented as a reverse spin-off. Under a
reverse spin-off, Newcastle Investment Corp. is treated as the continuing entity
and the assets that were retained by Newcastle Holdings and not contributed to
us are accounted for as if they were distributed at their historical book basis
through a spin-off to Newcastle Holdings. Our operations commenced on July 12,
2002.
Management's Discussion and Analysis of Pro Forma Financial Condition and
Results of Operations on the preceding pages pertains to current and historical
information regarding our operations on a stand-alone basis. The analysis in
this section discusses such information by treating us as the successor to
Newcastle Holdings and therefore includes historical information, through the
date of the commencement of our operations, regarding operations of Newcastle
Holdings which were distributed to them and therefore are unrelated to our
ongoing operations. Transactions completed by Newcastle Holdings related to
investments retained by Newcastle Holdings (not contributed to us) are referred
to as being completed by our predecessor.
Newcastle Holdings was incorporated on May 11, 1998 and was initially
capitalized through the sale of 50 shares of common stock for $1,000. In June
1998, Newcastle Holdings completed a private offering, including an
over-allotment option, for the sale of 20,912,401 shares of common stock for
proceeds of approximately $384.5 million, net of expenses. In addition, in July
1998, certain employees of Fortress Investment Group LLC purchased an aggregate
of 4,288 shares of the common stock of Newcastle Holdings resulting in
additional proceeds of approximately $0.1 million. In 2000 and 2001, Newcastle
Holdings repurchased an aggregate of 4,428,222 shares of its common stock for
$32.4 million of cash and $46.3 million of newly issued shares of its Series A
Cumulative Convertible Preferred Stock (the "Series A Preferred"). At the date
of the commencements of our operations, Newcastle Holdings had 16,488,517 shares
of its common stock outstanding. The Series A Preferred was fully redeemed by
June 14, 2002.
Our predecessor conducted its business through four primary segments: (1) real
estate securities, (2) revenue-producing real estate, primarily credit leased
real estate, (3) its investment in Fortress Investment Fund LLC ("Fund I") and
(4) real estate loans. Revenues attributable to each segment are disclosed
below. Newcastle Holdings' investments in real estate securities and a portion
of its investments in revenue-producing real estate were contributed to us. The
real estate (GSA portfolio) and real estate loans operations distributed to
Newcastle Holdings have been treated as discontinued operations, because they
constituted a component of an entity, while the other operations distributed to
Newcastle Holdings, including the investment in Fund I, have not been treated as
such, because they did not constitute a component of an entity as defined in
SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets."
26
Fortress
Real Estate Investment
Securities Real Estate Fund Unallocated Totals
---------- ----------- ---- ----------- ------
(unaudited and in thousands)
For the nine months ended September 30, 2002:
Revenues $58,728 $15,138 $ 3,287 $ 170 $77,323
For the nine months ended September 30, 2001:
Revenues $42,081 $15,661 $36,068 $ 1,585 $95,395
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Management's discussion and analysis of financial condition and results of
operations is based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States ("GAAP"). The preparation of financial statements in conformity
with GAAP requires the use of estimates and assumptions that could affect the
reported amounts of assets and liabilities, the disclosure of contingent assets
and liabilities and the reported amounts of revenue and expenses. Actual results
could differ from these estimates.
The investment in Fund I was retained by Newcastle Holdings. The managing member
of Fund I is Fortress Fund MM LLC (the "Fund I Managing Member"), which is owned
jointly, through subsidiaries, by Newcastle Holdings, approximately 94%, and the
Manager, approximately 6%. The Fund I Managing Member is entitled to an
incentive return (the "Fund Incentive Return") generally equal to 20% of Fund
I's returns, as defined, subject to: (1) a 10% preferred return payable to the
Investors and (2) a clawback provision which requires amounts previously
distributed as Fund Incentive Return to be returned to Fund I if, upon
liquidation of Fund I, the amounts ultimately distributed to each Investor do
not meet a 10% preferred return to the Investors. Fund I is managed by the
Manager pursuant to the Fund I Managing Member's operating agreement and a
management agreement between the Manager and the Fund I Managing Member. In
accordance with those documents, (1) the Manager is entitled to 100% of the
management fee payable by Fund I, (2) the Manager is entitled to 50% of the Fund
Incentive Return payable by Fund I, (3) Newcastle Holdings is entitled to 50% of
the Fund Incentive Return payable by Fund I and (4) Newcastle Holdings is
entitled to receive 100% of the investment income or loss attributable to the
capital invested in Fund I by the Fund I Managing Member. The Manager of Fund I
also manages Newcastle and Newcastle Holdings. We consolidated the financial
results of the Fund I Managing Member through our predecessor until the date of
the commencement of our operations because our predecessor owned substantially
all of the voting interest in the Fund I Managing Member. As a result, the
financial statements reflect all of the Fund Incentive Return payable to the
Fund I Managing Member, including the 50% portion payable to the Manager which
is treated as Incentive Return to Affiliates, through the date of the
commencement of our operations.
The Fund Incentive Return is payable on an asset-by-asset basis, as realized.
Accordingly, a Fund Incentive Return may be paid to the Fund I Managing Member
in connection with a particular Fund I investment if and when such investment
generates proceeds to Fund I in excess of the capital called with respect to
such investment, plus a 10% preferred return thereon. If, upon liquidation of
Fund I, the aggregate amount paid to the Fund I Managing Member as Fund
Incentive Return exceeds the amount actually due to the Fund I Managing Member
(that is, amounts that should instead have been paid to Investors) after taking
into account the aggregate return to Investors, the excess is required to be
returned by the Fund I Managing Member (that is "clawed back") to Fund I.
Our predecessor received a credit against management fees otherwise payable
under the Management Agreement with the Manager for management fees and any Fund
Incentive Return paid to the Manager by Fund I in connection with our
predecessor's investment in Fund I. Our predecessor had adopted Method 2 of
Emerging Issues Task Force Topic D-96 which specifies that companies with
management arrangements that contain a performance based incentive return that
is not finalized until the end of a period of time specified in the contract may
record such return as revenue in the amount that would be due under the formula
at any point in time as if the incentive return arrangement was terminated at
that date.
Our predecessor recorded as incentive income the amount that would be due based
on the fair value of the assets in Fund I exceeding the required return at a
specific point in time as if the management arrangement was terminated on that
date. Based on this methodology, our net income in each reporting period through
the date of the commencement of our operations reflected changes in the fair
value of the assets in Fund I. The fair value of the assets in Fund I is
27
determined by the Fund I Managing Member pursuant to guidelines established by
Fund I's board of directors. Due to the inherent uncertainty of valuations of
investments without a public market, the estimates of value may differ from the
values that are ultimately realized by Fund I, and the differences could be
material. Such estimates of fair value can fluctuate from quarter to quarter,
which resulted in material fluctuations in the amount of Fund Incentive Return
recorded.
RESULTS OF OPERATIONS
COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 2002 TO THE NINE MONTHS ENDED
SEPTEMBER 30, 2001
Interest and dividend income increased by $14.5 million or 39.1%, from $36.8
million to $51.3 million. This increase is primarily the result of interest
earned on the CBO II deposit and the CBO II collateral.
Rental and escalation income decreased by $0.3 million or 2.0%, from $15.5
million to $15.2 million. This decrease is primarily the result of foreign
currency fluctuations related to our Bell Canada and LIV portfolios.
Gain on settlement of investments increased by $0.1 million, from $7.5 million
to $7.6 million, primarily as a result of a slight increase in the volume of
sales of certain CBO collateral securities. Sales of CBO securities are based on
a number of factors including credit, asset type and industry and can be
expected to increase or decrease from time to time. Periodic fluctuations in the
volume of sales of securities is dependent upon, among other things,
management's assessment of credit risk, asset concentration, portfolio balance
and other factors. The increased volume of sales of securities during this
period reflects management's determination that the portfolio required slightly
more adjustment than in prior periods.
Equity in earnings of unconsolidated subsidiaries decreased by $1.5 million,
from $1.9 million to $0.4 million, as a result of the elimination of income from
our predecessor's investments in Fund I and Austin Holdings Corporation
subsequent to their distribution to Newcastle Holdings.
Incentive Income from our predecessor's investment in Fund I of $1.2 million of
loss was recorded during the period. We recorded as Fund Incentive Return the
amount that would be due based on the fair value of the assets in Fund I
exceeding the required return as if the management arrangement was terminated,
through the date of this investment's distribution to Newcastle Holdings. During
the period, the amount previously recognized as Fund Incentive Return in 2001
was reduced due to losses incurred in Fund I. The calculation of incentive
income is more fully discussed above.
Management fee income from Fund I, all of which is payable to the Manager and is
therefore included in management fee expense, had no net effect on our reported
operations.
Interest expense increased by $7.9 million or 29.3%, from $27.1 million to $35.0
million. This increase is primarily the result of interest on the CBO II
securitization ($11.8 million), partially offset by lower interest rates being
paid on the variable rate CBO securities classes.
Property operating expense decreased by $0.1 million or 1.7%, from $6.7 million
to $6.6 million, primarily as the result of foreign currency fluctuations
related to our Bell Canada and LIV portfolios.
Loan servicing and REO expense increased by $0.1 million from $0.2 million to
$0.3 million, primarily as a result of the acquisition of the CBO II collateral.
General and administrative expense increased by $1.1 million, from $1.1 million
to $2.2 million, primarily as a result of increased insurance costs and
increased state and local taxes.
Management fee expense decreased by $2.9 million, from $11.0 million to $8.1
million, based on the reduction in our equity resulting from the distribution of
assets to Newcastle Holdings. Management fee expense includes management fees
related to Fund I ($4.5 million), which are directly offset by management fee
income.
Preferred incentive return decreased by $14.7 million, from $16.1 million to
$1.4 million, primarily as a result of decreased earnings on our predecessor's
investment in Fund I, prior to this investment's distribution to Newcastle
Holdings.
28
Depreciation and amortization decreased by $0.2 million or 5.1%, from $2.7
million to $2.5 million, primarily as the result of the elimination of
amortization of certain costs related to our predecessor's investment in Fund I,
prior to this investment's distribution to Newcastle Holdings.
Preferred dividends and related accretion decreased by $0.7 million, from $1.9
million to $1.2 million, as a result of the redemption of such stock in June
2002.
COMPARISON OF THE THREE MONTHS ENDED SEPTEMBER 30, 2002 TO THE THREE MONTHS
ENDED SEPTEMBER 30, 2001
Interest and dividend income increased by $8.5 million or 72.0%, from $11.7
million to $20.2 million. This increase is primarily the result of interest
earned on the CBO II collateral.
Rental and escalation income increased by $0.3 million or 6.1%, from $4.9
million to $5.2 million. This increase is primarily the result of foreign
currency fluctuations related to our Bell Canada and LIV portfolios.
Gain on settlement of investments increased by $2.6 million, primarily as a
result of an increase in the volume of sales of certain CBO collateral
securities. Sales of CBO securities are based on a number of factors including
credit, asset type and industry and can be expected to increase or decrease from
time to time. Periodic fluctuations in the volume of sales of securities is
dependent upon, among other things, management's assessment of credit risk,
asset concentration, portfolio balance and other factors. The increased volume
of sales of securities during this period reflects management's determination
that the portfolio required more adjustment than in prior periods.
Equity in earnings of unconsolidated subsidiaries decreased by $0.8 million, as
a result of the elimination of income from our predecessor's investments in Fund
I and Austin Holdings Corporation subsequent to their distribution to Newcastle
Holdings.
Incentive Income from our predecessor's investment in Fund I and management fee
income from Fund I were similarly eliminated.
Interest expense increased by $5.0 million or 57.8%, from $8.5 million to $13.5
million. This increase is primarily the result of interest on the CBO II
securitization ($6.8 million), partially offset by lower interest rates being
paid on the variable rate CBO securities classes.
Property operating expense increased by $0.3 million or 13.9%, from $1.9 million
to $2.2 million, primarily as the result of foreign currency fluctuations
related to our Bell Canada and LIV portfolios.
Loan servicing expense increased by $0.1 million primarily as the result of the
acquisition of the CBO II collateral.
General and administrative expense increased by $0.2 million, from $0.5 million
to $0.7 million, primarily as a result of increased insurance costs and
increased state and local taxes.
Management fee expense decreased by $2.9 million, from $3.8 million to $0.9
million, based on the reduction in our equity resulting from the distribution of
assets to Newcastle Holdings. Management fee expense in the prior period
includes management fees related to Fund I ($2.2 million), which are directly
offset by management fee income.
Preferred incentive return decreased by $15.5 million, from $16.1 million to
$0.6 million, primarily as a result of decreased earnings on our predecessor's
investment in Fund I, prior to this investment's distribution to Newcastle
Holdings.
Depreciation and amortization decreased by $0.2 million or 23.3%, from $0.9
million to $0.7 million, primarily as the result of the sale of two small
properties.
Preferred dividends and related accretion decreased by $0.6 million as a result
of the redemption of such stock in June 2002.
LIQUIDITY AND CAPITAL RESOURCES
See Management's Discussion and Analysis of Pro Forma Financial Conditions and
Results of Operations - Liquidity and Capital Resources for a discussion of our
current liquidity and capital resources.
29
The following is a discussion of our predecessor's historical liquidity and
capital resources, primarily related to operations distributed to them.
Our primary sources of funds for liquidity, subsequent to our predecessor's
private equity offering in 1998, have consisted of net cash provided by
operating activities, borrowings under loans, the issuance of debt securities
and the settlement of investments.
Our predecessor had certain investments in, and commitments to, two
unconsolidated subsidiaries as described below. Both of these investments, and
the related commitments, were distributed to Newcastle Holdings.
Newcastle Holdings committed to contribute approximately $100 million to
Fortress Investment Fund LLC, along with other major institutional investors
who, together with Newcastle Holdings and its affiliates, committed
approximately $872.8 million over the three years ending April 28, 2003.
In 1998, Newcastle Holdings and Fortress Principal Investment Group LLC
("FPIG"), an affiliate of our manager, formed Austin Holdings Corporation
("Austin"). FPIG contributed cash and Newcastle Holdings contributed its
interest in entities that owned certain assets, primarily nonperforming loans
and foreclosed real estate intended for sale, which it originally acquired as
part of a loan pool acquisition. The assets Newcastle Holdings contributed, and
any income generated from them, are not well suited to be held by a REIT because
of the following reasons. If the assets were treated as inventory held for sale
in the ordinary course of business, any gain from the sale of these assets would
be subject to a 100% excise tax in the hands of a REIT. By holding these assets
indirectly through Austin, a corporate entity, Newcastle Holdings instead
received dividend income from the corporation, which is not subject to the 100%
excise tax, and is treated as qualifying income for purposes of the REIT 95%
income test. Newcastle Holdings holds non-voting preferred stock of Austin.
Newcastle Holdings' preferred stock in Austin represents a 95% economic
ownership interest in Austin and has a liquidation preference over the common
stockholders. Newcastle Holdings' interest in Austin is accounted for under the
equity method. Newcastle Holdings acquired stock that is non-voting in order to
comply with the rule that REITs generally may not hold more than 10% of the
voting stock of any corporation. FPIG is the holder of all of the common stock,
which represents 100% of the vote and 5% of the economic ownership interest in
Austin. Austin also owns 100% of the common stock of Ascend Residential
Holdings, Inc. ("Ascend"). Ascend's primary business is the acquisition,
rehabilitation and sale of single-family residential properties.
In August 1998, Newcastle Holdings closed on the $234.2 million GSA mortgage. In
March 1999, it closed on the $18.6 million GSA San Diego mortgage. In May 1999,
it repaid these two mortgages with proceeds from the $399.1 million GSA
securitization. The GSA securitization, and related assets, were retained by
Newcastle Holdings.
In November 1999, Newcastle Holdings securitized a U.S. commercial mortgage loan
by issuing $55.6 million of bonds. The bonds were also secured by a $15.0
million letter of credit. These obligations were repaid in December 2001.
In November 1999, Newcastle Holdings obtained the $24.8 million GSA Kansas City
mortgage, which was repaid in May 2002 upon sale of the related asset.
In July 2000, Newcastle Holdings entered into a $40 million revolving credit
agreement, which bore interest at LIBOR +4.25% and was due in July 2003.
Newcastle Holdings hedged its exposure to the risk of changes in market interest
rates with respect to the credit agreement by obtaining an interest rate swap.
This credit agreement was retained by Newcastle Holdings.
Net cash flow provided by operating activities decreased from $20.9 million for
the nine months ended September 30, 2001 to $15.3 million for the nine months
ended September 30, 2002. This change resulted from the acquisition and
settlement of Newcastle's investments as described above, including the
distribution of investments to Newcastle Holdings.
Investing activities provided (used) ($425.5 million) and $77.7 million during
the nine months ended September 30, 2002 and 2001, respectively. Investing
activities consisted primarily of the acquisition and improvement of properties
and the investments made in certain real estate securities, net of proceeds from
the settlement of debt and equity investments as well as the sale of properties.
Financing activities provided (used) $386.0 million and ($97.0 million) during
the nine months ended September 30, 2002 and 2001, respectively. The borrowings
and debt issuances described above served as the primary sources of cash flow
from financing activities. Offsetting uses included the payment of related
deferred financing costs (includ-
30
ing the purchase of hedging instruments), the payment of dividends, the
redemption of preferred stock and the repayment of debt as described above.
See the consolidated statements of cash flows included in our consolidated
financial statements included herein for a reconciliation of our cash position
(including our predecessor's cash position prior to the commencement of our
operations) for the periods described herein.
FUNDS FROM OPERATIONS
We believe Funds from Operations (FFO) is one appropriate measure of the
performance of real estate companies because it provides investors with an
understanding of our ability to incur and service debt and make capital
expenditures. Funds from Operations (FFO), for our purposes, represents net
income available for common shareholders (computed in accordance with accounting
principles generally accepted in the United States (GAAP)), excluding
extraordinary items, plus real estate depreciation and amortization, and after
adjustments for unconsolidated subsidiaries. We consider gains and losses on
resolution of our investments to be a normal part of our recurring operations
and therefore do not exclude such gains and losses when arriving at Funds from
Operations (FFO). In addition, we excluded accrued incentive income from our
predecessor's investment in Fortress Investment Fund LLC (Fund I) and included
incentive income distributed or distributable from Fund I in accordance with the
operating agreement of Fund I since this reflects cash distributed or
distributable from Fund I, while accrued incentive income is based upon the fair
value of Fund I's net assets, which is subject to fluctuation. Adjustments for
unconsolidated subsidiaries are calculated to reflect Funds from Operations
(FFO) on the same basis. Funds from Operations (FFO) does not represent cash
generated from operating activities in accordance with GAAP and therefore should
not be considered an alternative to net income as an indicator of operating
performance or as an alternative to cash flow as a measure of liquidity and is
not necessarily indicative of cash available to fund cash needs.
Funds from Operations is calculated as follows (unaudited) (in thousands):
For the Nine Months Ended
September 30,
2002 2001
---- ----
Income available for common shareholders $ 20,601 $ 36,531
Real estate depreciation and amortization 7,290 9,592
Accumulated depreciation on real estate sold (2,704) --
Real estate depreciation and amortization-unconsolidated subsidiaries 1,614 982
Incentive income accrued from Fortress Investment Fund(A) 609 (14,423)
Equity in incentive return accrued by Fortress Investment Fund (70) 1,652
Distributable incentive income from Fortress Investment Fund -- 2,639
-------- --------
Funds from Operations (FFO) $ 27,340 $ 36,973
======== ========
(A) Represents our predecessor's 50% interest
in incentive income as follows:
Total incentive income $ (1,218) $ 28,846
Manager portion 609 (14,423)
-------- --------
Our predecessor's incentive income $ (609) $ 14,423
======== ========
CAUTIONARY STATEMENTS
You should read this discussion and analysis in conjunction with the
consolidated financial statements and related notes thereto contained elsewhere
in this report, including the unaudited proforma consolidated statements of
income included in Note 6 to our consolidated financial statements.. The
information contained in this Quarterly Report on Form 10-Q is not a complete
description of our business or the risks associated with an investment in our
common stock. We urge you to carefully review and consider the various
disclosures made by us in this report and in our other filings with the SEC,
including the Risk Factors contained in our Registration Statement on Form S-11
(File No. 333-90578) declared effective by the SEC on October 9, 2002 (the "IPO
Registration Statement") that discuss our business in greater detail.
31
This report contains certain "forward-looking statements" within the meaning of
the Private Securities Litigation Reform Act of 1995. Such forward-looking
statements relate to, among other things, the operating performance of our
investments and financing needs. Forward-looking statements are generally
identifiable by use of forward-looking terminology such as "may," "will,"
"should," "potential," "intend," "expect," "endeavor," "seek," "anticipate,"
"estimate," "overestimate," "underestimate," "believe," "could," "project,"
"predict," "continue" or other similar words or expressions. Forward-looking
statements are based on certain assumptions, discuss future expectations,
describe future plans and strategies, contain projections of results of
operations or of financial condition or state other forward-looking information.
Our ability to predict results or the actual effect of future plans or
strategies is inherently uncertain. Although we believe that the expectations
reflected in such forward-looking statements are based on reasonable
assumptions, our actual results and performance could differ materially from
those set forth in the forward-looking statements. These forward-looking
statements involve risks, uncertainties and other factors that may cause our
actual results in future periods to differ materially from forecasted results.
Factors which could have a material adverse effect on our operations and future
prospects include, but are not limited to, changes in economic conditions
generally and the real estate and bond markets specifically,
legislative/regulatory changes (including changes to laws governing the taxation
of real estate investment trusts), availability of capital, interest rates and
interest rate spreads, generally accepted accounting principles and policies and
rules applicable to REITs. When considering forward-looking statements, you
should keep in mind the risk factors and other cautionary statements in our IPO
Registration Statement. Readers are cautioned not to place undue reliance on any
of these forward-looking statements, which reflect our management's views as of
the date of this report. The factors noted above and in our registration
statement could cause our actual results to differ significantly from those
contained in any forward-looking statement. For a discussion of our critical
accounting policies see "Management's Discussion and Analysis of Pro Forma
Financial Condition and Results of Operations - Critical Accounting Policies."
Although we believe that the expectations reflected in the forward-looking
statements are reasonable, we cannot guarantee future results, levels of
activity, performance or achievements. We are under no duty to update any of the
forward-looking statements after the date of this report to conform these
statements to actual results.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the exposure to loss resulting from changes in interest rates,
foreign currency exchange rates, commodity prices and equity prices. The primary
market risks that we are exposed to are interest rate risk and foreign currency
exchange rate risk. Interest rate risk and foreign currency exchange rate risk
are highly sensitive to many factors, including governmental monetary and tax
policies, domestic and international economic and political considerations and
other factors beyond our control. All of our market risk sensitive assets,
liabilities and related derivative positions are for non-trading purposes only.
Interest Rate Exposure
Our primary interest rate exposures relate to our loans, mortgage backed
securities and variable-rate debt, as well as our interest rate swaps and caps.
Changes in the general level of interest rates can effect our net interest
income, which is the difference between the interest income earned on
interest-earning assets and the interest expense incurred in connection with our
interest-bearing liabilities. Changes in the level of interest rates also can
effect, among other things, our ability to originate and acquire loans and
securities, the value of our loans and mortgage backed securities, and our
ability to realize gains from the settlement of such assets. We utilize interest
rate swaps, caps and match-funded financings in order to limit the effects of
interest rates on our operations. As of September 30, 2002, a 100 basis point
change in short term interest rates would affect our earnings by no more than
$2.4 million per annum.
Our financing strategy focuses on the use of match-funded financing structures.
This means that we seek to match the maturities of our financial obligations
with the maturities of our investments to minimize the risk that we have to
refinance our liabilities prior to the maturities of our assets, and to reduce
the impact of changing interest rates on earnings. In addition, we generally
match-fund interest rates with like-kind debt (i.e., fixed-rate assets are
financed with fixed-rate debt, and floating-rate assets are financed with
floating-rate debt), directly or through the use of hedges such as interest rate
swaps, caps, or other financial instruments, or through a combination of these
strategies. This allows us to reduce the impact of changing interest rates on
our earnings. In this regard, we utilize securitization structures, particularly
collateralized bond obligations, otherwise known as CBOs, as well as other
match-funded financing structures.
Currency Rate Exposure
Our primary foreign currency exchange rate exposures relate to our real estate
leases and assets. Our principal direct currency exposures are to the Euro and
the Canadian Dollar. Changes in the currency rates can adversely impact the
32
fair values and earnings streams of our international holdings. We have
attempted to mitigate this impact in part by utilizing local
currency-denominated financing on our foreign investments to partially hedge, in
effect, these assets.
We have material investments in a portfolio of Belgian properties, the LIV
portfolio, and a portfolio of Canadian properties, the Bell Canada portfolio.
These properties are financed utilizing debt instruments denominated in their
respective local currencies (the Euro and the Canadian Dollar). The net equity
invested in these portfolios, approximately $18.2 million and $18.9 million,
respectively, at September 30, 2002, is exposed to foreign currency exchange
risk.
Fair Values
For certain of our financial instruments, fair values are not readily available
since there are no active trading markets as characterized by current exchanges
between willing parties. Accordingly, fair values can only be derived or
estimated for these investments using various valuation techniques, such as
computing the present value of estimated future cash flows using discount rates
commensurate with the risks involved. However, the determination of estimated
future cash flows is inherently subjective and imprecise. We note that minor
changes in assumptions or estimation methodologies can have a material effect on
these derived or estimated fair values, and that the fair values reflected below
are indicative of the interest rate and currency rate environments as of
September 30, 2002 and do not take into consideration the effects of subsequent
interest rate or currency rate fluctuations.
We note that the values of our investments in real estate securities, primarily
the CBO collateral, and in derivative instruments, primarily interest rate
hedges on our debt, are sensitive to changes in market interest rates, interest
rate spreads, credit spreads and other market factors. The value of these
investments can vary, and has varied, materially from period to period.
Historically, the values of our real estate securities have tended to vary
inversely with those of our derivative instruments.
33
We held the following interest rate risk sensitive instruments at September 30,
2002 (unaudited) (dollars in thousands):
PRINCIPAL WEIGHTED
BALANCE OR AVERAGE
CARRYING NOTIONAL EFFECTIVE MATURITY
AMOUNT AMOUNT INTEREST RATE DATE OTHER TERMS FAIR VALUE
------ ------ ------------- ---- ----------- ----------
Various (mixed
floating and fixed
Assets: rates, amortizing and
CBO collateral, net (A).... $1,088,742 $1,059,103 8.16% Various interest only) $1,088,742
Marketable securities,
available for sale (B).. 7,184 19,326 18.94% (B) (B) 7,184
Interest rate caps, treated
as hedges, net (C)...... 5,720 198,764 N/A (C) (C) 5,720
Amortizes principal
based on collateral
Liabilities: payments, subject to
CBO bonds payable (D)...... 867,770 881,500 3.92% (D) reinvestment 887,862
Amortizes principal
with a balloon
payment at
Other bonds payable (E) 37,078 37,812 6.72% Apr-12 maturity 36,373
Amortizes principal
with a balloon
payment at
Notes payable(E)........... 50,618 50,618 4.63% Nov-16 maturity 50,618
Repurchase agree-
ment (E)................ 1,457 1,457 3.17% Short-term Interest only 1,457
Interest rate swaps,
treated as hedges,
net (F)................. 51,685 451,736 N/A (F) (F) 51,685
Non-hedge derivative
obligations (G)......... 511 (G) N/A (G) (G) 511
- ---------------
(A) The fair value of these securities is estimated by obtaining broker
quotations.
(B) These two securities with carrying amounts of $3.9 million and $3.2
million, respectively, mature in November 2007 and August 2030,
respectively, and represent subordinate and residual interests in
securitizations. The fair values of these securities, for which quoted
market prices are not readily available, are estimated by means of a
price/yield analysis based on our expected disposition strategies for such
assets.
(C) These two agreements have notional balances of $180.8 million and $18.0
million, respectively, mature in March 2009 and October 2015,
respectively, and cap 1-month LIBOR at 6.50% and 3-month LIBOR at 8.00%,
respectively. The fair value of these agreements is estimated by obtaining
counterparty quotations.
(D) For those bonds bearing floating rates at spreads over market indices,
representing approximately $710.3 million of the carrying amount of the
CBO bonds payable, we believe that for similar financial instruments with
comparable credit risks, the effective rates approximate market rates.
Accordingly, the carrying amount outstanding on these bonds is believed to
approximate fair value. For those bonds bearing fixed interest rates,
values were obtained by discounting expected future payments by a rate
calculated by imputing a spread over a market index on the date of
borrowing. The weighted average stated maturity of the CBO bonds payable
is September 2035.
(E) We believe that for similar financial instruments with comparable credit
risks, the stated interest rates (all of which are floating rates at
spreads over market indices) approximate market rates, with the exception
of the Bell Canada securitization which bears interest at a fixed rate.
The Bell Canada securitization was valued by discounting expected future
payments by a rate calculated by imputing a spread over a market index on
the date of borrowing.
(F) These two agreements have notional balances of $161.7 million and $290.0
million, respectively, mature in July 2005 and April 2011, respectively,
and swap 1-month LIBOR for 6.1755% and 3-month LIBOR for 5.93%,
respectively. The fair value of these agreements is estimated by obtaining
counterparty quotations.
34
(G) These are two essentially offsetting interest rate caps and two
essentially offsetting interest rate swaps, each with notional amounts of
$32.5 million, an interest rate cap with a notional balance of $17.5
million, and an interest rate cap with a notional balance of approximately
$58.7 million. It also includes the CBO III agreement which has a notional
amount of $123.7 million at September 30, 2002. The maturity date of the
purchased swap is July 2009; the maturity date of the sold swap is July
2014, the maturity date of the $32.5 million caps is July 2038, the
maturity date of the $17.5 million cap is July 2009, and the maturity date
of the $58.7 million cap is August 2004. They have been valued by
reference to counterparty quotations.
We held the following currency rate risk sensitive balances at September 30,
2002 (unaudited):
CURRENT EFFECT OF A 5% EFFCT OF A 5%
EXCHANGE NEGATIVE NEGATIVE
CARRYING LOCAL RATE TO CHANGE IN CHANGE IN
AMOUNT CURRENCY USD EURO RATE CAD RATE
------ -------- --- --------- --------
(DOLLARS IN THOUSANDS, EXCEPT EXCHANGE RATES)
Assets:
LIV portfolio ........ $ 64,229 Euro 1.01358 $ (3,211) N/A
Bell Canada portfolio 47,158 CAD 1.58680 N/A $ (2,358)
LIV other, net ....... 4,558 Euro 1.01358 (228) N/A
Bell Canada other, net 8,822 CAD 1.58680 N/A (441)
Liabilities:
LIV mortgage ......... 50,618 Euro 1.01358 2,531 N/A
Bell Canada bonds .... 37,078 CAD 1.58680 N/A 1,854
-------- --------
Total ................ $ (908) $ (945)
======== ========
- ---------------
USD refers to U.S. dollars; CAD refers to Canadian dollars
35
Item 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures. The Company's
Chief Executive Officer and Chief Financial Officer have evaluated the
effectiveness of the Company's disclosure controls and procedures (as such term
is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act
of 1934, as amended (the "Exchange Act")) as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation Date"). Based on such
evaluation, such officers have concluded that, as of the Evaluation Date, the
Company's disclosure controls and procedures are effective in alerting them on a
timely basis to material information relating to the Company (including its
consolidated subsidiaries) required to be included in the Company's reports
filed or submitted under the Exchange Act.
(b) Changes in Internal Controls. Since the Evaluation Date, there
have not been any significant changes in the Company's internal controls or in
other factors that could significantly affect such controls.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings -- The Company is not party to any material legal
proceedings.
Item 2. Change in Securities and Use of Proceeds
On June 6, 2002, the Company issued 1 share of its common stock to
Newcastle Investment Holdings Corp. for $1.00. On July 12, 2002, the Company
issued to Newcastle Investment Holdings 999 shares of common stock in exchange
for a contribution of certain assets with a book value, as of March 31, 2002, of
approximately $190 million.
Prior to the Company's initial public offering, the Company effected
a stock dividend pursuant to which 1,000 shares of its common stock were
converted into 16,488,517 shares of its common stock.
Pursuant to a registration statement declared effective by the
Securities and Exchange Commission on October 9, 2002 (File no. 333-90578), the
Company issued and sold 7 million shares of its common stock, par value $0.01
per share, in a public offering underwritten by Bear Stearns & Co. Inc., Lehman
Brothers, Banc of America Securities LLC and Friedman, Billings Ramsey & Co.,
Inc. The aggregate offering price for these shares was $91 million. The
aggregate underwriting discounts and commissions were approximately $6 million.
The Company also incurred a total of approximately $5 million of other expenses
in connection with the offering. None of these expenses were direct or indirect
payments to any directors, officers or partners of the Company or their
associates or to persons owning 10 percent or more of any class of the Company's
securities. Of the approximately $80 million of net proceeds to the Company
(after deducting the underwriters' discount and commission and other offering
expenses) approximately $13 million was used to pay a portion of the purchase
price for a portfolio of mortgage loans from an affiliate of Bear Stearns & Co.
Inc., approximately $25 million was used to make deposits on a portfolio of real
estate securities from an affiliate of Bear Sterns & Co. Inc., and the balance,
pending its use, is currently invested in interest bearing accounts.
Item 3. Defaults upon Senior Securities -- None
Item 4. Submission of Matters to a Vote of Security Holders -- None
Item 5. Other Information -- Not Applicable
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits filed with this Form 10-Q:
3.1 Articles of Amendment and Restatement (incorporated by
reference to the Registrant's Registration Statement on
Form S-11 (File No. 333-90578), Exhibit 3.1).
3.2 By-laws (incorporated by reference to the Registrant's
Registration Statement on Form S-11, (File No.
333-90578), Exhibit 3.2).
4.1 Rights Agreement between the Registrant and American
Stock Transfer and Trust Company, as Rights Agent, dated
October 16, 2002.
10.1 Management and Advisory Agreement by and among the
Registrant and Fortress Investment Group LLC, dated June
6, 2002.
36
99.1 Certification of Chief Executive Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
99.2 Certification of Chief Financial Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K filed by the registrant during its fiscal
quarter ended September 30, 2002:
None
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized:
NEWCASTLE INVESTMENT CORP.
November 22, 2002
By: /s/ Wesley R. Edens
----------------------
Wesley R. Edens
Chairman of the Board
November 22, 2002
By: /s/ Michael I. Wirth
----------------------
Michael I. Wirth
Chief Financial Officer
37
CERTIFICATION OF CHIEF EXECUTIVE OFFICER
REGARDING PERIODIC REPORT CONTAINING FINANCIAL STATEMENTS
I, Wesley R. Edens, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Newcastle Investment
Corp.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date
of this quarterly report (the "Evaluation Date"); and
c) Presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
November 22, 2002 /s/ Wesley R. Edens
------------------------- ----------------------------------
(Date) Wesley R. Edens, Chief Executive Officer
38
CERTIFICATION OF CHIEF FINANCIAL OFFICER
REGARDING PERIODIC REPORT CONTAINING FINANCIAL STATEMENTS
I, Michael I. Wirth, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Newcastle Investment
Corp.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date
of this quarterly report (the "Evaluation Date"); and
c) Presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
November 22, 2002 /s/ Michael I. Wirth
-------------------------- -----------------------------------------
(Date) Michael I. Wirth, Chief Financial Officer
39